10-Q 1 ch10q93003.txt CREATIVE HOST SERVICES, INC. FORM 10-Q 9-30-03 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 30, 2003 [ ] Transition Report Under Section 13 or 15 (d) of the Securities Exchange Act of 1934 For the transition period from ________ to _________. Commission file number 000-22845 CREATIVE HOST SERVICES, INC. ---------------------------- (Exact Name of Registrant as Specified in Its Charter) California 33-0169494 ------------------------------- ------------------ (State or Other Jurisdiction of (IRS Employer Incorporation or Organization) Identification No.) 16955 Via Del Campo, Suite 110, San Diego, CA 92127 --------------------------------------------------------- (Address of Principal Executive Offices) (858) 675-7711 -------------------------------------------------- (Registrant's Telephone Number, Including Area Code) Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months, and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] State the number of shares outstanding of each of the issuer's classes of Common equity, as of the latest practicable date: 8,358,533 shares of the issuer's no par value Common Stock were outstanding as of November 10, 2003. INDEX CREATIVE HOST SERVICES, INC. PART I FINANCIAL INFORMATION PAGE Item 1. Financial Statements Condensed Consolidated Balance Sheets at September 30, 2003 (Unaudited) and December 31, 2002 3 Condensed Consolidated Statements of Income for the three months and nine months ended September 30, 2003 and 2002 (Unaudited) 5 Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2003 and 2002 (Unaudited) 6 Notes to Unaudited Condensed Consolidated Financial Statements 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 15 Item 3. Quantitative and Qualitative Disclosures About Market Risk 23 Item 4. Controls and Procedures 24 PART II. OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K 24 SIGNATURES 25 -2- Item 1. Financial Statements

(Continued) See accompanying notes to the unaudited condensed consolidated financial statements. -3-

(Concluded) See accompanying notes to the unaudited condensed consolidated financial statements. -4-

See accompanying notes to the unaudited condensed consolidated financial statements. -5- CREATIVE HOST SERVICES, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS - UNAUDITED Nine Months Ended September 30, ------------------------- 2003 2002 ----------- ---------- Operating activities: Net income $ 583,258 $ 1,134,646 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 1,737,762 1,586,491 Provision for bad debts 22,690 57,330 Amortization of debt discount 83,812 88,640 Amortization of loan costs 250,054 29,469 Gain on sale of assets to related party - (80,487) Changes in assets and liabilities, net of effects of acquisition: Receivables 93,688 (44,771) Inventory (73,418) (58,136) Prepaid expenses and other current assets (452,019) (189,948) Deferred income taxes 300,000 - Deposits and other assets (114,630) 110,201 Accounts payable and accrued expenses 627,652 13,516 Deferred revenue 100 - Income taxes payable (535,965) 55,403 Other long-term liabilities 3,106 211,575 ---------- ---------- Net cash provided by operating activities 2,526,090 2,913,929 ---------- ---------- Investing activities: Purchases of property and equipment (4,985,194) (1,553,664) Payment for purchase of assets related to acquisition, net of cash acquired (1,075,542) - Acquisition costs - (103,470) Note receivable from related party - (55,000) Payments on note receivable from related party 20,349 10,703 ---------- ---------- Net cash used in investing activities (6,040,387) (1,701,431) ---------- ---------- Financing activities: Proceeds from notes payable 7,607,792 909,000 Proceeds from line of credit - 1,232,076 Issuance of common stock - 6,500 Payments on notes payable (926,749) (462,532) Payments on capital lease obligations (1,111,061) (822,894) Payments on line of credit (1,310,984) (1,900,980) Increase in restricted cash (200,000) - Debt issue costs (782,434) - ---------- ---------- Net cash provided by (used in) financing activities 3,276,564 (1,038,836) ---------- ---------- Net (decrease) increase in cash (237,733) 173,662 Cash, beginning of the period 1,241,766 1,801,288 ---------- ---------- Cash, end of the period $ 1,004,033 $ 1,974,950 ========== ========== (Continued) -6- CREATIVE HOST SERVICES, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS - UNAUDITED (Continued) Nine Months Ended September 30, ------------------------- 2003 2002 ----------- ---------- Supplemental disclosures of cash flow information: Interest paid $ 598,939 $ 390,338 ========== ========== Income taxes paid $ 587,320 $ 272,122 ========== ========== Supplemental disclosures of non-cash investing and financing activities: Equipment acquired and financed by a capital lease obligation associated with the Sanford acquisition $ 100,232 - ========== ========== Equipment acquired and financed by capital lease obligations $ 780,135 $ 1,244,799 ========== ========== Equity feature of discount on notes $ - $ 365,966 ========== ========== Warrants issued in connection with notes $ 352,599 $ - ========== ========== Common stock issued in exchange for services $ - $ 86,450 ========== ========== Assets sold by settling a contractual liability $ - $ 250,000 ========== ========== Notes payable converted to common stock, net $ 69,195 $ 100,000 ========== ==========
(Concluded) See accompanying notes to the unaudited condensed consolidated financial statements. -7- CREATIVE HOST SERVICES, INC. Notes to Unaudited Condensed Consolidated Financial Statements 1. BASIS OF PRESENTATION FINANCIAL STATEMENT PREPARATION: The accompanying unaudited condensed consolidated financial statements have been prepared by Creative Host Services, Inc. and its wholly owned subsidiaries (the "Company") in accordance with generally accepted accounting principles in the United States of America for interim financial information and with the instructions to Form 10-Q. Accordingly, they do not necessarily include all of the information and disclosures required for a complete presentation of financial position, results of operations and cash flows in conformity with accounting principles generally accepted in the United States of America. These condensed consolidated financial statements and related notes should be read in conjunction with the consolidated financial statements and related notes for the fiscal year ended December 31, 2002 included in the Company's annual report on Form 10-KSB and the review of the critical accounting policies identified under the caption "Critical Accounting Policies" in that report. In the opinion of the Company's management, all adjustments (consisting of normal and recurring accruals) necessary for a fair presentation of the Company's financial position and results of operations and cash flows for the interim periods have been included. Results for the interim periods presented in this report are not necessarily indicative of results which may be reported for any other interim period or for the entire fiscal year. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Certain amounts in the financial statements for the three and nine month periods ended September 30, 2002 have been reclassified to conform to current period presentation. INVENTORY: Inventory, consisting principally of foodstuffs and supplies, is valued at the lower of cost (first-in, first-out method) or market. CAPITALIZED INTEREST: Interest costs capitalized during the construction period of concession locations were $171,792 and $0 during the nine months ended September 30, 2003 and 2002, and $90,204 and $0 during the three months ended September 30, 2003 and 2002, respectively. -8- RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS: In January 2003, the FASB issued FASB Interpretation No. 46, "Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51." Interpretation No. 46 provides guidance for identifying a controlling financial interest established by means other than voting interests. It requires consolidation of a variable interest entity by an enterprise that holds such a controlling financial interest. This interpretation is still being developed and the earliest effective date for the Company will be the fourth quarter of 2003. The Company does not believe that the adoption of FASB Interpretation No. 46 will have a material impact on the Company's financial statements. During the three month period ended September 30, 2003, there were no recently issued accounting standards that the Company believes will have a material effect on its financial position, its results of operations or its cash flows. 2. STOCK-BASED COMPENSATION SFAS No. 123, "Accounting for Stock-Based Compensation" as amended by SFAS No. 148, "Accounting for Stock Based Compensation - Transition and Disclosure, an amendment of SFAS No. 123", provides accounting guidance related to stock-based employee compensation. SFAS No. 123, as amended, encourages, but does not require, companies to record compensation cost for stock-based employee compensation plans at fair value. The Company has chosen to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees", and related interpretations for all periods presented. Accordingly, compensation cost for stock options is measured as the excess, if any, of the fair value of the Company's stock at the date of the grant over the amount an employee must pay to acquire the stock. Pro forma information regarding net income and net income per share under the fair value method as prescribed under SAFS No. 123, as amended by SFAS No. 148, is as follows: Three Months Ended Nine Months Ended September 30, September 30, ----------------------- ------------------------- 2003 2002 2003 2002 ---------- ---------- ----------- ----------- Net income as reported $ 425,792 $ 344,269 $ 583,258 $ 1,134,646 Pro forma stock-based employee compensation expense determined under fair value based method, net of tax (7,568) (18,810) (70,907) (94,998) --------- --------- ---------- ---------- Pro forma net income $ 418,224 $ 325,459 $ 512,351 $ 1,039,648 ========= ========= ========== ========== Net income per share Basic - as reported $ .05 $ .04 $ .07 $ .14 ========= ========= ========== ========== Diluted - as reported $ .05 $ .04 $ .07 $ .14 ========= ========= ========== ========== Basic - pro forma $ .05 $ .04 $ .06 $ .13 ========= ========= ========== ========== Diluted - pro forma $ .05 $ .04 $ .06 $ .13 ========= ========= ========== ==========
-9- 3. ACQUISITION On January 15, 2003, the Company acquired the assets and concession leases of three locations at the Sanford International Airport in Orlando, Florida. Total consideration was approximately $1.2 million, substantially all of which was used to pay certain liabilities, transaction costs, and equipment lease obligations. The purchase price was allocated to the assets acquired based on their estimated fair values consisting of $.6 million of leasehold improvements, $.1 million of furniture and equipment, $.3 million of identifiable intangible assets which will be amortized over the life of the concession leases, and approximately $.2 million of goodwill. The Company has not finalized the allocation of the purchase price to the aforementioned assets and therefore has made an estimate of the amount of depreciation and amortization expense for the three and nine month periods ended September 30, 2003. The estimated depreciation and amortization expense and operations of the concession locations are included in the Company's consolidated results of operations from the date of the acquisition. 4. NOTES PAYABLE A summary of notes payable as of September 30, 2003 and December 31, 2002 is as follows: September 30, December 31, 2003 2002 (Unaudited) ------------ ------------ Subordinated convertible notes payable, interest at 9%, due quarterly, through December 31, 2006, (net of discount of $177,141 and $260,953) $ 442,859 $ 484,047 Note payable to a bank, interest at 9%, due July 2004, paid January 2003 - 633,183 Notes payable to former shareholders, interest at 9%, due in monthly installments of $4,797 through December 2003, paid January 2003 - 54,921 Note payable to a finance company, interest at 13.1%, due in monthly installments of $413 through April 2004, paid January 2003 - 6,025 Note payable to a corporation, interest at 8%, due in monthly installments of $1,784 through May 2006, paid January 2003 - 63,797 Note payable to a finance company, interest at 6.9%, due in monthly installments of $7,317 through May 2003, paid January 2003 - 35,963 Note payable to a finance company, interest at 5.75%, due in monthly installments of $27,476 through January 2004 108,598 - Note payable to a bank, interest at 12%, due quarterly, through December 31, 2007 5,966,334 - Note payable to a bank, interest at 3.5% above the bank's reference rate, due quarterly, through December 31, 2008 1,400,000 - ------------ ------------ 7,917,791 1,277,936 Less current maturities 162,127 - ------------ ------------ $ 7,755,664 $ 1,277,936 ============ ============ -10- In a private placement during the three months ended March 31, 2002, the Company issued 18.9 Units, with each Unit consisting of one $50,000 principal amount Series A 9% Subordinated Convertible Note and 37,500 warrants for common stock exercisable at $2.00 per share until November 21, 2006. The notes were convertible into a total of 900,000 shares of the Company's common stock. Two investors subsequently rescinded their investment in two of the Units, because they were unwilling to sign the subordination agreement required under the terms of the private placement. Additionally, the Company issued warrants to the brokers to purchase Units equivalent to 10% of the Units issued to the investors in the private placement at an exercise price of $50,000 per Unit for a period of five years from January 29, 2002. If these warrants are exercised, the Units purchased by the broker will have the same rights as the Units issued to the investors. On August 20, 2002, $100,000 of the Convertible Notes were converted into 95,238 shares of the Company's common stock. On February 6, 2003, $25,000 of the Convertible Notes were converted into 23,810 shares of the Company's common stock. On July 1, 2003, $100,000 of the Convertible Notes were converted into 95,238 shares of the Company's common stock. At September 30, 2003, $442,859, net of unamortized discount of $177,141, is included in notes payable related to this offering. In January 2003, the Company entered into a senior secured financing with a bank pursuant to the terms of a credit agreement. The credit agreement provides for a total financing commitment of $13,000,000 consisting of two separate facilities, a term loan facility and an expansion facility. These loans are secured by virtually all of the Company's assets. The term loan facility provides for financing in an amount up to $7,400,000 to be used to refinance the Company's existing debt, finance the price of an acquisition made on the closing date of the loan and lender-approved acquisitions after the closing date, to finance build-outs of the Company's concession locations, and pay fees and expenses associated with the financing and the closing date acquisitions. The Company used approximately $4,316,000 of this facility to refinance approximately $2,499,000 of existing debt, finance the purchase price of the Sanford acquisition of approximately $1,100,000 made on the closing date of the loan, and pay a portion of the fees and expenses associated with the financing of approximately $717,000. The expansion facility, in an amount up to $5,600,000, may be used to finance the cash purchase price for approved acquisitions, to finance build-outs of concession locations, to provide ongoing working capital needs of the Company and to provide a letter of credit sub-facility of $4,000,000. Availability under the expansion facility will be reduced by outstanding letters of credit. The expansion facility matures on December 31, 2008, with certain principal payments due on December 31, 2007, March 31, 2008 and June 30, 2008 equal to the greater of (i) fifteen percent of the reduced commitment amount or (ii) $800,000, with the remaining amount due on December 31, 2008. The term loan of the credit facility bears interest at a rate of 10% per annum plus 2% per annum paid in kind (PIK) rate. Interest accruing on the PIK rate will be paid annually in cash, or at the Company's option, such interest will accrue on the principal amount. The interest on the expansion facility is based, at the option of the Company, upon either a Eurodollar rate plus 3.5% or -11- the higher of Prime plus 1% or the Fed Funds Rate plus .5% per annum. A commitment fee is charged on the unused portion of the term loan and the expansion facility at rates of 0.75% and 0.5% per annum, respectively. The term loan is due December 31, 2007. As a condition of the financing, the Company was required to close an acquisition transaction at the same time as the financing, using proceeds from the term loan facility to finance the purchase price for the acquisition. The Company used $1,075,542 of the financing proceeds to acquire the assets and concession leases of three locations at the Sanford International Airport in Orlando, Florida in satisfaction of that condition. As additional consideration for the financing, the Company issued warrants to purchase 452,050 shares of common stock. The warrants have an exercise price of $1.87 per share, which was equal to the closing price of the Company's common stock on January 16, 2003 and expire on January 17, 2012. Terms and conditions of the warrants include, among others, shelf and piggyback registration rights, anti-dilution protection and "tag-along" rights. The warrants were recorded at $352,599, representing their estimated fair value, as debt issuance costs and additional paid-in-capital. The debt issuance costs are being amortized over the term of the debt agreement. 5. LINE OF CREDIT At December 31, 2002, the Company had a revolving line of credit with a bank expiring October 31, 2003. The line of credit originated on November 13, 2000, with maximum borrowing capacity of $2,500,000. The maximum borrowing allowed was reduced by $125,000 each quarter. The line of credit's interest rate was 0.25% under the bank's reference rate. The line was collateralized by inventory, furniture, equipment and intangible property. The amount outstanding on the line of credit at December 31, 2002 was $1,310,984. As discussed above, in January 2003, the Company entered into a new long-term credit agreement. A portion of the proceeds from the new financing was used to pay off this bank line of credit; therefore, the balance of $1,310,984 has been classified as long-term in the Company's balance sheet at December 31, 2002. 6. NET INCOME PER SHARE Basic net income per share is computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted net income per share reflects the potential dilution that could occur if securities or other contracts to issue common stock (convertible notes, warrants and options to purchase common stock) were exercised or converted into common stock. Potential common shares in the diluted computation are excluded when their effect would be anti-dilutive. The following table provides a reconciliation from the basic to the diluted net income per share for the three and nine month periods ended September 30, 2003 and 2002. -12-
Three Months Ended Nine Months Ended September 30, September 30, ----------------------- ------------------------- 2003 2002 2003 2002 ---------- ---------- ----------- ----------- Numerator: Net income for basic and diluted income per share $ 425,792 $ 344,269 $ 583,258 $1,134,646 ========= ========= ========= ========= Denominator: Basic: Weighted average common shares outstanding 8,110,955 7,924,613 8,124,223 7,878,060 Diluted: Effect of dilutive securities - Warrants 99,459 7,303 40,918 5,802 Common stock options 153,369 92,043 120,758 52,384 --------- --------- --------- --------- Dilutive potential common shares 8,363,783 8,023,959 8,285,899 7,936,246 ========= ========= ========= ========= Net income per share: Basic $ .05 $ .04 $ .07 $ .14 ========= ========= ========== ========== Diluted $ .05 $ .04 $ .07 $ .14 ========= ========= ========== ==========
For the three month periods ended September 30, 2003 and 2002, options to purchase 97,500 and 127,500 shares of common stock, respectively, were excluded from the computation of diluted net income per share, as the inclusion of such shares would be anti-dilutive. For the nine month periods ended September 30, 2003 and 2002, options to purchase 97,500 and 127,500 shares of common stock, respectively, were excluded from the computation of diluted net income per share, as the inclusion of such shares would be anti-dilutive. For the three month periods ended September 30, 2003 and 2002, warrants to purchase 438,982 and 718,982 shares of common stock, respectively, were excluded from the computation of diluted net income per share, as the inclusion of such shares would be anti-dilutive. For the nine month periods ended September 30, 2003 and 2002, warrants to purchase 438,982 and 718,982 shares of common stock, respectively, were excluded from the computation of diluted net income per share, as the inclusion of such shares would be anti-dilutive. On September 8, 2003, 151,128 warrants to purchase common stock at $13.20 per share expired. On October 2, 2003, 162,854 warrants to purchase common stock at $8.32 per share also expired. For the three month periods ended September 30, 2003 and 2002, notes convertible into 590,476 and 804,762 shares of common stock, respectively, were excluded from the computation of diluted net income per share, as the inclusion of such shares would be anti-dilutive. For the nine month periods ended September 30, 2003 and 2002, notes convertible into 590,476 and 804,762 shares of common stock, respectively, were excluded from the computation of diluted net income per share, as the inclusion of such shares would be anti-dilutive. -13- 7. INCOME TAX PROVISION The Company's income tax provision for the three and nine month periods ended September 30, 2003 has been determined using the estimated annual effective tax rate applied to the Company's income reported in the financial statements. The provision for the three and nine month periods ended September 30, 2002 has been reduced by the utilization of a portion of the deferred tax asset previously unrecognized due to a valuation allowance established against this asset. 8. RELATED PARTY TRANSACTIONS In January 2002, the Company sold its location in Atlantic City, New Jersey to the spouse of the President of GladCo for $250,000 cash. There were existing contractual liabilities, related to the acquisition of GladCo, owed to the President of GladCo at the time of the sale, and the $250,000 sales proceeds were offset against the contractual liabilities. The $250,000 sales price represents the estimated fair market value of the Atlantic City, New Jersey location at the date of the sale. A gain of $80,487 was recorded on this transaction during the three month period ended March 31, 2002. 9. COMMITMENTS AND CONTINGENCIES CONCESSIONAIRE AGREEMENTS ---------------- As of September 30, 2003, in connection with the concessionaire agreements with various airport authorities, the Company has obtained surety bond coverage in the aggregate amount of approximately $425,000 and has issued letters of credit in the aggregate amount of approximately $311,000 for the guarantee of lease payments in the event of non-performance under the agreements. The insurer may seek indemnification from the Company for any amounts paid under the bonds. The Company held $200,000 restricted cash at September 30, 2003 as collateral for one of the letters of credit. LEGAL CONTINGENCIES ------------------- The Company is not subject to any material legal proceedings. The Company is subject from time to time to legal claims in the ordinary course of its business. Management does not believe that any of these legal claims will have a significant adverse effect on its financial condition or business. -14- Item 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD-LOOKING STATEMENTS AND PROJECTIONS The Private Securities Reform Act of 1995 provides a "safe harbor" for forward- looking statements. Certain information included in this report, and other reports issued by the Company, contain statements that are forward looking. The Company may from time to time make forward-looking statements and projections concerning future expectations. When used in this discussion, the words "estimate," "project," "anticipate" and similar expressions are intended to identify forward-looking statements and include, but are not limited to, statements relating to anticipated trends in revenues, plans for future expansion and other business development activities, including acquisition of new concessions as well as other capital spending, financing sources, the effects of regulation and competition, and the ability to increase net income and cash flow. Such forward-looking information involves numerous risks and uncertainties that could significantly affect anticipated results in the future and, accordingly, such results may differ from those expressed in any forward- looking statements made by or on behalf of the Company. These risks and uncertainties include, but are not limited to, those relating to additional capital necessary to complete construction of capital improvements awarded under existing and future concession agreements, possible early termination of concession contracts, possible delay in the commencement of concession operations at newly awarded concession facilities, the need and ability to attract and retain qualified management, governmental regulatory requirements including applications for licenses and approvals under applicable jurisdictional laws and regulations, the terms and conditions of any potential merger or acquisition of existing airport concession operations, the volatility of the Company's stock price and of securities markets in general, domestic and international economic conditions, debt service (including sensitivity to fluctuations in interest rates), the impact of terrorism and war on tourism and airline travel, and other factors discussed in the Company's Form 10-KSB for the year ended December 31, 2002. OVERVIEW The Company commenced business in 1987 as an owner, operator and franchiser of French style cafes. The Company ceased the sale of new franchises in 1994 due to the lack of profitability of this business type. The Company entered the airport food and beverage concession market when it was awarded a concession to operate a food and beverage location, by one of the Company's franchisees, for John Wayne Airport in Orange County, California. In 1994, the Company was awarded its first multiple concession contract for the Denver International Airport. In 1996, the Company was awarded its first master concession contract to install and manage all food, beverage, news, gift and other services for the airport in Cedar Rapids, Iowa. The Company's historical revenues had been derived from three principal sources: airport concession revenues, restaurant franchise royalties and wholesale sales from its food preparation center. These revenue categories comprised a fluctuating percentage of total revenues from year to year. The food preparation center was sold in 2001. Over the past eight years, revenues from concession operations have grown from 59% of total revenues in 1995 to nearly 100% of total revenues in 2003. -15- THREE MONTHS ENDED SEPTEMBER 30, 2003 COMPARED TO THREE MONTHS ENDED SEPTEMBER 30, 2002 REVENUES. The Company's revenues for the three months ended September 30, 2003 were $10,805,939 compared to $9,104,194 for the three months ended September 30, 2002, an increase of $1,701,745 or 18.7%. Revenues from concession activities increased $1,707,364 ($10,797,372 as compared to $9,090,008). Revenue increased by $1,523,422 due to the opening of new locations in Newark, New Jersey beginning in May 2002, Sanford, Florida in January 2003, Santa Barbara, California in May 2003, Tallahassee, Florida in September 2003 and San Antonio, Texas in September 2003. Revenue at locations open during both periods increased $178,323, a 2.1% increase. OPERATING COSTS AND EXPENSES. Operating costs and expenses for the three months ended September 30, 2003 were $9,757,350 compared to $8,532,859 for the three months ended September 30, 2002. Cost of goods sold for the three months ended September 30, 2003 was $2,794,580 compared to $2,492,435 for the three months ended September 30, 2002. As a percentage of total revenue, cost of goods sold decreased to 25.9% for the three months ended September 30, 2003 from 27.4% for the three months ended September 30, 2002. The decrease was primarily attributable to greater efficiencies through volume purchasing. Payroll and other employee benefits increased by $367,790 to $3,183,194 for the three months ended September 30, 2003 from $2,815,404 for the three months ended September 30, 2002. Payroll and other employee benefits increased $384,911 due to the opening of new locations in Newark, New Jersey beginning in May 2002, Sanford, Florida in January 2003, Santa Barbara, California in May 2003, Tallahassee, Florida in September 2003 and San Antonio, Texas in September 2003. General and administrative payroll and employee benefits increased $72,377, while payroll and employee benefits at locations open during both periods decreased $89,498. As a percentage of total revenue, payroll and employee benefits decreased to 29.5% for the three months ended September 30, 2003 from 30.9% for the three months ended September 30, 2002. Occupancy expenses increased $242,558 to $1,711,843 for the three months ended September 30, 2003 from $1,469,285 for the three months ended September 30, 2002. Occupancy expenses increased $197,057 due to the opening of new locations in Newark, New Jersey beginning in May 2002, Sanford, Florida in January 2003, Santa Barbara, California in May 2003, Tallahassee, Florida in September 2003 and San Antonio, Texas in September 2003. Occupancy expenses at locations open during both periods increased $45,501. Selling expenses increased $86,901 to $842,523 for the three months ended September 30, 2003 from $755,622 for the three months ended September 30, 2002. As a percentage of total revenue, selling expenses decreased to 7.8% for the three months ended September 30, 2003 from 8.3% for the three months ended September 30, 2002. Selling expenses increased $97,253 due to the opening of new locations in Newark, New Jersey beginning in May 2002, Sanford, Florida in January 2003, Santa Barbara, California in May 2003, Tallahassee, Florida in September 2003 and San Antonio, Texas in September 2003. Selling expenses decreased $10,352 at locations open during both periods. General and administrative expenses increased to $609,784 for the three months ended September 30, 2003 from $458,937 for the three months ended September 30, 2002. As a percentage of revenue, general and administrative expenses increased to 5.6% for the three months ended September 30, 2003 from 5.0% for -17- the three months ended September 30, 2002. General and administrative expenses increased primarily due to expenses incurred responding to new requests for proposals. Depreciation and amortization expense increased to $615,426 for the three months ended September 30, 2003 from $541,176 for the three months ended September 30, 2002. This was due primarily to the depreciation related to new concessions. INTEREST EXPENSE, NET. Net interest expense increased to $306,845 for the three months ended September 30, 2003 from $196,081 for the three months ended September 30, 2002. The increase is due primarily to an increase in total debt as a result of financing the acquisition of additional property, equipment and other assets. INCOME TAXES. The Company's income tax provision for the three-month period ended September 30, 2003 has been determined using the estimated annual effective tax rate applied to the Company's income reported in the financial statements. The provision for the three month period ended September 30, 2002 has been reduced by the utilization of a portion of the deferred tax asset previously unrecognized due to a valuation allowance established against this asset. NET INCOME. Net income for the three months ended September 30, 2003 was $425,792 compared to $344,269 for the three months ended September 30, 2002. NINE MONTHS ENDED SEPTEMBER 30, 2003 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30, 2002 REVENUES. The Company's revenues for the nine months ended September 30, 2003 were $28,775,763 compared to $25,723,451 for the nine months ended September 30, 2002, an increase of $3,052,312 or 11.9%. Revenues from concession activities increased $3,054,282 ($28,739,037 as compared to $25,684,755). Revenue increased by $3,348,260 due to the opening of new locations in Newark, New Jersey beginning in May 2002, Sanford, Florida in January 2003, Santa Barbara, California in May 2003, Tallahassee, Florida in September 2003 and San Antonio, Texas in September 2003. This increase was offset by a decrease in revenue at locations open during both periods of $255,077 and by a decrease from operations that were sold that had $40,871 revenue for the nine months ended September 30, 2002. Revenue at the Pittsburgh location decreased $813,149 due to a decrease in US Air enplanements at that airport. Revenue at the Boston location decreased $650,466 due to construction-related closures. All concessions at the Boston location that were closed for construction re- opened in July 2003. Revenues at the remaining locations open during both periods increased $1,208,538, a 7.1% increase for the nine months ended September 30, 2003 from the nine months ended September 30, 2002. OPERATING COSTS AND EXPENSES. Operating costs and expenses for the nine months ended September 30, 2003 were $26,880,302 compared to $24,038,254 for the nine months ended September 30, 2002. Cost of goods sold for the nine months ended September 30, 2003 were $7,560,200 compared to $6,921,070 for the nine months ended September 30, 2002. As a percentage of total revenue, cost of goods sold decreased to 26.3% for the nine months ended September 30, 2003 from 26.9% for the nine months ended September 30, 2002. Payroll and other employee benefits increased $1,125,024 to $9,014,241 for the nine months ended September 30, 2003 from $7,889,217 for the nine months ended September 30, 2002. Payroll and other employee benefits increased $925,320 due to the opening of new locations in Newark, New Jersey beginning in May 2002, -18- Sanford, Florida in January 2003, Santa Barbara, California in May 2003, Tallahassee, Florida in September 2003 and San Antonio, Texas in September 2003. General and administrative payroll and other employee benefits increased $187,262, while payroll and other employee benefits at locations open during both periods increased $26,688. These increases were partially offset by operations that were sold that had $14,246 payroll and other employee benefits for the nine months ended September 30, 2002. As a percentage of total revenue, payroll and other employee benefits increased to 31.3% for the nine months ended September 30, 2003 from 30.7% for the nine months ended September 30, 2002. This increase was due primarily to an increase at the Pittsburgh location where decreases in staffing levels have lagged behind decreases in revenues and to an increase at the Boston location where training for new concessions occurred during the nine months ended September 30, 2003 while the locations had not yet opened. Occupancy expenses increased $583,521 to $4,723,865 for the nine months ended September 30, 2003 from $4,140,344 for the nine months ended September 30, 2002. Occupancy expenses increased $560,574 due to the opening of new locations in Newark, New Jersey beginning in May 2002, Sanford, Florida in January 2003, Santa Barbara, California in May 2003, Tallahassee, Florida in September 2003 and San Antonio, Texas in September 2003. Occupancy expenses increased $27,249 at locations open during both periods. These increases were partially offset by a decrease in occupancy expenses by operations that were sold that had $4,302 occupancy expenses for the nine months ended September 30, 2002. Selling expenses increased $259,001 to $2,426,750 for the nine months ended September 30, 2003 from $2,167,749 for the nine months ended September 30, 2002. As a percentage of total revenue, selling expenses remained unchanged at 8.4% for the nine months ended September 30, 2003 as compared to the nine months ended September 30, 2002. Selling expenses increased $230,738 due to the opening of new locations in Newark, New Jersey beginning in May 2002, Sanford, Florida in January 2003, Santa Barbara, California in May 2003, Tallahassee, Florida in September 2003 and San Antonio, Texas in September 2003. Selling expenses increased $33,703 at locations open during both periods. These increases were offset by operations that were sold that had $5,440 selling expenses for the nine months ended September 30, 2002. General and administrative expenses increased to $1,417,484 for the nine months ended September 30, 2003 from $1,362,852 for the nine months ended September 30, 2002. That increase was primarily attributable to costs associated with new concession bidding proposals. As a percentage of revenue, general and administrative expenses decreased to 4.9% for the nine months ended September 30, 2003 from 5.3% for the nine months ended September 30, 2002. Depreciation and amortization expense increased to $1,737,762 for the nine months ended September 30, 2003 from $1,557,022 for the nine months ended September 30, 2002. This was due primarily to the depreciation related to new concessions. INTEREST EXPENSE, NET. Net interest expense increased to $891,251 for the nine months ended September 30, 2003 from $522,038 for the nine months ended September 30, 2002. The increase is due primarily to an increase in total debt as a result of financing the acquisition of additional property, equipment and other assets. OTHER INCOME AND EXPENSE. The $80,487 gain on the sale of assets to related party for the nine months ended September 30, 2002 resulted from the sale of assets at the Atlantic City location. -19- INCOME TAXES. The Company's income tax provision for the nine month period ended September 30, 2003 has been determined using the estimated annual effective tax rate applied to the Company's income reported in the financial statements. The provision for the nine month period ended September 30, 2002 has been reduced by the utilization of a portion of the deferred tax asset previously unrecognized due to a valuation allowance established against this asset. NET INCOME. Net income for the nine months ended September 30, 2003 was $583,258 compared to $1,134,646 for the nine months ended September 30, 2002. The Company does not believe that inflation has had an adverse effect on its revenues and earnings. Historically, the Company has experienced seasonal variability in quarterly operating results with higher concessions revenue in the second and third quarters than in the first and fourth quarters. The higher concessions revenues in the second and third quarters improve profitability by increasing revenues and reducing the impact of fixed costs. This seasonal impact on operating results is expected to continue. LIQUIDITY AND CAPITAL RESOURCES The Company has funded its capital requirements in recent years through the sale of equity and debt securities, cash flow from operations and bank debt. The Company generated $2,526,090 and $2,913,929 in cash flow from operating activities for the nine months ended September 30, 2003 and 2002, respectively. Net cash from operating activities for the nine months ended September 30, 2003 is attributable primarily to net income of $583,258, depreciation and amortization of $2,071,628, a decrease in receivables of $93,688, and an increase in accounts payable and accrued expenses of $627,652, offset by an increase in prepaid expenses, inventory and other assets of $640,067 and by a decrease in income taxes payable of $535,965. Net cash used in investing activities was $6,040,387 for the nine months ended September 30, 2003, compared to $1,701,431 for the nine months ended September 30, 2002. Net cash used in investing activities for the nine months ended September 30, 2003 included $4,985,194 of purchases of property and equipment and $1,075,542 for the acquisition of the assets and concession leases of three locations at the Sanford International Airport in Orlando, Florida, offset by $20,349 payments received on a note receivable from a related party. Net cash provided by financing activities was $3,276,564 for the nine months ended September 30, 2003, compared to net cash used in financing activities of $1,038,836 for the nine months ended September 30, 2002. Net cash provided by financing activities for the nine months ended September 30, 2003 included the issuance of debt totaling $7,607,792 offset by payments on notes payable of $926,749, payments on capital lease obligations of $1,111,061, payments on a line of credit of $1,310,984, an increase in restricted cash of $200,000 and debt issue costs of $782,434. Net cash used in financing activities for the nine months ended September 30, 2002 included payments on notes payable of $462,532, payments on a line of credit of $1,900,980 and payments on capital lease obligations of $822,894, offset by proceeds from notes payable of $909,000, proceeds from a line of credit of $1,232,076 and proceeds from the issuance of common stock of $6,500. -20- During the first two months of 2002, the Company raised approximately $945,000 of capital in a private placement of convertible notes and warrants. Two investors subsequently rescinded their investments because they were unwilling to sign the subordination agreement required under the terms of the private placement and the Company refunded their investment in the total amount of $100,000 in September 2002. The convertible notes are convertible into a total of 804,762 shares of common stock, and the 633,750 warrants issued entitle the warrant holders to purchase a total of 633,750 additional shares of the Company's common stock for an exercise price of $2.00 per share for a period of five years from the date of issuance. The Company terminated the offering in early March 2002. As of September 30, 2003, a total of $225,000 of convertible notes have been converted to 214,286 shares of the Company's common stock, with no warrants exercised. In January 2003, the Company borrowed approximately $4,316,000 on its term loan facility which was used to refinance existing debt, finance the Sanford acquisition and pay fees and expenses related to the financing transaction. In connection with this transaction, the Company has a commitment for an additional $2,183,000 available for financing as well as an expansion facility, in an amount up to $5,600,000, to finance the cash purchase price for approved acquisitions, build outs of concession locations, and to provide ongoing working capital needs of the Company. As of September 30, 2003, $1,433,666 was available to the Company under the term loan and $4,200,000 was available under the expansion facility. The Company generally commits to expend a negotiated amount for capital improvements to newly awarded concession facilities. In addition, the Company is responsible for acquiring equipment necessary to conduct its operations. As a result, the Company incurs substantial costs for capital improvements at the commencement of a concession term. Generally, the term of the concession grant is for a period of 10 years, providing the Company with an opportunity to recover its capital expenditures. Substantially all of the Company's concession locations have been obtained in the past five years, which has resulted in significant capital needs. As a result, the Company has been required to seek capital, and to apply capital from operations, for leasehold improvements at newly awarded concession locations. The Company intends to continue to bid for concession locations. Cash flows from operations may not be sufficient to finance new acquisitions at the level of growth experienced over the past three years. Accordingly, to the extent the Company is successful in securing new concession contracts, the Company will continue to need additional capital, beyond cash flow from operations, to finance the construction of new capital improvements. The Company anticipates capital requirements of approximately $6.2 million in fiscal 2003 to complete the construction of improvements at concession facilities that have already been awarded. This includes approximately $4.8 million in connection with new concession agreements awarded in Newark International Airport in Newark, New Jersey, Boston Logan Airport in Boston Massachusetts, Santa Barbara Airport in Santa Barbara, California, San Antonio Airport in San Antonio, Texas, Tallahassee Regional Airport in Tallahassee, Florida, the recently acquired concession location in Sanford International Airport in Sanford, Florida, an additional $1.1 million at other existing concession locations where the Company gained extensions to its lease terms and other capital expenditures of $.3 million. Approximately $4.9 million has been spent through September 30, 2003. In addition, the Company has financed equipment purchases through capital lease obligations totaling $0.8 million. -21- The Company is continually evaluating other airport concession opportunities, including submitting bid proposals and acquiring existing concession owners and operators. The level of the Company's capital requirements will depend upon the number of airport concession facilities that are successfully acquired. The Company believes that the anticipated cash flow from operations combined with funds anticipated to be available from our existing credit facility and our cash balance of $1.0 million as of September 30, 2003 will be sufficient to satisfy our working capital and capital expenditure requirements for the next 12 months. Changes in our operating plans, our acquisition and growth plans, lower than anticipated sales from concession locations, our ability to meet the financial covenants of our credit facility, increased expenses or other unforeseen events may cause us to seek additional or alternative financing sooner than anticipated. Additional or alternative financing may not be available on acceptable terms or at all. Failure to obtain additional or alternative financing as needed could have a material adverse effect on our business and results of operations. CRITICAL ACCOUNTING POLICIES Critical accounting policies are those that are most important to the portrayal of a company's financial condition and results, and that require management's most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. The following is a review of the critical accounting policies and methods used by the Company. Revenue Recognition: The Company records concession revenues as the sales are made and it records revenues from in-flight catering upon delivery. Royalties from franchisee concession locations are recorded as revenue when earned. Goodwill: In connection with the Company's acquisition of GladCo Enterprises, Inc., which was accounted for under the purchase method of accounting, the Company recorded goodwill. Until the Company's adoption of Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets," on January 1, 2002, the Company amortized goodwill using the straight-line method over its estimated useful life of twenty years. Goodwill is tested for impairment at least annually to determine whether the carrying value of goodwill exceeds its implied fair value. The fair value of a reporting unit is based on discounted projected cash flow but the Company also considers factors such as market capitalization and comparable industry price multiples. The Company employs cash flow projections that are believed to be reasonable under current and forecasted circumstances, the results of which form the basis for making judgments about carrying values of the reported net assets of the Company's reporting units. Actual results may differ from these estimates under different assumptions or conditions. Income Taxes: The provision for income taxes is based on the income reported in the financial statements. The Company recognizes deferred tax assets for deductible temporary differences and deferred tax liabilities for taxable temporary differences. -22- Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases. The Company will reduce deferred tax assets by a valuation allowance when, in its opinion, it is more likely than not that some portion or all of the deferred tax assets will not be realized. As a result of the net income realized during 2001 and 2002 and other considerations, management's expectation is that these assets will in fact be realized and in 2002 reversed the valuation allowance accordingly. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. These accounting policies are applied consistently for all periods presented. Our operating results would be affected if other alternatives were used. Recent Accounting Pronouncements: In January 2003, the FASB issued FASB Interpretation No. 46, "Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51." Interpretation No. 46 provides guidance for identifying a controlling financial interest established by means other than voting interests. It requires consolidation of a variable interest entity by an enterprise that holds such a controlling financial interest. This interpretation is still being developed and the earliest effective date for the Company will be the fourth quarter of 2003. The Company does not believe that the adoption of FASB Interpretation No. 46 will have a material impact on the Company's financial statements. During the three month period ended September 30, 2003, there were no recently issued accounting standards that the Company believes will have a material effect on its financial position, its results of operations or its cash flows. Item 3. Quantitative and Qualitative Disclosures About Market Risk. The Company's market risk exposures are related to the impact of interest rate changes. The Company invests its excess cash in short-term certificates of deposit. These investments are not held for trading or other speculative purposes. Changes in interest rates and the related investment income do not materially impact the Company's cash flows and results of operations. As of September 30, 2003, the Company had available approximately $5.6 million of a total $13.0 million senior debt facility with a term loan and an expansion loan feature. Interest on the term loan is calculated at a rate of 10% per annum plus 2% per annum paid in kind (PIK) rate. Interest on the expansion facility is calculated at either a Eurodollar rate plus 3.5% or the higher of Prime plus 1% or the Fed Funds Rate plus .5% per annum. A commitment fee is charged on the unused portion of the term loan and the expansion facility at rates of 0.75% and 0.5% per annum, respectively. The maturity dates of the loans are December 31, 2007 and December 31, 2008, respectively. As of September 30, 2003, the Company has borrowed approximately $5.97 million against the term loan, and $0.1 million reserved in the form of a standby letter of credit as security for performance and compliance with certain of the Company's concession agreements. The interest on this portion of the Company's debt is calculated at a fixed rate. Additionally, the Company has $1.4 million outstanding on the expansion facility. The interest on this portion of the Company's debt is subject to fluctuations in the market. However, a 10% change in period-end interest rates or a hypothetical 100 basis point adverse move in interest rates would not have a significant negative affect on the Company's financial results. -23- Item 4. Controls and Procedures. (a) Disclosure Controls and Procedures. The Company's management, with the participation of the Company's Chief Executive Officer and the Chief Financial Officer, has evaluated the effectiveness of the design and operation Company's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the fiscal period covered by this Quarterly Report on Form 10- Q. Based upon such evaluation, the Chief Executive Officer and Chief Financial Officer has concluded that, as of the end of such period, the Company's disclosure controls and procedures are effective in ensuring that information required to be disclosed in this filing is accumulated and communicated to management and is recorded, processed, summarized and reported in a timely manner and in accordance with Securities and Exchange Commission rules and regulations. (b) Internal Control Over Financial Reporting. There has not been any changes in the Company's internal control over financial reporting during the fiscal period covered by this Quarterly Report on Form 10- Q that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. PART II. OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K. (a) Exhibits -------- 31.1 - Certification of Chief Executive Officer of Periodic Report Pursuant to Rule 13a-14(a) and Rule 15d-14(a). 31.2 - Certification of Chief Financial Officer of Periodic Report Pursuant to Rule 13a-14(a) and Rule 15d-14(a). 32.1 - Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350. 32.2 - Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350. (b) Reports on Form 8-K ------------------- The Company filed the following reports on Form 8-K during the quarter for which this report is filed. Date of Earliest Event Reported Item Nos. Description ---------------- -------------- ------------------------ August 15, 2003 Items 7 and 12 Press Release - financial results second quarter 2003 -24- SIGNATURES 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 thereunto duly authorized. CREATIVE HOST SERVICES, INC. (Registrant) Date: November 13, 2003 by /s/ Sayed Ali ---------------------------- Sayed Ali, President, Chief Executive Officer and Chief Financial Officer -25-

CREATIVE HOST SERVICES INC 10-Q