10-Q 1 form10q.txt FORM 10-Q FOR THE QUARTER ENDING SEPTEMBER 8, 2002 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ---------------------- FORM 10-Q ---------------------- (X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 8, 2002 OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 ------------- Commission file number 333-57931 TUMBLEWEED, INC. (Exact name of registrant as specified in its charter) DELAWARE 61-1327945 (State or other jurisdiction of ( I.R.S. Employer Identification No.) incorporation or organization) 2301 River Road, Suite 200, Louisville, Kentucky 40206 (Address of principal executive offices) (502) 893-0323 (Registrants telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No The number of shares of common stock, par value of $.01 per share, outstanding on October 14, 2002 was 5,916,153. TUMBLEWEED, INC. INDEX PART I. FINANCIAL INFORMATION PAGE Item 1. Financial Statements (Unaudited) a) Consolidated Statements of Operations for the thirty-six weeks and twelve weeks ended September 8, 2002 and the nine months and three months ended September 30, 2001 3 b) Consolidated Balance Sheets as of September 8, 2002 and December 31, 2001 4 c) Consolidated Statements of Cash Flows for the thirty-six weeks ended September 8, 2002 and the nine months ended September 30, 2001 5 d) Notes to Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 14 Item 3. Quantitative and Qualitative Disclosures About Market Risk 20 PART II. OTHER INFORMATION Item 1. Legal Proceedings 20 Item 6. Exhibits and Reports on Form 8-K 20 Signature 21 2 Tumbleweed, Inc. Consolidated Statements of Operations (Unaudited)

See accompanying notes. 3 Tumbleweed, Inc. Consolidated Balance Sheets

See accompanying notes. 4 Tumbleweed, Inc. Consolidated Statements of Cash Flows (Unaudited)

See accompanying notes. 5 TUMBLEWEED, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) September 8, 2002 1. BASIS OF PRESENTATION RESTAURANT FACILITIES As of September 8, 2002, the Company owned, franchised or licensed 57 Tumbleweed restaurants. The Company owned and operated 31 restaurants in Kentucky, Indiana and Ohio. There were 20 franchised restaurants located in Indiana, Illinois, Kentucky, Michigan, and Wisconsin and six licensed restaurants located outside the United States in Germany, Jordan, Egypt, England and Turkey. The following table reflects changes in the number of Company- owned, franchise and licensed restaurants during the thirty-six weeks ended September 8, 2002. Company-owned restaurants: In operation, beginning of period 36 Restaurants opened 0 Restaurant sold to franchisee (1) Restaurants closed (4) --------- In operation, end of period 31 Franchise and licensed restaurants: In operation, beginning of period 29 Restaurants opened 0 Restaurant purchased from Tumbleweed, Inc. 1 Restaurants closed (4) --------- In operation, end of period 26 --------- System Total 57 ========= During the first quarter of 2002, the Company closed four Company-owned restaurant locations. The restaurants were located in Cincinnati, Ohio (2), Columbus, Ohio (1), and Evansville, Indiana (1). The restaurant closings were part of a strategic management decision to eliminate lower sales volume restaurants that were unprofitable in 2001 and to focus its energies on the continued improvement of per-store average sales volumes. On January 1, 2002, the Company purchased from its joint venture partner the remaining 50% interest in a restaurant location. See Note 7 for a further discussion of this transaction. During the second quarter of 2002, the Company sold one of its restaurant locations to a franchisee. This was in accordance with the Company's plan it established in the fourth quarter of 2001. In connection with the plan, the Company had taken a charge to earnings in accordance with SFAS No. 121, "Impairment of Long-Lived Assets." The personal property had no value on the books of the Company as a result of this special charge. The franchisee assumed the building lease and purchased the inventory for $11,000. INTERIM FINANCIAL REPORTING The accompanying consolidated financial statements have been prepared by the Company without audit, with the exception of the December 31, 2001 consolidated balance sheet which was derived from the audited consolidated financial statements included in the Company's Form 10-K. The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial reporting and in accordance with Rule 10-01 of Regulation S-X. These consolidated financial statements, note disclosures and other information should be read in conjunction with the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2001. In the opinion of management, the unaudited interim consolidated financial statements contained in this report reflect all adjustments, consisting of a change in accounting principle and normal recurring accruals, which are necessary for a fair presentation. The results of operations for the thirty-six weeks and twelve weeks ended September 8 , 2002 are not necessarily indicative of the results that may be expected for the year ended December 31, 2002. 6 1. BASIS OF PRESENTATION (continued) FISCAL YEAR Beginning January 1, 2002, the Company changed its fiscal year to end on the last Sunday in December from a December 31 year end. The first three quarters of each fiscal year, beginning in 2002, consist of 12 weeks and the fourth quarter consists of 16 weeks. The first three quarters of 2002 consists of 251 days compared to 273 days in 2001 which resulted in lower revenues of approximately $3,400,000. RECENTLY ISSUED ACCOUNTING STANDARDS In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." This statement supercedes SFAS No. 121," Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of," and the accounting and reporting provisions of Accounting Principles Board (APB) Opinion No. 30, "Reporting Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions." SFAS No. 144 requires that one accounting model be used for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired, and it broadens the presentation of discontinued operations to include more disposal transactions. The Company adopted the provisions of SFAS No. 144 as of January 1, 2002 and determined that SFAS No. 144 had no impact on its financial position and results of operations. 2. GOODWILL AND INTANGIBLE ASSETS Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 141 eliminates the pooling of interest method of accounting and amortization of goodwill for business combinations initiated after June 30, 2001. SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment annually, or more frequently if certain indicators arise. The provisions of SFAS No. 142 also require the completion of a transitional impairment test within six months of adoption, with any impairments identified treated as a cumulative effect of a change in accounting principle. During the first quarter of 2002, the Company determined that all goodwill as of January 1, 2002 related to two reporting units. The fair value of each unit was determined using certain valuation techniques. As a result of the transitional impairment test, an impairment loss in the amount of $1,503,773, net of tax, was recorded as a cumulative effect of a change in accounting principle during the first quarter of 2002. If the Company had accounted for its goodwill under SFAS No. 142 for all periods presented, the Company's net income (loss) and income (loss) per share would have been as follows:

7 2. GOODWILL AND INTANGIBLE ASSETS (continued) The following table sets forth the Company's goodwill transactions in the first quarter of 2002. All transactions occurred in the restaurant segment. Balance as of January 1, 2002 $ 2,349,646 Goodwill acquired in the TW-Springhurst acquisition 174,657 Impairment loss (2,349,646) -------------- Balance as of September 8, 2002 $ 174,657 ============== The Company acquired Tumbleweed International, LLC (see Note 8) during the first quarter of 2002, which resulted in the acquisition of an intangible asset in the amount of $1,525,966 and is included in the corporate segment. 3. ACCRUED LIABILITIES Accrued liabilities consist of:

4. LONG-TERM DEBT Long-term debt consists of:

8 4. LONG-TERM DEBT (continued)

Property and equipment with a net book value of approximately $21,500,000 at September 8, 2002 collateralize the Company's long-term debt. In accordance with the loan agreement, the $925,000 mortgage revolving line of credit note was reduced to $875,000 on September 30, 2002. The Company was in violation of the debt coverage ratio covenant related to the revolving lines of credit (balances as of September 8, 2002 were $5,456,148 and $924,868) as of September 8, 2002. The covenant violation resulted primarily from the amount of the current maturities of debt. The lenders have waived the debt covenant violation as of September 8, 2002. The Company is currently seeking financing which would replace the majority of the Company's debt. There can be no assurances that this financing will be obtained or that such financing will be available on terms acceptable to the Company. If the refinancing is obtained, there will be a write-off of unamortized loan costs of approximately $90,000. If the refinancing is not obtained by the end of the fourth quarter, it is uncertain at this time if the Company will be in compliance with the debt coverage ratio covenant in future periods as a result of the current maturities of debt. If it does not comply with the covenants in future periods, the lenders would be entitled, at their discretion, to exercise certain remedies including acceleration of repayment. 9 5. EARNINGS PER SHARE The following is a reconciliation of the Company's basic and diluted earnings (loss) per share data for the thirty-six weeks and twelve weeks ended September 8, 2002 and the nine months and three months ended September 30, 2001 in accordance with FAS 128, "Earnings per Share."

6. SEGMENT INFORMATION The Company has three reportable segments: restaurants, commissary and corporate. The restaurant segment consists of the operations of all Company-owned restaurants and derives its revenues from the sale of food products to the general public. The commissary segment derives its revenues from the sale of food products to Company-owned and franchised restaurants. The corporate segment derives revenues from sale of franchise rights, franchise royalties and related services used in restaurant operations, and contains the selling, general and administrative activities of the Company. Generally, the Company evaluates performance and allocates resources based on pre-tax income. The accounting policies of the segments are the same as those described in the summary of significant accounting policies in the Company's Annual Report on Form 10-K. Segment information for the thirty-six weeks ended September 8, 2002 is as follows:

6. SEGMENT INFORMATION (continued) Segment information for the nine months ended September 30, 2001 is as follows:

7. INVESTMENT IN TW-SPRINGHURST During the year ended December 31, 2000, the Company made a $200,000 investment in TW-Springhurst, LLC ("TW-Springhurst"), the owner and operator of a Tumbleweed restaurant in Louisville, Kentucky. During the six months ended June 30, 2001, the Company received a cash distribution of $73,500 from TW-Springhurst. Through December 31, 2001, the Company had a 50% interest with the remaining 50% held by TW-Springhurst Investors, LLC. A current and former director of the Company own TW-Springhurst Investors, LLC. The Company's share of TW-Springhurst's net income was $54,531 for the nine months ended September 30, 2001. On January 1, 2002, the Company acquired the remaining 50% interest held by TW-Springhurst Investors for $267,000. The Company also assumed TW-Springhurst, LLC's note payable to a bank which had a balance of approximately 11 7. INVESTMENT IN TW-SPRINGHURST (continued) $161,000 on the date of purchase. An independent business valuation appraisal was used to assist Company management in determining the purchase price. The purchase price has been allocated as follows: Assets and liabilities acquired: Inventory $ 55,674 Property and equipment 317,601 Deposits 1,200 Other 5,677 Note payable (161,394) ------------- 218,758 Investment in TW-Springhurst (126,415) Goodwill 174,657 $ 267,000 ============= 8. ACQUISITION OF INTERNATIONAL On January 1, 2002, the Company purchased the ownership interest in Tumbleweed International, LLC ("International") for $1.5 million from TW-International Investors, Inc. and Chi-Chi's International Operations, Inc. ("CCIO"). CCIO owned 40% of International. The President and Chief Executive Officer of the Company is the sole shareholder of CCIO. Members of TW-International Investors, Inc. include three current directors of the Company. The acquisition gives the Company direct control and benefit of the international licensing of the Tumbleweed concept. In connection with the acquisition, the Company assumed an existing $1.4 million bank loan of TW- International Investors, Inc. and has issued 76,923 shares of its common stock to CCIO. The Company has entered into a commission agreement with CCIO in connection with the sale of international regional licenses by International. The transaction was accounted for as a purchase and the purchase price was allocated to the intangible assets acquired - the Tumbleweed international licensing rights and existing franchise contracts. The allocation of the purchase price is summarized as follows: Note payable $ 1,425,968 Common stock 769 Paid-in capital 99,229 ------------- $ 1,525,966 ============= Intangible assets: Tumbleweed licensing rights $ 1,455,966 Contracts in place 70,000 ------------- $ 1,525,966 ============= 9. INVOLUNTARY CONVERSION OF NON-MONETARY ASSETS As a result of a fire on July 11, 2002 at a Company-owned restaurant in Ohio, an involuntary conversion of a non- monetary asset occurred. The Company has accrued a receivable of approximately $450,000 during the quarter ended September 8, 2002 from the insurance company in relation to inventory and equipment that was destroyed in the fire ($320,000), business interruption ($70,000) and continuing expenses ($60,000). The Company's management does not anticipate that there will be a loss as a result of the fire. 10. INCOME TAXES Income taxes on the Company's income before income taxes and cumulative effect of a change in accounting principle for the thirty-six weeks ended September 8, 2002 and the nine months ended September 30, 2001 have been provided for at an estimated effective tax rate of 58% and 5%, respectively. The effective tax rate differs from the statutory 12 10. INCOME TAXES (continued) federal tax rate of 34% as a result of the impact of employment tax credits, state income taxes and increase in the valuation allowance for the deferred tax asset. The valuation allowance was increased $115,314 in the third quarter because it is more likely than not that an additional portion of the deferred tax asset related to certain tax credits will not be realized. 11. CONTINGENCIES The Company guaranteed certain equipment leases with a bank for TW-Tennessee, LLC, a former franchisee (TW- Tennessee) of the Company in which the Company and David M. Roth, a Director of the Company, were formerly members. The Company is in negotiation with the bank under the equipment leases and the other guarantors to resolve the Company's obligations relative to the equipment leases. The Company believes that it will be obligated to assume and pay one of the equipment leases totaling approximately $125,000 and will remain contingently liable on two other equipment leases which the Company believes will be assumed and paid by other guarantors. These negotiations are ongoing and no agreement has been reached. If no agreement is reached, the Company would have additional exposure totaling approximately $180,000. In the fourth quarter of 2001, the Company reserved $125,000 to cover its portion of the equipment lease it expects to assume. The Company's management believes it will not incur significant additional losses in connection with this matter. We are also subject to claims and legal actions in the ordinary course of our business. Certain of these claims and actions may involve related parties. We believe that all such claims and actions are either adequately covered by insurance or would not have a material adverse effect on us if decided in a manner unfavorable to us. 13 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL We make various forward-looking statements about our business in the following discussion. When making these forward-looking statements, we use words such as expects, believes, estimates, anticipates, plans and similar expressions to identify them. We also identify important cautionary factors that could cause our actual results to differ materially from those projected in the forward-looking statements we make. Factors that realistically could cause results to differ materially from those projected in the forward-looking statements include the availability and cost of financing and other events that affect our restaurant expansion program, changes in food and other costs, changes in national, regional or local economic conditions, changes in consumer tastes, competitive factors such as changes in the number and location of competing restaurants, the availability of experienced management and hourly employees, and other factors set forth below. As of September 8, 2002, we owned, franchised or licensed 57 Tumbleweed restaurants. The Company owned and operated 31 restaurants in Kentucky, Indiana and Ohio. There were 20 franchised restaurants in Indiana, Illinois, Kentucky, Wisconsin, and Michigan, and six licensed restaurants located outside the United States in Germany, Jordan, Egypt, England and Turkey. During the first quarter of 2002, the Company closed four Company-owned restaurant locations. The restaurants were located in Cincinnati, Ohio (2), Columbus, Ohio (1), and Evansville, Indiana (1). The restaurant closings were part of a strategic management decision to eliminate lower sales volume restaurants that were unprofitable in 2001 and to focus its energies on the continued improvement of per-store average sales volumes. On January 1, 2002, the Company purchased from its joint venture partner the remaining 50% interest in a restaurant location. See Note 7 to the consolidated financial statements for a further discussion of this transaction. During the second quarter of 2002, the Company sold one of its restaurant locations to a franchisee. This was in accordance with the Company's plan it established in the fourth quarter of 2001. In connection with the plan, the Company had taken a charge to earnings in accordance with SFAS No. 121, "Impairment of Long-Lived Assets." The personal property had no value on the books of the Company as a result of this special charge. The franchisee assumed the building lease and purchased the inventory for $11,000. The following section should be read in conjunction with our financial statements and the related notes included elsewhere in this filing. 12 RESULTS OF OPERATIONS The table below sets forth the percentage relationship to total revenues of certain income statement data, except where noted, for the periods indicated.

Beginning January 1, 2002, the Company changed its fiscal year to end on the last Sunday in December from a December 31 year end. The first three quarters of 2002 consists of 251 days compared to 273 days in 2001 and the third quarter of 2002 consists of 84 days compared to 92 days in 2001. On an overall basis, revenues and expenses decreased as a result of 22 fewer days in the first three quarters of 2002 compared to the first three quarters of 2001 and eight fewer days in the third quarter of 2002 compared to the third quarter of 2001. COMPARISON OF THE FIRST THREE QUARTERS OF 2002 AND 2001 Total revenues decreased by $3,466,758 or 7.7% for the first three quarters of 2002 compared to the same period in 2001 primarily as a result of the following: Restaurant sales decreased by $3,268,806 or 7.8% for the first three quarters of 2002 compared to the same period in 2001. The decrease in restaurant sales is primarily a result of the Company's change in its fiscal year, the closing of four Company-owned restaurants during the first quarter of 2002 and the sale of one Company-owned restaurant to a franchisee during the second quarter of 2002 (see above for discussion of all items). The decrease in restaurant sales is partially offset by a 2.4% increase in same store sales for the first thirty-six weeks. Commissary sales to franchised and licensed restaurants decreased by $176,364 or 13.0% for the first three quarters of 2002 compared to the same period in 2001. The decrease in commissary sales is primarily a result of the Company's change in its fiscal year. Franchise fees and royalties decreased by $122,066 or 12.6% for the first three quarters of 2002 compared to the same period in 2001. Franchise income decreased $110,000 as a result of having three franchise restaurant openings 15 in the first three quarters of 2001 compared to no franchise restaurant openings during the first three quarters of 2002. Royalty income decreased $12,066 primarily as a result of the Company's change in its fiscal year. Other revenues increased by $100,478 or 30.1% for the first three quarters of 2002 compared to the same period in 2001 primarily as a result of recognizing as income $55,000 of development fees which were forfeited by a franchisee. The increase in other revenues can also be attributed to increased purchasing rebates in 2002 compared to the 2001 period. The increase in other revenues is partially offset by a decrease in insurance proceeds which relate to business interruptions as a result of fires at two Company-owned restaurants. Other revenues includes $100,000 of insurance proceeds in the 2001 period, as a result of a fire which occurred in June 2000, compared to $70,000 in the 2002 period, as a result of a fire which occurred in July 2002. Restaurant cost of sales decreased by $1,486,958 or 11.2% for the first three quarters of 2002 compared to the same period in 2001. The decrease in restaurant cost of sales is primarily a result of the Company's change in its fiscal year, as discussed above. Restaurant cost of sales decreased as a percentage of sales by 1.2% to 30.2% for the 2002 period compared to 31.4% during the same period in 2001. The 1.2% decrease in cost of sales is primarily the result of a temporary increase in the cost of beef and pork (primarily steaks and ribs, respectively) during the first part of 2001. Commissary cost of sales decreased $131,494 or 11.1% for the first three quarters of 2002 compared to the same period in 2001. The decrease in commissary cost of sales is due primarily to the Company's change in its fiscal year, as discussed above. As a percentage to commissary sales, commissary cost of sales increased 1.9% for the 2002 period compared to the same period in 2001 as a result of higher raw material product costs. Restaurant operating expenses decreased by $1,422,839 or 6.2% for the first three quarters of 2002 compared to the same period in 2001. The decrease in operating expenses is primarily a result of the Company's change in its fiscal year, as discussed above. Operating expenses increased as a percentage of restaurant sales by 0.9% to 55.5% for the 2002 period from 54.6% for the same period in 2001 primarily as a result of increased local marketing costs and increased repair and maintenance costs. Selling, general and administrative expenses decreased by $554,075 or 12.0% for the first three quarters of 2002 compared to the same period in 2001. The decrease in selling, general and administrative expenses primarily is due to the fact that the 2001 period includes the cost of implementing a new menu of approximately $95,000. There was no similar expense in 2002. The decrease in selling, general and administrative expenses is also attributable to decreased payroll costs as a result of the elimination of several positions in the corporate segment and decreased advertising costs. As a percentage to total revenues, selling, general and administrative expenses were 9.8% and 10.3% for the 2002 and 2001 periods, respectively. Depreciation and amortization expense decreased $413,329 or 23.3% for the first three quarters of 2002 compared to the same period in 2001 as a result of goodwill no longer being amortized in accordance with SFAS No. 142, and the write-down of assets in the fourth quarter of 2001 (see above for discussion of both items). The decrease in depreciation and amortization expense is also attributed to the Company's change in its fiscal year. Net interest expense decreased $318,311 or 31.3% for the first three quarters of 2002 compared to the same period in 2001. The decrease in net interest expense is the result of decreases in the prime interest rate during 2001. Income taxes on the Company's income before income taxes and cumulative effect of a change in accounting principle for the thirty-six weeks ended September 8, 2002 and the nine months ended September 30, 2001 have been provided for at an estimated effective tax rate of 58% and 5%, respectively. The effective tax rate differs from the statutory federal tax rate of 34% as a result of the impact of employment tax credits, state income taxes and increase in the valuation allowance for the deferred tax asset. The valuation allowance was increased $115,314 in the third quarter because it is more likely than not that an additional portion of the deferred tax asset related to certain tax credits will not be realized. COMPARISON OF THE THIRD QUARTER OF 2002 VERSUS THE THIRD QUARTER OF 2001 Total revenues decreased by $2,078,943 or 13.7% for the third quarter of 2002 period compared to the same period in 2001 primarily as a result of the following: Restaurant sales decreased by $2,083,429 or 14.5% for the third quarter of 2002 compared to the same period in 2001. The decrease in restaurant sales is a result of the Company's change in its fiscal year, the closing of four 16 Company-owned restaurants during the first quarter of 2002 and the sale of one Company-owned restaurant to a franchisee during the second quarter of 2002 (see above for discussion of all items). The decrease in restaurant sales is partially offset by a 0.1% increase in same store sales for the third quarter. Commissary sales to franchised and licensed restaurants decreased by $55,785 or 12.6% for the third quarter of 2002 compared to the same period in 2001. The decrease in commissary sales is primarily a result of the Company's change in its fiscal year. Franchise fees and royalties decreased by $6,016 or 2.0% for the third quarter of 2002 compared to the same period in 2001 as a result of a decrease in royalty income. There was no franchise income in either the 2002 or 2001 periods. Other revenues increased by $66,287 or 91.2% for the third quarter of 2002 compared to the same period in 2001 due to $70,000 of insurance proceeds which relate to a business interruption as a result of a fire which occurred in July 2002 at a Company-owned restaurant. Restaurant cost of sales decreased by $719,349 or 16.3% for the third quarter of 2002 compared to the same period in 2001. The decrease in restaurant cost of sales is a result of the Company's change in its fiscal year, the closing of four Company-owned restaurants during the first quarter of 2002 and the sale of one Company-owned restaurant to a franchisee during the second quarter of 2002 (see above for discussion of all items). Restaurant cost of sales decreased as a percentage of sales by 0.6% to 30.0% for the third quarter of 2002 compared to 30.6% during the same period in 2001. The 0.6% decrease in cost of sales is primarily the result of a temporary increase in the cost of beef and pork (primarily steaks and ribs, respectively) during 2001. Commissary cost of sales decreased $42,857 or 11.0% for the third quarter of 2002 compared to the same period in 2001. The decrease in commissary cost of sales is primarily a result of the Company's change in its fiscal year, as discussed above. As a percentage to commissary sales, commissary cost of sales increased 1.5% for the third quarter of 2002 compared to the same period in 2001 as a result of higher raw material product costs. Restaurant operating expenses decreased by $910,737 or 11.6% for the third quarter of 2002 compared to the same period in 2001. The decrease in operating expenses is a result of the Company's change in its fiscal year, the closing of four Company-owned restaurants during the first quarter of 2002 and the sale of one Company-owned restaurant to a franchisee during the second quarter of 2002 (see above for discussion of all items). Operating expenses increased as a percentage of restaurant sales by 1.9% to 56.3% for the third quarter of 2002 from 54.4% for the same period in 2001 primarily as a result of increased repair and maintenance costs and local marketing expenses. Selling, general and administrative expenses decreased by $376,426 or 23.7% for the third quarter of 2002 compared to the same period in 2001. The decrease in selling, general and administrative expenses for the second quarter is primarily attributable to decreased payroll costs as a result of the elimination of several positions in the corporate segment, decreased corporate bonus expense and decreased advertising costs. As a percentage to total revenues, selling, general and administrative expenses were 9.2% and 10.4% for the third quarter of 2002 and 2001, respectively Depreciation and amortization expense decreased $153,248 or 25.5% for the third quarter of 2002 compared to the same period in 2001 as a result of goodwill no longer being amortized in accordance with SFAS No. 142, and the write-down of assets in the fourth quarter of 2001(see above for discussion of both items). The decrease in depreciation and amortization expense is also attributed to the Company's change in its fiscal year. Net interest expense decreased $57,769 or 19.7% for the third quarter of 2002 compared to the same period in 2001. The decrease in net interest expense for the third quarter is the result of decreases in the prime interest rate during 2001. The Company has provided for income taxes based on income before income taxes and cumulative effect of a change in accounting principle for the twelve weeks ended September 8, 2002 and the three months ended September 30, 2001. The effective tax rate differs from the statutory federal tax rate of 34% as a result of the impact of employment tax credits, state income taxes and increase in the valuation allowance for the deferred tax asset. The valuation allowance was increased $115,314 in the third quarter because it is more likely than not that an additional portion of the deferred tax asset related to certain tax credits will not be realized. 17 LIQUIDITY AND CAPITAL RESOURCES In 2002, the Company expects to begin construction of one additional restaurant facility. Our ability to expand our number of restaurants will depend on a number of factors, including the selection and availability of quality restaurant sites, the negotiation of acceptable lease or purchase terms, the securing of required governmental permits and approvals, the adequate supervision of construction, the hiring, training and retaining of skilled management and other personnel, the availability of adequate financing and other factors, many of which are beyond our control. The hiring and retention of management and other personnel may be difficult given the low unemployment rates in the areas in which we intend to operate. There can be no assurance that we will be successful in opening the number of restaurants anticipated in a timely manner. Furthermore, there can be no assurance that our new restaurants will generate sales revenue or profit margins consistent with those of our existing restaurants, or that these new restaurants will be operated profitably. Our capital needs during the period ended September 8, 2002 arose from maintenance and improvement of existing restaurant facilities. The source of capital to fund the maintenance and improvement expenditures was internally generated cash flow. Our capital needs for the period ended September 30, 2001 arose from the reconstruction of a restaurant facility which was damaged by fire during June 2000, and to a lesser extent, maintenance and improvement of existing restaurant facilities. The source of capital to fund the reconstruction was insurance proceeds received during 2000. The maintenance and improvement expenditures were funded by internally generated cash flow. The table below provides certain information regarding our sources and uses of cash for the periods presented. Thirty-Six Nine Months Weeks Ended Ended September 8, September 30, 2002 2001 ---------------- ----------------- Net cash provided by operations $ 1,327,526 $ 1,957,852 Purchases of property and equipment (630,905) (969,194) Business acquisition (267,000) - Net payments on long-term debt and capital lease obligations (915,443) (1,153,394) Our largest use of funds during the 2002 period was for the payment of long-term debt and capital lease obligations, maintenance and improvement of existing restaurant facilities, and for the acquisition of the remaining 50% interest in TW-Springhurst. Our largest use of funds during the 2001 period was for the reconstruction of a restaurant facility which was damaged by fire during 2000 and for payments on long-term debt and capital lease obligations. Sales are predominantly for cash and the business does not require the maintenance of significant receivables or inventories. In addition, it is common within the restaurant industry to receive trade credit on the purchase of food, beverage and supplies, thereby reducing the need for incremental working capital to support sales increases. The Company guaranteed certain equipment leases with a bank for TW-Tennessee, LLC, a former franchisee (TW- Tennessee) of the Company in which the Company and David M. Roth, a Director of the Company, were formerly members. The Company is in negotiation with the bank under the equipment leases and the other guarantors to resolve the Company's obligations relative to the equipment leases. The Company believes that it will be obligated to assume and pay one of the equipment leases totaling approximately $125,000 and will remain contingently liable on two other equipment leases which the Company believes will be assumed and paid by other guarantors. These negotiations are ongoing and no agreement has been reached. If no agreement is reached, the Company would have additional exposure totaling approximately $180,000. In the fourth quarter of 2001, the Company reserved $125,000 to cover its portion of the equipment lease it expects to assume. The Company's management believes it will not incur significant additional losses in connection with this matter. We are also subject to claims and legal actions in the ordinary course of our business. Certain of these claims and actions may involve related parties. We believe that all such claims and actions are either adequately covered by insurance or would not have a material adverse effect on us if decided in a manner unfavorable to us. The Company both owns and leases its restaurant facilities. Management determines whether to acquire or lease a restaurant facility based on its evaluation of the financing alternatives available for a particular site. 18 In the next 12 months, the Company expects the demand on future liquidity to be principally from the ongoing maintenance and improvement of existing restaurant facilities and from the construction of one to two additional restaurant facilities. As of September 8, 2002, the Company had no material commitments for the construction of new restaurants, maintenance or improvement of existing restaurant facilities. We will utilize mortgage, sale/leaseback and/or landlord financing, as well as equipment leasing and financing, for a portion of the development cost of the restaurant we plan to open in the next 12 months. The remaining costs will be funded by available cash reserves, cash provided from operations and borrowing capacity. Management believes such sources will be sufficient to fund our expansion plans in the next 12 months. Should our actual results of operations fall short of, or our rate of expansion significantly exceed plans, or should our costs of capital expenditures exceed expectations, we may need to seek additional financing in the future. In negotiating such financing, there can be no assurance that we will be able to raise additional capital on terms satisfactory to us. The Company has a $5,960,000 mortgage revolving line of credit with a bank. As of September 8, 2002, we had outstanding borrowings under the line of credit of $5,456,148. The note bears interest at the prime rate plus .25% (5.0% at September 8, 2002) and is due December 31, 2003. In accordance with the loan agreement, the availability on the mortgage revolving line of credit will be reduced to $5,420,000 on December 31, 2002. The Company also has a $925,000 mortgage revolving line of credit with a bank. As of September 8, 2002, we had outstanding borrowings under the line of credit of $924,868. The note bears interest at the prime rate plus 2.0% (6.75% at September 8, 2002). In accordance with the loan agreement, the $925,000 mortgage revolving line of credit note was reduced to $875,000 on September 30, 2002. The note matures April 1, 2003. Both of the revolving lines of credit impose restrictions on the Company with respect to the maintenance of certain financial ratios, the incurrence of indebtedness, the sale of assets, mergers, capital expenditures and the payment of dividends. The Company was in violation of the debt coverage ratio covenant related to the revolving lines of credit (balances as of September 8, 2002 were $5,456,148 and $924,868) as of September 8, 2002. The covenant violation resulted primarily from the amount of the current maturities of debt. The lenders have waived the debt covenant violation as of September 8, 2002. The Company is currently seeking financing which would replace the majority of the Company's debt. There can be no assurances that this financing will be obtained or that such financing will be available on terms acceptable to the Company. If the refinancing is obtained, there will be a write-off of unamortized loan costs of approximately $90,000. If the refinancing is not obtained by the end of the fourth quarter, it is uncertain at this time if the Company will be in compliance with the debt coverage ratio covenant in future periods as a result of the current maturities of debt. If it does not comply with the covenants in future periods, the lenders would be entitled, at their discretion, to exercise certain remedies including acceleration of repayment. OTHER EVENTS Beginning January 1, 2002, the Company implemented a 401(k) plan. All employees who are at least 21 years of age with one year of service in which they worked a minimum of 1,000 hours are eligible. An employee can contribute up to 15% of their gross salary. The Company will match 25% of the first 4% an employee contributes. The employee becomes vested in the Company contribution based on a five-year vesting schedule. On June 3, 2002, a group consisting of Gerald Mansbach, the Company's largest stockholder, Terrance A. Smith, the Company's Chairman, President and Chief Executive Officer, and David M. Roth, a director of the Company, submitted a proposal to the Company's Board of Directors to acquire all the Company's common stock not currently owned by them or others they may invite to join their group. The proposal contemplates a cash tender offer price of $1.75 per share. On June 5, 2002, three additional directors, Minx Auerbach, George Keller and Lewis Bass joined Gerald Mansbach, Terrance A. Smith and David M. Roth in their proposal to acquire all the Company's common stock not owned by their group at a price of $1.75 per share. The group owns approximately 60% of the Company's outstanding common stock. The Board has appointed a Special Committee of independent directors to evaluate the proposal. The Special Committee has engaged an investment banking firm and a law firm to act as advisors in connection with its review of the tender offer proposal. IMPACT OF INFLATION The impact of inflation on the cost of food, labor, equipment, land and construction costs could harm our operations. The Company pays a majority of its employees hourly rates related to federal and state minimum wage laws. As a result of increased competition and the low unemployment rates in the markets in which the Company's restaurants are 19 located, the Company has continued to increase wages and benefits in order to attract and retain management personnel and hourly workers. In addition, most of the Company's leases require the Company to pay taxes, insurance, maintenance, repairs and utility costs, and these costs are subject to inflationary pressures. Most of the leases provide for increases in rent based on increases in the consumer price index when the leases are renewed. The Company may attempt to offset the effect of inflation through periodic menu price increases, economies of scale in purchasing and cost controls and efficiencies at existing restaurants. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company does not enter into derivative transactions or speculate on the future direction of interest rates. The Company is exposed to interest rate changes primarily as a result of variable rate debt instruments. As of September 8, 2002, approximately $10,925,000 of the Company's debt bore interest at variable rates. A 1% change in the variable interest rate on this debt equates to an approximate $109,000 change in interest for a twelve month period. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The Company guaranteed certain equipment leases with a bank for TW-Tennessee, LLC, a former franchisee (TW- Tennessee) of the Company in which the Company and David M. Roth, a Director of the Company, were formerly members. The Company is in negotiation with the bank under the equipment leases and the other guarantors to resolve the Company's obligations relative to the equipment leases. The Company believes that it will be obligated to assume and pay one of the equipment leases totaling approximately $125,000 and will remain contingently liable on two other equipment leases which the Company believes will be assumed and paid by other guarantors. These negotiations are ongoing and no agreement has been reached. If no agreement is reached, the Company would have additional exposure totaling approximately $180,000. In the fourth quarter of 2001, the Company reserved $125,000 to cover its portion of the equipment lease it expects to assume. The Company's management believes it will not incur significant additional losses in connection with this matter. We are also subject to claims and legal actions in the ordinary course of our business. Certain of these claims and actions may involve related parties. We believe that all such claims and actions are either adequately covered by insurance or would not have a material adverse effect on us if decided in a manner unfavorable to us. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits Exhibit 99 - Sarbanes Section 906 Certification (b) Reports on Form 8-K None Items 2, 3, 4 and 5 are not applicable and have been omitted. 20 Signature Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned there unto duly authorized. Date: October 18, 2002 Tumbleweed, Inc. By: /s/ Glennon F. Mattingly -------------------- Glennon F. Mattingly Vice President and Chief Financial Officer I, Glennon F. Mattingly, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Tumbleweed, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: a. designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b. evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c. presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors: a. all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officer and I have indicated in this quarterly report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: October 18, 2002 /s/ Glennon F. Mattingly ------------------------ Glennon F. Mattingly Vice President and Chief Financial Officer I, Terrance A. Smith, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Tumbleweed, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 21 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: a. designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b. evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c. presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors: a. all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officer and I have indicated in this quarterly report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: October 18, 2002 /s/ Terrance A. Smith --------------------- Terrance A. Smith President and Chief Executive Officer 22

TUMBLEWEED INC 10-Q