Can Schlotzsky's Be Saved?

John Wooley and the battle to bring Schlotzsky's back to life

Can Schlotzsky's Be Saved?
Photo By Jana Birchum

On the morning of June 17, John Wooley peered out the window of an empty conference room at Schlotzsky's Inc. headquarters and was suddenly struck by a grave but certain premonition that he would be fired by lunchtime.

The view from the window told him as much. Headed toward the company's Third and Colorado office building were three of the company's directors, wearing grim faces. They looked, in Wooley's wary eyes, to be gathering a plan of attack for that day's board meeting, scheduled for 9am.

As the chief executive officer of a homegrown company, Wooley had been under intense pressure to shore up the struggling sandwich franchiser that he took public in 1995, winning the hearts of shareholders and consumers. But Schlotzsky's salad days of swagger and glory and fawning media attention had long since passed. At first Wooley could do no wrong, but in recent years, ballooning debt and deflating sales were taking their toll on the company and worrying the relatively new board – a slate of high-profile names that came with plenty of business and legal savvy, but no inside knowledge of the cut-throat nature of the fast-food industry. They did, however, know that last year's loss of $11.7 million, followed by a first-quarter loss of $671,000, did not inspire a lot of confidence in Wooley's ability to turn the company around. Moreover, the deli chain's franchise owners on the competitive battlefront were threatening revolt – an occupational hazard of the industry when companies are in decline – and the board appeared to be drawing on those complaints to confirm their hunches about a couple of things: One, that after 23 years at the top, Wooley and his brother, Jeff Wooley, the senior vice president, could no longer lead the company. And two, that a Chapter 11 bankruptcy filing seemed to be the only way out of this mess.

In general, John Wooley approached these types of crises with an entrepreneur's stubborn determination to conquer the odds, to put the best spin on the worst news, and to never, ever throw in the towel. Whether he was unfailingly optimistic or simply delusional remains open to debate. Since acquiring Schlotzsky's in 1981, the two brothers had steered the company through the devastating national savings and loan crash, the Austin real estate bust, and other cash-flow crunches. In their estimation, there was no reason to believe they couldn't guide the company out of this jam, too. As always, they had a plan.

But here it was five minutes to nine, and the other directors had yet to arrive for the board meeting. Something wasn't right. "That's when I told Jeff, 'Well, let's look out the window here and you'll see your board of directors come walking across the parking lot from their pre-meeting meeting,'" Wooley recalled of that morning. Sure enough, Wooley saw three of the directors: local power-broker attorney Pike Powers, former state comptroller John Sharp, and the newest director, Gary Cadenhead, a senior lecturer in entrepreneurship at UT's McCombs School of Business. They would eventually be joining the Wooleys and the rest of the board: Sarah Weddington, the celebrated lawyer in the landmark Roe v. Wade decision, and, via conference call from the Netherlands, Floor Mouthaan, a longtime board director and businessman.

Once the meeting got underway, the board would consider the first item of business – a restructuring plan that the Wooleys had worked up with a Canadian company, Groupe Le Duff America, a subsidiary of a Paris-based concern that owns several hundred restaurants and bakeries, including about 60 La Madeleine cafes acquired in 2001. Le Duff was proposing a noncontrolled equity investment in the deli chain, and the brothers pitched the plan as a viable option for infusing capital into the company.

But with the Wooleys' fate already sealed, the directors, after hearing a presentation from representatives of the Morgan Keegan & Co. Inc. financial firm, voted to reject the Le Duff deal, and instead moved through the agenda to elect a new board chairman. With that decision, the board effectively removed longtime Wooley ally Floor Mouthaan, and replaced him with Cadenhead, who, it appears now, had been drafted specifically to facilitate the delicate task of deposing the Wooleys.

The vote was 5-0-2, with the Wooleys abstaining. It's clear that even before the vote, the board had already lined up Sam Coats, a former airline executive, to replace Wooley as CEO. The Wooleys' seats on the board remained intact, but they resigned a little over two weeks later after filing a lawsuit against the company to try to recover loans they had made to Schlotzsky's. Meanwhile, with new management in place, Schlotzsky's began positioning itself for bankruptcy, making deep cuts across the board with top-down layoffs, restaurant closures (there are 513 stores operating now, down from 759 in 1999), and the cancellation of several community programs, including its KLRU-TV contract to sponsor Austin City Limits for two seasons through September 2005.

"The sad fact was that we didn't have the money to support ACL in our insolvent financial condition and were already behind on our payments," Coats said. In a lawsuit filed against Schlotzsky's last week, ACL's producer, Capital Sports & Entertainment Inc., claims it's owed $500,000 from the franchiser's advertising and marketing entity, which is not a part of the bankruptcy proceedings. (Yet even as it was cutting back everywhere else, Schlotzsky's agreed, over initial opposition from the Wooleys and other creditors, to pay $90,000 a month to BWK Trinity Capital Securities, a financial investment and consulting firm, to oversee the restructuring.)

On Aug. 3, the company filed for Chapter 11 bankruptcy protection, reporting $71.3 million in liabilities and $111.7 million in assets, with more than half of the latter amount, $64.8 million, tied up in intangible assets that can't readily be converted to cash – such as the value of Schlotzsky's "Funny Name. Serious Sandwich." trademark.


Battle Lines

Generally, when chief executives are ousted from closely watched companies, the dismissal – no matter how embattled internally – is framed for the public as the result of the CEO's desire to spend more time with family. The dethroned chiefs grimly accept their hefty severance packages and fade quietly away, thereby sparing themselves and the company any further embarrassment. But there was no "resignation" from the CEO's position at Schlotzsky's, and certainly no severance packages for the Wooleys; there was no repayment of the $2.5 million loan the brothers had made to the company last year, nor was there even a short-term extension provided on their health insurance plans. Those benefits expired the day they were fired.
John Wooley
John Wooley
Photo By Jana Birchum

And the firings were just the beginning of what has turned into one of the messiest and highly personalized bankruptcies in Austin's corporate history. This shouldn't come as a surprise to anyone familiar with the litigious history of John Wooley. He doesn't go down without a fight, and this was no exception – particularly when he and his brother, as both shareholders and creditors, are owed approximately $5.6 million by the company. But pending the outcome of the restructuring, how much of that sum they may be able to reclaim is uncertain.

As the battle has proceeded over the past year, the Wooleys have moved from the firing line to the firing squad, as they struggle to regain some control of Schlotzsky's future and simultaneously salvage their reputations as businessmen. The company, John Wooley insists, is in worse shape now than it was before the bankruptcy, and he has proposed a debt-to-equity conversion plan that he believes will save Schlotzsky's from ruin. The board-installed new management appears equally determined to eliminate any Wooley control, and they are aware that the brothers are so financially entrenched in the company that any plan they propose would essentially guarantee them sway over Schlotzsky's.

As far as Wooley is concerned, the current financial difficulty leading to the bankruptcy was a temporary cash-liquidity problem that did not warrant seeking cover in bankruptcy court. "We were current on all of our obligations – on the big-purchase buyout [of stores in a large territory], on our leases, our mortgages ... We had stretched accounts payable, yes, but those [creditors] were working with us. We did not have the situation that these guys created," he said. "They immediately defaulted on things. They went down this bankruptcy path because they have some bias. They learned the tricks in the airline industry." Indeed, Coats had learned a thing or two about troubled airlines, most recently in the Nineties, when he was part of a management team that guided Continental Airlines' restructuring.

From their perspective, Wooley and his allies argue that the company could have survived without bankruptcy, that the Chapter 11 process has thrown the product-distribution system off kilter, forcing franchisees to scramble for inventory, and that if the current state of affairs continues, the company will end up having to take whatever lowball offer comes along. Despite that potential risk, the company's new management team is conducting due diligence meetings with several potential investors, who may follow up with final proposals for restructuring the company. In any case, Schlotzsky's must have a plan submitted to the bankruptcy court by December. "My best hope is that we emerge from the bankruptcy and go forward in a positive and constructive way," said director Pike Powers, a point man on the board and the only director to respond to our request for an interview. But he declines to comment on the current polarized state of affairs. "I don't have any ax to grind or cross to bear," he said.

In the meantime, the board has placed its faith in Coats' ability to craft a plan that will pull the company out of its financial hole, without requiring a rapprochement with the former owners. From the board's actions thus far, it's safe to assume that the directors remain bullish on Schlotzsky's and its product – but not on the Wooleys.

But the Wooleys also have one important leveraging tool that could become a weapon of serious warfare: They effectively control the nonprofit advertising and marketing entity, NAMF (now the target of the claim filed by the producers of Austin City Limits), which draws its funding from 1% of the gross sales of franchisees and company-owned stores. For the moment, the company is hamstrung by a complex legal situation: While the fund was established as a nonprofit Schlotzsky's affiliate, the brothers control its board of directors. "The Wooleys' apparent unwillingness to resign is inconsistent with their statements that they are not interested in retaining or securing a management role in the company," Sarah Foster, a company bankruptcy lawyer, wrote in a Sept. 17 letter to the Wooleys' attorney, Joe Martinec. To date, the brothers haven't budged.

The Wooleys did, however, move quickly to sell the Third and Colorado building that houses Schlotzsky's headquarters, effectively severing their landlord relationship with the company. The brothers closed on the down-to-the-wire sale Tuesday morning, shortly before the foreclosure deadline set by Wells Fargo Bank after a missed rent payment. The sale to Austin-based Cypress Real Estate Advisors Inc. included most of Block 19, bounded by Second and Third streets, and Congress Avenue and Colorado, which is home to both Schlotzsky's and the Austin Children's Museum. The package deal also included a corner of Block 28, which houses Sullivan's Steakhouse. The properties were the last of the Wooleys' Downtown holdings. Most Downtown real estate investors believed that the brothers would be able to make a relatively quick sale on the property, given its hot location in the Warehouse District. "Everybody's interested in the property," developer Perry Lorenz said before the sale. "The question is who's going to step up with millions of dollars to pay for it." A Schlotzsky's spokesman said the purchase would not likely have any immediate impact on the company, whose lease extends through December 2006. "It means we would probably have a new landlord," said Anne Braidish. The acquisition is a coup for Cypress, which has been moving toward strengthening its real estate presence Downtown.


Recipes for Disaster

Though two years younger than his brother, John Wooley, 56, is the front man of this lifelong partnership with brother Jeff, a practicing lawyer, who is content to conduct business maneuvers out of the spotlight. Among lawyers and real estate professionals, the Wooleys are known for being super smart, but extremely difficult when it comes time to draw up a contract. "Everything with them has to be so complex," one local real estate investor groaned. "Nothing is easy."

The brotherly business relationship dates back to the Seventies, when the UT law graduates embarked on a roller-coaster run with the flamboyant and equally controversial Gary Bradley, who himself is nearing the end of his own personal bankruptcy tribulations (a judgment in Bradley's bankruptcy trial is expected soon). The young renegades took the plunge into real estate and developed the high-end Rob Roy subdivision in West Austin. Riding on that development's success, Wooley and Bradley began looking around for other businesses and landed on Schlotzsky's, then a 10-year-old company with 100 stores and a single product – the muffuletta-style Original sandwich on a sourdough bun. According to Wooley, the Schlotzsky's founding owners, Don and Delores Dissman, wanted $6 million for the company but eventually settled on less than $3 million after another deal fell through. Bradley and Wooley would part ways not long after that acquisition (see "Original History," p.34).

Schlotzsky's reached its revenue peak in 2001 at $62 million. It was downhill from there. Multiple factors weighed into the decline – 9/11 being the most obvious – but in the case of Schlotzsky's, one-time darling of Austin's public companies, Monday-morning quarterbacking became a popular sport for Wooley fans and foes.

It's impossible to pin the company's troubles on a single factor, and it's also difficult for Wooley to acknowledge his mistakes without blaming other contributors. Critics blame Schlotzsky's decline on the deli's ever-expanding and ever-diversifying menu, but the chain underwent its biggest menu conversion in 1991, expanding the number of choices from six sandwiches to 15 and adding pizzas and salads, long before its recent troubles. As the company's home base, Austin served as the laboratory for new breads – the lifeblood of the restaurants – and other new concepts, such as the new cafe and bakery remodeling initiative. The intent was to better position Schlotzsky's against its rivals – namely Subway, Quiznos, and Panera Bread Co. – all of which had mounted aggressive campaigns across the nation. And in more recent years, the entire fast-food industry had to make serious adjustments to accommodate low-carb, low-fat diets among the successful "fast-casual" competitors like Panera. Each of these factors played a role in the company's recent difficulties.

Sam Coats
Sam Coats
Photo By Jana Birchum

That said, those familiar with the industry cite two specific multimillion dollar money pits that Wooley should have avoided:

  • In 1999, when times were still flush, Schlotzsky's decided to repurchase restaurant development rights from a Dallas partnership, NS Associates I, Ltd., sticking the company with a $28 million note it couldn't afford. Wooley calls it "our biggest mistake – and I'll say ours because we were all in it together ... The market was ramping up and we believed we had the long-term financing so it would pay for itself. We bought at the top of the market, but when it came time to close the financing in 2002 the trend had gone negative, so the financing that we thought we had just kept slipping away. That was the big mistake that made us financially vulnerable."

  • Between 1994 and mid-2000, the company introduced a "turnkey" program, a fairly common industry practice of financing and building the franchisees' stores to streamline and shorten the process, and then literally turning the key over to the new operators, with the idea being that the franchisees would be successful. Wooley disputes critics' assessment that the program was a financial failure, and points out that it was outlined in the company's IPO documents and vetted with the board and the investment bankers underwriting the offering. But he estimated that of the 90 cases in which Schlotzsky's gave a limited guarantee on the franchisee's lease or mortgage, 30 proved financially unstable, prompting the company to take control of those stores. "It showed a loss on the books, but the cash drain was less than simply paying the guarantee and closing the store," he said. The program was halted in 2000. "It was too much like loaning money to a friend or relative," said Wooley, "as it was too easy for them to come and ask for a favor. The franchisees never treated the company with the respect they would a bank."

    As franchisees go, Don Stitt, who owns four stores in Amarillo, is one of Schlotzsky's success stories. Unlike other franchise owners, Stitt said he "followed and embraced" the remodeling and upgrades that Schlotzsky's instituted so he could stay competitive in the market. While the company's financial pinch did not necessarily affect his business, he says the bankruptcy has caused a series of "inconveniences" with vendors. "I spent all day yesterday looking for inventory that is no longer available," he said. Had the new management asked his opinion, Stitt, who is also a shareholder, said he would not have supported the bankruptcy. That's not to say there weren't problems. "I am looking for change and I'm supportive of that process, but I am not an unhappy franchisee," he said. "And I would support the elimination of some management team members, but not John [Wooley]. John and I worked very well together."

    Still, Stitt allowed that Wooley "should have made some aggressive moves earlier in the game. I think he could have done some things that would not have motivated the board to terminate him. But what I was most surprised about though was, through this whole process, there wasn't a shareholders meeting before it happened." (With some elbowing from the Securities and Exchange Commission, the company has since scheduled its annual meeting for Dec. 9.)


    Enter the Chainsaw

    Sam Coats is a 63-year-old lawyer who has spent much of his career in the turbulent airline industry, starting with the long-forgotten Texas International Airlines. Eventually he found himself on the corporate turnaround circuit. One early rescue mission he went on was at Braniff Airways, where as vice president for domestic and international affairs, Coats spent his days fielding hundreds of media calls about the company's slow death spiral. In 1982, he hopped aboard an up-and-coming Southwest Airlines, at the time a little regional carrier out of Dallas. In addition to his stint at Continental, he also made his way to Australia to help start an airline company. Coats' checkerboard career history spans several pages, including one term as a state legislator in the early Seventies. As at other companies, Coats' tenure at Schlotzsky's is strictly short-term, for a salary of $360,000 a year, and then he'll head back home to Dallas and probably to another company in trouble.

    Corporate turnaround artists are considered a special breed, for good or ill, who can make the kind of slash-and-burn decisions that generate a high body count. Coats' small build and soft Texas drawl don't evoke that chainsaw-style reputation, but one of Coats' first orders of business at Schlotzsky's was to do just that, starting at the top. One round of cuts took out 19 people in management, and only those willing to sign a confidentiality agreement were given either a one-week or two-week severance check. "We all knew that it was coming, because we knew that Sam had to do something fairly quickly to cut cash flow," recalled one former employee. Coats called a company meeting and delivered the bad news. "He told us that 19 of us were going to lose our jobs and that they were all real sorry, and that when we go back to our offices 19 people would have an envelope in their chairs." When the meeting dispersed, staffers scurried around the building to find out "who got the envelopes." In the next round of cuts, the ex-employee said, "they just sent people around to tell people they were fired."

    For companies in distress, layoffs are of course inevitable, and Coats says he suffers along with everyone else. "It's not fun to have to eliminate positions. I've never been able to do it without getting sick to my stomach," he said. "It's not fun to have to close restaurants and cut expenses, but some of the things were necessary in order to stop the bleeding ... The fact is that the company lost almost $12 million last year, and that's a lot of debt for a company this size. It had a lot of claims that were being asserted that were increasingly difficult to manage outside of the bankruptcy court."

    And when it's time to leave, Coats said, no one will need to kick him out the door. "Whoever wants to put the money into restructuring Schlotzsky's and help it get back on its feet doesn't have to worry about having to blast me out of the chair I'm in now," he said. "They don't have to worry about entrenched management. I'm not Michael Eisner, I'm not trying to perpetuate myself in this job for an indefinite period of time."

    By contrast, it's no surprise that Wooley has injected himself into the middle of the bankruptcy, and he makes no secret about his motives. He wants what is owed him and his brother, and he says he has a debt-to-equity conversion plan that would salvage the company and provide 100 cents on the dollar for creditors. He has presented the plan both to the board and a committee of creditors organized in the wake of the bankruptcy filing, thus far without visible success. That's understandable, given the ongoing tension between the ex-CEO and the company's new management, which by law has the first crack at proposing and confirming a plan of its own. Right now, the company is weighing its options in meetings with prospective bidders. The creditors' committee – representing a cross-section of various stakeholders – also carries considerable weight in the decision, and expects to be reviewing some firm proposals by midmonth. All Wooley can do in the meantime is wait and see what sort of proposed sale or restructuring plan the company will bring forward.

    But he's not going away.

    "I'm not surprised by that," said Berry Spears, a Winstead Sechrest & Minick attorney who represents the creditors' committee. "That's what many entrepreneurs are prone to do. This company has been his baby for [more than] 20 years, and it's not surprising that he would think that he knows the direction the company should go, but ... he's had his chance in a sense and failed." That's not to say Wooley should be kept out of the process, he added. "In a way I think it adds a healthy dynamic and discussion to the process, but we don't know yet whether he really has the answer."

    Wooley's termination has not exactly closed the book on the brothers' 23-year history with the sandwich chain. The shock of getting turned out of the company – his baby – has not quite worn off. "I thought they would come to me informally and say, look, this is what we're thinking, either get your Le Duff deal together by XYZ date, or else," Wooley said. "I was surprised that they would fire us without wanting to know anything about the company." Soon the recently remarried Wooley will be welcoming an altogether different baby into his life – his first child. He and his wife, Ianthe Brock, are expecting a girl in December. Apart from the bankruptcy, there is one other unknown that Wooley constantly wrestles with in classic entrepreneurial fashion. "I need to figure out what I want to do next," he said not long ago, taking a break from yard work on a weekday afternoon. "I need to do something." end story

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    KEYWORDS FOR THIS STORY

    bankruptcy, John Wooley, Jeff Wooley, Sam Coats, Schlotzsky's Inc., Pike Powers, John Sharp, Sarah Weddington, Gary Cadenhead, Sarah Foster, Berry Spears, Joe Martinec, Joseph Beard, Floor Mouthaan, Groupe Le Duff America, Gary Bradley, Don Stitt, Morgan Keegan & Co. Inc.

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