** **

**SECURITIES AND EXCHANGECOMMISSION**

**Washington,D.C. 20549**

** **

**FORM 10-Q**

** **

**(Mark One)**

ý**  QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934**

** **

**For thequarterly period ended September 27, 2005**

** **

**OR**

** **

o**  TRANSITION REPORT UNDER SECTION13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934**

** **

**CommissionFile Number 0-27148**

** **

**New World Restaurant Group, Inc.**

(Nameof Registrant as Specified in its Charter)

 

| **Delaware**                       | ** ** | **13-3690261**       |
|------------------------------------|------------|----------------------|
| (State  or other jurisdiction      |       | (I.R.S.  Employer    |
| of  Incorporation or Organization) |       | Identification  No.) |

 

**1687Cole Blvd., Golden, Colorado  80401**

(Addressof principal executive offices, including zip code)

 

**(303) 568-8000**

(Registrant’stelephone number, including area code)

 

Securitiesregistered pursuant to Section 12(b) of the Act:

**None**

 

 

Indicateby check 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 ý  No o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Securities Exchange Act of 1934).  Yes o  No ý

 

Indicateby check mark whether the registrant is a shell company (as defined inRule 12b-2 of the Exchange Act). Yes o  No ý

 

Asof November 2, 2005, 9,868,623 shares of Common Stock of the registrant wereoutstanding.

 

----

 

**NEWWORLD RESTAURANT GROUP, INC.**

 

September27, 2005

 

TABLEOF CONTENTS

 

 

 

** **
| **Part I**. **Financial Information** | ** **                                                                                                                                          |
|---------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------|
|                                  |                                                                                                                                                |   |
|  Item 1.                         | Financial Statements:                                                                                                                               |   |
|                                  |                                                                                                                                                |   |
|                                  | Consolidated Balance Sheets  (unaudited), September 27, 2005 and December 28, 2004                                                                  |   |
|                                  |                                                                                                                                                |   |
|                                  | Consolidated Statements of Operations  (unaudited), for the third quarter and year to date periods ended September  27, 2005 and September 28, 2004 |   |
|                                  |                                                                                                                                                |   |
|                                  | Consolidated Statements of Cash Flows  (unaudited), for the year to date periods ended September 27, 2005 and  September 28, 2004                   |   |
|                                  |                                                                                                                                                |   |
|                                  | Consolidated Statement of Changes in  Stockholders’ Equity (Deficit) (unaudited), for the year to date period ended  September 27, 2005        |   |
|                                  |                                                                                                                                                |   |
|                                  | Notes to the Consolidated  Financial Statements                                                                                                     |   |
|                                  |                                                                                                                                                |   |
|  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                                                                                                                                            |   |
|                                  |                                                                                                                                                |   |

 

 

2

----

 

**NEW WORLDRESTAURANT GROUP, INC.**

**CONSOLIDATED BALANCE SHEETS**

**AS OFSEPTEMBER 27, 2005 AND DECEMBER 28, 2004**

**(inthousands, except share information)**

**(unaudited)**

** **
| ** **                                                                                                                                                                 | ** ** | **September 27,** | ** ** | **December 28,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|------------------|------------|
| ** **                                                                                                                                                                 | ** ** | **2005**          | ** ** | **2004**         | ** ** |
| **ASSETS**                                                                                                                                                                 |       |              |       |             |       |
| Current assets:                                                                                                                                                            |       |              |       |             |       |
| Cash and cash equivalents                                                                                                                                                  |       | $                 | 6,827      |             | $          | 9,752 |   |
| Restricted cash                                                                                                                                                            |       | 789               |       | 1,269            |       |
| Franchise and other receivables, net of allowance of $1,098 and  $2,475                                                                                                    |       | 6,263             |       | 7,123            |       |
| Inventories                                                                                                                                                                |       | 5,205             |       | 4,941            |       |
| Prepaid expenses and other current assets                                                                                                                                  |       | 2,500             |       | 1,643            |       |
| Total current assets                                                                                                                                                       |       | 21,584            |       | 24,728           |       |
|                                                                                                                                                                       |       |              |       |             |       |
| Restricted cash long-term                                                                                                                                                  |       | 901               |       | 2,526            |       |
| Property, plant and equipment, net                                                                                                                                         |       | 33,685            |       | 41,855           |       |
| Trademarks and other intangibles, net                                                                                                                                      |       | 69,825            |       | 77,219           |       |
| Goodwill                                                                                                                                                                   |       | 4,875             |       | 4,875            |       |
| Debt issuance costs and other assets                                                                                                                                       |       | 5,766             |       | 7,253            |       |
| Total assets                                                                                                                                                               |       | $                 | 136,636    |             | $          | 158,456 |   |
|                                                                                                                                                                       |       |              |       |             |       |
| **LIABILITIES AND STOCKHOLDERS’  DEFICIT**                                                                                                                            |       |              |       |             |       |
| Current liabilities:                                                                                                                                                       |       |              |       |             |       |
| Accounts payable                                                                                                                                                           |       | $                 | 7,134      |             | $          | 8,243 |   |
| Accrued expenses                                                                                                                                                           |       | 28,460            |       | 34,836           |       |
| Short term debt and current portion of long-term debt                                                                                                                      |       | 280               |       | 295              |       |
| Current portion of obligations under capital leases                                                                                                                        |       | 16                |       | 16               |       |
| Total current liabilities                                                                                                                                                  |       | 35,890            |       | 43,390           |       |
|                                                                                                                                                                       |       |              |       |             |       |
| Senior notes and other long-term debt                                                                                                                                      |       | 160,840           |       | 160,840          |       |
| Obligations under capital leases                                                                                                                                           |       | 18                |       | 31               |       |
| Other liabilities                                                                                                                                                          |       | 8,593             |       | 9,678            |       |
| Mandatorily redeemable, Series Z Preferred Stock, $.001 par value,  $1,000 per share liquidation value; 2,000,000 shares authorized; 57,000  shares issued and outstanding |       | 57,000            |       | 57,000           |       |
| Total liabilities                                                                                                                                                          |       | 262,341           |       | 270,939          |       |
|                                                                                                                                                                       |       |              |       |             |       |
| Commitments and contingencies                                                                                                                                              |       |              |       |             |       |
|                                                                                                                                                                       |       |              |       |             |       |
| Stockholders’ deficit:                                                                                                                                                |       |              |       |             |       |
| Common stock, $.001 par value; 15,000,000 shares authorized;  9,868,623 and 9,848,713 shares issued and outstanding                                                        |       | 10                |       | 10               |       |
| Additional paid-in capital                                                                                                                                                 |       | 175,818           |       | 175,797          |       |
| Unamortized stock compensation                                                                                                                                             |       | (85               | )          | (137             | )          |
| Accumulated deficit                                                                                                                                                        |       | (301,448          | )          | (288,153         | )          |
| Total stockholders’ deficit                                                                                                                                           |       | (125,705          | )          | (112,483         | )          |
| Total liabilities and stockholders’ deficit                                                                                                                           |       | $                 | 136,636    |             | $          | 158,456 |   |

 

The accompanying notes arean integral part of these consolidated financial statements.

 

3

----

 

**NEW WORLDRESTAURANT GROUP, INC.**

**CONSOLIDATED STATEMENTSOF OPERATIONS**

**FOR THETHIRD QUARTER AND YEAR TO DATE PERIODS ENDED SEPTEMBER 27, 2005 AND SEPTEMBER28, 2004**

**(inthousands, except earnings per share and related share information)**

**(unaudited)**

 
| ** **                                                   | ** ** | **Third quarter ended:** | ** ** | **Year to date ended:** | ** ** |
|--------------------------------------------------------------|------------|--------------------------|------------|-------------------------|------------|
| ** **                                                   | ** ** | **Sept 27,**             | ** ** | **Sept 28,**            | ** ** | **Sept 27,** | ** ** | **Sept 28,** | ** ** |
| ** **                                                   | ** ** | **2005**                 | ** ** | **2004**                | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues:                                                    |       |                     |       |                    |       |   |   |   |   |
| Retail sales                                                 |       | $                        | 87,937     |                    | $          | 84,763 |   | $ | 265,912 |   | $ | 256,982 |   |
| Manufacturing revenues                                       |       | 5,270                    |       | 4,913                   |       | 14,905 |   | 15,270 |   |
| Franchise and license related revenues                       |       | 1,575                    |       | 1,503                   |       | 4,373 |   | 4,287 |   |
|                                                         |       |                     |       |                    |       |   |   |   |   |
| Total revenues                                               |       | 94,782                   |       | 91,179                  |       | 285,190 |   | 276,539 |   |
|                                                         |       |                     |       |                    |       |   |   |   |   |
| Cost of sales:                                               |       |                     |       |                    |       |   |   |   |   |
| Retail costs                                                 |       | 73,941                   |       | 70,315                  |       | 219,141 |   | 213,805 |   |
| Manufacturing costs                                          |       | 4,980                    |       | 4,603                   |       | 13,880 |   | 13,623 |   |
| Total cost of sales                                          |       | 78,921                   |       | 74,918                  |       | 233,021 |   | 227,428 |   |
|                                                         |       |                     |       |                    |       |   |   |   |   |
| Gross profit                                                 |       | 15,861                   |       | 16,261                  |       | 52,169 |   | 49,111 |   |
|                                                         |       |                     |       |                    |       |   |   |   |   |
| Operating expenses:                                          |       |                     |       |                    |       |   |   |   |   |
| General and administrative expenses                          |       | 8,868                    |       | 8,442                   |       | 26,857 |   | 25,260 |   |
| Depreciation and amortization                                |       | 5,798                    |       | 7,005                   |       | 19,583 |   | 20,882 |   |
| Loss (gain) on sale, disposal or abandonment of assets, net  |       | 104                      |       | (70                     | )          | 269 |   | 1,395 |   |
| Charges (adjustments) of integration and reorganization cost |       | 1                        |       | (44                     | )          | 6 |   | (843 | ) |
| Impairment charges and other related costs                   |       | 205                      |       | 402                     |       | 1,484 |   | 402 |   |
| Income from operations                                       |       | 885                      |       | 526                     |       | 3,970 |   | 2,015 |   |
|                                                         |       |                     |       |                    |       |   |   |   |   |
| Other expense (income):                                      |       |                     |       |                    |       |   |   |   |   |
| Interest expense, net                                        |       | 5,805                    |       | 5,723                   |       | 17,497 |   | 17,426 |   |
| Other                                                        |       | (106                     | )          | (98                     | )          | (232 | ) | (197 | ) |
| Loss before income taxes                                     |       | (4,814                   | )          | (5,099                  | )          | (13,295 | ) | (15,214 | ) |
|                                                         |       |                     |       |                    |       |   |   |   |   |
| Provision (benefit) for  state income taxes                  |       | —                   |       | (147                    | )          | — |   | 92 |   |
| Net loss                                                     |       | $                        | (4,814     | )                       | $          | (4,952 | ) | $ | (13,295 | ) | $ | (15,306 | ) |
| Net loss per common share  — Basic and Diluted          |       | $                        | (0.49      | )                       | $          | (0.50 | ) | $ | (1.35 | ) | $ | (1.56 | ) |
| Weighted average number of  common shares outstanding:       |       |                     |       |                    |       |   |   |   |   |
| Basic and Diluted                                            |       | 9,868,623                |       | 9,842,385               |       | 9,859,407 |   | 9,842,169 |   |

 

The accompanying notes arean integral part of these consolidated financial statements.

 

 

4

----

 

**NEW WORLDRESTAURANT GROUP, INC.**

**CONSOLIDATED STATEMENTSOF CASH FLOWS**

**FOR THEYEAR TO DATE PERIODS ENDED SEPTEMBER 27, 2005 AND SEPTEMBER 28, 2004**

**(inthousands)**

**(unaudited)**

** **
| ** **                                                                                 | ** ** | **Sept 27,** | ** ** | **Sept 28,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|--------------|------------|--------------|------------|
| ** **                                                                                 | ** ** | **2005**     | ** ** | **2004**     | ** ** |
| **OPERATING ACTIVITIES:**                                                                  |       |         |       |         |       |
| Net loss                                                                                   |       | $            | (13,295    | )            | $          | (15,306 | ) |
| Adjustments to reconcile net loss to net cash provided by (used in)  operating activities: |       |         |       |         |       |
| Depreciation and amortization                                                              |       | 19,583       |       | 20,882       |       |
| Stock based compensation expense                                                           |       | 52           |       | 51           |       |
| Loss, net of gains, on disposal of assets                                                  |       | 269          |       | 1,395        |       |
| Impairment charges and other related costs                                                 |       | 1,484        |       | 402          |       |
| Charges (adjustments) of integration and reorganization costs                              |       | 6            |       | (843         | )          |
| Provision for (reduction of) losses on accounts receivable, net                            |       | (78          | )          | 266          |       |
| Amortization of debt issuance and debt discount costs                                      |       | 1,386        |       | 1,387        |       |
| Changes in operating assets and liabilities:                                               |       |         |       |         |       |
| Franchise and other receivables                                                            |       | 938          |       | (796         | )          |
| Cash overdraft                                                                             |       | —       |       | 1,978        |       |
| Accounts payable and accrued expenses                                                      |       | (7,587       | )          | (10,279      | )          |
| Other assets and liabilities                                                               |       | 3            |       | 445          |       |
| Net cash provided by (used in) operating activities                                        |       | 2,761        |       | (418         | )          |
|                                                                                       |       |         |       |         |       |
| **INVESTING ACTIVITIES:**                                                                  |       |         |       |         |       |
| Purchase of property and  equipment                                                        |       | (5,775       | )          | (5,605       | )          |
| Proceeds from the sale of  equipment                                                       |       | 97           |       | 134          |       |
| Net cash used in investing activities                                                      |       | (5,678       | )          | (5,471       | )          |
|                                                                                       |       |         |       |         |       |
| **FINANCING ACTIVITIES:**                                                                  |       |         |       |         |       |
| Proceeds from line of  credit                                                              |       | 5,445        |       | 15,745       |       |
| Repayments of line of  credit                                                              |       | (5,460       | )          | (16,745      | )          |
| Repayment of other  borrowings                                                             |       | (14          | )          | (825         | )          |
| Proceeds upon warrant  exercise                                                            |       | 21           |       | 1            |       |
| Net cash used in financing activities                                                      |       | (8           | )          | (1,824       | )          |
|                                                                                       |       |         |       |         |       |
| Net decrease in cash and  cash equivalents                                                 |       | (2,925       | )          | (7,713       | )          |
| Cash and cash equivalents,  beginning of period                                            |       | 9,752        |       | 9,575        |       |
| Cash and cash equivalents,  end of period                                                  |       | $            | 6,827      |         | $          | 1,862 |   |
|                                                                                       |       |         |       |         |       |
| **SUPPLEMENTAL CASH FLOW  INFORMATION:**                                                   |       |         |       |         |       |
| Cash paid for interest                                                                     |       | $            | 21,411     |         | $          | 20,958 |   |
| Cash paid for income taxes                                                                 |       | $            | —     |         | $          | 572 |   |

 

The accompanying notes arean integral part of these consolidated financial statements.

 

5

----

 

**NEW WORLDRESTAURANT GROUP, INC.**

**CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY(DEFICIT)**

**FOR THEYEAR TO DATE PERIOD ENDED SEPTEMBER 27, 2005**

(in thousands, except shareinformation)

(unaudited)

 
| ** **                                    | ** ** | ** **       | ** ** | ** **  | ** ** | **Additional** | ** ** | **Unamortized**  | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
|-----------------------------------------------|------------|------------------|------------|-------------|------------|----------------|------------|------------------|------------|-----------------|------------|------------|------------|
| ** **                                    | ** ** | **Common Stock** | ** ** | **Paid In** | ** ** | **Stock**      | ** ** | **Deficit**      | ** ** | ** **      | ** ** |
| ** **                                    | ** ** | **Shares**       | ** ** | **Amount**  | ** ** | **Capital**    | ** ** | **Compensation** | ** ** | **Amount**      | ** ** | **Total**  | ** ** |
| Balance, December 28, 2004                    |       | 9,848,713        |       | $           | 10         |           | $          | 175,797          |       | $               | (137       | )          | $          | (288,153 | ) | $ | (112,483 | ) |
| Net loss                                      |       | —           |       | —      |       | —         |       | —           |       | (13,295         | )          | (13,295    | )          |
| Common stock issued upon exercise of warrants |       | 19,910           |       | —      |       | 21             |       | —           |       | —          |       | 21         |       |
| Amortization of stock compensation expense    |       | —           |       | —      |       | —         |       | 52               |       | —          |       | 52         |       |
| Balance, September 27,  2005                  |       | 9,868,623        |       | $           | 10         |           | $          | 175,818          |       | $               | (85        | )          | $          | (301,448 | ) | $ | (125,705 | ) |
|                                               |            |                  |            |             |            |                |            |                  |            |                 |            |            |            |  |  |  |  |  |  |  |

 

 

The accompanying notes arean integral part of these consolidated financial statements.

 

 

6

----

 

 

**NEW WORLD RESTAURANT GROUP, INC.**

 

Notes to Consolidated Financial Statements(Unaudited)

 

Third Quarterand Year to Date Periods Ended September 27, 2005 and September 28, 2004

 

 

 

**1.****             ****Basis of Presentation**

 

Theaccompanying consolidated financial statements of New World Restaurant Group,Inc. and its wholly-owned subsidiaries (collectively, “the Company”) have beenprepared pursuant to the rules and regulations of the Securities and ExchangeCommission (“SEC”). As of September 27, 2005, the Company owns, franchises orlicenses various restaurant concepts under the brand names of Einstein Bros.Bagels (“Einstein Bros.”), Einstein Bros. Café, Noah’s New York Bagels (“Noah’s”),Manhattan Bagel Company (“Manhattan”), Chesapeake Bagel Bakery (“Chesapeake”)and New World Coffee (“New World”). Our business is subject toseasonal trends. Generally, our revenues in the first fiscal quarter aresomewhat lower than in the other three fiscal quarters.

 

The accompanyingconsolidated financial statements asof September 27, 2005 and for the third quarter and year to date periods endedSeptember 27, 2005 and September 28, 2004 have been prepared withoutaudit. The balance sheet information as of December 28, 2004 has been derivedfrom our audited financial statements. The information furnished hereinreflects all adjustments (consisting only of normal recurring accruals andadjustments), which are, in our opinion, necessary to fairly state the interimoperating results for the respective periods.  However, these operatingresults are not necessarily indicative of the results expected for the fullfiscal year.  Certain information and footnote disclosures normallyincluded in annual financial statements prepared in accordance with generallyaccepted accounting principles in the United States have been omitted pursuantto SEC rules and regulations. The notes to the consolidated financialstatements (unaudited) should be read in conjunction with the notes to theconsolidated financial statements contained in our annual report on Form 10-Kfor the fiscal year ended December 28, 2004. We believe that the disclosures aresufficient for interim financial reporting purposes.

 

Certain reclassificationshave been made to conform previously reported data to the current presentation.These reclassifications have no effect on our net loss or financial position aspreviously reported.

 

During the third quarterended September 27, 2005, we corrected an overstatement of depreciation expenseof approximately $0.6 million related to the first and second quarters infiscal 2005. Amounts in the year to date period ended September 27, 2005 areproperly reflected.

 

 

**2.****             ****Stock Based Compensation**

 

Weapply the intrinsic value-based method of accounting prescribed by AccountingPrinciples Board (APB) Opinion No. 25, *Accountingfor Stock Issued to Employees*, and related interpretations, in accountingfor our fixed award stock options to our employees. As such, compensationexpense is recorded only if the current market price of the underlying commonstock exceeded the exercise price of the option on the date of grant. We applythe fair value-basis of accounting as prescribed by Statements of FinancialAccounting Standard (SFAS) No. 123, *Accounting for Stock-BasedCompensation* (SFAS No. 123)**in accountingfor our fixed award stock options to our consultants. Under SFAS No. 123,compensation expense is recognized based on the fair value of stock optionsgranted.  

 

7

----

 

Hadcompensation cost for stock options granted to employees been determined on thebasis of fair value using the following assumptions, net loss and loss pershare would have been increased to the following pro forma amounts (inthousands of dollars, except per share amounts):

 
| ** **                                     | ** ** | **Third quarter ended:** | ** ** | **Year to date ended:** | ** ** |
|------------------------------------------------|------------|--------------------------|------------|-------------------------|------------|
| ** **                                     | ** ** | **Sept 27,**             | ** ** | **Sept 28,**            | ** ** | **Sept 27,** | ** ** | **Sept 28,** | ** ** |
| ** **                                     | ** ** | **2005**                 | ** ** | **2004**                | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net loss, as reported                          |       | $                        | (4,814     | )                       | $          | (4,952 | ) | $ | (13,295 | ) | $ | (15,306 | ) |
| Deduct: fair value based  compensation expense |       | (199                     | )          | (183                    | )          | (538 | ) | (628 | ) |
| Pro forma net loss                             |       | (5,013                   | )          | (5,135                  | )          | (13,833 | ) | (15,934 | ) |
| Basic and diluted loss per  common share:      |       |                     |       |                    |       |   |   |   |   |
| As reported                                    |       | $                        | (0.49      | )                       | $          | (0.50 | ) | $ | (1.35 | ) | $ | (1.56 | ) |
| Pro forma                                      |       | $                        | (0.51      | )                       | $          | (0.52 | ) | $ | (1.40 | ) | $ | (1.62 | ) |
|                                           |       |                     |       |                    |       |   |   |   |   |
| Assumptions:                                   |       |                     |       |                    |       |   |   |   |   |
| Expected life of options  from date of grant   |       | —                   |       | —                  |       | 4.0  years |   | 4.0  years |   |
| Risk-free interest rate                        |       | —                   |       | —                  |       | 3.6  - 3.9 | % | 3.1 | % |
| Volatility                                     |       | —                   |       | —                  |       | 100.0 | % | 100.0 | % |
| Assumed dividend yield                         |       | —                   |       | —                  |       | 0.0 | % | 0.0 | % |

 

There were no stock options granted during third quarters ended 2005and 2004. 

 

Based on options granted and various assumptions used to calculatestock based compensation expense as of September 27, 2005, we believe that theadoption of SFAS No. 123 (revised 2004) will result in an increase in expenseof approximately $0.4 million and $0.1 million during fiscal 2006 and 2007,respectively. If actual events differ from our assumptions used to calculatethe expense or if we grant additional options, our financial results could beimpacted.

 

**3.****             ****Goodwill, Trademarks and Other Intangibles**

 

Intangibleassets include both goodwill and identifiable intangibles arising from theallocation of the purchase prices of assets acquired. Goodwill represents theexcess of cost over fair value of net assets acquired in the acquisition ofManhattan. Other intangibles consist mainly of trademarks, trade secrets andpatents.

 

Goodwilland other intangible assets with indefinite lives are not subject toamortization but are tested for impairment annually or more frequently ifevents or changes in circumstances indicate that the asset might be impaired.SFAS No. 142, “Goodwill and Other Intangible Assets” requires a two-stepapproach for testing impairment. First, the estimated fair value of eachreporting unit is compared to its carrying value to determine whether anindication of impairment exists. If impairment is indicated, then the secondstep of the impairment test is performed; the fair value of the reporting unit’sgoodwill is determined by allocating the unit’s fair value to its assets andliabilities (including any unrecognized intangible assets) as if the reportingunit had been acquired in a business combination. The amount of impairment forgoodwill and other intangible assets is measured as the excess of its carryingamount over its fair value. Intangible assets not subject to amortizationconsist primarily of the Einstein Bros. and Manhattan trademarks.

 

8

----

 

Intangibleassets with lives restricted by contractual, legal or other means are amortizedover their useful lives and consist primarily of patents used in ourmanufacturing process. Amortization expense is calculated using thestraight-line method over the estimated useful lives of approximately 5years.  Intangible assets subject toamortization are reviewed for impairment whenever events or changes in circumstancesindicate that the carrying amount of an asset may not be recoverable, inaccordance with SFAS No. 144, “Accounting for the Impairment or Disposal ofLong-Lived Assets.” Intangible assets subject to amortization consist of theChesapeake trademarks.

 

Duringthe second quarter ended 2004, we began an evaluation of whether each of ourbrands should be a part of our overall strategic business plan. As a result ofthis evaluation, we determined that the Chesapeake brand did not fit within ourlong-term business model. Accordingly, we performed an interim impairmentanalysis and determined that no impairment existed. We also performed alongevity analysis and determined that the brand had an estimated useful lifeof four years. The trademarks were previously treated as a non-amortizingintangible and were reclassified to an amortizing intangible at June 29, 2004.During the second quarter ended 2005, we re-visited the long term strategic fitof Chesapeake utilizing the recommendations of a third party consultantpreviously engaged to present viable alternatives for the brand. Based upon theconsultant’s recommendations, we began forming an exit strategy that webelieved could be completed within one year. Because there had been a change incircumstances, it was necessary to review the asset for impairment. Theanalysis indicated that the carrying amount of the Chesapeake trademarks wasgreater than its fair value and accordingly we recorded an impairment charge of$1.2 million during the quarter ended June 28, 2005. Currently, we are workingwith our remaining franchisees on an exit strategy that we anticipatecompleting by the end of fiscal year 2005. We also continue to review thecarrying amount of the assets in relation to their fair value. For the year todate period ended September 27, 2005, we have recorded impairment charges ofapproximately $1.3 million related to the Chesapeake trademarks.

 

Trademarksand other intangibles consist of the following (in thousands of dollars):

 
| ** **                                   | ** ** | **September 27,** | ** ** | **December 28,** | ** ** |
|----------------------------------------------|------------|-------------------|------------|------------------|------------|
| ** **                                   | ** ** | **2005**          | ** ** | **2004**         | ** ** |
| Amortizing intangibles:                      |       |              |       |             |       |
| Trade secrets                                |       | $                 | 5,385      |             | $          | 5,385 |   |
| Trademarks                                   |       | 743               |       | 2,062            |       |
| Patents-manufacturing process                |       | 33,741            |       | 33,741           |       |
|                                         |       | 39,869            |       | 41,188           |       |
| Less accumulated  amortization:              |       |              |       |             |       |
| Trade secrets                                |       | 4,563             |       | 3,770            |       |
| Trademarks                                   |       | 703               |       | 387              |       |
| Patents-manufacturing process                |       | 28,584            |       | 23,618           |       |
|                                         |       | 33,850            |       | 27,775           |       |
| Total amortizing  intangibles, net           |       | $                 | 6,019      |             | $          | 13,413 |   |
|                                         |       |              |       |             |       |
| Non-amortizing  intangibles:                 |       |              |       |             |       |
| Trademarks                                   |       | 63,806            |       | 63,806           |       |
| Total trademarks and other  intangibles, net |       | $                 | 69,825     |             | $          | 77,219 |   |

 

9

----

 

**4.****             ****Debt**

** **

 
| ** **                       | ** ** | **September 27,** | ** ** | **December 28,** | ** ** |
|----------------------------------|------------|-------------------|------------|------------------|------------|
| ** **                       | ** ** | **2005**          | ** ** | **2004**         | ** ** |
| $160 Million Notes               |       | $                 | 160,000    |             | $          | 160,000 |   |
| AmSouth Revolver                 |       | —            |       | 15               |       |
| New Jersey Economic  Development |       |              |       |             |       |
| Authority Note Payable           |       | 1,120             |       | 1,120            |       |
|                             |       | 161,120           |       | 161,135          |       |
| Less current portion of  debt    |       | 280               |       | 295              |       |
| Long-term debt                   |       | $                 | 160,840    |             | $          | 160,840 |   |

 

 

Debtconsists of the following (in thousands of dollars):

 

 

**$160Million Notes**

 

On July8, 2003, we issued $160 million of 13% senior secured notes maturing on July 1,2008 (“$160 Million Notes”).

 

The $160Million Notes are guaranteed, fully and unconditionally, jointly and severally,by us and all present and future subsidiaries of ours and are collateralized bysubstantially all of our assets in which we have an interest. Pursuant to anIntercreditor Agreement, the $160 Million Notes are subordinate to the AmSouthRevolver as described below.

 

The$160 Million Notes contain certain covenants, which, among others, includecertain financial covenants such as limitations on capital expenditures andminimum EBITDA as defined in the agreement. The covenants also preclude thedeclaration and payment of dividends or other distributions to holders of our commonstock. These covenants are measured on a rolling twelve-month period andfiscal quarter basis, respectively. This debt contains usual and customarydefault provisions. As of September 27, 2005, we were in compliance with allour financial and operating covenants.

 

Interestpayments under the $160 Million Notes are payable in arrears at the rate of 13%per year on July 1 and January 1, commencing January 1, 2004. The notes areredeemable, at our option, in whole or in part at any time after July 1, 2004at the following redemption prices (as expressed in percentages of theprincipal amount):

 

| **Commencing on July 1,** | ** ** | **Percentage** | ** ** |
|---------------------------|------------|----------------|------------|
| 2005                      |       | 103.0          | %          |
| 2006                      |       | 102.0          | %          |
| 2007                      |       | 101.0          | %          |
| 2008 and thereafter       |       | 100.0          | %          |

 

Debtissuance costs are capitalized and amortized using the effective interestmethod over the term of the $160 Million Notes.

 

10

----

 

**AmSouth Revolver**

 

OnJuly 8, 2003, we entered into a three-year, $15 million senior securedrevolving credit facility with AmSouth Bank (“AmSouth Revolver”). The AmSouthRevolver was subsequently amended to make technical corrections, clarifyambiguous terms and provide for increased limits with respect to letters ofcredit. Effective February 11, 2005, the AmSouth Revolver was amendedagain to increase our letter of credit sub-facility from $5 million to $7.5million.

 

TheAmSouth Revolver is collateralized by substantially all of our assets in whichwe have an interest and is senior to the $160 Million Notes pursuant to anIntercreditor Agreement.

 

TheAmSouth Revolver contains certain covenants, which, among others, includecertain financial covenants such as limitations on capital expenditures,operating lease obligations, minimum EBITDA as defined in the agreement,operating cash flow coverage ratio and minimum net worth. The covenants alsopreclude the declaration and payment of dividends or other distributions toholders of our common stock. These covenants are measured on a rollingtwelve-month period at each fiscal quarter or annually at year-end. Additionalcovenant restrictions exist if the total borrowings, including outstandingletters of credit exceed $10.0 million. This debt also contains usual andcustomary default provisions. As of September 27, 2005, we are in compliancewith all of our financial and operating covenants.

 

Interestpayments under the AmSouth Revolver are payable in arrears on the first of eachmonth. The net borrowings under the AmSouth Revolver bear an interest rateequal to the base rate plus an applicable margin with the base rate being theAmSouth Bank “prime rate” and the applicable margin being based on our fixedcharge coverage ratio with a minimum and maximum applicable margin of 0.5% and2.5% respectively. As of September 27, 2005, the prime interest rate under theAmSouth Revolver was 6.75%.

 

Weare required to pay an unused credit line fee of 0.50% per annum on the averagedaily unused amount. The unused line fee is payable monthly in arrears.Additionally, we are required to pay a letter of credit fee based on theaverage daily undrawn face amount for each letter of credit issued, of anapplicable margin being based on our fixed charge coverage ratio with a minimumand maximum applicable margin of 2.0% and 4.5% respectively. Letters of credit reduceour availability under the AmSouth Revolver. At September 27, 2005, we had $7.1million of letters of credit outstanding. The letters of credit expire onvarious dates during 2006, are automatically renewable for one additional yearand are payable upon demand in the event that we fail to pay certain workerscompensation claims. Our availability under the AmSouth Revolver was $7.9million at September 27, 2005.

 

Debtissuance costs are capitalized and amortized using the effective interestmethod over the term of the AmSouth Revolver.

 

**New Jersey Economic Development Authority Note Payable**

 

InDecember 1998, Manhattan Bagel Company, Inc. entered into a note payablein the principal amount of $2,800,000 with the New Jersey Economic DevelopmentAuthority (“NJEDA”) at an interest rate of 9% per annum. Principal is paidannually and interest is paid quarterly. The note matures on December 1, 2008and is secured by the assets of Manhattan Bagel Company, Inc.

 

On July 3, 2003, we placed an advanced funding of the note inescrow to enact a debt defeasance as allowed for in the agreement. Thisadvanced funding is shown as restricted cash and the note is included in bothcurrent portion and long-term portion of debt in the September 27, 2005 andDecember 28, 2004 consolidated balance sheets in accordance with thepayment terms. This classification will continue until the note is fully paidfrom the escrow amount proceeds.

 

11

----

 

**5.****             ****Net Loss Per Common Share**

 

In accordance with SFAS No.128, “Earnings per Share,” we compute basic net loss per common share bydividing the net loss for the period by the weighted average number of sharesof common stock outstanding during the period.

 

Diluted net loss per shareis computed by dividing the net loss for the period by the weighted averagenumber of shares of common stock and potential common stock equivalentsoutstanding during the period, if dilutive. Potential common stock equivalentsinclude incremental shares of common stock issuable upon the exercise of stockoptions. The effects of potential common stock equivalents have not beenincluded in the computation of diluted net loss per share as their effect isanti-dilutive.

 

Thefollowing table summarizes the weighted average number of common sharesoutstanding, as well as sets forth the computation of basic and diluted netloss per common share for the periods indicated (in thousands of dollars,except share and per share data):

 
| ** **                            | ** ** | **Third quarter ended:** | ** ** | **Year to date ended:** | ** ** |
|---------------------------------------|------------|--------------------------|------------|-------------------------|------------|
| ** **                            | ** ** | **Sept 27,**             | ** ** | **Sept 28,**            | ** ** | **Sept 27,** | ** ** | **Sept 28,** | ** ** |
| ** **                            | ** ** | **2005**                 | ** ** | **2004**                | ** ** | **2005** | ** ** | **2004** | ** ** |
| Weighted average shares  outstanding  |       |                     | 9,868,623  |                    |       | 9,842,385 |   |   | 9,859,407 |   |   | 9,842,169 |   |
| Net loss                              |       | $                        | (4,814     | )                       | $          | (4,952 | ) | $ | (13,295 | ) | $ | (15,306 | ) |
| Basic and diluted net loss  per share |       | $                        | (0.49      | )                       | $          | (0.50 | ) | $ | (1.35 | ) | $ | (1.56 | ) |
|                                       |            |                          |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

Stock options and warrantsto purchase an aggregate of 1,841,062 and 1,802,120 shares of common stock wereoutstanding as of September 27, 2005 and September 28, 2004, respectively.These stock options and warrants were not included in the computation ofdiluted earnings per share because their effect would have been anti-dilutive.

 

 

**6.****             ****Income Taxes**

 

We recorddeferred tax assets and liabilities based on the difference between thefinancial statement and income tax basis of assets and liabilities using theenacted statutory tax rate. Deferred income tax expenses or credits are basedon the changes in the asset or liability from period to period. The recordeddeferred tax assets are reviewed for impairment on a quarterly basis byreviewing our internal estimates for future net income. If we determine it tobe more likely than not that the recovery of the asset is in question in theimmediate, foreseeable future, we record a valuation allowance. On September27, 2005 and December 28, 2004, we recorded a full valuation allowance againstour net deferred tax asset. We will continue to record valuation allowancesagainst additional deferred tax assets until such time that it is more likelythan not that some portion or all of the deferred tax assets will be realized.

 

12

----

 

**7.****             ****Loss (Gain) on Sale, Disposal or Abandonment ofAssets**

 

Duringthe second quarter ended 2004, we recorded a loss of approximately $1.3 millionprimarily due to the disposal of menu boards as a result of new productofferings and due to the abandonment of leasehold improvements related toclosed restaurants and our administrative facilities located in New Jersey.

 

 

**8.****             ****Charges (Adjustments) of Integration and ReorganizationCost**

 

Charges(adjustments) of integration and reorganization cost primarily representsadjustments to previously recorded liabilities associated with the closing andcorporate consolidation of our Eatontown facilities during 2002. During April2004, we reached an agreement with the landlord of our Eatontown facility tosettle outstanding litigation. Previously recorded integration andreorganization estimates associated with closing this facility resulted in abenefit of $700,000 during the first quarter ended 2004 as a result of thissettlement.

 

 

**9.****             ****Impairment Charges and Other Related Costs**

 

Inaccordance with Statement of Financial Accounting Standard No. 144, *Accounting for the Impairment or Disposal of Long Lived Assets*,impairment losses are recorded on long-lived assets on arestaurant-by-restaurant basis whenever impairment indicators are determined tobe present. We consider a history of cash flow losses to be the primaryindicator of potential impairment for individual restaurant locations. Wedetermine whether a restaurant location is impaired based on expectedundiscounted future cash flows, considering location, local competition,current store management performance, existing pricing structure andalternatives available for the site. If impairment exists, the amount ofimpairment is measured as the excess of the carrying amount of the asset overits fair value as determined utilizing the estimated discounted future cashflows or the expected proceeds, net of costs to sell, upon sale of the asset.

 

For theyear to date period ended September 27, 2005, we recorded approximately $0.1million in impairment charges related to company-owned stores and approximately$0.1 million in exit costs from the decision to close one restaurant. Additionally,as further explained in Note 3, we recorded approximately $1.3 million inimpairment charges related to the Chesapeake trademarks.

 

 

**10.****      ****Litigation and Contingencies**

 

We are subject to claims andlegal actions in the ordinary course of our business, including claims by ourfranchisees, licensees and employees or former employees. We do not believethat an adverse outcome in any currently pending or threatened matter wouldhave a material adverse effect on our business, results of operations or financialcondition.

 

On July 31, 2002, TristanGoldstein and Valerie Bankhordar, former store managers, filed a putative classaction against Einstein and Noah Corp. (“ENC”) in the Superior Court for theState of California, County of San Francisco. The plaintiffs alleged that ENCfailed to pay overtime wages to managers and assistant managers of itsCalifornia stores who were improperly designated as exempt employees. In April2004, we reached an agreement in principle to settle the litigation, subject tofinal court approval. The final hearing on the fairness of the settlement hasbeen scheduled for January 4, 2006. Amounts representing our estimate tosettle this litigation were previously recorded in general and administrativeexpenses during fiscal 2003 and did not have a material adverse effect on ourconsolidated financial condition or results of operations.

 

13

----

 

On September 14, 2004,Atlantic Mutual Insurance Company brought an action in the Superior Court ofNew Jersey Law Division: Morris County, against the Company, Anthony Wedo,William Nimmo, Jerold Novack, Ramin Kamfar, Lexington Insurance Company, and XLSpecialty Insurance Company seeking declaratory judgment on insurance coverageissues in previously resolved litigation against Novack, our former ChiefFinancial Officer, and Kamfar, our former Chairman of the Board and ChiefExecutive Officer. Mr. Kamfar cross-claimed against us, claiming a right to beindemnified and for certain costs and attorneys fees incurred by him. TheCompany has put National Union, the Company’s officers and directors liabilityinsurer for the applicable time period, on notice that the Company believesthat Kamfar’s advancement and indemnity claims are an insured loss under theCompany’s policy with National Union. The parties have resolved matters withMr. Kamfar and have reached an agreement in principle as to the other issues.The resolution of this lawsuit did not have a material effect on ourconsolidated financial condition or results of operations.

 

 

*Guarantees*

 

Prior to 2001, we would occasionallyguarantee leases for the benefit of certain of our franchisees. None of theguarantees have been modified since their inception and we have sincediscontinued this practice. Current franchisees are the primary lessees underthe vast majority of these leases. Under the lease guarantees, we may berequired by the lessor to make all of the remaining monthly rental payments orproperty tax and common area maintenance payments if the franchisee does notmake the required payments in a timely manner. However, we believe that most,if not all, of the franchised locations could be subleased to third partiesminimizing our potential exposure. Additionally, we have indemnification agreementswith our franchisees under which the franchisees would be obligated toreimburse us for any amounts paid under such guarantees. Historically, we havenot been required to make such payments in significant amounts. We record aliability for our exposure under the guarantees in accordance with SFAS No. 5, “Accountingfor Contingencies,” following a probability related approach. In the event thattrends change in the future, our financial results could be impacted. As ofSeptember 27, 2005, we had outstanding guarantees of indebtedness under certainleases of approximately $0.7 million. Approximately $163,000 is reflected inaccrued expenses in our consolidated balance sheet at September 27, 2005.

 

 

*Insurance*

 

We are insured for lossesrelated to health, general liability and workers’ compensation under largedeductible policies. The insurance liability represents an estimate of theultimate cost of claims incurred and unpaid as of the balance sheet date. Theestimated liability is established based on actuarial estimates, is discountedat 10% based upon a discrete analysis of actual claims and historical data andis reviewed on a quarterly basis to ensure that the liability is appropriate.If actual trends, including the severity or frequency of claims differ from ourestimates, our financial results could be favorably or unfavorably impacted.

 

14

----

 

**11.****      ****Recent Accounting Pronouncements**

 

In December 2004, the FASB issued SFAS No.123 (revised 2004) entitled “Share-Based Payment” that addresses the accountingfor share-based payment transactions in which an enterprise receives employeeservices in exchange for a) equity instruments of the enterprise or b)liabilities that are based on the fair value of the enterprise’s equityinstruments or that may be settled by the issuance of such equity instruments.The Statement eliminates the ability to account for share-based compensationtransactions using APB Opinion No. 25, “Accounting for Stock Issued toEmployees,” and generally would require instead that such transactions beaccounted for using a fair-value-based method. This Statement is to beimplemented at the beginning of the next fiscal year that begins after June 15,2005. Based on options granted and various assumptions used to calculate stockbased compensation expense as of September 27, 2005, we believe that theadoption will result in an increase in expense of approximately $0.4 millionand $0.1 million during fiscal 2006 and 2007, respectively. If actual eventsdiffer from our assumptions used to calculate the expense or if we grantadditional options, our financial results could be impacted.

 

We have considered all other recently issuedaccounting pronouncements and do not believe that the adoption of such pronouncementswill have a material impact on our financial statements.

 

 

**12.****      ****Related Party Transactions**

 

GreenlightCapital, L.L.C. and its affiliates beneficially own approximately 97 percent ofour common stock on a fully diluted basis. As a result, Greenlight hassufficient voting power without the vote of any other stockholders to determinewhat matters will be submitted for approval by our stockholders, to approveactions by written consent without the approval of any other stockholders, toelect all of our board of directors, and among other things, to determinewhether a change in control of our company occurs.

 

15

----

 

**ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

The followingdiscussion and analysis supplements the management’s discussion and analysis inour Annual Report on Form 10-K for the year ended December 28, 2004 andpresumes that readers have read or have access to the discussion and analysisin our Annual Report. The following discussion and analysis includes historicaland certain forward-looking information that should be read together with theaccompanying consolidated financial statements, related footnotes and thediscussion below of certain risks and uncertainties that could cause futureoperating results to differ materially from historical results or from theexpected results indicated by forward looking statements.

 

 

**Business Overview**

 

Weare a leader in the quick casual segment of the restaurant industry. With 639locations in 34 states and the District of Columbia as of September 27, 2005,we operate and license locations primarily under the Einstein Bros. and Noah’sbrand names, and franchise locations primarily under the Manhattan andChesapeake brand names. We also operate a dough production facility. We viewour business as a single segment with a focus on our company-operatedrestaurants. Our manufacturing and franchise operations are either supportiveor ancillary to our main business focus.

 

Therestaurant industry, in which we operate, is intensely competitive. Theindustry is often affected by changes in demographics, consumers’ eating habitsand preferences, local and national economic conditions affecting consumerspending habits, population trends and local traffic patterns. Key elements ofcompetition in the industry are price, quality and value of products offered,quality and speed of service, advertising effectiveness, brand nameidentification, restaurant locations and attractiveness of facilities.

 

Ourfinancial focus is on long term, sustainable growth in free cash flow. Freecash flow represents net cash provided by operations less the investment in ourfacilities and fixed assets. By achieving free cash flow, we will be morecapable of paying down debt, saving cash for future use and buildingshareholder value. We also believe free cash flow may give us the ability topursue new opportunities and/or acquire other businesses. Increasing ouroperating profit and efficiently managing working capital and capitalexpenditures primarily drive free cash flow.

 

Inmeasuring our overall growth and progress, we focus on various key performanceindicators. Such key performance indicators include:

 

•              same-store sales growth, comprisedof average check and transactions,

•              restaurant level and concept levelmargins,

•              cash generated by operations,

•              Adjusted EBITDA (as defined in ourloan agreements),

•              number of company-owned restaurantopenings and closings, and

•              number of franchise and licensedrestaurant openings and closings.

 

Ourprogress against some of these key performance indicators is discussedthroughout the Management’s Discussion and Analysis.

 

16

----

 

**Significant Known Events, Trends or Uncertainties Expected to Impact2005 Results**

 

Thefollowing factors represent currently known trends or uncertainties that mayimpact the comparability of operating performance or could cause reportedfinancial information not to be necessarily indicative of future operatingresults or future financial condition.

 

 

*Revenue Trends*

 

Inan effort to strengthen the performance of our company-operated Einstein Bros.locations, we developed a brand refresh strategy that will include updates ofrestaurant interiors and improvements to service through new menu boards and a “payfirst” ordering system. Some of these enhancements reflect learning from ourEinstein Bros. Café concept, comprising eight restaurants in the Denver andColorado Springs, Colorado markets.

 

**We believe thatdietary trends and negative publicity on products high in carbohydrate contentmay have had an adverse impact on our sales historically. Accordingly, we beganaddressing the issue with modifications to our menu beginning in 2004.Additionally, we introduced limited time offerings featuring seasonal menuitems and implemented modifications to our customer service system. Westrengthened our catering programs in certain markets and initiated advertisingcampaigns during the fourth quarter ended 2004. We believe that changes in theproducts sold at our restaurants, price increases and shifts in product mixesto higher priced items coupled with initiatives in customer service and overallappearance at our restaurants, and advertising programs that build consumerawareness, have contributed to positive comparable store sales during 2005. Weare continuing to strengthen our existing catering programs, build cateringprograms in new markets, increase customer awareness of our retail products,emphasize bundling products such as “Sweeten’ the Deal,” and highlight favoriteproducts such as our egg sandwiches. We believe these initiatives willpositively impact revenue in future periods.**

** **

**Hurricane Wilmacaused many of our Florida restaurants to be temporarily closed due toevacuations and power shortages. At this time, we cannot estimate the negativeimpact this event will have on our revenue and margins for the fourth quarterof 2005.**

** **

 

*Expense Trends*

 

Ourexpense trends are generally affected by the following major categories:

 

•                  Changing pricesfor agricultural commodities,

•                  Rising energycosts and increasing costs of other natural resources,

•                  Increasinglabor costs, and

•                  Increasing taxrates and costs of compliance with regulatory requirements.

 

Infiscal 2004, prices for agricultural commodities such as dairy, cheese andbutter increased substantially. We have experienced slight decreases in dairyprices during 2005, but the decrease has been offset by increases in commoditycosts for coffee, flour and packaging. Because flour represents the mostsignificant raw ingredient we purchase, we implemented new cost reductionsolutions during the later half of the first quarter 2005 to offset the impactof increases in commodity costs and have begun to see the benefit whencomparing consecutive quarter’s performance.

 

Risingenergy costs and the increasing costs of other natural resources affect ourutility bills, the cost of packaging that is derived from petroleum productsand the cost of distribution to our restaurants. We have experienced increasesin the cost for energy and packaging materials during 2005 and believe suchcosts will continue to increase on average for the remainder of 2005. Ourdistribution partners and common freight carriers passed on fuel surcharges tous during fiscal 2004 and 2005. In addition, we are currently negotiatingcontract terms with a new distribution partner to improve quality andservice.  As a result, we anticipateincreased distribution costs beginning in the fourth quarter of 2005. We havealso experienced increases in our utility costs due to the heat wave impacting 

 

17

----

 

mostof the United States during third quarter of 2005. This trend negativelyimpacted retail sales and costs during the third quarter of 2005 but we do notanticipate a significant impact during the fourth quarter of 2005.

 

Dueto competition for personnel, limited availability in the labor pool, andchanges in the federal overtime regulations of the Fair Labor Standards Actwhich went into effect on August 23, 2004, we anticipate that we may experiencean increase in hourly wages during the remainder of 2005 contingent upon thenumber of overtime hours worked.

 

Certainstates and local governments have increased both the rate and nature of taxeson businesses in their regions in an effort to offset budget shortfalls. Theseincreased taxes include real estate and property taxes, state and local incometaxes, and various employment taxes.

 

Changesin any of the aforementioned categories could directly impact the profitabilityof our company-owned locations, manufacturing operations or distributionchannels. Increases in any of these expense trends in the near future maycontribute to degradation in our profit margins until such time as we are ableto pass on increased costs to our consumers.

 

*Impact of Inflation*

 

Wehave not experienced a significant overall impact from inflation. As operatingexpenses increase, we recover increased costs through pricing increases, to theextent permitted by competition. We also review and implement alternativeproducts or processes.

 

*Store Portfolio Strategy*

 

Inmid-2004, we began an in-depth strategic review of all brands and thelikelihood of providing additional capital and other resources to grow eachindependent brand. Additionally, we focused on individual store performance andcompliance at each of our company operated, franchised and licensed stores. Forthe Einstein Bros. brand, we engaged Birchwood Resultants, independentconsultants, to build market level and individual site level models to allowfor strategic growth and portfolio rationalization decisions based on soundmetrics. These models were built based on consumer research conducted at ourcompany operated Einstein Bros. locations and external demographic,psychographic and competitive databases. We considered various factors such aslocal market conditions, distribution and supply chain channels, competition,comparable store sales, store-level cash flows and existing lease terms. Basedon the store-level considerations, we then reviewed the economic and financialcosts of exiting poorly performing locations (where the leases permittedcessation of operations) or sub-leasing the location to a third party. We alsoconsidered the long-term options of locations that perform at break-even orslightly above break-even.  As a resultof our strategic review, we have deliberately reduced our store count based onbusiness decisions supported by quantitative data in an effort to improve ouroverall profitability. We also believe these efforts will identify markets forfuture store growth, allow us to better focus our time and resources, re-investin our existing business and contribute to long-term sustainable growth in freecash flow (cash generated from opreations less capital expenditures).

 

Webelieve we have a solid platform for growth through store licensing of our EinsteinBros. and Noah’s brands. The licensing program is available to qualifiedfoodservice operators and typically requires an upfront license fee that isfully earned at the time the licensee commences operations. Stores aredeveloped on college campuses, hospitals, airports, military installations andother locations. The licensed stores are generally opened during the third andfourth calendar quarters consistent with the timing of many government andhigher education projects and federal funding. We typically receive continuingroyalties on sales from each licensed store location. Our licensees are notrequired to buy all of their non-proprietary products directly from us, butrather their product sources must be approved by us.

 

Wehave a franchise base primarily in our Manhattan brand that generates arecurring revenue stream through fee and royalty payments. Our franchise baseprovides us with the ability to grow our brand with minimal commitment ofcapital by us, and creates a built-in customer base for our manufacturingoperations. We continue to look for franchisee candidates with appropriateoperational experience and financial stability, including specific net worth 

 

18

----

 

andliquidity requirements. During 2004 and 2005, we have worked to improve ourrelationship and communication with performing franchisees. In an effort tostrengthen the brand, we have terminated certain relationships with franchiseesthat are not performing in accordance with their franchise agreements. Webelieve that active involvement in and management of restaurant operations willresult in a successful franchise strategy.

 

We continually assess the financial andoperational alignment of our Manhattan, Chesapeake and New World brands. As theManhattan brand represents the majority of our franchise operations,revitalizing and strengthening this brand remains a challenge for ourmanagement team. In 2004, we recognized that our historic franchise model wasnot consistent with future operating plans for all of our brands due togeographic separation from core markets. As a result, we exited certain marketsduring the second quarter ended 2005. We believe that by focusing on coremarkets, we will continue to build stronger brand awareness, consistent levelsof performance and customer loyalty.

 

During the second quarter ended 2005, we reviewed the long term strategic fit of Chesapeake utilizingthe recommendations of a third party consultant previously engaged to presentviable alternatives for the brand. Based upon the consultant’s recommendations,we began forming an exit strategy that we believed could be completed withinone year. Because there had been a change in circumstances, it was necessary toreview the asset for impairment. The analysis indicated that the carryingamount of the Chesapeake trademarks was greater than its fair value andaccordingly we recorded an impairment charge of $1.2 million during the secondquarter ended June 28, 2005. Currently, we are working with our remainingfranchisees on an exit strategy that we anticipate completing by the end offiscal year 2005. We also continue to review the carrying amount of the assetsin relation to their fair value. For the year to date period ended September27, 2005, we have recorded impairment charges of approximately $1.3 millionrelated to the Chesapeake trademarks.

 

Thefollowing table details the total restaurants open at the end of the respectivethird quarter:

 
| ** **                               | ** ** | **Company** | ** ** | ** **   | ** ** | ** **     | ** ** | ** ** | ** ** |
|------------------------------------------|------------|-------------|------------|--------------|------------|----------------|------------|------------|------------|
| ** **                               | ** ** | **owned**   | ** ** | **Licensed** | ** ** | **Franchised** | ** ** | **Total**  | ** ** |
| **Einstein Bros Bagels:**                | ** ** | ** **  | ** ** | ** **   | ** ** | ** **     | ** ** | ** ** | ** ** |
| 2005                                     |       | 353         |       | 64           |       | —         |       | 417        |       |
| 2004                                     |       | 371         |       | 53           |       | —         |       | 424        |       |
| **Einstein Bros Cafe:**                  | ** ** | ** **  | ** ** | ** **   | ** ** | ** **     | ** ** | ** ** | ** ** |
| 2005                                     |       | 8           |       | —       |       | —         |       | 8          |       |
| 2004                                     |       | —      |       | —       |       | —         |       | —     |       |
| **Noah’s:**                         |       |        |       |         |       |           |       |       |       |
| 2005                                     |       | 74          |       | 3            |       | —         |       | 77         |       |
| 2004                                     |       | 78          |       | 3            |       | —         |       | 81         |       |
| **Manhattan:**                           |       |        |       |         |       |           |       |       |       |
| 2005                                     |       | —      |       | —       |       | 119            |       | 119        |       |
| 2004                                     |       | —      |       | —       |       | 154            |       | 154        |       |
| **Chesapeake:**                          |       |        |       |         |       |           |       |       |       |
| 2005                                     |       | —      |       | —       |       | 12             |       | 12         |       |
| 2004                                     |       | —      |       | —       |       | 32             |       | 32         |       |
| **New World Coffee/Willoughby’s*:** |       |        |       |         |       |           |       |       |       |
| 2005                                     |       | 2           |       | —       |       | 4              |       | 6          |       |
| 2004                                     |       | 7           |       | —       |       | 9              |       | 16         |       |
| **Total Restaurants:**                   |       |        |       |         |       |           |       |       |       |
| 2005                                     |       | 437         |       | 67           |       | 135            |       | 639        |       |
| 2004                                     |       | 456         |       | 56           |       | 195            |       | 707        |       |

----

*On October 6, 2004, we sold Willoughby’s.The Willoughby’s business consisted of a coffee roasting plant, threeretail locations and office space.

 

19

----

 

**Results ofOperations**

 

The table below sets forth, for the periodsindicated, certain amounts included in our consolidated statements ofoperations, the relative percentage that those amounts represent to totalrevenue (unless otherwise indicated), and the percentage change in thoseamounts from period to period. All percentages are calculated using actualamounts rounded to the nearest thousand.

 
| ** **                                                    | ** ** | ** **                     | ** ** | ** **     | ** ** | **Increase**                   | ** ** | ** **     | ** ** | ** **                      | ** ** | **Increase**                    | ** ** | ** **  | ** ** | ** **  | ** ** | ** **  | ** ** | ** **  | ** ** |
|---------------------------------------------------------------|------------|--------------------------------|------------|----------------|------------|--------------------------------|------------|----------------|------------|---------------------------------|------------|---------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|-------------|------------|
| ** **                                                    | ** ** | **Third  quarter ended:**      | ** ** | **(Decrease)** | ** ** | **Year to  date ended:**       | ** ** | **(Decrease)** | ** ** | **Third  quarter ended:**       | ** ** | **Year to  date ended:**        | ** ** |
| ** **                                                    | ** ** | **(in  thousands of dollars)** | ** ** | **2005**       | ** ** | **(in  thousands of dollars)** | ** ** | **2005**       | ** ** | **(percent  of total revenue)** | ** ** | **(percent  of total revenue)** | ** ** |
| ** **                                                    | ** ** | **9/27/05**                    | ** ** | **9/28/04**    | ** ** | **vs. 2004**                   | ** ** | **9/27/05**    | ** ** | **9/28/04**                     | ** ** | **vs. 2004**                    | ** ** | **9/27/05** | ** ** | **9/28/04** | ** ** | **9/27/05** | ** ** | **9/28/04** | ** ** |
| Revenues:                                                     |       |                           |       |           |       |                           |       |           |       |                            |       |                            |       |        |       |        |       |        |       |        |       |
| Retail sales                                                  |       | 87,937                         |       | 84,763         |       | 3.7                            | %          | 265,912        |       | 256,982                         |       | 3.5                             | %          | 92.8        | %          | 93.0        | %          | 93.2        | %          | 92.9        | %          |
| Manufacturing  revenues                                       |       | 5,270                          |       | 4,913          |       | 7.3                            | %          | 14,905         |       | 15,270                          |       | (2.4                            | )%         | 5.6         | %          | 5.4         | %          | 5.2         | %          | 5.5         | %          |
| Franchise and  license related revenues                       |       | 1,575                          |       | 1,503          |       | 4.8                            | %          | 4,373          |       | 4,287                           |       | 2.0                             | %          | 1.7         | %          | 1.6         | %          | 1.5         | %          | 1.6         | %          |
| Total revenues                                                |       | 94,782                         |       | 91,179         |       | 4.0                            | %          | 285,190        |       | 276,539                         |       | 3.1                             | %          | 100.0       | %          | 100.0       | %          | 100.0       | %          | 100.0       | %          |
| Cost of sales  (percentage of corresponding revenue stream):  |       |                           |       |           |       |                           |       |           |       |                            |       |                            |       |        |       |        |       |        |       |        |       |
| Retail costs                                                  |       | 73,941                         |       | 70,315         |       | 5.2                            | %          | 219,141        |       | 213,805                         |       | 2.5                             | %          | 84.1        | %          | 83.0        | %          | 82.4        | %          | 83.2        | %          |
| Manufacturing  costs                                          |       | 4,980                          |       | 4,603          |       | 8.2                            | %          | 13,880         |       | 13,623                          |       | 1.9                             | %          | 94.5        | %          | 93.7        | %          | 93.1        | %          | 89.2        | %          |
| Total cost of  sales                                          |       | 78,921                         |       | 74,918         |       | 5.3                            | %          | 233,021        |       | 227,428                         |       | 2.5                             | %          | 83.3        | %          | 82.2        | %          | 81.7        | %          | 82.2        | %          |
| Gross profit  (percentage of corresponding revenue stream):   |       |                           |       |           |       |                           |       |           |       |                            |       |                            |       |        |       |        |       |        |       |        |       |
| Retail                                                        |       | 13,996                         |       | 14,448         |       | (3.1                           | )%         | 46,771         |       | 43,177                          |       | 8.3                             | %          | 15.9        | %          | 17.0        | %          | 17.6        | %          | 16.8        | %          |
| Manufacturing                                                 |       | 290                            |       | 310            |       | (6.5                           | )%         | 1,025          |       | 1,647                           |       | (37.8                           | )%         | 5.5         | %          | 6.3         | %          | 6.9         | %          | 10.8        | %          |
| Franchise and  license                                        |       | 1,575                          |       | 1,503          |       | 4.8                            | %          | 4,373          |       | 4,287                           |       | 2.0                             | %          | 100.0       | %          | 100.0       | %          | 100.0       | %          | 100.0       | %          |
| Total gross  profit                                           |       | 15,861                         |       | 16,261         |       | (2.5                           | )%         | 52,169         |       | 49,111                          |       | 6.2                             | %          | 16.7        | %          | 17.8        | %          | 18.3        | %          | 17.8        | %          |
|                                                          |       |                           |       |           |       |                           |       |           |       |                            |       |                            |       |        |       |        |       |        |       |        |       |
| General and  administrative expenses                          |       | 8,868                          |       | 8,442          |       | 5.0                            | %          | 26,857         |       | 25,260                          |       | 6.3                             | %          | 9.4         | %          | 9.3         | %          | 9.4         | %          | 9.1         | %          |
| Depreciation and  amortization                                |       | 5,798                          |       | 7,005          |       | (17.2                          | )%         | 19,583         |       | 20,882                          |       | (6.2                            | )%         | 6.1         | %          | 7.7         | %          | 6.9         | %          | 7.6         | %          |
| Loss (gain) on  sale, disposal or abandonment of assets, net  |       | 104                            |       | (70            | )          | *                              |       | 269            |       | 1,395                           |       | (80.7                           | )%         | 0.1         | %          | (0.1        | )%         | 0.1         | %          | 0.5         | %          |
| Charges  (adjustments) of integration and reorganization cost |       | 1                              |       | (44            | )          | *                              |       | 6              |       | (843                            | )          | *                               |       | 0.0         | %          | (0.0        | )%         | 0.0         | %          | (0.3        | )%         |
| Impairment  charges and other related costs                   |       | 205                            |       | 402            |       | (49.0                          | )%         | 1,484          |       | 402                             |       | *                               |       | 0.2         | %          | 0.4         | %          | 0.5         | %          | 0.1         | %          |
| Income from  operations                                       |       | 885                            |       | 526            |       | 68.3                           | %          | 3,970          |       | 2,015                           |       | 97.0                            | %          | 0.9         | %          | 0.6         | %          | 1.4         | %          | 0.7         | %          |
| Other expense  (income):                                      |       |                           |       |           |       |                           |       |           |       |                            |       |                            |       |        |       |        |       |        |       |        |       |
| Interest expense,  net                                        |       | 5,805                          |       | 5,723          |       | 1.4                            | %          | 17,497         |       | 17,426                          |       | 0.4                             | %          | 6.1         | %          | 6.3         | %          | 6.1         | %          | 6.3         | %          |
| Other                                                         |       | (106                           | )          | (98            | )          | 8.2                            | %          | (232           | )          | (197                            | )          | 17.8                            | %          | (0.1        | )%         | (0.1        | )%         | (0.1        | )%         | (0.1        | )%         |
| Loss before  income taxes                                     |       | (4,814                         | )          | (5,099         | )          | (5.6                           | )%         | (13,295        | )          | (15,214                         | )          | (12.6                           | )%         | (5.1        | )%         | (5.6        | )%         | (4.7        | )%         | (5.5        | )%         |

----

   * not meaningful

 

20

----

 

*Revenues*

 

**Total revenues forthe third quarter and year to date period ended September 27, 2005 wereconsistent with our expectations. Our total revenues increased 4.0% and 3.1%when compared to the third quarter and year to date period ended 2004,respectively. This increase primarily resulted from a dollar increase in retailsales (e.g. company-operated store sales, which represent the mostsignificant component of revenue).  Ourretail comparable store sales increase of 5.9% consisted of a 5.5% increase inaverage check and a 0.4% increase in transactions during the third quarterended 2005. We also experienced a 5.6% increase in comparable store sales forthe year to date period ended September 27, 2005 which consisted of 6.0%increase in average check partially offset by 0.3% decrease in transactions.Comparable store sales represent sales at stores that were open for one fullyear and have not been relocated or closed during the current year. Comparablestore sales are also referred to as “same-store” sales and as “comp sales”within the restaurant industry.**

** **

**Throughout fiscal2004, the trend of lower comparable store sales began to reverse and ultimatelybecame positive during the fourth quarter of 2004. The following tablesummarizes the elements of comparable store sales for each quarter in fiscal2004 and 2005:**

 

| ** **                   | ** ** | **Comparable**  | ** ** | **Average** | ** ** | ** **       | ** ** |
|------------------------------|------------|-----------------|------------|-------------|------------|------------------|------------|
| **Period**                   | ** ** | **Store Sales** | ** ** | **Check**   | ** ** | **Transactions** | ** ** |
| First quarter, fiscal 2004   |       | (4.8            | )%         | 0.7         | %          | (5.5             | )%         |
| Second quarter, fiscal  2004 |       | (3.7            | )%         | 3.9         | %          | (7.3             | )%         |
| Third quarter, fiscal 2004   |       | (1.6            | )%         | 5.0         | %          | (6.3             | )%         |
| Fourth quarter, fiscal  2004 |       | 2.6             | %          | 5.2         | %          | (2.5             | )%         |
| First quarter, fiscal 2005   |       | 4.6             | %          | 6.4         | %          | (1.7             | )%         |
| Second quarter, fiscal  2005 |       | 6.3             | %          | 6.0         | %          | 0.3              | %          |
| Third quarter, fiscal 2005   |       | 5.9             | %          | 5.5         | %          | 0.4              | %          |

** **

** **

**We believe thepositive trend in comparable store sales is a result of price increases coupledwith a shift in the product mix to higher priced items, improvements in theoperation of our restaurants including initiatives in customer service andoverall store appearance, the introduction of new menu items, furtherdevelopment of catering programs in selected markets, and advertising campaignsthat were initiated in the fourth quarter ended 2004 and second and thirdquarters ended 2005 that strengthened consumer awareness.**

 

21

----

 

*Gross Profit*

 

Ourtotal gross profit decreased 2.5% for the third quarter ended 2005 when comparedto the same period in 2004 and increased 6.2% for the year to date period ended2005 when compared to the same period in 2004. The fluctuations were primarilydue to a decrease of 3.1% and an increase of 8.3% in our retail margins (e.g.company-operated store margins, which contribute the most significantcomponent of gross profit) during the third quarter and year to date periodsended 2005, respectively. Our retail margins are impacted by variousstore-level operating expenses such as the cost of products sold, salaries andbenefits, insurance, supplies, repair and maintenance expenses, advertising,rent, utilities and property taxes. Similarly, our manufacturing margins areimpacted by various manufacturing-level operating expenses such as the cost ofproducts sold, salaries and benefits, insurance, supplies, repair andmaintenance expenses, rent, utilities and property taxes. Depreciation,amortization and income taxes do not impact our retail or manufacturingmargins.

 

Forthe third quarter ended 2005, the increase in retail sales over the comparableperiod contributed approximately $2.2 million of store contribution marginrelated to the increased sales. This margin increase was partially offset byapproximately $1.5 million in additional marketing spend, $0.4 million inincreased energy and utility costs impacting our restaurants located in warmerclimates, and $0.2 million due to the timing of repair and maintenanceexpenditures. In the comparable 2004 quarter, we intentionally reducedmarketing spend as we focused on modifications to our customer service system,menu offerings and the “look and feel” of our restaurants. Additionally in thecomparable 2004 quarter, we recognized benefits in our group insurance IBNR(incurred but not recognized) estimates of approximately $0.6 million due tofavorable claims experience.

 

Forthe year to date period ended September 27, 2005, the increase in retail salesover the comparable period contributed approximately $8.5 million of storecontribution margin related to the increased sales. This margin increase waspartially offset by approximately $2.2 million in additional marketing spend,$0.6 million in increased bank charges and credit card fees, $0.4 million inincreased energy and utility costs impacting our restaurants located in warmerclimates, $0.5 million due to the timing of repair and maintenance expendituresand $0.5 million in increased real estate taxes and a real estate dispute. Inthe comparable year to date period ended 2004, we recognized benefits in ourgroup insurance IBNR (incurred but not recognized) estimates of approximately$0.7 million due to favorable claims experience. Because certain elements ofcost of sales are fixed in nature such as rent, utilities, property taxes andmanager salaries, incremental sales positively impact gross profit.

 

Ourmanufacturing operations are ancillary to our company-operated stores. For thethird quarter and year to date periods ended 2005 and 2004, our manufacturingmargins represented less than 1.0% of total revenues. Our manufacturing marginsdecreased 6.5% and 37.8% for the third quarter and year to date periods ended2005, respectively, when compared to the same periods in 2004. Manufacturingmargins for the year to date period ended September 27, 2005 were predominatelyimpacted by increases in labor and commodity costs. During the later half offirst quarter 2005, we implemented new cost reduction solutions to offset theimpact of increases in commodity costs and have begun to see the benefit whencomparing consecutive quarter’s performance.

 

 

*Other Operating Expenses*

 

**Our general andadministrative expenses increased 5.0% for the third quarter ended 2005 whencompared to the same period in 2004. The increase was primarily due to anadditional $0.3 million in bonuses payable to corporate office staff andmanagement due to improved operating performance.**

** **

**Our general andadministrative expenses increased 6.3% for the year to date period endedSeptember 27, 2005 when compared to the same period in 2004. For the year todate period ended 2005, approximately $1.6 million was the result of anincrease in bonuses payable to corporate office staff and management due toimproved operating performance. Also contributing to the increase wasapproximately $0.3 million in severance wages payable, $0.4 million inadditional vacation wages, $0.5 million in additional recruiting and relocationexpenses, offset by approximately $1.2 million in reduced legal spendingrelated to former employee matters that were resolved in early 2005.**

 

**22**

----

 

Depreciationand amortization expenses decreased 17.2% and 6.2%, respectively, for the thirdquarter and year to date period ended September 27, 2005, when compared to thesame periods in 2004. The decrease is partly due to a portion of our asset basebecoming fully depreciated. Additionally affecting the third quarterended September 27, 2005 is a correction of an overstatement of the firstand second quarters’ depreciation expense of approximately $0.6million that is properly reflected in the year to date period ended September27, 2005.

 

Duringthe second quarter ended 2004, we recorded a loss of approximately $1.3 millionprimarily due to the disposal of menu boards as a result of new productofferings and due to the abandonment of leasehold improvements related toclosed restaurants and our administrative facilities located in New Jersey.

 

Theadjustment of integration and reorganization cost primarily representsadjustments to previously recorded liabilities associated with the closing andcorporate consolidation of our Eatontown facilities during 2002. During April2004, we reached an agreement with the landlord of our Eatontown facility tosettle outstanding litigation. Previously recorded integration andreorganization estimates associated with closing this facility resulted in abenefit of $700,000 during the first quarter ended 2004 as a result of thissettlement.

 

As more fully discussed in note 3 to ourconsolidated financial statements,we recorded approximately $1.3 million in impairment charges related to theChesapeake trademarks during the year to date period ended September 27, 2005.We also recorded approximately $0.1 million in impairment charges related tocompany-owned stores and approximately $0.1 million in exit costs from thedecision to close one restaurant.

 

 

**Liquidity and Capital Resources**

 

Therestaurant industry is predominantly a cash business where cash is received atthe time of the transaction. We generate sufficient cash flow and we havesufficient availability under our AmSouth Revolver to fund operations, capitalexpenditures and required debt and interest payments. Our inventory turnsfrequently and accordingly our investment in inventory is minimal since our productsare perishable. Our accounts payable are on terms that we believe areconsistent with those of other companies within the industry.

 

Theprimary driver of our operating cash flow is our restaurant operations,specifically the gross margin from our company-operated restaurants. Therefore,we focus on the elements of those operations including comparable store salesand cash flows to ensure a steady stream of operating profits that enable us tomeet our cash obligations. On a weekly basis, we review our company-operatedstore performance compared with the same period in the prior year and ouroperating plan. We are continuously identifying and implementing cost reductioninitiatives, not only at the store operations level, but also within otherdisciplines such as supply chain, manufacturing operations and overhead.  During 2005, we have continued to identifycost reduction initiatives, including but not limited to: menu optimization toremove and/or modify slow moving products and thus reduce waste, reductions incost of goods sold through purchasing efficiencies, a focus on labor costs andefficiencies, and further refinement of programs that monitor theoretical foodcost. 

 

*Credit Facility*

 

OurAmSouth Revolver is a $15 million senior secured revolving credit facility,which matures on July 8, 2006. On September 27, 2005, our unused creditfacility totaled approximately $7.9 million, net of outstanding letters ofcredit of $7.1 million. Our credit facility contains financial covenantsrelating to the maintenance of leverage and coverage ratios. The creditfacility also contains affirmative and negative covenants including, amongother things, limitations on certain additional indebtedness, capitalexpenditures and minimum EBITDA as defined in the AmSouth agreement. We were incompliance with all covenants at September 27, 2005 and do not anticipate thatthe covenants will impact our ability to borrow under our credit facility forits remaining term.

 

Basedupon our projections for fiscal 2005 and beyond, we believe that the cash flowfrom operations coupled with the continued availability of our AmSouth Revolverwill be adequate to fund our operations, capital expenditures and required debtand interest repayments for the foreseeable future.

 

23

----

 

Inthe first quarter of 2005, we announced the engagement of Bear Stearns,investment bankers, to assist in the potential refinancing of our $160 MillionNotes and AmSouth Revolver. Due to the instability of the high yield marketduring the second quarter of 2005 and under advisement from Bear Stearns, wetemporarily suspended further refinancing activity until just recently.Currently, market conditions appear to have improved and we are reviewing ouroptions regarding refinancing with Bear Sterns. We believe that refinancing ourdebt at favorable interest rates could increase our letter of credit capacity,reduce interest expense and provide additional flexibility for future storegrowth.

 

 

*Operating Activities*

 

Forthe year to date period ended September 27, 2005, operations generated $2.8million of cash. We continue to see improvements in our cash flow fromoperations and believe that such cash flow will be adequate to fund operatingcosts. Due to the timing of interest payments under our $160 Million Notes,which are due January 1 and July 1, we generally consume cash from operationsduring the first and third fiscal quarters of each year. During the second andfourth fiscal quarters of each year, we generally generate cash fromoperations. Historically, our fourth quarter is our strongest quarter forgenerating cash due to seasonality and gift card promotions.

 

 

*Investing Activities*

 

Forthe year to date period ended September 27, 2005, we used approximately $5.8 millionof cash to purchase additional property and equipment which included $0.4million for new stores, $0.7 million for remodeling existing stores, $3.1million for replacement and new equipment at our existing company-operatedstores, $0.7 million for our manufacturing operations and less than $0.9million for general corporate purposes.

 

 

*Contractual Obligations*

 

Therewere no material changes to our contractual obligations during the thirdquarter ended 2005. For information regarding our contractual obligations atDecember 28, 2004, see our Annual Report on Form 10-K for the fiscal year endedDecember 28, 2004.

 

 

*Guarantees*

 

Prior to 2001, we would occasionallyguarantee leases for the benefit of certain of our franchisees. None of theguarantees have been modified since their inception and we have sincediscontinued this practice. Current franchisees are the primary lessees underthe vast majority of these leases. Under the lease guarantees, we may berequired by the lessor to make all of the remaining monthly rental payments orproperty tax and common area maintenance payments if the franchisee does notmake the required payments in a timely manner. However, we believe that most,if not all, of the franchised locations could be subleased to third partiesminimizing our potential exposure. Additionally, we have indemnificationagreements with our franchisees under which the franchisees would be obligatedto reimburse us for any amounts paid under such guarantees. Historically, wehave not been required to make such payments in significant amounts. We recorda liability for our exposure under the guarantees in accordance with SFAS No.5, “Accounting for Contingencies,” following a probability related approach. Inthe event that trends change in the future, our financial results could beimpacted. As of September 27, 2005, we had outstanding guarantees ofindebtedness under certain leases of approximately $0.7 million. Approximately$163,000 is reflected in accrued expenses in our consolidated balance sheet atSeptember 27, 2005.

 

24

----

 

*Insurance*

 

We are insured for losses related to health,general liability and workers’ compensation under large deductible policies.The insurance liability represents an estimate of the ultimate cost of claimsincurred and unpaid as of the balance sheet date. The estimated liability isestablished based on actuarial estimates, is discounted at 10% based upon adiscrete analysis of actual claims and historical data and is reviewed on aquarterly basis to ensure that the liability is appropriate. If actual trends,including the severity or frequency of claims differ from our estimates, ourfinancial results could be favorably or unfavorably impacted.

 

 

*Non-GAAP Financial Measures*

 

Adjusted EBITDA is a typical non-GAAPmeasurement for companies that issue debt and a measure used by our lenders.Adjusted EBITDA, as defined in our Indenture Agreement relating to the $160Million Notes and the revolving credit facility with AmSouth Bank (collectivelyreferred to herein as our loan agreements) represents earnings before interest,taxes, depreciation and amortization, and is further adjusted by various itemsincluding: (1) integration and reorganization charges and credits, (2)cumulative change in fair value of derivatives, (3) gain/loss on theinvestment, sale, disposal or exchange of assets, (4) impairment and otherrelated charges and (5) other expense (income). Adjusted EBITDA may also befurther adjusted by certain legal, financing and advisory fees, acquisition andintegration expenses, and other charges. Our loan agreements require thatAdjusted EBITDA be measured on a twelve month period ending on the last day ofeach fiscal quarter and be greater than $33 million. We present Adjusted EBITDAbecause it relates to a covenant contained in each of our loan agreements whichare material to us, our financial condition and liquidity. If we do not complywith the Adjusted EBITDA covenant, an Event of Default (as defined in our loanagreements) would occur and, subject to the applicable notice and cure periods,the lenders could declare all amounts outstanding immediately due and payableand pursue all available remedies for payment of such amounts.  As of September 27, 2005, we were incompliance with the Adjusted EBITDA covenant and we do not anticipate that thecovenant will impact our ability to borrow under the AmSouth revolving creditfacility.

 

Data regarding Adjusted EBITDA is provided asadditional information to help our bondholders understand our compliance withthe Adjusted EBITDA covenant. We also believe Adjusted EBITDA is useful to ourbondholders as an indicator of earnings available to service debt.  Adjusted EBITDA is not a recognized term underGAAP and does not purport to be an alternative to income (loss) fromoperations, an indicator of cash flow from operations or a measure ofliquidity. Because not all companies calculate Adjusted EBITDA identically,this presentation may not be comparable to similarly titled measures of othercompanies. We believe Adjusted EBITDA is a more meaningful indicator ofearnings available to service debt when certain charges (such as the gain orloss from the disposal of assets, impairment of assets and cumulative change inthe fair value of derivatives) are excluded from income (loss) from continuingoperations. Adjusted EBITDA is not intended to be a measure of free cash flowfor management’s discretionary use, as it does not consider certain cashrequirements such as interest expense, income taxes, debt service payments andcash costs arising from integration and reorganization activities.

 

25

----

 

The followingtables reconcile Adjusted EBITDA to net loss and cash flows used in operatingactivities, respectively:

 
| ** **                                                    | ** ** | **First quarter ended:** | ** ** | **Second quarter ended:** | ** ** | **Third quarter ended:** | ** ** | **Year to date:** | ** ** |
|---------------------------------------------------------------|------------|--------------------------|------------|---------------------------|------------|--------------------------|------------|-------------------|------------|
| ** **                                                    | ** ** | **Mar 29,**              | ** ** | **Mar 30,**               | ** ** | **Jun 28,**              | ** ** | **Jun 29,**       | ** ** | **Sept 27,** | ** ** | **Sept 28,** | ** ** | **Sept 27,** | ** ** | **Sept 28,** | ** ** |
| ** **                                                    | ** ** | **2005**                 | ** ** | **2004**                  | ** ** | **2005**                 | ** ** | **2004**          | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Reconciliation  of Net Loss to Adjusted EBITDA:**           | ** ** | ** **               | ** ** | ** **                | ** ** | ** **               | ** ** | ** **        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net loss                                                      |       | $                        | (4,198     | )                         | $          | (4,130                   | )          | $                 | (4,283     | ) | $ | (6,224 | ) | $ | (4,814 | ) | $ | (4,952 | ) | $ | (13,295 | ) | $ | (15,306 | ) |
| Adjustments as  defined in the loan agreements:               |       |                     |       |                      |       |                     |       |              |       |   |   |   |   |   |   |   |   |
| Interest expense,  net                                        |       | 5,919                    |       | 5,799                     |       | 5,773                    |       | 5,904             |       | 5,805 |   | 5,723 |   | 17,497 |   | 17,426 |   |
| Taxes                                                         |       | —                   |       | 55                        |       | —                   |       | 184               |       | — |   | (147 | ) | — |   | 92 |   |
| Depreciation and  amortization                                |       | 6,708                    |       | 6,819                     |       | 7,077                    |       | 7,058             |       | 5,798 |   | 7,005 |   | 19,583 |   | 20,882 |   |
| Loss (gain) on  sale, disposal or abandonment of assets, net  |       | 4                        |       | (7                        | )          | 161                      |       | 1,472             |       | 104 |   | (70 | ) | 269 |   | 1,395 |   |
| Charges  (adjustments) of integration and reorganization cost |       | 5                        |       | (760                      | )          | —                   |       | (39               | )          | 1 |   | (44 | ) | 6 |   | (843 | ) |
| Impairment  charges and other related costs                   |       | 97                       |       | —                    |       | 1,182                    |       | —            |       | 205 |   | 402 |   | 1,484 |   | 402 |   |
| Other expense  (income)                                       |       | (57                      | )          | (63                       | )          | (69                      | )          | (36               | )          | (106 | ) | (98 | ) | (232 | ) | (197 | ) |
| Certain legal,  financing and advisory fees                   |       | —                   |       | 75                        |       | 526                      |       | 688               |       | 99 |   | 494 |   | 625 |   | 1,257 |   |
| Certain corporate  expenses                                   |       | —                   |       | 225                       |       | —                   |       | —            |       | — |   | 174 |   | — |   | 399 |   |
| Certain other  charges                                        |       | —                   |       | 25                        |       | 700                      |       | —            |       | 25 |   | — |   | 725 |   | 25 |   |
| Adjusted EBITDA                                               |       | $                        | 8,478      |                      | $          | 8,038                    |       | $                 | 11,067     |   | $ | 9,007 |   | $ | 7,117 |   | $ | 8,487 |   | $ | 26,662 |   | $ | 25,532 |   |
|                                                               |            |                          |            |                           |            |                          |            |                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                                                       | ** ** | **First quarter ended:** | ** ** | **Second quarter ended:** | ** ** | **Third quarter ended:** | ** ** | **Year to date:** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------|------------|---------------------------|------------|--------------------------|------------|-------------------|------------|
| ** **                                                                       | ** ** | **March 29,**            | ** ** | **March 30,**             | ** ** | **June 28,**             | ** ** | **June 29,**      | ** ** | **Sept 27,** | ** ** | **Sept 28,** | ** ** | **Sept 27,** | ** ** | **Sept 28,** | ** ** |
| ** **                                                                       | ** ** | **2005**                 | ** ** | **2004**                  | ** ** | **2005**                 | ** ** | **2004**          | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Reconciliation  of Net Cash Used in Operating Activities to Adjusted EBITDA:** | ** ** | ** **               | ** ** | ** **                | ** ** | ** **               | ** ** | ** **        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net cash  generated by (used in) operating activities                            |       | $                        | (6,288     | )                         | $          | (4,175                   | )          | $                 | 14,353     |   | $ | 9,610 |   | $ | (5,304 | ) | $ | (5,853 | ) | $ | 2,761 |   | $ | (418 | ) |
| Adjustments as  defined in the loan agreements:                                  |       |                     |       |                      |       |                     |       |              |       |   |   |   |   |   |   |   |   |
| Changes in  operating assets and liabilities                                     |       | 9,292                    |       | 6,560                     |       | (9,784                   | )          | (6,768            | )          | 7,138 |   | 8,860 |   | 6,646 |   | 8,652 |   |
| Reduction in  (provision for) losses on accts receivable                         |       | 91                       |       | —                    |       | 47                       |       | (94               | )          | (60 | ) | (172 | ) | 78 |   | (266 | ) |
| Amortization of  debt issue costs                                                |       | (462                     | )          | (462                      | )          | (462                     | )          | (446              | )          | (462 | ) | (479 | ) | (1,386 | ) | (1,387 | ) |
| Stock based  compensation expense                                                |       | (17                      | )          | —                    |       | (17                      | )          | (35               | )          | (18 | ) | (16 | ) | (52 | ) | (51 | ) |
| Interest expense,  net                                                           |       | 5,919                    |       | 5,799                     |       | 5,773                    |       | 5,904             |       | 5,805 |   | 5,723 |   | 17,497 |   | 17,426 |   |
| Other income                                                                     |       | (57                      | )          | (64                       | )          | (69                      | )          | (36               | )          | (106 | ) | (97 | ) | (232 | ) | (197 | ) |
| Provision  (benefit) for state income taxes                                      |       | —                   |       | 55                        |       | —                   |       | 184               |       | — |   | (147 | ) | — |   | 92 |   |
| Certain legal,  financing and advisory fees                                      |       | —                   |       | 75                        |       | 526                      |       | 688               |       | 99 |   | 494 |   | 625 |   | 1,257 |   |
| Certain corporate  expenses                                                      |       | —                   |       | 225                       |       | —                   |       |              |       | — |   | 174 |   | — |   | 399 |   |
| Certain other  charges                                                           |       | —                   |       | 25                        |       | 700                      |       | —            |       | 25 |   | — |   | 725 |   | 25 |   |
| Adjusted EBITDA                                                                  |       | $                        | 8,478      |                      | $          | 8,038                    |       | $                 | 11,067     |   | $ | 9,007 |   | $ | 7,117 |   | $ | 8,487 |   | $ | 26,662 |   | $ | 25,532 |   |
|                                                                                  |            |                          |            |                           |            |                          |            |                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

26

----

 

### ***RiskFactors***

####  

We caution our readers that the followingimportant factors, among others, could cause the actual results to differmaterially from those indicated by forward-looking statements made in thisreport and from time to time in news releases, reports, proxy statements,registration statements and other written communications, as well as verbalforward-looking statements made from time to time by representatives of thecompany. Such forward-looking statements involve risks and uncertainties thatmay cause our actual results, performance or achievements to be materiallydifferent from any future performance or achievements expressed or implied bythese forward-looking statements. Factors that might cause actual events orresults to differ materially from those indicated by these forward-lookingstatements include, but are not limited to (i) future economic performance,(ii) success of cost reduction initiatives, (iii) the possibility ofrefinancing of our debt, (iv) restaurant openings or closings, (v) our abilityto identify new markets and locations, (vi) refreshing our existing locations,(vii) our ability to incorporate elements of Einstein Bros. Café to improveperformance of existing Einstein Bros. Bagels, (viii) our ability to executeour franchise and licensing strategy, (ix) operating margins, (x) theavailability of acceptable real estate locations, (xi) the success and consumeracceptance of our innovations and changes to our restaurants, (xii) our abilityto appropriately allocate capital expenditures to our restaurants, (xiii) thesufficiency of our cash balances, (xiv) cash generated from operating and financingactivities for our future liquidity and capital resource needs, (xv) thereliability of our distribution partners and channels, (xvi) costs of utilitiesand fuel; costs and availability of commodities and products and (xvii) othermatters, and are generally accompanied by words such as: believes, anticipates,estimates, predicts, expects, projects, and similar expressions that convey theuncertainty of future events or outcomes. An expanded discussion of some ofthese risks factors follows. You should also refer to the other information setforth in our Annual Report on Form 10-K for the fiscal year ended December 28,2004, including our consolidated financial statements and the related notes.

 

 

*We may not be successful in implementing any or all of the initiativesof our business strategy.*

 

Oursuccess depends in part on our ability to understand our customers’ needs. Webelieve successful deployment of our current business strategy will addresscustomers’ needs and contribute to overall company growth. While we believe ourrefresh strategy will strengthen the performance of our Einstein Bros. brand,its success is dependent upon various factors, including customer acceptance ofnew menu offerings and pricings, the look and feel of the restaurants, and thenew service system. In addition, the availability of capital and opportunitiesto make modifications to existing stores will be significant factors in thesuccess of our business strategy. If we improperly perceive customers’ needsand/or are not successful in implementing any or all of the initiatives of ourbusiness strategy, it could have a material adverse effect on our business,results of operations, and financial condition.

 

*We have and expect to continue to have a substantial amount of debt.*

 

Wehave a high level of debt and are highly leveraged. In addition, we may,subject to certain restrictions, incur substantial additional indebtedness inthe future. Our high level of debt, among other factors, could:

 

•                  make itdifficult for us to satisfy our obligations under our indebtedness;

•                  limit ourability to obtain additional financing for working capital, capitalexpenditures, acquisitions and general corporate purposes;

•                  increase ourvulnerability to downturns in our business or the economy generally; and

•                  limit ourability to withstand competitive pressures from our less leveraged competitors.

 

27

----

 

OurAmSouth Revolver and $160 Million Notes expire in July 2006 and July 2008,respectively. In first quarter 2005, we engaged Bear Stearns, investmentbankers, to assist us in refinancing our $160 Million Notes and the AmSouthRevolver. Due to the instability of the high yield market during the secondquarter of 2005 and under advisement from Bear Stearns, we temporarilysuspended further refinancing activity until just recently. Currently, marketconditions appear to have improved and we are reviewing our options regardingrefinancing with Bear Sterns. We believe that refinancing our debt at favorableinterest rates could increase our letter of credit capacity, reduce interestexpense and provide additional flexibility for future store growth. We cannotprovide any assurance that we will be successful in refinancing this debt orthat any refinancing will be on terms more favorable to us.

 

*We have certain covenantsinherent in our debt agreements with which we must* *be in* *compliance*.

 

Our debt agreements contain certaincovenants, which, among others, include certain financial covenants such aslimitations on capital expenditures, maintenance of the business, useof proceeds on sales of assets and minimum Adjusted EBITDA asdefined in the agreements. The covenants also preclude the declaration andpayment of dividends or other distributions to holders of our common stock.

 

We are subject to multiple economic,financial, competitive, legal and other risks that are beyond our control andcould harm our future financial results. Any adverse effect on ourbusiness or financial results could affect our ability to maintaincompliance with our debt covenants. A failure by us to comply with thecovenants in the instruments and agreements governing our indebtedness couldresult in an event of default that, if not cured or waived, could result in allof our indebtedness becoming immediately due and payable, which could render usinsolvent.

 

*We may not be able to generate sufficient cash flow to make payments onour indebtedness.*

 

Economic,financial, competitive, legislative and other factors beyond our control mayaffect our ability to generate cash flow from operations to make payments onour indebtedness, including the $160 Million Notes, and to fund necessaryworking capital. A significant reduction in operating cash flow would likelyincrease the need for alternative sources of liquidity. If we are unable togenerate sufficient cash flow to make payments on our debt, we will have topursue one or more alternatives, such as reducing or delaying capitalexpenditures, refinancing our debt on terms that are not favorable to us,selling assets or raising equity. We may not be able to accomplish any of thesealternatives on satisfactory terms, if at all, and even if accomplished, theymay not yield sufficient funds to service our debt.

 

*We are vulnerable to changes in consumer preferences and economicconditions that could harm our financial results.*

 

Foodservice businesses are often affected by changes in consumer tastes, dietarytrends, national, regional and local economic conditions and demographictrends. Factors such as traffic patterns, local demographics and the type,number and location of competing restaurants may adversely affect theperformance of individual locations. Shifts in consumer preferences away fromour type of cuisine and/or the quick casual style could have a material adverseaffect on our results of operations. We believe that the trend towardconsumption of food low in carbohydrate content may have had a negative impacton our sales and revenues. In addition, increased food, labor and energy costs haveaffected our results and may, in the future, together with inflation, harm therestaurant industry in general and our locations in particular. Adverse changesin any of these factors could reduce consumer traffic or impose practicallimits on pricing, which could harm our business prospects, financialcondition, operating results and cash flow. Our continued success will dependin part on our ability to anticipate, identify and respond to changing consumerpreferences and economic conditions.

 

28

----

 

*There is intense competition in the restaurant industry for personnel,real estate, advertising space, and customers, among other things.*

 

Ourindustry is intensely competitive and there are many well-established competitorswith substantially greater financial and other resources than we have. Inaddition to current competitors, one or more new major competitors withsubstantially greater financial, marketing and operating resources could enterthe market at any time and compete directly against us. In addition, invirtually every major metropolitan area in which we operate or expect to enter,local, regional or national competitors already exist. This may make it moredifficult to obtain real estate, advertising space, and retain customers andpersonnel.

 

*We are vulnerable to fluctuations in the cost, availability and qualityof our raw ingredients.*

 

Thecost, availability and quality of the ingredients we use to prepare our foodare subject to a range of factors, many of which are beyond our control.Fluctuations in economic and political conditions, weather and demand couldadversely affect the cost of our ingredients. We have limited control overfluctuations in the price and quality of commodities, and we may not be able topass through any cost increases to our customers. We are dependent on frequentdeliveries of fresh ingredients, thereby subjecting us to the risk of shortagesor interruptions in supply. All of these factors could adversely affect ourbusiness and financial results.

 

*We heavily depend on our suppliers and distributors.*

 

Wecurrently purchase our raw materials from various suppliers. We purchase amajority of our frozen bagel dough from one supplier (who utilizes ourproprietary processes), which we are dependent upon in the short-term.Additionally, we purchase all of our cream cheese from a single source. Thoughto date we have not experienced significant difficulties with our suppliers,our reliance on our suppliers subjects us to a number of risks, includingpossible delays or interruption in supplies, diminished control over qualityand a potential lack of adequate raw material capacity. Any disruption in thesupply or degradation in the quality of the materials provided by our supplierscould have a material adverse effect on our business, operating results andfinancial condition. In addition, such disruptions in supply or degradations inquality could have a long-term detrimental impact on our efforts to develop astrong brand identity and a loyal consumer base.

 

Wedepend on our network of six regional custom distributors to distribute frozenbagel dough and other materials to our locations. If any one or more of thesedistributors fails to perform as anticipated, or if there is any disruption inany of our distribution relationships for any reason, it could have a materialadverse effect on our business, financial condition and results of operations.We are currently negotiating contract terms with a new distribution partner toimprove quality and service.  As aresult, we anticipate increased distribution costs beginning in the fourthquarter of 2005.

 

*Increasing labor costs could adversely affect our continuedprofitability.*

 

Weare dependent upon an available labor pool of employees, many of whom arehourly employees whose wages may be affected by an increase in the federal orstate minimum wage. Numerous proposals have been made on federal, state andlocal levels to increase minimum wage levels. Although few, if any, of ouremployees are paid at the minimum wage level, an increase in the minimum wagemay create pressure to increase the pay scale for our employees, which wouldincrease our labor costs and those of our franchisees and licensees. A shortagein the labor pool or other general inflationary pressures or changes could alsoincrease labor costs. In addition, changes in labor laws or reclassificationsof employees from management to hourly employees could affect our labor cost.For example, federal overtime regulations under the Fair Labor Standards Act,which went into effect on August 23, 2004, impacted the classification ofseveral of our positions. A significant increase in the number of overtimehours worked could have a material adverse effect on our income from operationsand decrease our profitability and cash available to service our debtobligations if we are unable to recover these increases by raising the priceswe charge our customers.

 

29

----

 

*We face the risk of adverse publicity and litigation in connection withour operations.*

 

Weare from time to time the subject of complaints or litigation from ourconsumers alleging illness, injury or other food quality, health or operationalconcerns. Adverse publicity resulting from these allegations may materiallyadversely affect us, regardless of whether the allegations are valid or whetherwe are liable. In addition, employee claims against us based on, among otherthings, discrimination, harassment or wrongful termination may divert financialand management resources that would otherwise be used to benefit our futureperformance. We have been subject to claims from time to time, and althoughthese claims have not historically had a material impact on our operations, asignificant increase in the number of these claims or the number that aresuccessful could materially adversely affect our business, prospects, financialcondition, operating results or cash flows.

 

*We rely in part on our franchisees and licensees.*

 

Werely in part on our franchisees and licensees and the manner in which theyoperate their locations to develop and promote our business. Although we havedeveloped criteria to evaluate and screen prospective candidates, thecandidates may not have the business acumen or financial resources necessary tooperate successful locations in their respective areas. In addition,franchisees and licensees are subject to business risks similar to what we facesuch as competition, consumer acceptance, fluctuations in the cost, availabilityand quality of raw ingredients, and increasing labor costs. The failure offranchisees or licensees to operate successfully could have a material adverseeffect on us, our ability to collect royalties, our reputation, our brands andour ability to attract prospective candidates.

 

*We face risks associated with government regulation.*

 

Eachof our locations is subject to licensing and regulation by the health,sanitation, safety, labor, building and fire agencies of the respective statesand municipalities in which it is located. A failure to comply with one or moreregulations could result in the imposition of sanctions, including the closingof facilities for an indeterminate period of time, or third-partylitigation, any of which could have a material adverse effect on us and ourresults of operations.

 

Inaddition, our franchising operations are subject to regulation by the FederalTrade Commission. Our franchisees and we must also comply with statefranchising laws and a wide range of other state and local rules andregulations applicable to our business. The failure to comply with federal,state and local rules and regulations would have an adverse effect on ourfranchisees and us.

 

Undervarious federal, state and local laws, an owner or operator of real estate maybe liable for the costs of removal or remediation of certain hazardous or toxicsubstances on or in such property. Such liability may be imposed without regardto whether the owner or operator knew of, or was responsible for, the presenceof such hazardous or toxic substances. Although we are not aware of anyenvironmental conditions that require remediation by us under federal, state orlocal law at our properties, we have not conducted a comprehensiveenvironmental review of our properties or operations. We may not haveidentified all of the potential environmental liabilities at our properties,and any such liabilities that are identified in the future may have a materialadverse effect on our financial condition.

 

*We may not be able to protect ourtrademarks, service marks and other proprietary rights.*

 

Webelieve that our trademarks, service marks and other proprietary rights areimportant to our success and our competitive position. Accordingly, we devotesubstantial resources to the establishment and protection of our trademarks,service marks and proprietary rights. However, the actions we take may beinadequate to prevent imitation of our products and concepts by others or toprevent others from claiming violations of their trademarks and proprietaryrights by us. In addition, others may assert rights in our trademarks, servicemarks and other proprietary rights.

 

30

----

 

*We have a majority stockholder.*

 

GreenlightCapital, L.L.C. and its affiliates beneficially own approximately 97 percent ofour common stock on a fully diluted basis. As a result, Greenlight hassufficient voting power, without the vote of any other stockholders, todetermine what matters will be submitted for approval by our stockholders, toapprove actions by written consent without the approval of any otherstockholders, to elect all of our board of directors, and among other things,to determine whether a change in control of our company occurs. Greenlight’sinterests on matters submitted to stockholders may be different from those ofother stockholders. Greenlight is not involved in our day-to-day operations,but Greenlight has voted its shares to elect our current board of directors.The chairman of our board of directors is a current employee of Greenlight.

 

Ourcommon stock is not currently listed on any stock exchange or Nasdaq. As aresult, we are not subject to corporate governance rules adopted by the NewYork Stock Exchange, American Stock Exchange and Nasdaq requiring a majority ofdirectors to be independent and requiring compensation and nominatingcommittees that are composed solely of independent directors. However, we aresubject to rules requiring that the audit committee consist entirely ofindependent directors. Under the rules of these stock exchanges and Nasdaq, ifa single stockholder holds more that 50% of the voting power of a listedcompany, that company is considered a controlled company, and except for therules relating to independence of the audit committee, is exempt from theabove-mentioned independence rules. Because Greenlight beneficially ownsapproximately 97 percent of our common stock, we may take advantage of thecontrolled company exemption if our common stock becomes listed on an exchangeor Nasdaq in the future. As a result, our stockholders currently do not have,and may never have, the protections that these rules are intended to provide.

 

*Futuresales of shares of our common stock by our stockholders could cause our stockprice to fall.*

 

Ifa substantial number of shares of our common stock are sold in the publicmarket, the market price of our common stock could fall.  The perception among investors that thesesales will occur could also produce this effect.  Our majority stockholder Greenlightbeneficially owns approximately 97 percent of our common stock and sales byGreenlight or a perception that Greenlight will sell could cause a decrease inthe market price of our common stock. Additionally, holders of outstandingwarrants may convert and sell the underlying shares in the public market.Pursuant to our obligations under registration rights agreements, we haveregistered 957,872 shares of common stock underlying certain warrants, of whichGreenlight owns warrants to purchase approximately 493,683 shares of our commonstock. Sales of shares or a perception that there will be sales of theunderlying shares could also cause a decrease in the market price of our commonstock.

 

*Holders may find it difficult to effect transactions in our common stock.*

 

Ourcommon stock is currently quoted on the “pink sheets” under the symbol “NWRG.PK.”Since our common stock is not listed on Nasdaq, the American Stock Exchange orthe New York Stock Exchange, holders of our common stock may find that theliquidity of our common stock is impaired — not only in the number ofsecurities that can be bought and sold, but also through delays in the timingof transactions, reduction in security analysts’ and the news media’s coverageof us, and lower prices for our securities than might otherwise be attained.

 

Securitiesthat are not listed on a stock exchange, the Nasdaq National Market or theNasdaq SmallCap Market are subject to an SEC rule that imposes specialrequirements on broker-dealers who sell those securities to persons other thantheir established customers and accredited investors. The broker-dealer mustdetermine that the security is suitable for the purchaser and must obtain thepurchaser’s written consent prior to the sale. These requirements may make itmore difficult for stockholders to sell our stock than the stock of some othercompanies. It may also affect our ability to raise more capital if and whennecessary.

 

31

----

 

**Item 3.  Qualitative and Quantitative Disclosures AboutMarket Risk**

 

Duringthe third quarter ended 2005 and 2004, our results of operations, financialposition and cash flows were not affected by changes in the relative values ofnon-U.S. currencies to the U.S. dollar. We do not use derivative financialinstruments to limit our foreign currency risk exposure since virtually all ofour business is conducted in the United States.

 

Ourdebt at September 27, 2005 and December 28, 2004 was principally comprised ofthe $160 Million Notes due July 1, 2008 and the AmSouth Revolver. A 100 basispoint increase in market interest rates would have an immaterial effect on ourborrowing costs, since the interest rate on the $160 Million Notes is fixed.The interest rate on the AmSouth Revolver fluctuates with changes in the primerate, but is immaterial in relation to interest expense under the $160 MillionNotes and to our results of operations and financial condition.

 

Wepurchase certain commodities such as butter, cheese, coffee and flour. Thesecommodities are generally purchased based upon market prices established withvendors. These purchase arrangements may contain contractual features thatlimit the price paid by establishing certain price floors or caps. We do notuse financial instruments to hedge commodity prices because these purchasearrangements help control the ultimate cost paid and any commodity priceaberrations are generally short-term in nature.

 

Thismarket risk discussion contains forward-looking statements. Actual results maydiffer materially from this discussion based upon general market conditions andchanges in domestic and global financial markets.

 

 

**Item 4.  Controls and Procedures**

 

Anevaluation was carried out under the supervision and with the participation ofcompany management, including our chief executive officer and chief financialofficer, of the effectiveness of the design and operation of our disclosurecontrols and procedures (as defined in rule 13a-15(e) under the SecuritiesExchange Act of 1934, as amended) as of September 27, 2005. Based upon thatevaluation, our chief executive officer and our chief financial officer haveconcluded that the design and operation of our disclosure controls andprocedures were effective in timely making known to them material information relatingto the Company required to be disclosed in reports that we file or submit underthe Exchange Act rules.

 

Itshould be noted that any system of controls, however well designed andoperated, can provide only reasonable assurance regarding management’s controlobjectives. In addition, the design of any control system is based in part uponcertain assumptions about the likelihood of future events. Because of these andother inherent limitations of control systems, there can be no assurance thatany design will succeed in achieving its stated goals under all potentialfuture conditions, regardless of how remote.

 

Duringthe quarter ended September 27, 2005, there were no changes to our internalcontrols over financial reporting that were identified in connection with theevaluation of our disclosure controls and procedures required by the ExchangeAct rules and that have materially affected, or are reasonably likely tomaterially affect, our internal controls over financial reporting.

 

32

----

 

**PART II - OTHER INFORMATION**

**NEW WORLDRESTAURANT GROUP, INC.**

 

 

**Item 1.    LegalProceedings.**

 

Informationregarding legal proceedings is incorporated by reference from Note 10 to ourConsolidated Financial Statements set forth in Part I of this report.

 

 

**Item 6.  Exhibits**

 

31.1                           Certificationby Chief Executive Officer pursuant to Exchange Act Rule 13a-15(e), as adoptedpursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2                           Certificationby Chief Financial Officer pursuant to Exchange Act Rule 13a-15(e), as adoptedpursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1                           Certificationby Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adoptedpursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

32.2                           Certificationby Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adoptedpursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

 

33

----

 

**Signatures**

 

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

 

 
|   |             | NEW WORLD RESTAURANT GROUP,  INC.                         |
|--------|------------------|-----------------------------------------------------------|
|   |             |                                                      |
|   |             |                                                      |
| Date:  | November 8, 2005 | By: /s/ PAUL J.B. MURPHY, III                             |
|   |             | Paul J.B. Murphy, III                                     |
|   |             | Chief Executive Officer                                   |
|   |             |                                                      |
| Date:  | November 8, 2005 | By: /s/ RICHARD P. DUTKIEWICZ                             |
|   |             | Richard P. Dutkiewicz                                     |
|   |             | Chief Financial Officer and  Principal Accounting Officer |

 

34

----