**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

 

----

 

**FORM 10-Q**

** **

**ý****  QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934**

** **

**For the quarterly period ended September 24,2003**

** **

**OR**

** **

**o****  TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934**

** **

**For the transition periodfrom                to                **

** **

**Commission file number 0-21203**

** **

**DIEDRICH COFFEE, INC.**

(Exact Name of Registrant as Specified in Its Charter)

 

| **DELAWARE**                                                    |   | **33-0086628**                    |
|-----------------------------------------------------------------|--------|-----------------------------------|
| (State or Other Jurisdiction of  Incorporation or Organization) |   | (IRS Employer Identification No.) |
|                                                            |   |                              |
| **28 EXECUTIVE PARK, SUITE 200  IRVINE, CALIFORNIA 92614**      |
| (Address of Principal Executive Offices, Including Zip Code)    |
|                                                            |   |                              |
| **(949) 260-1600**                                              |
| (Registrant’s Telephone Number, Including Area Code)       |

 

----

 

Indicate bycheck mark whether the registrant: (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. YES ýNO o

 

Indicate bycheck mark whether the registrant is an accelerated filer (as defined in Rule12b-2 of the Exchange Act). YES o NOý

 

As of November6, 2003, there were 5,161,267 shares of common stock of the registrantoutstanding.

 

 

----

 

**DIEDRICH COFFEE, INC.**

**INDEX**

 
| **PART I -  FINANCIAL INFORMATION** |
|-------------------------------------|
|                                |   |
| Item 1.                             | Financial Statements |
|                                |   |
|                                | Condensed Consolidated Balance Sheets  (Unaudited) |
|                                |   |
|                                | Condensed Consolidated Statements of  Operations (Unaudited) |
|                                |   |
|                                | Condensed Consolidated Statements of Cash Flows (Unaudited) |
|                                |   |
|                                | Notes to  Condensed Consolidated Financial Statements (Unaudited) |
|                                |   |
| Item 2.                             | Management’s Discussion and Analysis of  Financial Condition and Results of Operations |
|                                |   |
| Item 3.                             | Quantitative and Qualitative Disclosures  About Market Risk |
|                                |   |
| Item 4.                             | Controls and Procedures |
|                                |   |
| **PART II  - OTHER INFORMATION**    |
|                                |   |
| Item 1.                             | Legal Proceedings |
|                                |   |
| Item 6.                             | Exhibits and Reports on Form 8-K |
|                                |   |
|                                | Signatures |

 

i

----

 

**PART I****- FINANCIALINFORMATION**

 

**Item1****.****           Financial Statements.**

 

DIEDRICH COFFEE, INC.

CONDENSED CONSOLIDATED BALANCESHEETS

(UNAUDITED)

 
|                                                                                                                                         |   | **September 24, 2003** |       | **July 2, 2003** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------|------------|------------------|--------|
|                                                                                                                                         |   |                   |       |             |   |
| **Assets**                                                                                                                                   |   |                   |       |             |   |
| Current assets:                                                                                                                              |   |                   |       |             |   |
| Cash                                                                                                                                         |   | $                      | 1,763,000  |             | $      | 2,625,000 |   |
| Accounts receivable, less allowance for  doubtful accounts of $1,427,000 at September 24, 2003, and $1,375,000 at July  2, 2003              |   | 2,517,000              |       | 2,454,000        |   |
| Inventories                                                                                                                                  |   | 3,251,000              |       | 2,611,000        |   |
| Current portion of notes receivable                                                                                                          |   | 55,000                 |       | 58,000           |   |
| Prepaid expenses                                                                                                                             |   | 456,000                |       | 901,000          |   |
| Total current assets                                                                                                                         |   | 8,042,000              |       | 8,649,000        |   |
| Property and equipment, net                                                                                                                  |   | 6,966,000              |       | 7,052,000        |   |
| Goodwill                                                                                                                                     |   | 10,190,000             |       | 10,190,000       |   |
| Notes receivable                                                                                                                             |   | 173,000                |       | 182,000          |   |
| Other assets                                                                                                                                 |   | 510,000                |       | 469,000          |   |
| Total assets                                                                                                                                 |   | $                      | 25,881,000 |             | $      | 26,542,000 |   |
|                                                                                                                                         |   |                   |       |             |   |
| **Liabilities and Stockholders’ Equity**                                                                                                |   |                   |       |             |   |
| Current liabilities:                                                                                                                         |   |                   |       |             |   |
| Current installments of obligations under  capital leases                                                                                    |   | $                      | 178,000    |             | $      | 185,000 |   |
| Current installments of long-term debt                                                                                                       |   | 1,517,000              |       | 1,459,000        |   |
| Accounts payable                                                                                                                             |   | 2,072,000              |       | 2,108,000        |   |
| Accrued compensation                                                                                                                         |   | 1,490,000              |       | 1,307,000        |   |
| Accrued expenses                                                                                                                             |   | 638,000                |       | 738,000          |   |
| Franchisee deposits                                                                                                                          |   | 654,000                |       | 671,000          |   |
| Deferred franchise fee income                                                                                                                |   | 536,000                |       | 549,000          |   |
| Accrued provision for store closure                                                                                                          |   | 433,000                |       | 425,000          |   |
| Total current liabilities                                                                                                                    |   | 7,518,000              |       | 7,442,000        |   |
| Obligations under capital leases, excluding  current installments                                                                            |   | 514,000                |       | 542,000          |   |
| Long term debt, excluding current  installments                                                                                              |   | 1,107,000              |       | 1,491,000        |   |
| Deferred rent                                                                                                                                |   | 454,000                |       | 478,000          |   |
| Total liabilities                                                                                                                            |   | 9,593,000              |       | 9,953,000        |   |
| Stockholders’ equity:                                                                                                                   |   |                   |       |             |   |
| Common stock, $0.01 par value; authorized  8,750,000 shares; issued and outstanding 5,161,000 shares at September 24,  2003 and July 2, 2003 |   | 52,000                 |       | 52,000           |   |
| Additional paid-in capital                                                                                                                   |   | 58,036,000             |       | 58,036,000       |   |
| Accumulated deficit                                                                                                                          |   | (41,800,000            | )          | (41,499,000      | )      |
| Total stockholders’ equity                                                                                                              |   | 16,288,000             |       | 16,589,000       |   |
| Commitments and contingencies                                                                                                                |   |                   |       |             |   |
| Total liabilities and stockholders’ equity                                                                                              |   | $                      | 25,881,000 |             | $      | 26,542,000 |   |

 

*See accompanyingnotes to condensed consolidated financial statements.*

 

1

----

 

DIEDRICH COFFEE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

 
|                                                          |   | **Twelve  Weeks Ended  September 24, 2003** |      | **Twelve  Weeks Ended  September 25, 2002** |   |
|---------------------------------------------------------------|--------|---------------------------------------------|-----------|---------------------------------------------|--------|
| Net Revenue:                                                  |   |                                        |      |                                        |   |
| Retail sales                                                  |   | $                                           | 6,873,000 |                                        | $      | 7,857,000 |   |
| Wholesale and other                                           |   | 2,874,000                                   |      | 3,035,000                                   |   |
| Franchise revenue                                             |   | 1,564,000                                   |      | 1,454,000                                   |   |
| Total revenue                                                 |   | 11,311,000                                  |      | 12,346,000                                  |   |
|                                                          |   |                                        |      |                                        |   |
| Costs and Expenses:                                           |   |                                        |      |                                        |   |
| Cost of sales and related occupancy costs                     |   | 5,111,000                                   |      | 5,712,000                                   |   |
| Operating expenses                                            |   | 3,700,000                                   |      | 4,031,000                                   |   |
| Depreciation and amortization                                 |   | 587,000                                     |      | 445,000                                     |   |
| General and administrative expenses                           |   | 2,144,000                                   |      | 2,093,000                                   |   |
| Gain on asset disposals                                       |   | —                                      |      | (20,000                                     | )      |
| Provision for asset impairment and  restructuring costs       |   | 4,000                                       |      | —                                      |   |
| Total costs and expenses                                      |   | 11,546,000                                  |      | 12,261,000                                  |   |
|                                                          |   |                                        |      |                                        |   |
| Operating income (loss)                                       |   | (235,000                                    | )         | 85,000                                      |   |
|                                                          |   |                                        |      |                                        |   |
| Interest expense                                              |   | (63,000                                     | )         | (93,000                                     | )      |
| Interest and other income, net                                |   | 6,000                                       |      | 11,000                                      |   |
| Income (loss) before income tax provision                     |   | (292,000                                    | )         | 3,000                                       |   |
|                                                          |   |                                        |      |                                        |   |
| Income tax provision                                          |   | 9,000                                       |      | 13,000                                      |   |
|                                                          |   |                                        |      |                                        |   |
| Net loss                                                      |   | $                                           | (301,000  | )                                           | $      | (10,000 | ) |
|                                                          |   |                                        |      |                                        |   |
| Net loss per share – basic and diluted                   |   | $                                           | (0.06     | )                                           | $      | 0.00 |   |
|                                                          |   |                                        |      |                                        |   |
| Weighted average shares outstanding – basic  and diluted |   | 5,161,000                                   |      | 5,161,000                                   |   |

 

*See accompanyingnotes to condensed consolidated financial statements.*

 

2

----

 

DIEDRICH COFFEE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

 
|                                                                                       |   | **Twelve  Weeks Ended  September 24, 2003** |      | **Twelve  Weeks Ended  September 25, 2002** |   |
|--------------------------------------------------------------------------------------------|--------|---------------------------------------------|-----------|---------------------------------------------|--------|
| Cash flows from operating activities:                                                      |   |                                        |      |                                        |   |
| Net loss                                                                                   |   | $                                           | (301,000  | )                                           | $      | (10,000 | ) |
| Adjustments to reconcile net loss to net cash provided by (used in)  operating activities: |   |                                        |      |                                        |   |
| Depreciation and amortization                                                              |   | 587,000                                     |      | 445,000                                     |   |
| Amortization of loan fees                                                                  |   | 20,000                                      |      | 33,000                                      |   |
| Provision for bad debt                                                                     |   | 66,000                                      |      | 23,000                                      |   |
| Provision for store closure                                                                |   | 35,000                                      |      | 5,000                                       |   |
| Gain on disposal of assets                                                                 |   | —                                      |      | (20,000                                     | )      |
| Changes in operating assets and  liabilities:                                              |   |                                        |      |                                        |   |
| Accounts receivable                                                                        |   | (129,000                                    | )         | (399,000                                    | )      |
| Inventories                                                                                |   | (640,000                                    | )         | (647,000                                    | )      |
| Prepaid expenses                                                                           |   | 445,000                                     |      | 296,000                                     |   |
| Other assets                                                                               |   | (62,000                                     | )         | (125,000                                    | )      |
| Accounts payable                                                                           |   | (36,000                                     | )         | 222,000                                     |   |
| Accrued compensation                                                                       |   | 183,000                                     |      | 321,000                                     |   |
| Accrued expenses                                                                           |   | (100,000                                    | )         | (23,000                                     | )      |
| Accrued provision for store closure                                                        |   | (27,000                                     | )         | (72,000                                     | )      |
| Deferred franchise fee income and  franchisee deposits                                     |   | (30,000                                     | )         | 117,000                                     |   |
| Deferred rent                                                                              |   | (24,000                                     | )         | 1,000                                       |   |
| Net cash provided by (used in) operating  activities                                       |   | (13,000                                     | )         | 167,000                                     |   |
| Cash flows from investing activities:                                                      |   |                                        |      |                                        |   |
| Capital expenditures for property and  equipment                                           |   | (502,000                                    | )         | (205,000                                    | )      |
| Proceeds from disposal of property and  equipment                                          |   | 2,000                                       |      | 140,000                                     |   |
| Payments received on notes receivable                                                      |   | 12,000                                      |      | 11,000                                      |   |
| Net cash used in investing activities                                                      |   | (488,000                                    | )         | (54,000                                     | )      |
| Cash flows from financing activities:                                                      |   |                                        |      |                                        |   |
| Payments on long-term debt                                                                 |   | (326,000                                    | )         | (226,000                                    | )      |
| Payments on capital lease obligations                                                      |   | (35,000                                     | )         | (46,000                                     | )      |
| Net cash used in financing activities                                                      |   | (361,000                                    | )         | (272,000                                    | )      |
|                                                                                       |   |                                        |      |                                        |   |
| Net decrease in cash                                                                       |   | (862,000                                    | )         | (159,000                                    | )      |
| Cash at beginning of period                                                                |   | 2,625,000                                   |      | 2,233,000                                   |   |
| Cash at end of period                                                                      |   | $                                           | 1,763,000 |                                        | $      | 2,074,000 |   |
|                                                                                       |   |                                        |      |                                        |   |
| Supplemental disclosure of cash flow  information:                                         |   |                                        |      |                                        |   |
| Cash paid during the period for:                                                           |   |                                        |      |                                        |   |
| Interest                                                                                   |   | $                                           | 33,000    |                                        | $      | 55,000 |   |
| Income taxes                                                                               |   | $                                           | 9,000     |                                        | $      | 14,000 |   |

* *

*See accompanyingnotes to consolidated financial statements.*

 

3

----

 

**DIEDRICH COFFEE, INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTSSEPTEMBER 24, 2003(UNAUDITED)**

 

1.                                       SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES

 

*Basis of Presentation*

 

The unauditedcondensed consolidated financial statements of Diedrich Coffee, Inc.  and its subsidiaries (the “Company”) havebeen prepared in accordance with generally accepted accounting principles, aswell as the instructions 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 opinionof management, all adjustments (consisting of normal, recurring adjustments andaccruals) considered necessary for a fair presentation have been included.  Operating results for interim periods arenot necessarily indicative of the results expected for a full year.

 

*Stock Option Plans*

 

The Companyapplies the intrinsic value-method of accounting prescribed by AccountingPrinciples Board (“APB”) Opinion No. 25, “Accounting for Stock Issued toEmployees,” and related interpretations, in accounting for employee stockoptions. As such, compensation expense would be recorded on the date of grantonly if the current market price of the underlying stock exceeded the exerciseprice. Statement of Financial Accounting Standards (“SFAS”) No. 123,“Accounting for Stock-Based Compensation,” established accounting anddisclosure requirements using a fair value-based method of accounting forstock-based employee compensation plans. In December 2002, the Financial Accounting Standards Board(“FASB”) issued SFAS No. 148, “Accounting for Stock-BasedCompensation — Transition and Disclosure.” SFAS No. 148 amends SFASNo. 123 to provide alternative methods of transition for a voluntary change tothe fair value method of accounting for stock-based employee compensation. Inaddition, SFAS No. 148 amends the disclosure requirements of SFASNo. 123 to require prominent disclosures in both annual and interimfinancial statements about the method of accounting for stock-based employeecompensation and the effect of the method on reported results. The Company hasadopted the disclosure provisions of SFAS No. 148 and continues to followAPB 25 for stock-based employee compensation.

 

Pro forma netloss and pro forma net loss per share, as if the fair value-based method hasbeen applied in measuring compensation cost for stock-based awards, is asfollows:

 
|                                                                     |   | **September  24, 2003** |     | **September  25, 2002** |   |
|--------------------------------------------------------------------------|--------|-------------------------|----------|-------------------------|--------|
| **Pro Forma**                                                            |   |                    |     |                    |   |
| Net loss                                                                 |   | $                       | (301,000 | )                       | $      | (10,000 | ) |
| Stock based employee compensation expense  included in reported net loss |   | —                  |     | —                  |   |
| SFAS 123 option expense                                                  |   | (160,000                | )        | (57,000                 | )      |
| Pro forma net loss                                                       |   | $                       | (461,000 | )                       | $      | (67,000 | ) |
| Basic and diluted loss per share                                         |   | $                       | (0.09    | )                       | $      | (0.01 | ) |

 

4

----

 

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

 
|                     |   | **September  24, 2003** |   | **September  25, 2002** |   |
|--------------------------|--------|-------------------------|--------|-------------------------|--------|
|                     |   |                    |   |                    |   |
| Risk free  interest rate |   | N/A                     |   | 2.57%                   |   |
| Expected  life           |   | N/A                     |   | 6 years                 |   |
| Expected  volatility     |   | N/A                     |   | 99%                     |   |
| Expected  dividend yield |   | N/A                     |   | 0%                      |   |

 

*Reclassifications*

 

Certain reclassifications havebeen made to the September 25, 2002 consolidated financial statements toconform to the September 24, 2003 presentation.

 

2.                                       INVENTORIES

 

Inventoriesconsist of the following:

 
|                              |   | **September 24, 2003** |      | **July 2, 2003** |   |
|-----------------------------------|--------|------------------------|-----------|------------------|--------|
| Unroasted coffee                  |   | $                      | 1,328,000 |             | $      | 1,034,000 |   |
| Roasted coffee                    |   | 697,000                |      | 572,000          |   |
| Accessory and specialty items     |   | 151,000                |      | 163,000          |   |
| Other food, beverage and supplies |   | 1,075,000              |      | 842,000          |   |
|                              |   | $                      | 3,251,000 |             | $      | 2,611,000 |   |

 

3.                                       LONG-TERMDEBT

 

Long-term debtconsists of the following:

 
|                                                                                                                                                                                                                                                                     |   | **September 24, 2003** |      | **July 2, 2003** |   |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------|-----------|------------------|--------|
| **Bank of the West**                                                                                                                                                                                                                                                     |   |                   |      |             |   |
| Note payable bearing interest at a rate of  3.25% over LIBOR, or 4.20% as of September 24, 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 its subsidiaries’ stock. |   | $                      | 1,700,000 |             | $      | 2,000,000 |   |
| **Bank of the West**                                                                                                                                                                                                                                                     |   |                   |      |             |   |
| Note payable bearing interest at a rate of  5.77% as of September 24, 2003 and payable in monthly installments of $26,000  plus interest. Due August 28, 2006. Note is secured by coffee packaging  equipment.                                                           |   | 924,000                |      | 950,000          |   |
|                                                                                                                                                                                                                                                                     |   | 2,624,000              |      | 2,950,000        |   |
| Less: current installments                                                                                                                                                                                                                                               |   | (1,517,000             | )         | (1,459,000       | )      |
| Long-term debt, excluding current  installments                                                                                                                                                                                                                          |   | $                      | 1,107,000 |             | $      | 1,491,000 |   |

 

On September3, 2002, the Company entered into a credit agreement (the “Credit Agreement”)with United California Bank, doing business as Bank of the West (“BOW”), inorder to repay the balance of all remaining amounts it owed to Fleet NationalBank (“Fleet”) under the Company’s credit agreement

 

5

----

 

with Fleet. Under the CreditAgreement, the Company immediately borrowed $3,000,000 under a replacement termloan, the proceeds of which were used to repay the Fleet term loan on September3, 2002, the amended maturity date of the Fleet term loan.

 

The Company’sobligations under the Credit Agreement are secured by all of the Company’sassets, including the stock of each of its subsidiaries (each of which hasguaranteed the Company’s obligations under the Credit Agreement), as well asall intangible assets it owns, including the intellectual property andtrademark assets that the Company and its subsidiaries own.

 

The term loanwith BOW requires monthly principal payments of $100,000 over 30 months and allamounts the Company owes under the term loan must be repaid by March 31,2005.  The Company is required to makemonthly interest payments on amounts outstanding under the term loan, computedat either BOW’s prime rate plus 1.0% or a LIBOR rate plus 3.25%.  At September 24, 2003, the applicableinterest rate was 4.20%, which was based on the LIBOR rate plus 3.25%.  The Company may periodically elect toconvert portions of its prime rate-based borrowings under the Credit Agreementinto LIBOR based borrowings in $100,000 increments, subject to restrictionscontained in the Credit Agreement.

 

In addition tothe $3,000,000 term loan, the Credit Agreement provided the Company with arevolving $1,000,000 equipment acquisition credit line for the acquisition ofspecified coffee packaging equipment. On April 10, 2003, the Company borrowed$950,000 under this revolving credit line, which converted to a term loan onAugust 28, 2003. The equipment term loan is secured by the coffee packagingequipment purchased with the proceeds, and, effective October 1, 2003, arestricted cash balance on deposit with BOW equal to the lesser of $800,000 orthe outstanding principal balance of the equipment term loan. The equipmentterm loan calls for monthly principal payments of $26,000 plus interest at afixed rate of 5.77% through the maturity date of August 28, 2006.

 

The CreditAgreement also provides the Company with a $675,000 revolving working capitaland letter of credit facility, subject to a number of restrictions. TheCompany’s working capital facility draws and letters of credit are limited to acombined maximum of $675,000 outstanding at any time. Furthermore, drawdownsagainst the working capital facility are subject to a sub-limit of $500,000,and letters of credit are subject to a sub-limit of $250,000.  The Company is permitted to draw fundsagainst the working capital facility throughout the fiscal year and may repayamounts that it borrows under the working capital facility at any time.Therefore, the Company may be able to re-borrow such funds on a revolving basis(subject to restrictions).  The workingcapital facility matures on April 15, 2004 and the letter of credit facilitymatures on October 15, 2004.  Anypayments made by BOW with regard to any letter of credit issued under theletter of credit facility must be repaid by the Company immediately upon thedate of such payment by BOW.  As ofSeptember 24, 2003, BOW had issued one letter of credit for $179,000.

 

In October2003, BOW provided the Company with an additional facility for issuance of upto $250,000 of letters of credit.  Thenew facility provides that issued letters of credit are to be secured byrestricted cash balances of an equal amount maintained on deposit with BOW.

 

The Company issubject to a number of restrictions under the Credit Agreement, as amended.  These include limitations on the Company’sability to sell assets, make capital expenditures, incur additionalindebtedness, permit new liens upon the Company’s assets, and pay dividends onor repurchase its common stock. The Company must also maintain compliance withagreed-upon financial covenants that require the Company to maintain aspecified minimum dollar value level of tangible net worth, maintain aspecified 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 and,effective October 1, 2003, requires the Company to maintain restricted cashbalances on deposit with BOW equal to the lesser of $800,000 or the outstandingprincipal balance of its equipment term loan. As of September 24, 2003, the Company was in compliance with thesecovenants.

 

Maturities oflong-term debt for years subsequent to September 24, 2003 are as follows:

 

6

----

 

| **Fiscal Year**      |   |    | ** ** |
|----------------------|--------|---------|------------|
| 2004                 |   | $       | 1,517,000  |   |
| 2005                 |   | 817,000 |       |
| 2006                 |   | 290,000 |       |
| Total long-term debt |   | $       | 2,624,000  |   |

 

4.                                       ACCRUEDPROVISION FOR STORE CLOSURE

 

Prior toDecember 31, 2002, the estimated cost associated with closing under-performingstores was accrued in the period in which the store was identified for closureby management under a plan of termination. Effective December 31, 2002, the Companyadopted SFAS No. 146, “Accounting for Costs Associated with Exit or DisposalActivities,” and now records these estimated costs when they are incurredrather than at the date of a commitment to an exit or disposal plan. Such costsprimarily consist of the estimated cost to terminate 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 |   |
| Twelve weeks ended September 24, 2003 |   | $               | 425,000 |                             | $      | 35,000          |   | $                  | —   |             | $      | (27,000 | ) | $ | 433,000 |   |
|                                                 |        |                 |         |                                  |        |                 |        |                    |          |                  |        |  |  |  |  |  |  |

 

For the twelveweeks ended September 24, 2003, the $35,000 of amounts charged to expense werecomprised of a $31,000 charge to cost of sales and related occupancy costs anda $4,000 charge to the provision for asset impairment. These charges primarilyrelated to negotiated lease settlements finalized during the first quarter offiscal 2004.

 

5.                                       EARNINGSPER SHARE

 

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

 
|                                                |   | **Twelve  Weeks Ended  September 24, 2003** |     | **Twelve  Weeks Ended  September 25, 2002** |   |
|-----------------------------------------------------|--------|---------------------------------------------|----------|---------------------------------------------|--------|
| **Numerator:**                                      |   |                                        |     |                                        |   |
| Net loss                                            |   | $                                           | (301,000 | )                                           | $      | (10,000 | ) |
| **Denominator:**                                    |   |                                        |     |                                        |   |
| Basic weighted average common shares  outstanding   |   | 5,161,000                                   |     | 5,161,000                                   |   |
| Effect of dilutive securities                       |   | —                                      |     | —                                      |   |
| Diluted weighted average common shares  outstanding |   | 5,161,000                                   |     | 5,161,000                                   |   |
|                                                |   |                                        |     |                                        |   |
| Basic and diluted net loss per share                |   | $                                           | (0.06    | )                                           | $      | (0.00 | ) |

 

All 748,000options outstanding and all of the 730,000 warrants to purchase shares ofcommon stock outstanding during the twelve weeks ended September 24, 2003 wereexcluded from the calculation of diluted net loss per share as their inclusionwould have been anti-dilutive.  All619,000 options outstanding and all of the 730,000 warrants to purchase sharesof common stock outstanding during the twelve weeks ended September 25, 2002were excluded from the calculation of diluted net loss per share as theirinclusion would have been anti-dilutive.

 

7

----

 

6.                                       SEGMENTAND RELATED INFORMATION

 

The Companyhas three reportable segments:  retail,wholesale, and franchise operations. The Company evaluates performance of its operating segments based onincome before income taxes.

 

Summarizedfinancial information concerning the Company’s reportable segments is shown inthe following table.  The other totalassets consist of corporate cash, corporate notes receivable, corporate prepaidexpenses, and corporate property and equipment.  The other component of segment profit before tax includescorporate general and administrative expenses, depreciation and amortizationexpense and interest expense.

 
|                                               |   | **Retail  Operations** |      | **Wholesale  Operations** |   | **Franchise  Operations** |   | **Other**  |      | **Total** |   |
|----------------------------------------------------|--------|------------------------|-----------|---------------------------|--------|---------------------------|--------|------------|-----------|-----------|--------|
| **Twelve Weeks Ended September 24, 2003**          |   |                   |      |                      |   |                      |   |       |      |      |   |
| Total revenue                                      |   | $                      | 6,873,000 |                      | $      | 2,874,000                 |   | $          | 1,564,000 |      | $      | — |   | $ | 11,311,000 |   |
| Interest expense                                   |   | 6,000                  |      | —                    |   | 10,000                    |   | 47,000     |      | 63,000    |   |
| Depreciation and amortization                      |   | 273,000                |      | 139,000                   |   | —                    |   | 175,000    |      | 587,000   |   |
| Segment income (loss) before income tax  provision |   | 159,000                |      | 429,000                   |   | 1,479,000                 |   | (2,359,000 | )         | (292,000  | )      |
| Total assets as of September 24, 2003              |   | $                      | 6,410,000 |                      | $      | 12,669,000                |   | $          | 3,958,000 |      | $      | 2,844,000 |   | $ | 25,881,000 |   |

 
|                                               |   | **Retail  Operations** |      | **Wholesale  Operations** |   | **Franchise  Operations** |   | **Other**  |      | **Total** |   |
|----------------------------------------------------|--------|------------------------|-----------|---------------------------|--------|---------------------------|--------|------------|-----------|-----------|--------|
| **Twelve Weeks Ended September 25, 2002**          |   |                   |      |                      |   |                      |   |       |      |      |   |
| Total revenue                                      |   | $                      | 7,857,000 |                      | $      | 3,035,000                 |   | $          | 1,454,000 |      | $      | — |   | $ | 12,346,000 |   |
| Interest expense                                   |   | 8,000                  |      | —                    |   | 14,000                    |   | 71,000     |      | 93,000    |   |
| Depreciation and amortization                      |   | 311,000                |      | 75,000                    |   | —                    |   | 59,000     |      | 445,000   |   |
| Segment income (loss) before income tax  provision |   | 334,000                |      | 486,000                   |   | 1,375,000                 |   | (2,192,000 | )         | 3,000     |   |
| Total assets as of July 2, 2003                    |   | $                      | 6,834,000 |                      | $      | 11,895,000                |   | $          | 3,985,000 |      | $      | 3,828,000 |   | $ | 26,542,000 |   |

 

7.                                       INTANGIBLEASSETS

 

Effective June28, 2001, the Company adopted SFAS Nos. 141 and 142, “Business Combinations”and “Goodwill and Other Intangible Assets,” respectively, which require thatthe Company prospectively cease amortization of goodwill and instead conductperiodic tests of goodwill for impairment.

 

There were nochanges in the carrying amount of goodwill for the twelve weeks ended September24, 2003.

 

Goodwill bysegment was as follows:

 
|                 |   | **September  24,  2003** |       | **July 2,  2003** |       |
|----------------------|--------|--------------------------|------------|-------------------|------------|
|                 |   |                     | ** ** |              | ** ** |
| Retail Operations    |   | $                        | 1,267,000  |              | $          | 1,267,000 |   |
| Franchise Operations |   | 6,311,000                |       | 6,311,000         |       |
| Wholesale Operations |   | 2,612,000                |       | 2,612,000         |       |
| Goodwill             |   | $                        | 10,190,000 |              | $          | 10,190,000 |   |

 

8

----

 

8.                                       LEASECONTINGENCIES

 

We are liableon the master leases for 119 franchise locations. Under our historicalfranchising business model, we executed the master leases for these locations,and entered into subleases on the same terms with our franchisees, whichtypically pay their rent directly to the landlords. If any of these franchiseesdefault on their subleases, we would be required to make all payments under themaster leases. Our maximum theoretical future exposure at September 24, 2003,computed as the sum of all remaining lease payments through the expirationdates of the respective leases, was $18,991,000. 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.

 

9

----

 

**Item 2****.****           Management’sDiscussion And Analysis Of Financial Condition And Results Of Operations.**

 

**AWarning About Forward Looking Statements.**

 

We makeforward-looking statements in this quarterly report that are subject to risksand uncertainties.  Theseforward-looking statements include information about possible or assumed futureresults of our financial condition, operations, plans, objectives andperformance. Additionally, when we use the words “believe,” “expect,”“anticipate,” “estimate” or similar expressions, we are making forward-lookingstatements.  Many possible events orfactors could affect our future financial results and performance.  This could cause our results or performanceto differ materially from those expressed in our forward-looking statements.You should consider these risks when you review this document, along with thefollowing 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.

 

Foreseeablerisks and uncertainties are described elsewhere in this report and in detailunder the caption “Risk Factors and Trends Affecting Diedrich Coffee and ItsBusiness” in our Annual Report on Form 10-K/A for the fiscal year ended July 2,2003 and in other reports that we file with the Securities and ExchangeCommission. We undertake no obligation to publicly release the results of anyrevision of the forward-looking statements. Unless otherwise indicated, “we,”“us,” “our,” and similar terms refer to Diedrich Coffee, Inc.

 

**General.**

 

DiedrichCoffee, Inc. is a specialty coffee roaster, wholesaler and retailer.  We sell brewed, espresso-based and variousblended beverages primarily made from our own fresh roasted premium coffeebeans, as well as light food items, whole bean coffee, and accessories throughour Company operated and franchised retail locations.  We also sell whole bean and ground coffees on a wholesale basisthrough a network of distributors in the Office Coffee Service (“OCS”) market,and to other wholesale customers, including restaurant chains and otherretailers.  Our brands include DiedrichCoffee, Gloria Jean’s Coffees, and Coffee People.  As of September 24, 2003, we owned and operated 58 retaillocations and franchised 372 other retail locations under these brands, for atotal of 430 retail coffee outlets.  Ourretail units are located in 36 states and 10 foreign countries.  As of September 24, 2003, we also had over230 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 retailoutlet distribution channel can be divided into two sub-channels, each with itsown distinct business model, including differences in revenue and coststructure, overhead, and capital requirements. These two retail sub-channels are Company operated retail outlets andfranchised retail

 

10

----

 

outlets.  We view retail outlets as a singledistribution channel, despite the differences noted above, primarily becauseour retail customers do not make any distinction between Company and franchiseoperated locations.  The criticalsuccess factors are, therefore, the same for each type of retail location,whether Company operated or franchised: quality of product, service, andatmosphere.  The economic model and coststructures are also the same for each type of location at the retail unitlevel, notwithstanding their different direct financial impacts on us in ourroles as both an operator and franchiser of retail outlets.  Furthermore, the potential contribution ofany given outlet, as measured by the amount of roasted coffee produced throughour roasting plant, is the same.

 

Presently, ourlargest brand is Gloria Jean’s and over 97% of Gloria Jean’s retail units arefranchised. Gloria Jean’s retail units are located throughout the UnitedStates, and in 10 foreign countries. Our Diedrich Coffee brand has a higher concentrationof Company operated units, with over 78% of retail locations operated byus.  Diedrich Coffee units are locatedprimarily in Orange County, California, although there are a number of DiedrichCoffee locations in Los Angeles, San Diego, Denver, Houston, and elsewhere inthe United States. We also operate retail coffee outlets under a third brand,Coffee People, which are 100% Company operated at this time. Our Coffee Peopleoutlets are all located in Portland, Oregon.

 

A tablesummarizing the relative sizes of each of our brands, on a unit count basis,and changes in unit count for each over the first quarter ended September 24,2003, is set forth below:

 
|                           |   | **Units at  July 2,  2003** |   | **Opened** |   | **Closed** |   | **Net  transfers  between the  Company and  Franchise** |   | **Units at  September 24,  2003** |   |
|--------------------------------|--------|-----------------------------|--------|------------|--------|------------|--------|---------------------------------------------------------|--------|-----------------------------------|--------|
| **Gloria Jean’s Brand**   |   |                        |   |       |   |       |   |                                                    |   |                              |   |
| Company Operated               |   | 11                          |   | —     |   | —     |   |                                                    |   | 11                                |   |
| Franchise – Domestic      |   | 143                         |   | 3          |   | (4         | )      |                                                    |   | 142                               |   |
| Franchise – International |   | 206                         |   | 19         |   | (2         | )      | —                                                  |   | 223                               |   |
| Subtotal Gloria Jean’s    |   | 360                         |   | 22         |   | (6         | )      | —                                                  |   | 376                               |   |
| **Diedrich Coffee Brand**      |   |                        |   |       |   |       |   |                                                    |   |                              |   |
| Company Operated               |   | 25                          |   |       |   | —     |   | —                                                  |   | 25                                |   |
| Franchise – Domestic      |   | 10                          |   | —     |   | (3         | )      | —                                                  |   | 7                                 |   |
| Subtotal Diedrich              |   | 35                          |   | —     |   | (3         | )      | —                                                  |   | 32                                |   |
| **Other Brands**               |   |                        |   |       |   |       |   |                                                    |   |                              |   |
| Company Operated               |   | 22                          |   | —     |   | —     |   | —                                                  |   | 22                                |   |
| **Total**                      |   | 417                         |   | 22         |   | (9         | )      | —                                                  |   | 430                               |   |

 

*Wholesale Distribution*

* *

We presentlyhave over 230 wholesale accounts not affiliated with our retail locations,which purchase coffee from us under both the Diedrich Coffee and Gloria Jean’sbrands. Our current wholesale accounts are in the Office Coffee Supply market,chain restaurants, independent restaurants, other hospitality industryenterprises and specialty retailers. Additionally, our franchise agreements require both Diedrich Coffee andGloria Jean’s franchisees to purchase substantially all of their coffee fromus.

 

*Seasonality and Quarterly Results*

* *

Our businessis subject to seasonal fluctuations as well as economic trends that affectretailers in general. Historically, our net sales are highest during the secondfiscal quarter, which includes the November – December holiday season. Hotweather tends to reduce sales. Quarterly results are affected by the timing ofthe opening of new stores, which may not occur as anticipated due to eventsoutside our control. As a result of these factors, the financial results forany individual quarter may not be indicative of the results that may beachieved in a full fiscal year.

 

11

----

 

**Resultsof Operations.**

 

*Twelve WeeksEnded September 24, 2003 Compared with the Twelve Weeks Ended September 25,2002*

* *

***Total Revenue.***  Total revenue for the twelve weeks endedSeptember 24, 2003 decreased by $1,035,000, or 8.4%, to $11,311,000 from$12,346,000 for the twelve weeks ended September 25, 2002. This decrease wasattributable to decreases in the retail and wholesale segments, partiallyoffset by an increase in franchise revenue. Each component is discussed below.

 

Retail salesfor the twelve weeks ended September 24, 2003 decreased by $984,000, or 12.5%,to $6,873,000 from $7,857,000 for the prior year period.  This decrease is primarily composed of twofactors.  First, retail sales decreasedby approximately $741,000 due to the decrease in the number of Company storesin the current year as a result of the closure of six Company operatedlocations since the prior year period, and the sale of six other Companyoperated locations to franchisees. Second, year-to-year same store sales declined by 3.3%.  These decreases were slightly offset bya  $22,000 increase in e-commerce retailsales.

 

Wholesalerevenue decreased $161,000, or 5.3%, to $2,874,000 for the twelve weeks endedSeptember 24, 2003 from $3,035,000 for the prior year period. Wholesale salesof roasted coffee to our franchisees decreased $200,000, or 15.0%, primarilydue to a 19-unit decrease in the number of domestic franchise stores whencompared to the prior year period. Additionally, wholesale sales to independent and chain restaurants andspecialty retailers declined by $16,000 as we decreased our focus on thesecustomers and increased our focus on the Keurig “K-cup” and the Office CoffeeService markets.  These decreases werepartially offset by a $62,000, or 4.6%, increase in sales of Keurig “K-cup” andOCS items.

 

Franchiserevenue increased over the prior year first quarter by $110,000, or 7.6%, to$1,564,000. Initial franchise fees and franchise renewal fees increasedapproximately $148,000 for the twelve weeks ended September 24, 2003 versus theprior year, primarily as a result of a dissolution settlement for the Malaysiafranchise agreement  Franchise royaltiesdecreased $44,000, or 3.6%, to $1,173,000 for the twelve weeks ended September24, 2003 versus the prior year period. This was the net impact of a reductionin domestic franchise royalties and an increase in international royalties.Domestic royalties decreased because of the 19-unit reduction in domesticfranchise stores from September 25, 2002 to September 24, 2003, and a declinein comparable store sales. The growth in international royalties reflects thecontinuing strength of those markets with a 52-unit increase in the number offranchise stores compared to the prior year.

 

***Cost of Sales andRelated Occupancy Costs*.**  Cost of sales and related occupancy costs for the twelve weeksended September 24, 2003 decreased 10.5% to $5,111,000 from the prior yearperiod.  Cost of sales and relatedoccupancy costs decreased to 45.2% of total revenue for the twelve weeks endedSeptember 24, 2003 from 46.3% of total revenue for the twelve weeks endedSeptember 25, 2002.  This marginimprovement primarily resulted from the implementation of new in-storeoperating systems, which help us better control our costs, and a decrease inroyalty fees paid to Keurig following the purchase of packaging equipmentduring the fourth quarter of fiscal year 2003. Occupancy costs remained constant as a percentage of sales in the firstfiscal quarter of each year.

 

***Operating Expenses.**** *Operating expenses for the twelveweeks ended September 24, 2003 decreased $331,000, or 8.2%, from the prior year period to $3,700,000.  On a margin basis, operating expensesremained constant at 32.7% in the first fiscal quarter of each year.  Labor expense increased as a percentage ofrevenues primarily as a result of lower revenues due to the closure and sale ofcoffeehouses, negative comparative sales for the quarter, and a deliberatedecision to improve customer service by increasing the staff at ourcoffeehouses.  Bad debt expense increasedfrom the prior year quarter by $43,000 due to a reduction in bad debt reservesrecorded in last year’s first fiscal quarter. Despite very low loss experience, California worker’s compensationinsurance expense increased by $20,000 over the prior year quarter.

 

12

----

 

***Depreciation andAmortization*.** Depreciation and amortization increased by $142,000 to $587,000 for thetwelve weeks ended September 24, 2003 from the prior year first fiscalquarter.  This increase was due todepreciation of the Keurig packaging equipment and other capital improvementsin our Castroville, California roasting facility and in Company operated retaillocations.

 

***General andAdministrative Expenses*.**  General and administrative expenses increased by $51,000, or2.4%, to $2,144,000 for the twelve weeks ended September 24, 2003 from theprior year fiscal quarter.  As apercentage of revenue, general and administrative expenses increased to 19.0%in the first quarter of fiscal 2003 from 17.0% in the prior year quarter.  This unfavorable percentage increase was theresult of an increase in overhead costs combined with an 8.4% decline inrevenues.  Salaries increased $142,000over the prior year quarter largely due to the addition of a Director ofOperations and other supervisory personnel for the Company owned retailstores.  Provision for bonuses declinedby $121,000 from the prior year quarter. Higher premiums increased the cost ofdirector’s and officer’s insurance by $37,000 over last year’s first quarter.

 

***Interest Expense andOther, Net.**** *Interestexpense and other, net decreased by $25,000 to $57,000 for the twelve weeksended September 24, 2003 from the prior year period.  This decrease is primarily due to lower market interest ratesand, to a lesser degree, a 12.5% reduction in total long-term debt from$3,000,000 at September 25, 2002 to $2,624,000 at September 24, 2003, and a20.4% reduction in our capital lease obligations from $869,000 at September 25,2002 to $692,000 at September 24, 2003.

 

**FinancialCondition, Liquidity and Capital Resources.**

 

***Current FinancialCondition. ***AtSeptember 24, 2003, we had working capital of $524,000, as compared to workingcapital of $1,207,000 as of July 2, 2003, and working capital of $619,000 as ofSeptember 25, 2002.  Purchases of fixedassets and decreases in revenues during the current fiscal quarter, resulted inreduced available working capital.

 

***Cash Flows. ***Cash used inoperating activities for the twelve weeks ended September 24, 2003 totaled$13,000 as compared with $167,000 in net cash provided by operating activitiesfor the twelve weeks ended September 25, 2002. Operations typically do not generate substantial cash flow in the firstfiscal quarter due to seasonal lows in revenues and high inventory build-up inpreparation for the second fiscal quarter, which includes the holidayseason.  Other factors affecting cashflow are more fully discussed in the Unaudited Condensed Consolidated Statementof Cash Flows in the accompanying financial statements.

 

Net cash usedin investing activities for the twelve weeks ended September 24, 2003 totaled$488,000 as compared with net cash used of $54,000 for the twelve weeks endedSeptember 25, 2002. During the twelve weeks ended September 24, 2003, net cashused in investing activities included $502,000 used for property and equipment expenditures, which consistedof $200,000 in new roasting plant equipment and approximately $302,000 in storeremodeling and improvements.

 

Net cash usedin financing activities for the twelve weeks ended September 24, 2003 totaled$361,000 as compared to the $272,000 in net cash used in financing activitiesfor the twelve weeks ended September 25, 2002. For both periods the net cashused in financing activities consisted of repayment of long-term debt and capitalleases.

 

***Bank RevolvingWorking Capital and Letter of Credit Facility.* **We have a $675,000 revolving workingcapital and letter of credit facility. The working capital facility draws and letters of credit are limited toa combined maximum of $675,000 outstanding at any time.  Letters of credit are subject to a sub-limitof $250,000. At September 24, 2003, there were no draws against the workingcapital facility and one letter of credit in the amount of $179,000 wasoutstanding.

 

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.

 

13

----

 

***OtherCommitments. ***Thefollowing represents a comprehensive list of our contractual obligations andcommitments as of September 24, 2003:

 
|                                                               |   | **Payments  Due by Period** |   |
|--------------------------------------------------------------------|--------|-----------------------------|--------|
|                                                               |   | **Total**                   |   | **2004** |   | **2005** |   | **2006** |   | **2007** |   | **2008** |   | **Thereafter** |   |
|                                                               |   | **(In thousands)**          |   |
| Note payable                                                       |   | $                           | 2,624  |   | $ | 1,517 |   | $ | 817 |   | $ | 290 |   | $ | — |   | $ | — |   | $ | — |   |
| Capital leases                                                     |   | 692                         |   | 178 |   | 146 |   | 60 |   | 23 |   | 24 |   | 261 |   |
| Company operated retail locations  and other operating leases |   | 18,784                      |   | 4,655 |   | 3,849 |   | 2,872 |   | 2,020 |   | 1,549 |   | 3,839 |   |
| Franchise operated retail locations  operating leases         |   | 18,991                      |   | 5,283 |   | 4,147 |   | 3,049 |   | 2,428 |   | 1,683 |   | 2,401 |   |
| Green coffee commitments                                           |   | 2,546                       |   | 1,630 |   | 916 |   | — |   | — |   | — |   | — |   |
|                                                               |   | $                           | 43,637 |   | $ | 13,263 |   | $ | 9,875 |   | $ | 6,271 |   | $ | 4,471 |   | $ | 3,256 |   | $ | 6,501 |   |
|                                                                    |        |                             |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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 119 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 September 24, 2003, computedas the sum of all remaining lease payments through the expiration dates of therespective leases, was $18,991,000. 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.

 

On August 1,2003, we executed a seven-year lease for a new home office facility, with abase rent amount of $27,000 per month, which became effective in October2003.  On September 10, 2003, weexecuted a three-year lease for a secondary warehouse, with a base rent amountof $5,000 per month, which became effective in October 2003.

 

**CriticalAccounting Policies.**

 

Thepreparation of our consolidated financial statements requires us to makeestimates 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

 

14

----

 

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 which could trigger an impairment review include significantunderperformance relative to expected historical or projected future operatingresults, significant changes in the manner of use of acquired assets or thestrategy for the overall business, and significant negative industry oreconomic trends. Our goodwill impairment analysis uses estimates andassumptions in order to determine the fair value of our reporting units,including estimating future cash flows, determining appropriate discount ratesand other assumptions. As a result of our changes in executive managementduring fiscal 2003, we reviewed our competitive position in certain markets inorder to better align our resources with our growth strategy.  As a result of this review, we modifiedcertain assumptions used in our goodwill impairment test.  If our assumptions are incorrect, thecarrying 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 we make in determining store closure reserves areassumptions regarding the estimated costs to maintain vacant properties orterminate leases.  Additionally, theamount of the reserve established for future lease payments on leased vacantunits is dependent on our ability to successfully negotiate early terminationlease agreements with our landlords.  Ifthe costs 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 AndQualitative Disclosures About Market Risk.

 

**MarketRisk Sensitive Items Entered Into for Trading Purposes**

 

None.

 

**MarketRisk Sensitive Items Entered Into for Other Than Trading Purposes**

 

*Interest Rate Risk.*  We are exposed to market risk from changesin interest rates on our outstanding bank debt.  At September 24, 2003, we had $1,700,000 in bank debt that wastied to changes in

 

15

----

 

short term interest rates. Atthe end of our first fiscal quarter of fiscal 2004, the interest rate was theLIBOR rate plus 3.25%.  The rate can befixed over periods ranging from one to six months, at our discretion.  At September 24, 2003, a hypothetical 100basis point increase in the adjusted LIBOR rate would result in additionalinterest expense of $17,000 on an annualized basis.

 

*Commodity Price Risk.*  Greencoffee, the principal raw material for our products, is subject to significantprice fluctuations caused by a number of factors, including weather, political,and economic conditions.  To date, wehave not used commodity based financial instruments to hedge againstfluctuations in the price of coffee.  Toensure that we have an adequate supply of coffee, however, we enter intoagreements to purchase green coffee in the future that may or may not be fixedas to price.  At September 24, 2003, wehad commitments to purchase coffee through fiscal year 2005 totaling $2,546,000for 1,985,000 pounds 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 approximately39% of our anticipated green coffee requirements for this fiscal year.  Assuming we require approximately 1,400,000additional 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 $14,000 of additional cost.  However,because the price we pay for green coffee is negotiated with suppliers, webelieve that the commodity market price for green coffee would have to increasesignificantly, by as much as $0.25 per pound, before suppliers would increasethe price they charge us.

 

#### **Item 4**.           Controls and Procedures.

#### ** **

(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

 

**Item 1.****           LegalProceedings.**

 

In theordinary course of our business, we may become involved in legal proceedingsfrom time to time. During the twelve-week period ending September 24, 2003, wewere not a party to any material legal proceedings.

 

**Item 6.****           Exhibitsand Reports on Form 8-K.**

 

(a)          *Exhibits.*

 

Set forth below is a list ofthe 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)                                                                                         |
| 10.1             |   | Form of  Indemnification Agreement(5)                                                                                                                                                                                 |
| 10.2             |   | Diedrich  Coffee, Inc. 2000 Equity Incentive Plan(9)*                                                                                                                                                                 |
| 10.3             |   | Diedrich  Coffee, Inc. 2000 Non-Employee Directors Stock Option Plan(10)*                                                                                                                                             |

 

16

----

 
| 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  Gloria Jean’s Franchise Agreement                                                                                                                |
| 10.8  |   | Form of  Diedrich Coffee, Inc. Area Development Agreement                                                                                                      |
| 10.9  |   | Form of  Diedrich Coffee, Inc. Franchise Agreement                                                                                                             |
| 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                                    |
| 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)*                                                                                |
| 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*                                                                         |
| 10.26 |   | Employment  Letter regarding the employment of Michael Zorehkey, dated February 3, 2000*                                                                       |
| 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.

 

17

----

(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)                      Previouslyfiled as Appendix A to Diedrich Coffee’s Definitive Proxy Statement, filed withthe Securities and Exchange Commission October 25, 2001.

 

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

 

(11)                Previouslyfiled as an exhibit to Diedrich Coffee’s Quarterly Report on Form 10-Q forthe period ended September 22, 1999, filed with the Securities andExchange Commission on November 5, 1999.

 

(12)                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 12, 1996 and declared effective on September 11, 1996.

 

(13)                Previouslyfiled as an exhibit to Diedrich Coffee’s Annual Report on Form 10-K for thefiscal year ended July 3, 2002, filed with the Securities and ExchangeCommission on October 1, 2002.

 

(14)                Previouslyfiled as an exhibit to Diedrich Coffee’s Quarterly Report on Form 10-Q for theperiod ended December 18, 2002, filed with the Securities and Exchange Commissionon January 31, 2003.

 

(15)                Previouslyfiled as an exhibit to Diedrich Coffee’s Quarterly Report on Form 10-Q for theperiod ended March 12, 2003, filed with the Securities and Exchange Commissionon April 28, 2003.

 

(16)                Previouslyfiled as an exhibit to Diedrich Coffee’s Annual Report on Form 10-K for thefiscal year ended July 2, 2003, filed with the Securities and ExchangeCommission on September 30, 2003.

 

(17)                Previouslyfiled as an exhibit to Diedrich Coffee’s Annual Report on Form 10-K for thefiscal year ended June 27, 2001, filed with the Securities and ExchangeCommission on September 25, 2001.

 

(18)                Previouslyfiled as an exhibit to Diedrich Coffee’s Annual Report on Form 10-K for thefiscal year ended June 28, 2000, filed with the Securities and ExchangeCommission on September 27, 2000.

 

(19)                Previouslyfiled as an exhibit to Diedrich Coffee’s Quarterly Report on Form 10-Q for theperiod ended September 20, 2000, filed with the Securities and ExchangeCommission on November 6, 2000.

 

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

 

None.

 

18

----

 

**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:  November 6, 2003 | **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) |
|                              |                                               |  |  |

 

19

----

 

**EXHIBIT INDEX**

 
| **Exhibit No.** |   | **Description**                                                                                                             |   |
|-----------------|--------|-----------------------------------------------------------------------------------------------------------------------------|--------|
| 10.7            |   | Form of  Gloria Jean’s Franchise Agreement                                                                             |   |
|            |   |                                                                                                                        |   |
| 10.8            |   | Form of Diedrich  Coffee, Inc. Area Development Agreement                                                                   |   |
|            |   |                                                                                                                        |   |
| 10.9            |   | Form of  Diedrich Coffee, Inc. Franchise Agreement                                                                          |   |
|            |   |                                                                                                                        |   |
| 10.18           |   | Fourth  Amendment to Credit Agreement by and between Diedrich Coffee, Inc. and Bank  of the West, effective October 1, 2003 |   |
|            |   |                                                                                                                        |   |
| 10.25           |   | Employment  Letter regarding the employment of Pamela Britton, dated February 6, 2001                                       |   |
|            |   |                                                                                                                        |   |
| 10.26           |   | Employment  Letter regarding the employment of Michael Zorehkey, dated February 3, 2000                                     |   |
|            |   |                                                                                                                        |   |
| 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                       |   |

 

 

----