##### Table of Contents

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549



---



FORM 10-Q



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



For the quarterly period ended September 21, 2005



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



DIEDRICH COFFEE, INC.

(Exact name of
registrant as specified in its charter)



|                                                               |  |                                  
|-------------------------------------------------------------- |  | ---------------------------------
|DELAWARE                                                       |  | 33-0086628                       
|(State or other jurisdiction of incorporation or organization) |  | (IRS Employer Identification No.)



28 EXECUTIVE PARK,
SUITE 200

IRVINE, CALIFORNIA 92614

(Address of principal executive offices, including zip code)



(949) 260-1600

(Registrants telephone number, including area code)



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 an accelerated filer (as defined in Rule
12b-2 of the Exchange Act). YES ̈NO  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 November 3, 2005, there were 5,307,789 shares of common stock of the registrant
outstanding.



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##### Table of Contents

DIEDRICH COFFEE, INC.

INDEX



|                               |  |                                                                                       |  |            
|------------------------------ |  | ------------------------------------------------------------------------------------- |  | -----------
|                               |  |                                                                                       |  | Page Number
|PART I  FINANCIAL INFORMATION |  |                                                                                      
|                               |  |                                                                                      
|Item 1.                        |  | Financial Statements                                                                  |  |            
|                               |  |                                                                                      
|                               |  | 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 |  | 12         
|                               |  |                                                                                      
|Item 3.                        |  | Quantitative and Qualitative Disclosures About Market Risk                            |  | 21         
|                               |  |                                                                                      
|Item 4.                        |  | Controls and Procedures                                                               |  | 21         
|                               | 
|PART II  OTHER INFORMATION    |  |                                                                                      
|                               |  |                                                                                      
|Item 1.                        |  | Legal Proceedings                                                                     |  | 22         
|                               |  |                                                                                      
|Item 6.                        |  | Exhibits                                                                              |  | 23         
|                               | 
|Signatures                     |  | 26                                                                                   



i



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##### Table of Contents

PART I - FINANCIAL INFORMATION



|Item 1. | Financial Statements.
|------- | ---------------------



DIEDRICH COFFEE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS



|                                                                                                                                                         |  |                    |             |   |               |   |             |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | ----------- | - | ------------- | - | ----------- | -
|                                                                                                                                                         |  | September 21, 2005 |             |   | June 29, 2005 |  
|                                                                                                                                                         |  | (Unaudited)        |             |   |               |  
|Assets                                                                                                                                                   |  |                    |             |   |               |   |             |  
|Current assets:                                                                                                                                          |  |                    |             |   |               |   |             |  
|Cash                                                                                                                                                     |  | $                  | 9,423,000   |   |               | $ | 10,493,000  |  
|Accounts receivable, less allowance for doubtful accounts of $1,459,000 at September 21, 2005 and $1,392,000 at June 29,
2005                            |  |                    | 2,117,000   |   |               |   | 2,203,000   |  
|Inventories                                                                                                                                              |  |                    | 3,637,000   |   |               |   | 3,426,000   |  
|Income tax refund                                                                                                                                        |  |                    | 1,562,000   |   |               |   | 1,220,000   |  
|Current portion of notes receivable                                                                                                                      |  |                    | 676,000     |   |               |   | 1,165,000   |  
|Advertising fund assets, restricted                                                                                                                      |  |                    | 259,000     |   |               |   | 218,000     |  
|Prepaid expenses                                                                                                                                         |  |                    | 865,000     |   |               |   | 489,000     |  
|                                                                                                                                                         |  |                    |             |   |               |   |             |  
|Total current assets                                                                                                                                     |  |                    | 18,539,000  |   |               |   | 19,214,000  |  
|Property, plant and equipment, net                                                                                                                       |  |                    | 8,825,000   |   |               |   | 7,974,000   |  
|Goodwill                                                                                                                                                 |  |                    | 8,179,000   |   |               |   | 8,179,000   |  
|Notes receivable                                                                                                                                         |  |                    | 4,634,000   |   |               |   | 4,554,000   |  
|Other assets                                                                                                                                             |  |                    | 385,000     |   |               |   | 392,000     |  
|                                                                                                                                                         |  |                    |             |   |               |   |             |  
|Total assets                                                                                                                                             |  | $                  | 40,562,000  |   |               | $ | 40,313,000  |  
|                                                                                                                                                         |  |                    |             |   |               |   |             |  
|Liabilities and Stockholders Equity                                                                                                                     |  |                    |             |   |               |   |             |  
|Current liabilities:                                                                                                                                     |  |                    |             |   |               |   |             |  
|Current installments of obligations under capital leases                                                                                                 |  | $                  | 57,000      |   |               | $ | 85,000      |  
|Accounts payable                                                                                                                                         |  |                    | 4,132,000   |   |               |   | 2,642,000   |  
|Accrued compensation                                                                                                                                     |  |                    | 2,704,000   |   |               |   | 2,886,000   |  
|Accrued expenses                                                                                                                                         |  |                    | 1,708,000   |   |               |   | 1,366,000   |  
|Franchisee deposits                                                                                                                                      |  |                    | 631,000     |   |               |   | 632,000     |  
|Deferred franchise fee income                                                                                                                            |  |                    | 82,000      |   |               |   | 91,000      |  
|Advertising fund liabilities                                                                                                                             |  |                    | 259,000     |   |               |   | 218,000     |  
|Accrued provision for store closure                                                                                                                      |  |                    | 5,000       |   |               |   | 91,000      |  
|                                                                                                                                                         |  |                    |             |   |               |   |             |  
|Total current liabilities                                                                                                                                |  |                    | 9,578,000   |   |               |   | 8,011,000   |  
|Obligations under capital leases, excluding current installments                                                                                         |  |                    | 323,000     |   |               |   | 328,000     |  
|Deferred rent                                                                                                                                            |  |                    | 487,000     |   |               |   | 452,000     |  
|Common stock warrants                                                                                                                                    |  |                    | 9,000       |   |               |   | 9,000       |  
|                                                                                                                                                         |  |                    |             |   |               |   |             |  
|Total liabilities                                                                                                                                        |  |                    | 10,397,000  |   |               |   | 8,800,000   |  
|                                                                                                                                                         |  |                    |             |   |               |   |             |  
|Commitments and contingencies (notes 3, 4 and 7)                                                                                                         |  |                    |             |   |               |   |             |  
|Stockholders equity:                                                                                                                                    |  |                    |             |   |               |   |             |  
|Common stock, $0.01 par value; authorized 8,750,000 shares; issued and outstanding 5,303,000 shares at September 21, 2005 and 5,273,000
at June 29, 2005 |  |                    | 53,000      |   |               |   | 53,000      |  
|Additional paid-in capital                                                                                                                               |  |                    | 58,676,000  |   |               |   | 58,472,000  |  
|Accumulated deficit                                                                                                                                      |  |                    | (28,564,000 | ) |               |   | (27,012,000 | )
|                                                                                                                                                         |  |                    |             |   |               |   |             |  
|Total stockholders equity                                                                                                                               |  |                    | 30,165,000  |   |               |   | 31,513,000  |  
|                                                                                                                                                         |  |                    |             |   |               |   |             |  
|Total liabilities and stockholders equity                                                                                                               |  | $                  | 40,562,000  |   |               | $ | 40,313,000  |  
|                                                                                                                                                         |  |                    |             |   |               |   |             |  



See accompanying
notes to condensed consolidated financial statements.



1



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DIEDRICH COFFEE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)



|                                                                                   |  |                                    |            |   |                                    |   |            |  
|---------------------------------------------------------------------------------- |  | ---------------------------------- | ---------- | - | ---------------------------------- | - | ---------- | -
|                                                                                   |  | Twelve WeeksEndedSeptember 21,2005 |            |   | Twelve WeeksEndedSeptember 22,2004 |  
|Net revenue:                                                                       |  |                                    |            |   |                                    |   |            |  
|Retail sales                                                                       |  | $                                  | 7,888,000  |   |                                    | $ | 7,129,000  |  
|Wholesale and other                                                                |  |                                    | 3,571,000  |   |                                    |   | 3,228,000  |  
|Franchise revenue                                                                  |  |                                    | 721,000    |   |                                    |   | 857,000    |  
|                                                                                   |  |                                    |            |   |                                    |   |            |  
|Total net revenue                                                                  |  |                                    | 12,180,000 |   |                                    |   | 11,214,000 |  
|                                                                                   |  |                                    |            |   |                                    |   |            |  
|Costs and expenses:                                                                |  |                                    |            |   |                                    |   |            |  
|Cost of sales and related occupancy costs                                          |  |                                    | 6,447,000  |   |                                    |   | 5,505,000  |  
|Operating expenses                                                                 |  |                                    | 4,350,000  |   |                                    |   | 3,914,000  |  
|Depreciation and amortization                                                      |  |                                    | 545,000    |   |                                    |   | 545,000    |  
|General and administrative expenses                                                |  |                                    | 2,863,000  |   |                                    |   | 2,566,000  |  
|Gain on asset disposals                                                            |  |                                    | (5,000     | ) |                                    |   | (15,000    | )
|                                                                                   |  |                                    |            |   |                                    |   |            |  
|Total costs and expenses                                                           |  |                                    | 14,200,000 |   |                                    |   | 12,515,000 |  
|                                                                                   |  |                                    |            |   |                                    |   |            |  
|Operating loss                                                                     |  |                                    | (2,020,000 | ) |                                    |   | (1,301,000 | )
|Interest expense                                                                   |  |                                    | (32,000    | ) |                                    |   | (42,000    | )
|Interest and other income, net                                                     |  |                                    | 152,000    |   |                                    |   | (1,000     | )
|                                                                                   |  |                                    |            |   |                                    |   |            |  
|Loss from continuing operations before income tax benefit                          |  |                                    | (1,900,000 | ) |                                    |   | (1,344,000 | )
|Income tax benefit                                                                 |  |                                    | (348,000   | ) |                                    |   | (320,000   | )
|                                                                                   |  |                                    |            |   |                                    |   |            |  
|Net loss from continuing operations                                                |  |                                    | (1,552,000 | ) |                                    |   | (1,024,000 | )
|Discontinued operations:                                                           |  |                                    |            |   |                                    |   |            |  
|Income from discontinued operations, net of $0 and $327,000 of taxes, respectively |  |                                    |           |   |                                    |   | 556,000    |  
|                                                                                   |  |                                    |            |   |                                    |   |            |  
|Net loss                                                                           |  | $                                  | (1,552,000 | ) |                                    | $ | (468,000   | )
|                                                                                   |  |                                    |            |   |                                    |   |            |  
|Basic and diluted net income (loss) per share:                                     |  |                                    |            |   |                                    |   |            |  
|Loss from continuing operations                                                    |  | $                                  | (0.29      | ) |                                    | $ | (0.20      | )
|                                                                                   |  |                                    |            |   |                                    |   |            |  
|Income from discontinued operations, net                                           |  | $                                  |           |   |                                    | $ | 0.11       |  
|                                                                                   |  |                                    |            |   |                                    |   |            |  
|Net loss                                                                           |  | $                                  | (0.29      | ) |                                    | $ | (0.09      | )
|                                                                                   |  |                                    |            |   |                                    |   |            |  
|Weighted average and equivalent shares outstanding:                                |  |                                    |            |   |                                    |   |            |  
|Basic and diluted                                                                  |  |                                    | 5,287,000  |   |                                    |   | 5,163,000  |  
|                                                                                   |  |                                    |            |   |                                    |   |            |  



See accompanying
notes to condensed consolidated financial statements.



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DIEDRICH COFFEE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)



|                                                                         |  |                                    |            |   |                                    |   |            |  
|------------------------------------------------------------------------ |  | ---------------------------------- | ---------- | - | ---------------------------------- | - | ---------- | -
|                                                                         |  | Twelve WeeksEndedSeptember 21,2005 |            |   | TwelveWeeks EndedSeptember 22,2004 |  
|Cash flows from operating activities:                                    |  |                                    |            |   |                                    |   |            |  
|Net loss                                                                 |  | $                                  | (1,552,000 | ) |                                    | $ | (468,000   | )
|Income from discontinued operations                                      |  |                                    |           |   |                                    |   | (556,000   | )
|                                                                         |  |                                    |            |   |                                    |   |            |  
|Loss from continuing operations:                                         |  |                                    | (1,552,000 | ) |                                    |   | (1,024,000 | )
|Adjustments to reconcile net loss to net cash from operating activities: |  |                                    |            |   |                                    |   |            |  
|Depreciation and amortization                                            |  |                                    | 545,000    |   |                                    |   | 545,000    |  
|Amortization of loan fees                                                |  |                                    | 10,000     |   |                                    |   | 8,000      |  
|Provision for bad debt                                                   |  |                                    | 92,000     |   |                                    |   | 65,000     |  
|Income tax benefit                                                       |  |                                    | (342,000   | ) |                                    |   |           |  
|Provision for inventory obsolescence                                     |  |                                    | 5,000      |   |                                    |   | 5,000      |  
|Stock compensation expense                                               |  |                                    | 85,000     |   |                                    |   |           |  
|Notes receivable issued for franchise fees                               |  |                                    | (20,000    | ) |                                    |   |           |  
|Gain on asset disposals                                                  |  |                                    | (5,000     | ) |                                    |   | (15,000    | )
|Amortization of discount on notes receivable                             |  |                                    | (84,000    | ) |                                    |   |           |  
|Changes in operating assets and liabilities:                             |  |                                    |            |   |                                    |   |            |  
|Accounts receivable                                                      |  |                                    | (6,000     | ) |                                    |   | (321,000   | )
|Inventories                                                              |  |                                    | (216,000   | ) |                                    |   | (147,000   | )
|Prepaid expenses                                                         |  |                                    | (376,000   | ) |                                    |   | (368,000   | )
|Notes receivable                                                         |  |                                    |           |   |                                    |   | (13,000    | )
|Other assets                                                             |  |                                    | (3,000     | ) |                                    |   | (72,000    | )
|Accounts payable                                                         |  |                                    | 1,490,000  |   |                                    |   | (226,000   | )
|Accrued compensation                                                     |  |                                    | (182,000   | ) |                                    |   | 459,000    |  
|Accrued expenses                                                         |  |                                    | 342,000    |   |                                    |   | 96,000     |  
|Franchisee deposits                                                      |  |                                    | (1,000     | ) |                                    |   | (9,000     | )
|Deferred franchise fee income                                            |  |                                    | (9,000     | ) |                                    |   | 104,000    |  
|Accrued provision for store closure                                      |  |                                    | (86,000    | ) |                                    |   | (9,000     | )
|Deferred rent                                                            |  |                                    | 40,000     |   |                                    |   | (2,000     | )
|                                                                         |  |                                    |            |   |                                    |   |            |  
|Net cash used in operating activities                                    |  |                                    | (273,000   | ) |                                    |   | (924,000   | )
|Net cash provided by discontinued operations                             |  |                                    |           |   |                                    |   | 352,000    |  
|                                                                         |  |                                    |            |   |                                    |   |            |  
|Net cash used by operating activities                                    |  |                                    | (273,000   | ) |                                    |   | (572,000   | )
|Cash flows from investing activities:                                    |  |                                    |            |   |                                    |   |            |  
|Capital expenditures for property, plant and equipment                   |  |                                    | (1,396,000 | ) |                                    |   | (798,000   | )
|Principal payments on notes receivable                                   |  |                                    | 513,000    |   |                                    |   | 11,000     |  
|                                                                         |  |                                    |            |   |                                    |   |            |  
|Net cash used in investing activities                                    |  |                                    | (883,000   | ) |                                    |   | (787,000   | )
|                                                                         |  |                                    |            |   |                                    |   |            |  
|Cash flows from financing activities:                                    |  |                                    |            |   |                                    |   |            |  
|Exercise of stock options                                                |  |                                    | 119,000    |   |                                    |   | 6,000      |  
|Borrowings under credit agreement                                        |  |                                    |           |   |                                    |   | 1,000,000  |  
|Payments on long-term debt                                               |  |                                    |           |   |                                    |   | (50,000    | )
|Payments on capital lease obligations                                    |  |                                    | (33,000    | ) |                                    |   | (36,000    | )
|                                                                         |  |                                    |            |   |                                    |   |            |  
|Net cash provided by financing activities                                |  |                                    | 86,000     |   |                                    |   | 920,000    |  
|                                                                         |  |                                    |            |   |                                    |   |            |  
|Net decrease in cash                                                     |  |                                    | (1,070,000 | ) |                                    |   | (439,000   | )
|Cash at beginning of period                                              |  |                                    | 10,493,000 |   |                                    |   | 1,799,000  |  
|                                                                         |  |                                    |            |   |                                    |   |            |  
|Cash at end of period                                                    |  | $                                  | 9,423,000  |   |                                    | $ | 1,360,000  |  
|                                                                         |  |                                    |            |   |                                    |   |            |  
|Supplemental disclosures of cash flow information:                       |  |                                    |            |   |                                    |   |            |  
|Cash paid during the period for:                                         |  |                                    |            |   |                                    |   |            |  
|Interest                                                                 |  | $                                  | 8,000      |   |                                    | $ | 33,000     |  
|                                                                         |  |                                    |            |   |                                    |   |            |  
|Income taxes                                                             |  | $                                  |           |   |                                    | $ | 7,000      |  
|                                                                         |  |                                    |            |   |                                    |   |            |  
|Non-cash transactions:                                                   |  |                                    |            |   |                                    |   |            |  
|Issuance of notes receivable                                             |  | $                                  | 20,000     |   |                                    | $ |           |  
|                                                                         |  |                                    |            |   |                                    |   |            |  



See accompanying
notes to condensed consolidated financial statements.



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DIEDRICH COFFEE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 21, 2005

(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 filed on September 29, 2005.



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 February 11, 2005, the Company completed the sale of its Gloria Jeans
international franchise operations to Jireh International Pty. Ltd., formerly the Gloria Jeans master franchisee for Australia, and certain of its affiliates (collectively, Jireh) for $16,000,000 in cash and an additional
$7,020,000 payable over the next six years under license, roasting and consulting agreements.



The sale included the immediate transfer of related franchise rights to Jireh of 338 Gloria Jeans retail locations outside the U.S. and Puerto Rico, including 242 located in Australia.



In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets, the financial results of Gloria Jeans international franchise operations are reported as discontinued operations for all periods presented. There was no activity related to discontinued operations in the quarter ended
September 21, 2005.



The following accounts are reflected in Discontinued
Operations:



| |  |  | International franchise royalties, new store fees and roasting fees
| | - |  | -------------------------------------------------------------------



| |  |  | Wholesale revenue and cost of goods sold associated with the sale of coffee to international franchisees
| | - |  | --------------------------------------------------------------------------------------------------------



| |  |  | Bad debt expense related to international franchisees
| | - |  | -----------------------------------------------------



| |  |  | General and administrative costs related to international operations and audit, tax and legal fees relating to the transaction
| | - |  | ------------------------------------------------------------------------------------------------------------------------------



| |  |  | Gain on sale of the international franchise operations, net of the related tax provision
| | - |  | ----------------------------------------------------------------------------------------



| |  |  | Provision for foreign taxes paid on international revenues
| | - |  | ----------------------------------------------------------



Recent Accounting Pronouncements



On October 6, 2005, the Financial Accounting Standards Board (FASB) released FASB Staff Position (FSP) FAS 13-1, Accounting for Rental
Costs Incurred during a Construction Period. This FSP affects companies that are engaged in construction activities on buildings or grounds accounted for as operating leases. The FSP requires the Company to expense rental costs associated with
these leases, starting on the date that the tenant is given control of the premises. As a result, companies must cease capitalizing rental costs during construction periods. The FSP is effective for the first reporting period beginning after
December 15, 2005. Retrospective application is permitted but not required. The Company has not yet determined what impact the adoption of FSP FAS 13-1 will have on its results of operations.



4



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##### Table of Contents

Income Taxes



The Company accounts for income taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and for operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured
using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income
in the period that includes the enactment date.



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 November 29, 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 on an
option-by-option basis determines the number of shares, except for automatic grants to non-employee directors, terms and exercise period. Options generally vest ratably over three years and expire ten years from the date of grant. The exercise price
of options granted is generally equivalent to the fair market value of the stock at the date of grant.



On June 30, 2005, the Company adopted the provisions of FASB Statement No. 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 values of the options granted were
estimated using the Black-Scholes option-pricing model based on the following weighted average assumptions:



|                        |  |                    |   |  |                    |  
|----------------------- |  | ------------------ | - |  | ------------------ | -
|                        |  | TWELVE WEEKS ENDED |  
|                        |  | September 21, 2005 |   |  | September 22, 2004 |  
|Risk free interest rate |  | 4.23               | % |  | 3.81               | %
|Expected life           |  | 6 years            |   |  | 6 Years            |  
|Expected volatility     |  | 75                 | % |  | 35                 | %
|Expected dividend yield |  | 0                  | % |  | 0                  | %
|Forfeiture rate         |  | 3.91               | % |  | 0                  | %



A summary of option activity under our
stock option plans for the twelve weeks ended September 21, 2005 is as follows:



|                                          |  |                  |   |  |                              |       |                                                |     |                            |   |          
|----------------------------------------- |  | ---------------- | - |  | ---------------------------- | ----- | ---------------------------------------------- | --- | -------------------------- | - | ---------
|                                          |  | Number of shares |   |  | Weightedaverageexerciseprice |       | Weightedaverageremainingcontractualterm(years) |     | Aggregateintrinsicvalue($)
|Options outstanding at June 29, 2005      |  | 938,000          |   |  | $                            | 5.27  |                                                |     |                            |   |          
|Plus options granted                      |  |                 |   |  |                              |      |                                                |     |                            |   |          
|Less:                                     |  |                  |   |  |                              |       |                                                |     |                            |   |          
|Options exercised                         |  | (30,000          | ) |  |                              | 3.97  |                                                |     |                            |   |          
|Options canceled or expired               |  | (2,000           | ) |  |                              | 12.00 |                                                |     |                            |   |          
|                                          |  |                  |   |  |                              |       |                                                |     |                            |   |          
|Options outstanding at September 21, 2005 |  | 906,000          |   |  |                              | 5.30  |                                                | 6.9 |                            | $ | 3,100,000
|                                          |  |                  |   |  |                              |       |                                                |     |                            |   |          
|Options exercisable at September 21, 2005 |  | 628,000          |   |  |                              | 5.91  |                                                | 6.3 |                            | $ | 1,800,000



5



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##### Table of Contents

Stock-based compensation expense included in the statement of operations for the twelve weeks ended September 21,
2005 was approximately $85,000. As of September 21, 2005, there were approximately $216,000 of total unrecognized stock-based compensation cost related to options granted under our plans that will be recognized over a weighted average period of
1.4 years. The total intrinsic value of options exercised during the twelve weeks ended September 21, 2005 was approximately $88,000.



Awards granted prior to the Companys implementation of SFAS 123R were accounted for under the recognition and measurement principles of APB Opinion No. 25,
Accounting for Stock Issued to Employees, and related interpretations. Accordingly, no stock-based employee compensation cost is reflected in net loss in the accompanying Unaudited Condensed Consolidated Statements of Operations for the
twelve weeks ended September 22, 2004, as all options granted under the Companys plans had exercise prices equal to the market value of the underlying common stock on the date of grant.



Pro forma net loss and net loss per share, as if the Company had applied the fair value
recognition provisions of SFAS 123, to stock-based compensation for periods presented prior to the Companys adoption of SFAS 123R, is as follows:



|                                                                                                                                 |  |                                      |          |  
|-------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------------ | -------- | -
|Pro Forma                                                                                                                        |  | TWELVE WEEKS ENDEDSeptember 22, 2004 |         
|Net loss                                                                                                                         |  | $                                    | (468,000 | )
|Deduct: Stock-based compensation expense determined under the fair value based method for all awards, net of related tax
effects |  |                                      | (181,000 | )
|                                                                                                                                 |  |                                      |          |  
|Pro forma net income (loss)                                                                                                      |  | $                                    | (649,000 | )
|                                                                                                                                 |  |                                      |          |  
|Basic and diluted income (loss) per share  as reported                                                                          |  | $                                    | (0.09    | )
|                                                                                                                                 |  |                                      |          |  
|Basic and diluted income (loss) per share  pro forma                                                                            |  | $                                    | (0.13    | )
|                                                                                                                                 |  |                                      |          |  



Reclassifications



Certain reclassifications have been made to the September 22, 2004 unaudited
condensed consolidated financial statements to conform to the September 21, 2005 presentation.



6



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|2. | INVENTORIES
|-- | -----------



Inventories consist of the following:



|                                  |  |                    |           |               |   |          
|--------------------------------- |  | ------------------ | --------- | ------------- | - | ---------
|                                  |  | September 21, 2005 |           | June 29, 2005
|Unroasted coffee                  |  | $                  | 1,228,000 |               | $ | 1,481,000
|Roasted coffee                    |  |                    | 659,000   |               |   | 643,000  
|Accessory and specialty items     |  |                    | 239,000   |               |   | 225,000  
|Other food, beverage and supplies |  |                    | 1,511,000 |               |   | 1,077,000
|                                  |  |                    |           |               |   |          
|Total inventory                   |  | $                  | 3,637,000 |               | $ | 3,426,000
|                                  |  |                    |           |               |   |          



|3. | NOTES RECEIVABLE
|-- | ----------------



In September 2005, the Company received a non-interest bearing note from a franchisee in exchange for franchise fees in the amount of $20,000. The note is due and payable in full on January 1, 2006.



In February 2005, the Company sold its international franchise operations for $16,000,000
in cash and $7,020,000 in notes receivable payable over the next six years under license, roasting and consulting agreements. See Note 1 to the condensed consolidated financial statements.



Notes receivable consist of the following:



|                                                                                                                                                                                                                                                                                                  |  |                    |           |   |               |   |            |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | --------- | - | ------------- | - | ---------- | -
|                                                                                                                                                                                                                                                                                                  |  | September 21, 2005 |           |   | June 29, 2005 |  
|Notes receivable bearing interest at rates from 0% to 10.0%, payable in monthly installments varying between $1,297 and $4,268 and due between
October 3, 2005 and July 1, 2007. Notes are secured by the assets sold under the asset purchase and sale agreements or general security agreement. |  | $                  | 187,000   |   |               | $ | 181,000    |  
|Notes receivable from a corporation discounted at an annual rate of 8.0%, payable annually in installments varying between $1,000,000 and
$2,000,000, due between January 31, 2006 and January 31, 2011.                                                                                          |  |                    | 5,123,000 |   |               |   | 5,538,000  |  
|Less: current portion of notes receivable                                                                                                                                                                                                                                                         |  |                    | (676,000  | ) |               |   | (1,165,000 | )
|                                                                                                                                                                                                                                                                                                  |  |                    |           |   |               |   |            |  
|Long-term portion of notes receivable                                                                                                                                                                                                                                                             |  | $                  | 4,634,000 |   |               | $ | 4,554,000  |  
|                                                                                                                                                                                                                                                                                                  |  |                    |           |   |               |   |            |  



7



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|4. | ACCRUED PROVISION FOR STORE CLOSURE
|-- | -----------------------------------



Effective January 1, 2003, the Company adopted SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, and now records these
estimated costs 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 |         | AmountsChargedto Expense |   | Adjustments |  |   | CashPayments |   |  | EndBalance
|Fiscal year ended June 29, 2005       |  | $           | 109,000 |                          | $ |            |  | $ |             |   |  | $          | (18,000 | ) |  | $ | 91,000
|Twelve weeks ended September 21, 2005 |  | $           | 91,000  |                          | $ |            |  | $ | (75,000      | ) |  | $          | (11,000 | ) |  | $ | 5,000 



For the twelve weeks ended
September 21, 2005, the Company adjusted the store closure accrual due to the transfer of a corporate store to a franchisee. The Company made cash payments in the amount of $11,000 for rent expense at an impaired store location.



8



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|5. | EARNINGS PER SHARE
|-- | ------------------



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



|                                                                |  |                                    |            |   |                                    |   |            |  
|--------------------------------------------------------------- |  | ---------------------------------- | ---------- | - | ---------------------------------- | - | ---------- | -
|                                                                |  | Twelve WeeksEndedSeptember 21,2005 |            |   | Twelve WeeksEndedSeptember 22,2004 |  
|Numerator:                                                      |  |                                    |            |   |                                    |   |            |  
|Net loss from continuing operations                             |  | $                                  | (1,552,000 | ) |                                    | $ | (1,024,000 | )
|                                                                |  |                                    |            |   |                                    |   |            |  
|Denominator:                                                    |  |                                    |            |   |                                    |   |            |  
|Basic weighted average shares outstanding                       |  |                                    | 5,287,000  |   |                                    |   | 5,163,000  |  
|Effect of dilutive securities                                   |  |                                    |           |   |                                    |   |           |  
|                                                                |  |                                    |            |   |                                    |   |            |  
|Diluted adjusted weighted average shares                        |  |                                    | 5,287,000  |   |                                    |   | 5,163,000  |  
|                                                                |  |                                    |            |   |                                    |   |            |  
|Basic and diluted net loss per share from continuing operations |  | $                                  | (0.29      | ) |                                    | $ | (0.20      | )
|                                                                |  |                                    |            |   |                                    |   |            |  



For computation of net income per
share from continuing operations, all 906,000 and 971,000 options outstanding as of September 21, 2005 and September 22, 2004, respectively, were excluded from the calculation of diluted net loss per share because their inclusion
would have been anti-dilutive. In addition, all 504,000 outstanding warrants to purchase shares of common stock as of September 21, 2005 and September 22, 2004 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 income per share:



|                                          |  |                                    |            |   |                                    |   |           |  
|----------------------------------------- |  | ---------------------------------- | ---------- | - | ---------------------------------- | - | --------- | -
|                                          |  | Twelve WeeksEndedSeptember 21,2005 |            |   | Twelve WeeksEndedSeptember 22,2004 |  
|Numerator:                                |  |                                    |            |   |                                    |   |           |  
|Net loss                                  |  | $                                  | (1,552,000 | ) |                                    | $ | (468,000  | )
|                                          |  |                                    |            |   |                                    |   |           |  
|Denominator:                              |  |                                    |            |   |                                    |   |           |  
|Basic weighted average shares outstanding |  |                                    | 5,287,000  |   |                                    |   | 5,163,000 |  
|Effect of dilutive securities             |  |                                    |           |   |                                    |   |          |  
|                                          |  |                                    |            |   |                                    |   |           |  
|Diluted adjusted weighted average shares  |  |                                    | 5,287,000  |   |                                    |   | 5,163,000 |  
|                                          |  |                                    |            |   |                                    |   |           |  
|Basic and diluted net loss per share      |  | $                                  | (0.29      | ) |                                    | $ | (0.09     | )
|                                          |  |                                    |            |   |                                    |   |           |  



|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.



9



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|                                                                        |  |                    |            |   |                    |   |            |  
|----------------------------------------------------------------------- |  | ------------------ | ---------- | - | ------------------ | - | ---------- | -
|                                                                        |  | TWELVE WEEKS ENDED |           
|                                                                        |  | September 21, 2005 |            |   | September 22, 2004 |  
|Revenue:                                                                |  |                    |            |   |                    |   |            |  
|Retail                                                                  |  | $                  | 7,888,000  |   |                    | $ | 7,129,000  |  
|Wholesale                                                               |  |                    | 3,571,000  |   |                    |   | 3,228,000  |  
|Franchise                                                               |  |                    | 721,000    |   |                    |   | 857,000    |  
|                                                                        |  |                    |            |   |                    |   |            |  
|Total revenue                                                           |  | $                  | 12,180,000 |   |                    | $ | 11,214,000 |  
|                                                                        |  |                    |            |   |                    |   |            |  
|Interest expense:                                                       |  |                    |            |   |                    |   |            |  
|Retail                                                                  |  | $                  | 7,000      |   |                    | $ | 4,000      |  
|Franchise                                                               |  |                    | 2,000      |   |                    |   | 7,000      |  
|Corporate                                                               |  |                    | 23,000     |   |                    |   | 31,000     |  
|                                                                        |  |                    |            |   |                    |   |            |  
|Total interest expense                                                  |  | $                  | 32,000     |   |                    | $ | 42,000     |  
|                                                                        |  |                    |            |   |                    |   |            |  
|Depreciation and amortization:                                          |  |                    |            |   |                    |   |            |  
|Retail                                                                  |  | $                  | 330,000    |   |                    | $ | 356,000    |  
|Wholesale                                                               |  |                    | 143,000    |   |                    |   | 128,000    |  
|Franchise                                                               |  |                    |           |   |                    |   |           |  
|Corporate                                                               |  |                    | 72,000     |   |                    |   | 61,000     |  
|                                                                        |  |                    |            |   |                    |   |            |  
|Total depreciation and amortization                                     |  | $                  | 545,000    |   |                    | $ | 545,000    |  
|                                                                        |  |                    |            |   |                    |   |            |  
|Segment loss from continuing operations before income tax benefit:      |  |                    |            |   |                    |   |            |  
|Retail                                                                  |  | $                  | 94,000     |   |                    | $ | 34,000     |  
|Wholesale                                                               |  |                    | 301,000    |   |                    |   | 451,000    |  
|Franchise                                                               |  |                    | 488,000    |   |                    |   | 699,000    |  
|Corporate                                                               |  |                    | (2,783,000 | ) |                    |   | (2,528,000 | )
|                                                                        |  |                    |            |   |                    |   |            |  
|Total segment loss from continuing operations before income tax benefit |  | $                  | (1,900,000 | ) |                    | $ | (1,344,000 | )
|                                                                        |  |                    |            |   |                    |   |            |  
|                                                                        |  |                   
|                                                                        |  | September 21, 2005 |            |   | June 29, 2005      |  
|Identifiable assets:                                                    |  |                    |            |   |                    |   |            |  
|Retail                                                                  |  | $                  | 8,116,000  |   |                    | $ | 7,152,000  |  
|Wholesale                                                               |  |                    | 6,212,000  |   |                    |   | 5,966,000  |  
|Franchise                                                               |  |                    | 1,932,000  |   |                    |   | 2,114,000  |  
|Corporate                                                               |  |                    | 16,123,000 |   |                    |   | 16,902,000 |  
|                                                                        |  |                    |            |   |                    |   |            |  
|Tangible assets                                                         |  |                    | 32,383,000 |   |                    |   | 32,134,000 |  
|Goodwill - Retail                                                       |  |                    | 1,347,000  |   |                    |   | 1,347,000  |  
|Goodwill - Wholesale                                                    |  |                    | 6,311,000  |   |                    |   | 6,311,000  |  
|Goodwill - Franchise                                                    |  |                    | 521,000    |   |                    |   | 521,000    |  
|                                                                        |  |                    |            |   |                    |   |            |  
|Total assets                                                            |  | $                  | 40,562,000 |   |                    | $ | 40,313,000 |  
|                                                                        |  |                    |            |   |                    |   |            |  



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|7. | LEASE CONTINGENCIES
|-- | -------------------



The Company is liable on the master real property leases for 86 Gloria Jeans franchise locations. Under the Companys historical franchising business model, the Company executed the master leases for these
locations and entered into subleases on the same terms with its franchisees, which typically pay their rent directly to the landlords. If any of these franchisees default on their subleases, the Company would be required to make all payments under
the master lease. The Companys maximum theoretical future exposure at September 21, 2005, computed as the sum of all remaining lease payments through the expiration dates of the respective leases, was $16,866,000. 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. | DISCONTINUED OPERATIONS
|-- | -----------------------



On February 11, 2005, the Company completed the sale of its Gloria Jeans international franchise operations to Jireh International Pty. Ltd., formerly the Gloria Jeans master franchisee for Australia,
and certain of its affiliates (collectively, Jireh) for $16,000,000 in cash and an additional $7,020,000 payable over the next six years under license, roasting and consulting agreements.



The sale included immediate transfer to Jireh of 338 Gloria Jeans retail locations
outside the U.S. and Puerto Rico, including 242 in Australia. After all payments have been made to the Company under the license, roasting and consulting agreements, all remaining Gloria Jeans trademarks, including those in the U.S., will be
transferred to Jireh. Concurrent with such future transfer, the Companys U.S.-based Gloria Jeans subsidiary will enter into a perpetual, royalty-free master franchise agreement with Jireh under which the Company will continue to have
exclusive rights to operate, franchise and develop Gloria Jeans locations throughout the U.S. and Puerto Rico and to continue its wholesale operations under the Gloria Jeans Coffees brand in these same markets.



The Company has agreed to not compete internationally through its Diedrich Coffee or Coffee
People brands for a period of two years from the date of sale. Other than that restriction, the Companys domestic Gloria Jeans outlets, its Castroville roasting operations, its wholesale operations and its company operated Diedrich
Coffee and Coffee People retail outlets were not significantly affected by this transaction.



In accordance with SFAS No. 144, the financial results of Gloria Jeans international franchise operations are reported as discontinued operations for all periods presented.



The financial results included in discontinued operations were as follows:



|                                                                                                          |  |                    |   |                    |   |          
|--------------------------------------------------------------------------------------------------------- |  | ------------------ | - | ------------------ | - | ---------
|                                                                                                          |  | TWELVE WEEKS ENDED
|                                                                                                          |  | September 21, 2005 |   | September 22, 2004
|Net revenue                                                                                               |  | $                  |  |                    | $ | 1,046,000
|                                                                                                          |  |                    |   |                    |   |          
|Earnings from discontinued operations before income taxes                                                 |  | $                  |  |                    | $ | 883,000  
|                                                                                                          |  |                    |   |                    |   |          
|Earnings from discontinued operations, net of $327,000 tax, for the twelve weeks ended September 22, 2004 |  | $                  |  |                    | $ | 556,000  
|                                                                                                          |  |                    |   |                    |   |          



11



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|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;
| | - |  | -----------------------------------------------------------------



| |  |  | 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 29, 2005 and in other reports that we file with the Securities and Exchange Commission. 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.



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.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | 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 21, 2005 to the results for the twelve weeks ended September 22, 2004.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | 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 21, 2005. 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.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



12



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OVERVIEW



Business



We are a specialty coffee roaster, wholesaler and retailer. We sell brewed, espresso based and various blended beverages primarily made from our own fresh roasted premium coffee beans, as well as light food items,
whole bean coffee and accessories, through our company operated and franchised retail locations. We also sell whole bean and ground coffees on a wholesale basis in the Office Coffee Service market and to other wholesale customers, including
restaurant chains and other retailers. We roast coffee at our coffee roasting facility in central California. It supplies freshly roasted coffee to our company operated and franchised retail locations and to our wholesale accounts.



Our brands include Diedrich Coffee, Gloria Jeans and Coffee People. The Diedrich Coffee
and Coffee People brands are primarily company store operations and the Gloria Jeans brand is primarily a franchised store operation. As of September 21, 2005, we owned and operated 59 retail locations and franchised 146 other retail
locations under these brands, for a total of 205 retail coffee outlets. As of September 21, 2005, our retail units were located in 32 states and we had over 460 wholesale accounts with Office Coffee Service distributors, chain and independent
restaurants and others. Although the specialty coffee industry is dominated by a single company which has more than 9,000 locations, we are one of the nations largest specialty coffee retailers.



We believe that we are differentiated from other specialty coffee companies by the quality of
our coffee products, the superior personalized customer service that we provide to our customers and the warm and friendly ambiance that our coffeehouses offer. We serve our distinctively roasted coffee products in all of our brand locations and an
extensive variety of fine quality flavored whole bean coffees are offered in our Gloria Jeans brand stores. Our roasting recipes take into account the specific variety, origin and physical characteristics of each coffee bean to maximize its
unique flavor.



Sale of International Franchise Operations



On February 11, 2005, we announced that we had sold our international Gloria
Jeans operations to our former Australian master franchisee, Jireh International Pty. Ltd., and certain of its affiliates. From this sale, we received $16,000,000 in cash and an additional $7,020,000 in payments to be received over the next
six years under license, roasting and consulting agreements.



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 2004 and fiscal 2005 through the quarter ended September 21, 2005, is set forth below:



|                                              |  |                      |  |        |  |                |   |  |                                            |   |  |                      |  |        |  |        |   |  |                                            |   |  |                          
|--------------------------------------------- |  | -------------------- |  | ------ |  | -------------- | - |  | ------------------------------------------ | - |  | -------------------- |  | ------ |  | ------ | - |  | ------------------------------------------ | - |  | -------------------------
|                                              |  | Units atJune 30,2004 |  | Opened |  | Closed/Sold(A) |   |  | Nettransfersbetween theCompanyandFranchise |   |  | Units atJune 29,2005 |  | Opened |  | Closed |   |  | Nettransfersbetween theCompanyandFranchise |   |  | Units atSeptember 21,2005
|Gloria Jeans Brand                           |  |                      |  |        |  |                |   |  |                                            |   |  |                      |  |        |  |        |   |  |                                            |   |  |                          
|Company Operated                              |  | 10                   |  | 1      |  | (1             | ) |  | 1                                          |   |  | 11                   |  |       |  |       |   |  | (3                                         | ) |  | 8                        
|Franchise  Domestic                          |  | 137                  |  | 11     |  | (15            | ) |  | (1                                         | ) |  | 132                  |  | 6      |  | (2     | ) |  | 3                                          |   |  | 139                      
|                                              |  |                      |  |        |  |                |   |  |                                            |   |  |                      |  |        |  |        |   |  |                                            |   |  |                          
|Total Company Operated and Franchise-Domestic |  | 147                  |  | 12     |  | (16            | ) |  |                                           |   |  | 143                  |  | 6      |  | (2     | ) |  |                                           |   |  | 147                      
|                                              |  |                      |  |        |  |                |   |  |                                            |   |  |                      |  |        |  |        |   |  |                                            |   |  |                          
|Franchise  International                     |  |                      |  |        |  |                |   |  |                                            |   |  |                      |  |        |  |        |   |  |                                            |   |  |                          
|Australia                                     |  | 196                  |  | 46     |  | (242           | ) |  |                                           |   |  |                     |  |       |  |       |   |  |                                           |   |  |                         
|Far East/Asia (B)                             |  | 19                   |  |       |  | (19            | ) |  |                                           |   |  |                     |  |       |  |       |   |  |                                           |   |  |                         
|Mexico                                        |  | 17                   |  |       |  | (17            | ) |  |                                           |   |  |                     |  |       |  |       |   |  |                                           |   |  |                         
|Other (C)                                     |  | 50                   |  | 14     |  | (64            | ) |  |                                           |   |  |                     |  |       |  |       |   |  |                                           |   |  |                         
|                                              |  |                      |  |        |  |                |   |  |                                            |   |  |                      |  |        |  |        |   |  |                                            |   |  |                          
|Total Franchise - International               |  | 282                  |  | 60     |  | (342           | ) |  |                                           |   |  |                     |  |       |  |       |   |  |                                           |   |  |                         
|                                              |  |                      |  |        |  |                |   |  |                                            |   |  |                      |  |        |  |        |   |  |                                            |   |  |                          
|Subtotal Gloria Jeans                        |  | 429                  |  | 72     |  | (358           | ) |  |                                           |   |  | 143                  |  | 6      |  | (2     | ) |  |                                           |   |  | 147                      
|                                              |  |                      |  |        |  |                |   |  |                                            |   |  |                      |  |        |  |        |   |  |                                            |   |  |                          
|Diedrich Coffee Brand                         |  |                      |  |        |  |                |   |  |                                            |   |  |                      |  |        |  |        |   |  |                                            |   |  |                          
|Company Operated                              |  | 23                   |  | 3      |  |               |   |  |                                           |   |  | 26                   |  | 1      |  |       |   |  |                                           |   |  | 27                       
|Franchise  Domestic                          |  | 7                    |  | 1      |  | (1             | ) |  |                                           |   |  | 7                    |  |       |  |       |   |  |                                           |   |  | 7                        
|                                              |  |                      |  |        |  |                |   |  |                                            |   |  |                      |  |        |  |        |   |  |                                            |   |  |                          
|Subtotal Diedrich                             |  | 30                   |  | 4      |  | (1             | ) |  |                                           |   |  | 33                   |  | 1      |  |       |   |  |                                           |   |  | 34                       
|                                              |  |                      |  |        |  |                |   |  |                                            |   |  |                      |  |        |  |        |   |  |                                            |   |  |                          
|Coffee People Brand                           |  |                      |  |        |  |                |   |  |                                            |   |  |                      |  |        |  |        |   |  |                                            |   |  |                          
|Company Operated                              |  | 23                   |  | 3      |  | (1             | ) |  |                                           |   |  | 25                   |  | 1      |  | (2     | ) |  |                                           |   |  | 24                       
|                                              |  |                      |  |        |  |                |   |  |                                            |   |  |                      |  |        |  |        |   |  |                                            |   |  |                          
|Total                                         |  | 482                  |  | 79     |  | (360           | ) |  |                                           |   |  | 201                  |  | 8      |  | (4     | ) |  |                                           |   |  | 205                      
|                                              |  |                      |  |        |  |                |   |  |                                            |   |  |                      |  |        |  |        |   |  |                                            |   |  |                          

---

|(A) | On February 11, 2005, in connection with the sale of our international Gloria Jeans operations, we sold the franchise rights to 338 Gloria Jean retail locations to Jireh
International Pty. Ltd. and certain of its affiliates.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(B) | Includes Japan and Korea.
|--- | -------------------------



|(C) | Includes Guam, Indonesia, Ireland, Turkey, Malaysia, New Zealand, Philippines, United Arab Emirates Romania, South Africa and Thailand.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------



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Seasonality and Quarterly Results



Our business is subject to seasonal fluctuations as well as economic trends that affect retailers in general. Historically, our net sales
are highest during our second fiscal quarter, which includes the November  December holiday season. Hot weather tends to reduce sales. Quarterly results are affected by the timing of the opening of new stores, which may not occur as
anticipated due to events outside our control. As a result of these factors, the financial results for any individual quarter may not be indicative of the results that may be achieved in a full fiscal year.



Key Performance Indicators



We use several key indicators to evaluate the performance of our business. These indicators
include same-store sales growth, the number of company operated and franchised stores opened and closed, and the measured relationship of cost of sales and related occupancy costs, operating expenses and general and administrative expenses to sales.



Same-store sales growth, or comparative sales growth, is a primary statistic
used in the retail industry to measure core revenues. This measure compares sales for all units open for one year or more to the comparable prior year period. We use this measure to evaluate single coffeehouse, total brand and total company sales
performance. Until recently, comparable sales of our company operated stores had declined, primarily as a result of aging stores, a lack of capital to fund store improvements, and no new store openings. New stores typically achieve relatively strong
comparative sales growth in their early years. Franchised units that are located in shopping malls have also experienced declining sales due to overall declines in mall traffic.



The number of operating units opened and closed is also a measure of the health of our brands and our business, although it is affected by a
number of factors, including the availability of capital to finance growth. Unlike new company operated stores, new franchised stores do not require our capital. In addition, franchised stores typically make an immediate profit contribution, whereas
company stores generally are not profitable in the first year.



We use the
relationship between cost of sales and related occupancy costs and operating expenses to sales to measure the operating efficiency of our individual coffeehouses and to measure the relationship between general and administrative expenses to sales to
monitor and control the level of corporate overhead. In recent years, cost of sales and related occupancy costs have declined and gross margins have improved, primarily because wholesale sales, which have higher gross margins than retail sales, have
become a higher percentage of our overall sales mix. Operating expenses have increased in the past two years as a result of dedicating more in-store labor and supervision to our retail stores. General and administrative expenses have increased as a
percentage of sales due to staffing for accelerated growth and to the effect of continuing declines in sales on a relatively fixed expense base.



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RESULTS OF OPERATIONS



Twelve weeks ended September 21, 2005 compared with the twelve weeks ended September 22, 2004



Total Revenue. Total revenue from continuing operations for the twelve weeks
ended September 21, 2005 increased by $966,000, or 8.6%, to $12,180,000 from $11,214,000 for the twelve weeks ended September 22, 2004. This result was the net result of a 10.6% increase in retail sales, a 10.6% increase in wholesale sales
and a 15.9% decrease in domestic franchise revenue. Each component of total revenue is discussed below.



Retail Sales. Our retail sales revenue for the twelve weeks ended September 21, 2005 increased by $759,000, or 10.6%, to $7,888,000 from $7,129,000 for the twelve weeks ended September 22, 2004.
This increase was primarily due to company operated same store sales increase of 3.8% and a net increase of three company stores since the beginning of the prior years twelve weeks ended September 22, 2004. Retail sales from our internet
website also increased by $47,000 from $88,000 for the twelve weeks ended September 22, 2004 to $135,000 for the twelve weeks ended September 21, 2005.



Wholesale Revenue. Our wholesale sales for the twelve weeks ended September 21, 2005 increased by $343,000, or 10.6%, to
$3,571,000 from $3,228,000 for the twelve weeks ended September 22, 2004. This increase was primarily the net result of the following factors:



Keurig K-cup and other Third Party Wholesale sales. Third party wholesale sales for the twelve weeks ended September 21, 2005 increased by
$382,000, or 17.7%, to $2,546,000 from $2,164,000 for the twelve weeks ended September 22, 2004 led by strong growth in the Keurig K-cup sales which increased by 26.0%.



Roasted coffee sales to franchisees. Sales of roasted coffee to our franchisees decreased $38,000 for the twelve weeks ended
September 21, 2005 due to 3.3% negative same store sales in the first quarter of fiscal 2006 for the Gloria Jeans domestic franchise system which reduced roasted coffee usage offset in part by a net increase of two domestic franchise
stores since the beginning of the fiscal 2005 twelve week period.



Franchise
Revenue. Our franchise revenue consists of initial franchise fees, franchise renewal fees, area development fees, and royalties received on sales at franchised locations. Our domestic franchise revenue decreased by $136,000, or 15.9%, to
$721,000 for the twelve weeks ended September 21, 2005 from $857,000 for the twelve weeks ended September 22, 2004. Of the decline, $91,000 was due to a reclassification of certain fees as a reduction of general and administrative
marketing expenses. The balance of the decline, $45,000, was due to a decline in franchise royalties, primarily due to declining same store sales at franchise locations, offset by an increase in franchise fee revenue.



Cost of Sales and Related Occupancy Costs. Cost of sales and related
occupancy costs increased as a percentage of total retail and wholesale sales from 53.2% for the twelve weeks ended September 22, 2004 to 56.3% for the twelve weeks ended September 21, 2005. Retail cost of sales remained relatively stable,
increasing from 34.1% to 35.1% but wholesale cost of sales increased from 69.2% to 74.0% due to a higher percentage of higher cost Keurig business for the twelve weeks ended September 21, 2005 and due to overall cost increases. Increased costs
will be reflected in pricing adjustments effective early in the second quarter of the 2006 fiscal year.



Operating Expenses. Operating expenses for the twelve weeks ended September 21, 2005, as a percentage of retail and wholesale sales, increased from 37.8% of retail and wholesale sales for the
twelve weeks ended September 22, 2004 to 38.0% for the twelve weeks ended September 21, 2005. Wholesale operating expenses increased as a percentage of wholesale sales from 11.1% for the twelve weeks ended September 22, 2004 to 13.6%
in the current year period due to increased promotional selling expenses.



Depreciation and Amortization. Depreciation and amortization was $545,000 in the first quarter of each of the years.



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General and Administrative Expenses. Our general and administrative expense increased by $297,000, or
11.6%, to $2,863,000 for the twelve weeks ended September 21, 2005. As a percentage of total revenue, general and administrative expenses increased from 22.9% for the twelve weeks ended September 22, 2004 to 23.5% for the twelve weeks
ended September 21, 2005. This increase was primarily due to $237,000 increase in audit and tax fees expensed in the first quarter of fiscal 2006, but related to the 2005 fiscal year end audit and tax returns, and $85,000 increase in
stock-based compensation expense due to the adoption of SFAS 123R in the first quarter of fiscal 2006.



Interest Expense and Other, Net. Interest expense, interest income and other income, net which was a net expense of $43,000 in the twelve weeks ended September 22, 2004, was a net income of
$120,000 in the twelve weeks ended September 21, 2005. This change was due to interest income on the cash proceeds from the sale of our international Gloria Jeans franchise operations and a reduction of interest expense.



Income Tax Benefit. We had losses from continuing operations and income
from discontinued operations for the twelve weeks ended September 22, 2004. In accordance with SFAS No. 109 Accounting for Income Taxes, the income tax benefit generated by the loss from continuing operations was $320,000 for
the twelve weeks ended September 22, 2004. For the twelve weeks ended September 21, 2005, a tax benefit of $348,000 was generated primarily due to net operating loss carry-backs to offset taxable income reported for the year ended June 29,
2005. As of September 21, 2005, net operating loss carry-forwards for federal and state income tax purposes of $3,615,000 and $739,000, respectively, are available to be utilized against future taxable income for years through fiscal 2024 for
federal taxes and 2014 for state taxes, subject to possible annual limitation pertaining to change in ownership rules under the Internal Revenue Code. Due to the uncertainty of future taxable income, deferred tax assets resulting from the net
operating loss carry-forwards have been fully reserved.



Results of
Discontinued Operations. As a result of the sale of the international Gloria Jeans franchise operations on February 11, 2005, the results from this component of our business are presented as discontinued operations for the
fiscal twelve weeks ended September 22, 2004 in accordance with SFAS 144 Accounting for the Impairment or Disposal of Long-Lived Assets. For the twelve weeks ended September 22, 2004 income from discontinued operations was
$556,000, net of $327,000 in taxes.



FINANCIAL CONDITION,
LIQUIDITY AND CAPITAL RESOURCES



Current Financial
Condition. At September 21, 2005, we had cash of $9,423,000 as compared to $10,493,000 at June 29, 2005, and we had working capital of $8,961,000, as compared to working capital of $11,203,000 at June 29, 2005. Total
outstanding capital lease obligations decreased from $413,000 at June 29, 2005 to $380,000 at September 21, 2005. No long-term debt was outstanding at September 21, 2005 or June 29, 2005. From June 29, 2005 to
September 21, 2005, stockholders equity decreased from $31,513,000 to $30,165,000.



Cash Flows. Cash used by operating activities for the twelve weeks ended September 21, 2005 totaled $273,000 as compared with cash used of $572,000 for the twelve weeks ended
September 22, 2004. This decrease is the net result of a number of factors more fully enumerated in the Unaudited Condensed Consolidated Statement of Cash Flows in the accompanying financial statements.



Net cash used in investing activities for the twelve weeks ended September 21, 2005
totaled $883,000 as compared with net cash used of $787,000 for the twelve weeks ended September 22, 2004. During the twelve weeks ended September 21, 2005, $1,396,000 was used to invest in property and equipment in our store remodel
project, new stores, our Castroville roasting facility and our home office facility. These expenditures were partially offset by $513,000 of payments received on notes receivable.



Net cash provided by financing activities for the twelve weeks ended September 21, 2005 totaled $86,000 as compared to $920,000 for the
twelve weeks ended September 22, 2004. The decrease was primarily due to net borrowings of $950,000 under our credit agreement for the twelve weeks ended September 22, 2004 as compared to no borrowings for the twelve weeks ended
September 21, 2005.



Outstanding Debt and Financing
Arrangements. On May 10, 2004, we entered into a $5,000,000 Contingent Convertible Note Purchase Agreement. The agreement provides for us to, at our election, issue notes to the lender, Sequoia Enterprises L.P., up to an
aggregate principal amount of $5,000,000. The notes are amortized on a monthly basis at a rate that will repay 60% of the principal amount of each note by May 10, 2007. The remaining 40% will mature on that date. Interest is payable at LIBOR
plus 3.30%, 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 we may have outstanding in relation to our tangible net worth and that
require us to maintain a specified minimum dollar value of earnings before interest, tax, depreciation and amortization for the trailing four fiscal quarters, among others. Notes are convertible into our common stock only upon certain changes of
control. For notes issued and repaid, warrants to purchase shares are 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 May 10, 2008. The lender under this agreement is a limited partnership of which the chairman of our board of directors serves as the sole general partner. On May 10, 2004, upon entering into the agreement,
we immediately issued a $1,000,000 note under the facility and used the proceeds from that note and other available cash to repay all outstanding debt with Bank of the West. On September 15, 2004, we issued a second note for $1,000,000 under
this facility. The price of our common stock on May 10, 2004, the date that the first $1,000,000 note was issued, was $3.95 per share. The price of our common stock on September 15, 2004, the date the second $1,000,000 note was issued, was
$4.95 per share. Since both the notes were fully paid off in fiscal year 2005, a total of 455,184 warrants are issuable. We have issued 4,219 warrants as of September 21, 2005. As of September 21, 2005, no borrowings were outstanding under
the facility and we were in compliance with all agreement covenants.



On
May 10, 2004, we also entered into an Amended and Restated Credit Agreement with Bank of the West. The agreement provides for a working capital facility of $250,000 and a letter of credit facility of $750,000. On September 21, 2005, no
debt was outstanding under the working capital facility and $576,000 of letters of credit were outstanding under the letter of credit facility. With respect to the working capital facility, we may elect to pay interest on amounts outstanding at the
Bank of the West reference rate plus 1.00% or LIBOR plus 3.25%. Borrowings and issuance of letters of credit under the Bank of the West facility are secured by substantially all of our assets. Letters of credit issued under the letter of credit
facility are subject to an annual fee of 2.00% of the face amount. The agreement contains covenants that limit the amount of indebtedness that we may have outstanding in relation to our tangible net worth and that require us to maintain a specified
minimum dollar value of earnings before interest, tax, depreciation and amortization for the trailing four fiscal quarters, among others. As of September 21, 2005, we were in compliance with all agreement covenants. The letter of credit
facility has been extended to October 15, 2006 and we terminated the working capital facility.



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Based upon the terms of our credit agreements, our recent operating performance and business outlook, and status of our
balance sheet, we believe that cash from operations, cash and cash equivalents, and funds available under our credit agreements will be sufficient to satisfy our working capital needs at the anticipated operating levels for at least the next twelve
months.



Off-balance sheet arrangements. We utilize a
segregated advertising fund to administer contributions received from our franchisees for advertising programs. Upon the adoption of FIN 46R, we consolidated the advertising fund. We have included $259,000 of advertising fund assets, restricted and
advertising fund liabilities in the accompanying unaudited condensed consolidated balance sheet as of September 21, 2005. The advertising contributions and disbursements are reported in the unaudited condensed consolidated statement of
operations on a net basis whereby contributions from franchisees are recorded as offsets to our reported general and administrative expenses.



Other Commitments. The following represents a comprehensive list of our contractual obligations and commitments as of September 21, 2005:



|                                                                   |  |                      |        |        |   |         |  |         |       |         |   |         |  |            |       |  |   |       |  |   |       
|------------------------------------------------------------------ |  | -------------------- | ------ | ------ | - | ------- |  | ------- | ----- | ------- | - | ------- |  | ---------- | ----- |  | - | ----- |  | - | ------
|                                                                   |  | Payments Due by Year
|                                                                   |  | Total                |        | 1 year |   | 2 years |  | 3 years |       | 4 years |   | 5 years |  | Thereafter
|                                                                   |  | (In thousands)      
|Capital leases                                                     |  |                      | 380    |        |   | 57      |  |         | 19    |         |   | 21      |  |            | 22    |  |   | 24    |  |   | 237   
|Company operated retail locations and other operating leases       |  |                      | 21,003 |        |   | 3,514   |  |         | 2,873 |         |   | 2,593   |  |            | 2,333 |  |   | 1,941 |  |   | 7,749 
|Gloria Jeans franchise operated retail locations operating leases |  |                      | 16,866 |        |   | 4,087   |  |         | 3,314 |         |   | 2,432   |  |            | 1,878 |  |   | 1,509 |  |   | 3,646 
|Green coffee commitments                                           |  |                      | 2,155  |        |   | 2,155   |  |         |      |         |   |        |  |            |      |  |   |      |  |   |      
|                                                                   |  |                      |        |        |   |         |  |         |       |         |   |         |  |            |       |  |   |       |  |   |       
|                                                                   |  | $                    | 40,404 |        | $ | 9,813   |  | $       | 6,206 |         | $ | 5,046   |  | $          | 4,233 |  | $ | 3,474 |  | $ | 11,632
|                                                                   |  |                      |        |        |   |         |  |         |       |         |   |         |  |            |       |  |   |       |  |   |       



We have also entered into employment
agreements with our President and Chief Executive Officer and three senior executive officers that provide for severance payments in the event that these individuals are terminated without cause or that 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 liability for severance under the contracts is currently $770,000. Because such amounts are contingent they have not been included in
the above table.



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 86 Gloria Jeans franchise locations. Under our historical franchising
business model, we executed the master leases for these locations and entered 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 21, 2005, computed as the sum of all remaining lease payments through the expiration dates of the respective leases, was
$16,866,000. 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.



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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.



Impairment of Goodwill



At the reporting unit level, goodwill is tested for impairment annually or whenever an event
or circumstance indicates that it is more likely than not 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 earnings.



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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 the present value of actuarial estimates of the amount of incurred and unpaid losses, based approximately on a risk-free interest rate. 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 No. 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 No. 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.



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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 have been profitable for a number of years and our prospects for the realization of our deferred tax assets are more likely than not, we would then reverse our valuation allowance and credit income tax expense. In assessing 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 21, 2005, our net deferred tax assets were fully reserved with a related valuation allowance that totaled approximately $2,765,000.



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|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 21, 2005, we had a $5,000,000 loan facility, with no outstanding balance
and a $250,000 working capital facility, with no outstanding balance, each of which could be affected by changes in short term interest rates.



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 21, 2005, we had commitments to
purchase coffee through fiscal year 2006 totaling $2,155,000 for 1,349,000 pounds of green coffee, some of which commitments were fixed as to price. The coffee scheduled to be delivered to us in the next twelve months pursuant to these commitments
will satisfy approximately 30% of our anticipated green coffee requirements for the next twelve months. Assuming we require approximately 3,092,000 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 $31,000 of additional cost.



Another ingredient that we used extensively in our products is fluid milk. Fluid milk prices in the United States rose significantly in 2004. We continue to monitor
published dairy prices on the related commodities markets, but cannot predict with any certainty whether future prices that we will pay for dairy products.



Our ability to raise sales prices in response to rising coffee or milk prices may be limited, and our profitability could be adversely affected if prices were to rise
substantially.



|Item 4. | Controls and Procedures.
|------- | ------------------------



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 defined in Rule 13a-15(e) under the Securities Exchange Act of 1934) as of September 21, 2005. Our management, with the participation of our Chief Executive Officer and Chief Financial Officer also conducted an evaluation of our
internal control over financial reporting to determine whether any changes occurred during the first quarter of fiscal 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of September 21, 2005. As described in further detail under Item 9A - Controls and
Procedures in our Annual Report on Form 10-K for the fiscal year ended June 29, 2005, which is incorporated herein by reference, the Audit Committee of our Board of Directors determined in April 2005 that certain of our historical
financial statements should be restated to correct certain errors related to accounting for leases, and subsequent to June 29, 2005, we have changed our accounting policies for leases to conform to accounting principles generally accepted in
the United States of America. We believe that these changes, as more fully described in the Form 10-K noted above, have remediated the material weakness in internal control over financial reporting described in the Form 10-K.



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##### Table of Contents

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 21, 2005, we were not a party to any material legal
proceedings.



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##### Table of Contents

|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)                                                                                                                                                                                
|            | 
|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)                                                                                       
|            | 
|10.1        |  | Form of Indemnification Agreement (5)                                                                                                                                                                              
|            | 
|10.2        |  | Diedrich Coffee, Inc. 2000 Equity Incentive Plan (8)*                                                                                                                                                              
|            | 
|10.3        |  | Diedrich Coffee, Inc. 2000 Non-Employee Directors Stock Option Plan (9)*                                                                                                                                           
|            | 
|10.4        |  | Amended and Restated Diedrich Coffee, Inc. 1996 Stock Incentive Plan (10)*                                                                                                                                         
|            | 
|10.5        |  | Diedrich Coffee, Inc. 1996 Non-Employee Directors Stock Option Plan (11)*                                                                                                                                          
|            | 
|10.6        |  | Form of Diedrich Coffee, Inc. Franchise Agreement (12)                                                                                                                                                             
|            | 
|10.7        |  | Form of Gloria Jeans Franchise Agreement (12)                                                                                                                                                                     
|            | 
|10.8        |  | Form of Diedrich Coffee, Inc. Area Development Agreement (12)                                                                                                                                                      
|            | 
|10.9        |  | Amended and Restated Credit Agreement with Bank of the West, effective May 10, 2004 (13)                                                                                                                           
|            | 
|10.10       |  | Security Agreement, dated September 3, 2002, by and between Diedrich Coffee, Inc. and Bank of the West d/b/a/ United California Bank (14)                                                                          
|            | 
|10.11       |  | Form of Supplemental Security Agreement (Trademarks) (14)                                                                                                                                                          
|            | 
|10.12       |  | Form of Guaranty (14)                                                                                                                                                                                              
|            | 
|10.13       |  | Form of Guarantor Security Agreement (14)                                                                                                                                                                          
|            | 
|10.14       |  | Employment Agreement with Roger M. Laverty, dated April 24, 2003 (15)*                                                                                                                                             
|            | 
|10.15       |  | Stock Option Plan and Agreement with Roger M. Laverty, dated April 24, 2003 (15)*                                                                                                                                  
|            | 
|10.16       |  | Employment Agreement with Martin A. Lynch, dated March 26, 2004 (16)*                                                                                                                                              
|            | 
|10.17       |  | Employment Agreement with Matthew McGuinness, effective March 13, 2000 (18)*                                                                                                                                       



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|      |  |                                                                                                                                                              
|----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------
|      | 
|10.18 |  | Employment Letter regarding the employment of Pamela Britton, dated February 6, 2001 (12)*                                                                   
|      | 
|10.19 |  | Employment Letter regarding the employment of Carl Mount dated October 29, 1999 (19)*                                                                        
|      | 
|10.20 |  | Separation Agreement by and between Diedrich Coffee, Inc. and Philip G. Hirsch (15)*                                                                         
|      | 
|10.21 |  | Form of Separation Agreement and Release with Martin Diedrich, effective October 28, 2004 (20)*                                                              
|      | 
|10.22 |  | Standard Industrial/Commercial Multi-Tenant Lease Agreement by and between The Westphal Family Trust and Diedrich Coffee, Inc., dated September 10, 2003 (21)
|      | 
|10.23 |  | Office Space Lease Agreement by and between The Irvine Company and Diedrich Coffee, Inc., dated August 1, 2003 (21)                                          
|      | 
|10.24 |  | Contingent Convertible Note Purchase Agreement, dated May 10, 2004 (includes form of convertible promissory note and form of warrant) (13)                   
|      | 
|10.25 |  | Asset Purchase Agreement, dated December 5, 2004, by and among, among others, Diedrich Coffee, Inc. and Jireh International Pty. Ltd. (17)                   
|      | 
|10.26 |  | Roasting License Agreement, dated February 10, 2005 (22)                                                                                                     
|      | 
|10.27 |  | Consulting Agreement, dated February 10, 2005 (22)                                                                                                           
|      | 
|10.28 |  | Trademark License Agreement, dated February 10, 2005 (22)                                                                                                    
|      | 
|10.29 |  | 1997 Non-Employee Director Stock Option Plan and Agreement (23)*                                                                                             
|      | 
|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                                                          

---

|* | 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.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(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 Definitive Proxy Statement, filed with the Securities and Exchange Commission on April 12, 2001.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

|(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 Quarterly Report on Form 10-Q for the period ended March 10, 2004, filed with the Securities and Exchange Commission on
January 30, 2004.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(9) | Previously filed as an exhibit to Diedrich Coffees Registration Statement on Form S-8, filed with the Securities and Exchange Commission on November 21, 2000.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------



|(10) | Previously filed as an exhibit to Diedrich Coffees Quarterly Report on Form 10-Q for the period ended September 22, 1999, filed with the Securities and Exchange
Commission on November 5, 1999.
|---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(11) | 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 12, 1996.
|---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(12) | Previously filed as an exhibit to Diedrich Coffees Quarterly Report on Form 10-Q for the period ended September 24, 2003, filed with the Securities and Exchange
Commission on November 7, 2003.
|---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(13) | Previously filed as an exhibit to Diedrich Coffees Annual Report on Form 10-K for the fiscal year ended June 30, 2004, filed with the Securities and Exchange Commission
on September 28, 2004.
|---- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(14) | Previously filed as an exhibit to Diedrich Coffees Annual Report on Form 10-K for the fiscal year ended July 3, 2002, filed with the Securities and Exchange Commission on
October 1, 2002.
|---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(15) | Previously filed as an exhibit to Diedrich Coffees Quarterly Report on Form 10-Q for the period ended March 12, 2003, filed with the Securities and Exchange Commission on
April 28, 2003.
|---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(16) | Previously filed as an exhibit to Diedrich Coffees Quarterly Report on Form 10-Q for the period ended March 10, 2004, filed with the Securities and Exchange Commission on
April 26, 2004.
|---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(17) | Previously filed as an exhibit to Diedrich Coffees Current Report on Form 8-K, filed with the Securities and Exchange Commission on December 6, 2004.
|---- | ------------------------------------------------------------------------------------------------------------------------------------------------------



|(18) | Previously filed as an exhibit to Diedrich Coffees Annual Report on Form 10-K for the fiscal year ended June 28, 2000, filed with the Securities and Exchange Commission
on September 27, 2000.
|---- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(19) | Previously filed as an exhibit to Diedrich Coffees Quarterly Report on Form 10-Q for the period ended September 20, 2000, filed with the Securities and Exchange
Commission on November 6, 2000.
|---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(20) | Previously filed as an exhibit to Diedrich Coffees Current Report on Form 8-K, filed with the Securities and Exchange Commission on November 3, 2004.
|---- | ------------------------------------------------------------------------------------------------------------------------------------------------------



|(21) | Previously filed as an exhibit to Diedrich Coffees Annual Report on Form 10-K for the fiscal year ended July 2, 2003, filed with the Securities and Exchange Commission on
September 30, 2003.
|---- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(22) | Previously filed as an exhibit to Diedrich Coffees Quarterly Report on Form 8-K, filed with the Securities and Exchange Commission on February 16, 2005.
|---- | ---------------------------------------------------------------------------------------------------------------------------------------------------------



|(23) | Previously filed as an exhibit to Diedrich Coffees Annual Report on Form 10-K405/A for the fiscal year ended January 27, 1999, filed with the Securities and Exchange
Commission on June 8, 1999.
|---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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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.



Date: November 4, 2005



DIEDRICH COFFEE, INC./s/ Roger M. LavertyRoger M. LavertyPresident and Chief Executive Officer(On behalf of the registrant)/s/ Martin A. LynchMartin A. LynchExecutive Vice President andChief Financial Officer(Principal financial officer)




26