**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

----

 

**FORM 10-Q**

 

**(Mark One)**

 

| **ý**                                          | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
|-----------------------------------------------------|----------------------------------------------------------------------------------------------------|
|                                                |                                                                                               |
| **For the  quarterly period ended October 2, 2005** |
|                                                |                                                                                               |
| **OR**                                              |
|                                                |                                                                                               |
| **o**                                               | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For thetransition period from              to              **

 

**CommissionFile No. 001-13579**

 

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**FRIENDLY ICE CREAM CORPORATION**

(Exact Name ofRegistrant as Specified in Its Charter)

 
| **Massachusetts**                                                                   |       | **04-2053130**       |
|-------------------------------------------------------------------------------------|------------|----------------------|
| (State or Other  Jurisdiction of                                                    |       | (IRS Employer        |
| Incorporation or  Organization)                                                     | ** ** | Identification  No.) |
|                                                                                |       |                 |
| **1855  Boston Road**                                                               |       |                 |
| **Wilbraham,  Massachusetts**                                                       |       | **01095**            |
| (Address of  Principal Executive Offices)                                           |       | (Zip Code)           |
|                                                                                |       |                 |
| **(413)  543-2400**                                                                 |
| (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 markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes ý  No o

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Exchange Act Rule12b-2). Yes ý   No o

 

Indicate by check markwhether the registrant is a shell company (as defined in Exchange Act Rule12b-2). Yes oNo ý

 

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock as of thelatest practicable date.

 
| **Class**                     | ** ** | **Outstanding at October 31, 2005** |
|-------------------------------|------------|-------------------------------------|
|                          |       |                                |
| Common Stock, $.01 par  value |       | 7,898,591 shares                    |

 

 

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**PART I –FINANCIAL INFORMATION**

 

**Item 1. Financial Statements**

 

**FRIENDLYICE CREAM CORPORATION AND SUBSIDIARIES**

 

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

(Unaudited)

(In thousands)

 
| ** **                                                                | ** ** | **October 2,** | ** ** | **January 2,** | ** ** |
|---------------------------------------------------------------------------|------------|----------------|------------|----------------|------------|
| ** **                                                                | ** ** | **2005**       | ** ** | **2005**       | ** ** |
|                                                                      |       |           |       |           |       |
| ASSETS                                                                    |       |           |       |           |       |
| CURRENT ASSETS:                                                           |       |           |       |           |       |
| Cash and cash  equivalents                                                |       | $              | 24,134     |           | $          | 13,405 |   |
| Restricted cash                                                           |       | 2,727          |       | 1,711          |       |
| Accounts  receivable, net                                                 |       | 10,224         |       | 10,448         |       |
| Inventories                                                               |       | 15,622         |       | 17,545         |       |
| Deferred income  taxes                                                    |       | 6,853          |       | 6,853          |       |
| Prepaid expenses  and other current assets                                |       | 6,319          |       | 4,562          |       |
| TOTAL CURRENT  ASSETS                                                     |       | 65,879         |       | 54,524         |       |
| DEFERRED INCOME  TAXES                                                    |       | 9,911          |       | 10,619         |       |
| PROPERTY AND  EQUIPMENT, net of accumulated depreciation and amortization |       | 148,646        |       | 156,232        |       |
| INTANGIBLE  ASSETS AND DEFERRED COSTS, net of accumulated amortization    |       | 19,143         |       | 20,510         |       |
| OTHER ASSETS                                                              |       | 7,305          |       | 6,999          |       |
| TOTAL ASSETS                                                              |       | $              | 250,884    |           | $          | 248,884 |   |
|                                                                      |       |           |       |           |       |
| LIABILITIES AND STOCKHOLDERS’ DEFICIT                                |       |           |       |           |       |
| CURRENT  LIABILITIES:                                                     |       |           |       |           |       |
| Current  maturities of long-term debt                                     |       | $              | 1,378      |           | $          | 5,224 |   |
| Current  maturities of capital lease and finance obligations              |       | 1,412          |       | 1,533          |       |
| Accounts payable                                                          |       | 23,179         |       | 21,536         |       |
| Accrued salaries  and benefits                                            |       | 8,908          |       | 8,740          |       |
| Accrued interest  payable                                                 |       | 5,049          |       | 1,427          |       |
| Insurance  reserves                                                       |       | 10,912         |       | 9,927          |       |
| Restructuring  reserves                                                   |       | 174            |       | 1,078          |       |
| Other accrued  expenses                                                   |       | 16,858         |       | 18,582         |       |
| TOTAL CURRENT  LIABILITIES                                                |       | 67,870         |       | 68,047         |       |
| CAPITAL LEASE  AND FINANCE OBLIGATIONS, less current maturities           |       | 6,302          |       | 7,380          |       |
| LONG-TERM DEBT,  less current maturities                                  |       | 225,809        |       | 225,752        |       |
| ACCRUED PENSION  COST                                                     |       | 17,746         |       | 17,532         |       |
| OTHER LONG-TERM  LIABILITIES                                              |       | 34,111         |       | 35,199         |       |
| COMMITMENTS AND  CONTINGENCIES                                            |       |           |       |           |       |
| STOCKHOLDERS’  DEFICIT:                                              |       |           |       |           |       |
| Common stock                                                              |       | 79             |       | 77             |       |
| Additional  paid-in capital                                               |       | 144,218        |       | 143,115        |       |
| Accumulated  other comprehensive loss                                     |       | (20,641        | )          | (20,670        | )          |
| Accumulated deficit                                                       |       | (224,610       | )          | (227,548       | )          |
| TOTAL  STOCKHOLDERS’ DEFICIT                                         |       | (100,954       | )          | (105,026       | )          |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ DEFICIT                         |       | $              | 250,884    |           | $          | 248,884 |   |

 

The accompanying notes are an integral part of thesecondensed consolidated financial statements.

 

1

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## **FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS**

(Unaudited)

(In thousands, except pershare data)

 
| ** **                                                              | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                                                              | ** ** | **October 2,**                 | ** ** | **September 26,**             | ** ** | **October 2,** | ** ** | **September 26,** | ** ** |
| ** **                                                              | ** ** | **2005**                       | ** ** | **2004**                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                              | ** ** | ** **                     | ** ** | **(Restated)**                | ** ** | ** ** | ** ** | **(Restated)** | ** ** |
| REVENUES:                                                               |       |                           |       |                          |       |   |   |   |   |
| Restaurant                                                              |       | $                              | 109,018    |                          | $          | 120,436 |   | $ | 317,909 |   | $ | 339,230 |   |
| Foodservice                                                             |       | 30,786                         |       | 29,110                        |       | 87,840 |   | 82,273 |   |
| Franchise                                                               |       | 3,753                          |       | 3,509                         |       | 10,879 |   | 9,822 |   |
| TOTAL REVENUES                                                          |       | 143,557                        |       | 153,055                       |       | 416,628 |   | 431,325 |   |
|                                                                    |       |                           |       |                          |       |   |   |   |   |
| COSTS AND  EXPENSES:                                                    |       |                           |       |                          |       |   |   |   |   |
| Cost of sales                                                           |       | 54,225                         |       | 57,368                        |       | 157,482 |   | 158,915 |   |
| Labor and  benefits                                                     |       | 38,337                         |       | 42,990                        |       | 114,773 |   | 125,079 |   |
| Operating  expenses                                                     |       | 29,326                         |       | 30,084                        |       | 82,342 |   | 83,109 |   |
| General and  administrative expenses                                    |       | 8,262                          |       | 9,054                         |       | 28,239 |   | 29,505 |   |
| Restructuring  expenses                                                 |       | —                         |       | —                        |       | — |   | 2,627 |   |
| Gain on  litigation settlement                                          |       | —                         |       | —                        |       | — |   | (3,644 | ) |
| Write-downs of  property and equipment                                  |       | —                         |       | —                        |       | 289 |   | 91 |   |
| Depreciation and  amortization                                          |       | 5,782                          |       | 5,533                         |       | 17,915 |   | 16,932 |   |
| Loss (gain) on  franchise sales of restaurant operations and properties |       | 7                              |       | (189                          | )          | (2,521 | ) | (1,102 | ) |
| (Gain) loss on  disposals of other property and equipment, net          |       | (1,771                         | )          | 153                           |       | (1,403 | ) | 661 |   |
|                                                                    |       |                           |       |                          |       |   |   |   |   |
| OPERATING INCOME                                                        |       | 9,389                          |       | 8,062                         |       | 19,512 |   | 19,152 |   |
|                                                                    |       |                           |       |                          |       |   |   |   |   |
| OTHER EXPENSES:                                                         |       |                           |       |                          |       |   |   |   |   |
| Interest  expense, net                                                  |       | 5,197                          |       | 5,235                         |       | 15,728 |   | 16,667 |   |
| Other (income)  expense, principally debt retirement costs              |       | (1                             | )          | —                        |       | (17 | ) | 9,235 |   |
|                                                                    |       |                           |       |                          |       |   |   |   |   |
| INCOME (LOSS)  BEFORE (PROVISION FOR) BENEFIT FROM INCOME TAXES         |       | 4,193                          |       | 2,827                         |       | 3,801 |   | (6,750 | ) |
|                                                                    |       |                           |       |                          |       |   |   |   |   |
| (Provision for)  benefit from income taxes                              |       | (786                           | )          | 651                           |       | (863 | ) | 3,566 |   |
|                                                                    |       |                           |       |                          |       |   |   |   |   |
| NET INCOME  (LOSS)                                                      |       | $                              | 3,407      |                          | $          | 3,478 |   | $ | 2,938 |   | $ | (3,184 | ) |
|                                                                    |       |                           |       |                          |       |   |   |   |   |
| BASIC NET INCOME  (LOSS) PER SHARE                                      |       | $                              | 0.43       |                          | $          | 0.45 |   | $ | 0.38 |   | $ | (0.42 | ) |
|                                                                    |       |                           |       |                          |       |   |   |   |   |
| DILUTED NET  INCOME (LOSS) PER SHARE                                    |       | $                              | 0.43       |                          | $          | 0.44 |   | $ | 0.37 |   | $ | (0.42 | ) |
|                                                                    |       |                           |       |                          |       |   |   |   |   |
| WEIGHTED AVERAGE  SHARES:                                               |       |                           |       |                          |       |   |   |   |   |
| Basic                                                                   |       | 7,840                          |       | 7,695                         |       | 7,770 |   | 7,611 |   |
| Diluted                                                                 |       | 7,988                          |       | 7,869                         |       | 7,909 |   | 7,611 |   |

 

The accompanying notes are an integral part of thesecondensed consolidated financial statements.

 

2

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**FRIENDLY ICE CREAM CORPORATIONAND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

(Unaudited)

(In thousands)

 
| ** **                                                                                | ** ** | **For the Nine Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                | ** ** | **October 2,**                | ** ** | **September 26,** | ** ** |
| ** **                                                                                | ** ** | **2005**                      | ** ** | **2004** | ** ** |
| ** **                                                                                | ** ** | ** **                    | ** ** | **(Restated)** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                    |       |                          |       |   |   |
| Net income  (loss)                                                                        |       | $                             | 2,938      |   | $ | (3,184 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by operating activities: |       |                          |       |   |   |
| Stock  compensation expense                                                               |       | 68                            |       | 427 |   |
| Depreciation and  amortization                                                            |       | 17,915                        |       | 16,932 |   |
| Write-offs of deferred  financing costs                                                   |       | —                        |       | 2,445 |   |
| Write-downs of  property and equipment                                                    |       | 289                           |       | 91 |   |
| Deferred income  tax expense (benefit)                                                    |       | 688                           |       | (3,566 | ) |
| Gain on  disposals of other property and equipment, net                                   |       | (3,929                        | )          | (459 | ) |
| Changes in  operating assets and liabilities:                                             |       |                          |       |   |   |
| Accounts  receivable                                                                      |       | 224                           |       | 83 |   |
| Inventories                                                                               |       | 1,923                         |       | (2,985 | ) |
| Other assets                                                                              |       | (2,692                        | )          | (3,585 | ) |
| Accounts payable                                                                          |       | 1,643                         |       | 4,960 |   |
| Accrued expenses  and other long-term liabilities                                         |       | 1,222                         |       | 1,233 |   |
| NET CASH  PROVIDED BY OPERATING ACTIVITIES                                                |       | 20,289                        |       | 12,392 |   |
|                                                                                      |       |                          |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                    |       |                          |       |   |   |
| Purchases of  property and equipment                                                      |       | (11,511                       | )          | (15,554 | ) |
| Proceeds from  sales of property and equipment                                            |       | 6,230                         |       | 4,048 |   |
| Purchases of  marketable securities                                                       |       | (499                          | )          | (1,022 | ) |
| Proceeds from  sales of marketable securities                                             |       | 163                           |       | 89 |   |
| NET CASH USED IN  INVESTING ACTIVITIES                                                    |       | (5,617                        | )          | (12,439 | ) |
|                                                                                      |       |                          |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                    |       |                          |       |   |   |
| Proceeds from  issuance of New Senior Notes                                               |       | —                        |       | 175,000 |   |
| Proceeds from  borrowings under revolving credit facility                                 |       | 16,250                        |       | 16,750 |   |
| Proceeds from  issuance of mortgages                                                      |       | 1,115                         |       | — |   |
| Repayments of  debt                                                                       |       | (21,153                       | )          | (193,555 | ) |
| Payments of  deferred financing costs                                                     |       | (43                           | )          | (6,625 | ) |
| Principal  payments of capital lease and finance obligations                              |       | (1,149                        | )          | (849 | ) |
| Stock options  exercised                                                                  |       | 1,037                         |       | 929 |   |
| NET CASH USED IN  FINANCING ACTIVITIES                                                    |       | (3,943                        | )          | (8,350 | ) |
|                                                                                      |       |                          |       |   |   |
| NET INCREASE  (DECREASE) IN CASH AND CASH EQUIVALENTS                                     |       | 10,729                        |       | (8,397 | ) |
|                                                                                      |       |                          |       |   |   |
| CASH AND CASH  EQUIVALENTS, BEGINNING OF PERIOD                                           |       | 13,405                        |       | 25,631 |   |
|                                                                                      |       |                          |       |   |   |
| CASH AND CASH  EQUIVALENTS, END OF PERIOD                                                 |       | $                             | 24,134     |   | $ | 17,234 |   |
|                                                                                      |       |                          |       |   |   |
| SUPPLEMENTAL  DISCLOSURES:                                                                |       |                          |       |   |   |
| Cash paid during  the period for:                                                         |       |                          |       |   |   |
| Interest                                                                                  |       | $                             | 11,378     |   | $ | 13,298 |   |
| Income taxes                                                                              |       | 686                           |       | 24 |   |
| Capital lease  obligations terminated                                                     |       | (51                           | )          | — |   |
| Capital lease  obligations incurred                                                       |       | —                        |       | 3,250 |   |

 

The accompanying notes are an integral part of thesecondensed consolidated financial statements.

 

3

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**FRIENDLY ICE CREAM CORPORATIONAND SUBSIDIARIES**

** **

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

** **

(Unaudited)

 

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

 

*InterimFinancial Information –*

 

The accompanyingcondensed consolidated financial statements as of October 2, 2005 and for thethree and nine months ended October 2, 2005 and September 26, 2004 areunaudited, but have been prepared in accordance with generally acceptedaccounting principles (“GAAP”) for interim financial information and with theinstructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of theinformation and footnotes required by GAAP for complete financialstatements.  In the opinion ofmanagement, all adjustments which are necessary for a fair presentation of theconsolidated financial position, results of operations, cash flows andcomprehensive income (loss) of Friendly Ice Cream Corporation (“FICC”) andsubsidiaries (unless the context indicates otherwise, collectively, the “Company”)have been included. Such adjustments consist solely of normal recurringaccruals. Operating results for the three and nine month periods ended October2, 2005 and September 26, 2004 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 2004 Annual Report on Form 10-K/A for the fiscal year endedJanuary 2, 2005 (“2004 Annual Report on Form 10-K/A”) should be read inconjunction with these condensed consolidated financial statements. Capitalizedterms not otherwise defined herein should be referenced to the 2004 AnnualReport on Form 10-K/A.

 

*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, income tax valuation allowances andpension and post-retirement medical and life insurance benefits expense. Actualamounts could differ significantly from the estimates.

 

*Inventories–*

 

Inventories are stated at the lower of first-in,first-out cost or market and consisted of the following at October 2, 2005 andJanuary 2, 2005 (in thousands):

 

| ** **       | ** ** | **October 2,** | ** ** | **January 2,** | ** ** |
|------------------|------------|----------------|------------|----------------|------------|
| ** **       | ** ** | **2005**       | ** ** | **2005**       | ** ** |
|             |       |           |       |           |       |
| Raw materials    |       | $              | 1,635      |           | $          | 2,685 |   |
| Goods in process |       | 141            |       | 157            |       |
| Finished goods   |       | 13,846         |       | 14,703         |       |
| Total            |       | $              | 15,622     |           | $          | 17,545 |   |

 

4

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*Other Assets* –

 

Other assets included notes receivable of $4,434,000and $4,524,000, which were net of allowances for doubtful accounts totaling$263,000 as of October 2, 2005 and January 2, 2005, respectively. As of January2, 2005, notes receivable included a balloon payment of $3,903,000, due from afranchisee on April 15, 2006, for a subordinated promissory note. On July 29,2005, the Company agreed to extend the term of the note for one year, with anew balloon payment of $3,796,000 due on April 15, 2007.

 

Also included in other assets as of October 2, 2005 and January 2, 2005were payments made to fronting insurance carriers of $1,404,000 and $1,402,000,respectively, to establish loss escrow funds.

 

*OtherAccrued Expenses–*

 

Other accrued expenses consisted of the following atOctober 2, 2005 and January 2, 2005 (in thousands):

 

| ** **                     | ** ** | **October 2,** | ** ** | **January 2,** | ** ** |
|--------------------------------|------------|----------------|------------|----------------|------------|
| ** **                     | ** ** | **2005**       | ** ** | **2005**       | ** ** |
|                           |       |           |       |           |       |
| Accrued rent                   |       | $              | 4,684      |           | $          | 4,781 |   |
| Gift cards  outstanding        |       | 2,324          |       | 4,068          |       |
| Accrued meals  and other taxes |       | 2,284          |       | 2,766          |       |
| Accrued  advertising           |       | 2,153          |       | 1,824          |       |
| Accrued  construction costs    |       | 1,325          |       | 1,236          |       |
| Unearned  revenues             |       | 1,286          |       | 1,056          |       |
| Accrued bonus                  |       | 78             |       | 751            |       |
| All other                      |       | 2,724          |       | 2,100          |       |
| Total                          |       | $              | 16,858     |           | $          | 18,582 |   |

 

*LeaseGuarantees and Contingencies –*

 

Primarily as a result of the Company’s re-franchisingefforts, the Company remains liable for certain lease assignments andguarantees. These leases have varying terms, the latest of which expires in2020. As of October 2, 2005, the potential amount of undiscounted payments theCompany could be required to make in the event of non-payment by the primarylessees was $6,093,000. The present value of these potential paymentsdiscounted at the Company’s pre-tax cost of debt at October 2, 2005 was$4,704,000. The Company generally has cross-default provisions with franchiseesthat would put the franchisee in default of its 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. Additionally, as of October 2, 2005, theCompany has no reason to believe that any franchisee will be unable to fulfillits obligations. Accordingly, no liability had been recorded for exposure undersuch leases at October 2, 2005 and January 2, 2005.

 

5

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*Income(Loss) Per Share –*

 

Basic net income (loss) per share is calculated bydividing net income (loss) by the weighted average number of common sharesoutstanding during the period. Diluted net income (loss) per share iscalculated by dividing net income (loss) by the weighted average number ofshares of common stock and common stock equivalents outstanding during theperiod. Common stock equivalents are dilutive stock options and warrants thatare assumed exercised for calculation purposes. The number of common stockoptions which could dilute basic net income (loss) per share in the future,that were not included in the computation of diluted net income (loss) pershare because to do so would have been antidilutive, was 125,086 and 133,989for the three months ended October 2, 2005 and September 26, 2004,respectively. The number of common stock options which could dilute basic netincome (loss) per share in the future, that were not included in thecomputation of diluted net income (loss) per share because to do so would havebeen antidilutive, was 125,086 and 271,404 for the nine months ended October 2,2005 and September 26, 2004, respectively.

 

During the nine months ended October2, 2005, the Company granted employee stock options to purchase approximately120,000 shares of common stock at an exercise price equal to the closing marketprices on the dates of grants. During the nine months ended October 2, 2005,185,312 employee stock options were exercised. The weighted-average exerciseprices of the options granted and options exercised were $8.87 and $5.59,respectively.

 

Presented below is the reconciliation between basicand diluted weighted average shares for the three and nine months ended October2, 2005 and September 26, 2004 (in thousands):

 
| ** **                                                              | ** ** | **For the Three Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                              | ** ** | **Basic**                      | ** ** | **Diluted** | ** ** |
| ** **                                                              | ** ** | **October 2,**                 | ** ** | **September 26,** | ** ** | **October 2,** | ** ** | **September 26,** | ** ** |
| ** **                                                              | ** ** | **2005**                       | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                    |       |                           |       |   |   |   |   |   |   |
| Weighted average  number of common shares outstanding during the period |       | 7,840                          |       | 7,695 |   | 7,840 |   | 7,695 |   |
| Adjustments:                                                            |       |                           |       |   |   |   |   |   |   |
| Assumed exercise  of stock options                                      |       | —                         |       | — |   | 148 |   | 174 |   |
| Weighted average  number of shares outstanding                          |       | 7,840                          |       | 7,695 |   | 7,988 |   | 7,869 |   |
|                                                                    |       |                           |       |   |   |   |   |   |   |
| ** **                                                              | ** ** | **For the Nine Months Ended**  | ** ** |
| ** **                                                              | ** ** | **Basic**                      | ** ** | **Diluted** | ** ** |
| ** **                                                              | ** ** | **October 2,**                 | ** ** | **September 26,** | ** ** | **October 2,** | ** ** | **September 26,** | ** ** |
| ** **                                                              | ** ** | **2005**                       | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                    |       |                           |       |   |   |   |   |   |   |
| Weighted average  number of common shares outstanding during the period |       | 7,770                          |       | 7,611 |   | 7,770 |   | 7,611 |   |
| Adjustments:                                                            |       |                           |       |   |   |   |   |   |   |
| Assumed exercise  of stock options                                      |       | —                         |       | — |   | 139 |   | — |   |
| Weighted average  number of shares outstanding                          |       | 7,770                          |       | 7,611 |   | 7,909 |   | 7,611 |   |

 

6

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*Stock-BasedCompensation –*

 

The Company accounts for stock-based compensation for employees underAccounting Principles Board (“APB”) Opinion No. 25, “Accounting for StockIssued to Employees,” and elected the disclosure-only alternative underStatement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting forStock-Based Compensation.”  Stock-based compensation cost of $68,000 and$222,000 related to modified stock option awards was included in net income(loss) for the nine months ended October 2, 2005 and September 26, 2004,respectively, for the Company’s Stock Option Plan and the Company’s 2003Incentive Plan.

 

In December 2002, the Financial Accounting StandardsBoard (“FASB”) issued SFAS No. 148, “Accounting for Stock-BasedCompensation—Transition and Disclosure,” which amended SFAS No. 123. SFAS No.148 allowed for three methods of transition for those companies that adopt SFASNo. 123’s provisions for fair value recognition. SFAS No. 148’s transitionguidance and provisions for annual disclosures were effective for fiscal yearsending after December 15, 2002. In accordance with SFAS No. 148, the Companycontinued to disclose the required pro-forma information in the notes to thecondensed consolidated financial statements.

 

In accordance with SFAS No. 148, the following tablepresents the effect on net income (loss) and net income (loss) per share hadcompensation cost for the Company’s stock plans been determined consistent withSFAS No. 123 (in thousands, except per share data):

 
| ** **                                                                                                                          | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                                                                                                                          | ** ** | **October 2,**                 | ** ** | **September 26,**             | ** ** | **October 2,** | ** ** | **September 26,** | ** ** |
| ** **                                                                                                                          | ** ** | **2005**                       | ** ** | **2004**                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                                                                |       |                           |       |                          |       |   |   |   |   |
| Net income  (loss) as reported                                                                                                      |       | $                              | 3,407      |                          | $          | 3,478 |   | $ | 2,938 |   | $ | (3,184 | ) |
|                                                                                                                                |       |                           |       |                          |       |   |   |   |   |
| Add stock-based  compensation expense included in reported net income (loss), net of related  income tax benefit                    |       | —                         |       | —                        |       | 40 |   | 131 |   |
| Less stock-based  compensation expense determined under fair value method for all stock  options, net of related income tax benefit |       | (27                            | )          | (103                          | )          | (67 | ) | (315 | ) |
| Pro forma net  income (loss)                                                                                                        |       | $                              | 3,380      |                          | $          | 3,375 |   | $ | 2,911 |   | $ | (3,368 | ) |
|                                                                                                                                |       |                           |       |                          |       |   |   |   |   |
| Basic net income  (loss) per share, as reported                                                                                     |       | $                              | 0.43       |                          | $          | 0.45 |   | $ | 0.38 |   | $ | (0.42 | ) |
| Basic net income  (loss) per share, pro forma                                                                                       |       | $                              | 0.43       |                          | $          | 0.44 |   | $ | 0.37 |   | $ | (0.44 | ) |
|                                                                                                                                |       |                           |       |                          |       |   |   |   |   |
| Diluted net  income (loss) per share, as reported                                                                                   |       | $                              | 0.43       |                          | $          | 0.44 |   | $ | 0.37 |   | $ | (0.42 | ) |
| Diluted net  income (loss) per share, pro forma                                                                                     |       | $                              | 0.42       |                          | $          | 0.43 |   | $ | 0.37 |   | $ | (0.44 | ) |

 

7

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*RecentlyIssued Accounting Pronouncements –*

 

In October2005, the FASB issued FASB Staff Position 13-1, “Accounting for Rental CostsIncurred during a Construction Period” (FSP 13-1”).  The FSPconcludes that rental costs incurred during and after a construction period arefor the right to control the use of a leased asset during and afterconstruction of a leased asset and that there is no distinction between theright to use a leased asset during the construction period and the right to usethat asset after the construction period. Therefore, rental costs associatedwith ground or building operating leases that are incurred during aconstruction period should be recognized as rental expense.  The guidance is effective for periodsbeginning after December 15, 2005. The adoption of FSP 13-1 is not expected tohave a material effect on the Company’s consolidated financial position orresults of operations.

 

In June 2005,the FASB’s Emerging Issues Task Force reached a consensus on Issue No. 05-6, “Determiningthe Amortization Period for Leasehold Improvements” (“EITF 05-6”). The guidancerequires that leasehold improvements acquired in a business combination orpurchased subsequent to the inception of a lease be amortized over the lesserof the useful life of the assets or a term that includes renewals that arereasonably assured at the date of the business combination or purchase. Theguidance is effective for periods beginning after June 29, 2005. The adoptionof EITF 05-6 is not expected to have a material effect on the Company’sconsolidated financial position or results of operations.

 

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections—A Replacement of APB Opinion No. 20 and FASB Statement No. 3.” SFAS No. 154 applies to all voluntary changes in accounting principles and requires retrospective application to prior periods’ financial statements of changes in accounting principles, unless it is impracticable. SFAS No. 154 requires that a change in depreciation, amortization, or depletion method for long-lived, nonfinancial assets be accounted for as a change of estimate affected by a change in accounting principles. SFAS No. 154 also carries forward without change the guidance in APB Opinion No. 20 with respect to accounting for changes in accounting estimates, changes in the reporting unit and correction of an error in previously issued financial statements. The Company is required to adopt SFAS No. 154 for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The adoption of SFAS No. 154 is not expected to have a material effect on the Company’s consolidated financial position or results of operations.

 

8

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On December 16, 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-BasedPayment” (“SFAS No. 123R”), which is a revision of SFAS No. 123, “Accountingfor Stock-Based Compensation.” SFAS No. 123R supersedes APB Opinion No. 25, “Accountingfor Stock Issued to Employees,” and amends SFAS No. 95, “Statement of CashFlows.” Generally, the approach in SFAS No. 123R is similar to the approachdescribed in SFAS No. 123. However, SFAS No. 123R requires all share-basedpayments to employees, including grants of employee stock options, to berecognized in the income statement based on their fair values. Pro formadisclosure is no longer an alternative. SFAS No. 123R must be adopted no laterthan the first annual period beginning after June 15, 2005. Early adoption willbe permitted in periods in which financial statements have not yet been issued.SFAS No. 123R allows companies to choose between the modified-prospective andmodified-retrospective transition alternatives in adopting SFAS No. 123R. Underthe modified-prospective transition method, compensation cost will berecognized in financial statements issued subsequent to the date of adoptionfor all shared-based payments granted, modified or settled after the date ofadoption, as well as for any unvested awards that were granted prior to thedate of adoption. Under the modified-retrospective transition method,compensation cost will be recognized in a manner consistent with themodified-prospective transition method, however, prior period financialstatements will also be restated by recognizing compensation cost as previouslyreported in the pro forma disclosures under SFAS No. 123. The restatementprovisions can be applied to either a) all periods presented or b) to thebeginning of the fiscal year in which SFAS No. 123R is adopted. The Companyexpects to adopt SFAS No. 123R on January 2, 2006 using themodified-prospective method. As the Company previously adopted only the proforma disclosure provisions of SFAS No. 123, the Company will recognizecompensation cost relating to the unvested portion of awards granted prior tothe date of adoption using the same estimate of the grant-date fair value andthe same attribution method used to determine the pro forma disclosures underSFAS No. 123.

 

As permitted by SFAS No. 123, the Company currently accounts forshare-based payments to employees using APB Opinion No. 25’s intrinsic valuemethod and, as such, generally recognizes no compensation cost for employee stockoptions.  Accordingly, the adoption ofSFAS No. 123R’s fair value method will have an impact on the Company’s resultsof operations, although it will have no impact on the overall financialposition. The impact of the adoption of SFAS No. 123R cannot be determined atthis time because it will depend upon levels of share-based payments granted inthe future. However, had the Company adopted SFAS No. 123R in prior periods,the impact of that statement would have approximated the impact as described inthe disclosure of pro forma net income (loss) and net income (loss) per sharepursuant to SFAS No. 123.  SFAS No. 123Ralso requires the benefits of tax deductions in excess of recognizedcompensation cost to be reported as a financing cash flow, rather than as anoperating cash flow as required under current literature.  This requirement will reduce net operatingcash flows and increase net financing cash flows in periods after adoption.  While the Company cannot estimate what thoseamounts will be in the future (because they depend on, among other things, whenemployees exercise stock options), the amount of operating cash flowsrecognized in prior years for such excess tax deductions were $818,000 and$165,000 in 2004 and 2003, respectively.

 

9

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In November 2004, theFASB issued SFAS No. 151, “Inventory Costs, an amendment of Accounting ResearchBulletin No. 43, Chapter 4”. The amendments made by SFAS No. 151 clarify thatabnormal amounts of idle facility expense, freight, handling costs, and wastedmaterials (spoilage) should be recognized as current-period charges and requirethe allocation of fixed production overheads to inventory based on the normalcapacity of the production facilities. SFAS No. 151 is the result of a broadereffort by the FASB to improve the comparability of cross-border financialreporting by working with the International Accounting Standards Board towarddevelopment of a single set of high-quality accounting standards. The guidanceis effective for inventory costs incurred during fiscal years beginning afterJune 15, 2005. The adoption of SFAS No. 151 is not expected to have a materialeffect on the Company’s consolidated financial position or results ofoperations.

 

**2. RESTATEMENT OF FINANCIALSTATEMENTS**

 

Following a review of the Company’slease accounting and leasehold depreciation practices in 2004, the Companyrestated its previously reported financial statements in its 2004 Annual Reporton Form 10-K/A.  The Company correctedits computation of straight-line rent expense and the related deferred rentliability as well as depreciation expense. Historically, when accounting forlease renewal options, rent expense was recorded on a straight-line basis overthe non-cancelable lease term. The depreciable lives of certain leaseholdimprovements and other long-lived assets on those properties were not alignedwith the non-cancelable lease term.

 

The Company believed that itsaccounting treatment was permitted under GAAP and that such treatment wasconsistent with the practices of other public companies. Following a review ofits lease accounting treatment and relevant accounting literature, the Companydetermined that it should: i) conform the depreciable lives for buildings onleased land and other leasehold improvements to the shorter of the economiclife of the asset or the lease term used for determining the capital versusoperating lease classification and calculating straight-line rent and ii)include option periods in the depreciable lives assigned to leased buildingsand leasehold improvements and in the calculation of straight-line rent expenseonly in instances in the which the exercise of the option period can bereasonably assured and failure to exercise such options would result in aneconomic penalty. The Company restated its financial statements in its 2004Annual Report on Form 10-K/A to accelerate depreciation for certain leaseholdimprovements and to record additional rent expense (the “Restatement”).

 

10

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The following is a summary of theimpact of the Restatement on the Company’s condensed consolidated statement ofoperations for the three and nine months ended September 26, 2004 (in thousandsexcept per share data):

 
| ** **                               | ** ** | **For the Three Months Ended September 26, 2004** | ** ** |
|------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                               | ** ** | **As Previously**                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                               | ** ** | **Reported**                                      | ** ** | **Adjustments** | ** ** | **Restated** | ** ** |
|                                     |       |                                              |       |   |   |   |   |
| Operating  expenses                      |       | $                                                 | 29,997     |   | $ | 87 |   | $ | 30,084 |   |
| Depreciation and  amortization           |       | 5,407                                             |       | 126 |   | 5,533 |   |
| Operating income                         |       | 8,275                                             |       | (213 | ) | 8,062 |   |
| Income before  benefit from income taxes |       | 3,040                                             |       | (213 | ) | 2,827 |   |
| Benefit from  income taxes               |       | 563                                               |       | 88 |   | 651 |   |
| Net income                               |       | 3,603                                             |       | (125 | ) | 3,478 |   |
|                                     |       |                                              |       |   |   |   |   |
| Basic net income  per share              |       | 0.47                                              |       | (0.02 | ) | 0.45 |   |
| Diluted net  income per share            |       | 0.46                                              |       | (0.02 | ) | 0.44 |   |
|                                     |       |                                              |       |   |   |   |   |
| ** **                               | ** ** | **For the Nine Months Ended September 26, 2004**  | ** ** |
| ** **                               | ** ** | **As Previously**                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                               | ** ** | **Reported**                                      | ** ** | **Adjustments** | ** ** | **Restated** | ** ** |
|                                     |       |                                              |       |   |   |   |   |
| Operating  expenses                      |       | $                                                 | 82,855     |   | $ | 254 |   | $ | 83,109 |   |
| Depreciation and  amortization           |       | 16,583                                            |       | 349 |   | 16,932 |   |
| Operating income                         |       | 19,755                                            |       | (603 | ) | 19,152 |   |
| Loss before  benefit from income taxes   |       | (6,147                                            | )          | (603 | ) | (6,750 | ) |
| Benefit from  income taxes               |       | 3,319                                             |       | 247 |   | 3,566 |   |
| Net loss                                 |       | (2,828                                            | )          | (356 | ) | (3,184 | ) |
|                                     |       |                                              |       |   |   |   |   |
| Basic and  diluted net loss per share    |       | (0.37                                             | )          | (0.05 | ) | (0.42 | ) |

 

11

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**3. EMPLOYEE BENEFIT PLANS**

 

The components of net periodic pension expense (benefit) for the threeand nine months ended October 2, 2005 and September 26, 2004 were (inthousands):

 
| ** **                              | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|-----------------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                              | ** ** | **October 2,**                 | ** ** | **September 26,**             | ** ** | **October 2,** | ** ** | **September 26,** | ** ** |
| ** **                              | ** ** | **2005**                       | ** ** | **2004**                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                              | ** ** | ** **                     | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest cost                           |       | $                              | 1,671      |                          | $          | 1,651 |   | $ | 5,013 |   | $ | 4,953 |   |
| Expected return  on assets              |       | (2,072                         | )          | (2,348                        | )          | (6,216 | ) | (7,043 | ) |
| Net  amortization:                      |       |                           |       |                          |       |   |   |   |   |
| Unrecognized net  actuarial loss        |       | 473                            |       | 168                           |       | 1,418 |   | 503 |   |
|                                    |       |                           |       |                          |       |   |   |   |   |
| Net periodic  pension expense (benefit) |       | $                              | 72         |                          | $          | (529 | ) | $ | 215 |   | $ | (1,587 | ) |

 

The components of the net postretirement medical and life insurancebenefit cost for the three and nine months ended October 2, 2005 and September26, 2004 were (in thousands):

 
| ** **                                              | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|---------------------------------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                                              | ** ** | **October 2,**                 | ** ** | **September 26,**             | ** ** | **October 2,** | ** ** | **September 26,** | ** ** |
| ** **                                              | ** ** | **2005**                       | ** ** | **2004**                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                              | ** ** | ** **                     | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service cost                                            |       | $                              | 41         |                          | $          | 28 |   | $ | 122 |   | $ | 84 |   |
| Interest cost                                           |       | 114                            |       | 116                           |       | 344 |   | 348 |   |
| Recognized  actuarial loss                              |       | 21                             |       | 23                            |       | 62 |   | 68 |   |
| Net amortization  of unrecognized prior service benefit |       | (36                            | )          | (35                           | )          | (107 | ) | (106 | ) |
|                                                    |       |                           |       |                          |       |   |   |   |   |
| Net postretirement  benefit cost                        |       | $                              | 140        |                          | $          | 132 |   | $ | 421 |   | $ | 394 |   |

 

On December 8, 2003, the Medicare Prescription Drug,Improvement and Modernization Act of 2003 (the “Act”), which introduced aMedicare prescription drug benefit, as well as a federal subsidy to sponsors ofretiree health care benefit plans that provide a benefit that is at leastactuarially equivalent to the Medicare benefit, was enacted. On May 19, 2004,the FASB issued Financial Staff Position No. 106-2, “Accounting and DisclosureRequirements Related to the Medicare Prescription Drug, Improvement andModernization Act of 2003” (“FSP 106-2”) to discuss certain accounting anddisclosure issues raised by the Act. FSP 106-2 addresses accounting for thefederal subsidy for the sponsors of single employer postretirement health careplans and disclosure requirements for plans for which the employer has not yetbeen able to determine actuarial equivalency. Except for certain nonpublicentities, FSP 106-2 became effective for the first interim or annual period beginningafter June 15, 2004 (the quarter ended September 26, 2004 for the Company).

 

12

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Basedon regulations issued by the Centers for Medicare & Medicaid Services, theCompany has concluded that, for certain participants, the benefits provided areat least actuarially equivalent to benefits available through Medicare PartD.  The Company has determined that theeffects of the Act are not significant. Therefore, the reported net benefitcost and the accumulated benefit obligation of the Company’s postretirementmedical and life insurance plan in the accompanying condensed consolidatedfinancial statements and notes thereto does not reflect the effects of the Act.The Company will recognize the effect on the next measurement date, which willbe included in the consolidated financial statements for the year endingJanuary 1, 2006.

 

**4. WRITE-DOWNS OF PROPERTY**

 

In accordance with SFAS No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets,” the Company reviews long-livedassets related to each restaurant to be held and used in the business quarterlyfor impairment, or whenever events or changes in circumstances indicate thatthe carrying amount of a restaurant may not be recoverable. The Company evaluatesrestaurants using a “two-year history of cash flow” as the primary indicator ofpotential impairment. Based on the best information available, the Companywrites down an impaired restaurant to its estimated fair market value, whichbecomes its new cost basis. Estimated fair market value is based on the Company’sexperience selling similar properties and local market conditions, less coststo sell for properties to be disposed of. In addition, restaurants scheduledfor closing are reviewed for impairment and depreciable lives are adjusted. Theimpairment evaluation is based on the estimated cash flows from continuing usethrough the expected disposal date and the expected terminal value.  SFAS No. 144 requires a long-lived asset tobe disposed of other than by sale to be classified as held and used until it isdisposed of.

 

Considerable management judgment is necessary toestimate future cash flows, including cash flows from continuing use, terminalvalue, closure costs and sublease income. Accordingly, actual results couldvary from estimates.

 

During the quarter ended October 2, 2005, theCompany committed to a plan to sell one closed restaurant property. The Companydetermined that the plan of sale criteria in SFAS No. 144 was met.  Accordingly, the carrying values of thisproperty as of October 2, 2005 and January 2, 2005, respectively, of $165,000and $180,000 was included in prepaid expenses and other current assets in theaccompanying condensed consolidated balance sheets. The carrying value of thisproperty was not adjusted since the carrying value is less than the estimatedfair market value less costs to sell.

 

During the nine months ended October 2, 2005, theCompany identified two restaurant properties to be disposed of other than bysale.  The Company determined that thecarrying values of these restaurant properties exceeded their estimated undiscountedcash flows and the carrying values werereduced by an aggregate of $289,000 accordingly. During the nine months endedSeptember 26, 2004, the Company determined that the carrying value of a vacantrestaurant land parcel and the carrying value of one restaurant propertyexceeded their estimated fair values less costs to sell.  The carrying values were reduced by anaggregate of $91,000.

 

13

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The table below identifies the components of the “(Gain)/loss ondisposals of other property and equipment, net” as shown on the condensedconsolidated statements of operations (in thousands):

 
| ** **                                                     | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                                                     | ** ** | **October 2,**                 | ** ** | **September 26,**             | ** ** | **October 2,** | ** ** | **September 26,** | ** ** |
| ** **                                                     | ** ** | **2005**                       | ** ** | **2004**                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                           |       |                           |       |                          |       |   |   |   |   |
| Restaurant  equipment assets retired due to remodeling         |       | $                              | —     |                          | $          | 22 |   | $ | 220 |   | $ | 195 |   |
| Restaurant  equipment assets retired due to replacement        |       | 51                             |       | 131                           |       | 146 |   | 290 |   |
| (Gain) loss on  property not held for disposition              |       | (1,942                         | )          | —                        |       | (1,902 | ) | 63 |   |
| All other                                                      |       | 120                            |       | —                        |       | 133 |   | 113 |   |
| (Gain) loss on  disposals of other property and equipment, net |       | $                              | (1,771     | )                             | $          | 153 |   | $ | (1,403 | ) | $ | 661 |   |

 

**5. DEBT**

 

Debt at October 2, 2005and January 2, 2005 consisted of the following (in thousands):

 
| ** **                                                   | ** ** | **October 2,** | ** ** | **January 2,** | ** ** |
|--------------------------------------------------------------|------------|----------------|------------|----------------|------------|
| ** **                                                   | ** ** | **2005**       | ** ** | **2005**       | ** ** |
| ** **                                                   | ** ** | ** **     | ** ** | ** **     | ** ** |
| New Senior  Notes, 8 3/8%, due June 15, 2012                 |       | $              | 175,000    |           | $          | 175,000 |   |
| Revolving credit  loans, due June 30, 2007                   |       | —         |       | 4,000          |       |
| Mortgage loans,  due October 3, 2005 through January 1, 2022 |       | 52,187         |       | 51,976         |       |
| Total debt                                                   |       | 227,187        |       | 230,976        |       |
| Less: current  portion                                       |       | (1,378         | )          | (5,224         | )          |
| Total long-term  debt                                        |       | $              | 225,809    |           | $          | 225,752 |   |

 

In February 2004, the Company announced a cashtender offer and consent solicitation for $176 million of its Senior Notes tobe financed with the proceeds from a $175 million private offering of new8.375% senior notes (the “New Senior Notes”), available cash and an amendedrevolving credit facility. In March 2004, $127.4 million of aggregate principalamount of Senior Notes were purchased at the tender offer and consentsolicitation price of 104% of the principal amount and $0.4 million ofaggregate principal amount of Senior Notes were purchased at the tender offerprice of 102% of the principal amount. In April 2004, the remaining $48.2million of Senior Notes were redeemed in accordance with the Senior Notesindenture at 103.5% of the principal amount. In connection with the tender offer, the Company wrote off unamortizeddeferred financing costs and incurred other direct expenses of $9.2 millionthat were included in the accompanying condensed consolidated statement ofoperations for the nine months ended September 26, 2004.

 

14

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The $175 million of New Senior Notes issued in March2004 are unsecured senior obligations of FICC, guaranteed on an unsecuredsenior basis by FICC’s Friendly’s Restaurants Franchise, Inc. subsidiary, but areeffectively subordinated to all secured indebtedness of FICC, including theindebtedness incurred under the New Credit Facility (as defined below). The NewSenior Notes mature on June 15, 2012. Interest on the New Senior Notes ispayable at 8.375% per annum semi-annually on June 15 and December 15 of eachyear.  The New Senior Notes areredeemable, in whole or in part, at any time on or after June 15, 2008 at FICC’soption at redemption prices from 104.188% to 100.00%, based on the redemptiondate.  In addition, at any time prior toJune 15, 2007, FICC may redeem, subject to certain conditions, up to 35% of theaggregate principal amount of the New Senior Notes with the proceeds of one ormore qualified equity offerings, as defined, at a redemption price of 108.375%of the principal amount, plus accrued interest.

 

The Company has a $35.0 million revolving credit facility (the “NewCredit Facility”).  The $35.0 millionrevolving credit commitment less outstanding letters of credit is available forborrowing to provide working capital and for other corporate needs. As ofOctober 2, 2005 and January 2, 2005, total letters of credit outstanding were$16.0 million and $15.2 million, respectively. During the nine months endedOctober 2, 2005 and September 26, 2004, there were no drawings against theletters of credit.  The revolving creditloans bear interest at the Company’s option at either (a) the Base Rateplus the applicable margin as in effect from time to time (the “Base Rate”)(9.25% at October 2, 2005) or (b) the Eurodollar rate plus the applicablemargin as in effect from time to time (the “Eurodollar Rate”) (8.30% at October2, 2005). As of October 2, 2005 there were no revolving credit loansoutstanding. As of January 2, 2005, $4.0 million of revolving credit loans wereoutstanding. As of October 2, 2005 and January 2, 2005, $19.0 million and$15.8 million, respectively, was available for borrowing.

 

The New Credit Facility has an annual “clean-up”provision, which obligates the Company to repay in full any and all outstandingrevolving credit loans on or before September 30, 2005 and maintain a zerobalance on such revolving credit for at least 30 consecutive days, to includeSeptember 30, 2005 immediately following the date of such repayment.  Commencing in 2006, the annual “clean-up”provision will require the Company to repay in full any and all outstandingrevolving credit loans on or before June 15 (or if June 15 is not a businessday, as defined, then the next business day) of each year and maintain a zerobalance on such revolving credit for at least 15 consecutive days, to includeJune 15, immediately following the date of such repayment.

 

The New Credit Facility includescertain restrictive covenants including limitations on indebtedness, restrictedpayments such as dividends and stock repurchases and sales of assets and ofsubsidiary stock. Additionally, the New Credit Facility limits the amount whichthe Company may spend on capital expenditures, restricts the use of proceeds,as defined, from asset sales and requires the Company to comply with certainfinancial covenants. On July 23, 2004 and October 19, 2004, the Companyobtained limited waivers regarding certain financial covenants of its NewCredit Facility, which the Company was not in full compliance with as of June27, 2004 and September 26, 2004.  OnDecember 17, 2004, the Company amended the New Credit Facility to, among otherthings, (i) revise certain financial covenants and eliminate the minimum quarterlyEBITDA requirement, (ii) amend the Company’s annual capital expenditures limitand (iii) increase the commitment fee from 0.50% to 0.75% of the unusedcommitment amount.  The Company was incompliance with the covenants under the New Credit Facility as of October 2,2005.

 

At this time, the Company believesthat it may not be in compliance with certain financial covenants under the NewCredit Facility as of January 1, 2006. Based on ongoing discussions with itslenders, its projected limited borrowings under the New Credit Facility and itsprojected liquidity related to the fourth quarter and beyond, the Companybelieves it will likely seek and obtain a covenant waiver and amendment to theNew Credit Facility or a new credit facility will be secured. In the event thatthe Company is not able to remedy such covenant violations at January 1, 2006,the Company will be in default under the New Credit Facility and, pursuant tocross default provisions, a technical default could be triggered regarding theCompany’s New Senior Notes, which would require a waiver or an amendment ofthat facility in order to maintain the current payment schedule of the NewSenior Notes.

 

In connection with the Company’s financialrestructuring completed in December 2001, the Company received proceeds of$55.0 million in a long-term mortgage financing (the

 

15

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“Mortgage Financing”).  Pursuantto the terms of the Mortgage Financing, the Company may sell propertiessecuring the Mortgage Financing obligations provided that other properties aresubstituted in place of the sold properties to secure the MortgageFinancing.  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.  Substitution properties mustsecure the Mortgage Financing obligations no later than March 1, 2006.  As of October 2, 2005, balances of $0.4million and $1.3 million were held as collateral pending property substitutionand were included in restricted cash on the accompanying condensed consolidatedbalance sheet as of October 2, 2005.

 

In September 2005, the Company acquired mortgagefinancing secured by its newly constructed Milford, MA restaurant. Thefinancing provided for a real estate improvement and equipment loan. The realestate improvement loan has a principal balance of $0.8 million, maturingOctober 1, 2010 and is amortized over 15 years. The equipment loan has a principalbalance of $0.3 million, maturing October 1, 2010 and is amortized over 7years. The interest rate is variable and is the sum of the 30-day LIBOR rate ineffect (3.86% at October 2, 2005) plus 4% on an annual basis. Changes in theinterest rate are calculated monthly and recognized annually when the monthlypayment amount is adjusted. Changes in the monthly payment amounts owed, due tointerest rate changes, are reflected in the principal balances, which arere-amortized over the remaining life of the mortgages. The variable rate notesare subject to prepayment penalties during the first three years.

 

16

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**6. SEGMENT REPORTING**

 

Operating segments arecomponents 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’s restaurantstarget families with kids and adults who desire a reasonably-priced meal in afull-service setting. The Company’s menu offers a broad selection of freshly-preparedfoods which appeal to customers throughout all dayparts. The menu currentlyfeatures over 100 items comprised of a broad selection of breakfast, lunch,dinner and afternoon and evening snack items. Foodservice operationsmanufactures premium ice cream dessert products and distributes suchmanufactured products and purchased finished goods to the Company’s restaurantsand franchised operations. Additionally, it sells premium ice cream dessertproducts to distributors and retail and institutional 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 legal, accounting, information systems and otherheadquarter functions.

 

The accounting policies of the operating segmentsare the same as those described in the summary of significant accountingpolicies except that the financial results for the foodservice operatingsegment, prior to inter-segment eliminations, have been prepared using amanagement approach, which is consistent with the basis and manner in which theCompany’s management internally reviews financial information for the purposeof assisting in making internal operating decisions. Using this approach, theCompany evaluates performance based on stand-alone operating segment income(loss) before income taxes and generally accounts for inter-segment sales andtransfers as if the sales or transfers were to third parties, that is, atcurrent market prices.

 

17

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EBITDA represents net income (loss) before (i)provision for (benefit from) income taxes, (ii) other (income) expense,principally debt retirement costs, (iii) interest expense, net,(iv) depreciation and amortization, (v) write-downs of property andequipment, (vi) net periodic pension expense (benefit) and (vii) other non-cashitems. The Company has included information concerning EBITDA in this Form 10-Qbecause the Company’s management incentive plan pays bonuses based on achievingEBITDA targets and the Company believes that such information is used bycertain investors as one measure of a company’s historical ability to servicedebt. EBITDA should not be considered as an alternative to, or more meaningfulthan, income (loss) from operations or other traditional indications of acompany’s operating performance.

 
| ** **              | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|-------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **              | ** ** | **October 2,**                 | ** ** | **September 26,**             | ** ** | **October 2,** | ** ** | **September 26,** | ** ** |
| ** **              | ** ** | **2005**                       | ** ** | **2004**                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **              | ** ** | **(in thousands)**             | ** ** | **(in thousands)**            | ** ** |
| Revenues:               |       |                           |       |                          |       |   |   |   |   |
| Restaurant              |       | $                              | 109,018    |                          | $          | 120,436 |   | $ | 317,909 |   | $ | 339,230 |   |
| Foodservice             |       | 62,576                         |       | 65,088                        |       | 181,960 |   | 182,364 |   |
| Franchise               |       | 3,753                          |       | 3,509                         |       | 10,879 |   | 9,822 |   |
| Total                   |       | $                              | 175,347    |                          | $          | 189,033 |   | $ | 510,748 |   | $ | 531,416 |   |
|                    |       |                           |       |                          |       |   |   |   |   |
| Intersegment  revenues: |       |                           |       |                          |       |   |   |   |   |
| Restaurant              |       | $                              | —     |                          | $          | — |   | $ | — |   | $ | — |   |
| Foodservice             |       | (31,790                        | )          | (35,978                       | )          | (94,120 | ) | (100,091 | ) |
| Franchise               |       | —                         |       | —                        |       | — |   | — |   |
| Total                   |       | $                              | (31,790    | )                             | $          | (35,978 | ) | $ | (94,120 | ) | $ | (100,091 | ) |
|                    |       |                           |       |                          |       |   |   |   |   |
| External  revenues:     |       |                           |       |                          |       |   |   |   |   |
| Restaurant              |       | $                              | 109,018    |                          | $          | 120,436 |   | $ | 317,909 |   | $ | 339,230 |   |
| Foodservice             |       | 30,786                         |       | 29,110                        |       | 87,840 |   | 82,273 |   |
| Franchise               |       | 3,753                          |       | 3,509                         |       | 10,879 |   | 9,822 |   |
| Total                   |       | $                              | 143,557    |                          | $          | 153,055 |   | $ | 416,628 |   | $ | 431,325 |   |

 

18

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| ** **                                                             | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|------------------------------------------------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                                                             | ** ** | **October 2,**                 | ** ** | **September 26,**             | ** ** | **October 2,** | ** ** | **September 26,** | ** ** |
| ** **                                                             | ** ** | **2005**                       | ** ** | **2004**                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                   |       | ** **                     |       | **(Restated)**                |       | ** ** |   | **(Restated)** |   |
| ** **                                                             | ** ** | **(in thousands)**             | ** ** | **(in thousands)**            | ** ** |
|                                                                   |       |                           |       |                          |       |   |   |   |   |
| EBITDA:                                                                |       |                           |       |                          |       |   |   |   |   |
| Restaurant                                                             |       | $                              | 9,940      |                          | $          | 11,845 |   | $ | 29,012 |   | $ | 32,435 |   |
| Foodservice                                                            |       | 4,344                          |       | 3,323                         |       | 10,725 |   | 9,725 |   |
| Franchise                                                              |       | 2,736                          |       | 2,506                         |       | 7,848 |   | 6,909 |   |
| Corporate                                                              |       | (3,621                         | )          | (4,084                        | )          | (13,784 | ) | (14,211 | ) |
| Gain on property  and equipment, net                                   |       | 1,772                          |       | 5                             |       | 3,915 |   | 300 |   |
| Restructuring  expenses                                                |       | —                         |       | —                        |       | — |   | (2,627 | ) |
| Gain on  litigation settlement                                         |       | —                         |       | —                        |       | — |   | 3,644 |   |
| Net periodic  pension expense (benefit) included in reporting segments |       | 72                             |       | (529                          | )          | 215 |   | (1,587 | ) |
| Total                                                                  |       | $                              | 15,243     |                          | $          | 13,066 |   | $ | 37,931 |   | $ | 34,588 |   |
|                                                                   |       |                           |       |                          |       |   |   |   |   |
| Interest  expense, net-Corporate                                       |       | $                              | 5,197      |                          | $          | 5,235 |   | $ | 15,728 |   | $ | 16,667 |   |
|                                                                   |       |                           |       |                          |       |   |   |   |   |
| Other (income)  expense, principally debt retirement costs             |       | $                              | (1         | )                             | $          | — |   | $ | (17 | ) | $ | 9,235 |   |
|                                                                   |       |                           |       |                          |       |   |   |   |   |
| Depreciation and  amortization:                                        |       |                           |       |                          |       |   |   |   |   |
| Restaurant                                                             |       | $                              | 4,185      |                          | $          | 3,853 |   | $ | 12,996 |   | $ | 11,777 |   |
| Foodservice                                                            |       | 800                            |       | 814                           |       | 2,427 |   | 2,503 |   |
| Franchise                                                              |       | 37                             |       | 67                            |       | 117 |   | 183 |   |
| Corporate                                                              |       | 760                            |       | 799                           |       | 2,375 |   | 2,469 |   |
| Total                                                                  |       | $                              | 5,782      |                          | $          | 5,533 |   | $ | 17,915 |   | $ | 16,932 |   |
|                                                                   |       |                           |       |                          |       |   |   |   |   |
| Other non-cash  expense (income):                                      |       |                           |       |                          |       |   |   |   |   |
| Net periodic  pension expense (benefit)                                |       | $                              | 72         |                          | $          | (529 | ) | $ | 215 |   | $ | (1,587 | ) |
| Write-downs of  property and equipment                                 |       | —                         |       | —                        |       | 289 |   | 91 |   |
| Total                                                                  |       | $                              | 72         |                          | $          | (529 | ) | $ | 504 |   | $ | (1,496 | ) |
|                                                                   |       |                           |       |                          |       |   |   |   |   |
| Income (loss)  before (provision for) benefit from income taxes:       |       |                           |       |                          |       |   |   |   |   |   |   |   |   |
| Restaurant                                                             |       | $                              | 5,755      |                          | $          | 7,992 |   | $ | 16,016 |   | $ | 20,658 |   |
| Foodservice                                                            |       | 3,544                          |       | 2,509                         |       | 8,298 |   | 7,222 |   |
| Franchise                                                              |       | 2,699                          |       | 2,439                         |       | 7,731 |   | 6,726 |   |
| Corporate                                                              |       | (9,577                         | )          | (10,118                       | )          | (31,870 | ) | (42,582 | ) |
| Gain on property  and equipment, net                                   |       | 1,772                          |       | 5                             |       | 3,626 |   | 209 |   |
| Restructuring  expenses                                                |       | —                         |       | —                        |       | — |   | (2,627 | ) |
| Gain on  litigation settlement                                         |       | —                         |       | —                        |       | — |   | 3,644 |   |
| Total                                                                  |       | $                              | 4,193      |                          | $          | 2,827 |   | $ | 3,801 |   | $ | (6,750 | ) |

 

19

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| ** **                                                             | ** ** | **For the Nine**   | ** ** | **For the Year** | ** ** |
|------------------------------------------------------------------------|------------|--------------------|------------|------------------|------------|
| ** **                                                             | ** ** | **Months Ended**   | ** ** | **Ended**        | ** ** |
| ** **                                                             | ** ** | **October 2,**     | ** ** | **January 2,**   | ** ** |
| ** **                                                             | ** ** | **2005**           | ** ** | **2005**         | ** ** |
| ** **                                                             | ** ** | **(in thousands)** | ** ** |
| Capital  expenditures, including assets acquired under capital leases: |       |               |       |             |       |
| Restaurant                                                             |       | $                  | 9,847      |             | $          | 20,309 |   |
| Foodservice                                                            |       | 1,141              |       | 1,700            |       |
| Corporate                                                              |       | 522                |       | 1,170            |       |
| Total                                                                  |       | $                  | 11,510     |             | $          | 23,179 |   |
|                                                                   |       |               |       |             |       |
| ** **                                                             | ** ** | **October 2,**     | ** ** | **January 2,**   | ** ** |
| ** **                                                             | ** ** | **2005**           | ** ** | **2005**         | ** ** |
| ** **                                                             | ** ** | **(in thousands)** | ** ** |
| Total assets:                                                          |       |               |       |             |       |
| Restaurant                                                             |       | $                  | 137,861    |             | $          | 142,366 |   |
| Foodservice                                                            |       | 37,336             |       | 40,567           |       |
| Franchise                                                              |       | 7,319              |       | 7,726            |       |
| Corporate                                                              |       | 68,368             |       | 58,225           |       |
| Total                                                                  |       | $                  | 250,884    |             | $          | 248,884 |   |

 

20

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**7. RESTRUCTURING RESERVES**

 

In March 2004, the Company recorded a pre-taxrestructuring charge of $2,627,000 for severance and outplacement servicesassociated with reduction in force actions taken during the first quarter of2004 that reduced headcount by approximately 20 permanent positions.

 

On October 10, 2001, the Company eliminated approximately70 positions at corporate headquarters. In addition, approximately 30 positionsin the restaurant construction and fabrication areas were eliminated byDecember 30, 2001. The purpose of the reduction was to streamline functions andreduce redundancy among its business segments. As a result of the eliminationof the positions and the outsourcing of certain functions, the Company reporteda pre-tax restructuring charge of $2,536,000 for severance, rent and unusableconstruction supplies in the year ended December 30, 2001.

 

In March 2000, the Company’s Board of Directorsapproved a restructuring plan that provided for the immediate closing of 81restaurants at the end of March 2000 and the disposition of an additional 70restaurants over the next 24 months. As a result of this plan, the Companyreported a pre-tax restructuring charge of $12,056,000 for severance, rent,utilities and real estate taxes, demarking, lease termination costs and certainother costs associated with the closing of the locations, along with a pre-taxwrite-down of property and equipment for these locations of approximately$17,000,000 in the year ended December 31, 2000. The Company reduced therestructuring reserve by $400,000 and $1,900,000 during the years endedDecember 29, 2002 and December 30, 2001, respectively, since the reserveexceeded estimated remaining payments.

 

21

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The following representsthe reserve and activity associated with the March 2004, October 2001 and March2000 restructurings (in thousands):

 
| ** **                       | ** ** | **For the Nine Months Ended October 2, 2005**    | ** ** |
|----------------------------------|------------|--------------------------------------------------|------------|
| ** **                       | ** ** | **Restructuring**                                | ** ** | ** ** | ** ** | ** ** | ** ** | **Restructuring** | ** ** |
| ** **                       | ** ** | **Reserves as of**                               | ** ** | ** ** | ** ** | ** ** | ** ** | **Reserves as of** | ** ** |
| ** **                       | ** ** | **January 2, 2005**                              | ** ** | **Expense** | ** ** | **Costs Paid** | ** ** | **October 2, 2005** | ** ** |
|                             |       |                                             |       |   |   |   |   |   |   |
| Rent                             |       | $                                                | 92         |   | $ | — |   | $ | (92 | ) | $ | — |   |
| Severence pay                    |       | 952                                              |       | — |   | (778 | ) | 174 |   |
| Other                            |       | 34                                               |       | — |   | (34 | ) | — |   |
| Total                            |       | $                                                | 1,078      |   | $ | — |   | $ | (904 | ) | $ | 174 |   |
|                             |       |                                             |       |   |   |   |   |   |   |
| ** **                       | ** ** | **For the Nine Months Ended September 26, 2004** | ** ** |
| ** **                       | ** ** | **Restructuring**                                | ** ** | ** ** | ** ** | ** ** | ** ** | **Restructuring** | ** ** |
| ** **                       | ** ** | **Reserves as of**                               | ** ** | ** ** | ** ** | ** ** | ** ** | **Reserves as of** | ** ** |
| ** **                       | ** ** | **December 28, 2003**                            | ** ** | **Expense** | ** ** | **Costs Paid** | ** ** | **September 26, 2004** | ** ** |
|                             |       |                                             |       |   |   |   |   |   |   |
| Rent                             |       | $                                                | 319        |   | $ | — |   | $ | (165 | ) | $ | 154 |   |
| Utilities and  real estate taxes |       | 40                                               |       | — |   | (16 | ) | 24 |   |
| Severence pay                    |       | —                                           |       | 2,549 |   | (1,284 | ) | 1,265 |   |
| Outplacement  services           |       | —                                           |       | 78 |   | (78 | ) | — |   |
| Other                            |       | 82                                               |       | — |   | (53 | ) | 29 |   |
| Total                            |       | $                                                | 441        |   | $ | 2,627 |   | $ | (1,596 | ) | $ | 1,472 |   |

 

Based on informationcurrently available, management believes that the restructuring reserves as ofOctober 2, 2005 were adequate and not excessive.

 

22

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**8. SUPPLEMENTAL CONDENSEDCONSOLIDATING FINANCIAL INFORMATION**

 

FICC’s obligationsrelated to its $175,000,000 8.375% senior notes (the “New Senior Notes”) issuedin March 2004 are 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’ assets wereowned by the LLCs, which are separate entities with separate creditors whichwill be entitled to be satisfied out of the LLCs’ assets. Separate completefinancial statements and other disclosures of the Guarantor Subsidiary as ofOctober 2, 2005 and January 2, 2005 and for the three and nine months endedOctober 2, 2005 and September 26, 2004 are not presented because management hasdetermined that such information is not material to investors.

 

Investments in subsidiaries are accounted for by the Parent Company onthe equity method for purposes of the supplemental consolidating presentation.Earnings of the subsidiaries are, therefore, reflected in the Parent Company’sinvestment accounts and earnings. The principal elimination entries eliminatethe Parent Company’s investments in subsidiaries and intercompany balances and transactions.

 

23

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**SupplementalCondensed Consolidating Balance Sheet**

**As ofOctober 2, 2005**

(In thousands)

 
| ** **                                                 | ** ** | ** **  | ** ** | ** **     | ** ** | **Non-**         | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------|------------|-------------|------------|----------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                 | ** ** | **Parent**  | ** ** | **Guarantor**  | ** ** | **guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                 | ** ** | **Company** | ** ** | **Subsidiary** | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                       |       |        |       |           |       |             |       |             |       |             |       |
| Assets                                                     |       |        |       |           |       |             |       |             |       |             |       |
|                                                       |       |        |       |           |       |             |       |             |       |             |       |
| Current assets:                                            |       |        |       |           |       |             |       |             |       |             |       |
| Cash and cash  equivalents                                 |       | $           | 19,159     |           | $          | 1,170            |       | $                | 3,805      |             | $          | — |   | $ | 24,134 |   |
| Restricted cash                                            |       | —      |       | —         |       | 2,727            |       | —           |       | 2,727            |       |
| Accounts  receivable, net                                  |       | 8,404       |       | 1,820          |       | —           |       | —           |       | 10,224           |       |
| Inventories                                                |       | 15,622      |       | —         |       | —           |       | —           |       | 15,622           |       |
| Deferred income  taxes                                     |       | 6,705       |       | 18             |       | —           |       | 130              |       | 6,853            |       |
| Prepaid expenses  and other current assets                 |       | 12,336      |       | 2,133          |       | 7,783            |       | (15,933          | )          | 6,319            |       |
| Total current  assets                                      |       | 62,226      |       | 5,141          |       | 14,315           |       | (15,803          | )          | 65,879           |       |
| Deferred income  taxes                                     |       | 9,675       |       | 366            |       | —           |       | (130             | )          | 9,911            |       |
| Property and  equipment, net                               |       | 105,348     |       | —         |       | 43,298           |       | —           |       | 148,646          |       |
| Intangibles and  deferred costs, net                       |       | 17,022      |       | —         |       | 2,121            |       | —           |       | 19,143           |       |
| Investments in  subsidiaries                               |       | 1,568       |       | —         |       | —           |       | (1,568           | )          | —           |       |
| Other assets                                               |       | 6,390       |       | 4,170          |       | 915              |       | (4,170           | )          | 7,305            |       |
|                                                       |       |        |       |           |       |             |       |             |       |             |       |
| Total assets                                               |       | $           | 202,229    |           | $          | 9,677            |       | $                | 60,649     |             | $          | (21,671 | ) | $ | 250,884 |   |
|                                                       |       |        |       |           |       |             |       |             |       |             |       |
| Liabilities and Stockholders’ (Deficit) Equity        |       |        |       |           |       |             |       |             |       |             |       |
|                                                       |       |        |       |           |       |             |       |             |       |             |       |
| Current  liabilities:                                      |       |        |       |           |       |             |       |             |       |             |       |
| Current  maturities of long-term obligations               |       | $           | 9,251      |           | $          | —           |       | $                | 1,315      |             | $          | (7,776 | ) | $ | 2,790 |   |
| Accounts payable                                           |       | 23,179      |       | —         |       | —           |       | —           |       | 23,179           |       |
| Accrued expenses                                           |       | 39,696      |       | 4,091          |       | 5,946            |       | (7,832           | )          | 41,901           |       |
| Total current  liabilities                                 |       | 72,126      |       | 4,091          |       | 7,261            |       | (15,608          | )          | 67,870           |       |
| Long-term  obligations, less current maturities            |       | 182,354     |       | —         |       | 49,757           |       | —           |       | 232,111          |       |
| Other long-term  liabilities                               |       | 48,703      |       | 1,068          |       | 6,581            |       | (4,495           | )          | 51,857           |       |
| Stockholders’ (deficit)  equity                       |       | (100,954    | )          | 4,518          |       | (2,950           | )          | (1,568           | )          | (100,954         | )          |
|                                                       |       |        |       |           |       |             |       |             |       |             |       |
| Total  liabilities and stockholders’ (deficit) equity |       | $           | 202,229    |           | $          | 9,677            |       | $                | 60,649     |             | $          | (21,671 | ) | $ | 250,884 |   |

 

24

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**SupplementalCondensed Consolidating Statement of Operations**

**For theThree Months Ended October 2, 2005**

(In thousands)

 
| ** **                                                                                       | ** ** | ** **  | ** ** | ** **     | ** ** | **Non-**         | ** ** | ** **       | ** ** | ** **       | ** ** |
|--------------------------------------------------------------------------------------------------|------------|-------------|------------|----------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                                       | ** ** | **Parent**  | ** ** | **Guarantor**  | ** ** | **guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                                                       | ** ** | **Company** | ** ** | **Subsidiary** | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                                                             |       |        |       |           |       |             |       |             |       |             |       |
| Revenues                                                                                         |       | $           | 140,721    |           | $          | 2,836            |       | $                | —     |             | $          | — |   | $ | 143,557 |   |
|                                                                                             |       |        |       |           |       |             |       |             |       |             |       |
| Costs and  expenses:                                                                             |       |        |       |           |       |             |       |             |       |             |       |
| Cost of sales                                                                                    |       | 54,225      |       | —         |       | —           |       | —           |       | 54,225           |       |
| Labor and  benefits                                                                              |       | 38,337      |       | —         |       | —           |       | —           |       | 38,337           |       |
| Operating  expenses and write-downs of property and equipment                                    |       | 31,075      |       | —         |       | (1,749           | )          | —           |       | 29,326           |       |
| General and  administrative expenses                                                             |       | 7,106       |       | 1,155          |       | 1                |       | —           |       | 8,262            |       |
| Depreciation and  amortization                                                                   |       | 5,230       |       | —         |       | 552              |       | —           |       | 5,782            |       |
| Loss on  franchise sales of restaurant operations and properties                                 |       | 7           |       | —         |       | —           |       | —           |       | 7                |       |
| Loss (gain) on  disposals of other property and equipment, net                                   |       | 385         |       | —         |       | (2,156           | )          | —           |       | (1,771           | )          |
| Interest  expense, net                                                                           |       | 4,065       |       | —         |       | 1,132            |       | —           |       | 5,197            |       |
| Other income                                                                                     |       | (1          | )          | —         |       | —           |       | —           |       | (1               | )          |
|                                                                                             |       |        |       |           |       |             |       |             |       |             |       |
| Income before  provision for income taxes and equity in net income of consolidated  subsidiaries |       | 292         |       | 1,681          |       | 2,220            |       | —           |       | 4,193            |       |
|                                                                                             |       |        |       |           |       |             |       |             |       |             |       |
| Provision for  income taxes                                                                      |       | (43         | )          | (689           | )          | (54              | )          | —           |       | (786             | )          |
|                                                                                             |       |        |       |           |       |             |       |             |       |             |       |
| Income before  equity in net income of consolidated subsidiaries                                 |       | 249         |       | 992            |       | 2,166            |       | —           |       | 3,407            |       |
|                                                                                             |       |        |       |           |       |             |       |             |       |             |       |
| Equity in net  income of consolidated subsidiaries                                               |       | 3,158       |       | —         |       | —           |       | (3,158           | )          | —           |       |
|                                                                                             |       |        |       |           |       |             |       |             |       |             |       |
| Net income                                                                                       |       | $           | 3,407      |           | $          | 992              |       | $                | 2,166      |             | $          | (3,158 | ) | $ | 3,407 |   |

 

25

----

 

**SupplementalCondensed Consolidating Statement of Operations**

**For theNine Months Ended October 2, 2005**

(In thousands)

 
| ** **                                                                                                             | ** ** | ** **  | ** ** | ** **     | ** ** | **Non-**         | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|-------------|------------|----------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                                                             | ** ** | **Parent**  | ** ** | **Guarantor**  | ** ** | **guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                                                                             | ** ** | **Company** | ** ** | **Subsidiary** | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Revenues                                                                                                               |       | $           | 408,306    |           | $          | 8,322            |       | $                | —     |             | $          | — |   | $ | 416,628 |   |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Costs and  expenses:                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Cost of sales                                                                                                          |       | 157,482     |       | —         |       | —           |       | —           |       | 157,482          |       |
| Labor and  benefits                                                                                                    |       | 114,773     |       | —         |       | —           |       | —           |       | 114,773          |       |
| Operating  expenses and write-downs of property and equipment                                                          |       | 87,878      |       | —         |       | (5,247           | )          | —           |       | 82,631           |       |
| General and  administrative expenses                                                                                   |       | 24,773      |       | 3,465          |       | 1                |       | —           |       | 28,239           |       |
| Depreciation and  amortization                                                                                         |       | 16,248      |       | —         |       | 1,667            |       | —           |       | 17,915           |       |
| Gain on  franchise sales of restaurant operations and properties                                                       |       | (2,521      | )          | —         |       | —           |       | —           |       | (2,521           | )          |
| Loss (gain) on  disposals of other property and equipment, net                                                         |       | 753         |       | —         |       | (2,156           | )          | —           |       | (1,403           | )          |
| Interest  expense, net                                                                                                 |       | 12,351      |       | —         |       | 3,377            |       | —           |       | 15,728           |       |
| Other income                                                                                                           |       | (17         | )          | —         |       | —           |       | —           |       | (17              | )          |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| (Loss) income  before benefit from (provision for) income taxes and equity in net income of consolidated  subsidiaries |       | (3,414      | )          | 4,857          |       | 2,358            |       | —           |       | 3,801            |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Benefit from  (provision for) income taxes                                                                             |       | 1,289       |       | (1,991         | )          | (161             | )          | —           |       | (863             | )          |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| (Loss) income  before equity in net income of consolidated subsidiaries                                                |       | (2,125      | )          | 2,866          |       | 2,197            |       | —           |       | 2,938            |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Equity in net  income of consolidated subsidiaries                                                                     |       | 5,063       |       | —         |       | —           |       | (5,063           | )          | —           |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Net income                                                                                                             |       | $           | 2,938      |           | $          | 2,866            |       | $                | 2,197      |             | $          | (5,063 | ) | $ | 2,938 |   |

 

26

----

 

**SupplementalCondensed Consolidating Statement of Cash Flows**

**For theNine Months Ended October 2, 2005**

(In thousands)

 
| ** **                                                | ** ** | ** **  | ** ** | ** **     | ** ** | **Non-**         | ** ** | ** **       | ** ** | ** **       | ** ** |
|-----------------------------------------------------------|------------|-------------|------------|----------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                | ** ** | **Parent**  | ** ** | **Guarantor**  | ** ** | **guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                | ** ** | **Company** | ** ** | **Subsidiary** | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| Net cash  provided by (used in) operating activities      |       | $           | 20,437     |           | $          | (190             | )          | $                | 676        |             | $          | (634 | ) | $ | 20,289 |   |
|                                                      |       |        |       |           |       |             |       |             |       |             |       |
| Cash flows from  investing activities:                    |       |        |       |           |       |             |       |             |       |             |       |
| Purchases of  property and equipment                      |       | (11,511     | )          | —         |       | —           |       | —           |       | (11,511          | )          |
| Proceeds from  sales of property and equipment            |       | 3,358       |       | —         |       | 2,872            |       | —           |       | 6,230            |       |
| Purchases of  marketable securities                       |       | (499        | )          | —         |       | —           |       | —           |       | (499             | )          |
| Proceeds from  sales of marketable securities             |       | 163         |       | —         |       | —           |       | —           |       | 163              |       |
| Return of  investment in subsidiary                       |       | 378         |       | —         |       | —           |       | (378             | )          | —           |       |
| Net cash (used  in) provided by investing activities      |       | (8,111      | )          | —         |       | 2,872            |       | (378             | )          | (5,617           | )          |
|                                                      |       |        |       |           |       |             |       |             |       |             |       |
| Cash flows from  financing activities:                    |       |        |       |           |       |             |       |             |       |             |       |
| Proceeds from  borrowings under revolving credit facility |       | 16,250      |       | —         |       | —           |       | —           |       | 16,250           |       |
| Proceeds from  issuance of mortgages                      |       | 1,115       |       | —         |       | —           |       | —           |       | 1,115            |       |
| Repayments of  obligations                                |       | (21,399     | )          | —         |       | (903             | )          | —           |       | (22,302          | )          |
| Payments of  deferred financing costs                     |       | (43         | )          | —         |       | —           |       | —           |       | (43              | )          |
| Stock options  exercised                                  |       | 1,037       |       | —         |       | —           |       | —           |       | 1,037            |       |
| Reinsurance  deposits received                            |       | —      |       | —         |       | 114              |       | (114             | )          | —           |       |
| Reinsurance  payments made from deposits                  |       | —      |       | —         |       | (748             | )          | 748              |       | —           |       |
| Dividends paid                                            |       | —      |       | —         |       | (378             | )          | 378              |       | —           |       |
| Net cash used in  financing activities                    |       | (3,040      | )          | —         |       | (1,915           | )          | 1,012            |       | (3,943           | )          |
|                                                      |       |        |       |           |       |             |       |             |       |             |       |
| Net increase  (decrease) in cash and cash equivalents     |       | 9,286       |       | (190           | )          | 1,633            |       | —           |       | 10,729           |       |
|                                                      |       |        |       |           |       |             |       |             |       |             |       |
| Cash and cash  equivalents, beginning of period           |       | 9,873       |       | 1,360          |       | 2,172            |       | —           |       | 13,405           |       |
|                                                      |       |        |       |           |       |             |       |             |       |             |       |
| Cash and cash  equivalents, end of period                 |       | $           | 19,159     |           | $          | 1,170            |       | $                | 3,805      |             | $          | — |   | $ | 24,134 |   |
|                                                      |       |        |       |           |       |             |       |             |       |             |       |
| Supplemental  disclosures:                                |       |        |       |           |       |             |       |             |       |             |       |
| Interest paid                                             |       | $           | 7,982      |           | $          | —           |       | $                | 3,396      |             | $          | — |   | $ | 11,378 |   |
| Income taxes  (refunded) paid                             |       | (2,057      | )          | 2,584          |       | 159              |       | —           |       | 686              |       |
| Capital lease  obligations terminated                     |       | 51          |       | —         |       | —           |       | —           |       | 51               |       |

 

27

----

 

**Supplemental Condensed Consolidating Balance Sheet**

**As of January 2, 2005**

(In thousands)

 
| ** **                                                 | ** ** | ** **  | ** ** | ** **     | ** ** | **Non-**         | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------|------------|-------------|------------|----------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                 | ** ** | **Parent**  | ** ** | **Guarantor**  | ** ** | **guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                 | ** ** | **Company** | ** ** | **Subsidiary** | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                       |       |        |       |           |       |             |       |             |       |             |       |
| Assets                                                     |       |        |       |           |       |             |       |             |       |             |       |
|                                                       |       |        |       |           |       |             |       |             |       |             |       |
| Current assets:                                            |       |        |       |           |       |             |       |             |       |             |       |
| Cash and cash  equivalents                                 |       | $           | 9,873      |           | $          | 1,360            |       | $                | 2,172      |             | $          | — |   | $ | 13,405 |   |
| Restricted cash                                            |       | —      |       | —         |       | 1,711            |       | —           |       | 1,711            |       |
| Accounts  receivable, net                                  |       | 8,548       |       | 1,900          |       | —           |       | —           |       | 10,448           |       |
| Inventories                                                |       | 17,545      |       | —         |       | —           |       | —           |       | 17,545           |       |
| Deferred income  taxes                                     |       | 6,705       |       | 18             |       | —           |       | 130              |       | 6,853            |       |
| Prepaid expenses  and other current assets                 |       | 11,171      |       | 2,512          |       | 7,782            |       | (16,903          | )          | 4,562            |       |
| Total current  assets                                      |       | 53,842      |       | 5,790          |       | 11,665           |       | (16,773          | )          | 54,524           |       |
| Deferred income  taxes                                     |       | 10,383      |       | 366            |       | —           |       | (130             | )          | 10,619           |       |
| Property and  equipment, net                               |       | 110,707     |       | —         |       | 45,525           |       | —           |       | 156,232          |       |
| Intangibles and  deferred costs, net                       |       | 18,234      |       | —         |       | 2,276            |       | —           |       | 20,510           |       |
| Investments in  subsidiaries                               |       | (3,117      | )          | —         |       | —           |       | 3,117            |       | —           |       |
| Other assets                                               |       | 6,083       |       | 1,216          |       | 915              |       | (1,215           | )          | 6,999            |       |
|                                                       |       |        |       |           |       |             |       |             |       |             |       |
| Total assets                                               |       | $           | 196,132    |           | $          | 7,372            |       | $                | 60,381     |             | $          | (15,001 | ) | $ | 248,884 |   |
|                                                       |       |        |       |           |       |             |       |             |       |             |       |
| Liabilities and Stockholders’ (Deficit) Equity        |       |        |       |           |       |             |       |             |       |             |       |
|                                                       |       |        |       |           |       |             |       |             |       |             |       |
| Current  liabilities:                                      |       |        |       |           |       |             |       |             |       |             |       |
| Current  maturities of long-term obligations               |       | $           | 13,309     |           | $          | —           |       | $                | 1,224      |             | $          | (7,776 | ) | $ | 6,757 |   |
| Accounts payable                                           |       | 21,536      |       | —         |       | —           |       | —           |       | 21,536           |       |
| Accrued expenses                                           |       | 38,085      |       | 4,829          |       | 5,650            |       | (8,810           | )          | 39,754           |       |
| Total current  liabilities                                 |       | 72,930      |       | 4,829          |       | 6,874            |       | (16,586          | )          | 68,047           |       |
| Long-term  obligations, less current maturities            |       | 182,380     |       | —         |       | 50,752           |       | —           |       | 233,132          |       |
| Other long-term  liabilities                               |       | 45,848      |       | 891            |       | 7,524            |       | (1,532           | )          | 52,731           |       |
| Stockholders’  (deficit) equity                       |       | (105,026    | )          | 1,652          |       | (4,769           | )          | 3,117            |       | (105,026         | )          |
|                                                       |       |        |       |           |       |             |       |             |       |             |       |
| Total  liabilities and stockholders’ (deficit) equity |       | $           | 196,132    |           | $          | 7,372            |       | $                | 60,381     |             | $          | (15,001 | ) | $ | 248,884 |   |

 

28

----

 

**SupplementalCondensed Consolidating Statement of Operations**

**For the ThreeMonths Ended September 26, 2004**

**(Restated)**

(In thousands)

 
| ** **                                                                                                      | ** ** | ** **  | ** ** | ** **     | ** ** | **Non-**         | ** ** | ** **       | ** ** | ** **       | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|-------------|------------|----------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                                                      | ** ** | **Parent**  | ** ** | **Guarantor**  | ** ** | **guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                                                                      | ** ** | **Company** | ** ** | **Subsidiary** | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                                                                            |       |        |       |           |       |             |       |             |       |             |       |
| Revenues                                                                                                        |       | $           | 150,164    |           | $          | 2,891            |       | $                | —     |             | $          | — |   | $ | 153,055 |   |
|                                                                                                            |       |        |       |           |       |             |       |             |       |             |       |
| Costs and  expenses:                                                                                            |       |        |       |           |       |             |       |             |       |             |       |
| Cost of sales                                                                                                   |       | 57,368      |       | —         |       | —           |       | —           |       | 57,368           |       |
| Labor and  benefits                                                                                             |       | 42,990      |       | —         |       | —           |       | —           |       | 42,990           |       |
| Operating  expenses and write-downs of property and equipment                                                   |       | 31,823      |       | —         |       | (1,739           | )          | —           |       | 30,084           |       |
| General and  administrative expenses                                                                            |       | 7,899       |       | 1,155          |       | —           |       | —           |       | 9,054            |       |
| Depreciation and  amortization                                                                                  |       | 4,975       |       | —         |       | 558              |       | —           |       | 5,533            |       |
| Gain on  franchise sales of restaurant operations and properties                                                |       | (189        | )          | —         |       | —           |       | —           |       | (189             | )          |
| Loss on  disposals of other property and equipment, net                                                         |       | 140         |       | —         |       | 13               |       | —           |       | 153              |       |
| Interest  expense, net                                                                                          |       | 4,103       |       | —         |       | 1,132            |       | —           |       | 5,235            |       |
|                                                                                                            |       |        |       |           |       |             |       |             |       |             |       |
| Income before  benefit from (provision for) income taxes and equity in net income of consolidated  subsidiaries |       | 1,055       |       | 1,736          |       | 36               |       | —           |       | 2,827            |       |
|                                                                                                            |       |        |       |           |       |             |       |             |       |             |       |
| Benefit from  (provision for) income taxes                                                                      |       | 1,413       |       | (712           | )          | (50              | )          | —           |       | 651              |       |
|                                                                                                            |       |        |       |           |       |             |       |             |       |             |       |
| Income (loss)  before equity in net income of consolidated subsidiaries                                         |       | 2,468       |       | 1,024          |       | (14              | )          | —           |       | 3,478            |       |
|                                                                                                            |       |        |       |           |       |             |       |             |       |             |       |
| Equity in net  income of consolidated subsidiaries                                                              |       | 1,010       |       | —         |       | —           |       | (1,010           | )          | —           |       |
|                                                                                                            |       |        |       |           |       |             |       |             |       |             |       |
| Net income  (loss)                                                                                              |       | $           | 3,478      |           | $          | 1,024            |       | $                | (14        | )                | $          | (1,010 | ) | $ | 3,478 |   |

 

29

----

 

**SupplementalCondensed Consolidating Statement of Operations**

**For theNine Months Ended September 26, 2004**

**(Restated)**

(In thousands)

 
| ** **                                                                                                             | ** ** | ** **  | ** ** | ** **     | ** ** | **Non-**         | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|-------------|------------|----------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                                                             | ** ** | **Parent**  | ** ** | **Guarantor**  | ** ** | **guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                                                                             | ** ** | **Company** | ** ** | **Subsidiary** | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Revenues                                                                                                               |       | $           | 423,217    |           | $          | 8,108            |       | $                | —     |             | $          | — |   | $ | 431,325 |   |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Costs and  expenses:                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Cost of sales                                                                                                          |       | 158,915     |       | —         |       | —           |       | —           |       | 158,915          |       |
| Labor and  benefits                                                                                                    |       | 125,079     |       | —         |       | —           |       | —           |       | 125,079          |       |
| Operating  expenses and write-downs of property and equipment                                                          |       | 88,411      |       | —         |       | (5,211           | )          | —           |       | 83,200           |       |
| General and  administrative expenses                                                                                   |       | 26,040      |       | 3,465          |       | —           |       | —           |       | 29,505           |       |
| Restructuring  expenses                                                                                                |       | 2,627       |       | —         |       | —           |       | —           |       | 2,627            |       |
| Gain on  litigation settlement                                                                                         |       | (3,644      | )          | —         |       | —           |       | —           |       | (3,644           | )          |
| Depreciation and  amortization                                                                                         |       | 15,247      |       | —         |       | 1,685            |       | —           |       | 16,932           |       |
| Gain on  franchise sales of restaurant operations and properties                                                       |       | (1,102      | )          | —         |       | —           |       | —           |       | (1,102           | )          |
| Loss on  disposals of other property and equipment, net                                                                |       | 645         |       | —         |       | 16               |       | —           |       | 661              |       |
| Interest  expense, net                                                                                                 |       | 13,280      |       | —         |       | 3,387            |       | —           |       | 16,667           |       |
| Other expenses,  principally debt retirement costs                                                                     |       | 9,235       |       | —         |       | —           |       | —           |       | 9,235            |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| (Loss) income  before benefit from (provision for) income taxes and equity in net income of consolidated  subsidiaries |       | (11,516     | )          | 4,643          |       | 123              |       | —           |       | (6,750           | )          |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Benefit from  (provision for) income taxes                                                                             |       | 5,617       |       | (1,904         | )          | (147             | )          | —           |       | 3,566            |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| (Loss) income  before equity in net income of consolidated subsidiaries                                                |       | (5,899      | )          | 2,739          |       | (24              | )          | —           |       | (3,184           | )          |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Equity in net  income of consolidated subsidiaries                                                                     |       | 2,715       |       | —         |       | —           |       | (2,715           | )          | —           |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Net (loss)  income                                                                                                     |       | $           | (3,184     | )              | $          | 2,739            |       | $                | (24        | )                | $          | (2,715 | ) | $ | (3,184 | ) |

 

30

----

 

**SupplementalCondensed Consolidating Statement of Cash Flows**

**For theNine Months Ended September 26, 2004**

(In thousands)

 
| ** **                                            | ** ** | ** **  | ** ** | ** **     | ** ** | **Non-**         | ** ** | ** **       | ** ** | ** **       | ** ** |
|-------------------------------------------------------|------------|-------------|------------|----------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                            | ** ** | **Parent**  | ** ** | **Guarantor**  | ** ** | **guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                            | ** ** | **Company** | ** ** | **Subsidiary** | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                  |       |        |       |           |       |             |       |             |       |             |       |
| Net cash  provided by (used in) operating activities  |       | $           | 11,526     |           | $          | (790             | )          | $                | 1,392      |             | $          | 264 |   | $ | 12,392 |   |
|                                                  |       |        |       |           |       |             |       |             |       |             |       |
| Cash flows from  investing activities:                |       |        |       |           |       |             |       |             |       |             |       |
| Purchases of  property and equipment                  |       | (15,554     | )          | —         |       | —           |       | —           |       | (15,554          | )          |
| Proceeds from  sales of property and equipment        |       | 4,048       |       | —         |       | —           |       | —           |       | 4,048            |       |
| Purchases of  marketable securities                   |       | (1,022      | )          | —         |       | —           |       | —           |       | (1,022           | )          |
| Proceeds from  sales of marketable securities         |       | 89          |       | —         |       | —           |       | —           |       | 89               |       |
| Return of  investment in subsidiary                   |       | 551         |       | —         |       | —           |       | (551             | )          | —           |       |
| Net cash used in  investing activities                |       | (11,888     | )          | —         |       | —           |       | (551             | )          | (12,439          | )          |
|                                                  |       |        |       |           |       |             |       |             |       |             |       |
| Cash flows from  financing activities:                |       |        |       |           |       |             |       |             |       |             |       |
| Proceeds from  issuance of senior notes               |       | 175,000     |       | —         |       | —           |       | —           |       | 175,000          |       |
| Proceeds from  other borrowings                       |       | 16,750      |       | —         |       | —           |       | —           |       | 16,750           |       |
| Repayments of  obligations                            |       | (193,576    | )          | —         |       | (828             | )          | —           |       | (194,404         | )          |
| Payments of  deferred financing costs                 |       | (6,625      | )          | —         |       | —           |       | —           |       | (6,625           | )          |
| Stock options  exercised                              |       | 929         |       | —         |       | —           |       | —           |       | 929              |       |
| Reinsurance  deposits received                        |       | —      |       | —         |       | 1,131            |       | (1,131           | )          | —           |       |
| Reinsurance payments  made from deposits              |       | —      |       | —         |       | (867             | )          | 867              |       | —           |       |
| Dividends paid                                        |       | —      |       | —         |       | (551             | )          | 551              |       | —           |       |
| Net cash used in  financing activities                |       | (7,522      | )          | —         |       | (1,115           | )          | 287              |       | (8,350           | )          |
|                                                  |       |        |       |           |       |             |       |             |       |             |       |
| Net (decrease)  increase in cash and cash equivalents |       | (7,884      | )          | (790           | )          | 277              |       | —           |       | (8,397           | )          |
|                                                  |       |        |       |           |       |             |       |             |       |             |       |
| Cash and cash  equivalents, beginning of period       |       | 21,640      |       | 2,173          |       | 1,818            |       | —           |       | 25,631           |       |
|                                                  |       |        |       |           |       |             |       |             |       |             |       |
| Cash and cash  equivalents, end of period             |       | $           | 13,756     |           | $          | 1,383            |       | $                | 2,095      |             | $          | — |   | $ | 17,234 |   |
|                                                  |       |        |       |           |       |             |       |             |       |             |       |
| Supplemental  disclosures:                            |       |        |       |           |       |             |       |             |       |             |       |
| Interest paid                                         |       | $           | 9,891      |           | $          | —           |       | $                | 3,407      |             | $          | — |   | $ | 13,298 |   |
| Income taxes  (refunded) paid                         |       | (1,653      | )          | 1,529          |       | 148              |       | —           |       | 24               |       |
| Capital lease  obligations incurred                   |       | 3,250       |       | —         |       | —           |       | —           |       | 3,250            |       |

 

31

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**Item 2.Management’s Discussion and Analysis of Financial Condition and Results ofOperations**

 

*Thefollowing discussion should be read in conjunction with the CondensedConsolidated Financial Statements of the Company and the notes thereto includedelsewhere herein.*

 

**ForwardLooking Statements**

 

Statements contained herein that are not historicalfacts constitute “forward looking statements” as that term is defined in thePrivate Securities Litigation Reform Act of 1995. Words such as “believes,” “plans,” “anticipates,” “expects,” “will” andsimilar expressions are intended to identify forward looking statements.* *Forwardlooking statements include, but are not limited to, statements relating to thesufficiency of the Company’s capital resources, changes in commodity prices,anticipated capital expenditures and the Company’s plans with respect torestaurant openings, closings, reimagings and re-franchisings.  All forward looking statements are subject toknown and unknown risks, uncertainties and other factors which could causeactual results to differ materially from those anticipated. These factorsinclude: the Company’s highly competitive business environment; exposure tofluctuating commodity prices; risks associated with the foodservice industry,such as changes in consumer tastes and adverse publicity resulting from foodquality, illness, injury or other health concerns; the ability to retain andattract new employees; government regulations; the Company’s high geographicconcentration in the Northeast and its attendant weather patterns; conditionsneeded to meet restaurant re-imaging and new opening targets; risks anduncertainties arising out of accounting adjustments; the Company’s ability toservice its debt and other obligations; the Company’s ability to meet ongoingfinancial covenants contained in the Company’s 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 the Company’s prospects in general are included in the Company’sother filings with the Securities and Exchange Commission.**TheCompany is not obligated to update any forward looking statements, whether as aresult of new information, future events or otherwise.

 

**Overview**

 

The Company’s revenues are derivedprimarily from the operation of full-service restaurants, the distribution andsale of premium ice cream desserts through retail and institutional locationsand franchising. As of October 2, 2005, Friendly’s operated 330 full-servicerestaurants, franchised 198 full-service restaurants and seven non-traditionalunits and manufactured a full line of premium ice cream desserts distributedthrough more than 4,500 supermarkets and other retail locations in 13 states.

 

32

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Following is asummary of the Company-operated and franchised units:

 
| ** **             | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **             | ** ** | **October 2,**                 | ** ** | **September 26,**             | ** ** | **October 2,** | ** ** | **September 26,** | ** ** |
| ** **             | ** ** | **2005**                       | ** ** | **2004**                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|                   |       |                           |       |                          |       |   |   |   |   |
| Company Units:         |       |                           |       |                          |       |   |   |   |   |
| Beginning of  period   |       | 332                            |       | 360                           |       | 347 |   | 380 |   |
| Openings               |       | —                         |       | 4                             |       | 1 |   | 4 |   |
| Refranchised  closings |       | —                         |       | —                        |       | (10 | ) | (18 | ) |
| Closings               |       | (2                             | )          | (6                            | )          | (8 | ) | (8 | ) |
| End of period          |       | 330                            |       | 358                           |       | 330 |   | 358 |   |
|                   |       |                           |       |                          |       |   |   |   |   |
| Franchised  Units:     |       |                           |       |                          |       |   |   |   |   |
| Beginning of  period   |       | 205                            |       | 186                           |       | 195 |   | 163 |   |
| Refranchised  openings |       | —                         |       | —                        |       | 10 |   | 18 |   |
| Openings               |       | —                         |       | 2                             |       | 2 |   | 7 |   |
| Closings               |       | —                         |       | (2                            | )          | (2 | ) | (2 | ) |
| End of period          |       | 205                            |       | 186                           |       | 205 |   | 186 |   |

 

***Three months endedOctober 2, 2005 compared with three months ended September 26, 2004***

 

*Revenues:*

 

*Total Revenues -*Total revenues decreased $9.5 million, or 6.2%, to $143.6 million for the threemonths ended October 2, 2005 from $153.1 million for the same period in 2004.

 

*RestaurantRevenues -* Restaurant revenues decreased $11.4 million, or9.5%, to $109.0 million for the three months ended October 2, 2005 from $120.4million for the same period in 2004. ComparableCompany-operated restaurant revenues decreased 4.0%, from the 2004quarter to the 2005 quarter as the Company experienced declines in comparableCompany-operated restaurant revenues of 11.4%, 14.9% and 11.2% during the firstthree weeks of September 2005.  Higherprices for gasoline, especially during the three weeks in September 2005 posthurricane Katrina, appeared to have had a negative impact on the number ofcustomer visits during all day-parts with the Company’s afternoon and eveningsnack periods experiencing the greatest declines. The closing of 16 locations and the re-franchising of 19locations over the past 15 months resulted in declines of $2.6 million and $5.5million, respectively, in restaurant revenues in the third quarter of 2005 ascompared to the same period in 2004. These declines were partially offset byincreased revenues of $1.0 million in the third quarter of 2005 as compared tothe same period in 2004 due to the opening of five new restaurants over the past15 months. There were no new restaurants opened during the third quarter of2005.

 

33

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*FoodserviceRevenues -* Foodservice(product sales to franchisees and retail customers) revenues increased $1.7million, or 5.8% to $30.8 million for the three months ended October 2, 2005from $29.1 million for the three months ended September 26, 2004. This increasewas partially due to a $0.7 million increase in franchised restaurant productrevenue resulting from the increased number of franchised restaurants in thethird quarter of 2005 compared to the same period in 2004.  Sales to foodservice retail supermarketcustomers increased $1.0 million due to fewer promotions during the 2005quarter and a 0.3% increase in case volume inthe Company’s retail supermarket business in the three months ended October 2,2005 when compared to the three months ended September 26, 2004. Case volumeincreased primarily as a result of higher volume of individual sundae cups andthe introduction of new decorative cakes.

 

*FranchiseRevenues -* Franchise royaltyand fee revenues increased $0.3 million, or 7.0%, to $3.8 million for the threemonths ended October 2, 2005 compared to $3.5 million for the same period in2004 due primarily to increases in royalties on franchised sales and rentalincome for leased and subleased franchise locations, partially offset by adecline in franchise fees.

 

Royalties on franchised sales increased $0.2 million for the threemonths ended October 2, 2005 as compared to the same period in 2004. Comparablefranchised revenues decreased 2.6% from the three months ended September 26,2004 to the three months ended October 2, 2005 largely due to a 7.8% decline incomparable sales in the month of September. Higher prices for gasoline,especially during the three weeks in September 2005 post hurricane Katrina,appeared to have had a negative impact on the number of customer visits. Theopening of five new franchise restaurants and 19 re-franchised restaurantsduring the last 15 months increased royalty revenues by $0.3 million while theclosing of five under-performing locations during the same period had minimalimpact.

 

Initial franchise fees decreased $0.2 million duringthe three months ended October 2, 2005 when compared to the same period in2004. During the three months ended September 26, 2004, the Company received$0.1 million in franchise fees related to the sale of leasehold improvementsand equipment and the assignment of a lease for one refranchised location andthe sale of equipment at three other refranchised locations to the existingfranchisee.  Additionally, during thethree months ended September 26, 2004, the Company received $0.1 in franchisefees from the opening of two new locations during that period.

 

An increase in rental income for leased andsubleased franchise locations of $0.3 million due primarily to an increasednumber of leased and subleased franchised locations contributed to the higherrevenues for the three months ended October 2, 2005 compared to the same periodin 2004. There were 205 and 186 franchise units open at October 2, 2005 andSeptember 26, 2004, respectively.

 

*Cost of sales:*

 

Cost of sales decreased $3.2 million, or 5.5%, to$54.2 million for the three months ended October 2, 2005 from $57.4 million forthe same period in 2004. Cost of sales as a percentage of total revenues was37.8% and 37.5% for the three months ended October 2, 2005 and September 26,2004, respectively.

 

34

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The slight increase incost of sales as a percentage of total revenues for the three months endedOctober 2, 2005 compared to the same period in 2004 was primarily due to ashift in sales mix from Company-operated restaurant sales to foodservice sales.Foodservice sales to franchisees and retail supermarket customers (21.4% and19.0% of total revenues for the three months ended October 2, 2005 andSeptember 26, 2004, respectively) have higher food costs as a percentage ofrevenue, at 90.3%, than sales in Company-operated restaurants to restaurantpatrons. The growth in franchise revenues reduced cost of sales as a percentageof total revenues by 0.1% for the three months ended October 2, 2005 whencompared to the 2004 period since franchise revenues have no product costsassociated with such revenues. Additionally, foodservice retail salespromotional allowances, recorded as offsets to revenues, decreased by 4.6% inthe 2005 quarter as a percentage of sales to foodservice retail supermarketcustomers when compared to the 2004 quarter due to fewer promotions during the2005 quarter. This decrease also had a favorable impact on the overall cost ofsales as a percentage of total revenues as did a lower cost for cream in the2005 period when compared to the same period in 2004. Manufacturingefficiencies improved in the current period when compared to the same period ayear ago due to cost reductions associated with scheduling improvements;however, higher fuel costs in the 2005 period versus the 2004 period offset someof the benefit.

 

Restaurant cost of salesas a percentage of restaurant revenues decreased to 27.3% in the third quarterof 2005 from 27.5% in the third quarter of 2004. The decrease in the 2005quarter when compared to the 2004 quarter was in part due to lower cream pricesin the current period when compared the same period a year ago and fewer freedessert promotions in the 2005 quarter.

 

The cost of cream was approximately $0.5 million lowerin the three months ended October 2, 2005 when compared to the three monthsended September 26, 2004. For the remainder of 2005, the Company expects thatcream prices will be lower than the prices experienced in 2004.  Futures and options on AA butter are tradedon the Chicago Mercantile Exchange and AA butter is the commodity used toderive the price of cream.  A tableshowing the average monthly price of a pound of AA butter obtained from marketquotes provided by the USDA’s Agricultural Marketing Service is includedelsewhere herein.

 

*Labor and benefits:*

 

Labor and benefits decreased $4.7 million, or 10.8%, to $38.3 millionfor the three months ended October 2, 2005 from $43.0 million for the threemonths ended September 26, 2004. Labor and benefits as a percentage of totalrevenues decreased to 26.7% in the 2005 quarter from 28.1% in the 2004 quarter.As a percentage of restaurant revenues, labor and benefits decreased to 35.2%in the 2005 quarter from 35.7% in the 2004 quarter. Lower hourly labor costsaccounted for 0.4% of the decrease in labor and benefits costs as a percentageof restaurant revenues, which was the result of restructuring of the restaurantmanagement team, with fewer guest service supervisors and more servers,resulting in lower average hourly rates.  Restaurant general managerbonuses were also lower during the 2005 period when compared to the same periodin 2004, due primarily to a change in the bonus plan, and accounted for 0.6% ofthe period to period decrease in labor and benefits costs as a percentage ofrestaurant revenues.  Also as a percentageof restaurant revenues, partially offsetting these benefits, were increases inpension expense and other fringe costs of 0.4% and 0.1%, respectively, in the2005 period when compared to the 2004 period. Revenue increases derived fromfranchised locations and product sales to franchisees and retail customers,which do not have any associated restaurant labor and benefits, alsocontributed to the lower labor and benefits as a percentage of total revenues.

 

35

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*Operating expenses:*

 

Operating expenses decreased $0.8 million, or 2.5%, to$29.3 million for the three months ended October 2, 2005 from $30.1 million forthe three months ended September 26, 2004. Operating expenses as a percentageof total revenues were 20.4% and 19.7% in the 2005 and 2004 periods,respectively.  The 0.7% increase in operating expenses as a percentage oftotal revenues resulted from higher restaurant costs for utilities andmaintenance of 0.5% and 0.6% in the 2005 period when compared to the 2004period, respectively. Total advertising costs as a percentage of totalrevenues were lower by 0.4% in the 2005 periodwhen compared to the same period in 2004.

 

*General and administrative expenses:*

 

General and administrative expenses were $8.3 million and $9.1 millionfor the three months ended October 2, 2005 and September 26, 2004,respectively. General and administrative expenses as a percentage of totalrevenues decreased to 5.8% in the 2005 period from 5.9% in the 2004 period. The $0.8 million decrease is primarily the result ofdecreases in bonuses, outside restaurant guest evaluation services,Sarbanes-Oxley related audit fees and recruitment costs of $0.4 million, $0.3million, $0.3 million and $0.3 million, respectively.  Partially offsetting these decreases werehigher costs of $0.4 million for other professional services and $0.1 millionfor severance during the three-month period ended October 2, 2005.

 

Depreciation and amortization:

 

Depreciation and amortization was $5.8 million and$5.5 million for the three months ended October 2, 2005 and September 26, 2004,respectively. Depreciation and amortization as a percentage of total revenueswas 4.0% and 3.6% in the 2005 and 2004 quarters, respectively.  The increase in depreciation expense isprimarily the result of the opening of five new restaurants over the last 15months and the reduction of the lives of leasehold improvement assets as aresult of management decisions to close certain leased properties sooner thanpreviously anticipated.

 

*Gain on franchise sales of restaurant operationsand properties:*

 

During the three months ended September 26, 2004, theCompany sold leasehold improvements and equipment and assigned the lease forone refranchised location and sold equipment at three other refranchisedlocations to the existing franchisee, resulting in gains of approximately $0.2million.

 

36

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*(Gain)loss on disposals of other property and equipment, net:*

 

The gain on disposals of otherproperty and equipment, net, was $1.8 million for the three months endedOctober 2, 2005 primarily due to the sale of two restaurant properties.  The loss on disposals of other property andequipment, net was $0.2 million for the three months ended September 26,2004.  The table below identifiesthe components of the (gain) loss on disposals of other property and equipment,net as shown on the accompanying condensed consolidated statements ofoperations (in thousands):

 
| ** **                                                     | ** ** | **For the Three Months Ended** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                     | ** ** | **October 2,**                 | ** ** | **September 26,** | ** ** |
| ** **                                                     | ** ** | **2005**                       | ** ** | **2004** | ** ** |
| ** **                                                     | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Restaurant  equipment assets retired due to remodeling         |       | $                              | —     |   | $ | 22 |   |
| Restaurant  equipment assets retired due to replacement        |       | 51                             |       | 131 |   |
| Gain on property  not held for disposition                     |       | (1,942                         | )          | — |   |
| All other                                                      |       | 120                            |       | — |   |
| (Gain) loss on  disposals of other property and equipment, net |       | $                              | (1,771     | ) | $ | 153 |   |

 

*Interest expense, net:*

 

Interest expense, net of capitalized interest and interest income, was$5.2 million for the three months ended October 2, 2005 and September 26, 2004.

 

*Provision for (benefit from) incometaxes:*

 

The provision for income taxes was$0.8 million, or 18.7% of income before provision for income taxes, for thethree months ended October 2, 2005. Generally, the Company records income taxesbased on the effective rate for the year with any changes in the valuationallowance reflected in the period of change. Had the Company used the effectivetax rate anticipated for the fiscal year, an unreliable rate would haveresulted due to the impact of federal tax credits on lower than originallyanticipated pre-tax earnings. Accordingly, the Company chose to compute taxexpense for the period using the statutory rate of 41% less the anticipated taxbenefit from applicable tax credits.

 

The Company had approximately $16.8 million of netdeferred tax assets recorded as of October 2, 2005, for which no valuationallowance has been established since management believes it is more likely thannot that the benefit of these assets will be realized in future periods fromfuture taxable income.  A key source offuture taxable income includes gains from refranchising Company-operatedrestaurants, the benefits from future improvements to be made to customerservice in Company-operated restaurants and additional taxable income from theCompany’s retail supermarket ice cream business.  Management evaluates the need for a valuationallowance on a quarterly basis.  A morein depth evaluation is made as part of the annual and strategic planningprocess conducted in the fourth quarter of each year.

 

The benefit from income taxes was $0.7 million, aneffective tax rate of 23.0%, for the three months ended September 26,2004.  The tax rate for the 2004 fiscalyear was 68.8%, as the final benefit from income taxes for 2004 included a $2.2million reversal of income tax accruals recorded in prior years. These accrualsrelated to tax matters that, based upon additional information obtained duringthe fourth quarter of 2004, were no longer necessary.  The reversal was recorded in the fourthquarter of 2004.

 

37

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*Net income:*

 

Net income was $3.4 million and $3.5 million for thethree months ended October 2, 2005 and September 26, 2004, respectively, forthe reasons discussed above.

 

***Nine months endedOctober 2, 2005 compared with nine months ended September 26, 2004***

 

*Revenues:*

 

*Total Revenues -*Total revenues decreased $14.7 million, or 3.4%, to $416.6 million for the ninemonths ended October 2, 2005 from $431.3 million for the same period in 2004.

 

*RestaurantRevenues -* Restaurant revenues decreased $21.3 million, or6.3%, to $317.9 million for the nine months ended October 2, 2005 from $339.2million for the same period in 2004. ComparableCompany-operated restaurant revenues decreased 1.3% from the 2004 periodto the 2005 period. Higher prices for gasoline, especially during the threeweeks in September 2005 post hurricane Katrina, appeared to have had a negativeimpact on the number of customer visits during all day-parts, with the Company’safternoon and evening snack periods experiencing the greatest declines.  Also contributing to the reduced comparablerevenues was an unfavorable shift in the timing of the year-end holiday periodas New Year’s Day was included in the nine months ended September 26, 2004 butwas not included in the 2005 period. Also, there were additional operating dayslost due to weather closings in 2005 when compared to 2004 as most markets inNew England recorded higher than normal snowfall.  Additionally, the closing of 18 locations and the re-franchising of 37locations over the past 21 months resulted in declines of $6.0 million and$15.0 million, respectively, in restaurant revenues in the nine months endedOctober 2, 2005 as compared to the same period in 2004. These declines werepartially offset by increased revenues of $3.9 million in the nine months endedOctober 2, 2005 as compared to the same period in 2004 due to the opening offive new restaurants over the past 21 months. There was one new restaurant openedduring the nine months ended October 2, 2005.

 

*FoodserviceRevenues -* Foodservice(product sales to franchisees and retail customers) revenues increased $5.5million, or 6.8%, to $87.8 million for the nine months ended October 2, 2005from $82.3 million for the nine months ended September 26, 2004. This increasewas primarily due to a $4.3 million increase in franchised restaurant productrevenue resulting from the increased number of franchised restaurants in thenine months ended October 2, 2005 compared to the same period in 2004.  Sales to foodservice retail supermarketcustomers increased $1.2 million, or 3.8%, during the nine months ended October2, 2005 compared to the same period in 2004. Case volume in the Company’sretail supermarket business increased 1.3% for the nine months ended October 2,2005 when compared to the nine months ended September 26, 2004 primarily as aresult of higher volume of individual sundae cups and the introduction of newdecorative cakes.

 

*FranchiseRevenues -* Franchise royaltyand fee revenues increased $1.1 million, or 10.8%, to $10.9 million for thenine months ended October 2, 2005 compared to $9.8 million for the same periodin 2004 due primarily to increases in royalties on franchised sales and rentalincome for leased and subleased franchise locations, partially offset by adecline in franchise fees.

 

38

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Royalties on franchised sales increased $0.8 million in the nine monthsended October 2, 2005 as compared to the same period in 2004. Comparablefranchised revenues grew 1.4% from the nine months ended September 26, 2004 tothe nine months ended October 2, 2005. The opening of 10 new franchiserestaurants and 37 re-franchised restaurants during the last 21 months increasedroyalty revenues by $0.9 million while the closing of five under-performinglocations during the same period reduced royalties by $0.1 million.

 

Franchise fees declined by $0.6 million during thenine months ended October 2, 2005 when compared to the same period in 2004. TheCompany re-franchised 18 Company-operated restaurants and franchisees openedsix new restaurants and one new café during the nine months ended September 26,2004. Additionally in 2004, the Company received $0.1 million in franchise feesassociated with the sale of leasehold improvements and equipment and assignmentof the lease for one re-franchised location and the sale of equipment at threeother re-franchised locations to the existing franchisee. During the ninemonths ended October 2, 2005, the Company re-franchised 10 Company-operatedlocations and franchisees opened two new locations.

 

Additionally, an increase in rental income forleased and subleased franchise locations of $0.9 million, due primarily to anincreased number of leased and subleased franchised locations, contributed tothe higher revenues in the nine months ended October 2, 2005 compared to thenine months ended September 26, 2004. There were 205 and 186 franchise units open at October 2, 2005 andSeptember 26, 2004, respectively.

 

*Cost of sales:*

 

Cost of sales decreased $1.4 million, or 0.9%, to$157.5 million for the nine months ended October 2, 2005 from $158.9 millionfor the same period in 2004. Cost of sales as a percentage of total revenueswas 37.8 % and 36.8% for the nine months ended October 2, 2005 and September26, 2004, respectively.  A shift in salesmix from Company-operated restaurant sales to foodservice sales added to theincrease in cost of sales as a percentage of total revenue. Foodservice salesto franchisees and retail supermarket customers (21.1% and 19.1% of totalrevenues for the nine monthsended October 2, 2005 and September 26, 2004, respectively) have higher foodcosts as a percentage of revenue, at 91.1%, than sales in Company-operatedrestaurants to restaurant patrons. This increase was partially offset bythe growth in franchise revenues, which reduced cost of sales as a percentageof total revenues by 0.2% for the nine months ended October 2, 2005 whencompared to the 2004 period since franchise revenues have no product costsassociated with such revenues. Additionally, foodservice retail salespromotional allowances, recorded as offsets to revenues, decreased by 0.9% inthe 2005 period as a percentage of sales to foodservice retail supermarketcustomers when compared to the 2004 period due to fewer promotions during the2005 period. This decrease also had a favorable impact on the overall cost ofsales as a percentage of total revenues. Manufacturing efficiencies improvedduring the current period when compared to the same period a year ago,especially during the recent quarter, due to cost reductions associated withscheduling improvements; however, higher fuel costs in the 2005 period versusthe 2004 period offset most of the benefit.

 

Restaurant cost of sales as apercentage of restaurant revenues was 27.1% in the nine months ended October 2,2005 and September 26, 2004.

 

39

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The relatively high priceof butter in December 2004 resulted in unfavorable cream costs in the firstquarter of 2005, as the market price of butter is generally reflected in theCompany’s cost of sales approximately 30 days later. During the third quarterof 2005, butter prices had a favorable impact on the price of cream whencompared to the same period in 2004.  Thecost of cream was approximately $1.0 million lower in the nine months endedOctober 2, 2005 when compared to the nine months ended September 26, 2004.Additionally, in the nine months ended October 2, 2005, market losses of $0.2million were realized due to unfavorable positions on commodity optioncontracts while market gains of $0.5 million were realized in the same periodof 2004. The Company enters into commodity option contracts from time to timeto manage dairy cost pressures. The Company’s commodity option contracts do notmeet hedge 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 theresulting gains or losses recognized in cost of sales.

 

For the remainder of 2005, the Company expects thatcream prices will be lower than the prices experienced in 2004.  However, the results derived from options forbutter futures contracts are likely to continue to be unfavorable in 2005 whencompared to the gains experienced in 2004.

 

The table below shows the average monthly price of apound of AA butter.  Futures and optionson AA butter are traded on the Chicago Mercantile Exchange and AA butter is thecommodity used to derive the price of cream. The prices represented were obtained from market quotes provided by theUSDA’s Agricultural Marketing Service.

 
| **Month:**       | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
|------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| January          |       | $        | 1.5775     |     | $          | 1.4320   |       | $        | 1.0815     |     | $          | 1.3454   |       | $ | 1.2531 |   | $ | 0.9090 |   |
| February         |       | 1.6145   |       | 1.7132   |       | 1.0405   |       | 1.2427   |       | 1.3852   |       | 0.9245   |       |
| March            |       | 1.5527   |       | 2.1350   |       | 1.0915   |       | 1.2473   |       | 1.5708   |       | 1.0200   |       |
| April            |       | 1.4933   |       | 2.2204   |       | 1.0906   |       | 1.1712   |       | 1.8217   |       | 1.0691   |       |
| May              |       | 1.4044   |       | 2.0363   |       | 1.0919   |       | 1.0590   |       | 1.8713   |       | 1.2450   |       |
| June             |       | 1.5313   |       | 1.9300   |       | 1.1142   |       | 1.0427   |       | 1.9783   |       | 1.2440   |       |
| July             |       | 1.6210   |       | 1.7458   |       | 1.1985   |       | 1.0302   |       | 1.8971   |       | 1.1790   |       |
| August           |       | 1.6861   |       | 1.5408   |       | 1.1708   |       | 0.9752   |       | 2.0880   |       | 1.1933   |       |
| September        |       | 1.6988   |       | 1.7656   |       | 1.1731   |       | 0.9635   |       | 2.0563   |       | 1.1727   |       |
| October          |       |     |       | 1.6475   |       | 1.1846   |       | 1.0315   |       | 1.4070   |       | 1.1462   |       |
| November         |       |     |       | 1.9238   |       | 1.2057   |       | 1.0425   |       | 1.3481   |       | 1.6490   |       |
| December         |       |     |       | 1.7083   |       | 1.2969   |       | 1.1198   |       | 1.2793   |       | 1.3700   |       |
| Mathematical Avg |       |     |       | $        | 1.8166     |     | $          | 1.1450   |       | $        | 1.1059     |     | $          | 1.6630 |   | $ | 1.1768 |   |
|                  |            |          |            |          |            |          |            |          |            |          |            |          |            |  |  |  |  |  |  |

 

The cost of cream, the principalingredient used in making ice cream, affects cost of sales as a percentage oftotal revenues, especially in foodservice’s retail business. A $0.10 increasein the cost of a pound of AA butter adversely affects the Company’s annual costof sales by approximately $0.9 million. This adverse impact may be offset by price increases or other factors.However, no assurance can be given that the Company will be able to offset anycost increases in the future and future increases in cream prices could have amaterial adverse effect on the Company’s results of operations. To minimizerisk, alternative supply sources continue to be pursued.

 

The Company purchases butter option contracts tominimize the impact of increases in the cost of cream. When available, optionson butter futures are purchased to cover up to 50% of the cream needs of themanufacturing plant.  Option contractsare offered in the months of March, May, July, September, October and December;however, there is often not enough open interest in them to allow the Companyto buy even very limited coverage without paying an exorbitant premium.

 

During the third quarter of 2005, the ChicagoMercantile Exchange launched a cash settled butter futures contract, which mayprovide Friendly’s with additional hedging opportunities going forward.  This new cash settled contract provideshedging opportunities in all twelve months versus the older deliverable buttercontract, which was only available for six months out of the year.  The Company is currently in the process ofevaluating the liquidity of the cash settled butter futures contract and is developinga strategy for obtaining an appropriate level of coverage for its cream needs.

 

*Labor and benefits:*

 

Labor and benefits decreased $10.3 million, or 8.2%, to $114.8 millionfor the nine months ended October 2, 2005 from $125.1 million for the ninemonths ended September 26, 2004. Labor and benefits as a percentage of totalrevenues decreased to 27.5% in the 2005

 

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period from 29.0%in the 2004 period. As a percentage of restaurant revenues, labor and benefitsdecreased to 36.1% in the 2005 period from 36.9% in the 2004 period. Lowerhourly labor costs accounted for 0.7% of the decrease in labor and benefitscosts as a percentage of restaurant revenues, which was the result ofrestructuring of the restaurant management team, with fewer guest servicesupervisors and more servers, resulting in lower average hourly rates.  Restaurantgeneral manager bonuses were also lower during the 2005 period when compared tothe same period in 2004 due primarily to a change in the bonus plan andaccounted for 0.6% of the period to period decrease in labor and benefits costsas percentage of restaurant revenues. Partially offsetting these benefits were increases in pension expenseand other fringe costs of 0.4% and 0.1%, respectively, in the 2005 period whencompared to the 2004 period. Revenue increases derived from franchisedlocations and product sales to franchisees and retail customers, which do nothave any associated restaurant labor and benefits, also contributed to thelower labor and benefits as a percentage of total revenues.

 

*Operating expenses:*

 

Operating expenses were $82.3 million and $83.1 million for the ninemonths ended October 2, 2005 and September 26, 2004, respectively. Operatingexpenses as a percentage of total revenues were 19.8% and 19.3% in the 2005 and2004 periods, respectively. The 0.5% increase in operating expenses as a percentage of total revenues resultedfrom higher restaurant costs for supplies, utilities and maintenance of 0.1%,0.2% and 0.6% in the 2005 period when compared to the 2004 period,respectively.  Total advertising costs asa percentage of total revenues were 0.4% lowerin the 2005 period when compared to the same period in 2004.

 

*General and administrative expenses:*

 

General and administrative expenses were $28.2 millionand $29.5 million for the nine months ended October 2, 2005 and September 26,2004, respectively. General and administrative expenses as a percentage oftotal revenues were 6.8% in the 2005 and the 2004 periods. The $1.3 million decrease is primarily the result ofdecreases in bonuses, outside restaurant guest evaluation services,Sarbanes-Oxley related audit fees, legal fees (net of insurance reimbursementsof $0.4 million) and recruitment costs of $0.4 million, $0.7 million, $0.1million, $0.6 million and $0.5 million, respectively.  Partially offsetting these decreases werehigher costs of $0.7 million and $0.4 million for other professional servicesand severance pay, respectively, during the nine-month period ended October 2,2005 as compared to the 2004 period.

 

*Restructuringexpenses:*

 

Restructuring expenses of $2.6 million during thenine months ended September 26, 2004 related to severance and other benefitsassociated with reduction in force actions taken during the first quarter of2004 that reduced headcount by approximately 20 permanent positions.

 

*Gain onlitigation settlement:*

 

In January 2004, a settlement was reached in a lawsuitfiled by the Company against a former administrator of one of the Company’sbenefit plans.  The settlement was basedon the administrator’s alleged failure to adhere to the terms of a contract andresulted in a one-time payment to the Company of approximately $3.8 million,which was received on April 2, 2004. As a result of this lawsuit, the Companyincurred professional fees of approximately $0.5 million which were included inthe consolidated statement of operations for the year ended December 28, 2003and an additional $0.2 million in professional fees, which were offset againstthe payment in the accompanying condensed consolidated statement of operationsfor the nine months ended September 26, 2004.

 

W*rite-downs of property andequipment:*

 

Write-downs of property and equipment were $0.3million and $0.1 million in the nine months ended October 2, 2005 and September26, 2004, respectively. During the nine months ended October 2, 2005, theCompany identified two restaurant properties to be disposed of other than bysale and determined that the carrying values of these restaurant propertiesexceeded their estimated undiscounted cash flows.  Thecarrying values were reduced by an aggregate of $0.3 million accordingly.During the nine months ended September 26, 2004, it was determined that thecarrying value of one property and a vacant land parcel exceeded theirestimated fair values less costs to sell and the carrying values were reducedby an aggregate of $0.1 million accordingly.

 

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*Depreciation and amortization:*

 

Depreciation and amortization was $17.9 million and$16.9 million for the nine months ended October 2, 2005 and September 26, 2004,respectively. Depreciation and amortization as a percentage of total revenueswas 4.3% and 3.9% in the 2005 and 2004 periods, respectively. The increase indepreciation expense is primarily the result of the opening of five newrestaurants over the last 21 months and the reduction of the lives of leaseholdimprovement assets as a result of management decisions to close certain leased propertiessooner than previously anticipated.

 

*Gain on franchise sales of restaurant operationsand properties:*

 

Gain on franchise sales of restaurant operations andproperties was $2.5 million and $1.1 million in the nine months ended October2, 2005 and September 26, 2004, respectively. During the nine months endedOctober 2, 2005, the Company recognized a gain of $2.5 million associated withthe sale of certain equipmentassets, lease and sublease rights and franchise rights in four existingrestaurants to two franchisees. During the nine months ended September26, 2004, the Company recognized a gain of approximately $0.7 millionassociated with the sale of certain equipment assets, lease and sublease rightsand franchise rights in 10 existing Company-operated restaurants to afranchisee.  Additionally, during thenine months ended September 26, 2004, the Company sold leasehold improvementsand equipment and assigned the lease for one re-franchised location and soldequipment at three other re-franchised locations to the existing franchisee,resulting in a gain of approximately $0.2 million. The Company also sold thereal property and equipment for one re-franchised location and assigned thelease and sold the equipment for a second re-franchised location to theexisting franchisee, resulting in a gain of approximately $0.2 million duringthe nine months ended September 26, 2004.

 

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*(Gain)loss on disposals of other property and equipment, net:*

 

The gain on disposals of otherproperty and equipment, net, was $1.4 million for the nine months ended October2, 2005 as compared to a loss of $0.7 million for the nine months endedSeptember 26, 2004.  The tablebelow identifies the components of the (gain) loss on disposals of otherproperty and equipment, net as shown on the accompanying condensed consolidatedstatements of operations (in thousands):

 
| ** **                                                     | ** ** | **For the Nine Months Ended** | ** ** |
|----------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                     | ** ** | **October 2,**                | ** ** | **September 26,** | ** ** |
| ** **                                                     | ** ** | **2005**                      | ** ** | **2004** | ** ** |
| ** **                                                     | ** ** | ** **                    | ** ** | ** ** | ** ** |
| Restaurant  equipment assets retired due to remodeling         |       | $                             | 220        |   | $ | 195 |   |
| Restaurant  equipment assets retired due to replacement        |       | 146                           |       | 290 |   |
| (Gain) loss on  property not held for disposition              |       | (1,902                        | )          | 63 |   |
| All other                                                      |       | 133                           |       | 113 |   |
| (Gain) loss on  disposals of other property and equipment, net |       | $                             | (1,403     | ) | $ | 661 |   |

 

*Interest expense, net:*

 

Interest expense, net of capitalized interest and interest income was$15.7 million and $16.7 million for the nine months ended October 2, 2005 andSeptember 26, 2004, respectively. The decrease in interest expense in the firstnine months of 2005 compared to the same period in 2004 is primarily due tolower interest rates on the Company’s debt as a result of the refinancing of$176.0 million of the Company’s 101⁄2% senior notes (the “Senior Notes”).

 

*Other (income) expense, principally debt retirementcosts:*

 

Other (income) expense, principally debtretirement costs for the nine months ended September 26, 2004 representsthe $6.8 million premium and the write-offof unamortized deferred financing costs of $2.5 million in connectionwith the tender offer for the $176.0 million of Senior Notes. In March 2004,$127.8 million of aggregate principal amount of Senior Notes were purchasedpursuant to the tender offer and in April 2004, the remaining $48.2 million of SeniorNotes were redeemed in accordance with the Senior Notes indenture at 103.5% ofthe principal amount.

 

*Provision for (benefit from) incometaxes:*

 

The provision for income taxes was$0.9 million, or 22.7% of income before provision for income taxes, for thenine months ended October 2, 2005. During the second quarter of 2005, theCompany reduced the benefit from income taxes by $0.2 million due to certainitems discussed with the IRS.  Currently,the IRS is auditing fiscal years 2002 through 2004. Generally, the Companyrecords income taxes based on the anticipated effective rate for the year withany changes in valuation allowances reflected in the period of change. Had theCompany used the effective tax rate anticipated for the fiscal year, an unreliablerate would have resulted due to the impact of federal tax credits on lower thanoriginally anticipated pre-tax earnings. Accordingly, the Company chose tocompute tax expense for the period using the statutory rate of 41% less theanticipated tax benefit from applicable tax credits.

 

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The Company had approximately $16.8 million of netdeferred tax assets recorded as of October 2, 2005, for which no valuationallowance has been established since management believes it is more likely thannot that the benefit of these assets will be realized in future periods fromfuture taxable income.  A key source offuture taxable income includes gains from re-franchising Company-operatedrestaurants, the benefits from future improvements to be made to customerservice in Company-operated restaurants and additional taxable income from theCompany’s retail supermarket ice cream business.  Management evaluates the need for a valuationallowance on a quarterly basis.  A morein depth evaluation is made as part of the annual and strategic planningprocess conducted in the fourth quarter of each year.

 

The benefit from income taxes was $3.6 million, aneffective tax rate of 52.8%, for the nine months ended September 26, 2004.  The tax rate for the 2004 fiscal year was68.8%, as the final benefit from income taxes for 2004 included a $2.2 millionreversal of income tax accruals recorded in prior years. These accruals relatedto tax matters that, based upon additional information obtained during thefourth quarter of 2004, were no longer necessary.  The reversal was recorded in the fourthquarter of 2004.

 

*Net income (loss):*

 

Net income was $2.9 million for the nine monthsended October 2, 2005 as compared to net loss of $3.2 million for the ninemonths ended September 26, 2004 for the reasons discussed above.

 

**Liquidity and Capital Resources**

 

*General:*

 

The Company’s primary sources of liquidity and capitalresources are cash generated from operations and, if needed, borrowings underits revolving credit facility. Additionalsources of liquidity consist of capital and operating leases for financingleased restaurant locations (in malls and shopping centers and land or buildingleases), restaurant equipment, manufacturing equipment, distribution vehiclesand computer equipment. Additionally, sales of under-performing existingrestaurant properties and other assets (to the extent FICC’s and itssubsidiaries’ debt instruments permit) are sources of cash. The amount of debtfinancing that FICC will be able to incur is limited by the terms of its NewCredit Facility and New Senior Notes indenture. Below was the financingstatus of the Company’s operating restaurants at October 2, 2005:

 

| Owned and  mortgaged               |   | 63  |   |
|------------------------------------|--------|-----|--------|
| Sold and leased back               |   | 60  |   |
| Owned land and building            |   | 26  |   |
| Leased land, owned building        |   | 73  |   |
| Leased land and building           |   | 108 |   |
| Total Company-operated restaurants |   | 330 |   |

 

The restaurants above not identified as owned andmortgaged or sold and leased back secure the Company’s obligations under theNew Credit Facility.  Of the 26restaurant properties identified as owned land and building, six were availableto be sold.

 

In addition to the 63 properties identified as ownedand mortgaged, the Company owns and mortgages an additional 10 properties inthis category which are operated by franchisees.

 

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*OperatingCash Flows:*

 

Net cash provided by operating activities was $20.3million and $12.4 million for the nine months ended October 2, 2005 andSeptember 26, 2004, respectively. The increase of $7.9 million in cash providedby operating activities between the two periods was largely due to the $6.8million premium paid in 2004inconnection with the tender offer for the $176.0 million of Senior Notes.

 

The Company had a working capital deficit of $2.0million and $13.5 million as of October 2, 2005 and January 2, 2005,respectively. The working capital needs of companies engaged in the restaurantindustry are generally low and as a result, restaurants are frequently able tooperate with a working capital deficit because: (i) restaurant operations areconducted primarily on a cash (and cash equivalent) basis with a low level ofaccounts receivable; (ii) rapid turnover allows a limited investment ininventories; and (iii) cash from sales is usually received before relatedexpenses for food, supplies and payroll are paid.

 

*Investing CashFlows:*

 

Net cash used in investing activities was $5.6million and $12.4 million for the nine months ended October 2, 2005 andSeptember 26, 2004, respectively.

 

During the nine months ended October 2, 2005 andSeptember 26, 2004, the Company spent $11.5 million and $18.8 million,respectively, on capital expenditures, of which $9.8 million and $16.7 million,respectively, was spent on restaurant operations. Capital expenditures wereoffset by proceeds from the sales of property and equipment of $6.2 million and$4.0 million for the nine months ended October 2, 2005 and September 26, 2004,respectively. The proceeds in 2005 were the result of re-franchisingtransactions and the sale of two restaurant properties.  The proceeds in 2004 were primarily theresult of re-franchising transactions.

 

During the nine months ended October 2, 2005, theCompany completed two re-franchising transactions in which two existingfranchisees purchased four existing Company restaurants and agreed to develop atotal of five new restaurants in future years. Gross proceeds from these transactions were $3.5 million, of which $0.1million was for franchise fees and $3.4 million was for the sale of certainassets and leasehold rights.  Inaddition, the Company completed three transactions in which three formeremployees received franchises to operate six existing restaurants with optionsto purchase the restaurants within two years. If the options are exercised, one franchisee will also agree to developtwo new restaurants in future years. Proceeds from option transactions will be recognized upon purchase.

 

During the nine months ended September 26, 2004, the Company completedone re-franchising transaction in which a franchisee purchased a total of 10existing restaurants and agreed to develop a total of 10 new restaurants infuture years.  Gross proceeds from the sale were $3.2 million ofwhich $0.3 million was for franchise fees for the initial 10 restaurants. Inaddition, the Company sold the real property and equipment for one franchisedlocation and assigned the lease and sold the equipment for four otherfranchised locations to the existing franchisees. Gross proceeds from the sales were $1.3 million, of which $0.2 million wasfor franchise fees and $1.1 million was for the sale of assets and leaseassignment.

 

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*Financing CashFlows:*

 

Net cash used in financing activities was $3.9million and $8.4 million for the nine months ended October 2, 2005 andSeptember 26, 2004, respectively.

 

In February 2004, the Company announced a cashtender offer and consent solicitation for $176 million of its Senior Notes tobe financed with the proceeds from a $175 million private offering of new8.375% senior notes (the “New Senior Notes”), available cash and an amendedrevolving credit facility. In March 2004, $127.4 million of aggregate principalamount of Senior Notes were purchased at the tender offer and consentsolicitation price of 104% of the principal amount and $0.4 million ofaggregate principal amount of Senior Notes were purchased at the tender offerprice of 102% of the principal amount. In April 2004, the remaining $48.2million of Senior Notes were redeemed in accordance with the Senior Notesindenture at 103.5% of the principal amount. In connection with the tender offer, the Company wrote off unamortizeddeferred financing costs and incurred other direct expenses of $9.2 millionthat were included in the accompanying condensed consolidated statement ofoperations for the nine months ended September 26, 2004.

 

The $175 million of New Senior Notes issued in March2004 are unsecured senior obligations of FICC, guaranteed on an unsecuredsenior basis by FICC’s Friendly’s Restaurants Franchise, Inc. subsidiary, butare effectively subordinated to all secured indebtedness of FICC, including theindebtedness incurred under the New Credit Facility (as defined below). The NewSenior Notes mature on June 15, 2012. Interest on the New Senior Notes ispayable at 8.375% per annum semi-annually on June 15 and December 15 of eachyear.  The New Senior Notes areredeemable, in whole or in part, at any time on or after June 15, 2008 at FICC’soption at redemption prices from 104.188% to 100.00%, based on the redemptiondate.  In addition, at any time prior toJune 15, 2007, FICC may redeem, subject to certain conditions, up to 35% of theaggregate principal amount of the New Senior Notes with the proceeds of one ormore qualified equity offerings, as defined, at a redemption price of 108.375%of the principal amount, plus accrued interest.

 

The Company has a $35.0 million revolving credit facility (the “NewCredit Facility”).  The $35.0 millionrevolving credit commitment less outstanding letters of credit is available forborrowing to provide working capital and for other corporate needs. As ofOctober 2, 2005 and January 2, 2005, total letters of credit outstanding were$16.0 million and $15.2 million, respectively. During the nine months endedOctober 2, 2005 and September 26, 2004, there were no drawings against theletters of credit.  The revolving creditloans bear interest at the Company’s option at either (a) the Base Rateplus the applicable margin as in effect from time to time (the “Base Rate”)(9.25% at October 2, 2005) or (b) the Eurodollar rate plus the applicablemargin as in effect from time to time (the “Eurodollar Rate”) (8.30% at October2, 2005). As of October 2, 2005 there were no revolving credit loansoutstanding. As of January 2, 2005, $4.0 million of revolving credit loans wereoutstanding. As of October 2, 2005 and January 2, 2005, $19.0 million and$15.8 million, respectively, was available for borrowing.

 

The New Credit Facility has an annual “clean-up”provision, which obligates the Company to repay in full any and all outstandingrevolving credit loans on or before September 30, 2005 and maintain a zerobalance on such revolving credit for at least 30 consecutive days, to includeSeptember 30, 2005 immediately following the date of such repayment.  Commencing in 2006, the annual “clean-up”provision will require the Company to repay in full any and all outstandingrevolving credit loans on or before June 15 (or if June 15 is not a businessday, as defined, then the next business day) of each year and maintain a zerobalance on such revolving credit for at least 15 consecutive days, to includeJune 15, immediately following the date of such repayment.

 

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The New Credit Facility includescertain restrictive covenants including limitations on indebtedness, restrictedpayments such as dividends and stock repurchases and sales of assets and ofsubsidiary stock. Additionally, the New Credit Facility limits the amount whichthe Company may spend on capital expenditures, restricts the use of proceeds,as defined, from asset sales and requires the Company to comply with certainfinancial covenants. On July 23, 2004 and October 19, 2004, the Companyobtained limited waivers regarding certain financial covenants of its NewCredit Facility, which the Company was not in full compliance with as of June27, 2004 and September 26, 2004.  OnDecember 17, 2004, the Company amended the New Credit Facility to, among otherthings, (i) revise certain financial covenants and eliminate the minimumquarterly EBITDA requirement, (ii) amend the Company’s annual capitalexpenditures limit and (iii) increase the commitment fee from 0.50% to 0.75% ofthe unused commitment amount.  TheCompany was in compliance with the covenants under the New Credit Facility asof October 2, 2005.

 

At this time, the Company believesthat it may not be in compliance with certain financial covenants under the NewCredit Facility as of January 1, 2006. Based on ongoing discussions with itslenders, its projected limited borrowings under the New Credit Facility and itsprojected liquidity related to the fourth quarter and beyond, the Companybelieves it will likely seek and obtain a covenant waiver and amendment to theNew Credit Facility or a new credit facility will be secured. In the event thatthe Company is not able to remedy such covenant violations at January 1, 2006,the Company will be in default under the New Credit Facility and, pursuant tocross default provisions, a technical default could be triggered regarding theCompany’s New Senior Notes, which would require a waiver or an amendment ofthat facility in order to maintain the current payment schedule of the NewSenior Notes.

 

In connection with the Company’s financialrestructuring completed in December 2001, the Company received proceeds of$55.0 million in a long-term mortgage financing (the “Mortgage Financing”).  Pursuant to the terms of the MortgageFinancing, the Company may sell properties securing the Mortgage Financingobligations provided that other properties are substituted in place of the soldproperties to secure the Mortgage Financing. The substituted properties must meet certain requirements under theterms of the Mortgage Financing.  InAugust 2005, proceeds of $0.4 million and $2.7 million were received inconnection with the sale of two mortgaged properties.  Substitution properties must secure theMortgage Financing obligations no later than March 1, 2006.  As of October 2, 2005, balances of $0.4million and $1.3 million were held as collateral pending property substitutionand were included in restricted cash on the accompanying condensed consolidatedbalance sheet as of October 2, 2005.

 

In September 2005, the Company acquired mortgagefinancing secured by its newly constructed Milford, MA restaurant. Thefinancing provided for a real estate improvement and equipment loan. The realestate improvement loan has a principal balance of $0.8 million, maturingOctober 1, 2010 and is amortized over 15 years. The equipment loan has aprincipal balance of $0.3 million, maturing October 1, 2010 and is amortizedover 7 years. The interest rate is variable and is the sum of the 30-day LIBORrate in effect (3.86% at October 2, 2005) plus 4% on an annual basis. Changesin the interest rate are calculated monthly and recognized annually when themonthly payment amount is adjusted. Changes in the monthly payment amountsowed, due to interest rate changes, are reflected in the principal balances,which are re-amortized over the remaining life of the mortgages. The variablerate notes are subject to prepayment penalties during the first three years.

 

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The Company anticipates requiring capital in thefuture principally to maintain existing restaurant and plant facilities and tocontinue to renovate and re-image existing restaurants. Capital expendituresfor 2005 are anticipated to be between $20.0 million and $25.0 million in theaggregate, of which between $17.0 million and $21.0 million is expected to bespent on restaurants. The Company’s actual 2005 capital expenditures may varyfrom these estimated amounts. The Company believes that the combination of thefunds generated from operating activities and borrowing availability under itsrevolving credit facility will be sufficient to meet the Company’s anticipatedoperating requirements, debt service requirements, lease obligations, capitalrequirements and obligations associated with the corporate restructurings.

 

There have been no material changes to the Company’scontractual obligations and commitments from those disclosed in the Company’s2004 Annual Report on Form 10-K/A.

 

**Seasonality**

 

Due to the seasonality of ice cream consumption, and the effect fromtime to time of weather on patronage of the restaurants, the Company’s revenuesand operating income are typically higher in its second and third quarters.

 

**GeographicConcentration**

 

Approximately 98% of the Company-operatedrestaurants are located, and substantially all of its retail sales aregenerated, in the Northeast. As a result, a severe or prolonged economicrecession or changes in demographic mix, employment levels, population density,weather, real estate market conditions or other factors specific to thisgeographic region may adversely affect the Company more than certain of itscompetitors which are more geographically diverse.

 

**CriticalAccounting Estimates**

 

The discussion and analysis of the Company’sconsolidated financial condition and results of operations are based upon theCompany’s interim condensed consolidated financial statements, which have beenprepared in accordance with generally accepted accounting principles in theU.S. The preparation of these condensed consolidated financial statementsrequires the Company to make estimates and judgments that affect the reportedamounts of assets, liabilities, revenues and expenses, and related disclosureof contingent assets and liabilities. On an on-going basis, the Companyevaluates its estimates, including those related to revenue recognition,insurance reserves, recoverability of accounts receivable, income tax valuationallowances and pension and other post-retirement benefits expense.  The Company bases its estimates on historicalexperience and on various other assumptions that are believed to be reasonableunder the circumstances, the results of which form the basis for makingjudgments about the carrying values of assets and liabilities that are notreadily apparent from other sources.

 

The criticalaccounting estimates that the Company believes affect the reported amounts ofassets, liabilities, revenues and expenses, and the related disclosure ofcontingent assets and liabilities in the Company’s condensed consolidatedfinancial statements presented in this report are described in the Company’sManagement’s Discussion and Analysis of Financial Condition and Results ofOperations and in the Notes to the consolidated financial statements includedin the Company’s Annual Report on Form 10-K/A for the fiscal year ended January2, 2005. There have been no material changesto the critical accounting estimates.

 

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Actual results may differfrom these estimates under different assumptions or conditions. Any differencesmay have a material impact on the Company’s financial condition and results ofoperations. For a discussion of how these and other factors may affect the Company’sbusiness, see the “Forward Looking Statements” above and other factors includedin the Company’s other filings with the Securities and Exchange Commission.

 

**Recently Issued AccountingPronouncements**

 

In October2005, the FASB issued FASB Staff Position 13-1, “Accounting for Rental CostsIncurred during a Construction Period” (“FSP 13-1”).  The FSPconcludes that rental costs incurred during and after a construction period arefor the right to control the use of a leased asset during and after constructionof a leased asset and that there is no distinction between the right to use aleased asset during the construction period and the right to use that assetafter the construction period. Therefore, rental costs associated with groundor building operating leases that are incurred during a construction periodshould be recognized as rental expense. The guidance is effective for periods beginning after December 15, 2005.The adoption of FSP 13-1 is not expected to have a material effect on theCompany’s consolidated financial position or results of operations.

 

In June 2005,the FASB’s Emerging Issues Task Force reached a consensus on Issue No. 05-6, “Determiningthe Amortization Period for Leasehold Improvements” (“EITF 05-6”). The guidancerequires that leasehold improvements acquired in a business combination orpurchased subsequent to the inception of a lease be amortized over the lesserof the useful life of the assets or a term that includes renewals that arereasonably assured at the date of the business combination or purchase. Theguidance is effective for periods beginning after June 29, 2005. The adoptionof EITF 05-6 is not expected to have a material effect on the Company’sconsolidated financial position or results of operations.

 

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections—A Replacement of APB Opinion No. 20 and FASB Statement No. 3.” SFAS No. 154 applies to all voluntary changes in accounting principles and requires retrospective application to prior periods’ financial statements of changes in accounting principles, unless it is impracticable. SFAS No. 154 requires that a change in depreciation, amortization, or depletion method for long-lived, nonfinancial assets be accounted for as a change of estimate affected by a change in accounting principles. SFAS No. 154 also carries forward without change the guidance in APB Opinion No. 20 with respect to accounting for changes in accounting estimates, changes in the reporting unit and correction of an error in previously issued financial statements. The Company is required to adopt SFAS No. 154 for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The adoption of SFAS No. 154 is not expected to have a material effect on the Company’s consolidated financial position or results of operations.

 

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On December 16, 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-BasedPayment” (“SFAS No. 123R”), which is a revision of SFAS No. 123, “Accountingfor Stock-Based Compensation.” SFAS No. 123R supersedes APB Opinion No. 25,Accounting for Stock Issued to Employees,” and amends SFAS No. 95, “Statementof Cash Flows.” Generally, the approach in SFAS No. 123R is similar to theapproach described in SFAS No. 123. However, SFAS No. 123R requires allshare-based payments to employees, including grants of employee stock options,to be recognized in the income statement based on their fair values. Pro formadisclosure is no longer an alternative. SFAS No. 123R must be adopted no laterthan the first annual period beginning after June 15, 2005. Early adoption willbe permitted in periods in which financial statements have not yet been issued.SFAS No. 123R allows companies to choose between the modified-prospective andmodified-retrospective transition alternatives in adopting SFAS No. 123R. Underthe modified-prospective transition method, compensation cost will berecognized in financial statements issued subsequent to the date of adoptionfor all shared-based payments granted, modified or settled after the date ofadoption, as well as for any unvested awards that were granted prior to thedate of adoption. Under the modified-retrospective transition method,compensation cost will be recognized in a manner consistent with themodified-prospective transition method, however, prior period financialstatements will also be restated by recognizing compensation cost as previouslyreported in the pro forma disclosures under SFAS No. 123. The restatementprovisions can be applied to either a) all periods presented or b) to thebeginning of the fiscal year in which SFAS No. 123R is adopted. The Companyexpects to adopt SFAS No. 123R on January 2, 2006 using themodified-prospective method. As the Company previously adopted only the proforma disclosure provisions of SFAS No. 123, the Company will recognizecompensation cost relating to the unvested portion of awards granted prior tothe date of adoption using the same estimate of the grant-date fair value andthe same attribution method used to determine the pro forma disclosures underSFAS No. 123.

 

As permitted by SFAS No. 123, the Company currently accounts forshare-based payments to employees using APB Opinion No. 25’s intrinsic valuemethod and, as such, generally recognizes no compensation cost for employeestock options.  Accordingly, the adoptionof SFAS No. 123R’s fair value method will have an impact on the Company’sresults of operations, although it will have no impact on the overall financialposition. The impact of the adoption of SFAS No. 123R cannot be determined atthis time because it will depend upon levels of share-based payments granted inthe future. However, had the Company adopted SFAS No. 123R in prior periods, theimpact of that statement would have approximated the impact as described in thedisclosure of pro forma net income (loss) and net income (loss) per sharepursuant to SFAS No. 123.  SFAS No. 123Ralso requires the benefits of tax deductions in excess of recognizedcompensation cost to be reported as a financing cash flow, rather than as anoperating cash flow as required under current literature.  This requirement will reduce net operatingcash flows and increase net financing cash flows in periods after adoption.  While the Company cannot estimate what thoseamounts will be in the future (because they depend on, among other things, whenemployees exercise stock options), the amount of operating cash flowsrecognized in prior years for such excess tax deductions were $0.8 million and$0.2 million in 2004 and 2003, respectively.

 

In November 2004, theFASB issued SFAS No. 151, “Inventory Costs, an amendment of Accounting ResearchBulletin No. 43, Chapter 4”. The amendments made by SFAS No. 151 clarify thatabnormal amounts of idle facility expense, freight, handling costs, and wastedmaterials (spoilage) should be recognized as current-period charges and requirethe allocation of fixed production overheads to inventory based on the normalcapacity of the production facilities. SFAS No. 151 is the result of a broadereffort by the FASB to improve the comparability of cross-border financialreporting by working with the International Accounting Standards Board towarddevelopment of a single set of high-quality accounting standards. The guidanceis effective for inventory costs incurred during fiscal years beginning afterJune 15, 2005. The adoption of SFAS No. 151 is not expected to have a materialeffect on the Company’s consolidated financial position or results ofoperations.

 

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**Item 3.Quantitative and Qualitative Disclosures About Market Risk**

 

There has been nomaterial change in the Company’s market risk exposure since the filing of the2004 Annual Report on Form 10-K/A.

 

**Item 4.Controls and Procedures**

 

As of October 2, 2005, an evaluation was performedunder the supervision and with the participation of the Company’s management,including the Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”),of the effectiveness of the design and operation of the Company’s disclosurecontrols and procedures (as defined in Rule 13a-15(e) under the ExchangeAct).  Based on that evaluation, theCompany’s CEO and CFO concluded that the Company’s disclosure controls andprocedures were effective as of October 2, 2005.

 

There were no significant changes inthe Company’s internal control over financial reporting that occurred duringthe Company’s last fiscal quarter that have materially affected, or arereasonably likely to materially affect, the Company’s internal control overfinancial reporting.

 

**PART II –OTHER INFORMATION**

 

**Item 6.  Exhibits**

 

Exhibits

 

Theexhibit index is incorporated by reference herein.

 

**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly 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:                           | November 9, 2005 |

 

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**EXHIBIT INDEX**

 
| 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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