**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

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**FORM 10-Q**

**(MarkOne)**
| **x** | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|------------|---------------------------------------------------------------------------------------------------|

 

**For thequarterly period ended July 2, 2006**

**OR**
| **o** | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|------------|----------------------------------------------------------------------------------------------------|

 

**For the transition period from *            * to*         ***

*** ***

**Commission File No. 001-13579**

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**FRIENDLY ICE CREAM CORPORATION**

(Exact Name of Registrantas Specified in Its Charter)
| **Massachusetts**                                                                   | **04-2053130**                     |
|-------------------------------------------------------------------------------------|------------------------------------|
| (State or Other  Jurisdiction of  Incorporation or Organization)                    | (IRS Employer  Identification No.) |
|                                                                                |                               |
| **1855  Boston Road  Wilbraham, Massachusetts**                                     | **01095**                          |
| (Address of  Principal Executive Offices)                                           | (Zip Code)                         |
|                                                                                |                               |
| **(413)  731-4000**                                                                 |
| (Registrant’s  Telephone Number, Including Area Code)                          |
|                                                                                |                               |
| **Not  Applicable**                                                                 |
| (Former name,  former address and former fiscal year, if changed since last report) |

 

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.  Yes x   No o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer andlarge accelerated filer” in Rule 12b-2 of the Exchange Act.

Large AcceleratedFiler   o               AcceleratedFiler   x               Non-AcceleratedFiler   o

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o   No x

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock as of the latest practicable date.
| Class                         | ** ** | **Outstanding at July 28, 2006** |
|-------------------------------|------------|----------------------------------|
|                          |       |                             |
| Common Stock,  $.01 par value |       | 7,924,758 shares                 |

 

 

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**PART I — FINANCIAL INFORMATION**

**Item1.  Financial Statements**

**FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCESHEETS**(Unaudited)(In thousands)
| ** **                                                                | ** ** | **July 2,** | ** ** | **January 1,** | ** ** |
|---------------------------------------------------------------------------|------------|------------------|------------|---------------------|------------|
| ** **                                                                | ** ** | **2006**         | ** ** | **2006**            | ** ** |
|                                                                      |       |             |       |                |       |
| ASSETS                                                                    |       |             |       |                |       |
| CURRENT ASSETS:                                                           |       |             |       |                |       |
| Cash and cash equivalents                                                 |       | $                | 24,373     |                | $          | 14,597 |   |
| Restricted cash                                                           |       | 393              |       | 2,549               |       |
| Accounts receivable, net                                                  |       | 18,976           |       | 10,757              |       |
| Inventories                                                               |       | 16,916           |       | 15,775              |       |
| Assets held for sale                                                      |       | 1,119            |       | 1,157               |       |
| Prepaid expenses and other current assets                                 |       | 4,277            |       | 5,044               |       |
| TOTAL CURRENT  ASSETS                                                     |       | 66,054           |       | 49,879              |       |
| PROPERTY AND  EQUIPMENT, net of accumulated depreciation and amortization |       | 137,017          |       | 143,290             |       |
| INTANGIBLE  ASSETS AND DEFERRED COSTS, net of accumulated amortization    |       | 18,230           |       | 19,063              |       |
| OTHER ASSETS                                                              |       | 1,703            |       | 6,010               |       |
| TOTAL ASSETS                                                              |       | $                | 223,004    |                | $          | 218,242 |   |
|                                                                      |       |             |       |                |       |
| LIABILITIES AND  STOCKHOLDERS’ DEFICIT                               |       |             |       |                |       |
| CURRENT LIABILITIES:                                                      |       |             |       |                |       |
| Current maturities of long-term debt                                      |       | $                | 1,531      |                | $          | 1,426 |   |
| Current maturities of capital lease and finance  obligations              |       | 1,428            |       | 1,419               |       |
| Accounts payable                                                          |       | 23,938           |       | 24,968              |       |
| Accrued salaries and benefits                                             |       | 9,877            |       | 8,212               |       |
| Accrued interest payable                                                  |       | 1,353            |       | 1,324               |       |
| Insurance reserves                                                        |       | 11,082           |       | 9,002               |       |
| Restructuring reserves                                                    |       | —           |       | 72                  |       |
| Other accrued expenses                                                    |       | 20,446           |       | 19,866              |       |
| TOTAL CURRENT  LIABILITIES                                                |       | 69,655           |       | 66,289              |       |
| CAPITAL LEASE  AND FINANCE OBLIGATIONS, less current maturities           |       | 5,436            |       | 6,173               |       |
| LONG-TERM DEBT,  less current maturities                                  |       | 224,101          |       | 224,894             |       |
| ACCRUED PENSION  COST                                                     |       | 29,682           |       | 28,904              |       |
| OTHER LONG-TERM  LIABILITIES                                              |       | 32,864           |       | 33,820              |       |
| COMMITMENTS AND  CONTINGENCIES                                            |       |             |       |                |       |
| STOCKHOLDERS’ DEFICIT:                                               |       |             |       |                |       |
| Common stock                                                              |       | 79               |       | 79                  |       |
| Additional paid-in capital                                                |       | 144,940          |       | 144,675             |       |
| Accumulated other comprehensive loss                                      |       | (31,785          | )          | (31,785             | )          |
| Accumulated deficit                                                       |       | (251,968         | )          | (254,807            | )          |
| TOTAL  STOCKHOLDERS’ DEFICIT                                         |       | (138,734         | )          | (141,838            | )          |
| TOTAL LIABILITIES AND  STOCKHOLDERS’ DEFICIT                         |       | $                | 223,004    |                | $          | 218,242 |   |

 

Theaccompanying notes are an integral part of these condensed consolidatedfinancial statements.

 

1

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**FRIENDLY ICE CREAMCORPORATION AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**(Unaudited)(In thousands, except per share data)
| ** **                                                                                                                                                                                                                                                       | ** ** | **For the Three Months Ended** | ** ** | **For the Six Months Ended** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                                                                                                                                                                                       | ** ** | **July 2,**                                   | ** ** | **July 3,**                                 | ** ** | **July 2,** | ** ** | **July 3,** | ** ** |
| ** **                                                                                                                                                                                                                                                       | ** ** | **2006**                                           | ** ** | **2005**                                         | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                                                                                                                                                                                                             |       |                                               |       |                                             |       |   |   |   |   |
| REVENUES:                                                                                                                                                                                                                                                        |       |                                               |       |                                             |       |   |   |   |   |
| Restaurant                                                                                                                                                                                                                                                       |       | $                                                  | 105,271    |                                             | $          | 109,469 |   | $ | 200,547 |   | $ | 202,576 |   |
| Foodservice                                                                                                                                                                                                                                                      |       | 32,137                                             |       | 31,748                                           |       | 59,031 |   | 57,054 |   |
| Franchise                                                                                                                                                                                                                                                        |       | 4,082                                              |       | 3,876                                            |       | 7,627 |   | 7,126 |   |
| TOTAL REVENUES                                                                                                                                                                                                                                                   |       | 141,490                                            |       | 145,093                                          |       | 267,205 |   | 266,756 |   |
|                                                                                                                                                                                                                                                             |       |                                               |       |                                             |       |   |   |   |   |
| COSTS AND EXPENSES:                                                                                                                                                                                                                                              |       |                                               |       |                                             |       |   |   |   |   |
| Cost of sales                                                                                                                                                                                                                                                    |       | 51,939                                             |       | 54,585                                           |       | 100,324 |   | 101,474 |   |
| Labor and benefits                                                                                                                                                                                                                                               |       | 36,943                                             |       | 38,476                                           |       | 72,955 |   | 73,560 |   |
| Operating expenses                                                                                                                                                                                                                                               |       | 26,816                                             |       | 27,488                                           |       | 50,815 |   | 50,889 |   |
| General and administrative expenses                                                                                                                                                                                                                              |       | 11,449                                             |       | 10,528                                           |       | 22,546 |   | 19,977 |   |
| Write-downs of property and equipment                                                                                                                                                                                                                            |       | —                                             |       | 289                                              |       | 215 |   | 289 |   |
| Depreciation and amortization                                                                                                                                                                                                                                    |       | 5,740                                              |       | 5,632                                            |       | 11,520 |   | 11,783 |   |
| Gain on  franchise sales of restaurant operations and properties                                                                                                                                                                                                 |       | (1,145                                             | )          | (1,219                                           | )          | (2,011 | ) | (2,528 | ) |
| Loss on  disposals of other property and equipment, net                                                                                                                                                                                                          |       | 366                                                |       | 273                                              |       | 475 |   | 342 |   |
|                                                                                                                                                                                                                                                             |       |                                               |       |                                             |       |   |   |   |   |
| OPERATING INCOME                                                                                                                                                                                                                                                 |       | 9,382                                              |       | 9,041                                            |       | 10,366 |   | 10,970 |   |
|                                                                                                                                                                                                                                                             |       |                                               |       |                                             |       |   |   |   |   |
| Interest  expense, net                                                                                                                                                                                                                                           |       | 5,147                                              |       | 5,229                                            |       | 10,567 |   | 10,515 |   |
|                                                                                                                                                                                                                                                             |       |                                               |       |                                             |       |   |   |   |   |
| INCOME (LOSS)  FROM CONTINUING OPERATIONS BEFORE PROVISION FOR INCOME TAXES                                                                                                                                                                                      |       | 4,235                                              |       | 3,812                                            |       | (201 | ) | 455 |   |
|                                                                                                                                                                                                                                                             |       |                                               |       |                                             |       |   |   |   |   |
| Provision for  income taxes                                                                                                                                                                                                                                      |       | (250                                               | )          | (1,163                                           | )          | (250 | ) | (424 | ) |
|                                                                                                                                                                                                                                                             |       |                                               |       |                                             |       |   |   |   |   |
| INCOME (LOSS)  FROM CONTINUING OPERATIONS                                                                                                                                                                                                                        |       | 3,985                                              |       | 2,649                                            |       | (451 | ) | 31 |   |
|                                                                                                                                                                                                                                                             |       |                                               |       |                                             |       |   |   |   |   |
| INCOME (LOSS)  FROM DISCONTINUED OPERATIONS, net of income tax effect of ($450) and $91 for  the three months ended July 2, 2006 and July 3, 2005, respectively, and  ($450) and $347 for the six months ended July 2, 2006 and July 3, 2005,  respectively |       | 674                                                |       | (132                                             | )          | 3,290 |   | (500 | ) |
|                                                                                                                                                                                                                                                             |       |                                               |       |                                             |       |   |   |   |   |
| NET INCOME  (LOSS)                                                                                                                                                                                                                                               |       | $                                                  | 4,659      |                                             | $          | 2,517 |   | $ | 2,839 |   | $ | (469 | ) |
|                                                                                                                                                                                                                                                             |       |                                               |       |                                             |       |   |   |   |   |
| BASIC NET INCOME (LOSS)  PER SHARE:                                                                                                                                                                                                                              |       |                                               |       |                                             |       |   |   |   |   |
| Income (loss) from continuing operations                                                                                                                                                                                                                         |       | $                                                  | 0.50       |                                             | $          | 0.34 |   | $ | (0.06 | ) | $ | — |   |
| Income (loss) from discontinued operations                                                                                                                                                                                                                       |       | 0.09                                               |       | (0.02                                            | )          | 0.42 |   | (0.06 | ) |
| Net income (loss)                                                                                                                                                                                                                                                |       | $                                                  | 0.59       |                                             | $          | 0.32 |   | $ | 0.36 |   | $ | (0.06 | ) |
|                                                                                                                                                                                                                                                             |       |                                               |       |                                             |       |   |   |   |   |
| DILUTED NET INCOME  (LOSS) PER SHARE:                                                                                                                                                                                                                            |       |                                               |       |                                             |       |   |   |   |   |
| Income (loss) from continuing operations                                                                                                                                                                                                                         |       | $                                                  | 0.50       |                                             | $          | 0.34 |   | $ | (0.06 | ) | $ | — |   |
| Income (loss) from discontinued operations                                                                                                                                                                                                                       |       | 0.08                                               |       | (0.02                                            | )          | 0.41 |   | (0.06 | ) |
| Net income (loss)                                                                                                                                                                                                                                                |       | $                                                  | 0.58       |                                             | $          | 0.32 |   | $ | 0.35 |   | $ | (0.06 | ) |
|                                                                                                                                                                                                                                                             |       |                                               |       |                                             |       |   |   |   |   |
| WEIGHTED AVERAGE  SHARES:                                                                                                                                                                                                                                        |       |                                               |       |                                             |       |   |   |   |   |
| Basic                                                                                                                                                                                                                                                            |       | 7,913                                              |       | 7,753                                            |       | 7,907 |   | 7,735 |   |
| Diluted                                                                                                                                                                                                                                                          |       | 8,044                                              |       | 7,893                                            |       | 8,048 |   | 7,735 |   |

 

Theaccompanying notes are an integral part of these condensed consolidatedfinancial statements.

 

2

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** **

**FRIENDLY ICE CREAMCORPORATION AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**(Unaudited)(In thousands)
| ** **                                                                                | ** ** | **For the Six Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                | ** ** | **July 2,**                                 | ** ** | **July 3,** | ** ** |
| ** **                                                                                | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                    |       |                                             |       |   |   |
| Net income (loss)                                                                         |       | $                                                | 2,839      |   | $ | (469 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by operating activities: |       |                                             |       |   |   |
| Stock compensation expense                                                                |       | 200                                              |       | 68 |   |
| Depreciation and amortization                                                             |       | 11,520                                           |       | 11,783 |   |
| Noncash (income) loss from discontinued operations                                        |       | (4,068                                           | )          | 376 |   |
| Write-downs of property and equipment                                                     |       | 215                                              |       | 289 |   |
| Deferred income tax benefit                                                               |       | —                                           |       | (98 | ) |
| Gain on disposals of other property and equipment,  net                                   |       | (1,551                                           | )          | (2,192 | ) |
| Changes in  operating assets and liabilities:                                             |       |                                             |       |   |   |
| Accounts receivable                                                                       |       | (8,219                                           | )          | (4,233 | ) |
| Inventories                                                                               |       | (1,141                                           | )          | 1,269 |   |
| Other assets                                                                              |       | 7,230                                            |       | (1,201 | ) |
| Accounts payable                                                                          |       | (1,030                                           | )          | 2,464 |   |
| Accrued expenses and other long-term liabilities                                          |       | 4,104                                            |       | 3,234 |   |
| NET CASH  PROVIDED BY OPERATING ACTIVITIES                                                |       | 10,099                                           |       | 11,290 |   |
|                                                                                      |       |                                             |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                    |       |                                             |       |   |   |
| Purchases of property and equipment                                                       |       | (7,967                                           | )          | (7,309 | ) |
| Proceeds from sales of property and equipment                                             |       | 9,200                                            |       | 3,359 |   |
| Purchases of marketable securities                                                        |       | —                                           |       | (345 | ) |
| Proceeds from sales of marketable securities                                              |       | —                                           |       | 143 |   |
| NET CASH  PROVIDED BY (USED IN) INVESTING ACTIVITIES                                      |       | 1,233                                            |       | (4,152 | ) |
|                                                                                      |       |                                             |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                    |       |                                             |       |   |   |
| Proceeds from borrowings under revolving credit  facility                                 |       | 8,000                                            |       | 16,250 |   |
| Repayments of debt                                                                        |       | (8,688                                           | )          | (20,964 | ) |
| Payments of deferred financing costs                                                      |       | (205                                             | )          | (11 | ) |
| Principal payments of capital lease and finance  obligations                              |       | (728                                             | )          | (763 | ) |
| Stock options exercised                                                                   |       | 65                                               |       | 330 |   |
| NET CASH USED IN FINANCING ACTIVITIES                                                     |       | (1,556                                           | )          | (5,158 | ) |
|                                                                                      |       |                                             |       |   |   |
| NET INCREASE IN  CASH AND CASH EQUIVALENTS                                                |       | 9,776                                            |       | 1,980 |   |
|                                                                                      |       |                                             |       |   |   |
| CASH AND CASH  EQUIVALENTS, BEGINNING OF PERIOD                                           |       | 14,597                                           |       | 13,405 |   |
|                                                                                      |       |                                             |       |   |   |
| CASH AND CASH  EQUIVALENTS, END OF PERIOD                                                 |       | $                                                | 24,373     |   | $ | 15,385 |   |
|                                                                                      |       |                                             |       |   |   |
| SUPPLEMENTAL  DISCLOSURES:                                                                |       |                                             |       |   |   |
| Cash paid (refunded)  during the period for:                                              |       |                                             |       |   |   |
| Interest                                                                                  |       | $                                                | 10,138     |   | $ | 10,275 |   |
| Income taxes                                                                              |       | (287                                             | )          | 50 |   |

 

Theaccompanying notes are an integral part of these condensed consolidatedfinancial statements.

3

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**FRIENDLY ICE CREAMCORPORATION AND SUBSIDIARIES**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

(Unaudited)

**1.      NATURE OF OPERATIONS**

As of July 2, 2006,Friendly’s operated 309 full-service restaurants and franchised 210full-service restaurants and seven non-traditional units. The Companymanufactures and distributes a full line of premium ice cream dessert products.These products are distributed to Friendly’s restaurants, supermarkets andother retail locations in 13 states. The restaurants offer a wide variety ofbreakfast, lunch and dinner menu items as well as premium ice cream dessertproducts.

Referencesherein to “Friendly’s” or the “Company” refer to Friendly Ice CreamCorporation, its predecessor and its consolidated subsidiaries; references hereinto “FICC” refer to Friendly Ice Cream Corporation and not its subsidiaries; andas used herein, “Northeast” refers to the Company’s core markets, which includeConnecticut, Maine, Massachusetts, New Hampshire, New Jersey, New York,Pennsylvania, Rhode Island and Vermont.

Followingis a summary of the Company-operated and franchised units:

|                        | ** ** | **For the Three Months Ended** | ** ** | **For the Six Months Ended** | ** ** |
|------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **             | ** ** | **July 2,**               | ** ** | **July 3,**             | ** ** | **July 2,** | ** ** | **July 3,** | ** ** |
| ** **             | ** ** | **2006**                       | ** ** | **2005**                     | ** ** | **2006** | ** ** | **2005** | ** ** |
| Company Units:         |       |                           |       |                         |       |   |   |   |   |
| Beginning of  period   |       | 312                            |       | 337                          |       | 314 |   | 347 |   |
| Openings               |       | 1                              |       | 1                            |       | 2 |   | 1 |   |
| Refranchised  closings |       | (3                             | )          | (3                           | )          | (4 | ) | (10 | ) |
| Closings               |       | (1                             | )          | (3                           | )          | (3 | ) | (6 | ) |
| End of period          |       | 309                            |       | 332                          |       | 309 |   | 332 |   |
|                   |       |                           |       |                         |       |   |   |   |   |
| Franchised Units:      |       |                           |       |                         |       |   |   |   |   |
| Beginning of  period   |       | 214                            |       | 201                          |       | 213 |   | 195 |   |
| Refranchised  openings |       | 3                              |       | 3                            |       | 4 |   | 10 |   |
| Openings               |       | 1                              |       | 1                            |       | 1 |   | 2 |   |
| Closings               |       | (1                             | )          | —                       |       | (1 | ) | (2 | ) |
| End of period          |       | 217                            |       | 205                          |       | 217 |   | 205 |   |

 

**2.      BASIS OF PRESENTATION AND SIGNIFICANTACCOUNTING POLICIES**

*InterimFinancial Information —*

The accompanyingcondensed consolidated financial statements as of July 2, 2006 and for thethree and six months ended July 2, 2006 and July 3, 2005 are unaudited, buthave been prepared in accordance with generally accepted accounting principles(“GAAP”) for interim financial information and with the instructions to Form10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotesrequired by GAAP for complete financial statements.  In the opinion of management, all adjustmentswhich are necessary for a fair presentation of the consolidated financialposition, results of operations, cash flows and comprehensive income (loss) ofthe Company have been included. Such adjustments consist solely of normalrecurring accruals. Operating results for the three and six month periods endedJuly 2, 2006 and July 3, 2005 are not necessarily indicative of the resultsthat may be expected for the entire year due, in part, to the seasonality ofthe Company’s business. Historically, higher revenues and operating income havebeen experienced during the second and third fiscal quarters. The Company’sconsolidated financial statements, including the notes thereto, which arecontained in the 2005 Annual Report on Form 10-K for the fiscal year endedJanuary 1, 2006 (“2005 Annual Report on Form 10-K”) should be read inconjunction with these condensed, consolidated financial statements.Capitalized terms not otherwise defined herein should be referenced to the 2005Annual Report on Form 10-K.

4

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*Use ofEstimates in the Preparation of Financial Statements —*

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities and thedisclosure of contingent assets and liabilities at the dates of the financialstatements and the reported amounts of revenues and expenses during thereporting periods. The critical accounting policies and most significantestimates and assumptions relate to revenue recognition, insurance reserves,recoverability of accounts receivable, pension and post-retirement medical andlife insurance benefits expense, asset impairment analysis, stock compensationexpense and income tax valuation allowances and tax contingency reserves.Actual amounts could differ significantly from the estimates.

*Inventories —*

Inventories are stated at thelower of first-in, first-out cost or market and consisted of thefollowing at July 2, 2006 and January 1, 2006 (in thousands):

|                  | ** ** | **July 2,** | ** ** | **January 1,** | ** ** |
|------------------|------------|-------------|------------|----------------|------------|
| ** **       | ** ** | **2006**    | ** ** | **2006**       | ** ** |
| Raw materials    |       | $           | 1,494      |           | $          | 1,657 |   |
| Goods in process |       | 203         |       | 106            |       |
| Finished goods   |       | 15,219      |       | 14,012         |       |
| Total            |       | $           | 16,916     |           | $          | 15,775 |   |

 

*Other Accrued Expenses —*

Other accrued expensesconsisted of the following at July 2, 2006 and January 1, 2006 (in thousands):

|                                    | ** ** | **July 2,** | ** ** | **January 1,** | ** ** |
|------------------------------------|------------|-------------|------------|----------------|------------|
| ** **                         | ** ** | **2006**    | ** ** | **2006**       | ** ** |
| Accrued rent                       |       | $           | 4,748      |           | $          | 4,739 |   |
| Accrued meals  and other taxes     |       | 2,558       |       | 2,219          |       |
| Gift cards  outstanding            |       | 2,515       |       | 4,280          |       |
| Accrued  construction costs        |       | 2,203       |       | 1,335          |       |
| Income taxes  payable              |       | 1,998       |       | 2,761          |       |
| Accrued  advertising               |       | 1,578       |       | 1,211          |       |
| Accrued bonus                      |       | 1,377       |       | 58             |       |
| Unearned  revenues                 |       | 1,157       |       | 1,205          |       |
| Current portion  of deferred gains |       | 638         |       | 638            |       |
| All other                          |       | 1,674       |       | 1,420          |       |
| Total                              |       | $           | 20,446     |           | $          | 19,866 |   |

 

5

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*Income Taxes—*

The Company accounts forincome taxes in accordance with Statement of Financial Accounting Standards (“SFAS”)No. 109, “Accounting for Income Taxes,” which requires recognition of deferredtax assets and liabilities for the expected future tax consequences of eventsthat have been included in the financial statements or tax returns. The Companyrecords deferred tax assets to the extent it believes there will be sufficientfuture taxable income to utilize those assets prior to their expiration. To theextent deferred tax assets may be unable to be utilized, the Company records avaluation allowance against the potentially unrealizable amount and records acharge against earnings.  The calculationof the Company’s tax liabilities involves uncertainties in the application ofcomplex tax regulations in several different tax jurisdictions. The Company isperiodically reviewed by tax authorities. These reviews include questionsregarding the timing and amount of deductions. In evaluating the exposureassociated with various filing positions, the Company records estimatedreserves for probable exposures.

Due to ever-changing taxlaws and income tax rates, significant judgment is required to estimate theeffective tax rate expected to apply to tax differences that are expected toreverse in the future. The Company must also make estimates about thesufficiency of taxable income in future periods to offset any deductionsrelated to deferred tax assets currently recorded. Accordingly, the Companybelieves estimates related to income taxes are critical.

Duringthe fourth quarter of 2005, the Company entered a three-year cumulative lossposition and revised its projections of the amount and timing of profitabilityin future periods.  As a result, theCompany increased the valuation allowance during the fourth quarter of 2005 byapproximately $26.7 million ($22.2 million to income tax expense and $4.5 millionto stockholders’ deficit) to reduce the carrying value of deferred tax assetsto zero.  The Company expects to record afull valuation allowance on tax benefits until it can sustain an appropriatelevel of profitability.

*Lease Guarantees and Contingencies —*

Primarily as a result ofthe Company’s re-franchising efforts, the Company remains liable for certainlease assignments and guarantees. These leases have varying terms, the latestof which expires in 2020. As of July 2, 2006, the potential amount ofundiscounted payments the Company could be required to make in the event ofnon-payment by the primary lessees was $7,588,000. The present value of thesepotential payments discounted at the Company’s pre-tax cost of debt at July 2,2006 was $5,753,000. The Company generally has cross-default provisions withfranchisees that would put them in default of their franchise agreement in theevent of non-payment under the lease. The Company believes these cross-defaultprovisions significantly reduce the risk that the Company will be required tomake payments under these leases and, historically, the Company has not beenrequired to make such payments. However, as of July 2, 2006, the Companybelieves that one franchisee may be unable to fulfill its lease obligationsduring 2006. Under the terms of the assignment of the leases to thisfranchisee, the Company has the right to recover possession of the premisesbefore lease default. The Company believes that it has the management resourcesto assume operation of the restaurants if it were to take back possession ofthis franchisee’s locations. Accordingly, no liability has been recorded forexposure under such leases at July 2, 2006 and January 1, 2006.

6

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*Net Income (Loss) Per Share —*

Basicnet income (loss) per share is calculated by dividing net income (loss) by theweighted average number of common shares outstanding during the period. Dilutednet income (loss) per share is calculated by dividing net income (loss) by theweighted average number of shares of common stock and common stock equivalentsoutstanding during the period. Common stock equivalents are dilutive stockoptions and warrants that are assumed exercised for calculation purposes. Thenumber of common stock options which could dilute basic earnings per share inthe future, that were not included in the computation of diluted earnings pershare because to do so would have been antidilutive, was 274,158 and 129,817for the three months ended July 2, 2006 and July 3, 2005, respectively.  The number of common stock options whichcould dilute basic earnings per share in the future, that were not included inthe computation of diluted earnings per share because to do so would have beenantidilutive, was 274,158 and 284,651 for the six months ended July 2, 2006 andJuly 3, 2005, respectively.

Presented below is the reconciliation between basicand diluted weighted average shares for the three and six months ended July 2,2006 and July 3, 2005 (in thousands):
| ** **                                                              | ** ** | **For the Three Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                              | ** ** | **Basic**                      | ** ** | **Diluted** | ** ** |
| ** **                                                              | ** ** | **July 2,**               | ** ** | **July 3,** | ** ** | **July 2,** | ** ** | **July 3,** | ** ** |
| ** **                                                              | ** ** | **2006**                       | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| Weighted average  number of common shares outstanding during the period |       | 7,913                          |       | 7,753 |   | 7,913 |   | 7,753 |   |
| Adjustments:                                                            |       |                           |       |   |   |   |   |   |   |
| Assumed exercise  of stock options                                      |       | —                         |       | — |   | 131 |   | 140 |   |
| Weighted average number  of shares outstanding                          |       | 7,913                          |       | 7,753 |   | 8,044 |   | 7,893 |   |

 
| ** **                                                              | ** ** | **For the Six Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                              | ** ** | **Basic**                    | ** ** | **Diluted** | ** ** |
| ** **                                                              | ** ** | **July 2,**             | ** ** | **July 3,** | ** ** | **July 2,** | ** ** | **July 3,** | ** ** |
| ** **                                                              | ** ** | **2006**                     | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| Weighted average  number of common shares outstanding during the period |       | 7,907                        |       | 7,735 |   | 7,907 |   | 7,735 |   |
| Adjustments:                                                            |       |                         |       |   |   |   |   |   |   |
| Assumed exercise  of stock options                                      |       | —                       |       | — |   | 141 |   | — |   |
| Weighted average number  of shares outstanding                          |       | 7,907                        |       | 7,735 |   | 8,048 |   | 7,735 |   |

 

7

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*Stock-Based Compensation —*

Prior to January 2,2006, the Company accounted for stock-based compensation for employeesunder Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for StockIssued to Employees,” and related interpretations.  The Company had adopted the disclosure-onlyprovisions of SFAS No. 123, “Accountingfor Stock-Based Compensation” and the disclosures required by SFAS No. 148, “Accounting for Stock-Based Compensation—Transition andDisclosure.”  In accordance withAPB Opinion No. 25, the Company generally recognized no stock-based compensation cost, as all options granted during that periodhad an exercise price equal to the market value of the stock on the date ofgrant. Stock-based compensation cost of $68,000 related to modified optionawards was included in net loss for the six months ended July 3, 2005, for theCompany’s 1997 Stock Option Plan and the Company’s 2003 Equity Incentive Plan.

OnDecember 16, 2004, the Financial Accounting Standards Board (“FASB”) issuedSFAS No. 123 (revised 2004), “Share-BasedPayment”**(“SFAS No. 123R”).SFAS No. 123R supersedes APB Opinion No. 25 and amends SFAS No. 95, “Statement of Cash Flows.” Generally,the approach in SFAS No. 123R is similar to the approach described in SFAS No.123. However, SFAS No. 123R requires all share-based payments to employees,including grants of employee stock options, to be recognized in the incomestatement based on their fair values at the date of grant. Pro forma disclosureis no longer an alternative.

OnJanuary 2, 2006 (the first day of its 2006 fiscal year), the Company adoptedSFAS No. 123R using the modified prospective method as permitted under SFAS No.123R. Under this transition method, compensation cost recognized in the sixmonths ended July 2, 2006 included: (a) compensation cost for allshare-based payments granted prior to but not yet vested as of January 1, 2006,based on the grant-date fair value estimated in accordance with the provisionsof SFAS No. 123, and (b) compensation cost for all share-based payments grantedsubsequent to January 1, 2006, based on the grant-date fair value estimated inaccordance with the provisions of SFAS No. 123R. In accordance with themodified prospective method of adoption, the Company’s results of operationsand financial position for prior periods have not been restated.

*Recently Issued Accounting Pronouncements —*

InJuly 2006, the FASB issued FASB Interpretation No. 48, “Accounting forUncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (“FIN48”), which clarifies the accounting for uncertainty in tax positions. FIN 48requires that the Company recognize in its financial statements the impact of atax position, if that position is more likely than not of being sustained onaudit based on the technical merits of the position. The provisions of FIN 48are effective as of the beginning of the Company’s 2007 fiscal year, with thecumulative effect of the change in accounting principle recorded as anadjustment to opening retained earnings. The Company is currently evaluatingthe impact of adopting FIN 48 on its financial statements.

8

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**3.      STOCK BASED COMPENSATION**

*Equity Compensation Plans* —

TheCompany currently grants stock awards under the following equity compensationplans:

*1997Stock Option Plan (“1997 Plan”)*- The 1997 Plan was adoptedby the Company’s Board of Directors in November 1997 and subsequently amendedon March 27, 2000 and October 24, 2001. Under the 1997 Plan, the Company’sBoard of Directors may grant options to purchase up to 1,034,970 shares ofcommon stock to employees, executive officers and directors. The 1997 Planprovides for the issuance of nonqualified stock options and incentive stockoptions (which are intended to satisfy the requirements of Section 422 of theInternal Revenue Code) and stock appreciation rights (“SARs”). The CompensationCommittee of the Board of Directors determines the employees who will receiveawards under the 1997 Plan and the terms of such awards. The exercise price ofa stock option or SAR granted or awarded under the 1997 Plan may not be lessthan the fair market value of one share of common stock on the date the stockoption or SAR is granted.

*The2003 Equity Incentive Plan (the “2003 Incentive Plan”)*- OnApril 9, 2003, the Board of Directors adopted an equity incentive plan, subjectto approval by the Company’s shareholders. On May 14, 2003, the shareholdersapproved the 2003 Incentive Plan, which became effective as of March 30,2003.  On May 10, 2006, the shareholdersapproved an amendment to the 2003 Incentive Plan, and increased the number ofshares of common stock reserved for issuance under the 2003 Incentive Plan. The2003 Incentive Plan provides for the issuance of nonqualified stock options andincentive stock options (which are intended to satisfy the requirements ofSection 422 of the Internal Revenue Code), SARs, bonus stock, stock units,performance shares, performance units, restricted stock and restricted stockunits. No more than 607,000 shares of common stock may be delivered toparticipants and their beneficiaries under the 2003 Incentive Plan. TheCompensation Committee of the Board of Directors determines the employees whowill receive awards under the 2003 Incentive Plan and the terms of suchawards.  The exercise price of a stockoption or SAR granted or awarded under the 2003 Incentive Plan may not be lessthan the fair market value of one share of common stock on the date the stockoption or SAR is granted.

OnDecember 20, 2004, the Company’s Board of Directors approved the vesting of alloutstanding and unvested options under the Company’s 1997 Plan and the 2003Incentive Plan.  This action was taken toreduce, or eliminate to the extent permitted, the transition expense related tooutstanding stock option awards under SFAS No. 123R. The 259,850 options thatwere vested included 145,239 options with exercise prices greater than theCompany’s closing stock price on the modification date. Under the accountingguidance of APB Opinion No. 25, the accelerated vesting resulted in stock-basedcompensation cost of $9,400 (net of related income tax benefit of $6,600),which was included in net loss for the year ended January 2, 2005.  Additionally, the effect of the acceleratedvesting in the Company’s pro-forma disclosure was incremental stock-basedcompensation of approximately $666,000 (net of related income tax benefit of$463,000). Stock-based compensation expense of $434,000 and $96,000 wouldotherwise have been recognized in accordance with SFAS No. 123R in the Company’sconsolidated statements of operations during the 2006 and 2007 fiscal years,respectively.

Optionsissued subsequent to December 20, 2004 generally vest over three years. Optionsissued prior to July 24, 2002 expire 10 years from the date of grant. Optionsissued subsequent to that date have a five year expiration date.

9

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*Grant-DateFair Value* —

TheCompany uses the Black-Scholes option pricing model to calculate the grant-datefair value of an award. The fair value of options granted during the three andsix months ended July 2, 2006 and July 3, 2005 were calculated using thefollowing estimated weighted average assumptions:
| ** **                              | ** ** | **For the Three Months Ended** | ** ** | **For the Six Months Ended** | ** ** |
|-----------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                              | ** ** | **July 2, 2006**               | ** ** | **July 3, 2005**             | ** ** | **July 2, 2006** | ** ** | **July 3, 2005** | ** ** |
| Options granted                         |       | —                         |       | 6,000                        |       | 145,409 |   | 119,953 |   |
| Weighted-average  exercise price        |       | —                         |       | $                            | 9.04       |   | $ | 8.10 |   | $ | 8.87 |   |
| Weighted-average  grant date fair value |       | —                         |       | $                            | 4.28       |   | $ | 3.82 |   | $ | 4.68 |   |
| Assumptions:                            |       |                           |       |                         |       |   |   |   |   |
| Risk free  interest rate                |       | —                         |       | 3.93                         | %          | 4.68 | % | 3.58%-3.93 | % |
| Expected life  (in years)               |       | —                         |       | 4                            |       | 4 |   | 4-5 |   |
| Expected  volatility                    |       | —                         |       | 56.56                        | %          | 54.86 | % | 56.00%-58.16 | % |
| Expected dividend yield                 |       | —                         |       | 0.00                         | %          | 0.00 | % | 0.00 | % |

 

Risk-freeinterest rate — the yield on zero-coupon U.S. Treasury securities for a periodthat is commensurate with the expected term assumption is used as the risk-freeinterest rate.

Expectedlife — the Company uses historical employee exercise and option expiration datato estimate the expected life assumption for the Black-Scholes grant-datevaluation. The Company believes that this historical data is currently the bestestimate of the expected life of a new option.

Expectedvolatility — the Company is responsible for estimating volatility and has usedhistorical volatility to estimate the grant-date fair value of stock options.Management considered the guidance in SFAS No. 123R and believes that thehistorical estimated volatility is materially indicative of expectations aboutfuture volatility.

Expected dividend yield — the Companyhas not paid any dividends in the last five years and currently intends toretain any earnings to finance future growth and, therefore, does notanticipate paying any cash dividends on its common stock in the foreseeablefuture.

*Expense* —

TheCompany used the straight-line attribution method to recognize expense for alloptions granted.

Theamount of stock-based compensation recognized during a period is based on thevalue of the portion of the awards that are ultimately expected to vest. SFASNo. 123R requires forfeitures to be estimated at the time of grant and revised,if necessary, in subsequent periods if actual forfeitures differ from thoseestimates. The term “forfeitures” is distinct from “cancellations” or “expirations”and represents only the unvested portion of the surrendered option. The Companycurrently expects, based on an analysis of its historical forfeitures thatapproximately 97% of its options will actually vest, and therefore has appliedan annual forfeiture rate of 3% to options granted as of July 2, 2006. Thisanalysis will be re-evaluated quarterly and the forfeiture rate will beadjusted as necessary. Ultimately, the actual expense recognized over thevesting period will only be for those shares that vest.

Theadoption of SFAS No. 123R on January 2, 2006 resulted in lower operating incomebefore tax and lower net income of $120,000 and $200,000 for the three and sixmonths ended July 2, 2006, respectively.

10

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Thefollowing table details the effect on net income (loss) and income (loss) pershare had stock-based compensation expense been recorded in fiscal 2005 basedon the fair-value method under SFAS No. 123 (in thousands, except per share data).**The reported and pro forma net income (loss) and income(loss) per share for the three and six months ended July 2, 2006 are the samesince stock-based compensation expense was calculated under the provisions ofSFAS No. 123R.
| ** **                                                                                                                          | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                                                                          | ** ** | **July 3, 2005**       | ** ** | **July 3, 2005**     | ** ** |
|                                                                                                                                |       |                   |       |                 |       |
| Net income  (loss) as reported                                                                                                      |       | $                      | 2,517      |                 | $          | (469 | ) |
| Add stock-based  compensation expense included in reported net income (loss), net of related  income tax benefit                    |       | 40                     |       | 40                   |       |
| Less stock-based  compensation expense determined under fair value method for all stock  options, net of related income tax benefit |       | (50                    | )          | (64                  | )          |
| Pro forma net  income (loss)                                                                                                        |       | $                      | 2,507      |                 | $          | (493 | ) |
|                                                                                                                                |       |                   |       |                 |       |
| Basic net income  (loss) per share, as reported                                                                                     |       | $                      | 0.32       |                 | $          | (0.06 | ) |
| Basic net income  (loss) per share, pro forma                                                                                       |       | $                      | 0.32       |                 | $          | (0.06 | ) |
|                                                                                                                                |       |                   |       |                 |       |
| Diluted net  income (loss) per share, as reported                                                                                   |       | $                      | 0.32       |                 | $          | (0.06 | ) |
| Diluted net income  (loss) per share, pro forma                                                                                     |       | $                      | 0.32       |                 | $          | (0.06 | ) |

 

*OptionActivity* —

Asummary of the activity under the Company’s equity compensation plans as ofJuly 2, 2006 and changes during the six-month period then ended is presentedbelow:
| ** **                                            | ** ** | **Options**     | ** ** | **Contractual**   | ** ** | **Average**        | ** ** | **Intrinsic** | ** ** |
|-------------------------------------------------------|------------|-----------------|------------|-------------------|------------|--------------------|------------|---------------|------------|
| ** **                                            | ** ** | **Outstanding** | ** ** | **Life in Years** | ** ** | **Exercise Price** | ** ** | **Value**     | ** ** |
|                                                  |       |            |       |              |       |               |       |          |       |
| Options outstanding at                                |       |            |       |              |       |               |       |          |       |
| January 1, 2006                                       |       | 621,450         |       |              |       | $                  | 7.82       |          |       |   |
| Granted                                               |       | 145,409         |       |              |       | $                  | 8.10       |          |       |   |
| Cancelled                                             |       | (11,140         | )          |              |       | $                  | 13.12      |          |       |   |
| Forfeited                                             |       | (4,027          | )          |              |       | $                  | 8.86       |          |       |   |
| Exercised                                             |       | (25,107         | )          |              |       | $                  | 2.58       |          |       |   |
| Options  outstanding at July 2, 2006                  |       | 726,585         |       | 3.52              |       | $                  | 7.97       |          | $          | 806,513 |   |
|                                                  |       |            |       |              |       |               |       |          |       |
| Options fully  vested and exercisable at July 2, 2006 |       | 489,706         |       | 3.11              |       | $                  | 7.72       |          | $          | 806,513 |   |

 

Duringthe three and six months ended July 2, 2006, the total intrinsic value ofoptions exercised (i.e. the difference between the market price at exercise andthe price paid by the employee to exercise the options) was $131,000 and$145,000, respectively, and the total amount of cash received from exercise ofstock options was $46,000 and $65,000, respectively.

Asof July 2, 2006, there was $859,000 of average unrecognized compensation costrelated to unvested stock options. That cost is expected to be recognized overa weighted-average period of 2.46 years.

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*RestrictedStock Unit Activity* —

OnDecember 2, 2005, 30,000 restricted stock units were issued to directors with aweighted average fair value of $8.90 at grant date.  During the three and six months ended July 2,2006, stock-based compensation cost of $22,000 and $44,000, respectively, wasrecorded related to these units. No additional units were granted or forfeitedduring the six months ended July 2, 2006.

Asof July 2, 2006, there was $216,000 of total unrecognized compensation costrelated to unvested restricted stock units. That cost is expected to berecognized over a weighted-average period of 2.42 years.

**4.   EMPLOYEEBENEFIT PLANS**

The components of net periodic pension cost forthe three and six months ended July 2, 2006 and July 3, 2005 were (in thousands):
| ** **                                           | ** ** | **For the Three Months Ended** | ** ** | **For the Six Months Ended** | ** ** |
|------------------------------------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                           | ** ** | **July 2,**                                   | ** ** | **July 3,**                                 | ** ** | **July 2,** | ** ** | **July 3,** | ** ** |
| ** **                                           | ** ** | **2006**                                           | ** ** | **2005**                                         | ** ** | **2006** | ** ** | **2005** | ** ** |
| Interest cost                                        |       | $                                                  | 1,672      |                                             | $          | 1,715 |   | $ | 3,392 |   | $ | 3,342 |   |
| Expected return  on assets                           |       | (1,996                                             | )          | (2,047                                           | )          | (3,965 | ) | (4,144 | ) |
| Net amortization  of unrecognized net actuarial loss |       | 632                                                |       | 531                                              |       | 1,351 |   | 945 |   |
| Net periodic pension  cost                           |       | $                                                  | 308        |                                             | $          | 199 |   | $ | 778 |   | $ | 143 |   |

 

The components of the net postretirement medicaland life insurance benefit cost for the three and six months ended July 2, 2006and July 3, 2005 were (in thousands):
| ** **                                              | ** ** | **For the Three Months Ended** | ** ** | **For the Six Months Ended** | ** ** |
|---------------------------------------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                              | ** ** | **July 2,**                                   | ** ** | **July 3,**                                 | ** ** | **July 2,** | ** ** | **July 3,** | ** ** |
| ** **                                              | ** ** | **2006**                                           | ** ** | **2005**                                         | ** ** | **2006** | ** ** | **2005** | ** ** |
| Service cost                                            |       | $                                                  | 41         |                                             | $          | 41 |   | $ | 82 |   | $ | 81 |   |
| Interest cost                                           |       | 95                                                 |       | 115                                              |       | 190 |   | 230 |   |
| Recognized actuarial  loss                              |       | 4                                                  |       | 20                                               |       | 8 |   | 41 |   |
| Net amortization  of unrecognized prior service benefit |       | (36                                                | )          | (35                                              | )          | (72 | ) | (71 | ) |
| Net postretirement  benefit cost                        |       | $                                                  | 104        |                                             | $          | 141 |   | $ | 208 |   | $ | 281 |   |

 

12

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**5.   ASSETIMPAIRMENT AND DISCONTINUED OPERATIONS**

As of January 1, 2006, the Company had 11 restaurants that were reportedas “held for sale” in accordance with SFAS No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets.” During the six months ended July 2, 2006, the Company sold seven ofthese restaurants.  Gross proceedsfrom these transactions were $6,892,000. The Company recognized a net gain related to the sales of the assets of$4,068,000.  At July 2, 2006, the remaining four properties, and one additionalproperty that closed during the six months ended July 2, 2006, met the criteriafor “held for sale” as defined in SFAS No. 144. The carrying values ofthese five properties of $1,119,000 and $1,157,000 as of July 2, 2006 andJanuary 1, 2006, respectively, were reported as assets held for sale in theaccompanying condensed consolidated balance sheets. The carrying values ofthese properties were not adjusted since the carrying values were less than theestimated fair market values less costs to sell.

Thetable below identifies the components of the “Loss on disposals of otherproperty and equipment, net” as shown in the accompanying condensedconsolidated statements of operations (in thousands):
| ** **                                              | ** ** | **For the Three Months Ended** | ** ** | **For the Six Months Ended** | ** ** |
|---------------------------------------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                              | ** ** | **July 2,**                                   | ** ** | **July 3,**                                 | ** ** | **July 2,** | ** ** | **July 3,** | ** ** |
| ** **                                              | ** ** | **2006**                                           | ** ** | **2005**                                         | ** ** | **2006** | ** ** | **2005** | ** ** |
| Restaurant  equipment assets retired due to remodeling  |       | $                                                  | 296        |                                             | $          | 220 |   | $ | 296 |   | $ | 220 |   |
| Restaurant  equipment assets retired due to replacement |       | 67                                                 |       | 43                                               |       | 142 |   | 95 |   |
| Gain due to restaurant  flood and fire                  |       | (79                                                | )          | —                                           |       | (48 | ) | — |   |
| All other                                               |       | 82                                                 |       | 10                                               |       | 85 |   | 27 |   |
| Loss on disposals of  other property and equipment, net |       | $                                                  | 366        |                                             | $          | 273 |   | $ | 475 |   | $ | 342 |   |

 

SFASNo. 144 also requires the results of operations of a component of an entitythat is classified as held for sale or that has been disposed of to be reportedas discontinued operations in the statement of operations if certain conditionsare met. These conditions include commitment to a plan of disposal after theeffective date of this statement, elimination of the operations and cash flowsof the entity component from the ongoing operations of the company and nosignificant continuing involvement in the operations of the entity componentafter the disposal transaction.

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In accordance with SFAS No. 144, the results of operations of the sevenproperties that were disposed of during the six months ended July 2, 2006 andthe 14 properties that were disposed of during 2005 and the related net gain onthe disposals, as well as the results of operations of the properties held forsale at July 2, 2006, were reported separately as discontinued operations inthe accompanying condensed consolidated statements of operations for allperiods presented.  Operating results forthe three and six months ended July 2, 2006 and the net gain on disposals ofthe properties as well as operating results that were included in therestaurant segment in the previously issued Quarterly Report on Form 10-Q forthe three and six months ended July 3, 2005 are summarized below (inthousands):
| ** **                                          | ** ** | **For the Three Months Ended** | ** ** | **For the Six Months Ended** | ** ** |
|-----------------------------------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                          | ** ** | **July 2,**                                   | ** ** | **July 3,**                                 | ** ** | **July 2,** | ** ** | **July 3,** | ** ** |
| ** **                                          | ** ** | **2006**                                           | ** ** | **2005**                                         | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net sales                                           |       | $                                                  | —     |                                             | $          | 3,330 |   | $ | — |   | $ | 6,315 |   |
| Operating loss                                      |       | (79                                                | )          | (198                                             | )          | (328 | ) | (821 | ) |
| Gain (loss) on  disposals of property and equipment |       | 1,203                                              |       | (25                                              | )          | 4,068 |   | (26 | ) |
| Income tax  (expense) benefit                       |       | (450                                               | )          | 91                                               |       | (450 | ) | 347 |   |
| Income (loss) from  discontinued operations         |       | $                                                  | 674        |                                             | $          | (132 | ) | $ | 3,290 |   | $ | (500 | ) |

 

Duringthe six months ended July 2, 2006, the Company determined that the carryingvalue of one operating restaurant property exceeded its estimated fair valueless costs to sell and the carrying value was reduced by $215,000 accordingly.

Duringthe six months ended July 3, 2005, the Company identified two restaurantproperties to be disposed of other than by sale.  The Company determined that the carryingvalue of these restaurant properties exceeded their estimated undiscountedcash flows and the carrying valueswere reduced by an aggregate of $289,000 accordingly.

**6.   SEGMENT REPORTING**

Operating segmentsare components of an enterprise about which separate financial information isavailable that is evaluated regularly by the chief operating decision-maker, ordecision-making group, in deciding how to allocate resources and in assessingperformance. The Company’s chief operating decision-maker is the ChiefExecutive Officer and President of the Company. The Company’s operatingsegments include restaurant, foodservice and franchise. The revenues from thesesegments include both sales to unaffiliated customers and inter-segment sales,which generally are accounted for on a basis consistent with sales tounaffiliated customers. Intersegment sales and other inter-segment transactionshave been eliminated in the accompanying condensed consolidated financialstatements.

The Company’srestaurants target families with kids and adults who desire a reasonably-pricedmeal in a full-service setting. The Company’s menu offers a broadselection of freshly-prepared foods which appeal to customers throughoutall dayparts. The menu currently features over 100 items comprised of a broadselection of breakfast, lunch, dinner and afternoon and evening snack items.Foodservice operations manufactures premium ice cream dessert products anddistributes such manufactured products and purchased finished goods toCompany-operated and franchised restaurants. Additionally, it sells premium icecream dessert products to distributors and retail locations. The Company’sfranchise segment includes a royalty based on franchise restaurant revenue. Inaddition, the Company receives rental income from various franchisedrestaurants. The Company does not allocate general and administrative expensesassociated with its headquarters operations to any business segment. Thesecosts include expenses of the following functions: legal, accounting, personnelnot directly related to a segment, information systems and other headquarteractivities.

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Theaccounting policies of the operating segments are the same as those described inthe summary of significant accounting policies except that the financialresults for the foodservice operating segment, prior to inter-segmenteliminations, have been prepared using a management approach, which isconsistent with the basis and manner in which the Company’s managementinternally reviews financial information for the purpose of assisting in makinginternal operating decisions. Using this approach, the Company evaluatesperformance based on stand-alone operating segment income (loss) before incometaxes and generally accounts for inter-segment sales and transfers as if thesales or transfers were to third parties, that is, at current market prices.

AdjustedEBITDA represents net income (loss) before (i) (provisionfor) benefit from income taxes, (ii) interest expense, net,(iii) depreciation and amortization, (iv) write-downs of propertyand equipment, (v) net periodic pension cost and (vi) other non-cashitems. Adjusted EBITDA is a non-GAAP financial measure.  The Company has included informationconcerning adjusted EBITDA in this Form 10-Q because the Company’s managementincentive plan pays bonuses based on achieving adjusted EBITDA targets and theCompany believes that such information is used by certain investors as onemeasure of a company’s historical ability to service debt. Adjusted EBITDAshould not be considered as an alternative to, or more meaningful than,earnings (loss) from operations or other traditional indications of a company’soperating performance.

|                        | ** ** | **For the Three Months Ended** | ** ** | **For the Six Months Ended** | ** ** |
|------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **             | ** ** | **July 2,**                                   | ** ** | **July 3,**                                 | ** ** | **July 2,** | ** ** | **July 3,** | ** ** |
| ** **             | ** ** | **2006**                                           | ** ** | **2005**                                         | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **             | ** ** | **(in thousands)**                            | ** ** | **(in thousands)**                          | ** ** |
| Revenues:              |       |                                               |       |                                             |       |   |   |   |   |
| Restaurant             |       | $                                                  | 105,271    |                                             | $          | 109,469 |   | $ | 200,547 |   | $ | 202,576 |   |
| Foodservice            |       | 62,891                                             |       | 65,220                                           |       | 117,849 |   | 119,384 |   |
| Franchise              |       | 4,082                                              |       | 3,876                                            |       | 7,627 |   | 7,126 |   |
| Total                  |       | $                                                  | 172,244    |                                             | $          | 178,565 |   | $ | 326,023 |   | $ | 329,086 |   |
|                   |       |                                               |       |                                             |       |   |   |   |   |
| Intersegment revenues: |       |                                               |       |                                             |       |   |   |   |   |
| Restaurant             |       | $                                                  | —     |                                             | $          | — |   | $ | — |   | $ | — |   |
| Foodservice            |       | (30,754                                            | )          | (33,472                                          | )          | (58,818 | ) | (62,330 | ) |
| Franchise              |       | —                                             |       | —                                           |       | — |   | — |   |
| Total                  |       | $                                                  | (30,754    | )                                                | $          | (33,472 | ) | $ | (58,818 | ) | $ | (62,330 | ) |
|                   |       |                                               |       |                                             |       |   |   |   |   |
| External revenues:     |       |                                               |       |                                             |       |   |   |   |   |
| Restaurant             |       | $                                                  | 105,271    |                                             | $          | 109,469 |   | $ | 200,547 |   | $ | 202,576 |   |
| Foodservice            |       | 32,137                                             |       | 31,748                                           |       | 59,031 |   | 57,054 |   |
| Franchise              |       | 4,082                                              |       | 3,876                                            |       | 7,627 |   | 7,126 |   |
| Total                  |       | $                                                  | 141,490    |                                             | $          | 145,093 |   | $ | 267,205 |   | $ | 266,756 |   |

 

15

----

 
| ** **                                                                   | ** ** | **For the Three Months Ended** | ** ** | **For the Six Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                   | ** ** | **July 2,**                                   | ** ** | **July 3,**                                 | ** ** | **July 2,** | ** ** | **July 3,** | ** ** |
| ** **                                                                   | ** ** | **2006**                                           | ** ** | **2005**                                         | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                   | ** ** | **(in thousands)**                            | ** ** | **(in thousands)**                          | ** ** |
| Adjusted EBITDA:                                                             |       |                                               |       |                                             |       |   |   |   |   |
| Restaurant                                                                   |       | $                                                  | 11,929     |                                             | $          | 12,382 |   | $ | 18,764 |   | $ | 19,658 |   |
| Foodservice                                                                  |       | 5,638                                              |       | 4,234                                            |       | 8,185 |   | 6,382 |   |
| Franchise                                                                    |       | 2,889                                              |       | 2,845                                            |       | 5,307 |   | 5,112 |   |
| Corporate                                                                    |       | (6,113                                             | )          | (5,434                                           | )          | (11,692 | ) | (10,279 | ) |
| Gain on property and equipment, net                                          |       | 779                                                |       | 935                                              |       | 1,537 |   | 2,169 |   |
| Add back pension cost included in reporting segments                         |       | 308                                                |       | 199                                              |       | 778 |   | 143 |   |
| Total                                                                        |       | $                                                  | 15,430     |                                             | $          | 15,161 |   | $ | 22,879 |   | $ | 23,185 |   |
| Interest  expense, net—Corporate                                        |       | $                                                  | 5,147      |                                             | $          | 5,229 |   | $ | 10,567 |   | $ | 10,515 |   |
|                                                                         |       |                                               |       |                                             |       |   |   |   |   |
| Depreciation and  amortization:                                              |       |                                               |       |                                             |       |   |   |   |   |
| Restaurant                                                                   |       | $                                                  | 4,021      |                                             | $          | 3,992 |   | $ | 8,164 |   | $ | 8,462 |   |
| Foodservice                                                                  |       | 720                                                |       | 803                                              |       | 1,456 |   | 1,627 |   |
| Franchise                                                                    |       | 70                                                 |       | 40                                               |       | 138 |   | 79 |   |
| Corporate                                                                    |       | 929                                                |       | 797                                              |       | 1,762 |   | 1,615 |   |
| Total                                                                        |       | $                                                  | 5,740      |                                             | $          | 5,632 |   | $ | 11,520 |   | $ | 11,783 |   |
|                                                                         |       |                                               |       |                                             |       |   |   |   |   |
| Other non-cash expense:                                                      |       |                                               |       |                                             |       |   |   |   |   |
| Net periodic pension cost                                                    |       | $                                                  | 308        |                                             | $          | 199 |   | $ | 778 |   | $ | 143 |   |
| Write-downs of property and equipment                                        |       | —                                             |       | 289                                              |       | 215 |   | 289 |   |
| Total                                                                        |       | $                                                  | 308        |                                             | $          | 488 |   | $ | 993 |   | $ | 432 |   |
|                                                                         |       |                                               |       |                                             |       |   |   |   |   |
| Income (loss) from  continuing operations before provision for income taxes: |       |                                               |       |                                             |       |   |   |   |   |
| Restaurant                                                                   |       | $                                                  | 7,908      |                                             | $          | 8,390 |   | $ | 10,600 |   | $ | 11,196 |   |
| Foodservice                                                                  |       | 4,918                                              |       | 3,431                                            |       | 6,729 |   | 4,755 |   |
| Franchise                                                                    |       | 2,819                                              |       | 2,805                                            |       | 5,169 |   | 5,033 |   |
| Corporate                                                                    |       | (12,189                                            | )          | (11,460                                          | )          | (24,021 | ) | (22,409 | ) |
| Gain on property and equipment, net                                          |       | 779                                                |       | 646                                              |       | 1,322 |   | 1,880 |   |
| Total                                                                        |       | $                                                  | 4,235      |                                             | $          | 3,812 |   | $ | (201 | ) | $ | 455 |   |

 

16

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|                                                                        | ** ** | **For the Six**  | ** ** | **For the Year**    | ** ** |
|------------------------------------------------------------------------|------------|----------------------------|------------|-------------------------------|------------|
| ** **                                                             | ** ** | **Months Ended**      | ** ** | **Ended**                     | ** ** |
| ** **                                                             | ** ** | **July 2, 2006** | ** ** | **January 1, 2006** | ** ** |
| ** **                                                             | ** ** | **(in thousands)**    | ** ** |
| Capital  expenditures, including assets acquired under capital leases: |       |                       |       |                          |       |
| Restaurant                                                             |       | $                          | 6,679      |                          | $          | 14,674 |   |
| Foodservice                                                            |       | 499                        |       | 1,516                         |       |
| Corporate                                                              |       | 789                        |       | 968                           |       |
| Total                                                                  |       | $                          | 7,967      |                          | $          | 17,158 |   |

 

 

|               | ** ** | **July 2, 2006** | ** ** | **January 1, 2006** | ** ** |
|---------------|------------|----------------------------|------------|-------------------------------|------------|
| ** **    | ** ** | **(in thousands)**    | ** ** |
| Total assets: |       |                       |       |                          |       |
| Restaurant    |       | $                          | 126,254    |                          | $          | 131,810 |   |
| Foodservice   |       | 39,098                     |       | 38,609                        |       |
| Franchise     |       | 12,206                     |       | 7,634                         |       |
| Corporate     |       | 45,446                     |       | 40,189                        |       |
| Total         |       | $                          | 223,004    |                          | $          | 218,242 |   |

 

**7.   RELATED PARTYTRANSACTIONS**

On March 20, 2006,Friendly’s entered into an agreement with The Ice Cream Company (“TICC”)pursuant to which TICC purchased, at fair market value, certain assets andleasehold rights for three existing Company-operated restaurants located inLancaster and York, Pennsylvania. At closing, TICC was also granted anexclusive right to develop six new Friendly’s restaurants in Lancaster, Chesterand Montgomery counties, Pennsylvania by April 2012. Gross proceeds from thistransaction were $1,725,000, of which $90,000 was for initial franchise fees,$90,000 was for development fees and $1,545,000 was for the assets and rightsat the three existing restaurants. During the quarter ended July 2, 2006, theCompany recorded $90,000 as franchise fee revenue and recognized a gain of$1,146,000 related to the sale of the assets.

The owners of TICC arefamily members of the Company’s Chairman of the Board of Directors. Prior tothe closing of this transaction on May 22, 2006, TICC operated three Friendly’srestaurants under franchise agreements with Friendly’s Restaurants Franchise,Inc. (“FRFI”), a subsidiary of Friendly’s. The terms of the franchise agreement with TICC are identical in allmaterial respects to the terms generally offered to unrelated franchisees ofFRFI in the ordinary course of Friendly’s business.

TICC purchases fromFriendly’s certain food products used in the normal course of its franchisebusiness.  For the six months ended July2, 2006 and July 3, 2005, TICC paid Friendly’s $1,306,000 and $1,063,000,respectively, for franchise royalty fees, marketing fees, food purchases andmiscellaneous other products and services.

17

----

 

**8.   SUBSEQUENT EVENT**

On August 1, 2006, the Company amended its $35 millionCredit Facility with Wells Fargo Foothill, to, among other things, (i) extendthe maturity date from June 30, 2007 to June 30, 2010, (ii) eliminate theinterest coverage requirement and (iii) reduce the applicable margin rates atwhich the revolving credit loans bear interest by .50% to .75% to a range of3.00% to 4.00% (depending on the leverage ratios).

The Company expects to incur approximately $473,000 ofcosts associated with the amendment to the $35 million Credit Facility whichwill be deferred and amortized over the life of the amended $35 million CreditFacility.

**9.   SUPPLEMENTAL CONDENSEDCONSOLIDATING FINANCIAL INFORMATION**

FICC’s obligationrelated to its $175,000,000 8.375% senior notes (the “Senior Notes”) issued inMarch 2004 is guaranteed fully and unconditionally by one of FICC’s whollyowned subsidiaries. There are no restrictions on FICC’s ability to obtaindividends or other distributions of funds from this subsidiary, except thoseimposed by applicable law. The following supplemental financial informationsets forth, on a condensed consolidating basis, balance sheets, statements ofoperations and statements of cash flows for FICC (the “Parent Company”),Friendly’s Restaurants Franchise, Inc. (the “Guarantor Subsidiary”) andFriendly’s International, Inc., Restaurant Insurance Corporation, Friendly’sRealty I, LLC, Friendly’s Realty II, LLC and Friendly’s Realty III, LLC(collectively, the “Non-guarantor Subsidiaries”). All of the LLCs’ assetswere owned by the LLCs, which are separate entities with separate creditorswhich will be entitled to be satisfied out of the LLCs’ assets. Separatecomplete financial statements and other disclosures of the Guarantor Subsidiaryas of July 2, 2006 and January 1, 2006 and for the three and six months endedJuly 2, 2006 and July 3, 2005 were not presented because management hasdetermined that such information is not material to investors.

Investmentsin subsidiaries are accounted for by the Parent Company on the equity methodfor purposes of the supplemental consolidating presentation. Earnings of thesubsidiaries are, therefore, reflected in the Parent Company’s investmentaccounts and earnings. The principal elimination entries eliminate the ParentCompany’s investments in subsidiaries and intercompany balances andtransactions.

18

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**Supplemental CondensedConsolidating Balance Sheet****As of July 2, 2006**(In thousands)

 
| ** **                                                 | ** ** | ** **  | ** ** | ** **     | ** ** | **Non-**         | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------|------------|-------------|------------|----------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                 | ** ** | **Parent**  | ** ** | **Guarantor**  | ** ** | **guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                 | ** ** | **Company** | ** ** | **Subsidiary** | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                       |       |        |       |           |       |             |       |             |       |             |       |
| Assets                                                     |       |        |       |           |       |             |       |             |       |             |       |
|                                                       |       |        |       |           |       |             |       |             |       |             |       |
| Current assets:                                            |       |        |       |           |       |             |       |             |       |             |       |
| Cash and cash  equivalents                                 |       | $           | 20,532     |           | $          | 1,426            |       | $                | 2,415      |             | $          | — |   | $ | 24,373 |   |
| Restricted cash                                            |       | —      |       | —         |       | 393              |       | —           |       | 393              |       |
| Accounts  receivable, net                                  |       | 16,572      |       | 2,404          |       | —           |       | —           |       | 18,976           |       |
| Inventories                                                |       | 16,916      |       | —         |       | —           |       | —           |       | 16,916           |       |
| Assets held for  sale                                      |       | 1,119       |       | —         |       | —           |       | —           |       | 1,119            |       |
| Deferred income  taxes                                     |       | —      |       | 26             |       | —           |       | (26              | )          | —           |       |
| Prepaid expenses  and other current assets                 |       | 5,606       |       | 1,475          |       | 7,785            |       | (10,589          | )          | 4,277            |       |
| Total current assets                                       |       | 60,745      |       | 5,331          |       | 10,593           |       | (10,615          | )          | 66,054           |       |
| Deferred income taxes                                      |       | —      |       | 381            |       | —           |       | (381             | )          | —           |       |
| Property and equipment,  net                               |       | 94,719      |       | —         |       | 42,298           |       | —           |       | 137,017          |       |
| Intangibles and  deferred costs, net                       |       | 16,091      |       | —         |       | 2,139            |       | —           |       | 18,230           |       |
| Investments in  subsidiaries                               |       | 6,343       |       | —         |       | —           |       | (6,343           | )          | —           |       |
| Other assets                                               |       | 788         |       | 6,813          |       | 915              |       | (6,813           | )          | 1,703            |       |
|                                                       |       |        |       |           |       |             |       |             |       |             |       |
| Total assets                                               |       | $           | 178,686    |           | $          | 12,525           |       | $                | 55,945     |             | $          | (24,152 | ) | $ | 223,004 |   |
|                                                       |       |        |       |           |       |             |       |             |       |             |       |
| Liabilities and  Stockholders’ (Deficit) Equity       |       |        |       |           |       |             |       |             |       |             |       |
|                                                       |       |        |       |           |       |             |       |             |       |             |       |
| Current liabilities:                                       |       |        |       |           |       |             |       |             |       |             |       |
| Current  maturities of long-term obligations               |       | $           | 9,268      |           | $          | —           |       | $                | 1,467      |             | $          | (7,776 | ) | $ | 2,959 |   |
| Accounts payable                                           |       | 23,938      |       | —         |       | —           |       | —           |       | 23,938           |       |
| Deferred income  taxes                                     |       | 131         |       | —         |       | —           |       | (131             | )          | —           |       |
| Accrued expenses                                           |       | 39,739      |       | 4,107          |       | 1,499            |       | (2,587           | )          | 42,758           |       |
| Total current  liabilities                                 |       | 73,076      |       | 4,107          |       | 2,966            |       | (10,494          | )          | 69,655           |       |
| Deferred income taxes                                      |       | 276         |       | —         |       | —           |       | (276             | )          | —           |       |
| Long-term obligations,  less current maturities            |       | 181,450     |       | —         |       | 48,087           |       | —           |       | 229,537          |       |
| Other long-term  liabilities                               |       | 62,618      |       | 1,030          |       | 5,937            |       | (7,039           | )          | 62,546           |       |
| Stockholders’ (deficit)  equity                       |       | (138,734    | )          | 7,388          |       | (1,045           | )          | (6,343           | )          | (138,734         | )          |
|                                                       |       |        |       |           |       |             |       |             |       |             |       |
| Total liabilities and  stockholders’ (deficit) equity |       | $           | 178,686    |           | $          | 12,525           |       | $                | 55,945     |             | $          | (24,152 | ) | $ | 223,004 |   |

 

19

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**Supplemental CondensedConsolidating Statement of Operations****For the Three Months Ended July 2, 2006**(In thousands)
| ** **                                                                                                             | ** ** | ** **  | ** ** | ** **     | ** ** | **Non-**         | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|-------------|------------|----------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                                                             | ** ** | **Parent**  | ** ** | **Guarantor**  | ** ** | **guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                                                                             | ** ** | **Company** | ** ** | **Subsidiary** | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Revenues                                                                                                               |       | $           | 138,434    |           | $          | 3,056            |       | $                | —     |             | $          | — |   | $ | 141,490 |   |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Costs and  expenses:                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Cost of sales                                                                                                          |       | 51,939      |       | —         |       | —           |       | —           |       | 51,939           |       |
| Labor and benefits                                                                                                     |       | 36,943      |       | —         |       | —           |       | —           |       | 36,943           |       |
| Operating expenses and write-downs of property and  equipment                                                          |       | 28,384      |       | —         |       | (1,568           | )          | —           |       | 26,816           |       |
| General and administrative expenses                                                                                    |       | 10,293      |       | 1,156          |       | —           |       | —           |       | 11,449           |       |
| Depreciation and amortization                                                                                          |       | 5,193       |       | —         |       | 547              |       | —           |       | 5,740            |       |
| Gain on franchise  sales of restaurant operations and properties                                                       |       | (1,145      | )          | —         |       | —           |       | —           |       | (1,145           | )          |
| Loss on  disposals of other property and equipment, net                                                                |       | 263         |       | —         |       | 103              |       | —           |       | 366              |       |
| Interest  expense, net                                                                                                 |       | 4,064       |       | —         |       | 1,083            |       | —           |       | 5,147            |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Income (loss)  before benefit from (provision for) income taxes and equity in net income of  consolidated subsidiaries |       | 2,500       |       | 1,900          |       | (165             | )          | —           |       | 4,235            |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Benefit from  (provision for) income taxes                                                                             |       | 587         |       | (779           | )          | (58              | )          | —           |       | (250             | )          |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Income (loss)  from continuing operations                                                                              |       | 3,087       |       | 1,121          |       | (223             | )          | —           |       | 3,985            |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Income from  discontinued operations, net of income tax effect                                                         |       | 674         |       | —         |       | —           |       | —           |       | 674              |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Income (loss)  before equity in net income of consolidated subsidiaries                                                |       | 3,761       |       | 1,121          |       | (223             | )          | —           |       | 4,659            |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Equity in net  income of consolidated subsidiaries                                                                     |       | 898         |       | —         |       | —           |       | (898             | )          | —           |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Net income (loss)                                                                                                      |       | $           | 4,659      |           | $          | 1,121            |       | $                | (223       | )                | $          | (898 | ) | $ | 4,659 |   |

 

20

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**SupplementalCondensed Consolidating Statement of OperationsFor the Six Months Ended July 2, 2006** (In thousands)
| ** **                                                                                                             | ** ** | ** **  | ** ** | ** **     | ** ** | **Non-**         | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|-------------|------------|----------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                                                             | ** ** | **Parent**  | ** ** | **Guarantor**  | ** ** | **guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                                                                             | ** ** | **Company** | ** ** | **Subsidiary** | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Revenues                                                                                                               |       | $           | 261,531    |           | $          | 5,674            |       | $                | —     |             | $          | — |   | $ | 267,205 |   |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Costs and expenses:                                                                                                    |       |        |       |           |       |             |       |             |       |             |       |
| Cost of sales                                                                                                          |       | 100,324     |       | —         |       | —           |       | —           |       | 100,324          |       |
| Labor and  benefits                                                                                                    |       | 72,955      |       | —         |       | —           |       | —           |       | 72,955           |       |
| Operating  expenses and write-downs of property and equipment                                                          |       | 54,304      |       | —         |       | (3,274           | )          | —           |       | 51,030           |       |
| General and  administrative expenses                                                                                   |       | 20,235      |       | 2,311          |       | —           |       | —           |       | 22,546           |       |
| Depreciation and  amortization                                                                                         |       | 10,430      |       | —         |       | 1,090            |       | —           |       | 11,520           |       |
| Gain on franchise sales  of restaurant operations and properties                                                       |       | (2,011      | )          | —         |       | —           |       | —           |       | (2,011           | )          |
| Loss on disposals of  other property and equipment, net                                                                |       | 372         |       | —         |       | 103              |       | —           |       | 475              |       |
| Interest expense, net                                                                                                  |       | 8,401       |       | —         |       | 2,166            |       | —           |       | 10,567           |       |
| (Loss) income before  benefit from (provision for) income taxes and equity in net income of  consolidated subsidiaries |       | (3,479      | )          | 3,363          |       | (85              | )          | —           |       | (201             | )          |
| Benefit from (provision  for) income taxes                                                                             |       | 1,241       |       | (1,379         | )          | (112             | )          | —           |       | (250             | )          |
| (Loss) income from  continuing operations                                                                              |       | (2,238      | )          | 1,984          |       | (197             | )          | —           |       | (451             | )          |
| Income from  discontinued operations, net of income tax effect                                                         |       | 3,290       |       | —         |       | —           |       | —           |       | 3,290            |       |
| Income (loss) before  equity in net income of consolidated subsidiaries                                                |       | 1,052       |       | 1,984          |       | (197             | )          | —           |       | 2,839            |       |
| Equity in net income of  consolidated subsidiaries                                                                     |       | 1,787       |       | —         |       | —           |       | (1,787           | )          | —           |       |
| Net income (loss)                                                                                                      |       | $           | 2,839      |           | $          | 1,984            |       | $                | (197       | )                | $          | (1,787 | ) | $ | 2,839 |   |

 

21

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**Supplemental Condensed Consolidating Statement of CashFlowsFor the Six Months Ended July 2, 2006**

(In thousands)
| ** **                                           | ** ** | ** **  | ** ** | ** **     | ** ** | **Non-**         | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------|------------|-------------|------------|----------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                           | ** ** | **Parent**  | ** ** | **Guarantor**  | ** ** | **guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                           | ** ** | **Company** | ** ** | **Subsidiary** | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                 |       |        |       |           |       |             |       |             |       |             |       |
| Net cash  provided by operating activities           |       | $           | 7,151      |           | $          | 646              |       | $                | 2,826      |             | $          | (524 | ) | $ | 10,099 |   |
|                                                 |       |        |       |           |       |             |       |             |       |             |       |
| Cash flows from  investing activities:               |       |        |       |           |       |             |       |             |       |             |       |
| Purchases of property and equipment                  |       | (7,102      | )          | —         |       | (865             | )          | —           |       | (7,967           | )          |
|  Proceeds from  sales of property and equipment |       | 9,200       |       | —         |       | —           |       | —           |       | 9,200            |       |
|  Return of  investment in subsidiary            |       | 633         |       | —         |       | —           |       | (633             | )          | —           |       |
| Net cash  provided by (used in) investing activities |       | 2,731       |       | —         |       | (865             | )          | (633             | )          | 1,233            |       |
|                                                 |       |        |       |           |       |             |       |             |       |             |       |
| Cash flows from  financing activities:               |       |        |       |           |       |             |       |             |       |             |       |
|  Proceeds from  revolving credit facility       |       | 8,000       |       | —         |       | —           |       | —           |       | 8,000            |       |
|  Repayments of  obligations                     |       | (8,756      | )          | —         |       | (660             | )          | —           |       | (9,416           | )          |
|  Payments of  deferred financing costs          |       | (205        | )          | —         |       | —           |       | —           |       | (205             | )          |
|  Stock options  exercised                       |       | 65          |       | —         |       | —           |       | —           |       | 65               |       |
|  Reinsurance  payments made from deposits       |       | —      |       | —         |       | (524             | )          | 524              |       | —           |       |
|  Dividends  paid                                |       | —      |       | —         |       | (633             | )          | 633              |       | —           |       |
| Net cash used in  financing activities               |       | (896        | )          | —         |       | (1,817           | )          | 1,157            |       | (1,556           | )          |
|                                                 |       |        |       |           |       |             |       |             |       |             |       |
| Net increase in  cash and cash equivalents           |       | 8,986       |       | 646            |       | 144              |       | —           |       | 9,776            |       |
|                                                 |       |        |       |           |       |             |       |             |       |             |       |
| Cash and cash  equivalents, beginning of period      |       | 11,546      |       | 780            |       | 2,271            |       | —           |       | 14,597           |       |
|                                                 |       |        |       |           |       |             |       |             |       |             |       |
| Cash and cash  equivalents, end of period            |       | $           | 20,532     |           | $          | 1,426            |       | $                | 2,415      |             | $          | — |   | $ | 24,373 |   |
|                                                 |       |        |       |           |       |             |       |             |       |             |       |
| Supplemental  disclosures:                           |       |        |       |           |       |             |       |             |       |             |       |
|  Interest paid                                  |       | $           | 8,016      |           | $          | —           |       | $                | 2,122      |             | $          | — |   | $ | 10,138 |   |
|  Income taxes (refunded) paid                   |       | (2,975      | )          | 2,574          |       | 114              |       | —           |       | (287             | )          |

 

22

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**Supplemental CondensedConsolidating Balance SheetAs of January 1, 2006**(In thousands)
| ** **                                                 | ** ** | ** **  | ** ** | ** **     | ** ** | **Non-**         | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------|------------|-------------|------------|----------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                 | ** ** | **Parent**  | ** ** | **Guarantor**  | ** ** | **guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                 | ** ** | **Company** | ** ** | **Subsidiary** | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                       |       |        |       |           |       |             |       |             |       |             |       |
| Assets                                                     |       |        |       |           |       |             |       |             |       |             |       |
|                                                       |       |        |       |           |       |             |       |             |       |             |       |
| Current assets:                                            |       |        |       |           |       |             |       |             |       |             |       |
| Cash and cash equivalents                                  |       | $           | 11,546     |           | $          | 780              |       | $                | 2,271      |             | $          | — |   | $ | 14,597 |   |
| Restricted cash                                            |       | —      |       | —         |       | 2,549            |       | —           |       | 2,549            |       |
| Accounts receivable, net                                   |       | 9,036       |       | 1,721          |       | —           |       | —           |       | 10,757           |       |
| Inventories                                                |       | 15,775      |       | —         |       | —           |       | —           |       | 15,775           |       |
| Assets held for sale                                       |       | 1,157       |       | —         |       | —           |       | —           |       | 1,157            |       |
| Deferred income taxes                                      |       | (131        | )          | 26             |       | —           |       | 105              |       | —           |       |
| Prepaid expenses and other current assets                  |       | 7,571       |       | 2,565          |       | 7,785            |       | (12,877          | )          | 5,044            |       |
| Total current  assets                                      |       | 44,954      |       | 5,092          |       | 12,605           |       | (12,772          | )          | 49,879           |       |
| Deferred income  taxes                                     |       | (276        | )          | 381            |       | —           |       | (105             | )          | —           |       |
| Property and  equipment, net                               |       | 100,780     |       | —         |       | 42,510           |       | —           |       | 143,290          |       |
| Intangibles and  deferred costs, net                       |       | 16,808      |       | —         |       | 2,255            |       | —           |       | 19,063           |       |
| Investments in  subsidiaries                               |       | 5,188       |       | —         |       | —           |       | (5,188           | )          | —           |       |
| Other assets                                               |       | 5,095       |       | 5,118          |       | 915              |       | (5,118           | )          | 6,010            |       |
|                                                       |       |        |       |           |       |             |       |             |       |             |       |
| Total assets                                               |       | $           | 172,549    |           | $          | 10,591           |       | $                | 58,285     |             | $          | (23,183 | ) | $ | 218,242 |   |
|                                                       |       |        |       |           |       |             |       |             |       |             |       |
| Liabilities and  Stockholders’ (Deficit) Equity       |       |        |       |           |       |             |       |             |       |             |       |
|                                                       |       |        |       |           |       |             |       |             |       |             |       |
| Current liabilities:                                       |       |        |       |           |       |             |       |             |       |             |       |
| Current maturities of long-term obligations                |       | $           | 9,253      |           | $          | —           |       | $                | 1,368      |             | $          | (7,776 | ) | $ | 2,845 |   |
| Accounts payable                                           |       | 24,968      |       | —         |       | —           |       | —           |       | 24,968           |       |
| Accrued expenses                                           |       | 37,237      |       | 4,258          |       | 1,825            |       | (4,844           | )          | 38,476           |       |
| Total current  liabilities                                 |       | 71,458      |       | 4,258          |       | 3,193            |       | (12,620          | )          | 66,289           |       |
| Long-term  obligations, less current maturities            |       | 182,221     |       | —         |       | 48,846           |       | —           |       | 231,067          |       |
| Other long-term  liabilities                               |       | 60,708      |       | 930            |       | 6,461            |       | (5,375           | )          | 62,724           |       |
| Stockholders’  (deficit) equity                       |       | (141,838    | )          | 5,403          |       | (215             | )          | (5,188           | )          | (141,838         | )          |
|                                                       |       |        |       |           |       |             |       |             |       |             |       |
| Total liabilities and  stockholders’ (deficit) equity |       | $           | 172,549    |           | $          | 10,591           |       | $                | 58,285     |             | $          | (23,183 | ) | $ | 218,242 |   |

** **

23

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**Supplemental CondensedConsolidating Statement of OperationsFor the Three Months Ended July 3, 2005**(Inthousands)
| ** **                                                                                                  | ** ** | ** **  | ** ** | ** **     | ** ** | **Non-**         | ** ** | ** **       | ** ** | ** **       | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|-------------|------------|----------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                                                  | ** ** | **Parent**  | ** ** | **Guarantor**  | ** ** | **guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                                                                  | ** ** | **Company** | ** ** | **Subsidiary** | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                                                                        |       |        |       |           |       |             |       |             |       |             |       |
| Revenues                                                                                                    |       | $           | 142,079    |           | $          | 3,014            |       | $                | —     |             | $          | — |   | $ | 145,093 |   |
|                                                                                                        |       |        |       |           |       |             |       |             |       |             |       |
| Costs and expenses:                                                                                         |       |        |       |           |       |             |       |             |       |             |       |
| Cost of sales                                                                                               |       | 54,585      |       | —         |       | —           |       | —           |       | 54,585           |       |
| Labor and benefits                                                                                          |       | 38,476      |       | —         |       | —           |       | —           |       | 38,476           |       |
| Operating expenses and write-downs of property and  equipment                                               |       | 29,536      |       | —         |       | (1,759           | )          | —           |       | 27,777           |       |
| General and administrative expenses                                                                         |       | 9,374       |       | 1,154          |       | —           |       | —           |       | 10,528           |       |
| Depreciation and amortization                                                                               |       | 5,075       |       | —         |       | 557              |       | —           |       | 5,632            |       |
| Gain on  franchise sales of restaurant operations and properties                                            |       | (1,219      | )          | —         |       | —           |       | —           |       | (1,219           | )          |
| Loss on  disposals of other property and equipment, net                                                     |       | 273         |       | —         |       | —           |       | —           |       | 273              |       |
| Interest  expense, net                                                                                      |       | 4,103       |       | —         |       | 1,126            |       | —           |       | 5,229            |       |
|                                                                                                        |       |        |       |           |       |             |       |             |       |             |       |
| Income before  provision for income taxes and equity in net income of consolidated subsidiaries   |       | 1,876       |       | 1,860          |       | 76               |       | —           |       | 3,812            |       |
|                                                                                                        |       |        |       |           |       |             |       |             |       |             |       |
| Provision for  income taxes                                                                                 |       | (345        | )          | (762           | )          | (56              | )          | —           |       | (1,163           | )          |
|                                                                                                        |       |        |       |           |       |             |       |             |       |             |       |
| Income from  continuing operations                                                                          |       | 1,531       |       | 1,098          |       | 20               |       | —           |       | 2,649            |       |
|                                                                                                        |       |        |       |           |       |             |       |             |       |             |       |
| Loss from  discontinued operations, net of income tax effect                                                |       | (132        | )          | —         |       | —           |       | —           |       | (132             | )          |
|                                                                                                        |       |        |       |           |       |             |       |             |       |             |       |
| Income before  equity in net income of consolidated subsidiaries                                            |       | 1,399       |       | 1,098          |       | 20               |       | —           |       | 2,517            |       |
|                                                                                                        |       |        |       |           |       |             |       |             |       |             |       |
| Equity in net  income of consolidated subsidiaries                                                          |       | 1,118       |       | —         |       | —           |       | (1,118           | )          | —           |       |
|                                                                                                        |       |        |       |           |       |             |       |             |       |             |       |
| Net income                                                                                                  |       | $           | 2,517      |           | $          | 1,098            |       | $                | 20         |             | $          | (1,118 | ) | $ | 2,517 |   |

 

24

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**Supplemental Condensed Consolidating Statement ofOperations**

**For the Six Months Ended July 3, 2005**

(In thousands)
| ** **                                                                                                             | ** ** | ** **  | ** ** | ** **     | ** ** | **Non-**         | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|-------------|------------|----------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                                                             | ** ** | **Parent**  | ** ** | **Guarantor**  | ** ** | **guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                                                                             | ** ** | **Company** | ** ** | **Subsidiary** | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Revenues                                                                                                               |       | $           | 261,270    |           | $          | 5,486            |       | $                | —     |             | $          | — |   | $ | 266,756 |   |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Costs and expenses:                                                                                                    |       |        |       |           |       |             |       |             |       |             |       |
| Cost of sales                                                                                                          |       | 101,474     |       | —         |       | —           |       | —           |       | 101,474          |       |
| Labor and benefits                                                                                                     |       | 73,560      |       | —         |       | —           |       | —           |       | 73,560           |       |
| Operating expenses and write-downs of property and  equipment                                                          |       | 54,676      |       | —         |       | (3,498           | )          | —           |       | 51,178           |       |
| General and administrative expenses                                                                                    |       | 17,667      |       | 2,310          |       | —           |       | —           |       | 19,977           |       |
| Depreciation and amortization                                                                                          |       | 10,668      |       | —         |       | 1,115            |       | —           |       | 11,783           |       |
| Gain on  franchise sales of restaurant operations and properties                                                       |       | (2,528      | )          | —         |       | —           |       | —           |       | (2,528           | )          |
| Loss on disposals  of other property and equipment, net                                                                |       | 342         |       | —         |       | —           |       | —           |       | 342              |       |
| Interest  expense, net                                                                                                 |       | 8,270       |       | —         |       | 2,245            |       | —           |       | 10,515           |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| (Loss) income  before benefit from (provision for) income taxes and equity in net income of consolidated  subsidiaries |       | (2,859      | )          | 3,176          |       | 138              |       | —           |       | 455              |       |
| Benefit from  (provision for) income taxes                                                                             |       | 985         |       | (1,302         | )          | (107             | )          | —           |       | (424             | )          |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| (Loss) income  from continuing operations                                                                              |       | (1,874      | )          | 1,874          |       | 31               |       | —           |       | 31               |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Loss from  discontinued operations, net of income tax effect                                                           |       | (500        | )          | —         |       | —           |       | —           |       | (500             | )          |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| (Loss) income  before equity in net income of consolidated subsidiaries                                                |       | (2,374      | )          | 1,874          |       | 31               |       | —           |       | (469             | )          |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Equity in net  income of consolidated subsidiaries                                                                     |       | 1,905       |       | —         |       | —           |       | (1,905           | )          | —           |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Net (loss) income                                                                                                      |       | $           | (469       | )              | $          | 1,874            |       | $                | 31         |             | $          | (1,905 | ) | $ | (469 | ) |

 

25

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**Supplemental CondensedConsolidating Statement of Cash FlowsFor the Six Months Ended July 3, 2005**(Inthousands)
| ** **                                            | ** ** | ** **  | ** ** | ** **     | ** ** | **Non-**         | ** ** | ** **       | ** ** | ** **       | ** ** |
|-------------------------------------------------------|------------|-------------|------------|----------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                            | ** ** | **Parent**  | ** ** | **Guarantor**  | ** ** | **guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                            | ** ** | **Company** | ** ** | **Subsidiary** | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                  |       |        |       |           |       |             |       |             |       |             |       |
| Net cash  provided by operating activities            |       | $           | 10,354     |           | $          | 29               |       | $                | 1,312      |             | $          | (405 | ) | $ | 11,290 |   |
|                                                  |       |        |       |           |       |             |       |             |       |             |       |
| Cash flows from  investing activities:                |       |        |       |           |       |             |       |             |       |             |       |
| Purchases of property and equipment                   |       | (7,309      | )          | —         |       | —           |       | —           |       | (7,309           | )          |
| Proceeds from sales of property and equipment         |       | 3,359       |       | —         |       | —           |       | —           |       | 3,359            |       |
| Purchases of marketable securities                    |       | (345        | )          | —         |       | —           |       | —           |       | (345             | )          |
| Proceeds from sales of marketable securities          |       | 143         |       | —         |       | —           |       | —           |       | 143              |       |
| Return of investment in subsidiary                    |       | 324         |       | —         |       | —           |       | (324             | )          | —           |       |
| Net cash used in  investing activities                |       | (3,828      | )          | —         |       | —           |       | (324             | )          | (4,152           | )          |
|                                                  |       |        |       |           |       |             |       |             |       |             |       |
| Cash flows from  financing activities:                |       |        |       |           |       |             |       |             |       |             |       |
| Proceeds from revolving credit facility               |       | 16,250      |       | —         |       | —           |       | —           |       | 16,250           |       |
| Repayments of obligations                             |       | (21,014     | )          | —         |       | (713             | )          | —           |       | (21,727          | )          |
| Payments of deferred financing costs                  |       | (11         | )          | —         |       | —           |       | —           |       | (11              | )          |
| Stock options exercised                               |       | 330         |       | —         |       | —           |       | —           |       | 330              |       |
| Reinsurance deposits received                         |       | —      |       | —         |       | 114              |       | (114             | )          | —           |       |
| Reinsurance payments made from deposits               |       | —      |       | —         |       | (519             | )          | 519              |       | —           |       |
| Dividends paid                                        |       | —      |       | —         |       | (324             | )          | 324              |       | —           |       |
| Net cash used in  financing activities                |       | (4,445      | )          | —         |       | (1,442           | )          | 729              |       | (5,158           | )          |
|                                                  |       |        |       |           |       |             |       |             |       |             |       |
| Net increase  (decrease) in cash and cash equivalents |       | 2,081       |       | 29             |       | (130             | )          | —           |       | 1,980            |       |
|                                                  |       |        |       |           |       |             |       |             |       |             |       |
| Cash and cash  equivalents, beginning of period       |       | 9,873       |       | 1,360          |       | 2,172            |       | —           |       | 13,405           |       |
|                                                  |       |        |       |           |       |             |       |             |       |             |       |
| Cash and cash  equivalents, end of period             |       | $           | 11,954     |           | $          | 1,389            |       | $                | 2,042      |             | $          | — |   | $ | 15,385 |   |
|                                                  |       |        |       |           |       |             |       |             |       |             |       |
| Supplemental  disclosures:                            |       |        |       |           |       |             |       |             |       |             |       |
| Interest paid                                         |       | $           | 7,790      |           | $          | —           |       | $                | 2,485      |             | $          | — |   | $ | 10,275 |   |
| Income taxes  (refunded) paid                         |       | (2,607      | )          | 2,552          |       | 105              |       | —           |       | 50               |       |

 

26

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**Item 2.**                          Management’sDiscussion and Analysis of Financial Condition and Results of Operations

*The following discussion shouldbe read in conjunction with the Condensed Consolidated Financial Statements ofthe Company and the notes thereto included elsewhere herein.*

**ForwardLooking Statements**

Statementscontained herein that are not historical facts constitute “forward lookingstatements” as that term is defined in the Private Securities Litigation ReformAct of 1995. Words such as “believes,” “plans,” “anticipates,” “expects,” “will”and similar expressions are intended to identify forward looking statements. Forwardlooking statements include, but are not limited to, statements relating to thesufficiency of our capital resources, changes in commodity prices, anticipatedcapital expenditures, costs and expenses of litigation and our plans withrespect to restaurant openings, closings, re-imagings and re-franchisings. Allforward looking statements are subject to known and unknown risks,uncertainties and other factors which could cause actual results to differmaterially from those anticipated. These factors include: our highlycompetitive business environment; exposure to fluctuating commodity prices;risks associated with the foodservice industry, such as changes in consumertastes and adverse publicity resulting from food quality, illness, injury orother health concerns; the ability to retain and attract new employees;government regulations; high geographic concentration in the Northeast and itsattendant weather patterns; conditions needed to meet restaurant re-imaging andnew opening targets; risks and uncertainties arising out of accountingadjustments; our ability to service our debt and other obligations; our abilityto meet ongoing financial covenants contained in our debt instruments, loanagreements, leases and other long-term commitments; and costs associated withimproved service and other initiatives. Other factors that may cause actualresults to differ from the forward looking statements contained herein and thatmay affect our prospects in general are included in our other filings with theSecurities and Exchange Commission. We are not obligated to update any forwardlooking statements, whether as a result of new information, future events or otherwise.

**Overview**

Ourrevenues are derived primarily from the operation of full-servicerestaurants, the distribution and sale of premium ice cream desserts throughretail locations and franchising. As of July 2, 2006, we operated 309full-service restaurants, franchised 210 full-service restaurants and sevennon-traditional units and manufactured a full line of premium ice creamdesserts distributed through more than 4,500 supermarkets and other retaillocations in 13 states.

27

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Following is a summaryof the Company-operated and franchised units:
| ** **             | ** ** | **For the Three Months Ended** | ** ** | **For the Six Months Ended** | ** ** |
|------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **             | ** ** | **July 2,**                                   | ** ** | **July 3,**                                 | ** ** | **July 2,** | ** ** | **July 3,** | ** ** |
| ** **             | ** ** | **2006**                                           | ** ** | **2005**                                         | ** ** | **2006** | ** ** | **2005** | ** ** |
| Company Units:         |       |                                               |       |                                             |       |   |   |   |   |
| Beginning of  period   |       | 312                                                |       | 337                                              |       | 314 |   | 347 |   |
| Openings               |       | 1                                                  |       | 1                                                |       | 2 |   | 1 |   |
| Refranchised  closings |       | (3                                                 | )          | (3                                               | )          | (4 | ) | (10 | ) |
| Closings               |       | (1                                                 | )          | (3                                               | )          | (3 | ) | (6 | ) |
| End of period          |       | 309                                                |       | 332                                              |       | 309 |   | 332 |   |
|                   |       |                                               |       |                                             |       |   |   |   |   |
| Franchised  Units:     |       |                                               |       |                                             |       |   |   |   |   |
| Beginning of  period   |       | 214                                                |       | 201                                              |       | 213 |   | 195 |   |
| Refranchised  openings |       | 3                                                  |       | 3                                                |       | 4 |   | 10 |   |
| Openings               |       | 1                                                  |       | 1                                                |       | 1 |   | 2 |   |
| Closings               |       | (1                                                 | )          | —                                           |       | (1 | ) | (2 | ) |
| End of period          |       | 217                                                |       | 205                                              |       | 217 |   | 205 |   |

 

***Discontinued Operations***

During December 2005,we closed seven restaurants and committed to a plan to sell the sevenrestaurants as well as four restaurants that were closed in 2004. During thesix months ended July 2, 2006, we sold seven of these restaurants. At July 2,2006, the remaining four properties and one additional property closed duringthe six months ended July 2, 2006 met the criteria for “held for sale” asdefined in SFAS No. 144.

In accordance with SFAS No. 144, the results of operations of the sevenproperties that were disposed of during the six months ended July 2, 2006and the 14 properties that were disposed of during 2005 and the related netgain on the disposals, as well as the results of operations of the propertiesheld for sale at July 2, 2006, were reported separately as discontinuedoperations.

***Three Months Ended July 2, 2006Compared With Three Months Ended July 3, 2005***

*Revenues:*

*Total revenues — *Totalrevenues decreased $3.6 million, or 2.5%, to $141.5 million for thethree months ended July 2, 2006 from $145.1 million for the samequarter in 2005.

*Restaurant revenues — *Restaurantrevenues decreased $4.2 million, or 3.8%, to $105.3 million for thethree months ended July 2, 2006 from $109.5 million for the sameperiod in 2005. ComparableCompany-operated restaurant revenues during this perioddecreased by $2.5 million, or 1.8%, as high gasoline prices continuedthroughout the quarter and record June rainfall was experienced in many ofour Northeast and Mid-Atlantic operating areas. These factors particularlyaffected our evening snack daypart and ice cream business, which reported thegreatest sales declines during the quarter. The opening of four new restaurants over the past 15 monthsincreased revenues by $1.4 million. These increases were more thanoffset by the closing of three locationsand the re-franchising of 12 locations over the past 15 months resulting indeclines of $0.6 million and $2.5 million, respectively, inrestaurant revenues in the second quarter of 2006 as compared to the sameperiod in 2005.

There was one new restaurant opened during the secondquarters of both 2006 and 2005; a total of 22 restaurants were remodeled duringthe 2006 quarter as compared to six restaurants remodeled during the 2005quarter.

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*Foodservice revenues** — *Foodservice revenues(product sales to franchisees and retail customers) increased $0.4 million,or 1.2%, to $32.1 million for the three months ended July 2, 2006from $31.7 million for the three months ended July 3, 2005. Sales tofoodservice retail supermarket customers increased $0.3 million in thethree months ended July 2, 2006 compared to the same period in 2005. Atthe beginning of 2006, we decided to cease our relationship with certainnon-profitable customers, which represented approximately 5% of our totalretail volume in fiscal 2005. While our case volume was down 2.7% during thethree month period ended July 2, 2006 from the same quarter in 2005 as aresult of this decision (mainly in our 56 ounce carton business, as ourspecialty line of products continues to grow), a reduction in promotional tradespending and sales allowances of 0.6% of sales during the quarter slightlyoffset the decrease in revenues resulting from the volume decline. Franchisedrestaurant product revenue increased marginally at $0.1 million. Revenuesincreased due to the additional number of operating franchised restaurants, 217at the end of the second quarter of 2006 compared to 205 at the end of thesecond quarter of 2005; however, this was offset by lower product shipmentsresulting from a 3.9% reduction in comparable franchised restaurant revenuesduring the quarter.

*Franchise revenues** — *Franchise royalty andfee revenues increased $0.2 million, or 5.3%, to $4.1 million for thethree months ended July 2, 2006 compared to $3.9 million for the sameperiod in 2005. This was primarily due to an increase in rental income forleased and subleased franchise locations of $0.2 million, to a total of$1.1 million for the three months ended July 2, 2006 from the sameperiod in 2005, due to an increase in the number of operating franchisedstores.

Royalties of $2.9 millionduring the second quarter of 2006 were comparable to the same period in 2005.Total royalties increased due to the opening of seven new franchisedrestaurants and the re-franchising of 12 restaurants during the last 15 months,but were partially offset by the closing of three under-performing locationsduring the same period. This increase in royalties was completely offset,however, due to a 3.9% reduction in comparable franchised restaurant revenueswhich was experienced during the second quarter of 2006, following the strong5.4% increase in franchised restaurant revenues experienced in the secondquarter of 2005.

Initialfranchise fees of $0.1 million remained constant during the three monthsended July 2, 2006 when compared to the same period in 2005, resultingfrom the refranchising of three Company-operated locations and one new locationopening during the quarter ended July 2, 2006, against the refranchisingof three Company-operated locations and two new location openings during thequarter ended July 3, 2005.

*Cost of sales:*

Cost of sales decreased $2.7 million, or 4.8%, to$51.9 million for the three months ended July 2, 2006 from $54.6 millionfor the same period in 2005. Cost of sales as a percentage of total revenueswas 36.7% and 37.6% for the three months ended July 2, 2006 and July 3,2005, respectively. This improvement resulted from a combination of lower costof sales within the restaurant segment of 0.5%, lower cost of sales within thefoodservice segment of 3.9%, with a partial offset due to a slightlyunfavorable shift in sales mix away from Company restaurant revenues (whichcarried a lower cost of sales percentage of 26.1%) to foodservice revenues(which carried a higher cost of sales percentage of 76.3%) during the secondquarter of 2006. Company restaurant revenues declined as a percentage of totalrevenue from 75.4% in the second quarter of 2005 to 74.4% in the second quarterof 2006, while foodservice revenues increased as a percentage of total revenuesfrom 21.9% in the second quarter of 2005 to 22.7% in the second quarter of2006.

Restaurantcost of sales as a percentage of restaurant revenues decreased to 26.1% in thesecond quarter of 2006 from 26.6% in the second quarter of 2005. Thisimprovement was due to menu price increases of approximately 3.9% and productre-formulations, as overall food commodities were generally flat against theprior year quarter. Decreases in certain meat, poultry, fish and dairy products(primarily cream) were offset by increases in certain other food productcategories, such as frozen foods (french fries) and beverages.

Foodservice cost of sales as a percentage offoodservice revenues decreased to 76.3% in the second quarter of 2006 from80.2% in the second quarter of 2005. This improvement is primarily a result oflower cream costs in the second quarter of 2006 compared to the same period in2005.

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Thecost of cream, the principal ingredient used in making ice cream, affects costof sales as a percentage of total revenues, especially in our foodserviceretail business. Cream is priced directly off of AA butter prices quoted on theChicago Mercantile Exchange. As an example, a $0.10 increase in the cost of apound of AA butter adversely affects our annual cost of sales by approximately$0.9 million. This adverse impact may be offset by price increases orother factors. However, no assurance can be given that we will be able tooffset any cost increases in the future and future increases in cream pricescould have a material adverse effect on our results of operations. To minimizerisk, alternative supply sources continue to be pursued.

The overall cost of cream was approximately $0.8 millionlower in the three month period ended July 2, 2006 (weighted average priceof $1.15 per pound) when compared to the same period in 2005 (weighted averageprice of $1.53 per pound); however, market losses on cash-settled butterfutures contracts were $0.1 million greater than the losses experienced onbutter future contracts during the second quarter of 2005. Approximately 70% ofthis $0.7 million net cost of sales benefit in the second quarter, orapproximately $0.5 million, was reported within our foodservice segment.

We enter into commodity option contracts from time totime to manage dairy cost pressures. Our commodity option contracts do not meethedge accounting criteria as defined by SFAS No. 133, “Accounting forDerivative Instruments and Hedging Activities,” and its related amendment, SFASNo. 138, “Accounting for Certain Derivative Instruments and Certain HedgingActivities”, and, accordingly, are marked to market each period with the resultinggains or losses recognized in cost of sales.

Forthe remainder of 2006, we expect that cream prices will be lower than theprices experienced in 2005. Additionally, the results derived from options forbutter futures contracts are more likely to be unfavorable in 2006 whencompared to 2005.

On September 19,2005, the Chicago Mercantile Exchange launched the first electronically traded,cash-settled butter futures contract. This new futures contract is designed tomeet the needs of food and dairy companies that have exposure to butterfatprice risk but do not want to expose themselves to the possibility of beingcompelled to take physical delivery of butter. The size of the contractis 20,000 pounds of AA butter, versus the traditional butterfutures contract, which is 40,000 pounds. The contract is cash settledbased upon the USDA monthly weighted average price for butter in the UnitedStates. With this new type of futures contract, there is no risk ofdelivery of butter; therefore it offers us the ability to hedge the price riskof cream (on a butter basis) without having to take delivery of commoditybutter. We have evaluated this new hedging instrument and believe it is anattractive way to hedge the price risk related to cream. At July 2, 2006,we held 59 contracts spread over the remaining months of 2006. These contractscorrespond to approximately 20% of our anticipated cream purchases for theremainder of the year. Additionally, we held five February 2007 contracts whichalone provide minimal coverage for next year’s volumes in total, butapproximately 20% coverage for the month of February because production istypically low that time of year.

*Labor and benefits:*

Labor and benefits,which were only reported within our restaurant segment, decreased $1.6 million,or 4.0%, to $36.9 million for the three months ended July 2, 2006from $38.5 million for the three months ended July 3, 2005. As apercentage of total revenues, labor and benefits decreased to 26.1% in thesecond quarter of 2006 from 26.5% in the second quarter of 2005. This reductionwas due entirely to the shift in sales mix away from Company restaurantrevenues to foodservice revenues. Labor and benefits in the second quarter of2006, as a percentage of Company restaurant revenue only, remained flatcompared to the second quarter of 2005 at 35.1%.

30

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*Operating expenses:*

Operatingexpenses decreased $0.7 million, or 2.4%, to $26.8 million for thethree months ended July 2, 2006 from $27.5 million for the threemonths ended July 3, 2005. Operating expenses as a percentage of totalrevenues were 19.0% and 18.9% in the 2006 and 2005 periods, respectively. Asignificant portion of these expenses ($25.2 million in 2006 and $25.9 millionin 2005) were reported within our restaurant segment. In the second quarter of2006, these costs consisted of $4.1 million in supplies, $4.6 millionin utilities, $3.4 million in maintenance and cleaning, $4.2 millionin advertising, $5.3 million in occupancy and $3.6 million in otherrestaurant expenses. The dollar decrease of $0.7 millionprimarily resulted from lower advertising costs of $1.4 million, partiallyoffset by higher costs for utilities of $0.8 million.

*General and administrative expenses:*

General andadministrative expenses increased $0.9 million, or 8.7%, to $11.4 millionfor the three months ended July 2, 2006 from $10.5 million for thethree months ended July 3, 2005. General and administrative expenses as apercentage of total revenues increased to 8.1% in the 2006 period from 7.3% inthe 2005 period. The $0.9 millionincrease is primarily the result of increases in salaries ($0.2 million),pension costs ($0.2 million), stock compensation expense ($0.1 million)and legal fees ($0.4 million).

The increase in legalfees was primarily due to the ongoing shareholder derivative lawsuit filed byS. Prestley Blake against us and our Chairman of the Board. On May 24,2006, the Court denied the Committee’s motion to dismiss and allowed thejoinder, as defendants, of current Board members Steven L. Ezzes, Michael J.Daly and Burton J. Manning, and former Board member Charles A. Ledsinger, Jr.,and The Restaurant Company, The Restaurant Holding Corporation and TRC Realty,LLC. As a result of the Court’s denial of our motion to dismiss, we expect tocontinue to incur increased legal fees in the defense of this lawsuit.

*Stock-based compensation expense:*

OnJanuary 2, 2006, we adopted the Financial Accounting Standards Board’sStatement of Financial Accounting Standard No. 123 (revised 2004), “Share-Based Payment,”*(“*SFAS No. 123R”), using themodified prospective application method. Compensation cost is calculated on thedate of grant using the fair value of the options as determined by theBlack-Scholes valuation model. The Black-Scholes valuation model requires us tomake several assumptions, including volatility. We have considered the guidancein SFAS No. 123R and believe that our historical estimated volatility ismaterially indicative of expectations about future volatility.

Duringthe three months ended July 2, 2006, we recognized $0.1 million oftotal stock-based compensation expense as a result of the adoption of SFAS No.123R, which was included in general and administrative expenses. We expect torecognize an additional $0.3 million of stock compensation expense duringthe remainder of 2006 related to the awards outstanding at July 2, 2006.

Priorto the adoption of SFAS No. 123R, we accounted for share-based payments toemployees using APB Opinion No. 25’s, “Accountingfor Stock Issued to Employees,” intrinsic value method and, as such,generally recognized no compensation cost for employee stock options. Theadoption of SFAS No. 123R under the modified prospective application methodallowed us to recognize compensation cost (a) based on the requirement of SFAS123R for all share-based payments granted after the effective date and (b)based on the requirements of SFAS No. 123 for all awards granted to employeesprior to the effective date of SFAS No. 123R that remain unvested on theeffective date. Under the modified prospective application method, priorperiods were not restated for the effect of SFAS No. 123R. We used thestraight-line attribution method to recognize expense for all grants made.

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Asof July 2, 2006, there was $1.1 million of total unrecognizedcompensation cost related to unvested share-based awards. That cost is expectedto be recognized over a weighted-average period of 2.5 years.

SeeNote 3 of Notes to Condensed Consolidated Financial Statements contained inItem 1 of this Quarterly Report on Form 10-Q for further information regardingour adoption of SFAS No. 123R.

W*rite-downs of property and equipment:*

Duringthe three months ended July 3, 2005, the Company identified two restaurantproperties to be disposed of other than by sale and determined that thecarrying values of these restaurant properties exceeded their estimatedundiscounted cash flows. The carrying values were reduced by an aggregate of$0.3 million accordingly. There were no such reductions during the threemonths ended July 2, 2006.

*Depreciation and amortization:*

Depreciationand amortization was $5.7 million and $5.6 million for the threemonths ended July 2, 2006 and July 3, 2005, respectively.Depreciation and amortization as a percentage of total revenues was 4.1% and3.9% in the 2006 and 2005 quarters, respectively.

*Gain on franchise sales of restaurant operationsand properties:*

Gainon franchise sales of restaurant operations and properties was $1.1 millionand $1.2 million in the three months ended July 2, 2006 and July 3,2005, respectively.

Duringthe three months ended July 2, 2006, we recognized a gain of $1.1 millionassociated with the sale of certain equipment assets, lease and sublease rightsand franchise rights in three existing Company-operated restaurants located inLancaster and York, Pennsylvania. During the three months ended July 3,2005, we recognized a gain of $1.2 million associated with the sale ofcertain equipment assets, lease and sublease rights and franchise rights inthree existing Company-operated restaurants.

*Loss on disposals of other property and equipment, net:*

Theloss on disposals of other property and equipment, net was $0.4 millionand $0.3 million for the three months ended July 2, 2006 and July 3,2005, respectively. The table below identifies the components of the loss ondisposals of other property and equipment, net as shown on the accompanyingcondensed consolidated statements of operations (in thousands):

 

|                                                         | ** ** | **For the Three Months Ended** | ** ** |
|---------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                              | ** ** | **July 2,**                                   | ** ** | **July 3,** | ** ** |
| ** **                                              | ** ** | **2006**                                           | ** ** | **2005** | ** ** |
|                                                    |       |                                               |       |   |   |
| Restaurant  equipment assets retired due to remodeling  |       | $                                                  | 296        |   | $ | 220 |   |
| Restaurant  equipment assets retired due to replacement |       | 67                                                 |       | 43 |   |
| Gain due to  restaurant flood                           |       | (79                                                | )          | — |   |
| All other                                               |       | 82                                                 |       | 10 |   |
| Loss on disposals of  other property and equipment, net |       | $                                                  | 366        |   | $ | 273 |   |

 

*Interest expense, net:*

Interest expense, net ofcapitalized interest and interest income, was $5.1 million and $5.2 millionfor the three months ended July 2, 2006 and July 3, 2005,respectively.

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*Provisionfor income taxes:*

The provision for incometaxes was $0.3 million for the three months ended July 2, 2006. As a result ofour intent to continue recording a full valuation allowance on tax benefitsuntil we can sustain an appropriate level of profitability, the provision wasbased on an estimate of our current taxes payable through the second quarter of2006. The provision for income taxes was $1.2 million, an effective tax rate of30.5%, for the three months ended July 3, 2005.

*Income (loss) from continuing operations:*

Incomefrom continuing operations was $4.0 million and $2.6 million for the threemonths ended July 2, 2006 and July 3, 2005, respectively, for the reasonsdiscussed above.

*Income (loss) from discontinuedoperations:*

Inaccordance with SFAS No. 144, “Accounting for the Impairment or Disposal ofLong-Lived Assets,” the results of operations of a component of an entity thateither has been disposed of or is classified as held for sale and any relatedgain (loss) on the sales are reported in discontinued operations if both of thefollowing conditions are met: (a) the operations and cash flows of thecomponent have been (or will be) eliminated from the ongoing operations of theentity as a result of the disposal transaction and (b) the entity will nothave any significant continuing involvement in the operations of the componentafter the disposal transaction.

Reported in discontinued operations were the results ofoperations of the sevenproperties that were disposed of during the six months ended July 2, 2006, the14 properties disposed of during 2005 and the related net gain on disposals, aswell as the results of operations of the properties held for sale at July 2,2006.  For the quarters ended July 2,2006 and July 3, 2005, this consisted of thefollowing (in thousands):

|                                              | ** ** | **For the Three Months Ended** | ** ** |
|----------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                   | ** ** | **July 2,**                                   | ** ** | **July 3,** | ** ** |
| ** **                                   | ** ** | **2006**                                           | ** ** | **2005** | ** ** |
|                                         |       |                                               |       |   |   |
| Net sales                                    |       | $                                                  | —     |   | $ | 3,330 |   |
|                                         |       |                                               |       |   |   |
| Operating loss                               |       | (79                                                | )          | (198 | ) |
| Gain on disposals of  property and equipment |       | 1,203                                              |       | (25 | ) |
| Income tax (expense)  benefit                |       | (450                                               | )          | 91 |   |
| Income (loss) from discontinued operations   |       | $                                                  | 674        |   | $ | (132 | ) |

 

***SixMonths Ended July 2, 2006 Compared With Six Months Ended July 3, 2005***

*Revenues:*

*Total revenues —* Totalrevenues increased $0.4 million, or 0.2%, to $267.2 million for the six monthsended July 2, 2006 from $266.8 million for the same period in 2005.

*Restaurant revenues —* Restaurantrevenues decreased $2.1 million, or 1.0%, to $200.5 million for the six monthsended July 2, 2006 from $202.6 million for the same period in 2005. Comparable Company-operated restaurant revenues during this periodincreased by $2.0 million, or 1.2%, on strong first quarter comparable sales of4.8%.  Increases occurred in mostdayparts, with the largest occurring during the dinner and afternoon snackperiods.  Operating days lost due toweather closings were lower in 2006 when compared to 2005 as most markets inNew England recorded higher than normal snowfall during 2005.  Additionally, the opening of four new restaurants over the past 18 monthsincreased revenues by $2.5 million. These increases were more than offset by the closing of three locations and the re-franchising of 19 locations over the past18 months resulting in declines of $0.8 million and $5.8 million, respectively,in restaurant revenues in the six months ended July 2, 2006 as compared to thesame period in 2005.

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There were two new restaurants opened during the six monthsended July 2, 2006 compared to one new restaurant opened during the same periodin 2005. There were 23 and seven restaurants remodeled during the 2006 periodand the 2005 period, respectively.

*Foodservice revenues**—* Foodservice revenues (product sales tofranchisees and retail customers) increased $1.9 million, or 3.5%, to $59.0 millionfor the six months ended July 2, 2006 from $57.1 million for the six monthsended July 3, 2005. Sales to foodservice retail supermarket customers increased$0.6 million in the six months ended July 2, 2006 compared to the same periodin 2005. While case volume was up 1.7% due to the favorable timing ofpromotions affecting volume in the first quarter, higher promotional tradespending and sales allowances of 1.0% of sales during the period slightlyoffset the revenue increase resulting from the volume growth.  Franchised restaurant product revenueincreased $1.4 million. Revenues increased due to the additional number ofoperating franchised restaurants, 217 at the end of the second quarter of 2006compared to 205 at the end of the second quarter of 2005; however, thisincrease in revenues was partially offset by lower product case shipmentsresulting from a 1.9% reduction in comparable franchised restaurant revenuesduring the first six months of 2006 compared to the same period in 2005.

*Franchise revenues**—* Franchise royalty and fee revenuesincreased $0.5 million, or 7.0%, to $7.6 million for the six months ended July2, 2006 compared to $7.1 million for the same period in 2005 primarily due toan increase in rental income for leased and subleased franchise locations of$0.3 million, to a total of $2.0 million, for the six months ended July 2, 2006due an increase in the number of operating franchised stores.

Royalties of $5.4million increased $0.2 million for the six months ended July 2, 2006 as comparedto the same period in 2005 due primarily to the opening of seven new franchiserestaurants and 19 re-franchised restaurants during the last 18 months. Theclosing of four under-performing locations during the same period had littleimpact.  This increase in royalties waspartially offset, however, due to a 1.9% reduction in comparable franchisedrestaurant revenues which was experienced during the six months ended July 2,2006, following the 3.5% increase in comparable franchised restaurant revenues experiencedin the six months ended July 3, 2005.

Initialfranchise fees decreased slightly during the six months ended July 2, 2006 whencompared to the same period in 2005, resulting from the refranchising of fourCompany-operated locations and one new location opening during the six monthsended July 2, 2006, against the refranchising of four Company-operatedlocations and two new locations opening during the six months ended July 3,2005.  Last year, we also completed threetransactions in which three former employees received franchises to operate sixexisting restaurants for a period of two years with options to purchase therestaurants within the two years.  If theoptions are exercised, one franchisee has agreed to develop two new restaurantsin future years.  Proceeds from optiontransactions will be recognized upon purchase.

*Cost of sales:*

Cost of sales decreased $1.2 million, or 1.1%, to$100.3 million for the six months ended July 2, 2006 from $101.5 million forthe same period in 2005. Cost of sales as a percentage of total revenues was37.5% and 38.0% for the six months ended July 2, 2006 and July 3, 2005,respectively. This improvement resulted from a combination of a reduction ofcost of sales within the restaurant segment of 0.6%, a reduction of cost ofsales within the foodservice segment of 2.0%, and a partial offset due to aslightly unfavorable shift in sales mix away from Company restaurant revenues(which carried a lower cost of sales percentage of 26.4%) to foodservicerevenues (which carried a higher cost of sales percentage of 80.2%) during thesix months ended July 2, 2006. Company restaurant revenues declined as apercentage of total revenue from 75.9% in the 2005 period to 75.1% in the 2006period, while foodservice revenues increased as a percentage of total revenuesfrom 21.4% in the 2005 period, to 22.0% in the 2006 period.

Restaurantcost of sales as a percentage of restaurant revenues decreased to 26.4% for thesix months ended July 2, 2006 from 27.0% for the same period in 2005. Thisimprovement was due to menu price increases and product re-formulations, asoverall food commodities were generally flat against the prior year.  Decreases in certain meat, poultry, fish anddairy products (primarily cream) were offset by increases in certain other foodproduct categories, such as frozen foods (french fries) and beverages.

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Foodservicecost of sales as a percentage of foodservice revenues decreased to 80.2% in thesix months ended July 2, 2006 from 82.2% in the six months ended July 3, 2005.This improvement was primarily a result of lower cream costs in the 2006 periodcompared to the same period in 2005.

The overall cost of cream was approximately $1.5million lower in the six month period ended July 2, 2006 (weighted averageprice of $1.24 per pound) when compared to the same period in 2005 (weightedaverage price of $1.64 per pound); however, market losses on cash-settledbutter futures contracts were $0.3 million greater than the losses experiencedon butter future contracts during the second quarter of 2005.  Approximately 70% of this $1.2 million netcost of sales benefit on a year to date basis, or approximately $0.8 million,was reported within our foodservice segment.

*Labor and benefits:*

Labor and benefits,which were only reported within our restaurant segment, decreased $0.6 million,or 0.8%, to $73.0 million for the six months ended July 2, 2006 from $73.6million for the six months ended July 3, 2005. As a percentage of totalrevenues, labor and benefits decreased to 27.3% for the six months ended July2, 2006 from 27.6% for the six months ended July 3, 2005. This reduction wasdue entirely to the shift in sales mix away from Company restaurant revenues tofoodservice revenues. Labor and benefits, as a percentage of Company restaurantrevenue only, increased only marginally to 36.4% for the six months ended July2, 2006 from 36.3% for the same period in 2005.

*Operating expenses:*

Operating expensesdecreased $0.1 million, or 0.1%, to $50.8 million for the six months ended July2, 2006 from $50.9 million for the six months ended July 3, 2005. Operatingexpenses as a percentage of total revenues were 19.0% and 19.1% in the 2006 and2005 periods, respectively. A significant portion of these expenses ($48.1million in 2006 and $48.2 million in 2005) were reported within our restaurantsegment. In the six months ended July 2, 2006, these costs consisted of $7.6million in supplies, $9.5 million in utilities, $6.5 million in maintenance andcleaning, $6.4 million in advertising, $10.6 million in occupancy and $7.5million in other restaurant expenses. The dollar decrease of $0.1 million primarily resulted from lower advertising andmaintenance and cleaning costs of $0.9 million and $0.5 million, respectively,partially offset by higher costs for utilities of $1.2 million in the 2006period when compared to the 2005 period.

*General and administrative expenses:*

General andadministrative expenses were $22.5 million and $20.0 million for the six monthsended July 2, 2006 and July 3, 2005, respectively. General and administrativeexpenses as a percentage of total revenues increased to 8.4% in the 2006 periodfrom 7.5% in the 2005 period. The $2.5 millionincrease was primarily the result of increases in salaries ($1.3 million),severance costs ($0.4 million), pension costs ($0.3 million), stockcompensation expense ($0.2 million) and legal fees ($0.6 million).

The increase in legalfees was primarily due to the ongoing shareholder derivative lawsuit filed byS. Prestley Blake against us and our Chairman of the Board.  On May 24, 2006, the Court denied theCommittee’s motion to dismiss and allowed the joinder, as defendants, ofcurrent Board members Steven L. Ezzes, Michael J. Daly and Burton J. Manning,and former Board member Charles A. Ledsinger, Jr., and The Restaurant Company,The Restaurant Holding Corporation and TRC Realty, LLC.  As a result of the Court’s denial of ourmotion to dismiss, we expect to continue to incur increased legal fees in thedefense of this lawsuit.

*Stock-based compensation expense:*

OnJanuary 2, 2006, we adopted the Financial Accounting Standards Board’sStatement of Financial Accounting Standard No. 123 (revised 2004), “Share-Based Payment,”*(“*SFAS No. 123R”), using themodified prospective application method. Compensation cost is calculated on thedate of grant using the fair value of the options as determined by theBlack-Scholes valuation model. The Black-Scholes valuation model requires us tomake several assumptions including volatility. We have considered the guidancein SFAS No. 123R and believe that our historical estimated volatility ismaterially indicative of expectations about future volatility.

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Duringthe six months ended July 2, 2006, we recognized $0.2 million of totalstock-based compensation expense as a result of the adoption of SFAS No. 123R,which was included in general and administrative expenses.  We expect to recognize an additional $0.3million of stock compensation expense during the remainder of 2006 related tothe awards outstanding at July 2, 2006.

Priorto the adoption of SFAS No. 123R, we accounted for share-based payments toemployees using APB Opinion No. 25’s, “Accountingfor Stock Issued to Employees,” intrinsic value method and, as such,generally recognized no compensation cost for employee stock options. Theadoption of SFAS No. 123R under the modified prospective application methodallowed us to recognize compensation cost (a) based on the requirement of SFAS123R for all share-based payments granted after the effective date and (b)based on the requirements of SFAS No. 123 for all awards granted to employeesprior to the effective date of SFAS No. 123R that remain unvested on theeffective date. Under the modified prospective application method, priorperiods were not restated for the effect of SFAS No. 123R. We used thestraight-line attribution method to recognize expense for all grants made.

Asof July 2, 2006, there was $1.1 million of total unrecognized compensation costrelated to unvested share-based awards. That cost is expected to be recognizedover a weighted-average period of 2.5 years.

SeeNote 3 of Notes to Condensed Consolidated Financial Statements contained inItem 1 of this Quarterly Report on Form 10-Q for further information regardingour adoption of SFAS No. 123R.

*Write-downs of property and equipment:*

Write-downsof property and equipment were $0.2 million and $0.3 million in the six monthsended July 2, 2006 and July 3, 2005, respectively. During the six months endedJuly 2, 2006, we determined that the carrying value of one restaurant propertyexceeded its estimated fair value less costs to sell and the carrying value wasreduced by $0.2 million accordingly. During the six months ended July 3, 2005, the Company identified tworestaurant properties to be disposed of other than by sale and determined thatthe carrying values of these restaurant properties exceeded their estimated undiscountedcash flows.  The carrying values were reduced by an aggregate of $0.3 millionaccordingly.

*Depreciation and amortization:*

Depreciationand amortization was $11.5 million and $11.8 million for the six months endedJuly 2, 2006 and July 3, 2005, respectively. Depreciation and amortization as apercentage of total revenues was 4.3% and 4.4% in the 2006 and 2005 periods,respectively. The 2005 period was higher primarily due to a reduction of thelives of leasehold improvement assets as a result of management decisions toclose certain leased properties sooner than previously anticipated.

*Gain on franchise sales of restaurant operationsand properties:*

Gainon franchise sales of restaurant operations and properties was $2.0 million and$2.5 million in the six months ended July 2, 2006 and July 3, 2005,respectively. During the six months ended July 2, 2006, we recognized gains of $2.0million associated with the sale of certain equipment assets, lease andsublease rights and franchise rights in four existing Company-operatedrestaurants.  During the six months endedJuly 3, 2005, we recognized a gain of $2.5 million associated with the sale ofcertain equipment assets, lease and sublease rights and franchise rights infour existing Company-operated restaurants.

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*Loss on disposals of other property and equipment, net:*

Theloss on disposals of other property and equipment, net was $0.5 million and$0.3 million for the six months ended July 2, 2006 and July 3, 2005,respectively.  The table below identifiesthe components of the loss on disposals of other property and equipment, net asshown on the accompanying condensed consolidated statements of operations (inthousands):

|                                                         | ** ** | **For the Six Months Ended** | ** ** |
|---------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                              | ** ** | **July 2,**                                 | ** ** | **July 3,** | ** ** |
| ** **                                              | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Restaurant equipment  assets retired due to remodeling  |       | $                                                | 296        |   | $ | 220 |   |
| Restaurant equipment  assets retired due to replacement |       | 142                                              |       | 95 |   |
| Gain due to restaurant  flood                           |       | (48                                              | )          | — |   |
| All other                                               |       | 85                                               |       | 27 |   |
| Loss on disposals of other property and equipment, net  |       | $                                                | 475        |   | $ | 342 |   |

 

*Interest expense, net:*

Interest expense, net ofcapitalized interest and interest income, was $10.6 million and $10.5 millionfor the six months ended July 2, 2006 and July 3, 2005, respectively. Theincrease in interest expense in the 2006 period compared to the same period in2005 was primarily due to a fee of $0.2 million associated with the assignmentof our Credit Facility from Bank of America and certain other lenders to WellsFargo Foothill.  This fee was partiallyoffset by reduced amounts of interest on capital leases and lower interestrates on our mortgage financing. Total outstanding debt, including capitallease and finance obligations, decreased from $234.4 million at July 3, 2005 to$232.5 million at July 2, 2006.

*Provisionfor income taxes:*

The provision for incometaxes was $0.3 million for the six months ended July 2, 2006. As a result ofour intent to continue recording a full valuation allowance on tax benefitsuntil we can sustain an appropriate level of profitability, the provision wasbased on an estimate of our current taxes payable through the second quarter2006.

The provision for incometaxes was $0.4 million for the six months ended July 3, 2005. The $0.4 milliontax provision included $0.2 million of tax expense allocated specifically tocontinuing operations increased by an additional $0.2 million resulting fromcertain items then being discussed with the IRS.

*(Loss) income from continuing operations:*

Lossfrom continuing operations was $0.5 million for the six months ended July 2,2006 compared to income from continuing operations of $31,000 for the sixmonths ended July 3, 2005 for the reasons discussed above.

*Income (loss) from discontinuedoperations:*

Inaccordance with SFAS No. 144, “Accounting for the Impairment or Disposal ofLong-Lived Assets,” the results of operations of a component of an entity thateither has been disposed of or is classified as held for sale and any relatedgain (loss) on the sales are reported in discontinued operations if both of thefollowing conditions are met: (a) the operations and cash flows of thecomponent have been (or will be) eliminated from the ongoing operations of theentity as a result of the disposal transaction and (b) the entity will nothave any significant continuing involvement in the operations of the componentafter the disposal transaction.

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Reportedin discontinued operations were the results of operations of the seven properties that were disposed of during the six months endedJuly 2, 2006, the 14 properties disposed of during 2005 and the related netgain on disposals, as well as the results of operations of the properties heldfor sale at July 2, 2006.  For the sixmonths ended July 2, 2006 and July 3, 2005, this consisted of the following (in thousands):

|                                                     | ** ** | **For the Six Months Ended** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                          | ** ** | **July 2,**                                 | ** ** | **July 3,** | ** ** |
| ** **                                          | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Net sales                                           |       | $                                                | —     |   | $ | 6,315 |   |
|                                                |       |                                             |       |   |   |
| Operating loss                                      |       | (328                                             | )          | (821 | ) |
| Gain (loss) on  disposals of property and equipment |       | 4,068                                            |       | (26 | ) |
| Income tax (expense)  benefit                       |       | (450                                             | )          | 347 |   |
| Income (loss) from discontinued operations          |       | $                                                | 3,290      |   | $ | (500 | ) |

 

**Liquidityand Capital Resources**

*General:*

Ourprimary sources of liquidity and capital resources are cash generated fromoperations and, if needed, borrowings under our $35 million revolving credit facility(the “Credit Facility”). Additional sources of liquidity consist of capital andoperating leases for financing leased restaurant locations (in malls andshopping centers and land or building leases), restaurant equipment,manufacturing equipment, distribution vehicles and computer equipment. Othersources of cash are sales of under-performing existing restaurant propertiesand other assets and re-franchising (to the extent FICC’s and its subsidiaries’debt instruments permit). The amount of debt financing that FICC is able toincur is limited by the terms of our Credit Facility and 8.375% senior notesindenture. Below was the financing status of our operating restaurants andproperties that we lease to our franchisees as of July 2, 2006:

|                                              | ** ** | **Company  Operated** | ** ** | **Franchise  Operated** | ** ** |
|----------------------------------------------|------------|-----------------------|------------|-------------------------|------------|
| Owned land and  building, mortgaged          |       | 62                    |       | 11                      |       |
| Leased land, owned  building, mortgaged      |       | 1                     |       | 0                       |       |
| Sold and leased back                         |       | 59                    |       | 3                       |       |
| Owned land and building                      |       | 16                    |       | 5                       |       |
| Leased land, owned  building                 |       | 69                    |       | 25                      |       |
| Leased land and  building                    |       | 102                   |       | 12                      |       |
| Total Company/franchise-operated restaurants |       | 309                   |       | 56                      |       |

 

TheCompany-operated restaurants above not identified as owned land and building,mortgaged or sold and leased back secure our obligations under the CreditFacility. Of the 16 restaurant properties identified as owned land andbuilding, six were available to be sold.

Inaddition to our 309 operating restaurants, we have five closed properties thatare classified as held for sale in accordance with SFAS No. 144, “Accounting forthe Impairment or Disposal of Long-Lived Assets”.

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*Operating Cash Flows:*

Net cash provided byoperating activities was $10.1 million and $11.3 million for the six monthsended July 2, 2006 and July 3, 2005, respectively. Net loss excluding the gainson sales of fixed assets and other non-cash expenses contributed $0.6 millionto the $1.2 million decline in cash provided by operating activities. Changesin working capital reduced cash by an additional $0.6 million as cash refundsof federal income taxes and the release of escrow funds related to twopreviously mortgaged properties of $1.2 million and $1.7 million, respectively,were more than offset by unfavorable changes in inventory and accounts payable.We increased our production and inventory of ice cream during the quarter inorder to take advantage of favorable cream prices.

We had a working capitaldeficit of $3.6 million and $16.4 million as of July 2, 2006 and January 1,2006, respectively. Our working capital deficit includes assets classified asheld for sale in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” Theworking capital needs of companies engaged in the restaurant industry aregenerally low and as a result, restaurants are frequently able to operate witha working capital deficit because: (i) restaurant operations are conductedprimarily on a cash (and cash equivalent) basis with a low level of accountsreceivable; (ii) rapid turnover allows a limited investment in inventories; and(iii) cash from sales is usually received before related expenses for food,supplies and payroll are paid.

*Investing Cash Flows:*

Netcash provided by investing activities was $1.2 million for the six months endedJuly 2, 2006 as compared to net cash used in investing activities of $4.2million for the six months ended July 3, 2005.

Duringthe six month periods ended July 2, 2006 and July 3, 2005, we spent $8.0million and $7.3 million on capital expenditures, of which $6.7 million and$4.5 million, respectively, was spent on restaurant operations. Capitalexpenditures were offset by net proceeds from the sales of property andequipment of $9.2 million and $3.4 million for the six months ended July 2,2006 and July 3, 2005, respectively.

As of January 1, 2006,we had 11 restaurants that were reported as “held for sale” in accordance withSFAS No. 144. During the six months ended July 2, 2006, we sold seven of theserestaurants.  In accordance with SFAS No. 144, the results of operations of theseven properties that were disposed of during the six months ended July 2, 2006and the 14 properties that were disposed of during 2005 and the related netgain on the disposals, as well as the results of operations of the propertiesheld for sale at July 2, 2006, were reported separately as discontinuedoperations in the accompanying condensed consolidated statements of operationsfor all periods presented.  Operatinglosses before depreciation from these properties were $0.3 million and $0.5million during the six months ended July 2, 2006 and July 3, 2005,respectively.  Net proceeds on thedisposals of the seven properties sold during the six months ended July 2, 2006were $6.3 million.  There were no “heldfor sale” properties sold during the six months ended July 3, 2005.

During the six monthsended July 2, 2006, we completed two re-franchising transactions in whichexisting franchisees purchased four existing Company-operated restaurants andagreed to develop a total of eight new restaurants in future years.  Net proceeds from these transactions were$2.8 million, of which $0.2 million was for franchise fees and $2.6 million wasfor the sale of certain assets and leasehold rights.

During the six monthsended July 3, 2005, the Company completed two re-franchising transactions inwhich two existing franchisees purchased four existing Company restaurants andagreed to develop a total of five new restaurants in future years.  Gross proceeds from these transactions were$3.5 million, of which $0.1 million was for franchise fees and $3.4 million wasfor the sale of certain assets and leasehold rights.  In addition, we completed three transactionsin which three former employees received franchises to operate six existingrestaurants with options to purchase the restaurants within two years.  If the options are exercised, one franchiseewill also agree to develop two new restaurants in future years.  Proceeds from option transactions will berecognized upon purchase.

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*Financing Cash Flows:*

Netcash used in financing activities was $1.6 million and $5.2 million for the sixmonths ended July 2, 2006 and July 3, 2005, respectively. There were $4.0million of revolving credit loans outstanding at the end of 2004 that wererepaid in the first quarter of 2005. There were no revolving credit loans outstanding at the end of 2005.

*Outstanding Debt:*

*Sale/Leaseback and MortgageFinancings*.  In December 2001, we completed a financial restructuring plan whichincluded the repayment of all amounts outstanding under our then existingcredit facility and the purchase of approximately $21.3 million of our 10.5%senior notes with the proceeds from $55.0 million in long-term mortgagefinancing (the “Mortgage Financing”) and a $33.7 million sale and leasebacktransaction (the “Sale/Leaseback Financing”).

In connection withthe Sale/Leaseback Financing, we sold 44 properties operating as Friendly’srestaurants and entered into a master lease with the buyer to lease the 44properties for an initial term of 20 years under a triple net lease. There arefour five-year renewal options and lease payments are subject to escalatorprovisions every five years based upon increases in the Consumer Price Index.

Interest on $10.0million of the original $55.0 million from the Mortgage Financing is variable (“VariableMortgages”) and the remaining $45.0 million of the original $55.0 million fromthe Mortgage Financing bears interest at a fixed annual rate of 10.16% (“FixedMortgages”). The Fixed Mortgages have a maturity date of January 1, 2022 andare amortized over 20 years.

On December 30,2005, we completed a refinancing of the Variable Mortgages (the “VariableRefinancing”).  Under the terms of theloan agreement for the Variable Refinancing, we borrowed an aggregate sum of$8.5 million. The interest rate is variable and is the sum of the 90-day LIBORrate in effect (5.48% at July 2, 2006) plus 4% on an annual basis. Changes inthe interest rate are calculated monthly and recognized annually when themonthly payment amount is adjusted. Changes in the monthly payment amounts oweddue to interest rate changes are reflected in the principal balances, which arere-amortized over the remaining life of the mortgages. The loans under theVariable Refinancing have a maturity date of January 1, 2020 and are beingamortized over 14 years.

The primarypurposes of the Variable Refinancing were to (i) reduce the variable interestrate on the Variable Mortgages from LIBOR plus 6% on an annual basis to LIBORplus 4% on an annual basis, (ii) enable the partial prepayment of the loans,subject to applicable prepayment premiums during the first three years and anagreed upon release value for properties released in connection with partialprepayments, and (iii) permit partial lien releases on the properties subjectto the loans upon partial prepayments. In addition, in connection with thistransaction, we prepaid two mortgage loans from the lender in the aggregateamount of $1.0 million from existing cash.

Pursuant to the terms ofthe Mortgage Financing, we may sell properties securing our obligationsprovided that other properties are substituted in place of the soldproperties.  The substituted propertiesmust meet certain requirements under the terms of the Mortgage Financing.  In August 2005, proceeds of $0.4 million and$2.7 million were received in connection with the sale of two mortgagedproperties and $0.4 million and $1.3 million was placed in escrow.  As of January 1, 2006, these balances wereheld as collateral and were included in restricted cash on the accompanyingcondensed consolidated balance sheet as of January 1, 2006.  In connection with the Variable Refinancing,the mortgage on one of these properties was released and the $0.4 million wasreleased from escrow during the first quarter of 2006.  A substitution property for the secondproperty was obtained during the second quarter of 2006 in compliance with thesubstitution agreement. On June 15, 2006, the balance of $1.3 million wasreleased from escrow.

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InSeptember 2005, we acquired additional financing secured by our newlyconstructed Milford, MA restaurant (the “Milford Mortgage”). The financingprovided for a real estate improvement and equipment loan. The real estateimprovement loan has a principal balance of $0.8 million and is amortized over15 years with a balloon payment due on October 1, 2010. The equipment loan hasa principal balance of $0.3 million and is amortized over seven years with aballoon payment due on October 1, 2010. The interest rate is variable and isthe sum of the 90-day LIBOR rate in effect (5.48% at July 2, 2006) plus 4% onan annual basis. Changes in the interest rate are calculated monthly andrecognized annually when the monthly payment amount is adjusted. Changes in themonthly payment amounts owed due to interest rate changes are reflected in theprincipal balances, which are re-amortized over the remaining life of themortgages. The variable rate notes are subject to prepayment penalties duringthe first three years.

All mortgage financingsare subject to annual covenants, including various minimum fixed chargecoverage ratios.  We were in compliancewith the covenants for the Variable Mortgages and the Fixed Mortgages as ofJanuary 1, 2006.  As of January 1, 2006,we were not in compliance with the fixed charge coverage ratio related to theMilford Mortgage. We obtained a waiver from the Milford Mortgage lender onMarch 7, 2006 waiving this covenant requirement for the year ended January 1,2006.  On April 5, 2006, an amendment wasmade to the Milford Mortgage changing the fixed charge coverage ratio.  The amendment was effective as of the date ofthe Loan Agreement, September 30, 2005.

*8.375% Senior Notes.*  In 2003 and 2004, we purchased or redeemedall of the remaining outstanding 10.5% senior notes in a series oftransactions. In February 2004, weannounced a cash tender offer and consent solicitation for $176 million of our10.5% senior notes to be financed with the proceeds from a $175 million privateoffering of new 8.375% senior notes (the “Senior Notes”), available cash andour Credit Facility. In March 2004, $127.4 million of aggregate principalamount of 10.5% senior notes were purchased at the tender offer and consentsolicitation price of 104% of the principal amount and $0.5 million ofaggregate principal amount of 10.5% senior notes were purchased at the tenderoffer price of 102% of the principal amount. In April 2004, the remaining $48.1million of 10.5% senior notes were redeemed in accordance with the 10.5% seniornotes indenture at 103.5% of the principal amount.

The$175 million of Senior Notes issued in March 2004 are unsecured seniorobligations of FICC, guaranteed on an unsecured senior basis by FICC’s Friendly’sRestaurants Franchise, Inc. subsidiary, but are effectively subordinated to allsecured indebtedness of FICC, including the indebtedness incurred under ourCredit Facility. The Senior Notes mature on June 15, 2012. Interest on theSenior Notes is payable at 8.375% per annum semi-annually on June 15 andDecember 15 of each year.  The SeniorNotes are redeemable, in whole or in part, at any time on or after June 15,2008 at FICC’s option at redemption prices from 104.188% to 100.00%, based onthe redemption date.  In addition, at anytime prior to June 15, 2007, FICC may redeem, subject to certain conditions, upto 35% of the aggregate principal amount of the Senior Notes with the proceedsof one or more qualified equity offerings, as defined, at a redemption price of108.375% of the principal amount, plus accrued interest.

*Revolving Credit Facility.*  We have a $35.0 million Credit Facility whichis available for borrowings to provide working capital, for letters of creditand for other corporate needs. As of July 2, 2006 and January 1, 2006, totalletters of credit outstanding were $16.0 million. During 2006 and 2005, therewere no drawings against the letters of credit. The revolving credit loans bear interest at our option at either(a) the base rate plus the applicable margin as in effect from time totime (the “Base Rate”) (10.75% at July 2, 2006) or (b) the Eurodollar rateplus the applicable margin as in effect from time to time (the “Eurodollar Rate”)(9.81% at July 2, 2006). As of July 2, 2006 and January 1, 2006, there were norevolving credit loans outstanding. As of July 2, 2006 and January 1, 2006,$19.0 million was available for borrowing.

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The Credit Facility hasan annual “clean-up” provision which obligates us to repay in full any and alloutstanding revolving credit loans for a period of not less than 15 consecutivedays during the period beginning on or after May 1 and ending on or before June15 (or the next business day, if, in any year, June 15 is not a business day)of each calendar year, such that immediately following the date of suchrepayment, the amount of all outstanding revolving credit loans shall bezero.  The Credit Facility includescertain restrictive covenants including limitations on indebtedness, restrictedpayments such as dividends and stock repurchases, liens, mergers, investmentsand sales of assets and of subsidiary stock. Additionally, the Credit Facilitylimits the amount which we may spend on capital expenditures, restricts the useof proceeds, as defined, from asset sales and requires that we comply with certainfinancial covenants. On March 15, 2006, we amended and restated the CreditFacility as of December 30, 2005 to, among other things, (i) revise certainfinancial covenants (including leverage,interest coverage, minimum EBITDA and the deletion of the tangible networth covenant) beginning with the fourth quarter of 2005 and extending throughthe Credit Facility maturity date of June 30, 2007 and (ii) permit certaintransactions to be excluded from our annual capital expenditures limit.  We were in compliance with the covenants inthe Credit Facility as of July 2, 2006.

On August 1, 2006, the Company amended its $35 millionCredit Facility with Wells Fargo Foothill, to, among other things, (i) extendthe maturity date from June 30, 2007 to June 30, 2010, (ii) eliminate theinterest coverage requirement and (iii) reduce the applicable margin rates atwhich the revolving credit loans bear interest by .50% to .75% to a range of3.00% to 4.00% (depending on the leverage ratios).

We expect to incur approximately $0.5 million of costsassociated with the amendment to the $35 million Credit Facility which will bedeferred and amortized over the life of the amended $35 million CreditFacility.

Weanticipate requiring capital in the future principally to maintain existingrestaurant and plant facilities and to continue to renovate and re-imageexisting restaurants. We anticipate that capital expenditures for 2006 will bebetween $18.0 million and $26.0 million in the aggregate, of which we expect tospend between $14.0 million and $18.0 million on restaurants. Our actual 2006capital expenditures may vary from these estimated amounts. We believe that thecombination of the funds generated from operating activities and borrowingavailability under our Credit Facility will be sufficient to meet ouranticipated operating requirements, debt service requirements, leaseobligations and capital requirements.

Therehave been no material changes to our contractual obligations and commitmentsfrom those disclosed in our 2005 Annual Report on Form 10-K.

**Seasonality**

Due to the seasonalityof ice cream consumption, and the effect from time to time of weather onpatronage of the restaurants, our revenues and operating income are typicallyhigher in our second and third quarters.

**Geographic Concentration**

Approximately97% of the Company-operated restaurants are located, and substantially all ofits retail sales are generated, in the Northeast. As a result, a severe orprolonged economic recession or changes in demographic mix, employment levels,population density, weather, real estate market conditions or other factorsspecific to this geographic region may adversely affect us more than certain ofour competitors which are more geographically diverse.

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**Critical Accounting Estimates**

Thediscussion and analysis of our consolidated financial condition and results ofoperations are based upon our interim condensed consolidated financialstatements, which have been prepared in accordance with accounting principlesgenerally accepted in the U.S. The preparation of these condensed consolidatedfinancial statements requires us to make estimates and judgments that affectthe reported amounts of assets, liabilities, revenues and expenses and relateddisclosure of contingent assets and liabilities. On an on-going basis, weevaluate our estimates, including those related to revenue recognition,insurance reserves, recoverability of accounts receivable, stock compensationexpense, income tax valuation allowances and pension and other post-retirementbenefits expense. We base our estimates on historical experience and on variousother assumptions that are believed to be reasonable under the circumstances,the results of which form the basis for making judgments about the carryingvalues of assets and liabilities that are not readily apparent from othersources.

Thecritical accounting estimates that we believe affect the more significantjudgments and estimates used in the preparation of our condensed consolidatedfinancial statements presented in this report are described in our Management’sDiscussion and Analysis of Financial Condition and Results of Operations and inthe Notes to the consolidated financial statements included in our AnnualReport on Form 10-K for the fiscal year ended January 1, 2006. The onlymaterial change to our critical accounting estimates relates to stock-basedcompensation and is described below.

Actualresults may differ from these estimates under different assumptions orconditions. Any differences may have a material impact on our financialcondition and results of operations. For a discussion of how these and otherfactors may affect our business, see the “Forward Looking Statements” above andother factors included in our other filings with the Securities and ExchangeCommission.

*Stock-Based Compensation —*

Theadoption of SFAS No. 123R in the first quarter of fiscal 2006 requires thatstock-based compensation expense associated with stock options be recognized inthe statement of operations, rather than being disclosed in a pro formafootnote to the consolidated financial statements. Determining the amount ofstock-based compensation to be recorded requires us to develop estimates to beused in calculating the grant-date fair value of stock options. We calculatethe grant-date fair values using the Black-Scholes valuation model. The use ofvaluation models requires us to make estimates of the following assumptions:

Expectedvolatility * —* we are responsible for estimatingvolatility and have used historical volatility to estimate the grant-date fairvalue of stock options. Management considered the guidance in SFAS No. 123R andbelieves that the historical estimated volatility is materially indicative ofexpectations about future volatility.  Ingeneral, the higher the expected volatility used in the Black-Scholes valuationmodel, the higher the grant-date fair value of the option.

Expectedterm * —* we use historical employeeexercise and option expiration data to estimate the expected term assumptionfor the Black-Scholes grant-date valuation. We believe that this historicaldata is currently the best estimate of the expected term of a new option.Currently stock options are only issued to corporate officers anddirectors.  In general, the longer theexpected term used in the Black-Scholes valuation model, the higher thegrant-date fair value of the option.

Risk-freeinterest rate * —* the yield on zero-coupon U.S.Treasury securities for a period that is commensurate with the expected termassumption is used as the risk-free interest rate.

Expected dividend yield * —* we have not paid any dividends in thelast five years and currently intend to retain any earnings to finance futuregrowth and, therefore, do not anticipate paying any cash dividends on ourcommon stock in the foreseeable future.

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The amount of stock-based compensation recognizedduring a period is based on the value of the portion of the awards that areultimately expected to vest. SFAS No. 123R requires forfeitures to be estimatedat the time of grant and revised, if necessary, in subsequent periods if actualforfeitures differ from those estimates. The term “forfeitures” is distinctfrom “cancellations” or “expirations” and represents only the unvested portionof the surrendered option. We currently expect, based on an analysis of ourhistorical forfeitures, that approximately 97% of our options will actuallyvest, and therefore have applied an annual forfeiture rate of 3% to all optionsgranted as of July 2, 2006. This analysis will be re-evaluated quarterly andthe forfeiture rate will be adjusted as necessary. Ultimately, the actualexpense recognized over the vesting period will only be for those shares thatvest.

**Recently Issued Accounting Pronouncements**

InJuly 2006, the Financial Accounting Standards Board (“FASB”) issued FASBInterpretation No. 48, “Accounting for Uncertainty in Income Taxes—aninterpretation of FASB Statement No. 109” (“FIN 48”), which clarifies theaccounting for uncertainty in tax positions. FIN 48 requires that we recognizein our financial statements the impact of a tax position, if that position ismore likely than not of being sustained on audit based on the technical meritsof the position. The provisions of FIN 48 are effective as of the beginning ofour 2007 fiscal year, with the cumulative effect of the change in accountingprinciple recorded as an adjustment to opening retained earnings. We arecurrently evaluating the impact of adopting FIN 48 on our financial statements.

**Item 3.**                          Quantitativeand Qualitative Disclosures About Market Risk

There has been nomaterial change in our market risk exposure since the filing of the 2005 AnnualReport on Form 10-K.

**Item 4.**                       Controlsand Procedures

As ofJuly 2, 2006, an evaluation was performed under the supervision and with theparticipation of our management, including our Chief Executive Officer (“CEO”)and Chief Financial Officer (“CFO”), of the effectiveness of the design andoperation of our disclosure controls and procedures (as defined in Rule13a-15(e) and Rule 15d-15(e) under the Exchange Act).  Based on that evaluation, our CEO and CFOconcluded that our disclosure controls and procedures were effective as of July2, 2006.

There were no significant changes in our internal controlover financial reporting that occurred during our last fiscal quarter that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

**PART II — OTHERINFORMATION**

**Item 1.**                          LegalProceedings

OnFebruary 25, 2003, S. Prestley Blake (“Blake”), holder of approximately 10% ofour outstanding common stock, sued Friendly’s and our Chairman in a purportedderivative action in Hampden Superior Court, Massachusetts. The suit allegesbreach of fiduciary duty and misappropriation of corporate assets in that wepaid certain expenses relating to a corporate jet and the Chairman’s use ofthat jet and use of an office in Illinois. The suit seeks to require the Chairman to reimburse us and for Friendly’sto pay Blake’s attorneys’ fees.  Friendly’sand its Chairman have denied Blake’s allegations and are vigorously defendingthe lawsuit.

On June 27, 2005, Mr. Blake sent a demand letter toour Board of Directors demanding that our Board of Directors address hisconcerns and beliefs that are subject to the litigation filed on February 25,2003. On July 14, 2005, our Board of Directors formed a special litigationcommittee consisting solely of independent directors (the “Committee”) toinvestigate the concerns and beliefs raised in Blake’s demand letter dated June27, 2005.  The Committee issued itsreport on October 24, 2005 and a supplemental report on November 30, 2005.  Based on its findings, the Committee filed aMotion to Dismiss the claims made by Mr. Blake. On May 24, 2006, the Court denied the Committee’s motion to dismiss andallowed the joinder, as defendants, of current Board members Steven L. Ezzes,Michael J. Daly and Burton J. Manning, and former Board member Charles A.Ledsinger, Jr., and The Restaurant Company, The Restaurant Holding Corporationand TRC Realty, LLC.

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**Item1A.**                 RiskFactors

Therehave been no material changes to our risk factors from those disclosed in our2005 Annual Report on Form 10-K.

**Item 4.**                          Submissionof matters to a vote of security holders

(a)      An annual meeting of the Company’sshareholders was held on May 10, 2006.

(b)      Not applicable.

(c)      At the Annual Meeting of Shareholders, theshareholders voted on the following matters:

(1)                    The electionof the Class III Director to serve until the 2009 Annual Meeting ofShareholders;

(2)                    Theratification of the appointment of Ernst & Young LLP as the Company’sindependent registered public accountants for fiscal 2006;

(3)                    The proposalto amend the Company’s 2003 Incentive Plan to increase the number of shares ofcommon stock reserved for issuance under the 2003 Incentive Plan.

Thevoting results with respect to the election of the Class III Director were asfollows:

| **Director**    | ** ** | **Affirmative  Votes** | ** ** | **Votes  Withheld** |
|-----------------|------------|------------------------|------------|---------------------|
| Donald N. Smith |       | 5,023,471              |       | 2,422,712           |

 

Additional Directors,whose terms of office as Directors continued after the meeting, are as follows:

| **Term Expiring in 2007**               | ** ** | **Term  Expiring in 2008** |
|-----------------------------------------|------------|----------------------------|
| Michael J. Daly     |       | Steven L. Ezzes            |
| Burton J.  Manning                      |       | Perry D. Odak    |

 

The voting results withrespect to the ratification of the appointment of Ernst & Young LLP as theCompany’s independent public accountants for fiscal 2006 were as follows:

| **Affirmative Votes** | ** ** | **Negative  Votes** | ** ** | **Votes  Withheld** |
|-----------------------|------------|---------------------|------------|---------------------|
| 6,626,732             |       | 812,881             |       | 6,570               |

 

The voting results withrespect to the proposal to amend the Company’s 2003 Incentive Plan to increasethe number of shares of common stock reserved for issuance under the 2003Incentive Plan were as follows:

| **Affirmative Votes** | ** ** | **Negative  Votes** | ** ** | **Votes  Withheld** | ** ** | **Broker  Non-Votes(1)** |
|-----------------------|------------|---------------------|------------|---------------------|------------|--------------------------|
| 3,665,235             |       | 1,075,102           |       | 22,284              |       | 2,683,562                |

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(1)             Theaffirmative vote of the majority of the shares present in person or representedby proxy at the meeting and entitled to vote on Proposal 3 was required to passthe proposal.  For certain types of “non-routine”proposals, such as Proposal 3, brokers do not have the discretionary authorityto vote their clients’ shares, and therefore they must refrain from voting andare not entitled to vote on such proposals in the absence of instructions fromtheir clients.

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**Item 5.**                          OtherInformation

On August 1, 2006, the Company amended its $35 millionCredit Facility with Wells Fargo Foothill, to, among other things, (i) extendthe maturity date from June 30, 2007 to June 30, 2010, (ii) eliminate theinterest coverage requirement and (iii) reduce the applicable margin rates atwhich the revolving credit loans bear interest by .50% to .75% to a range of3.00% to 4.00% (depending on the leverage ratios).

The Company expects to incurapproximately $0.5 million of costs associated with the amendment to the $35million Credit Facility which will be deferred and amortized over the life ofthe amended $35 million Credit Facility.

**Item 6.**                          Exhibits

(a)Exhibits

The exhibit index isincorporated by reference herein.

**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 
|        | Friendly Ice Cream Corporation |
|--------|--------------------------------|
|   |                           |   |
|   | By:                            |  /s/ PAUL V.  HOAGLAND |
|   |                           | Name: Paul V. Hoagland   Title: Executive Vice President of   Administration and Chief Financial Officer  (Principal Financial Officer) |
|   |                           |   |
|   | Date:                          | August 7, 2006 |

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**EXHIBIT INDEX**
| 4.10 | Amendment Number One to Amended and Restated  Revolving Credit Agreement dated as of August 1, 2006.                                                                    |
|------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1 | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002 signed by John L. Cutter.                                                                      |
| 31.2 | Certification pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002 signed by Paul V. Hoagland.                                                                    |
| 32.1 | Certification pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 signed by  John L. Cutter and Paul V. Hoagland. |

 

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