**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

| **ý**                                                                                                                                  |   | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE****SECURITIES EXCHANGE ACT OF 1934** |
|---------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------|
|                                                                                                                                        |
| **For the quarterly period ended June 27, 2004**                                                                                       |
|                                                                                                                                        |
| **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  Incorporation or Organization)                     |   | (IRS Employer  Identification No.) |
|                                                                                |   |                               |
| **1855 Boston Road  Wilbraham, Massachusetts**                                      |   | **01095**                          |
| (Address of Principal Executive Offices)                                            |   | (Zip Code)                         |
|                                                                                |
| **(413) 543-2400**                                                                  |
| (Registrant’s Telephone Number, Including Area Code)                           |
|                                                                                |
| **Not Applicable**                                                                  |
| (Former name, former address and former fiscal year, if changed since  last report) |

 

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes  ý  No o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inExchange Act Rule 12b-2). Yes  o  No ý

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock as of the latest practicable date.

 

| **Class**                    |   | **Outstanding  at July 23, 2004** |
|------------------------------|--------|----------------------------------------|
| Common Stock, $.01 par value |   | 7,693,870 shares                       |

 

 

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**PART I - FINANCIAL INFORMATION**

 

**Item 1.  FinancialStatements**

 

**FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

 

(In thousands)
|                                                                      |   | **June 27,  2004** |    | **December 28,  2003** |   |
|---------------------------------------------------------------------------|--------|-------------------------|---------|-----------------------------|--------|
|                                                                      |   | **(unaudited)**         |    |                        |   |
| ASSETS                                                                    |   |                    |    |                        |   |
| CURRENT ASSETS:                                                           |   |                    |    |                        |   |
| Cash and cash equivalents                                                 |   | $                       | 12,211  |                        | $      | 25,631 |   |
| Restricted cash                                                           |   | 2,162                   |    | 1,671                       |   |
| Accounts receivable, net                                                  |   | 14,400                  |    | 10,384                      |   |
| Inventories                                                               |   | 17,707                  |    | 15,669                      |   |
| Deferred income taxes                                                     |   | 6,647                   |    | 6,647                       |   |
| Prepaid expenses and other current assets                                 |   | 5,206                   |    | 1,539                       |   |
| TOTAL CURRENT ASSETS                                                      |   | 58,333                  |    | 61,541                      |   |
| DEFERRED INCOME TAXES                                                     |   | 1,467                   |    | —                      |   |
| PROPERTY AND EQUIPMENT, net of accumulated  depreciation and amortization |   | 164,309                 |    | 167,109                     |   |
| INTANGIBLE ASSETS AND DEFERRED COSTS, net  of accumulated amortization    |   | 21,172                  |    | 17,890                      |   |
| OTHER ASSETS                                                              |   | 6,664                   |    | 5,912                       |   |
| TOTAL ASSETS                                                              |   | $                       | 251,945 |                        | $      | 252,452 |   |
|                                                                      |   |                    |    |                        |   |
| LIABILITIES AND STOCKHOLDERS’ DEFICIT                                |   |                    |    |                        |   |
| CURRENT LIABILITIES:                                                      |   |                    |    |                        |   |
| Current maturities of long-term debt                                      |   | $                       | 1,196   |                        | $      | 1,127 |   |
| Current maturities of capital lease and  finance obligations              |   | 1,324                   |    | 911                         |   |
| Accounts payable                                                          |   | 27,488                  |    | 22,475                      |   |
| Accrued salaries and benefits                                             |   | 10,670                  |    | 9,635                       |   |
| Accrued interest payable                                                  |   | 1,164                   |    | 2,033                       |   |
| Insurance reserves                                                        |   | 11,345                  |    | 10,041                      |   |
| Restructuring reserves                                                    |   | 2,055                   |    | 441                         |   |
| Other accrued expenses                                                    |   | 16,364                  |    | 19,055                      |   |
| TOTAL CURRENT LIABILITIES                                                 |   | 71,606                  |    | 65,718                      |   |
| DEFERRED INCOME TAXES                                                     |   | —                  |    | 1,289                       |   |
| CAPITAL LEASE AND FINANCE OBLIGATIONS, less  current maturities           |   | 7,086                   |    | 5,773                       |   |
| LONG-TERM DEBT, less current maturities                                   |   | 226,341                 |    | 227,937                     |   |
| ACCRUED PENSION COST                                                      |   | 15,069                  |    | 16,127                      |   |
| OTHER LONG-TERM LIABILITIES                                               |   | 35,180                  |    | 33,634                      |   |
| COMMITMENTS AND CONTINGENCIES                                             |   |                    |    |                        |   |
| STOCKHOLDERS’ DEFICIT:                                               |   |                    |    |                        |   |
| Common stock                                                              |   | 76                      |    | 75                          |   |
| Additional paid-in capital                                                |   | 141,954                 |    | 140,826                     |   |
| Accumulated other comprehensive loss                                      |   | (19,931                 | )       | (19,922                     | )      |
| Accumulated deficit                                                       |   | (225,436                | )       | (219,005                    | )      |
| TOTAL STOCKHOLDERS’ DEFICIT                                          |   | (103,337                | )       | (98,026                     | )      |
| TOTAL LIABILITIES AND STOCKHOLDERS’ DEFICIT                          |   | $                       | 251,945 |                        | $      | 252,452 |   |

 

The accompanying notes are an integral part of these condensedconsolidated financial statements.

 

1

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## **FRIENDLY ICE CREAM CORPORATION ANDSUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

(Unaudited)

(In thousands, except per share data)

 
|                                                             |   | **For the  Three Months Ended** |    | **For the  Six Months Ended** |   |
|------------------------------------------------------------------|--------|---------------------------------|---------|-------------------------------|--------|
|                                                             |   | **June 27,  2004**         |    | **June 29,  2003**       |   | **June 27,  2004** |   | **June 29,  2003** |   |
|                                                             |   |                            |    |                          |   |   |   |   |   |
| REVENUES:                                                        |   |                            |    |                          |   |   |   |   |   |
| Restaurant                                                       |   | $                               | 114,441 |                          | $      | 123,002 |   | $ | 218,794 |   | $ | 226,170 |   |
| Foodservice                                                      |   | 29,820                          |    | 29,936                        |   | 53,163 |   | 53,203 |   |
| Franchise                                                        |   | 3,255                           |    | 2,710                         |   | 6,313 |   | 4,965 |   |
| TOTAL REVENUES                                                   |   | 147,516                         |    | 155,648                       |   | 278,270 |   | 284,338 |   |
|                                                             |   |                            |    |                          |   |   |   |   |   |
| COSTS AND EXPENSES:                                              |   |                            |    |                          |   |   |   |   |   |
| Cost of sales                                                    |   | 55,959                          |    | 55,179                        |   | 101,547 |   | 101,156 |   |
| Labor and benefits                                               |   | 42,155                          |    | 43,796                        |   | 82,089 |   | 81,924 |   |
| Operating expenses                                               |   | 27,806                          |    | 29,757                        |   | 52,858 |   | 54,045 |   |
| General and administrative expenses                              |   | 9,754                           |    | 9,952                         |   | 20,451 |   | 20,015 |   |
| Restructuring expenses                                           |   | —                          |    | —                        |   | 2,627 |   | — |   |
| Gain on litigation settlement                                    |   | —                          |    | —                        |   | (3,644 | ) | — |   |
| Write-downs of property and equipment                            |   | 91                              |    | —                        |   | 91 |   | — |   |
| Depreciation and amortization                                    |   | 5,570                           |    | 5,746                         |   | 11,176 |   | 11,373 |   |
| Gain on franchise sales of restaurant  operations and properties |   | (7                              | )       | —                        |   | (913 | ) | — |   |
| Loss on disposals of other property and  equipment, net          |   | 337                             |    | 835                           |   | 508 |   | 1,408 |   |
|                                                             |   |                            |    |                          |   |   |   |   |   |
| OPERATING INCOME                                                 |   | 5,851                           |    | 10,383                        |   | 11,480 |   | 14,417 |   |
|                                                             |   |                            |    |                          |   |   |   |   |   |
| OTHER EXPENSES:                                                  |   |                            |    |                          |   |   |   |   |   |
| Interest expense, net                                            |   | 5,368                           |    | 6,092                         |   | 11,432 |   | 12,194 |   |
| Other expenses, principally debt retirement  costs               |   | 2,343                           |    | —                        |   | 9,235 |   | — |   |
|                                                             |   |                            |    |                          |   |   |   |   |   |
| (LOSS) INCOME BEFORE BENEFIT FROM  (PROVISION FOR) INCOME TAXES  |   | (1,860                          | )       | 4,291                         |   | (9,187 | ) | 2,223 |   |
|                                                             |   |                            |    |                          |   |   |   |   |   |
| Benefit from (provision for) income taxes                        |   | 558                             |    | (1,201                        | )      | 2,756 |   | (622 | ) |
|                                                             |   |                            |    |                          |   |   |   |   |   |
| NET (LOSS) INCOME                                                |   | $                               | (1,302  | )                             | $      | 3,090 |   | $ | (6,431 | ) | $ | 1,601 |   |
|                                                             |   |                            |    |                          |   |   |   |   |   |
| BASIC NET (LOSS) EARNINGS PER SHARE                              |   | $                               | (0.17   | )                             | $      | 0.42 |   | $ | (0.85 | ) | $ | 0.22 |   |
|                                                             |   |                            |    |                          |   |   |   |   |   |
| DILUTED NET (LOSS) EARNINGS PER SHARE                            |   | $                               | (0.17   | )                             | $      | 0.41 |   | $ | (0.85 | ) | $ | 0.21 |   |
|                                                             |   |                            |    |                          |   |   |   |   |   |
| WEIGHTED AVERAGE SHARES:                                         |   |                            |    |                          |   |   |   |   |   |
| Basic                                                            |   | 7,611                           |    | 7,441                         |   | 7,569 |   | 7,428 |   |
| Diluted                                                          |   | 7,611                           |    | 7,574                         |   | 7,569 |   | 7,564 |   |

 

Theaccompanying notes are an integral part of these condensed consolidated financialstatements.

 

2

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**FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

(Unaudited)

(In thousands)

 
|                                                                                      |   | **For the  Six Months Ended** |   |
|-------------------------------------------------------------------------------------------|--------|-------------------------------|--------|
|                                                                                      |   | **June 27,  2004**       |   | **June 29,  2003** |   |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                     |   |                          |   |   |   |
| Net (loss) income                                                                         |   | $                             | (6,431 | ) | $ | 1,601 |   |
| Adjustments to reconcile net (loss) income  to net cash provided by operating activities: |   |                          |   |   |   |
| Stock compensation expense                                                                |   | 380                           |   | 129 |   |
| Depreciation and amortization                                                             |   | 11,176                        |   | 11,373 |   |
| Write-offs of deferred financing costs                                                    |   | 2,445                         |   | — |   |
| Write-downs of property and equipment                                                     |   | 91                            |   | — |   |
| Deferred income tax (benefit) expense                                                     |   | (2,756                        | )      | 353 |   |
| (Gain) loss on disposals of other property  and equipment, net                            |   | (405                          | )      | 1,408 |   |
| Changes in operating assets and  liabilities:                                             |   |                          |   |   |   |
| Accounts receivable                                                                       |   | (4,016                        | )      | (2,830 | ) |
| Inventories                                                                               |   | (2,038                        | )      | 1,629 |   |
| Other assets                                                                              |   | (4,103                        | )      | (2,199 | ) |
| Accounts payable                                                                          |   | 5,013                         |   | 8,452 |   |
| Accrued expenses and other long-term  liabilities                                         |   | 881                           |   | (6,097 | ) |
| NET CASH PROVIDED BY OPERATING ACTIVITIES                                                 |   | 237                           |   | 13,819 |   |
|                                                                                      |   |                          |   |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                     |   |                          |   |   |   |
| Purchases of property and equipment                                                       |   | (8,262                        | )      | (16,201 | ) |
| Proceeds from sales of property and  equipment                                            |   | 3,378                         |   | — |   |
| Purchases of marketable securities                                                        |   | (905                          | )      | — |   |
| Proceeds from sales of marketable securites                                               |   | 89                            |   | — |   |
| NET CASH USED IN INVESTING ACTIVITIES                                                     |   | (5,700                        | )      | (16,201 | ) |
|                                                                                      |   |                          |   |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                     |   |                          |   |   |   |
| Proceeds from issuance of senior notes                                                    |   | 175,000                       |   | — |   |
| Proceed from other borrowings                                                             |   | 11,000                        |   | — |   |
| Repayments of debt                                                                        |   | (187,527                      | )      | (510 | ) |
| Payments of deferred financing costs                                                      |   | (6,625                        | )      | — |   |
| Repayments of capital lease and finance  obligations                                      |   | (554                          | )      | (890 | ) |
| Stock options exercised                                                                   |   | 749                           |   | 188 |   |
| NET CASH USED IN FINANCING ACTIVITIES                                                     |   | (7,957                        | )      | (1,212 | ) |
|                                                                                      |   |                          |   |   |   |
| NET DECREASE IN CASH AND CASH EQUIVALENTS                                                 |   | (13,420                       | )      | (3,594 | ) |
|                                                                                      |   |                          |   |   |   |
| CASH AND CASH EQUIVALENTS, BEGINNING OF  PERIOD                                           |   | 25,631                        |   | 34,341 |   |
| CASH AND CASH EQUIVALENTS, END OF PERIOD                                                  |   | $                             | 12,211 |   | $ | 30,747 |   |
|                                                                                      |   |                          |   |   |   |
| SUPPLEMENTAL DISCLOSURES:                                                                 |   |                          |   |   |   |
| Cash paid during the period for:                                                          |   |                          |   |   |   |
| Interest                                                                                  |   | $                             | 11,975 |   | $ | 12,056 |   |
| Income taxes                                                                              |   | 16                            |   | 863 |   |
| Capital lease obligations incurred                                                        |   | 2,280                         |   | — |   |
| Lease incentive equipment received                                                        |   | —                        |   | 243 |   |

 

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

 

3

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**FRIENDLY ICE CREAM CORPORATION ANDSUBSIDIARIES**

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

 

(Unaudited)

 

**1. BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES**

 

*Interim Financial Information -*

 

Theaccompanying condensed consolidated financial statements as of June 27,2004 and for the three and six months ended June 27, 2004 andJune 29, 2003 are unaudited, but, in the opinion of management, includeall adjustments which are necessary for a fair presentation of the consolidatedfinancial position, results of operations, cash flows and comprehensive loss ofFriendly Ice Cream Corporation (“FICC”) and subsidiaries (unless the contextindicates otherwise, collectively, the “Company”). Such adjustments consistsolely of normal recurring accruals. Operating results for the three and sixmonth periods ended June 27, 2004 and June 29, 2003 are notnecessarily indicative of the results that may be expected for the entire yeardue, in part, to the seasonality of the Company’s business. Historically,higher revenues and operating income have been experienced during the secondand third fiscal quarters. The Company’s consolidated financial statements,including the notes thereto, which are contained in the 2003 Annual Report onForm 10-K should be read in conjunction with these condensed consolidatedfinancial statements. Capitalized terms not otherwise defined herein should be referencedto the 2003 Annual Report on Form 10-K.

 

*Use of Estimates in the Preparation of Financial Statements-*

 

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities andthe disclosure of contingent assets and liabilities at the dates of thefinancial statements and the reported amounts of revenues and expenses duringthe reporting periods. The critical accounting policies and most significantestimates and assumptions relate to revenue recognition, insurance reserves,recoverability of accounts receivable, valuation allowances and pension andother post-retirement benefits expense. Actual amounts could differsignificantly from the estimates.

 

*Revenue Recognition -*

 

TheCompany’s revenues are derived primarily from the operation of full-servicerestaurants, the distribution and sale of premium ice cream desserts throughretail and institutional locations and franchising. The Company recognizesrestaurant revenue upon receipt of payment from the customer and retailrevenue, net of discounts and allowances, upon delivery of product. Reservesfor discounts and allowances from retail sales are estimated and accrued whenrevenue is recorded. Actual amounts could differ materially from the estimates.Franchise royalty income, generally calculated as 4% of net sales offranchisees, is recorded monthly based upon the actual sales reported by eachfranchisee for the month just completed. Franchise fees are recorded as revenueupon completion of all significant services, generally upon opening of therestaurant.

 

*Shipping and Handling Costs -*

 

Costsrelated to shipping and handling are included in cost of sales in theaccompanying condensed consolidated statements of operations for all periodspresented.

 

4

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*Insurance Reserves -*

 

TheCompany is self-insured through retentions or deductibles for the majority ofits workers’ compensation, automobile, general liability, employer’s liability,product liability and group health insurance programs. Self-insurance amountsvary up to $500,000 per occurrence. Insurance with third parties, some of whichis then reinsured through Restaurant Insurance Corporation (“RIC”), theCompany’s wholly owned subsidiary, is in place for claims in excess of theseself-insured amounts. RIC reinsures 100% of the risk from $500,000 to$1,000,000 per occurrence through September 2, 2000 for FICC’s workers’compensation, general liability, employer’s liability and product liabilityinsurance. Subsequent to September 2, 2000, the Company discontinued itsuse of RIC as a captive insurer for new claims. FICC’s and RIC’s liabilitiesfor estimated incurred losses are actuarially determined and recorded in theaccompanying condensed consolidated financial statements on an undiscountedbasis. Actual incurred losses may vary from the estimated incurred losses andcould have a material effect on the Company’s insurance expense.

 

*Accounts Receivable and Allowance for Doubtful Accounts -*

 

AtJune 27, 2004 and December 28, 2003, accounts receivable of$14,400,000 and $10,384,000 were net of allowances for doubtful accountstotaling $723,000 and $696,000, respectively. Accounts receivable consistsprimarily of amounts due from the sale of products to franchisees andsupermarkets. Accounts receivable also includes amounts related to franchiseroyalties, rents and other miscellaneous items.

 

TheCompany recognizes allowances for doubtful accounts to ensure receivables arenot overstated due to uncollectibility. Bad debt reserves are maintained forcustomers in the aggregate based on a variety of factors, including the lengthof time receivables are past due, significant one-time events and historicalexperience. An additional reserve for individual accounts is recorded when theCompany becomes aware of a customer’s inability to meet its financialobligations, such as in the case of bankruptcy filings or deterioration in thecustomer’s operating results or financial position. If circumstances related tocustomers change, estimates of the recoverability of receivables would befurther adjusted.

 

*Pension and Other Post-Retirement Benefits -*

 

Thedetermination of the Company’s obligation and expense for pension and otherpost-retirement benefits is dependent upon the selection of certain assumptionsused by actuaries in calculating such amounts. Those assumptions include, amongother things, the discount rate, expected long-term rate of return on planassets and rates of increase in health care costs. In accordance withaccounting principles generally accepted in the United States, actual resultsthat differ from the assumptions are accumulated and amortized over futureperiods and, therefore, generally affect the recognized expense and recordedobligation in such future periods. Significant differences in actual experienceor significant changes in the assumptions may materially affect the future pensionand other post-retirement obligations and expense.

 

*Cash and Cash Equivalents -*

 

TheCompany considers all investments with an original maturity of three months orless when purchased to be cash equivalents.

 

5

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*Restricted Cash -*

 

RICis required to hold assets in trust whose value is at least equal to certain ofRIC’s outstanding estimated insurance claim liabilities. Accordingly, as ofJune 27, 2004 and December 28, 2003, cash of $2,162,000 and $1,671,000,respectively, was restricted.

 

*Inventories -*

 

Inventoriesare stated at the lower of first-in, first-out cost or market and consisted ofthe following at June 27, 2004 and December 28, 2003 (in thousands):

 

|             |   | **June 27,  2004** |   | **December 28,  2003** |   |
|------------------|--------|-------------------------|--------|-----------------------------|--------|
|             |   |                    |   |                        |   |
| Raw materials    |   | $                       | 2,451  |                        | $      | 1,557 |   |
| Goods in process |   | 185                     |   | 114                         |   |
| Finished goods   |   | 15,071                  |   | 13,998                      |   |
| Total            |   | $                       | 17,707 |                        | $      | 15,669 |   |

 

*Long-Lived Assets -*

 

Inaccordance with Statement of Financial Accounting Standard (“SFAS”) No. 144,“Accounting for the Impairment or Disposal of Long-Lived Assets,” which wasadopted in 2002, the Company reviews its Non-Friendly Marks, which wereassigned to the Company by Hershey in September 2002, for impairment on aquarterly basis. The Company recognizes impairment has occurred when thecarrying value of the Non-Friendly Marks exceeds the estimated futurediscounted cash flows of the trademarked products. Additionally, the Companyreviews long-lived assets related to each restaurant to be held and used in thebusiness quarterly for impairment, or whenever events or changes incircumstances indicate that the carrying amount of a restaurant may not berecoverable. The Company evaluates restaurants using a “two-year history ofcash flow” as the primary indicator of potential impairment. Based on the bestinformation available, the Company writes down an impaired restaurant to itsestimated fair market value, which becomes its new cost basis. Estimated fairmarket value is based on the Company’s experience selling similar propertiesand local market conditions, less costs to sell for properties to be disposedof. In addition, restaurants scheduled for closing are reviewed for impairmentand depreciable lives are adjusted. The impairment evaluation is based on theestimated cash flows from continuing use through the expected disposal date andthe expected terminal value.

 

Storeclosure costs include costs of disposing of the assets as well as otherfacility-related expenses from previously closed stores. These store closurecosts are expensed as incurred. Additionally, at the date the closure occurs,the Company records a liability for the amount of any remaining operating leaseobligations subsequent to the expected closure date, net of estimated subleaseincome, if any.

 

6

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SFASNo. 144 also requires the results of operations of a component 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 component entity from the ongoing operations of the company and no significantcontinuing involvement in the operations of the component entity after thedisposal transaction. The results of operations of stores meeting all of theseconditions that were disposed of in 2004 or classified as held for sale atJune 27, 2004 were not material for the quarters or six months endedJune 27, 2004 and June 29, 2003.

 

Considerablemanagement judgment is necessary to estimate future cash flows, including cashflows from continuing use, terminal value, closure costs and sublease income. Accordingly,actual results could vary significantly from estimates.

 

Duringthe six months ended June 27, 2004, it was determined that the carryingvalue of a vacant restaurant land parcel and the carrying value of onerestaurant property exceeded their estimated fair values less cost tosell.  The carrying values were reducedby an aggregate of $91,000.

 

*Other Assets* -

 

Otherassets included notes receivable of $4,583,000 and $4,638,000, which were netof allowances for doubtful accounts totaling $263,000 and $313,000, as ofJune 27, 2004 and December 28, 2003, respectively. Also included inother assets as of June 27, 2004 and December 28, 2003 were paymentsmade to fronting insurance carriers of $1,213,000 and $1,211,000, respectively,to establish loss escrow funds.

 

*Other Accrued Expenses-*

 

Otheraccrued expenses consisted of the following at June 27, 2004 andDecember 28, 2003 (in thousands):

 
|                          |   | **June 27,  2004** |   | **December 28,  2003** |   |
|-------------------------------|--------|-------------------------|--------|-----------------------------|--------|
|                          |   |                    |   |                        |   |
| Accrued meals and other taxes |   | $                       | 3,200  |                        | $      | 2,947 |   |
| Accrued advertising           |   | 3,097                   |   | 1,554                       |   |
| Accrued rent                  |   | 2,434                   |   | 2,416                       |   |
| Gift cards outstanding        |   | 2,096                   |   | 3,975                       |   |
| Accrued bonus                 |   | 1,753                   |   | 2,853                       |   |
| Accrued construction costs    |   | 1,050                   |   | 2,331                       |   |
| Unearned revenues             |   | 898                     |   | 894                         |   |
| All other                     |   | 1,836                   |   | 2,085                       |   |
| Total                         |   | $                       | 16,364 |                        | $      | 19,055 |   |

 

7

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*Income Taxes -*

 

TheCompany accounts for income taxes in accordance with SFAS No. 109, “Accountingfor Income Taxes,” which requires recognition of deferred tax assets andliabilities for the expected future tax consequences of events that have beenincluded in the financial statements or tax returns. A valuation allowance isrecorded for deferred tax assets whose realization is not likely. The Companyrecords income taxes based on the effective rate expected for the year with anychanges in the valuation allowance reflected in the period of change. As ofJune 27, 2004 and December 28, 2003, a valuation allowance of$10,130,000 existed related to state NOL carryforwards due to restrictions onthe usage of state NOL carryforwards and short carryforward periods for certainstates. Taxable income by state for future periods is difficult to estimate.The amount and timing of any future taxable income may affect the usage of suchcarryforwards, which could result in a material change in the valuationallowance.

 

*Derivative Instruments and Hedging Agreements -*

 

TheCompany enters into commodity option contracts from time to time to managedairy cost pressures. The Company’s commodity option contracts do not meethedge accounting criteria as defined by SFAS No. 133, “Accounting forDerivative Instruments and Hedging Activities,” and, accordingly, are marked tomarket each period, with the resulting gains or losses recognized in cost ofsales. For the three months ended June 27, 2004 and June 29, 2003,losses of approximately $251,000 and $27,000, respectively, were included incost of sales related to these option contracts. For the six months endedJune 27, 2004 and June 29, 2003, gains of approximately $520,000 andlosses of approximately $280,000, respectively, were included in cost of salesrelated to these option contracts.

 

*Marketable Securities -*

 

TheCompany accounts for marketable securities in accordance with SFAS No. 115,“Accounting for Certain Investments in Debt and Equity Securities.”  At June 27, 2004, the Company’sinvestments in marketable securities were classified as available-for-sale, andas a result, were reported at fair value. Unrealized gains and losses arereported as a component of accumulated other comprehensive loss instockholders’ deficit.  The Companyfollows its investment managers’ methods of determining the cost basis incomputing realized gains and losses on the sale of its available-for-salesecurities, which is the average cost method. Realized gains and losses are included in other expenses, principallydebt retirement costs in the accompanying condensed consolidated statements ofoperations.

 

8

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*Lease Guarantees and Contingencies -*

 

Primarilyas a result of the Company’s refranchising efforts, the Company remains liablefor certain lease assignments and guarantees. These leases have varying terms,the latest of which expires in 2020. As of June 27, 2004, the potentialamount of undiscounted payments the Company could be required to make in theevent of non-payment by the primary lessee was $9,700,000. The present value ofthese potential payments discounted at the Company’s pre-tax cost of debt atJune 27, 2004 was $7,450,000. The Company generally has cross-defaultprovisions with franchisees that would put them in default of their franchiseagreement in the event of non-payment under the lease. The Company believesthese cross-default provisions significantly reduce the risk that the Companywill be required to make payments under these leases and, historically, theCompany has not been required to make such payments. Additionally, as ofJune 27, 2004, the Company has no reason to believe that the franchiseeswill be unable to fulfill their obligations. Accordingly, no liability has beenrecorded for exposure under such leases at June 27, 2004 andDecember 28, 2003.

 

*(Loss) Earnings Per Share -*

 

Basic(loss) earnings per share is calculated by dividing net (loss) income by theweighted average number of common shares outstanding during the period. Diluted(loss) earnings 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 and warrants that are assumed exercised for calculation purposes. Thenumber of common stock options which could dilute basic earnings per share inthe future, that were not included in the computation of diluted earnings pershare because to do so would have been antidilutive, was 284,289 and 191,110for the three months ended June 27, 2004 and June 29, 2003,respectively. The number of common stock options which could dilute basicearnings per share in the future, that were not included in the computation ofdiluted earnings per share because to do so would have been antidilutive, was289,195 and 191,110 for the six months ended June 27, 2004 andJune 29, 2003, respectively.

 

9

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Presentedbelow is the reconciliation between basic and diluted weighted average sharesfor the three and six months ended June 27, 2004 and June 29, 2003(in thousands):

 
|                                                                    |   | **For the  Three Months Ended** |       |
|-------------------------------------------------------------------------|--------|---------------------------------|------------|
|                                                                    |   | **Basic**                       |       | **Diluted** |   |
|                                                                    |   | **June 27,  2004**         |       | **June 29,  2003** |   | **June 27,  2004** |   | **June 29,  2003** |   |
|                                                                    |   |                            |       |   |   |   |   |   |   |
| Weighted average number of common shares  outstanding during the period |   | 7,611                           |       | 7,441 |   | 7,611 |   | 7,441 |   |
| Adjustments:                                                            |   |                            |       |   |   |   |   |   |   |
| Assumed exercise of stock options                                       |   | —                          |       | — |   | — |   | 133 |   |
| Weighted average number of shares  outstanding                          |   | 7,611                           |       | 7,441 |   | 7,611 |   | 7,574 |   |
|                                                                    |   |                            |       |   |   |   |   |   |   |
|                                                                    |   | **For the  Six Months Ended**   | ** ** |
|                                                                    |   | **Basic**                       |       | **Diluted** | ** ** |
|                                                                    |   | **June 27,  2004**         |       | **June 29,  2003** |   | **June 27,  2004** |   | **June 29,  2003** | ** ** |
|                                                                    |   |                            |       |   |   |   |   |   |   |
| Weighted average number of common shares  outstanding during the period |   | 7,569                           |       | 7,428 |   | 7,569 |   | 7,428 |   |
| Adjustments:                                                            |   |                            |       |   |   |   |   |   |   |
| Assumed exercise of stock options                                       |   | —                          |       | — |   | — |   | 136 |   |
| Weighted average number of shares  outstanding                          |   | 7,569                           |       | 7,428 |   | 7,569 |   | 7,564 |   |

 

*Stock-Based Compensation -*

 

TheCompany accounts for stock-based compensation for employees under AccountingPrinciples Board (“APB”) Opinion No. 25, “Accounting for Stock Issued toEmployees,” and elected the disclosure-only alternative under SFAS No. 123,“Accounting for Stock-Based Compensation.” Stock-based compensation cost of approximately $222,000 related tomodified option awards was included in net loss for the six months endedJune 27, 2004 for the Company’s Stock Option Plan and the Company’s 2003Incentive Plan. No stock-based compensation cost was included in net income forthe six months ended June 29, 2003 for the Company’s Stock Option Plan orthe Company’s 2003 Incentive Plan, as all options granted during this periodhad an exercise price equal to the market value of the stock on the date ofgrant.

 

InDecember 2002, the Financial Accounting Standards Board (“FASB”) issuedSFAS No. 148, “Accounting for Stock-Based Compensation—Transition andDisclosure,” which amends SFAS No. 123. SFAS No. 148 allows for three methodsof transition for those companies that adopt SFAS No. 123’s provisions for fairvalue recognition. SFAS No. 148’s transition guidance and provisions for annualdisclosures are effective for fiscal years ending after December 15, 2002.In accordance with SFAS No. 148, the Company will continue to disclose therequired pro-forma information in the notes to the consolidated financialstatements.

 

10

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Inaccordance with SFAS No. 148, the following table presents the effect on net(loss) income and net (loss) income per share had compensation cost for theCompany’s stock plans been determined consistent with SFAS No. 123 (inthousands, except per share data):

 
|                                                                                                                                |   | **For the  Three Months Ended** |   | **For the Six  Months Ended** |   |
|-------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------|--------|-------------------------------|--------|
|                                                                                                                                |   | **June 27,  2004**         |   | **June 29,  2003**       |   | **June 27,  2004** |   | **June 29,  2003** |   |
|                                                                                                                                |   |                            |   |                          |   |   |   |   |   |
| Net (loss) income as reported                                                                                                       |   | $                               | (1,302 | )                             | $      | 3,090 |   | $ | (6,431 | ) | $ | 1,601 |   |
|                                                                                                                                |   |                            |   |                          |   |   |   |   |   |
| Add stock-based compensation expense  included in reported net loss, net of related income tax benefit                              |   | —                          |   | —                        |   | 131 |   | — |   |
| Less stock-based compensation expense  determined under fair value method for all stock options, net of related  income tax benefit |   | (106                            | )      | (75                           | )      | (211 | ) | (176 | ) |
| Pro forma net (loss) income                                                                                                         |   | $                               | (1,408 | )                             | $      | 3,015 |   | $ | (6,511 | ) | $ | 1,425 |   |
|                                                                                                                                |   |                            |   |                          |   |   |   |   |   |
| Basic net (loss) income per share, as  reported                                                                                     |   | $                               | (0.17  | )                             | $      | 0.42 |   | $ | (0.85 | ) | $ | 0.22 |   |
| Basic net (loss) income per share, pro  forma                                                                                       |   | $                               | (0.18  | )                             | $      | 0.41 |   | $ | (0.86 | ) | $ | 0.19 |   |
|                                                                                                                                |   |                            |   |                          |   |   |   |   |   |
| Diluted net (loss) income per share, as  reported                                                                                   |   | $                               | (0.17  | )                             | $      | 0.41 |   | $ | (0.85 | ) | $ | 0.21 |   |
| Diluted net (loss) income per share, pro  forma                                                                                     |   | $                               | (0.18  | )                             | $      | 0.40 |   | $ | (0.86 | ) | $ | 0.19 |   |

 

*Reclassifications -*

 

Certainprior year amounts have been reclassified to conform with current year presentation,including $782,000 and $1,557,000 from operating expenses to general andadministrative expenses for the three and six months ended June 29, 2003,respectively.

 

*Recently Issued Accounting Pronouncements -*

 

InJanuary 2003, the FASB issued Interpretation No. 46, “Consolidation ofVariable Interest Entities, an Interpretation of Accounting Research Bulletin(“ARB”) No. 51” (“FIN 46”). FIN 46 requires certain variable interest entitiesto be consolidated by the primary beneficiary of the entity if the equityinvestors in the entity do not have the characteristics of a controllingfinancial interest or do not have sufficient equity at risk for the entity tofinance its activities without additional subordinated financial support fromother parties. FIN 46 is effective for all entities subject to thisinterpretation no later than the end of the first period that ends afterMarch 15, 2004. The adoption of FIN 46 in 2003 had no material impact onthe Company’s results of operations or financial position.

 

11

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**2. DEBT**

 

Debtat June 27, 2004 and December 28, 2003 consisted of the following (inthousands):

 
|                                                                |   | **June 27,  2004** |    | **December 28,  2003** |   |
|---------------------------------------------------------------------|--------|-------------------------|---------|-----------------------------|--------|
|                                                                |   |                    |    |                        |   |
| New Senior Notes, 8 3/8%, due June 15,  2012                   |   | $                       | 175,000 |                        | $      | — |   |
| Senior Notes, 10 1/2%, originally due  December 1, 2007        |   | —                  |    | 175,977                     |   |
| Revolving credit loans, due June 30,  2007                     |   | —                  |    | —                      |   |
| Mortgage loans, due July 1, 2004  through January 1, 2022 |   | 52,537                  |    | 53,087                      |   |
| Total debt                                                          |   | 227,537                 |    | 229,064                     |   |
| Less: current portion                                               |   | (1,196                  | )       | (1,127                      | )      |
| Total long-term debt                                                |   | $                       | 226,341 |                        | $      | 227,937 |   |

 

InNovember 1997, FICC entered into a credit facility that included revolvingcredit loans, term loans and letters of credit (the “Old CreditFacility”).  Also in November 1997,FICC completed a public offering of $200,000,000 of senior notes (the “SeniorNotes”).

 

InDecember 2001, the Company completed a financial restructuring plan (the“Refinancing Plan”) which included the repayment of the $64,545,000 outstandingunder the Old Credit Facility and the purchase of $21,273,000 in Senior Noteswith the proceeds from $55,000,000 in long-term mortgage financing (the“Mortgage Financing”) and a $33,700,000 sale and leaseback transaction (the“Sale/Leaseback Financing”). In addition, FICC secured a new $30,000,000revolving credit facility (the “New Credit Facility”) of which up to$20,000,000 is available to support letters of credit.  On July 3, 2003, FICC obtained alimited waiver to the New Credit Facility allowing the purchase of certain ofthe Senior Notes in an amount up to $3,000,000, subject to certain conditions.In July 2003, FICC purchased $2,750,000 in aggregate principal amount ofthe Senior Notes for $2,826,000, the then current market value.

 

12

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InFebruary 2004, the Company announced a cash tender offer and consentsolicitation for the $175,977,000 of Senior Notes to be financed with theproceeds from a private offering of new senior notes (the “New Senior Notes”),available cash and an amended New Credit Facility (the “2004Refinancing”).  In March 2004,$127,357,000 of aggregate principal amount of Senior Notes were purchased atthe tender offer and consent solicitation price of 104% of the principal amountand $476,000 of aggregate principal amount of Senior Notes were purchased atthe tender offer price of 102% of the principal amount. In April 2004, theremaining $48,144,000 of Senior Notes were redeemed in accordance with theSenior Notes indenture at 103.5% of the principal amount.  The Senior Notes would have matured onDecember 1, 2007.  Interest on theSenior Notes was payable at 10.5% per annum semi-annually on June 1 andDecember 1 of each year.  Inconnection with the tender offer, the Company wrote off unamortized deferredfinancing costs of $2,445,000 and paid a premium of $6,790,000 that wasincluded in the accompanying condensed consolidated statement of operations forthe six months ended June 27, 2004.

 

The$175,000,000 of New Senior Notes issued in March 2004 are unsecured seniorobligations of FICC, guaranteed on an unsecured senior basis by FICC’sFriendly’s Restaurants Franchise, Inc. subsidiary, but are effectivelysubordinated to all secured indebtedness of FICC, including the indebtednessincurred under the New Credit Facility. The New Senior Notes mature onJune 15, 2012. Interest on the New Senior Notes is payable at 8.375% perannum semi-annually on June 15 and December 15 of each yearcommencing June 15, 2004.  The NewSenior Notes are redeemable, in whole or in part, at any time on or afterJune 15, 2008 at FICC’s option at redemption prices from 104.188% to100.00%, based on the redemption date. In addition, at any time prior to June 15, 2007, FICC may redeem,subject to certain conditions, up to 35% of the aggregate principal amount ofthe New Senior Notes with the proceeds of one or more qualified equityofferings, as defined, at a redemption price of 108.375% of the principalamount, plus accrued interest.

 

Inconnection with the 2004 Refinancing, the New Credit Facility was amended inMarch 2004.  The total commitmentamount was increased from $30,000,000 to $35,000,000 and the maturity date wasextended from December 17, 2005 to June 30, 2007, in addition toother changes.

 

13

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TheNew Credit Facility is secured by substantially all of the assets of FICC andtwo of its six subsidiaries, Friendly’s Restaurants Franchise, Inc. andFriendly’s International Inc. These two subsidiaries also guarantee FICC’s obligationsunder the New Credit Facility.

 

TheNew Credit Facility includes certain restrictive covenants includinglimitations on indebtedness, restricted payments such as dividends and stockrepurchases and sales of assets and of subsidiary stock. Additionally, the NewCredit Facility limits the amount which the Company may spend on capitalexpenditures, restricts the use of proceeds, as defined, from asset sales andrequires the Company to comply with certain financial covenants. OnJuly 23, 2004, the Company successfully obtained a limited waiverregarding a quarterly EBITDA covenant of its New Credit Facility.

 

TheNew Credit Facility has an annual “clean-up” provision, commencing in 2005,which obligates the Company to repay in full all revolving credit loans on orbefore September 30 (or, if September 30 is not a business day, asdefined, then the next business day) of each year and maintain a zero balanceon such revolving credit for at least 30 consecutive days, to includeSeptember 30, immediately following the date of such repayment.

 

The$35,000,000 revolving credit commitment less outstanding letters of credit isavailable for borrowing to provide working capital and for other corporateneeds. As of June 27, 2004 and December 28, 2003, total letters ofcredit outstanding were $14,474,000 and $13,550,000, respectively. During thesix months ended June 27, 2004 and June 29, 2003, there were nodrawings against the letters of credit.

 

Therevolving credit loans bear interest at the Company’s option at either (a) theBase Rate plus the applicable margin in effect from time to time (the “BaseRate”) (6.50% at June 27, 2004) or (b) the Eurodollar rate plus theapplicable margin in effect from time to time (the “Eurodollar Rate”) (5.76% atJune 27, 2004).  As ofJune 27, 2004 and December 28, 2003, there were no revolving creditloans outstanding and $20,526,000 and $16,450,000, respectively, was availablefor borrowing.

 

Inconnection with the Mortgage Financing in December 2001, three new limitedliability companies (“LLCs”) were organized. Friendly Ice Cream Corporation is the sole member of each LLC. FICC sold75 of its operating Friendly’s restaurants to the LLCs in exchange for theproceeds from the Mortgage Financing. Promissory notes were issued for each ofthe 75 properties. Each LLC is a separate entity with separate creditors whowill be entitled to be satisfied out of such LLC’s assets. Each LLC is aborrower under the Mortgage Financing.

 

TheMortgage Financing has a maturity date of January 1, 2022 and is amortizedover 20 years. Interest on $10,000,000 of the original $55,000,000 from theMortgage Financing is variable and is the sum of the 30-day LIBOR rate ineffect (1.33% at June 27, 2004) plus 6% on an annual basis. Changes in theinterest rate are calculated monthly and recognized annually when the monthlypayment amount is adjusted. Changes in the monthly payment amounts owed due tointerest rate changes are reflected in the principal balances, which arere-amortized over the remaining life of the mortgages. The remaining$45,000,000 of the original $55,000,000 from the Mortgage Financing bearsinterest at a fixed annual rate of 10.16%. Each promissory note may be prepaidin full. The variable rate notes are subject to prepayment penalties during thefirst five years. The fixed rate notes may not

 

14

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be prepaid without the Company providing the note holders with a yieldmaintenance premium.

 

TheMortgage Financing requires the Company to maintain a fixed charge coverageratio, as defined, of at least 1.10 to 1 and each LLC to maintain a fixedcharge coverage ratio, as defined, on an aggregate restaurant basis of at least1.25 to 1, in each case calculated as of the last day of each fiscal year. TheCompany is in compliance with these covenants.

 

**3. INTANGIBLE ASSETS AND DEFERRED COSTS**

 

Intangibleassets and deferred costs as of June 27, 2004 and December 28, 2003were (in thousands):

 
|                                                                                                |   | **June 27,  2004** |   | **December 28,  2003** |   |
|-----------------------------------------------------------------------------------------------------|--------|-------------------------|--------|-----------------------------|--------|
|                                                                                                |   |                    |   |                        |   |
| 1988 Non-Friendly Marks amortized over 40  years on a straight-line basis                           |   | $                       | 18,650 |                        | $      | 18,650 |   |
| Deferred financing costs amortized over the  terms of the related loans on an effective yield basis |   | 10,121                  |   | 10,486                      |   |
| Other                                                                                               |   | 876                     |   | 876                         |   |
| Intangible assets and deferred costs                                                                |   | 29,647                  |   | 30,012                      |   |
| Less: accumulated amortization                                                                      |   | (8,475                  | )      | (12,122                     | )      |
| Net                                                                                                 |   | $                       | 21,172 |                        | $      | 17,890 |   |

 

Inconnection with the 2004 Refinancing, the Company wrote off unamortizeddeferred financing costs related to the tender offer for the Senior Notes in March 2004and the redemption of the remaining Senior Notes in April 2004 of$1,788,000 and $657,000, respectively. The $2,445,000 was included in otherexpenses, principally debt retirement costs in the accompanying condensedconsolidated statement of operations for the six months ended June 27,2004. Additionally, the Company incurred $6,550,000 of costs associated withthe issuance of the New Senior Notes and the amendment to the New CreditFacility, which were included in intangible assets and deferred costs in theaccompanying condensed consolidated balance sheet as of June 27, 2004.These costs will be amortized over the terms of the New Senior Notes and theamended New Credit Facility.

 

Amortizationexpense was $452,000 and $428,000 for the three months ended June 27, 2004and June 29, 2003, respectively. Amortization expense was $898,000 and$856,000 for the six months ended June 27, 2004 and June 29, 2003,respectively.

 

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Futureamortization expense related to these intangible assets and deferred costs asof June 27, 2004 was (in thousands):

 

| **Year**   |   | **Amount** |   |
|------------|--------|------------|--------|
|       |   |       |   |
| 2004       |   | $          | 915    |   |
| 2005       |   | 1,783      |   |
| 2006       |   | 1,778      |   |
| 2007       |   | 1,608      |   |
| 2008       |   | 1,441      |   |
| Thereafter |   | 13,647     |   |
| Total      |   | $          | 21,172 |   |

 

**4. EMPLOYEE BENEFIT PLANS**

 

Thecomponents of net periodic pension benefit for the three and six months endedJune 27, 2004 and June 29, 2003 were (in thousands):

 
|                               |   | **For the  Three Months Ended** |   | **For the  Six Months Ended** |   |
|------------------------------------|--------|---------------------------------|--------|-------------------------------|--------|
|                               |   | **June 27,  2004**         |   | **June 29,  2003**       |   | **June 27,  2004** |   | **June 29,  2003** |   |
|                               |   |                            |   |                          |   |   |   |   |   |
| Service cost                       |   | $                               | — |                          | $      | 553 |   | $ | — |   | $ | 1,105 |   |
| Interest cost                      |   | 1,675                           |   | 1,606                         |   | 3,302 |   | 3,212 |   |
| Expected return on assets          |   | (2,364                          | )      | (2,274                        | )      | (4,695 | ) | (4,549 | ) |
| Net amortization:                  |   |                            |   |                          |   |   |   |   |   |
| Unrecognized prior service benefit |   | —                          |   | (320                          | )      | — |   | (640 | ) |
| Unrecognized net actuarial loss    |   | 182                             |   | 151                           |   | 335 |   | 302 |   |
|                               |   |                            |   |                          |   |   |   |   |   |
| Net periodic pension benefit       |   | $                               | (507   | )                             | $      | (284 | ) | $ | (1,058 | ) | $ | (570 | ) |

 

16

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TheCompany provides health care and life insurance benefits to certain groups ofemployees upon retirement. The components of the net postretirement benefitcost for the three and six months ended June 27, 2004 and June 29,2003 were (in thousands):

 
|                                                    |   | **For the  Three Months Ended** |   | **For the  Six Months Ended** |   |
|---------------------------------------------------------|--------|---------------------------------|--------|-------------------------------|--------|
|                                                    |   | **June 27,  2004**         |   | **June 29,  2003**       |   | **June 27,  2004** |   | **June 29,  2003** |   |
|                                                    |   |                            |   |                          |   |   |   |   |   |
| Service cost                                            |   | $                               | 28     |                          | $      | 25 |   | $ | 56 |   | $ | 49 |   |
| Interest cost                                           |   | 116                             |   | 117                           |   | 232 |   | 235 |   |
| Recognized actuarial loss                               |   | 23                              |   | 16                            |   | 45 |   | 31 |   |
| Net amortization of unrecognized prior service  benefit |   | (35                             | )      | (36                           | )      | (71 | ) | (71 | ) |
|                                                    |   |                            |   |                          |   |   |   |   |   |
| Net postretirement benefit cost                         |   | $                               | 132    |                          | $      | 122 |   | $ | 262 |   | $ | 244 |   |

 

DuringJanuary 2004, the FASB issued FASB Staff Position (“FSP”) 106-1,“Accounting and Disclosure Requirements Related to the Medicare PrescriptionDrug, Improvement and Modernization Act of 2003 (the “Act”)”, which permits asponsor of a postretirement health care plan that provides a prescription drugbenefit to make a one-time election to defer accounting for the effects of theAct. The guidance in this FSP is effective for interim or annual financialstatements of fiscal years ending after December 7, 2003. The election todefer accounting for the Act is a one-time election that must be made beforenet periodic postretirement benefit costs for the period that includes theAct’s enactment date are first included in reported financial informationpursuant to the requirements of SFAS No. 106, “Employers’ Accounting forPostretirement Benefits Other than Pensions.” In accordance with FSP 106-1, the Company has elected to deferaccounting for the effects of the Act and accordingly, the measures of theaccumulated postretirement benefit obligation and the net postretirementbenefit cost do not reflect the effects of the Act.

 

TheCompany’s election to defer accounting for the effects of the Act may not bechanged and the deferral will continue to apply until authoritative guidance onthe accounting for the federal subsidy is issued, or until the guidance in thefollowing sentence applies. The election to defer expires if, subsequent toJanuary 31, 2004, but prior to the issuance of additional authoritativeguidance, a significant event occurs that ordinarily would call forremeasurement of a plan’s assets and obligations-for example, a plan amendment,settlement, or curtailment. Upon the occurrence of such an event, the Companywould be required to account for that event pursuant to the guidance in SFASNo. 106 and also reflect in its accounting for postretirement benefits otherthan pensions its best estimate of the effects of the Act, including thefederal subsidy (if applicable based on the terms of the plan and the sponsor’sanalysis of generally accepted accounting principles) and any effects onparticipation rates and health care cost estimates.

 

Authoritativeguidance on accounting for the federal subsidy is pending. The expected effectsof the Act will be factored into the Company’s year-end measurement ofpostretirement benefit costs for fiscal 2004. If the final authoritativeaccounting guidance is issued after the provisions of the Act are reflected inthe year-end measurement of the obligation and net postretirement benefit costsestimate for fiscal 2004, the guidance could require the Company to changepreviously reported information. The Company has not yet determined the impactof the Act on these benefits.

 

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**5. SEGMENT REPORTING**

 

Operatingsegments are components of an enterprise about which separate financialinformation is available that is evaluated regularly by the chief operatingdecision-maker, or decision-making group, in deciding how to allocate resourcesand in assessing performance. The Company’s chief operating decision-maker isthe Chief Executive Officer and President of the Company. The Company’soperating segments include restaurant, foodservice and franchise. The revenuesfrom these segments include both sales to unaffiliated customers andintersegment sales, which generally are accounted for on a basis consistent withsales to unaffiliated customers. Intersegment sales and other intersegmenttransactions have been eliminated in the accompanying condensed consolidatedfinancial statements.

 

TheCompany’s restaurants target families with children and adults who desire areasonably priced meal in a full-service setting. The Company’s menu offers abroad selection of freshly-prepared foods, which appeal to customers throughoutall dayparts. The menu currently features over 100 items comprised of a broadselection of breakfast, lunch, dinner and afternoon and evening snack items.Foodservice operations manufactures frozen dessert products and distributessuch manufactured products and purchased finished goods to the Company’srestaurants and franchised operations. Additionally, it sells frozen dessertproducts to distributors and retail and institutional locations. The Company’sfranchise segment includes a royalty based on franchise restaurant revenue. Inaddition, the Company receives rental income from various franchised restaurants.The Company does not allocate general and administrative expenses associatedwith its headquarters operations to any business segment. These costs includeexpenses of the following functions: legal, accounting, personnel not directlyrelated to a segment, information systems and other headquarters activities.

 

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

 

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

 
|                   |   | **For the  Three Months Ended** |    | **For the  Six Months Ended** |   |
|------------------------|--------|---------------------------------|---------|-------------------------------|--------|
|                   |   | **June 27,  2004**         |    | **June 29,  2003**       |   | **June 27,  2004** |   | **June 29,  2003** |   |
|                   |   | **(in  thousands)**             |    | **(in  thousands)**           |   |
| Revenues:              |   |                            |    |                          |   |   |   |   |   |
| Restaurant             |   | $                               | 114,441 |                          | $      | 123,002 |   | $ | 218,794 |   | $ | 226,170 |   |
| Foodservice            |   | 63,915                          |    | 64,633                        |   | 117,277 |   | 116,959 |   |
| Franchise              |   | 3,255                           |    | 2,710                         |   | 6,313 |   | 4,965 |   |
| Total                  |   | $                               | 181,611 |                          | $      | 190,345 |   | $ | 342,384 |   | $ | 348,094 |   |
|                   |   |                            |    |                          |   |   |   |   |   |
| Intersegment revenues: |   |                            |    |                          |   |   |   |   |   |
| Restaurant             |   | $                               | —  |                          | $      | — |   | $ | — |   | $ | — |   |
| Foodservice            |   | (34,095                         | )       | (34,697                       | )      | (64,114 | ) | (63,756 | ) |
| Franchise              |   | —                          |    | —                        |   | — |   | — |   |
| Total                  |   | $                               | (34,095 | )                             | $      | (34,697 | ) | $ | (64,114 | ) | $ | (63,756 | ) |
|                   |   |                            |    |                          |   |   |   |   |   |
| External revenues:     |   |                            |    |                          |   |   |   |   |   |
| Restaurant             |   | $                               | 114,441 |                          | $      | 123,002 |   | $ | 218,794 |   | $ | 226,170 |   |
| Foodservice            |   | 29,820                          |    | 29,936                        |   | 53,163 |   | 53,203 |   |
| Franchise              |   | 3,255                           |    | 2,710                         |   | 6,313 |   | 4,965 |   |
| Total                  |   | $                               | 147,516 |                          | $      | 155,648 |   | $ | 278,270 |   | $ | 284,338 |   |

 

19

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|                                                             |   | **For the  Three Months Ended** |   | **For the  Six Months Ended** |   |
|------------------------------------------------------------------|--------|---------------------------------|--------|-------------------------------|--------|
|                                                             |   | **June 27,  2004**         |   | **June 29,  2003**       |   | **June 27,  2004** |   | **June 29,  2003** |   |
|                                                             |   | **(in  thousands)**             |   | **(in  thousands)**           |   |
|                                                             |   |                            |   |                          |   |   |   |   |   |
| EBITDA:                                                          |   |                            |   |                          |   |   |   |   |   |
| Restaurant                                                       |   | $                               | 11,424 |                          | $      | 14,402 |   | $ | 20,757 |   | $ | 24,483 |   |
| Foodservice                                                      |   | 2,870                           |   | 5,258                         |   | 6,403 |   | 8,447 |   |
| Franchise                                                        |   | 2,311                           |   | 2,002                         |   | 4,402 |   | 3,563 |   |
| Corporate                                                        |   | (4,714                          | )      | (4,651                        | )      | (10,127 | ) | (9,480 | ) |
| (Loss) gain on property and equipment, net                       |   | (379                            | )      | (882                          | )      | 295 |   | (1,223 | ) |
| Restructuring expenses                                           |   | —                          |   | —                        |   | (2,627 | ) | — |   |
| Gain on litigation settlement                                    |   | —                          |   | —                        |   | 3,644 |   | — |   |
| Less pension benefit included in reporting  segments             |   | (507                            | )      | (284                          | )      | (1,058 | ) | (570 | ) |
| Total                                                            |   | $                               | 11,005 |                          | $      | 15,845 |   | $ | 21,689 |   | $ | 25,220 |   |
|                                                             |   |                            |   |                          |   |   |   |   |   |
| Interest expense, net-Corporate                                  |   | $                               | 5,368  |                          | $      | 6,092 |   | $ | 11,432 |   | $ | 12,194 |   |
|                                                             |   |                            |   |                          |   |   |   |   |   |
| Other expenses, principally debt retirement  costs               |   | $                               | 2,343  |                          | $      | — |   | $ | 9,235 |   | $ | — |   |
|                                                             |   |                            |   |                          |   |   |   |   |   |
| Depreciation and amortization:                                   |   |                            |   |                          |   |   |   |   |   |
| Restaurant                                                       |   | $                               | 3,844  |                          | $      | 3,965 |   | $ | 7,694 |   | $ | 7,765 |   |
| Foodservice                                                      |   | 840                             |   | 746                           |   | 1,696 |   | 1,482 |   |
| Franchise                                                        |   | 68                              |   | 38                            |   | 116 |   | 77 |   |
| Corporate                                                        |   | 818                             |   | 997                           |   | 1,670 |   | 2,049 |   |
| Total                                                            |   | $                               | 5,570  |                          | $      | 5,746 |   | $ | 11,176 |   | $ | 11,373 |   |
|                                                             |   |                            |   |                          |   |   |   |   |   |
| Other non-cash (income) expense:                                 |   |                            |   |                          |   |   |   |   |   |
| Net periodic pension benefit                                     |   | $                               | (507   | )                             | $      | (284 | ) | $ | (1,058 | ) | $ | (570 | ) |
| Write-downs of property and equipment                            |   | 91                              |   | —                        |   | 91 |   | — |   |
| Total                                                            |   | $                               | (416   | )                             | $      | (284 | ) | $ | (967 | ) | $ | (570 | ) |
|                                                             |   |                            |   |                          |   |   |   |   |   |
| Income (loss) before (provision for)  benefit from income taxes: |   |                            |   |                          |   |   |   |   |   |
| Restaurant                                                       |   | $                               | 7,580  |                          | $      | 10,437 |   | $ | 13,063 |   | $ | 16,718 |   |
| Foodservice                                                      |   | 2,030                           |   | 4,512                         |   | 4,707 |   | 6,965 |   |
| Franchise                                                        |   | 2,243                           |   | 1,964                         |   | 4,286 |   | 3,486 |   |
| Corporate                                                        |   | (13,243                         | )      | (11,740                       | )      | (32,464 | ) | (23,723 | ) |
| (Loss) gain on property and equipment, net                       |   | (470                            | )      | (882                          | )      | 204 |   | (1,223 | ) |
| Restructuring expenses                                           |   | —                          |   | —                        |   | (2,627 | ) | — |   |
| Gain on litigation settlement                                    |   | —                          |   | —                        |   | 3,644 |   | — |   |
| Total                                                            |   | $                               | (1,860 | )                             | $      | 4,291 |   | $ | (9,187 | ) | $ | 2,223 |   |

 

20

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|                                                                   |   | **For the  Six  Months Ended  June 27,  2004** |       | **For the  Year  Ended  December 28,  2003** |       |
|------------------------------------------------------------------------|--------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
|                                                                   |   | **(in  thousands)**                                 |       |
| Capital expenditures, including assets  acquired under capital leases: |   |                                                |       |                                              |       |
| Restaurant                                                             |   | $                                                   | 7,003      |                                              | $          | 25,024 |   |
| Foodservice                                                            |   | 845                                                 |       | 4,862                                             |       |
| Corporate                                                              |   | 414                                                 |       | 1,830                                             |       |
| Total                                                                  |   | $                                                   | 8,262      |                                              | $          | 31,716 |   |
|                                                                   |   |                                                |       |                                              |       |
|                                                                   |   | **June 27,  2004**                             |       | **December 28,  2003**                       | ** ** |
|                                                                   |   | **(in  thousands)**                                 | ** ** |
| Total assets:                                                          |   |                                                |       |                                              |       |
| Restaurant                                                             |   | $                                                   | 150,537    |                                              | $          | 152,228 |   |
| Foodservice                                                            |   | 45,640                                              |       | 39,404                                            |       |
| Franchise                                                              |   | 8,371                                               |       | 8,644                                             |       |
| Corporate                                                              |   | 47,397                                              |       | 52,176                                            |       |
| Total                                                                  |   | $                                                   | 251,945    |                                              | $          | 252,452 |   |

 

21

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**6. RESTRUCTURING RESERVES**

 

DuringMarch 2004, the Company recorded a pre-tax restructuring charge of$2,627,000 for severance and outplacement services associated with reduction inforce actions taken during the first quarter of 2004 that reduced headcount byapproximately 20 permanent positions.

 

OnOctober 10, 2001, the Company eliminated approximately 70 positions atcorporate headquarters. In addition, approximately 30 positions in the restaurantconstruction and fabrication areas were eliminated by December 30, 2001.The purpose of the reduction was to streamline functions and reduce redundancyamong its business segments. As a result of the elimination of the positionsand the outsourcing of certain functions, the Company reported a pre-taxrestructuring charge of $2,536,000 for severance, rent and unusableconstruction supplies in the year ended December 30, 2001.

 

InMarch 2000, the Company’s Board of Directors approved a restructuring planthat provided for the immediate closing of 81 restaurants at the end ofMarch 2000 and the disposition of an additional 70 restaurants over thenext 24 months. As a result of this plan, the Company reported a pre-taxrestructuring charge of $12,056,000 for severance, rent, utilities and realestate taxes, demarking, lease termination costs and certain other costsassociated with the closing of the locations, along with a pre-tax write-downof property and equipment for these locations of approximately $17,000,000 inthe year ended December 31, 2000. The Company reduced the restructuringreserve by $400,000 and $1,900,000 during the years ended December 29,2002 and December 30, 2001, respectively, since the reserve exceededestimated remaining payments.

 

22

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Thefollowing represents the reserves and activity associated with theMarch 2004, October 2001 and March 2000 restructurings (inthousands):

 
|                            |   | **For the  Six Months Ended June 27, 2004**          |       |
|---------------------------------|--------|-----------------------------------------------------------|------------|
|                            |   | **Restructuring  Reserves as of  December 28, 2003** |       | **Expense** |   | **Costs Paid** |   | **Restructuring  Reserves as of  June 27, 2004** |   |
|                            |   |                                                      |       |   |   |   |   |   |   |
| Rent                            |   | $                                                         | 319        |   | $ | — |   | $ | (119 | ) | $ | 200 |   |
| Utilities and real estate taxes |   | 40                                                        |       | — |   | (13 | ) | 27 |   |
| Severence pay                   |   | —                                                    |       | 2,549 |   | (762 | ) | 1,787 |   |
| Outplacement services           |   | —                                                    |       | 78 |   | (78 | ) | — |   |
| Other                           |   | 82                                                        |       | — |   | (41 | ) | 41 |   |
| Total                           |   | $                                                         | 441        |   | $ | 2,627 |   | $ | (1,013 | ) | $ | 2,055 |   |
|                            |   |                                                      |       |   |   |   |   |   |   |
|                            |   | **For the  Six Months Ended June 29, 2003**          | ** ** |
|                            |   | **Restructuring  Reserves as of  December 29, 2002** |       | **Expense** |   | **Costs Paid** |   | **Restructuring  Reserves as of  June 29, 2003** | ** ** |
|                            |   |                                                      |       |   |   |   |   |   |   |
| Rent                            |   | $                                                         | 679        |   | $ | — |   | $ | (128 | ) | $ | 551 |   |
| Utilities and real estate taxes |   | 121                                                       |       | — |   | (59 | ) | 62 |   |
| Equipment                       |   | 77                                                        |       | — |   | (77 | ) | — |   |
| Other                           |   | 60                                                        |       | — |   | (24 | ) | 36 |   |
| Total                           |   | $                                                         | 937        |   | $ | — |   | $ | (288 | ) | $ | 649 |   |

 

Basedon information currently available, management believes that the restructuringreserves as of June 27, 2004 were adequate and not excessive.

 

**7. GAIN ON LITIGATION SETTLEMENT**

 

InJanuary 2004, a settlement was reached in a lawsuit filed by the Companyagainst a former administrator of one of the Company’s benefit plans.  The settlement was based on theadministrator’s alleged failure to adhere to the terms of a contract andresulted in a one-time payment to the Company of $3,775,000, which was receivedon April 2, 2004. As a result of this lawsuit, the Company incurredprofessional fees of approximately $500,000 which were included in theconsolidated statement of operations for the year ended December 28, 2003and an additional $131,000 in professional fees, which were offset against thepayment in the accompanying condensed consolidated statement of operations forthe six months ended June 27, 2004.

 

23

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**8. FRANCHISE TRANSACTIONS**

 

OnMarch 5, 2004, the Company sold the real property and equipment for onefranchised location and assigned the lease and sold the equipment for a secondfranchised location to the existing franchisee. Gross proceeds from the salewere approximately $485,000, of which $70,000 was for franchise fees and$415,000 was for the sale of assets and lease assignment. In March 2004,the Company recorded $70,000 as franchise fee revenue and recognized a gain ofapproximately $248,000 related to the sale of assets.

 

OnJanuary 15, 2004, the Company entered into an agreement granting CentralFlorida Restaurants LLC (“Central Florida”) certain limited exclusive rights tooperate and develop Friendly’s full-service restaurants in designated areaswithin the Orlando, Florida market (the “Central Florida Agreement”).  Pursuant to the Central Florida Agreement,Central Florida purchased certain equipment assets, lease and sublease rightsand franchise rights in 10 existing Friendly’s restaurants and committed toopen an additional 10 restaurants over the next six years with an option for 15more restaurants in the following five years. Gross proceeds from the sale wereapproximately $3,150,000 of which $310,000 was for franchise fees for theinitial 10 restaurants. In January 2004, the Company recorded $310,000 asfranchise fee revenue and recognized a gain of approximately $658,000 relatedto the sale of the assets for the 10 locations.

 

DuringJuly 2003, the Company entered into a development agreement granting JaxFamily Rest., Inc. (“Jax”) certain limited exclusive rights to operate anddevelop Friendly’s full-service restaurants in designated areas within Baker,Clay, Nassau, Putnam and St. John’s counties, Florida (the “Jax Agreement”).Pursuant to the Jax Agreement, Jax agreed to open 10 new restaurants over the nextseven years. The Company received development fees of $155,000, which representone-half of the initial franchise fees. The $155,000 will be recognized intoincome as restaurants are opened. During the quarter ended June 27, 2004,Jax opened one new restaurant.

 

InDecember 2000, the Company and its first franchisee, Friendco RestaurantsInc. (“Friendco”), a subsidiary of Davco Restaurants, Inc. (“Davco”), agreed toterminate Friendco’s rights as the exclusive developer of new Friendly’srestaurants in Maryland, Delaware, the District of Columbia and northernVirginia. Friendco also obtained the right to close existing franchisedlocations subject, however, to liquidated damages on 22 of its 48 franchiseagreements. During the year ended December 30, 2001, Friendco transferredits rights to three franchised locations to a third party and closed tworestaurants.  During the year endedDecember 29, 2002, Friendco transferred its rights to 24 additionalfranchised locations to six separate third parties and closed six restaurants.During the year ended December 28, 2003, Friendco closed five restaurantsand transferred its rights to three additional franchised locations to twothird parties. During June 2003, the Company entered into a SettlementAgreement and Mutual General Release with Davco releasing Davco from allobligations and guarantees related to leases associated with the franchisedlocations and providing for a payment of $250,000 to the Company, which wasrecorded as revenue in the year ended December 28, 2003. During the sixmonths ended June 27, 2004, Friendco transferred its rights to onefranchised location to a third party and at June 27, 2004, retained fourfranchised restaurants.

 

24

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**9. DEFERRED COMPENSATION PLAN**

 

During2004, the Company established a nonqualified deferred compensation plan(“Deferred Comp Plan”) that was developed as a retirement plan for a selectgroup of management employees that are not allowed to participate in the Company’sEmployee Savings and Investment Plan. There are various types of compensation that can be deferred into theDeferred Comp Plan, e.g., regular salary, annual bonus or long-term bonus.  There is also a Company contribution that isassociated with the Deferred Comp Plan for participants that choose to defer apercentage of their salary.

 

TheCompany accounts for the Deferred Comp Plan in accordance with Emerging IssuesTask Force No. 97-14, “Accounting for Deferred Compensation Arrangements WhereAmounts Are Held in a Rabbi Trust and Invested.” The investments of the rabbitrust are included in other assets in the accompanying condensed consolidatedbalance sheet as of June 27, 2004. A corresponding liability is includedin other long-term liabilities.

 

TheDeferred Comp Plan assets consist of investments in marketable securities,classified as available-for-sale and reported at fair value with the unrealizedgains and losses reported as a component of accumulated other comprehensiveloss in stockholders’ deficit.  TheCompany follows its investment managers’ methods of determining the cost basisin computing realized gains and losses on the sale of its available-for-salesecurities, which is the average cost method. Realized gains and losses are included in other expenses, principallydebt retirement costs in the accompanying condensed consolidated statements ofoperations and the offsetting compensation expense is included in general andadministrative expenses. Net unrealized losses of $9,000 were recorded as ofJune 27, 2004 and net realized losses of $1,000 were recorded during thesix months ended June 27, 2004.

 

25

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**10. SUPPLEMENTAL CONDENSED CONSOLIDATING FINANCIALINFORMATION**

 

FICC’sobligations related to the New Senior Notes are guaranteed fully andunconditionally by one of FICC’s wholly owned subsidiaries. There are norestrictions on FICC’s ability to obtain dividends or other distributions offunds from this subsidiary, except those imposed by applicable law. Thefollowing supplemental financial information sets forth, on a condensedconsolidating basis, balance sheets, statements of operations and statements ofcash flows for FICC (the “Parent Company”), Friendly’s Restaurants Franchise,Inc. (the “Guarantor Subsidiary”) and Friendly’s International, Inc.,Restaurant Insurance Corporation, Friendly’s Realty I, LLC, Friendly’s RealtyII, LLC and Friendly’s Realty III, LLC (collectively, the “Non-guarantorSubsidiaries”). All of 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 June 27, 2004 andDecember 28, 2003 and for the three months and six months endedJune 27, 2004 and June 29, 2003 were not presented because managementhas determined that such information is not material to investors.

 

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

 

26

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**Supplemental Condensed Consolidating Balance Sheet**

**As of June 27, 2004**

(In thousands)

 
|                                                       |   | **Parent  Company** |    | **Guarantor  Subsidiary** |   | **Non-  guarantor  Subsidiaries** |   | **Eliminations** |   | **Consolidated** |   |
|------------------------------------------------------------|--------|---------------------|---------|---------------------------|--------|-----------------------------------|--------|------------------|--------|------------------|--------|
|                                                       |   |                |    |                      |   |                              |   |             |   |             |   |
| Assets                                                     |   |                |    |                      |   |                              |   |             |   |             |   |
|                                                       |   |                |    |                      |   |                              |   |             |   |             |   |
| Current assets:                                            |   |                |    |                      |   |                              |   |             |   |             |   |
| Cash and cash equivalents                                  |   | $                   | 8,808   |                      | $      | 1,408                             |   | $                | 1,995  |             | $      | — |   | $ | 12,211 |   |
| Restricted cash                                            |   | —              |    | —                    |   | 2,162                             |   | —           |   | 2,162            |   |
| Accounts receivable, net                                   |   | 12,575              |    | 1,825                     |   | —                            |   | —           |   | 14,400           |   |
| Inventories                                                |   | 17,707              |    | —                    |   | —                            |   | —           |   | 17,707           |   |
| Deferred income taxes                                      |   | 6,559               |    | 18                        |   | —                            |   | 70               |   | 6,647            |   |
| Prepaid expenses and other current assets                  |   | 10,498              |    | 1,259                     |   | 7,778                             |   | (14,329          | )      | 5,206            |   |
| Total current assets                                       |   | 56,147              |    | 4,510                     |   | 11,935                            |   | (14,259          | )      | 58,333           |   |
| Deferred income taxes                                      |   | 1,332               |    | 205                       |   | —                            |   | (70              | )      | 1,467            |   |
| Property and equipment, net                                |   | 117,981             |    | —                    |   | 46,328                            |   | —           |   | 164,309          |   |
| Intangibles and deferred costs, net                        |   | 18,786              |    | —                    |   | 2,386                             |   | —           |   | 21,172           |   |
| Investments in subsidiaries                                |   | 6,525               |    | —                    |   | —                            |   | (6,525           | )      | —           |   |
| Other assets                                               |   | 5,749               |    | 10,292                    |   | 915                               |   | (10,292          | )      | 6,664            |   |
|                                                       |   |                |    |                      |   |                              |   |             |   |             |   |
| Total assets                                               |   | $                   | 206,520 |                      | $      | 15,007                            |   | $                | 61,564 |             | $      | (31,146 | ) | $ | 251,945 |   |
|                                                       |   |                |    |                      |   |                              |   |             |   |             |   |
| Liabilities and Stockholders’ Equity  (Deficit)       |   |                |    |                      |   |                              |   |             |   |             |   |
|                                                       |   |                |    |                      |   |                              |   |             |   |             |   |
| Current liabilities:                                       |   |                |    |                      |   |                              |   |             |   |             |   |
| Current maturities of long-term obligations                |   | $                   | 9,100   |                      | $      | —                            |   | $                | 1,196  |             | $      | (7,776 | ) | $ | 2,520 |   |
| Accounts payable                                           |   | 27,488              |    | —                    |   | —                            |   | —           |   | 27,488           |   |
| Accrued expenses                                           |   | 38,449              |    | 3,457                     |   | 6,120                             |   | (6,428           | )      | 41,598           |   |
| Total current liabilities                                  |   | 75,037              |    | 3,457                     |   | 7,316                             |   | (14,204          | )      | 71,606           |   |
| Long-term obligations, less current  maturities            |   | 182,086             |    | —                    |   | 51,341                            |   | —           |   | 233,427          |   |
| Other long-term liabilities                                |   | 52,734              |    | 802                       |   | 7,130                             |   | (10,417          | )      | 50,249           |   |
| Stockholders’ (deficit) equity                        |   | (103,337            | )       | 10,748                    |   | (4,223                            | )      | (6,525           | )      | (103,337         | )      |
|                                                       |   |                |    |                      |   |                              |   |             |   |             |   |
| Total liabilities and stockholders’ equity  (deficit) |   | $                   | 206,520 |                      | $      | 15,007                            |   | $                | 61,564 |             | $      | (31,146 | ) | $ | 251,945 |   |

 

27

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**Supplemental Condensed Consolidating Statement ofOperations**

**For the Three Months Ended June 27, 2004**

(In thousands)

 
|                                                                                                                   |   | **Parent  Company** |    | **Guarantor  Subsidiary** |   | **Non-  guarantor  Subsidiaries** |   | **Eliminations** |   | **Consolidated** |   |
|------------------------------------------------------------------------------------------------------------------------|--------|---------------------|---------|---------------------------|--------|-----------------------------------|--------|------------------|--------|------------------|--------|
|                                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| Revenues                                                                                                               |   | $                   | 144,863 |                      | $      | 2,653                             |   | $                | — |             | $      | — |   | $ | 147,516 |   |
|                                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| Costs and expenses:                                                                                                    |   |                |    |                      |   |                              |   |             |   |             |   |
| Cost of sales                                                                                                          |   | 55,959              |    | —                    |   | —                            |   | —           |   | 55,959           |   |
| Labor and benefits                                                                                                     |   | 42,155              |    | —                    |   | —                            |   | —           |   | 42,155           |   |
| Operating expenses and write-downs of  property and equipment                                                          |   | 29,633              |    | —                    |   | (1,736                            | )      | —           |   | 27,897           |   |
| General and administrative expenses                                                                                    |   | 8,599               |    | 1,155                     |   | —                            |   | —           |   | 9,754            |   |
| Depreciation and amortization                                                                                          |   | 5,006               |    | —                    |   | 564                               |   | —           |   | 5,570            |   |
| Gain on franchise sales of restaurant  operations and properties                                                       |   | (7                  | )       | —                    |   | —                            |   | —           |   | (7               | )      |
| Loss on disposals of other property and  equipment, net                                                                |   | 337                 |    | —                    |   | —                            |   | —           |   | 337              |   |
| Interest expense, net                                                                                                  |   | 4,244               |    | —                    |   | 1,124                             |   | —           |   | 5,368            |   |
| Other expenses, principally debt retirement  costs                                                                     |   | 2,343               |    | —                    |   | —                            |   | —           |   | 2,343            |   |
|                                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| (Loss) income before benefit from  (provision for) income taxes and equity in net income of consolidated  subsidiaries |   | (3,406              | )       | 1,498                     |   | 48                                |   | —           |   | (1,860           | )      |
|                                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| Benefit from (provision for) income taxes                                                                              |   | 1,220               |    | (614                      | )      | (48                               | )      | —           |   | 558              |   |
|                                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| (Loss) income before equity in net income  of consolidated subsidiaries                                                |   | (2,186              | )       | 884                       |   | —                            |   | —           |   | (1,302           | )      |
|                                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| Equity in net income of consolidated  subsidiaries                                                                     |   | 884                 |    | —                    |   | —                            |   | (884             | )      | —           |   |
|                                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| Net (loss) income                                                                                                      |   | $                   | (1,302  | )                         | $      | 884                               |   | $                | — |             | $      | (884 | ) | $ | (1,302 | ) |

 

28

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**Supplemental Condensed Consolidating Statement ofOperations**

**For the Six Months Ended June 27, 2004**

(In thousands)

 
|                                                                                                                   |   | **Parent  Company** |    | **Guarantor  Subsidiary** |   | **Non-  guarantor  Subsidiaries** |   | **Eliminations** |   | **Consolidated** |   |
|------------------------------------------------------------------------------------------------------------------------|--------|---------------------|---------|---------------------------|--------|-----------------------------------|--------|------------------|--------|------------------|--------|
|                                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| Revenues                                                                                                               |   | $                   | 273,053 |                      | $      | 5,217                             |   | $                | — |             | $      | — |   | $ | 278,270 |   |
|                                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| Costs and expenses:                                                                                                    |   |                |    |                      |   |                              |   |             |   |             |   |
| Cost of sales                                                                                                          |   | 101,547             |    | —                    |   | —                            |   | —           |   | 101,547          |   |
| Labor and benefits                                                                                                     |   | 82,089              |    | —                    |   | —                            |   | —           |   | 82,089           |   |
| Operating expenses and write-downs of  property and equipment                                                          |   | 56,421              |    | —                    |   | (3,472                            | )      | —           |   | 52,949           |   |
| General and administrative expenses                                                                                    |   | 18,141              |    | 2,310                     |   | —                            |   | —           |   | 20,451           |   |
| Restructuring expenses                                                                                                 |   | 2,627               |    | —                    |   | —                            |   | —           |   | 2,627            |   |
| Gain on litigation settlement                                                                                          |   | (3,644              | )       | —                    |   | —                            |   | —           |   | (3,644           | )      |
| Depreciation and amortization                                                                                          |   | 10,049              |    | —                    |   | 1,127                             |   | —           |   | 11,176           |   |
| Gain on franchise sales of restaurant  operations and properties                                                       |   | (913                | )       | —                    |   | —                            |   | —           |   | (913             | )      |
| Loss on disposals of other property and  equipment, net                                                                |   | 505                 |    | —                    |   | 3                                 |   | —           |   | 508              |   |
| Interest expense, net                                                                                                  |   | 9,177               |    | —                    |   | 2,255                             |   | —           |   | 11,432           |   |
| Other expenses, principally debt retirement  costs                                                                     |   | 9,235               |    | —                    |   | —                            |   | —           |   | 9,235            |   |
|                                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| (Loss) income before benefit from  (provision for) income taxes and equity in net income of consolidated  subsidiaries |   | (12,181             | )       | 2,907                     |   | 87                                |   | —           |   | (9,187           | )      |
|                                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| Benefit from (provision for) income taxes                                                                              |   | 4,045               |    | (1,192                    | )      | (97                               | )      | —           |   | 2,756            |   |
|                                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| (Loss) income before equity in net income  of consolidated subsidiaries                                                |   | (8,136              | )       | 1,715                     |   | (10                               | )      | —           |   | (6,431           | )      |
|                                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| Equity in net income of consolidated  subsidiaries                                                                     |   | 1,705               |    | —                    |   | —                            |   | (1,705           | )      | —           |   |
|                                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| Net (loss) income                                                                                                      |   | $                   | (6,431  | )                         | $      | 1,715                             |   | $                | (10    | )                | $      | (1,705 | ) | $ | (6,431 | ) |

 

29

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**Supplemental Condensed Consolidating Statement of CashFlows**

**For the Six Months Ended June 27, 2004**

(In thousands)

 
|                                                  |   | **Parent  Company** |   | **Guarantor  Subsidiary** |   | **Non-  guarantor  Subsidiaries** |   | **Eliminations** |   | **Consolidated** |   |
|-------------------------------------------------------|--------|---------------------|--------|---------------------------|--------|-----------------------------------|--------|------------------|--------|------------------|--------|
|                                                  |   |                |   |                      |   |                              |   |             |   |             |   |
| Net cash (used in) provided by operating  activities  |   | $                   | (92    | )                         | $      | (765                              | )      | $                | 604    |             | $      | 490 |   | $ | 237 |   |
|                                                  |   |                |   |                      |   |                              |   |             |   |             |   |
| Cash flows from investing activities:                 |   |                |   |                      |   |                              |   |             |   |             |   |
| Purchases of property and equipment                   |   | (8,262              | )      | —                    |   | —                            |   | —           |   | (8,262           | )      |
| Proceeds from sales of property and  equipment        |   | 3,378               |   | —                    |   | —                            |   | —           |   | 3,378            |   |
| Purchases of marketable securities                    |   | (905                | )      | —                    |   | —                            |   | —           |   | (905             | )      |
| Proceeds from sales of marketable  securities         |   | 89                  |   | —                    |   | —                            |   | —           |   | 89               |   |
| Return of investment in subsidiary                    |   | 367                 |   | —                    |   | —                            |   | (367             | )      | —           |   |
| Net cash used in investing activities                 |   | (5,333              | )      | —                    |   | —                            |   | (367             | )      | (5,700           | )      |
|                                                  |   |                |   |                      |   |                              |   |             |   |             |   |
| Cash flows from financing activities:                 |   |                |   |                      |   |                              |   |             |   |             |   |
| Proceeds from issuance of senior notes                |   | 175,000             |   | —                    |   | —                            |   | —           |   | 175,000          |   |
| Proceeds from other borrowings                        |   | 11,000              |   | —                    |   | —                            |   | —           |   | 11,000           |   |
| Repayments of obligations                             |   | (187,531            | )      | —                    |   | (550                              | )      | —           |   | (188,081         | )      |
| Payments of deferred financing costs                  |   | (6,625              | )      | —                    |   | —                            |   | —           |   | (6,625           | )      |
| Stock options exercised                               |   | 749                 |   | —                    |   | —                            |   | —           |   | 749              |   |
| Reinsurance deposits received                         |   | —              |   | —                    |   | 1,131                             |   | (1,131           | )      | —           |   |
| Reinsurance payments made from deposits               |   | —              |   | —                    |   | (641                              | )      | 641              |   | —           |   |
| Dividends paid                                        |   | —              |   | —                    |   | (367                              | )      | 367              |   | —           |   |
| Net cash used in financing activities                 |   | (7,407              | )      | —                    |   | (427                              | )      | (123             | )      | (7,957           | )      |
|                                                  |   |                |   |                      |   |                              |   |             |   |             |   |
| Net (decrease) increase in cash and cash  equivalents |   | (12,832             | )      | (765                      | )      | 177                               |   | —           |   | (13,420          | )      |
|                                                  |   |                |   |                      |   |                              |   |             |   |             |   |
| Cash and cash equivalents, beginning of  period       |   | 21,640              |   | 2,173                     |   | 1,818                             |   | —           |   | 25,631           |   |
|                                                  |   |                |   |                      |   |                              |   |             |   |             |   |
| Cash and cash equivalents, end of period              |   | $                   | 8,808  |                      | $      | 1,408                             |   | $                | 1,995  |             | $      | — |   | $ | 12,211 |   |
|                                                  |   |                |   |                      |   |                              |   |             |   |             |   |
| Supplemental disclosures:                             |   |                |   |                      |   |                              |   |             |   |             |   |
| Interest paid                                         |   | $                   | 9,702  |                      | $      | —                            |   | $                | 2,273  |             | $      | — |   | $ | 11,975 |   |
| Income taxes (refunded) paid                          |   | (1,591              | )      | 1,508                     |   | 99                                |   | —           |   | 16               |   |
| Capital lease obligations incurred                    |   | 2,280               |   | —                    |   | —                            |   | —           |   | 2,280            |   |

 

30

----

 

**Supplemental Condensed Consolidating Balance Sheet**

**As of December 28, 2003**

(In thousands)

 
|                                                       |   | **Parent  Company** |    | **Guarantor  Subsidiary** |   | **Non-  guarantor  Subsidiaries** |   | **Eliminations** |   | **Consolidated** |   |
|------------------------------------------------------------|--------|---------------------|---------|---------------------------|--------|-----------------------------------|--------|------------------|--------|------------------|--------|
|                                                       |   |                |    |                      |   |                              |   |             |   |             |   |
| Assets                                                     |   |                |    |                      |   |                              |   |             |   |             |   |
|                                                       |   |                |    |                      |   |                              |   |             |   |             |   |
| Current assets:                                            |   |                |    |                      |   |                              |   |             |   |             |   |
| Cash and cash equivalents                                  |   | $                   | 21,640  |                      | $      | 2,173                             |   | $                | 1,818  |             | $      | — |   | $ | 25,631 |   |
| Restricted cash                                            |   | —              |    | —                    |   | 1,671                             |   | —           |   | 1,671            |   |
| Accounts receivable, net                                   |   | 9,163               |    | 1,221                     |   | —                            |   | —           |   | 10,384           |   |
| Inventories                                                |   | 15,669              |    | —                    |   | —                            |   | —           |   | 15,669           |   |
| Deferred income taxes                                      |   | 6,559               |    | 18                        |   | —                            |   | 70               |   | 6,647            |   |
| Prepaid expenses and other current assets                  |   | 7,148               |    | 1,469                     |   | 7,778                             |   | (14,856          | )      | 1,539            |   |
| Total current assets                                       |   | 60,179              |    | 4,881                     |   | 11,267                            |   | (14,786          | )      | 61,541           |   |
| Deferred income taxes                                      |   | —              |    | 205                       |   | —                            |   | (205             | )      | —           |   |
| Property and equipment, net                                |   | 119,759             |    | —                    |   | 47,350                            |   | —           |   | 167,109          |   |
| Intangibles and deferred costs, net                        |   | 15,396              |    | —                    |   | 2,494                             |   | —           |   | 17,890           |   |
| Investments in subsidiaries                                |   | 5,187               |    | —                    |   | —                            |   | (5,187           | )      | —           |   |
| Other assets                                               |   | 4,997               |    | 8,582                     |   | 915                               |   | (8,582           | )      | 5,912            |   |
|                                                       |   |                |    |                      |   |                              |   |             |   |             |   |
| Total assets                                               |   | $                   | 205,518 |                      | $      | 13,668                            |   | $                | 62,026 |             | $      | (28,760 | ) | $ | 252,452 |   |
|                                                       |   |                |    |                      |   |                              |   |             |   |             |   |
| Liabilities and Stockholders’ (Deficit)  Equity       |   |                |    |                      |   |                              |   |             |   |             |   |
|                                                       |   |                |    |                      |   |                              |   |             |   |             |   |
| Current liabilities:                                       |   |                |    |                      |   |                              |   |             |   |             |   |
| Current maturities of long-term obligations                |   | $                   | 8,687   |                      | $      | —                            |   | $                | 1,127  |             | $      | (7,776 | ) | $ | 2,038 |   |
| Accounts payable                                           |   | 22,475              |    | —                    |   | —                            |   | —           |   | 22,475           |   |
| Accrued expenses                                           |   | 38,076              |    | 3,893                     |   | 6,146                             |   | (6,910           | )      | 41,205           |   |
| Total current liabilities                                  |   | 69,238              |    | 3,893                     |   | 7,273                             |   | (14,686          | )      | 65,718           |   |
| Deferred income taxes                                      |   | 1,424               |    | —                    |   | —                            |   | (135             | )      | 1,289            |   |
| Long-term obligations, less current  maturities            |   | 181,750             |    | —                    |   | 51,960                            |   | —           |   | 233,710          |   |
| Other long-term liabilities                                |   | 51,132              |    | 743                       |   | 6,638                             |   | (8,752           | )      | 49,761           |   |
| Stockholders’ (deficit) equity                        |   | (98,026             | )       | 9,032                     |   | (3,845                            | )      | (5,187           | )      | (98,026          | )      |
|                                                       |   |                |    |                      |   |                              |   |             |   |             |   |
| Total liabilities and stockholders’  (deficit) equity |   | $                   | 205,518 |                      | $      | 13,668                            |   | $                | 62,026 |             | $      | (28,760 | ) | $ | 252,452 |   |

 

31

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**Supplemental Condensed Consolidating Statement ofOperations**

**For the Three Months Ended June 29, 2003**

(In thousands)

 
|                                                                                                   |   | **Parent  Company** |    | **Guarantor  Subsidiary** |   | **Non-  guarantor  Subsidiaries** |   | **Eliminations** |   | **Consolidated** |   |
|--------------------------------------------------------------------------------------------------------|--------|---------------------|---------|---------------------------|--------|-----------------------------------|--------|------------------|--------|------------------|--------|
|                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| Revenues                                                                                               |   | $                   | 153,464 |                      | $      | 2,184                             |   | $                | — |             | $      | — |   | $ | 155,648 |   |
|                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| Costs and expenses:                                                                                    |   |                |    |                      |   |                              |   |             |   |             |   |
| Cost of sales                                                                                          |   | 55,179              |    | —                    |   | —                            |   | —           |   | 55,179           |   |
| Labor and benefits                                                                                     |   | 43,796              |    | —                    |   | —                            |   | —           |   | 43,796           |   |
| Operating expenses and write-downs of property  and equipment                                          |   | 31,467              |    | —                    |   | (1,710                            | )      | —           |   | 29,757           |   |
| General and administrative expenses                                                                    |   | 8,793               |    | 1,159                     |   | —                            |   | —           |   | 9,952            |   |
| Depreciation and amortization                                                                          |   | 5,173               |    | —                    |   | 573                               |   | —           |   | 5,746            |   |
| Loss on disposals of other property and  equipment, net                                                |   | 780                 |    | —                    |   | 55                                |   | —           |   | 835              |   |
| Interest expense, net                                                                                  |   | 4,935               |    | —                    |   | 1,157                             |   | —           |   | 6,092            |   |
|                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| Income (loss) before provision for income  taxes and equity in net income of consolidated subsidiaries |   | 3,341               |    | 1,025                     |   | (75                               | )      | —           |   | 4,291            |   |
|                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| Provision for income taxes                                                                             |   | (737                | )       | (420                      | )      | (44                               | )      | —           |   | (1,201           | )      |
|                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| Income (loss) before equity in net income  of consolidated subsidiaries                                |   | 2,604               |    | 605                       |   | (119                              | )      | —           |   | 3,090            |   |
|                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| Equity in net income of consolidated  subsidiaries                                                     |   | 486                 |    | —                    |   | —                            |   | (486             | )      | —           |   |
|                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| Net income (loss)                                                                                      |   | $                   | 3,090   |                      | $      | 605                               |   | $                | (119   | )                | $      | (486 | ) | $ | 3,090 |   |

 

32

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**Supplemental Condensed Consolidating Statement ofOperations**

**For the Six Months Ended June 29, 2003**

(In thousands)

 
|                                                                                                                   |   | **Parent  Company** |    | **Guarantor  Subsidiary** |   | **Non-  guarantor  Subsidiaries** |   | **Eliminations** |   | **Consolidated** |   |
|------------------------------------------------------------------------------------------------------------------------|--------|---------------------|---------|---------------------------|--------|-----------------------------------|--------|------------------|--------|------------------|--------|
|                                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| Revenues                                                                                                               |   | $                   | 280,164 |                      | $      | 4,174                             |   | $                | — |             | $      | — |   | $ | 284,338 |   |
|                                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| Costs and expenses:                                                                                                    |   |                |    |                      |   |                              |   |             |   |             |   |
| Cost of sales                                                                                                          |   | 101,156             |    | —                    |   | —                            |   | —           |   | 101,156          |   |
| Labor and benefits                                                                                                     |   | 81,924              |    | —                    |   | —                            |   | —           |   | 81,924           |   |
| Operating expenses and write-downs of  property and equipment                                                          |   | 57,504              |    | —                    |   | (3,459                            | )      | —           |   | 54,045           |   |
| General and administrative expenses                                                                                    |   | 17,697              |    | 2,318                     |   | —                            |   | —           |   | 20,015           |   |
| Depreciation and amortization                                                                                          |   | 10,225              |    | —                    |   | 1,148                             |   | —           |   | 11,373           |   |
| Loss on disposals of other property and  equipment, net                                                                |   | 1,291               |    | —                    |   | 117                               |   | —           |   | 1,408            |   |
| Interest expense, net                                                                                                  |   | 9,889               |    | —                    |   | 2,305                             |   | —           |   | 12,194           |   |
|                                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| Income (loss) before benefit from  (provision for) income taxes and equity in net income of consolidated  subsidiaries |   | 478                 |    | 1,856                     |   | (111                              | )      | —           |   | 2,223            |   |
|                                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| Benefit from (provision for) income taxes                                                                              |   | 232                 |    | (761                      | )      | (93                               | )      | —           |   | (622             | )      |
|                                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| Income (loss) before equity in net income  of consolidated subsidiaries                                                |   | 710                 |    | 1,095                     |   | (204                              | )      | —           |   | 1,601            |   |
|                                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| Equity in net income of consolidated  subsidiaries                                                                     |   | 891                 |    | —                    |   | —                            |   | (891             | )      | —           |   |
|                                                                                                                   |   |                |    |                      |   |                              |   |             |   |             |   |
| Net income (loss)                                                                                                      |   | $                   | 1,601   |                      | $      | 1,095                             |   | $                | (204   | )                | $      | (891 | ) | $ | 1,601 |   |

 

33

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**Supplemental Condensed Consolidating Statement of CashFlows**

**For the Six Months Ended June 29, 2003**

(In thousands)

 
|                                                 |   | **Parent  Company** |   | **Guarantor  Subsidiary** |   | **Non-  guarantor  Subsidiaries** |   | **Eliminations** |   | **Consolidated** |   |
|------------------------------------------------------|--------|---------------------|--------|---------------------------|--------|-----------------------------------|--------|------------------|--------|------------------|--------|
|                                                 |   |                |   |                      |   |                              |   |             |   |             |   |
| Net cash provided by (used in) operating  activities |   | $                   | 15,195 |                      | $      | (1,173                            | )      | $                | (1,365 | )                | $      | 1,162 |   | $ | 13,819 |   |
|                                                 |   |                |   |                      |   |                              |   |             |   |             |   |
| Cash flows from investing activities:                |   |                |   |                      |   |                              |   |             |   |             |   |
| Purchases of property and equipment                  |   | (16,201             | )      | —                    |   | —                            |   | —           |   | (16,201          | )      |
| Return of investment in subsidiary                   |   | 357                 |   | —                    |   | —                            |   | (357             | )      | —           |   |
| Net cash used in investing activities                |   | (15,844             | )      | —                    |   | —                            |   | (357             | )      | (16,201          | )      |
|                                                 |   |                |   |                      |   |                              |   |             |   |             |   |
| Cash flows from financing activities:                |   |                |   |                      |   |                              |   |             |   |             |   |
| Repayments of obligations                            |   | (890                | )      | —                    |   | (510                              | )      | —           |   | (1,400           | )      |
| Stock options exercised                              |   | 188                 |   | —                    |   | —                            |   | —           |   | 188              |   |
| Reinsurance deposits received                        |   | —              |   | —                    |   | 2,207                             |   | (2,207           | )      | —           |   |
| Reinsurance payments made from deposits              |   | —              |   | —                    |   | (1,045                            | )      | 1,045            |   | —           |   |
| Dividends paid                                       |   | —              |   | —                    |   | (357                              | )      | 357              |   | —           |   |
| Net cash (used in) provided by financing  activities |   | (702                | )      | —                    |   | 295                               |   | (805             | )      | (1,212           | )      |
|                                                 |   |                |   |                      |   |                              |   |             |   |             |   |
| Net decrease in cash and cash equivalents            |   | (1,351              | )      | (1,173                    | )      | (1,070                            | )      | —           |   | (3,594           | )      |
|                                                 |   |                |   |                      |   |                              |   |             |   |             |   |
| Cash and cash equivalents, beginning of  period      |   | 29,717              |   | 1,944                     |   | 2,680                             |   | —           |   | 34,341           |   |
|                                                 |   |                |   |                      |   |                              |   |             |   |             |   |
| Cash and cash equivalents, end of period             |   | $                   | 28,366 |                      | $      | 771                               |   | $                | 1,610  |             | $      | — |   | $ | 30,747 |   |
|                                                 |   |                |   |                      |   |                              |   |             |   |             |   |
| Supplemental disclosures:                            |   |                |   |                      |   |                              |   |             |   |             |   |
| Interest paid                                        |   | $                   | 9,733  |                      | $      | —                            |   | $                | 2,323  |             | $      | — |   | $ | 12,056 |   |
| Income taxes (refunded) paid                         |   | (706                | )      | 1,239                     |   | 330                               |   | —           |   | 863              |   |
| Lease incentive equipment received                   |   | 243                 |   | —                    |   | —                            |   | —           |   | 243              |   |

 

34

----

 

**Item 2. Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

 

*The following discussion should be read in conjunction withthe Condensed Consolidated Financial Statements of the Company and the notesthereto 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. All forward looking statements are subject to risks anduncertainties which could cause results to differ materially from thoseanticipated. These factors include the Company’s highly competitive businessenvironment, exposure to commodity prices, risks associated with thefoodservice industry, the ability to retain and attract new employees, governmentregulations, the Company’s high geographic concentration in the Northeast andits attendant weather patterns, conditions needed to meet restaurant re-imagingand new opening targets and costs associated with improved service and otherinitiatives. Other factors that may cause actual results to differ from theforward looking statements contained herein and that may affect the Company’sprospects in general are included in the Company’s other filings with theSecurities and Exchange Commission.

 

**Overview**

 

TheCompany’s revenues are derived primarily from the operation of full-servicerestaurants, the distribution and sale of premium ice cream desserts throughretail and institutional locations and franchising. As of June 27, 2004,Friendly’s operated 360 full-service restaurants, franchised 179 full-servicerestaurants and seven non-traditional units and manufactured a full line ofpremium ice cream desserts distributed through more than 4,500 supermarkets andother retail locations in 13 states.

 

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

 
|                  |   | **For the  Three Months Ended** |   | **For the  Six Months Ended** |   |
|-----------------------|--------|---------------------------------|--------|-------------------------------|--------|
|                  |   | **June 27,  2004**         |   | **June 29,  2003**       |   | **June 27,  2004** |   | **June 29,  2003** |   |
|                  |   |                            |   |                          |   |   |   |   |   |
| Company Units:        |   |                            |   |                          |   |   |   |   |   |
| Beginning of period   |   | 362                             |   | 385                           |   | 380 |   | 387 |   |
| Openings              |   | —                          |   | 1                             |   | — |   | 1 |   |
| Refranchised closings |   | (1                              | )      | —                        |   | (18 | ) | — |   |
| Closings              |   | (1                              | )      | (4                            | )      | (2 | ) | (6 | ) |
| End of period         |   | 360                             |   | 382                           |   | 360 |   | 382 |   |
|                  |   |                            |   |                          |   |   |   |   |   |
| Franchised Units:     |   |                            |   |                          |   |   |   |   |   |
| Beginning of period   |   | 182                             |   | 164                           |   | 163 |   | 162 |   |
| Refranchised openings |   | 1                               |   | —                        |   | 18 |   | — |   |
| Openings              |   | 3                               |   | —                        |   | 5 |   | 2 |   |
| Closings              |   | —                          |   | (2                            | )      | — |   | (2 | ) |
| End of period         |   | 186                             |   | 162                           |   | 186 |   | 162 |   |

 

35

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***Three months ended June 27,2004 compared with three months ended June 29, 2003***

 

*Revenues:*

 

Totalrevenues decreased $8.2 million, or 5.2%, to $147.5 million for the secondquarter ended June 27, 2004 from $155.7 million for the same quarter in2003. Restaurant revenues decreased $8.6 million, or 7.0%, to $114.4 millionfor the three months ended June 27, 2004 from $123.0 million for the sameperiod in 2003. Comparable company-operated restaurant revenues decreased 3.0%from the 2003 quarter to the 2004 quarter as decreases occurred in alldayparts. Sales growth in fast food restaurants and higher gas prices may havehad a negative impact on comparable sales. This was the first decline incomparable sales since the fourth quarter of fiscal 2000.  Seven and 13 locations were re-imaged duringthe quarters ended June 27, 2004 and June 29, 2003,respectively.  The opening of three newrestaurants over the past 15 months increased restaurant revenues by $1.0million. The closing of ten locations and the re-franchising of 18 locationsover the past 15 months resulted in declines of $1.4 million and $4.9 million,respectively, in restaurant revenues in the second quarter of 2004 as comparedto the same period in 2003. Foodservice (product sales to franchisees andretail customers) revenues decreased $0.1 million or 0.4% to $29.8 million forthe second quarter ended June 27, 2004 from $29.9 million for the samequarter in 2003. Franchised restaurant product revenues increased by $2.3million while sales to foodservice retail supermarket customers declined by$2.4 million. Case volume in the Company’s retail supermarket business fell by14.3% for the quarter ended June 27, 2004 when compared to the quarterended June 29, 2003. Franchise royalty and fee revenues increased $0.6million, or 20.1%, to $3.3 million for the three months ended June 27,2004 compared to $2.7 million for the same period in 2003. Royalties onfranchised restaurant sales increased $0.3 million.  Comparable franchised revenues grew 0.8% from the quarter endedJune 29, 2003 to the quarter ended June 27, 2004. Including resultsof the current quarter, the Company has reported thirteen consecutive quartersof positive comparable franchised restaurant sales.  The opening of eight new franchise restaurants and 18re-franchised restaurants during the last 15 months increased royalty revenuesby $0.3 million.  The closing of fiveunder-performing locations during the same period had little impact.  Initial franchise fees were higher by $0.2million during the three months ended June 27, 2004 when compared to thesame period in 2003 due to the refranchising of one company-operated restaurantand the opening of two new restaurants and one new cafe during the quarterended June 27, 2004 versus no new openings during the quarter endedJune 29, 2003. Additionally, an increase in rental income for leased andsubleased franchise locations of $0.1 million contributed to the higherrevenues. These increases were partially offset by $0.3 million received in the2003 quarter pursuant to an agreement terminating Friendco’s rights as the exclusivedeveloper of new Friendly’s restaurants in Maryland, Delaware, the District ofColumbia and northern Virginia. There were 186 and 162 franchise units open atJune 27, 2004 and June 29, 2003, respectively.

 

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*Cost of sales:*

 

Costof sales increased $0.8 million, or 1.4%, to $56.0 million for the secondquarter ended June 27, 2004 from $55.2 million for the same period in2003. Cost of sales as a percentage of total revenues was 37.9% and 35.5% forthe quarters ended June 27, 2004 and June 29, 2003, respectively.Higher commodity costs, especially for cream, raw milk and vanilla had anunfavorable impact on cost of sales as a percentage of total revenues. Marketlosses on options for butter futures contracts were greater in the three monthsended June 27, 2004 when compared to the three months ended June 29,2003. A shift in sales mix from company-operated restaurant sales tofoodservice sales also had an unfavorable effect.  Foodservice sales to franchisees and supermarket customers (20.2%and 19.2% of total revenues for the three months ended June 27, 2004 andJune 29, 2003, respectively) have a higher food cost as a percentage ofrevenue than sales in company-operated restaurants to restaurant patrons. Thegrowth in franchise royalty, fee and rental revenues reduced cost of sales, asa percentage of total revenues, by 0.2% for the three months endedJune 27, 2004 when compared to the three months ended June 29, 2003.Foodservice retail sales promotional allowances, recorded as offsets torevenues, were increased by 3.8% in the 2004 quarter as a percentage of grossretail sales when compared to the 2003 quarter as a result of a change in mixof promotional activities. This increase had an unfavorable impact on theoverall cost of sales as a percentage of total revenues. Distribution costswere higher in the quarter ended June 27, 2004 when compared to the samequarter in 2003 as a result of the unfavorable impact of new federalrestrictions imposed on driver hours, higher fuel costs and increases inliability insurance. Restaurant cost of sales as a percentage of restaurantrevenues increased to 27.3% in the second quarter of 2004 from 26.6% in thesecond quarter of 2003. The increase in the 2004 quarter when compared to the2003 quarter was in part due to commodity cost increases mentioned above thathad not yet been offset by menu price increases. The conversion during thefirst quarter of 2004 from a 64-ounce container to a 56-ounce container onlypartially offset the increases in ice cream ingredient costs.  The Company expects cream prices to continueto exceed prices experienced in 2003. A table showing the average monthly priceof a pound of AA butter obtained from market quotes provided by the USDA’s AgriculturalMarketing Service is included elsewhere herein.

 

*Labor and benefits:*

 

Laborand benefits decreased $1.6 million, or 3.7%, to $42.2 million for the threemonths ended June 27, 2004 from $43.8 million for the three months endedJune 29, 2003. Labor and benefits as a percentage of total revenuesincreased to 28.6% in the 2004 quarter from 28.1% in the 2003 quarter. As apercentage of restaurant revenues, labor and benefits increased to 36.8% in the2004 quarter from 35.6% in the 2003 quarter. The increase in labor and benefitswas due to training costs associated with the rollout of a new point of saleregister system in the remaining 159 Company-operated restaurants during thequarter, higher insurance and payroll tax costs and increases in restaurantgeneral manager compensation. In April 2004, the Company initiated aprogram to reinforce proper labor scheduling techniques. Scheduling improved inthe second quarter of 2004 when compared to the same period in 2003.  Revenue derived from franchised locationsand retail supermarket customers, which do not have any associated restaurantlabor and benefits, reduced the impact of the higher restaurant labor andbenefits as a percentage of total revenues.

 

37

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*Operating expenses:*

 

Operatingexpenses decreased $2.0 million, or 6.6%, to $27.8 million in the three monthsended June 27, 2004 from $29.8 million for the three months endedJune 29, 2003. Operating expenses as a percentage of total revenues were18.8% and 19.1% in the 2004 and 2003 periods, respectively. The decrease indollars resulted from lower restaurant advertising, maintenance costs andutility costs in the 2004 period when compared to the 2003 period. Thesedecreases were partially offset by higher general liability insurance in the2004 period when compared to the 2003 period.

 

*General and administrative expenses:*

 

Generaland administrative expenses were $9.8 million and $9.9 million for the quartersended June 27, 2004 and June 29, 2003, respectively. General andadministrative expenses as a percentage of total revenues increased to 6.6% inthe 2004 period from 6.4% in the 2003 period. The percentage increase isprimarily the result of higher costs for group insurance, computer equipmentrentals and legal and professional fees. These increases were partially offsetby lower salaries and wages.

 

*Depreciation and amortization:*

 

Depreciationand amortization was $5.6 million and $5.7 million for the quarters endedJune 27, 2004 and June 29, 2003, respectively. Depreciation andamortization as a percentage of total revenues was 3.8% and 3.7% in the 2004and 2003 quarters, respectively.

 

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

 

Theloss on disposals of other property and equipment, net, was $0.3 million and$0.8 million for the quarters ended June 27, 2004 and June 29, 2003,respectively.  The table belowidentifies the components of the loss on disposals of other property andequipment, net, as shown on the accompanying condensed consolidated statementsof operations (in thousands):

 
|                                                    |   | **For the  Three Months Ended** |   |
|---------------------------------------------------------|--------|---------------------------------|--------|
|                                                    |   | **June 27,  2004**         |   | **June 29,  2003** |   |
|                                                    |   |                            |   |   |   |
| Restaurant assets retired due to remodeling             |   | $                               | 173    |   | $ | 455 |   |
| Restaurant equipment assets retired due to  replacement |   | 87                              |   | 92 |   |
| Loss on property held for disposition                   |   | —                          |   | 141 |   |
| Loss on property not held for disposition               |   | 62                              |   | — |   |
| All other                                               |   | 15                              |   | 147 |   |
| Loss on disposals of other property and  equipment, net |   | $                               | 337    |   | $ | 835 |   |

 

*Other expenses, principally debt retirement costs:*

 

Otherexpenses, principally debt retirement costs represents the $1.7 million premiumand the write off of unamortized deferred financing costs of approximately $0.6million in connection with the tender offer for the $176.0 million of SeniorNotes. In March 2004, $127.8 million of aggregate principal amount ofSenior Notes were purchased pursuant to the tender offer and inApril 2004, the remaining $48.2 million of Senior Notes were redeemed inaccordance with the Senior Notes indenture at 103.5% of the principal amount.

 

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*Interest expense, net:*

 

Interestexpense, net of capitalized interest and interest income, was $5.4 million and$6.1 million, respectively, for the quarters ended June 27, 2004 andJune 29, 2003, primarily as a result of the lower interest ratesassociated with the New Senior Notes in the 2004 period as compared to the 2003period.

 

*Benefit from (provision for) income taxes:*

 

Thebenefit from income taxes was $0.6 million, or 30.0%, for the three monthsended June 27, 2004. At this time, the Company estimates that theeffective tax rate for 2004 will be 30.0%. The Company records income taxesbased on the effective rate expected for the year with any changes in thevaluation allowance reflected in the period of change. The provision for incometaxes was $1.2 million, or 28.0%, for the three months ended June 29,2003. The rate in 2003 was increased in the fourth quarter due to a one-timepension curtailment gain of $8.1 million in 2003. The tax rate for the 2003fiscal year was 32.5%.

 

*Net (loss) income:*

 

Netloss was $1.3 million for the second quarter ended June 27, 2004 ascompared to net income of $3.1 million for the second quarter endedJune 29, 2003, for the reasons discussed above.

 

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***Six months ended June 27, 2004compared with six months ended June 29, 2003***

 

*Revenues:*

 

Totalrevenues decreased $6.0 million, or 2.1%, to $278.3 million for the six monthsended June 27, 2004 from $284.3 million for the same period in 2003.Restaurant revenues decreased $7.4 million, or 3.3%, to $218.8 million for thesix months ended June 27, 2004 from $226.2 million for the same period in2003. Comparable company-operated restaurant revenues increased 0.2% from the2003 period to the 2004 period as declines occurred in lunch and afternoonsnack dayparts. Record snowfall during the first quarter of 2003 had anunfavorable impact on restaurant revenues in the first quarter of 2003. Thishad a favorable impact on restaurant revenues when compared to the firstquarter of the current year, as operating days lost due to weather closingswere minimal in 2004. However, sales growth in the fast food restaurant segmentand higher gas prices may have contributed to a decline in comparablerestaurant revenues during the second quarter. Seven and 24 restaurants were re-imaged during the six months endedJune 27, 2004 and June 29, 2003, respectively.  The opening of three new restaurants overthe past 18 months increased restaurant revenues by $2.1 million. The closingof 12 locations and the re-franchising of 18 restaurants over the past 18months resulted in declines of $3.2 million and $7.8 million, respectively, inrestaurant revenues in the 2004 period as compared to the same period in 2003.Foodservice (product sales to franchisees and retail customers) revenues were$53.2 million for the six months ended June 27, 2004 and June 29,2003. Franchised restaurant product revenues increased by $3.8 million while salesto foodservice retail supermarket customers declined by $3.8 million. Casevolume in the Company’s retail supermarket business fell by 12.6% for the sixmonths ended June 27, 2004 when compared to the six months endedJune 29, 2003.  During the quarterended March 28, 2004, the Company reduced the size of its retailsupermarket ice cream container to a 56-ounce product from a 64-ounceproduct.  Franchise royalty and feerevenues increased $1.3 million, or 27.2%, to $6.3 million for the six monthsended June 27, 2004 compared to $5.0 million for the same period in 2003.Royalties on franchised restaurant sales increased $0.6 million as the numberof franchised units increased and comparable franchised revenues grew 3.2% fromthe six months ended June 29, 2003 to the six months ended June 27,2004. The opening of ten new franchise restaurants and eighteen re-franchisedrestaurants during the last 18 months increased royalty revenues by $0.4million while the closing of 5 under-performing locations during the same periodhad little impact.  Initial franchisefees were higher by $0.4 million during the six months ended June 27, 2004when compared to the same period in 2003 due to the refranchising of 18company-operated restaurants, the opening of four new restaurants and theopening of one new café during the six months ended June 27, 2004 versustwo new restaurant openings during the six months ended June 29, 2003.Additionally, an increase in rental income for leased and subleased franchiselocations of $0.3 million contributed to the higher revenues. These increaseswere partially offset by $0.3 million received in the 2003 period pursuant toan agreement terminating Friendco’s rights as the exclusive developer of newFriendly’s restaurants in Maryland, Delaware, the District of Columbia andnorthern Virginia. There were 186 and 162 franchise units open at June 27,2004 and June 29, 2003, respectively.

 

40

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*Cost of sales:*

 

Costof sales increased $0.3 million, or 0.4%, to $101.5 million for the six monthsended June 27, 2004 from $101.2 million for the same period in 2003. Costof sales as a percentage of total revenues was 36.5 % and 35.6% for the sixmonths ended June 27, 2004 and June 29, 2003, respectively. Highercommodity costs, especially for cream, raw milk and vanilla had an unfavorableimpact on cost of sales as a percentage of total revenues. A shift in sales mixfrom company-operated restaurant sales to foodservice sales added to theincrease in cost of sales as a percentage of total revenues. Foodservice salesto franchisees and retail supermarket customers (19.1% and 18.7% of totalrevenues for the six months ended June 27, 2004 and June 29, 2003,respectively) have a higher food cost as a percentage of revenue than sales incompany-operated restaurants to restaurant patrons. The growth in franchiseroyalty, fee and rental revenues reduced cost of sales, as a percentage oftotal revenues, by 0.2% for the six months ended June 27, 2004 whencompared to the six months ended June 29, 2003. Foodservice retail salespromotional allowances, recorded as offsets to revenues, increased by 3.0% inthe 2004 period as a percentage of gross retail sales when compared to the 2003period as a result of a change in mix of promotional activities. This increasehad an unfavorable impact on the overall cost of sales as a percentage of totalrevenues. Distribution costs were higher in the six months ended June 27,2004 when compared to the same period in 2003 as a result of the unfavorableimpact of new federal restrictions imposed on driver hours, higher fuel costsand increases in liability insurance. Restaurant cost of sales as a percentageof restaurant revenues increased to 26.8% in the six months ended June 27,2004 from 26.7% for the same period in 2003 as menu price increases have laggedincreases in the commodity costs mentioned above. Cream prices for the sixmonths ended June 27, 2004 were higher than the first six months of 2003.The conversion during the first quarter of 2004 from a 64-ounce container to a56-ounce container partially offset higher prices for cream and othercommodities. The Company expects that cream prices will continue to exceedprices experienced in 2003.  Additionally,the benefits derived from options for butter futures contracts realized in thefirst quarter of 2004 did not continue in the second quarter and are not likelyto benefit the remainder of fiscal 2004.

 

Thetable below shows the average monthly price of a pound of AA butter. The pricesrepresented were obtained from market quotes provided by the USDA’sAgricultural Marketing Service.

 
| **Month:**       |   | **2004** |   | **2003** |   | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------|--------|
| January          |   | $        | 1.4320 |     | $      | 1.0815   |   | $        | 1.3454 |     | $      | 1.2531   |   | $ | 0.9090 |   | $ | 1.4222 |   |
| February         |   | 1.7132   |   | 1.0405   |   | 1.2427   |   | 1.3852   |   | 0.9245   |   | 1.3153   |   |
| March            |   | 2.1350   |   | 1.0915   |   | 1.2473   |   | 1.5708   |   | 1.0200   |   | 1.2927   |   |
| April            |   | 2.2204   |   | 1.0906   |   | 1.1712   |   | 1.8217   |   | 1.0691   |   | 1.0298   |   |
| May              |   | 2.0363   |   | 1.0919   |   | 1.0590   |   | 1.8713   |   | 1.2450   |   | 1.1289   |   |
| June             |   | 1.9300   |   | 1.1142   |   | 1.0427   |   | 1.9783   |   | 1.2440   |   | 1.4931   |   |
| July             |   |     |   | 1.1985   |   | 1.0302   |   | 1.8971   |   | 1.1790   |   | 1.3444   |   |
| August           |   |     |   | 1.1708   |   | 0.9752   |   | 2.0880   |   | 1.1933   |   | 1.3963   |   |
| September        |   |     |   | 1.1731   |   | 0.9635   |   | 2.0563   |   | 1.1727   |   | 1.3393   |   |
| October          |   |     |   | 1.1846   |   | 1.0315   |   | 1.4070   |   | 1.1462   |   | 1.1248   |   |
| November         |   |     |   | 1.2057   |   | 1.0425   |   | 1.3481   |   | 1.6490   |   | 1.0675   |   |
| December         |   |     |   | 1.2969   |   | 1.1198   |   | 1.2793   |   | 1.3700   |   | 0.9163   |   |
| Mathematical Avg |   |     |   | $        | 1.1450 |     | $      | 1.1059   |   | $        | 1.6630 |     | $      | 1.1768 |   | $ | 1.2392 |   |
|                  |        |          |        |          |        |          |        |          |        |          |        |          |        |  |  |  |  |  |  |

 

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Thecost of cream, the principal ingredient used in making ice cream, affects costof sales as a percentage of total revenues, especially in foodservice’s retailbusiness. A $0.10 increase in the cost of a pound of AA butter adverselyaffects the Company’s annual cost of sales by approximately $1.0 million.  This adverse impact may be offset by priceincreases or other factors. However, no assurance can be given that the Companywill be able to offset any cost increases in the future and future increases incream prices could have a material adverse effect on the Company’s results ofoperations. To minimize risk, alternative supply sources continue to bepursued.

 

TheCompany purchases butter option contracts to minimize the impact of increasesin the cost of cream. When available, options on butter futures are purchasedto cover up to 50% of the cream needs of the manufacturing plant.  Option contracts are offered in the monthsof March, May, July, September, October and December; however, there isoften not enough open interest in them to allow the Company to buy even verylimited coverage without paying high premiums.

 

*Labor and benefits:*

 

Laborand benefits increased $0.2 million, or 0.2%, to $82.1 million for the sixmonths ended June 27, 2004 from $81.9 million for the six months endedJune 29, 2003. Labor and benefits as a percentage of total revenuesincreased to 29.5% in the 2004 period from 28.8% in the 2003 period. As apercentage of restaurant revenues, labor and benefits increased to 37.5% in the2004 period from 36.2% in the 2003 period. The increase in labor and benefitswas due to training costs associated with the rollout of a new point of saleregister system in 300 restaurants during the six month period and declines inlabor scheduling efficiencies, especially during off meal periods during thewinter months. Day to day weather changes, particularly in the winter months,can result in over scheduling labor when daypart sales fall short ofexpectations. In April 2004, the Company initiated a program to reinforceproper labor scheduling techniques. Payroll taxes and insurance costs alsoincreased in the 2004 period when compared to the 2003 period. Revenueincreases derived from franchised locations and retail supermarket customers,which do not have any associated restaurant labor and benefits, reduced theimpact of the higher restaurant labor and benefits as a percentage of totalrevenues.

 

*Operating expenses:*

 

Operatingexpenses decreased $1.2 million, or 2.2%, to $52.8 million in the six monthsended June 27, 2004 from $54.0 million for the six months endedJune 29, 2003. Operating expenses as a percentage of total revenues were19.0% in the 2004 and 2003 periods. The decrease in dollars resulted from loweradvertising, maintenance costs and utility costs.  These decreases were partially offset by higher general liabilityinsurance and restaurant menu and kid premium supply costs in the 2004 periodwhen compared to the 2003 period.

 

*General and administrative expenses:*

 

Generaland administrative expenses were $20.5 million and $20.0 million for the sixmonths ended June 27, 2004 and June 29, 2003, respectively. Generaland administrative expenses as a percentage of total revenues increased to 7.3%in the 2004 period from 7.0% in the 2003 period. The dollar increase is primarilythe result of higher costs for group insurance, computer equipment rentals andlegal and professional fees. These increases were partially offset by lowersalaries and wages. The 2004 period also included a charge for future rentsassociated with a vacated training facility.

 

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*Restructuring expenses:*

 

Restructuringexpenses of $2.6 million related to severance and other benefits associatedwith reduction in force actions taken during the first quarter of 2004 thatreduced headcount by approximately 20 permanent positions.

 

*Gain on litigation settlement:*

 

InJanuary 2004, a settlement was reached in a lawsuit filed by the Companyagainst a former administrator of one of the Company’s benefit plans.  The settlement was based on theadministrator’s alleged failure to adhere to the terms of a contract andresulted in a one-time payment to the Company of approximately $3.8 million,which was received on April 2, 2004. As a result of this lawsuit, the Companyincurred professional fees of approximately $0.5 million which were included inthe consolidated statement of operations for the year ended December 28,2003 and an additional $0.2 million in professional fees, which were offsetagainst the payment in the accompanying condensed consolidated statement ofoperations for the six months ended June 27, 2004.

 

*Depreciation and amortization:*

 

Depreciationand amortization was $11.2 million and $11.4 million for the six months endedJune 27, 2004 and June 29, 2003, respectively. Depreciation andamortization as a percentage of total revenues was 4.0% in the 2004 and 2003periods.

 

*Gain on franchise sales of restaurant operations andproperties:*

 

Gainon franchise sales of restaurant operations and properties was $0.9 million inthe six months ended June 27, 2004. During the six months endedJune 27, 2004, the Company recognized a gain of approximately $0.7 millionassociated with the sale of certain equipment assets, lease and sublease rightsand franchise rights in 10 existing Company-operated restaurants tofranchisees.  Additionally, the Companysold the real property and equipment for one franchised location and assignedthe lease and sold the equipment for a second franchised location to theexisting franchisee, resulting in a gain of approximately $0.2 million.

 

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

 

Theloss on disposals of other property and equipment, net, was $0.5 million and$1.4 million for the six months ended June 27, 2004 and June 29,2003, respectively.  The table belowidentifies the components of the loss on disposals of other property andequipment, net as shown in the accompanying condensed consolidated statementsof operations (in thousands):

 
|                                                    |   | **For the  Six Months Ended** |   |
|---------------------------------------------------------|--------|-------------------------------|--------|
|                                                    |   | **June 27,  2004**       |   | **June 29,  2003** |   |
|                                                    |   |                          |   |   |   |
| Restaurant assets retired due to remodeling             |   | $                             | 173    |   | $ | 898 |   |
| Restaurant equipment assets retired due to  replacement |   | 159                           |   | 199 |   |
| Loss on property held for disposition                   |   | —                        |   | 141 |   |
| Loss on property not held for disposition               |   | 63                            |   | — |   |
| All other                                               |   | 113                           |   | 170 |   |
| Loss on disposals of other property and  equipment, net |   | $                             | 508    |   | $ | 1,408 |   |

 

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*Other expenses, principally debt retirement costs:*

 

Otherexpenses, principally debt retirement costs represents the $6.8 million premiumand the write off of unamortized deferred financing costs of approximately $2.5million in connection with the tender offer for the $176.0 million of SeniorNotes. In March 2004, $127.8 million of aggregate principal amount ofSenior Notes were purchased pursuant to the tender offer and inApril 2004, the remaining $48.2 million of Senior Notes were redeemed inaccordance with the Senior Notes indenture at 103.5% of the principal amount.

 

*Interest expense, net:*

 

Interestexpense, net of capitalized interest and interest income, was $11.4 million and$12.2 million for the six months ended June 27, 2004 and June 29,2003, respectively. Total outstanding debt, including capital lease and financeobligations, decreased from $237.9 million at June 29, 2003 to $235.9million at June 27, 2004. In March 2004, $127.8 million of aggregateprincipal amount of Senior Notes were purchased in a tender offer with theproceeds from the issuance of $175.0 million of New Senior Notes with a lowerinterest rate and in April 2004, the remaining $48.2 million of SeniorNotes were redeemed in accordance with the Senior Notes indenture at 103.5% ofthe principal amount.

 

*Benefit from (provision for) income taxes:*

 

Thebenefit from income taxes was $2.8 million, or 30.0%, for the six months endedJune 27, 2004. At this time, the Company estimates that the effective taxrate for 2004 will be 30.0%. The Company records income taxes based on theeffective rate expected for the year with any changes in the valuationallowance reflected in the period of change. The provision for income taxes was$0.6 million, or 28.0%, for the six months ended June 29, 2003. The ratein 2003 was increased in the fourth quarter due to a one-time pension curtailmentgain of $8.1 million in 2003. The tax rate for the 2003 fiscal year was 32.5%.

 

*Net (loss) income:*

 

Netloss was $6.4 million for the six months ended June 27, 2004 as comparedto net income of $1.6 million for the six months ended June 29, 2003, forthe reasons discussed above.

 

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**Liquidity and Capital Resources**

 

TheCompany’s primary sources of liquidity and capital resources are cash generatedfrom operations and, if needed, borrowings under its revolving credit facility.Net cash provided by operating activities was $0.2 million and $13.8 millionfor the six months ended June 27, 2004 and June 29, 2003,respectively. Additional sources of liquidity consist of capital and operatingleases for financing leased restaurant locations (in malls and shopping centersand land or building leases), restaurant equipment, manufacturing equipment,distribution vehicles and computer equipment. Additionally, sales ofunder-performing existing restaurant properties and other assets (to the extentFICC’s and its subsidiaries’ debt instruments permit) are sources of cash. Theamount of debt financing that FICC will be able to incur is limited by theterms of its New Credit Facility and New Senior Notes Indenture. Below was thefinancing status of the Company’s operating restaurants at June 27, 2004:

 

| Owned and mortgaged                |   | 72  |   |
|------------------------------------|--------|-----|--------|
| Sold and leased back               |   | 61  |   |
| Owned land and building            |   | 35  |   |
| Leased land, owned building        |   | 82  |   |
| Leased land and building           |   | 110 |   |
| Total Company-operated restaurants |   | 360 |   |

 

Therestaurants above not identified as owned and mortgaged or sold and leased backsecure the Company’s obligations under the New Credit Facility. In addition tothe 72 properties identified as owned and mortgaged, the Company owns anadditional three properties in this category that are now operated by afranchisee. Of the 35 restaurant properties identified as owned land andbuilding, six were available to be sold, if necessary, and of the 82 restaurantproperties identified as leased land, owned building, one was available to bemortgaged, if necessary.

 

TheCompany’s cash flows were used primarily to pay expenses associated with thetender offer for the Senior Notes, to maintain existing restaurant and plantfacilities, to continue to renovate and re-image existing restaurants and forgeneral corporate purposes. During the six months ended June 27, 2004 andJune 29, 2003, the Company spent $8.3 million and $16.2 million,respectively, on capital expenditures, of which $1.1 million and $4.8 million,respectively, was for the renovation of restaurants under its revitalizationand re-imaging programs. Capital expenditures were offset by proceeds from thesales of property and equipment of $3.4 million for the six months ended June 27,2004.  There were no proceeds from thesales of property and equipment during the six months ended June 29, 2003.

 

TheCompany had a working capital deficit of $13.3 million and $4.2 million as ofJune 27, 2004 and December 28, 2003, respectively. 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.

 

Netcash used in financing activities was $8.0 million and $1.2 million for the sixmonths ended June 27, 2004 and June 29, 2003, respectively.

 

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InNovember 1997, FICC entered into a credit facility that included revolvingcredit loans, term loans and letters of credit (the “Old CreditFacility”).  Also in November 1997,FICC completed a public offering of $200 million of senior notes (the “SeniorNotes”). In December 2001, the Company completed a financial restructuringplan (the “Refinancing Plan”) which included the repayment of the $64.5 millionoutstanding under the Old Credit Facility and the purchase of approximately$21.3 million in Senior Notes with the proceeds from $55.0 million in long-termmortgage financing (the “Mortgage Financing”) and a $33.7 million sale andleaseback transaction (the “Sale/Leaseback Financing”). In addition, FICCsecured a new $30.0 million revolving credit facility (the “New CreditFacility”) of which up to $20.0 million is available to support letters ofcredit.  On July 3, 2003, FICCobtained a limited waiver to the New Credit Facility allowing the purchase ofcertain of the Senior Notes in an amount up to $3.0 million, subject to certainconditions. In July 2003, FICC purchased approximately $2.7 million inaggregate principal amount of the Senior Notes for approximately $2.8 million,the then current market value.

 

InFebruary 2004, the Company announced a cash tender offer and consentsolicitation for the $176.0 million of Senior Notes to be financed with theproceeds from a private offering of new senior notes (the “New Senior Notes”),available cash and an amended New Credit Facility (the “2004Refinancing”).  In March 2004,$127.4 million of aggregate principal amount of Senior Notes were purchased atthe tender offer and consent solicitation price of 104% of the principal amountand $0.4 million of aggregate principal amount of Senior Notes were purchasedat the tender offer price of 102% of the principal amount. In April 2004,the remaining $48.2 million of Senior Notes were redeemed in accordance withthe Senior Notes indenture at 103.5% of the principal amount.  The Senior Notes would have matured onDecember 1, 2007.  Interest on theSenior Notes was payable at 10.5% per annum semi-annually on June 1 andDecember 1 of each year.  Inconnection with the tender offer, the Company wrote off unamortized deferredfinancing costs and incurred other direct expenses of $9.2 million that wereincluded in the accompanying condensed consolidated statement of operations forthe six months ended June 27, 2004.

 

The$175.0 million of New Senior Notes issued in March 2004 are unsecuredsenior obligations of FICC, guaranteed on an unsecured senior basis by FICC’sFriendly’s Restaurants Franchise, Inc. subsidiary, but are effectivelysubordinated to all secured indebtedness of FICC, including the indebtednessincurred under the New Credit Facility. The New Senior Notes mature onJune 15, 2012. Interest on the New Senior Notes is payable at 8.375% perannum semi-annually on June 15 and December 15 of each yearcommencing June 15, 2004.  The NewSenior Notes are redeemable, in whole or in part, at any time on or afterJune 15, 2008 at FICC’s option at redemption prices from 104.188% to100.00%, based on the redemption date. In addition, at any time prior to June 15, 2007, FICC may redeem,subject to certain conditions, up to 35% of the aggregate principal amount ofthe New Senior Notes with the proceeds of one or more qualified equityofferings, as defined, at a redemption price of 108.375% of the principalamount, plus accrued interest.

 

Inconnection with the 2004 Refinancing, the New Credit Facility was amended inMarch 2004.  The total commitmentamount was increased from $30.0 million to $35.0 million and the maturity datewas extended from December 17, 2005 to June 30, 2007, in addition toother changes.

 

TheNew Credit Facility is secured by substantially all of the assets of FICC andtwo of its six subsidiaries, Friendly’s Restaurants Franchise, Inc. andFriendly’s International Inc. These two subsidiaries also guarantee FICC’sobligations under the New Credit Facility.

 

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TheNew Credit Facility includes certain restrictive covenants including limitationson indebtedness, restricted payments such as dividends and stock repurchasesand sales of assets and of subsidiary stock. Additionally, the New CreditFacility limits the amount which the Company may spend on capital expenditures,restricts the use of proceeds, as defined, from asset sales and requires theCompany to comply with certain financial covenants. On July 23, 2004, theCompany successfully obtained a limited waiver regarding a quarterly EBITDAcovenant of its New Credit Facility.

 

TheNew Credit Facility has an annual “clean-up” provision, commencing in 2005,which obligates the Company to repay in full all revolving credit loans on orbefore September 30 (or, if September 30 is not a business day, asdefined, then the next business day) of each year and maintain a zero balanceon such revolving credit for at least 30 consecutive days, to includeSeptember 30, immediately following the date of such repayment.

 

The$35.0 million revolving credit commitment less outstanding letters of credit isavailable for borrowing to provide working capital and for other corporateneeds. As of June 27, 2004 and December 28, 2003, total letters ofcredit outstanding were approximately $14.5 million and $13.6 million,respectively. During the six months ended June 27, 2004 and June 29,2003, there were no drawings against the letters of credit.

 

Therevolving credit loans bear interest at the Company’s option at either (a) theBase Rate plus the applicable margin as in effect from time to time (the “BaseRate”) (6.50% at June 27, 2004) or (b) the Eurodollar rate plus theapplicable margin as in effect from time to time (the “Eurodollar Rate”) (5.76%at June 27, 2004).  As ofJune 27, 2004 and December 28, 2003, there were no revolving creditloans outstanding and $20.5 million and $17.4 million, respectively, wasavailable for borrowing.

 

TheCompany anticipates requiring capital in the future principally to maintainexisting restaurant and plant facilities and to continue to renovate andre-image existing restaurants. Capital expenditures for 2004, including assetsto be acquired under capital leases, are anticipated to be between $20.0million and $25.0 million in the aggregate, of which $15.0 million to $20.0million is expected to be spent on restaurant operations. The Company’s actual2004 capital expenditures may vary from these estimated amounts. The Companybelieves that the combination of the funds anticipated to be generated fromoperating activities and borrowing availability under the New Credit Facilitywill be sufficient to meet the Company’s anticipated operating requirements,capital requirements and obligations associated with the restructuringreserves.

 

InJanuary 2004, a settlement was reached in a lawsuit filed by the Companyagainst a former administrator of one of the Company’s benefit plans.  The settlement was based on theadministrator’s alleged failure to adhere to the terms of a contract andresulted in a one-time payment to the Company of approximately $3.8 million,which was received on April 2, 2004. As a result of this lawsuit, theCompany incurred professional fees of approximately $0.5 million which wereincluded in the consolidated statement of operations for the year endedDecember 28, 2003 and an additional $0.2 million in professional fees,which were offset against the payment in the accompanying condensedconsolidated statement of operations for the six months ended June 27,2004. The net cash proceeds were used in April 2004 in connection with theredemption of the remaining $48.2 million of Senior Notes.

 

OnMarch 5, 2004, the Company sold the real property and equipment for onefranchised location and assigned the lease and sold the equipment for a secondfranchised location to the existing franchisee. Gross proceeds from the salewere approximately $0.5 million, of which $0.1 million was for franchise feesand $0.4 million was for the sale of assets and lease assignment.

 

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OnJanuary 15, 2004, the Company entered into an agreement granting CentralFlorida Restaurants LLC (“Central Florida”) certain limited exclusive rights tooperate and develop Friendly’s full-service restaurants in designated areaswithin the Orlando, Florida market (the “Central Florida Agreement”).  Pursuant to the Central Florida Agreement,Central Florida purchased certain equipment assets, lease and sublease rightsand franchise rights in 10 existing Friendly’s restaurants and committed toopen an additional 10 restaurants over the next six years with an option for 15more restaurants in the following five years. Gross proceeds from the sale wereapproximately $3.2 million of which approximately $0.3 million was forfranchise fees for the initial 10 restaurants.

 

DuringJuly 2003, the Company entered into a development agreement granting JaxFamily Rest., Inc. (“Jax”) certain limited exclusive rights to operate anddevelop Friendly’s full-service restaurants in designated areas within Baker,Clay, Nassau, Putnam and St. John’s counties, Florida (the “Jax Agreement”).Pursuant to the Jax Agreement, Jax agreed to open 10 new restaurants over thenext seven years. The Company received development fees of $0.2 million, whichrepresent one-half of the initial franchise fees. Jax opened one new restaurantduring the three months ended June 27, 2004.

 

Thefollowing represents the contractual obligations and commercial commitments ofthe Company as of June 27, 2004 (in thousands):

 
|                                  |   | **Payments  Due by Period**                    |       |
|---------------------------------------|--------|------------------------------------------------|------------|
| **Contractual Obligations:**          |   | **Total**                                      |       | **Remainder  of  2004** |   | **Fiscal  Years  2005 & 2006** |   | **Fiscal  Years  2007 & 2008** |   | **Fiscal  Years  Beyond  2008** |   |
| Short-term and long-term debt         |   | $                                              | 227,537    |   | $ | 577 |   | $ | 2,636 |   | $ | 3,179 |   | $ | 221,145 |   |
| Capital lease and finance obligations |   | 11,812                                         |       | 1,050 |   | 3,835 |   | 3,359 |   | 3,568 |   |
| Operating leases                      |   | 144,683                                        |       | 9,470 |   | 31,610 |   | 24,102 |   | 79,501 |   |
| Purchase commitments                  |   | 62,771                                         |       | 62,410 |   | 338 |   | 23 |   | — |   |
|                                  |   |                                           |       |   |   |   |   |   |   |   |   |
|                                  |   | **Amount of  Commitment Expiration by Period** | ** ** |
| **Other Commercial Commitments:**     |   | **Total**                                      |       | **Remainder  of  2004** |   | **Fiscal  Years  2005 & 2006** |   | **Fiscal  Years  2007 & 2008** |   | **Fiscal  Years  Beyond  2008** | ** ** |
| Letters of credit                     |   | $                                              | 14,474     |   | $ | — |   | $ | — |   | $ | 14,474 |   | $ | — |   |

 

**Seasonality**

 

Dueto the seasonality of ice cream consumption, and the effect from time to timeof weather on patronage of the restaurants, the Company’s revenues andoperating income are typically higher in its second and third quarters.

 

**Geographic Concentration**

 

Approximately93% of the Company-operated restaurants are located, and substantially all ofits retail sales are generated, in the Northeast. As a result, a severe orprolonged economic recession or changes in demographic mix, employment levels,population density, weather, real estate market conditions or other factorsspecific to this geographic region may adversely affect the Company more thancertain of its competitors which are more geographically diverse.

 

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**Significant Accounting Policies**

 

FinancialReporting Release No. 60 issued by the Securities and Exchange Commissionrequires all companies to include a discussion of critical accounting policiesor methods used in the preparation of financial statements. The following is abrief discussion of the more significant accounting policies and methods usedby the Company. The Company’s condensed consolidated financial statements,including the notes thereto, which are included elsewhere herein, should beread in conjunction with this discussion.

 

*Use of Estimates in the Preparation of Financial Statements-*

 

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities andthe disclosure of contingent assets and liabilities at the dates of thefinancial statements and the reported amounts of revenues and expenses duringthe reporting periods. The critical accounting policies and most significantestimates and assumptions relate to revenue recognition, insurance reserves, recoverabilityof accounts receivable, valuation allowances and pension and otherpost-retirement benefits expense. Actual amounts could differ significantlyfrom the estimates.

 

*Revenue Recognition -*

 

TheCompany’s revenues are derived primarily from the operation of full-servicerestaurants, the distribution and sale of premium ice cream desserts throughretail and institutional locations and franchising. The Company recognizesrestaurant revenue upon receipt of payment from the customer and retail revenue,net of discounts and allowances, upon delivery of product. Reserves fordiscounts and allowances from retail sales are estimated and accrued whenrevenue is recorded based on promotional planners prepared by the Company’sretail sales force. Actual amounts could differ materially from the estimates.Franchise royalty income, generally calculated as 4% of net sales offranchisees, is recorded monthly based upon the actual sales reported by eachfranchisee for the month just completed. Franchise fees are recorded as revenueupon completion of all significant services, generally upon opening of therestaurant.

 

*Insurance Reserves -*

 

TheCompany is self-insured through retentions or deductibles for the majority ofits workers’ compensation, automobile, general liability, employer’s liability,product liability and group health insurance programs. Self-insurance amountsvary up to $0.5 million per occurrence. Insurance with third parties, some ofwhich is then reinsured through Restaurant Insurance Corporation (“RIC”), theCompany’s wholly owned subsidiary, is in place for claims in excess of theseself-insured amounts. RIC reinsures 100% of the risk from $0.5 million to $1.0million per occurrence through September 2, 2000 for FICC’s workers’compensation, general liability, employer’s liability and product liabilityinsurance. Subsequent to September 2, 2000, the Company discontinued itsuse of RIC as a captive insurer for new claims.

 

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TheCompany’s liabilities for estimated ultimate losses for workers’ compensation,automobile, general liability, employer’s liability and product liability areactuarially determined and recorded in the accompanying condensed consolidatedfinancial statements on an undiscounted basis. The projections of estimatedultimate losses are based on commonly used actuarial procedures.  These procedures take into considerationcertain actuarial assumptions or management judgments regarding economicconditions, the frequency and severity of claims and claim settlementpractices.  While the estimated ultimatelosses are reasonable, any actuarial estimate is subject to uncertainty due tothe volatility inherent in casualty exposures and changes in theassumptions.  The Company’s provision forinsurance expense reflects estimated amounts for the current year as well asrevisions in estimates to prior years. Actual losses could vary significantly from the estimated losses andwould have a material affect on the Company’s insurance expense.

 

TheCompany records a liability for its group health insurance programs for allestimated unpaid claims based primarily upon loss development analyses derivedfrom actual claim payment experience provided by the Company’s third partyadministrators.

 

*Concentration of Credit Risk -*

 

Financialinstruments, which potentially expose the Company to concentrations of creditrisk, consist principally of accounts receivable. The Company performs ongoingcredit evaluations of its customers and generally requires no collateral tosecure accounts receivable. The credit review is based on both financial andnon-financial factors. The Company maintains a reserve for potentiallyuncollectible accounts receivable based on its assessment of the collectibilityof accounts receivable.

 

*Pension and Other Post-RetirementBenefits -*

 

Certainof the Company’s employees are covered under a noncontributory defined benefitpension plan. The determination of the Company’s obligation and expense forpension and other post-retirement benefits is dependent upon the selection ofcertain assumptions used by actuaries in calculating such amounts. Thoseassumptions include, among other things, the discount rate, expected long-termrate of return on plan assets and rates of increase in health care costs. Inaccordance with accounting principles generally accepted in the United States,actual results that differ from the assumptions are accumulated and amortizedover future periods and, therefore, generally affect the recognized expense andrecorded obligation in such future periods. Significant differences in actualexperience or significant changes in the assumptions may materially affect thefuture pension and other post-retirement obligations and expense.

 

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*Long-Lived Assets -*

 

Inaccordance with SFAS No. 144, “Accounting for the Impairment or Disposal ofLong-Lived Assets,” the Company reviews its Non-Friendly Marks, which wereassigned to the Company by Hershey in September 2002, for impairment on aquarterly basis. The Company recognizes impairment has occurred when thecarrying value of the Non-Friendly Marks exceeds the estimated futurediscounted cash flows of the trademarked products. Additionally, the Companyreviews long-lived assets related to each restaurant to be held and used in thebusiness quarterly for impairment or whenever events or changes incircumstances indicate that the carrying amount of a restaurant may not berecoverable. The Company evaluates restaurants using a “two-year history ofcash flow” as the primary indicator of potential impairment. Based on the bestinformation available, the Company writes down an impaired restaurant to itsestimated fair market value, which becomes its new cost basis. Estimated fairmarket value is based on the Company’s experience selling similar propertiesand local market conditions, less costs to sell for properties to be disposedof. In addition, restaurants scheduled for closing are reviewed for impairmentand depreciable lives are adjusted. The impairment evaluation is based on theestimated cash flows from continuing use through the expected disposal date andthe expected terminal value.

 

Considerablemanagement judgment is necessary to estimate future cash flows, including cashflows from continuing use, terminal value, closure costs and sublease income.Accordingly, actual results could vary significantly from these estimates.

 

*Income Taxes -*

 

TheCompany accounts for income taxes in accordance with SFAS No. 109, “Accountingfor Income Taxes,” which requires recognition of deferred tax assets andliabilities for the expected future tax consequences of events that have beenincluded in the financial statements or tax returns. Management recordsdeferred tax assets to the extent it believes there will be sufficient futuretaxable income to utilize those assets prior to their expiration. To the extentdeferred tax assets may be unable to be utilized, the Company records avaluation allowance against the unrealizable amount and records a chargeagainst earnings.

 

TheCompany records income taxes based on the effective rate expected for the yearwith any changes in the valuation allowance reflected in the period of change.As of June 27, 2004 and December 28, 2003, a valuation allowance of$10.1 million existed related to state NOL carryforwards due to restrictions onthe usage of state NOL carryforwards and short carryforward periods for certainstates. Due to ever-changing tax laws and income tax rates, significantjudgment is required to estimate the effective tax rate expected to apply totax differences that are expected to reverse in the future. Management mustalso make estimates about the sufficiency of taxable income in future periodsto offset any deductions related to deferred tax assets currently recorded.Accordingly, management believes estimates related to income taxes arecritical.

 

*Derivative Instruments and Hedging Agreements -*

 

TheCompany purchases butter option contracts to minimize the impact of increasesin the cost of cream. When available, options on butter futures are purchasedto cover up to 50% of the cream needs of the manufacturing plant.  Option contracts are offered in the monthsof March, May, July, September, October and December; however, there isoften not enough open interest in them to allow the Company to buy even verylimited coverage without paying high premiums.

 

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Inaddition to hedging, the Company pursues fixed price cream contracts to managedairy cost pressures. The Company was unable to find a supplier interested inan agreement for a fixed-price load of cream for part of the year or the fullyear of 2003 or 2004. The situation surrounding the supply of cream (whichdepends on milk production, milk per cow, number of cows, butter inventories,etc.) is very uncertain in the wake of the National Milk Producers Federation’s“Cooperatives Working Together” program.

 

TheCompany’s commodity option contracts do not meet hedge accounting criteria asdefined by SFAS No. 133, “Accounting for Derivative Instruments and HedgingActivities,” and, accordingly, are marked to market each period, with theresulting gains or losses recognized in cost of sales. For the quarter endedJune 27, 2004, losses of approximately $0.3 million were included in costof sales related to these option contracts. There were no gains or lossesrecognized during the quarter ended June 29, 2003. For the six monthsended June 27, 2004, gains of approximately $0.5 million were included incost of sales related to these option contracts as compared to losses ofapproximately $0.3 million for the six months ended June 29, 2003.

 

*Contingencies -*

 

Fromtime to time the Company is named as a defendant in legal actions arising inthe ordinary course of its business. The Company does not believe that theresolutions of these claims will have a material adverse effect on theCompany’s consolidated financial condition or consolidated results ofoperations.

 

*Stock-Based Compensation -*

 

TheCompany accounts for stock-based compensation for employees under AccountingPrinciples Board (“APB”) Opinion No. 25, “Accounting for Stock Issued toEmployees,” and elected the disclosure-only alternative under SFAS No. 123,“Accounting for Stock-Based Compensation.”  Stock-based compensation cost of approximately $0.2 millionrelated to modified option awards was included in net loss for the six monthsended June 27, 2004 for the Company’s Stock Option Plan and the Company’s2003 Incentive Plan. No stock-based compensation cost was included in netincome for the six months ended June 29, 2003 for the Company’s StockOption Plan or the Company’s 2003 Incentive Plan, as all options granted duringthis period had an exercise price equal to the market value of the stock on thedate of grant. In accordance with SFAS No. 148, “Accounting for Stock BasedCompensation-Transition and Disclosure,” the Company will continue to disclosethe required pro-forma information in the notes to the consolidated financialstatements.

 

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

 

Therehas been no material change in the Company’s market risk exposure since thefiling of the 2003 Annual Report on Form 10-K.

 

**Item 4. Controls and Procedures**

 

Asof June 27, 2004, an evaluation was performed under the supervision andwith the participation of the Company’s management, including the ChiefExecutive Officer (“CEO”) and Chief Financial Officer (“CFO”), of theeffectiveness of the design and operation of the Company’s disclosure controlsand procedures (as defined in Rule 13a-15(e) under the Exchange Act).  Based on that evaluation, the Company’s CEOand CFO concluded that the Company’s disclosure controls and procedures wereeffective as of June 27, 2004.

 

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**PART II - OTHER INFORMATION**

 

**Item 4.  Submission ofmatters to a vote of security holders**

 

(a)                An annual meeting of the Company’sshareholders was held on May 19, 2004.

 

(b)               Not applicable.

 

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

 

(1)          The election of two directors to serve until the 2007 Annual Meeting ofShareholders and

 

(2)          The ratification of the appointment of the independent auditors for2004

 

Thevoting results were as follows:

 

| **Directors**     |   | **Affirmative  Votes** |   | **Votes  Withheld** |   |
|-------------------|--------|------------------------|--------|---------------------|--------|
| Michael J. Daly   |   | 6,183,204              |   | 253,495             |   |
| Burton J. Manning |   | 6,203,624              |   | 233,075             |   |

 

AdditionalDirectors, whose terms of office as Directors continued after the meeting, areas follows:

 

| **Term  Expiring in 2005** |   | **Term  Expiring in 2006** |   |
|----------------------------|--------|----------------------------|--------|
| Steven L. Ezzes            |   | Donald N. Smith            |   |
| Charles A. Ledsinger, Jr.  |   |                       |   |

 

Theproposal to approve the appointment of independent auditors for 2004 wasapproved by shareholders as follows:

 

| **Affirmative  Votes** |   | **Negative  Votes** |   | **Votes Withheld** |   |
|------------------------|--------|---------------------|--------|--------------------|--------|
| 6,311,764              |   | 121,305             |   | 3,630              |   |

 

Therewere no matters voted upon at the Company’s annual meeting to which brokernon-votes applied.

 

**Item 6.  Exhibits andreports on Form 8-K**

 

(a)                Exhibits

 

Theexhibit index is incorporated by reference herein.

 

(b)               Reports on Form 8-K

 

None

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned, 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 |
|   |   |                            |   |
|   |   | Date:                           | July 30,  2004 |
|        |        |                                 |  |  |  |

 

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**EXHIBIT INDEX**

 
| 31.1   |   | Certification  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 signed by John  L. Cutter.                                                                           |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                               |
| 31.2   |   | Certification  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 signed by Paul  V. Hoagland.                                                                         |
|   |   |                                                                                                                                                                               |
| 32.1   |   | Certification  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 signed by John L. Cutter  and Paul V. Hoagland. |

 

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