**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

----

**FORM 10-Q**

**(Mark One)**

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934

**Forthe quarterly period ended October 1, 2006**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934

**For the transition periodfrom                     * *to                     * ***

**CommissionFile No. 001-13579**

----

**FRIENDLY ICE CREAM CORPORATION**

(Exact Name of Registrantas Specified in Its Charter)

| **Massachusetts**                |   | **04-2053130**       |
|----------------------------------|--------|----------------------|
| (State or Other  Jurisdiction of |   | (IRS Employer        |
| Incorporation or  Organization)  |   | Identification  No.) |

 

|                                           |   |       |
|-------------------------------------------|--------|------------|
| **1855  Boston Road**                     |   | ** ** |
| **Wilbraham,  Massachusetts**             |   | **01095**  |
| (Address of  Principal Executive Offices) |   | (Zip Code) |

 

**(413) 731-4000**

(Registrant’sTelephone Number, Including Area Code)

**Not Applicable**

(Former name, formeraddress and former fiscal year, if changed since last report)

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

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

Large Accelerated Filer o               AcceleratedFiler x               Non-AcceleratedFiler o

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

Indicate thenumber of shares outstanding of each of the issuer’s classes of common stock asof the latest practicable date.

| Class                         | ** ** | **Outstanding at October 31, 2006** |
|-------------------------------|------------|-------------------------------------|
| Common Stock,  $.01 par value |       | 7,926,058 shares                    |

 

 

----

** **

**PART I — FINANCIALINFORMATION**

**Item 1.**                          FinancialStatements

**FRIENDLY ICE CREAM CORPORATION AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(Unaudited)**

**(In thousands)**
| ** **                                                                | ** ** | **October 1,** | ** ** | **January 1,** | ** ** |
|---------------------------------------------------------------------------|------------|---------------------|------------|---------------------|------------|
| ** **                                                                | ** ** | **2006**            | ** ** | **2006**            | ** ** |
|                                                                      |       |                |       |                |       |
| ASSETS                                                                    |       |                |       |                |       |
| CURRENT ASSETS:                                                           |       |                |       |                |       |
| Cash and cash  equivalents                                                |       | $                   | 28,030     |                | $          | 14,597 |   |
| Restricted cash                                                           |       | 213                 |       | 2,549               |       |
| Accounts  receivable, net                                                 |       | 16,625              |       | 10,757              |       |
| Inventories                                                               |       | 15,983              |       | 15,775              |       |
| Assets held for  sale                                                     |       | 1,119               |       | 1,157               |       |
| Prepaid expenses  and other current assets                                |       | 4,176               |       | 5,044               |       |
| TOTAL CURRENT ASSETS                                                      |       | 66,146              |       | 49,879              |       |
| PROPERTY AND EQUIPMENT,  net of accumulated depreciation and amortization |       | 136,974             |       | 143,290             |       |
| INTANGIBLE ASSETS AND  DEFERRED COSTS, net of accumulated amortization    |       | 18,186              |       | 19,063              |       |
| OTHER ASSETS                                                              |       | 1,917               |       | 6,010               |       |
| TOTAL ASSETS                                                              |       | $                   | 223,223    |                | $          | 218,242 |   |
|                                                                      |       |                |       |                |       |
| LIABILITIES AND  STOCKHOLDERS’ DEFICIT                               |       |                |       |                |       |
| CURRENT LIABILITIES:                                                      |       |                |       |                |       |
| Current  maturities of long-term debt                                     |       | $                   | 1,573      |                | $          | 1,426 |   |
| Current  maturities of capital lease and finance obligations              |       | 1,471               |       | 1,419               |       |
| Accounts payable                                                          |       | 22,221              |       | 24,968              |       |
| Accrued salaries  and benefits                                            |       | 8,750               |       | 8,212               |       |
| Accrued interest  payable                                                 |       | 4,908               |       | 1,324               |       |
| Insurance  reserves                                                       |       | 10,758              |       | 9,002               |       |
| Restructuring  reserves                                                   |       | —              |       | 72                  |       |
| Other accrued  expenses                                                   |       | 21,077              |       | 19,866              |       |
| TOTAL CURRENT  LIABILITIES                                                |       | 70,758              |       | 66,289              |       |
| CAPITAL LEASE AND  FINANCE OBLIGATIONS, less current maturities           |       | 5,052               |       | 6,173               |       |
| LONG-TERM DEBT, less  current maturities                                  |       | 223,700             |       | 224,894             |       |
| ACCRUED PENSION COST                                                      |       | 27,920              |       | 28,904              |       |
| OTHER LONG-TERM  LIABILITIES                                              |       | 32,391              |       | 33,820              |       |
| COMMITMENTS AND  CONTINGENCIES                                            |       |                |       |                |       |
| STOCKHOLDERS’ DEFICIT:                                               |       |                |       |                |       |
| Common stock                                                              |       | 79                  |       | 79                  |       |
| Additional  paid-in capital                                               |       | 145,105             |       | 144,675             |       |
| Accumulated  other comprehensive loss                                     |       | (31,785             | )          | (31,785             | )          |
| Accumulated  deficit                                                      |       | (249,997            | )          | (254,807            | )          |
| TOTAL STOCKHOLDERS’  DEFICIT                                         |       | (136,598            | )          | (141,838            | )          |
| TOTAL LIABILITIES AND STOCKHOLDERS’ DEFICIT                          |       | $                   | 223,223    |                | $          | 218,242 |   |

 

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

1

----

 

**FRIENDLY ICE CREAMCORPORATION AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**(Unaudited)(In thousands, except per share data)
| ** **                                                                                                                                                                                                                                                                | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                                                                                                                                                                                                | ** ** | **October 1,**                                | ** ** | **October 2,**                               | ** ** | **October 1,** | ** ** | **October 2,** | ** ** |
| ** **                                                                                                                                                                                                                                                                | ** ** | **2006**                                           | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                                                                                                                                                                                                                | ** ** | ** **                                         | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| REVENUES:                                                                                                                                                                                                                                                                 |       |                                               |       |                                              |       |   |   |   |   |
| Restaurant                                                                                                                                                                                                                                                                |       | $                                                  | 104,840    |                                              | $          | 106,602 |   | $ | 305,387 |   | $ | 309,178 |   |
| Foodservice                                                                                                                                                                                                                                                               |       | 32,850                                             |       | 30,786                                            |       | 91,881 |   | 87,840 |   |
| Franchise                                                                                                                                                                                                                                                                 |       | 4,194                                              |       | 3,753                                             |       | 11,821 |   | 10,879 |   |
| TOTAL REVENUES                                                                                                                                                                                                                                                            |       | 141,884                                            |       | 141,141                                           |       | 409,089 |   | 407,897 |   |
|                                                                                                                                                                                                                                                                      |       |                                               |       |                                              |       |   |   |   |   |
| COSTS AND EXPENSES:                                                                                                                                                                                                                                                       |       |                                               |       |                                              |       |   |   |   |   |
| Cost of sales                                                                                                                                                                                                                                                             |       | 53,221                                             |       | 53,537                                            |       | 153,545 |   | 155,011 |   |
| Labor and  benefits                                                                                                                                                                                                                                                       |       | 35,972                                             |       | 37,260                                            |       | 108,927 |   | 110,820 |   |
| Operating  expenses                                                                                                                                                                                                                                                       |       | 28,535                                             |       | 28,522                                            |       | 79,350 |   | 79,411 |   |
| General and  administrative expenses                                                                                                                                                                                                                                      |       | 10,374                                             |       | 8,262                                             |       | 32,920 |   | 28,239 |   |
| Write-downs of  property and equipment                                                                                                                                                                                                                                    |       | 307                                                |       | —                                            |       | 522 |   | 289 |   |
| Depreciation and  amortization                                                                                                                                                                                                                                            |       | 5,636                                              |       | 5,655                                             |       | 17,156 |   | 17,438 |   |
| (Gain) loss on  franchise sales of restaurant operations and properties                                                                                                                                                                                                   |       | (80                                                | )          | 7                                                 |       | (2,091 | ) | (2,521 | ) |
| Loss on disposals of  other property and equipment, net                                                                                                                                                                                                                   |       | 534                                                |       | 181                                               |       | 1,009 |   | 523 |   |
|                                                                                                                                                                                                                                                                      |       |                                               |       |                                              |       |   |   |   |   |
| OPERATING INCOME                                                                                                                                                                                                                                                          |       | 7,385                                              |       | 7,717                                             |       | 17,751 |   | 18,687 |   |
|                                                                                                                                                                                                                                                                      |       |                                               |       |                                              |       |   |   |   |   |
| Interest expense, net                                                                                                                                                                                                                                                     |       | 5,061                                              |       | 5,196                                             |       | 15,628 |   | 15,711 |   |
| Other income                                                                                                                                                                                                                                                              |       | (329                                               | )          | —                                            |       | (329 | ) | — |   |
|                                                                                                                                                                                                                                                                      |       |                                               |       |                                              |       |   |   |   |   |
| INCOME FROM CONTINUING  OPERATIONS BEFORE PROVISION FOR INCOME TAXES                                                                                                                                                                                                      |       | 2,653                                              |       | 2,521                                             |       | 2,452 |   | 2,976 |   |
|                                                                                                                                                                                                                                                                      |       |                                               |       |                                              |       |   |   |   |   |
| Provision for income  taxes                                                                                                                                                                                                                                               |       | (650                                               | )          | (101                                              | )          | (900 | ) | (525 | ) |
|                                                                                                                                                                                                                                                                      |       |                                               |       |                                              |       |   |   |   |   |
| INCOME FROM CONTINUING  OPERATIONS                                                                                                                                                                                                                                        |       | 2,003                                              |       | 2,420                                             |       | 1,552 |   | 2,451 |   |
|                                                                                                                                                                                                                                                                      |       |                                               |       |                                              |       |   |   |   |   |
| (LOSS) INCOME FROM  DISCONTINUED OPERATIONS, net of income tax effect of $0 and ($685) for the  three months ended October 1, 2006 and October 2, 2005, respectively, and  ($450) and ($338) for the nine months ended October 1, 2006 and October 2,  2005, respectively |       | (32                                                | )          | 987                                               |       | 3,258 |   | 487 |   |
|                                                                                                                                                                                                                                                                      |       |                                               |       |                                              |       |   |   |   |   |
| NET INCOME                                                                                                                                                                                                                                                                |       | $                                                  | 1,971      |                                              | $          | 3,407 |   | $ | 4,810 |   | $ | 2,938 |   |
|                                                                                                                                                                                                                                                                      |       |                                               |       |                                              |       |   |   |   |   |
| BASIC NET INCOME PER  SHARE:                                                                                                                                                                                                                                              |       |                                               |       |                                              |       |   |   |   |   |
| Income from  continuing operations                                                                                                                                                                                                                                        |       | $                                                  | 0.24       |                                              | $          | 0.31 |   | $ | 0.20 |   | $ | 0.32 |   |
| Income from  discontinued operations                                                                                                                                                                                                                                      |       | —                                             |       | 0.12                                              |       | 0.41 |   | 0.06 |   |
| Net income                                                                                                                                                                                                                                                                |       | $                                                  | 0.24       |                                              | $          | 0.43 |   | $ | 0.61 |   | $ | 0.38 |   |
|                                                                                                                                                                                                                                                                      |       |                                               |       |                                              |       |   |   |   |   |
| DILUTED NET INCOME PER  SHARE:                                                                                                                                                                                                                                            |       |                                               |       |                                              |       |   |   |   |   |
| Income from  continuing operations                                                                                                                                                                                                                                        |       | $                                                  | 0.24       |                                              | $          | 0.30 |   | $ | 0.19 |   | $ | 0.31 |   |
| Income from  discontinued operations                                                                                                                                                                                                                                      |       | —                                             |       | 0.13                                              |       | 0.41 |   | 0.06 |   |
| Net income                                                                                                                                                                                                                                                                |       | $                                                  | 0.24       |                                              | $          | 0.43 |   | $ | 0.60 |   | $ | 0.37 |   |
|                                                                                                                                                                                                                                                                      |       |                                               |       |                                              |       |   |   |   |   |
| WEIGHTED AVERAGE  SHARES:                                                                                                                                                                                                                                                 |       |                                               |       |                                              |       |   |   |   |   |
| Basic                                                                                                                                                                                                                                                                     |       | 7,925                                              |       | 7,840                                             |       | 7,913 |   | 7,770 |   |
| Diluted                                                                                                                                                                                                                                                                   |       | 8,044                                              |       | 7,988                                             |       | 8,045 |   | 7,909 |   |

 

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

2

----

**FRIENDLY ICE CREAMCORPORATION AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**(Unaudited)(In thousands)
| ** **                                                                         | ** ** | **For the Nine Months Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                         | ** ** | **October 1,**                               | ** ** | **October 2,** | ** ** |
| ** **                                                                         | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                             |       |                                              |       |   |   |
| Net income                                                                         |       | $                                                 | 4,810      |   | $ | 2,938 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |       |                                              |       |   |   |
| Stock compensation expense                                                         |       | 351                                               |       | 68 |   |
| Depreciation and amortization                                                      |       | 17,156                                            |       | 17,438 |   |
| Noncash income from discontinued operations                                        |       | (4,079                                            | )          | (1,449 | ) |
| Write-downs of property and equipment                                              |       | 522                                               |       | 289 |   |
| Deferred income tax expense                                                        |       | —                                            |       | 688 |   |
| Gain on disposals of other property and equipment,  net                            |       | (1,096                                            | )          | (2,003 | ) |
| Changes in operating assets and liabilities:                                       |       |                                              |       |   |   |
| Accounts receivable                                                                |       | (5,868                                            | )          | 224 |   |
| Inventories                                                                        |       | (208                                              | )          | 1,923 |   |
| Other assets                                                                       |       | 7,297                                             |       | (2,692 | ) |
| Accounts payable                                                                   |       | (2,747                                            | )          | 1,643 |   |
| Accrued expenses and other long-term liabilities                                   |       | 4,604                                             |       | 1,222 |   |
| NET CASH  PROVIDED BY OPERATING ACTIVITIES                                         |       | 20,742                                            |       | 20,289 |   |
|                                                                               |       |                                              |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                             |       |                                              |       |   |   |
| Purchases of property and equipment                                                |       | (14,032                                           | )          | (11,511 | ) |
| Proceeds from sales of property and equipment                                      |       | 9,396                                             |       | 6,230 |   |
| Purchases of marketable securities                                                 |       | —                                            |       | (499 | ) |
| Proceeds from sales of marketable securities                                       |       | —                                            |       | 163 |   |
| NET CASH USED IN  INVESTING ACTIVITIES                                             |       | (4,636                                            | )          | (5,617 | ) |
|                                                                               |       |                                              |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                             |       |                                              |       |   |   |
| Proceeds from borrowings under revolving credit  facility                          |       | 8,000                                             |       | 16,250 |   |
| Proceeds from issuance of mortgages                                                |       | —                                            |       | 1,115 |   |
| Repayments of debt                                                                 |       | (9,047                                            | )          | (21,153 | ) |
| Payments of deferred financing costs                                               |       | (636                                              | )          | (43 | ) |
| Principal payments of capital lease and finance  obligations                       |       | (1,069                                            | )          | (1,149 | ) |
| Stock options exercised                                                            |       | 79                                                |       | 1,037 |   |
| NET CASH USED IN  FINANCING ACTIVITIES                                             |       | (2,673                                            | )          | (3,943 | ) |
|                                                                               |       |                                              |       |   |   |
| NET INCREASE IN  CASH AND CASH EQUIVALENTS                                         |       | 13,433                                            |       | 10,729 |   |
|                                                                               |       |                                              |       |   |   |
| CASH AND CASH  EQUIVALENTS, BEGINNING OF PERIOD                                    |       | 14,597                                            |       | 13,405 |   |
|                                                                               |       |                                              |       |   |   |
| CASH AND CASH  EQUIVALENTS, END OF PERIOD                                          |       | $                                                 | 28,030     |   | $ | 24,134 |   |
|                                                                               |       |                                              |       |   |   |
| SUPPLEMENTAL  DISCLOSURES:                                                         |       |                                              |       |   |   |
| Cash paid  (refunded) during the period for:                                       |       |                                              |       |   |   |
| Interest                                                                           |       | $                                                 | 11,455     |   | $ | 11,378 |   |
| Income taxes                                                                       |       | (328                                              | )          | 686 |   |
| Capital lease  obligations terminated                                              |       | —                                            |       | 51 |   |

 

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

3

----

**FRIENDLYICE CREAM CORPORATION AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**(Unaudited)

**1. NATUREOF OPERATIONS**

As of October 1, 2006, Friendly’s operated 307 full-servicerestaurants and franchised 210 full-service restaurants and sevennon-traditional units. The Company manufactures and distributes a full line ofpremium ice cream dessert products. These products are distributed to Friendly’srestaurants, supermarkets and other retail locations in 13 states. Therestaurants offer a wide variety of breakfast, lunch and dinner menu items aswell as premium ice cream dessert products.

References herein to “Friendly’s” or the “Company”refer to Friendly Ice Cream Corporation, its predecessor and its consolidatedsubsidiaries; references herein to “FICC” refer to Friendly Ice CreamCorporation and not its subsidiaries; and as used herein, “Northeast” refers tothe Company’s core markets, which include Connecticut, Maine, Massachusetts,New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island and Vermont.

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

|                       | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|-----------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **            | ** ** | **October 1,**                                | ** ** | **October 2,**                               | ** ** | **October 1,** | ** ** | **October 2,** | ** ** |
| ** **            | ** ** | **2006**                                           | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
|                  |       |                                               |       |                                              |       |   |   |   |   |
| Company Units:        |       |                                               |       |                                              |       |   |   |   |   |
| Beginning of period   |       | 309                                                |       | 332                                               |       | 314 |   | 347 |   |
| Openings              |       | —                                             |       | —                                            |       | 2 |   | 1 |   |
| Refranchised closings |       | (2                                                 | )          | —                                            |       | (6 | ) | (10 | ) |
| Closings              |       | —                                             |       | (2                                                | )          | (3 | ) | (8 | ) |
| End of period         |       | 307                                                |       | 330                                               |       | 307 |   | 330 |   |
|                  |       |                                               |       |                                              |       |   |   |   |   |
| Franchised Units:     |       |                                               |       |                                              |       |   |   |   |   |
| Beginning of period   |       | 217                                                |       | 205                                               |       | 213 |   | 195 |   |
| Refranchised openings |       | 2                                                  |       | —                                            |       | 6 |   | 10 |   |
| Openings              |       | 1                                                  |       | —                                            |       | 2 |   | 2 |   |
| Closings              |       | (3                                                 | )          | —                                            |       | (4 | ) | (2 | ) |
| End of period         |       | 217                                                |       | 205                                               |       | 217 |   | 205 |   |

 

**2. BASISOF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES**

*InterimFinancial Information —*

The accompanying condensed consolidated financialstatements as of October 1, 2006 and for the three and nine months endedOctober 1, 2006 and October 2, 2005 are unaudited, but have been prepared inaccordance with generally accepted accounting principles (“GAAP”) for interimfinancial information and with the instructions to Form 10-Q and Article 10 ofRegulation S-X.  Accordingly, they do notinclude all of the information and footnotes required by GAAP for completefinancial statements.  In the opinion of management,all adjustments which are necessary for a fair presentation of the consolidatedfinancial position, results of operations, cash flows and comprehensive income(loss) of the Company have been included. Such adjustments consist solely ofnormal recurring accruals. Operating results for the three and nine monthperiods ended October 1, 2006 and October 2, 2005 are not necessarilyindicative of the results that may be expected for the entire year due, inpart, to the seasonality of the Company’s business. Historically, higherrevenues and operating income have been experienced during the second and thirdfiscal quarters. The Company’s consolidated financial statements, including thenotes thereto, which are contained in the 2005 Annual Report on Form 10-K forthe fiscal year ended January 1, 2006 (“2005 Annual Report on Form 10-K”)should be read in conjunction with these condensed, consolidated financialstatements. Capitalized terms not otherwise defined herein should be referencedto the 2005 Annual Report on Form 10-K.

4

----

*Use ofEstimates in the Preparation of Financial Statements —*

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States requiresmanagement to make estimates and assumptions that affect the reported amountsof 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, pensionand post-retirement medical and life insurance benefits expense, assetimpairment analysis, stock compensation expense and income tax rates andvaluation allowances and tax contingency reserves. Actual amounts could differsignificantly from the estimates.

*Inventories —*

Inventories are stated atthe lower of first-in, first-out cost or market and consisted ofthe following at October 1, 2006 and January 1, 2006 (in thousands):

|                  | ** ** | **October 1,** | ** ** | **January 1,** | ** ** |
|------------------|------------|---------------------|------------|---------------------|------------|
| ** **       | ** ** | **2006**            | ** ** | **2006**            | ** ** |
|             |       |                |       |                |       |
| Raw materials    |       | $                   | 1,613      |                | $          | 1,657 |   |
| Goods in process |       | 135                 |       | 106                 |       |
| Finished goods   |       | 14,235              |       | 14,012              |       |
| Total            |       | $                   | 15,983     |                | $          | 15,775 |   |

 

*Other Accrued Expenses —*

Other accrued expensesconsisted of the following at October 1, 2006 and January 1, 2006 (inthousands):

|                                    | ** ** | **October 1,** | ** ** | **January 1,** | ** ** |
|------------------------------------|------------|---------------------|------------|---------------------|------------|
| ** **                         | ** ** | **2006**            | ** ** | **2006**            | ** ** |
| ** **                         | ** ** | ** **          | ** ** | ** **          | ** ** |
| Accrued rent                       |       | $                   | 4,710      |                | $          | 4,739 |   |
| Income taxes payable               |       | 2,699               |       | 2,761               |       |
| Accrued bonus                      |       | 2,486               |       | 58                  |       |
| Accrued meals and other  taxes     |       | 2,305               |       | 2,219               |       |
| Accrued construction  costs        |       | 2,296               |       | 1,335               |       |
| Gift cards outstanding             |       | 2,250               |       | 4,280               |       |
| Unearned revenues                  |       | 1,173               |       | 1,205               |       |
| Accrued advertising                |       | 944                 |       | 1,211               |       |
| Current portion of  deferred gains |       | 638                 |       | 638                 |       |
| All other                          |       | 1,576               |       | 1,420               |       |
| Total                              |       | $                   | 21,077     |                | $          | 19,866 |   |

 

5

----

*Income Taxes —*

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

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

Duringthe fourth quarter of 2005, the Company entered a three-year cumulative lossposition and revised its projections of the amount and timing of profitabilityin future periods.  As a result, theCompany increased the valuation allowance during the fourth quarter of 2005 by$26,729,000 ($22,184,000 to income tax expense and $4,545,000 to stockholders’deficit) to reduce the carrying value of deferred tax assets to zero.  The Company expects to record a fullvaluation allowance on tax benefits until it can sustain an appropriate levelof profitability.

*Lease Guarantees and Contingencies —*

Primarily as a result ofthe Company’s re-franchising efforts, the Company remains liable for certainlease assignments and guarantees. These leases have varying terms, the latestof which expires in 2020. As of October 1, 2006, the potential amount ofundiscounted payments the Company could be required to make in the event ofnon-payment by the primary lessees was $7,103,000. The present value of thesepotential payments discounted at the Company’s pre-tax cost of debt at October1, 2006 was $5,386,000. The Company generally has cross-default provisions withfranchisees that would put them in default of their franchise agreement in theevent of non-payment under the lease. The Company believes these cross-defaultprovisions significantly reduce the risk that the Company will be required tomake payments under these leases and, historically, the Company has not beenrequired to make such payments. As of July 2, 2006, the Company believed thatone franchisee may have been unable to fulfill its lease obligations during2006 due to the franchisee’s financial situation.  During the third quarter of 2006, thefranchisee was recapitalized and took significant steps to regain its financialstability.  Accordingly, no liability hasbeen recorded for exposure under such leases at October 1, 2006 and January 1,2006.

6

----

*Net Income (Loss) Per Share —*

Basic net income (loss) per share is calculated bydividing net income (loss) by the weighted average number of common sharesoutstanding during the period. Diluted net income (loss) per share iscalculated by dividing net income (loss) by the weighted average number ofshares of common stock and common stock equivalents outstanding during theperiod. Common stock equivalents are dilutive stock options and warrants thatare assumed exercised for calculation purposes. The number of common stockoptions which could dilute basic 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 247,041 and 125,086 for the three monthsended October 1, 2006 and October 2, 2005, respectively.  The number of common stock options whichcould dilute basic earnings per share in the future, that were not included inthe computation of diluted earnings per share because to do so would have beenantidilutive, was 247,041 and 125,086 for the nine months ended October 1, 2006and October 2, 2005, respectively.

Presentedbelow is the reconciliation between basic and diluted weighted average sharesfor the three and nine months ended October 1, 2006 and October 2, 2005 (inthousands):
| ** **                                                              | ** ** | **For the Three Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                              | ** ** | **Basic**                                          | ** ** | **Diluted** | ** ** |
| ** **                                                              | ** ** | **October 1,**                                | ** ** | **October 2,** | ** ** | **October 1,** | ** ** | **October 2,** | ** ** |
| ** **                                                              | ** ** | **2006**                                           | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                    |       |                                               |       |   |   |   |   |   |   |
| Weighted average number  of common shares outstanding during the period |       | 7,925                                              |       | 7,840 |   | 7,925 |   | 7,840 |   |
| Adjustments:                                                            |       |                                               |       |   |   |   |   |   |   |
| Assumed exercise of  stock options                                      |       | —                                             |       | — |   | 119 |   | 148 |   |
| Weighted average number  of shares outstanding                          |       | 7,925                                              |       | 7,840 |   | 8,044 |   | 7,988 |   |

 
| ** **                                                              | ** ** | **For the Nine Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                              | ** ** | **Basic**                                         | ** ** | **Diluted** | ** ** |
| ** **                                                              | ** ** | **October 1,**                               | ** ** | **October 2,** | ** ** | **October 1,** | ** ** | **October 2,** | ** ** |
| ** **                                                              | ** ** | **2006**                                          | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                    |       |                                              |       |   |   |   |   |   |   |
| Weighted average number  of common shares outstanding during the period |       | 7,913                                             |       | 7,770 |   | 7,913 |   | 7,770 |   |
| Adjustments:                                                            |       |                                              |       |   |   |   |   |   |   |
| Assumed exercise of  stock options                                      |       | —                                            |       | — |   | 132 |   | 139 |   |
| Weighted average number of shares outstanding                           |       | 7,913                                             |       | 7,770 |   | 8,045 |   | 7,909 |   |

 

7

----

*Stock-Based Compensation —*

Prior to January 2, 2006, the Company accounted forstock-based compensation for employees under Accounting Principles Board(“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and relatedinterpretations.  The Company had adoptedthe disclosure-only provisions of SFAS No. 123, “Accounting for Stock-BasedCompensation” and the disclosures required by SFAS No. 148, “Accounting forStock-Based Compensation—Transition and Disclosure.”  In accordance with APB Opinion No. 25, theCompany generally recognized no stock-based compensation cost, as all optionsgranted during that period had an exercise price equal to the market value ofthe stock on the date of grant. Stock-based compensation cost of $68,000related to modified option awards was included in net income for the ninemonths ended October 2, 2005 for the Company’s 1997 Stock Option Plan and theCompany’s 2003 Equity Incentive Plan.

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

OnJanuary 2, 2006 (the first day of its 2006 fiscal year), the Company adoptedSFAS No. 123R using the modified prospective method as permitted under SFAS No.123R. Under this transition method, compensation cost recognized in the threeand nine months ended October 1, 2006 included: (a) compensation cost forall share-based payments granted prior to but not yet vested as of January 1,2006, based on the grant-date fair value estimated in accordance with theprovisions of SFAS No. 123, and (b) compensation cost for all share-basedpayments granted subsequent to January 1, 2006, based on the grant-date fairvalue estimated in accordance with the provisions of SFAS No. 123R. Inaccordance with the modified prospective method of adoption, the Company’sresults of operations and financial position for prior periods have not beenrestated.

*Recently Issued Accounting Pronouncements —*

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

InOctober 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for DefinedBenefit Pension and Other Postretirement Plans, an amendment of FASB StatementsNo. 87, 88, 106 and 132(R)” (“SFAS No. 158”), which requires an entity to: (a)recognize in its statement of financial position an asset for a defined benefitpostretirement plan’s overfunded status or a liability for a plan’s underfundedstatus, (b) measure a defined benefit postretirement plan’s assets andobligations that determine its funded status as of the end of the employer’sfiscal year, and (c) recognize changes in the funded status of a definedbenefit postretirement plan in comprehensive income in the year in which thechanges occur.  The requirement torecognize the funded status of a defined benefit postretirement plan and thedisclosure requirements are effective for the Company’s 2006 fiscal year.  The adoption of SFAS No. 158 is not expectedto have a material effect on the Company’s consolidated financial position orresults of operations.

8

----

**3. STOCKBASED COMPENSATION**

*Equity Compensation Plans* —

TheCompany currently grants stock awards under the following equity compensationplans:

*1997Stock Option Plan (“1997 Plan”)*— The 1997 Plan was adoptedby the Company’s Board of Directors and stockholders in November 1997 and was subsequentlyamended on March 27, 2000 and October 24, 2001. Under the 1997 Plan, theCompany’s Board of Directors may grant options to purchase up to 1,034,970shares of common stock to employees, executive officers and directors. The 1997Plan provides for the issuance of nonqualified stock options and incentivestock options (which are intended to satisfy the requirements of Section 422 ofthe Internal Revenue Code) and stock appreciation rights (“SARs”). TheCompensation Committee of the Board of Directors determines the employees whowill receive awards under the 1997 Plan and the terms of such awards. Theexercise price of a stock option or SAR granted or awarded under the 1997 Planmay not be less than the fair market value of one share of common stock on thedate the stock option or SAR is granted.

*The2003 Equity Incentive Plan (the “2003 Incentive Plan”)*— OnApril 9, 2003, the Board of Directors adopted an equity incentive plan, subjectto approval by the Company’s shareholders. On May 14, 2003, the shareholdersapproved the 2003 Incentive Plan, which became effective as of March 30,2003.  On May 10, 2006, the shareholdersapproved an amendment to the 2003 Incentive Plan to increase the number ofshares of common stock reserved for issuance under the 2003 Incentive Plan from307,000 to 607,000 shares. The 2003 Incentive Plan provides for the issuance ofnonqualified stock options and incentive stock options (which are intended tosatisfy the requirements of Section 422 of the Internal Revenue Code), SARs,bonus stock, stock units, performance shares, performance units, restrictedstock and restricted stock units.  TheCompensation Committee of the Board of Directors determines the employees whowill receive awards under the 2003 Incentive Plan and the terms of suchawards.  The exercise price of a stockoption or SAR granted or awarded under the 2003 Incentive Plan may not be lessthan the fair market value of one share of common stock on the date the stockoption or SAR is granted.

Outstanding options issued prior to December 20, 2004are fully vested.  Options issuedsubsequent to December 20, 2004 generally vest over three years. Options issuedprior to July 24, 2002 expire 10 years from the date of grant. Options issuedsubsequent to that date have a five year expiration date.

 

9

----

* *

*Grant-DateFair Value* —

The Company uses the Black-Scholes option pricingmodel to calculate the grant-date fair value of an award. There were no optionsissued during the quarters ended October 1, 2006 and October 2, 2005.  The fair value of options granted during thenine months ended October 1, 2006 and October 2, 2005 were calculated based onthe following:

|                                          | ** ** | **For the Nine Months Ended** | ** ** |
|------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                               | ** ** | **October 1, 2006**                     | ** ** | **October 2, 2005** | ** ** |
| Options granted                          |       | 145,409                                           |       | 119,953 |   |
| Weighted-average exercise  price         |       | $                                                 | 8.10       |   | $ | 8.87 |   |
| Weighted-average grant  date fair value  |       | $                                                 | 3.82       |   | $ | 4.68 |   |
| Estimated Weighted  Average Assumptions: |       |                                              |       |   |   |
| Risk free  interest rate                 |       | 4.68                                              | %          | 3.58%-3.93 | % |
| Expected life  (in years)                |       | 4                                                 |       | 4-5 |   |
| Expected  volatility                     |       | 54.86                                             | %          | 56.56%-58.16 | % |
| Expected dividend yield                  |       | 0.00                                              | %          | 0.00 | % |

 

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

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

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

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

*Expense* —

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

Theamount of stock-based compensation recognized during a period is based on thevalue of the portion of the awards that are ultimately expected to vest. SFASNo. 123R requires forfeitures to be estimated at the time of grant and revised,if necessary, in subsequent periods if actual forfeitures differ from thoseestimates. The term “forfeitures” is distinct from “cancellations” or “expirations”and represents only the unvested portion of the surrendered option. The Companycurrently expects, based on an analysis of its historical forfeitures that approximately94.5% of its options will actually vest, and therefore has applied an annualforfeiture rate of 5.5% to options granted as of October 1, 2006. This analysiswill be re-evaluated quarterly and the forfeiture rate will be adjusted asnecessary. Ultimately, the actual expense recognized over the vesting periodwill only be for those shares that vest.

Theadoption of SFAS No. 123R on January 2, 2006 resulted in lower operating incomebefore tax and lower net income of $112,000 and $312,000 for the three and ninemonths ended October 1, 2006, respectively.

10

----

 

The following table details the effect on net incomeand income per share had stock-based compensation expense been recorded infiscal 2005 based on the fair-value method under SFAS No. 123 (in thousands, except per share data).**The reported and pro forma netincome and income per share for the three and nine months ended October 1, 2006are the same since stock-based compensation expense was calculated under theprovisions of SFAS No. 123R.
|                                                                                                                                     | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                          | ** ** | **October 2, 2005**    | ** ** | **October 2, 2005**   | ** ** |
|                                                                                                                                |       |                             |       |                            |       |
| Net income as reported                                                                                                              |       | $                                | 3,407      |                            | $          | 2,938 |   |
|                                                                                                                                |       |                             |       |                            |       |
| Add stock-based  compensation expense included in reported net income, net of related income  tax benefit                           |       | —                           |       | 40                              |       |
| Less stock-based  compensation expense determined under fair value method for all stock  options, net of related income tax benefit |       | (27                              | )          | (67                             | )          |
| Pro forma net income                                                                                                                |       | $                                | 3,380      |                            | $          | 2,911 |   |
|                                                                                                                                |       |                             |       |                            |       |
| Basic net income per  share, as reported                                                                                            |       | $                                | 0.43       |                            | $          | 0.38 |   |
| Basic net income per  share, pro forma                                                                                              |       | $                                | 0.43       |                            | $          | 0.37 |   |
|                                                                                                                                |       |                             |       |                            |       |
| Diluted net income per  share, as reported                                                                                          |       | $                                | 0.43       |                            | $          | 0.37 |   |
| Diluted net income per share, pro forma                                                                                             |       | $                                | 0.42       |                            | $          | 0.37 |   |

 

*OptionActivity* —

Asummary of the activity under the Company’s equity compensation plans as ofOctober 1, 2006 and changes during the nine-month period then ended ispresented below:
|                                                          | ** ** | ** **      | ** ** | **Weighted-**               | ** ** | ** **              | ** ** | ** **    | ** ** |
|----------------------------------------------------------|------------|-----------------|------------|-----------------------------|------------|-------------------------|------------|---------------|------------|
| ** **                                               | ** ** | ** **      | ** ** | **Average**                 | ** ** | ** **              | ** ** | ** **    | ** ** |
| ** **                                               | ** ** | ** **      | ** ** | **Remaining**               | ** ** | **Weighted-**           | ** ** | **Aggregate** | ** ** |
| ** **                                               | ** ** | **Options**     | ** ** | **Contractual**             | ** ** | **Average**             | ** ** | **Intrinsic** | ** ** |
| ** **                                               | ** ** | **Outstanding** | ** ** | **Life in Years** | ** ** | **Exercise Price** | ** ** | **Value**     | ** ** |
|                                                     |       |            |       |                        |       |                    |       |          |       |
| Options outstanding at                                   |       |            |       |                        |       |                    |       |          |       |
| January 1, 2006                                          |       | 621,450         |       |                        |       | $                       | 7.82       |          |       |   |
| Granted                                                  |       | 145,409         |       |                        |       | $                       | 8.10       |          |       |   |
| Cancelled                                                |       | (13,290         | )          |                        |       | $                       | 11.84      |          |       |   |
| Forfeited                                                |       | (81,914         | )          |                        |       | $                       | 8.38       |          |       |   |
| Exercised                                                |       | (27,467         | )          |                        |       | $                       | 2.88       |          |       |   |
| Options outstanding at  October 1, 2006                  |       | 644,188         |       | 2.48                        |       | $                       | 7.94       |          | $          | 1,815,964 |   |
|                                                     |       |            |       |                        |       |                    |       |          |       |
| Options fully vested  and exercisable at October 1, 2006 |       | 485,196         |       | 1.94                        |       | $                       | 7.74       |          | $          | 1,815,964 |   |

 

Duringthe three and nine months ended October 1, 2006, the total intrinsic value ofoptions exercised (i.e., the difference between the market price at exerciseand the price paid by the employee to exercise the options) was $8,000 and$153,000, respectively, and the total amount of cash received from exercise ofstock options was $14,000 and $79,000, respectively.

11

----

 

Asof October 1, 2006, there was $744,000 of average unrecognized compensationcost related to unvested stock options. That cost is expected to be recognizedover a weighted-average period of 2.23 years.

*RestrictedStock Unit Activity* —

On December 2, 2005, 30,000 restricted stock unitswere issued to directors with a weighted average fair value of $8.90 at grantdate.  During the three and nine monthsended October 1, 2006, stock-based compensation cost of $22,000 and $66,000,respectively, was recorded related to these units.

Asof October 1, 2006, there was $193,000 of total unrecognized compensation costrelated to unvested restricted stock units. That cost is expected to berecognized over a weighted-average period of 2.17 years.

On August 1, 2006 theCompensation Committee of the Board of Directors approved the issuance ofrestricted stock units to five officers (each, an “Award”) under the Company’slong-term incentive plan if the Company exceeds a certain threshold EBITDAtarget for 2006 (the “Threshold EBITDA”). If the Company exceeds the Threshold EBITDA, then each of the officerswill receive an Award having a specified value based on the Company’s actualEBITDA for 2006 compared to projected EBITDA and a percentage of each officer’starget award.  The following table setsforth the range of values of the Award each officer may receive:

| Name            | ** ** | **Value of Award** | ** ** |
|-----------------|------------|------------------------------|------------|
| John Cutter     |       | $                            | 174,267    |   | to |   | $ | 522,801 |   |
| Paul Hoagland   |       | $                            | 82,028     |   | to |   | $ | 246,084 |   |
| Gregory Pastore |       | $                            | 34,438     |   | to |   | $ | 103,314 |   |
| Kenneth Green   |       | $                            | 39,698     |   | to |   | $ | 119,093 |   |
| Garrett Ulrich  |       | $                            | 39,865     |   | to |   | $ | 119,595 |   |

 

The Award, if any, is expected to be grantedfollowing the Board of Directors’ meetings scheduled to be held on February27-28, 2007.  The number of Awards to begranted, if any, will be calculated by dividing the value of the Award by 90%of the closing price of the Company’s common stock on the date of grant.  If issued, 25 percent of the Award will veston the grant date and 25 percent of the Award will vest in each of thefollowing three years. During the three and nine months ended October 1, 2006,stock-based compensation cost of $39,000 was recorded related to these Awards.

12

----

 

**4.EMPLOYEE BENEFIT PLANS**

Thecomponents of net periodic pension cost for the three and nine months endedOctober 1, 2006 and October 2, 2005 were (in thousands):
| ** **                                           | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|------------------------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                           | ** ** | **October 1,**                                | ** ** | **October 2,**                               | ** ** | **October 1,** | ** ** | **October 2,** | ** ** |
| ** **                                           | ** ** | **2006**                                           | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                 |       |                                               |       |                                              |       |   |   |   |   |
| Interest cost                                        |       | $                                                  | 1,695      |                                              | $          | 1,671 |   | $ | 5,087 |   | $ | 5,013 |   |
| Expected return on  assets                           |       | (1,983                                             | )          | (2,072                                            | )          | (5,948 | ) | (6,216 | ) |
| Net amortization of  unrecognized net actuarial loss |       | 676                                                |       | 473                                               |       | 2,027 |   | 1,418 |   |
|                                                 |       |                                               |       |                                              |       |   |   |   |   |
| Net periodic pension cost                            |       | $                                                  | 388        |                                              | $          | 72 |   | $ | 1,166 |   | $ | 215 |   |

 

Thecomponents of the net postretirement medical and life insurance benefit costfor the three and nine months ended October 1, 2006 and October 2, 2005 were(in thousands):
| ** **                                              | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|---------------------------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                              | ** ** | **October 1,**                                | ** ** | **October 2,**                               | ** ** | **October 1,** | ** ** | **October 2,** | ** ** |
| ** **                                              | ** ** | **2006**                                           | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                    |       |                                               |       |                                              |       |   |   |   |   |
| Service cost                                            |       | $                                                  | 40         |                                              | $          | 41 |   | $ | 122 |   | $ | 122 |   |
| Interest cost                                           |       | 95                                                 |       | 114                                               |       | 285 |   | 344 |   |
| Recognized actuarial  loss                              |       | 3                                                  |       | 21                                                |       | 11 |   | 62 |   |
| Net amortization of  unrecognized prior service benefit |       | (35                                                | )          | (36                                               | )          | (107 | ) | (107 | ) |
|                                                    |       |                                               |       |                                              |       |   |   |   |   |
| Net postretirement benefit cost                         |       | $                                                  | 103        |                                              | $          | 140 |   | $ | 311 |   | $ | 421 |   |

 

In August 2006,the Pension Protection Act of 2006 (the “Act”) was signed into law.  As a result of the Act, the Companycontributed $2,150,000 to the Company’s defined benefit cash balance pensionplan during the quarter ended October 1, 2006 and anticipates an additionalcontribution of approximately $3,500,000 in 2008.

13

----

 

**5. ASSETIMPAIRMENT AND DISCONTINUED OPERATIONS**

As of January 1, 2006, theCompany had 11 restaurants that were reported as “held for sale” in accordancewith SFAS No. 144, “Accounting for the Impairment or Disposal ofLong-Lived Assets.” During the nine monthsended October 1, 2006, the Company sold seven of these restaurants.  Gross proceeds from these transactionswere $6,892,000.  The Company recognizeda net gain related to the sales of the assets of $4,079,000.  AtOctober 1, 2006, the remaining four properties, and one additional propertythat closed during the nine months ended October 1, 2006, met the criteria for “heldfor sale” as defined in SFAS No. 144.  Thecarrying values of these five properties of $1,119,000 and $1,157,000 as ofOctober 1, 2006 and January 1, 2006, respectively, were reported as assets heldfor sale in the accompanying condensed consolidated balance sheets. Thecarrying values of these properties were not adjusted since the carrying valueswere less than the estimated fair market values less costs to sell.

The table below identifies the components of the “Losson disposals of other property and equipment, net” as shown in the accompanyingcondensed consolidated statements of operations (in thousands):
| ** **                                              | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|---------------------------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                              | ** ** | **October 1,**                                | ** ** | **October 2,**                               | ** ** | **October 1,** | ** ** | **October 2,** | ** ** |
| ** **                                              | ** ** | **2006**                                           | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                              | ** ** | ** **                                         | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Restaurant equipment  assets retired due to remodeling  |       | $                                                  | 438        |                                              | $          | — |   | $ | 734 |   | $ | 220 |   |
| Restaurant equipment  assets retired due to replacement |       | 80                                                 |       | 51                                                |       | 222 |   | 146 |   |
| Gain due to restaurant  flood                           |       | (5                                                 | )          | —                                            |       | (53 | ) | — |   |
| All other                                               |       | 21                                                 |       | 130                                               |       | 106 |   | 157 |   |
| Loss on disposals of other property and equipment, net  |       | $                                                  | 534        |                                              | $          | 181 |   | $ | 1,009 |   | $ | 523 |   |

 

SFAS No. 144 also requires the results of operationsof a component of an entity that is classified as held for sale or that hasbeen disposed of to be reported as discontinued operations in the statement ofoperations if certain conditions are met. These conditions include commitmentto a plan of disposal after the effective date of this statement, eliminationof the operations and cash flows of the entity component from the ongoingoperations of the company and no significant continuing involvement in theoperations of the entity component after the disposal transaction.

14

----

 

In accordance with SFAS No. 144, the results of operations of the sevenproperties that were disposed of during the nine months ended October 1, 2006and the 14 properties that were disposed of during 2005 and the related netgain on the disposals, as well as the results of operations of the propertiesheld for sale at October 1, 2006, were reported separately as discontinuedoperations in the accompanying condensed consolidated statements of operationsfor all periods presented.  Operatingresults for the three and nine months ended October 1, 2006 and the net gain ondisposals of the properties as well as operating results that were included inthe restaurant segment in the previously issued Quarterly Report on Form 10-Qfor the three and nine months ended October 2, 2005 are summarized below (inthousands):
| ** **                                   | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|----------------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                   | ** ** | **October 1,**                                | ** ** | **October 2,**                               | ** ** | **October 1,** | ** ** | **October 2,** | ** ** |
| ** **                                   | ** ** | **2006**                                           | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                   | ** ** | ** **                                         | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                    |       | $                                                  | —     |                                              | $          | 2,416 |   | $ | — |   | $ | 8,731 |   |
|                                         |       |                                               |       |                                              |       |   |   |   |   |
| Operating loss                               |       | (43                                                | )          | (280                                              | )          | (371 | ) | (1,101 | ) |
| Gain on  disposals of property and equipment |       | 11                                                 |       | 1,952                                             |       | 4,079 |   | 1,926 |   |
| Income tax  expense                          |       | —                                             |       | (685                                              | )          | (450 | ) | (338 | ) |
| (Loss) income from  discontinued operations  |       | $                                                  | (32        | )                                                 | $          | 987 |   | $ | 3,258 |   | $ | 487 |   |

 

During the nine months ended October 1, 2006, theCompany determined that the carrying values of two operating restaurantproperties exceeded their estimated fair values less costs to sell and thecarrying values were reduced by an aggregate of $522,000 accordingly.

During the nine months ended October 2, 2005, theCompany identified two restaurant properties to be disposed of other than bysale.  The Company determined that thecarrying values of these restaurant properties exceeded their estimatedundiscounted cash flows and the carrying values were reduced by an aggregate of$289,000 accordingly.

**6. SEGMENT REPORTING**

Operating segmentsare components of an enterprise about which separate financial information isavailable that is evaluated regularly by the chief operating decision-maker, ordecision-making group, in deciding how to allocate resources and in assessingperformance. The Company’s operating segments include restaurant, foodserviceand franchise. The revenues from these segments include both sales to unaffiliatedcustomers and intersegment sales, which generally are accounted for on a basisconsistent with sales to unaffiliated customers. Intersegment sales and otherintersegment transactions have been eliminated in the accompanying condensedconsolidated financial statements.

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

15

----

 

The accounting policies of the operating segments arethe same as those described in the summary of significant accounting policiesexcept that the financial results for the foodservice operating segment, priorto intersegment eliminations, have been prepared using a management approach,which is consistent with the basis and manner in which the Company’s managementinternally reviews financial information. Using this approach, the Companyevaluates performance based on stand-alone operating segment income (loss)before income taxes and generally accounts for intersegment sales and transfersas if the sales or transfers were to third parties, that is, at current marketprices.

Adjusted EBITDA represents net income (loss) fromcontinuing operations before (i) (provision for) benefit from income taxes,(ii) interest expense, net, (iii) depreciation and amortization, (iv)write-downs of property and equipment, (v) net periodic pension cost and(vi) other non-cash items. Adjusted EBITDA is a non-GAAP financialmeasure.  The Company has includedinformation concerning adjusted EBITDA in this Form 10-Q because the Company’smanagement incentive plan pays bonuses based on achieving adjusted EBITDAtargets and the Company believes that such information is used by certaininvestors as one measure of a company’s historical ability to service debt.Adjusted EBITDA should not be considered as an alternative to, or moremeaningful than, earnings (loss) from continuing operations or othertraditional indications of the Company’s operating performance.
| ** **              | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|-------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **              | ** ** | **October 1,**                                | ** ** | **October 2,**                               | ** ** | **October 1,** | ** ** | **October 2,** | ** ** |
| ** **              | ** ** | **2006**                                           | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **              | ** ** | **(in thousands)**                            | ** ** | **(in thousands)**                           | ** ** |
| Revenues:               |       |                                               |       |                                              |       |   |   |   |   |
| Restaurant              |       | $                                                  | 104,840    |                                              | $          | 106,602 |   | $ | 305,387 |   | $ | 309,178 |   |
| Foodservice             |       | 63,277                                             |       | 62,576                                            |       | 181,126 |   | 181,960 |   |
| Franchise               |       | 4,194                                              |       | 3,753                                             |       | 11,821 |   | 10,879 |   |
| Total                   |       | $                                                  | 172,311    |                                              | $          | 172,931 |   | $ | 498,334 |   | $ | 502,017 |   |
|                    |       |                                               |       |                                              |       |   |   |   |   |
| Intersegment  revenues: |       |                                               |       |                                              |       |   |   |   |   |
| Restaurant              |       | $                                                  | —     |                                              | $          | — |   | $ | — |   | $ | — |   |
| Foodservice             |       | (30,427                                            | )          | (31,790                                           | )          | (89,245 | ) | (94,120 | ) |
| Franchise               |       | —                                             |       | —                                            |       | — |   | — |   |
| Total                   |       | $                                                  | (30,427    | )                                                 | $          | (31,790 | ) | $ | (89,245 | ) | $ | (94,120 | ) |
|                    |       |                                               |       |                                              |       |   |   |   |   |
| External  revenues:     |       |                                               |       |                                              |       |   |   |   |   |
| Restaurant              |       | $                                                  | 104,840    |                                              | $          | 106,602 |   | $ | 305,387 |   | $ | 309,178 |   |
| Foodservice             |       | 32,850                                             |       | 30,786                                            |       | 91,881 |   | 87,840 |   |
| Franchise               |       | 4,194                                              |       | 3,753                                             |       | 11,821 |   | 10,879 |   |
| Total                   |       | $                                                  | 141,884    |                                              | $          | 141,141 |   | $ | 409,089 |   | $ | 407,897 |   |

 

16

----

 
| ** **                                                            | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                            | ** ** | **October 1,**                                | ** ** | **October 2,**                               | ** ** | **October 1,** | ** ** | **October 2,** | ** ** |
| ** **                                                            | ** ** | **2006**                                           | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                            | ** ** | **(in thousands)**                            | ** ** | **(in thousands)**                           | ** ** |
|                                                                  |       |                                               |       |                                              |       |   |   |   |   |
| Adjusted EBITDA:                                                      |       |                                               |       |                                              |       |   |   |   |   |
| Restaurant                                                            |       | $                                                  | 10,793     |                                              | $          | 10,150 |   | $ | 29,557 |   | $ | 29,809 |   |
| Foodservice                                                           |       | 5,344                                              |       | 4,344                                             |       | 13,529 |   | 10,725 |   |
| Franchise                                                             |       | 2,960                                              |       | 2,736                                             |       | 8,267 |   | 7,848 |   |
| Corporate                                                             |       | (4,986                                             | )          | (3,678                                            | )          | (16,678 | ) | (13,957 | ) |
| (Loss) gain on  property and equipment, net                           |       | (454                                               | )          | (180                                              | )          | 1,083 |   | 1,989 |   |
| Add back pension  cost included in reporting segments                 |       | 388                                                |       | 72                                                |       | 1,166 |   | 215 |   |
| Total                                                                 |       | $                                                  | 14,045     |                                              | $          | 13,444 |   | $ | 36,924 |   | $ | 36,629 |   |
|                                                                  |       |                                               |       |                                              |       |   |   |   |   |
| Interest expense, net—Corporate                                  |       | $                                                  | 5,061      |                                              | $          | 5,196 |   | $ | 15,628 |   | $ | 15,711 |   |
|                                                                  |       |                                               |       |                                              |       |   |   |   |   |
| Depreciation and  amortization:                                       |       |                                               |       |                                              |       |   |   |   |   |
| Restaurant                                                            |       | $                                                  | 3,938      |                                              | $          | 4,058 |   | $ | 12,102 |   | $ | 12,519 |   |
| Foodservice                                                           |       | 705                                                |       | 800                                               |       | 2,161 |   | 2,427 |   |
| Franchise                                                             |       | 82                                                 |       | 37                                                |       | 220 |   | 117 |   |
| Corporate                                                             |       | 911                                                |       | 760                                               |       | 2,673 |   | 2,375 |   |
| Total                                                                 |       | $                                                  | 5,636      |                                              | $          | 5,655 |   | $ | 17,156 |   | $ | 17,438 |   |
|                                                                  |       |                                               |       |                                              |       |   |   |   |   |
| Other non-cash expense:                                               |       |                                               |       |                                              |       |   |   |   |   |
| Net periodic  pension cost                                            |       | $                                                  | 388        |                                              | $          | 72 |   | $ | 1,166 |   | $ | 215 |   |
| Write-downs of  property and equipment                                |       | 307                                                |       | —                                            |       | 522 |   | 289 |   |
| Total                                                                 |       | $                                                  | 695        |                                              | $          | 72 |   | $ | 1,688 |   | $ | 504 |   |
|                                                                  |       |                                               |       |                                              |       |   |   |   |   |
| Income from continuing  operations before provision for income taxes: |       |                                               |       |                                              |       |   |   |   |   |
| Restaurant                                                            |       | $                                                  | 6,855      |                                              | $          | 6,092 |   | $ | 17,455 |   | $ | 17,290 |   |
| Foodservice                                                           |       | 4,639                                              |       | 3,544                                             |       | 11,368 |   | 8,298 |   |
| Franchise                                                             |       | 2,878                                              |       | 2,699                                             |       | 8,047 |   | 7,731 |   |
| Corporate                                                             |       | (10,958                                            | )          | (9,634                                            | )          | (34,979 | ) | (32,043 | ) |
| (Loss) gain on  property and equipment, net                           |       | (761                                               | )          | (180                                              | )          | 561 |   | 1,700 |   |
| Total                                                                 |       | $                                                  | 2,653      |                                              | $          | 2,521 |   | $ | 2,452 |   | $ | 2,976 |   |

 

17

----

 

|                                                                        | ** ** | **For the Nine**    | ** ** | **For the Year**    | ** ** |
|------------------------------------------------------------------------|------------|-------------------------------|------------|-------------------------------|------------|
| ** **                                                             | ** ** | **Months Ended**         | ** ** | **Ended**                     | ** ** |
| ** **                                                             | ** ** | **October 1, 2006** | ** ** | **January 1, 2006** | ** ** |
| ** **                                                             | ** ** | **(in thousands)**       | ** ** |
| Capital  expenditures, including assets acquired under capital leases: |       |                          |       |                          |       |
| Restaurant                                                             |       | $                             | 11,711     |                          | $          | 14,674 |   |
| Foodservice                                                            |       | 1,344                         |       | 1,516                         |       |
| Corporate                                                              |       | 977                           |       | 968                           |       |
| Total                                                                  |       | $                             | 14,032     |                          | $          | 17,158 |   |

 

|               | ** ** | **October 1, 2006** | ** ** | **January 1, 2006** | ** ** |
|---------------|------------|-------------------------------|------------|-------------------------------|------------|
| ** **    | ** ** | **(in thousands)**       | ** ** |
| Total assets: |       |                          |       |                          |       |
| Restaurant    |       | $                             | 123,227    |                          | $          | 131,810 |   |
| Foodservice   |       | 39,474                        |       | 38,609                        |       |
| Franchise     |       | 10,291                        |       | 7,634                         |       |
| Corporate     |       | 50,231                        |       | 40,189                        |       |
| Total         |       | $                             | 223,223    |                          | $          | 218,242 |   |

 

**7. RELATEDPARTY TRANSACTIONS**

On May 22, 2006, The Ice Cream Company (“TICC”)purchased, at fair market value, certain assets and leasehold rights for threeexisting Company-operated restaurants located in Lancaster and York,Pennsylvania.  At closing, TICC was alsogranted an exclusive right to develop six new Friendly’s restaurants inLancaster, Chester and Montgomery counties, Pennsylvania by April 2012. Grossproceeds from this transaction were $1,725,000, of which $90,000 was forinitial franchise fees, $90,000 was for development fees and $1,545,000 was forthe assets and rights at the three existing restaurants. During the nine monthsended October 1, 2006, the Company recorded $90,000 as franchise fee revenueand recognized a gain of $1,146,000 related to the sale of the assets.

The owners of TICC are family members of the Company’sChairman of the Board of Directors. Prior to the closing of this transaction onMay 22, 2006, TICC operated three Friendly’s restaurants under franchiseagreements with Friendly’s Restaurants Franchise, Inc. (“FRFI”), a subsidiaryof Friendly’s.  The terms of thefranchise agreements with TICC are identical in all material respects to theterms generally offered to unrelated franchisees of FRFI in the ordinary courseof Friendly’s business.

TICC purchases from Friendly’s certain food productsused in the normal course of its franchise business.  For the nine months ended October 1, 2006 andOctober 2, 2005, TICC paid Friendly’s $2,379,000 and $1,621,000, respectively,for franchise royalty fees, marketing fees, food purchases and miscellaneousother products and services.

18

----

 

**8. DEBT**

Debt at October 1,2006 and January 1, 2006 consisted of the following (in thousands):

|                                                              | ** ** | **October 1,** | ** ** | **January 1,** | ** ** |
|--------------------------------------------------------------|------------|---------------------|------------|---------------------|------------|
| ** **                                                   | ** ** | **2006**            | ** ** | **2006**            | ** ** |
|                                                         |       |                |       |                |       |
|                                                         |       |                |       |                |       |
| New Senior  Notes, 8.375%, due June 15, 2012                 |       | $                   | 175,000    |                | $          | 175,000 |   |
| Revolving credit  loans, due June 30, 2010                   |       | —              |       | —              |       |
| Mortgage loans,  due October 2, 2006 through January 1, 2022 |       | 50,273              |       | 51,320              |       |
| Total debt                                                   |       | 225,273             |       | 226,320             |       |
| Less: current  portion                                       |       | (1,573              | )          | (1,426              | )          |
| Total long-term debt                                         |       | $                   | 223,700    |                | $          | 224,894 |   |

 

In December 2001, the Company completed a financialrestructuring plan which included the repayment of all amounts outstandingunder its then existing credit facility and the purchase of approximately$21,273,000 of its 10.5% senior notes with the proceeds from $55,000,000 inlong-term mortgage financing (the “Mortgage Financing”) and a $33,700,000 saleand leaseback transaction (the “Sale/Leaseback Financing”).

Interest on $10,000,000 of the original $55,000,000from the Mortgage Financing is variable (“Variable Mortgages”) and theremaining $45,000,000 of the original $55,000,000 from the Mortgage Financingbears interest at a fixed annual rate of 10.16% (“Fixed Mortgages”). The FixedMortgages have a maturity date of January 1, 2022 and are amortized over 20years.

On December 30, 2005, the Company completed arefinancing of the Variable Mortgages (the “Variable Refinancing”). Under theterms of the loan agreement for the Variable Refinancing, the Company borrowedan aggregate sum of $8,500,000 at a variable interest rate equal to the sum ofthe 90-day LIBOR rate in effect (5.37% at October 1, 2006) plus 4% on an annualbasis. Changes in the interest rate are calculated monthly and recognizedannually when the monthly payment amount is adjusted. Changes in the monthlypayment amounts owed due to interest rate changes are reflected in theprincipal balances, which are re-amortized over the remaining life of themortgages. The loans under the Variable Mortgages have a maturity date ofJanuary 1, 2020 and are being amortized over 14 years.

Pursuant to the terms of the Mortgage Financing, theCompany may sell properties securing its obligations provided that otherproperties are substituted in place of the sold properties.  The substituted properties must meet certainrequirements under the terms of the Mortgage Financing.  In August 2005, proceeds of $415,000 and$2,650,000 were received in connection with the sale of two mortgagedproperties, of which $400,000 and $1,250,000 of such amounts was placed inescrow pending the inclusion of a substitute property.  As of January 1, 2006, these balances wereheld as collateral and were included in restricted cash on the accompanyingcondensed consolidated balance sheet as of January 1, 2006.  In connection with the Variable Refinancing,the mortgage on one of these properties was released and the remaining $400,000related to the sale of this property was released from escrow during the firstquarter of 2006.  A substitution propertyfor the second property was obtained during the second quarter of 2006 incompliance with the substitution agreement. On June 15, 2006, the remaining$1,250,000 was released from escrow.

19

----

 

In September 2005, the Company acquired additionalfinancing secured by its newly constructed Milford, MA restaurant (the “MilfordMortgage”). The financing provided for a real estate improvement and equipmentloan. The real estate improvement loan has a principal balance of $821,000 andis amortized over 15 years with a balloon payment due on October 1, 2010. Theequipment loan has a principal balance of $294,000 and is amortized over sevenyears with a balloon payment due on October 1, 2010. The interest rate on theloans is variable and is the sum of the 90-day LIBOR rate in effect (5.37% atOctober 1, 2006) plus 4% on an annual basis. Changes in the interest rate arecalculated monthly and recognized annually when the monthly payment amount isadjusted. Changes in the monthly payment amounts owed due to interest ratechanges are reflected in the principal balances, which are re-amortized overthe remaining life of the mortgages. The variable rate notes are subject toprepayment penalties during the first three years.

All mortgage financings are subject to annualcovenants, including various minimum fixed charge coverage ratios.  The Company was in compliance with thecovenants for the Variable Mortgages and the Fixed Mortgages as of January 1,2006.  As of January 1, 2006, the Companywas not in compliance with the fixed charge coverage ratio related to theMilford Mortgage. The Company obtained a waiver from the Milford Mortgagelender on March 7, 2006 waiving this covenant requirement for the year endedJanuary 1, 2006.  On April 5, 2006, anamendment was made to the Milford Mortgage changing the fixed charge coverageratio.  The amendment was effective as ofthe date of the Loan Agreement, September 30, 2005.

In 2003 and 2004, the Company purchased or redeemedall of its remaining outstanding 10.5% senior notes in a series oftransactions. In February 2004, the Company announced a cash tender offer andconsent solicitation for $176,000,000 of its 10.5% senior notes which was financedwith the proceeds from a $175,000,000 private offering of new 8.375% seniornotes (the “Senior Notes”), available cash and its Credit Facility. In March2004, $127,357,000 of aggregate principal amount of the 10.5% senior notes waspurchased at the tender offer and consent solicitation price of 104% of theprincipal amount and $476,000 of aggregate principal amount of 10.5% seniornotes were purchased at the tender offer price of 102% of the principal amount.In April 2004, the remaining $48,144,000 of the 10.5% senior notes was redeemedin accordance with the 10.5% senior notes indenture at 103.5% of the principalamount.

The $175,000,000 of Senior Notes issued in March 2004are unsecured senior obligations of FICC, guaranteed on an unsecured senior basisby FICC’s Friendly’s Restaurants Franchise, Inc. subsidiary, but areeffectively subordinated to all secured indebtedness of FICC, including theindebtedness incurred under the Company’s Credit Facility. The Senior Notesmature on June 15, 2012. Interest on the Senior Notes is payable at 8.375% perannum semi-annually on June 15 and December 15 of each year.  The Senior Notes are redeemable, in whole orin part, at any time on or after June 15, 2008 at FICC’s option at redemptionprices from 104.188% to 100.00%, based on the redemption date.  In addition, at any time prior to June 15,2007, FICC may redeem, subject to certain conditions, up to 35% of theaggregate principal amount of the Senior Notes with the proceeds of one or morequalified equity offerings, as defined, at a redemption price of 108.375% ofthe principal amount, plus accrued interest.

20

----

 

The Company has a $35,000,000 Credit Facility which isavailable for borrowings to provide working capital, for issuances of lettersof credit and for other corporate needs. As of October 1, 2006 and January 1,2006, total letters of credit outstanding were $15,974,000. During 2006 and2005, there were no drawings against the letters of credit.  The revolving credit loans bear interest atthe Company’s option at either (a) the base rate plus the applicablemargin as in effect from time to time (the “Base Rate”) (10.25% at October 1,2006) or (b) the Eurodollar rate plus the applicable margin as in effectfrom time to time (the “Eurodollar Rate”) (9.32% at October 1, 2006). As ofOctober 1, 2006 and January 1, 2006, there were no revolving credit loansoutstanding. As of October 1, 2006 and January 1, 2006, $19,026,000 wasavailable for borrowing.

The Credit Facility has an annual “clean-up” provisionwhich obligates the Company to repay in full any and all outstanding revolvingcredit loans for a period of not less than 15 consecutive days during theperiod beginning on or after May 1 and ending on or before June 15 (or the nextbusiness day, if, in any year, June 15 is not a business day) of each calendaryear, such that immediately following the date of such repayment, the amount ofall outstanding revolving credit loans shall be zero.  The Credit Facility includes certainrestrictive covenants including limitations on indebtedness, restrictedpayments such as dividends and stock repurchases, liens, mergers, investmentsand sales of assets and of subsidiary stock. Additionally, the Credit Facilitylimits the amount which the Company may spend on capital expenditures,restricts the use of proceeds, as defined, from asset sales and requires thatthe Company comply with certain financial covenants. On March 15, 2006, theCompany amended and restated the Credit Facility as of December 30, 2005 to,among other things, (i) revise certain financial covenants (including leverage, interest coverage, minimum EBITDAand the deletion of the tangible net worth covenant) beginning with thefourth quarter of 2005 and extending through the Credit Facility maturity dateof June 30, 2007 and (ii) permit certain transactions to be excluded from theannual capital expenditures limit.  TheCompany was in compliance with the covenants in the Credit Facility as ofOctober 1, 2006.

On August 1, 2006, the Company further amended its $35,000,000Credit Facility to, among other things, (i) extend the maturity date from June30, 2007 to June 30, 2010, (ii) eliminate the interest coverage requirement and(iii) reduce by .50% to .75% the applicable margin rates at which the revolvingcredit loans bear interest to a range of 3.00% to 4.00% (depending on theleverage ratio).

The Company incurred approximately $473,000 of costsassociated with this amendment to the $35,000,000 Credit Facility which will bedeferred and amortized over the life of the amended $35,000,000 CreditFacility.

21

----

 

**9. INSURANCERECOVERY**

On February 25, 2003, S. Prestley Blake (“Blake”),holder of approximately 10% of the Company’s outstanding common stock, suedFriendly’s and its Chairman in a purported derivative action in HampdenSuperior Court, Massachusetts. The suit alleges breach of fiduciary duty andmisappropriation of corporate assets in that Friendly’s paid certain expensesrelating to a corporate jet and the Chairman’s use of that jet and use of anoffice in Illinois.  The suit seeks torequire the Chairman to reimburse Friendly’s and for Friendly’s to pay Blake’sattorneys’ fees.  Friendly’s and itsChairman have denied Blake’s allegations and are vigorously defending thelawsuit.

On June 27, 2005, Mr. Blake sent a demand letter tothe Company’s Board of Directors demanding that its Board of Directors addresshis concerns and beliefs that are subject to the litigation filed on February25, 2003. On July 14, 2005, the Company’s Board of Directors formed a speciallitigation committee consisting solely of independent directors (the “Committee”)to investigate the concerns and beliefs raised in Blake’s demand letter datedJune 27, 2005.  The Committee issued itsreport on October 24, 2005 and a supplemental report on November 30, 2005.  Based on its findings, the Committee filed aMotion to Dismiss the claims made by Mr. Blake. On May 24, 2006, the Court denied the Committee’s motion to dismiss andallowed the joinder, as defendants, of current Board members Steven L. Ezzes,Michael J. Daly and Burton J. Manning, and former Board member Charles A.Ledsinger, Jr., and The Restaurant Company, The Restaurant Holding Corporationand TRC Realty, LLC.

On July 26, 2006, director defendants Michael J. Daly,Steven L. Ezzes, and Burton J. Manning, and former director defendant CharlesA. Ledsinger, Jr., filed motions to dismiss the claims brought against them forfailure to state a claim on the grounds that both the exculpatory provision inthe Company’s Restated Articles of Organization and the business judgment rulebarred plaintiff’s claims.  The Courtheard oral argument on these defendants’ motions on September 20, 2006 and tookthe motions under advisement.  The Courthas set a deadline for fact discovery of May 31, 2007, with a trial, ifnecessary, to begin on January 7, 2008.

On January 27, 2006, the Company initiated litigationagainst its insurance carrier to recoup defense expenses related to the Blakelitigation.  On September 27, 2006, theCompany entered into a settlement agreement with its insurance carrier whichprovides, in part, for 1) a lump sum payment to settle past disputed expensesand 2) clarification of coverage of future defense expenses related to thismatter.

During the quarter ended October 1, 2006, pursuant tothe settlement agreement with the Company’s insurance carrier, the Companyreceived insurance recoveries of $550,000 related to costs and expensesincurred related to the above matter. Additionally, the Company has recorded a receivable for insurancerecoveries to the extent defense expenses have been incurred and realization ofa related insurance claim is probable. As of October 1, 2006, the receivablefor insurance recoveries totaled $646,000.

22

----

 

**10. SUPPLEMENTALCONDENSED CONSOLIDATING FINANCIAL INFORMATION**

FICC’s obligation related to the Senior Notes isguaranteed fully and unconditionally by one of FICC’s wholly ownedsubsidiaries. There are no restrictions on FICC’s ability to obtain dividendsor other distributions of funds from this subsidiary, except those imposed byapplicable law. The following supplemental financial information sets forth, ona condensed consolidating basis, balance sheets, statements of operations andstatements of cash flows for FICC (the “Parent Company”), Friendly’s RestaurantsFranchise, Inc. (the “Guarantor Subsidiary”) and Friendly’s International,Inc., Restaurant Insurance Corporation, Friendly’s Realty I, LLC, Friendly’sRealty II, LLC and Friendly’s Realty III, LLC (collectively, the “Non-guarantorSubsidiaries”). All of the limited liability companies’ (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 October 1, 2006 and January 1, 2006 and for the three and nine monthsended October 1, 2006 and October 2, 2005 were not presented because managementhas determined that such information is not material to investors.

Investments in subsidiaries are accounted for by theParent Company on the equity method for purposes of the supplementalconsolidating presentation. Earnings of the subsidiaries are, therefore,reflected in the Parent Company’s investment accounts and earnings. Theprincipal elimination entries eliminate the Parent Company’s investments insubsidiaries and intercompany balances and transactions.

23

----

**SupplementalCondensed Consolidating Balance SheetAs of October 1, 2006**(Inthousands)
| ** **                                                | ** ** | ** **  | ** ** | ** **     | ** ** | **Non-**         | ** ** | ** **       | ** ** | ** **       | ** ** |
|-----------------------------------------------------------|------------|-------------|------------|----------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                | ** ** | **Parent**  | ** ** | **Guarantor**  | ** ** | **guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                | ** ** | **Company** | ** ** | **Subsidiary** | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                      |       |        |       |           |       |             |       |             |       |             |       |
| Assets                                                    |       |        |       |           |       |             |       |             |       |             |       |
|                                                      |       |        |       |           |       |             |       |             |       |             |       |
| Current assets:                                           |       |        |       |           |       |             |       |             |       |             |       |
| Cash and cash  equivalents                                |       | $           | 24,528     |           | $          | 1,196            |       | $                | 2,306      |             | $          | — |   | $ | 28,030 |   |
| Restricted cash                                           |       | —      |       | —         |       | 213              |       | —           |       | 213              |       |
| Accounts  receivable, net                                 |       | 14,648      |       | 1,977          |       | —           |       | —           |       | 16,625           |       |
| Inventories                                               |       | 15,983      |       | —         |       | —           |       | —           |       | 15,983           |       |
| Assets held for  sale                                     |       | 1,119       |       | —         |       | —           |       | —           |       | 1,119            |       |
| Deferred income  taxes                                    |       | —      |       | 26             |       | —           |       | (26              | )          | —           |       |
| Prepaid expenses  and other current assets                |       | 6,298       |       | 2,278          |       | 7,785            |       | (12,185          | )          | 4,176            |       |
| Total current  assets                                     |       | 62,576      |       | 5,477          |       | 10,304           |       | (12,211          | )          | 66,146           |       |
| Deferred income taxes                                     |       | —      |       | 381            |       | —           |       | (381             | )          | —           |       |
| Property and equipment,  net                              |       | 95,232      |       | —         |       | 41,742           |       | —           |       | 136,974          |       |
| Intangibles and  deferred costs, net                      |       | 16,104      |       | —         |       | 2,082            |       | —           |       | 18,186           |       |
| Investments in  subsidiaries                              |       | 2,333       |       | —         |       | —           |       | (2,333           | )          | —           |       |
| Other assets                                              |       | 1,002       |       | 3,252          |       | 915              |       | (3,252           | )          | 1,917            |       |
|                                                      |       |        |       |           |       |             |       |             |       |             |       |
| Total assets                                              |       | $           | 177,247    |           | $          | 9,110            |       | $                | 55,043     |             | $          | (18,177 | ) | $ | 223,223 |   |
|                                                      |       |        |       |           |       |             |       |             |       |             |       |
| Liabilities and  Stockholders’ (Deficit) Equity      |       |        |       |           |       |             |       |             |       |             |       |
|                                                      |       |        |       |           |       |             |       |             |       |             |       |
| Current liabilities:                                      |       |        |       |           |       |             |       |             |       |             |       |
| Current  maturities of long-term obligations              |       | $           | 9,313      |           | $          | —           |       | $                | 1,507      |             | $          | (7,776 | ) | $ | 3,044 |   |
| Accounts payable                                          |       | 22,221      |       | —         |       | —           |       | —           |       | 22,221           |       |
| Deferred income  taxes                                    |       | 131         |       | —         |       | —           |       | (131             | )          | —           |       |
| Accrued expenses                                          |       | 43,891      |       | 4,507          |       | 1,281            |       | (4,186           | )          | 45,493           |       |
| Total current  liabilities                                |       | 75,556      |       | 4,507          |       | 2,788            |       | (12,093          | )          | 70,758           |       |
| Deferred income taxes                                     |       | 276         |       | —         |       | —           |       | (276             | )          | —           |       |
| Long-term obligations,  less current maturities           |       | 181,049     |       | —         |       | 47,703           |       | —           |       | 228,752          |       |
| Other long-term  liabilities                              |       | 56,964      |       | 1,067          |       | 5,755            |       | (3,475           | )          | 60,311           |       |
| Stockholders’ (deficit)  equity                      |       | (136,598    | )          | 3,536          |       | (1,203           | )          | (2,333           | )          | (136,598         | )          |
|                                                      |       |        |       |           |       |             |       |             |       |             |       |
| Total liabilities and stockholders’ (deficit) equity |       | $           | 177,247    |           | $          | 9,110            |       | $                | 55,043     |             | $          | (18,177 | ) | $ | 223,223 |   |

 

24

----

 

**SupplementalCondensed Consolidating Statement of OperationsFor the Three Months Ended October 1, 2006**(Inthousands)
| ** **                                                                                                             | ** ** | ** **  | ** ** | ** **     | ** ** | **Non-**         | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|-------------|------------|----------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                                                             | ** ** | **Parent**  | ** ** | **Guarantor**  | ** ** | **guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                                                                             | ** ** | **Company** | ** ** | **Subsidiary** | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Revenues                                                                                                               |       | $           | 138,783    |           | $          | 3,101            |       | $                | —     |             | $          | — |   | $ | 141,884 |   |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Costs and expenses:                                                                                                    |       |        |       |           |       |             |       |             |       |             |       |
| Cost of sales                                                                                                          |       | 53,221      |       | —         |       | —           |       | —           |       | 53,221           |       |
| Labor and  benefits                                                                                                    |       | 35,972      |       | —         |       | —           |       | —           |       | 35,972           |       |
| Operating  expenses and write-downs of property and equipment                                                          |       | 30,483      |       | —         |       | (1,641           | )          | —           |       | 28,842           |       |
| General and  administrative expenses                                                                                   |       | 9,220       |       | 1,154          |       | —           |       | —           |       | 10,374           |       |
| Depreciation and  amortization                                                                                         |       | 5,085       |       | —         |       | 551              |       | —           |       | 5,636            |       |
| Gain on franchise sales  of restaurant operations and properties                                                       |       | (80         | )          | —         |       | —           |       | —           |       | (80              | )          |
| Loss on disposals of  other property and equipment, net                                                                |       | 473         |       | —         |       | 61               |       | —           |       | 534              |       |
| Interest expense, net                                                                                                  |       | 3,974       |       | —         |       | 1,087            |       | —           |       | 5,061            |       |
| Other income                                                                                                           |       | (329        | )          | —         |       | —           |       | —           |       | (329             | )          |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Income (loss) before  benefit from (provision for) income taxes and equity in net income of  consolidated subsidiaries |       | 764         |       | 1,947          |       | (58              | )          | —           |       | 2,653            |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Benefit from (provision  for) income taxes                                                                             |       | 205         |       | (798           | )          | (57              | )          | —           |       | (650             | )          |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Income (loss) from  continuing operations                                                                              |       | 969         |       | 1,149          |       | (115             | )          | —           |       | 2,003            |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Loss from discontinued  operations                                                                                     |       | (32         | )          | —         |       | —           |       | —           |       | (32              | )          |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Income (loss) before  equity in net income of consolidated subsidiaries                                                |       | 937         |       | 1,149          |       | (115             | )          | —           |       | 1,971            |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Equity in net income of  consolidated subsidiaries                                                                     |       | 1,034       |       | —         |       | —           |       | (1,034           | )          | —           |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Net income (loss)                                                                                                      |       | $           | 1,971      |           | $          | 1,149            |       | $                | (115       | )                | $          | (1,034 | ) | $ | 1,971 |   |

 

25

----

 

**SupplementalCondensed Consolidating Statement of OperationsFor the Nine Months Ended October 1, 2006**(Inthousands)
| ** **                                                                                                             | ** ** | ** **  | ** ** | ** **     | ** ** | **Non-**         | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|-------------|------------|----------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                                                             | ** ** | **Parent**  | ** ** | **Guarantor**  | ** ** | **guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                                                                             | ** ** | **Company** | ** ** | **Subsidiary** | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| Revenues                                                                                                               |       | $           | 400,314    |           | $          | 8,775            |       | $                | —     |             | $          | — |   | $ | 409,089 |   |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Costs and expenses:                                                                                                    |       |        |       |           |       |             |       |             |       |             |       |
| Cost of sales                                                                                                          |       | 153,545     |       | —         |       | —           |       | —           |       | 153,545          |       |
| Labor and  benefits                                                                                                    |       | 108,927     |       | —         |       | —           |       | —           |       | 108,927          |       |
| Operating  expenses and write- downs of property and equipment                                                         |       | 84,787      |       | —         |       | (4,915           | )          | —           |       | 79,872           |       |
| General and  administrative expenses                                                                                   |       | 29,455      |       | 3,465          |       | —           |       | —           |       | 32,920           |       |
| Depreciation and  amortization                                                                                         |       | 15,515      |       | —         |       | 1,641            |       | —           |       | 17,156           |       |
| Gain on franchise sales  of restaurant operations and properties                                                       |       | (2,091      | )          | —         |       | —           |       | —           |       | (2,091           | )          |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Loss on disposals of  other property and equipment, net                                                                |       | 845         |       | —         |       | 164              |       | —           |       | 1,009            |       |
| Interest expense, net                                                                                                  |       | 12,375      |       | —         |       | 3,253            |       | —           |       | 15,628           |       |
| Other income                                                                                                           |       | (329        | )          | —         |       | —           |       | —           |       | (329             | )          |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| (Loss) income before  benefit from (provision for) income taxes and equity in net income of  consolidated subsidiaries |       | (2,715      | )          | 5,310          |       | (143             | )          | —           |       | 2,452            |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Benefit from (provision  for) income taxes                                                                             |       | 1,446       |       | (2,177         | )          | (169             | )          | —           |       | (900             | )          |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| (Loss) income from  continuing operations                                                                              |       | (1,269      | )          | 3,133          |       | (312             | )          | —           |       | 1,552            |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Income from  discontinued operations, net of income tax expense                                                        |       | 3,258       |       | —         |       | —           |       | —           |       | 3,258            |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Income (loss) before  equity in net income of consolidated subsidiaries                                                |       | 1,989       |       | 3,133          |       | (312             | )          | —           |       | 4,810            |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Equity in net income of  consolidated subsidiaries                                                                     |       | 2,821       |       | —         |       | —           |       | (2,821           | )          | —           |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Net income (loss)                                                                                                      |       | $           | 4,810      |           | $          | 3,133            |       | $                | (312       | )                | $          | (2,821 | ) | $ | 4,810 |   |

 

26

----

**SupplementalCondensed Consolidating Statement of Cash FlowsFor the Nine Months Ended October 1, 2006**(Inthousands)
| ** **                                                | ** ** | ** **  | ** ** | ** **     | ** ** | **Non-**         | ** ** | ** **       | ** ** | ** **       | ** ** |
|-----------------------------------------------------------|------------|-------------|------------|----------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                | ** ** | **Parent**  | ** ** | **Guarantor**  | ** ** | **guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                | ** ** | **Company** | ** ** | **Subsidiary** | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                      |       |        |       |           |       |             |       |             |       |             |       |
| Net cash provided by  operating activities                |       | $           | 17,745     |           | $          | 416              |       | $                | 3,287      |             | $          | (706 | ) | $ | 20,742 |   |
|                                                      |       |        |       |           |       |             |       |             |       |             |       |
| Cash flows from  investing activities:                    |       |        |       |           |       |             |       |             |       |             |       |
| Purchases of  property and equipment                      |       | (13,167     | )          | —         |       | (865             | )          | —           |       | (14,032          | )          |
| Proceeds from  sales of property and equipment            |       | 9,396       |       | —         |       | —           |       | —           |       | 9,396            |       |
| Return of  investment in subsidiary                       |       | 677         |       | —         |       | —           |       | (677             | )          | —           |       |
| Net cash used in  investing activities                    |       | (3,094      | )          | —         |       | (865             | )          | (677             | )          | (4,636           | )          |
|                                                      |       |        |       |           |       |             |       |             |       |             |       |
| Cash flows from  financing activities:                    |       |        |       |           |       |             |       |             |       |             |       |
| Proceeds from  borrowings under revolving credit facility |       | 8,000       |       | —         |       | —           |       | —           |       | 8,000            |       |
| Repayments of  obligations                                |       | (9,112      | )          | —         |       | (1,004           | )          | —           |       | (10,116          | )          |
| Payments of  deferred financing costs                     |       | (636        | )          | —         |       | —           |       | —           |       | (636             | )          |
| Stock options  exercised                                  |       | 79          |       | —         |       | —           |       | —           |       | 79               |       |
| Reinsurance  payments made from deposits                  |       | —      |       | —         |       | (706             | )          | 706              |       | —           |       |
| Dividends paid                                            |       | —      |       | —         |       | (677             | )          | 677              |       | —           |       |
| Net cash used in  financing activities                    |       | (1,669      | )          | —         |       | (2,387           | )          | 1,383            |       | (2,673           | )          |
|                                                      |       |        |       |           |       |             |       |             |       |             |       |
| Net increase in cash  and cash equivalents                |       | 12,982      |       | 416            |       | 35               |       | —           |       | 13,433           |       |
|                                                      |       |        |       |           |       |             |       |             |       |             |       |
| Cash and cash equivalents,  beginning of period           |       | 11,546      |       | 780            |       | 2,271            |       | —           |       | 14,597           |       |
|                                                      |       |        |       |           |       |             |       |             |       |             |       |
| Cash and cash  equivalents, end of period                 |       | $           | 24,528     |           | $          | 1,196            |       | $                | 2,306      |             | $          | — |   | $ | 28,030 |   |
|                                                      |       |        |       |           |       |             |       |             |       |             |       |
| Supplemental  disclosures:                                |       |        |       |           |       |             |       |             |       |             |       |
| Interest paid                                             |       | $           | 8,245      |           | $          | —           |       | $                | 3,210      |             | $          | — |   | $ | 11,455 |   |
| Income taxes  (refunded) paid                             |       | (3,078      | )          | 2,579          |       | 171              |       | —           |       | (328             | )          |
| Non-cash dividend paid  to parent                         |       | 5,000       |       | (5,000         | )          | —           |       | —           |       | —           |       |

 

27

----

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

 

28

----

 

**SupplementalCondensed Consolidating Statement of OperationsFor the Three Months Ended October 2, 2005**(Inthousands)
| ** **                                                                                                             | ** ** | ** **  | ** ** | ** **     | ** ** | **Non-**         | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|-------------|------------|----------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                                                             | ** ** | **Parent**  | ** ** | **Guarantor**  | ** ** | **guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                                                                             | ** ** | **Company** | ** ** | **Subsidiary** | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Revenues                                                                                                               |       | $           | 138,305    |           | $          | 2,836            |       | $                | —     |             | $          | — |   | $ | 141,141 |   |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Costs and expenses:                                                                                                    |       |        |       |           |       |             |       |             |       |             |       |
| Cost of sales                                                                                                          |       | 53,537      |       | —         |       | —           |       | —           |       | 53,537           |       |
| Labor and  benefits                                                                                                    |       | 37,260      |       | —         |       | —           |       | —           |       | 37,260           |       |
| Operating  expenses and write- downs of property and equipment                                                         |       | 30,271      |       | —         |       | (1,749           | )          | —           |       | 28,522           |       |
| General and  administrative expenses                                                                                   |       | 7,106       |       | 1,155          |       | 1                |       | —           |       | 8,262            |       |
| Depreciation and  amortization                                                                                         |       | 5,103       |       | —         |       | 552              |       | —           |       | 5,655            |       |
| Loss on franchise sales  of restaurant operations and properties                                                       |       | 7           |       | —         |       | —           |       | —           |       | 7                |       |
| Loss (gain) on  disposals of other property and equipment, net                                                         |       | 2,337       |       | —         |       | (2,156           | )          | —           |       | 181              |       |
| Interest expense, net                                                                                                  |       | 4,064       |       | —         |       | 1,132            |       | —           |       | 5,196            |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| (Loss) income before  benefit from (provision for) income taxes and equity in net income of consolidated  subsidiaries |       | (1,380      | )          | 1,681          |       | 2,220            |       | —           |       | 2,521            |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Benefit from (provision  for) income taxes                                                                             |       | 642         |       | (689           | )          | (54              | )          | —           |       | (101             | )          |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| (Loss) income from  continuing operations                                                                              |       | (738        | )          | 992            |       | 2,166            |       | —           |       | 2,420            |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Income from  discontinued operations, net of income tax expense                                                        |       | 987         |       | —         |       | —           |       | —           |       | 987              |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Income before equity in  net income of consolidated subsidiaries                                                       |       | 249         |       | 992            |       | 2,166            |       | —           |       | 3,407            |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Equity in net income of  consolidated subsidiaries                                                                     |       | 3,158       |       | —         |       | —           |       | (3,158           | )          | —           |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Net income                                                                                                             |       | $           | 3,407      |           | $          | 992              |       | $                | 2,166      |             | $          | (3,158 | ) | $ | 3,407 |   |

 

29

----

 

**SupplementalCondensed Consolidating Statement of OperationsFor the Nine Months Ended October 2, 2005**(Inthousands)
| ** **                                                                                                             | ** ** | ** **  | ** ** | ** **     | ** ** | **Non-**         | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|-------------|------------|----------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                                                             | ** ** | **Parent**  | ** ** | **Guarantor**  | ** ** | **guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                                                                             | ** ** | **Company** | ** ** | **Subsidiary** | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Revenues                                                                                                               |       | $           | 399,575    |           | $          | 8,322            |       | $                | —     |             | $          | — |   | $ | 407,897 |   |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Costs and expenses:                                                                                                    |       |        |       |           |       |             |       |             |       |             |       |
| Cost of sales                                                                                                          |       | 155,011     |       | —         |       | —           |       | —           |       | 155,011          |       |
| Labor and  benefits                                                                                                    |       | 110,820     |       | —         |       | —           |       | —           |       | 110,820          |       |
| Operating  expenses and write- downs of property and equipment                                                         |       | 84,947      |       | —         |       | (5,247           | )          | —           |       | 79,700           |       |
| General and  administrative expenses                                                                                   |       | 24,773      |       | 3,465          |       | 1                |       | —           |       | 28,239           |       |
| Depreciation and  amortization                                                                                         |       | 15,771      |       | —         |       | 1,667            |       | —           |       | 17,438           |       |
| Gain on franchise sales  of restaurant operations and properties                                                       |       | (2,521      | )          | —         |       | —           |       | —           |       | (2,521           | )          |
| Loss (gain) on  disposals of other property and equipment, net                                                         |       | 2,679       |       | —         |       | (2,156           | )          | —           |       | 523              |       |
| Interest expense, net                                                                                                  |       | 12,334      |       | —         |       | 3,377            |       | —           |       | 15,711           |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| (Loss) income before  benefit from (provision for) income taxes and equity in net income of  consolidated subsidiaries |       | (4,239      | )          | 4,857          |       | 2,358            |       | —           |       | 2,976            |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Benefit from (provision  for) income taxes                                                                             |       | 1,627       |       | (1,991         | )          | (161             | )          | —           |       | (525             | )          |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| (Loss) income from  continuing operations                                                                              |       | (2,612      | )          | 2,866          |       | 2,197            |       | —           |       | 2,451            |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Income from discontinued  operations, net of income tax expense                                                        |       | 487         |       | —         |       | —           |       | —           |       | 487              |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| (Loss) income before  equity in net income of consolidated subsidiaries                                                |       | (2,125      | )          | 2,866          |       | 2,197            |       | —           |       | 2,938            |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Equity in net income of  consolidated subsidiaries                                                                     |       | 5,063       |       | —         |       | —           |       | (5,063           | )          | —           |       |
|                                                                                                                   |       |        |       |           |       |             |       |             |       |             |       |
| Net income                                                                                                             |       | $           | 2,938      |           | $          | 2,866            |       | $                | 2,197      |             | $          | (5,063 | ) | $ | 2,938 |   |

 

30

----

 

**SupplementalCondensed Consolidating Statement of Cash FlowsFor the Nine Months Ended October 2, 2005**(Inthousands)
| ** **                                                | ** ** | ** **  | ** ** | ** **     | ** ** | **Non-**         | ** ** | ** **       | ** ** | ** **       | ** ** |
|-----------------------------------------------------------|------------|-------------|------------|----------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                | ** ** | **Parent**  | ** ** | **Guarantor**  | ** ** | **guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                | ** ** | **Company** | ** ** | **Subsidiary** | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                      |       |        |       |           |       |             |       |             |       |             |       |
| Net cash provided by  (used in) operating activities      |       | $           | 20,437     |           | $          | (190             | )          | $                | 676        |             | $          | (634 | ) | $ | 20,289 |   |
|                                                      |       |        |       |           |       |             |       |             |       |             |       |
| Cash flows from  investing activities:                    |       |        |       |           |       |             |       |             |       |             |       |
| Purchases of  property and equipment                      |       | (11,511     | )          | —         |       | —           |       | —           |       | (11,511          | )          |
| Proceeds from  sales of property and equipment            |       | 3,358       |       | —         |       | 2,872            |       | —           |       | 6,230            |       |
| Purchases of  marketable securities                       |       | (499        | )          | —         |       | —           |       | —           |       | (499             | )          |
| Proceeds from  sales of marketable securities             |       | 163         |       | —         |       | —           |       | —           |       | 163              |       |
| Return of  investment in subsidiary                       |       | 378         |       | —         |       | —           |       | (378             | )          | —           |       |
| Net cash (used in)  provided by investing activities      |       | (8,111      | )          | —         |       | 2,872            |       | (378             | )          | (5,617           | )          |
|                                                      |       |        |       |           |       |             |       |             |       |             |       |
| Cash flows from  financing activities:                    |       |        |       |           |       |             |       |             |       |             |       |
| Proceeds from  borrowings under revolving credit facility |       | 16,250      |       | —         |       | —           |       | —           |       | 16,250           |       |
| Proceeds from  issuance of mortgage                       |       | 1,115       |       | —         |       | —           |       | —           |       | 1,115            |       |
| Repayments of  obligations                                |       | (21,399     | )          | —         |       | (903             | )          | —           |       | (22,302          | )          |
| Payments of  deferred financing costs                     |       | (43         | )          | —         |       | —           |       | —           |       | (43              | )          |
| Stock options  exercised                                  |       | 1,037       |       | —         |       | —           |       | —           |       | 1,037            |       |
| Reinsurance  deposits received                            |       | —      |       | —         |       | 114              |       | (114             | )          | —           |       |
| Reinsurance  payments made from deposits                  |       | —      |       | —         |       | (748             | )          | 748              |       | —           |       |
| Dividends paid                                            |       | —      |       | —         |       | (378             | )          | 378              |       | —           |       |
| Net cash used in  financing activities                    |       | (3,040      | )          | —         |       | (1,915           | )          | 1,012            |       | (3,943           | )          |
|                                                      |       |        |       |           |       |             |       |             |       |             |       |
| Net increase (decrease)  in cash and cash equivalents     |       | 9,286       |       | (190           | )          | 1,633            |       | —           |       | 10,729           |       |
|                                                      |       |        |       |           |       |             |       |             |       |             |       |
| Cash and cash  equivalents, beginning of period           |       | 9,873       |       | 1,360          |       | 2,172            |       | —           |       | 13,405           |       |
|                                                      |       |        |       |           |       |             |       |             |       |             |       |
| Cash and cash  equivalents, end of period                 |       | $           | 19,159     |           | $          | 1,170            |       | $                | 3,805      |             | $          | — |   | $ | 24,134 |   |
|                                                      |       |        |       |           |       |             |       |             |       |             |       |
| Supplemental  disclosures:                                |       |        |       |           |       |             |       |             |       |             |       |
| Interest paid                                             |       | $           | 7,982      |           | $          | —           |       | $                | 3,396      |             | $          | — |   | $ | 11,378 |   |
| Income taxes  (refunded) paid                             |       | (2,057      | )          | 2,584          |       | 159              |       | —           |       | 686              |       |
| Capital lease  obligations terminated                     |       | 51          |       | —         |       | —           |       | —           |       | 51               |       |

 

31

----

** **

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

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

**ForwardLooking Statements**

Statementscontained herein that are not historical facts constitute “forward lookingstatements” as that term is defined in the Private Securities Litigation ReformAct of 1995. Words such as “believes,” “plans,” “anticipates,” “expects,” “will”and similar expressions are intended to identify forward lookingstatements.  Forward looking statements include, but are not limited to,statements relating to the sufficiency of our capital resources, changes incommodity prices, anticipated capital expenditures, costs and expenses oflitigation, including anticipated insurance recoveries relating to litigation,anticipated pension plan contributions, our plans with respect to restaurantopenings, closings, re-imagings and re-franchisings, our ability to find asuitable replacement chief executive officer and estimates and assumptions usedin the preparation of our financial statements.  All forward lookingstatements are subject to known and unknown risks, uncertainties and otherfactors which could cause actual results to differ materially from thoseanticipated. These factors include: our highly competitive businessenvironment; exposure to fluctuating commodity prices; risks associated withthe 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 and qualified employees;government regulations; high geographic concentration in the Northeast and itsattendant weather patterns; conditions needed to meet restaurant re-imaging andnew opening targets; risks and uncertainties arising out of accountingestimates and adjustments; our ability to service our debt and otherobligations; our ability to meet ongoing financial covenants contained in ourdebt instruments, loan agreements, leases and other long-term commitments; andcosts associated with improved service and other initiatives. Other factorsthat may cause actual results to differ from the forward looking statementscontained herein and that may affect our prospects in general are included inour other filings with the Securities and Exchange Commission. We are notobligated to update any forward looking statements, whether as a result of new information,future events or otherwise.

**Overview**

Our revenues are derived primarily from the operationof full-service restaurants, the distribution and sale of premium icecream desserts through retail locations and franchising. As of October 1, 2006,we operated 307 full-service restaurants, franchised 210 full-servicerestaurants and seven non-traditional units and manufactured a full line ofpremium ice cream dessert products distributed through more than 4,500supermarkets and other retail locations in 13 states.

Following is a summary of the Company-operated andfranchised units:

|                        | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **             | ** ** | **October 1,**                                | ** ** | **October 2,**                               | ** ** | **October 1,** | ** ** | **October 2,** | ** ** |
| ** **             | ** ** | **2006**                                           | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Company Units:         |       |                                               |       |                                              |       |   |   |   |   |
| Beginning of  period   |       | 309                                                |       | 332                                               |       | 314 |   | 347 |   |
| Openings               |       | —                                             |       | —                                            |       | 2 |   | 1 |   |
| Refranchised  closings |       | (2                                                 | )          | —                                            |       | (6 | ) | (10 | ) |
| Closings               |       | —                                             |       | (2                                                | )          | (3 | ) | (8 | ) |
| End of period          |       | 307                                                |       | 330                                               |       | 307 |   | 330 |   |
|                   |       |                                               |       |                                              |       |   |   |   |   |
| Franchised  Units:     |       |                                               |       |                                              |       |   |   |   |   |
| Beginning of  period   |       | 217                                                |       | 205                                               |       | 213 |   | 195 |   |
| Refranchised  openings |       | 2                                                  |       | —                                            |       | 6 |   | 10 |   |
| Openings               |       | 1                                                  |       | —                                            |       | 2 |   | 2 |   |
| Closings               |       | (3                                                 | )          | —                                            |       | (4 | ) | (2 | ) |
| End of period          |       | 217                                                |       | 205                                               |       | 217 |   | 205 |   |

 

32

----

 

***Discontinued Operations***

During December 2005, weclosed seven restaurants and committed to a plan to sell those seven restaurantsas well as four restaurants that were closed in 2004. During the nine monthsended October 1, 2006, we sold seven of these restaurants.  AtOctober 1, 2006, the remaining four properties and one additional propertyclosed during the nine months ended October 1, 2006 met the criteria for “heldfor sale” as defined in SFAS No. 144.

In accordance with SFAS No.144, the results of operations of the seven properties that were disposed ofduring the nine months ended October 1, 2006 and the 14 properties that weredisposed of during 2005 and the related net gain on the disposals, as well asthe results of operations of the properties held for sale at October 1, 2006,were reported separately as discontinued operations.

***Three Months Ended October 1, 2006 Compared With ThreeMonths Ended October 2, 2005***

*Revenues:*

*Totalrevenues -* Total revenues increased $0.8 million, or 0.5%, to$141.9 million for the three months ended October 1, 2006 from $141.1 millionfor the same quarter in 2005.

*Restaurantrevenues -* Restaurant revenues decreased $1.8 million, or1.7%, to $104.8 million for the three months ended October 1, 2006 from $106.6million for the same period in 2005. Comparable Company-operated restaurantrevenues during this period increased by $0.8 million, or 1.7% compared to the4.0% decline experienced in the third quarter of 2005 following higher pricesfor gasoline, especially during the three weeks in September 2005 posthurricane Katrina.  The opening of threenew restaurants over the past 15 months increased revenues by $1.0million.  These increases were more thanoffset by the closing of three locations and the re-franchising of 11 locationsover the past 15 months resulting in declines of $0.6 million and $3.0 million,respectively, in restaurant revenues in the third quarter of 2006 as comparedto the same period in 2005.

There were no newrestaurants opened during the third quarters of 2006 or 2005; a total of 36restaurants were remodeled during the 2006 quarter as compared to tworestaurants remodeled during the 2005 quarter.

*Foodservice revenues -*Foodservice revenues (product sales to franchisees and retail customers)increased $2.1 million, or 6.7%, to $32.9 million for the three months endedOctober 1, 2006 from $30.8 million for the three months ended October 2, 2005.Sales to foodservice retail supermarket customers increased $0.9 million in thethree months ended October 1, 2006 compared to the same period in 2005. Casevolume was up 14.4% during the three month period ended October 1, 2006 fromthe same quarter in 2005 primarily driven by increased promotional activity inkey New England accounts and the continued development and growth of our retailcake business.  An increase inpromotional trade spending and sales allowances of 5.0% of sales during thequarter partially offset the increase in revenues resulting from the increasedvolume.  Franchised restaurant productrevenue increased by $1.2 million. Revenues from product sales to franchiseesincreased due to the additional number of operating franchised restaurants, 217at the end of the third quarter of 2006 compared to 205 at the end of the thirdquarter of 2005; however, this was partially offset by lower product shipmentsresulting from a 1.7% reduction in comparable franchised restaurant revenuesduring the quarter.

*Franchiserevenues -* Franchise revenues increased $0.4 million, or11.8%, to $4.2 million for the three months ended October 1, 2006 compared to$3.8 million for the same period in 2005.

Royalties of $3.0 million during the third quarter of2006 increased by $0.1 million compared to the same period in 2005. Totalroyalties increased due to the opening of six new franchised restaurants andthe re-franchising of 11 restaurants during the last 15 months, but were partiallyoffset by the closing of five under-performing locations during the same periodand a 1.7% reduction in comparable franchised restaurant revenues which wasexperienced during the third quarter of 2006.

33

----

 

Initial franchise fees of $0.1 million increased by$0.1 million for the three months ended October 1, 2006 when compared to thesame period in 2005, resulting from the refranchising of two Company-operatedlocations and one new location opening during the quarter ended October 1,2006, against no refranchised or new location openings during the quarter endedOctober 2, 2005.

Rental income for leased and subleased franchiselocations increased by $0.2 million to a total of $1.1 million for the threemonths ended October 1, 2006 from the same period in 2005, due to an increasein the number of operating franchised restaurants.

*Cost of sales:*

Cost of sales decreased $0.3 million, or 0.6%, to$53.2 million for the three months ended October 1, 2006 from $53.5 million forthe same period in 2005. Cost of sales as a percentage of total revenues was37.5% and 37.9% for the three months ended October 1, 2006 and October 2, 2005,respectively. This improvement resulted from a combination of lower cost ofsales within the restaurant segment of 1.1% and lower cost of sales within thefoodservice segment of 0.9%, which was partially offset due to a slightlyunfavorable shift in sales mix away from Company restaurant revenues (whichcarried a lower cost of sales percentage of 26.2%) to foodservice revenues(which carried a higher cost of sales percentage of 78.5%) during the thirdquarter of 2006. Company restaurant revenues declined as a percentage of totalrevenue from 75.5% in the third quarter of 2005 to 73.9% in the third quarterof 2006, while foodservice revenues increased as a percentage of total revenuesfrom 21.8% in the third quarter of 2005 to 23.2% in the third quarter of 2006.

Restaurantcost of sales as a percentage of restaurant revenues decreased to 26.2% in thethird quarter of 2006 from 27.3% in the third quarter of 2005. This improvementwas due to menu price increases of approximately 3.9% and productre-formulations, as overall prices for food commodities were generally flatagainst the prior year quarter.  Decreasesin commodity prices for certain meat, poultry, fish and dairy products(primarily cream) were offset by increases in commodity prices for certainother food product categories, such as frozen foods (french fries) andbeverages.

Foodservice cost of sales as a percentage offoodservice revenues decreased to 78.5% in the third quarter of 2006 from 79.4%in the third quarter of 2005. This improvement is primarily a result of lowercream costs in the third quarter of 2006 compared to the same period in 2005.

Thecost of cream, the principal ingredient used in making ice cream, affects costof sales as a percentage of total revenues, especially in our foodserviceretail business. Cream is priced directly off of AA butter prices quoted on theChicago Mercantile Exchange.  As anexample, a $0.10 increase in the cost of a pound of AA butter adversely affectsour annual cost of sales by approximately $0.9 million.  This adverse impact may be offset by priceincreases or other factors. However, no assurance can be given that we will beable to offset any cost increases in the future and future increases in creamprices could have a material adverse effect on our results of operations. Tominimize risk, alternative supply sources continue to be pursued.

The overall cost of cream was approximately $1.4 millionlower in the three month period ended October 1, 2006 (weighted average priceof $1.18 per pound) when compared to the same period in 2005 (weighted averageprice of $1.62 per pound); additionally, market gains on cash-settled butterfutures contracts were $0.1 million greater than the losses experienced onbutter future contracts during the third quarter of 2005.  Approximately 70% of this $1.5 million netcost of sales benefit in the third quarter, or approximately $1.0 million, wasreported within our foodservice segment.

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

Forthe remainder of 2006, we expect that cream prices will be lower than theprices experienced for the same period in 2005 due to the wide spread in thenearby futures market compared to the actual prices of late last year.

34

----

 

OnSeptember 19, 2005, the Chicago Mercantile Exchange launched the firstelectronically traded, cash-settled butter futures contract.  This newfutures contract is designed to meet the needs of food and dairy companies thathave exposure to butterfat price risk but do not want to expose themselves tothe possibility of being compelled to take physical delivery of butter. The size of the contract is 20,000 pounds of AA butter, versus thetraditional butter futures contract, which is 40,000 pounds. The contract is cash settled based upon the USDA monthly weighted averageprice for butter in the United States.  With this new type of futurescontract, there is no risk of delivery of butter; therefore, it offers us theability to hedge the price risk of cream (on a butter basis) without having totake delivery of commodity butter.  We have evaluated this new hedginginstrument and believe it is an attractive way to hedge the price risk relatedto cream. At October 1, 2006, we held 56 contracts spread over the remainingmonths of 2006. These contracts correspond to approximately 20% of ouranticipated cream purchases for the remainder of the year. Additionally, weheld 26 contracts spanning the period of January 2007 to June 2007, whichprovide approximately 13% coverage for that time period’s manufacturingrequirements.

*Labor and benefits:*

Labor and benefits, which were only reported withinour restaurant segment, decreased $1.3 million, or 3.5%, to $36.0 million forthe three months ended October 1, 2006 from $37.3 million for the three monthsended October 2, 2005. As a percentage of total revenues, labor and benefitsdecreased to 25.4% in the third quarter of 2006 from 26.4% in the third quarterof 2005. This reduction was primarily due to the shift in sales mix away fromCompany restaurant revenues to foodservice revenues and to a decrease in laborand benefits as a percentage of Company restaurant revenue to 34.3% in thethird quarter of 2006 as compared to 35.0% in the third quarter of 2005.

Labor decreased by 0.7% of Company restaurant revenues,primarily related to menu price increases of 3.9%, which offset anapproximately 1.7% increase in average hourly rates of crew level employees andan increase in general manager compensation of 6.5% due to higher bonusesrealized from the positive comparable Company restaurant revenues achievedduring the quarter.  Fringe benefitsdecreased by 0.1% of Company restaurant revenues, due mostly to a slightreduction in group insurance related claims.

*Operating expenses:*

Operating expensesremained flat at $28.5 million for the three months ended October 1, 2006 andOctober 2, 2005. Operating expenses as a percentage of total revenues were20.1% and 20.2% in the 2006 and 2005 periods, respectively. A significantportion of these expenses ($27.3 million in both 2006 and 2005) were reportedwithin our restaurant segment. In the third quarter of 2006, these costsconsisted of $4.1 million in supplies, $5.3 million in utilities, $3.6 millionin maintenance and cleaning, $5.3 million in advertising, $5.4 million inoccupancy and $3.6 million in other restaurant expenses. A decrease of $0.4million in advertising costs during the third quarter of 2006 offset a $0.4million increase in utilities.

*General and administrative expenses:*

General and administrative expenses increased $2.1million, or 25.6%, to $10.4 million for the three months ended October 1, 2006from $8.3 million for the three months ended October 2, 2005. General andadministrative expenses as a percentage of total revenues increased to 7.3% in the2006 period from 5.9% in the 2005 period. The $2.1 million increase isprimarily the result of increases in bonus ($1.9 million) as the majority ofbonus expense was reversed in the 2005 quarter as a result of our shortfall toplan, severance costs ($0.6 million), employment agency fees ($0.2 million),pension costs ($0.1 million) and stock compensation expense ($0.1million).  These increases were partiallyoffset by reduced legal fees ($0.3 million) and lower other professionalservices ($0.4 million).

EffectiveSeptember 28, 2006, John Cutter resigned as our President and Chief ExecutiveOfficer to pursue other interests. We have recorded estimated separation costsof $0.6 million associated with his resignation.  These separation costs account for the majorityof the severance costs above.

35

----

 

Thedecrease in legal fees was primarily due to insurance recoveries receivedpursuant to a settlement agreement with our insurance company inconnection with costs and expenses we have incurred in the defense of theongoing shareholder derivative lawsuit brought by S. Prestley Blake against usand certain of our directors.  Pursuantto the settlement agreement, during the quarter ended October 1, 2006, wereceived insurance recoveries of $0.5 million for costs and expenses incurredand we recorded a receivable in the amount of $0.6 million for expectedadditional insurance recoveries. Although we have received certain insurance recoveries and may receiveadditional recoveries in the future, we expect to continue to incur additionallegal fees in the defense of this lawsuit.

*Stock-based compensation expense:*

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

Duringthe three months ended October 1, 2006, we recognized $0.1 million of totalstock-based compensation expense as a result of the adoption of SFAS No. 123R,which was included in general and administrative expenses.  We expect to recognize an additional $0.1million of stock compensation expense during the remainder of 2006 related tothe awards outstanding at October 1, 2006.

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

Asof October 1, 2006, there was $0.9 million of total unrecognized compensationcost related to unvested share-based awards. That cost is expected to berecognized over a weighted-average period of 2.2 years.

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

*Write-downs of property and equipment:*

Duringthe three months ended October 1, 2006, we determined that the carrying valueof one restaurant property exceeded the estimated fair value less costs to selland the carrying value was reduced by $0.3 million accordingly.  There were no such write-downs during thequarter ended October 2, 2005.

*Depreciation and amortization:*

Depreciationand amortization was $5.6 million and $5.7 million for the three months endedOctober 1, 2006 and October 2, 2005, respectively. Depreciation andamortization as a percentage of total revenues was 4.0% in both the 2006 and2005 quarters.

*(Gain) loss on franchise sales of restaurantoperations and properties:*

Duringthe three months ended October 1, 2006, we recognized a gain of $0.1 millionassociated with the sale of certain equipment assets, lease and sublease rightsand franchise rights in one existing Company-operated restaurant located inMetuchen, New Jersey.

36

----

 

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

The loss on disposals of other property and equipment,net was $0.5 million and $0.2 million for the three months ended October 1,2006 and October 2, 2005, respectively. The table below identifies the components of the loss on disposals ofother property and equipment, net as shown on the accompanying condensedconsolidated statements of operations (in thousands):

|                                                         | ** ** | **For the Three Months Ended** | ** ** |
|---------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                              | ** ** | **October 1,**                                | ** ** | **October 2,** | ** ** |
| ** **                                              | ** ** | **2006**                                           | ** ** | **2005** | ** ** |
| Restaurant  equipment assets retired due to remodeling  |       | $                                                  | 438        |   | $ | — |   |
| Restaurant  equipment assets retired due to replacement |       | 80                                                 |       | 51 |   |
| Gain due to  restaurant flood                           |       | (5                                                 | )          | — |   |
| All other                                               |       | 21                                                 |       | 130 |   |
| Loss on disposals of  other property and equipment, net |       | $                                                  | 534        |   | $ | 181 |   |

 

*Interest expense, net:*

Interest expense, net of capitalized interest andinterest income, was $5.1 million and $5.2 million for the three months endedOctober 1, 2006 and October 2, 2005, respectively. The decrease in interestexpense in the 2006 period compared to the same period in 2005 was primarilydue to increased interest income as a result of increased cash and lowerinterest rates on our mortgage financing.

*Otherincome:*

Duringthe three months ended October 1, 2006, we received $0.1 million in settlementof a title insurance class action lawsuit in which we were a class member.  Additionally, we received confirmation of a$0.2 million settlement related to a Mastercard/Visa class action lawsuit inwhich we were a class member.

*Provisionfor income taxes:*

The provision for incometaxes was $0.7 million for the three months ended October 1, 2006. As a resultof our intent to continue recording a full valuation allowance on tax benefitsuntil we can sustain an appropriate level of profitability, the provision wasbased on an estimate of our current taxes payable through the third quarter of2006. The provision for income taxes was $0.1 million, an effective tax rate of4.0%, for the three months ended October 2, 2005.

*Income from continuing operations:*

Income from continuing operations was $2.0 million and$2.4 million for the three months ended October 1, 2006 and October 2, 2005,respectively, for the reasons discussed above.

37

----

* *

*(Loss)income from discontinued operations:*

In accordance with SFAS No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets,” the results of operations of acomponent of an entity that either has been disposed of or is classified asheld for sale and any related gain (loss) on the sales are reported indiscontinued operations if both of the following conditions are met:(a) the operations and cash flows of the component have been (or will be)eliminated from the ongoing operations of the entity as a result of thedisposal transaction and (b) the entity will not have any significantcontinuing involvement in the operations of the component after the disposaltransaction.

Reported in discontinued operations were the resultsof operations of the seven propertiesthat were disposed of during the nine months ended October 1, 2006, the 14properties disposed of during 2005 and the related net gain on disposals, aswell as the results of operations of the properties held for sale at October 1,2006.  For the quarters ended October 1,2006 and October 2, 2005, this consisted of the following (inthousands):

|                                              | ** ** | **For the Three Months Ended** | ** ** |
|----------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                   | ** ** | **October 1,**                                | ** ** | **October 2,** | ** ** |
| ** **                                   | ** ** | **2006**                                           | ** ** | **2005** | ** ** |
| Net sales                                    |       | $                                                  | —     |   | $ | 2,416 |   |
|                                         |       |                                               |       |   |   |
| Operating loss                               |       | (43                                                | )          | (280 | ) |
| Gain on disposals of  property and equipment |       | 11                                                 |       | 1,952 |   |
| Income tax expense                           |       | —                                             |       | (685 | ) |
| (Loss) income from discontinued operations   |       | $                                                  | (32        | ) | $ | 987 |   |

 

***NineMonths Ended October 1, 2006 Compared With Nine Months Ended October 2, 2005***

*Revenues:*

*Totalrevenues -* Total revenues increased $1.2 million, or 0.3%, to$409.1 million for the nine months ended October 1, 2006 from $407.9 millionfor the same period in 2005.

*Restaurantrevenues -* Restaurant revenues decreased $3.8 million, or1.2%, to $305.4 million for the nine months ended October 1, 2006 from $309.2million for the same period in 2005. Comparable Company-operated restaurantrevenues during this period increased by $2.9 million, or 1.4%.  Increases occurred in most dayparts, with thelargest occurring during the dinner and afternoon snack periods.  Operating days lost due to weather closingswere lower in 2006 when compared to 2005 as most markets in New Englandrecorded higher than normal snowfall during the first quarter of 2005.  Additionally, the opening of four newrestaurants over the past 21 months increased revenues by $3.5 million.  These increases were more than offset by theclosing of three locations and the re-franchising of 14 locations over the past18 months resulting in declines of $1.5 million and $8.7 million, respectively,in restaurant revenues in the nine months ended October 1, 2006 as compared tothe same period in 2005.

There were two newrestaurants opened during the nine months ended October 1, 2006 compared to onenew restaurant opened during the same period in 2005. There were 59 and ninerestaurants remodeled during the 2006 period and the 2005 period, respectively.

38

----

 

*Foodservicerevenues—*Foodservice revenues (product sales to franchiseesand retail customers) increased $4.1 million, or 4.6%, to $91.9 million for thenine months ended October 1, 2006 from $87.8 million for the nine months endedOctober 2, 2005. Sales to foodservice retail supermarket customers increased$1.5 million in the nine months ended October 1, 2006 compared to the sameperiod in 2005. While case volume was up 6.2% primarily driven by increasedpromotional activity in key New England accounts and the continued developmentand growth of our retail cake business, higher promotional trade spending andsales allowances of 2.5% of sales during the period slightly offset the revenueincrease resulting from the volume growth. Franchised restaurant product revenue increased $2.6 million. Revenuesfrom product sales to franchisees increased due to the additional number ofoperating franchised restaurants, 217 at the end of the nine months endedOctober 2, 2006 compared to 205 at the end of the nine months ended October 1,2005; however, this increase in revenues was partially offset by lower productcase shipments resulting from a 1.7% reduction in comparable franchisedrestaurant revenues during the first nine months of 2006 compared to the sameperiod in 2005.

*Franchiserevenues—* Franchise revenues increased $0.9 million, or 8.7%,to $11.8 million for the nine months ended October 1, 2006 compared to $10.9million for the same period in 2005.

Royalties of $8.5 million increased $0.5 million forthe nine months ended October 1, 2006 as compared to the same period in 2005due primarily to the opening of eight new franchise restaurants and 14re-franchised restaurants during the last 18 months. The closing of sixunder-performing locations during the same period had little impact.  This increase in royalties was partiallyoffset, however, by a 1.7% reduction in comparable franchised restaurantrevenues which was experienced during the nine months ended October 1, 2006,compared to the 1.4% increase in comparable franchised restaurant revenuesexperienced in the nine months ended October 2, 2005.

Initial franchise fees of $0.3 million increased $0.1million during the nine months ended October 1, 2006 when compared to the sameperiod in 2005, resulting from the re- franchising of six Company-operatedlocations, including three to The Ice Cream Company (“TICC”) and two newlocation openings during the nine months ended October 1, 2006, against therefranchising of four Company-operated locations and two new location openingsduring the nine months ended October 2, 2005.

On May 22, 2006, TICCpurchased, at fair market value, certain assets and leasehold rights for threeexisting Company-operated restaurants located in Lancaster and York,Pennsylvania.  At closing, TICC was alsogranted an exclusive right to develop six new Friendly’s restaurants inLancaster, Chester and Montgomery counties, Pennsylvania by April 2012. Grossproceeds from this transaction were $1.7 million, of which $0.1 million was forinitial franchise fees, $0.1 million was for development fees and $1.5 millionwas for the assets and rights at the three existing restaurants. During thenine months ended October 1, 2006, the Company recorded $0.1 million asfranchise fee revenue.

The owners of TICC are family members of the Company’sChairman of the Board of Directors. Prior to the closing of this transaction onMay 22, 2006, TICC operated three Friendly’s restaurants under franchiseagreements with Friendly’s Restaurants Franchise, Inc. (“FRFI”), a subsidiaryof Friendly’s.  The terms of thefranchise agreements with TICC are identical in all material respects to theterms generally offered to unrelated franchisees of FRFI in the ordinary courseof Friendly’s business.

Rental income for leased and subleased franchiselocations increased $0.5 million, to a total of $3.0 million, for the nine monthsended October 1, 2006 primarily due an increase in the number of operatingfranchised restaurants.

39

----

 

*Cost of sales:*

Cost of sales decreased $1.5 million, or 0.9%, to$153.5 million for the nine months ended October 1, 2006 from $155.0 millionfor the same period in 2005. Cost of sales as a percentage of total revenueswas 37.5% and 38.0% for the nine months ended October 1, 2006 and October 2,2005, respectively. This improvement resulted from a combination of a reductionof cost of sales within the restaurant segment of 0.8% and a reduction of costof sales within the foodservice segment of 1.6%, which was partially offset dueto a slightly unfavorable shift in sales mix away from Company restaurantrevenues (which carried a lower cost of sales percentage of 26.3%) tofoodservice revenues (which carried a higher cost of sales percentage of 79.6%)during the nine months ended October 1, 2006. Company restaurant revenuesdeclined as a percentage of total revenue from 75.8% in the 2005 period to74.7% in the 2006 period, while foodservice revenues increased as a percentageof total revenues from 21.5% in the 2005 period to 22.5% in the 2006 period.

Restaurantcost of sales as a percentage of restaurant revenues decreased to 26.3% for thenine months ended October 1, 2006 from 27.1% for the same period in 2005. Thisimprovement was due to menu price increases and product re-formulations, asoverall prices for food commodities were generally flat against the prioryear.  Decreases in commodity prices forcertain meat, poultry, fish and dairy products (primarily cream) were offset byincreases in commodity prices for certain other food product categories, suchas frozen foods (french fries) and beverages.

Foodservice cost of sales as a percentage offoodservice revenues decreased to 79.6% in the nine months ended October 1,2006 from 81.2% in the nine months ended October 2, 2005. This improvement wasprimarily a result of lower cream costs in the 2006 period compared to the sameperiod in 2005.

The overall cost of cream was approximately $3.2million lower in the nine month period ended October 1, 2006 (weighted averageprice of $1.22 per pound) when compared to the same period in 2005 (weightedaverage price of $1.63 per pound); however, market losses on cash-settledbutter futures contracts were $0.2 million greater than the losses experiencedon butter future contracts during the nine months ended October 2, 2005.  Approximately 70% of this $3.0 million netcost of sales benefit on a year to date basis, or approximately $2.1 million,was reported within our foodservice segment.

*Labor and benefits:*

Labor and benefits, which were only reported withinour restaurant segment, decreased $1.9 million, or 1.7%, to $108.9 million forthe nine months ended October 1, 2006 from $110.8 million for the nine monthsended October 2, 2005. As a percentage of total revenues, labor and benefitsdecreased to 26.6% for the nine months ended October 1, 2006 from 27.2% for thenine months ended October 2, 2005. This reduction was due entirely to the shiftin sales mix away from Company restaurant revenues to foodservice revenues.Labor and benefits, as a percentage of Company restaurant revenue only,decreased marginally to 35.7% for the nine months ended October 1, 2006 from35.8% for the same period in 2005.

*Operating expenses:*

Operating expenses were $79.4 million for both ninemonth periods ended October 1, 2006 and October 2, 2005. Operating expenses asa percentage of total revenues were 19.4% and 19.5% in the 2006 and 2005 periods,respectively. A significant portion of these expenses ($75.4 million in 2006and $75.5 million in 2005) were reported within our restaurant segment. In thenine months ended October 1, 2006, these costs consisted of $11.7 million insupplies, $14.9 million in utilities, $10.1 million in maintenance andcleaning, $11.7 million in advertising, $16.0 million in occupancy and $11.0million in other restaurant expenses. Decreases in advertising and maintenanceand cleaning costs of $1.3 million and $0.4 million, respectively, were offsetby higher costs for utilities and other restaurant expenses of $1.6 million and$0.1 million, respectively, in the 2006 period when compared to the 2005period.

40

----

 

*General and administrative expenses:*

General and administrative expenses were $32.9 millionand $28.2 million for the nine months ended October 1, 2006 and October 2,2005, respectively. General and administrative expenses as a percentage oftotal revenues increased to 8.0% in the 2006 period from 6.9% in the 2005 period.The $4.7 million increase was primarily the result of increases in bonus ($2.1million) as the majority of bonus expense was reversed in the 2005 period as aresult of our shortfall to plan, severance costs ($1.0 million), pension costs($0.5 million), stock compensation expense ($0.2 million) and legal fees ($0.4million).

EffectiveSeptember 28, 2006, John Cutter resigned as our President and Chief ExecutiveOfficer to pursue other interests. We have recorded estimated separation costsof $0.6 million associated with his resignation.  These separation costs account for themajority of the severance costs noted above.

The increase in legal fees was primarily due to theongoing shareholder derivative lawsuit filed by S. Prestley Blake against usand certain of our directors.  Pursuantto a settlement agreement with our insurance company in connection with costsand expenses we have incurred in the defense of this lawsuit, during thequarter ended October 1, 2006, we received insurance recoveries of $0.5 millionand we recorded a receivable in the amount of $0.6 million for expectedadditional insurance recoveries. Although we have received certain insurance recoveries and may receiveadditional recoveries in the future, we expect to continue to incur additionallegal fees in the defense of this lawsuit.

*Stock-based compensation expense:*

Duringthe nine months ended October 1, 2006, we recognized $0.3 million of totalstock-based compensation expense as a result of the adoption of SFAS No. 123R,which was included in general and administrative expenses.  We expect to recognize an additional $0.1million of stock compensation expense during the remainder of 2006 related tothe awards outstanding at October 1, 2006.

Asof October 1, 2006, there was $0.9 million of total unrecognized compensationcost related to unvested share-based awards. That cost is expected to berecognized over a weighted-average period of 2.2 years.

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

*Write-downs of property and equipment:*

Write-downs of property and equipment were $0.5million and $0.3 million in the nine months ended October 1, 2006 and October2, 2005, respectively. During the nine months ended October 1, 2006, wedetermined that the carrying values of two restaurant properties exceeded theirestimated fair values less costs to sell and the carrying values were reducedby an aggregate of $0.5 million accordingly. During the nine months ended October 2, 2005, the Company identified tworestaurant properties to be disposed of other than by sale and determined thatthe carrying values of these restaurant properties exceeded their estimatedundiscounted cash flows.  The carryingvalues were reduced by an aggregate of $0.3 million accordingly.

*Depreciation and amortization:*

Depreciationand amortization was $17.2 million and $17.4 million for the nine months endedOctober 1, 2006 and October 2, 2005, respectively. Depreciation andamortization as a percentage of total revenues was 4.2% and 4.3% in the 2006and 2005 periods, respectively. The 2005 period was higher primarily due to areduction of the lives of leasehold improvement assets as a result ofmanagement decisions to close certain leased properties sooner than previouslyanticipated.

41

----

 

*Gain on franchise sales of restaurant operationsand properties:*

Gainon franchise sales of restaurant operations and properties was $2.1 million and$2.5 million in the nine months ended October 1, 2006 and October 2, 2005,respectively. During the nine months ended October 1, 2006, we recognized gainsof $2.1 million associated with the sale of certain equipment assets, lease andsublease rights and franchise rights in five existing Company-operatedrestaurants.  During the nine monthsended October 2, 2005, we recognized a gain of $2.5 million associated with thesale of certain equipment assets, lease and sublease rights and franchiserights in four existing Company-operated restaurants.

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

Theloss on disposals of other property and equipment, net was $1.0 million and$0.5 million for the nine months ended October 1, 2006 and October 2, 2005,respectively.  The table below identifiesthe components of the loss on disposals of other property and equipment, net asshown on the accompanying condensed consolidated statements of operations (inthousands):

|                                                         | ** ** | **For the Nine Months Ended** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                              | ** ** | **October 1,**                               | ** ** | **October 2,** | ** ** |
| ** **                                              | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| Restaurant equipment  assets retired due to remodeling  |       | $                                                 | 734        |   | $ | 220 |   |
| Restaurant equipment  assets retired due to replacement |       | 222                                               |       | 146 |   |
| Gain due to restaurant  flood                           |       | (53                                               | )          | — |   |
| All other                                               |       | 106                                               |       | 157 |   |
| Loss on disposals of other property and equipment, net  |       | $                                                 | 1,009      |   | $ | 523 |   |

 

*Interest expense, net:*

Interest expense, net of capitalized interest andinterest income, was $15.6 million and $15.7 million for the nine months endedOctober 1, 2006 and October 2, 2005, respectively. The decrease in interestexpense in the 2006 period compared to the same period in 2005 was primarilydue to reduced amounts of interest on capital leases and lower interest rateson our mortgage financing. Total outstanding debt, including capital lease andfinance obligations, decreased from $234.9 million at October 2, 2005 to $231.8million at October 1, 2006.

*Otherincome:*

Duringthe nine months ended October 1, 2006, we received $0.1 million in settlementof a title insurance class action lawsuit in which we were a class member.  Additionally, we received confirmation of a$0.2 million settlement related to a Mastercard/Visa class action lawsuit inwhich we were a class member.

*Provisionfor income taxes:*

The provision for incometaxes was $0.9 million for the nine months ended October 1, 2006. As a resultof our intent to continue recording a full valuation allowance on tax benefitsuntil we can sustain an appropriate level of profitability, the provision wasbased on an estimate of our current taxes payable through the third quarter of2006.

The provision for incometaxes was $0.5 million for the nine months ended October 2, 2005. The $0.5million tax provision included $0.3 million of tax expense allocatedspecifically to continuing operations increased by an additional $0.2 millionresulting from certain items then being discussed with the IRS, which havesince been resolved.

42

----

 

*Income from continuing operations:*

Income from continuing operations was $1.6 million forthe nine months ended October 1, 2006 compared to income from continuingoperations of $2.5 million for the nine months ended October 2, 2005 for thereasons discussed above.

*Income(loss) from discontinued operations:*

Reported in discontinuedoperations were the results of operations of the seven properties that were disposed of during the nine months endedOctober 1, 2006, the 14 properties disposed of during 2005 and the related netgain on disposals, as well as the results of operations of the properties heldfor sale at October 1, 2006.  For thenine months ended October 1, 2006 and October 2, 2005, this consisted ofthe following (in thousands):

|                                              | ** ** | **For the Nine Months Ended** | ** ** |
|----------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                   | ** ** | **October 1,**                               | ** ** | **October 2,** | ** ** |
| ** **                                   | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| Net sales                                    |       | $                                                 | —     |   | $ | 8,731 |   |
|                                         |       |                                              |       |   |   |
| Operating loss                               |       | (371                                              | )          | (1,101 | ) |
| Gain on disposals of  property and equipment |       | 4,079                                             |       | 1,926 |   |
| Income tax expense                           |       | (450                                              | )          | (338 | ) |
| Income from discontinued operations          |       | $                                                 | 3,258      |   | $ | 487 |   |

 

**Liquidity and Capital Resources**

*General:*

Ourprimary sources of liquidity and capital resources are cash generated fromoperations and, if needed, borrowings under our $35 million revolving creditfacility (the “Credit Facility”). Additional sources of liquidity consist ofcapital and operating leases for financing leased restaurant locations (inmalls and shopping centers and land or building leases), restaurant equipment,manufacturing equipment, distribution vehicles and computer equipment. Othersources of cash are sales of under-performing existing restaurant properties andother assets and re-franchising (to the extent FICC’s and its subsidiaries’debt instruments permit). The amount of debt financing that FICC is able toincur is limited by the terms of our Credit Facility and 8.375% senior notesindenture. Below was the financing status of our operating restaurants andproperties that we lease to our franchisees as of October 1, 2006:

|                                         | ** ** | **Company  Operated** | ** ** | **Franchise  Operated** | ** ** |
|-----------------------------------------|------------|-----------------------|------------|-------------------------|------------|
| Owned land and  building, mortgaged     |       | 61                    |       | 12                      |       |
| Leased land, owned  building, mortgaged |       | 1                     |       | 0                       |       |
| Sold and leased back                    |       | 57                    |       | 3                       |       |
| Owned land and building                 |       | 16                    |       | 5                       |       |
| Leased land, owned  building            |       | 68                    |       | 25                      |       |
| Leased land and  building               |       | 104                   |       | 12                      |       |
| Total                                   |       | 307                   |       | 57                      |       |

 

43

----

 

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

Inaddition to our 307 operating restaurants, we have five closed properties thatare classified as held for sale in accordance with SFAS No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets”.

*Operating Cash Flows:*

Net cash provided byoperating activities was $20.7 million and $20.3 million for the nine monthsended October 1, 2006 and October 2, 2005, respectively. Changes in workingcapital increased cash by $0.7 million as we received insurance recoveries of$0.7 million, $0.5 million of which is pursuant to a settlement agreement withour insurance company in connection with our claims for reimbursement of costsand expenses we have incurred in the defense of the ongoing shareholderderivative lawsuit brought by S. Prestley Blake against us and certain of ourdirectors.  We also received cash refundsof federal income taxes and the release of escrow funds related to twopreviously mortgaged properties of $1.2 million and $1.7 million, respectively.These increases were partially offset by a contribution to our defined benefitcash balance pension plan of $2.2 million as a result of the Pension ProtectionAct of 2006 and unfavorable changes in accounts receivable and accountspayable.  We anticipate an additionalcontribution to our defined benefit cash balance pension plan of approximately$3.5 million in 2008 as a result of the Pension Protection Act of 2006.  Net loss excluding the gains on sales offixed assets and other non-cash expenses decreased cash provided by operatingactivities by $0.3 million.

We had a working capital deficit of $4.6 million and$16.4 million as of October 1, 2006 and January 1, 2006, respectively. Ourworking capital deficit includes assets classified as held for sale inaccordance with SFAS No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets.” The workingcapital needs of companies engaged in the restaurant industry are generally lowand as a result, restaurants are frequently able to operate with a workingcapital deficit because: (i) restaurant operations are conducted primarily on acash (and cash equivalent) basis with a low level of accounts receivable; (ii)rapid turnover allows a limited investment in inventories; and (iii) cash fromsales is usually received before related expenses for food, supplies andpayroll are paid.

*InvestingCash Flows:*

Net cash used in investing activities was $4.6 millionand $5.6 million for the nine months ended October 1, 2006 and October 2, 2005,respectively.

During the nine month periods ended October 1, 2006and October 2, 2005, we spent $14.0 million and $11.5 million on capitalexpenditures, of which $11.7 million and $9.8 million, respectively, was spenton restaurant operations. Capital expenditures were offset by net proceeds fromthe sales of property and equipment of $9.4 million and $6.2 million for thenine months ended October 1, 2006 and October 2, 2005, respectively.

As of January 1, 2006, we had 11 restaurants that werereported as “held for sale” in accordance with SFAS No. 144. During the ninemonths ended October 1, 2006, we sold seven of these restaurants.  In accordance with SFAS No. 144, the resultsof operations of the seven properties that were disposed of during the ninemonths ended October 1, 2006 and the 14 properties that were disposed of during2005 and the related net gain on the disposals, as well as the results ofoperations of the properties held for sale at October 1, 2006, were reportedseparately as discontinued operations in the accompanying condensed consolidatedstatements of operations for all periods presented.  Operating losses before depreciation fromthese properties were $0.4 million and $0.6 million during the nine monthsended October 1, 2006 and October 2, 2005, respectively.  Net proceeds on the disposals of the sevenproperties sold during the nine months ended October 1, 2006 were $6.4million.  There were no “held for sale”properties sold during the three months ended October 2, 2005.

44

----

 

During the nine monthsended October 1, 2006, we completed three re-franchising transactions in whichThe Ice Cream Company (“TICC”) and other existing franchisees purchased fiveexisting Company-operated restaurants and agreed to develop a total of ten newrestaurants in future years.  Grossproceeds from these transactions were $3.0 million, of which $0.2 million wasfor franchise fees and $2.8 million was for the sale of certain assets andleasehold rights.  In addition, wecompleted one transaction in which a former employee received franchise rightsto operate one existing restaurant with an option to purchase the restaurantwithin two years.  If the option isexercised, the franchisee will also agree to develop one new restaurant in thefuture.  Proceeds from the optiontransaction will be recognized upon purchase.

On May 22, 2006, TICCpurchased, at fair market value, certain assets and leasehold rights for threeexisting Company-operated restaurants located in Lancaster and York,Pennsylvania.  At closing, TICC was alsogranted an exclusive right to develop six new Friendly’s restaurants inLancaster, Chester and Montgomery counties, Pennsylvania by April 2012. Grossproceeds from this transaction were $1.7 million, of which $0.1 million was forinitial franchise fees, $0.1 million was for development fees and $1.5 millionwas for the assets and rights at the three existing restaurants. During thenine months ended October 1, 2006, the Company recorded $0.1 million asfranchise fee revenue.

The owners of TICC are family members of the Company’sChairman of the Board of Directors. Prior to the closing of this transaction onMay 22, 2006, TICC operated three Friendly’s restaurants under franchiseagreements with Friendly’s Restaurants Franchise, Inc. (“FRFI”), a subsidiaryof Friendly’s.  The terms of the franchiseagreements with TICC are identical in all material respects to the termsgenerally offered to unrelated franchisees of FRFI in the ordinary course ofFriendly’s business.

During the nine monthsended October 2, 2005, the Company completed two re-franchising transactions inwhich two existing franchisees purchased four existing Company restaurants andagreed to develop a total of five new restaurants in future years.  Gross proceeds from these transactions were$3.5 million, of which $0.1 million was for franchise fees and $3.4 million wasfor the sale of certain assets and leasehold rights.  In addition, we completed three transactionsin which three former employees received franchises to operate six existing restaurantswith options to purchase the restaurants within two years.  If the options are exercised, one franchiseewill also agree to develop two new restaurants in future years.  Proceeds from option transactions will berecognized upon purchase.

*FinancingCash Flows:*

Net cash used in financing activities was $2.7 millionand $3.9 million for the nine months ended October 1, 2006 and October 2, 2005,respectively. There were $4.0 million of revolving credit loans outstanding atthe end of 2004 that were repaid in the first quarter of 2005.  There were no revolving credit loansoutstanding at the end of 2005.

*OutstandingDebt:*

*Sale/Leaseback and Mortgage Financings*.  In December 2001, we completed a financialrestructuring plan which included the repayment of all amounts outstandingunder our then existing credit facility and the purchase of approximately $21.3million of our 10.5% senior notes with the proceeds from $55.0 million inlong-term mortgage financing (the “Mortgage Financing”) and a $33.7 millionsale and leaseback transaction (the “Sale/Leaseback Financing”).

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

45

----

 

Interest on $10.0 million of the original $55.0million from the Mortgage Financing is variable (“Variable Mortgages”) and theremaining $45.0 million of the original $55.0 million from the MortgageFinancing bears interest at a fixed annual rate of 10.16% (“Fixed Mortgages”).The Fixed Mortgages have a maturity date of January 1, 2022 and are amortizedover 20 years.

On December 30,2005, we completed a refinancing of the Variable Mortgages (the “VariableRefinancing”).  Under the terms of theloan agreement for the Variable Refinancing, we borrowed an aggregate sum of$8.5 million. The interest rate is variable and is the sum of the 90-day LIBORrate in effect (5.37% at October 1, 2006) plus 4% on an annual basis. Changesin the interest rate are calculated monthly and recognized annually when themonthly payment amount is adjusted. Changes in the monthly payment amounts oweddue to interest rate changes are reflected in the principal balances, which arere-amortized over the remaining life of the mortgages. The loans under theVariable Refinancing have a maturity date of January 1, 2020 and are beingamortized over 14 years.

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

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

InSeptember 2005, we acquired additional financing secured by our newlyconstructed Milford, MA restaurant (the “Milford Mortgage”). The financingprovided for a real estate improvement and equipment loan. The real estateimprovement loan has a principal balance of $0.8 million and is amortized over15 years with a balloon payment due on October 1, 2010. The equipment loan hasa principal balance of $0.3 million and is amortized over seven years with aballoon payment due on October 1, 2010. The interest rate is variable and isthe sum of the 90-day LIBOR rate in effect (5.37% at October 1, 2006) plus 4%on an annual basis. Changes in the interest rate are calculated monthly andrecognized annually when the monthly payment amount is adjusted. Changes in themonthly payment amounts owed due to interest rate changes are reflected in theprincipal balances, which are re-amortized over the remaining life of themortgages. The variable rate notes are subject to prepayment penalties duringthe first three years.

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

46

----

 

*8.375% Senior Notes.*  In 2003 and 2004, we purchased or redeemedall of the remaining outstanding 10.5% senior notes in a series oftransactions. In February 2004, we announced a cash tender offer and consentsolicitation for $176 million of our 10.5% senior notes to be financed with theproceeds from a $175 million private offering of new 8.375% senior notes (the “SeniorNotes”), available cash and our Credit Facility. In March 2004, $127.4 millionof aggregate principal amount of 10.5% senior notes were purchased at thetender offer and consent solicitation price of 104% of the principal amount and$0.5 million of aggregate principal amount of 10.5% senior notes were purchasedat the tender offer price of 102% of the principal amount. In April 2004, theremaining $48.1 million of 10.5% senior notes were redeemed in accordance withthe 10.5% senior notes indenture at 103.5% of the principal amount.

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

*Revolving Credit Facility.*  We have a $35 million Credit Facility whichis available for borrowings to provide working capital, for issuances ofletters of credit and for other corporate needs. As of October 1, 2006 andJanuary 1, 2006, total letters of credit outstanding were $16.0 million. During2006 and 2005, there were no drawings against the letters of credit.  The revolving credit loans bear interest atour option at either (a) the base rate plus the applicable margin as ineffect from time to time (the “Base Rate”) (10.25% at October 1, 2006) or(b) the Eurodollar rate plus the applicable margin as in effect from timeto time (the “Eurodollar Rate”) (9.32% at October 1, 2006). As of October 1,2006 and January 1, 2006, there were no revolving credit loans outstanding. Asof October 1, 2006 and January 1, 2006, $19.0 million was available forborrowing.

The Credit Facility has an annual “clean-up” provisionwhich obligates us to repay in full any and all outstanding revolving creditloans for a period of not less than 15 consecutive days during the periodbeginning on or after May 1 and ending on or before June 15 (or the nextbusiness day, if, in any year, June 15 is not a business day) of each calendaryear, such that immediately following the date of such repayment, the amount ofall outstanding revolving credit loans shall be zero.  The Credit Facility includes certain restrictivecovenants including limitations on indebtedness, restricted payments such asdividends and stock repurchases, liens, mergers, investments and sales ofassets and of subsidiary stock. Additionally, the Credit Facility limits theamount which we may spend on capital expenditures, restricts the use ofproceeds, as defined, from asset sales and requires that we comply with certainfinancial covenants. On March 15, 2006, we amended and restated the CreditFacility as of December 30, 2005 to, among other things, (i) revise certainfinancial covenants (including leverage,interest coverage, minimum EBITDA and the deletion of the tangible networth covenant) beginning with the fourth quarter of 2005 and extending throughthe Credit Facility maturity date of June 30, 2007 and (ii) permit certain transactionsto be excluded from our annual capital expenditures limit. We were incompliance with the covenants in the Credit Facility as of October 1, 2006.

On August 1, 2006, we further amended our $35 millionCredit Facility to, among other things, (i) extend the maturity date from June30, 2007 to June 30, 2010, (ii) eliminate the interest coverage requirement and(iii) reduce by .50% to .75% the applicable margin rates at which the revolvingcredit loans bear interest to a range of 3.00% to 4.00% (depending on theleverage ratio).

We incurred approximately $0.5 million of costsassociated with this amendment to the $35 million Credit Facility which wasdeferred and is being amortized over the life of the amended $35 million CreditFacility.

47

----

 

Weanticipate requiring capital in the future principally to maintain existingrestaurant and plant facilities and to continue to renovate and re-imageexisting restaurants. We anticipate that capital expenditures for 2006 will bebetween $22.0 million and $24.0 million in the aggregate, of which we expect tospend between $14.0 million and $18.0 million on restaurants. Our actual 2006capital expenditures may vary from these estimated amounts. We believe that thecombination of the funds generated from operating activities and borrowingavailability under our Credit Facility will be sufficient to meet ouranticipated operating requirements, debt service requirements, leaseobligations and capital requirements.

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

**Seasonality**

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

**Geographic Concentration**

Approximately 97% 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 us more than certain of our competitors which are moregeographically diverse.

**Critical Accounting Estimates**

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

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

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

48

----

 

*Stock-Based Compensation—*

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

Expectedvolatility - we are responsible for estimating volatility and have usedhistorical volatility to estimate the grant-date fair value of stock options.Management considered the guidance in SFAS No. 123R and believes that thehistorical estimated volatility is materially indicative of expectations aboutfuture volatility.  In general, thehigher the expected volatility used in the Black-Scholes valuation model, thehigher the grant-date fair value of the option.

Expectedterm - we use historical employee exercise and option expiration data toestimate the expected term assumption for the Black-Scholes grant-datevaluation. We believe that this historical data is currently the best estimateof the expected term of a new option. Currently stock options are only issuedto corporate officers and directors.  Ingeneral, the longer the expected term used in the Black-Scholes valuationmodel, the higher the grant-date fair value of the option.

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

Expected dividend yield - we have notpaid any dividends in the last five years and currently intend to retain anyearnings to finance future growth and, therefore, do not anticipate paying anycash dividends on our common stock in the foreseeable future.

Theamount of stock-based compensation recognized during a period is based on thevalue of the portion of the awards that are ultimately expected to vest. SFASNo. 123R requires forfeitures to be estimated at the time of grant and revised,if necessary, in subsequent periods if actual forfeitures differ from thoseestimates. The term “forfeitures” is distinct from “cancellations” or “expirations”and represents only the unvested portion of the surrendered option. Wecurrently expect, based on an analysis of our historical forfeitures, thatapproximately 94.5% of our options will actually vest, and therefore haveapplied an annual forfeiture rate of 5.5% to all options granted as of October1, 2006. This analysis will be re-evaluated quarterly and the forfeiture ratewill be adjusted as necessary. Ultimately, the actual expense recognized overthe vesting period will only be for those shares that vest.

**Recently Issued Accounting Pronouncements**

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

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

There has been no material change in our market riskexposure since the filing of the 2005 Annual Report on Form 10-K.

49

----

 

**Item 4.**                          Controlsand Procedures

As of October 1, 2006, an evaluation was performedunder the supervision and with the participation of our management, includingour Chairman of the Board and acting Principal Executive Officer and our ChiefFinancial Officer, of the effectiveness of the design and operation of ourdisclosure controls and procedures (as defined in Rule 13a-15(e) and Rule15d-15(e) under the Exchange Act).  Basedon that evaluation, our acting Principal Executive Officer and Chief FinancialOfficer concluded that our disclosure controls and procedures were effective asof October 1, 2006.

There were no significant changes in our internalcontrol over financial reporting that occurred during our last fiscal quarterthat have materially affected, or are reasonably likely to materially affect,our internal control over financial reporting.

**PART II — OTHERINFORMATION**

**Item 1.**                          LegalProceedings

On February 25, 2003, S. Prestley Blake (“Blake”),holder of approximately 10% of our outstanding common stock, sued Friendly’sand our Chairman in a purported derivative action in Hampden Superior Court,Massachusetts. The suit alleges breach of fiduciary duty and misappropriationof corporate assets in that we paid certain expenses relating to a corporate jetand the Chairman’s use of that jet and use of an office in Illinois.  The suit seeks to require the Chairman toreimburse us and for Friendly’s to pay Blake’s attorneys’ fees.  Friendly’s and its Chairman have denied Blake’sallegations and are vigorously defending the lawsuit.

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

On July 26, 2006, director defendants Michael J. Daly,Steven L. Ezzes, and Burton J. Manning, and former director defendant CharlesA. Ledsinger, Jr., filed motions to dismiss the claims brought against them forfailure to state a claim on the grounds that both the exculpatory provision inthe Company’s Restated Articles of Organization and the business judgment rulebarred plaintiff’s claims.  The Courtheard oral argument on these defendants’ motions on September 20, 2006 and tookthe motions under advisement.  The Courthas set a deadline for fact discovery of May 31, 2007, with a trial, ifnecessary, to begin on January 7, 2008.

**Item 1A.**                 Risk Factors

There have been no material changes to our riskfactors from those disclosed in our 2005 Annual Report on Form 10-K, except asfollows:

**Our failure toattract and retain qualified employees may adversely affect us.**

In September 2006, John Cutter, our former presidentand chief executive officer, resigned to pursue other interests.  We are currently searching for a replacementpresident and chief executive officer. In the interim, Donald Smith, our Chairman of the Board, has assumedoversight responsibilities while we conduct our search for a replacementpresident and chief executive officer. Our success depends upon our ability to attract and retain a sufficientnumber of qualified employees, including key executives, skilled management,customer service personnel and wait and kitchen staff. We face significantcompetition in the recruitment of qualified employees.  Our inability to recruit and retain qualifiedindividuals, such as for the position of president and chief executive officer,could have a material adverse effect on our ability to implement our strategiesand initiatives, result in higher employee turnover, affect our ability to providea high quality customer experience in restaurants or exert pressure on wages orother employee benefits to attract qualified personnel. Any of theseconsequences could have a material adverse effect on our business and resultsof operations.

50

----

 

**Item 5.**                          OtherInformation

On August 1, 2006the Compensation Committee of the Board of Directors approved the issuance ofrestricted stock units to five officers (each, an “Award”) under the Company’slong-term incentive plan if the Company exceeds a certain threshold EBITDAtarget for 2006 (the “Threshold EBITDA”). If the Company exceeds the Threshold EBITDA, then each of the officerswill receive an Award having a specified value based on the Company’s actualEBITDA for 2006 compared to projected EBITDA and a percentage of each officer’starget award.  The following table setsforth the range of values of the Award each officer may receive:

| Name            | ** ** | **Value of Award** | ** ** |
|-----------------|------------|--------------------|------------|
| John Cutter     |       | $174,267           |       | to |   | $522,801 |   |
| Paul Hoagland   |       | $82,028            |       | to |   | $246,084 |   |
| Gregory Pastore |       | $34,438            |       | to |   | $103,314 |   |
| Kenneth Green   |       | $39,698            |       | to |   | $119,093 |   |
| Garrett Ulrich  |       | $39,865            |       | to |   | $119,595 |   |

 

The Award, if any, is expected to be granted followingthe Board of Directors’ meetings scheduled to be held on February 27-28, 2007.  The number of Awards to be granted, if any,will be calculated by dividing the value of the Award by 90% of the closingprice of the Company’s common stock on the date of grant.  If issued, 25 percent of the Award will veston the grant date and 25 percent of the Award will vest in each of thefollowing three years. During the nine months ended October 1, 2006,stock-based compensation cost of $39,000 was recorded related to these Awards.

Effective September 28, 2006, Mr. John Cutter resignedas President and Chief Executive Officer of the Company to pursue otherinterests.  On November 6, 2006, theCompany and Mr. Cutter entered into an agreement concerning Mr. Cutter’sseparation from employment with the Company. Pursuant to the Agreement, the Company will continue to pay Mr. Cuttersemi-monthly until March 14, 2007 at his rate of pay at the time of separation,less applicable withholding and deductions. In addition, on or before March 15, 2007, the Company will pay Mr.Cutter a lump-sum payment equal to the semi-monthly pay Mr. Cutter would havereceived between March 15, 2007 and September 27, 2007, at his base rate of payat the time of separation, less applicable withholding and deductions.  Mr. Cutter is also eligible to receive abonus under the Company’s 2006 Annual Incentive Plan, pursuant to which, ifcertain operating EBITDA targets for the Company are achieved for 2006, Mr.Cutter may receive a target payout which ranges up to 75% of his basesalary.  The Company will continue to payfor fees associated with financial services and planning provided to Mr. Cutterthrough June 1, 2007 and will pay for up to $10,000 for outplacementservices.  The Company also agreed toreimburse Mr. Cutter for COBRA continuation premiums paid by Mr. Cutter for periodsthrough December 31, 2007 and membership dues through December 31, 2006.  In exchange for these payments, Mr. Cutterreleased certain statutory and common law claims he may have against theCompany and its officers and directors among others.  In addition, Mr. Cutter agreed not to competewith the Company or solicit its employees or customers for one year aftertermination of his employment.

On October 31, 2006, the Board of Directors of theCompany eliminated the Nominating Committee of the Board of Directors. In lieuof the Nominating Committee, the entire Board of Directors, based on arecommendation of at least a majority of its independent directors, will selectthe candidates for director in accordance with the policies and proceduresdescribed in the Company’s proxy statement for its annual meeting ofshareholders held on May 10, 2006. No material changes have been made to theprocedures by which shareholders may recommend nominees to the Company’s Boardof Directors.

51

----

 

**Item 6.**                          Exhibits

(a)   Exhibits

The exhibit index is incorporated by reference herein.

**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.
|        | Friendly Ice Cream Corporation |
|--------|--------------------------------|
|   |                           |   |
|   |                           |   |
|   | By:                            | /s/ PAUL V. HOAGLAND |
|   |                           | Name: Paul V. Hoagland |
|   |                           | Title: Executive Vice President of |
|   |                           | Administration and Chief Financial Officer |
|   |                           | (Principal Financial Officer) |
|   |                           |   |
|   | Date:                          | November 8, 2006 |

 

52

----

 

**EXHIBIT INDEX**

10.1                           Agreementbetween the Company and John L. Cutter effective as of September 28, 2006.*

31.1                           Certificationpursuant to Section 302 of the Sarbanes-Oxley Act of 2002 signed by Donald N.Smith.

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

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

----

*                    ManagementContract or Compensatory Plan or Arrangement

----