**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**FORM 10-Q**

(**Mark One**)
|                                                  | **x**                               | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE**  |
|--------------------------------------------------|-------------------------------------|--------------------------------------------------------------------|
| ** **                                       | **SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                       | ** **                          |
| **For the  quarterly period ended July 1, 2007** |
| ** **                                       |
| **OR**                                           |
|                                             | **o**                               | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE** |
|                                             | **SECURITIES EXCHANGE ACT OF 1934** |

 

**For the transition period from                   to                   **

**Commission File No. 001-13579**

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**FRIENDLY ICE CREAM CORPORATION**

(Exact Name of Registrant 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) 731-4000**                                                             |
| (Registrant’s  Telephone Number, Including Area Code)                          |
|                                                                                |
| **Not  Applicable**                                                       |
| (Former name,  former address and former fiscal year, if changed since last report) |

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filedby Section 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 x  No o

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer,or a non-accelerated filer.  Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2 ofthe Exchange Act.
| Large Accelerated Filer  o | Accelerated Filer  x | Non-Accelerated Filer  o |
|--------------------------------------|--------------------------------|------------------------------------|

 

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). Yes oNo x

Indicate thenumber of shares outstanding of each of the issuer’s classes of common stock asof the latest practicable date.
| Class                        | ** ** | **Outstanding at July 31, 2007** |
|------------------------------|------------|----------------------------------|
|                         |       |                             |
| Common Stock, $.01 par value |       | 8,176,121 shares            |

 

 

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**PART I – FINANCIAL INFORMATION**

**Item 1.  Financial Statements**

**FRIENDLYICE CREAM CORPORATION AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

(Unaudited)

(In thousands)
| ** **                                                                | ** ** | **July 1,  2007** | ** ** | **December 31,  2006** | ** ** |
|---------------------------------------------------------------------------|------------|------------------------|------------|-----------------------------|------------|
| ** **                                                                | ** ** | ** **             | ** ** | ** **                  | ** ** |
| ASSETS                                                                    |       |                   |       |                        |       |
| CURRENT ASSETS:                                                           |       |                   |       |                        |       |
| Cash and cash  equivalents                                                |       | $                      | 21,927     |                        | $          | 25,077 |   |
| Restricted cash                                                           |       | 230                    |       | 517                         |       |
| Accounts  receivable, net                                                 |       | 13,252                 |       | 11,435                      |       |
| Inventories                                                               |       | 17,610                 |       | 17,059                      |       |
| Assets held for  sale                                                     |       | 896                    |       | 896                         |       |
| Prepaid expenses  and other current assets                                |       | 3,295                  |       | 3,127                       |       |
| TOTAL CURRENT ASSETS                                                      |       | 57,210                 |       | 58,111                      |       |
| DEFERRED INCOME TAXES                                                     |       | 928                    |       | 928                         |       |
| PROPERTY AND EQUIPMENT,  net of accumulated depreciation and amortization |       | 132,329                |       | 137,425                     |       |
| INTANGIBLE ASSETS AND  DEFERRED COSTS, net of accumulated amortization    |       | 16,899                 |       | 17,783                      |       |
| OTHER ASSETS                                                              |       | 6,378                  |       | 5,920                       |       |
| TOTAL ASSETS                                                              |       | $                      | 213,744    |                        | $          | 220,167 |   |
|                                                                      |       |                   |       |                        |       |
| LIABILITIES AND  STOCKHOLDERS’ DEFICIT                               |       |                   |       |                        |       |
| CURRENT LIABILITIES:                                                      |       |                   |       |                        |       |
| Current  maturities of long-term debt                                     |       | $                      | 1,635      |                        | $          | 1,563 |   |
| Current  maturities of capital lease and finance obligations              |       | 1,659                  |       | 1,541                       |       |
| Accounts payable                                                          |       | 24,970                 |       | 22,247                      |       |
| Accrued salaries  and benefits                                            |       | 9,525                  |       | 8,230                       |       |
| Accrued interest  payable                                                 |       | 1,131                  |       | 1,173                       |       |
| Insurance  reserves                                                       |       | 13,232                 |       | 11,462                      |       |
| Other accrued  expenses                                                   |       | 16,114                 |       | 22,475                      |       |
| TOTAL CURRENT  LIABILITIES                                                |       | 68,266                 |       | 68,691                      |       |
| CAPITAL LEASE AND  FINANCE OBLIGATIONS, less current maturities           |       | 3,847                  |       | 4,682                       |       |
| LONG-TERM DEBT, less  current maturities                                  |       | 221,816                |       | 222,650                     |       |
| LIABILITY FOR PENSION  BENEFITS                                           |       | 20,977                 |       | 20,302                      |       |
| OTHER LONG-TERM  LIABILITIES                                              |       | 31,503                 |       | 30,738                      |       |
| COMMITMENTS AND  CONTINGENCIES                                            |       |                   |       |                        |       |
| STOCKHOLDERS’ DEFICIT:                                               |       |                   |       |                        |       |
| Common stock                                                              |       | 81                     |       | 81                          |       |
| Additional  paid-in capital                                               |       | 147,091                |       | 146,398                     |       |
| Accumulated  other comprehensive loss                                     |       | (23,514                | )          | (23,514                     | )          |
| Accumulated  deficit                                                      |       | (256,323               | )          | (249,861                    | )          |
| TOTAL STOCKHOLDERS’  DEFICIT                                         |       | (132,665               | )          | (126,896                    | )          |
| TOTAL LIABILITIES AND STOCKHOLDERS’ DEFICIT                          |       | $                      | 213,744    |                        | $          | 220,167 |   |

 

The accompanyingnotes are an integral part of these condensed consolidated financialstatements.

1

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## **FRIENDLY ICE CREAM CORPORATION ANDSUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS**

(Unaudited)

(In thousands,except per share data)
| ** **                                                                                                                                                                                                                                           | ** ** | **For the Three Months Ended** | ** ** | **For the Six Months Ended** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                                                                                                                                                                           | ** ** | **July 1,  2007**                             | ** ** | **July 2,  2006**                           | ** ** | **July 1,  2007** | ** ** | **July 2,  2006** | ** ** |
| ** **                                                                                                                                                                                                                                           | ** ** | ** **                                         | ** ** | ** **                                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| REVENUES:                                                                                                                                                                                                                                            |       |                                               |       |                                             |       |   |   |   |   |
| Restaurant                                                                                                                                                                                                                                           |       | $                                                  | 107,173    |                                             | $          | 105,271 |   | $ | 199,970 |   | $ | 200,547 |   |
| Foodservice                                                                                                                                                                                                                                          |       | 31,132                                             |       | 32,137                                           |       | 57,075 |   | 59,031 |   |
| Franchise                                                                                                                                                                                                                                            |       | 3,937                                              |       | 4,082                                            |       | 7,432 |   | 7,627 |   |
| TOTAL REVENUES                                                                                                                                                                                                                                       |       | 142,242                                            |       | 141,490                                          |       | 264,477 |   | 267,205 |   |
|                                                                                                                                                                                                                                                 |       |                                               |       |                                             |       |   |   |   |   |
| COSTS AND  EXPENSES:                                                                                                                                                                                                                                 |       |                                               |       |                                             |       |   |   |   |   |
| Cost of sales                                                                                                                                                                                                                                        |       | 54,642                                             |       | 51,939                                           |       | 101,627 |   | 100,324 |   |
| Labor and benefits                                                                                                                                                                                                                                   |       | 38,577                                             |       | 36,943                                           |       | 72,824 |   | 72,955 |   |
| Operating expenses                                                                                                                                                                                                                                   |       | 27,954                                             |       | 26,816                                           |       | 52,825 |   | 50,815 |   |
| General and administrative expenses                                                                                                                                                                                                                  |       | 11,291                                             |       | 11,449                                           |       | 21,925 |   | 22,546 |   |
| Write-down of property and equipment                                                                                                                                                                                                                 |       | 409                                                |       | —                                           |       | 615 |   | 215 |   |
| Depreciation and amortization                                                                                                                                                                                                                        |       | 5,554                                              |       | 5,740                                            |       | 11,696 |   | 11,520 |   |
| Gain on  franchise sales of restaurant operations and properties                                                                                                                                                                                     |       | —                                             |       | (1,145                                           | )          | — |   | (2,011 | ) |
| (Gain) loss on  disposals of other property and equipment, net                                                                                                                                                                                       |       | (404                                               | )          | 366                                              |       | (370 | ) | 475 |   |
|                                                                                                                                                                                                                                                 |       |                                               |       |                                             |       |   |   |   |   |
| OPERATING INCOME                                                                                                                                                                                                                                     |       | 4,219                                              |       | 9,382                                            |       | 3,335 |   | 10,366 |   |
|                                                                                                                                                                                                                                                 |       |                                               |       |                                             |       |   |   |   |   |
| Interest  expense, net                                                                                                                                                                                                                               |       | 4,952                                              |       | 5,147                                            |       | 9,876 |   | 10,567 |   |
|                                                                                                                                                                                                                                                 |       |                                               |       |                                             |       |   |   |   |   |
| (LOSS) INCOME  FROM CONTINUING OPERATIONS BEFORE PROVISION FOR INCOME TAXES                                                                                                                                                                          |       | (733                                               | )          | 4,235                                            |       | (6,541 | ) | (201 | ) |
|                                                                                                                                                                                                                                                 |       |                                               |       |                                             |       |   |   |   |   |
| Provision for  income taxes                                                                                                                                                                                                                          |       | (48                                                | )          | (250                                             | )          | (142 | ) | (250 | ) |
|                                                                                                                                                                                                                                                 |       |                                               |       |                                             |       |   |   |   |   |
| (LOSS) INCOME  FROM CONTINUING OPERATIONS                                                                                                                                                                                                            |       | (781                                               | )          | 3,985                                            |       | (6,683 | ) | (451 | ) |
|                                                                                                                                                                                                                                                 |       |                                               |       |                                             |       |   |   |   |   |
| INCOME FROM  DISCONTINUED OPERATIONS, net of income tax effect of ($0) and ($450) for the  three months ended July 1, 2007 and July 2, 2006, respectively, and ($0) and  ($450) for the six months ended July 1, 2007 and July 2, 2006, respectively |       | 493                                                |       | 674                                              |       | 442 |   | 3,290 |   |
|                                                                                                                                                                                                                                                 |       |                                               |       |                                             |       |   |   |   |   |
| NET (LOSS)  INCOME                                                                                                                                                                                                                                   |       | $                                                  | (288       | )                                                | $          | 4,659 |   | $ | (6,241 | ) | $ | 2,839 |   |
|                                                                                                                                                                                                                                                 |       |                                               |       |                                             |       |   |   |   |   |
| BASIC NET (LOSS)  INCOME PER SHARE:                                                                                                                                                                                                                  |       |                                               |       |                                             |       |   |   |   |   |
| (Loss) income from continuing operations                                                                                                                                                                                                             |       | $                                                  | (0.10      | )                                                | $          | 0.50 |   | $ | (0.82 | ) | $ | (0.06 | ) |
| Income from discontinued operations                                                                                                                                                                                                                  |       | 0.06                                               |       | 0.09                                             |       | 0.05 |   | 0.42 |   |
| Net (loss) income                                                                                                                                                                                                                                    |       | $                                                  | (0.04      | )                                                | $          | 0.59 |   | $ | (0.77 | ) | $ | 0.36 |   |
|                                                                                                                                                                                                                                                 |       |                                               |       |                                             |       |   |   |   |   |
| DILUTED NET  (LOSS) INCOME PER SHARE:                                                                                                                                                                                                                |       |                                               |       |                                             |       |   |   |   |   |
| (Loss) income from continuing operations                                                                                                                                                                                                             |       | $                                                  | (0.10      | )                                                | $          | 0.50 |   | $ | (0.82 | ) | $ | (0.06 | ) |
| Income from discontinued operations                                                                                                                                                                                                                  |       | 0.06                                               |       | 0.08                                             |       | 0.05 |   | 0.41 |   |
| Net (loss) income                                                                                                                                                                                                                                    |       | $                                                  | (0.04      | )                                                | $          | 0.58 |   | $ | (0.77 | ) | $ | 0.35 |   |
|                                                                                                                                                                                                                                                 |       |                                               |       |                                             |       |   |   |   |   |
| WEIGHTED AVERAGE  SHARES:                                                                                                                                                                                                                            |       |                                               |       |                                             |       |   |   |   |   |
| Basic                                                                                                                                                                                                                                                |       | 8,136                                              |       | 7,913                                            |       | 8,129 |   | 7,907 |   |
| Diluted                                                                                                                                                                                                                                              |       | 8,136                                              |       | 8,044                                            |       | 8,129 |   | 8,048 |   |

 

The accompanying notesare an integral part of these condensed consolidated financial statements.

2

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**FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

(Unaudited)

(In thousands)
| ** **                                                                                | ** ** | **For the Six Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                | ** ** | **July 1,  2007**                           | ** ** | **July 2,  2006** | ** ** |
|                                                                                      |       |                                             |       |   |   |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                    |       |                                             |       |   |   |
| Net (loss)  income                                                                        |       | $                                                | (6,241     | ) | $ | 2,839 |   |
| Adjustments to  reconcile net (loss) income to net cash provided by operating activities: |       |                                             |       |   |   |
| Stock compensation expense                                                                |       | 538                                              |       | 200 |   |
| Depreciation and amortization                                                             |       | 11,696                                           |       | 11,520 |   |
| Non-cash income from discontinued operations                                              |       | (544                                             | )          | (4,068 | ) |
| Write-downs of property and equipment                                                     |       | 615                                              |       | 215 |   |
| Gain on disposals of property and equipment, net                                          |       | (370                                             | )          | (1,551 | ) |
| Changes in operating assets and liabilities:                                              |       |                                             |       |   |   |
| Accounts receivable                                                                       |       | (1,817                                           | )          | (8,219 | ) |
| Inventories                                                                               |       | (551                                             | )          | (1,141 | ) |
| Other assets                                                                              |       | 410                                              |       | 7,230 |   |
| Accounts payable                                                                          |       | 2,723                                            |       | (1,030 | ) |
| Accrued expenses and other long-term liabilities                                          |       | (2,119                                           | )          | 4,104 |   |
| NET CASH  PROVIDED BY OPERATING ACTIVITIES                                                |       | 4,340                                            |       | 10,099 |   |
|                                                                                      |       |                                             |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                    |       |                                             |       |   |   |
| Purchases of  property and equipment                                                      |       | (6,851                                           | )          | (7,967 | ) |
| Proceeds from  sales of property and equipment                                            |       | 720                                              |       | 9,200 |   |
| NET CASH (USED  IN) PROVIDED BY INVESTING ACTIVITIES                                      |       | (6,131                                           | )          | 1,233 |   |
|                                                                                      |       |                                             |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                    |       |                                             |       |   |   |
| Proceeds from  borrowings under revolving credit facility                                 |       | —                                           |       | 8,000 |   |
| Repayments of  debt                                                                       |       | (762                                             | )          | (8,688 | ) |
| Payments of  deferred financing costs                                                     |       | —                                           |       | (205 | ) |
| Repayments of  capital lease and finance obligations                                      |       | (752                                             | )          | (728 | ) |
| Stock options  exercised                                                                  |       | 155                                              |       | 65 |   |
| NET CASH USED IN  FINANCING ACTIVITIES                                                    |       | (1,359                                           | )          | (1,556 | ) |
|                                                                                      |       |                                             |       |   |   |
| NET (DECREASE)  INCREASE IN CASH AND CASH EQUIVALENTS                                     |       | (3,150                                           | )          | 9,776 |   |
|                                                                                      |       |                                             |       |   |   |
| CASH AND CASH  EQUIVALENTS, BEGINNING OF PERIOD                                           |       | 25,077                                           |       | 14,597 |   |
|                                                                                      |       |                                             |       |   |   |
| CASH AND CASH  EQUIVALENTS, END OF PERIOD                                                 |       | $                                                | 21,927     |   | $ | 24,373 |   |
|                                                                                      |       |                                             |       |   |   |
| SUPPLEMENTAL  DISCLOSURES:                                                                |       |                                             |       |   |   |
| Capital lease  obligations incurred                                                       |       | 35                                               |       | — |   |
| Note received  from sale of lease rights                                                  |       | 750                                              |       | — |   |
|                                                                                      |       |                                             |       |   |   |
| Cash paid  (refunded) during the period for:                                              |       |                                             |       |   |   |
| Interest                                                                                  |       | $                                                | 9,876      |   | $ | 10,138 |   |
| Income taxes                                                                              |       | 289                                              |       | (287 | ) |

 

The accompanyingnotes are an integral part of these condensed consolidated financialstatements.

3

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**FRIENDLYICE CREAM CORPORATION AND SUBSIDIARIES**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

(Unaudited)

**1. RECENT DEVELOPMENTS ANDSUBSEQUENT EVENT**

**RecentDevelopments**

On June 17, 2007,the Company entered into a definitive merger agreement (the “Merger Agreement”)with Freeze Operations Holding Corp. (“Parent”) and Freeze Operations, Inc., awholly owned subsidiary of Parent (“Merger Sub”), pursuant to which, subject tothe satisfaction or waiver of the conditions therein, Merger Sub will merge withand into the Company, and the Company would continue as the survivingcorporation of the merger (the “Merger”). Parent is an affiliate of Sun CapitalPartners, a private equity firm. Upon completion of the Merger, (i) the Companywill become a privately held, wholly owned subsidiary of Parent, (ii) eachshare of Company common stock issued and outstanding immediately prior to thecompletion of the Merger (other than shares held in treasury by the Company orheld by any wholly owned subsidiary of the Company) will be converted into theright to receive $15.50 in cash (the “Merger Consideration”), (iii) each optionto purchase Company common stock that is outstanding and unexercisedimmediately prior to the completion of the Merger will be canceled and convertedinto the right to receive an amount in cash as provided in the Merger Agreementand (iv) each restricted share that is outstanding immediately prior to thecompletion of the Merger will be canceled and converted into the right toreceive, in respect of each underlying share of Company common stock, theMerger Consideration.

The Company hasmade customary representations and warranties and covenants in the MergerAgreement, including covenants relating to obtaining the requisite approval ofits shareholders, the Company’s conduct of business between the date of thesigning of the Merger Agreement and the closing of the transaction and, subjectto certain exceptions, the Company’s agreement not to solicit, enter intodiscussions regarding, or provide information in connection with, alternativetransactions.

The MergerAgreement has been approved by the Company’s board of directors. Completion ofthe Merger is not subject to a financing condition, but is subject to customaryconditions to closing, including, among other things, the adoption of theMerger Agreement by the Company’s shareholders. The U.S. antitrust agencies have granted early termination of thewaiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976,as amended.  The Merger Agreementcontains certain termination rights of both parties and provides that, upon thetermination of the Merger Agreement under certain circumstances, the Companywould be required to pay Parent a termination fee of $5.0 million plus certainexpenses of Parent, and Parent would be required to pay the Company atermination fee of $5.0 million. A Special Meeting of Shareholders has beenscheduled for August 29, 2007 for a vote on the proposed Merger and thetransaction is expected to close in the third quarter of 2007.

The Companyexpects that shortly after shareholder approval is received, the transactionwill close.  In connection with theclosing, the Company expects to record compensation expense in the amount of$6,410,000 related to the acceleration of stock options, restricted stock,restricted stock units and performance units.

4

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**SubsequentEvent**

On July 26, 2007,at the request of Parent pursuant to the terms of the Merger Agreement and inconnection with the Merger, the Company commenced an offer (the “Offer”) topurchase for cash any and all of its outstanding $175,000,000 aggregateprincipal amount of 8.375% Senior Notes due 2012 (the “Senior Notes”), on theterms and subject to the conditions set forth in the Company’s Offer toPurchase and Solicitation Statement dated July 26, 2007 (the “Offer to Purchaseand Solicitation Statement”).  TheCompany is also soliciting consents (the “Solicitation”) from holders of theSenior Notes for certain amendments to the indenture governing the Senior Notesthat would, among other things, eliminate substantially all of the restrictivecovenants and certain events of default contained in the indenture under whichthe Senior Notes were issued.  TheSolicitation is expected to expire at 5:00 p.m., New York City time, on August8, 2007, unless earlier extended or terminated (the “Consent Date”), and theOffer is expected to expire at 12:00 a.m., New York City Time, on August 22,2007, unless extended or earlier terminated (the “Expiration Time”).  The total consideration to be paid for each$1,000 in principal amount of the Senior Notes validly tendered and acceptedfor purchase will be paid in cash and will be calculated based on a fixedspread pricing formula.  The totalconsideration will be determined on the tenth business day prior to theexpiration time of the Offer based, in part, upon a fixed spread of 50 basispoints over the yield of the 4.875% U.S. Treasury Note due May 31, 2008.  The total consideration includes a consentpayment equal to $30 per $1,000 in principal amount of the Senior Notes.  The detailed methodology for calculating thetotal consideration for the Senior Notes is outlined in the Offer to Purchaseand Solicitation Statement.  Holders ofSenior Notes who tender on or prior to the Consent Date will be eligible toreceive the total consideration, and holders who validly tender their SeniorNotes after the Consent Date, but on or prior to the Expiration Time, will beeligible to receive the total consideration less the consent payment.  In either case, all holders who validlytender their Senior Notes will receive accrued and unpaid interest up to, butnot including the date of settlement. The Company’s Offer and Solicitation areconditioned on the closing of the Merger, the receipt of valid consents fromholders of a majority of the aggregate principal amount of the Senior Notes,the execution and delivery of a supplemental indenture which implements theproposed amendments in respect of the Senior Notes upon receipt of the consentsrequired for those amendments, and certain other general conditions.  The completion of the Offer and Solicitationis not a condition to the completion of the Merger.

In connection withthe Offer, the Company expects to write off unamortized deferred financing costsof $3,543,000.

5

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**2. NATURE OF OPERATIONS**

As of July 1,2007, Friendly’s operated 316 full-service restaurants and franchised 199full-service restaurants and seven non-traditional units. The Companymanufactures and distributes a full line of premium ice cream dessert products.These products are distributed to Friendly’s restaurants, supermarkets andother retail locations in 12 states. The restaurants offer a wide variety ofbreakfast, lunch and dinner menu items as well as premium ice cream dessert products.

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

Following is asummary of Company-operated and franchised units:
|                            | ** ** | **For the Three Months Ended** | ** ** | **For the Six Months Ended** | ** ** |
|----------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                 | ** ** | **July 1,  2007**                             | ** ** | **July 2,  2006**                           | ** ** | **July 1,  2007** | ** ** | **July 2,  2006** | ** ** |
|                       |       |                                               |       |                                             |       |   |   |   |   |
| Company Units:             |       |                                               |       |                                             |       |   |   |   |   |
| Beginning of  period       |       | 317                                                |       | 312                                              |       | 316 |   | 314 |   |
| Openings                   |       | —                                             |       | 1                                                |       | 1 |   | 2 |   |
| Acquired from  franchisees |       | —                                             |       | —                                           |       | 1 |   | — |   |
| Acquired by  franchisees   |       | —                                             |       | (3                                               | )          | — |   | (4 | ) |
| Closings                   |       | (1                                                 | )          | (1                                               | )          | (2 | ) | (3 | ) |
| End of period              |       | 316                                                |       | 309                                              |       | 316 |   | 309 |   |
|                       |       |                                               |       |                                             |       |   |   |   |   |
| Franchised  Units:         |       |                                               |       |                                             |       |   |   |   |   |
| Beginning of  period       |       | 205                                                |       | 214                                              |       | 205 |   | 213 |   |
| Openings                   |       | 3                                                  |       | 1                                                |       | 4 |   | 1 |   |
| Acquired by  franchisees   |       | —                                             |       | 3                                                |       | — |   | 4 |   |
| Acquired from  franchisees |       | —                                             |       | —                                           |       | (1 | ) | — |   |
| Closings                   |       | (2                                                 | )          | (1                                               | )          | (2 | ) | (1 | ) |
| End of period              |       | 206                                                |       | 217                                              |       | 206 |   | 217 |   |

 

6

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**3. BASIS OF PRESENTATION ANDSIGNIFICANT ACCOUNTING POLICIES**

*InterimFinancial Information -*

The accompanyingcondensed consolidated financial statements as of July 1, 2007 and for thethree and six months ended July 1, 2007 and July 2, 2006 are unaudited, buthave been prepared in accordance with U.S. generally accepted accountingprinciples (“GAAP”) for interim financial information and with the instructionsto Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotesrequired by GAAP for complete financial statements.  In the opinion of management, all adjustmentswhich are necessary for a fair presentation of the consolidated financialposition, results of operations, cash flows and comprehensive loss of theCompany have been included. Such adjustments consist solely of normal recurringaccruals. Operating results for the three and six month periods ended July 1,2007 and July 2, 2006 are not necessarily indicative of the results that may beexpected for the entire year due, in part, to the seasonality of the Company’sbusiness. Historically, higher revenues and operating income have beenexperienced during the second and third fiscal quarters. The Company’sconsolidated financial statements, including the notes thereto, which arecontained in the 2006 Annual Report on Form 10-K for the fiscal year endedDecember 31, 2006, as amended (“2006 Annual Report on Form 10-K/A”) should beread in conjunction with these condensed, consolidated financial statements.Capitalized terms not otherwise defined herein should be referenced to the 2006Annual Report on Form 10-K/A.

*Use ofEstimates in the Preparation of Financial Statements -*

The preparation offinancial statements in conformity with GAAP requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and the disclosure of contingent assets and liabilities at thedates of the financial statements and the reported amounts of revenues andexpenses during the reporting periods. The critical accounting policies andmost significant estimates and assumptions relate to revenue recognition, insurancereserves, recoverability of accounts receivable and notes receivable, pensionand post-retirement medical and life insurance benefits expense, assetimpairment analysis, income tax valuation allowances and tax contingencyreserves. Actual amounts could differ significantly from the estimates.

*Inventories-*

Inventories arestated at the lower of first-in, first-out cost or market andconsisted of the following at July 1, 2007 and December 31, 2006 (inthousands):
|                  | ** ** | **July 1,  2007** | ** ** | **December 31,  2006** | ** ** |
|------------------|------------|------------------------|------------|-----------------------------|------------|
|             |       |                   |       |                        |       |
| Raw materials    |       | $                      | 1,812      |                        | $          | 1,640 |   |
| Goods in process |       | 848                    |       | 158                         |       |
| Finished goods   |       | 14,950                 |       | 15,261                      |       |
| Total            |       | $                      | 17,610     |                        | $          | 17,059 |   |

 

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*OtherAccrued Expenses -*

Other accruedexpenses consisted of the following at July 1, 2007 and December 31, 2006 (inthousands):
|                                    | ** ** | **July 1,  2007** | ** ** | **December 31,  2006** | ** ** |
|------------------------------------|------------|------------------------|------------|-----------------------------|------------|
|                               |       |                   |       |                        |       |
| Accrued rent                       |       | $                      | 5,101      |                        | $          | 5,178 |   |
| Accrued meals  and other taxes     |       | 2,757                  |       | 2,241                       |       |
| Gift cards  outstanding            |       | 2,505                  |       | 4,317                       |       |
| Accrued  construction costs        |       | 1,361                  |       | 918                         |       |
| Unearned  revenues                 |       | 1,078                  |       | 1,153                       |       |
| Current portion  of deferred gains |       | 651                    |       | 638                         |       |
| Accrued  advertising               |       | 632                    |       | 1,150                       |       |
| Income taxes  payable              |       | 488                    |       | 1,962                       |       |
| Accrued bonus                      |       | 389                    |       | 3,635                       |       |
| All other                          |       | 1,152                  |       | 1,283                       |       |
| Total                              |       | $                      | 16,114     |                        | $          | 22,475 |   |

 

*IncomeTaxes -*

The Companyaccounts for income taxes in accordance with Statement of Financial AccountingStandards (“SFAS”) No. 109, “Accounting for Income Taxes,” which requiresrecognition of deferred tax assets and liabilities for the expected future taxconsequences of events that have been included in the financial statements ortax returns. The Company records deferred tax assets to the extent it believesthere will be sufficient future taxable income to utilize those assets prior totheir expiration. To the extent deferred tax assets may be unable to beutilized, the Company records a valuation allowance against the potentiallyunrealizable amount and records a charge against earnings.   The calculation of the Company’s taxliabilities involves dealing with uncertainties in the application of complextax regulations in several different tax jurisdictions. The Company isperiodically reviewed by tax authorities regarding the amount of taxes due.These reviews include questions regarding the timing and amount of deductions.In evaluating the exposure associated with various filing positions, theCompany records estimated reserves for probable exposures.

As of December 31,2006 the Company remained in a three-year cumulative loss position and expectedto record valuation allowances on future tax benefits until it can sustain anappropriate level of profitability. However, the Company incurred approximately$1,093,000 of federal tax liabilities for 2005 and 2006 combined. Approximately$928,000 of the $1,093,000 would be available for refund if 2007 results in aloss for income tax purposes. As a result, the valuation allowances as ofDecember 31, 2006 of $27,429,000 reduced the carrying value of net deferred taxassets to $928,000. Should the Company’s future profitability providesufficient evidence, in accordance with SFAS No. 109, to support the ultimaterealization of income tax benefits attributable to net operating loss (“NOL”)and credit carryforwards and other deductible temporary differences, areduction in the valuation allowance may be recorded and the carrying value ofdeferred tax assets may be restored, resulting in a non-cash credit toearnings.

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*LeaseGuarantees and Contingencies -*

Primarily as aresult of the Company’s strategy to sell Company-operated restaurants tofranchisees, the Company remains liable for certain lease assignments andguarantees. These leases have varying terms, the latest of which expires in2020. As of July 1, 2007, the potential amount of undiscounted payments theCompany could be required to make in the event of non-payment by the primarylessees was $6,512,000. The present value of these potential paymentsdiscounted at the Company’s pre-tax cost of debt at July 1, 2007 was$4,940,000. The Company generally has cross-default provisions with franchiseesthat would put them in default of their franchise agreement in the event ofnon-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. Accordingly, no liability has been recorded forexposure under such leases at July 1, 2007 and December 31, 2006.

*Net(Loss) Income Per Share -*

Basic net (loss)income per share is calculated by dividing net (loss) income by the weightedaverage number of common shares outstanding during the period. Diluted net(loss) income per share is calculated by dividing net (loss) income by theweighted average number of shares of common stock and common stock equivalentsoutstanding during the period. Common stock equivalents are dilutive stockoptions that are assumed exercised for calculation purposes. The number ofcommon stock options which could dilute basic earnings per share in the future,that were not included in the computation of diluted earnings per share becauseto do so would have been antidilutive, was 261,125 and 274,158 for the threemonths ended July 1, 2007 and July 2, 2006, respectively.  The number of common stock options whichcould dilute basic earnings per share in the future, that were not included inthe computation of diluted earnings per share because to do so would have beenantidilutive, was 218,616 and 274,158 for the six months ended July 1, 2007 andJuly 2, 2006, respectively.

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Presented below isthe reconciliation between basic and diluted weighted average shares for thethree and six months ended July 1, 2007 and July 2, 2006 (in thousands):
| ** **                                                              | ** ** | **For the Three Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                              | ** ** | **Basic**                                          | ** ** | **Diluted** | ** ** |
| ** **                                                              | ** ** | **July 1,  2007**                             | ** ** | **July 2,  2006** | ** ** | **July 1,  2007** | ** ** | **July 2,  2006** | ** ** |
|                                                                    |       |                                               |       |   |   |   |   |   |   |
| Weighted average  number of common shares outstanding during the period |       | 8,136                                              |       | 7,913 |   | 8,136 |   | 7,913 |   |
| Adjustments:                                                            |       |                                               |       |   |   |   |   |   |   |
| Assumed exercise  of stock options                                      |       | —                                             |       | — |   | — |   | 131 |   |
| Weighted average number  of shares outstanding                          |       | 8,136                                              |       | 7,913 |   | 8,136 |   | 8,044 |   |

 
| ** **                                                              | ** ** | **For the Six Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                              | ** ** | **Basic**                                        | ** ** | **Diluted** | ** ** |
| ** **                                                              | ** ** | **July 1,  2007**                           | ** ** | **July 2,  2006** | ** ** | **July 1,  2007** | ** ** | **July 2,  2006** | ** ** |
|                                                                    |       |                                             |       |   |   |   |   |   |   |
| Weighted average  number of common shares outstanding during the period |       | 8,129                                            |       | 7,907 |   | 8,129 |   | 7,907 |   |
| Adjustments:                                                            |       |                                             |       |   |   |   |   |   |   |
| Assumed exercise  of stock options                                      |       | —                                           |       | — |   | — |   | 141 |   |
| Weighted average number  of shares outstanding                          |       | 8,129                                            |       | 7,907 |   | 8,129 |   | 8,048 |   |

 

*Stock-BasedCompensation -*

The Companyaccounts for stock-based compensation in accordance with SFAS No. 123 (revised2004), “Share-Based Payment”**(“SFAS No. 123R”) which requiresall share-based payments to employees, including grants of employee stockoptions, to be recognized in the income statement based on their fair values atthe date of grant.

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**4. STOCK BASED COMPENSATION**

*EquityCompensation Plans* -

The Companycurrently grants stock awards under the following equity compensation plans:

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

*The 2003 Equity Incentive Plan (the “2003Incentive Plan”)*- On April 9, 2003, the Board of Directorsadopted an equity incentive plan, which was approved by shareholders on May 14,2003. On May 10, 2006, the shareholders approved an amendment to the 2003Incentive Plan to increase the number of shares of common stock reserved forissuance under the 2003 Incentive Plan from 307,000 to 607,000 shares. The 2003Incentive Plan provides for the issuance of nonqualified stock options andincentive stock options (which are intended to satisfy the requirements ofSection 422 of the Internal Revenue Code), SARs, bonus stock, stock units,performance shares, performance units, restricted stock and restricted stockunits. The Compensation Committee of the Board of Directors determines theemployees who will receive awards under the 2003 Incentive Plan and the termsof such awards.  The exercise price of astock option or SAR granted or awarded under the 2003 Incentive Plan may not beless than the fair market value of one share of common stock on the date thestock option or SAR is granted.

*Key Executive Stock Option -* OnJanuary 8, 2007, as a material inducement to the employment of George M.Condos, the Company’s President and Chief Executive Officer, the Companygranted Mr. Condos stock options to purchase an aggregate of 75,000 shares ofthe Company’s common stock, at an exercise price of $11.80 per share (equal tothe closing price of the Company’s common stock on the American Stock Exchangeon the date of grant).  These stockoptions were granted outside of any of the Company’s equity incentive and stockoption plans, pursuant to an exemption from the American Stock Exchangestockholder approval requirement set forth in Section 711 of the American StockExchange Company Guide.  The stockoptions vest in three equal annual installments and expire five years after thedate of grant.

Options issuedpursuant to the 1997 Plan and the 2003 Incentive Plan generally vest over threeyears, and have a five year expiration date.

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Grant-Date FairValue -

The Company usesthe Black-Scholes option pricing model to calculate the grant-date fair valueof an award. The fair value of options granted during the six months ended July1, 2007 and July 2, 2006 were calculated using the following estimated weightedaverage assumptions:
|                                         | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------|------------|--------------------------------|------------|
| ** **                              | ** ** | **July 1, 2007**     | ** ** | **July 2, 2006** | ** ** |
| Options granted                         |       | 136,720                        |       | 145,409 |   |
| Weighted-average  exercise price        |       | $                              | 13.02      |   | $ | 8.10 |   |
| Weighted-average  grant date fair value |       | $                              | 4.90       |   | $ | 3.82 |   |
| Assumptions:                            |       |                           |       |   |   |
| Risk free  interest rate                |       | 4.45%-4.6                      | 6%         | 4.68 | % |
| Expected life  (in years)               |       | 4                              |       | 4 |   |
| Expected  volatility                    |       | 40.13                          | %          | 54.86 | % |
| Expected dividend yield                 |       | 0.00                           | %          | 0.00 | % |

 

There were nooptions granted during the three months ended July 1, 2007 or July 2, 2006.

Risk-free interestrate – the yield on zero-coupon U.S. Treasury securities for a period that iscommensurate with the expected term assumption is used as the risk-freeinterest rate.

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

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

Expected dividend yield – the Company has not paid any dividends in thelast five years and currently intends to retain any earnings to finance futuregrowth and, therefore, does not anticipate paying any cash dividends on itscommon stock in the foreseeable future.

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*Expense*-

The Company usedthe straight-line attribution method to recognize expense for all optionsgranted. Stock-based compensation is included in general and administrativeexpenses in the accompanying condensed consolidated statements of operations.

The amount ofstock-based compensation recognized during a period is based on the value ofthe portion of the awards that are ultimately expected to vest. SFAS No. 123Rrequires forfeitures to be estimated at the time of grant and revised, ifnecessary, in subsequent periods if actual forfeitures differ from those estimates.The term “forfeitures” is distinct from “cancellations” or “expirations” andrepresents only the unvested portion of the surrendered option. The Companycurrently expects that 100% of its outstanding stock options will become fullyvested upon completion of the proposed merger with an affiliate of Sun Capitalpursuant to that certain definitive merger agreement and plan of merger datedJune 17, 2007 by and among the Company, Freeze Operations Holding Corp. andFreeze Operations, Inc., and therefore has applied no annual forfeiture rate tostock options granted as of July 1, 2007. See Note 1.

*OptionActivity* -

A summary of thestock option activity under the Company’s equity compensation plans as of July1, 2007 and changes during the six-month period then ended is presented below:
| ** **                                            | ** ** | **Options  Outstanding** | ** ** | **Weighted-  Average  Remaining  Contractual  Life in Years** | ** ** | **Weighted-  Average  Exercise Price** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|-------------------------------------------------------|------------|--------------------------|------------|-------------------------------------------------------------------------|------------|---------------------------------------------|------------|---------------------------------|------------|
|                                                  |       |                     |       |                                                                    |       |                                        |       |                            |       |
| Options  outstanding at December 31, 2006             |       | 452,280                  |       |                                                                    |       | $                                           | 8.83       |                            |       |   |
| Granted                                               |       | 136,720                  |       |                                                                    |       | $                                           | 13.02      |                            |       |   |
| Cancelled                                             |       | (800                     | )          |                                                                    |       | $                                           | 17.38      |                            |       |   |
| Forfeited                                             |       | (14,164                  | )          |                                                                    |       | $                                           | 8.29       |                            |       |   |
| Exercised                                             |       | (17,139                  | )          |                                                                    |       | $                                           | 9.12       |                            |       |   |
| Options  outstanding at July 1, 2007                  |       | 556,897                  |       | 3.34                                                                    |       | $                                           | 9.85       |                            | $          | 4,587,741 |   |
|                                                  |       |                     |       |                                                                    |       |                                        |       |                            |       |
| Options fully  vested and exercisable at July 1, 2007 |       | 309,442                  |       | 2.58                                                                    |       | $                                           | 8.76       |                            | $          | 2,065,136 |   |
|                                                  |       |                     |       |                                                                    |       |                                        |       |                            |       |

 

During the threeand six months ended July 1, 2007, the total intrinsic value of optionsexercised (i.e., the difference between the market price at exercise and theprice paid by the employee to exercise the options) was $69,000 and $79,000,respectively, and the total amount of cash received from exercise of stockoptions was $120,000 and $156,000, respectively.

As of July 1,2007, there was $949,000 of unrecognized compensation cost related to unvestedstock options. That cost is expected to be recognized over a weighted-averageperiod of 2.33 years.

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*RestrictedStock and Restricted Stock Unit Activity* -

On December 2,2005, 30,000 restricted stock units were issued to directors with a weightedaverage fair value of $8.90 at grant date. On November 1, 2006, 30,000 restricted stock units were issued to directorswith a weighted average fair value of $10.61 at grant date.  The restricted stock units were issuedpursuant to and subject to the terms of the Company’s 2003 Incentive Plan.  Subject to the terms of the 2003 IncentivePlan, each restricted stock unit provides the holder with the right to receiveone share of common stock of the Company when the restrictions lapse or vest.The restricted stock units granted to the directors vest three years after thedate of grant if the recipient is a member of the Company’s Board of Directorson such date, subject to accelerated vesting in the event of a change incontrol or the director’s death, disability or retirement.

Pursuantto a long-term incentive plan for fiscal 2006 approved by the CompensationCommittee of the Board of Directors under the Company’s 2003 Incentive Plan,the Compensation Committee established target EBITDA levels for the Company forfiscal 2006 and target awards for each officer named below based on apercentage (ranging from 50% to 100%) of each such officer’s base salary.

OnFebruary 28, 2007 the Compensation Committee determined that the Companyexceeded the threshold EBITDA for fiscal 2006, and awarded shares of restrictedcommon stock under the Company’s 2003 Incentive Plan to each of the officersnamed below.  The number of shares ofrestricted common stock issued to each officer listed below was determined bydividing the officer’s 2006 Award Value (set forth below) by 90% of the closingprice of the Company’s common stock on the date of grant as reported on theAmerican Stock Exchange.  25% of theshares of restricted common stock issued to each officer were fully vested uponissuance.  The remaining 75% of theshares of restricted common stock will vest in three equal annual installmentsfollowing issuance if the officer remains employed by the Company.  The unvested shares of restricted commonstock will also fully vest upon a change in control, as provided in the 2003Incentive Plan.

Thefollowing table sets forth for each officer listed below the 2006 Award Valueand the number of shares of restricted common stock such officer received underthe long-term incentive plan for fiscal 2006.
| Name            | ** ** | **Award Value** | ** ** | **Number of Shares** | ** ** |
|-----------------|------------|----------------------|------------|--------------------------------|------------|
| Paul Hoagland   |       | $                    | 188,664    |                           | 17,469     |   |
| Gregory Pastore |       | $                    | 79,207     |                           | 7,334      |   |
| Kenneth Green   |       | $                    | 91,304     |                           | 8,454      |   |
| Garrett Ulrich  |       | $                    | 91,690     |                           | 8,490      |   |

 

Forawards that vest subject to performance conditions, compensation expense isrecognized ratably for each tranche of the award over the performance period ifit is probable that performance conditions will be met.  During the three months ended July 1, 2007and July 2, 2006, stock-based compensation cost of $246,000 and $22,000,respectively, was recorded related to the restricted stock units issued andshares of restricted common stock issued pursuant to the long-term incentiveplan for fiscal 2006.  During the sixmonths ended July 1, 2007 and July 2, 2006, stock-based compensation cost of$327,000 and $44,000, respectively, was recorded related to the restrictedstock units issued and shares of restricted common stock issued pursuant to thelong-term incentive plan for fiscal 2006. As of July 1, 2007, there was $547,000 of total unrecognizedcompensation cost related to unvested restricted stock units and shares ofrestricted common stock.  That cost isexpected to be recognized over a weighted-average period of 2.15 years.

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*2007 Long-Term Incentive Plan*

OnFebruary 28, 2007 the Compensation Committee approved a long-term incentiveplan for fiscal 2007 under the Company’s 2003 Incentive Plan, pursuant to whichthe Compensation Committee established target EBITDA levels for the Company forfiscal 2007 and target awards for each officer named below based on apercentage (ranging from 50% to 100%) of each officer’s base salary.  The actual awards for each officer arepayable in shares of restricted stock (representing approximately two-thirds ofthe value of the target award) and stock options to purchase shares of commonstock (representing approximately one-third of the value of the target award).

Withrespect to the potential restricted stock awards, the Compensation Committeeapproved the issuance of restricted stock unit award agreements (the “RestrictedStock Units Award Agreements”) for each of the officers named below, pursuantto which each officer is eligible to receive a certain number of shares ofrestricted common stock of the Company calculated in accordance with the termsof the officer’s individual Restricted Stock Unit Award Agreement. If theCompany meets or exceeds a certain threshold EBITDA for fiscal 2007 (the “2007Threshold EBITDA”), then the officer will receive an award payable in shares ofrestricted common stock having a value determined based on the Company’s actualEBITDA for fiscal 2007 compared to projected EBITDA for fiscal 2007 and thepercentage (ranging from 50% to 150%) of the officer’s target award applicableto those results (the “2007 Award Value”). In the event of a change in control, as provided under the 2003Incentive Plan, prior to the Compensation Committee’s determination of the 2007Award Value, the 2007 Threshold EBITDA shall be deemed to have been achievedand the 2007 Award Value shall be deemed to be equal to the target EBITDA forfiscal 2007.  The number of shares ofcommon stock to be issued to the officer, if any, will be calculated bydividing the 2007 Award Value by 90% of the closing price of the Company’scommon stock on the date of grant as reported by the American Stock Exchange(or such other exchange on which the Company’s common stock is traded) (the “AwardShares”).

Thefollowing table sets forth the range of 2007 Award Values each officer mayreceive under the long-term incentive plan for fiscal 2007:
| Name            | ** ** | **Value of Award** | ** ** |
|-----------------|------------|------------------------------|------------|
| George Condos   |       | $                            | 159,125    |   | To |   | $ | 477,375 |   |
| Paul Hoagland   |       | $                            | 83,670     |   | To |   | $ | 251,009 |   |
| Gregory Pastore |       | $                            | 35,477     |   | To |   | $ | 106,430 |   |
| Kenneth Green   |       | $                            | 44,053     |   | To |   | $ | 132,158 |   |
| Garrett Ulrich  |       | $                            | 41,071     |   | To |   | $ | 123,213 |   |

 

The2007 Award Value will be determined, and the date of grant of any Award Shareswill occur, upon the earlier of (i) the date of the Compensation Committee’sfirst regularly scheduled meeting held after the completion of the Company’sindependent audit for fiscal 2007 and the Company’s Audit Committee’srecommendation to include the Company’s audited financial statements in theCompany’s Annual Report on Form 10-K or (ii) immediately prior to theconsummation of a change in control of the Company (the “Issue Date”).  If the officer’s employment with the Companyor one of its affiliates is terminated due to death, disability, retirement,involuntary (with or without cause) or voluntary termination prior to the IssueDate, then the officer’s Restricted Stock Unit Award Agreement shall terminateand the officer shall have no right to receive any Award Shares.

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IfAward Shares are issued to the officer, 25% of the shares of restricted commonstock issued to each officer will be fully vested upon issuance. The remaining75% of the shares of restricted common stock will vest in three equal annualinstallments following issuance if the officer remains employed by theCompany.  The unvested shares ofrestricted common stock will also fully vest upon a change in control, asprovided in the 2003 Incentive Plan.

Duringthe three and six months ended July 1, 2007, no stock-based compensation wasrecorded related to the foregoing awards as it was not probable thatperformance conditions will be met.

**5.EMPLOYEE BENEFIT PLANS**

Thecomponents of net periodic pension cost for the three and six months ended July1, 2007 and July 2, 2006 were (in thousands):
| ** **                                           | ** ** | **For the Three Months Ended** | ** ** | **For the Six Months Ended** | ** ** |
|------------------------------------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                           | ** ** | **July 1,  2007**                             | ** ** | **July 2,  2006**                           | ** ** | **July 1,  2007** | ** ** | **July 2,  2006** | ** ** |
| ** **                                           | ** ** | ** **                                         | ** ** | ** **                                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest cost                                        |       | $                                                  | 1,702      |                                             | $          | 1,672 |   | $ | 3,404 |   | $ | 3,392 |   |
| Expected return on  assets                           |       | (1,976                                             | )          | (1,996                                           | )          | (3,951 | ) | (3,965 | ) |
| Net amortization of  unrecognized net actuarial loss |       | 611                                                |       | 632                                              |       | 1,221 |   | 1,351 |   |
|                                                 |       |                                               |       |                                             |       |   |   |   |   |
| Net periodic pension cost                            |       | $                                                  | 337        |                                             | $          | 308 |   | $ | 674 |   | $ | 778 |   |

 

Thecomponents of the net postretirement medical and life insurance benefit costfor the three and six months ended July 1, 2007 and July 2, 2006 were (inthousands):
| ** **                                              | ** ** | **For the Three Months Ended** | ** ** | **For the Six Months Ended** | ** ** |
|---------------------------------------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                              | ** ** | **July 1,  2007**                             | ** ** | **July 2,  2006**                           | ** ** | **July 1,  2007** | ** ** | **July 2,  2006** | ** ** |
| ** **                                              | ** ** | ** **                                         | ** ** | ** **                                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service cost                                            |       | $                                                  | 36         |                                             | $          | 41 |   | $ | 72 |   | $ | 82 |   |
| Interest cost                                           |       | 105                                                |       | 95                                               |       | 210 |   | 190 |   |
| Recognized actuarial  loss                              |       | 9                                                  |       | 4                                                |       | 19 |   | 8 |   |
| Net amortization of  unrecognized prior service benefit |       | (35                                                | )          | (36                                              | )          | (71 | ) | (72 | ) |
|                                                    |       |                                               |       |                                             |       |   |   |   |   |
| Net postretirement benefit cost                         |       | $                                                  | 115        |                                             | $          | 104 |   | $ | 230 |   | $ | 208 |   |

 

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**6. ASSETIMPAIRMENT AND DISCONTINUED OPERATIONS**

SFASNo. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,”requires the results of operations of a component of an entity that isclassified as held for sale or that has been disposed of to be reported asdiscontinued operations in the statement of operations if certain conditionsare met. These conditions include commitment to a plan of disposal after theeffective date of this statement, elimination of the operations and cash flowsof the entity component from the ongoing operations of the Company and nosignificant continuing involvement in the operations of the entity componentafter the disposal transaction.

In accordance withSFAS No. 144, the results of operations of the eight properties that weredisposed of during 2006 and the two properties that were disposed of during2007 and any related net gain on the disposals, as well as the results ofoperations of the properties held for sale at July 1, 2007 were reportedseparately as discontinued operations in the accompanying condensedconsolidated statements of operations for all periods presented.

The results ofoperations associated with one property that meets the criteria for “held for sale” as defined in SFAS No. 144 andthe results of the two properties that were closed during 2007 were notmaterial and therefore were reported within continuing operations in theaccompanying condensed consolidated statements of operations for the three andsix month periods ended July 2, 2006.

For the three andsix months ended July 1, 2007 and July 2, 2006, these discontinued resultsconsisted of the following (in thousands):
| ** **                                   | ** ** | **For the Three Months Ended** | ** ** | **For the Six Months Ended** | ** ** |
|----------------------------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                   | ** ** | **July 1,  2007**                             | ** ** | **July 2,  2006**                           | ** ** | **July 1,  2007** | ** ** | **July 2,  2006** | ** ** |
| ** **                                   | ** ** | ** **                                         | ** ** | ** **                                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                    |       | $                                                  | 171        |                                             | $          | — |   | $ | 561 |   | $ | — |   |
|                                         |       |                                               |       |                                             |       |   |   |   |   |
| Operating loss                               |       | (242                                               | )          | (79                                              | )          | (293 | ) | (328 | ) |
| Gain on disposals of  property and equipment |       | 735                                                |       | 1,203                                            |       | 735 |   | 4,068 |   |
| Income tax expense                           |       | —                                             |       | (450                                             | )          | — |   | (450 | ) |
| Income from discontinued operations          |       | $                                                  | 493        |                                             | $          | 674 |   | $ | 442 |   | $ | 3,290 |   |

 

17

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The table belowidentifies the components of the “(gain) loss on disposals of other propertyand equipment, net” as shown in the accompanying condensed consolidatedstatements of operations (in thousands):
| ** **                                                    | ** ** | **For the Three Months Ended** | ** ** | **For the Six Months Ended** | ** ** |
|---------------------------------------------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                    | ** ** | **July 1,  2007**                             | ** ** | **July 2,  2006**                           | ** ** | **July 1,  2007** | ** ** | **July 2,  2006** | ** ** |
| ** **                                                    | ** ** | ** **                                         | ** ** | ** **                                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Restaurant equipment  assets retired due to remodeling        |       | $                                                  | —     |                                             | $          | 296 |   | $ | — |   | $ | 296 |   |
| Restaurant equipment  assets retired due to replacement       |       | 33                                                 |       | 67                                               |       | 67 |   | 142 |   |
| Gain due to restaurant  flood and fire                        |       | (437                                               | )          | (79                                              | )          | (437 | ) | (48 | ) |
| All other                                                     |       | —                                             |       | 82                                               |       | — |   | 85 |   |
| (Gain) loss on disposals of other property and equipment, net |       | $                                                  | (404       | )                                                | $          | 366 |   | $ | (370 | ) | $ | 475 |   |

 

During the threeand six months ended July 1, 2007, the Company determined that the carryingvalue of three operating restaurant properties and four operating restaurantproperties, respectively, exceeded their estimated fair values less costs tosell and the carrying values were reduced by $409,000 and $615,000,respectively.

During the sixmonths ended July 2, 2006, the Company determined that the carrying value ofone operating restaurant property exceeded its estimated fair value less coststo sell and the carrying value was reduced by $215,000 accordingly.

18

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**7. INCOMETAXES**

InJuly 2006, the Financial Accounting Standards Board (“FASB”) issued FASBInterpretation No. 48, “Accounting for Uncertainty in Income Taxes–aninterpretation of FASB Statement No. 109” (“FIN 48”), which clarifies theaccounting for uncertainty in tax positions. FIN 48 requires that the Companyrecognize in its financial statements the impact of a tax position, if thatposition is more likely than not of being sustained on audit based on thetechnical merits of the position. The provisions of FIN 48 are effective as ofthe beginning of the Company’s 2007 fiscal year, with the cumulative effect ofthe change in accounting principle recorded as an adjustment to openingretained earnings.

TheCompany adopted the provisions of FIN 48 on January 1, 2007. As a result of theimplementation of FIN 48 on January 1, 2007, the Company recognizedan additional $221,000 as a decrease to retained earnings.  As of the date of adoption, the Company’sunrecognized tax benefits totaled $1,579,000, which would affect the Company’stax rate if recognized.  During the threeand six months ended July 1, 2007, the Company recognized $48,000 and $142,000,respectively, in potential tax and interest associated with uncertain taxpositions and settled one previously uncertain tax position which resulted inthe payment of $72,065 of tax and $7,324 of interest.

The Company files numerous consolidated and separateincome tax returns in the United States Federal jurisdiction and in many statejurisdictions. With few exceptions, the Company is no longer subject to USFederal and state and local income tax examinations for years before 2003.

The Company recognizespotential accrued interest and penalties related to unrecognized tax benefitswithin its operations as income tax expenses. As of the date of implementationof FIN 48, the Company had approximately $580,000 accrued for interest andpenalties.  To the extent interest andpenalties are not assessed with respect to uncertain tax positions, amountsaccrued will be reduced and reflected as a reduction of the overall income taxprovision.

The Company anticipates that the total unrecognizedtax benefits will decrease by approximately $500,000 due to the settlement ofongoing state voluntary disclosure processes prior to March 30, 2008.

19

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**8. SEGMENT REPORTING**

Operating segmentsare components of an enterprise about which separate financial information isavailable that is evaluated regularly by the chief operating decision-maker, ordecision-making group, in deciding how to allocate resources and in assessingperformance. The Company’s operating segments include restaurant, foodserviceand franchise. The revenues from these segments include both sales tounaffiliated customers and intersegment sales, which generally are accountedfor on a basis consistent with sales to unaffiliated customers. Intersegmentsales and other intersegment transactions have been eliminated in theaccompanying condensed consolidated financial statements.

The Company’srestaurants target families with children and adults who desire areasonably-priced meal in a full-service setting. The Company’s menuoffers a broad selection of freshly-prepared foods which appeal tocustomers throughout all dayparts. The menu currently features over 100 itemscomprised of a broad selection of breakfast, lunch, dinner and afternoon andevening snack items. The Company’s foodservice operations manufactures premiumice cream dessert products and distributes such manufactured products andpurchased finished goods to Company-operated and franchised restaurants.Additionally, the Company sells premium ice cream dessert products todistributors and retail locations. The Company’s franchise segment includes aroyalty based on franchise restaurant revenue. In addition, the Companyreceives rental income from various franchised restaurants. The Company doesnot allocate general and administrative expenses associated with itsheadquarters operations to any business segment. These costs include expensesof the following functions: legal, accounting, personnel not directly relatedto a segment, information systems and other headquarter activities.

The accountingpolicies of the operating segments are the same as those described in thesummary of significant accounting policies except that the financial resultsfor the foodservice operating segment, prior to intersegment eliminations, havebeen prepared using a management approach, which is consistent with the basisand manner in which the Company’s management internally reviews financialinformation. Using this approach, the Company evaluates performance based onstand-alone operating segment income (loss) before income taxes and generallyaccounts for intersegment sales and transfers as if the sales or transfers wereto third parties, that is, at current market prices.

Adjusted EBITDArepresents net income (loss) from continuing operations before (i) (provisionfor) benefit from income taxes, (ii) interest expense, net,(iii) depreciation and amortization, (iv) write-downs of property andequipment, (v) net periodic pension cost and (vi) other non-cash items.Adjusted EBITDA is a non-GAAP financial measure.  The Company has included informationconcerning adjusted EBITDA in this Form 10-Q because the Company’s managementincentive plan pays bonuses based on achieving operating segment adjustedEBITDA targets and the Company believes that such information is used bycertain investors as one measure of a company’s historical ability to servicedebt. Adjusted EBITDA should not be considered as an alternative to, or moremeaningful than, earnings (loss) from continuing operations or othertraditional indications of the Company’s operating performance.

Due to areorganization of the finance group, positions within the foodserviceaccounting department were absorbed by various corporate financedepartments.  The costs related to thosepositions are now included in general and administrative corporateexpenses.  Results for the three and sixmonths ended July 2, 2006 have been restated accordingly.  Adjusted EBITDA and loss from continuingoperations before benefit from income taxes have been restated to remove thecosts associated with this department of $110,000 and $230,000, respectively,during the three and six month periods ended July 2, 2006.

20

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| ** **             | ** ** | **For the Three Months Ended** | ** ** | **For the Six Months Ended** | ** ** |
|------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **             | ** ** | **July 1,  2007**                             | ** ** | **July 2,  2006**                           | ** ** | **July 1,  2007** | ** ** | **July 2,  2006** | ** ** |
| ** **             | ** ** | **(in thousands)**                            | ** ** | **(in thousands)**                          | ** ** |
| Revenues:              |       |                                               |       |                                             |       |   |   |   |   |
| Restaurant             |       | $                                                  | 107,173    |                                             | $          | 105,271 |   | $ | 199,970 |   | $ | 200,547 |   |
| Foodservice            |       | 63,422                                             |       | 62,891                                           |       | 117,009 |   | 117,849 |   |
| Franchise              |       | 3,937                                              |       | 4,082                                            |       | 7,432 |   | 7,627 |   |
| Total                  |       | $                                                  | 174,532    |                                             | $          | 172,244 |   | $ | 324,411 |   | $ | 326,023 |   |
|                   |       |                                               |       |                                             |       |   |   |   |   |
| Intersegment revenues: |       |                                               |       |                                             |       |   |   |   |   |
| Restaurant             |       | $                                                  | —     |                                             | $          | — |   | $ | — |   | $ | — |   |
| Foodservice            |       | (32,290                                            | )          | (30,754                                          | )          | (59,934 | ) | (58,818 | ) |
| Franchise              |       | —                                             |       | —                                           |       | — |   | — |   |
| Total                  |       | $                                                  | (32,290    | )                                                | $          | (30,754 | ) | $ | (59,934 | ) | $ | (58,818 | ) |
|                   |       |                                               |       |                                             |       |   |   |   |   |
| External revenues:     |       |                                               |       |                                             |       |   |   |   |   |
| Restaurant             |       | $                                                  | 107,173    |                                             | $          | 105,271 |   | $ | 199,970 |   | $ | 200,547 |   |
| Foodservice            |       | 31,132                                             |       | 32,137                                           |       | 57,075 |   | 59,031 |   |
| Franchise              |       | 3,937                                              |       | 4,082                                            |       | 7,432 |   | 7,627 |   |
| Total                  |       | $                                                  | 142,242    |                                             | $          | 141,490 |   | $ | 264,477 |   | $ | 267,205 |   |

 

21

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| ** **                                                                   | ** ** | **For the Three Months Ended** | ** ** | **For the Six Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                   | ** ** | **July 1,  2007**                             | ** ** | **July 2,  2006**                           | ** ** | **July 1,  2007** | ** ** | **July 2,  2006** | ** ** |
| ** **                                                                   | ** ** | **(in thousands)**                            | ** ** | **(in thousands)**                          | ** ** |
|                                                                         |       |                                               |       |                                             |       |   |   |   |   |
| Adjusted EBITDA:                                                             |       |                                               |       |                                             |       |   |   |   |   |
| Restaurant                                                                   |       | $                                                  | 9,819      |                                             | $          | 11,929 |   | $ | 15,564 |   | $ | 18,764 |   |
| Foodservice                                                                  |       | 3,677                                              |       | 5,748                                            |       | 6,853 |   | 8,415 |   |
| Franchise                                                                    |       | 2,720                                              |       | 2,889                                            |       | 4,836 |   | 5,307 |   |
| Corporate                                                                    |       | (6,440                                             | )          | (6,223                                           | )          | (11,980 | ) | (11,922 | ) |
| Gain on property  and equipment, net                                         |       | 406                                                |       | 779                                              |       | 373 |   | 1,537 |   |
| Add back pension  cost included in reporting segments                        |       | 337                                                |       | 308                                              |       | 674 |   | 778 |   |
| Total                                                                        |       | $                                                  | 10,519     |                                             | $          | 15,430 |   | $ | 16,320 |   | $ | 22,879 |   |
|                                                                         |       |                                               |       |                                             |       |   |   |   |   |
| Interest expense,  net-Corporate                                             |       | $                                                  | 4,952      |                                             | $          | 5,147 |   | $ | 9,876 |   | $ | 10,567 |   |
|                                                                         |       |                                               |       |                                             |       |   |   |   |   |
|                                                                         |       |                                               |       |                                             |       |   |   |   |   |
| Depreciation and  amortization:                                              |       |                                               |       |                                             |       |   |   |   |   |
| Restaurant                                                                   |       | $                                                  | 3,839      |                                             | $          | 4,021 |   | $ | 7,717 |   | $ | 8,164 |   |
| Foodservice                                                                  |       | 762                                                |       | 720                                              |       | 2,037 |   | 1,456 |   |
| Franchise                                                                    |       | 112                                                |       | 70                                               |       | 249 |   | 138 |   |
| Corporate                                                                    |       | 841                                                |       | 929                                              |       | 1,693 |   | 1,762 |   |
| Total                                                                        |       | $                                                  | 5,554      |                                             | $          | 5,740 |   | $ | 11,696 |   | $ | 11,520 |   |
|                                                                         |       |                                               |       |                                             |       |   |   |   |   |
| Other non-cash expense:                                                      |       |                                               |       |                                             |       |   |   |   |   |
| Net periodic  pension cost                                                   |       | $                                                  | 337        |                                             | $          | 308 |   | $ | 674 |   | $ | 778 |   |
| Write-downs of  property and equipment                                       |       | 409                                                |       | —                                           |       | 615 |   | 215 |   |
| Total                                                                        |       | $                                                  | 746        |                                             | $          | 308 |   | $ | 1,289 |   | $ | 993 |   |
|                                                                         |       |                                               |       |                                             |       |   |   |   |   |
| Income (loss) from  continuing operations before provision for income taxes: |       |                                               |       |                                             |       |   |   |   |   |
| Restaurant                                                                   |       | $                                                  | 5,980      |                                             | $          | 7,908 |   | $ | 7,847 |   | $ | 10,600 |   |
| Foodservice                                                                  |       | 2,915                                              |       | 5,028                                            |       | 4,816 |   | 6,959 |   |
| Franchise                                                                    |       | 2,608                                              |       | 2,819                                            |       | 4,587 |   | 5,169 |   |
| Corporate                                                                    |       | (12,233                                            | )          | (12,299                                          | )          | (23,549 | ) | (24,251 | ) |
| Gain on property  and equipment, net                                         |       | (3                                                 | )          | 779                                              |       | (242 | ) | 1,322 |   |
| Total                                                                        |       | $                                                  | (733       | )                                                | $          | 4,235 |   | $ | (6,541 | ) | $ | (201 | ) |

 

22

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|                                                                        | ** ** | **For the Six  Months Ended  July 1, 2007** | ** ** | **For the  Year Ended  December 31, 2006** | ** ** |
|------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                                             | ** ** | **(in thousands)**                                              | ** ** |
| Capital  expenditures, including assets acquired under capital leases: |       |                                                                 |       |                                                           |       |
| Restaurant                                                             |       | $                                                                    | 4,950      |                                                           | $          | 16,068 |   |
| Foodservice                                                            |       | 1,691                                                                |       | 4,306                                                          |       |
| Corporate                                                              |       | 245                                                                  |       | 1,350                                                          |       |
| Total                                                                  |       | $                                                                    | 6,886      |                                                           | $          | 21,724 |   |

 
|               | ** ** | **July 1,  2007**  | ** ** | **December 31,  2006** | ** ** |
|---------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **    | ** ** | **(in thousands)** | ** ** |
| Total assets: |       |                    |       |                        |       |
| Restaurant    |       | $                       | 115,718    |                        | $          | 119,787 |   |
| Foodservice   |       | 44,051                  |       | 40,875                      |       |
| Franchise     |       | 10,787                  |       | 11,827                      |       |
| Corporate     |       | 43,188                  |       | 47,678                      |       |
| Total         |       | $                       | 213,744    |                        | $          | 220,167 |   |

 

**9. SUPPLEMENTAL CONDENSEDCONSOLIDATING FINANCIAL INFORMATION**

FICC’s obligationrelated to its Senior Notes is guaranteed fully and unconditionally by one ofFICC’s wholly owned subsidiaries. There are no restrictions on FICC’s abilityto obtain dividends or other distributions of funds from this subsidiary,except those imposed by applicable law. The following supplemental financialinformation sets forth, on a condensed consolidating basis, balance sheets,statements of operations and statements of cash flows for FICC (the “ParentCompany”), Friendly’s Restaurants Franchise, LLC (the “Guarantor Subsidiary”)and Friendly’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 limitedliability companies’ (the “LLCs”) assets were owned by the LLCs, which areseparate entities with separate creditors which will be entitled to besatisfied out of the LLCs’ assets. Separate complete financial statements andother disclosures of the Guarantor Subsidiary as of July 1, 2007 and December31, 2006 and for the three and six months ended July 1, 2007 and July 2, 2006were not presented because management has determined that such information isnot material to investors.

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

23

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**Supplemental CondensedConsolidating Balance Sheet**

**As of July 1, 2007**

(In thousands)
| ** **                                                 | ** ** | **Parent  Company** | ** ** | **Guarantor  Subsidiary** | ** ** | **Non-  guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------------|------------|---------------------|------------|---------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
|                                                       |       |                |       |                      |       |                              |       |             |       |             |       |
| Assets                                                     |       |                |       |                      |       |                              |       |             |       |             |       |
|                                                       |       |                |       |                      |       |                              |       |             |       |             |       |
| Current assets:                                            |       |                |       |                      |       |                              |       |             |       |             |       |
| Cash and cash equivalents                                  |       | $                   | 18,546     |                      | $          | 1,075                             |       | $                | 2,306      |             | $          | — |   | $ | 21,927 |   |
| Restricted cash                                            |       | —              |       | —                    |       | 230                               |       | —           |       | 230              |       |
| Accounts receivable, net                                   |       | 11,233              |       | 2,019                     |       | —                            |       | —           |       | 13,252           |       |
| Inventories                                                |       | 17,610              |       | —                    |       | —                            |       | —           |       | 17,610           |       |
| Assets held for sale                                       |       | 896                 |       | —                    |       | —                            |       | —           |       | 896              |       |
| Deferred income taxes                                      |       | —              |       | 156                       |       | —                            |       | (156             | )          | —           |       |
| Prepaid expenses and other current assets                  |       | 3,795               |       | 74                        |       | 7,785                             |       | (8,359           | )          | 3,295            |       |
| Total current  assets                                      |       | 52,080              |       | 3,324                     |       | 10,321                            |       | (8,515           | )          | 57,210           |       |
| Deferred income  taxes                                     |       | 928                 |       | 288                       |       | —                            |       | (288             | )          | 928              |       |
| Property and  equipment, net                               |       | 92,717              |       | —                    |       | 39,612                            |       | —           |       | 132,329          |       |
| Intangibles and  deferred costs, net                       |       | 14,986              |       | —                    |       | 1,913                             |       | —           |       | 16,899           |       |
| Investments in  subsidiaries                               |       | 1,409               |       | —                    |       | —                            |       | (1,409           | )          | —           |       |
| Other assets                                               |       | 5,463               |       | 1,292                     |       | 915                               |       | (1,292           | )          | 6,378            |       |
|                                                       |       |                |       |                      |       |                              |       |             |       |             |       |
| Total assets                                               |       | $                   | 167,583    |                      | $          | 4,904                             |       | $                | 52,761     |             | $          | (11,504 | ) | $ | 213,744 |   |
|                                                       |       |                |       |                      |       |                              |       |             |       |             |       |
|                                                       |       |                |       |                      |       |                              |       |             |       |             |       |
| Liabilities and Stockholders’ (Deficit) Equity        |       |                |       |                      |       |                              |       |             |       |             |       |
|                                                       |       |                |       |                      |       |                              |       |             |       |             |       |
| Current  liabilities:                                      |       |                |       |                      |       |                              |       |             |       |             |       |
| Current maturities of long-term obligations                |       | $                   | 9,506      |                      | $          | —                            |       | $                | 1,564      |             | $          | (7,776 | ) | $ | 3,294 |   |
| Accounts payable                                           |       | 24,970              |       | —                    |       | —                            |       | —           |       | 24,970           |       |
| Deferred income taxes                                      |       | 156                 |       | —                    |       | —                            |       | (156             | )          | —           |       |
| Accrued expenses                                           |       | 37,365              |       | 1,712                     |       | 1,508                             |       | (583             | )          | 40,002           |       |
| Total current  liabilities                                 |       | 71,997              |       | 1,712                     |       | 3,072                             |       | (8,515           | )          | 68,266           |       |
| Deferred income  taxes                                     |       | 288                 |       | —                    |       | —                            |       | (288             | )          | —           |       |
| Long-term  obligations, less current maturities            |       | 179,798             |       | —                    |       | 45,865                            |       | —           |       | 225,663          |       |
| Other long-term  liabilities                               |       | 48,165              |       | 545                       |       | 5,062                             |       | (1,292           | )          | 52,480           |       |
| Stockholders’  (deficit) equity                       |       | (132,665            | )          | 2,647                     |       | (1,238                            | )          | (1,409           | )          | (132,665         | )          |
|                                                       |       |                |       |                      |       |                              |       |             |       |             |       |
| Total liabilities and  stockholders’ (deficit) equity |       | $                   | 167,583    |                      | $          | 4,904                             |       | $                | 52,761     |             | $          | (11,504 | ) | $ | 213,744 |   |

 

24

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**Supplemental CondensedConsolidating Statement of Operations**

**For the Three Months Ended July1, 2007**

(In thousands)
| ** **                                                                                                             | ** ** | **Parent  Company** | ** ** | **Guarantor  Subsidiary** | ** ** | **Non-  guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|---------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
|                                                                                                                   |       |                |       |                      |       |                              |       |             |       |             |       |
| Revenues                                                                                                               |       | $                   | 139,332    |                      | $          | 2,910                             |       | $                | —     |             | $          | — |   | $ | 142,242 |   |
|                                                                                                                   |       |                |       |                      |       |                              |       |             |       |             |       |
| Costs and expenses:                                                                                                    |       |                |       |                      |       |                              |       |             |       |             |       |
| Cost of sales                                                                                                          |       | 54,642              |       | —                    |       | —                            |       | —           |       | 54,642           |       |
| Labor and  benefits                                                                                                    |       | 38,577              |       | —                    |       | —                            |       | —           |       | 38,577           |       |
| Operating  expenses and write-downs of property and equipment                                                          |       | 29,976              |       | —                    |       | (1,613                            | )          | —           |       | 28,363           |       |
| General and  administrative expenses                                                                                   |       | 10,136              |       | 1,155                     |       | —                            |       | —           |       | 11,291           |       |
| Depreciation and  amortization                                                                                         |       | 5,018               |       | —                    |       | 536                               |       | —           |       | 5,554            |       |
| Gain on franchise sales  of restaurant operations and properties                                                       |       | —              |       | —                    |       | —                            |       | —           |       | —           |       |
| (Gain) loss on  disposals of other property and equipment, net                                                         |       | (408                | )          | —                    |       | 4                                 |       | —           |       | (404             | )          |
| Interest expense, net                                                                                                  |       | 3,903               |       | —                    |       | 1,049                             |       | —           |       | 4,952            |       |
|                                                                                                                   |       |                |       |                      |       |                              |       |             |       |             |       |
| (Loss) income before  benefit from (provision for) income taxes and equity in net income of  consolidated subsidiaries |       | (2,512              | )          | 1,755                     |       | 24                                |       | —           |       | (733             | )          |
|                                                                                                                   |       |                |       |                      |       |                              |       |             |       |             |       |
| Benefit from (provision  for) income taxes                                                                             |       | 9                   |       | —                    |       | (57                               | )          | —           |       | (48              | )          |
|                                                                                                                   |       |                |       |                      |       |                              |       |             |       |             |       |
| (Loss) income from  continuing operations                                                                              |       | (2,503              | )          | 1,755                     |       | (33                               | )          | —           |       | (781             | )          |
|                                                                                                                   |       |                |       |                      |       |                              |       |             |       |             |       |
| Income from  discontinued operations                                                                                   |       | 493                 |       | —                    |       | —                            |       | —           |       | 493              |       |
|                                                                                                                   |       |                |       |                      |       |                              |       |             |       |             |       |
| (Loss) income before equity  in net income of consolidated subsidiaries                                                |       | (2,010              | )          | 1,755                     |       | (33                               | )          | —           |       | (288             | )          |
|                                                                                                                   |       |                |       |                      |       |                              |       |             |       |             |       |
| Equity in net income of  consolidated subsidiaries                                                                     |       | 1,722               |       | —                    |       | —                            |       | (1,722           | )          | —           |       |
|                                                                                                                   |       |                |       |                      |       |                              |       |             |       |             |       |
| Net (loss) income                                                                                                      |       | $                   | (288       | )                         | $          | 1,755                             |       | $                | (33        | )                | $          | (1,722 | ) | $ | (288 | ) |

 

25

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**Supplemental CondensedConsolidating Statement of Operations**

**For the Six Months Ended July 1,2007**

(In thousands)

 
| ** **                                                                                                             | ** ** | **Parent  Company** | ** ** | **Guarantor  Subsidiary** | ** ** | **Non-  guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|---------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
|                                                                                                                   |       |                |       |                      |       |                              |       |             |       |             |       |
| Revenues                                                                                                               |       | $                   | 259,124    |                      | $          | 5,353                             |       | $                | —     |             | $          | — |   | $ | 264,477 |   |
|                                                                                                                   |       |                |       |                      |       |                              |       |             |       |             |       |
| Costs and  expenses:                                                                                                   |       |                |       |                      |       |                              |       |             |       |             |       |
| Cost of sales                                                                                                          |       | 101,627             |       | —                    |       | —                            |       | —           |       | 101,627          |       |
| Labor and benefits                                                                                                     |       | 72,824              |       | —                    |       | —                            |       | —           |       | 72,824           |       |
| Operating expenses and write-downs of property and  equipment                                                          |       | 56,659              |       | —                    |       | (3,219                            | )          | —           |       | 53,440           |       |
| General and administrative expenses                                                                                    |       | 19,615              |       | 2,310                     |       | —                            |       | —           |       | 21,925           |       |
| Depreciation and amortization                                                                                          |       | 10,626              |       | —                    |       | 1,070                             |       | —           |       | 11,696           |       |
| Gain on  franchise sales of restaurant operations and properties                                                       |       | —              |       | —                    |       | —                            |       | —           |       | —           |       |
| (Gain) loss on  disposals of other property and equipment, net                                                         |       | (374                | )          | —                    |       | 4                                 |       | —           |       | (370             | )          |
| Interest  expense, net                                                                                                 |       | 7,780               |       | —                    |       | 2,096                             |       | —           |       | 9,876            |       |
|                                                                                                                   |       |                |       |                      |       |                              |       |             |       |             |       |
| (Loss) income  before benefit from (provision for) income taxes and equity in net income of  consolidated subsidiaries |       | (9,633              | )          | 3,043                     |       | 49                                |       | —           |       | (6,541           | )          |
|                                                                                                                   |       |                |       |                      |       |                              |       |             |       |             |       |
| Benefit from  (provision for) income taxes                                                                             |       | 497                 |       | (528                      | )          | (111                              | )          | —           |       | (142             | )          |
|                                                                                                                   |       |                |       |                      |       |                              |       |             |       |             |       |
| (Loss) income  from continuing operations                                                                              |       | (9,136              | )          | 2,515                     |       | (62                               | )          | —           |       | (6,683           | )          |
|                                                                                                                   |       |                |       |                      |       |                              |       |             |       |             |       |
| Income from  discontinued operations                                                                                   |       | 442                 |       | —                    |       | —                            |       | —           |       | 442              |       |
|                                                                                                                   |       |                |       |                      |       |                              |       |             |       |             |       |
| (Loss) income  before equity in net income of consolidated subsidiaries                                                |       | (8,694              | )          | 2,515                     |       | (62                               | )          | —           |       | (6,241           | )          |
|                                                                                                                   |       |                |       |                      |       |                              |       |             |       |             |       |
| Equity in net  income of consolidated subsidiaries                                                                     |       | 2,453               |       | —                    |       | —                            |       | (2,453           | )          | —           |       |
|                                                                                                                   |       |                |       |                      |       |                              |       |             |       |             |       |
| Net (loss) income                                                                                                      |       | $                   | (6,241     | )                         | $          | 2,515                             |       | $                | (62        | )                | $          | (2,453 | ) | $ | (6,241 | ) |

 

26

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**Supplemental CondensedConsolidating Statement of Cash Flows**

**For the Six Months Ended July 1,2007**

(In thousands)
| ** **                                                | ** ** | **Parent  Company** | ** ** | **Guarantor  Subsidiary** | ** ** | **Non-  guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------|------------|---------------------|------------|---------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
|                                                      |       |                |       |                      |       |                              |       |             |       |             |       |
| Net cash provided by  (used in) operating activities      |       | $                   | 3,096      |                      | $          | 277                               |       | $                | 1,276      |             | $          | (309 | ) | $ | 4,340 |   |
|                                                      |       |                |       |                      |       |                              |       |             |       |             |       |
| Cash flows from  investing activities:                    |       |                |       |                      |       |                              |       |             |       |             |       |
| Purchases of  property and equipment                      |       | (6,851              | )          | —                    |       | —                            |       | —           |       | (6,851           | )          |
| Proceeds from  sales of property and equipment            |       | 720                 |       | —                    |       | —                            |       | —           |       | 720              |       |
| Return of  investment in subsidiary                       |       | 151                 |       | —                    |       | —                            |       | (151             | )          | —           |       |
| Net cash used in  investing activities                    |       | (5,980              | )          | —                    |       | —                            |       | (151             | )          | (6,131           | )          |
|                                                      |       |                |       |                      |       |                              |       |             |       |             |       |
| Cash flows from  financing activities:                    |       |                |       |                      |       |                              |       |             |       |             |       |
| Proceeds from  borrowings under revolving credit facility |       | —              |       | —                    |       | —                            |       | —           |       | —           |       |
| Repayments of  obligations                                |       | (783                | )          | —                    |       | (731                              | )          | —           |       | (1,514           | )          |
| Payments of  deferred financing costs                     |       | —              |       | —                    |       | —                            |       | —           |       | —           |       |
| Stock options  exercised                                  |       | 155                 |       | —                    |       | —                            |       | —           |       | 155              |       |
| Reinsurance  payments made from deposits                  |       | —              |       | —                    |       | (309                              | )          | 309              |       | —           |       |
| Dividends paid                                            |       | —              |       | —                    |       | (151                              | )          | 151              |       | —           |       |
| Net cash used in  financing activities                    |       | (628                | )          | —                    |       | (1,191                            | )          | 460              |       | (1,359           | )          |
|                                                      |       |                |       |                      |       |                              |       |             |       |             |       |
| Net (decrease) increase  in cash and cash equivalents     |       | (3,512              | )          | 277                       |       | 85                                |       | —           |       | (3,150           | )          |
|                                                      |       |                |       |                      |       |                              |       |             |       |             |       |
| Cash and cash  equivalents, beginning of period           |       | 22,058              |       | 798                       |       | 2,221                             |       | —           |       | 25,077           |       |
|                                                      |       |                |       |                      |       |                              |       |             |       |             |       |
| Cash and cash  equivalents, end of period                 |       | $                   | 18,546     |                      | $          | 1,075                             |       | $                | 2,306      |             | $          | — |   | $ | 21,927 |   |
|                                                      |       |                |       |                      |       |                              |       |             |       |             |       |
| Supplemental  disclosures:                                |       |                |       |                      |       |                              |       |             |       |             |       |
| Interest paid                                             |       | $                   | 7,763      |                      | $          | —                            |       | $                | 2,113      |             | $          | — |   | $ | 9,876 |   |
| Income taxes  paid                                        |       | 73                  |       | 155                       |       | 61                                |       | —           |       | 289              |       |
| Capital lease  obligations incurred                       |       | 35                  |       | —                    |       | —                            |       | —           |       | 35               |       |
| Non-cash  dividend paid to parent                         |       | 1,000               |       | (1,000                    | )          | —                            |       | —           |       | —           |       |
| Note received from sale  of lease rights                  |       | 750                 |       | —                    |       | —                            |       | —           |       | 750              |       |

 

27

----

**Supplemental CondensedConsolidating Balance Sheet**

**As of December 31, 2006**

(In thousands)
| ** **                                                 | ** ** | **Parent  Company** | ** ** | **Guarantor  Subsidiary** | ** ** | **Non-  guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------------|------------|---------------------|------------|---------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
|                                                       |       |                |       |                      |       |                              |       |             |       |             |       |
| Assets                                                     |       |                |       |                      |       |                              |       |             |       |             |       |
|                                                       |       |                |       |                      |       |                              |       |             |       |             |       |
| Current assets:                                            |       |                |       |                      |       |                              |       |             |       |             |       |
| Cash and cash equivalents                                  |       | $                   | 22,057     |                      | $          | 798                               |       | $                | 2,222      |             | $          | — |   | $ | 25,077 |   |
| Restricted cash                                            |       | —              |       | —                    |       | 517                               |       | —           |       | 517              |       |
| Accounts receivable, net                                   |       | 9,593               |       | 1,842                     |       | 7,776                             |       | (7,776           | )          | 11,435           |       |
| Inventories                                                |       | 17,059              |       | —                    |       | —                            |       | —           |       | 17,059           |       |
| Assets held for sale                                       |       | 896                 |       | —                    |       | —                            |       | —           |       | 896              |       |
| Deferred income taxes                                      |       | —              |       | 156                       |       | —                            |       | (156             | )          | —           |       |
| Prepaid expenses and other current assets                  |       | 3,181               |       | (2                        | )          | 9                                 |       | (61              | )          | 3,127            |       |
| Total current  assets                                      |       | 52,786              |       | 2,794                     |       | 10,524                            |       | (7,993           | )          | 58,111           |       |
| Deferred income  taxes                                     |       | 928                 |       | 288                       |       | —                            |       | (288             | )          | 928              |       |
| Property and  equipment, net                               |       | 96,850              |       | —                    |       | 40,575                            |       | —           |       | 137,425          |       |
| Intangibles and  deferred costs, net                       |       | 15,759              |       | —                    |       | 2,024                             |       | —           |       | 17,783           |       |
| Investments in  subsidiaries                               |       | 107                 |       | —                    |       | —                            |       | (107             | )          | —           |       |
| Other assets                                               |       | 5,005               |       | 851                       |       | 915                               |       | (851             | )          | 5,920            |       |
|                                                       |       |                |       |                      |       |                              |       |             |       |             |       |
| Total assets                                               |       | $                   | 171,435    |                      | $          | 3,933                             |       | $                | 54,038     |             | $          | (9,239 | ) | $ | 220,167 |   |
|                                                       |       |                |       |                      |       |                              |       |             |       |             |       |
| Liabilities and Stockholders’ (Deficit) Equity        |       |                |       |                      |       |                              |       |             |       |             |       |
|                                                       |       |                |       |                      |       |                              |       |             |       |             |       |
| Current  liabilities:                                      |       |                |       |                      |       |                              |       |             |       |             |       |
| Current maturities of long-term obligations                |       | $                   | 9,387      |                      | $          | —                            |       | $                | 1,493      |             | $          | (7,776 | ) | $ | 3,104 |   |
| Accounts payable                                           |       | 22,247              |       | —                    |       | —                            |       | —           |       | 22,247           |       |
| Accrued expenses                                           |       | 39,926              |       | 2,098                     |       | 1,533                             |       | (217             | )          | 43,340           |       |
| Total current  liabilities                                 |       | 71,560              |       | 2,098                     |       | 3,026                             |       | (7,993           | )          | 68,691           |       |
| Long-term  obligations, less current maturities            |       | 180,665             |       | —                    |       | 46,667                            |       | —           |       | 227,332          |       |
| Other long-term  liabilities                               |       | 46,106              |       | 702                       |       | 5,371                             |       | (1,139           | )          | 51,040           |       |
| Stockholders’  (deficit) equity                       |       | (126,896            | )          | 1,133                     |       | (1,026                            | )          | (107             | )          | (126,896         | )          |
|                                                       |       |                |       |                      |       |                              |       |             |       |             |       |
| Total liabilities and  stockholders’ (deficit) equity |       | $                   | 171,435    |                      | $          | 3,933                             |       | $                | 54,038     |             | $          | (9,239 | ) | $ | 220,167 |   |

 

28

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**Supplemental CondensedConsolidating Statement of Operations**

**For the Three Months Ended July2, 2006**

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

 

29

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**Supplemental CondensedConsolidating Statement of Operations**

**For the Six Months Ended July 2,2006**

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

 

30

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**Supplemental CondensedConsolidating Statement of Cash Flows**

**For the Six Months Ended July 2,2006**

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

 

31

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

*The following discussion should be read inconjunction with the Condensed Consolidated Financial Statements of the Companyand the notes thereto included elsewhere herein.*

**Forward Looking Statements**

Statementscontained herein that are not historical facts constitute “forward lookingstatements” as that term is defined in the Private Securities Litigation ReformAct of 1995. Words such as “believes,” “plans,” “anticipates,” “expects,” “will”and similar expressions are intended to identify forward lookingstatements.  Forward looking statements include, but are not limited to,statements relating to the sufficiency of our capital resources, trendsrelating to our results of operations, changes in commodity prices, anticipatedcapital expenditures, estimates and assumptions used in the preparation of ourfinancial statements, and the anticipated impact, benefits, results and timingof our proposed merger with an affiliate of Sun Capital Partners and thetransactions contemplated thereby.

Allforward looking statements are subject to known and unknown risks,uncertainties and other factors which could cause our or the foodserviceindustry’s actual results, performance or achievements to be materiallydifferent from any future results, performance or achievements expressed orimplied by the forward-looking statements. These factors include: our highlycompetitive business environment; exposure to fluctuating commodity prices;risks associated with the foodservice industry, such as changes in consumertastes and adverse publicity resulting from food quality, illness, injury orother health concerns; the ability to retain and attract new and qualifiedemployees; government regulations; high geographic concentration in theNortheast and its attendant weather patterns; conditions needed to meetrestaurant re-imaging and new opening targets; risks and uncertainties arisingout of accounting estimates and adjustments; our ability to service our debtand other obligations; our ability to meet ongoing financial covenantscontained in our debt instruments, loan agreements, leases and other long-termcommitments; unforeseen or increased costs associated with litigation andsimilar matters; costs associated with improved service and other initiatives;and the risks relating to the proposed merger set forth in Item 1A of Part IIof this Form 10-Q.  Other factors thatcould adversely affect our business and prospects are described in our filingswith the Securities and Exchange Commission, including our most recent filingson Form 10-K, 10-Q and 8-K.

Giventhese uncertainties, you should not place undue reliance on theseforward-looking statements. Also, these forward-looking statements representour estimates and assumptions only as of the date of this report.  Exceptas otherwise required by law, we expressly disclaim any obligation or undertakingto release publicly any updates or revisions to any forward-looking statementcontained in this report to reflect any change in expectations or any change inevents, conditions or circumstances on which any of our forward-lookingstatements are based.

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**Overview**

We are a leading full-service, casual diningrestaurant company and provider of premium ice cream products with locationsprimarily in the Northeast.  As of July1, 2007, we operated 316 full-service restaurants and franchised 199 full-servicerestaurants and seven non-traditional units, located in 16 states.

Our revenues are derived from three primary sources:

·                  Restaurantrevenue, which consists of sales from Company-operated full-servicerestaurants;

·                  Foodservicerevenue, which consists of sales of food and premium ice cream products that wedistribute and sell to our franchisees and to more than 4,000 supermarkets andother retail locations in 12 states; and

·                  Franchiserevenue, which consists of franchise fees, royalty income we receive from ourfranchisees, and other franchise income. Initial franchise fees typically rangefrom $30,000 to $35,000 for each restaurant opened.  Franchise royalties are generally 4% of eachfranchise restaurant’s monthly net sales. Other franchise income includes rental income on any properties we ownand lease or sublease to franchisees.

Following is a summary of the Company-operated and franchised units:
|                            | ** ** | **For the Three Months Ended** | ** ** | **For the Six Months Ended** | ** ** |
|----------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                 | ** ** | **July 1,  2007**                             | ** ** | **July 2,  2006**                           | ** ** | **July 1,  2007** | ** ** | **July 2,  2006** | ** ** |
|                       |       |                                               |       |                                             |       |   |   |   |   |
| Company Units:             |       |                                               |       |                                             |       |   |   |   |   |
| Beginning of  period       |       | 317                                                |       | 312                                              |       | 316 |   | 314 |   |
| Openings                   |       | —                                             |       | 1                                                |       | 1 |   | 2 |   |
| Acquired from  franchisees |       | —                                             |       | —                                           |       | 1 |   | — |   |
| Acquired by  franchisees   |       | —                                             |       | (3                                               | )          | — |   | (4 | ) |
| Closings                   |       | (1                                                 | )          | (1                                               | )          | (2 | ) | (3 | ) |
| End of period              |       | 316                                                |       | 309                                              |       | 316 |   | 309 |   |
|                       |       |                                               |       |                                             |       |   |   |   |   |
| Franchised  Units:         |       |                                               |       |                                             |       |   |   |   |   |
| Beginning of  period       |       | 205                                                |       | 214                                              |       | 205 |   | 213 |   |
| Openings                   |       | 3                                                  |       | 1                                                |       | 4 |   | 1 |   |
| Acquired by  franchisees   |       | —                                             |       | 3                                                |       | — |   | 4 |   |
| Acquired from  franchisees |       | —                                             |       | —                                           |       | (1 | ) | — |   |
| Closings                   |       | (2                                                 | )          | (1                                               | )          | (2 | ) | (1 | ) |
| End of period              |       | 206                                                |       | 217                                              |       | 206 |   | 217 |   |

 

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***Recent Developments***

OnJune 17, 2007, we entered into a definitive merger agreement (the “MergerAgreement”) with Freeze Operations Holding Corp. (“Parent”) and FreezeOperations, Inc., a wholly owned subsidiary of Parent (“Merger Sub”), pursuantto which, subject to the satisfaction or waiver of the conditions therein,Merger Sub will merge with and into us, and we would continue as the survivingcorporation of the merger (the “Merger”). Parent is an affiliate of Sun Capital Partners, a private equityfirm.  Upon completion of the Merger, (i)we will become a privately held, wholly owned subsidiary of Parent, (ii) eachshare of our common stock issued and outstanding immediately prior to thecompletion of the Merger (other than shares held in treasury by us or held byany wholly owned subsidiary of the Company) will be converted into the right toreceive $15.50 in cash (the “Merger Consideration”), (iii) each option topurchase our common stock that is outstanding and unexercised immediately priorto the completion of the Merger will be canceled and converted into the rightto receive an amount in cash as provided in the Merger Agreement and (iv) eachrestricted share that is outstanding immediately prior to the completion of theMerger will be canceled and converted into the right to receive, in respect ofeach underlying share of our common stock, the Merger Consideration.

Wehave made customary representations and warranties and covenants in the MergerAgreement, including covenants relating to obtaining the requisite approval ofour shareholders, the conduct of our business between the date of the signingof the Merger Agreement and the closing of the transaction and, subject tocertain exceptions, our agreement not to solicit, enter into discussionsregarding, or provide information in connection with, alternative transactions.

TheMerger Agreement has been approved by our board of directors. Completion of thetransaction is not subject to a financing condition, but is subject tocustomary conditions to closing, including, among other things, the adoption ofthe Merger Agreement by our shareholders. The U.S. antitrust agencies have granted early termination of thewaiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, asamended.  The Merger Agreement containscertain termination rights of both parties and provides that, upon thetermination of the Merger Agreement under certain circumstances, we would berequired to pay Parent a termination fee of $5.0 million plus certain expensesof Parent, and Parent would be required to pay us a termination fee of $5.0million. A Special Meeting of Shareholders has been scheduled for August 29,2007 for a vote on the proposed Merger and the transaction is expected to closein the third quarter of 2007.

The Company expects that shortly after shareholderapproval is received, the transaction will close.  In connection with the closing, the Companyexpects to record compensation expense in the amount of $6.4 million related tothe acceleration of stock options, restricted stock, restricted stock units andperformance units.

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On July 26, 2007, at the request of Parent pursuant tothe terms of the Merger Agreement and in connection with the Merger, wecommenced an offer (the “Offer”) to purchase for cash any and all of ouroutstanding Senior Notes, on the terms and subject to the conditions set forthin our Offer to Purchase and Solicitation Statement dated July 26, 2007 (the “Offerto Purchase and Solicitation Statement”). We are also soliciting consents (the “Solicitation”) from holders of theSenior Notes for certain amendments to the indenture governing the Senior Notesthat would, among other things, eliminate substantially all of the restrictivecovenants and certain events of default contained in the indenture under whichthe Senior Notes were issued.  TheSolicitation is expected to expire at 5:00 p.m., New York City time, on August8, 2007, unless earlier extended or terminated (the “Consent Date”), and theOffer is expected to expire at 12:00 a.m., New York City Time, on August 22,2007, unless extended or earlier terminated (the “Expiration Time”).  The total consideration to be paid for each$1,000 in principal amount of the Senior Notes validly tendered and acceptedfor purchase will be paid in cash and will be calculated based on a fixedspread pricing formula.  The totalconsideration will be determined on the tenth business day prior to theExpiration Time of the Offer based, in part, upon a fixed spread of 50 basispoints over the yield of the 4.875% U.S. Treasury Note due May 31, 2008.  The total consideration includes a consentpayment equal to $30 per $1,000 in principal amount of the Senior Notes.  The detailed methodology for calculating thetotal consideration for the Senior Notes is outlined in the Offer to Purchaseand Solicitation Statement. Holders of Senior Notes who tender on or prior tothe Consent Date will be eligible to receive the total consideration, andholders who validly tender their Senior Notes after the Consent Date, but on orprior to the Expiration Time, will be eligible to receive the totalconsideration less the consent payment. In either case, all holders who validly tender their Senior Notes willreceive accrued and unpaid interest up to, but not including the date ofsettlement. The Offer and Solicitation are conditioned on the closing of theMerger, the receipt of valid consents from holders of a majority of theaggregate principal amount of the Senior Notes, the execution and delivery of asupplemental indenture which implements the proposed amendments in respect ofthe Senior Notes upon receipt of the consents required for those amendments,and certain other general conditions. The completion of the Offer and Solicitation is not a condition to thecompletion of the Merger.

***Discontinued Operations***

SFAS No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets,” requires the results ofoperations of a component of an entity that is classified as held for sale orthat has been disposed of to be reported as discontinued operations in thestatement of operations if certain conditions are met. These conditions includecommitment to a plan of disposal after the effective date of this statement,elimination of the operations and cash flows of the entity component from ourongoing operations and no significant continuing involvement in the operationsof the entity component after the disposal transaction.

In accordance with SFAS No. 144, the results ofoperations of the eight properties that were disposed of during 2006 and anyrelated net gain on the disposals, as well as the results of operations ofthree properties held for sale at July 1, 2007 were reported separately asdiscontinued operations in the accompanying condensed consolidated statementsof operations for the three and six months ended July 1, 2007 and July 2, 2006.

During 2006, weclosed one restaurant and committed to a plan to sell that restaurant.  At July 1, 2007, this property met thecriteria for “held for sale” as defined in SFAS No. 144.  The results of operations associated withthis restaurant were not material and therefore were reported within continuingoperations in the accompanying condensed consolidated statements of operationsfor all periods presented.

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***Three Months Ended July 1, 2007 Compared With Three MonthsEnded July 2, 2006***

*Revenues:*

*Totalrevenues -* Total revenues increased $0.7 million, or 0.5%, to$142.2 million for the three months ended July 1, 2007 from $141.5 million forthe same quarter in 2006.

Restaurant revenues - Restaurant revenues increased$1.9 million, or 1.8%, to $107.2 million for the three months ended July 1,2007 from $105.3 million for the same period in 2006. ComparableCompany-operated restaurant revenues during this period decreased slightly by0.3% compared to a decrease of 1.8% experienced during the same period in2006.  The opening of two new restaurantsand the assumption of the operation of twelve formerly franchised restaurantsover the past 15 months resulted in increased revenues of $3.8 million.  We began operating the twelve restaurants inDecember 2006 following a default and peaceful surrender by a former franchiseeunder its leases and franchise agreements with us. We and the former franchisee’slenders and landlord had entered into agreements pursuant to which we agreed tomake recurring monthly rent and loan payments and the lenders and landlordagreed not to interfere with our operations while we operate therestaurants.  Except for our agreement tomake certain payments while we are operating the restaurants, we did not assumeany of the former franchisee’s obligations to its lender.  On July 26, 2007, we terminated theseagreements.  We are currently operatingthese restaurants while we search for a new franchisee to take over theiroperation.  If the properties are notre-franchised, we may acquire or close the restaurants, at our option.

The closing of five locations and the acquisition offive Company-operated locations by franchisees over the past 15 months resultedin declines of $0.8 million and $1.1 million, respectively, in restaurantrevenues in the three months ended July 1, 2007 as compared to the same periodin 2006.

There was one new restaurant opened during the secondquarter of 2006.  There were no new restaurantsopened during the second quarter of 2007.

*Foodservice revenues -* Foodservicerevenues (product sales to franchisees and retail customers) decreased $1.0million, or 3.1%, to $31.1 million for the three months ended July 1, 2007 from$32.1 million for the three months ended July 2, 2006. Sales to foodserviceretail supermarket customers decreased $1.8 million in the three months endedJuly 1, 2007 compared to the same period in 2006 primarily due to lower casevolume of 10.4% and higher promotional trade spending and sales allowances of2.7% of sales during the period. Franchised restaurant product revenue increased $0.8 million primarilydue to higher prices for commodities which are passed along to franchised restaurants.  This increase was partially offset by a 2.7%reduction in comparable franchised restaurant revenues which was experiencedduring the three months ended July 1, 2007, compared to the 3.9% decrease incomparable franchised restaurant revenues experienced in the three months endedJuly 2, 2006.

*Franchiserevenues -* Franchise revenues decreased $0.2 million, or 3.6%to $3.9 million for the three months ended July 1, 2007 from $4.1 million forthe three months ended July 2, 2006.

Royalties of $2.8 million decreased $0.1 million forthe three months ended July 1, 2007 as compared to the same period in 2006 dueprimarily to a lower average number of operating franchised restaurantsthroughout the quarter (206 for the 2007 quarter compared to 215 for the 2006quarter).  Additionally, a 2.7% reductionin comparable franchised restaurant revenues was experienced during the threemonths ended July 1, 2007, compared to the 3.9% decrease in comparablefranchised restaurant revenues experienced in the three months ended July 2,2006.

Initial franchise fees and rental income for leasedand subleased franchise locations remained flat at $0.1 million and $1.0million, respectively, during both of the three month periods ended July 1,2007 and July 2, 2006.

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*Cost of sales:*

Costof sales increased $2.7 million, or 5.2%, to $54.6 million for the three monthsended July 1, 2007 from $51.9 million for the same period in 2006. Cost ofsales as a percentage of total revenues was 38.4% and 36.7% for the threemonths ended July 1, 2007 and July 2, 2006, respectively. This unfavorablechange resulted primarily from a 1.1% increase in cost of sales experiencedwithin the foodservice segment due primarily to increases in the cost of dairyrelated raw material ingredients (milk, cream) and certain dry powders (whey protein),as the overall sales mix between restaurants and foodservice remainedessentially the same year over year.

Restaurantcost of sales as a percentage of restaurant revenues increased to 26.6% for thethree months ended July 1, 2007 from 26.1% for the same period in 2006. Thisincrease was due primarily to normal increases in prices for commodities(French fries, beverages, fry oil and dairy related products), as menu pricingwas only marginally up year over year.

Foodservicecost of sales as a percentage of foodservice revenues increased to 84.0% in thethree months ended July 1, 2007 from 76.3% in the three months ended July 2,2006. This increase was primarily a result of higher costs of dairy related rawmaterial ingredients (milk and cream) and whey protein in the 2007 periodcompared to the same period in 2006.

Theoverall cost of cream was approximately $0.3 million higher in the three monthperiod ended July 1, 2007 (weighted average price of $1.35 per pound) whencompared to the same period in 2006 (weighted average price of $1.15 perpound).  Additionally, market gains oncash-settled butter futures contracts were $0.1 million during the three monthsended July 1, 2007 as compared to market losses of $0.1 million experienced onbutter future contracts during the three months ended July 2, 2006.  Approximately 70% of this $0.2 million netcost of sales benefit on a year to date basis was reported within ourfoodservice segment.

Thecost of cream, the principal ingredient used in making ice cream, affects ourcosts of sales as a percentage of total revenues, especially in our foodserviceretail business.  The price of cream isdirectly affected by changes in the market price for AA butter traded on theChicago Mercantile Exchange.  As anexample, a $0.10 increase in the cost of a pound of AA butter affects ourannual costs of sales by approximately $0.9 million.  This adverse impact may be offset by priceincreases or other factors.  However, noassurance can be given that we will be able to offset any cost increases in thefuture and future increases in cream prices could have a material adverseeffect on our results of operations.  Tominimize risk, alternative supply sources continue to be pursued.

When available, wepurchase butter option and/or futures contracts to minimize the impact ofincreases in the cost of cream. Our strategy related to hedging is never tohedge more than 50% of our needs using these instruments, so as not to put usin an uncompetitive position.  Optioncontracts are offered in the months of March, May, July, September, October andDecember; however, there is often not enough open interest in them to allow usto buy even very limited coverage without paying high premiums.  Our commodity option contracts andcash-settled butter futures contracts do not meet hedge accounting criteria asdefined by SFAS No. 133, “Accounting for Certain Derivative Instruments andCertain Hedging Activities,” and its related amendment, SFAS No. 138, “Accountingfor Certain Derivative Instruments and Certain Hedging Activities,” andaccordingly, are marked to market each period with the resulting gains orlosses recognized in cost of sales.

At July 1, 2007, we held42 contracts, spread over the remaining months of 2007.  These contracts correspond to approximately20% of our anticipated cream purchases for the periods represented.

For the remainder of2007, we expect that cream prices will be higher than the prices experiencedfor the same period in 2006 due to the spread in the futures market compared tothe actual prices of last year.

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*Labor and benefits:*

Labor and benefits, which were only reported withinour restaurant segment, increased $1.7 million, or 4.4%, to $38.6 million forthe three months ended July 1, 2007 from $36.9 million for the three monthsended July 2, 2006. As a percentage of total revenues, labor and benefitsincreased to 27.1% for the three months ended July 1, 2007 from 26.1% for thethree months ended July 2, 2006. Labor and benefits, as a percentage of Companyrestaurant revenue only, increased to 36.0% for the three months ended July 1,2007 from 35.1% for the same period in 2006. The increase was partially aresult of additional labor hours required to serve samples associated with therollout of cold beverages in June along with normal wage rate pressures aspricing was minimal during the three month period.  The increase in hourly labor was partiallyoffset by reduced group insurance costs and lower general manager bonus.

*Operating expenses:*

Operating expenses increased $1.2 million, or 4.2%, to$28.0 million for the three months ended July 1, 2007 from $26.8 million forthe three months ended July 2, 2006. Operating expenses as a percentage of total revenues were 19.7% and19.0% in the 2007 and 2006 periods, respectively. A significant portion ofthese expenses ($26.8 million in 2007 and $25.2 million in 2006) were reportedwithin our restaurant segment. In the three months ended July 1, 2007, thesecosts consisted of $4.3 million in supplies, $4.6 million in utilities, $2.8million in maintenance, $5.2 million in advertising, $5.7 million in occupancyand $4.2 million in other restaurant expenses. The increase is primarily due toincreases in costs related to one additional week of television advertising,and higher supplies associated with the rollout of cold beverages.

*General and administrative expenses:*

General and administrative expenses were $11.3 millionand $11.4 million for the three months ended July 1, 2007 and July 2, 2006,respectively. General and administrative expenses as a percentage of totalrevenues were 7.9% and 8.1%  for thethree months ended July 1, 2007 and July 2, 2006, respectively. Lower salariesand bonus expense of $0.4 million and $1.1 million, respectively, were mostlyoffset by costs of $1.3 million related to the proposed merger with anaffiliate of Sun Capital Partners and increased stock compensation costs.

*Write-downs of property and equipment:*

Write-downs of property and equipment were $0.4million in the three month period ended July 1, 2007. During the three monthperiod ended July 1, 2007, we determined that the carrying values of threerestaurant properties exceeded their estimated fair values less costs to selland the carrying values were reduced by $0.4 million accordingly.  There were no write-downs of property andequipment during the 2006 quarter.

*Depreciation and amortization:*

Depreciationand amortization were $5.6 million and $5.7 million for the three months endedJuly 1, 2007 and July 2, 2006, respectively. Depreciation and amortization as apercentage of total revenues was 3.9% and 4.1% in the 2007 and 2006 periods,respectively.

*Gain on franchise sales of restaurant operationsand properties:*

Gainon franchise sales of restaurant operations and properties was $1.1 million inthe three months ended July 2, 2006 associated with the sale of certainequipment assets, lease and sublease rights and franchise rights in threeexisting Company-operated restaurants located in Lancaster and York,Pennsylvania. There was no gain on sales of restaurant operations andproperties during the three months ended July 1, 2007.

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

Thegain on disposals of other property and equipment, net was $0.4 million for thethree months ended July 1, 2007 as compared to a loss of $0.4 million for thethree months ended July 2, 2006.  Thetable below identifies the components of the loss on disposals of otherproperty and equipment, net as shown on the accompanying condensed consolidatedstatements of operations (in thousands):
|                                                          | ** ** | **For the Three Months Ended** | ** ** |
|----------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                               | ** ** | **July 1,  2007**                             | ** ** | **July 2,  2006** | ** ** |
|                                                     |       |                                               |       |   |   |
| Restaurant  equipment assets retired due to remodeling   |       | $                                                  | —     |   | $ | 296 |   |
| Restaurant  equipment assets retired due to replacement  |       | 33                                                 |       | 67 |   |
| Gain due to  restaurant flood/fire                       |       | (437                                               | )          | (79 | ) |
| All other                                                |       | —                                             |       | 82 |   |
| Loss on disposals of  other property and equipment, net. |       | $                                                  | (404       | ) | $ | 366 |   |

 

*Interest expense, net:*

Interest expense, net of capitalized interest andinterest income, was $5.0 million and $5.1 million for the three months endedJuly 1, 2007 and July 2, 2006, respectively. Total outstanding debt, includingcapital lease and finance obligations, decreased from $232.5 million at July 2,2006 to $229.0 million at July 1, 2007.

*Provisionfor income taxes:*

The provision for incometaxes of $48,000 for the three months ended July 1, 2007 related to interestaccrued associated with amounts accrued for uncertain tax positions.  The provision was $0.3 million for the threemonths ended July 2, 2006.  We continueto record valuation allowances on tax benefits due to uncertainty surroundingfuture taxable income. We did not record any benefit for our losses for thethree months ended July 1, 2007.

*(Loss) income from continuing operations:*

(Loss) income from continuing operations was ($0.8)million and $4.0 million for the three months ended July 1, 2007 and July 2,2006, respectively, for the reasons discussed above.

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*Incomefrom discontinued operations:*

In accordance withSFAS No. 144, the results of operations of the eight properties that weredisposed of during 2006 and the two properties that were disposed of during2007 and any related net gain on the disposals, as well as the results ofoperations of the properties held for sale at July 1, 2007 were reportedseparately as discontinued operations in the accompanying condensedconsolidated statements of operations.

The results ofoperations associated with one property that met the criteria for “held for sale” as defined in SFAS No. 144 andthe results of the two properties that were closed during 2007 were notmaterial and therefore were reported within continuing operations in theaccompanying condensed consolidated statements of operations for the threemonth period ended July 2, 2006.

For the three months endedJuly 1, 2007 and July 2, 2006, discontinued operations consisted of thefollowing (in thousands):
|                                              | ** ** | **For the Three Months Ended** | ** ** |
|----------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                   | ** ** | **July 1,  2007**                             | ** ** | **July 2,  2006** | ** ** |
|                                         |       |                                               |       |   |   |
| Net sales                                    |       | $                                                  | 171        |   | $ | — |   |
|                                         |       |                                               |       |   |   |
| Operating loss                               |       | $                                                  | (242       | ) | $ | (79 | ) |
| Gain on  disposals of property and equipment |       | 735                                                |       | 1,203 |   |
| Income tax  benefit                          |       | —                                             |       | (450 | ) |
| Income from  discontinued operations         |       | $                                                  | 493        |   | $ | 674 |   |

 

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***Six Months Ended July 1, 2007 Compared With Six Months EndedJuly 2, 2006***

*Revenues:*

*Totalrevenues -* Total revenues decreased $2.7 million, or 1.0%, to$264.5 million for the six months ended July 1, 2007 from $267.2 million forthe same period in 2006.

*Restaurantrevenues -* Restaurant revenues decreased $0.5 million, or0.3%, to $200.0 million for the six months ended July 1, 2007 from $200.5million for the six months ended July 2, 2006. Comparable Company-operatedrestaurant revenues during this period decreased by $3.7 million, or 2.1%,compared to an increase of 1.2% experienced during the same period in 2006.Colder weather during the first quarter of 2007, especially at night, combinedwith a greater number of operating days with significant snow and rain events,had a negative impact on sales. The closing of seven locations and theacquisition of six Company-operated locations by franchisees resulted indecreased revenues of 1.8 million and $2.8 million, respectively, in restaurantrevenues in the six months ended July 1, 2007 as compared to the same period in2006. These decreases were partially offset by our opening three newrestaurants and our assumption of the operation of twelve formerly franchisedrestaurants over the past 18 months, which resulted in increased revenues of$7.8 million.  We began operating thetwelve restaurants in December 2006 following a default and peaceful surrenderby a former franchisee under its leases and franchise agreements with us. Weand the former franchisee’s lenders and landlord had entered into agreementspursuant to which we agreed to make recurring monthly rent and loan paymentsand the lenders and landlord agreed not to interfere with our operations whilewe operate the restaurants.  Except forour agreement to make certain payments while we are operating the restaurants,we did not assume any of the former franchisee’s obligations to itslender.  On July 26, 2007, we terminatedthese agreements.  We are currentlyoperating these restaurants while we search for a new franchisee to take overtheir operation.  If the properties arenot re-franchised, we may acquire or close the restaurants, at our option.

There were one andtwo new restaurants opened during the six months ended July 1, 2007 and July 2,2006, respectively.

*Foodservice revenues -* Foodservicerevenues (product sales to franchisees and retail customers) decreased $1.9million, or 3.3%, to $57.1 million for the six months ended July 1, 2007 from$59.0 million for the six months ended July 2, 2006. Sales to foodserviceretail supermarket customers decreased $2.5 million in the six months endedJuly 1, 2007 compared to the same period in 2006 primarily due to lower casevolume of 8.4% and higher promotional trade spending and sales allowances of1.8% of sales during the period. Franchised restaurant product revenue increased $0.6 million primarilydue to higher prices for commodities which are passed along to franchisedrestaurants.  This increase was partiallyoffset by lower average number of operating franchised restaurants throughoutthe period (206 for the 2007 period compared to 215 for the 2006 period).  The lower average number of operatingfranchised restaurants was primarily due to the default by a former franchiseeunder its leases and franchise agreements with us with respect to twelvefranchised restaurants.  We are currentlyoperating these restaurants while we seek a new franchisee.  Additionally, a 3.7% reduction in comparablefranchised restaurant revenues was experienced during the six months ended July1, 2007, compared to the 1.9% decrease in comparable franchised restaurantrevenues experienced in the six months ended July 2, 2006.

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*Franchiserevenues -* Franchise revenues were $7.4 million and $7.6million during the six months ended July 1, 2007 and July 2, 2006.

Royalties of $5.2 million decreased $0.3 million forthe six months ended July 1, 2007 as compared to the same period in 2006 dueprimarily to a lower average number of operating franchised restaurantsthroughout the period, 206 for the 2007 period compared to 215 for the 2006period.  Additionally, a 3.7% reductionin comparable franchised restaurant revenues was experienced during the sixmonths ended July 1, 2007, compared to the 1.9% decrease in comparablefranchised restaurant revenues experienced in the six months ended July 2,2006.

Initial franchise fees were $0.2 million during bothof the six month periods ended July 1, 2007 and July 2, 2006.

Rental income for leased and subleased franchiselocations increased $0.1 million, to a total of $2.1 million, for the sixmonths ended July 1, 2007 primarily due to increases in miscellaneous occupancyrevenues, which were partially offset by a decrease in the number of operatingfranchised locations.

*Cost of sales:*

Cost of sales increased $1.3 million, or 1.3%, to$101.6 million for the six months ended July 1, 2007 from $100.3 million forthe same period in 2006. Cost of sales as a percentage of total revenues was38.4% and 37.5% for the six months ended July 1, 2007 and July 2, 2006,respectively. This unfavorable change resulted primarily from a 3.9% increasein cost of sales experienced within the foodservice segment due primarily toincreases in the cost of dairy related raw material ingredients (milk, cream)and certain dry powders (whey protein), as the overall sales mix betweenrestaurants and foodservice remained essentially the same year over year.

Restaurant cost of sales as a percentage of restaurantrevenues increased to 26.8% for the six months ended July 1, 2007 from 26.4%for the same period in 2006. This increase was due primarily to normalincreases in prices for commodities (French fries, beverages, fry oil and dairyrelated products), as menu pricing was only up 0.8% year over year.

Foodservice cost of sales as a percentage offoodservice revenues increased to 84.1% in the six months ended July 1, 2007from 80.2% in the six months ended July 2, 2006. This increase was primarily aresult of higher dairy related raw material ingredients (milk and cream) andwhey protein costs in the 2007 period compared to the same period in 2006.

The cost of cream, the principal ingredient used inmaking ice cream, affects our costs of sales as a percentage of total revenues,especially in our foodservice retail business. The price of cream is directly affected by changes in the market pricefor AA butter traded on the Chicago Mercantile Exchange.  As an example, a $0.10 increase in the costof a pound of AA butter affects our annual costs of sales by approximately $0.9million.  This adverse impact may beoffset by price increases or other factors. However, no assurance can be given that we will be able to offset anycost increases in the future and future increases in cream prices could have amaterial adverse effect on our results of operations.  To minimize risk, alternative supply sourcescontinue to be pursued.

The overall cost of cream was approximately $0.1million higher in the six month period ended July 1, 2007 (weighted averageprice of $1.28 per pound) when compared to the same period in 2006 (weightedaverage price of $1.24 per pound).  Thiswas partially offset by market gains on cash-settled butter futures contractsof $0.1 million during the six months ended July 1, 2007 compared to losses of$0.5 million experienced on butter future contracts during the six months endedJuly 2, 2006.  Approximately 70% of this$0.6 million net cost of sales benefit on a year to date basis, orapproximately $0.4 million, was reported within our foodservice segment.

When available, wepurchase butter option and/or futures contracts to minimize the impact ofincreases in the cost of cream. Our strategy related to hedging is never tohedge more than 50% of our needs using these instruments, so as not to put usin an uncompetitive position.  Optioncontracts are offered in the months of March, May, July, September, October andDecember; however, there is often not enough open interest in them to allow usto buy even very limited coverage without paying high premiums.  Our commodity option contracts andcash-settled butter futures contracts do not meet hedge accounting criteria asdefined by SFAS No. 133, “Accounting for Certain Derivative Instruments andCertain Hedging Activities,” and its related amendment, SFAS No. 138,“Accounting for Certain

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Derivative Instruments and Certain HedgingActivities,” and accordingly, are marked to market each period with theresulting gains or losses recognized in cost of sales.

At July 1, 2007, we held42 contracts, spread over the remaining months of 2007.  These contracts correspond to approximately20% of our anticipated cream purchases for the periods represented.

For the remainder of2007, we expect that cream prices will be higher than the prices experiencedfor the same period in 2006 due to the spread in the futures market compared tothe actual prices of last year.

*Labor and benefits:*

Labor and benefits, which were only reported withinour restaurant segment, decreased only slightly by $0.2 million, or 0.2%, to$72.8 million for the six months ended July 1, 2007 from $73.0 million for thesix months ended July 2, 2006. As a percentage of total revenues, labor andbenefits increased to 27.5% for the six months ended July 1, 2007 from 27.3%for the six months ended July 2, 2006. Labor and benefits, as a percentage ofCompany restaurant revenue only, remained flat at 36.4% for the six monthsended July 1, 2007 and for the same period in 2006. While hourly labor costsincreased, in part, due to additional labor hours required to serve samplesassociated with the rollout of cold beverages, this increase was partiallyoffset by lower general manager bonus of $0.5 million resulting from thenegative comparable restaurant revenues generated during the period. Inaddition, fringe benefits decreased by 0.2% of Company restaurant revenues, dueto a slight reduction in non-group related insurance costs such as workers compensationas well as a slight reduction in group insurance costs.

*Operating expenses:*

Operating expenses increased $2.0 million, or 4.0%, to$52.8 million for the six months ended July 1, 2007 from $50.8 million for thesix months ended July 2, 2006.  Operatingexpenses as a percentage of total revenues were 20.0% and 19.0% in the 2007 and2006 periods, respectively. A significant portion of these expenses ($50.9million in 2007 and $48.1 million in 2006) were reported within our restaurantsegment. In the six months ended July 1, 2007, these costs consisted of $8.0million in supplies, $9.9 million in utilities, $5.5 million in maintenance,$7.9 million in advertising, $11.3 million in occupancy and $8.3 million inother restaurant expenses. The increase is primarily due to increases in costsrelated to three additional weeks of television advertising, higher occupancycosts, higher utility costs and an increase in supplies due, in part, to therollout of cold beverages.

*General and administrative expenses:*

General and administrative expenses were $21.9 millionand $22.5 million for the six months ended July 1, 2007 and July 2, 2006,respectively. General and administrative expenses as a percentage of totalrevenues were 8.3% and 8.4% for the six months ended July 1, 2007 and July 2,2006, respectively. Lower salaries and bonus expense of $0.7 million and $1.4million, respectively, were mostly offset by costs of $1.3 million related tothe proposed merger with an affiliate of Sun Capital Partners and increasedstock compensation costs.

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*Write-downs of property and equipment:*

Write-downs of property and equipment were $0.6million and $0.2 million in the six months ended July 1, 2007 and July 2, 2006,respectively. During the six months ended July 1, 2007 we determined that thecarrying values of four restaurant properties exceeded their estimated fairvalues less costs to sell and the carrying values were reduced by $0.6 millionaccordingly.  During the six months endedJuly 2, 2006, we determined that the carrying value of one restaurant propertyexceeded its estimated fair value less costs to sell and the carrying value wasreduced by $0.2 million accordingly.

*Depreciation and amortization:*

Depreciationand amortization was $11.7 million and $11.5 million for the six months endedJuly 1, 2007 and July 2, 2006, respectively. Depreciation and amortization as apercentage of total revenues was 4.4% and 4.3% in the 2007 and 2006 periods,respectively.  The increase indepreciation and amortization was primarily related to accelerated depreciationon equipment associated with the conversion of our 56 oz packaging format fromthe traditional “brick” container to the more contemporary andconsumer-friendly “sqround” package.

*Gain on franchise sales of restaurant operationsand properties:*

Gainon franchise sales of restaurant operations and properties was $2.0 million inthe six months ended July 2, 2006 associated with the sale of certain equipmentassets, lease and sublease rights and franchise rights in four existingCompany-operated restaurants.  There wasno gain on sales of restaurant operations and properties during the six monthsended July 1, 2007.

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

Thegain on disposals of other property and equipment, net was $0.4 million for thesix months ended July 1, 2007 as compared to loss on disposals of otherproperty and equipment, net of $0.5 million for the six months ended July 2,2006.  The table below identifies thecomponents of the loss on disposals of other property and equipment, net asshown on the accompanying condensed consolidated statements of operations (inthousands):

|                                                         | ** ** | **For the Six Months Ended** | ** ** | ** **       |
|---------------------------------------------------------|------------|--------------------------------------------------|------------|------------------|
| ** **                                              | ** ** | **July 1,**                                 | ** ** | **July 2,** | ** ** | ** ** |   |
| ** **                                              | ** ** | **2007**                                         | ** ** | **2006**         | ** ** | ** ** |   |
|                                                    |       |                                             |       |             |   |   |
| Restaurant  equipment assets retired due to remodeling  |       | $                                                | —     |             | $ | 296 |   |   |
| Restaurant  equipment assets retired due to replacement |       | 67                                               |       | 142              |   |   |
| Gain due to  restaurant fire/flood                      |       | (437                                             | )          | (48              | ) |   |
| All other                                               |       | —                                           |       | 85               |   |   |
| Loss on disposals of  other property and equipment, net |       | $                                                | (370       | )                | $ | 475 |   |   |
|                                                         |            |                                                  |            |                  |  |  |  |  |  |  |  |

 

*Interest expense, net:*

Interest expense, net of capitalized interest andinterest income, was $9.9 million and $10.6 million for the six months endedJuly 1, 2007 and July 2, 2006, respectively. The decrease in interest expensein the 2007 period compared to the same period in 2006 was primarily due toreduced amounts of interest on our revolving credit facility as there were noborrowings against the revolving credit facility during the 2007 period ascompared to borrowings of $8.0 million during the first quarter of 2006. Totaloutstanding debt, including capital lease and finance obligations, decreasedfrom $232.5 million at July 2, 2006 to $229.0 million at July 1, 2007.

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*Provisionfor income taxes:*

The provision for incometaxes of $0.1 million for the six months ended July 1, 2007 related to interestaccrued associated with amounts accrued for uncertain tax positions.  The provision was $0.3 million for the sixmonths ended July 2, 2006.  We continueto record valuation allowances on tax benefits due to uncertainty surroundingfuture taxable income. We did not record any benefit for our losses for the sixmonths ended July 1, 2007.

*(Loss) income from continuing operations:*

(Loss) income from continuing operations was ($6.7)million and ($0.5) million for the six months ended July 1, 2007 and July 2,2006, respectively, for the reasons discussed above.

*Incomefrom discontinued operations:*

In accordance withSFAS No. 144, the results of operations of the eight properties that weredisposed of during 2006 and the two properties that were disposed of during2007 and any related net gain on the disposals, as well as the results ofoperations of the properties held for sale at July 1, 2007 were reportedseparately as discontinued operations in the accompanying condensedconsolidated statements of operations.

The results ofoperations associated one property that met the criteria for “held for sale” as defined in SFAS No. 144 andthe results of the two properties that were closed during 2007 were notmaterial and therefore were reported within continuing operations in theaccompanying condensed consolidated statements of operations for the six monthperiod ended July 2, 2006.

For the six months endedJuly 1, 2007 and July 2, 2006, discontinued operations consisted of thefollowing (in thousands):
|                                              | ** ** | **For the Six Months Ended** | ** ** |
|----------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                   | ** ** | **July 1,**                                 | ** ** | **July 2,** | ** ** |
| ** **                                   | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
|                                         |       |                                             |       |   |   |
|                                         |       |                                             |       |   |   |
| Net sales                                    |       | $                                                | 561        |   | $ | — |   |
|                                         |       |                                             |       |   |   |
| Operating loss                               |       | $                                                | (292       | ) | $ | (328 | ) |
| Gain on  disposals of property and equipment |       | 734                                              |       | 4,068 |   |
| Income tax  benefit                          |       | —                                           |       | (450 | ) |
| Income from  discontinued operations         |       | $                                                | 442        |   | $ | 3,290 |   |

 

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**Liquidity and Capital Resources**

*General:*

Ourprimary sources of liquidity and capital resources are cash generated fromoperations and, if needed, borrowings under our $35 million revolving creditfacility (the “Credit Facility”). Additional sources of liquidity consist ofcapital and operating leases for financing leased restaurant locations (inmalls and shopping centers and land or building leases), restaurant equipment,manufacturing equipment, distribution vehicles and computer equipment. Othersources of cash are sales of under-performing existing restaurant propertiesand other assets and sales of Company-operated locations to franchisees (to theextent our debt instruments permit). The amount of debt financing that we areable to incur is limited by the terms of our Credit Facility and 8.375% seniornotes indenture. Below was the financing status of our operating restaurantsand properties that we lease to our franchisees as of July 1, 2007:

|                                         | ** ** | **Company  Operated** | ** ** | **Franchise  Operated** | ** ** |
|-----------------------------------------|------------|-----------------------|------------|-------------------------|------------|
| Owned land and  building, mortgaged     |       | 59                    |       | 12                      |       |
| Leased land,  owned building, mortgaged |       | 1                     |       | 0                       |       |
| Sold and leased  back                   |       | 58                    |       | 4                       |       |
| Owned land and  building                |       | 18                    |       | 4                       |       |
| Leased land,  owned building            |       | 74                    |       | 18                      |       |
| Leased land and  building               |       | 106                   |       | 8                       |       |
| Total                                   |       | 316                   |       | 46                      |       |

 

TheCompany-operated restaurants above not identified as owned land and building,mortgaged or sold and leased back secure our obligations under the CreditFacility. Of the 18 restaurant properties identified as owned land andbuilding, five were available to be sold.

Inaddition to our 316 operating restaurants, we have four closed properties thatare classified as held for sale in accordance with SFAS No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets”.

*Operating Cash Flows:*

Netcash provided by operating activities decreased to $4.3 million for the sixmonths ended July 1, 2007 from $10.1 million for the six months ended July 2,2006 due largely to the net loss of $6.4 million.  This net loss was offset by increases of$12.1 million for other non-cash expenses of depreciation and amortization, netwrite-downs of property and equipment and stock compensation expense.  The net cash provided by operating activitieswas reduced by unfavorable changes in operating assets and liabilitiesprimarily related to accounts receivable and bonuses for fiscal 2006, whichwere paid in the first quarter of 2007.

We had a working capital deficit of $11.1 million and$10.6 million as of July 1, 2007 and December 31, 2006, respectively. Ourworking capital deficit includes assets classified as held for sale inaccordance with SFAS No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets.” The workingcapital needs of companies engaged in the restaurant industry are generally lowand as a result, restaurants are frequently able to operate with a workingcapital deficit because: (i) restaurant operations are conducted primarily on acash (and cash equivalent) basis with a low level of accounts receivable; (ii)rapid turnover allows a limited investment in inventories; and (iii) cash fromsales is usually received before related expenses for food, supplies andpayroll are paid.

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*InvestingCash Flows:*

Net cash used in investing activities was $6.1 millionfor the six months ended July 1, 2007 as compared to net cash provided byinvesting activities of $1.2 million for the six months ended July 2, 2006.

During the six months ended July 1, 2007 and July 2,2006, we spent $6.9 million and $8.0 million, respectively on capitalexpenditures, of which $5.0 million and $6.7 million, respectively, was spenton restaurant operations. Capital expenditures were offset by net proceeds fromthe sales of property and equipment of $0.7 million and $9.2 million for thesix months ended July 1, 2007 and July 2, 2006, respectively.

During the six monthsended July 1, 2007, we received proceeds of $0.4 million related to a floodloss incurred during 2006.  Additionally,we sold our rights to a lease on one restaurant property.  Proceeds received related to this sale were$0.3 million in cash and a promissory note in the aggregate principal amount of$0.8 million together with 8.0% interest per annum, amortized over 48 months.

As of January 1, 2006, we had 11 restaurants that werereported as “held for sale” in accordance with SFAS No. 144. During the sixmonths ended July 2, 2006, we sold seven of these restaurants.  Net proceeds on the disposals of the sevenproperties sold during the 2006 period were $6.3 million.  There were no properties sold during the 2007 period that werepreviously classified as “held for sale.”

During the six monthsended July 2, 2006, we completed two transactions in which existing franchiseespurchased four existing Company-operated restaurants and agreed to develop atotal of eight new restaurants in future years. Net proceeds from these transactions were $2.8 million, of which $0.2million was for franchise fees and $2.6 million was for the sale of certainassets and leasehold rights.  There wereno such transactions during 2007.

*Borrowingsand Credit Facility:*

*8.375% Senior Notes.*  In March 2004, we issued $175 million of8.375% senior notes (the “Senior Notes”) in a private offering to finance theredemption in full of our then outstanding 10.5% senior notes.  The Senior Notes are unsecured seniorobligations of FICC, guaranteed on an unsecured senior basis by FICC’s Friendly’sRestaurants Franchise, LLC subsidiary, but are effectively subordinated to allsecured indebtedness of FICC, including the indebtedness incurred under ourCredit Facility. The Senior Notes mature on June 15, 2012. Interest on theSenior Notes is payable at 8.375% per annum semi-annually on June 15 andDecember 15 of each year.  The SeniorNotes are redeemable, in whole or in part, at any time on or after June 15,2008 at FICC’s option at redemption prices from 104.188% to 100.00%, based onthe redemption date.  In addition, at anytime prior to June 15, 2007, FICC may redeem, subject to certain conditions, upto 35% of the aggregate principal amount of the Senior Notes with the proceedsof one or more qualified equity offerings, as defined, at a redemption price of108.375% of the principal amount, plus accrued interest.

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As described aboveunder “Recent Developments”, on July 26, 2007, in connection with the MergerAgreement and the Merger, we commenced an Offer to purchase for cash any andall of our outstanding Senior Notes, on the terms and subject to the conditionsset forth in our Offer to Purchase and Solicitation Statement dated July 26,2007 and a Solicitation of consents from holders of the Senior Notes forcertain amendments to the indenture governing the Senior Notes that would,among other things, eliminate substantially all of the restrictive covenantsand certain events of default contained in the indenture under which the SeniorNotes were issued.  The Offer andSolicitation is conditioned on the closing of the Merger, the receipt of validconsents from holders of a majority of the aggregate principal amount of theSenior Notes, the execution and delivery of a supplemental indenture whichimplements the proposed amendments in respect of the Senior Notes upon receiptof the consents required for those amendments, and certain other generalconditions.  The completion of the Offerand Solicitation is not a condition to the completion of the Merger.  If all holders of Senior Notes tender by theConsent Date, the total amount of funds required by us to pay the tender offerconsideration and the consent payments on the settlement date, includingaccrued interest as well as other costs and expenses related to the Offer andthe Solicitation, is estimated to be approximately $189 million, based on thehypothetical calculation set forth in the Offer to Purchase and SolicitationStatement.  We expect to fund this amountwith a combination of funds to be provided by Parent to Merger Sub as an equitycontribution and funds borrowed by us, as the surviving corporation of the Merger,concurrently with the completion of the Merger.

*Revolving Credit Facility.*  We have a $35 million Credit Facility whichis available for borrowings to provide working capital, for issuances ofletters of credit and for other corporate needs. As of July 1, 2007 andDecember 31, 2006, total letters of credit outstanding were $15.2 million and$15.5 million, respectively. During 2007 and 2006, there were no drawingsagainst the letters of credit.  Therevolving credit loans bear interest at our option at either (a) the baserate plus the applicable margin as in effect from time to time (the “Base Rate”)(10.00% at July 1, 2007) or (b) the Eurodollar rate plus the applicablemargin as in effect from time to time (the “Eurodollar Rate”) (9.06% at July 1,2007). As of July 1, 2007 and December 31, 2006, there were no revolving creditloans outstanding. As of July 1, 2007 and December 31, 2006, $19.8 million and$19.5 million, respectively, was available for borrowing.

The Credit Facility includes certain restrictivecovenants including limitations on indebtedness, restricted payments such asdividends and stock repurchases, liens, mergers, investments and sales ofassets and of subsidiary stock. Additionally, the Credit Facility limits theamount which we may spend on capital expenditures, restricts the use ofproceeds from certain asset sales, obligates us to repay outstanding amountsduring certain periods of time during the year, and requires that we complywith certain financial covenants.  Wewere in compliance with the covenants in the Credit Facility as of July 1, 2007and we expect to be in compliance for 2007.

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*Mortgage Financings*.

We have outstanding mortgage loans in connection withour $45 million fixed interest rate mortgage financing completed in December2001 (the “Fixed Rate Mortgages”), and our $8.5 million variable interest ratemortgage financing completed in December 2005 (the “Variable Rate Mortgages”,and together with the Fixed Rate Mortgages, the “Mortgage Financings”).  The Fixed Rate Mortgages bear interest at afixed annual rate of 10.16%, have a maturity date of January 1, 2022 and areamortized over 20 years.  The interestrate of the Variable Rate Mortgages is the sum of the 90-day LIBOR rate ineffect (5.36% at July 1, 2007) plus 4% on an annual basis. Changes in theinterest rate for the Variable Rate Mortgages are calculated monthly andrecognized annually when the monthly payment amount is adjusted. Changes in themonthly payment amounts owed due to interest rate changes for the Variable RateMortgages are reflected in the principal balances, which are re-amortized overthe remaining life of the mortgages. The Variable Rate Mortgages have amaturity date of January 1, 2020 and are amortized over 14 years.  All of the Mortgage Financings are subject toannual covenants, including various minimum fixed charge coverage ratios.  We were in compliance with the covenants forthe Variable Rate Mortgages and Fixed Rate Mortgages as of December 31, 2006.

*Capital Expenditures.*

We anticipate requiringcapital in the future principally to maintain existing restaurant and plantfacilities and to continue to renovate and re-image existing restaurants. Weanticipate that capital expenditures for 2007 will be between $16.0 million and$19.0 million in the aggregate, of which we expect to spend between $13.0million and $16.0 million on restaurants. Our actual 2007 capital expendituresmay vary from these estimated amounts. We believe that the combination of thefunds generated from operating activities and borrowing availability under our CreditFacility will be sufficient to meet our anticipated operating requirements,debt service requirements, lease obligations and capital requirements.

*Contractual Obligations and Commitments.*

Therehave been no material changes to our contractual obligations and commitmentsfrom those disclosed in our 2006 Annual Report on Form 10-K/A.

**Seasonality**

Due to the seasonality of ice cream consumption, andthe effect from time to time of weather on patronage of the restaurants, ourrevenues and operating income are typically higher in our second and thirdquarters.

**Geographic Concentration**

Approximately 94% of our Company-operated restaurantsare located, and substantially all of our retail sales are generated, in theNortheast. As a result, a severe or prolonged economic recession or changes indemographic mix, employment levels, population density, weather, real estatemarket conditions or other factors specific to this geographic region mayadversely affect us more than certain of our competitors which are more geographicallydiverse.

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**Critical Accounting Estimates**

Thediscussion and analysis of our consolidated financial condition and results ofoperations are based upon our interim condensed consolidated financialstatements, which have been prepared in accordance with U.S. generally acceptedaccounting principles. The preparation of these condensed consolidatedfinancial statements requires us to make estimates and judgments that affectthe reported amounts of assets, liabilities, revenues and expenses and relateddisclosure of contingent assets and liabilities. On an on-going basis, weevaluate our estimates, including those related to revenue recognition,insurance reserves, recoverability of accounts receivable and notes receivable,stock compensation expense, income tax valuation allowances and pension andother post-retirement benefits expense. We base our 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.

Thecritical accounting estimates that we believe affect the more significantjudgments and estimates used in the preparation of our condensed consolidatedfinancial statements presented in this report are described in our Management’sDiscussion and Analysis of Financial Condition and Results of Operations and inthe Notes to the consolidated financial statements included in our 2006 AnnualReport on Form 10-K/A. There has been no material change to our criticalaccounting estimates from those disclosed in our 2006 Annual Report on Form10-K/A.

Actualresults may differ from these estimates under different assumptions or conditions.Any differences may have a material impact on our financial condition andresults of operations. For a discussion of how these and other factors mayaffect our business, see the “Forward Looking Statements” above and otherfactors included in our other filings with the Securities and ExchangeCommission.

**Recently Issued Accounting Pronouncements**

InJuly 2006, the FASB issued FASB Interpretation No. 48, “Accounting forUncertainty in Income Taxes–an interpretation of FASB Statement No. 109” (“FIN48”), which clarifies the accounting for uncertainty in tax positions. FIN 48requires that we recognize in our financial statements the impact of a taxposition, if that position is more likely than not of being sustained on auditbased on the technical merits of the position. The provisions of FIN 48 areeffective as of the beginning of our 2007 fiscal year, with the cumulativeeffect of the change in accounting principle recorded as an adjustment toopening retained earnings.

Weadopted the provisions of FIN 48 on January 1, 2007. As a result of theimplementation of FIN 48 on January 1, 2007, we recognized an additional $0.2million as a decrease to retained earnings. As of the date of adoption, our unrecognized tax benefits totaled $1.6million, which would affect our tax rate if recognized.  During the three and six months ended July 1,2007, we recognized $48,000 million and $142,000 in potential tax and interestassociated with uncertain tax positions and settled one previously uncertaintax position which resulted in the payment of $72,065 of tax and $7,324 ofinterest.

We file numerous consolidated and separate income taxreturns in the United States Federal jurisdiction and in many statejurisdictions. With few exceptions, we are no longer subject to US Federal andstate and local income tax examinations for years before 2003.

We recognize potentialaccrued interest and penalties related to unrecognized tax benefits within ouroperations as income tax expenses. As of the date of implementation of FIN 48,we had approximately $0.6 million accrued for interest and penalties.  To the extent interest and penalties are notassessed with respect to uncertain tax positions, amounts accrued will bereduced and reflected as a reduction of the overall income tax provision.

We anticipate that the total unrecognized tax benefitswill decrease by approximately $0.5 million due to the settlement of ongoingstate voluntary disclosure processes prior to March 30, 2008.

**Item 3. Quantitative and Qualitative Disclosures About MarketRisk**

There has been no material change in our market riskexposure since the filing of the 2006 Annual Report on Form 10-K/A.

**Item 4. Controls and Procedures**

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As of July 1, 2007, our management, under thesupervision and with the participation of our Chief Executive Officer (“CEO”)and Chief Financial Officer (“CFO”), evaluated the effectiveness of the designand operation of our disclosure controls and procedures (as defined in Rule13a-15(e) and Rule 15d-15(e) under the Exchange Act).  Based on that evaluation, our CEO and CFOconcluded that our disclosure controls and procedures were effective as of July1, 2007.

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

**PART II – OTHER INFORMATION**

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**Item1A.  Risk Factors**

Therehave been no material changes to our risk factors from those disclosed in our 2006Annual Report on Form 10-K/A, except as follows:

**Failure to complete the proposed merger withan affiliate of Sun Capital Partners could negatively impact the market priceof our common stock and our future business and operations.**

On June 17, 2007, we announced that wehad signed a definitive merger agreement to be acquired by an affiliate of SunCapital Partners, a private equity firm.  There is no assurance that the merger agreement and the merger will beapproved by our shareholders, and there is no assurance that the otherconditions to the completion of the merger will be satisfied.  If the merger is delayed or not completed forany reason, we will be subject to a number of material risks, including:

·                  the occurrenceof any event, fact, condition, change, development or effect that could giverise to the termination of the merger agreement;

·                  the adverseoutcome of any legal proceedings that may be instituted against us and othersfollowing announcement of entering into the merger agreement;

·                  undercircumstances described in the merger agreement, we could be required to pay atermination fee of up to $5.0 million, plus expenses;

·                  the currentmarket price of our common stock may reflect a market assumption that themerger will occur, and a failure to complete the merger could result in adecline in the market price of our common stock;

·                  certain costs,fees, expenses and charges relating to the merger, such as legal, accountingand certain investment banking fees, are payable by us whether or not themerger is completed;

·                  there may besubstantial disruption to our current plans and operations and a distraction ofour management and employees from day-to-day operations, because mattersrelated to the merger may require substantial commitments of their time andresources;

·                  uncertaintyabout the effect of the merger may make it difficult to retain key employees;and

·                  uncertaintyabout the effect of the merger may adversely affect our relationships with ourcustomers, suppliers, vendors, franchisees and other persons with whom we havebusiness relationships.

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If the proposed merger is not completedfor any reason, including without limitation the inability of Parent to obtainthe necessary financing set forth in Parent’s commitment letter, we may not beable to identify alternative strategic options that are worth pursuing. Priorto the closing of the proposed merger, or, if the proposed merger is notcompleted, prior to the identification and closing of an alternativetransaction, we will be subject to other uncertainties and risks, including:

·                  perceiveduncertainties as to our future direction may result in the loss of, or failureto attract, employees, customers, suppliers, vendors, franchisees or otherbusiness partners; and

·                  the diversionof management’s attention could have a material adverse effect on our business,financial condition or results of operations.

During the pendency of the proposedmerger, we may not be able to enter into a merger or business combination withanother party at a favorable price because of restrictions in the definitivemerger agreement. Covenants in the merger agreement may also impede our abilityto make acquisitions or complete other transactions that are not in theordinary course of business but that could be favorable to us and ourshareholders. As a result, if the proposed merger is not completed, we may beat a disadvantage to our competitors.

**Item6.  Exhibits**

(a)     Exhibits

The exhibit 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:                          | August 3, 2007 |

 

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**EXHIBIT INDEX**

2.1                                Agreement and Plan of Merger, dated as of June 17, 2007, by and among Friendly Ice Cream Corporation, Freeze Operations Holding Corp. and Freeze Operations, Inc. (Incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed with the Commission on June 19, 2007, File No. 001-13579).

4.1                                AmendmentNo. 1, dated as of June 17, 2007, to the Rights Agreement, dated as of November19, 1997, by and between Friendly Ice Cream Corporation and The Bank of NewYork (Incorporated by reference to Exhibit 4.1 to the Company’s Current Reporton Form 8-K filed with the Commission on June 19, 2007, File No. 001-13579).

4.2                                Amendment No. 2, dated as of July 3, 2007, to the Rights Agreement, dated as of November 19, 1997, by and between Friendly Ice Cream Corporation and The Bank of New York, as amended by Amendment No. 1 to the Rights Agreement, dated as of June 17, 2007 (Incorporated by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K filed with the Commission on July 5, 2007, File No. 001-13579).

10.1                        Form of Change of Control Agreement between the Company and each of Messrs. Hoagland, Green, Pastore, Ulrich and Hopkins (Incorporated by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K/A filed with the Commission on April 5, 2007, File No. 001-13579).*

10.2                        Change of Control Agreement between the Company and George M. Condos (Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K/A filed with the Commission on April 5, 2007, File No. 001-13579).*

31.1                        Certificationpursuant to Section 302 of the Sarbanes-Oxley Act of 2002 signed by George M.Condos.

31.2                        Certificationpursuant to Section 302 of the Sarbanes-Oxley Act of 2002 signed by Paul V.Hoagland.

32.1                        Certificationpursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of theSarbanes-Oxley Act of 2002 signed by George M. Condos and Paul V. Hoagland.

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* - ManagementContract or Compensatory Plan or Arrangement

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