<PAGE>

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                    SECURITIES AND EXCHANGE COMMISSION

                          WASHINGTON, D.C. 20549

                               -------------

                                 FORM 10-Q

          /X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF
                    THE SECURITIES EXCHANGE ACT OF 1934

              For the quarterly period ended October 28, 1998

                                    OR

         / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF
                    THE SECURITIES EXCHANGE ACT OF 1934

        For the transition period from ___________ to ____________

                      COMMISSION FILE NUMBER 0-21203

                           DIEDRICH COFFEE, INC.
          (Exact name of registrant as specified in its charter)

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

                           2144 MICHELSON DRIVE
                         IRVINE, CALIFORNIA 92612
        (Address of Principal Executive Offices including Zip Code)

                              (949) 260-1600
            (Registrant's Telephone Number including Area Code)

                               -------------

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

     As of December 1, 1998, there were 5,988,764 shares of common stock of 
the registrant outstanding.

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<PAGE>

                           DIEDRICH COFFEE, INC.

                                   INDEX
<TABLE>
<CAPTION>
PART I - FINANCIAL INFORMATION                                  PAGE NO.
<S>                                                             <C>

Item 1.   Financial Statements

          Condensed Balance Sheets............................     3

          Condensed Statements of Operations..................     4

          Condensed Statements of Cash Flows..................     5

          Notes to Condensed Financial Statements.............     6

Item 2.   Management's Discussion and Analysis of Financial 
          Condition and Results of Operations.................    10

          Liquidity and Capital Resources.....................    13

Item 3    Quantitative and Qualitative Disclosures About 
          Market Risk.........................................    14

PART II - OTHER INFORMATION

Item 1    Legal Proceedings...................................    15

Item 5    Other Information...................................    15

Item 6    Exhibits and Reports on Form 8-K....................    15

          Signatures..........................................    16
</TABLE>


                                     2
<PAGE>


                         PART I - FINANCIAL INFORMATION
                          ITEM 1. FINANCIAL STATEMENTS

                              DIEDRICH COFFEE, INC.
                            CONDENSED BALANCE SHEETS
<TABLE>
<CAPTION>

                                                                     OCTOBER 28, 1998        JANUARY 28, 1998
                                                                     -----------------       -----------------
<S>                                                                  <C>                    <C>
ASSETS (Note 3)

Current Assets:
   Cash                                                              $         863,730       $       1,408,161
   Accounts receivable                                                         289,131                 181,628
   Inventories (Note 2)                                                      1,334,488               1,375,119
   Prepaid expenses                                                            292,459                 157,393
   Income taxes receivable                                                      17,686                  42,528
                                                                     -----------------       -----------------
     Total current assets                                                    2,797,494               3,164,829

Property and equipment, net                                                  9,388,599              10,104,843
Costs in excess of net assets acquired, net                                    335,897                 389,651
Other assets                                                                   270,107                 289,103
                                                                     -----------------       -----------------
     Total assets                                                    $      12,792,097       $      13,948,426
                                                                     -----------------       -----------------
                                                                     -----------------       -----------------

LIABILITIES AND STOCKHOLDERS' EQUITY

Current Liabilities:

   Current installments of obligations under capital lease           $         169,488       $         168,139
   Accounts payable                                                          1,395,798               1,204,366
   Accrued compensation                                                        848,774                 716,742
   Accrued expenses                                                          1,220,318               1,796,869
   Provision for store closings and restructuring costs                        124,217                 237,320
                                                                     -----------------       -----------------
     Total current liabilities                                               3,758,595               4,123,436

Obligation under capital lease - long term                                     306,183                 317,292
Long term debt (Note 3)                                                      2,500,000               2,500,000
Deferred rent                                                                  200,338                 172,231
                                                                     -----------------       -----------------
     Total liabilities                                                       6,765,116               7,112,959
                                                                     -----------------       -----------------

Stockholders' Equity: (Note 4)

Common stock                                                                    59,478                  57,417
Additional paid-in capital                                                  18,254,247              16,928,546
Accumulated deficit                                                        (12,286,744)            (10,150,496)
                                                                     ------------------      ------------------
     Total stockholders' equity                                              6,026,981               6,835,457
                                                                     -----------------       -----------------
Commitments and contingencies

     Total liabilities and stockholders' equity                      $      12,792,097       $      13,948,426
                                                                     -----------------       -----------------
                                                                     -----------------       -----------------
</TABLE>

See accompanying notes to financial statements.

                                       3


<PAGE>

                              DIEDRICH COFFEE, INC.
                        CONDENSED STATEMENT OF OPERATIONS
                                   (UNAUDITED)
<TABLE>
<CAPTION>
                                           THIRTEEN WEEKS      THIRTEEN WEEKS     THIRTY-NINE WEEKS    THIRTY-NINE WEEKS
                                          ENDED OCTOBER 28,   ENDED OCTOBER 29,    ENDED OCTOBER 28,    ENDED OCTOBER 29,
                                               1998                1997                 1998                 1997
                                          ----------------     ---------------    ----------------       ---------------
<S>                                       <C>                  <C>                <C>                    <C>
Net Sales:
   Retail                                 $      5,268,622     $     4,989,024    $     15,897,471       $    15,632,429
   Wholesale and other                             674,630             573,848           1,998,657             1,608,685
   Franchise area development fees                 100,000                   -             100,000                     -
                                          ----------------     ---------------    ----------------       ---------------
     Total                                       6,043,252           5,562,872          17,996,128            17,241,114
                                          ----------------     ---------------    ----------------       ---------------

Cost and Expenses:

   Cost of sales and related
     occupancy costs                             2,718,436           2,716,323           8,113,504             8,619,031
   Store operating expenses                      2,187,605           2,029,491           6,744,513             6,536,446
   Other operating expenses                        165,595              92,896             460,896               232,985
   Depreciation and amortization                   490,531             426,778           1,434,105             1,313,294
   Provision for store closings and
     restructuring costs                                 -                   -                     -           4,550,068
   General and administrative expenses           1,002,556             951,683           3,090,934             2,695,562
                                          ----------------     ---------------    ----------------       ---------------
     Total                                       6,564,723           6,217,171          19,843,952            23,947,386
                                          ----------------     ---------------    ----------------       ---------------


Operating loss                                    (521,471)           (654,299)         (1,847,824)           (6,706,272)


Interest expense                                   (94,640)            (79,954)           (291,894)             (101,605)


Interest and other income                            7,280              (4,501)             27,686                (9,258)
                                          ----------------     ----------------   ----------------       ----------------


Loss before income taxes                          (608,831)           (738,754)         (2,112,032)           (6,817,135)


Income tax provision                                     -                   -               3,690                 2,890
                                          ----------------     ---------------    ----------------       ---------------


Net loss                                          (608,831)    $      (738,754)         (2,115,722)      $    (6,820,025)
                                          ----------------     ---------------    ----------------       ---------------
                                          ----------------     ---------------    ----------------       ---------------


   Basic net loss per share:              $          (0.10)    $         (0.14)   $          (0.36)      $         (1.27)
                                          ----------------     ---------------    ----------------       ---------------
                                          ----------------     ---------------    ----------------       ---------------

   Diluted net loss per share:

                                          $          (0.10)    $         (0.14)   $          (0.36)      $         (1.27)
                                          ----------------     ---------------    ----------------       ---------------
                                          ----------------     ---------------    ----------------       ---------------



Weighted average shares outstanding              5,944,146           5,391,650           5,895,596             5,391,650
                                          ----------------     ---------------    ----------------       ---------------
                                          ----------------     ---------------    ----------------       ---------------
</TABLE>

See accompanying notes to financial statements.

                                       4

<PAGE>

                              DIEDRICH COFFEE, INC.
                       CONDENSED STATEMENTS OF CASH FLOWS
                                   (UNAUDITED)

<TABLE>
<CAPTION>

                                                                     THIRTY-NINE WEEKS       THIRTY-NINE WEEKS
                                                                     ENDED OCTOBER 28,       ENDED OCTOBER 29,
                                                                            1998                   1997
                                                                     -----------------       -----------------
<S>                                                                  <C>                     <C>
Cash flows from operating activities:
   Net loss                                                          $     (2,115,722)        $     (6,820,025)
   Adjustments to reconcile net loss to cash used in operating 
     activities:
     Depreciation and amortization                                          1,434,105                1,313,294
     Provision for asset impairment and restructuring costs                        -                 3,903,280
     Changes in assets and liabilities:
       Accounts receivable                                                   (107,503)                 (55,522)
       Inventories                                                             40,631                   45,466
       Prepaid expenses                                                      (135,066)                (335,895
       Income taxes receivable                                                 24,842                  241,744
       Other assets                                                           (16,947)                   5,124
       Accounts payable                                                       191,432                 (387,820)
       Accrued compensation                                                    19,117                 (115,363)
       Accrued expenses                                                       (47,660)                 214,498
       Deferred rent                                                           28,107                    5,854
                                                                     ----------------         ----------------
Net cash used in operating activities                                        (684,664)              (1,985,365)
                                                                     -----------------        ----------------

Cash flows from investing activities:
     Capital expenditures for property and equipment                       (1,103,116)              (1,536,263)
     Property disposition                                                           -                        -
                                                                     ----------------         ----------------
Net cash used in investing activities                                $     (1,103,116)        $     (1,754,268)
                                                                     ----------------         ----------------
                                                                     ----------------         ----------------

Cash flows from financing activities:
     Proceeds from issuance of common stock, net fees paid                  1,307,236                        -
     Proceeds from long-term debt                                                  -                 3,000,000
     Payment on capital lease obligation                                      (63,887)                       -
                                                                     -----------------        ----------------

Net cash provided by financing activities                            $      1,243,349         $      3,000,000
                                                                     ----------------         ----------------
Net increase (decrease) in cash                                              (544,431)                (521,628)
                                                                     -----------------        -----------------
Cash at beginning of period                                                 1,408,161                2,071,904
                                                                     ----------------         ----------------
Cash at end of period                                                         863,730         $      1,550,276
                                                                     ----------------         ----------------
                                                                     ----------------         ----------------


Supplemental disclosure of cash flow information:
   Cash paid during the period for:
     Interest                                                        $        205,950         $         64,729
                                                                     ----------------         ----------------
                                                                     ----------------         ----------------
     Income taxes                                                    $          3,690         $          2,890
                                                                     ----------------         ----------------
                                                                     ----------------         ----------------

Non-cash transactions

Equipment purchased under capital lease                              $         54,127         $        146,819
                                                                     ----------------         ----------------
                                                                     ----------------         ----------------

</TABLE>

See accompanying notes to financial statements

                                       5

<PAGE>

                              DIEDRICH COFFEE, INC.
                     NOTES TO CONDENSED FINANCIAL STATEMENTS
                                 OCTOBER 28, 1998
                                   (UNAUDITED)

1.       SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

         BASIS OF PRESENTATION

         The unaudited condensed financial statements of Diedrich Coffee, Inc.
(the "Company") have been prepared in accordance with generally accepted
accounting principles for interim financial information. In the opinion of
management, all adjustments (consisting of normal, recurring adjustments and
accruals) considered necessary for a fair presentation of the Company's
financial position at October 28, 1998 and the results of operations and cash
flows for both the thirteen and thirty-nine weeks ended October 28, 1998 and
October 29, 1997 have been included. Results for the interim periods are not
necessarily indicative of the results for an entire year. This information
should be read in conjunction with the financial statements and the notes
thereto included in the Company's Annual Report on Form 10-K for the year ended
January 28, 1998.

         In June 1998, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative
Instruments and Hedging Activities." This pronouncement will require the Company
to recognize derivatives on its balance sheet at fair value. Changes in the fair
values of derivatives that qualify as cash flow hedges will be recognized in
comprehensive income until the hedged item is recognized in earnings. The
Company expects that this new standard will not have a significant effect on its
results of operations. SFAS No. 133 is effective for fiscal years beginning
after June 15, 1999.

         NET LOSS PER COMMON SHARE

         The computation of basic earnings per share in accordance with
Statement of Financial Accounting Standard ("SFAS") No. 128, "Earnings Per
Share" is based on the weighted average number of common shares outstanding
during the periods presented. All periods presented have been calculated in
accordance with SFAS No. 128.

2.       INVENTORIES

         Inventories consist of the following:

<TABLE>
<CAPTION>
                                                            OCTOBER 28, 1998             JANUARY 28, 1998
                                                            ----------------             ----------------
<S>                                                            <C>                          <C>

                Green coffee (raw materials)                   $  449,568                   $  535,885
                Roasted coffee (finished goods)                   134,909                       67,965
                Accessory and specialty items                     215,153                      230,502
                Other food, beverage and supplies                 534,858                      540,767
                                                               ----------                   ----------
                                                               $1,334,488                   $1,375,119
                                                               ----------                   ----------
                                                               ----------                   ----------
</TABLE>

                                      6

<PAGE>

                              DIEDRICH COFFEE, INC.
                     NOTES TO CONDENSED FINANCIAL STATEMENTS
                                   OCTOBER 28, 1998
                                   (UNAUDITED)

3.         DEBT

           Long-term debt consists of the following:

<TABLE>
<CAPTION>
                                                         OCTOBER 28, 1998     JANUARY 28, 1998
                                                         ----------------     ----------------

           <S>                                                 <C>                  <C>
 
           NUVRTY, INC.
           Note payable bearing interest at prime
           rate plus 3 1/2%, interest payable monthly.
           Note is secured by the assets of the
           Company.  Due September 30, 2002                    $1,000,000           $1,000,000

           GRANDVIEW TRUST
           Note payable bearing interest at prime
           rate plus 3 1/2%, interest payable monthly.
           Note is secured by the assets of the
           Company.  Due October 15, 2002                         750,000              750,000

           OCEAN TRUST
           Note payable bearing interest at prime
           rate plus 3 1/2%, interest payable monthly.
           Note is secured by the assets of the
           Company.  Due October 16, 2002                         750,000             $750,000
                                                               ----------           ----------
                                                               $2,500,000           $2,500,000
                                                               ----------           ----------
                                                               ----------           ----------

</TABLE>


         On September 30, 1997 the Company entered into a promissory note, term
loan agreement and security agreement with Nuvrty, Inc., a Colorado corporation
controlled by Amre Youness, a former director of the Company (the "Nuvrty Loan
Documents"). All outstanding principal and accrued interest is due and payable
on September 30, 2002. The loan is secured by the assets of the Company and
provides for borrowings up to $1,000,000 with interest accruing and paid monthly
at the prime rate plus 3 1/2%. The Company borrowed the full amount under the
loan.


         In connection with the Nuvrty Loan Documents, the Company issued a 
warrant to Nuvrty to purchase up to 170,000 shares of the Company's common 
stock if the loan was repaid in full within 120 days of closing and up to 
340,000 shares of the Company's common stock if the loan was not repaid 
within 120 days, all at a price of $2.25 per share. The warrants are 
exercisable immediately and expire on the later of September 30, 2003 or one 
year following payment in full of the loan.

         On October 16, 1997 the Company entered into parallel promissory 
notes, term loan agreements and security agreements with the Ocean and 
Grandview Trusts on terms identical to those entered into with Nuvrty, Inc. 
(the "Ocean Trust Loan Documents" and the "Grandview Trust Loan Documents", 
respectively). The Ocean Trust Loan Documents and the Grandview Trust Loan 
Documents provide for borrowing up to $750,000 from each Trust. Each loan is 
secured by the assets of the Company. Interest on advances is accrued and 
payable monthly at the prime rate plus 3 1/2%. The Company borrowed $750,000 
under each facility. All outstanding principal and accrued interest is due 
and payable to each of the Ocean and Grandview Trusts on October 16, 2002.

         In connection with the Ocean Trust Loan Documents and the Grandview 
Trust Loan Documents the Company issued warrants to each Trust respectively 
to purchase up to 127,500 shares each of the Company's common stock if the 
loans were repaid in full within 120 days of closing, or up to 255,000 shares 
respectively of the Company's common stock if the loans were not repaid in 
full within 120 days of closing, all at a price of $2.25 per share. The 
warrants are exercisable immediately and expire on the later of October 16, 
2003 or one year following payment in full of the respective loans. The 
Company used the proceeds from the Ocean Trust and Grandview Trust loans to 
pay off and discharge outstanding indebtedness.

                                       7

<PAGE>

                              DIEDRICH COFFEE, INC.
                     NOTES TO CONDENSED FINANCIAL STATEMENTS
                                OCTOBER 28, 1998
                                   (UNAUDITED)

         The warrants associated with all the above debt were accounted for 
in accordance with the provisions of APB 14, "Accounting for Convertible Debt 
and Debt Issued Stock Purchase Warrants." Due to the relative immateriality 
of the fair value of the warrants, none of the proceeds from issuance of the 
debt were allocated to the warrants. The determination of fair value was 
calculated using both a Cost of Replacement Model and the Monte Carlo 
simulation of possible warrant exercise.

         On April 14, 1998 the Company announced the commitment of Franchise 
Mortgage Acceptance Company ("FMAC") to make a secured loan of up to $5 
million to the Company. After extensive discussions, the Company determined 
that the structure required by FMAC was not in the Company's best interest. 
In anticipation of this possible outcome, the Company engaged an investment 
banker in November 1998 to seek alternative sources of capital. The Company 
is currently operating at a net cash deficit and, in addition to working with 
the investment bankers, is pursuing alternative sources of capital. 
Management believes that one or more of these sources will be in place by the 
end of the current fiscal year.

4.       STOCKHOLDERS' EQUITY

         On April 25, 1997, the Company's Board of Directors approved the 
1997 Non-Employee Directors Stock Option Plan under which options for 10,000 
shares each were granted to two non-employee directors. These options have an 
exercise price of $2.75, became vested on April 25, 1998 and expire on April 
25, 2007.

         On November 18, 1997, Mr. John E. Martin joined the Company's Board 
of Directors as Chairman, replacing Lawrence Goelman. On November 17, 1997, 
Mr. Martin entered into a letter agreement with the Company appointing him 
Chairman of the Board of the Company. The Company and Mr. Martin also entered 
into an agreement under which Mr. Martin would be granted the option to 
purchase up to 850,000 shares of the common stock of the Company subject to 
stockholder approval ("Martin Option Agreement"). Mr. Martin and the Company 
also agreed to terms under which Mr. Martin would purchase 333,333 shares of 
the Company's common stock at $3.00 per share, following stockholder approval 
of the Martin Option Agreement.

         On November 18, 1997, Mr. Timothy J. Ryan joined the Company as 
Diedrich Coffee's President and Chief Executive Officer to replace Lawrence 
Goelman, Interim Chief Executive Officer. Subject to stockholder approval, 
the Company entered into a performance based Stock Option Plan and Agreement 
under which Mr. Ryan would be granted the option to purchase up to 600,000 
shares of the common stock of the Company and Mr. Ryan would purchase 16,667 
shares at $3.00 per share in the Company pursuant to a private sale of 
restricted stock.

         On January 22, 1998 the stockholders of the Company approved the 
stock option plans and agreements with John Martin and Timothy Ryan. On 
January 28, 1998 Messrs. Martin and Ryan completed their respective private 
purchases of Company stock of $1,000,000 and $50,000, respectively.

         On March 30, 1998 the Company agreed to a private placement of 
200,000 shares of the Company's common stock to Franchise Mortgage Acceptance 
Company ("FMAC") at a price of $6.375 (the stock's closing sale price for 
that day on the Nasdaq National Stock Market). In addition, FMAC also 
received an option to purchase 100,000 additional shares of the Company's 
common stock; this option may be exercised in increments of 25,000 shares or 
more and expires on April 3, 2000. The exercise prices of this option are as 
follows: 50,000 shares are exercisable at $10.00 per share and $12.50 per 
share, respectively. The fair value of this option is estimated to be 
$72,042. The estimated fair value of the option has been charged to equity 
and will be amortized ratably over the two year life of the option. 
Amortization for the period ended July 29, 1998 totaled $11,548. This 
transaction was completed on April 3, 1998.

         The Company's registration statements on Form S-8 for the 1997 
Non-employee Directors Stock Option Plan, the John E. Martin Option Plan and 
Agreement and the Tim J. Ryan Option Plan and Agreement were filed on August 
12, 1998.

                                       8
<PAGE>

                              DIEDRICH COFFEE, INC.
                     NOTES TO CONDENSED FINANCIAL STATEMENTS
                                OCTOBER 28, 1998
                                   (UNAUDITED)

         The Company filed a registration statement on Form S-3 which was
declared effective on August 24, 1998 registering the following shares: 79,183
shares of common stock are issuable upon exercise of options granted to Steven
Lupinacci (former President and Chief Executive Officer of the Company), 160,000
shares of Common Stock are issuable to The Boston Group (underwriters of the
Company's initial public offering) and certain of its officers and affiliates
upon exercise of warrants to purchase common stock, 25,000 shares of common
stock are issuable upon exercise of options granted to Gregg Rondinelli
(financial consultant to the Company), 85,000 shares of common stock are
issuable to Virginia R. Cirica Trust upon exercise of a warrants, 340,000 shares
of common stock issuable to Nuvurty, Inc. upon the exercise of warrants, 255,000
shares of common stock issuable to Ocean Trust upon exercise of warrants,
255,000 shares of common stock issuable to Grandview Trust upon exercise of
warrants, 200,000 shares of common stock were issued pursuant to the Common
Stock and Option Purchase Agreement with FMAC, and 100,000 shares issuable upon
exercise of options to purchase common stock pursuant to the FMAC agreement.

         On September 22, 1998, 6,140 shares of common stock were issued
pursuant to the exercise of certain Boston Group warrants. On October 28, 1998 ,
18.382 shares of common stock were issued pursuant to the exercise of certain
options granted under the Company's 1996 Stock Incentive Plan.

         Subsequently to the end of the quarter an additional 15,120 shares of
common stock were issued pursuant to the exercise of certain Boston Group
warrants and 7,472 shares of common stock were issued pursuant to the exercise
of options granted under the Company's 1996 Stock Incentive Plan.


                                       9
<PAGE>

                         PART I - FINANCIAL INFORMATION

                       ITEM 2. MANAGEMENT'S DISCUSSION AND
                       ANALYSIS OF FINANCIAL CONDITION AND
                              RESULTS OF OPERATIONS

FORWARD LOOKING STATEMENTS

         From time to time, in both written reports and oral statements, the
Company makes "forward-looking statements" within the meaning of Federal and
state securities laws. Disclosures that use words such as the Company
"believes," "anticipates," "expects," "may" or "plans" and similar expressions
are intended to identify forward-looking statements. These forward-looking
statements reflect the Company's current expectations and are based upon data
available at the time of the statements. Such statements are subject to certain
risks and uncertainties that could cause actual results to differ materially
from expectations. Any such forward-looking statements, whether made in this
report or elsewhere, should be considered in context with the various
disclosures made by the Company about its business, including the factors
discussed below. These projections or forward looking statements fall under the
safe harbors of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended. Foreseeable
risks and uncertainties are described elsewhere in this report and in detail
under "Risk Factors and Trends Affecting Diedrich Coffee and Its Business" in
the Company's annual report on Form 10-K for the fiscal year ended January 28,
1998 and in reports filed by the Company with the Securities and Exchange
Commission.

GENERAL

         The Company commenced operations in 1972 as a private company and
completed its initial public offering in September 1996. The Company, a custom
roaster of specialty coffee, sells coffee and a broad range of espresso drinks
through its own coffeehouses. The Company's objective is to be the leading
national chain of neighborhood coffeehouses serving the best coffee possible. To
complement its beverage sales, the Company sells light food items and whole bean
coffee through its coffeehouses. The Company also sells roasted coffee as well
as coffee brewing and espresso equipment through its wholesale division. As of
October 28, 1998, the Company operated thirty-six coffeehouses and seven coffee
carts located in California, Colorado and Texas.

         FIRST THREE QUARTERS. In the first thirty-nine weeks of the current
fiscal year the Company experienced losses of approximately $2.1 million
principally related to an increase in interest expense and general and
administrative expense. The level of general and administrative expense is
directly related to management's commitment to grow the Company through retail
coffeehouse development, new wholesale channels, and franchise area development.
Achieving this goal depends upon, among other things, obtaining and maintaining
sufficient working capital, aggressive growth in the wholesale division,
execution of new store management systems, successful negotiation of franchise
area development agreements and improved store management and customer
satisfaction. Pursuant to the Company's strategic plan, the roasting facility in
Denver, Colorado was closed in the first quarter and the roasting was
consolidated in Southern California. The Company also closed an under-performing
store in San Diego and one in Denver, Colorado. Four coffee cart locations at
premium Irvine Office Company locations were opened in the first quarter.
Additional coffee cart locations are under consideration and in discussion with
the Irvine Office Company and similar commercial property managers, but no
assurances can be given as to when or how many more coffee carts may be
installed.

         AREA DEVELOPMENT. Management's franchise area development goals are to
enter into fifteen to seventeen franchise area development agreements covering
most major U. S. markets by the end of fiscal year 2000. As of July 29, 1998,
the Company had filed a Uniform Franchise Offering Circular in 32 states which
describes the expected terms of the offered franchises. On September 16, 1998
the Company announced its first franchise area development agreement which calls
for the development of 44 coffeehouses and an undisclosed number of carts and
kiosks in the state of North Carolina over a five year period. In connection
with the signing this agreement the Company recorded area development fee income
of $100,000. On November 16, 1998 the Company announced its second franchise
area development agreement which provides for the development of 50 coffeehouses
and an undisclosed number of carts and kiosks in San Diego, Palm Springs and
Temecula, California over the next five years.


                                       10
<PAGE>

         Although the Company is engaged in discussions with potential
additional area developers, there can be no assurances given as to when or at
what rate area development agreements are entered into. Area development
agreements commit the area developer to build and open coffeehouses in the
agreed-upon territory according to an agreed-upon schedule covering several
years. No assurances can be given as to the rate of new coffeehouse
construction, much less related franchise revenues. Successful area development
depends significantly upon the expertise, staff and capital of the area
developer as well as all of the contingencies and uncertainties to which the
Company and its business are subject.

         Management plans to continue to develop, over the next five years,
Company-owned coffee houses, kiosks and mobile carts in Orange County,
California and in two to four other major U. S. markets. Outside of Orange
County, Company-owned store development will depend upon franchise area
development revenues and continued growth and improvements in Company operations
and coffee house-level execution.

         On April 14, 1998 the Company announced the commitment of Franchise 
Mortgage Acceptance Company ("FMAC") to make a secured loan of up to $5 
million to the Company. After extensive discussions, the Company determined 
that the structure required by FMAC was not in the Company's best interest. 
In anticipation of this possible outcome, the Company engaged an investment 
banker in November 1998 to seek alternative sources of capital. The Company 
is currently operating at a net cash deficit and, in addition to working with 
the investment bankers, is pursuing alternative sources of capital. 
Management believes that one or more of these sources will be in place by the 
end of the current fiscal year.

         GREEN COFFEE PRICES. Worldwide coffee commodity prices have moderated
from the record levels reached in the second and third quarters of fiscal 1998.
In the first quarter of fiscal year 1999, however, the Company's cost of green
coffee exceeded prior year levels by approximately 7%, while in the second and
third quarters the Company's cost of green coffee fell below the prior year
levels by approximately 8% on a year to date basis. The Company usually pays a
premium over the commodity price for the select grade coffee beans that it
purchases. As worldwide demand for coffee of all types remains strong, the
Company expects the prices that it pays to remain comparatively high into the
foreseeable future.

         GREEN COFFEE AVAILABILITY. The Company believes that it has adequate
sources of supply of high quality, green arabica coffee to meet its projected
needs for the foreseeable future. While the Company seeks to carefully
anticipate its green coffee needs, there can be no assurance that supplies and
prices will not be affected by political and social events, the weather in the
coffee growing regions of the world, unexpected demand or other market forces.
Green coffee is an international agricultural commodity product subject to
considerable price fluctuations.

         YEAR 2000 As a component of the Company's comprehensive enterprise
information systems architecture review the Year 2000 problem is being addressed
on a system by system basis. To date the Company has upgraded its general
accounting and fixed assets systems to current releases which are Year 2000
compliant. The general accounting system upgrade was planned prior to the
emergence of the Year 2000 problem as a specific project; the cost of this
upgrade was approximately $30,000. The fixed asset system upgrade was
implemented earlier than originally planned in order to address the Year 2000
problem; the cost of this upgrade was approximately $3,500. The Company is
continuing to review its information technology ("IT") hardware and software for
Year 2000 compliance issues and has identified selected additional required
upgrades that in aggregate are expected to cost less that $20,000; the Company
has not completed its review at this time. The Company has not begun its review
of non-IT systems but expects to do this before the end of the current fiscal
year. The Company believes that the most significant risks associated with Year
2000 compliance exist in its general accounting system (which includes invoicing
and accounts receivable for its wholesale business) and within the systems of
the five banks with whom it maintains depository accounts as well as the credit
card processing services. The Company has not confirmed that these organizations
have Year 2000 compliant systems. The Company has no formal contingency plan at
this time. The Company has not yet determined the extent to which it will
develop a formal contingency plan.


                                       11
<PAGE>

         SEASONALITY AND QUARTERLY RESULTS. The Company's business is subject to
seasonal fluctuations as well as economic trends that affect retailers in
general. Historically, the Company's net sales have not been realized
proportionately in each quarter, with net sales being the highest during the
last fiscal quarter which includes the December holiday season. Hot weather
tends to reduce sales. Quarterly results are affected by the timing of the
opening of new stores, which may not occur as anticipated due to events outside
the Company's control. As a result of these factors, and of the other
contingencies and risk factors described elsewhere in this report, the financial
results for any individual quarter may not be indicative of the results that may
be achieved in a full fiscal year. Due to all of the foregoing and variables,
the Company's future earnings and the market price of the Company's securities
are subject to change. There can be no assurance of when the Company will return
to profitability nor of its future growth rate.

RESULTS OF OPERATIONS

THIRTEEN AND THIRTY-NINE WEEKS ENDED OCTOBER 28, 1998 COMPARED WITH THE 
THIRTEEN AND THIRTY-NINE WEEKS ENDED OCTOBER 29, 1997

         NET SALES. Net sales for the thirteen weeks ended October 28, 1998
increased 8.6% to $6,043,000 from $5,563,000 for the thirteen weeks ended
October 29, 1997. During this most recent quarter, the Company derived 87.2% of
net sales from its retail coffeehouse operations. The Company's wholesale and
mail order sales accounted for 11.2% of net sales and franchise area development
fees accounted for 1.7% of net sales. Net retail sales for the thirteen weeks
ended October 28, 1998 increased 5.6% to $5,269,000 from $4,989,000 in the
thirteen weeks October 29, 1997. As of October 28, 1998, the Company operated 36
coffeehouses and seven carts; as of October 29, 1997, the Company operated 36
coffeehouses and one cart. The percentage increase in comparable store sales was
1.3% during the third quarter of fiscal 1999.

         Wholesale and other sales increased 17.6% to $675,000 in the thirteen
weeks ended October 28, 1998 from $574,000 in the thirteen weeks ended October
29, 1997. The increase reflects increasing demand for the Company's wholesale
coffee products and increased sales efforts. Although the Company anticipates
continued improvement in wholesale sales, this depends upon successful marketing
of products produced using the new packaging equipment which the Company
acquired and installed in the second quarter. There can be no assurances that
the anticipated wholesale sales gains will happen.

          Net sales for the thirty-nine weeks ended October 28, 1998 increased
4.4% to $17,996,000 from $17,241,000 for the thirty-nine weeks ended October 29,
1997. Net retail sales for the thirty-nine weeks ended October 28, 1998
increased 1.7% to $15,897,000 from $15,632,000 in the thirty-nine weeks October
29, 1997. Wholesale and other sales for the thirty-nine weeks ended October 28,
1998 increased 24.2% to $1,999,000 from $1,609,000 for the thirty-nine weeks
ended October 29, 1997. The percentage increase in comparable store sales was
1.1% for the thirty-nine weeks ended October 28, 1998.

         COST OF SALES AND RELATED OCCUPANCY COSTS. Cost of roasted coffee,
dairy, food, paper and bar supplies, accessories and clothing (cost of sales)
and rent (related occupancy costs) for the thirteen weeks ended October 28, 1998
increased to $2,718,000 from $2,716,000 for the thirteen weeks ended October 29,
1997. As a percentage of net sales, cost of sales and related occupancy costs
decreased to 44.9% in the third quarter of fiscal 1999 from 48.8% for the third
quarter of fiscal 1998. This decreased percentage was the result of average unit
volume efficiencies resulting from the closure of low volume locations, lower
green coffee prices as well as purchasing efficiencies and the addition of
franchise area development revenues. These more than offset the impact of
increased occupancy costs, and an increase in the percentage of total revenues
contributed by wholesale sales.

         Cost of sales and related occupancy costs for the thirty-nine weeks
ended October 28, 1998 decreased to $8,114,000 from $8,619,000 for the
thirty-nine weeks ended October 29, 1997. As a percentage of net sales, costs of
sales and related occupancy costs decreased to 45.1% for the first three
quarters in fiscal 1999 from 50.0% for the first three quarters in fiscal 1998.
This decrease stems from lower green coffee prices, the closure of low volume
locations, and improved controls.


                                       12
<PAGE>

         STORE OPERATING EXPENSES. Store operating expenses increased to
$2,188,000 for the thirteen weeks ended October 28, 1998 from $2,029,000 for the
thirteen weeks ended October 29, 1997. As a percentage of retail net sales,
store operating expenses increased to 41.5% in the third quarter of fiscal 1999
from 40.7% in the prior fiscal year's third quarter. For the thirty-nine weeks
ended October 28, 1998, store operating expenses, as a percentage of retail net
sales, increased to 42.4% from 41.8% for the thirty-nine weeks ended October 29,
1997. These increases were due to additional management and related expenses at
the coffeehouse level.

         OTHER OPERATING EXPENSES. Other operating expenses (those associated
with wholesale and other sales) increased to $166,000 for the third quarter of
fiscal 1999 from $93,000 in the third quarter of fiscal 1998. These expenses, as
a percentage of the net sales from the wholesale division, increased to 24.5%
from 16.2%. For the thirty-nine weeks ended October 28, 1998, other operating
expenses, as a percentage of wholesale net sales, increased to 23.1% from 14.5%
for the thirty-nine weeks ended October 29, 1997. These increases reflect the
cost of additional management and sales staff recruited to further develop the
sales of the wholesale division. As a percentage of net sales these costs should
decrease as wholesale sales increase

         DEPRECIATION AND AMORTIZATION. Depreciation and amortization increased
to $491,000 for the thirteen weeks ended October 28, 1998 from $427,000 for the
thirteen weeks ended October 29, 1997. As a percentage of net sales,
depreciation and amortization increased to 8.1% in comparison to 7.7% in the
prior year. Depreciation and amortization increased to $1,434,000 for the
thirty-nine weeks ended October 28, 1998 from $1,313,000 for the thirty-nine
weeks ended October 29, 1997.

         GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative
expenses increased to $1,003,000 for the third quarter of fiscal 1999 from
$952,000 for the third quarter of fiscal 1998. As a percentage of net sales,
general and administrative expenses decreased to 16.6% from 17.1%. The Company
believes that it will continue to see a reduction in general and administrative
expenses relative to sales over the next several quarters as revenue flows
increase, assuming successful execution of the new business plan. As a
percentage of net sales, general and administrative expenses increased to 17.2%
for the thirty-nine weeks ended October 28, 1998 from 15.6% for the thirty-nine
weeks ended October 29, 1997 due to the ongoing costs associated with the
management resources added in the fourth quarter of fiscal 1998 and the first
half of fiscal 1999.

         PROVISION FOR STORE CLOSINGS AND RESTRUCTURING COSTS. The restructuring
charge recorded in fiscal 1998 included primarily lease termination and other
costs associated with store closures as well as a provision for the impairment
of long-lived assets in accordance with SFAS No. 121.

         INTEREST EXPENSE. Interest expense increased to $87,000 for the
thirteen weeks ended October 28, 1998 from $84,000 for the thirteen weeks ended
October 29, 1997. For the thirty-nine weeks ended October 28, 1998 interest and
other increased to $264,000 from $111,000 for the thirty-nine weeks ended
October 29, 1997; this increase resulted from the addition of the $2.5 million
in long-term debt and $553,000 in assets under capital leases.

         LOSS BEFORE TAXES. Loss before taxes for the thirteen weeks ended
October 28, 1998 was $609,000 compared to loss before taxes of $739,000 for the
thirteen weeks ended October 29, 1997. This decreased loss was primarily due to
franchise area development income and improved retail operating margins. Loss
before taxes for the thirty-nine weeks ended October 28, 1998 was $2,112,000
compared to a loss before taxes of $6,820,000 for the thirty-nine weeks ended
October 29, 1997. This change was principally the result of the restructuring
charge taken in the first quarter of fiscal 1998.

LIQUIDITY AND CAPITAL RESOURCES

         The Company had working capital deficit of $(961,000) as of October 28,
1998 compared to working capital deficit of $(959,000) as of January 28, 1998.
The current period working capital includes remaining restructuring liabilities
of $124,000. Cash used by operating activities for the thirty-nine weeks ended
October 28, 1998 totaled $(685,000).

                                      13

<PAGE>

         On April 3, 1998, the Company closed a private placement with Franchise
Mortgage Acceptance Company of Los Angeles, California ("FMAC") of 200,000
shares of Company restricted common stock at a price of $6.375 per share, or
approximately a $1,275,000 equity investment in the Company. In addition to the
private purchase, FMAC also acquired options to purchase restricted shares of
the Company's common stock, 50,000 shares at $10.00 and 50,000 shares at $12.50.
John Martin, Chairman of the Board of the Company, serves as a member of the
Board of Directors of FMAC.

         On April 14, 1998 the Company announced the commitment of Franchise 
Mortgage Acceptance Company ("FMAC") to make a secured loan of up to $5 
million to the Company. After extensive discussions, the Company determined 
that the structure required by FMAC was not in the Company's best interest. 
In anticipation of this possible outcome, the Company engaged an investment 
banker in November 1998 to seek alternative sources of capital. The Company 
is currently operating at a net cash deficit and, in addition to working with 
the investment bankers, is pursuing alternative sources of capital. 
Management believes that one or more of these sources will be in place by the 
end of the current fiscal year.

         The Company believes that cash from operations and the aforementioned
financing activities will be sufficient to satisfy the Company's working capital
needs through fiscal year 2000.

                      ITEM 3. QUANTITATIVE AND QUALITATIVE
                          DISCLOSURES ABOUT MARKET RISK

         DERIVATIVE INSTRUMENTS. The Company did not invest in market risk
sensitive instruments in fiscal 1998, nor in the first two quarters of 1999.
From time to time, the Company enters into agreements to purchase green coffee
in the future at prices to be determined within two to twelve months of the time
of actual purchase. At October 28, 1998 these commitments totaled $559,000.
These agreements are tied to specific market prices (defined by both the origin
of the coffee and the month of delivery) but the Company has significant
flexibility in selecting the date of the market price to be used in each
contract. The Company does not use commodity based financial instruments to
hedge coffee or any other commodity as the Company believes there will continue
to be a high probability of maintaining a strong correlation between increases
in green coffee prices and the final selling prices of the Company's products.

         MARKET RISK. The Company's market risk exposure with regard to
financial instruments is to changes in the "prime rate" in the United States.
The Company borrowed $2,500,000 at the prime rate plus 3 1/2%. At July 29, 1998,
a hypothetical 100 basis point increase in the prime rate would result in
additional interest expense of $25,278 on an annualized basis. At October 28,
1998 the prime rate was 8%.

         The Company does not and has not used derivative financial instruments
for any purpose, including hedging or mitigating interest rate risk.

                                      14
<PAGE>

                        PART II - OTHER INFORMATION

                         ITEM 1. LEGAL PROCEEDINGS

         In the ordinary course of its business, the Company may become 
involved in legal proceedings from time to time. As of December 1, 1998, the 
Company was not a party to any material pending legal proceedings.

                         ITEM 5. OTHER INFORMATION

         MINIMUM ADVANCE NOTICE OF STOCKHOLDER PROPOSALS.  Stockholders of 
the Company are advised that the Company must be notified at least 45 days 
prior to the month and day of mailing the prior year's proxy statement of any 
proposal or solicitation that any stockholder intends to present at the next 
annual meeting of stockholders AND which the stockholder has not sought to 
have included in the Company's Proxy Statement for the meeting in accordance 
with Rule 14a-8 under the Securities Exchange Act. If a proponent fails to 
notify the Company before the required deadline, management proxies will be 
allowed to use their discretionary voting authority when the proposal is 
raised at the annual meeting, without any discussion of the matter in the 
Company's Proxy Statement.

                 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.

(A)      EXHIBITS

         Set forth below is a list of the exhibits included as part of this 
Quarterly Report.

         <TABLE>
         <CAPTION>
         EXHIBIT NO.       DESCRIPTION
         -----------       -----------
         <S>               <C>
         3.1               Certificate of Incorporation of the Company (1)
         3.2               Bylaws of the Company (1)
         10.46             Form of Franchise Agreement
         10.47             Form of Area Development Agreement
         27                Financial data schedule
         </TABLE>

         (1)  Incorporated by reference to the exhibit of the same number to 
              the Company's Registration Statement on Form S-1 (No. 
              333-08633), as amended, as declared effective by the Securities 
              and Exchange Commission on September 11, 1996.

(B)      REPORTS ON FORM 8-K

         None.


                                      15
<PAGE>

                                  SIGNATURES

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

Dated: December 10, 1998        DIEDRICH COFFEE, INC.

                                /s/  TIMOTHY J. RYAN
                                -------------------------------------
                                Timothy J. Ryan,
                                President and Chief Executive Officer
                                (Principal Executive Officer)



                                /s/  ANN WRIDE
                                -------------------------------------
                                Ann Wride
                                Vice President and Chief Financial Officer
                                (Principal Financial and Accounting Officer)


                                      16