**SECURITIES ANDEXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

**(Mark One)**

 
| **ý**                                             | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**  |
|--------------------------------------------------------|----------------------------------------------------------------------------------------------------|
| ** **                                             | ** **                                                                                         |
| **For the quarterly period ended September 26,  2004** |
| ** **                                             | ** **                                                                                         |
| **OR**                                                 |
| ** **                                             | ** **                                                                                         |
| **o**                                                  | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934** |

 

**For the transition periodfrom          to         **

 

**Commission File No. 001-13579**

 

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**FRIENDLY ICE CREAM CORPORATION**

(Exact Name of Registrant as Specified in ItsCharter)

 
| **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) |

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past 90 days. Yes ý  No o

 

Indicate by check mark whether the registrant is anaccelerated filer (as defined in Exchange 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 October 15, 2004** |
|------------------------------|------------|-------------------------------------|
|                         |       |                                |
| Common Stock, $.01 par value |       | 7,702,572 shares                    |

 

 

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** **

**PART I – FINANCIAL INFORMATION**

 

**Item 1.  Financial Statements**

 

**FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

 

(In thousands)

 
| ** **                                                                | ** ** | **September 26,  2004** | ** ** | **December 28,  2003** | ** ** |
|---------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                                                                | ** ** | **(unaudited)**         | ** ** | ** **             | ** ** |
| ASSETS                                                                    |       |                    |       |                   |       |
| CURRENT ASSETS:                                                           |       |                    |       |                   |       |
| Cash and cash  equivalents                                                |       | $                       | 17,234     |                   | $          | 25,631 |   |
| Restricted cash                                                           |       | 1,936                   |       | 1,671                  |       |
| Accounts  receivable, net                                                 |       | 10,301                  |       | 10,384                 |       |
| Inventories                                                               |       | 18,654                  |       | 15,669                 |       |
| Assets held for  sale                                                     |       | 1,463                   |       | 1,448                  |       |
| Deferred income  taxes                                                    |       | 6,647                   |       | 6,647                  |       |
| Prepaid expenses  and other current assets                                |       | 4,559                   |       | 1,539                  |       |
| TOTAL CURRENT  ASSETS                                                     |       | 60,794                  |       | 62,989                 |       |
| DEFERRED INCOME  TAXES                                                    |       | 2,030                   |       | —                 |       |
| PROPERTY AND  EQUIPMENT, net of accumulated depreciation and amortization |       | 165,536                 |       | 165,661                |       |
| INTANGIBLE  ASSETS AND DEFERRED COSTS, net of accumulated amortization    |       | 20,928                  |       | 17,890                 |       |
| OTHER ASSETS                                                              |       | 6,921                   |       | 5,912                  |       |
| TOTAL ASSETS                                                              |       | $                       | 256,209    |                   | $          | 252,452 |   |
|                                                                      |       |                    |       |                   |       |
| LIABILITIES AND STOCKHOLDERS’ DEFICIT                                |       |                    |       |                   |       |
| CURRENT  LIABILITIES:                                                     |       |                    |       |                   |       |
| Current  maturities of long-term debt                                     |       | $                       | 1,225      |                   | $          | 1,127 |   |
| Current  maturities of capital lease and finance obligations              |       | 1,489                   |       | 911                    |       |
| Accounts payable                                                          |       | 27,435                  |       | 22,475                 |       |
| Accrued salaries  and benefits                                            |       | 10,211                  |       | 9,635                  |       |
| Accrued interest  payable                                                 |       | 4,824                   |       | 2,033                  |       |
| Insurance  reserves                                                       |       | 10,700                  |       | 10,041                 |       |
| Restructuring  reserves                                                   |       | 1,472                   |       | 441                    |       |
| Other accrued  expenses                                                   |       | 15,258                  |       | 19,055                 |       |
| TOTAL CURRENT  LIABILITIES                                                |       | 72,614                  |       | 65,718                 |       |
| DEFERRED INCOME  TAXES                                                    |       | —                  |       | 1,289                  |       |
| CAPITAL LEASE  AND FINANCE OBLIGATIONS, less current maturities           |       | 7,596                   |       | 5,773                  |       |
| LONG-TERM DEBT,  less current maturities                                  |       | 226,034                 |       | 227,937                |       |
| ACCRUED PENSION  COST                                                     |       | 14,540                  |       | 16,127                 |       |
| OTHER LONG-TERM  LIABILITIES                                              |       | 34,940                  |       | 33,634                 |       |
| COMMITMENTS AND  CONTINGENCIES                                            |       |                    |       |                   |       |
| STOCKHOLDERS’  DEFICIT:                                              |       |                    |       |                   |       |
| Common stock                                                              |       | 77                      |       | 75                     |       |
| Additional  paid-in capital                                               |       | 142,180                 |       | 140,826                |       |
| Accumulated  other comprehensive loss                                     |       | (19,939                 | )          | (19,922                | )          |
| Accumulated  deficit                                                      |       | (221,833                | )          | (219,005               | )          |
| TOTAL  STOCKHOLDERS’ DEFICIT                                         |       | (99,515                 | )          | (98,026                | )          |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ DEFICIT                         |       | $                       | 256,209    |                   | $          | 252,452 |   |

 

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

 

1

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**FRIENDLY ICE CREAM CORPORATIONAND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

(Unaudited)

(In thousands, except per share data)

 
| ** **                                                       | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|------------------------------------------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                                                       | ** ** | **September 26,  2004**        | ** ** | **September 28,  2003**       | ** ** | **September 26,  2004** | ** ** | **September 28,  2003** | ** ** |
|                                                             |       |                           |       |                          |       |   |   |   |   |
| REVENUES:                                                        |       |                           |       |                          |       |   |   |   |   |
| Restaurant                                                       |       | $                              | 120,436    |                          | $          | 127,605 |   | $ | 339,230 |   | $ | 353,775 |   |
| Foodservice                                                      |       | 29,110                         |       | 30,174                        |       | 82,273 |   | 83,377 |   |
| Franchise                                                        |       | 3,509                          |       | 2,571                         |       | 9,822 |   | 7,536 |   |
| TOTAL REVENUES                                                   |       | 153,055                        |       | 160,350                       |       | 431,325 |   | 444,688 |   |
|                                                             |       |                           |       |                          |       |   |   |   |   |
| COSTS AND  EXPENSES:                                             |       |                           |       |                          |       |   |   |   |   |
| Cost of sales                                                    |       | 57,368                         |       | 56,561                        |       | 158,915 |   | 157,717 |   |
| Labor and  benefits                                              |       | 42,990                         |       | 45,402                        |       | 125,079 |   | 127,326 |   |
| Operating  expenses                                              |       | 29,997                         |       | 28,739                        |       | 82,855 |   | 82,784 |   |
| General and  administrative expenses                             |       | 9,054                          |       | 10,710                        |       | 29,505 |   | 30,725 |   |
| Restructuring  expenses                                          |       | —                         |       | —                        |       | 2,627 |   | — |   |
| Gain on  litigation settlement                                   |       | —                         |       | —                        |       | (3,644 | ) | — |   |
| Write-downs of  property and equipment                           |       | —                         |       | 26                            |       | 91 |   | 26 |   |
| Depreciation and  amortization                                   |       | 5,407                          |       | 5,391                         |       | 16,583 |   | 16,764 |   |
| Gain on  franchise sales of restaurant operations and properties |       | (189                           | )          | —                        |       | (1,102 | ) | — |   |
| Loss on  disposals of other property and equipment, net          |       | 153                            |       | 91                            |       | 661 |   | 1,499 |   |
|                                                             |       |                           |       |                          |       |   |   |   |   |
| OPERATING INCOME                                                 |       | 8,275                          |       | 13,430                        |       | 19,755 |   | 27,847 |   |
|                                                             |       |                           |       |                          |       |   |   |   |   |
| OTHER EXPENSES:                                                  |       |                           |       |                          |       |   |   |   |   |
| Interest  expense, net                                           |       | 5,235                          |       | 6,048                         |       | 16,667 |   | 18,242 |   |
| Other expenses,  principally debt retirement costs               |       | —                         |       | —                        |       | 9,235 |   | — |   |
|                                                             |       |                           |       |                          |       |   |   |   |   |
| INCOME (LOSS)  BEFORE BENEFIT FROM (PROVISION FOR) INCOME TAXES  |       | 3,040                          |       | 7,382                         |       | (6,147 | ) | 9,605 |   |
|                                                             |       |                           |       |                          |       |   |   |   |   |
| Benefit from  (provision for) income taxes                       |       | 563                            |       | (2,067                        | )          | 3,319 |   | (2,689 | ) |
|                                                             |       |                           |       |                          |       |   |   |   |   |
| NET INCOME  (LOSS)                                               |       | $                              | 3,603      |                          | $          | 5,315 |   | $ | (2,828 | ) | $ | 6,916 |   |
|                                                             |       |                           |       |                          |       |   |   |   |   |
| BASIC NET  EARNINGS (LOSS) PER SHARE                             |       | $                              | 0.47       |                          | $          | 0.71 |   | $ | (0.37 | ) | $ | 0.93 |   |
|                                                             |       |                           |       |                          |       |   |   |   |   |
| DILUTED NET  EARNINGS (LOSS) PER SHARE                           |       | $                              | 0.46       |                          | $          | 0.70 |   | $ | (0.37 | ) | $ | 0.91 |   |
|                                                             |       |                           |       |                          |       |   |   |   |   |
| WEIGHTED AVERAGE  SHARES:                                        |       |                           |       |                          |       |   |   |   |   |
| Basic                                                            |       | 7,695                          |       | 7,452                         |       | 7,611 |   | 7,436 |   |
| Diluted                                                          |       | 7,869                          |       | 7,606                         |       | 7,611 |   | 7,577 |   |

 

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

 

2

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** **

**FRIENDLY ICE CREAM CORPORATIONAND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS**

(Unaudited)

(In thousands)

 
| ** **                                                                                | ** ** | **For the Nine Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                | ** ** | **September 26,  2004**       | ** ** | **September 28,  2003** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                    |       |                          |       |   |   |
| Net (loss)  income                                                                        |       | $                             | (2,828     | ) | $ | 6,916 |   |
| Adjustments to  reconcile net (loss) income to net cash provided by operating activities: |       |                          |       |   |   |
| Stock  compensation expense                                                               |       | 427                           |       | 184 |   |
| Depreciation and  amortization                                                            |       | 16,583                        |       | 16,764 |   |
| Write-offs of  deferred financing costs                                                   |       | 2,445                         |       | 44 |   |
| Write-downs of  property and equipment                                                    |       | 91                            |       | 26 |   |
| Deferred income  tax (benefit) expense                                                    |       | (3,319                        | )          | 2,323 |   |
| (Gain) loss on  disposals of other property and equipment, net                            |       | (459                          | )          | 1,499 |   |
| Changes in  operating assets and liabilities:                                             |       |                          |       |   |   |
| Accounts  receivable                                                                      |       | 83                            |       | 401 |   |
| Inventories                                                                               |       | (2,985                        | )          | 1,885 |   |
| Other assets                                                                              |       | (3,585                        | )          | (1,707 | ) |
| Accounts payable                                                                          |       | 4,960                         |       | (1,337 | ) |
| Accrued expenses  and other long-term liabilities                                         |       | 979                           |       | (4,086 | ) |
| NET CASH  PROVIDED BY OPERATING ACTIVITIES                                                |       | 12,392                        |       | 22,912 |   |
|                                                                                      |       |                          |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                    |       |                          |       |   |   |
| Purchases of  property and equipment                                                      |       | (15,554                       | )          | (21,291 | ) |
| Proceeds from  sales of property and equipment                                            |       | 4,048                         |       | 63 |   |
| Purchases of  marketable securities                                                       |       | (1,022                        | )          | — |   |
| Proceeds from  sales of marketable securites                                              |       | 89                            |       | — |   |
| NET CASH USED IN  INVESTING ACTIVITIES                                                    |       | (12,439                       | )          | (21,228 | ) |
|                                                                                      |       |                          |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                    |       |                          |       |   |   |
| Proceeds from  issuance of senior notes                                                   |       | 175,000                       |       | — |   |
| Proceeds from  other borrowings                                                           |       | 16,750                        |       | — |   |
| Repayments of  debt                                                                       |       | (193,555                      | )          | (3,510 | ) |
| Payments of  deferred financing costs                                                     |       | (6,625                        | )          | — |   |
| Repayments of  capital lease and finance obligations                                      |       | (849                          | )          | (1,192 | ) |
| Stock options  exercised                                                                  |       | 929                           |       | 228 |   |
| NET CASH USED IN  FINANCING ACTIVITIES                                                    |       | (8,350                        | )          | (4,474 | ) |
|                                                                                      |       |                          |       |   |   |
| NET DECREASE IN  CASH AND CASH EQUIVALENTS                                                |       | (8,397                        | )          | (2,790 | ) |
|                                                                                      |       |                          |       |   |   |
| CASH AND CASH  EQUIVALENTS, BEGINNING OF PERIOD                                           |       | 25,631                        |       | 34,341 |   |
| CASH AND CASH  EQUIVALENTS, END OF PERIOD                                                 |       | $                             | 17,234     |   | $ | 31,551 |   |
|                                                                                      |       |                          |       |   |   |
| SUPPLEMENTAL  DISCLOSURES:                                                                |       |                          |       |   |   |
| Cash paid during  the period for:                                                         |       |                          |       |   |   |
| Interest                                                                                  |       | $                             | 13,298     |   | $ | 13,435 |   |
| Income taxes                                                                              |       | 24                            |       | 961 |   |
| Capital lease  obligations incurred                                                       |       | 3,250                         |       | 680 |   |
| Lease incentive  equipment received                                                       |       | —                        |       | 243 |   |

 

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

 

3

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**FRIENDLY ICECREAM CORPORATION AND SUBSIDIARIES**

** **

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

** **

(Unaudited)

 

 

**1. BASIS OFPRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES**

 

*Interim Financial Information –*

 

Theaccompanying condensed consolidated financial statements as of September 26,2004 and for the three and nine months ended September 26, 2004 and September28, 2003 are unaudited, but, in the opinion of management, include alladjustments which are necessary for a fair presentation of the consolidatedfinancial position, results of operations, cash flows and comprehensive income(loss) of Friendly Ice Cream Corporation (“FICC”) and subsidiaries (unless thecontext indicates otherwise, collectively, the “Company”). Such adjustmentsconsist solely of normal recurring accruals. Operating results for the threeand nine month periods ended September 26, 2004 and September 28, 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 bereferenced to 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, income tax valuation allowances andpension and other post-retirement benefits expense. Actual amounts could differsignificantly from the estimates.

 

*Revenue Recognition -*

 

The Company’s revenues are derivedprimarily from the operation of full-service restaurants, the distribution andsale of premium ice cream desserts through retail and institutional locationsand franchising. The Company recognizes restaurant revenue upon receipt of paymentfrom the customer and retail revenue, net of discounts and allowances, upondelivery of product. Reserves for discounts and allowances from retail salesare estimated and accrued when revenue is recorded. Actual amounts could differmaterially from the estimates. Franchise royalty income, generally calculatedas 4% of net sales of franchisees, is recorded monthly based upon the actualsales reported by each franchisee for the month just completed. Franchise feesare recorded as revenue upon completion of all significant services, generallyupon opening of the restaurant.

 

*Shipping and Handling Costs -*

 

Costs related to shipping andhandling are included in cost of sales in the accompanying condensedconsolidated statements of operations for all periods presented.

 

4

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*Insurance Reserves -*

 

The Company is self-insured throughretentions or deductibles for the majority of its workers’ compensation,automobile, general liability, employer’s liability, product liability andgroup health insurance programs. Self-insurance amounts vary up to $500,000 peroccurrence. Insurance with third parties, some of which is then reinsuredthrough Restaurant Insurance Corporation (“RIC”), the Company’s wholly ownedsubsidiary, is in place for claims in excess of these self-insured amounts. RICreinsures 100% of the risk from $500,000 to $1,000,000 per occurrence throughSeptember 2, 2000 for FICC’s workers’ compensation, general liability, employer’sliability and product liability insurance. Subsequent to September 2, 2000, theCompany discontinued its use of RIC as a captive insurer for new claims. FICC’sand RIC’s liabilities for estimated incurred losses are actuarially determinedand recorded in the accompanying condensed consolidated financial statements onan undiscounted basis. Actual incurred losses may vary from the estimatedincurred losses and could have a material effect on the Company’s insuranceexpense.

 

*Accounts Receivable and Allowance for Doubtful Accounts–*

 

At September 26, 2004 and December28, 2003, accounts receivable of $10,301,000 and $10,384,000 were net ofallowances for doubtful accounts totaling $485,000 and $696,000, respectively.Accounts receivable consists primarily of amounts due from the sale of productsto franchisees and supermarkets. Accounts receivable also includes amountsrelated to franchise royalties, 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 -*

 

The determination of the Company’sobligation and expense for pension and other post-retirement benefits is dependentupon the selection of certain assumptions used by actuaries in calculating suchamounts. Those assumptions include, among other things, the discount rate,expected long-term rate of return on plan assets and rates of increase inhealth care costs. In accordance with accounting principles generally acceptedin the United States, actual results that differ from the assumptions areaccumulated and amortized over future periods and, therefore, generally affectthe recognized expense and recorded obligation in such future periods.Significant differences in actual experience or significant changes in theassumptions may materially affect the future pension and other post-retirementobligations and expense.

 

*Cash and Cash Equivalents -*

 

The Company considers allinvestments with an original maturity of three months or less when purchased tobe cash equivalents.

 

5

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* *

*Restricted Cash -*

 

RIC is required to hold assets intrust whose value is at least equal to certain of RIC’s outstanding estimatedinsurance claim liabilities. Accordingly, as of September 26, 2004 and December28, 2003, cash of $1,936,000 and $1,671,000, respectively, was restricted.

 

*Inventories -*

 

Inventories are stated at the lowerof first-in, first-out cost or market and consisted of the following atSeptember 26, 2004 and December 28, 2003 (in thousands):

 
| ** **       | ** ** | **September 26,  2004** | ** ** | **December 28,  2003** | ** ** |
|------------------|------------|-------------------------|------------|------------------------|------------|
|             |       |                    |       |                   |       |
| Raw materials    |       | $                       | 2,354      |                   | $          | 1,557 |   |
| Goods in process |       | 68                      |       | 114                    |       |
| Finished goods   |       | 16,232                  |       | 13,998                 |       |
| Total            |       | $                       | 18,654     |                   | $          | 15,669 |   |

 

*Long-Lived Assets –*

 

In accordance with Statement ofFinancial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairmentor Disposal of Long-Lived Assets,” which was adopted in 2002, the Company reviewsits Non-Friendly Marks, which were assigned to the Company by Hershey inSeptember 2002, for impairment on a quarterly basis. The Company recognizesimpairment has occurred when the carrying value of the Non-Friendly Marksexceeds the estimated future discounted cash flows of the trademarked products.Additionally, the Company reviews long-lived assets related to each restaurantto be held and used in the business quarterly for impairment, or wheneverevents or changes in circumstances indicate that the carrying amount of arestaurant may not be recoverable. The Company evaluates restaurants using a “two-yearhistory of cash flow” as the primary indicator of potential impairment. Basedon the best information available, the Company writes down an impairedrestaurant to its estimated fair market value, which becomes its new costbasis. Estimated fair market value is based on the Company’s experience sellingsimilar properties and local market conditions, less costs to sell forproperties to be disposed of. In addition, restaurants scheduled for closingare reviewed for impairment and depreciable lives are adjusted. The impairmentevaluation is based on the estimated cash flows from continuing use through theexpected disposal date and the expected terminal value.

 

Store closure costs include costsof disposing of the assets as well as other facility-related expenses frompreviously closed stores. These store closure costs are expensed as incurred.Additionally, at the date the closure occurs, the Company records a liabilityfor the amount of any remaining operating lease obligations subsequent to theexpected closure date, net of estimated sublease income, if any.

 

6

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During the quarter ended September26, 2004, the Company committed to a plan to close and sell fourunderperforming restaurants. The Company has determined that the plan of salecriteria in SFAS No. 144 has been met. Accordingly, the carrying value of these properties is separatelypresented as Assets Held For Sale in the accompanying condensed consolidatedbalance sheets as of September 26, 2004 and December 28, 2003. The carryingvalue of these properties was not adjusted since the carrying value for eachproperty is less than the estimated fair market value less costs to sell.

 

SFAS No. 144 also requires theresults of operations of a component entity that is classified as held for saleor that has been disposed of to be reported as discontinued operations in thestatement of operations if certain conditions are met. These conditions includecommitment to a plan of disposal after the effective date of this statement,elimination of the operations and cash flows of the component entity from theongoing operations of the company and no significant continuing involvement inthe operations of the component entity after the disposal transaction. Theresults of operations, and any related gain or loss, of stores meeting all ofthese conditions that were disposed of in 2004 or classified as held for sale atSeptember 26, 2004 were not material for the quarters or nine months endedSeptember 26, 2004 and September 28, 2003.

 

Considerable management judgment isnecessary to estimate future cash flows, including cash flows from continuinguse, terminal value, closure costs and sublease income. Accordingly, actualresults could vary significantly from estimates.

 

During the nine months endedSeptember 26, 2004, the Company determined that the carrying value of a vacantrestaurant land parcel and the carrying value of one restaurant propertyexceeded their estimated fair market values less cost to sell.  The carrying values were reduced by anaggregate of $91,000. During the nine months ended September 28, 2003, theCompany determined that the carrying value of one land parcel exceeded itsestimated fair market value less cost to sell. The carrying value was reduced by $26,000.

 

*Other Assets* –

 

Other assets included notesreceivable of $4,554,000 and $4,638,000, which were net of allowances fordoubtful accounts totaling $263,000 and $313,000, as of September 26, 2004 andDecember 28, 2003, respectively. Also included in other assets as of September26, 2004 and December 28, 2003 were payments made to fronting insurancecarriers of $1,402,000 and $1,211,000, respectively, to establish loss escrowfunds.

 

7

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* *

*Other Accrued Expenses-*

 

Otheraccrued expenses consisted of the following at September 26, 2004 and December28, 2003 (in thousands):

 
| ** **                     | ** ** | **September 26,  2004** | ** ** | **December 28,  2003** | ** ** |
|--------------------------------|------------|-------------------------|------------|------------------------|------------|
|                           |       |                    |       |                   |       |
| Accrued  advertising           |       | $                       | 3,443      |                   | $          | 1,554 |   |
| Accrued rent                   |       | 3,155                   |       | 2,416                  |       |
| Accrued meals  and other taxes |       | 2,451                   |       | 2,947                  |       |
| Gift cards  outstanding        |       | 1,882                   |       | 3,975                  |       |
| Accrued  construction costs    |       | 918                     |       | 2,331                  |       |
| Unearned  revenues             |       | 881                     |       | 894                    |       |
| Accrued bonus                  |       | 807                     |       | 2,853                  |       |
| All other                      |       | 1,721                   |       | 2,085                  |       |
| Total                          |       | $                       | 15,258     |                   | $          | 19,055 |   |

* *

*Income Taxes -*

 

The Company accounts for incometaxes in accordance with SFAS No. 109, “Accounting for Income Taxes,” whichrequires recognition of deferred tax assets and liabilities for the expectedfuture tax consequences of events that have been included in the financialstatements or tax returns. A valuation allowance is recorded for deferred taxassets whose realization is not likely. The Company records income taxes basedon the effective rate expected for the year with any changes in the valuationallowance reflected in the period of change. As of September 26, 2004 andDecember 28, 2003, a valuation allowance of $10,130,000 existed related tostate NOL carryforwards due to restrictions on the usage of state NOLcarryforwards and short carryforward periods for certain states. Taxable incomeby state for future periods is difficult to estimate. The amount and timing ofany future taxable income may affect the usage of such carryforwards, whichcould result in a material change in the valuation allowance.

 

*Derivative Instruments and Hedging Agreements –*

 

The Company enters into commodityoption contracts from time to time to manage dairy cost pressures. The Company’scommodity option contracts do not meet hedge accounting criteria as defined bySFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,”and, accordingly, are marked to market each period, with the resulting gains orlosses recognized in cost of sales. There were no gains or losses recognizedduring the quarters ended September 26, 2004 and September 28, 2003. For thenine months ended September 26, 2004, gains of approximately $523,000 wereincluded in cost of sales related to these option contracts as compared tolosses of approximately $290,000 for the nine months ended September 28, 2003.

 

8

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* *

*MarketableSecurities -*

 

The Company accounts for marketablesecurities in accordance with SFAS No. 115, “Accounting for Certain Investmentsin Debt and Equity Securities.”  AtSeptember 26, 2004, the Company’s investments in marketable securities wereclassified as available-for-sale, and as a result, were reported at fair value.Unrealized gains and losses are reported as a component of accumulated othercomprehensive loss in stockholders’ deficit. The Company follows its investment managers’ methods of determining thecost basis in 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.

 

*Lease Guarantees and Contingencies –*

 

Primarily as a result of theCompany’s refranchising efforts, the Company remains liable for certain leaseassignments and guarantees. These leases have varying terms, the latest ofwhich expires in 2020. As of September 26, 2004, the potential amount ofundiscounted payments the Company could be required to make in the event ofnon-payment by the primary lessees was $8,140,000. The present value of thesepotential payments discounted at the Company’s pre-tax cost of debt atSeptember 26, 2004 was $5,904,000. 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 ofSeptember 26, 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 September 26, 2004 and December 28,2003.

 

*(Loss) Earnings Per Share –*

 

Basic (loss) earnings per share iscalculated by dividing net (loss) income by the weighted average number ofcommon shares outstanding during the period. Diluted (loss) earnings per shareis calculated by dividing net (loss) income by the weighted average number ofshares of common stock and common stock equivalents outstanding during theperiod. Common stock equivalents are dilutive stock options and warrants thatare assumed exercised for calculation purposes. The number of common stockoptions which could dilute basic earnings per share in the future, that werenot included in the computation of diluted earnings per share because to do sowould have been antidilutive, was 133,989 and 158,236 for the three monthsended September 26, 2004 and September 28, 2003, respectively. The number ofcommon stock options which could dilute basic earnings per share in the future,that were not included in the computation of diluted (loss) earnings per sharebecause to do so would have been antidilutive, was 271,404 and 195,626 for thenine months ended September 26, 2004 and September 28, 2003, respectively.

 

9

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Presentedbelow is the reconciliation between basic and diluted weighted average sharesfor the three and nine months ended September 26, 2004 and September 28, 2003(in thousands):

 
| ** **                                                              | ** ** | **For the Three Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                              | ** ** | **Basic**                      | ** ** | **Diluted** | ** ** |
| ** **                                                              | ** ** | **September 26,  2004**        | ** ** | **September 28,  2003** | ** ** | **September 26,  2004** | ** ** | **September 28,  2003** | ** ** |
|                                                                    |       |                           |       |   |   |   |   |   |   |
| Weighted average  number of common shares outstanding during the period |       | 7,695                          |       | 7,452 |   | 7,695 |   | 7,452 |   |
| Adjustments:                                                            |       |                           |       |   |   |   |   |   |   |
| Assumed exercise  of stock options                                      |       | —                         |       | — |   | 174 |   | 154 |   |
| Weighted average  number of shares outstanding                          |       | 7,695                          |       | 7,452 |   | 7,869 |   | 7,606 |   |

 
| ** **                                                              | ** ** | **For the Nine Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                              | ** ** | **Basic**                     | ** ** | **Diluted** | ** ** |
| ** **                                                              | ** ** | **September 26,  2004**       | ** ** | **September 28,  2003** | ** ** | **September 26,  2004** | ** ** | **September 28,  2003** | ** ** |
|                                                                    |       |                          |       |   |   |   |   |   |   |
| Weighted average  number of common shares outstanding during the period |       | 7,611                         |       | 7,436 |   | 7,611 |   | 7,436 |   |
| Adjustments:                                                            |       |                          |       |   |   |   |   |   |   |
| Assumed exercise  of stock options                                      |       | —                        |       | — |   | — |   | 141 |   |
| Weighted average  number of shares outstanding                          |       | 7,611                         |       | 7,436 |   | 7,611 |   | 7,577 |   |

 

*Stock-Based Compensation –*

 

The Company accounts for stock-basedcompensation for employees under Accounting Principles Board (“APB”) OpinionNo. 25, “Accounting for Stock Issued to Employees,” and elected the disclosure-onlyalternative under SFAS No. 123, “Accounting for Stock-Based Compensation.”  Stock-based compensation cost ofapproximately $222,000 related to modified option awards was included in netloss for the nine months ended September 26, 2004 for the Company’s StockOption Plan and the Company’s 2003 Incentive Plan. No stock-based compensationcost was included in net income for the nine months ended September 28, 2003for the Company’s Stock Option Plan or the Company’s 2003 Incentive Plan, asall options granted during this period had an exercise price equal to themarket value of the stock on the date of grant.

 

In December 2002, the FinancialAccounting Standards Board (“FASB”) issued SFAS No. 148, “Accounting for Stock-BasedCompensation–Transition and Disclosure,” which amends SFAS No. 123. SFAS No.148 allows for three methods of transition for those companies that adopt SFASNo. 123’s provisions for fair value recognition. SFAS No. 148’s transitionguidance and provisions for annual disclosures are effective for fiscal yearsending after December 15, 2002. In accordance with SFAS No. 148, the Companywill continue to disclose the required pro-forma information in the notes tothe consolidated financial statements.

 

10

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In accordance with SFAS No. 148,the following table presents the effect on net income (loss) and net income(loss) per share had compensation cost for the Company’s stock plans beendetermined consistent with SFAS No. 123 (in thousands, except per share data):

 
| ** **                                                                                                                          | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                                                                                                                          | ** ** | **September 26,  2004**        | ** ** | **September 28,  2003**       | ** ** | **September 26,  2004** | ** ** | **September 28,  2003** | ** ** |
|                                                                                                                                |       |                           |       |                          |       |   |   |   |   |
| Net income  (loss) as reported                                                                                                      |       | $                              | 3,603      |                          | $          | 5,315 |   | $ | (2,828 | ) | $ | 6,916 |   |
|                                                                                                                                |       |                           |       |                          |       |   |   |   |   |
| 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 |       | (103                           | )          | (97                           | )          | (315 | ) | (273 | ) |
| Pro forma net  income (loss)                                                                                                        |       | $                              | 3,500      |                          | $          | 5,218 |   | $ | (3,012 | ) | $ | 6,643 |   |
|                                                                                                                                |       |                           |       |                          |       |   |   |   |   |
| Basic net income  (loss) per share, as reported                                                                                     |       | $                              | 0.47       |                          | $          | 0.71 |   | $ | (0.37 | ) | $ | 0.93 |   |
| Basic net income  (loss) per share, pro forma                                                                                       |       | $                              | 0.45       |                          | $          | 0.64 |   | $ | (0.39 | ) | $ | 0.85 |   |
|                                                                                                                                |       |                           |       |                          |       |   |   |   |   |
| Diluted net  income (loss) per share, as reported                                                                                   |       | $                              | 0.46       |                          | $          | 0.70 |   | $ | (0.37 | ) | $ | 0.91 |   |
| Diluted net  income (loss) per share, pro forma                                                                                     |       | $                              | 0.44       |                          | $          | 0.63 |   | $ | (0.39 | ) | $ | 0.83 |   |

 

*Reclassifications –*

 

Certainprior year amounts have been reclassified to conform with current yearpresentation, including $771,000 and $2,328,000 from operating expenses togeneral and administrative expenses for the three and nine months ended September28, 2003, respectively.

 

*Recently Issued Accounting Pronouncements –*

 

OnDecember 8, 2003, the Medicare Prescription Drug, Improvement and ModernizationAct of 2003 (the “Act”), which introduces a Medicare prescription drug benefit,as well as a federal subsidy to sponsors of retiree health care benefit plansthat provide a benefit that is at least actuarially equivalent to the Medicarebenefit, was enacted. On May 19, 2004, the FASB issued Financial Staff PositionNo. 106-2, “Accounting and Disclosure Requirements Related to the MedicarePrescription Drug, Improvement and Modernization Act of 2003” (“FSP 106-2”) todiscuss certain accounting and disclosure issues raised by the Act. FSP 106-2addresses accounting for the federal subsidy for the sponsors of singleemployer defined benefit postretirement healthcare plans and disclosurerequirements for plans for which the employer has not yet been able todetermine actuarial equivalency. Except for certain nonpublic entities, FSP106-2 is effective for the first interim or annual period beginning after June15, 2004 (the quarter ending September 26, 2004 for the Company).

 

Actuarialequivalence will be determined under regulations issued by the Centers forMedicare & Medicaid Services (“CMS”). Based on proposed CMS regulations issued to date, the Company is unableto conclude whether benefits provided are at least

 

11

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actuarially equivalent to benefits available through Medicare PartD.  Therefore, the reported net periodicpostretirement benefit cost and the accumulated postretirement benefitobligation of the Company’s postretirement plan in the accompanying condensedconsolidated financial statements and notes thereto does not reflect theeffects of the Act. The Company does not believe at this time that the effectsof the Act, once determined, will materially affect the accumulatedpostretirement benefit obligation or the net periodic postretirement benefitcost reported in future periods.

 

In January 2003, the FASB issuedInterpretation No. 46, “Consolidation of Variable Interest Entities, anInterpretation of Accounting Research Bulletin (“ARB”) No. 51” (“FIN 46”). FIN46 requires certain variable interest entities to be consolidated by theprimary beneficiary of the entity if the equity investors in the entity do nothave the characteristics of a controlling financial interest or do not havesufficient equity at risk for the entity to finance its activities withoutadditional subordinated financial support from other parties. FIN 46 iseffective for all entities subject to this interpretation no later than the endof the first period that ends after March 15, 2004. The adoption of FIN 46 in2003 had no material impact on the Company’s results of operations or financialposition.

 

**2. DEBT**

 

Debt at September 26, 2004 and December 28, 2003 consistedof the following (in thousands):

 
| ** **                                                   | ** ** | **September 26,  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 October 1, 2004 through January 1, 2022 |       | 52,259                  |       | 53,087                 |       |
| Total debt                                                   |       | 227,259                 |       | 229,064                |       |
| Less: current  portion                                       |       | (1,225                  | )          | (1,127                 | )          |
| Total long-term  debt                                        |       | $                       | 226,034    |                   | $          | 227,937 |   |

 

In November 1997, FICC entered intoa credit facility that included revolving credit loans, term loans and lettersof credit (the “Old Credit Facility”). Also in November 1997, FICC completed a public offering of $200,000,000of senior notes (the “Senior Notes”).

 

In December 2001, the Companycompleted a financial restructuring plan (the “Refinancing Plan”) whichincluded the repayment of the $64,545,000 outstanding under the Old CreditFacility and the purchase of $21,273,000 in Senior Notes with 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”). Inaddition, FICC secured a new $30,000,000 revolving credit facility (the “NewCredit Facility”) of which up to $20,000,000 is available to support letters ofcredit.  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 of theSenior Notes for $2,826,000, the then current market value.

 

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In February 2004, the Companyannounced a cash tender offer and consent solicitation for the $175,977,000 ofSenior Notes to be financed with the proceeds from a private offering of newsenior notes (the “New Senior Notes”), available cash and an amended New CreditFacility (the “2004 Refinancing”).  InMarch 2004, $127,357,000 of aggregate principal amount of Senior Notes werepurchased at the tender offer and consent solicitation price of 104% of theprincipal amount and $476,000 of aggregate principal amount of Senior Noteswere purchased at the tender offer price of 102% of the principal amount. InApril 2004, the remaining $48,144,000 of Senior Notes were redeemed inaccordance with the Senior Notes indenture at 103.5% of the principal amount.  The Senior Notes would have matured onDecember 1, 2007.  Interest on the SeniorNotes was payable at 10.5% per annum semi-annually on June 1 and December 1 ofeach year.  In connection with the tenderoffer, the Company wrote off unamortized deferred financing costs of $2,445,000and paid a premium of $6,790,000 that was included in the accompanyingcondensed consolidated statement of operations for the nine months endedSeptember 26, 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’s Friendly’sRestaurants Franchise, Inc. subsidiary, but are effectively subordinated to allsecured indebtedness of FICC, including the indebtedness incurred under the NewCredit Facility. The New Senior Notes mature on June 15, 2012. Interest on theNew Senior Notes is payable at 8.375% per annum semi-annually on June 15and December 15 of each year.  TheNew Senior 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% to 100.00%,based on the redemption date.  Inaddition, at any time prior to June 15, 2007, FICC may redeem, subject tocertain conditions, up to 35% of the aggregate principal amount of the NewSenior Notes with the proceeds of one or more qualified equity offerings, asdefined, at a redemption price of 108.375% of the principal amount, plusaccrued interest.

 

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

 

The New Credit Facility is securedby substantially all of the assets of FICC and two of its six subsidiaries,Friendly’s Restaurants Franchise, Inc. and Friendly’s International Inc. Thesetwo subsidiaries also guarantee FICC’s obligations under the New CreditFacility.

 

The New Credit Facility includescertain restrictive covenants including limitations on indebtedness, restrictedpayments such as dividends and stock repurchases and sales of assets and ofsubsidiary stock. Additionally, the New Credit Facility limits the amount whichthe Company may spend on capital expenditures, restricts the use of proceeds,as defined, from asset sales and requires the Company to comply with certainfinancial covenants. On July 23, 2004, the Company successfully obtained alimited waiver regarding a quarterly EBITDA covenant of its New Credit Facilityas of the June 27, 2004 measurement date.

 

On October 19, 2004, the Companysuccessfully obtained a limited waiver regarding certain quarterly financialcovenants of its New Credit Facility, which the Company was not in full compliancewith at September 26, 2004. At this time, the Company believes that it againwill not be in compliance with these financial covenants as of January 2, 2005.Based on ongoing discussions with its lenders, its projected limited use of therevolver portion of the facility and its projected liquidity related to thefourth quarter and beyond, the Company believes a covenant waiver, amendment tothe existing facility or new credit facility will be secured. In the event thatthe Company is not

 

13

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able to remedy such covenant violations at January 2, 2005, a technicaldefault could be triggered with the Company's New Senior Notes, which wouldrequire a waiver or an amendment of that facility in order to maintain thecurrent payment schedule of those notes.

 

The New Credit Facility has anannual “clean-up” provision, commencing in 2005, which obligates the Company torepay in full all revolving credit loans on or before September 30 (or, ifSeptember 30 is not a business day, as defined, then the next business day) ofeach year and maintain a zero balance on such revolving credit for at least 30consecutive days, to include September 30, immediately following the date ofsuch repayment.

 

The $35,000,000 revolving creditcommitment less outstanding letters of credit is available for borrowing toprovide working capital and for other corporate needs. As of September 26, 2004and December 28, 2003, total letters of credit outstanding were $14,474,000 and$13,550,000, respectively. During the nine months ended September 26, 2004 andSeptember 28, 2003, there were no drawings against the letters of credit.

 

The revolving credit loans bearinterest at the Company’s option at either (a) the Base Rate plus theapplicable margin in effect from time to time (the “Base Rate”) (7.25% atSeptember 26, 2004) or (b) the Eurodollar rate plus the applicable margin ineffect from time to time (the “Eurodollar Rate”) (6.27% at September 26,2004).  As of September 26, 2004 andDecember 28, 2003, there were no revolving credit loans outstanding and$20,526,000 and $16,450,000, respectively, was available for borrowing.

 

In connection with the MortgageFinancing in December 2001, three new limited liability companies (“LLCs”) wereorganized.  Friendly Ice CreamCorporation is the sole member of each LLC. FICC sold 75 of its operatingFriendly’s restaurants to the LLCs in exchange for the proceeds from theMortgage Financing. Promissory notes were issued for each of the 75 properties.Each LLC is a separate entity with separate creditors who will be entitled tobe satisfied out of such LLC’s assets. Each LLC is a borrower under theMortgage Financing.

 

The Mortgage Financing has amaturity date of January 1, 2022 and is amortized over 20 years. Interest on$10,000,000 of the original $55,000,000 from the Mortgage Financing is variableand is the sum of the 30-day LIBOR rate in effect (1.84% at September 26, 2004)plus 6% on an annual basis. Changes in the interest rate are calculated monthlyand recognized annually when the monthly payment amount is adjusted. Changes inthe monthly payment amounts owed due to interest rate changes are reflected inthe principal balances, which are re-amortized over the remaining life of themortgages. The remaining $45,000,000 of the original $55,000,000 from theMortgage Financing bears interest at a fixed annual rate of 10.16%. Eachpromissory note may be prepaid in full. The variable rate notes are subject toprepayment penalties during the first five years. The fixed rate notes may notbe prepaid without the Company providing the note holders with a yieldmaintenance premium.

 

The Mortgage Financing requires theCompany to maintain a fixed charge coverage ratio, as defined, of at least 1.10to 1 and each LLC to maintain a fixed charge coverage ratio, as defined, on anaggregate restaurant basis of at least 1.25 to 1, in each case calculated as ofthe last day of each fiscal year. The Company is in compliance with thesecovenants.

 

**3. INTANGIBLEASSETS AND DEFERRED COSTS**

 

Intangible assets and deferred costs as of September 26,2004 and December 28, 2003 were (in thousands):

 

14

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| ** **                                                                                           | ** ** | **September 26,  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                                                                                                |       | 1,083                   |       | 876                    |       |
| Intangible  assets and deferred costs                                                                |       | 29,854                  |       | 30,012                 |       |
| Less:  accumulated amortization                                                                      |       | (8,926                  | )          | (12,122                | )          |
| Net                                                                                                  |       | $                       | 20,928     |                   | $          | 17,890 |   |

 

In connection with the 2004Refinancing, the Company wrote off unamortized deferred financing costs relatedto the tender offer for the Senior Notes in March 2004 and the redemption ofthe remaining Senior Notes in April 2004 of $1,788,000 and $657,000,respectively. The $2,445,000 was included in other expenses, principally debtretirement costs in the accompanying condensed consolidated statement ofoperations for the nine months ended September 26, 2004. Additionally, theCompany incurred $6,550,000 of costs associated with the issuance of the NewSenior Notes and the amendment to the New Credit Facility, which were includedin intangible assets and deferred costs in the accompanying condensedconsolidated balance sheet as of September 26, 2004. These costs will beamortized over the terms of the New Senior Notes and the amended New CreditFacility.

 

Amortization expense was $451,000and $426,000 for the three months ended September 26, 2004 and September 28,2003, respectively. Amortization expense was $1,349,000 and $1,282,000 for thenine months ended September 26, 2004 and September 28, 2003, respectively.

 

15

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Future amortization expense relatedto these intangible assets and deferred costs as of September 26, 2004 was (inthousands):

 

| **Year**   | ** ** | **Amount** | ** ** |
|------------|------------|------------|------------|
|       |       |       |       |
| 2004       |       | $          | 473        |   |
| 2005       |       | 1,804      |       |
| 2006       |       | 1,798      |       |
| 2007       |       | 1,628      |       |
| 2008       |       | 1,462      |       |
| Thereafter |       | 13,763     |       |
| Total      |       | $          | 20,928     |   |

 

**4. WRITE-DOWNS OF PROPERTY AND EQUIPMENT AND PROPERTY HELD FOR SALE**

 

During the quarter ended September26, 2004, the Company committed to a plan to close and sell fourunderperforming restaurants. The Company has determined that the plan of salecriteria in SFAS No. 144 has been met. Accordingly, the carrying value of these properties is separatelypresented as Assets Held For Sale in the accompanying condensed consolidatedbalance sheets as of September 26, 2004 and December 28, 2003. The carryingvalue of these properties was not adjusted since the carrying value for eachproperty is less than the estimated fair market value less costs to sell.

 

SFAS No. 144 also requires theresults of operations of a component entity that is classified as held for saleor that has been disposed of to be reported as discontinued operations in thestatement of operations if certain conditions are met. These conditions includecommitment to a plan of disposal after the effective date of this statement,elimination of the operations and cash flows of the component entity from theongoing operations of the company and no significant continuing involvement inthe operations of the component entity after the disposal transaction. TheCompany adopted SFAS No. 144 on December 31, 2001. The results of operationsand any related gain or loss associated with all closings or properties heldfor sale since the adoption of SFAS No. 144 were immaterial. In addition, withthe Company’s high market penetration in New England, the closing of theserestaurants benefited other Company-operated restaurants. Therefore, theresults of operations and any related gain or loss have been included in incomefrom operations in the Company’s financial statements for the three andnine-month periods ended September 26, 2004 and September 28, 2003.

 

16

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The table below identifies thecomponents of the “Loss on disposals of other property and equipment, net” asshown on the consolidated statements of operations (in thousands):

 
| ** **                                                       | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|------------------------------------------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                                                       | ** ** | **September 26,  2004**        | ** ** | **September 28,  2003**       | ** ** | **September 26,  2004** | ** ** | **September 28,  2003** | ** ** |
| ** **                                                       | ** ** | ** **                     | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Restaurant assets  retired due to remodeling                     |       | $                              | 22         |                          | $          | 47 |   | $ | 195 |   | $ | 945 |   |
| Restaurant  equipment assets retired due to replacement          |       | 131                            |       | 103                           |       | 290 |   | 302 |   |
| Loss on property  held for disposition                           |       | —                         |       | 148                           |       | — |   | 289 |   |
| Loss on property  not held for disposition                       |       | —                         |       | —                        |       | 63 |   | — |   |
| All other                                                        |       | —                         |       | (207                          | )          | 113 |   | (37 | ) |
| Loss on  disposals of other property property and equipment, net |       | $                              | 153        |                          | $          | 91 |   | $ | 661 |   | $ | 1,499 |   |

 

During the nine months endedSeptember 26, 2004, the Company determined that the carrying value of a vacantrestaurant land parcel and the carrying value of one restaurant property exceededtheir estimated fair values less cost to sell. The carrying values were reduced by an aggregate of $91,000. During thenine months ended September 28, 2003, the Company determined that the carryingvalue of one land parcel exceeded its estimated fair value less cost tosell.  The carrying value was reduced by$26,000.

 

**5. EMPLOYEE BENEFIT PLANS**

 

The components of net periodicpension benefit for the three and nine months ended September 26, 2004 andSeptember 28, 2003 were (in thousands):

 
| ** **                          | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|-------------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                          | ** ** | **September 26,  2004**        | ** ** | **September 28,  2003**       | ** ** | **September 26,  2004** | ** ** | **September 28,  2003** | ** ** |
| ** **                          | ** ** | ** **                     | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service cost                        |       | $                              | —     |                          | $          | 553 |   | $ | — |   | $ | 1,658 |   |
| Interest cost                       |       | 1,651                          |       | 1,606                         |       | 4,953 |   | 4,818 |   |
| Expected return  on assets          |       | (2,348                         | )          | (2,274                        | )          | (7,043 | ) | (6,823 | ) |
| Net  amortization:                  |       |                           |       |                          |       |   |   |   |   |
| Unrecognized  prior service benefit |       | —                         |       | (319                          | )          | — |   | (959 | ) |
| Unrecognized net  actuarial loss    |       | 168                            |       | 153                           |       | 503 |   | 455 |   |
|                                |       |                           |       |                          |       |   |   |   |   |
| Net periodic  pension benefit       |       | $                              | (529       | )                             | $          | (281 | ) | $ | (1,587 | ) | $ | (851 | ) |

 

 

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The Company provides health careand life insurance benefits to certain groups of employees upon retirement. Thecomponents of the net postretirement benefit cost for the three and nine monthsended September 26, 2004 and September 28, 2003 were (in thousands):

 
| ** **                                              | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|---------------------------------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                                              | ** ** | **September 26,  2004**        | ** ** | **September 28,  2003**       | ** ** | **September 26,  2004** | ** ** | **September 28,  2003** | ** ** |
| ** **                                              | ** ** | ** **                     | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service cost                                            |       | $                              | 28         |                          | $          | 25 |   | $ | 84 |   | $ | 74 |   |
| Interest cost                                           |       | 116                            |       | 117                           |       | 348 |   | 352 |   |
| Recognized  actuarial loss                              |       | 23                             |       | 16                            |       | 68 |   | 47 |   |
| Net amortization  of unrecognized prior service benefit |       | (35                            | )          | (36                           | )          | (106 | ) | (107 | ) |
|                                                    |       |                           |       |                          |       |   |   |   |   |
| Net  postretirement benefit cost                        |       | $                              | 132        |                          | $          | 122 |   | $ | 394 |   | $ | 366 |   |

 

OnDecember 8, 2003, the Medicare Prescription Drug, Improvement and ModernizationAct of 2003 (the “Act”), which introduces a Medicare prescription drug benefit,as well as a federal subsidy to sponsors of retiree health care benefit plansthat provide a benefit that is at least actuarially equivalent to the Medicarebenefit, was enacted. On May 19, 2004, the FASB issued Financial Staff PositionNo. 106-2, “Accounting and Disclosure Requirements Related to the MedicarePrescription Drug, Improvement and Modernization Act of 2003” (“FSP 106-2”) todiscuss certain accounting and disclosure issues raised by the Act. FSP 106-2addresses accounting for the federal subsidy for the sponsors of singleemployer defined benefit postretirement healthcare plans and disclosurerequirements for plans for which the employer has not yet been able todetermine actuarial equivalency. Except for certain nonpublic entities, FSP106-2 is effective for the first interim or annual period beginning after June15, 2004 (the quarter ending September 26, 2004 for the Company).

 

Actuarialequivalence will be determined under regulations issued by the Centers forMedicare & Medicaid Services (“CMS”). Based on proposed CMS regulations issued to date, the Company is unableto conclude whether benefits provided are at least actuarially equivalent tobenefits available through Medicare Part D. Therefore, the reported net periodic postretirement benefit cost and theaccumulated postretirement benefit obligation of the Company’s postretirementplan in the accompanying condensed consolidated financial statements and notesthereto does not reflect the effects of the Act. The Company does not believeat this time that the effects of the Act, once determined, will materiallyaffect the accumulated postretirement benefit obligation or the net periodicpostretirement benefit cost reported in future periods.

 

18

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** **

**6. SEGMENTREPORTING**

 

Operating segments are components of an enterprise aboutwhich separate financial information is available that is evaluated regularlyby the chief operating decision-maker, or decision-making group, in decidinghow to allocate resources and in assessing performance.  The Company’s chief operating decision-makeris the 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 consistentwith sales to unaffiliated customers. Intersegment sales and other intersegmenttransactions have been eliminated in the accompanying condensed consolidatedfinancial statements.

 

The Company’s restaurants targetfamilies with children and adults who desire a reasonably priced meal in a full-servicesetting. The Company’s menu offers a broad selection of freshly-prepared foods,which appeal to customers throughout all dayparts. The menu currently featuresover 100 items comprised of a broad selection of breakfast, lunch, dinner andafternoon and evening snack items. Foodservice operations manufactures frozendessert products and distributes such manufactured products and purchasedfinished goods to the Company’s restaurants and franchised operations.Additionally, it sells frozen dessert products to distributors and retail andinstitutional locations. The Company’s franchise segment includes a royaltybased on franchise restaurant revenue. In addition, the Company receives rentalincome from various franchised restaurants. The Company does not allocategeneral and administrative expenses associated with its headquarters operationsto any business segment. These costs include expenses of the following functions:legal, accounting, personnel not directly related to a segment, informationsystems and other headquarters activities.

 

19

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The accounting policies of theoperating segments are the same as those described in the summary ofsignificant accounting policies except that the financial results for thefoodservice operating segment, prior to intersegment eliminations, have beenprepared using a management approach, which is consistent with the basis and mannerin which the Company’s management internally reviews financial information forthe purpose of assisting in making internal operating decisions. Using thisapproach, the Company evaluates performance based on stand-alone operatingsegment income (loss) before income taxes and generally accounts forintersegment sales and transfers as if the sales or transfers were to thirdparties, that is, at current market prices.

 

EBITDA represents net income (loss)before (i) benefit from (provision for) income taxes, (ii) other expenses,principally debt retirement costs, (iii) interest expense, net,(iv) depreciation and amortization, (v) write-downs of property andequipment, (vi) net periodic pension benefit and (vii) other non-cash items.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 Nine Months Ended** | ** ** |
|-------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **              | ** ** | **September 26,  2004**        | ** ** | **September 28,  2003**       | ** ** | **September 26,  2004** | ** ** | **September 28,  2003** | ** ** |
| ** **              | ** ** | **(in thousands)**             | ** ** | **(in thousands)**            | ** ** |
| Revenues:               |       |                           |       |                          |       |   |   |   |   |
| Restaurant              |       | $                              | 120,436    |                          | $          | 127,605 |   | $ | 339,230 |   | $ | 353,775 |   |
| Foodservice             |       | 65,088                         |       | 66,352                        |       | 182,364 |   | 183,311 |   |
| Franchise               |       | 3,509                          |       | 2,571                         |       | 9,822 |   | 7,536 |   |
| Total                   |       | $                              | 189,033    |                          | $          | 196,528 |   | $ | 531,416 |   | $ | 544,622 |   |
|                    |       |                           |       |                          |       |   |   |   |   |
| Intersegment  revenues: |       |                           |       |                          |       |   |   |   |   |
| Restaurant              |       | $                              | —     |                          | $          | — |   | $ | — |   | $ | — |   |
| Foodservice             |       | (35,978                        | )          | (36,178                       | )          | (100,091 | ) | (99,934 | ) |
| Franchise               |       | —                         |       | —                        |       | — |   | — |   |
| Total                   |       | $                              | (35,978    | )                             | $          | (36,178 | ) | $ | (100,091 | ) | $ | (99,934 | ) |
|                    |       |                           |       |                          |       |   |   |   |   |
| External  revenues:     |       |                           |       |                          |       |   |   |   |   |
| Restaurant              |       | $                              | 120,436    |                          | $          | 127,605 |   | $ | 339,230 |   | $ | 353,775 |   |
| Foodservice             |       | 29,110                         |       | 30,174                        |       | 82,273 |   | 83,377 |   |
| Franchise               |       | 3,509                          |       | 2,571                         |       | 9,822 |   | 7,536 |   |
| Total                   |       | $                              | 153,055    |                          | $          | 160,350 |   | $ | 431,325 |   | $ | 444,688 |   |

 

20

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| ** **                                                       | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|------------------------------------------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                                                       | ** ** | **September 26,  2004**        | ** ** | **September 28,  2003**       | ** ** | **September 26,  2004** | ** ** | **September 28,  2003** | ** ** |
| ** **                                                       | ** ** | **(in thousands)**             | ** ** | **(in thousands)**            | ** ** |
|                                                             |       |                           |       |                          |       |   |   |   |   |
| EBITDA:                                                          |       |                           |       |                          |       |   |   |   |   |
| Restaurant                                                       |       | $                              | 11,932     |                          | $          | 17,308 |   | $ | 32,688 |   | $ | 41,791 |   |
| Foodservice                                                      |       | 3,323                          |       | 5,573                         |       | 9,726 |   | 14,020 |   |
| Franchise                                                        |       | 2,506                          |       | 1,769                         |       | 6,909 |   | 5,332 |   |
| Corporate                                                        |       | (4,084                         | )          | (5,539                        | )          | (14,211 | ) | (15,019 | ) |
| Gain (loss) on  property and equipment, net                      |       | 5                              |       | (264                          | )          | 300 |   | (1,487 | ) |
| Restructuring  expenses                                          |       | —                         |       | —                        |       | (2,627 | ) | — |   |
| Gain on  litigation settlement                                   |       | —                         |       | —                        |       | 3,644 |   | — |   |
| Less pension  benefit included in reporting segments             |       | (529                           | )          | (281                          | )          | (1,587 | ) | (851 | ) |
| Total                                                            |       | $                              | 13,153     |                          | $          | 18,566 |   | $ | 34,842 |   | $ | 43,786 |   |
|                                                             |       |                           |       |                          |       |   |   |   |   |
| Interest  expense, net-Corporate                                 |       | $                              | 5,235      |                          | $          | 6,048 |   | $ | 16,667 |   | $ | 18,242 |   |
|                                                             |       |                           |       |                          |       |   |   |   |   |
| Other expenses,  principally debt retirement costs               |       | $                              | —     |                          | $          | — |   | $ | 9,235 |   | $ | — |   |
|                                                             |       |                           |       |                          |       |   |   |   |   |
| Depreciation and  amortization:                                  |       |                           |       |                          |       |   |   |   |   |
| Restaurant                                                       |       | $                              | 3,723      |                          | $          | 3,648 |   | $ | 11,417 |   | $ | 11,412 |   |
| Foodservice                                                      |       | 818                            |       | 770                           |       | 2,514 |   | 2,253 |   |
| Franchise                                                        |       | 67                             |       | 39                            |       | 183 |   | 116 |   |
| Corporate                                                        |       | 799                            |       | 934                           |       | 2,469 |   | 2,983 |   |
| Total                                                            |       | $                              | 5,407      |                          | $          | 5,391 |   | $ | 16,583 |   | $ | 16,764 |   |
|                                                             |       |                           |       |                          |       |   |   |   |   |
| Other non-cash  (income) expense:                                |       |                           |       |                          |       |   |   |   |   |
| Net periodic  pension benefit                                    |       | $                              | (529       | )                             | $          | (281 | ) | $ | (1,587 | ) | $ | (851 | ) |
| Write-downs of  property and equipment                           |       | —                         |       | 26                            |       | 91 |   | 26 |   |
| Total                                                            |       | $                              | (529       | )                             | $          | (255 | ) | $ | (1,496 | ) | $ | (825 | ) |
|                                                             |       |                           |       |                          |       |   |   |   |   |
| Income (loss)  before benefit from (provision for) income taxes: |       |                           |       |                          |       |   |   |   |   |
| Restaurant                                                       |       | $                              | 8,209      |                          | $          | 13,660 |   | $ | 21,271 |   | $ | 30,379 |   |
| Foodservice                                                      |       | 2,505                          |       | 4,803                         |       | 7,212 |   | 11,767 |   |
| Franchise                                                        |       | 2,439                          |       | 1,730                         |       | 6,726 |   | 5,216 |   |
| Corporate                                                        |       | (10,118                        | )          | (12,521                       | )          | (42,582 | ) | (36,244 | ) |
| Gain (loss) on  property and equipment, net                      |       | 5                              |       | (290                          | )          | 209 |   | (1,513 | ) |
| Restructuring  expenses                                          |       | —                         |       | —                        |       | (2,627 | ) | — |   |
| Gain on  litigation settlement                                   |       | —                         |       | —                        |       | 3,644 |   | — |   |
| Total                                                            |       | $                              | 3,040      |                          | $          | 7,382 |   | $ | (6,147 | ) | $ | 9,605 |   |

 

21

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** **
| ** **                                                             | ** ** | **For the Nine   Months Ended   September 26,  2004** | ** ** | **For the Year   Ended   December 28,  2003** | ** ** |
|------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                             | ** ** | **(in thousands)**                                    | ** ** |
| ** **                                                             | ** ** | ** **                                            | ** ** |
| Capital  expenditures, including assets acquired under capital leases: |       |                                                  |       |                                          |       |
| Restaurant                                                             |       | $                                                     | 16,718     |                                          | $          | 25,024 |   |
| Foodservice                                                            |       | 1,188                                                 |       | 4,862                                         |       |
| Corporate                                                              |       | 898                                                   |       | 1,830                                         |       |
| Total                                                                  |       | $                                                     | 18,804     |                                          | $          | 31,716 |   |

 
| ** **    | ** ** | **September 26,  2004** | ** ** | **December 28,  2003** | ** ** |
|---------------|------------|-------------------------|------------|------------------------|------------|
| ** **    | ** ** | **(in thousands)**      | ** ** |
| Total assets: |       |                    |       |                   |       |
| Restaurant    |       | $                       | 153,924    |                   | $          | 152,228 |   |
| Foodservice   |       | 42,548                  |       | 39,404                 |       |
| Franchise     |       | 8,090                   |       | 8,644                  |       |
| Corporate     |       | 51,647                  |       | 52,176                 |       |
| Total         |       | $                       | 256,209    |                   | $          | 252,452 |   |

 

22

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**7. RESTRUCTURINGRESERVES**

 

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

 

On October 10, 2001, the Companyeliminated approximately 70 positions at corporate headquarters. In addition,approximately 30 positions in the restaurant construction and fabrication areaswere eliminated by December 30, 2001. The purpose of the reduction was tostreamline functions and reduce redundancy among its business segments. As aresult of the elimination of the positions and the outsourcing of certainfunctions, the Company reported a pre-tax restructuring charge of $2,536,000for severance, rent and unusable construction supplies in the year endedDecember 30, 2001.

 

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

 

23

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

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

 
| ** **                       | ** ** | **For the Nine Months Ended September 28, 2003**     | ** ** |
|----------------------------------|------------|------------------------------------------------------|------------|
| ** **                       | ** ** | **Restructuring  Reserves as of  December 29, 2002** | ** ** | **Expense** | ** ** | **Costs Paid** | ** ** | **Restructuring  Reserves as of  September 28, 2003** | ** ** |
|                             |       |                                                 |       |   |   |   |   |   |   |
| Rent                             |       | $                                                    | 679        |   | $ | — |   | $ | (216 | ) | $ | 463 |   |
| Utilities and  real estate taxes |       | 121                                                  |       | — |   | (85 | ) | 36 |   |
| Equipment                        |       | 77                                                   |       | — |   | (77 | ) | — |   |
| Other                            |       | 60                                                   |       | — |   | (29 | ) | 31 |   |
| Total                            |       | $                                                    | 937        |   | $ | — |   | $ | (407 | ) | $ | 530 |   |

 

Basedon information currently available, management believes that the restructuringreserves as of September 26, 2004 were adequate and not excessive.

 

**8. GAIN ONLITIGATION SETTLEMENT**

 

In January 2004, the Companyreached a settlement in a lawsuit filed against a former administrator of oneof the Company’s benefit plans.  Thesettlement was based on the administrator’s alleged failure to adhere to theterms of a contract and resulted in a one-time payment to the Company of$3,775,000, which was received on April 2, 2004. As a result of this lawsuit,the Company incurred professional fees of approximately $500,000 which wereincluded in the consolidated statement of operations for the year endedDecember 28, 2003 and an additional $131,000 in professional fees that wereoffset against the payment in the accompanying condensed consolidated statementof operations for the nine months ended September 26, 2004.

 

24

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**9. FRANCHISE TRANSACTIONS**

 

On September 13, 2004, the Companysold leasehold improvements and equipment and assigned the lease for onerefranchised location and sold equipment at three other refranchised locationsto the existing franchisee.  In addition,as part of the Company’s agreement with the franchisee, the franchiseecommitted to open five new restaurants in the Dayton, OH market over the nextsix years with an option to open an additional five restaurants in thefollowing five years.  Gross proceedsfrom the sale were approximately $800,000, of which $130,000 was for franchisefees and $670,000 was for the sale of assets and lease assignment.  In September 2004, the Company recorded$130,000 of franchise fee revenue and recognized a gain of approximately$206,000 related to the sale of assets.

 

On March 5, 2004, the Company soldthe real property and equipment for one refranchised location and assigned thelease and sold the equipment for a second refranchised location to the existingfranchisee. Gross proceeds from the sale were approximately $485,000, of which$70,000 was for franchise fees and $415,000 was for the sale of assets andlease assignment. In March 2004, the Company recorded $70,000 as franchise feerevenue and recognized a gain of approximately $248,000 related to the sale ofassets.

 

On January 15, 2004, the Company entered into anagreement granting Central Florida Restaurants LLC (“Central Florida”) certainlimited exclusive rights to operate and develop Friendly’s full-servicerestaurants in designated areas within the Orlando, Florida market (the “CentralFlorida Agreement”).  Pursuant to the CentralFlorida Agreement, Central Florida purchased certain equipment assets, leaseand sublease rights and franchise rights in 10 existing Friendly’s restaurantsand committed to open an additional 10 restaurants over the next six years withan option for 15 more restaurants in the following five years. Gross proceedsfrom the sale were approximately $3,150,000 of which $310,000 was for franchisefees for the initial 10 restaurants. In January 2004, the Company recorded$310,000 as franchise fee revenue and recognized a gain of approximately$658,000 related to the sale of the assets for the 10 locations.

 

DuringJuly 2003, the Company entered into a development agreement granting Jax FamilyRest., Inc. (“Jax”) certain limited exclusive rights to operate and developFriendly’s full-service restaurants in designated areas within Baker, Clay,Nassau, Putnam and St. John’s counties, Florida (the “Jax Agreement”). Pursuantto the Jax Agreement, Jax agreed to open 10 new restaurants over the next sevenyears. 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 nine months ended September 26,2004, Jax opened one new restaurant.

 

25

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In December 2000, the Company andits first franchisee, Friendco Restaurants Inc. (“Friendco”), a subsidiary ofDavco Restaurants, Inc. (“Davco”), agreed to terminate Friendco’s rights as theexclusive developer of new Friendly’s restaurants in Maryland, Delaware, theDistrict of Columbia and northern Virginia. Friendco also obtained the right toclose existing franchised locations subject, however, to liquidated damages on22 of its 48 franchise agreements. During the year ended December 30, 2001,Friendco transferred its rights to three franchised locations to a third partyand closed two restaurants.  During theyear ended December 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 restaurants andtransferred its rights to three additional franchised locations to two thirdparties. During June 2003, the Company entered into a Settlement Agreement andMutual General Release with Davco releasing Davco from all obligations andguarantees related to leases associated with the franchised locations andproviding for a payment of $250,000 to the Company, which was recorded asrevenue in the year ended December 28, 2003. During the nine months endedSeptember 26, 2004, Friendco closed two restaurants and transferred its rightsto two franchised locations to two third parties and at September 26, 2004,retained one franchised restaurant.

 

**10. DEFERREDCOMPENSATION PLAN**

 

During 2004, the Company establisheda nonqualified deferred compensation plan (“Deferred Comp Plan”) that wasdeveloped as a retirement plan for a select group of management employees thatare not allowed to participate in the Company’s Employee Savings and InvestmentPlan.  There are various types ofcompensation that can be deferred into the Deferred Comp Plan, e.g., regularsalary, annual bonus or long-term bonus. There is also a Company contribution that is associated with theDeferred Comp Plan for participants that choose to defer a percentage of theirsalary.

 

The Company accounts for theDeferred Comp Plan in accordance with Emerging Issues Task Force No. 97-14, “Accountingfor Deferred Compensation Arrangements Where Amounts Are Held in a Rabbi Trustand Invested.” The investments of the rabbi trust are included in other assetsin the accompanying condensed consolidated balance sheet as of September 26,2004. A corresponding liability is included in other long-term liabilities.

 

The Deferred Comp Plan assetsconsisted of investments in marketable securities classified asavailable-for-sale and reported at fair value with the unrealized gains andlosses reported as a component of accumulated other comprehensive loss instockholders’ deficit.  The Companyfollowed its investment managers’ methods of determining the cost basis incomputing realized gains and losses on the sale of its available-for-salesecurities, which was the average cost method. Realized gains and losses were included in other expenses, principallydebt retirement costs in the accompanying condensed consolidated statements ofoperations for the three and nine months ended September 26, 2004. Compensationexpense, which offset the changes in the corresponding liability, was includedin general and administrative expenses for the three and nine months endedSeptember 26, 2004. Net unrealized losses of $17,000 were recorded as ofSeptember 26, 2004 and net realized losses of $1,000 were recorded during thenine months ended September 26, 2004.

 

26

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** **

**11. SUPPLEMENTALCONDENSED CONSOLIDATING FINANCIAL INFORMATION**

 

FICC’s obligations related to theNew Senior Notes are guaranteed fully and unconditionally by one of FICC’swholly owned subsidiaries. There are no restrictions on FICC’s ability toobtain dividends or other distributions of funds from this subsidiary, exceptthose imposed by applicable law. The following supplemental financial informationsets forth, on a condensed consolidating basis, balance sheets, statements ofoperations and statements of cash flows for FICC (the “Parent Company”),Friendly’s Restaurants Franchise, Inc. (the “Guarantor Subsidiary”) andFriendly’s International, Inc., Restaurant Insurance Corporation, Friendly’sRealty I, LLC, Friendly’s Realty II, LLC and Friendly’s Realty III, LLC(collectively, the “Non-guarantor Subsidiaries”). All of the LLCs’ assetswere owned by the LLCs, which are separate entities with separate creditorswhich will be entitled to be satisfied out of the LLCs’ assets. Separatecomplete financial statements and other disclosures of the Guarantor Subsidiaryas of September 26, 2004 and December 28, 2003 and for the three months andnine months ended September 26, 2004 and September 28, 2003 were not presentedbecause management has determined that such information is not material toinvestors.

 

Investments in subsidiaries areaccounted for by the Parent Company on the equity method for purposes of thesupplemental consolidating presentation. Earnings of the subsidiaries are,therefore, reflected in the Parent Company’s investment accounts and earnings.The principal elimination entries eliminate the Parent Company’s investments insubsidiaries and intercompany balances and transactions.

 

27

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**Supplemental Condensed Consolidating Balance Sheet**

**As of September 26, 2004**

(Inthousands)

 
| ** **                                                 | ** ** | **Parent  Company** | ** ** | **Guarantor  Subsidiary** | ** ** | **Non-  guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------------|------------|---------------------|------------|---------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
|                                                       |       |                |       |                      |       |                              |       |             |       |             |       |
| Assets                                                     |       |                |       |                      |       |                              |       |             |       |             |       |
|                                                       |       |                |       |                      |       |                              |       |             |       |             |       |
| Current assets:                                            |       |                |       |                      |       |                              |       |             |       |             |       |
| Cash and cash  equivalents                                 |       | $                   | 13,756     |                      | $          | 1,383                             |       | $                | 2,095      |             | $          | — |   | $ | 17,234 |   |
| Restricted cash                                            |       | —              |       | —                    |       | 1,936                             |       | —           |       | 1,936            |       |
| Accounts receivable,  net                                  |       | 8,530               |       | 1,771                     |       | —                            |       | —           |       | 10,301           |       |
| Inventories                                                |       | 18,654              |       | —                    |       | —                            |       | —           |       | 18,654           |       |
| Assets held for  sale                                      |       | 835                 |       | —                    |       | 628                               |       | —           |       | 1,463            |       |
| Deferred income  taxes                                     |       | 6,559               |       | 18                        |       | —                            |       | 70               |       | 6,647            |       |
| Prepaid expenses  and other current assets                 |       | 10,543              |       | 1,992                     |       | 7,778                             |       | (15,754          | )          | 4,559            |       |
| Total current  assets                                      |       | 58,877              |       | 5,164                     |       | 12,437                            |       | (15,684          | )          | 60,794           |       |
| Deferred income  taxes                                     |       | 1,895               |       | 205                       |       | —                            |       | (70              | )          | 2,030            |       |
| Property and  equipment, net                               |       | 120,353             |       | —                    |       | 45,183                            |       | —           |       | 165,536          |       |
| Intangibles and  deferred costs, net                       |       | 18,596              |       | —                    |       | 2,332                             |       | —           |       | 20,928           |       |
| Investments in  subsidiaries                               |       | 7,351               |       | —                    |       | —                            |       | (7,351           | )          | —           |       |
| Other assets                                               |       | 6,006               |       | 11,456                    |       | 915                               |       | (11,456          | )          | 6,921            |       |
|                                                       |       |                |       |                      |       |                              |       |             |       |             |       |
| Total assets                                               |       | $                   | 213,078    |                      | $          | 16,825                            |       | $                | 60,867     |             | $          | (34,561 | ) | $ | 256,209 |   |
|                                                       |       |                |       |                      |       |                              |       |             |       |             |       |
| Liabilities and Stockholders’ (Deficit) Equity        |       |                |       |                      |       |                              |       |             |       |             |       |
|                                                       |       |                |       |                      |       |                              |       |             |       |             |       |
| Current  liabilities:                                      |       |                |       |                      |       |                              |       |             |       |             |       |
| Current  maturities of long-term obligations               |       | $                   | 9,265      |                      | $          | —                            |       | $                | 1,225      |             | $          | (7,776 | ) | $ | 2,714 |   |
| Accounts payable                                           |       | 27,435              |       | —                    |       | —                            |       | —           |       | 27,435           |       |
| Accrued expenses                                           |       | 40,069              |       | 4,133                     |       | 6,125                             |       | (7,862           | )          | 42,465           |       |
| Total current  liabilities                                 |       | 76,769              |       | 4,133                     |       | 7,350                             |       | (15,638          | )          | 72,614           |       |
| Long-term  obligations, less current maturities            |       | 182,596             |       | —                    |       | 51,034                            |       | —           |       | 233,630          |       |
| Other long-term  liabilities                               |       | 53,228              |       | 921                       |       | 6,903                             |       | (11,572          | )          | 49,480           |       |
| Stockholders’  (deficit) equity                       |       | (99,515             | )          | 11,771                    |       | (4,420                            | )          | (7,351           | )          | (99,515          | )          |
|                                                       |       |                |       |                      |       |                              |       |             |       |             |       |
| Total  liabilities and stockholders’ (deficit) equity |       | $                   | 213,078    |                      | $          | 16,825                            |       | $                | 60,867     |             | $          | (34,561 | ) | $ | 256,209 |   |

 

28

----

 

**Supplemental Condensed Consolidating Statement of Operations**

**For the Three Months Ended September 26, 2004**

(Inthousands)

 
| ** **                                                                                                      | ** ** | **Parent  Company** | ** ** | **Guarantor  Subsidiary** | ** ** | **Non-  guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|---------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
|                                                                                                            |       |                |       |                      |       |                              |       |             |       |             |       |
| Revenues                                                                                                        |       | $                   | 150,164    |                      | $          | 2,891                             |       | $                | —     |             | $          | — |   | $ | 153,055 |   |
|                                                                                                            |       |                |       |                      |       |                              |       |             |       |             |       |
| Costs and  expenses:                                                                                            |       |                |       |                      |       |                              |       |             |       |             |       |
| Cost of sales                                                                                                   |       | 57,368              |       | —                    |       | —                            |       | —           |       | 57,368           |       |
| Labor and  benefits                                                                                             |       | 42,990              |       | —                    |       | —                            |       | —           |       | 42,990           |       |
| Operating  expenses and write-downs of property and equipment                                                   |       | 31,736              |       | —                    |       | (1,739                            | )          | —           |       | 29,997           |       |
| General and  administrative expenses                                                                            |       | 7,899               |       | 1,155                     |       | —                            |       | —           |       | 9,054            |       |
| Depreciation and  amortization                                                                                  |       | 4,849               |       | —                    |       | 558                               |       | —           |       | 5,407            |       |
| Gain on  franchise sales of restaurant operations and properties                                                |       | (189                | )          | —                    |       | —                            |       | —           |       | (189             | )          |
| Loss on  disposals of other property and equipment, net                                                         |       | 140                 |       | —                    |       | 13                                |       | —           |       | 153              |       |
| Interest  expense, net                                                                                          |       | 4,103               |       | —                    |       | 1,132                             |       | —           |       | 5,235            |       |
|                                                                                                            |       |                |       |                      |       |                              |       |             |       |             |       |
| Income before  benefit from (provision for) income taxes and equity in net income of consolidated  subsidiaries |       | 1,268               |       | 1,736                     |       | 36                                |       | —           |       | 3,040            |       |
|                                                                                                            |       |                |       |                      |       |                              |       |             |       |             |       |
| Benefit from  (provision for) income taxes                                                                      |       | 1,325               |       | (712                      | )          | (50                               | )          | —           |       | 563              |       |
|                                                                                                            |       |                |       |                      |       |                              |       |             |       |             |       |
| Income (loss)  before equity in net income of consolidated subsidiaries                                         |       | 2,593               |       | 1,024                     |       | (14                               | )          | —           |       | 3,603            |       |
|                                                                                                            |       |                |       |                      |       |                              |       |             |       |             |       |
| Equity in net  income of consolidated subsidiaries                                                              |       | 1,010               |       | —                    |       | —                            |       | (1,010           | )          | —           |       |
|                                                                                                            |       |                |       |                      |       |                              |       |             |       |             |       |
| Net income  (loss)                                                                                              |       | $                   | 3,603      |                      | $          | 1,024                             |       | $                | (14        | )                | $          | (1,010 | ) | $ | 3,603 |   |

 

29

----

 

**Supplemental Condensed Consolidating Statement of Operations**

**For the Nine months Ended September 26, 2004**

(Inthousands)

 
| ** **                                                                                                             | ** ** | **Parent  Company** | ** ** | **Guarantor  Subsidiary** | ** ** | **Non-  guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|---------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
|                                                                                                                   |       |                |       |                      |       |                              |       |             |       |             |       |
| Revenues                                                                                                               |       | $                   | 423,217    |                      | $          | 8,108                             |       | $                | —     |             | $          | — |   | $ | 431,325 |   |
|                                                                                                                   |       |                |       |                      |       |                              |       |             |       |             |       |
| Costs and  expenses:                                                                                                   |       |                |       |                      |       |                              |       |             |       |             |       |
| Cost of sales                                                                                                          |       | 158,915             |       | —                    |       | —                            |       | —           |       | 158,915          |       |
| Labor and  benefits                                                                                                    |       | 125,079             |       | —                    |       | —                            |       | —           |       | 125,079          |       |
| Operating expenses  and write-downs of property and equipment                                                          |       | 88,157              |       | —                    |       | (5,211                            | )          | —           |       | 82,946           |       |
| General and  administrative expenses                                                                                   |       | 26,040              |       | 3,465                     |       | —                            |       | —           |       | 29,505           |       |
| Restructuring  expenses                                                                                                |       | 2,627               |       | —                    |       | —                            |       | —           |       | 2,627            |       |
| Gain on  litigation settlement                                                                                         |       | (3,644              | )          | —                    |       | —                            |       | —           |       | (3,644           | )          |
| Depreciation and  amortization                                                                                         |       | 14,898              |       | —                    |       | 1,685                             |       | —           |       | 16,583           |       |
| Gain on  franchise sales of restaurant operations and properties                                                       |       | (1,102              | )          | —                    |       | —                            |       | —           |       | (1,102           | )          |
| Loss on  disposals of other property and equipment, net                                                                |       | 645                 |       | —                    |       | 16                                |       | —           |       | 661              |       |
| Interest  expense, net                                                                                                 |       | 13,280              |       | —                    |       | 3,387                             |       | —           |       | 16,667           |       |
| Other expenses,  principally debt retirement costs                                                                     |       | 9,235               |       | —                    |       | —                            |       | —           |       | 9,235            |       |
|                                                                                                                   |       |                |       |                      |       |                              |       |             |       |             |       |
| (Loss) income  before benefit from (provision for) income taxes and equity in net income of consolidated  subsidiaries |       | (10,913             | )          | 4,643                     |       | 123                               |       | —           |       | (6,147           | )          |
|                                                                                                                   |       |                |       |                      |       |                              |       |             |       |             |       |
| Benefit from  (provision for) income taxes                                                                             |       | 5,370               |       | (1,904                    | )          | (147                              | )          | —           |       | 3,319            |       |
|                                                                                                                   |       |                |       |                      |       |                              |       |             |       |             |       |
| (Loss) income  before equity in net income of consolidated subsidiaries                                                |       | (5,543              | )          | 2,739                     |       | (24                               | )          | —           |       | (2,828           | )          |
|                                                                                                                   |       |                |       |                      |       |                              |       |             |       |             |       |
| Equity in net  income of consolidated subsidiaries                                                                     |       | 2,715               |       | —                    |       | —                            |       | (2,715           | )          | —           |       |
|                                                                                                                   |       |                |       |                      |       |                              |       |             |       |             |       |
| Net (loss)  income                                                                                                     |       | $                   | (2,828     | )                         | $          | 2,739                             |       | $                | (24        | )                | $          | (2,715 | ) | $ | (2,828 | ) |

 

30

----

 

**Supplemental Condensed Consolidating Statement of Cash Flows**

**For the Nine months Ended September 26, 2004**

(Inthousands)

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

 

31

----

 

**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           |       |
| Assets held for  sale                                      |       | 819                 |       | —                    |       | 629                               |       | —           |       | 1,448            |       |
| 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                                      |       | 60,998              |       | 4,881                     |       | 11,896                            |       | (14,786          | )          | 62,989           |       |
| Deferred income  taxes                                     |       | —              |       | 205                       |       | —                            |       | (205             | )          | —           |       |
| Property and  equipment, net                               |       | 118,940             |       | —                    |       | 46,721                            |       | —           |       | 165,661          |       |
| 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 |   |

 

32

----

 

**Suspplemental Condensed Consolidating Statement of Operations**

**For the Three Months Ended September 28, 2003**

(Inthousands)

 
| ** **                                                                                       | ** ** | **Parent  Company** | ** ** | **Guarantor  Subsidiary** | ** ** | **Non-  guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|---------------------|------------|---------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
|                                                                                             |       |                |       |                      |       |                              |       |             |       |             |       |
| Revenues                                                                                         |       | $                   | 158,083    |                      | $          | 2,267                             |       | $                | —     |             | $          | — |   | $ | 160,350 |   |
|                                                                                             |       |                |       |                      |       |                              |       |             |       |             |       |
| Costs and  expenses:                                                                             |       |                |       |                      |       |                              |       |             |       |             |       |
| Cost of sales                                                                                    |       | 56,561              |       | —                    |       | —                            |       | —           |       | 56,561           |       |
| Labor and  benefits                                                                              |       | 45,402              |       | —                    |       | —                            |       | —           |       | 45,402           |       |
| Operating  expenses and write-downs of property and equipment                                    |       | 30,505              |       | —                    |       | (1,740                            | )          | —           |       | 28,765           |       |
| General and  administrative expenses                                                             |       | 9,552               |       | 1,158                     |       | —                            |       | —           |       | 10,710           |       |
| Depreciation and  amortization                                                                   |       | 4,821               |       | —                    |       | 570                               |       | —           |       | 5,391            |       |
| Loss on  disposals of other property and equipment, net                                          |       | 88                  |       | —                    |       | 3                                 |       | —           |       | 91               |       |
| Interest  expense, net                                                                           |       | 4,883               |       | —                    |       | 1,165                             |       | —           |       | 6,048            |       |
|                                                                                             |       |                |       |                      |       |                              |       |             |       |             |       |
| Income before  provision for income taxes and equity in net income of consolidated  subsidiaries |       | 6,271               |       | 1,109                     |       | 2                                 |       | —           |       | 7,382            |       |
|                                                                                             |       |                |       |                      |       |                              |       |             |       |             |       |
| Provision for  income taxes                                                                      |       | (1,561              | )          | (455                      | )          | (51                               | )          | —           |       | (2,067           | )          |
|                                                                                             |       |                |       |                      |       |                              |       |             |       |             |       |
| Income (loss)  before equity in net income of consolidated subsidiaries                          |       | 4,710               |       | 654                       |       | (49                               | )          | —           |       | 5,315            |       |
|                                                                                             |       |                |       |                      |       |                              |       |             |       |             |       |
| Equity in net  income of consolidated subsidiaries                                               |       | 605                 |       | —                    |       | —                            |       | (605             | )          | —           |       |
|                                                                                             |       |                |       |                      |       |                              |       |             |       |             |       |
| Net income  (loss)                                                                               |       | $                   | 5,315      |                      | $          | 654                               |       | $                | (49        | )                | $          | (605 | ) | $ | 5,315 |   |

 

33

----

 

**Supplemental Condensed Consolidating Statement of Operations**

**For the Nine months Ended September 28, 2003**

(Inthousands)

 
| ** **                                                                                              | ** ** | **Parent  Company** | ** ** | **Guarantor  Subsidiary** | ** ** | **Non-  guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|---------------------|------------|---------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
|                                                                                                    |       |                |       |                      |       |                              |       |             |       |             |       |
| Revenues                                                                                                |       | $                   | 438,247    |                      | $          | 6,441                             |       | $                | —     |             | $          | — |   | $ | 444,688 |   |
|                                                                                                    |       |                |       |                      |       |                              |       |             |       |             |       |
| Costs and  expenses:                                                                                    |       |                |       |                      |       |                              |       |             |       |             |       |
| Cost of sales                                                                                           |       | 157,717             |       | —                    |       | —                            |       | —           |       | 157,717          |       |
| Labor and  benefits                                                                                     |       | 127,326             |       | —                    |       | —                            |       | —           |       | 127,326          |       |
| Operating  expenses and write-downs of property and equipment                                           |       | 88,009              |       | —                    |       | (5,199                            | )          | —           |       | 82,810           |       |
| General and  administrative expenses                                                                    |       | 27,249              |       | 3,476                     |       | —                            |       | —           |       | 30,725           |       |
| Depreciation and  amortization                                                                          |       | 15,046              |       | —                    |       | 1,718                             |       | —           |       | 16,764           |       |
| Loss on  disposals of other property and equipment, net                                                 |       | 1,379               |       | —                    |       | 120                               |       | —           |       | 1,499            |       |
| Interest  expense, net                                                                                  |       | 14,772              |       | —                    |       | 3,470                             |       | —           |       | 18,242           |       |
|                                                                                                    |       |                |       |                      |       |                              |       |             |       |             |       |
| Income (loss)  before provision for income taxes and equity in net income of consolidated  subsidiaries |       | 6,749               |       | 2,965                     |       | (109                              | )          | —           |       | 9,605            |       |
|                                                                                                    |       |                |       |                      |       |                              |       |             |       |             |       |
| Provision for  income taxes                                                                             |       | (1,329              | )          | (1,216                    | )          | (144                              | )          | —           |       | (2,689           | )          |
|                                                                                                    |       |                |       |                      |       |                              |       |             |       |             |       |
| Income (loss)  before equity in net income of consolidated subsidiaries                                 |       | 5,420               |       | 1,749                     |       | (253                              | )          | —           |       | 6,916            |       |
|                                                                                                    |       |                |       |                      |       |                              |       |             |       |             |       |
| Equity in net  income of consolidated subsidiaries                                                      |       | 1,496               |       | —                    |       | —                            |       | (1,496           | )          | —           |       |
|                                                                                                    |       |                |       |                      |       |                              |       |             |       |             |       |
| Net income  (loss)                                                                                      |       | $                   | 6,916      |                      | $          | 1,749                             |       | $                | (253       | )                | $          | (1,496 | ) | $ | 6,916 |   |

 

34

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**Supplemental Condensed Consolidating Statement of Cash Flows**

**For the Nine months Ended September 28, 2003**

(Inthousands)

 
| ** **                                            | ** ** | **Parent  Company** | ** ** | **Guarantor  Subsidiary** | ** ** | **Non-  guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-------------------------------------------------------|------------|---------------------|------------|---------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
|                                                  |       |                |       |                      |       |                              |       |             |       |             |       |
| Net cash  provided by (used in) operating activities  |       | $                   | 21,572     |                      | $          | 1,004                             |       | $                | (592       | )                | $          | 928 |   | $ | 22,912 |   |
|                                                  |       |                |       |                      |       |                              |       |             |       |             |       |
| Cash flows from  investing activities:                |       |                |       |                      |       |                              |       |             |       |             |       |
| Purchases of property  and equipment                  |       | (21,291             | )          | —                    |       | —                            |       | —           |       | (21,291          | )          |
| Proceeds from  sales of property and equipment        |       | 63                  |       | —                    |       | —                            |       | —           |       | 63               |       |
| Return of  investment in subsidiary                   |       | 535                 |       | —                    |       | —                            |       | (535             | )          | —           |       |
| Net cash used in  investing activities                |       | (20,693             | )          | —                    |       | —                            |       | (535             | )          | (21,228          | )          |
|                                                  |       |                |       |                      |       |                              |       |             |       |             |       |
| Cash flows from  financing activities:                |       |                |       |                      |       |                              |       |             |       |             |       |
| Repayments of  obligations                            |       | (3,942              | )          | —                    |       | (760                              | )          | —           |       | (4,702           | )          |
| Stock options  exercised                              |       | 228                 |       | —                    |       | —                            |       | —           |       | 228              |       |
| Reinsurance  deposits received                        |       | —              |       | —                    |       | 2,207                             |       | (2,207           | )          | —           |       |
| Reinsurance  payments made from deposits              |       | —              |       | —                    |       | (1,279                            | )          | 1,279            |       | —           |       |
| Dividends paid                                        |       | —              |       | —                    |       | (535                              | )          | 535              |       | —           |       |
| Net cash used in  financing activities                |       | (3,714              | )          | —                    |       | (367                              | )          | (393             | )          | (4,474           | )          |
|                                                  |       |                |       |                      |       |                              |       |             |       |             |       |
| Net (decrease)  increase in cash and cash equivalents |       | (2,835              | )          | 1,004                     |       | (959                              | )          | —           |       | (2,790           | )          |
|                                                  |       |                |       |                      |       |                              |       |             |       |             |       |
| Cash and cash  equivalents, beginning of period       |       | 29,717              |       | 1,944                     |       | 2,680                             |       | —           |       | 34,341           |       |
|                                                  |       |                |       |                      |       |                              |       |             |       |             |       |
| Cash and cash  equivalents, end of period             |       | $                   | 26,882     |                      | $          | 2,948                             |       | $                | 1,721      |             | $          | — |   | $ | 31,551 |   |
|                                                  |       |                |       |                      |       |                              |       |             |       |             |       |
| Supplemental  disclosures:                            |       |                |       |                      |       |                              |       |             |       |             |       |
| Interest paid                                         |       | $                   | 9,945      |                      | $          | —                            |       | $                | 3,490      |             | $          | — |   | $ | 13,435 |   |
| Income taxes  (refunded) paid                         |       | (653                | )          | 1,251                     |       | 363                               |       | —           |       | 961              |       |
| Capital lease  obligations incurred                   |       | 680                 |       |                      |       |                              |       |             |       | 680              |       |
| Lease incentive  equipment received                   |       | 243                 |       | —                    |       | —                            |       | —           |       | 243              |       |

 

35

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** **

**Item 2. Management’s Discussion and Analysis of Financial Condition andResults of Operations**

 

*The followingdiscussion should be read in conjunction with the Condensed ConsolidatedFinancial Statements of the Company and the notes thereto included elsewhereherein.*

 

**ForwardLooking Statements**

 

Statements contained herein thatare not historical facts constitute “forward looking statements” as that termis defined in the Private Securities Litigation Reform Act of 1995. Words such as “believes,” “plans,” “anticipates,”“expects,” “will” and similar expressions are intended to identifyforward-looking statements.* *All forward lookingstatements are subject to known and unknown risks, uncertainties and otherfactors which could cause actual results to differ materially from thoseanticipated. Forward looking statements include, but are not limited to,statements relating to the sufficiency of the Company’s capital resources,changes in commodity prices and the Company’s plans with respect to restaurantopenings, closings, reimagings and refranchising.  These factors include: the Company’s highlycompetitive business environment; exposure to commodity prices; risks associatedwith the foodservice industry, such as changes in consumer tastes and adversepublicity resulting from food quality, illness, injury or other healthconcerns; 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; the Company’s ability to service its debt and otherobligations; the Company’s ability to meet ongoing financial covenantscontained in the Company’s debt instruments, loan agreements, leases and otherlong-term commitments; 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.**The Company is not obligated to update anyforward-looking statements, whether as a result of new information, futureevents or otherwise.

 

36

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**Overview**

 

The Company’s revenues are derivedprimarily from the operation of full-service restaurants, thedistribution and sale of premium ice cream desserts through retail andinstitutional locations and franchising. As of September 26, 2004, Friendly’soperated 358 full-service restaurants, franchised 179 full-service restaurantsand seven non-traditional units and manufactured a full line of premium icecream desserts distributed through more than 4,500 supermarkets and otherretail locations in 13 states.

 

Following is a summary of theCompany-operated and franchised units:

 
| ** **             | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **             | ** ** | **September 26,  2004**        | ** ** | **September 28,  2003**       | ** ** | **September 26,  2004** | ** ** | **September 28,  2003** | ** ** |
|                   |       |                           |       |                          |       |   |   |   |   |
| Company Units:         |       |                           |       |                          |       |   |   |   |   |
| Beginning of  period   |       | 360                            |       | 382                           |       | 380 |   | 387 |   |
| Openings               |       | 4                              |       | —                        |       | 4 |   | 1 |   |
| Refranchised  closings |       | —                         |       | —                        |       | (18 | ) | — |   |
| Closings               |       | (6                             | )          | (2                            | )          | (8 | ) | (8 | ) |
| End of period          |       | 358                            |       | 380                           |       | 358 |   | 380 |   |
|                   |       |                           |       |                          |       |   |   |   |   |
| Franchised  Units:     |       |                           |       |                          |       |   |   |   |   |
| Beginning of  period   |       | 186                            |       | 162                           |       | 163 |   | 162 |   |
| Refranchised  openings |       | —                         |       | —                        |       | 18 |   | — |   |
| Openings               |       | 2                              |       | 1                             |       | 7 |   | 3 |   |
| Closings               |       | (2                             | )          | (2                            | )          | (2 | ) | (4 | ) |
| End of period          |       | 186                            |       | 161                           |       | 186 |   | 161 |   |

 

***Threemonths ended September 26, 2004 compared with three months ended September 28,2003***

 

*Revenues:*

 

*Total Revenues -* Total revenues decreased $7.3 million, or 4.5%, to$153.1 million for the third quarter ended September 26, 2004 from $160.4million for the same quarter in 2003.

 

*RestaurantRevenues -* Restaurantrevenues decreased $7.2 million, or 5.6%, to $120.4 million for the threemonths ended September 26, 2004 from $127.6 million for the same period in2003. Comparable company-operated restaurant revenues decreased 1.7% from the2003 quarter to the 2004 quarter as decreases occurred in all dayparts with thelargest decline occurring during the evening snack period. Sales growth in fastfood restaurants, higher gas prices and fewer ninety-degree summer days mayhave had a negative impact on comparable sales. The closing of 12 locations andthe re-franchising of 18 locations over the past 15 months resulted inrestaurant revenue declines of $1.4 million and $5.3 million, respectively,during the third quarter of 2004 as compared to the same period in 2003. Thesedeclines were partially offset by increased restaurant revenues of $1.4 millionin the third quarter of 2004 as compared to the same quarter of 2003 due to theopening of six new restaurants over the past 15 months.

 

37

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*FoodserviceRevenues -* Foodservicerevenues (product sales to franchisees and retail customers) decreased $1.1million or 3.5% to $29.1 million for the third quarter ended September 26, 2004from $30.2 million for the same quarter in 2003. Franchised restaurant productrevenues increased by $2.3 million in the third quarter of 2004 as compared tothe same quarter of 2003 due primarily to the increased number of franchisedrestaurants, while sales to foodservice retail supermarket customers declinedby $3.4 million due primarily to a decline in case volume sold to retailsupermarkets. Case volume in the Company’s retail supermarket business fell by14.5% for the quarter ended September 26, 2004 when compared to the quarterended September 28, 2003. Increases in competitive discounting and a highernon-discounted selling price to final consumers, as a result of higheringredient costs, may have contributed to the case decline.

 

*FranchiseRevenues -* Franchiseroyalty, fee and rental revenues increased $0.9 million, or 36.5%, to $3.5million for the three months ended September 26, 2004 compared to $2.6 millionfor the same period in 2003. Royalties on franchised restaurant sales increased$0.4 million in the third quarter of 2004 as compared to the third quarter of2003.  Comparable franchised restaurantrevenues grew 2.7% from the quarter ended September 28, 2003 to the quarterended September 26, 2004. Including results of the current quarter, franchisedrestaurants have reported 14 consecutive quarters of positive comparablerestaurant sales.  The opening of 11 newfranchise restaurants and 18 re-franchised restaurants during the last 15months increased royalty revenues by $0.3 million.  The closing of five under-performinglocations during the last 15 months had little impact on franchised restaurantroyalty revenues.  Initial franchise feesincreased by $0.2 million during the three months ended September 26, 2004 whencompared to the same period in 2003. The increase was due primarily to thereceipt of $0.1 million in franchise fees associated with the sale of leaseholdimprovements and equipment and assignment of the lease for one refranchisedlocation and the sale of equipment at three other refranchised locations to theexisting franchisee. In addition, as part of the Company’s agreement with thefranchisee, the franchisee committed to open five new restaurants in theDayton, OH market over the next six years with an option to open an additionalfive restaurants in the following five years. Gross proceeds from the sale were$0.8 million, of which $0.1 million was for franchise fees and $0.7 million wasfor the sale of assets and lease assignment. Franchise fees also increased due to the opening of the two newfranchised restaurants in the third quarter of 2004.  There was one new opening during the quarterended September 28, 2003. Additionally, an increase in rental income for leasedand subleased franchise locations of $0.3 million contributed to the higherfranchise revenues. There were 186 and 161 franchise units open at September26, 2004 and September 28, 2003, respectively.

 

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*Cost of sales:*

 

Cost of sales increased $0.8 million, or 1.4%, to$57.4 million for the third quarter ended September 26, 2004 from $56.6 millionfor the same period in 2003. Cost of sales as a percentage of total revenueswas 37.5% and 35.3% for the quarters ended September 26, 2004 and September 28,2003, respectively. Higher commodity costs, especially for cream, raw milk andvanilla had an unfavorable impact on cost of sales as a percentage of totalrevenues. A shift in sales mix from Company-operated restaurant sales to foodservicesales also had an unfavorable effect. Foodservice sales to franchisees and supermarket customers (19.0% and18.8% of total revenues for the three months ended September 26, 2004 andSeptember 28, 2003, respectively) have a higher food cost as a percentage ofrevenue than sales in Company-operated restaurants to restaurant patrons.Foodservice retail sales promotional allowances, recorded as offsets torevenues, were increased by 8.0% 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 September 26, 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, additional operatingleases for new equipment and increases in liability insurance. Restaurant costof sales as a percentage of restaurant revenues increased to 27.5% in the thirdquarter of 2004 from 26.9% in the third quarter of 2003. The increase in the2004 quarter when compared to the 2003 quarter was due, in part, to commoditycost increases mentioned above that have not yet been offset by menu priceincreases. The conversion during the first quarter of 2004 from a 64-ouncecontainer to a 56-ounce container only partially offset the increases in icecream ingredient costs. The growth in franchise royalty, fee and rentalrevenues reduced cost of sales, as a percentage of total revenues, by 0.3% forthe three months ended September 26, 2004 when compared to the three monthsended September 28, 2003.

 

The Company expects cream prices to continue toexceed prices experienced in 2003. A table showing the average monthly price ofa pound of AA butter obtained from market quotes provided by the USDA’sAgricultural Marketing Service is included elsewhere herein.

 

*Labor and benefits:*

 

Labor and benefits decreased $2.4 million, or 5.3%,to $43.0 million for the three months ended September 26, 2004 from $45.4million for the three months ended September 28, 2003. Labor and benefits as apercentage of total revenues decreased to 28.1% in the 2004 quarter from 28.3%in the 2003 quarter. As a percentage of restaurant revenues, labor and benefitsincreased to 35.7% in the 2004 quarter from 35.6% in the 2003 quarter. Theincrease in labor and benefits as a percentage of restaurant revenues was dueto higher insurance and payroll tax costs. Revenue derived from franchisedlocations and retail supermarket customers, which do not have any associatedrestaurant labor and benefits, reduced the impact of the higher restaurantlabor and benefits as a percentage of total revenues.

 

39

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* *

*Operating expenses:*

 

Operating expenses increased $1.3 million, or 4.4%,to $30.0 million in the three months ended September 26, 2004 from $28.7million for the three months ended September 28, 2003. Operating expenses as apercentage of total revenues were 19.6% and 17.9% in the 2004 and 2003 periods,respectively. The increase in dollars primarily resulted from higher marketing,restaurant supply and general liability insurance costs, new restaurantpre-opening expenses and occupancy costs in the 2004 period when compared tothe 2003 period.

 

*General and administrativeexpenses:*

 

General and administrative expenses were $9.1million and $10.7 million for the quarters ended September 26, 2004 and September28, 2003, respectively. General and administrative expenses as a percentage oftotal revenues decreased to 5.9% in the 2004 period from 6.7% in the 2003period. The decrease is primarily the result of lower bonus expense and areduction in salaries and wages, which resulted from the elimination of certainpositions during the first quarter of 2004. The decrease was partially offset by increased group insurance andcomputer rentals and legal, accounting and recruitment fees.  The Company has and will continue to incurhigher accounting fees as it documents and tests its significant processes asrequired by Section 404 of the Sarbanes-Oxley Act of 2002.

 

*Depreciation andamortization:*

 

Depreciation and amortization was$5.4 million for the quarters ended September 26, 2004 and September 28, 2003.Depreciation and amortization as a percentage of total revenues was 3.5% and3.4% in the 2004 and 2003 quarters, respectively.

 

*Gain on franchise sales ofrestaurant operations and properties:*

 

Gain on franchise sales ofrestaurant operations and properties was $0.2 million for the quarter endedSeptember 26, 2004. During the three months ended September 26, 2004, theCompany sold leasehold improvements and equipment and assigned the lease forone refranchised location and sold equipment at three other refranchisedlocations to the existing franchisee, resulting in gains of approximately $0.2million.

 

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

 

The loss on disposals of otherproperty and equipment, net, was $0.2 million and $0.1 million for the quartersended September 26, 2004 and September 28, 2003, respectively.  The table below identifies the components ofthe loss on disposals of other property and equipment, net, as shown on theaccompanying condensed consolidated statements of operations (in thousands):

 
| ** **                                              | ** ** | **For the Three Months Ended** | ** ** |
|---------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                              | ** ** | **September 26,  2004**        | ** ** | **September 28,  2003** | ** ** |
| ** **                                              | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Restaurant  assets retired due to remodeling            |       | $                              | 22         |   | $ | 47 |   |
| Restaurant  equipment assets retired due to replacement |       | 131                            |       | 103 |   |
| Loss on property  held for disposition                  |       | —                         |       | 148 |   |
| All other                                               |       | —                         |       | (207 | ) |
| Loss on  disposals of other property and equipment, net |       | $                              | 153        |   | $ | 91 |   |

 

40

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*Interest expense, net:*

 

Interest expense, net of capitalized interest andinterest income, was $5.2 million and $6.0 million, respectively, for thequarters ended September 26, 2004 and September 28, 2003, primarily as a resultof the lower interest rate associated with the New Senior Notes in the 2004period as compared to interest associated with the old Senior Notes in the 2003period.

 

*Benefit from (provision for) income taxes:*

 

The benefit from income taxes was $0.6 million, or(18.5%), for the three months ended September 26, 2004. At this time, theCompany estimates that the effective tax rate for 2004 will be 54.0%. 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.The provision for income taxes was $2.1 million, or 28.0%, for the three monthsended September 28, 2003. The rate in 2003 was increased in the fourth quarterdue to a one-time pension curtailment gain of $8.1 million in 2003. The taxrate for the 2003 fiscal year was 32.5%.

 

*Net income:*

 

Net income was $3.6 million and $5.3 million for thethird quarters ended September 26, 2004 and September 28, 2003, respectively,for the reasons discussed above.

 

***Ninemonths ended September 26, 2004 compared with nine months ended September 28,2003***

 

*Revenues:*

 

*Total Revenues -* Total revenues decreased $13.4 million, or 3.0%, to$431.3 million for the nine months ended September 26, 2004 from $444.7 millionfor the same period in 2003.

 

*RestaurantRevenues -* Restaurantrevenues decreased $14.6 million, or 4.1%, to $339.2 million for the ninemonths ended September 26, 2004 from $353.8 million for the same period in2003. Comparable Company-operated restaurant revenues decreased 0.9% from the2003 period to the 2004 period as declines occurred in lunch and snack daypartswith the largest occurring during the evening snack period. Record snowfallduring the first quarter of 2003 had an unfavorable impact on restaurantrevenues in the first quarter of 2003. This had a favorable impact on restaurantrevenues when compared to the first quarter of the current year, as operatingdays lost due to weather closings were minimal in 2004. However, sales growthin the fast food restaurant segment, higher gas prices and fewer ninety-degreesummer days in the Northeast may have contributed to a decline in comparablerestaurant revenues during the past six months.   Eight and 26 restaurants were re-imagedduring the nine months ended September 26, 2004 and September 28, 2003,respectively.  The closing of 18Company-operated restaurants and the re-franchising of 18 restaurants over thepast 21 months resulted in restaurant revenue declines of $4.6 million and$13.0 million, respectively, during the 2004 period as compared to the sameperiod in 2003. These declines were partially offset by a $3.5 million increasein restaurant revenues due to the opening of seven new restaurants over thepast 21 months.

 

41

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*FoodserviceRevenues -* Foodservicerevenues (product sales to franchisees and retail customers) decreased $1.1million, or 1.3%, to $82.3 million for the nine months ended September 26, 2004from $83.4 million for the nine months ended September 28, 2003. Franchisedrestaurant product revenues increased by $6.1 million in the nine months endedSeptember 26, 2004 as compared to the same period of 2003 due primarily to theincreased number of franchised restaurants, while sales to foodservice retailsupermarket customers declined by $7.2 million due primarily to a decline incase volume sold to retail supermarket customers. Case volume in the Company’sretail supermarket business fell by 13.3% for the nine months ended September26, 2004 when compared to the nine months ended September 28, 2003. Increasesin competitive discounting and a higher non-discounted selling price to finalconsumers, as a result of higher ingredient costs, may have contributed to thecase decline. During the quarter ended March 28, 2004, the Company reduced thesize of its retail supermarket ice cream container to a 56-ounce product from a64-ounce product.

 

*FranchiseRevenues -* Franchiseroyalty, fee and rental revenues increased $2.3 million, or 30.3%, to $9.8million for the nine months ended September 26, 2004 compared to $7.5 millionfor the same period in 2003. Royalties on franchised restaurant sales increased$1.1 million during the nine months ended September 26, 2004 when compared tothe same period in 2003 as the number of franchised units increased andcomparable franchised revenues grew 2.7% from the nine months ended September28, 2003 to the nine months ended September 26, 2004. The opening of 13 newfranchise restaurants and 18 refranchised restaurants during the last 21 monthsincreased royalty revenues by $0.7 million while the closing of sevenunder-performing locations during the same period had no material impact onfranchised royalty revenues.  Initialfranchise fees increased by $0.6 million during the nine months ended September26, 2004 when compared to the same period in 2003 due primarily to therefranchising of 18 Company-operated restaurants, the opening of six newrestaurants and the opening of one new café during the nine months endedSeptember 26, 2004. Additionally, the Company received $0.1 million in franchisefees associated with the sale of leasehold improvements and equipment andassignment of the lease for one refranchised location and the sale of equipmentat three other refranchised locations to the existing franchisee.  In addition, as part of the Company’sagreement with the franchisee, the franchisee committed to open five newrestaurants in the Dayton, OH market over the next six years with an option toopen an additional five restaurants in the following five years. Gross proceedsfrom the sale were $0.8 million, of which $0.1 million was for franchise feesand $0.7 million was for the sale of assets and lease assignment.  Franchise fees also increased due to theopening of two new franchised restaurants in the third quarter of 2004.  There were three new restaurant openingsduring the nine months ended September 28, 2003. Additionally, an increase inrental income for leased and subleased franchise locations of $0.9 millioncontributed to the higher revenues. These increases were partially offset by$0.3 million received in the 2003 period pursuant to an agreement terminatingFriendco’s rights as the exclusive developer of new Friendly’s restaurants inMaryland, Delaware, the District of Columbia and northern Virginia. There were186 and 161 franchise units open at September 26, 2004 and September 28, 2003,respectively.

 

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*Cost of sales:*

 

Cost of sales increased $1.2 million, or 0.8%, to$158.9 million for the nine months ended September 26, 2004 from $157.7 millionfor the same period in 2003. Cost of sales as a percentage of total revenueswas 36.8% and 35.5% for the nine months ended September 26, 2004 and September28, 2003, respectively. Higher commodity costs, especially for cream, raw milkand vanilla had an unfavorable impact on cost of sales as a percentage of totalrevenues. A shift in sales mix from Company-operated restaurant sales tofoodservice sales added to the increase in cost of sales as a percentage oftotal revenues. Foodservice sales to franchisees and retail supermarketcustomers (19.1% and 18.7% of total revenues for the nine months endedSeptember 26, 2004 and September 28, 2003, respectively) have a higher foodcost as a percentage of revenue than sales in Company-operated restaurants torestaurant patrons. Foodservice retail sales promotional allowances, recordedas offsets to revenues, increased by 4.9% in the 2004 period as a percentage ofgross retail sales when compared to the 2003 period as a result of a change inmix of promotional activities. This increase had an unfavorable impact on theoverall cost of sales as a percentage of total revenues. Distribution costswere higher in the nine months ended September 26, 2004 when compared to thesame period in 2003 as a result of the unfavorable impact of new federalrestrictions imposed on driver hours, higher fuel costs, additional operatingleases for new equipment and increases in general liability insurance.Restaurant cost of sales as a percentage of restaurant revenues increased to27.1% in the nine months ended September 26, 2004 from 26.8% for the sameperiod in 2003 as menu price increases have lagged increases in the commoditycosts mentioned above. Cream prices for the nine months ended September 26,2004 were higher than the first nine months of 2003. The conversion during thefirst quarter of 2004 from a 64-ounce container to a 56-ounce container andgains realized in the first quarter of 2004 due to favorable positions onoptions for butter futures contracts partially offset higher prices for creamand other commodities. The Company expects that cream prices will continue toexceed prices experienced in 2003. Additionally, the benefits derived from options for butter futures contractsrealized in the first quarter of 2004 did not continue in the second and thirdquarters and are not likely to benefit the remainder of 2004. The growth infranchise royalty, fee and rental revenues reduced cost of sales as apercentage of total revenues by 0.2% for the nine months ended September 26,2004 when compared to the nine months ended September 28, 2003.

 

The table below shows the averagemonthly price of a pound of AA butter. The prices represented were obtainedfrom market quotes provided by the USDA’s Agricultural 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             |       | 1.7458   |       | 1.1985   |       | 1.0302   |       | 1.8971   |       | 1.1790   |       | 1.3444   |       |
| August           |       | 1.5408   |       | 1.1708   |       | 0.9752   |       | 2.0880   |       | 1.1933   |       | 1.3963   |       |
| September        |       | 1.7656   |       | 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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The cost of cream, the principalingredient used in making ice cream, affects cost of sales as a percentage oftotal revenues, especially in foodservice’s retail business. A $0.10 increasein the cost of a pound of AA butter adversely affects the Company’s annual costof sales by approximately $1.0 million. This adverse impact may be offset by price increases or other factors.However, no assurance can be given that the Company will be able to offset anycost increases in the future and future increases in cream prices could have amaterial adverse effect on the Company’s results of operations. To minimizerisk, the Company continues to pursue alternative supply sources.

 

The Company occasionally purchasesbutter option contracts to minimize the impact of increases in the cost ofcream. When available, options on butter futures are purchased to cover up to50% of the cream needs of the manufacturing plant.  Option contracts are offered in the months ofMarch, May, July, September, October and December; however, there is often notenough open interest in them to allow the Company to buy even very limitedcoverage without paying high premiums.

 

*Labor and benefits:*

 

Labor and benefits decreased $2.2 million, or 1.8%,to $125.1 million for the nine months ended September 26, 2004 from $127.3million for the nine months ended September 28, 2003. Labor and benefits as apercentage of total revenues increased to 29.0% in the 2004 period from 28.6%in the 2003 period. As a percentage of restaurant revenues, labor and benefitsincreased to 36.9% in the 2004 period from 36.0% in the 2003 period. Theincrease in labor and benefits as a percentage of restaurant revenues was dueto training costs associated with the rollout of a new point of sale registersystem in 300 restaurants during the nine month period and declines in laborscheduling efficiencies during the first quarter of 2004, especially during offmeal periods in the winter months. Day to day weather changes, particularly inthe winter months, can result in over scheduling labor when daypart sales fallshort of expectations. In April 2004, the Company initiated a program toreinforce proper labor scheduling techniques. Payroll taxes, insurance costsand general manager compensation also increased as a percent of sales in the2004 period when compared to the 2003 period. Revenue increases derived fromfranchised locations and retail supermarket customers, which do not have anyassociated restaurant labor and benefits, reduced the impact of the higherrestaurant labor and benefits as a percentage of total revenues.

 

*Operating expenses:*

 

Operating expenses increased $0.1 million, or 0.1%,to $82.9 million in the nine months ended September 26, 2004 from $82.8 millionfor the nine months ended September 28, 2003. Operating expenses as apercentage of total revenues were 19.2% and 18.6% in the 2004 and 2003 periods,respectively. The percentage increase resulted from higher general liabilityinsurance, restaurant menu costs, kid premium supply costs and new restaurantpre-opening expenses in the 2004 period when compared to the 2003 period.

 

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* *

*General and administrativeexpenses:*

 

General and administrative expenses were $29.5million and $30.7 million for the nine months ended September 26, 2004 andSeptember 28, 2003, respectively. General and administrative expenses as apercentage of total revenues decreased to 6.8% in the 2004 period from 6.9% inthe 2003 period. The dollar decrease is primarily the result of lower bonusexpense and a reduction in salaries and wages, which resulted from theelimination of certain positions during the first quarter of 2004.  The decrease was partially offset byincreased group insurance and computer rental costs and legal, accounting,recruitment and other professional fees in the 2004 period when compared to the2003 period.  The 2004 period alsoincluded a charge for future rents associated with a vacated trainingfacility.  The Company has and expects tocontinue to incur higher accounting fees as it documents and tests itssignificant processes as required by Section 404 of the Sarbanes-Oxley Act of2002.

 

*Restructuring expenses:*

 

Restructuring expenses of $2.6 million related toseverance and other benefits associated with reduction in force actions takenduring the first quarter of 2004 that reduced headcount by approximately 20permanent positions.

 

*Gain on litigation settlement:*

 

In January 2004, the Companyreached a settlement in a lawsuit filed against a former administrator of oneof the Company’s benefit plans.  Thesettlement was based on the administrator’s alleged failure to adhere to theterms of a contract and resulted in a one-time payment to the Company ofapproximately $3.8 million, which was received on April 2, 2004. As a result ofthis lawsuit, the Company incurred professional fees of approximately $0.5 millionthat were included in the consolidated statement of operations for the yearended December 28, 2003 and an additional $0.2 million in professional feesthat were offset against the payment in the accompanying condensed consolidatedstatement of operations for the nine months ended September 26, 2004.

 

*Depreciation andamortization:*

 

Depreciation and amortization was$16.6 million and $16.8 million for the nine months ended September 26, 2004and September 28, 2003, respectively. Depreciation and amortization as apercentage of total revenues was 3.8% in the 2004 and 2003 periods.

 

*Gain on franchise sales ofrestaurant operations and properties:*

 

Gain on franchise sales ofrestaurant operations and properties was $1.1 million in the nine months endedSeptember 26, 2004. During the nine months ended September 26, 2004, theCompany recognized a gain of approximately $0.7 million associated with thesale of certain equipment assets, lease and sublease rights and franchiserights in 10 existing Company-operated restaurants to a franchisee.  Additionally, during the nine months endedSeptember 26, 2004, the Company sold leasehold improvements and equipment andassigned the lease for one refranchised location and sold equipment at threeother refranchised locations to the existing franchisee, resulting in a gain ofapproximately $0.2 million. The Company also sold the real property andequipment for one refranchised location and assigned the lease and sold theequipment for a second refranchised location to the existing franchisee,resulting in a gain of approximately $0.2 million.

 

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

 

The loss on disposals of otherproperty and equipment, net, was $0.7 million and $1.5 million for the ninemonths ended September 26, 2004 and September 28, 2003, respectively.  The table below identifies the components ofthe loss on disposals of other property and equipment, net as shown in theaccompanying condensed consolidated statements of operations (in thousands):

 
| ** **                                              | ** ** | **For the Nine Months Ended** | ** ** |
|---------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                              | ** ** | **September 26,  2004**       | ** ** | **September 28,  2003** | ** ** |
| ** **                                              | ** ** | ** **                    | ** ** | ** ** | ** ** |
| Restaurant  assets retired due to remodeling            |       | $                             | 195        |   | $ | 945 |   |
| Restaurant  equipment assets retired due to replacement |       | 290                           |       | 302 |   |
| Loss on property  held for disposition                  |       | —                        |       | 289 |   |
| Loss on property  not held for disposition              |       | 63                            |       | — |   |
| All other                                               |       | 113                           |       | (37 | ) |
| Loss on  disposals of other property and equipment, net |       | $                             | 661        |   | $ | 1,499 |   |

 

*Other expenses, principallydebt retirement costs:*

 

Other expenses,principally debt retirement costs represents the $6.8 million premium and the write off of unamortizeddeferred financing costs of approximately $2.5 million in connection with thetender offer for the $176.0 million of Senior Notes. In March 2004, $127.8million of aggregate principal amount of Senior Notes were purchased pursuantto the tender offer and in April 2004, the remaining $48.2 million of SeniorNotes were redeemed in accordance with the Senior Notes indenture at 103.5% ofthe principal amount.

 

*Interest expense, net:*

 

Interest expense, net of capitalized interest andinterest income, was $16.7 million and $18.2 million for the nine months endedSeptember 26, 2004 and September 28, 2003, respectively. Total outstandingdebt, including capital lease and finance obligations, increased from $235.2million at September 28, 2003 to $236.3 million at September 26, 2004. In March2004, $127.8 million of aggregate principal amount of Senior Notes werepurchased in a tender offer with the proceeds from the issuance of $175.0million of New Senior Notes with a lower interest rate.  In April 2004, the remaining $48.2 million ofSenior Notes were redeemed in accordance with the Senior Notes indenture at 103.5%of the principal amount.

 

*Benefit from (provision for) income taxes:*

 

The benefit from income taxes was $3.3 million, or54.0%, for the nine months ended September 26, 2004. At this time, the Companyestimates that the effective tax rate for 2004 will be 54.0%. 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. Theprovision for income taxes was $2.7 million, or 28.0%, for the nine monthsended September 28, 2003. The rate in 2003 was increased in the fourth quarterdue to a one-time pension curtailment gain of $8.1 million in 2003. The taxrate for the 2003 fiscal year was 32.5%.

 

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* *

*Net (loss) income:*

 

Net loss was $2.8 million for the nine months endedSeptember 26, 2004 as compared to net income of $6.9 million for the ninemonths ended September 28, 2003, for the reasons discussed above.

 

**Liquidity andCapital Resources**

 

The Company’s primary sources of liquidity andcapital resources are cash generated from operations and, if needed, borrowingsunder its revolving credit facility. Net cash provided by operating activitieswas $12.4 million and $22.9 million for the nine months ended September 26,2004 and September 28, 2003, respectively. Additional sources of liquidityconsist of capital and operating leases for financing leased restaurantlocations (in malls and shopping centers and land or building leases),restaurant equipment, manufacturing equipment, distribution vehicles and computerequipment. Additionally, sales of under-performing existing restaurantproperties and other assets (to the extent FICC’s and its subsidiaries’ debtinstruments permit) are sources of cash. The amount of debt financing that FICCwill be able to incur is limited by the terms of its New Credit Facility andNew Senior Notes indenture. Below was the financing status of the Company’soperating restaurants at September 26, 2004:

 

| Owned and  mortgaged                |   | 71  |   |
|-------------------------------------|--------|-----|--------|
| Sold and leased  back               |   | 61  |   |
| Owned land and  building            |   | 31  |   |
| Leased land,  owned building        |   | 83  |   |
| Leased land and  building           |   | 112 |   |
| Total  Company-operated restaurants |   | 358 |   |

 

The restaurants above notidentified as owned and mortgaged or sold and leased back secure the Company’sobligations under the New Credit Facility. In addition to the 71 propertiesidentified as owned and mortgaged, the Company owns an additional threeproperties in this category that are now operated by a franchisee. Of the 31restaurant properties identified as owned land and building, six were availableto be sold, if necessary, and of the 83 restaurant properties identified asleased land, owned building, two were available to be mortgaged, if necessary.In addition, the Company held four non-operating restaurant properties thatwere available for sale.

 

The Company’s cash flows were used primarily to payexpenses associated with the tender offer for the Senior Notes, to maintainexisting restaurants and open four new restaurants, to continue to renovate andre-image existing restaurant and plant facilities and for generalcorporate purposes. During the nine months ended September 26, 2004 andSeptember 28, 2003, the Company spent $18.8 million and $22.2 million,respectively, on capital expenditures, of which 16.7 million and $17.9 million,respectively, was spent on restaurant operations. Capital expenditures wereoffset by proceeds from the sales of property and equipment of $4.0 million and$0.1 million for the nine months ended September 26, 2004 and September 28,2003, respectively.

 

The Company had a working capital deficit of $11.8million and $4.2 million as of September 26, 2004 and December 28, 2003,respectively. The working capital needs of companies engaged in the restaurantindustry are generally low and as a result, restaurants are frequently able tooperate with a working capital deficit because: (i) restaurant operations areconducted primarily on a cash (and cash equivalent) basis with a low level ofaccounts receivable; (ii) rapid turnover allows a limited investment in inventories;and (iii) cash from sales is usually received before related expenses for food,supplies and payroll are paid.

 

Net cash used in financing activities was $8.4million and $4.5 million for the nine months ended September 26, 2004 andSeptember 28, 2003, respectively.

 

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In November 1997, FICC entered into a creditfacility that included revolving credit loans, term loans and letters of credit(the “Old Credit Facility”).  Also inNovember 1997, FICC completed a public offering of $200 million of senior notes(the “Senior Notes”). In December 2001, the Company completed a financialrestructuring plan (the “Refinancing Plan”) which included the repayment of the$64.5 million outstanding under the Old Credit Facility and the purchase ofapproximately $21.3 million in Senior Notes with the proceeds from $55.0million in long-term mortgage financing (the “Mortgage Financing”) and a $33.7million sale and leaseback transaction (the “Sale/Leaseback Financing”). Inaddition, FICC secured a new $30.0 million revolving credit facility (the “NewCredit Facility”) of which up to $20.0 million is available to support lettersof credit.  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, thethen current market value.

 

In February 2004, the Company announced a cashtender offer and consent solicitation for the $176.0 million of Senior Notes tobe financed with the proceeds from a private offering of new senior notes (the “NewSenior Notes”), available cash and an amended New Credit Facility (the “2004Refinancing”).  In March 2004, $127.4million of aggregate principal amount of Senior Notes were purchased at thetender offer and consent solicitation price of 104% of the principal amount and$0.4 million of aggregate principal amount of Senior Notes were purchased atthe tender offer price of 102% of the principal amount. In April 2004, theremaining $48.2 million 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 the SeniorNotes was payable at 10.5% per annum semi-annually on June 1 and December 1 ofeach year.  In connection with the tenderoffer, the Company wrote off unamortized deferred financing costs and incurredother direct expenses of $9.2 million that were included in the accompanyingcondensed consolidated statement of operations for the nine months endedSeptember 26, 2004.

 

The $175.0 million of New SeniorNotes issued in March 2004 are unsecured senior obligations of FICC, guaranteedon an unsecured senior basis by FICC’s Friendly’s Restaurants Franchise, Inc.subsidiary, but are effectively subordinated to all secured indebtedness ofFICC, including the indebtedness incurred under the New Credit Facility. TheNew Senior Notes mature on June 15, 2012. Interest on the New Senior Notes ispayable at 8.375% per annum semi-annually on June 15 andDecember 15 of each year.  The NewSenior Notes are redeemable, in whole or in part, at any time on or after June15, 2008 at FICC’s option at redemption prices from 104.188% to 100.00%, basedon the redemption date.  In addition, atany time prior to June 15, 2007, FICC may redeem, subject to certainconditions, up to 35% of the aggregate principal amount of the New Senior Noteswith the proceeds of one or more qualified equity offerings, as defined, at aredemption price of 108.375% of the principal amount, plus accrued interest.

 

In connection with the 2004 Refinancing,the New Credit Facility was amended in March 2004.  The total commitment amount was increasedfrom $30.0 million to $35.0 million and the maturity date was extended fromDecember 17, 2005 to June 30, 2007, in addition to other changes.

 

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The New Credit Facility is secured by substantiallyall of the assets of FICC and two of its six subsidiaries, Friendly’sRestaurants Franchise, Inc. and Friendly’s International Inc. These twosubsidiaries also guarantee FICC’s obligations under the New Credit Facility.

 

The New Credit Facility includescertain restrictive covenants including limitations on indebtedness, restrictedpayments such as dividends and stock repurchases and sales of assets and ofsubsidiary stock. Additionally, the New Credit Facility limits the amount whichthe Company may spend on capital expenditures, restricts the use of proceeds,as defined, from asset sales and requires the Company to comply with certainfinancial covenants. On July 23, 2004, the Company successfully obtained alimited waiver regarding a quarterly EBITDA covenant of its New Credit Facilityas of the June 27, 2004 measurement date.

 

On October 19, 2004, the Companysuccessfully obtained a limited waiver regarding certain quarterly financialcovenants of its New Credit Facility, which the Company was not in fullcompliance with at September 26, 2004. At this time, the Company believes thatit again will not be in compliance with these financial covenants as of January2, 2005. Based on ongoing discussions with its lenders, its projected limiteduse of the revolver portion of the facility and its projected liquidity relatedto the fourth quarter and beyond, the Company believes a covenant waiver,amendment to the existing facility or new credit facility will be secured. Inthe event that the Company is not able to remedy such covenant violations atJanuary 2, 2005, a technical default could be triggered with the Company's NewSenior Notes, which would require a waiver or an amendment of that facility inorder to maintain the current payment schedule of those notes.

 

The New Credit Facility has an annual “clean-up”provision, commencing in 2005, which obligates the Company to repay in full allrevolving credit loans on or before September 30 (or, if September 30 is not abusiness day, as defined, then the next business day) of each year and maintaina zero balance on such revolving credit for at least 30 consecutive days, toinclude September 30, immediately following the date of such repayment.

 

The $35.0 million revolving credit commitment lessoutstanding letters of credit is available for borrowing to provide workingcapital and for other corporate needs. As of September 26, 2004 and December28, 2003, total letters of credit outstanding were $14.5 million and $13.6million, respectively. During the nine months ended September 26, 2004 andSeptember 28, 2003, there were no drawings against the letters of credit.

 

The revolving credit loans bear interest at theCompany’s option at either (a) the Base Rate plus the applicable margin as ineffect from time to time (the “Base Rate”) (7.25% at September 26, 2004) or (b)the Eurodollar rate plus the applicable margin as in effect from time to time(the “Eurodollar Rate”) (6.27% at September 26, 2004).  As of September 26, 2004 and December 28,2003, there were no revolving credit loans outstanding and $20.5 million and$16.4 million, respectively, was available for borrowing.

 

The Company anticipates requiringcapital in the future principally to maintain existing restaurant and plantfacilities and to continue to renovate and re-image existing restaurants.Capital expenditures for 2004, including assets to be acquired under capitalleases, are anticipated to be between $20.0 million and $25.0 million in theaggregate, of which $16.0 million to $21.0 million is expected to be spent onrestaurant operations. The Company’s actual 2004 capital expenditures may varyfrom these estimated amounts. The Company believes that the combination of thefunds generated from operating activities and borrowing availability under theNew Credit Facility will be sufficient to meet the Company’s anticipatedoperating requirements, debt service requirements, lease obligations, capitalrequirements and obligations associated with the restructurings.

 

In January 2004, the Companyreached a settlement in a lawsuit filed against a former administrator of oneof the Company’s benefit plans.  Thesettlement was based on the administrator’s alleged failure to adhere to theterms of a contract and resulted in a 

 

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one-time payment to the Company ofapproximately $3.8 million, which was received on April 2, 2004. As a result ofthis lawsuit, the Company incurred professional fees of approximately $0.5million that were included in the consolidated statement of operations for theyear ended December 28, 2003 and an additional $0.2 million in professionalfees that were offset against the payment in the accompanying condensedconsolidated statement of operations for the nine months ended September 26,2004. The net cash proceeds were used in April 2004 in connection with theredemption of the remaining $48.2 million of Senior Notes.

 

On September 13, 2004, the Companysold leasehold improvements and equipment and assigned the lease for onerefranchised location and sold equipment at three other refranchised locationsto the existing franchisee.  Grossproceeds from the sale were approximately $0.8 million, of which $0.1 millionwas for franchise fees and $0.7 million was for the sale of assets and leaseassignment.

 

On March 5, 2004, the Company sold the real propertyand equipment for one refranchised location and assigned the lease and sold theequipment for a second refranchised location to the existing franchisee. Grossproceeds from the sale were approximately $0.5 million, of which $0.1 millionwas for franchise fees and $0.4 million was for the sale of assets and leaseassignment.

 

On January 15, 2004, the Company entered into anagreement granting Central Florida Restaurants LLC (“Central Florida”) certainlimited exclusive rights to operate and develop Friendly’s full-servicerestaurants in designated areas within the Orlando, Florida market (the “CentralFlorida Agreement”).  Pursuant to theCentral Florida Agreement, Central Florida purchased certain equipment assets,lease and sublease rights and franchise rights in 10 existing Friendly’s restaurantsand committed to open an additional 10 restaurants over the next six years withan option for 15 more restaurants in the following five years. Gross proceedsfrom the sale were approximately $3.2 million of which approximately $0.3million was for franchise fees for the initial 10 restaurants.

 

During July 2003, the Company entered into adevelopment agreement granting Jax Family Rest., Inc. (“Jax”) certain limitedexclusive rights to operate and develop Friendly’s full-service restaurants indesignated 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 newrestaurants over the next seven years. The Company received development fees of$0.2 million, which represent one-half of the initial franchise fees. Jaxopened one new restaurant during the nine months ended September 26, 2004.

 

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The following represents the contractual obligationsand commercial commitments of the Company as of September 26, 2004 (inthousands):

 
| ** **                             | ** ** | **Payments Due by Period** | ** ** |
|----------------------------------------|------------|----------------------------|------------|
| ** **                             | ** ** | **Total**                  | ** ** | **Remainder of  2004** | ** ** | **Fiscal Years  2005 & 2006** | ** ** | **Fiscal Years  2007 & 2008** | ** ** | **Fiscal Years  Beyond  2008** | ** ** |
| **Contractual Obligations:**           | ** ** | ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Short-term and  long-term debt         |       | $                          | 227,259    |   | $ | 299 |   | $ | 2,636 |   | $ | 3,179 |   | $ | 221,145 |   |
| Capital lease  and finance obligations |       | 12,624                     |       | 590 |   | 4,360 |   | 3,890 |   | 3,784 |   |
| Operating leases                       |       | 147,820                    |       | 5,646 |   | 33,365 |   | 25,783 |   | 83,026 |   |
| Purchase  commitments                  |       | 32,961                     |       | 32,615 |   | 338 |   | 8 |   | — |   |
|                                        |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                         | ** ** | **Amount of Commitment Expiration by Period** | ** ** |
|------------------------------------|------------|-----------------------------------------------|------------|
| ** **                         | ** ** | **Total**                                     | ** ** | **Remainder of  2004** | ** ** | **Fiscal Years  2005 & 2006** | ** ** | **Fiscal Years  2007 & 2008** | ** ** | **Fiscal Years  Beyond  2008** | ** ** |
| **Other  Commercial Commitments:** | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Letters of  credit                 |       | $                                             | 14,474     |   | $ | — |   | $ | — |   | $ | 14,474 |   | $ | — |   |
|                                    |            |                                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Seasonality**

 

Due to the seasonality of ice cream consumption, andthe effect from time to time of weather on patronage of the restaurants, theCompany’s revenues and operating income are typically higher in its second andthird quarters.

 

**Geographic Concentration**

 

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

 

**Significant Known Events, Trends or Uncertainties**

 

Defined Benefit Pension Plan

 

Certainof the Company’s employees are covered under a noncontributory defined benefitpension plan. As disclosed in the Company’s 2003 Annual Report on Form 10-K, asof the 2003 measurement date (i.e., the Company’s fiscal 2003 year end), thisplan had an accumulated benefit obligation of $107.0 million, which exceededthe fair value of plan assets of $90.9 million. As a result of the underfunded status of the plan, the Company recordeda charge to stockholders’ deficit during the year ended December 28, 2003 of$9.1 million ($5.4 million, net of income tax benefit). The Company initiallyrecorded an additional minimum pension liability in 2002, the first measurementdate where the accumulated benefit obligation exceeded the fair value of planassets. As of December 28, 2003, the cumulative additional minimum pensioncharge included in accumulated other comprehensive loss was $33.8 million,($19.9 million, net of income tax benefit). Given the sensitivity of theprojected benefit obligation to changes in discount rates, future changes inmarket interest rates may significantly increase or reduce the pension planfunded status. As of the 2004 measurement date, the Company will likely berequired to record an additional charge to stockholders’ deficit. Although theCompany has not yet determined the exact amount of the charge, the Companycurrently estimates the increased amount of the unfunded accumulated benefitobligation to be approximately $5.1 million and the net charge to stockholders’deficit to be less than the amount of this underfunding.

 

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**Significant Accounting Policies**

 

Financial Reporting Release No. 60 issued by theSecurities and Exchange Commission requires all companies to include adiscussion of critical accounting policies or methods used in the preparationof financial statements. The following is a brief discussion of the moresignificant accounting policies and methods used by the Company. The Company’scondensed consolidated financial statements, including the notes thereto, whichare included elsewhere herein, should be read in conjunction with thisdiscussion.

 

*Use of Estimates in thePreparation of Financial Statements -*

 

The preparation of financial statements inconformity with accounting principles generally accepted in the United Statesrequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and the disclosure of contingent assets andliabilities at the dates of the financial statements and the reported amountsof revenues and expenses during the reporting periods. The critical accountingpolicies and most significant estimates and assumptions relate to revenuerecognition, insurance reserves, recoverability of accounts receivable, incometax valuation allowances and pension and other post-retirement benefitsexpense. Actual amounts could differ significantly from the estimates.

 

*Revenue Recognition -*

 

The Company’s revenues are derived primarily fromthe operation of full-service restaurants, the distribution and sale of premiumice cream desserts through retail and institutional locations and franchising.The Company recognizes restaurant revenue upon receipt of payment from thecustomer and retail revenue, net of discounts and allowances, upon delivery ofproduct. Reserves for discounts and allowances from retail sales are estimatedand accrued when revenue is recorded based on promotional planners prepared bythe Company’s retail sales force. Actual amounts could differ materially fromthe estimates. Franchise royalty income, generally calculated as 4% of netsales of franchisees, is recorded monthly based upon the actual sales reportedby each franchisee for the month just completed. Franchise fees are recorded asrevenue upon completion of all significant services, generally upon opening ofthe restaurant.

 

*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 its use ofRIC 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 liabilitycoverages are actuarially determined and recorded in the accompanying condensedconsolidated financial statements on an undiscounted basis. The projections ofestimated ultimate 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 settlement practices.  While the estimated ultimate losses arereasonable, any actuarial estimate is subject to uncertainty due to thevolatility inherent in casualty exposures and changes in the assumptions.  The Company’s provision for insurance expensereflects estimated amounts for the current year as well as revisions inestimates to prior years.  Actual lossescould vary significantly from the estimated losses and would have a materialaffect 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 –*

 

Financial instruments, which potentially expose theCompany to concentrations of credit risk, consist principally of accountsreceivable. The Company performs ongoing credit evaluations of its customersand generally requires no collateral to secure accounts receivable. The creditreview is based on both financial and non-financial factors. The Companymaintains a reserve for potentially uncollectible accounts receivable based onits assessment of the collectibility of accounts receivable.

 

*Pension and Other Post-Retirement Benefits -*

 

Certain of the Company’s employees are covered undera noncontributory defined benefit pension plan. The determination of theCompany’s obligation and expense for pension and other post-retirement benefitsis dependent upon the selection of certain assumptions used by actuaries incalculating such amounts. Those assumptions include, among other things, thediscount rate, expected long-term rate of return on plan assets and rates ofincrease in health care costs. In accordance with accounting principlesgenerally accepted in the United States, actual results that differ from theassumptions are accumulated and amortized over future periods and, therefore,generally affect the recognized expense and recorded obligation in such future periods.Significant differences in actual experience or significant changes in theassumptions may materially affect the future pension and other post-retirementobligations and expense.

 

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*Long-Lived Assets –*

 

In accordance with SFAS No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets,” the Company reviews itsNon-Friendly Marks, which were assigned to the Company by Hershey in September2002, for impairment on a quarterly basis. The Company recognizes impairmenthas occurred when the carrying value of the Non-Friendly Marks exceeds theestimated future discounted cash flows of the trademarked products.Additionally, the Company reviews long-lived assets related to each restaurantto be held and used in the business quarterly for impairment or whenever eventsor changes in circumstances indicate that the carrying amount of a restaurantmay not be recoverable. The Company evaluates restaurants using a “two-yearhistory of cash flow” as the primary indicator of potential impairment. Basedon the best information available, the Company writes down an impairedrestaurant to its estimated fair market value, which becomes its new costbasis. Estimated fair market value is based on the Company’s experience sellingsimilar properties and local market conditions, less costs to sell forproperties to be disposed of. In addition, restaurants scheduled for closingare reviewed for impairment and depreciable lives are adjusted. The impairmentevaluation is based on the estimated cash flows from continuing use through theexpected disposal date and the expected terminal value.

 

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

 

During the nine months ended September 26, 2004, theCompany determined that the carrying value of a vacant restaurant land parceland the carrying value of one restaurant property exceeded their estimated fairvalues less cost to sell.  The carryingvalues were reduced by an aggregate of $91,000. During the nine months endedSeptember 28, 2003, the Company determined that the carrying value of one landparcel exceeded its estimated fair value less cost to sell.  The carrying value was reduced by $26,000.

 

*Income Taxes -*

 

The Company accounts for incometaxes in accordance with SFAS No. 109, “Accounting for Income Taxes,” whichrequires recognition of deferred tax assets and liabilities for the expectedfuture tax consequences of events that have been included in the financialstatements or tax returns. Management records deferred tax assets to the extentit believes there will be sufficient future taxable income to utilize thoseassets prior to their expiration. To the extent deferred tax assets may beunable to be utilized, the Company records a valuation allowance against theunrealizable amount and records a charge against earnings.

 

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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. As of September 26, 2004and December 28, 2003, a valuation allowance of $10.1 million existed relatedto state NOL carryforwards due to restrictions on the usage of state NOLcarryforwards and short carryforward periods for certain states. Due toever-changing tax laws and income tax rates, significant judgment is requiredto estimate the effective tax rate expected to apply to tax differences thatare expected to reverse in the future. Management must also make estimatesabout the sufficiency of taxable income in future periods to offset anydeductions related to deferred tax assets currently recorded. Accordingly,management believes estimates related to income taxes are critical.

 

*Derivative Instruments and Hedging Agreements –*

 

The Company purchases butter optioncontracts to minimize the impact of increases in the cost of cream. Whenavailable, options on butter futures are purchased to cover up to 50% of thecream needs of the manufacturing plant. Option contracts are offered in the months of March, May, July, September,October and December; however, there is often not enough open interest in themto allow the Company to buy even very limited coverage without paying highpremiums.

 

In addition to hedging, the Company pursues fixedprice cream contracts to manage dairy cost pressures. The Company was unable tofind a supplier interested in an agreement for a fixed-price load of cream forpart of the year or the full year of 2003 or 2004. The situation surroundingthe supply of cream (which depends on milk production, milk per cow, number ofcows, butter inventories, etc.) is very uncertain in the wake of the NationalMilk 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. There were no gains orlosses recognized during the third quarters ended September 26, 2004 orSeptember 28, 2003. For the nine months ended September 26, 2004, gains ofapproximately $0.5 million were included in cost of sales related to theseoption contracts as compared to losses of approximately $0.3 million for thenine months ended September 28, 2003.

 

*Contingencies –*

 

From time to time the Company is named as adefendant in legal actions arising in the ordinary course of its business. TheCompany does not believe that the resolutions of these claims will have amaterial adverse effect on the Company’s consolidated financial condition orconsolidated results of operations.

 

*Stock-Based Compensation –*

 

The Company accounts for stock-based compensationfor employees under Accounting Principles Board Opinion No. 25, “Accounting forStock Issued to Employees,” and elected the disclosure-only alternativeunder SFAS No. 123, “Accounting for Stock-Based Compensation.”  Stock-based compensation cost ofapproximately $0.2 million related to modified option awards was included innet loss for the nine months ended September 26, 2004 for the Company’s StockOption Plan and the Company’s 2003 Incentive Plan. No stock-based compensationcost was included in net income for the nine months ended September 28, 2003for the Company’s Stock Option Plan or the Company’s 2003 Incentive Plan, asall options granted during this period had an exercise price equal to themarket value of the stock on the date of grant. In accordance with SFAS No.148, “Accounting for Stock Based Compensation-Transition and Disclosure,” theCompany will continue to disclose the required pro-forma information in thenotes to the consolidated financial statements.

 

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

 

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. Controlsand Procedures**

 

As of September 26, 2004, an evaluation wasperformed under the supervision and with the participation of the Company’smanagement, including the Chief Executive Officer (“CEO”) and Chief FinancialOfficer (“CFO”), of the effectiveness of the design and operation of theCompany’s disclosure controls and procedures (as defined in Rule 13a-15(e)under the Exchange Act).  Based on thatevaluation, the Company’s CEO and CFO concluded that the Company’s disclosurecontrols and procedures were effective as of September 26, 2004.

 

**PART II – OTHER INFORMATION**

 

**Item 6.  Exhibits and reports on Form 8-K**

 
| (a)    | Exhibits                                                |
|--------|---------------------------------------------------------|
|   |                                                    |
|   | The exhibit index is incorporated  by reference herein. |
|   |                                                    |
| (b)    | Reports on Form 8-K                                     |
|   |                                                    |
|   | None                                                    |

 

**SIGNATURES**

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.

 

 
|   | Friendly Ice Cream Corporation(Registrant) |
|--------|--------------------------------------------|
|   |                                       |
|   | By:                                        | /s/PAUL  V. HOAGLAND |   |
|   |                                       | Name: | Paul  V. Hoagland |
|   |                                       | Title: | Executive  Vice President of Administration and Chief |
|   |                                       | Financial  Officer |
|   |                                       |   |
|   | Date:                                      | October  29, 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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