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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-Q



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|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------

For the quarterly period ended September 20, 2006

OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------

For the transition period from  to

Commission File Number 0-21203



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DIEDRICH COFFEE, INC.

(Exact Name of Registrant as Specified in Its Charter)



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|                                                               |  |                                  
|-------------------------------------------------------------- |  | ---------------------------------
|Delaware                                                       |  | 33-0086628                       
|(State or Other Jurisdiction of Incorporation or Organization) |  | (IRS Employer Identification No.)

28 Executive Park

Irvine, California 92614

(Address of Principal Executive Offices, Zip Code)

(949) 260-1600

(Registrants Telephone Number, including Area Code)



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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in
Rule 12b-2 of the Exchange Act.



|                         |  |                    |  |                         
|------------------------ |  | ------------------ |  | ------------------------
|Large Accelerated Filer ̈ |  | Accelerated Filer ̈ |  | Non-Accelerated Filer  x

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

As of October 31, 2006, there were 5,358,770 shares of common stock of the registrant outstanding.



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TABLE OF CONTENTS



|                               |  |                                                                                               |  |            
|------------------------------ |  | --------------------------------------------------------------------------------------------- |  | -----------
|                               |  |                                                                                               |  | Page Number
|PART I - FINANCIAL INFORMATION |  | 1                                                                                            
|                               |  |                                                                                              
|                               |  | Item 1. Financial Statements                                                                  |  | 1          
|                               |  |                                                                                              
|                               |  | CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)                                             |  | 1          
|                               |  |                                                                                              
|                               |  | CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)                                   |  | 2          
|                               |  |                                                                                              
|                               |  | CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)                                   |  | 3          
|                               |  |                                                                                              
|                               |  | NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)                              |  | 4          
|                               |  |                                                                                              
|                               |  | Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations |  | 13         
|                               |  |                                                                                              
|                               |  | Item 3. Quantitative And Qualitative Disclosures About Market Risk                            |  | 23         
|                               |  |                                                                                              
|                               |  | Item 4. Controls and Procedures                                                               |  | 23         
|                               | 
|PART II - OTHER INFORMATION    |  | 24                                                                                           
|                               |  |                                                                                              
|                               |  | Item 1. Legal Proceedings                                                                     |  | 24         
|                               |  |                                                                                              
|                               |  | Item 1A. Risk Factors                                                                         |  | 24         
|                               |  |                                                                                              
|                               |  | Item 2. Unregistered Sales of Equity Securities and Use of Proceeds                           |  | 25         
|                               |  |                                                                                              
|                               |  | Item 3. Defaults upon Senior Securities                                                       |  | 25         
|                               |  |                                                                                              
|                               |  | Item 4. Submission of Matters to a Vote of Security Holders                                   |  | 25         
|                               |  |                                                                                              
|                               |  | Item 5. Other Information                                                                     |  | 25         
|                               |  |                                                                                              
|                               |  | Item 6. Exhibits                                                                              |  | 25         
|                               | 
|SIGNATURES                     |  | 28                                                                                           



i



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PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

DIEDRICH COFFEE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS



|                                                                                                                                                                        |  |                    |             |   |               |   |             |  
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | ----------- | - | ------------- | - | ----------- | -
|                                                                                                                                                                        |  | September 20, 2006 |             |   | June 28, 2006 |  
|                                                                                                                                                                        |  | (Unaudited)        |             |   |               |  
|Assets                                                                                                                                                                  |  |                    |             |   |               |   |             |  
|Current assets:                                                                                                                                                         |  |                    |             |   |               |   |             |  
|Cash                                                                                                                                                                    |  | $                  | 1,706,000   |   |               | $ | 2,593,000   |  
|Restricted cash                                                                                                                                                         |  |                    | 587,000     |   |               |   | 583,000     |  
|Accounts receivable, less allowance for doubtful accounts of $1,839,000 at September 20, 2006 and $1,863,000 at June 28,
2006                                           |  |                    | 3,446,000   |   |               |   | 2,829,000   |  
|Inventories                                                                                                                                                             |  |                    | 3,716,000   |   |               |   | 3,846,000   |  
|Assets held for sale                                                                                                                                                    |  |                    | 6,182,000   |   |               |   | 6,568,000   |  
|Income tax refund                                                                                                                                                       |  |                    | 506,000     |   |               |   | 516,000     |  
|Current portion of notes receivable                                                                                                                                     |  |                    | 1,206,000   |   |               |   | 1,137,000   |  
|Advertising fund assets, restricted                                                                                                                                     |  |                    | 98,000      |   |               |   | 217,000     |  
|Prepaid expenses                                                                                                                                                        |  |                    | 787,000     |   |               |   | 426,000     |  
|                                                                                                                                                                        |  |                    |             |   |               |   |             |  
|Total current assets                                                                                                                                                    |  |                    | 18,234,000  |   |               |   | 18,715,000  |  
|Property and equipment, net                                                                                                                                             |  |                    | 4,192,000   |   |               |   | 4,061,000   |  
|Goodwill                                                                                                                                                                |  |                    | 6,832,000   |   |               |   | 6,832,000   |  
|Notes receivable                                                                                                                                                        |  |                    | 3,509,000   |   |               |   | 3,972,000   |  
|Cash surrender value of life insurance policy                                                                                                                           |  |                    | 436,000     |   |               |   | 391,000     |  
|Other assets                                                                                                                                                            |  |                    | 147,000     |   |               |   | 159,000     |  
|                                                                                                                                                                        |  |                    |             |   |               |   |             |  
|Total assets                                                                                                                                                            |  | $                  | 33,350,000  |   |               | $ | 34,130,000  |  
|                                                                                                                                                                        |  |                    |             |   |               |   |             |  
|Liabilities and Stockholders Equity                                                                                                                                    |  |                    |             |   |               |   |             |  
|Current liabilities:                                                                                                                                                    |  |                    |             |   |               |   |             |  
|Current installments of obligations under capital leases                                                                                                                |  | $                  | 19,000      |   |               | $ | 19,000      |  
|Current installments of long-term debt                                                                                                                                  |  |                    | 327,000     |   |               |   |            |  
|Accounts payable                                                                                                                                                        |  |                    | 3,103,000   |   |               |   | 2,929,000   |  
|Accrued compensation                                                                                                                                                    |  |                    | 2,135,000   |   |               |   | 2,481,000   |  
|Accrued expenses                                                                                                                                                        |  |                    | 1,849,000   |   |               |   | 1,779,000   |  
|Franchisee deposits                                                                                                                                                     |  |                    | 579,000     |   |               |   | 599,000     |  
|Deferred franchise fee income                                                                                                                                           |  |                    | 85,000      |   |               |   | 104,000     |  
|Advertising fund liabilities                                                                                                                                            |  |                    | 98,000      |   |               |   | 217,000     |  
|Accrued provision for store closure                                                                                                                                     |  |                    | 471,000     |   |               |   | 401,000     |  
|                                                                                                                                                                        |  |                    |             |   |               |   |             |  
|Total current liabilities                                                                                                                                               |  |                    | 8,666,000   |   |               |   | 8,529,000   |  
|Obligations under capital leases, excluding current installments                                                                                                        |  |                    | 304,000     |   |               |   | 309,000     |  
|Long term debt, less unamortized discount of $25,000 at September 20, 2006, excluding current installments                                                              |  |                    | 648,000     |   |               |   |            |  
|Deferred rent                                                                                                                                                           |  |                    | 607,000     |   |               |   | 603,000     |  
|Deferred compensation                                                                                                                                                   |  |                    | 467,000     |   |               |   | 422,000     |  
|                                                                                                                                                                        |  |                    |             |   |               |   |             |  
|Total liabilities                                                                                                                                                       |  |                    | 10,692,000  |   |               |   | 9,863,000   |  
|                                                                                                                                                                        |  |                    |             |   |               |   |             |  
|Commitments and contingencies (notes 7 and 8)                                                                                                                           |  |                    |             |   |               |   |             |  
|Stockholders equity:                                                                                                                                                   |  |                    |             |   |               |   |             |  
|Common stock, $0.01 par value; authorized 8,750,000 shares; 5,349,000 and 5,308,000 shares issued and outstanding at September 20, 2006
and June 28, 2006, respectively |  |                    | 53,000      |   |               |   | 53,000      |  
|Additional paid-in capital                                                                                                                                              |  |                    | 59,059,000  |   |               |   | 59,022,000  |  
|Accumulated deficit                                                                                                                                                     |  |                    | (36,454,000 | ) |               |   | (34,808,000 | )
|                                                                                                                                                                        |  |                    |             |   |               |   |             |  
|Total stockholders equity                                                                                                                                              |  |                    | 22,658,000  |   |               |   | 24,267,000  |  
|                                                                                                                                                                        |  |                    |             |   |               |   |             |  
|Total liabilities and stockholders equity                                                                                                                              |  | $                  | 33,350,000  |   |               | $ | 34,130,000  |  
|                                                                                                                                                                        |  |                    |             |   |               |   |             |  

See accompanying notes to condensed consolidated financial statements.



1



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DIEDRICH COFFEE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)



|                                                          |  |                                      |            |   |                                      |   |            |  
|--------------------------------------------------------- |  | ------------------------------------ | ---------- | - | ------------------------------------ | - | ---------- | -
|                                                          |  | Twelve WeeksEnded September 20, 2006 |            |   | Twelve WeeksEnded September 21, 2005 |  
|Net revenue:                                              |  |                                      |            |   |                                      |   |            |  
|Wholesale and other                                       |  | $                                    | 5,120,000  |   |                                      | $ | 3,571,000  |  
|Franchise revenue                                         |  |                                      | 768,000    |   |                                      |   | 721,000    |  
|Retail sales                                              |  |                                      | 536,000    |   |                                      |   | 844,000    |  
|                                                          |  |                                      |            |   |                                      |   |            |  
|Total revenue                                             |  |                                      | 6,424,000  |   |                                      |   | 5,136,000  |  
|                                                          |  |                                      |            |   |                                      |   |            |  
|Costs and expenses:                                       |  |                                      |            |   |                                      |   |            |  
|Cost of sales and related occupancy costs                 |  |                                      | 4,102,000  |   |                                      |   | 3,249,000  |  
|Operating expenses                                        |  |                                      | 1,565,000  |   |                                      |   | 929,000    |  
|Depreciation and amortization                             |  |                                      | 230,000    |   |                                      |   | 252,000    |  
|General and administrative expenses                       |  |                                      | 1,799,000  |   |                                      |   | 2,475,000  |  
|Gain on asset disposals                                   |  |                                      | (12,000    | ) |                                      |   | (5,000     | )
|                                                          |  |                                      |            |   |                                      |   |            |  
|Total costs and expenses                                  |  |                                      | 7,684,000  |   |                                      |   | 6,900,000  |  
|                                                          |  |                                      |            |   |                                      |   |            |  
|Operating loss from continuing operations                 |  |                                      | (1,260,000 | ) |                                      |   | (1,764,000 | )
|Interest expense                                          |  |                                      | (26,000    | ) |                                      |   | (26,000    | )
|Interest and other income, net                            |  |                                      | 91,000     |   |                                      |   | 152,000    |  
|                                                          |  |                                      |            |   |                                      |   |            |  
|Loss from continuing operations before income tax benefit |  |                                      | (1,195,000 | ) |                                      |   | (1,638,000 | )
|Income tax benefit                                        |  |                                      |           |   |                                      |   | (348,000   | )
|                                                          |  |                                      |            |   |                                      |   |            |  
|Loss from continuing operations                           |  |                                      | (1,195,000 | ) |                                      |   | (1,290,000 | )
|Loss from discontinued operations                         |  |                                      | (451,000   | ) |                                      |   | (262,000   | )
|                                                          |  |                                      |            |   |                                      |   |            |  
|Net loss                                                  |  | $                                    | (1,646,000 | ) |                                      | $ | (1,552,000 | )
|                                                          |  |                                      |            |   |                                      |   |            |  
|Basic and diluted net loss per share:                     |  |                                      |            |   |                                      |   |            |  
|Loss from continuing operations                           |  | $                                    | (0.23      | ) |                                      | $ | (0.24      | )
|                                                          |  |                                      |            |   |                                      |   |            |  
|Loss from discontinued operations                         |  | $                                    | (0.08      | ) |                                      | $ | (0.05      | )
|                                                          |  |                                      |            |   |                                      |   |            |  
|Net loss                                                  |  | $                                    | (0.31      | ) |                                      | $ | (0.29      | )
|                                                          |  |                                      |            |   |                                      |   |            |  
|Weighted average and equivalent shares outstanding:       |  |                                      |            |   |                                      |   |            |  
|Basic and diluted                                         |  |                                      | 5,308,000  |   |                                      |   | 5,287,000  |  
|                                                          |  |                                      |            |   |                                      |   |            |  

See accompanying notes to condensed consolidated financial statements.



2



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DIEDRICH COFFEE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)



|                                                                                                   |  |                                       |            |   |                                       |   |            |  
|-------------------------------------------------------------------------------------------------- |  | ------------------------------------- | ---------- | - | ------------------------------------- | - | ---------- | -
|                                                                                                   |  | Twelve Weeks Ended September 20, 2006 |            |   | Twelve Weeks Ended September 21, 2005 |  
|Cash flows from operating activities:                                                              |  |                                       |            |   |                                       |   |            |  
|Loss from continuing operations                                                                    |  | $                                     | (1,195,000 | ) |                                       | $ | (1,290,000 | )
|Adjustments to reconcile loss from continuing operations to net cash used in operating activities: |  |                                       |            |   |                                       |   |            |  
|Depreciation and amortization                                                                      |  |                                       | 230,000    |   |                                       |   | 252,000    |  
|Amortization of loan fees                                                                          |  |                                       | 7,000      |   |                                       |   | 10,000     |  
|Provision (reduction) for bad debt                                                                 |  |                                       | (25,000    | ) |                                       |   | 92,000     |  
|Income tax benefit                                                                                 |  |                                       |           |   |                                       |   | (342,000   | )
|Provision for inventory obsolescence                                                               |  |                                       | 9,000      |   |                                       |   | 5,000      |  
|Provision for store closure                                                                        |  |                                       | 70,000     |   |                                       |   |           |  
|Stock compensation expense                                                                         |  |                                       | 67,000     |   |                                       |   | 85,000     |  
|Notes receivable issued for franchise fees                                                         |  |                                       | (89,000    | ) |                                       |   | (20,000    | )
|Gain on disposals of assets                                                                        |  |                                       | (12,000    | ) |                                       |   | (5,000     | )
|Changes in operating assets and liabilities:                                                       |  |                                       |            |   |                                       |   |            |  
|Accounts receivable                                                                                |  |                                       | (580,000   | ) |                                       |   | (2,000     | )
|Inventories                                                                                        |  |                                       | 93,000     |   |                                       |   | (240,000   | )
|Prepaid expenses                                                                                   |  |                                       | (326,000   | ) |                                       |   | (320,000   | )
|Notes receivable                                                                                   |  |                                       | (84,000    | ) |                                       |   | (84,000    | )
|Other assets                                                                                       |  |                                       | (44,000    | ) |                                       |   | 5,000      |  
|Accounts payable                                                                                   |  |                                       | 174,000    |   |                                       |   | 1,490,000  |  
|Accrued compensation                                                                               |  |                                       | (292,000   | ) |                                       |   | (294,000   | )
|Accrued expenses                                                                                   |  |                                       | 77,000     |   |                                       |   | 308,000    |  
|Franchisee deposits                                                                                |  |                                       | (20,000    | ) |                                       |   | (1,000     | )
|Deferred franchise fee income                                                                      |  |                                       | (19,000    | ) |                                       |   | (9,000     | )
|Accrued provision for store closure                                                                |  |                                       |           |   |                                       |   | (86,000    | )
|Deferred rent                                                                                      |  |                                       | 5,000      |   |                                       |   | 4,000      |  
|                                                                                                   |  |                                       |            |   |                                       |   |            |  
|Net cash used in operating activities of continuing operations                                     |  |                                       | (1,954,000 | ) |                                       |   | (442,000   | )
|Net cash (used in) provided by discontinued operations                                             |  |                                       | (143,000   | ) |                                       |   | 169,000    |  
|                                                                                                   |  |                                       |            |   |                                       |   |            |  
|Net cash used in operating activities                                                              |  |                                       | (2,097,000 | ) |                                       |   | (273,000   | )
|                                                                                                   |  |                                       |            |   |                                       |   |            |  
|Cash flows used in investing activities:                                                           |  |                                       |            |   |                                       |   |            |  
|Capital expenditures for property and equipment                                                    |  |                                       | (383,000   | ) |                                       |   | (682,000   | )
|Proceeds from disposal of property and equipment                                                   |  |                                       | 12,000     |   |                                       |   |           |  
|Principal payments received on notes receivable                                                    |  |                                       | 568,000    |   |                                       |   | 513,000    |  
|Investment in restricted money market account                                                      |  |                                       | (4,000     | ) |                                       |   |           |  
|                                                                                                   |  |                                       |            |   |                                       |   |            |  
|Net cash provided by (used in) investing activities of continuing operations                       |  |                                       | 193,000    |   |                                       |   | (169,000   | )
|Net cash used in discontinued operations                                                           |  |                                       | (12,000    | ) |                                       |   | (714,000   | )
|                                                                                                   |  |                                       |            |   |                                       |   |            |  
|Net cash provided by (used in) investing activities                                                |  |                                       | 181,000    |   |                                       |   | (883,000   | )
|                                                                                                   |  |                                       |            |   |                                       |   |            |  
|Cash flows provided by financing activities:                                                       |  |                                       |            |   |                                       |   |            |  
|Exercise of stock options                                                                          |  |                                       | 34,000     |   |                                       |   | 119,000    |  
|Borrowings under credit agreement                                                                  |  |                                       | 1,000,000  |   |                                       |   |           |  
|Payments on capital lease obligations                                                              |  |                                       |           |   |                                       |   | (28,000    | )
|                                                                                                   |  |                                       |            |   |                                       |   |            |  
|Net cash provided by financing activities of continuing operations                                 |  |                                       | 1,034,000  |   |                                       |   | 91,000     |  
|Net cash used in discontinued operations                                                           |  |                                       | (5,000     | ) |                                       |   | (5,000     | )
|                                                                                                   |  |                                       |            |   |                                       |   |            |  
|Net cash provided by financing activities                                                          |  |                                       | 1,029,000  |   |                                       |   | 86,000     |  
|                                                                                                   |  |                                       |            |   |                                       |   |            |  
|Net decrease in cash                                                                               |  |                                       | (887,000   | ) |                                       |   | (1,070,000 | )
|Cash at beginning of period                                                                        |  |                                       | 2,593,000  |   |                                       |   | 10,493,000 |  
|                                                                                                   |  |                                       |            |   |                                       |   |            |  
|Cash at end of period                                                                              |  | $                                     | 1,706,000  |   |                                       | $ | 9,423,000  |  
|                                                                                                   |  |                                       |            |   |                                       |   |            |  
|Supplemental disclosures of cash flow information:                                                 |  |                                       |            |   |                                       |   |            |  
|Non-cash transactions:                                                                             |  |                                       |            |   |                                       |   |            |  
|Value of common stock warrants recorded as debt discount                                           |  | $                                     | 25,000     |   |                                       | $ |           |  
|                                                                                                   |  |                                       |            |   |                                       |   |            |  
|Cash paid during the period for:                                                                   |  |                                       |            |   |                                       |   |            |  
|Interest                                                                                           |  | $                                     | 16,000     |   |                                       | $ | 8,000      |  
|                                                                                                   |  |                                       |            |   |                                       |   |            |  
|Income taxes                                                                                       |  | $                                     | 58,000     |   |                                       | $ |           |  
|                                                                                                   |  |                                       |            |   |                                       |   |            |  
|Issuance of notes receivable                                                                       |  | $                                     | 89,000     |   |                                       | $ | 20,000     |  
|                                                                                                   |  |                                       |            |   |                                       |   |            |  

See accompanying notes to condensed consolidated financial statements.



3



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DIEDRICH COFFEE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 20, 2006

(UNAUDITED)

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis
of Presentation

The unaudited condensed consolidated financial statements of Diedrich Coffee, Inc. and its subsidiaries (the Company) have
been prepared in accordance with accounting principles generally accepted in the United States of America, as well as the instructions to Form 10-Q and Article 10 of Regulation S-X. These statements should be read in conjunction with the
consolidated financial statements and the notes thereto included in the Companys Annual Report on Form 10-K for the year ended June 28, 2006.

In the opinion of management, all adjustments (consisting of normal, recurring adjustments and accruals) considered necessary for a fair presentation have been included. Operating results for interim periods are not necessarily indicative
of the results expected for a full year.

Discontinued Operations

On September 14, 2006, the Company and Starbucks Corporation entered into an asset purchase agreement pursuant to which Starbucks has agreed to purchase the Companys leasehold interests in up to 40 of the
47 locations where the Company operates retail stores under the Diedrich Coffee and Coffee People brands, along with certain related fixtures and equipment, improvements, prepaid items, and ground lease improvements, and to assume certain
liabilities as set forth in the asset purchase agreement.

In accordance with Statement of Financial Accounting Standards (SFAS) 144,
Accounting for the Impairment or Disposal of Long-Lived Assets, the financial results of Companys Diedrich Coffee and Coffee People retail operations are reported as discontinued operations for all periods presented.

Assets held for sale in the Condensed Consolidated balance sheets include the following assets:



| |  |  | Property and equipment, net for Diedrich Coffee, Inc. and Coffee People, Inc. retail stores
| | - |  | -------------------------------------------------------------------------------------------



| |  |  | Goodwill
| | - |  | --------



| |  |  | Other assets
| | - |  | ------------

The following accounts are reflected in Loss from
Discontinued Operations in the Condensed Consolidated Statements of Operations:



| |  |  | Retail Revenues for Diedrich Coffee, Inc. and Coffee People, Inc.
| | - |  | -----------------------------------------------------------------



| |  |  | Cost of sales and related occupancy costs
| | - |  | -----------------------------------------



| |  |  | Operating expenses
| | - |  | ------------------



| |  |  | Depreciation and amortization
| | - |  | -----------------------------



| |  |  | General and administrative expenses
| | - |  | -----------------------------------



| |  |  | Interest expense
| | - |  | ----------------



| |  |  | Provision for taxes paid
| | - |  | ------------------------



4



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Recent Accounting Pronouncements

In July 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109 (FIN 48) which seeks to reduce the
diversity in practice associated with the accounting and reporting for uncertainty in income tax positions. FIN 48 prescribes a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of uncertain tax
positions taken or expected to be taken in income tax returns. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company will adopt the new requirements in its fiscal first quarter of 2008. The cumulative effects, if
any, of adopting FIN 48 will be recorded as an adjustment to retained earnings as of the beginning of the period of adoption. The Company has not yet determined the impact, if any, of adopting FIN 48 on its consolidated financial statements.

Income Taxes

The Company accounts for income
taxes under SFAS No. 109, Accounting for Income Taxes (SFAS No. 109). This statement requires the recognition of deferred tax assets and liabilities for the future consequences of events that have been
recognized in the Companys financial statements or tax returns. The measurement of the deferred items is based on enacted tax laws. In the event the future consequences of differences between financial reporting bases and the tax bases of the
Companys assets and liabilities result in a deferred tax asset, SFAS No. 109 requires an evaluation of the probability of being able to realize the future benefits indicated by such asset. A valuation allowance related to a deferred tax
asset is recorded when it is more likely than not that some portion or all of the deferred tax asset will not be realized.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management
to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could materially differ from those estimates.

Stock-Based Compensation

On October 20, 2000, the Companys board of directors authorized the adoption of the Diedrich Coffee, Inc. 2000 Equity Incentive Plan (the 2000 Equity
Incentive Plan) and the concurrent discontinuation of the option grants under the Diedrich Coffee, Inc. Amended and Restated 1996 Stock Incentive Plan and the Diedrich Coffee, Inc. 1996 Non-Employee Directors Stock Option Plan. The
Companys stockholders approved the 2000 Equity Incentive Plan on October 16, 2000. A total of 1,087,500 shares of the Companys common stock may be issued under the 2000 Equity Incentive Plan, as amended. The board of directors
determines the number of shares, terms and exercise periods for awards under the 2000 Equity Incentive Plan on a case by case basis, except for automatic annual grants of options to non-employee directors. Options generally vest ratably over three
years and expire ten years from the date of grant. The exercise price of options is generally equivalent to the fair market value of the Companys common stock on the date of grant.

On June 30, 2005, the Company adopted the provisions of SFAS 123R, Share-Based Payment (SFAS 123R). SFAS 123R sets accounting requirements for share-based
compensation to employees and non-employee directors, including employee stock purchase plans, and requires companies to recognize in the statement of operations the grant-date fair value of stock options and other equity-based compensation.

The Company chose the modified-prospective transition alternatives in adopting SFAS 123R. Under the modified-prospective transition method, compensation
cost is recognized in financial statements issued subsequent to the date of adoption for all stock-based payments granted, modified or settled after the date of adoption, as well as for any unvested awards that were granted prior to the date of
adoption. Because the Company previously adopted only the pro forma disclosure provisions of SFAS 123, it will recognize compensation cost relating to the unvested portion of awards granted prior to the date of adoption using the same estimate of
the grant-date fair value and the same attribution method used to determine the pro forma disclosures under SFAS 123, except that forfeitures rate will be estimated for all options, as required by SFAS 123R.

The fair value of each option award is estimated on the date of grant using a Black-Scholes option valuation model that uses the assumptions noted in the following
table. Expected volatility is based on the historical volatility of the price of the Companys stock. The Company uses historical data to estimate option exercise and employee termination rates within the valuation model. The



5



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expected term of options is derived from the output of the option valuation model and represents the period of time that options are expected to be
outstanding. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The fair values of the options were estimated using the Black-Scholes option-pricing
model based on the following assumptions:



|                        |  |                    |   |  |                    |  
|----------------------- |  | ------------------ | - |  | ------------------ | -
|                        |  | TWELVE WEEKS ENDED |  
|                        |  | September 20, 2006 |   |  | September 21, 2005 |  
|Risk free interest rate |  | 5.29               | % |  | 4.23               | %
|Expected life           |  | 2 years            |   |  | 6 years            |  
|Expected volatility     |  | 55                 | % |  | 75                 | %
|Expected dividend yield |  | 0                  | % |  | 0                  | %
|Forfeiture rate         |  | 5.02               | % |  | 3.91               | %

A summary of option activity under our stock option plans for the twelve weeks ended September 20, 2006 is as
follows:



|                                          |  |                  |   |  |                               |       |                                                 |     |                             |   |  
|----------------------------------------- |  | ---------------- | - |  | ----------------------------- | ----- | ----------------------------------------------- | --- | --------------------------- | - | -
|                                          |  | Number ofoptions |   |  | Weightedaverage exerciseprice |       | Weightedaverageremainingcontractual term(years) |     | Aggregateintrinsic Value($)
|Options outstanding at June 28, 2006      |  | 941,000          |   |  | $                             | 4.94  |                                                 |     |                             |   |  
|Less:                                     |  |                  |   |  |                               |       |                                                 |     |                             |   |  
|Options exercised                         |  | (160,000         | ) |  |                               | 3.38  |                                                 |     |                             |   |  
|Options canceled or expired               |  | (66,000          | ) |  |                               | 10.05 |                                                 |     |                             |   |  
|                                          |  |                  |   |  |                               |       |                                                 |     |                             |   |  
|Options outstanding at September 20, 2006 |  | 715,000          |   |  |                               | 4.81  |                                                 | 6.7 |                             | $ | 
|                                          |  |                  |   |  |                               |       |                                                 |     |                             |   |  
|Options exercisable at September 20, 2006 |  | 560,000          |   |  | $                             | 4.86  |                                                 | 6.0 |                             | $ | 
|                                          |  |                  |   |  |                               |       |                                                 |     |                             |   |  

Stock-based compensation expense included in the statement of operations for the twelve weeks ended
September 20, 2006 was approximately $67,000 and for the twelve weeks ended September 21, 2005 was approximately $85,000. As of September 20, 2006, there was approximately $195,000 of total unrecognized stock-based compensation cost
related to options granted under our plans that will be recognized over a weighted average period of 1.7 years. The total intrinsic value of options exercised during the twelve weeks ended September 20, 2006 was approximately $111,000.

A summary of the status of the Companys unvested options as of September 20, 2006, and changes during the twelve weeks ended September 20,
2006, is presented below:



|                                       |  |         |  |                                             |     
|-------------------------------------- |  | ------- |  | ------------------------------------------- | ----
|Unvested Options                       |  | Options |  | Weighted Average Grant-Date Fair Value ($)
|Unvested options at June 28, 2006      |  | 155,000 |  | $                                           | 4.64
|Granted                                |  |        |  |                                             |    
|Vested                                 |  |        |  |                                             |    
|Forfeited                              |  |        |  |                                             |    
|Unvested options at September 20, 2006 |  | 155,000 |  | $                                           | 4.64

No options vested during the twelve weeks ended September 20, 2006.

Cash Surrender Value of Life Insurance

The change in the cash
surrender value (CSV) of company owned life insurance (COLI) contracts, net of insurance premiums paid and gains realized, is reported in compensation and benefits expense. See Note 10.



6



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Reclassifications

Certain reclassifications have been made to the September 21, 2005 unaudited condensed consolidated financial statements to conform to the September 20, 2006 presentation.

2. INVENTORIES

Inventories consist of the following:



|                                  |  |                    |           |               |   |          
|--------------------------------- |  | ------------------ | --------- | ------------- | - | ---------
|                                  |  | September 20, 2006 |           | June 28, 2006
|Unroasted coffee                  |  | $                  | 1,523,000 |               | $ | 1,522,000
|Roasted coffee                    |  |                    | 743,000   |               |   | 791,000  
|Accessory and specialty items     |  |                    | 192,000   |               |   | 136,000  
|Other food, beverage and supplies |  |                    | 1,258,000 |               |   | 1,397,000
|                                  |  |                    |           |               |   |          
|Total inventory                   |  | $                  | 3,716,000 |               | $ | 3,846,000
|                                  |  |                    |           |               |   |          

3. NOTES RECEIVABLE

Notes receivable consist of the following:



|                                                                                                                                                                                                                                                                               |  |                    |            |   |               |   |            |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | ------------------ | ---------- | - | ------------- | - | ---------- | -
|                                                                                                                                                                                                                                                                               |  | September 20, 2006 |            |   | June 28, 2006 |  
|Notes receivable bearing interest at rates from 0% to 9.5%, payable in installments of between $115 and $4,268 and due between January 2006
and October 2016. Notes are secured by the assets sold under the asset purchase and sale agreements or general security agreement. |  | $                  | 228,000    |   |               | $ | 206,000    |  
|Notes receivable from a corporation discounted at an annual rate of 8.0%, payable annually in installments of between $1,000,000 and
$2,000,000, due between January 31, 2007 and January 31, 2011.                                                                            |  |                    | 4,487,000  |   |               |   | 4,903,000  |  
|Less: current portion of notes receivable                                                                                                                                                                                                                                      |  |                    | (1,206,000 | ) |               |   | (1,137,000 | )
|                                                                                                                                                                                                                                                                               |  |                    |            |   |               |   |            |  
|Long-term portion of notes receivable                                                                                                                                                                                                                                          |  | $                  | 3,509,000  |   |               | $ | 3,972,000  |  
|                                                                                                                                                                                                                                                                               |  |                    |            |   |               |   |            |  

4. ACCRUED PROVISION FOR STORE CLOSURE

As required by SFAS 146, Accounting for Costs Associated with Exit or Disposal Activities, the Company records estimated costs for store closures when they are incurred rather than at the date of a
commitment to an exit or disposal plan. These costs primarily consist of the estimated cost to terminate real estate leases.



|                                      |  |             |         |                           |   |             |  |   |              |   |  |             |         |   |  |   |        
|------------------------------------- |  | ----------- | ------- | ------------------------- | - | ----------- |  | - | ------------ | - |  | ----------- | ------- | - |  | - | -------
|                                      |  | Beg Balance |         | AmountsCharged to Expense |   | Adjustments |  |   | CashPayments |   |  | End Balance
|Fiscal year ended June 28, 2006       |  | $           | 91,000  |                           | $ | 401,000     |  | $ | (75,000      | ) |  | $           | (16,000 | ) |  | $ | 401,000
|Twelve weeks ended September 20, 2006 |  | $           | 401,000 |                           | $ | 70,000      |  | $ |             |   |  | $           |        |   |  | $ | 471,000

Amounts charged to expense for the twelve weeks ended September 20, 2006 were $70,000.

5. EARNINGS PER SHARE

The following table sets forth the computation of
basic and diluted net loss per share from continuing operations:



|                                                                |  |                                       |            |   |                                       |   |            |  
|--------------------------------------------------------------- |  | ------------------------------------- | ---------- | - | ------------------------------------- | - | ---------- | -
|                                                                |  | Twelve Weeks Ended September 20, 2006 |            |   | Twelve Weeks Ended September 21, 2005 |  
|Numerator:                                                      |  |                                       |            |   |                                       |   |            |  
|Net loss from continuing operations                             |  | $                                     | (1,195,000 | ) |                                       | $ | (1,290,000 | )
|                                                                |  |                                       |            |   |                                       |   |            |  
|Denominator:                                                    |  |                                       |            |   |                                       |   |            |  
|Basic weighted average shares outstanding                       |  |                                       | 5,308,000  |   |                                       |   | 5,287,000  |  
|Effect of dilutive securities                                   |  |                                       |           |   |                                       |   |           |  
|                                                                |  |                                       |            |   |                                       |   |            |  
|Diluted adjusted weighted average shares                        |  |                                       | 5,308,000  |   |                                       |   | 5,287,000  |  
|                                                                |  |                                       |            |   |                                       |   |            |  
|Basic and diluted net loss per share from continuing operations |  | $                                     | (0.23      | ) |                                       | $ | (0.24      | )
|                                                                |  |                                       |            |   |                                       |   |            |  



7



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For computation of net loss per share from continuing operations, all 715,000 and 906,000 options outstanding as of
September 20, 2006 and September 21, 2005, respectively, were excluded because their inclusion would have been anti-dilutive. In addition, all 951,000 warrants to purchase shares of common stock as of September 20, 2006 and
September 21, 2005, were excluded from the calculation of diluted net loss per share because their inclusion would have been anti-dilutive.

The
following table sets forth the computation of basic and diluted net loss per share:



|                                                                |  |                                       |            |   |                                       |   |            |  
|--------------------------------------------------------------- |  | ------------------------------------- | ---------- | - | ------------------------------------- | - | ---------- | -
|                                                                |  | Twelve Weeks Ended September 20, 2006 |            |   | Twelve Weeks Ended September 21, 2005 |  
|Numerator:                                                      |  |                                       |            |   |                                       |   |            |  
|Net loss                                                        |  | $                                     | (1,646,000 | ) |                                       | $ | (1,552,000 | )
|                                                                |  |                                       |            |   |                                       |   |            |  
|Denominator:                                                    |  |                                       |            |   |                                       |   |            |  
|Basic weighted average shares outstanding                       |  |                                       | 5,308,000  |   |                                       |   | 5,287,000  |  
|Effect of dilutive securities                                   |  |                                       |           |   |                                       |   |           |  
|                                                                |  |                                       |            |   |                                       |   |            |  
|Diluted adjusted weighted average shares                        |  |                                       | 5,308,000  |   |                                       |   | 5,287,000  |  
|                                                                |  |                                       |            |   |                                       |   |            |  
|Basic and diluted net loss per share from continuing operations |  | $                                     | (0.31      | ) |                                       | $ | (0.29      | )
|                                                                |  |                                       |            |   |                                       |   |            |  

6. SEGMENT AND RELATED INFORMATION

The Company has three reportable segments: retail operations, wholesale operations, and franchise operations. The Company evaluates performance of its operating segments based on income (loss) before income taxes.

Summarized financial information concerning the Companys reportable segments is shown in the following table. Corporate identifiable assets consist
of corporate cash, corporate notes receivable, corporate prepaid expenses, and corporate property and equipment. The corporate component of segment loss before tax includes corporate general and administrative expenses, depreciation and amortization
expense, interest income and interest expense.



|                                    |  |                    |           |                    |   |          
|----------------------------------- |  | ------------------ | --------- | ------------------ | - | ---------
|                                    |  | TWELVE WEEKS ENDED
|                                    |  | September 20, 2006 |           | September 21, 2005
|Revenue:                            |  |                    |           |                    |   |          
|Wholesale                           |  | $                  | 5,120,000 |                    | $ | 3,571,000
|Franchise                           |  |                    | 768,000   |                    |   | 721,000  
|Retail                              |  |                    | 536,000   |                    |   | 844,000  
|                                    |  |                    |           |                    |   |          
|Total revenue                       |  | $                  | 6,424,000 |                    | $ | 5,136,000
|                                    |  |                    |           |                    |   |          
|Interest expense:                   |  |                    |           |                    |   |          
|Wholesale                           |  | $                  |          |                    | $ |         
|Franchise                           |  |                    |          |                    |   | 2,000    
|Corporate                           |  |                    | 26,000    |                    |   | 24,000   
|                                    |  |                    |           |                    |   |          
|Total interest expense              |  | $                  | 26,000    |                    | $ | 26,000   
|                                    |  |                    |           |                    |   |          
|Depreciation and amortization:      |  |                    |           |                    |   |          
|Retail                              |  | $                  | 50,000    |                    | $ | 37,000   
|Wholesale                           |  |                    | 111,000   |                    |   | 143,000  
|Corporate                           |  |                    | 69,000    |                    |   | 72,000   
|                                    |  |                    |           |                    |   |          
|Total depreciation and amortization |  | $                  | 230,000   |                    | $ | 252,000  
|                                    |  |                    |           |                    |   |          



8



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|                                                                            |  |                    |            |   |                    |   |            |  
|--------------------------------------------------------------------------- |  | ------------------ | ---------- | - | ------------------ | - | ---------- | -
|                                                                            |  | TWELVE WEEKS ENDED |           
|                                                                            |  | September 20, 2006 |            |   | September 21, 2005 |  
|Segment income (loss) from continuing operations before income tax benefit: |  |                    |            |   |                    |   |            |  
|Wholesale                                                                   |  | $                  | 590,000    |   |                    | $ | 301,000    |  
|Franchise                                                                   |  |                    | 29,000     |   |                    |   | 488,000    |  
|Retail                                                                      |  |                    | (23,000    | ) |                    |   | (32,000    | )
|Corporate                                                                   |  |                    | (1,791,000 | ) |                    |   | (2,395,000 | )
|                                                                            |  |                    |            |   |                    |   |            |  
|Total segment loss from continuing operations before income tax provision   |  | $                  | (1,195,000 | ) |                    | $ | (1,638,000 | )
|                                                                            |  |                    |            |   |                    |   |            |  
|                                                                            |  |                   
|                                                                            |  | September 20, 2006 |            |   | June 29, 2006      |  
|Identifiable assets:                                                        |  |                    |            |   |                    |   |            |  
|Assets held for sale                                                        |  | $                  | 4,835,000  |   |                    | $ | 5,222,000  |  
|Retail                                                                      |  |                    | 2,673,000  |   |                    |   | 2,547,000  |  
|Wholesale                                                                   |  |                    | 8,011,000  |   |                    |   | 7,431,000  |  
|Franchise                                                                   |  |                    | 1,010,000  |   |                    |   | 1,276,000  |  
|Corporate                                                                   |  |                    | 8,642,000  |   |                    |   | 9,475,000  |  
|                                                                            |  |                    |            |   |                    |   |            |  
|Tangible assets                                                             |  |                    | 25,171,000 |   |                    |   | 25,951,000 |  
|Assets held for sale                                                        |  |                    | 1,347,000  |   |                    |   | 1,347,000  |  
|Goodwill  Wholesale                                                        |  |                    | 6,311,000  |   |                    |   | 6,311,000  |  
|Goodwill  Franchise                                                        |  |                    | 521,000    |   |                    |   | 521,000    |  
|                                                                            |  |                    |            |   |                    |   |            |  
|Total assets                                                                |  | $                  | 33,350,000 |   |                    | $ | 34,130,000 |  
|                                                                            |  |                    |            |   |                    |   |            |  

7. LEASE CONTINGENCIES

The Company is liable on the master real property leases for 81 Gloria Jeans franchise locations. Under the Companys historical franchising business model, the Company executed the master lease for these locations and entered
into subleases on the same terms with its franchisees, which typically pay their rent directly to the landlords. Should any of these franchisees default on their subleases, the Company would be responsible for making required to make all payments
under the master lease. The Companys maximum theoretical future exposure at September 20, 2006, computed as the sum of all remaining lease payments through the expiration dates of the respective leases, was $19,641,000. This amount does
not take into consideration any mitigating measures that the Company could take to reduce this exposure in the event of default, including re-leasing the location or terminating the master lease by negotiating a lump sum payment to the landlord in
an amount that is less than the sum of all remaining future rents.

8. OUTSTANDING FINANCING ARRANGEMENTS AND RESTRICTED CASH

On May 10, 2004 the Company entered into a $5,000,000 Contingent Convertible Note Purchase Agreement. The agreement provides for the Company to, at its election,
issue notes with up to an aggregate principal amount of $5,000,000. The notes are to be amortized on a monthly basis at a rate that will repay 60% of the principal amount of the note by June 30, 2008. The remaining 40% will mature on that date.
Interest is payable at three-month LIBOR plus 5.30%, and a facility fee of 1.00% annually is payable on the unused portion of the facility. The agreement contains covenants that limit the amount of indebtedness that the Company may have outstanding
in relation to its tangible net worth. As of September 20, 2006, the Company was in compliance with all the covenants in the agreement. Notes are convertible into common stock only upon certain changes of control. For notes issued and repaid,
warrants to purchase shares are to be issued with the same rights and restrictions for exercise as existed for convertibility of the notes at the time of their issuance. Warrants are exercisable only in the event of a change of control and expire on
June 30, 2010. The fair value of warrants issued with respect to notes repaid will be recorded as a discount to debt, at the date of issuance, which will then be amortized using the effective interest method. Warrants to purchase common stock
of the Company will be issued only upon a change in control of the Company. The lender under this agreement is a limited partnership of which the chairman of the Companys board of directors serves as the sole general partner. A total of
455,184 warrants are issuable upon a change in control for previous debt repayments under this facility. The Company has issued 4,219 warrants as of September 20, 2006. On August 23, 2006, the Company



9



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issued a $1,000,000 note under the facility and recorded a discount of $25,000 to reflect the value of the warrants as of the borrowing date. As of
September 20, 2006, the Company had $4,000,000 available for future borrowing.

On June 30, 2004, the Company entered into
Amendment No. 1 to Contingent Convertible Note Purchase Agreement (Amendment No. 1), which revised the definition of Availability to mean, on any date, the loan amount less the sum of the principal amounts then
outstanding under the Note Purchase Agreement. Under the original Note Purchase Agreement, availability was calculated using a formula that reduced availability over time.

On November 4, 2005, the Company entered into a new Credit Agreement with Bank of the West. The agreement provides for a $750,000 letter of credit
facility that expires on October 15, 2007. The letter of credit facility is secured by a deposit account at Bank of the West. As of September 20, 2006, this deposit account had a balance of $587,000, which is shown as restricted cash on
the consolidated balance sheets. As of September 20, 2006, $651,000 of letters of credit was outstanding under the letter of credit facility. The agreement contains covenants that, among other matters, require the Company to submit financial
statements to the bank within specified time periods. As of September 20, 2006, the Company was in compliance with all Bank of the West agreement covenants.

On March 31, 2006, the Company entered into Amendment No. 2 to Contingent Convertible Note Purchase Agreement (Amendment No. 2). Amendment No. 2: (i) contains a waiver with respect
to the default of the Minimum EBITDA Covenant as of March 8, 2006 and removes the Minimum EBITDA from the Note Purchase Agreement; (ii) clarifies that warrants to purchase common stock of the Company will be issued with respect to repaid
principal amounts only upon a change in control of the Company; (iii) increases the interest rate applicable to outstanding amounts under the credit facility by 2%, to LIBOR plus 5.30%; and (iv) extended the exercise date of all warrants
issued or to be issued under the Note Purchase Agreement by one year, to May 10, 2009, which was subsequently extended as discussed below. The maturity date for any notes issued in the future was unaffected by Amendment No. 2. As of
September 20, 2006, the Company was in compliance with all agreement covenants as amended by Amendment No 2.

On September 22,
2006, the Company entered into Amendment No. 3 to Contingent Convertible Note Purchase Agreement (Amendment No. 3). Amendment No. 3 (i) changes the date specified in the definition of Maturity Date from
May 10, 2007 to June 30, 2008; (ii) adjusts the calculation of monthly payments to reflect the extended maturity date; (iii) removes a condition precedent to each loan that previously required there to be no material adverse
effect or event reasonably likely to result in a material adverse effect before the obligation of the lender to purchase any note arose; (iv) amends the events of default so that an event that has, or is reasonably likely to have, a material
adverse effect will not be considered such an event of default; (v) amends the notice requirements so that the Company is not required to give notice to the lender of any event that is reasonably likely to have a material adverse effect; and
(vi) extends the exercise date of all warrants issued or to be issued under the Note Purchase Agreement to June 30, 2010.

9. DISCONTINUED
OPERATIONS

The Companys strategic direction will focus on growing the wholesale business segment and the related distribution
channels, including franchise stores. As part of the plan to narrow the focus of the retail business segment to only franchise operations, the Company plans to close all Diedrich Coffee and Coffee People company-operated locations, but retain
the two brands for its wholesale and franchise operations. In conjunction with the proposed transaction with Starbucks Corporation, the Company will exit any remaining Diedrich Coffee and Coffee People company-operated locations not
included in the completed transaction.

On September 14, 2006, the Company and Starbucks Corporation entered into an asset purchase
agreement pursuant to which Starbucks has agreed to purchase the Companys leasehold interests in up to 40 of the 47 locations where the Company operates retail stores under the Diedrich Coffee and Coffee People brands, along with certain
related fixtures and equipment, improvements, prepaid items, and ground lease improvements, and to assume certain liabilities as set forth in the asset purchase agreement.



10



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Pursuant to the asset purchase agreement, Starbucks will pay the Company up to $13,520,000 in cash, which
includes payment of $120,000 as consideration for the Companys agreement to a non-compete provision, plus the amount of any prepaid items associated with the Company Stores that are transferred. The actual amount paid by Starbucks under the
asset purchase agreement is dependent on which and how many of the Company Stores are ultimately transferred to Starbucks. Ten percent of the amount paid to the Company upon transfer of the Company Stores will be deposited into an escrow fund to be
held in connection with the Companys indemnification obligations. The Closing is expected to occur approximately 90 days after the date of the asset purchase agreement, provided that certain conditions, including that a specified minimum
number of Company Stores are transferred to Starbucks at Closing, are met. After the Closing, the Company and Starbucks have agreed to use commercially reasonable efforts to transfer certain remaining Company Stores until approximately 150 days
after the date of the asset purchase agreement or such other longer period as agreed to by the Company and Starbucks.

The Company and
Starbucks have made certain customary representations, warranties and covenants in the asset purchase agreement. Specifically, they have agreed that, subject to a fiduciary-out provision and payment of a break-up fee, the Company will
not (i) take any action to solicit any proposal from, (ii) furnish any information to, or (iii) participate in any discussions with, any entity other than Starbucks regarding any transaction involving the Company Stores. Upon
termination of the asset purchase agreement under certain circumstances, including the Companys entry into an alternative transaction involving the Company Stores, the Company shall pay Starbucks actual fees and expenses incurred in
connection with the Transaction up to a maximum amount of $500,000; provided, however, that Starbucks is entitled to a minimum of $250,000, regardless of its actual fees and expenses. The asset purchase agreement also contains customary
indemnification provisions for certain claims and provides for a basket of $100,000 and a cap of $2,000,000 for breaches of the Companys representations and warranties contained in the asset purchase agreement.

The consummation of the transaction is subject to certain customary conditions, including: approval of the transaction by the Companys
stockholders; a specified minimum number of Company Stores transferred to Starbucks at Closing; the receipt by Starbucks of permits and approvals for at least 70% of certain Company Stores that are transferred if the Closing occurs within 90 days of
the date of the asset purchase agreement; receipt of lease extensions of at least 10 years for at least 40% of certain Company Stores that are transferred; and, receipt of consents to the assignment of the leases for each of the Company Stores that
are transferred, with estoppel provisions being agreed to for at least 50% of the Company Stores that are transferred. The asset purchase agreement contains customary termination provisions and may be terminated by either the Company or Starbucks if
the Closing does not occur within 150 days from the date of the asset purchase agreement. The Company may also terminate the asset purchase agreement if the Closing has not occurred within 90 days, provided that Starbucks has not used commercially
reasonable efforts to achieve the Closing.



11



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As part of the asset purchase agreement, the Company has agreed to a non-compete provision that for three
years after the Closing restricts the Companys ability to operate or have any interest in the ownership or operation of any entity operating any retail specialty coffee stores in any city where a Company Store is presently located. The
non-compete provision applies only to stores opened after the date of the asset purchase agreement and does not apply to (1) any retail stores operated under the Gloria Jeans brand name, (2) wholesale sales to retail
businesses that are not operated by the Company, or other non-retail businesses, or (3) the conversion of Company-operated stores existing on the date of the asset purchase agreement to franchise stores. The Company has also agreed that it will
not solicit any Starbucks employee to enter the Companys employment for three years after the Closing.

No assurances can be given
that the asset purchase will be completed according to the foregoing terms, if at all.

Assets held for sale consisted of the following:



|                            |  |                    |           |               |   |          
|--------------------------- |  | ------------------ | --------- | ------------- | - | ---------
|                            |  | September 20, 2006 |           | June 28, 2006
|Property and equipment, net |  | $                  | 4,642,000 |               | $ | 5,027,000
|Goodwill, net               |  |                    | 1,347,000 |               |   | 1,347,000
|Other assets                |  |                    | 193,000   |               |   | 194,000  
|                            |  |                    |           |               |   |          
|Total assets held for sale  |  | $                  | 6,182,000 |               | $ | 6,568,000
|                            |  |                    |           |               |   |          

In accordance with SFAS 144, the financial results of the retail operations are reported as discontinued
operations for all periods presented.

The financial results included in discontinued operations were as follows:



|                                                          |  |                    |           |   |                    |   |           |  
|--------------------------------------------------------- |  | ------------------ | --------- | - | ------------------ | - | --------- | -
|                                                          |  | TWELVE WEEKS ENDED |          
|                                                          |  | September 20, 2006 |           |   | September 21, 2005 |  
|Net revenue                                               |  | $                  | 6,981,000 |   |                    | $ | 7,044,000 |  
|                                                          |  |                    |           |   |                    |   |           |  
|Loss from discontinued operations, net of $0 income taxes |  | $                  | (451,000  | ) |                    | $ | (262,000  | )
|                                                          |  |                    |           |   |                    |   |           |  

10. EMPLOYEE BENEFITS

401(k) Plan

The Company maintains a 401(k) Salary Deferral Plan (the 401(k) Plan) for eligible employees. Employer matching
contributions relating to the 401(k) Plan totaled $13,000 and $12,000 for the twelve weeks ended September 20, 2006 and September 21, 2005, respectively.

Deferred Compensation Plan

Effective December 15, 2005, the Company amended its non-qualified deferred compensation plan. Under the
amended plan, plan participants may elect to defer, on a pre-tax basis, a portion (from 0% to 100%) of their base salary, service bonus, and performance-based compensation. Any amounts deferred by a plan participant will be credited to the plan
participants deferred compensation account. The plan further provides that the Company may make discretionary contributions to a plan participants deferred compensation account. Each plan participant will be vested in the amounts held in
the plan participants deferred compensation account as follows: (i) one hundred percent (100%) vested at all times with respect to all amounts of deferred compensation; and (ii) one hundred percent (100%) vested at all
times with respect to all employer discretionary contributions. The Company made no discretionary contributions to plan participants accounts for the twelve weeks ended September 20, 2006 and September 21, 2005.

The plan also provides that any amounts deferred under the plan may not be distributed to a plan participant until the earlier of: (i) the plan participants
separation from service with the Company; (ii) the Plan participants retirement from the Company; (iii) the plan participants disability; (iv) the plan participants death; (v) the occurrence of a change in
control of the Company; (vi) the occurrence of an unforeseeable emergency, as defined in the plan; or (vii) such other date as set forth in the plan participants deferral election,



12



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including a date that occurs prior to the plan participants separation from service with the Company. Any amounts distributed to a plan participant
will be paid in a form specified by the plan participant, or in the form of either a lump sum payment in an amount equal to the plan participants deferred compensation account balance or equal annual installments of the plan participants
deferred compensation account balance over a period not to exceed (i) 20 years in the case of a distribution due to separation from service, death or disability or (ii) five years in the case of a distribution for educational expenses.

The Company has purchased a COLI contract insuring two of the participants in the deferred compensation plan. The policy is held in a trust to provide
additional benefit security for the deferred compensation plan. The assets in the trust are owned by the Company and are subject to claims of its creditors. The gross cash surrender value of these contracts as of September 20, 2006 was $436,000
as shown in the accompanying consolidated balance sheets. Total death benefits payable were $14,908,000 at September 20, 2006. Management intends to use the future death benefits from these insurance contracts to fund the deferred compensation
arrangements; however, there may not be a direct correlation between the timing of the future cash receipts and disbursements under these arrangements.

Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations.

A
WARNING ABOUT FORWARD LOOKING STATEMENTS.

We make forward-looking statements in this quarterly report that are subject to risks and uncertainties.
These forward-looking statements include information about possible or assumed future results of our financial condition, operations, plans, objectives and performance. Additionally, when we use the words believe, expect,
anticipate, estimate or similar expressions, we are making forward-looking statements. A number of events and factors could affect our future financial results and performance. This could cause our results or performance to
differ materially from those expressed in our forward-looking statements. You should consider these risks when you review this report, along with the following possible events or factors:



| |  |  | the financial and operating performance of our retail operations;
| | - |  | -----------------------------------------------------------------



| |  |  | the timing and success of the pending sale of retail store locations to Starbucks Corporation;
| | - |  | ----------------------------------------------------------------------------------------------



| |  |  | our ability to maintain profitability over time;
| | - |  | ------------------------------------------------



| |  |  | the successful execution of our growth strategies;
| | - |  | --------------------------------------------------



| |  |  | our franchisees adherence to our practices, policies and procedures;
| | - |  | ---------------------------------------------------------------------



| |  |  | the impact of competition; and
| | - |  | ------------------------------



| |  |  | the availability of working capital.
| | - |  | ------------------------------------

Additional risks and uncertainties
are described elsewhere in this report and in detail under the caption Risk Factors and Trends Affecting Diedrich Coffee and Its Business in our Annual Report on Form 10-K for the fiscal year ended June 28, 2006 and in other reports
that we file with the Securities and Exchange Commission. You are cautioned not to place undue reliance on these forward-looking statements, which reflect managements analysis only as of the date of this quarterly report. We undertake no
obligation to revise or update any forward-looking statements whether as a result of new information, future events or changed circumstances. Unless otherwise indicated, we, us, our, and similar terms refer to
Diedrich Coffee, Inc. and its subsidiaries.

INTRODUCTION

Managements discussion and analysis of financial condition and results of operations is provided as a supplement to the accompanying unaudited condensed consolidated financial statements and footnotes to help
provide an understanding of our financial condition, the changes in our financial condition and our results of operations. Our discussion is organized as follows:



| |  |  | Overview. This section provides a general description of our business and recent significant transactions that we believe are important in understanding our results of
operations. This section also contains a discussion of trends in our operations and key performance indicators that we use to evaluate business results.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | Results of operations. This section provides an analysis of our results of operations presented in the accompanying unaudited condensed consolidated statements of operations
by comparing the results for the twelve weeks ended September 20, 2006 to the results for the twelve weeks ended September 21, 2005.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Financial condition, liquidity and capital resources. This section provides an analysis of our cash flows and a discussion of our outstanding debt and commitments, both firm
and contingent, that existed as of September 20, 2006. Included in the discussion of outstanding debt is a discussion of our financial capacity to fund our future commitments and a discussion of other financing arrangements.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Critical accounting estimates. This section contains a discussion of the accounting policies that we believe are important to our financial condition and results and that
require significant judgment and estimates on the part of management in their application. In addition, all of our significant accounting policies, including the critical accounting policies, are summarized in Note 1 to the accompanying unaudited
condensed consolidated financial statements.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

OVERVIEW

Business

We are a specialty coffee roaster, wholesaler and retailer and our brands include Diedrich Coffee, Gloria
Jeans, and Coffee People. We roast high quality specialty coffees at our roasting facility in central California and sell whole bean and ground coffees to our franchise partners, office coffee service distributors, foodservice customers
including restaurants and hotels; other wholesale customers such as specialty retailers, and directly to individual consumers via our web stores. We believe that we are differentiated from other specialty coffee companies by the quality of our
coffee products and the superior customer service that we provide to our customers. Our roasting recipes take into account the specific variety, origin and physical characteristics of each coffee bean to maximize its unique flavor.

As of September 20, 2006, we owned and operated 52 retail locations and franchised 149 other retail locations under these brands, for a total of 201 retail coffee
outlets. As of September 20, 2006, our retail units were located in 33 states and we had over 800 wholesale accounts with office coffee service distributors, chain and independent restaurants and others.

Recent Developments

The Companys strategic
direction will focus on growing the wholesale business segment and the related distribution channels, including franchise stores. As part of the plan to narrow the focus of the retail business segment to only franchise operations, the Company
plans to close all Diedrich Coffee and Coffee People company-operated locations, but retain the two brands for its wholesale and franchise operations. In conjunction with the proposed transaction with Starbucks Corporation, the Company will
exit any remaining Diedrich Coffee and Coffee People company-operated locations not included in any completed transaction with Starbucks.

On September 14, 2006, we and Starbucks entered into an asset purchase agreement pursuant to which Starbucks has agreed to purchase our leasehold interests in up to 40 of the 47 locations where we operate retail stores under the
Diedrich Coffee and Coffee People brands, along with certain related fixtures and equipment, improvements, prepaid items, and ground lease improvements, and to assume certain liabilities as set forth in the asset purchase agreement.

Pursuant to the asset purchase agreement, Starbucks will pay us up to $13,520,000 in cash, which includes payment of $120,000 as consideration for our
agreement to a non-compete provision, plus the amount of any prepaid items associated with the Company Stores that are transferred. The actual amount paid by Starbucks under the asset purchase agreement is dependent on which and how many of the
Company Stores are ultimately transferred to Starbucks. Ten percent of the amount paid to us upon transfer of the Company Stores will be deposited into an escrow fund to be held in connection with our indemnification obligations. The Closing is
expected to occur approximately 90 days after the date of the asset purchase agreement, provided that certain conditions, including that a specified minimum number of Company Stores are transferred to Starbucks at Closing, are met. After the
Closing, we and



14



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Starbucks have agreed to use commercially reasonable efforts to transfer certain remaining Company Stores until approximately 150 days after the date of the
asset purchase agreement or such other longer period as agreed to by us and Starbucks.

We and Starbucks have made certain customary
representations, warranties and covenants in the asset purchase agreement. Specifically, we have agreed that, subject to a fiduciary-out provision and payment of a break-up fee, we will not (i) take any action to solicit any
proposal from, (ii) furnish any information to, or (iii) participate in any discussions with, any entity other than Starbucks regarding any transaction involving the Company Stores. Upon termination of the asset purchase agreement under
certain circumstances, including the Companys entry into an alternative transaction involving the Company Stores, we shall pay Starbucks actual fees and expenses incurred in connection with the Transaction up to a maximum amount of
$500,000; provided, however, that Starbucks is entitled to a minimum of $250,000, regardless of its actual fees and expenses. The asset purchase agreement also contains customary indemnification provisions for certain claims and provides for a
basket of $100,000 and a cap of $2,000,000 for breaches of our representations and warranties contained in the asset purchase agreement.

The consummation of the Transaction is subject to certain customary conditions, including: approval of the Transaction by our stockholders; a specified minimum number of Company Stores transferred to Starbucks at Closing; the receipt by
Starbucks of permits and approvals for at least 70% of certain Company Stores that are transferred if the Closing occurs within 90 days of the date of the asset purchase agreement; receipt of lease extensions of at least 10 years for at least 40% of
certain Company Stores that are transferred; and, receipt of consents to the assignment of the leases for each of the Company Stores that are transferred, with estoppel provisions being agreed to for at least 50% of the Company Stores that are
transferred. The asset purchase agreement contains customary termination provisions and may be terminated by either us or Starbucks if the Closing does not occur within 150 days from the date of the asset purchase agreement. We may also terminate
the asset purchase agreement if the Closing has not occurred within 90 days, provided that Starbucks has not used commercially reasonable efforts to achieve the Closing.

As part of the asset purchase agreement, we have agreed to a non-compete provision that for three years after the Closing restricts our ability to operate or have any interest in the ownership or operation of any
entity operating any retail specialty coffee stores in any city where a Company Store is presently located. The non-compete provision applies only to stores opened after the date of the asset purchase agreement and does not apply to (1) any
retail stores operated under the Gloria Jeans brand name, (2) wholesale sales to retail businesses that are not operated by us, or other non-retail businesses, or (3) the conversion of Company-operated stores existing on
the date of the asset purchase agreement to franchise stores. We have also agreed that we will not solicit any Starbucks employee to enter our employment for three years after the Closing.



15



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A table summarizing the relative sizes of each of our brands, on a unit count basis, and changes in unit count for each
brand for fiscal 2006 and fiscal 2007 through the twelve weeks ended September 20, 2006, is set forth below:



|                       |  |                      |  |        |  |             |   |  |                                                  |   |  |                      |  |        |  |        |   |  |                              
|---------------------- |  | -------------------- |  | ------ |  | ----------- | - |  | ------------------------------------------------ | - |  | -------------------- |  | ------ |  | ------ | - |  | -----------------------------
|                       |  | Units atJune 29,2005 |  | Opened |  | Closed/Sold |   |  | Net transfersbetween theCompany andFranchise (A) |   |  | Units atJune 28,2006 |  | Opened |  | Closed |   |  | Units atSeptember 20,2006 (B)
|Gloria Jeans Brand    |  |                      |  |        |  |             |   |  |                                                  |   |  |                      |  |        |  |        |   |  |                              
|Company Operated       |  | 11                   |  | 1      |  | (1          | ) |  | (6                                               | ) |  | 5                    |  |       |  |       |   |  | 5                            
|Franchise              |  | 132                  |  | 16     |  | (15         | ) |  | 6                                                |   |  | 139                  |  | 4      |  | (3     | ) |  | 140                          
|                       |  |                      |  |        |  |             |   |  |                                                  |   |  |                      |  |        |  |        |   |  |                              
|Subtotal Gloria Jeans |  | 143                  |  | 17     |  | (16         | ) |  |                                                 |   |  | 144                  |  | 4      |  | (3     | ) |  | 145                          
|                       |  |                      |  |        |  |             |   |  |                                                  |   |  |                      |  |        |  |        |   |  |                              
|Diedrich Coffee Brand  |  |                      |  |        |  |             |   |  |                                                  |   |  |                      |  |        |  |        |   |  |                              
|Company Operated       |  | 26                   |  | 1      |  |            |   |  | (1                                               | ) |  | 26                   |  |       |  |       |   |  | 26                           
|Franchise  Domestic   |  | 7                    |  | 1      |  | (1          | ) |  | 1                                                |   |  | 8                    |  |       |  |       |   |  | 8                            
|                       |  |                      |  |        |  |             |   |  |                                                  |   |  |                      |  |        |  |        |   |  |                              
|Subtotal Diedrich      |  | 33                   |  | 2      |  | (1          | ) |  |                                                 |   |  | 34                   |  |       |  |       |   |  | 34                           
|                       |  |                      |  |        |  |             |   |  |                                                  |   |  |                      |  |        |  |        |   |  |                              
|Coffee People Brand    |  |                      |  |        |  |             |   |  |                                                  |   |  |                      |  |        |  |        |   |  |                              
|Company Operated       |  | 25                   |  | 4      |  | (7          | ) |  | (1                                               | ) |  | 21                   |  |       |  |       |   |  | 21                           
|Franchise - Domestic   |  |                     |  |       |  |            |   |  | 1                                                |   |  | 1                    |  |       |  |       |   |  | 1                            
|                       |  |                      |  |        |  |             |   |  |                                                  |   |  |                      |  |        |  |        |   |  |                              
|Subtotal Coffee People |  | 25                   |  | 4      |  | (7          | ) |  |                                                 |   |  | 22                   |  |       |  |       |   |  | 22                           
|                       |  |                      |  |        |  |             |   |  |                                                  |   |  |                      |  |        |  |        |   |  |                              
|Total                  |  | 201                  |  | 23     |  | (24         | ) |  |                                                 |   |  | 200                  |  | 4      |  | (3     | ) |  | 201                          
|                       |  |                      |  |        |  |             |   |  |                                                  |   |  |                      |  |        |  |        |   |  |                              

---

|(A) | Six company operated Gloria Jeans, one company operated Diedrich Coffee, and one company operated Coffee People coffeehouses were transferred to franchisees during fiscal year
2006.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(B) | On September 14, 2006, we and Starbucks entered into an agreement pursuant to which Starbucks has agreed to purchase our leasehold interests in up to 40 of the 47 locations
where we operate retail stores under the Diedrich Coffee and Coffee People brands. See Recent Developments above.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Seasonality
and Quarterly Results

Historically, our business has experienced variations in sales and earnings from quarter to quarter due to the holiday season and
a variety of other factors, including, but not limited to, general economic trends, green coffee costs, competitive factors, marketing initiatives, weather and special or unusual events which are outside of our control. Our franchise partners are
subject to the seasonal fluctuations that affect retailers in general. Because of the seasonality our business, results for any quarter are not necessarily indicative of the results that may be achieved for the full fiscal year.

Results of operations

Twelve weeks ended September 20, 2006
compared with the twelve weeks ended September 21, 2005

Total Revenue. Total revenue for the twelve weeks ended September 20,
2006 increased by $1,288,000, or 25.1%, to $6,424,000 from $5,136,000 for the twelve weeks ended September 21, 2005. Each component of total revenue is discussed below.

Wholesale Revenue. Our wholesale sales for the twelve weeks ended September 20, 2006 increased by $1,549,000, or 43.4%, to $5,120,000
from $3,571,000 for the twelve weeks ended September 21, 2005. Wholesale sales to OCS and foodservice customers for the twelve weeks ended September 20, 2006 increased by $1,520,000, or 59.7%, to $4,066,000 from $2,546,000 for the
twelve weeks ended September 21, 2005 led by a 65.2% increase in Keurig K-cup sales. Sales of roasted coffee to our franchisees remained relatively flat at an increase of $28,000, or 2.7%, for the twelve weeks ended
September 20, 2006 as compared to the twelve weeks ended September 21, 2005.

Franchise Revenue. Our franchise revenue
consists of initial franchise fees, franchise renewal fees, area development fees, and royalties received on sales at franchised locations. Franchise revenue increased by $47,000, or 6.5%, to $768,000 for the twelve weeks ended
September 20, 2006 from $721,000 for the twelve weeks ended September 21, 2005. The increase was primarily due to a net increase of ten franchise stores since the beginning of the prior year. Comparable store sales at Diedrich
franchise locations increased 0.4% and decreased 0.7% at Gloria Jeans franchise locations during the first quarter.



16



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Retail Sales. Retail sales for the twelve weeks ended September 20, 2006 decreased by
$308,000, or 36.5%, to $536,000 from $844,000 for the prior year period. This decrease was primarily due to a net decrease of six company-operated Gloria Jeans stores since September 21, 2005. Comparable store sales at Gloria
Jeans company-operated locations increased 6.0% during the first quarter. Retail sales from our internet website also increased by $69,000, or 51.1%, to $204,000 for the twelve weeks ended September 20, 2006 from $135,000 for the twelve
weeks ended September 21, 2005.

Cost of Sales and Related Occupancy Costs. Cost of sales and related occupancy costs for the twelve
weeks ended September 20, 2006 increased $853,000, or 26.3%, to $4,102,000 from $3,249,000 in the prior year period, but remained relatively flat as a percentage of total revenue at 63.9% in the current quarter when compared to 63.5% in the
prior year. Wholesale cost of sales remained flat year over year at 74.0% as a percentage of wholesale revenue. Occupancy costs for the twelve weeks ended September 20, 2006 decreased $146,000, or 55.5 %, to $117,000 from
$263,000 in the prior year period primarily due to a decrease in franchise rent expense associated with closed stores.

Operating Expenses.
Operating expenses for the twelve weeks ended September 20, 2006, as a percentage of retail and wholesale sales, increased from 21.0% of retail and wholesale sales for the twelve weeks ended September 21, 2005 to 27.7% for the twelve weeks
ended September 20, 2006. This increase is the result of the realignment of certain functions of the franchise segment to include costs associated with salaries and related general and administrative functions previously reflected in general
and administrative expenses in the prior year.

Depreciation and Amortization. Depreciation remained relatively flat with a slight decrease
of $22,000 to $230,000 for the twelve weeks ended September 20, 2006 as compared to the twelve weeks ended September 21, 2005.

General and
Administrative Expenses. Our general and administrative expenses decreased by $676,000, or 27.3%, to $1,799,000 for the twelve weeks ended September 20, 2006 compared to $2,475,000 for the twelve weeks ended September 21, 2005. As
a percentage of total revenue, general and administrative expenses decreased from 48.2% for the twelve weeks ended September 21, 2005 to 28.0% for the twelve weeks ended September 20, 2006 due primarily as a result of the reclassification
of salaries and related franchise direct overhead costs to operating expenses in the current year as a result of the realignment of certain functions.

Interest Expense and Other, Net. Interest expense, interest income and other income, net was $65,000 in the twelve weeks ended September 20, 2006 compared to $126,000 in the twelve weeks ended September 21, 2005.
This change was the result of a reduction in interest income due to a decrease in invested cash compared to the prior year same period.

Income Tax
Benefit. We had losses from continuing operations and from discontinued operations for the twelve weeks ended September 20, 2006 and September 21, 2005. In accordance with SFAS 109 Accounting for Income Taxes,
the income tax benefit generated by the loss has been fully reserved due to the uncertainty of generating future taxable income.

Results of
Discontinued Operations. As a result of the pending sale of the Diedrich Coffee and Coffee People retail stores, the results from these components of our business are presented as discontinued operations for all periods presented in
accordance with SFAS 144 Accounting for the Impairment or Disposal of Long-Lived Assets. Losses from discontinued operations were $340,000, net of $0 in taxes for the twelve weeks ended September 20, 2006. Losses from
discontinued operations were $262,000, net of $0 in taxes for the twelve weeks ended September 21, 2005.

FINANCIAL CONDITION,
LIQUIDITY AND CAPITAL RESOURCES

Current Financial Condition. At September 20, 2006, we had cash of $1,706,000 as compared to
$2,593,000 at June 28, 2006, and we had working capital of $9,568,000 at September 20, 2006 as compared to working capital of $10,186,000 at June 28, 2006. Total outstanding capital lease obligations decreased to $323,000 at
September 20, 2006 from $328,000 at June 28, 2006. At September 20, 2006, we had $1,000,000 of outstanding long-term debt compared to $0 at June 28, 2006. From June 28, 2006 to September 20, 2006, stockholders
equity decreased from $24,267,000 to $22,658,000.



17



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The accounts receivable balance of $3,446,000 as of September 20, 2006 is an increase of $617,000 from the
June 28, 2006 balance of $2,829,000. This increase is related to the seasonality of our business and to an increase in wholesale sales to third parties. The accounts payable balance of $3,103,000 as of September 20, 2006 is an increase of
$174,000 from the June 28, 2006 balance of $2,929,000. This increase is also attributable to the seasonality of our business along with the increase in wholesale sales to third parties.

Cash Flows. Net cash used in operating activities for the twelve weeks ended September 20, 2006 totaled $2,097,000 as compared with $273,000 cash used
in operating activities for the twelve weeks ended September 21, 2005. This increase is the net result of many factors more fully enumerated in the Unaudited Condensed Consolidated Statement of Cash Flows in the accompanying financial
statements.

Net cash provided by investing activities for the twelve weeks ended September 20, 2006 totaled $181,000 as compared with net cash used
of $883,000 for the twelve weeks ended September 21, 2005. During the twelve weeks ended September 20, 2006, a total of $383,000 was used to invest in property and equipment primarily related to retail stores of $267,000, our Castroville
roasting facility $65,000 and our home office facility $51,000. These expenditures were partially offset by $568,000 of payments received on notes receivable.

Net cash provided by financing activities for the twelve weeks ended September 20, 2006 totaled $1,029,000 as compared to $86,000 for the twelve weeks ended September 21, 2005. The increase is primarily attributed to $1,000,000 in
borrowings under our contingent convertible note purchase agreement during the twelve weeks ended September 20, 2006 with no comparable activity in the prior period.

Outstanding Debt and Financing Arrangements. On May 10, 2004 the Company entered into a $5,000,000 Contingent Convertible Note Purchase Agreement. The agreement provides for the Company to, at its
election, issue notes with up to an aggregate principal amount of $5,000,000. The notes are to be amortized on a monthly basis at a rate that will repay 60% of the principal amount of the note by June 30, 2008. The remaining 40% will mature on
that date. Interest is payable at three-month LIBOR plus 5.30%, and a facility fee of 1.00% annually is payable on the unused portion of the facility. The agreement contains covenants that limit the amount of indebtedness that the Company may have
outstanding in relation to its tangible net worth. As of September 20, 2006, the Company was in compliance with all the covenants in the agreement. Notes are convertible into common stock only upon certain changes of control. For notes issued
and repaid, warrants to purchase shares are to be issued with the same rights and restrictions for exercise as existed for convertibility of the notes at the time of their issuance. Warrants are exercisable only in the event of a change of control
and expire on June 30, 2010. The fair value of warrants issued with respect to notes repaid will be recorded as a discount to debt, at the date of issuance, which will then be amortized using the effective interest method. Warrants to purchase
common stock of the Company will be issued only upon a change in control of the Company. The lender under this agreement is a limited partnership of which the chairman of the Companys board of directors serves as the sole general partner. A
total of 455,184 warrants are issuable upon a change in control for previous debt repayments under this facility. The Company has issued 4,219 warrants as of September 20, 2006. As of September 20, 2006, the Company had $1,000,000 of
borrowings outstanding under the facility and $4,000,000 available for borrowing at that date.

On June 30, 2004, the Company entered into Amendment
No. 1 to Contingent Convertible Note Purchase Agreement (Amendment No. 1) which revised the definition of Availability to mean, on any date, the loan amount less the sum of the principal amounts then outstanding
under the Note Purchase Agreement. Under the original Note Purchase Agreement, availability was calculated using a formula that reduced availability over time.

On November 4, 2005, the Company entered into a new Credit Agreement with Bank of the West. The agreement provides for a $750,000 letter of credit facility that expires on October 15, 2007. The letter of credit facility is secured
by a deposit account at Bank of the West. As of September 20, 2006, this deposit account had a balance of $587,000, which is shown as restricted cash on the consolidated balance sheets. As of September 20, 2006, $651,000 of letters of
credit was outstanding under the letter of credit facility. The agreement contains covenants that, among other matters, require the Company to submit financial statements to the bank within specified time periods. As of September 20, 2006, the
Company was in compliance with all Bank of the West agreement covenants.



18



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On March 31, 2006, the Company entered into Amendment No. 2 to Contingent Convertible Note Purchase Agreement
(Amendment No. 2). Amendment No. 2: (i) contains a waiver with respect to the default of the Minimum EBITDA Covenant as of March 8, 2006 and removes the Minimum EBITDA from the Note Purchase Agreement;
(ii) clarifies that warrants to purchase common stock of the Company will be issued with respect to repaid principal amounts only upon a change in control of the Company; (iii) increases the interest rate applicable to outstanding amounts
under the credit facility by 2%, to LIBOR plus 5.30%; and (iv) extended the exercise date of all warrants issued or to be issued under the Note Purchase Agreement by one year, to May 10, 2009, which was subsequently extended as discussed
below. The maturity date for any notes issued in the future was unaffected by Amendment No. 2. As of September 20, 2006, the Company was in compliance with all agreement covenants as amended by Amendment No 2.

On September 22, 2006, the Company entered into Amendment No. 3 to Contingent Convertible Note Purchase Agreement (Amendment No. 3). Amendment
No. 3 (i) changes the date specified in the definition of Maturity Date from May 10, 2007 to June 30, 2008; (ii) adjusts the calculation of monthly payments to reflect the extended maturity date;
(iii) removes a condition precedent to each loan that previously required there to be no material adverse effect or event reasonably likely to result in a material adverse effect before the obligation of the lender to purchase any note arose;
(iv) amends the events of default so that an event that has, or is reasonably likely to have, a material adverse effect will not be considered such an event of default; (v) amends the notice requirements so that the Company is not required
to give notice to the lender of any event that is reasonably likely to have a material adverse effect; and (vi) extends the exercise date of all warrants issued or to be issued under the Note Purchase Agreement to June 30, 2010.

Based on the terms of our credit agreements, as amended, our managements expectations that the transaction to exit the company operated Diedrich and
Coffee People retail locations will be completed, the focus on growing the wholesale and franchise business segments, the status of our balance sheet and the overall business outlook for us and the specialty coffee market, our management believes
that cash from ongoing operations, the anticipated proceeds from the sale transaction and funds available to us from our current credit agreements will be sufficient to satisfy our working capital needs at the anticipated operating levels for at
least the next twelve months. Our future capital requirements will depend on many factors, including the extent and timing of the rate at which our business grows, if at all, with corresponding demands for working capital. We may be required to seek
additional funding through either debt financing, or public or equity, or a combination of funding methods to meet our capital requirements and sustain our operations. However, additional funds may not be available on terms acceptable to us or at
all.

Other Commitments. The following represents a comprehensive list of our contractual obligations and commitments as of
September 20, 2006:



|                                                             |  |                        |        |                  |   |           |  |           |        |                   |   |        |  |   |       
|------------------------------------------------------------ |  | ---------------------- | ------ | ---------------- | - | --------- |  | --------- | ------ | ----------------- | - | ------ |  | - | ------
|                                                             |  | Payments Due By Period
|                                                             |  | Total                  |        | Less than 1 year |   | 1-3 years |  | 3-5 years |        | More than 5 years
|                                                             |  | (In thousands)        
|Capital leases (including interest)                          |  | $                      | 493    |                  | $ | 44        |  | $         | 88     |                   | $ | 88     |  | $ | 273   
|Company operated retail locations and other operating leases |  |                        | 27,775 |                  |   | 4,208     |  |           | 7,680  |                   |   | 6,052  |  |   | 9,835 
|Franchise operated retail locations operating leases         |  |                        | 19,641 |                  |   | 4,091     |  |           | 5,836  |                   |   | 4,208  |  |   | 5,506 
|Green coffee commitments                                     |  |                        | 1,657  |                  |   | 1,561     |  |           | 96     |                   |   |       |  |   |      
|Note payable                                                 |  |                        | 1,000  |                  |   | 327       |  |           | 673    |                   |   |       |  |   |      
|                                                             |  |                        |        |                  |   |           |  |           |        |                   |   |        |  |   |       
|                                                             |  | $                      | 50,566 |                  | $ | 10,231    |  | $         | 14,373 |                   | $ | 10,348 |  | $ | 15,614
|                                                             |  |                        |        |                  |   |           |  |           |        |                   |   |        |  |   |       



19



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As of September 20, 2006, there were employment agreements with two of our officers that provide for severance
payments in the event that these individuals are terminated by us without cause or they terminate their employment as a result of a constructive termination. These severance payments range from six months to one years salary. Our maximum
theoretical liability for severance under the contracts is currently $368,000. Because these amounts are contingent, they have not been included in the table above.

As reflected in the table above, we have obligations under non-cancelable operating leases for our coffee houses, roasting facility and administrative offices. Lease terms are generally for periods of 10 to 20 years
with renewal options, and generally require us to pay a proportionate share of real estate taxes, insurance, common area, and other operating costs. Some retail leases provide for contingent rental payments based on sales thresholds. In addition, we
are liable on the master real property leases for 81 Gloria Jeans franchise locations. Under our franchising business model, from time to time we execute the master lease for a location and enter into subleases on the same terms with our
franchisees, which typically pay their rent directly to the landlords. If any of these franchisees default on their subleases, we would be required to make all payments under the master lease. Our maximum theoretical future exposure at
September 20, 2006, computed as the sum of all remaining lease payments through the expiration dates of the respective leases, was $19,641,000. This amount does not take into consideration any mitigating measures that we could take to reduce
this exposure in the event of default, including re-leasing the location or terminating the master lease by negotiating a lump sum payment to the landlord in an amount that is less than the sum of all remaining future rents.

CRITICAL ACCOUNTING ESTIMATES

The preparation of our
unaudited condensed consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts. The estimates and assumptions are evaluated on an ongoing basis and are based on historical experience and on
various other factors that we believe to be reasonable. Accounts significantly impacted by estimates and assumptions include, but are not limited to, franchise receivables, allowance for bad debt reserves, fixed asset lives, goodwill, intangible
assets, income taxes, self-insurance and workers compensation reserves, store closure reserves, stock-based compensation, the valuation allowance for net deferred tax assets and contingencies. We believe that the following represent the
critical accounting policies and estimates that we use in the preparation of our unaudited condensed consolidated financial statements. The following discussion, however, does not list all of our accounting policies and estimates.

Impairment of Property and Equipment and Other Amortizable Long-Lived Assets Held and Used

Each quarter, we evaluate the carrying value of individual stores when the operating results have reasonably progressed to a point to adequately evaluate the probability of continuing operating losses or a current
expectation that a store will be sold or otherwise disposed of before the end of its previously estimated useful life. In making these judgments, we consider the period of time since the store was opened or remodeled, and the trend of operations and
expectations for future sales growth. For stores selected for review, we estimate the future estimated cash flows from operating the store over its estimated useful life. We make judgments about future same-store sales and the operating expenses and
estimated useful life that we would expect with such level of same-store sales.

The most significant assumptions in our analysis are those used when we
estimate a units future cash flows. We generally use the assumptions in our strategic plan and modify them as necessary based on unit specific information. If our assumptions are incorrect, the carrying value of our operating unit assets may
be overstated or understated.



20



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Impairment of Goodwill

At the reporting unit level, goodwill is tested for impairment at least annually or whenever an event or circumstance indicates that it is more likely than not that an impairment may have occurred. We consider the reporting unit level to be
the segment level since the components within each segment have similar economic characteristics, including products and services, production processes, types or classes of customers and distribution methods. The impairment, if any, is measured
based on the estimated fair value of the segment. Fair value can be determined based on discounted cash flows or valuations of similar businesses. Impairment occurs when the carrying amount of goodwill exceeds its estimated fair value.

The most significant assumptions we use in this analysis are those made in estimating future cash flows. In estimating future cash flows, we consider historical
results as well as the assumptions utilized in our strategic plan for items such as same-store sales, store count growth rates, and the discount rate we consider to be the market discount rate used for acquisitions of similar businesses.

If our assumptions used in performing the impairment test prove inaccurate, the fair value of the segments may ultimately prove to be significantly lower, thereby
causing the carrying value to exceed the fair value and indicating an impairment has occurred. If our assumptions are incorrect, the carrying value of our goodwill may be understated or overstated. Our annual impairment measurement date is our
fiscal year-end.

Estimated Liability for Closing Stores

We make decisions to close stores based on prospects for estimated future profitability and sometimes we are forced to close stores due to circumstances beyond our control (for example, a landlords refusal to negotiate a new lease).
Our management team evaluates each stores performance every period. When stores continue to perform poorly, we consider the demographics of the location, as well as the likelihood of being able to improve the performance of an unprofitable
store. Based on managements judgment, we estimate the future cash flows. If we determine that the store will not, within a reasonable period of time, operate at break-even cash flow or be profitable, and we are not contractually obligated to
continue operating the store, we may close the store. Additionally, franchisees may close stores for which we are the primary lessee. If the franchisee cannot make payments on the lease, we continue making the lease payments and establish an
estimated liability for the closed store if we decide not to operate it as a company operated store. Effective January 1, 2003, we establish the estimated liability on the actual closure date.

The estimated liability for closing stores on properties vacated is generally based on the term of the lease and the lease termination fee we expect to pay, as well as
estimated maintenance costs until the lease has been abated. The amount of the estimated liability established is generally the present value of these estimated future payments. The interest rate used to calculate the present value of these
liabilities is based on our incremental borrowing rate at the time the liability is established. The related discount is amortized and shown in the provision for asset impairment and restructuring costs, net in our unaudited condensed consolidated
statements of operations.

A significant assumption used in determining the amount of the estimated liability for closing stores is the amount of the
estimated liability for future lease payments on vacant stores, which we determine based on our assessment of our ability to successfully negotiate early terminations of our lease agreements with the lessors or to sublease the property.
Additionally, we estimate the cost to maintain leased and owned vacant properties until the lease has been abated. If the costs to maintain properties increase, or it takes longer than anticipated to sell properties or sublease or terminate leases,
we may need to record additional estimated liabilities. If the leases on the vacant stores are not terminated or subleased on the terms we used to estimate the liabilities, we may be required to record losses in future periods. Conversely, if the
leases on the vacant stores are terminated or subleased on more favorable terms than we used to estimate the liabilities, we reverse previously established estimated liabilities, resulting in an increase in operating income.

Estimated Liability for Self-Insurance

Effective
October 1, 2003, we became self-insured for a portion of our current years losses related to workers compensation insurance. We have obtained stop loss insurance for individual workers compensation claims with a $250,000
deductible per occurrence and a program maximum for all claims of $750,000. Insurance liabilities and reserves are accounted for based on



21



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actuarial estimates of the amount of incurred and unpaid losses. These estimates rely on actuarial observations of historical claim loss development. The
actuary, in determining the estimated liability, bases the assumptions on the average historical losses on claims we have incurred. The actual loss development may be better or worse than the development we estimated in conjunction with the actuary.
In that event, we will modify the reserve. As such, if we experience a higher than expected number of claims or the costs of claims rise more than expected, then we may, in conjunction with the actuary, adjust the expected losses upward and our
future self-insurance expenses will rise.

Franchised Operations

We monitor the financial condition of our franchisees and record provisions for estimated losses on receivables when we believe that our franchisees are unable to make their required payments to us. Each period we
perform an analysis to develop estimated bad debts for each franchisee. We then compare the aggregate result of that analysis to the amount recorded in our unaudited condensed consolidated financial statements as the allowance for doubtful accounts
and adjust the allowance as appropriate. Over time, our assessment of individual franchisees may change. For instance, in the past, we have had some franchisees which we had determined required an estimated loss equal to the total amount of the
receivable, but which have paid us in full or established a consistent record of payments (generally one year) such that we subsequently determined that an allowance was no longer required.

Depending on the facts and circumstances, there are a number of different actions we and/or our franchisees may take to resolve franchise collections issues. These
actions may include the purchase of franchise stores by us or by other franchisees, a modification to the franchise agreement, which may include a provision to defer certain royalty payments or reduce royalty rates in the future, a restructuring of
the franchisees business and/or finances (including the restructuring of leases for which we are the primary or secondary obligee), or, if necessary, the termination of the franchise agreement. The allowance is based on our assessment of the
most probable course of action that will occur.

In accordance with SFAS 146, which we adopted on January 1, 2003, an estimated liability for future
lease obligations on stores operated by franchisees for which we are the primary or secondary obligee is established on the date the franchisee closes the store. Also, we record an estimated liability for subsidized lease payments when we sign a
sublease agreement committing us to the subsidy.

The amount of the estimated liability is established using the methodology described above under the
heading Estimated Liability for Closing Stores. Consistent with SFAS 146, we have not established an additional estimated liability for potential losses not yet incurred. If sales trends or economic conditions worsen for our franchisees,
their financial health may worsen, our collection rates may decline and we may be required to assume the responsibility for additional lease payments on franchised stores. Entering into restructured franchise agreements may result in reduced
franchise royalty rates in the future.

Stock-Based Compensation

As discussed in the notes to consolidated financial statements, we have various stock-based compensation plans that provide options for certain employees
and outside directors to purchase common shares of stock. Prior to June 30, 2005, we elected to account for stock-based compensation in accordance with Accounting Principles Board (APB) Opinion No. 25, Accounting for
Stock Issued to Employees, which utilizes the intrinsic value method of accounting for stock-based compensation, as opposed to using the fair-value method prescribed in SFAS No. 123, Accounting for Stock-Based
Compensation. Because of this election, we were required to make certain disclosures of pro forma net income assuming we had adopted SFAS No. 123. Starting June 30, 2005, we adopted the provisions of SFAS 123R, which sets
accounting requirements for share-based compensation to employees and non-employee directors, including employee stock purchase plans, and requires companies to recognize in the statement of operations the grant-date fair value of stock
options and other equity-based compensation.

We determine the estimated fair value of stock-based compensation on the date of the grant
using the Black-Scholes option-pricing model. The Black-Scholes option-pricing model requires us to apply highly subjective assumptions, including our historical stock price volatility, expected life of the option and the risk-free interest rate. A
change in one or more of the assumptions used in the Black-Scholes option-pricing model may result in a material change to the estimated fair value of the stock-based compensation.



22



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Valuation Allowance for Net Deferred Tax Assets

As discussed above, we have recorded a 100% valuation allowance against our net deferred tax assets. If we become profitable for a number of years and our prospects for
the realization of our deferred tax assets are more likely than not, we would expect to reverse our valuation allowance and credit income tax expense. In analyzing the prospects for future profitability, many of the assessments of same-store sales
and cash flows discussed above become relevant. When circumstances warrant, we assess the likelihood that our net deferred tax assets will more likely than not be realized from future taxable income. As of September 20, 2006, our net deferred
tax assets were fully reserved with a related valuation allowance that totaled approximately $5,736,000.

Item 3. Quantitative And Qualitative Disclosures About Market Risk.

Market Risk Sensitive Items Entered Into for
Trading Purposes

None.

Market Risk
Sensitive Items Entered Into for Other Than Trading Purposes

Interest Rate Risk. We are exposed to market risk from changes in interest
rates on our outstanding debt. At September 20, 2006, we had a $5,000,000 loan facility, with $1,000,000 outstanding balance that could be affected by changes in short term interest rates. We pay interest on our facility at a three-month LIBOR
plus 5.30%. Three month LIBOR rates ranged from 5.39% to 5.52% during our first fiscal quarter. At September 20, 2006, a hypothetical 100 basis point increase in the adjusted rates would result in additional interest expense of $10,000 on an
annualized basis.

Commodity Price Risk. The supply and price of green coffee, the principal raw material for our products, are subject to
significant volatility. Although most coffee trades in the commodity market, coffee of the quality that we seek tends to trade on a negotiated basis at a substantial premium above commodity coffee prices, depending upon the supply and demand at the
time of purchase. Supply and price can be affected by a number of factors in the producing countries, including weather, political and economic conditions. In addition, green coffee prices have been affected in the past, and may be affected in the
future, by the actions of certain organizations and associations that have historically attempted to influence commodity prices of green coffee through agreements establishing export quotas or restricting coffee supplies worldwide.

To date, we have not used commodity based financial instruments to hedge against fluctuations in the price of coffee. To ensure that we have an adequate supply of
coffee, however, we enter into agreements to purchase green coffee in the future that may or may not be fixed as to price. As of September 20, 2006, we had commitments to purchase coffee totaling $1,657,000 for 1,117,000 pounds of green coffee,
some of which commitments were fixed as to price. Most of these commitments are for fiscal year 2007. The coffee scheduled to be delivered to us in the next twelve months pursuant to these commitments will satisfy approximately 38% of our
anticipated green coffee requirements for the next twelve months. Assuming we require approximately 3,462,000 additional pounds of green coffee during the next twelve months for which no price has yet been fixed, each $0.01 per pound increase in the
price of green coffee could result in approximately $35,000 of additional cost. However, because the price we pay for green coffee is negotiated with suppliers, we believe that the commodity market price for green coffee would have to increase
significantly, by as much as $0.25 per pound, before suppliers would increase the price they charge us.

Item 4. Controls and Procedures.

(a) As of the end of the period covered by this quarterly report our management, with
the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of
1934, as amended (the Exchange Act)). Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective.



23



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(b) There was no change in our internal control over financial reporting that occurred during our most recent fiscal
quarter that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II - OTHER INFORMATION

Item 1. Legal Proceedings.

In the ordinary course of our business, we may become involved in legal proceedings from time
to time. As of and for the twelve week period ending September 20, 2006, we were not a party to any material legal proceedings.

Item 1A. Risk Factors.

The risk factors described below regarding the proposed sale of certain leasehold interests and
certain other assets to Starbucks (the Transaction) pursuant to the asset purchase agreement dated September 14, 2006 (the Asset Purchase Agreement), supplement the risk factors previously disclosed in Part I,
Item 1A of our Annual Report on Form 10-K for the fiscal year ended June 28, 2006.

We will be restricted in our ability to
open retail specialty coffee stores as a result of the non-compete provision in the Asset Purchase Agreement.

We have agreed to a
non-compete provision in the Asset Purchase Agreement that, for three years after the closing of the Transaction, restricts our ability to operate or have any interest in the ownership or operation of any entity operating any retail specialty coffee
stores in any city where a Company store that we are selling is presently located. The non-compete provision applies only to stores opened after the date of the Asset Purchase Agreement and does not apply to (1) any retail stores operated under
the Gloria Jeans brand name, (2) wholesale sales to retail businesses that are not operated by us, or other non-retail businesses, or (3) the conversion of our company-operated stores existing on the date of the Asset
Purchase Agreement to franchise stores.

Our focus on wholesale operations after consummation of the Transaction may not result in a
successful business model.

Upon consummation of the Transaction, we intend to focus on strengthening the wholesale business and its
distribution channels, including the franchise locations. If we are unable to successfully implement our strategy in focusing on this business segment, our business, results of operations, financial condition and stock price could be materially
adversely affected.

We do not intend to distribute any of the proceeds from the Transaction to our stockholders.

We do not intend to distribute any of the proceeds from the Transaction to our stockholders. At this time, we intend to use such proceeds to fund and
grow our wholesale operations, which may be a use of proceeds that our stockholders may not agree with.

Our business may be harmed
if the Transaction disrupts our business and prevents us from realizing intended benefits.

The Transaction may disrupt our business
and prevent us from realizing intended benefits due to problems that may arise, such as:



| |  |  | a loss of key employees;
| | - |  | ------------------------



| |  |  | a failure to adjust or implement our future business plans; and
| | - |  | ---------------------------------------------------------------



| |  |  | a diversion of managements attention from our operations.
| | - |  | ----------------------------------------------------------

We are obligated to indemnify Starbucks under certain circumstances.

We have agreed to indemnify Starbucks and its
representatives for any and all losses resulting from:



| |  |  | the breach or inaccuracy (subject to applicable qualifications) of any representation or warranty made by us in the Asset Purchase Agreement, in any sellers certificate or
transaction document delivered by us in connection with the Asset Purchase Agreement;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



24



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| |  |  | the material breach or nonperformance of any covenant or agreement by us or Coffee People contained in the Asset Purchase Agreement or any sellers certificate or transaction
document delivered in connection with the Asset Purchase Agreement;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | all causes of action, lawsuits, judgments, claims and demands of any nature arising out of or relating to our franchise operations, supplier contracts, and any other excluded
business or excluded assets;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our failure to discharge any liabilities not assumed by Starbucks;
| | - |  | ------------------------------------------------------------------



| |  |  | the termination or suspension of any previous or existing discussions or negotiations with any third party with respect to the leasehold assets that were terminated or suspended, or
will be terminated or suspended, as a result of the Asset Purchase Agreement, whether or not the transactions contemplated by the Asset Purchase Agreement are consummated; and
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | any breach by us of the Asset Purchase Agreements indemnification provisions.
| | - |  | ------------------------------------------------------------------------------

Starbucks has agreed not to seek indemnification for breaches of certain of our representations and warranties until the aggregate amount of its claims exceeds $100,000, in which event we will be liable only for such
claims to the extent they exceed $100,000. In no event will our aggregate liability arising under the indemnification provisions of the Asset Purchase Agreement with respect to breaches of our representations and warranties exceed $2,000,000;
provided, however, that, with respect to the representations and warranties relating to authority to enter into the Asset Purchase Agreement, consents, good title to the leasehold assets, tax matters, environmental matters, employment matters,
certain provisions related to third party assets, transfer fees and taxes, or any fraud or knowing or intentional breach of any representation and warranty, we will be liable from dollar one up to, but not in excess of, the total amount of
consideration actually received by us under the Asset Purchase Agreement.

Item 2. Unregistered sales of Equity Securities and use of Proceeds.

None

Item 3. Defaults upon Senior Securities.

None

Item 4. Submission of Matters to a Vote of Security Holders.

None

Item 5. Other Information.

None

Item 6. Exhibits.

Set forth below is a list of the exhibits included as part of this quarterly report.



|            |  |                                                                                                                                                                                       
|----------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                           
|            | 
|2.1         |  | Agreement and Plan of Merger, dated March 16, 1999, among Diedrich Coffee, Inc., CP Acquisition Corp., a wholly owned subsidiary of Diedrich Coffee, Inc., and Coffee People, Inc.
(1)
|            | 
|3.1         |  | Restated Certificate of Incorporation of Diedrich Coffee, Inc., dated May 11, 2001 (2)                                                                                                
|            | 
|3.2         |  | Bylaws of Diedrich Coffee, Inc. (3)                                                                                                                                                   



25



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|            |  |                                                                                                                                                                                                                    
|----------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                                                        
|            | 
|4.1         |  | Specimen Common Stock Certificate (4)                                                                                                                                                                              
|            | 
|4.2         |  | Purchase Agreement for Series A Preferred Stock dated as of December 11, 1992 by and among Diedrich Coffee, Inc., Martin R. Diedrich, Donald M. Holly, SNV Enterprises, and D.C.H., LP
(5)                         
|            | 
|4.3         |  | Purchase Agreement for Series B Preferred Stock dated as of June 29, 1995 by and among Diedrich Coffee, Inc., Martin R. Diedrich, Steven A. Lupinacci, Redwood Enterprises VII, LP, and
Diedrich Partners I, LP (5)
|            | 
|4.4         |  | Form of Conversion Agreement in connection with the conversion of Series A and Series B Preferred Stock into Common Stock (3)                                                                                      
|            | 
|4.5         |  | Common Stock and Warrant Purchase Agreement, dated March 14, 2001 (6)                                                                                                                                              
|            | 
|4.6         |  | Form of Warrant, dated May 8, 2001 (2)                                                                                                                                                                             
|            | 
|4.7         |  | Registration Rights Agreement, dated May 8, 2001 (2)                                                                                                                                                               
|            | 
|4.8         |  | Form of Common Stock and Option Purchase Agreement with Franchise Mortgage Acceptance Company, dated as of April 3, 1998 (7)                                                                                       
|            | 
|10.31       |  | Agreement of Purchase and Sale of Assets by and between Starbucks Corporation, Diedrich Coffee, Inc. and Coffee People, Inc. (24)                                                                                  
|            | 
|31.1        |  | Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                                
|            | 
|31.2        |  | Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                                
|            | 
|32.1        |  | Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                                                                                 
|            | 
|32.2        |  | Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                                                                                 
|            | 
|*           |  | Management contract or compensatory plan or arrangement                                                                                                                                                            
|            | 
|(1)         |  | Previously filed as Appendix A to Diedrich Coffees Registration Statement on Form S-4, filed with the Securities and Exchange Commission on April 23, 1999.                                                       
|            | 
|(2)         |  | Previously filed as an exhibit to Diedrich Coffees Current Report on Form 8-K, filed with the Securities and Exchange Commission on May 16, 2001.                                                                 
|            | 
|(3)         |  | Previously filed as an exhibit to Diedrich Coffees Registration Statement on Form S-1/A (Registration No. 333-08633), filed with the Securities and Exchange Commission on August 28,
1996.                       



26



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|            |  |                                                                                                                                                                                                 
|----------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                                     
|            | 
|(4)         |  | Previously filed as an exhibit to Diedrich Coffees Registration Statement on Form S-3 (Registration No. 333-66744), filed with the Securities and Exchange Commission on August 3,
2001.       
|            | 
|(5)         |  | Previously filed as an exhibit to Diedrich Coffees Registration Statement on Form S-1 (Registration No. 333-08633), filed with the Securities and Exchange Commission on July 23,
1996.        
|            | 
|(6)         |  | Previously filed as Annex B to Diedrich Coffees Definitive Proxy Statement, filed with the Securities and Exchange Commission on April 12, 2001.                                               
|            | 
|(7)         |  | Previously filed as an exhibit to Diedrich Coffees Annual Report on Form 10-K for the fiscal year ended January 28, 1998, filed with the Securities and Exchange Commission on April 28,
1998. 
|            | 
|(8)         |  | Previously filed as an exhibit to Diedrich Coffees Annual Report on Form 10-K for the fiscal year ended June 28, 2006, filed with the Securities and Exchange Commission on September 26,
2006.



27



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SIGNATURES

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



|                        |  |                                           
|----------------------- |  | ------------------------------------------
|Dated: November 6, 2006 |  | DIEDRICH COFFEE, INC.                     
|                        | 
|                        |  | /s/ Stephen V. Coffey                     
|                        |  | Stephen V. Coffey                         
|                        |  | Chief Executive Officer                   
|                        |  | (On behalf of the registrant)             
|                        | 
|                        |  | /s/ Sean M. McCarthy                      
|                        |  | Sean M. McCarthy                          
|                        |  | Vice President and Chief Financial Officer
|                        |  | (Principal financial officer)             



28



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EXHIBIT INDEX



|            |  |                                                                                                    
|----------- |  | ---------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                        
|            | 
|31.1        |  | Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
|            | 
|31.2        |  | Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
|            | 
|32.1        |  | Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
|            | 
|32.2        |  | Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002



29