**UNITED STATES****SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

 

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**FORM 10-Q**

 

| **ý****QUARTERLY REPORT  PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934**                                                                                         |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                            |
| **For the quarterly period ended December 17,  2003**                                                                                                                                           |
|                                                                                                                                                                                            |
| **OR**                                                                                                                                                                                          |
|                                                                                                                                                                                            |
| **o****TRANSITION REPORT  PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934**                                                                                             |
|                                                                                                                                                                                            |
| **For the transition period from                 to             ** |
|                                                                                                                                                                                            |
| **Commission file number 0-21203**                                                                                                                                                              |

 

**DIEDRICH COFFEE, INC.**

(Exact Name of Registrant as Specified in ItsCharter)

 

| **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)      |

 

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Indicate by check mark whether the registrant: (1) has filed allreports required to be filed by Section 13 or 15(d) of the Securities ExchangeAct of 1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. YES ýNO o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act). YES oNO ý

 

As of January27, 2004, there were 5,161,263 shares of common stock of the registrantoutstanding.

 

 

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**DIEDRICH COFFEE, INC.INDEX**

 
|                                    | **Page Number**                                                                             |
|-----------------------------------------|---------------------------------------------------------------------------------------------|
| **PART I – FINANCIAL INFORMATION** |                                                                                        |
|                                    |                                                                                        |
| Item 1.                                 | Financial Statements                                                                        |   |   |
|                                    |                                                                                        |
|                                    | Condensed Consolidated Balance Sheets  (Unaudited)                                          | 1 |
|                                    |                                                                                        |   |
|                                    | Condensed Consolidated Statements of  Earnings (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 | 10 |
|                                    |                                                                                        |   |
| Item 3.                                 | Quantitative and Qualitative Disclosures  About Market Risk                                 | 19 |
|                                    |                                                                                        |   |
| Item 4.                                 | Controls and Procedures                                                                     | 20 |
|                                    |                                                                                        |
| **PART II – OTHER INFORMATION**    |                                                                                        |
|                                    |                                                                                        |
| Item 1.                                 | Legal Proceedings                                                                           | 20 |
|                                    |                                                                                        |
| Item 4.                                 | Submission of Matters to a Vote of Security  Holders                                        | 20 |
|                                    |                                                                                        |
| Item 6.                                 | Exhibits and Reports on Form 8-K                                                            | 22 |
|                                    |                                                                                        |
| Signatures                              | 27                                                                                          |
|                                         |                                                                                             |  |  |  |

 

i

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**PART I - FINANCIALINFORMATION**

 

**Item 1.****           FinancialStatements.**

 

DIEDRICH COFFEE, INC.CONDENSED CONSOLIDATED BALANCESHEETS(UNAUDITED)
|                                                                                                                                        |   | **December 17, 2003** |       | **July 2, 2003** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------|------------|------------------|--------|
|                                                                                                                                        |   |                  |       |             |   |
| **Assets**                                                                                                                                  |   |                  |       |             |   |
| Current assets:                                                                                                                             |   |                  |       |             |   |
| Cash                                                                                                                                        |   | $                     | 1,535,000  |             | $      | 2,625,000 |   |
| Accounts receivable, less allowance for  doubtful accounts of $1,579,000 at December 17, 2003 and $1,375,000 at July  2, 2003               |   | 3,243,000             |       | 2,454,000        |   |
| Inventories                                                                                                                                 |   | 2,922,000             |       | 2,611,000        |   |
| Current portion of notes receivable                                                                                                         |   | 61,000                |       | 58,000           |   |
| Prepaid expenses                                                                                                                            |   | 754,000               |       | 901,000          |   |
| Total current assets                                                                                                                        |   | 8,515,000             |       | 8,649,000        |   |
| Restricted cash                                                                                                                             |   | 883,000               |       | —           |   |
| Property and equipment, net                                                                                                                 |   | 7,077,000             |       | 7,052,000        |   |
| Goodwill                                                                                                                                    |   | 10,190,000            |       | 10,190,000       |   |
| Notes receivable                                                                                                                            |   | 158,000               |       | 182,000          |   |
| Other assets                                                                                                                                |   | 519,000               |       | 469,000          |   |
| Total assets                                                                                                                                |   | $                     | 27,342,000 |             | $      | 26,542,000 |   |
|                                                                                                                                        |   |                  |       |             |   |
| **Liabilities and  Stockholders’ Equity**                                                                                              |   |                  |       |             |   |
| Current liabilities:                                                                                                                        |   |                  |       |             |   |
| Current installments of obligations under  capital leases                                                                                   |   | $                     | 171,000    |             | $      | 185,000 |   |
| Current installments of long-term debt                                                                                                      |   | 1,517,000             |       | 1,459,000        |   |
| Accounts payable                                                                                                                            |   | 2,894,000             |       | 2,108,000        |   |
| Accrued compensation                                                                                                                        |   | 1,648,000             |       | 1,307,000        |   |
| Accrued expenses                                                                                                                            |   | 791,000               |       | 738,000          |   |
| Franchisee deposits                                                                                                                         |   | 663,000               |       | 671,000          |   |
| Deferred franchise fee income                                                                                                               |   | 844,000               |       | 549,000          |   |
| Accrued provision for store closure                                                                                                         |   | 183,000               |       | 425,000          |   |
| Total current liabilities                                                                                                                   |   | 8,711,000             |       | 7,442,000        |   |
| Obligations under capital leases, excluding  current installments                                                                           |   | 478,000               |       | 542,000          |   |
| Long term debt, excluding current  installments                                                                                             |   | 854,000               |       | 1,491,000        |   |
| Deferred rent                                                                                                                               |   | 468,000               |       | 478,000          |   |
| Total liabilities                                                                                                                           |   | 10,511,000            |       | 9,953,000        |   |
| Stockholders’ equity:                                                                                                                  |   |                  |       |             |   |
| Common stock, $0.01 par value; authorized  8,750,000 shares; issued and outstanding 5,161,000 shares at December 17,  2003 and July 2, 2003 |   | 52,000                |       | 52,000           |   |
| Additional paid-in capital                                                                                                                  |   | 58,036,000            |       | 58,036,000       |   |
| Accumulated deficit                                                                                                                         |   | (41,257,000           | )          | (41,499,000      | )      |
| Total stockholders’ equity                                                                                                             |   | 16,831,000            |       | 16,589,000       |   |
| Commitments and contingencies                                                                                                               |   |                  |       |             |   |
| Total liabilities and stockholders’ equity                                                                                             |   | $                     | 27,342,000 |             | $      | 26,542,000 |   |

* *

*See accompanying notes to condensed consolidated financial statements.*

 

1

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DIEDRICHCOFFEE, INC.CONDENSED CONSOLIDATED STATEMENTSOF EARNINGS(UNAUDITED)
|                                                    |   | **Twelve  Weeks  Ended  December 17,  2003** |      | **Twelve  Weeks  Ended  December 18,  2002** |   | **Twenty-Four  Weeks Ended  December 17,  2003** |   | **Twenty-Four  Weeks Ended  December 18,  2002** |       |
|---------------------------------------------------------|--------|----------------------------------------------|-----------|----------------------------------------------|--------|--------------------------------------------------|--------|--------------------------------------------------|------------|
| Net revenue:                                            |   |                                         |      |                                         |   |                                             |   |                                             |       |
| Retail sales                                            |   | $                                            | 7,571,000 |                                         | $      | 8,329,000                                        |   | $                                                | 14,444,000 |   | $ | 16,186,000 |   |
| Wholesale and other                                     |   | 4,833,000                                    |      | 5,163,000                                    |   | 7,707,000                                        |   | 8,198,000                                        |       |
| Franchise revenue                                       |   | 1,848,000                                    |      | 1,476,000                                    |   | 3,411,000                                        |   | 2,930,000                                        |       |
| Total revenue                                           |   | 14,252,000                                   |      | 14,968,000                                   |   | 25,562,000                                       |   | 27,314,000                                       |       |
|                                                    |   |                                         |      |                                         |   |                                             |   |                                             |       |
| Costs and expenses:                                     |   |                                         |      |                                         |   |                                             |   |                                             |       |
| Cost of sales and related occupancy costs               |   | 6,745,000                                    |      | 7,288,000                                    |   | 11,855,000                                       |   | 13,000,000                                       |       |
| Operating expenses                                      |   | 3,991,000                                    |      | 4,166,000                                    |   | 7,683,000                                        |   | 8,194,000                                        |       |
| Depreciation and amortization                           |   | 440,000                                      |      | 461,000                                      |   | 1,028,000                                        |   | 906,000                                          |       |
| General and administrative expenses                     |   | 2,374,000                                    |      | 2,134,000                                    |   | 4,525,000                                        |   | 4,230,000                                        |       |
| Provision for asset impairment and  restructuring costs |   | 90,000                                       |      | 106,000                                      |   | 94,000                                           |   | 106,000                                          |       |
| (Gain) loss on asset disposals                          |   | —                                       |      | 18,000                                       |   | —                                           |   | (2,000                                           | )          |
| Total costs and expenses                                |   | 13,640,000                                   |      | 14,173,000                                   |   | 25,185,000                                       |   | 26,434,000                                       |       |
|                                                    |   |                                         |      |                                         |   |                                             |   |                                             |       |
| Operating income                                        |   | 612,000                                      |      | 795,000                                      |   | 377,000                                          |   | 880,000                                          |       |
|                                                    |   |                                         |      |                                         |   |                                             |   |                                             |       |
| Interest expense                                        |   | (73,000                                      | )         | (70,000                                      | )      | (136,000                                         | )      | (163,000                                         | )          |
|                                                    |   |                                         |      |                                         |   |                                             |   |                                             |       |
| Interest and other income, net                          |   | 5,000                                        |      | 13,000                                       |   | 11,000                                           |   | 24,000                                           |       |
|                                                    |   |                                         |      |                                         |   |                                             |   |                                             |       |
| Income before income tax provision                      |   | 544,000                                      |      | 738,000                                      |   | 252,000                                          |   | 741,000                                          |       |
|                                                    |   |                                         |      |                                         |   |                                             |   |                                             |       |
| Income tax provision                                    |   | 1,000                                        |      | 26,000                                       |   | 10,000                                           |   | 39,000                                           |       |
|                                                    |   |                                         |      |                                         |   |                                             |   |                                             |       |
| Net income                                              |   | $                                            | 543,000   |                                         | $      | 712,000                                          |   | $                                                | 242,000    |   | $ | 702,000 |   |
|                                                    |   |                                         |      |                                         |   |                                             |   |                                             |       |
| Net income per share – basic                       |   | $                                            | 0.11      |                                         | $      | 0.14                                             |   | $                                                | 0.05       |   | $ | 0.14 |   |
|                                                    |   |                                         |      |                                         |   |                                             |   |                                             |       |
| Net income per share – diluted                     |   | $                                            | 0.10      |                                         | $      | 0.14                                             |   | $                                                | 0.05       |   | $ | 0.14 |   |
|                                                    |   |                                         |      |                                         |   |                                             |   |                                             |       |
| Number of shares used in per share  computations:       |   |                                         |      |                                         |   |                                             |   |                                             |       |
| Basic                                                   |   | 5,161,000                                    |      | 5,161,000                                    |   | 5,161,000                                        |   | 5,161,000                                        |       |
| Diluted                                                 |   | 5,211,000                                    |      | 5,255,000                                    |   | 5,186,000                                        |   | 5,199,000                                        |       |

 

*See accompanying notes to condensed consolidated financial statements.*

 

2

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DIEDRICHCOFFEE, INC.CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS(UNAUDITED)
|                                                                           |   | **Twenty-Four  Weeks Ended  December 17, 2003** |      | **Twenty-Four  Weeks Ended  December 18, 2002** |   |
|--------------------------------------------------------------------------------|--------|-------------------------------------------------|-----------|-------------------------------------------------|--------|
| Cash flows from operating activities:                                          |   |                                            |      |                                            |   |
| Net income                                                                     |   | $                                               | 242,000   |                                            | $      | 702,000 |   |
| Adjustments to reconcile net income to cash  provided by operating activities: |   |                                            |      |                                            |   |
| Depreciation and amortization                                                  |   | 1,028,000                                       |      | 906,000                                         |   |
| Amortization of loan fees                                                      |   | 39,000                                          |      | 45,000                                          |   |
| Provision for bad debt                                                         |   | 218,000                                         |      | 48,000                                          |   |
| Provision for inventory obsolescence                                           |   | 143,000                                         |      | (9,000                                          | )      |
| Provision for asset impairment                                                 |   | 90,000                                          |      | 106,000                                         |   |
| Provision for (benefit from) store closure                                     |   | (70,000                                         | )         | 20,000                                          |   |
| Gain on disposal of assets                                                     |   | —                                          |      | (2,000                                          | )      |
| Changes in operating assets and  liabilities:                                  |   |                                            |      |                                            |   |
| Accounts receivable                                                            |   | (1,007,000                                      | )         | (1,488,000                                      | )      |
| Inventories                                                                    |   | (454,000                                        | )         | (207,000                                        | )      |
| Prepaid expenses                                                               |   | 147,000                                         |      | 97,000                                          |   |
| Other assets                                                                   |   | (92,000                                         | )         | (135,000                                        | )      |
| Accounts payable                                                               |   | 786,000                                         |      | 461,000                                         |   |
| Accrued compensation                                                           |   | 341,000                                         |      | (13,000                                         | )      |
| Accrued expenses                                                               |   | 53,000                                          |      | 102,000                                         |   |
| Accrued provision for store closure                                            |   | (172,000                                        | )         | (154,000                                        | )      |
| Deferred franchise income and franchisee  deposits                             |   | 287,000                                         |      | 69,000                                          |   |
| Deferred rent                                                                  |   | (10,000                                         | )         | (4,000                                          | )      |
| Net cash provided by operating activities                                      |   | 1,569,000                                       |      | 544,000                                         |   |
| Cash flows from investing activities:                                          |   |                                            |      |                                            |   |
| Capital expenditures for property and  equipment                               |   | (1,146,000                                      | )         | (343,000                                        | )      |
| Proceeds from disposal of property and equipment                               |   | 6,000                                           |      | 275,000                                         |   |
| Payments received on notes receivable                                          |   | 21,000                                          |      | 23,000                                          |   |
| Net cash used in investing activities                                          |   | (1,119,000                                      | )         | (45,000                                         | )      |
| Cash flows from financing activities:                                          |   |                                            |      |                                            |   |
| Restricted cash                                                                |   | (883,000                                        | )         | —                                          |   |
| Payments on long-term debt                                                     |   | (579,000                                        | )         | (526,000                                        | )      |
| Payments on capital lease obligations                                          |   | (78,000                                         | )         | (95,000                                         | )      |
| Net cash used in financing activities                                          |   | (1,540,000                                      | )         | (621,000                                        | )      |
|                                                                           |   |                                            |      |                                            |   |
| Net decrease in cash                                                           |   | (1,090,000                                      | )         | (122,000                                        | )      |
| Cash at beginning of period                                                    |   | 2,625,000                                       |      | 2,233,000                                       |   |
| Cash at end of period                                                          |   | $                                               | 1,535,000 |                                            | $      | 2,111,000 |   |
|                                                                           |   |                                            |      |                                            |   |
| Supplemental disclosure of cash flow  information:                             |   |                                            |      |                                            |   |
| Cash paid during the period for:                                               |   |                                            |      |                                            |   |
| Interest                                                                       |   | $                                               | 56,000    |                                            | $      | 108,000 |   |
| Income taxes                                                                   |   | $                                               | 10,000    |                                            | $      | 41,000 |   |

 

*See accompanying notes to condensed consolidated financial statements.*

 

3

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**DIEDRICH COFFEE, INC.NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTSDECEMBER 17, 2003(UNAUDITED)**

1.                                       SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES

 

*Basis of Presentation*

 

The unaudited condensed consolidated financial statements of DiedrichCoffee, Inc. and its subsidiaries (the “Company”) have been prepared inaccordance with generally accepted accounting principles, as well as theinstructions to Form 10-Q and Article 10 of Regulation S-X.  These statements should be read inconjunction with the consolidated financial statements and the notes theretoincluded in the Company’s Annual Report on Form 10-K/A filed on October 3,2003.

 

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

 

*Stock Option Plans*

 

The Company applies the intrinsic value-method of accounting prescribedby Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for StockIssued to Employees,” and related interpretations, in accounting for employeestock options. As such, compensation expense would be recorded on the date ofgrant only if the current market price of the underlying stock exceeded theexercise price. Statement of Financial Accounting Standards (“SFAS”) No. 123,“Accounting for Stock-Based Compensation,” as amended, established accountingand disclosure requirements using a fair value-based method of accounting forstock-based employee compensation plans. The Company has adopted the disclosure provisions of SFASNo. 123 and continues to follow APB 25 for stock-based employeecompensation.

 

Pro forma net income (loss) and pro forma net income (loss) per share,as if the fair value-based method of SFAS 123 had been applied in measuringcompensation cost for stock-based awards, is as follows:

 
|                                                                     |   | **TWELVE WEEKS ENDED** |    | **TWENTY-FOUR WEEKS ENDED** |   |
|--------------------------------------------------------------------------|--------|------------------------|---------|-----------------------------|--------|
| **Pro Forma**                                                            |   | **December 17,  2003** |    | **December 18,  2002**      |   | **December 17,  2003** |   | **December 18,  2002** |   |
| Net income                                                               |   | $                      | 543,000 |                        | $      | 712,000 |   | $ | 242,000 |   | $ | 702,000 |   |
| Stock based employee compensation expense  included in reported net loss |   | —                 |    | —                      |   | — |   | — |   |
| SFAS 123 option expense                                                  |   | (226,000               | )       | (172,000                    | )      | (386,000 | ) | (228,000 | ) |
| Pro forma net income (loss)                                              |   | $                      | 317,000 |                        | $      | 540,000 |   | $ | (144,000 | ) | $ | 474,000 |   |
| Basic and diluted income (loss) per share                                |   | $                      | 0.06    |                        | $      | 0.10 |   | $ | (0.03 | ) | $ | 0.09 |   |

 

4

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The fairvalues of the options granted were estimated using the Black-Scholesoption-pricing model based on the following weighted average assumptions:

 
|                    |   | **TWELVE AND TWENTY-FOUR  WEEKS ENDED** |   |
|-------------------------|--------|-----------------------------------------|--------|
|                    |   | **December 17,  2003**                  |   | **December 18,  2002** | ** ** |
|                    |   |                                    |   |   | ** ** |
| Risk free interest rate |   | 2.57                                    | %      | 2.57 | % |
| Expected life           |   | 6 years                                 |   | 6 years |   |
| Expected volatility     |   | 99                                      | %      | 99 | % |
| Expected dividend yield |   | 0                                       | %      | 0 | % |

 

*Reclassifications*

 

Certain reclassifications have been made to the December 18, 2002consolidated financial statements to conform to the December 17, 2003presentation.

 

2.                                       INVENTORIES

 

Inventories consist of the following:

 
|                              |   | **December 17, 2003** |      | **July 2, 2003** |   |
|-----------------------------------|--------|-----------------------|-----------|------------------|--------|
| Unroasted coffee                  |   | $                     | 962,000   |             | $      | 1,034,000 |   |
| Roasted coffee                    |   | 763,000               |      | 572,000          |   |
| Accessory and specialty items     |   | 229,000               |      | 163,000          |   |
| Other food, beverage and supplies |   | 968,000               |      | 842,000          |   |
|                              |   | $                     | 2,922,000 |             | $      | 2,611,000 |   |

 

5

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3.                                       LONG-TERMDEBT

 

Long-term debt consists of the following:

 
|                                                                                                                                                                                                                                                                         |   | **December 17, 2003** |      | **July 2, 2003** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------|-----------|------------------|--------|
| **Term Loan**                                                                                                                                                                                                                                                                |   |                  |      |             |   |   |   |
| Note payable bearing interest at a rate of  3.25% over LIBOR, or 4.45% as of December 17, 2003, and payable in monthly  installments of $100,000 plus interest. Due March 31, 2005. Note is secured  by the assets of the Company and the stock of its subsidiaries.    |   | $                     | 1,500,000 |             | $      | 2,000,000 |   |
| **Packaging Equipment Note**                                                                                                                                                                                                                                                 |   |                  |      |             |   |   |   |
| Note payable bearing interest at a rate of  5.77% as of December 17, 2003 and payable in monthly installments of $26,000  plus interest. Due August 28, 2006. Note is secured by coffee packaging  equipment and a restricted cash balance of $800,000 at December 17, 2003. |   | 871,000               |      | 950,000          |   |
|                                                                                                                                                                                                                                                                         |   | 2,371,000             |      | 2,950,000        |   |
| Less: current installments                                                                                                                                                                                                                                                   |   | (1,517,000            | )         | (1,459,000       | )      |
| Long-term debt, excluding current  installments                                                                                                                                                                                                                              |   | $                     | 854,000   |             | $      | 1,491,000 |   |

 

On September 3, 2002, the Company entered into a credit agreement (the“Credit Agreement”) with United California Bank, doing business as Bank of theWest (“BOW”).  Two notes payable issuedunder the Credit Agreement are currently outstanding.  In addition, under the Credit Agreement, the Company has arevolving working capital and letter of credit facility.

 

The Company’s obligations under the Credit Agreement are secured by allof the Company’s assets, including the stock of each of its subsidiaries (eachof which has guaranteed the Company’s obligations under the Credit Agreement),as well as all intangible assets it owns, including the intellectual propertyand trademark assets that the Company and its subsidiaries own.

 

In addition to the equipment purchased with the proceeds of the note,the Packaging Equipment Note is secured by a restricted cash balance on depositwith BOW equal to the lesser of $800,000 or the outstanding principal balanceof the equipment term loan.  Therestricted cash balance was $800,000 on December 17, 2003.

 

The Credit Agreement also provides the Company with a $675,000revolving working capital and letter of credit facility, subject to a number ofrestrictions. The Company’s working capital facility draws and letters ofcredit are limited to a combined maximum of $675,000 outstanding at any time.Furthermore, draw-downs against the working capital facility are subject to asub-limit of $500,000, and letters of credit are subject to a sub-limit of$250,000.  The Company is permitted todraw funds against the working capital facility throughout the fiscal year andmay repay amounts that it borrows under the working capital facility at anytime. Therefore, the Company may be able to re-borrow such funds on a revolvingbasis (subject to restrictions).  Theworking capital facility matures on April 15, 2004 and the letter of creditfacility matures on October 15, 2004. Any payments made by BOW with regard to any letter of credit issuedunder the letter of credit facility must be repaid by the Company immediatelyupon the date of such payment by BOW. As of December 17, 2003, BOW had issued one letter of credit for$179,000.

 

In October 2003, BOW provided the Company with an additional facilityfor issuance of up to $250,000 of letters of credit.  The new facility provides that issued letters of credit are to besecured by restricted cash balances of an equal amount maintained on depositwith BOW.  As of December 17, 2003, BOWhad issued one letter of credit for $83,000 under this facility.

 

6

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The Company is subject to a number of restrictions under the CreditAgreement, as amended.  These includelimitations on the Company’s ability to sell assets, make capital expenditures,incur additional indebtedness, permit new liens upon the Company’s assets, andpay dividends on or repurchase its common stock. The Company must also maintaincompliance with agreed-upon financial covenants that require the Company tomaintain a specified minimum dollar value level of tangible net worth, maintaina specified minimum dollar value level of EBITDA for the trailing four fiscalquarters and certain minimum ratios of cash flow to debt service obligations,maintain a specified minimum level of profitability, limit the amount ofindebtedness it may have outstanding in relation to its tangible net worth, andrequire the Company to maintain restricted cash balances on deposit with BOWequal to the lesser of $800,000 or the outstanding principal balance of itsequipment term loan.  As of December 17,2003 the Company was in compliance with these covenants.

 

Maturities oflong-term debt for years subsequent to December 17, 2003 are as follows:

 
| **Fiscal Year**      |   |    |      |
|----------------------|--------|---------|-----------|
| 2004                 |   | $       | 1,517,000 |   |
| 2005                 |   | 617,000 |      |
| 2006                 |   | 237,000 |      |
| Total long-term debt |   | $       | 2,371,000 |   |

 

4.                                       ACCRUEDPROVISION FOR STORE CLOSURE

 

Prior to December 31, 2002, the estimated cost associated with closingunder-performing stores was accrued in the period in which the store wasidentified for closure by management under a plan of termination. EffectiveDecember 31, 2002, the Company adopted SFAS No. 146, “Accounting for CostsAssociated with Exit or Disposal Activities,” and now records these estimatedcosts when they are incurred rather than at the date of a commitment to an exitor disposal plan. Such costs primarily consist of the estimated cost toterminate real estate leases.

 
|                                      |   | **Beg Balance** |    | **Amounts  Charged  to Expense** |   | **Adjustments** |   | **Cash  Payments** |     | **End  Balance** |   |
|-------------------------------------------|--------|-----------------|---------|----------------------------------|--------|-----------------|--------|--------------------|----------|------------------|--------|
| Year ended July 2, 2003                   |   | $               | 581,000 |                             | $      | 193,000         |   | $                  | (116,000 | )                | $      | (233,000 | ) | $ | 425,000 |   |
|                                      |   |            |    |                             |   |            |   |               |     |             |   |
| Twenty-four weeks ended December 17, 2003 |   | $               | 425,000 |                             | $      | 36,000          |   | $                  | (106,000 | )                | $      | (172,000 | ) | $ | 183,000 |   |

 

For the twenty-four weeks ended December 17, 2003, the $36,000 chargedto expense was comprised of a $31,000 charge to cost of sales and relatedoccupancy costs, a $4,000 charge to the provision for asset impairment, and a$1,000 charge to general and administrative expense. These charges primarilyrelated to negotiated lease settlements finalized during the first quarter offiscal 2004.  Also included in theprovision for store closure was a benefit of $106,000, which reduced cost ofsales and related occupancy costs due to a favorable lease settlement of aclosed location.

 

7

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5.                                       EARNINGSPER SHARE

 

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

 
|                                      |   | **Twelve  Weeks  Ended  December 17, 2003** |    | **Twelve  Weeks Ended  December 18,  2002** |   | **Twenty-Four  Weeks Ended  December 17,  2003** |   | **Twenty-Four  Weeks Ended  December 18,  2002** |    |
|-------------------------------------------|--------|---------------------------------------------|---------|---------------------------------------------|--------|--------------------------------------------------|--------|--------------------------------------------------|---------|
| **Numerator**:                            |   |                                        |    |                                        |   |                                             |   |                                             |    |
| Net income                                |   | $                                           | 543,000 |                                        | $      | 712,000                                          |   | $                                                | 242,000 |   | $ | 702,000 |   |
| **Denominator:**                          |   |                                        |    |                                        |   |                                             |   |                                             |    |
| Basic weighted average shares outstanding |   | 5,161,000                                   |    | 5,161,000                                   |   | 5,161,000                                        |   | 5,161,000                                        |    |
|                                      |   |                                        |    |                                        |   |                                             |   |                                             |    |
| Effect of dilutive securities             |   | 50,000                                      |    | 94,000                                      |   | 25,000                                           |   | 38,000                                           |    |
|                                      |   |                                        |    |                                        |   |                                             |   |                                             |    |
| Diluted adjusted weighted average shares  |   | 5,211,000                                   |    | 5,255,000                                   |   | 5,186,000                                        |   | 5,199,000                                        |    |
|                                      |   |                                        |    |                                        |   |                                             |   |                                             |    |
| Basic net income per share                |   | $                                           | 0.11    |                                        | $      | 0.14                                             |   | $                                                | 0.05    |   | $ | 0.14 |   |
|                                      |   |                                        |    |                                        |   |                                             |   |                                             |    |
| Diluted net income per share              |   | $                                           | 0.10    |                                        | $      | 0.14                                             |   | $                                                | 0.05    |   | $ | 0.14 |   |

 

Of the 973,000options outstanding as of December 17, 2003, 445,000 and 548,000 were excludedfrom the calculation of diluted net loss per share for the twelve weeks andtwenty-four weeks, respectively, as their inclusion would have beenanti-dilutive.  Further, all of the518,000 warrants to purchase shares of common stock outstanding during thetwelve weeks and twenty-four weeks ended December 17, 2003 were excluded fromthe calculation of diluted net loss per share as their inclusion would havebeen anti-dilutive.  Of the 658,000options outstanding as of December 18, 2002, 177,000 and 478,000 were excludedfrom the calculation of diluted net loss per share for the twelve weeks andtwenty-four weeks, respectively, as their inclusion would have beenanti-dilutive.  Further, all of the730,000 warrants to purchase shares of common stock outstanding during thetwelve weeks and twenty-four weeks ended December 18, 2002 were excluded fromthe calculation of diluted net loss per share as their inclusion would havebeen anti-dilutive.

 

6.                                       SEGMENTAND RELATED INFORMATION

 

The Company has three reportablesegments:  retail operations, wholesaleoperations and franchise operations. The Company evaluates performance of its operating segments based onincome before income taxes.

 

8

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Summarized financial information concerningthe Company’s reportable segments is shown in the following table.  Other identifiable assets consist ofcorporate cash, corporate notes receivable, corporate prepaid expenses, andcorporate property and equipment.  Theother component of segment profit before tax includes corporate general andadministrative expenses, depreciation and amortization expense and interestexpense.

 
|                                              |   | **TWELVE WEEKS ENDED** |       | **TWENTY-FOUR WEEKS ENDED** |       |
|---------------------------------------------------|--------|------------------------|------------|-----------------------------|------------|
|                                              |   | **December 17,  2003** |       | **December 18,  2002**      |       | **December 17,  2003** |   | **December 18,  2002** | ** ** |
| Revenue:                                          |   |                   | ** ** |                        | ** ** |   | ** ** |   | ** ** |
| Retail                                            |   | $                      | 7,571,000  |                        | $          | 8,329,000 |   | $ | 14,444,000 |   | $ | 16,186,000 |   |
| Wholesale                                         |   | 4,833,000              |       | 5,163,000                   |       | 7,707,000 |   | 8,198,000 |   |
| Franchise                                         |   | 1,848,000              |       | 1,476,000                   |       | 3,411,000 |   | 2,930,000 |   |
|                                              |   |                   |       |                        |       |   |   |   |   |
| Total revenue                                     |   | $                      | 14,252,000 |                        | $          | 14,968,000 |   | $ | 25,562,000 |   | $ | 27,314,000 |   |
|                                              |   |                   |       |                        |       |   |   |   |   |
| Interest expense:                                 |   |                   |       |                        |       |   |   |   |   |
| Retail                                            |   | $                      | 9,000      |                        | $          | 11,000 |   | $ | 14,000 |   | $ | 19,000 |   |
| Wholesale                                         |   | —                 |       | —                      |       | — |   | — |   |
| Franchise                                         |   | 10,000                 |       | 14,000                      |       | 21,000 |   | 28,000 |   |
| Other                                             |   | 54,000                 |       | 45,000                      |       | 101,000 |   | 116,000 |   |
|                                              |   |                   |       |                        |       |   |   |   |   |
| Total interest expense                            |   | $                      | 73,000     |                        | $          | 70,000 |   | $ | 136,000 |   | $ | 163,000 |   |
|                                              |   |                   |       |                        |       |   |   |   |   |
| Depreciation and amortization:                    |   |                   |       |                        |       |   |   |   |   |
| Retail                                            |   | $                      | 259,000    |                        | $          | 322,000 |   | $ | 531,000 |   | $ | 628,000 |   |
| Wholesale                                         |   | 127,000                |       | 71,000                      |       | 265,000 |   | 146,000 |   |
| Franchise                                         |   | 1,000                  |       | 5,000                       |       | 3,000 |   | 10,000 |   |
| Other                                             |   | 53,000                 |       | 63,000                      |       | 229,000 |   | 122,000 |   |
|                                              |   |                   |       |                        |       |   |   |   |   |
| Total depreciation and amortization               |   | $                      | 440,000    |                        | $          | 461,000 |   | $ | 1,028,000 |   | $ | 906,000 |   |
|                                              |   |                   |       |                        |       |   |   |   |   |
| Segment profit before income tax provision:       |   |                   |       |                        |       |   |   |   |   |
| Retail                                            |   | $                      | 455,000    |                        | $          | 457,000 |   | $ | 616,000 |   | $ | 797,000 |   |
| Wholesale                                         |   | 877,000                |       | 804,000                     |       | 1,306,000 |   | 1,291,000 |   |
| Franchise                                         |   | 1,660,000              |       | 1,733,000                   |       | 3,110,000 |   | 3,102,000 |   |
| Other                                             |   | (2,448,000             | )          | (2,256,000                  | )          | (4,780,000 | ) | (4,449,000 | ) |
|                                              |   |                   |       |                        |       |   |   |   |   |
| Total segment profit before income tax  provision |   | $                      | 544,000    |                        | $          | 738,000 |   | $ | 252,000 |   | $ | 741,000 |   |

 
|                 |   | **December 17,  2003** |       | **July 2,  2003** |   |
|----------------------|--------|------------------------|------------|-------------------|--------|
| Identifiable assets: |   |                   |       |              |   |
| Retail               |   | $                      | 5,643,000  |              | $      | 5,567,000 |   |
| Wholesale            |   | 6,334,000              |       | 5,584,000         |   |
| Franchise            |   | 1,592,000              |       | 1,373,000         |   |
| Other                |   | 3,583,000              |       | 3,828,000         |   |
|                 |   |                   |       |              |   |
| Tangible assets      |   | 17,152,000             |       | 16,352,000        |   |
|                 |   |                   |       |              |   |
| Goodwill - Retail    |   | 1,267,000              |       | 1,267,000         |   |
| Goodwill - Wholesale |   | 6,311,000              |       | 6,311,000         |   |
| Goodwill - Franchise |   | 2,612,000              |       | 2,612,000         |   |
|                 |   |                   |       |              |   |
| Total assets         |   | $                      | 27,342,000 |              | $      | 26,542,000 |   |

 

7.                                       LEASECONTINGENCIES

 

We are liable on the master leases for 118 franchise locations. Underthe Company’s historical franchising business model, the Company executed themaster leases for these locations and entered into subleases on the same termswith its franchisees, which typically pay their rent directly to the landlords.If any of these franchisees default on their subleases, the Company would berequired to make all payments under the master leases. The Company’s maximumtheoretical future exposure at December 17, 2003, computed as the sum of allremaining lease payments through the expiration dates of the respective leases,was $18,186,000. This amount does not take into consideration any mitigatingmeasures that the Company could take to reduce this exposure in the event ofdefault, including re-leasing the locations or terminating the master lease bynegotiating a lump sum payment to the landlord in an amount that is less thanthe sum of all remaining future rents.

 

9

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**Item 2.****           Management’sDiscussion 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 aresubject to risks and uncertainties. These forward-looking statements include information about possible orassumed 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 makingforward-looking statements.  Manypossible events or factors could affect our future financial results andperformance.  This could cause ourresults or performance to differ materially from those expressed in ourforward-looking statements. You should consider these risks when you reviewthis document, along with the following possible events or factors:

 

•            the financial andoperating performance of our retail operations;

 

•            our ability tomaintain profitability over time;

 

•            our ability to performwithin the terms of our credit agreement;

 

•            the successfulexecution of our growth strategies;

 

•            our franchisees’adherence to our practices, policies and procedures;

 

•            the impact ofcompetition; and

 

•            the availability ofworking capital.

 

Foreseeable risks and uncertainties are described elsewhere in thisreport and in detail under the caption “Risk Factors and Trends AffectingDiedrich Coffee and Its Business” in our Annual Report on Form 10-K for thefiscal year ended July 2, 2003 and in other reports that we file with theSecurities and Exchange Commission. We undertake no obligation to publiclyrelease the results of any revision of the forward-looking statements. Unlessotherwise indicated, “we,” “us,” “our,” and similar terms refer to DiedrichCoffee, Inc.

 

**General.**

Diedrich Coffee, Inc. is a specialty coffee roaster, wholesaler andretailer.  We sell brewed,espresso-based and various blended beverages primarily made from our own freshroasted premium coffee beans, as well as light food items, whole bean coffee,and accessories through our Company operated and franchised retaillocations.  We also sell whole bean andground coffees on a wholesale basis through a network of distributors in theoffice coffee service (“OCS”) market, and to other wholesale customers,including restaurant chains and other retailers.  Our brands include Diedrich Coffee, Gloria Jean’s Coffees andCoffee People.  As of December 17, 2003,Diedrich Coffee owned and operated 59 retail locations and franchised 397 otherretail locations under these brands, for a total of 456 retail coffee outlets.Our retail units are located in 35 states and 13 foreign countries.  As of December 17, 2003, we also have over460 wholesale accounts with OCS distributors, chain and independent restaurantsand others.  In addition, we operate alarge coffee roasting facility in central California that supplies freshlyroasted coffee to our retail locations and wholesale accounts.

 

*Retail Outlets*

 

Our retail outlet distribution channel can bedivided into two sub-channels, each with its own distinct business model,including differences in revenue and cost structure, overhead, and capitalrequirements.  These two retailsub-channels are Company operated retail outlets and franchised retailoutlets.  We view retail outlets as asingle distribution channel, despite the differences noted above, primarilybecause our retail customers do not make any distinction between Company andfranchise

 

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operatedlocations.  The critical success factorsare, therefore, the same for each type of retail location, whether Companyoperated or franchised: quality of product, service, and atmosphere.  The economic model and cost structures arealso the same for each type of location at the retail unit level,notwithstanding their different direct financial impacts on us in our roles asboth an operator and franchiser of retail outlets.  Furthermore, the potential contribution of any given outlet towhich we provide coffee, as measured by the amount of roasted coffee producedthrough our roasting plant, is the same.

 

Presently, our largest brand is Gloria Jean’s and approximately 97% ofGloria Jean’s retail units are franchised. Gloria Jean’s retail units arelocated throughout the United States and in 13 foreign countries. Our DiedrichCoffee brand has a higher concentration of Company operated units, with 78% ofretail locations operated by us. Diedrich Coffee units are located primarily inOrange County, California, although there are a number of Diedrich locations inDenver, Houston, and elsewhere in the United States. We also operate retailcoffee outlets under a third brand, Coffee People, which are 100% Companyoperated at this time. Our Coffee People outlets are all located in Portland,Oregon.

 

A table summarizing the relative sizes ofeach of our brands, on a unit count basis, and changes in unit count for eachover the twenty-four weeks ended December 17, 2003, is set forth below:

 
|                            |   | **Units at  July 2,  2003** |   | **Opened** |   | **Closed** |   | **Net transfers  between the  Company and  Franchise** |   | **Units at  December 17,  2003** |   |
|---------------------------------|--------|-----------------------------|--------|------------|--------|------------|--------|--------------------------------------------------------|--------|----------------------------------|--------|
| **Gloria Jean’s Brand**    |   |                        |   |       |   |       |   |                                                   |   |                             |   |
| Company Operated                |   | 11                          |   | —     |   | (1         | )      | 2                                                      |   | 12                               |   |
| Franchise – Domestic       |   | 143                         |   | 4          |   | (4         | )      | (2                                                     | )      | 141                              |   |
| Franchise – International  |   |                        |   |       |   |       |   |                                                   |   |                             |   |
| Australia                       |   | 142                         |   | 31         |   | —     |   | —                                                 |   | 173                              |   |
| Far East/Asia (1)               |   | 18                          |   | 1          |   | —     |   | —                                                 |   | 19                               |   |
| Mexico                          |   | 15                          |   | 3          |   | —     |   | —                                                 |   | 18                               |   |
| Other (2)                       |   | 31                          |   | 10         |   | (2         | )      | —                                                 |   | 39                               |   |
| Total Franchise - International |   | 206                         |   | 45         |   | (2         | )      | —                                                 |   | 249                              |   |
| Subtotal Gloria Jean’s     |   | 360                         |   | 49         |   | (7         | )      | —                                                 |   | 402                              |   |
|                            |   |                        |   |       |   |       |   |                                                   |   |                             |   |
| **Diedrich Coffee  Brand**      |   |                        |   |       |   |       |   |                                                   |   |                             |   |
| Company Operated                |   | 25                          |   | —     |   | —     |   | —                                                 |   | 25                               |   |
| Franchise – Domestic       |   | 10                          |   | —     |   | (3         | )      | —                                                 |   | 7                                |   |
| Subtotal Diedrich               |   | 35                          |   | —     |   | (3         | )      | —                                                 |   | 32                               |   |
|                            |   |                        |   |       |   |       |   |                                                   |   |                             |   |
| **Coffee People Brand**         |   |                        |   |       |   |       |   |                                                   |   |                             |   |
| Company Operated                |   | 22                          |   | —     |   | —     |   | —                                                 |   | 22                               |   |
| **Total**                       |   | 417                         |   | 49         |   | (10        | )      | —                                                 |   | 456                              |   |

 

----

(1)                                  IncludesJapan and Korea.

 

(2)                                  IncludesGuam, Indonesia, Ireland, Turkey, Malaysia, New Zealand, Philippines,  United Arab Emirates and Thailand.

 

11

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*Wholesale Distribution*

* *

We currently have over 460 wholesale accountsnot affiliated with our retail locations that purchase coffee from us underboth the Diedrich Coffee and Gloria Jean’s brands. Our current wholesaleaccounts are in the Office Coffee Supply market, chain restaurants, independentrestaurants, other hospitality industry enterprises and specialtyretailers.  Additionally, except for ourfranchisees in Australia and Mexico, our franchise agreements require bothDiedrich Coffee and Gloria Jean’s franchisees to purchase substantially all oftheir coffee from us.

 

*Seasonality and Quarterly Results*

 

Our business is subject to seasonalfluctuations as well as economic trends that affect retailers in general.Historically, our net sales have not been realized proportionately in eachquarter, with net sales being the highest during the second fiscal quarter,which includes the November – December holiday season. Hot weather tends toreduce sales. Quarterly results are affected by the timing of the opening ofnew stores, which may not occur as anticipated due to events outside ourcontrol. As a result of these factors, the financial results for any individualquarter may not be indicative of the results that may be achieved in a fullfiscal year.

 

**Results of Operations.**

 

*Twelve Weeks Ended December 17, 2003, Compared with the Twelve WeeksEnded December 18, 2002*

 

***Total Revenue.***  Total revenue for the twelve weeks endedDecember 17, 2003 decreased by $716,000, or 4.8%, to $14,252,000 from$14,968,000 for the twelve weeks ended December 18, 2002. This decrease wasattributable to decreases in retail, wholesale and other sales, slightly offsetby an increase in franchise revenue. Each component is discussed below.

 

The mix ofCompany owned and franchised stores and the mix of domestic and internationalstores continues to change.  Since thebeginning of the second fiscal quarter of 2003, Company owned stores havedeclined by eight units and franchised stores have increased by 78 units.  Domestic stores have declined by 24 unitsand international stores have grown by 94 units.  These changes impact our retail sales and franchise revenueresults because, among other matters, sales and operating expenses are reportedfor Company stores, but only fees from franchisees are reported for franchiseunits.  In addition, domestic franchisefees are at higher rates than international franchise fees, and coffee is soldto domestic franchise stores, but not to the majority of our internationalfranchise stores.  Therefore, althoughthe new store growth is much stronger in international franchises, per storefranchise fees increase more slowly than domestic per store franchise fees andmanufacturing sales and profitability is generally not affected by the newinternational store growth.

 

Retail salesfor the twelve weeks ended December 17, 2003 decreased by $758,000, or 9.1%, to$7,571,000 from $8,329,000 in the prior year period.  This decrease primarily represented the net impact of severalfactors. First, the number of Company stores decreased in the current yearversus the earlier period because of the closure or sale of 10 Company operatedlocations since the beginning of the prior year period. The reduction in retailsales from the sale or closure of these coffeehouses was approximately$1,017,000. This decrease was partially offset by an increase in retail salesof approximately $180,000, a 2.5% increase in comparable store sales forCompany operated units during the quarter, as well as a $79,000 increase inretail sales from our internet website.

 

Wholesale revenue decreased $330,000, or 6.4%, for the twelve weeksended December 17, 2003, to $4,833,000 from $5,163,000 in the prior yearperiod.  This decrease was primarily thecombined result of the following factors:

 

12

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*Wholesale revenue from franchisees*.  Sales of roasted coffee to our franchiseesdecreased $580,000, or 17.8%, for the twelve weeks ended December 17, 2003,which was primarily the result of disappointing sales of the holiday gift packinventories and to an extent, the net impact of a 12 unit decrease in thenumber of domestic franchises compared to the beginning of the prior yearquarter, and a 2.6% decrease in Gloria Jean’s domestic franchise comparablestore sales for the quarter. The unfavorable same store sales for the quarteris another indication of the disappointing sales results with respect toholiday gift packs.

 

*Keurig “K-cup” and other OCS sales*.  Keurig and other Office Coffee Service salesincreased by $265,000 to $1,752,000 for the twelve weeks ended December 17,2003, a 17.8% increase over the prior year quarter.

 

*Coffee sales to independent and chainrestaurants and specialty retailers*.  Wholesale coffee sales to independent andchain restaurants and other specialty retailers decreased by $29,000, or 6.8%,versus the prior year quarter because we decreased focus on this lessprofitable wholesale segment.

 

Franchise revenue increased by $372,000, or 25.2%, for the twelve weeks ended December 17, 2003 to$1,848,000 from $1,476,000 in the prior year period.  Franchise revenue consists of initial franchise fees, franchiserenewal fees, area development fees, royalties received on sales at franchisedlocations, and miscellaneous other franchise revenue, including coordinationfees received from product suppliers. The increase in franchise revenue was theresult of very strong growth in our international franchise operations and anincrease in domestic revenue, which is attributable to unusually low revenue inthe prior year quarter.  Revenues fromour Australia franchisee accounted for $422,000, or 22.8%, of total franchiserevenue for the second quarter of the current fiscal year.

 

***Cost of Sales andRelated Occupancy Costs.***  Cost of sales and related occupancy costs for the twelve weeksended December 17, 2003 decreased 7.5% to $6,745,000 from $7,288,000 in theprior year period.  On a margin basis,cost of sales and related occupancy costs improved from 48.7% of total sales inthe prior year period to 47.3% in the current year period.  As a percent of total retail and wholesalesales, cost of sales and related occupancy costs increased to 54.4% for the twelveweeks ended December 17, 2003 from 54.0% for the twelve weeks ended December18, 2002.  This unfavorable 0.4 marginbasis point change was the net impact of an unfavorable 0.8 percentage pointchange in cost of sales, partially offset by a favorable 0.4 margin basis pointchange in occupancy costs.  Occupancycosts experienced a margin basis point improvement primarily due to a $106,000favorable lease settlement involving one of our closed company coffeehouse locations.  Cost of sales as a percentage of totalretail and wholesale sales increased slightly during the current quarterprimarily due to excess capacity costs of the roasting plant and a $141,000write-down of holiday gift pack inventories.

 

***Operating Expenses.**** *Operating expenses for the twelveweeks ended December 17, 2003 declined by $175,000, or 4.2%, to $3,991,000from  $4,166,000 in the prior yearperiod.  Retail operating expenses as apercentage of retail sales increased from 44.0% in the prior year quarter to46.1% in the current year quarter.  Thepercentage increase was due to an increase in marketing for our e-commerceprogram and planned additional in-store and supervisory labor.  Effective October 1, 2003, we becameself-insured for workers compensation with a $250,000 deductible per occurrenceand a program maximum for all claims of $750,000.  This change had no material impact in the current yearquarter.  Wholesale operating expenses,as a percentage of wholesale sales, declined from 12.1% in the prior yearsecond quarter to 7.2% in the current year quarter.  This decrease was due to the $157,000 decline in wholesale baddebt expense.  The prior year bad debtcharge was substantial due to the bankruptcy of a major wholesaledistributor.  Wholesale operatingexpenses also decreased in the current quarter by $54,000 due to the withdrawalfrom the grocery store distribution channel. Growth of coffee sales through grocery markets never achievedanticipated levels and the long-running Southern California supermarket strikecontributed to this segment of our wholesale business being unprofitable.  During the second quarter of the currentfiscal year, the Company elected to exit this channel to focus on moreprofitable alternatives.  Franchiseoperating expense increased $286,000 in the current quarter, $285,000 of whichwas due to an increase in franchise bad debt expense.  This bad debt increase is primarily related to a $181,000reduction of bad debt reserves in the prior year quarter due to favorablecollections.

 

13

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***Depreciation andAmortization*.** Depreciation and amortization decreased by $21,000 to $440,000 for thetwelve weeks ended December 17, 2003 from $461,000 for the twelve weeks endedDecember 18, 2002.  This decrease wasprimarily due to reductions in depreciation related to the impairment of assetsat one of our coffeehouse locations.

 

***General andAdministrative Expenses*.**  General and administrative expenses increased by $240,000, or11.2%, to $2,374,000 for the twelve weeks ended December 17, 2003 from  $2,134,000 for the prior year quarter. On amargin basis, general and administrative expenses increased to 16.7% of totalrevenue in the second quarter of fiscal 2004 from 14.3% in the year agoquarter.  This 2.4 unfavorable marginbasis point change was primarily related to salary and bonus increases due tothe addition of an Executive Vice President of Development, a Director ofOperations, and the fact that the Chief Executive Officer position was notfilled for part of the prior year period. Rent also increased by $57,000, primarily as a result of a subleaserental credit recorded in the prior year quarter.

 

***Provision for AssetImpairment*.** The second quarter of fiscal 2004 included a provision for assetimpairment costs of  $90,000 as a resultof the early termination of a Diedrich coffeehouse lease.  The second quarter of fiscal 2003 included aprovision for asset impairment costs of $106,000 to reduce the carrying valueof one coffeehouse.

 

***Interest Expense andOther, Net.**** *Interestexpense and other, net increased by $11,000 to $68,000 for the twelve weeksended December 17, 2003. This increase is primarily due to an increase in loanfees recognized during the second quarter.

 

***Income Tax Expense.***  Net operating losses generated in previousyears resulted in no federal income tax liability and only a nominal amount ofstate income tax expense for the twelve weeks ended December 17, 2003 and theprior year period. Due to the uncertainty of future taxable income, deferred taxassets resulting from these net operating losses have been fully reserved. Theslight fluctuation in expense between the twelve weeks ended December 17, 2003versus the prior year period is due to changes in state income taxes owed inconjunction with the portfolio of company operated Gloria Jean's units, whichare located in a variety of states. As of December 17, 2003 net operating losscarryforwards for federal and state income tax purposes of $33,422,000 and$18,471,000, respectively, are available to be utilized against future taxableincome for years through fiscal 2024 for federal and fiscal 2014 for state,subject to possible annual limitations pertaining to change in ownership rulesunder the Internal Revenue Code.  Forthe twelve weeks ended December 17, 2003, our valuation allowance decreased$101,000.

 

*Twenty-Four Weeks Ended December 17, 2003,Compared with the Twenty-Four Weeks Ended December 18, 2002*

 

***Total Revenue.***  Total revenue for the twenty-four weeksended December 17, 2003 decreased by $1,752,000, or 6.4%, to  $25,562,000 from $27,314,000 for thetwenty-four weeks ended December 18, 2002. This decrease was attributable to decreases in retail and wholesale sales,partially offset by an increase in franchise revenue.  Each component is discussed below.

 

The mix ofCompany owned and franchised stores and the mix of domestic and internationalstores continues to change.  Since thebeginning of the prior fiscal year, company stores have declined by 11 unitsand franchised stores have increased by 90 units.  Domestic stores have declined by 30 units and internationalstores have grown by 109 units.  Thesechanges impact our retail sales and franchise revenue results because, amongother matters, sales and operating expenses are reported for Company stores,but only fees from franchisees are reported for franchise units.  In addition, domestic franchise fees are athigher rates than international franchise fees, and coffee is sold to domesticfranchise stores, but not to the majority of our international franchisestores.  Therefore, although the newstore growth is much stronger in international franchises, per store franchisefees increase more slowly than domestic per store franchise fees andmanufacturing sales and profitability is generally not affected by the newinternational store growth.

 

Retail sales for the twenty-four weeks ended December 17, 2003decreased by $1,742,000, or 10.8%, to $14,444,000 from $16,186,000 for theprior year period.  This decreaseprimarily represented the combined impact of two factors.  First, the number of Company storesdecreased in the current year because of the sale or closure of 13Company-operated locations since the beginning of the prior year period. Thereduction in retail sales from the sale or closure of these coffeehouses wasapproximately $1,761,000. Retail sales also declined by $82,000 due to a 1.0%decrease in comparable store sales for Company operated units.  A $101,000 increase in retail sales from ourInternet website partially offset the overall decline.

 

Wholesale revenue decreased $491,000, or 6.0%, to $7,707,000 for thetwenty-four weeks ended December 17, 2003 from $8,198,000 for the prior yearperiod.  This decrease was primarily thecombined result of the following factors:

 

14

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*Wholesale revenue from franchisees*.  Sales of roasted coffee to our franchiseesdecreased $780,000, or 6.0%, for the twenty-four weeks ended December 17, 2003primarily because of a 14 unit decrease in the number of domestic franchisescompared to the prior year, along with negative year-to-year same store salesfor Gloria Jean’s domestic franchise units of 1.2%. The negative same storesales for the quarter were primarily due to the weak sales of the holiday gift packinventories.

 

*Keurig “K-cup” and other OCS sales*.  Keurig and other Office Coffee Service salesincreased by $327,000 to $3,163,000 for the twelve weeks ended December 17,2003, from $2,836,000 in the prior year period an 11.5% increase.

 

*Coffee sales to independent and chainrestaurants and specialty retailers*.  Wholesale coffee sales to independent andchain restaurants and other specialty retailers decreased by $45,000, or 5.7%,versus the prior year period because of our decreased focus on this less profitablesegment.

 

Franchise revenue increased by $481,000, or16.4%, to $3,411,000 for the twenty-four weeks ended December 17, 2003 from$2,930,000 for the prior year period. The increase in franchise revenue is due to several factors. Initialfranchise fees and franchise renewal fees increased approximately $159,000 forthe twenty-four weeks ended December 17, 2003 versus the prior year, primarilyas a result of a dissolution settlement of $150,000 for the Malaysia franchiseagreement. International franchise royalties increased  $364,000 over the prior year period.  Revenues from our Australia franchiseeaccounted for $908,000, or 26.6%, of total franchise revenue in the currentyear period.  Domestic royaltiesdecreased $60,000 primarily because of the 14 unit reduction in domesticfranchise stores and 1.2% franchisee negative same store sales due primarily toweakness in the current year holiday gift pack program.

 

***Cost of Sales andRelated Occupancy Costs*.**  Cost of sales and related occupancy costs for the twenty-fourweeks ended December 17, 2003 were $11,855,000, a decrease of 8.8% on a 9.2%decline in retail and wholesale sales.  On a margin basis, cost of sales and related occupancy costs improvedfrom 47.6% of total sales in the prior year period to 46.4% in the current yearperiod.  As a percent of total retailand wholesale sales, cost of sales and related occupancy costs increased from53.3% in the prior year period to 53.5% in the current year.  This 0.2 unfavorable margin basis pointchange was due to an unfavorable 0.2 cost of sales margin basis pointchange.  Occupancy costs as a percentageof total retail and wholesale sales remained constant at 7.3% for the currentand prior year periods because a $106,000 favorable lease settlement involvingone of our closed company coffeehouse locations recorded in the current yearwas offset by a favorable lease settlement of $149,000 recorded in the prioryear period.  Cost of sales decreasedslightly during the current year primarily due to excess capacity costs of theroasting plant and a $141,000 write-down of holiday gift pack inventories.

 

***Operating Expenses.**** *Operating expenses for the twentyfour weeks ended December 17, 2003 declined by $511,000, or 6.2%, to $7,683,000from $8,194,000 in the prior year period. Retail operating expenses as a percentage of retail sales increased from44.6% in the prior year period to 46.8% in this year’s period.  This was largely due to planned additionalin-store and supervisory labor. Effective October 1, 2003, the Company became self-insured for workerscompensation with a $250,000 deductible per occurrence and a program maximumfor all claims of $750,000.  This changehad no material impact in the current year period.  Wholesale operating expenses, as a percentage of wholesale sales,declined from 12.5% in the prior year period to 9.2% in this year’s firsthalf.  This was due to a $157,000decline in wholesale bad debt expense. The prior year bad debt charge was substantial due to the bankruptcy ofa major wholesale distributor. Wholesale operating expenses in the current year also decreased by$59,000 as a result of our withdrawal from the grocery store distributionchannel.  Growth of coffee sales throughgrocery markets never achieved anticipated levels and the long-running SouthernCalifornia supermarket strike contributed to this segment of our wholesalebusiness being unprofitable.  During thesecond quarter of the current fiscal quarter, the Company elected to exit thischannel to focus on more profitable alternatives.  Franchise operating expense increased $286,000 in the currentperiod, $285,000 of which was due to an increase in franchise bad debtexpense.  This bad debt increase isprimarily related to a $181,000 reduction of bad debt reserves in the prioryear period due to favorable collections.

 

15

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***Depreciation andAmortization*.** Depreciation and amortization increased by $122,000 to $1,028,000 forthe twenty-four weeks ended December 17, 2003. This increase was primarily due to the depreciation of the Keurigpackaging equipment purchased during fiscal 2003 and the incremental capitalexpenditures related to the facility improvement program underway in thecurrent year.

 

***General andAdministrative Expenses*.**  General and administrative expenses increased by $295,000, or7.0%, to $4,525,000 for the twenty-four weeks ended December 17, 2003.  On a margin basis, general and administrativeexpenses increased to 17.7% of total revenue in the first half of fiscal 2004from 15.5% in the prior year period. This 2.2 unfavorable margin basis point change was primarily due todecreased total revenue and $177,000 of increased payroll costs.  The payroll increases included the additionof an Executive Vice President of Development, a Director of Operations and thefact that the Chief Executive Officer position was not filled for part of theprior year period.  Rents also increased$51,000 from the prior year due to a $50,000 sublease rental credit received inthe first half of the prior year.

 

***Provision for AssetImpairment*.** The twenty-four weeks ended December 17, 2003 included a $90,000impairment charge as a result of the early termination of a Diedrichcoffeehouse lease and a $4,000 provision related to the closure of onecoffeehouse.  Prior year resultsincluded a $106,000 provision to reduce the carrying value of one coffeehouse.

 

***Interest Expense andOther, Net.**** *Interestexpense and other, net decreased from $139,000 in the prior year to $125,000for the twenty-four weeks ended December 17, 2003.  This decrease is due to a reduction in debt, and to a lesserextent, a reduction on our interest rate.

 

***Income Tax Expense.***  Net operating losses generated in previousyears resulted in no federal income tax liability and only a nominal amount ofstate income tax expense for the twenty-four weeks ended December 17, 2003 andthe prior year period. Due to the uncertainty of future taxable income,deferred tax assets resulting from these net operating losses have been fullyreserved. The slight fluctuation in expense between the twenty-four weeks endedDecember 17, 2003 versus the prior year period is due to changes in stateincome taxes owed in conjunction with the portfolio of company operated GloriaJean's units, which are located in a variety of states. As of December 17, 2003net operating loss carryforwards for federal and state income tax purposes of$33,422,000 and $18,471,000, respectively, are available to be utilized againstfuture taxable income for years through fiscal 2024 for federal and fiscal 2014for state, subject to possible annual limitations pertaining to change inownership rules under the Internal Revenue Code.  For the twenty-four weeks ended December 17, 2003, our valuationallowance decreased $101,000.

 

**Financial Condition, Liquidity and CapitalResources.**

 

***Current FinancialCondition. ***AtDecember 17, 2003, we had negative working capital of $196,000, compared toworking capital of $1,207,000 at July 2, 2003. This decrease was primarily due to an $800,000 restricted cashrequirement imposed by the third BOW amendment, in addition to the $83,000restricted cash requirement related to our outstanding letter of creditfacility, as discussed in more detail in Note 3 to the Condensed Consolidated FinancialStatements.

 

On December 2,2003, at the annual meeting of stockholders, the stockholders approved aproposal to enter into a transaction pursuant to which we may borrow up to $5million from Sequoia Enterprises, LP (the “Lender”).  Our Chairman, Paul Heeschen, is the sole general partner of theLender.  The Company is currentlydocumenting the terms of a Contingent Convertible Note Purchase Agreement (the“Agreement”) which will provide for the issuance of one or more unsecuredcontingent convertible promissory notes (the “Notes”) with an aggregateprincipal amount not to exceed $5 million. At our election, for a period of three years, we may issue to the Lenderon the effective date of the Agreement, or on the first day of any fiscalquarter, one or more Notes having a minimum principal amount of $300,000 up toan aggregate principal amount of $5 million. Interest on the Notes will accrue at a rate equal to LIBOR plus 3.30%per annum calculated on the basis of a 360 day year and actual days elapsed.  We will be required to make payments to theLender monthly on the first day of each month. Each monthly payment will be equal to the sum of (a) all accruedinterest on each of the outstanding Notes for the prior month, plus (b) 1.67%of the outstanding aggregate principal amount of the Notes, plus (c) acommitment fee equal to 0.0833% of the difference between $5 million and theprincipal amount of all issued Notes. The principal amount of the Notes plus any accrued and unpaid interestwill be due on the earlier of a change in control or the third anniversary ofthe effective date of the Agreement. The Agreement will contain customary financial covenants, including arestriction regarding the amount of additional debt we may incur, and customaryevents of default.

 

The Notes will be convertible into our common stock upon the occurrenceof a change in control.  In addition,upon repayment of the amount of indebtedness evidenced by the Notes, we will beobligated to issue the Lender warrants to purchase shares of our common stock,which warrants will be exercisable upon the occurrence of a change incontrol.  Any warrants issued by us willonly be exercisable immediately prior to a change of control and will expire andno longer be exercisable on the fourth

 

16

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anniversary of the effectivedate of the Agreement.  Additionaldetails regarding the terms of the proposed facility can be found in the proxystatement for our 2003 annual meeting of stockholders.

 

Based upon the terms of the contingent convertible note purchaseagreement, the existing BOW Credit Agreement, our recent operating performanceand business outlook, and status of our balance sheet, we believe that cash onhand, cash from operations, and funds available under our current and expectedcredit facilities will be sufficient to satisfy our working capitalrequirements for at least the next 12 months.

 

***Cash Flows. ***Cash providedby operating activities for the twenty-four weeks ended December 17, 2003totaled $1,569,000 as compared with $544,000 for the twenty-four weeks endedDecember 18, 2002.  This improvement isthe net result of many factors more fully enumerated in the Unaudited CondensedConsolidated Statement of Cash Flows in the accompanying financial statements.

 

Net cash used in investing activities for the twenty-four weeks endedDecember 17, 2003 totaled $1,119,000 as compared with $45,000 used for thetwenty-four weeks ended December 18, 2002. During the twenty-four weeks endedDecember 17, 2003, $1,146,000 was used to invest in property and equipment inour store remodel project, our Castroville roasting facility and our homeoffice facility. These expenditures were partially offset by $21,000 ofpayments received on notes receivable and $6,000 in proceeds from disposal ofproperty and equipment.

 

Net cash used in financing activities for the twenty-four weeks endedDecember 17, 2003 totaled $1,540,000 as compared to $621,000 in net cash usedin financing activities for the twenty-four weeks ended December 18, 2002.During the twenty-four weeks ended December 17, 2003, $883,000 of cash wasrestricted in accordance with the $800,000 restricted cash requirement imposedby the third BOW amendment, in addition to the $83,000 restricted cash requirementrelated to our outstanding letter of credit facility, as discussed above. Forboth periods the net cash used in financing activities consisted of repaymentof long-term debt and capital leases.

 

***Outstanding Debt andFinancing Arrangements.***  We have a $675,000 revolving working capital and letter of creditfacility.  The total borrowings underthe working capital facility and letters of credit are limited to a combinedmaximum of $675,000 outstanding at any time. Letters of credit are subject to a sub-limit of $250,000.  We also have an additional $250,000 letterof credit facility.  At December 17,2003, there were two letters of credit in the amounts of $179,000 and $83,000outstanding under the two letter of credit facilities, and no draws against theworking capital facility.

 

For additionalinformation regarding our banking relationship and further details of therevolving working capital and letter of credit facility please refer to theaccompanying Unaudited Condensed Consolidated Financial Statements and relatednotes.

 

***OtherCommitments. ***Thefollowing represents a comprehensive list of our contractual obligations andcommitments as of December 17, 2003:

 
|                                                          |   | **Payments  Due by Period** |   |
|---------------------------------------------------------------|--------|-----------------------------|--------|
|                                                          |   | **Total**                   |   | **2004** |   | **2005** |   | **2006** |   | **2007** |   | **2008** |   | **Thereafter** |   |
|                                                          |   | (In thousands)              |   |
| Note payable                                                  |   | $                           | 2,371  |   | $ | 1,517 |   | $ | 617 |   | $ | 237 |   | $ | — |   | $ | — |   | $ | — |   |
| Capital leases                                                |   | 649                         |   | 171 |   | 144 |   | 31 |   | 23 |   | 25 |   | 255 |   |
| Company operated retail locations and other  operating leases |   | 17,379                      |   | 4,363 |   | 3,674 |   | 2,529 |   | 1,819 |   | 1,316 |   | 3,678 |   |
| Franchise operated retail locations  operating leases         |   | 18,186                      |   | 4,989 |   | 3,781 |   | 2,918 |   | 2,396 |   | 1,580 |   | 2,523 |   |
| Green coffee commitments                                      |   | 2,638                       |   | 1,589 |   | 1,049 |   | — |   | — |   | — |   | — |   |
|                                                          |   | $                           | 41,223 |   | $ | 12,629 |   | $ | 9,265 |   | $ | 5,715 |   | $ | 4,238 |   | $ | 2,921 |   | $ | 6,456 |   |

 

17

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We haveobligations 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 renewaloptions, and generally require us to pay a proportionate share of real estatetaxes, insurance, common area, and other operating costs.  Some retail leases provide for contingentrental payments based on sales thresholds. In addition, we are liable on themaster leases for 118 franchise locations. Under our historical franchisingbusiness model, we executed the master leases for these locations and enteredinto subleases on the same terms with our franchisees, which typically paytheir rent directly to the landlords. If any of these franchisees default ontheir subleases, we would be required to make all payments under the masterleases. Our maximum theoretical future exposure at December 17, 2003, computedas the sum of all remaining lease payments through the expiration dates of therespective leases, was $18,186,000. This amount does not take intoconsideration any mitigating measures that we could take to reduce thisexposure in the event of default, including re-leasing the locations orterminating the master lease by negotiating a lump sum payment to the landlordin an amount that is less than the sum of all remaining future rents.

 

**Critical Accounting Policies.**

 

The preparation of our consolidated financial statements requires us tomake estimates and assumptions that affect the reported amounts.  The estimates and assumptions are evaluatedon an ongoing basis and are based on historical experience and on various otherfactors that are believed to be reasonable. Accounts significantly impacted byestimates and assumptions include, but are not limited to, franchisereceivables, allowance for bad debt reserves, assets held for sale, fixed assetlives, goodwill, intangible assets, income taxes, self-insurance and workers’compensation reserves, store closure reserves, and contingencies. We believethat the following represent our critical accounting policies and estimatesused in the preparation of our consolidated financial statements. The followingdiscussion, however, does not list all of our accounting policies andestimates.

 

***Revenue Recognition- Franchise Operations. ***Initialfranchise fees are recognized when a franchised coffeehouse begins operations,at which time we have performed our obligations related to such fees.  Fees received pursuant to area developmentagreements, which grant the right to develop franchised units in future periodsin specific geographic areas, are deferred and recognized on a pro rata basisas the franchised units subject to the development agreements begin operations.In light of our revenue recognition policies, we have little or no control overwhen we recognize revenue related to these initial franchise fees and areadevelopment fees.  We monitor thefinancial condition of franchisees and record provisions for estimated losseson receivables when we believe that our franchisees are unable to make requiredpayments to us.  Additionally, we ceaserecording royalties from franchisees that are delinquent in paying us until wehave a history of payments being made when due.  If sales or economic conditions worsen for our franchisees, theirfinancial performance may worsen, our collection rates may decline, and we maybe required to assume their responsibility for real property lease payments.

 

***Valuation of Long-Lived Assets. ***Weevaluate the carrying value of assets for impairment when the operations of oneor more of our brands experience a negative event, including, but not limitedto, a significant downturn in sales, a substantial loss of customers, anunfavorable change in demographics, or unit closures.  Upon the occurrence of a negative event, we estimate the futureundiscounted cash flows for the individual units that are affected by thenegative event.  If the projected cashflows do not exceed the carrying value of the assets allocated to each unit, wewrite-down the assets to fair value based on: the estimated net proceeds we believe we can obtain for the unit uponsale, the discounted projected cash flows derived from the unit, or thehistorical net proceeds obtained from sales of similar units.  The most significant assumptions in ouranalysis are those used when we estimate a unit’s future cash flows.  We generally use the assumptions in our strategicplan and modify them as necessary based on unit specific information.  If our assumptions are incorrect, thecarrying value of our operating unit assets may be overstated or understated.

 

***Goodwill. ***Goodwill istested for impairment annually or whenever events or changes in circumstancesindicate that the carrying value may not be recoverable. Factors we considerimportant

 

18

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which couldtrigger an impairment review include significant underperformance relative toexpected historical or projected future operating results, significant changesin the manner of use of acquired assets or the strategy for the overallbusiness, and significant negative industry or economic trends. Our goodwillimpairment analysis uses estimates and assumptions in order to determine thefair value of our reporting units, including estimating future cash flows,determining appropriate discount rates and other assumptions. As a result ofour changes in executive management during fiscal 2003, we reviewed ourcompetitive position in certain markets in order to better align our resourceswith our growth strategy.  As a resultof this review, we modified certain assumptions used in our goodwill impairmenttest.  If our assumptions are incorrect,the carrying value of our goodwill may be understated or overstated. Our annualimpairment measurement date is our fiscal year end.

 

***Store ClosureReserves. ***  We decide whether to close a unit based onits recent cash flows and its future estimated profitability.  We evaluate each unit’s performance eachfinancial period.  When units performpoorly, we consider the demographics of the location as well as our ability tocause an unprofitable unit to become profitable. Based on management’sjudgment, we estimate the future cash flows of the unit.  If we determine that the unit will not beprofitable, and there are no contractual requirements that require us tocontinue to operate the unit, we close the unit.  We establish a reserve for the net present value of the unit’sfuture rents and other fixed costs.  Themost significant assumptions that we make in determining store closure reservesare assumptions regarding the estimated costs to maintain vacant properties orterminate leases.  Additionally, theamount of the reserve established for future lease payments on leased vacantunits depend upon our ability to successfully negotiate early termination leaseagreements with our landlords.  If thecosts to maintain properties rise or if it takes longer than anticipated tosell properties or terminate leases, we may need to record additional reserves.

 

#### **Item 3.**           Quantitative And Qualitative DisclosuresAbout Market Risk.

 

**Market Risk Sensitive Items Entered Into forTrading Purposes**

 

None.

 

**Market Risk Sensitive Items Entered Into forOther Than Trading Purposes**

 

*Interest Rate Risk.*  We are exposed to market risk from changesin interest rates on our outstanding bank debt.  At December 17, 2003, we had $1,500,000 in bank debt that wastied to changes in short term interest rates. At the end of our second fiscalquarter of fiscal 2004, the interest rate was the LIBOR rate plus 3.25%.  The rate can be fixed over periods rangingfrom one to six months, at our discretion. At December 17, 2003, a hypothetical 100 basis point increase in theadjusted LIBOR rate would result in additional interest expense of $15,000 onan annualized basis.

 

*Commodity Price Risk.*  Green coffee, the principal raw material forour products, is subject to significant price fluctuations caused by a numberof factors, including weather, political, and economic conditions.  To date, we have not used commodity basedfinancial instruments to hedge against fluctuations in the price ofcoffee.  To ensure that we have anadequate supply of coffee, however, we enter into agreements to purchase greencoffee in the future that may or may not be fixed as to price.  At December 17, 2003, we had commitments topurchase coffee through fiscal year 2005 totaling $2,638,000 for 2,468,000pounds of green coffee, all of which were fixed as to price.  The coffee scheduled to be delivered to usin this fiscal year pursuant to these commitments will satisfy approximately90% of our anticipated green coffee requirements for this fiscal year.  Assuming we require approximately 155,000additional pounds of green coffee during 2004 for which no price has yet beenfixed, each $0.01 per pound increase in the price of green coffee could resultin approximately $2,000 of additional cost. However, because the price we pay for green coffee is negotiated withsuppliers, we believe that the commodity market price for green coffee wouldhave to increase significantly, by as much as $0.25 per pound, before supplierswould increase the price they charge us.

 

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**Item4.****           Controls andProcedures.**

 

(a)  As of the end of the period covered by thisquarterly report, we carried out an evaluation, under the supervision and withthe participation of our management, including our Chief Executive Officer andChief Financial Officer, of the effectiveness of the design and operation ofour disclosure controls and procedures. Based on that evaluation, our Chief Executive Officer and ChiefFinancial Officer have concluded that these disclosure controls and proceduresare effective in timely alerting them to material information relating toDiedrich Coffee (including our subsidiaries) required to be included in ourperiodic SEC filings.

 

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

 

**PART II - OTHER INFORMATION**

 

**Item1.****           Legal Proceedings.**

 

In the ordinary course of our business, we may become involved in legalproceedings from time to time. During the twenty-four week period endingDecember 17, 2003, we were not a party to any material legal proceedings.

 

**Item4.****           Submission of Mattersto a Vote of Security Holders**

 

The annualmeeting of stockholders was held on December 2, 2003.  Peter Churm, Martin Diedrich, Lawrence Goelman, Paul Heeschen,Roger Laverty, Randy Powell and Richard Spencer were elected to the board ofdirectors to serve until the next annual meeting.  Set forth below is a brief description of each matter voted uponat the annual meeting, together with the votes cast on each matter.

 

**Election of Directors**

 

Thestockholders elected all of the director nominees named in the proxystatement.  The votes cast for eachnominee and the votes withheld with respect to each nominee are set forthbelow:

 
| **Director Nominee** |   | **Votes For** |   | **Votes  Withheld** |   |
|----------------------|--------|---------------|--------|---------------------|--------|
|                 |   |          |   |                |   |
| Peter Churm          |   | 4,877,155     |   | 144,344             |   |
|                 |   |          |   |                |   |
| Martin Diedrich      |   | 4,366,139     |   | 695,350             |   |
|                 |   |          |   |                |   |
| Lawrence Goelman     |   | 4,338,835     |   | 692,654             |   |
|                 |   |          |   |                |   |
| Paul Heeschen        |   | 4,889,905     |   | 141,584             |   |
|                 |   |          |   |                |   |
| Roger Laverty        |   | 4,345,888     |   | 685,601             |   |
|                 |   |          |   |                |   |
| Randy Powell         |   | 4,929,251     |   | 102,238             |   |
|                 |   |          |   |                |   |
| Richard Spencer      |   | 4,932,489     |   | 99,000              |   |

 

20

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**Ratification of the Appointment of KPMG LLP**

 

The stockholders ratified theappointment of KPMG LLP as our independent auditor for our fiscal year endingJune 30, 2004.  The votes cast on theproposal are set forth below.

 
| For     |   | 5,022,891 |   |
|---------|--------|-----------|--------|
|    |   |      |   |
| Against |   | 7,330     |   |
|    |   |      |   |
| Abstain |   | 1,268     |   |

 

**Approval of an amendment to the Diedrich Coffee, Inc. 2000Equity Incentive Plan to increase the number of shares that may be issued underthe plan**

 

The stockholders approved anamendment to the Diedrich Coffee, Inc. 2000 Equity Incentive Plan to increasethe number of shares that may be issued under the plan by 650,000.  The votes cast on the proposal are set forthbelow.

 
| For:              |   | 2,894,073 |   |
|-------------------|--------|-----------|--------|
|              |   |      |   |
| Against:          |   | 922,586   |   |
|              |   |      |   |
| Abstain:          |   | 865       |   |
|              |   |      |   |
| Broker Non-Votes: |   | 1,213,965 |   |

** **

**Approval of an amendment to the Diedrich Coffee, Inc. 2000Equity Incentive Plan to increase the number of options granted to directorsupon election and re-election to the board of directors**

 

The stockholders approved anamendment to the Diedrich Coffee, Inc. 2000 Equity Incentive Plan to increasethe number of options granted to directors upon election and re-election to theboard of directors.  The votes cast onthe proposal are set forth below.

 
| For              |   | 2,992,331 |   |
|------------------|--------|-----------|--------|
|             |   |      |   |
| Against          |   | 822,821   |   |
|             |   |      |   |
| Abstain          |   | 2,372     |   |
|             |   |      |   |
| Broker Non-Votes |   | 1,213,965 |   |

** **

**Approval of the Stock Option Plan and Agreement with Roger M.Laverty**

 

The stockholders approved theStock Option Plan and Agreement with Roger M. Laverty.  The votes cast on the proposal are set forthbelow.

 
| For              |   | 3,723,394 |   |
|------------------|--------|-----------|--------|
|             |   |      |   |
| Against          |   | 81,385    |   |
|             |   |      |   |
| Abstain          |   | 12,745    |   |
|             |   |      |   |
| Broker Non-Votes |   | 1,213,965 |   |

 

21

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**Approval of a financing transaction**

 

The stockholders approved theissuance of one or more contingent convertible promissory notes with up to a $5million aggregate principal amount in a financing transaction with one of oursignificant stockholders.  The votescast on the proposal are set forth below.

 
| For              |   | 1,424,913 |   |
|------------------|--------|-----------|--------|
|             |   |      |   |
| Against          |   | 921,561   |   |
|             |   |      |   |
| Abstain          |   | 1,471,050 |   |
|             |   |      |   |
| Broker Non-Votes |   | 1,213,965 |   |

 

## **Item6.**           Exhibits and Reports on Form8-K.

 

(a)          *Exhibits.*

 

Set forthbelow 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 the Company, dated May 11,  2001(2)                                                                                                                                         |
|            |   |                                                                                                                                                                                                                 |
| 3.2             |   | Bylaws of the Company(3)                                                                                                                                                                                             |
|            |   |                                                                                                                                                                                                                 |
| 4.1             |   | Specimen 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 Warrant Agreement with Nuvrty, Inc., Ocean Trust, and  Grandview Trust(7)                                                                                                                                    |
|            |   |                                                                                                                                                                                                                 |
| 4.9             |   | Form of Common Stock and Option Purchase Agreement with Franchise  Mortgage Acceptance Company, dated as of April 3, 1998(8)                                                                                         |

 

22

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| 10.1   |   | Form of Indemnification Agreement(5)                                                                                                      |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                      |
| 10.2   |   | Diedrich Coffee, Inc. 2000 Equity Incentive Plan*                                                                                         |
|   |   |                                                                                                                                      |
| 10.3   |   | Diedrich Coffee, Inc. 2000 Non-Employee Directors Stock Option  Plan(10)*                                                                 |
|   |   |                                                                                                                                      |
| 10.4   |   | Amended and Restated Diedrich Coffee, Inc. 1996 Stock Incentive  Plan(11)*                                                                |
|   |   |                                                                                                                                      |
| 10.5   |   | Diedrich Coffee, Inc. 1996 Non-Employee Directors Stock Option  Plan(12)*                                                                 |
|   |   |                                                                                                                                      |
| 10.6   |   | Reserved.                                                                                                                                 |
|   |   |                                                                                                                                      |
| 10.7   |   | Form of Diedrich Coffee Franchise Agreement(20)                                                                                           |
|   |   |                                                                                                                                      |
| 10.8   |   | Form of Gloria Jean’s Franchise Agreement(20)                                                                                        |
|   |   |                                                                                                                                      |
| 10.9   |   | Form of Area Development Agreement(20)                                                                                                    |
|   |   |                                                                                                                                      |
| 10.10  |   | Credit Agreement, dated September 3, 2002, by and between Diedrich  Coffee, Inc. and Bank of the West d/b/a/ United California Bank(13)   |
|   |   |                                                                                                                                      |
| 10.11  |   | Form of Guaranty(13)                                                                                                                      |
|   |   |                                                                                                                                      |
| 10.12  |   | Form of Guarantor Security Agreement(13)                                                                                                  |
|   |   |                                                                                                                                      |
| 10.13  |   | Form of Supplemental Security Agreement (Trademarks)(13)                                                                                  |
|   |   |                                                                                                                                      |
| 10.14  |   | Security Agreement, dated September 3, 2002, by and between Diedrich  Coffee, Inc. and Bank of the West d/b/a/ United California Bank(13) |
|   |   |                                                                                                                                      |
| 10.15  |   | First Amendment to Credit Agreement by and between Diedrich Coffee,  Inc. and Bank of the West, effective December 17, 2002(14)           |
|   |   |                                                                                                                                      |
| 10.16  |   | Second Amendment to Credit Agreement by and between Diedrich Coffee,  Inc. and Bank of the West, effective March 11, 2003(15)             |
|   |   |                                                                                                                                      |
| 10.17  |   | Third Amendment to Credit Agreement by and between Diedrich Coffee,  Inc. and Bank of the West, effective July 1, 2003(16)                |
|   |   |                                                                                                                                      |
| 10.18  |   | Fourth Amendment to Credit Agreement by and between Diedrich Coffee,  Inc. and Bank of the West, effective October 1, 2003 (20)           |
|   |   |                                                                                                                                      |
| 10.19  |   | Reserved.                                                                                                                                 |
|   |   |                                                                                                                                      |
| 10.20  |   | Employment Agreement with Roger M. Laverty, dated April 24, 2003(15)*                                                                     |
|   |   |                                                                                                                                      |
| 10.21  |   | Stock Option Plan and Agreement with Roger M. Laverty, dated April  24, 2003(15)*                                                         |
|   |   |                                                                                                                                      |
| 10.22  |   | Reserved.                                                                                                                                 |
|   |   |                                                                                                                                      |
| 10.23  |   | Form of Employment Agreement with Martin R. Diedrich, dated June 29,  2001(17)*                                                           |

 

23

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| 10.24  |   | Employment Agreement with Matthew McGuinness, effective March 13,  2000(18)*                                                                                   |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                           |
| 10.25  |   | Employment Letter regarding the employment of Pamela Britton, dated  February 6, 2001(20)*                                                                     |
|   |   |                                                                                                                                                           |
| 10.26  |   | Employment Letter regarding the employment of Michael Zorehkey, dated  February 3, 2000(20)*                                                                   |
|   |   |                                                                                                                                                           |
| 10.27  |   | Employment Letter regarding the employment of Carl Mount dated  October 29, 1999(19)*                                                                          |
|   |   |                                                                                                                                                           |
| 10.28  |   | Separation Agreement by and between Diedrich Coffee, Inc. and Philip  G. Hirsch(15)*                                                                           |
|   |   |                                                                                                                                                           |
| 10.29  |   | Reserved.                                                                                                                                                      |
|   |   |                                                                                                                                                           |
| 10.30  |   | Standard Industrial/Commercial Multi-Tenant Lease Agreement by and  between The Westphal Family Trust and Diedrich Coffee, Inc., dated September  10, 2003(16) |
|   |   |                                                                                                                                                           |
| 10.31  |   | Office Space Lease Agreement by and between The Irvine Company and  Diedrich Coffee, Inc., dated August 1, 2003(16)                                            |
|   |   |                                                                                                                                                           |
| 10.32  |   | Reserved.                                                                                                                                                      |
|   |   |                                                                                                                                                           |
| 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                                                           |

 

----

*                 Managementcontract or compensatory plan or arrangement

 

(1)                      Previouslyfiled 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)                      Previouslyfiled as an exhibit to Diedrich Coffee’s Current Report on Form 8-K, filed withthe Securities and Exchange Commission on May 16, 2001.

 

(3)                      Previouslyfiled as an exhibit to Diedrich Coffee’s Registration Statement on Form S-1/A(Registration No. 333-08633), filed with the Securities and Exchange Commissionon August 28, 1996 and declared effective on September 11, 1996.

 

(4)                      Previouslyfiled as an exhibit to Diedrich Coffee’s Registration Statement on Form S-3(Registration No. 333-66744), filed with the Securities and Exchange Commissionon August 3, 2001.

 

(5)                      Previouslyfiled as an exhibit to Diedrich Coffee’s Registration Statement on Form S-1(Registration No. 333-08633), filed with the Securities and Exchange Commissionon July 24, 1996 and declared effective on September 11, 1996.

 

24

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(6)                      Previouslyfiled as Appendix B to Diedrich Coffee’ Definitive Proxy Statement, filed withthe Securities and Exchange Commission on April 12, 2001.

 

(7)                      Previouslyfiled as an exhibit to Diedrich Coffee’s Quarterly Report on Form 10-Q for theperiod ended October 29, 1997, filed with the Securities and ExchangeCommission on December 11, 1997.

 

(8)                      Previouslyfiled as an exhibit to Diedrich Coffee’s Annual Report on Form 10-K for thefiscal year ended January 28, 1998, filed with the Securities and ExchangeCommission on April 28, 1998.

 

(9)                      Reserved.

 

(10)                Previously filedas an exhibit to Diedrich Coffee’s Registration Statement on Form S-8, filedwith the Securities and Exchange Commission on November 21, 2000.

 

(11)                Previously filedas an exhibit to Diedrich Coffee’s Quarterly Report on Form 10-Q for theperiod ended September 22, 1999, filed with the Securities and ExchangeCommission on November 5, 1999.

 

(12)                Previously filedas an exhibit to Diedrich Coffee’s Registration Statement on Form S-1/A(Registration No. 333-08633), filed with the Securities and Exchange Commissionon August 12, 1996 and declared effective on September 11, 1996.

 

(13)                Previously filedas an exhibit to Diedrich Coffee’s Annual Report on Form 10-K for the fiscalyear ended July 3, 2002, filed with the Securities and Exchange Commission onOctober 1, 2002.

 

(14)                Previously filedas an exhibit to Diedrich Coffee’s Quarterly Report on Form 10-Q for the periodended December 18, 2002, filed with the Securities and Exchange Commission onJanuary 31, 2003.

 

(15)                Previously filedas an exhibit to Diedrich Coffee’s Quarterly Report on Form 10-Q for the periodended March 12, 2003, filed with the Securities and Exchange Commission onApril 28, 2003.

 

(16)                Previously filedas an exhibit to Diedrich Coffee’s Annual Report on Form 10-K for the fiscalyear ended July 2, 2003, filed with the Securities and Exchange Commission onSeptember 30, 2003.

 

(17)                Previously filedas an exhibit to Diedrich Coffee’s Annual Report on Form 10-K for the fiscalyear ended June 27, 2001, filed with the Securities and Exchange Commission onSeptember 25, 2001.

 

(18)                Previously filedas an exhibit to Diedrich Coffee’s Annual Report on Form 10-K for the fiscalyear ended June 28, 2000, filed with the Securities and Exchange Commission onSeptember 27, 2000.

 

(19)                Previously filedas an exhibit to Diedrich Coffee’s Quarterly Report on Form 10-Q for the periodended September 20, 2000, filed with the Securities and Exchange Commission onNovember 6, 2000.

 

(20)                Previously filedas an exhibit to Diedrich Coffee’s Quarterly Report on Form 10-Q for the periodended September 24, 2003, filed with the Securities and Exchange Commission onNovember 7, 2003.

 

25

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(b)                                 *Reports on Form 8-K.*

 

On November 5, 2003, we furnished a Current Report on Form 8-K toreport the financial results of our first fiscal quarter.

 

26

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**SIGNATURES**

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
| Date:  January 30, 2004 | **DIEDRICH COFFEE, INC.**                    |
|------------------------------|----------------------------------------------|
|                         |                                         |
|                         |                                         |
|                         | /s/ Roger M. Laverty                         |   |
|                         | Roger M. Laverty                             |
|                         | President and Chief Executive Officer        |
|                         | (Principal Executive Officer)                |
|                         |                                         |
|                         |                                         |
|                         | /s/ Martin A. Lynch                          |   |
|                         | Martin A. Lynch                              |
|                         | Executive Vice President and                 |
|                         | Chief Financial Officer                      |
|                         | (Principal Financial and Accounting Officer) |

 

27

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