**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-Q**

**(Mark One)**

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

**For thequarterly period ended July 4, 2006**

**OR**

**o  TRANSITION REPORT UNDER SECTION 13 OR 15 (d)OF THE SECURITIES EXCHANGE ACT OF 1934**

**CommissionFile Number 0-27148**

**New World Restaurant Group, Inc.**

(Name of Registrant asSpecified in its Charter)

 

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

 

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

(Address of principalexecutive offices, including zip code)

 

**(303) 568-8000**

(Registrant’s telephonenumber, including area code)

 

Securities registered pursuantto Section 12(b) of the Act:

**None**

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.  Yes x  No o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer or a non-accelerated filer (asdefined in Rule 12b-2 of the Securities Exchange Act of 1934).  
| Large accelerated filer o | Accelerated filer o | Non-accelerated filer x |
|---------------------------|---------------------|-------------------------|

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Securities Exchange Act of1934). Yes o No x

As of July    ,2006,         shares of Common Stock of theregistrant were outstanding.

 

 

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**NEW WORLDRESTAURANT GROUP, INC.**

July 4, 2006

TABLE OF CONTENTS
| **Part I. Financial  Information** |
|------------------------------------|
|                               |   |
| Item 1.                            | Financial  Statements: |   |
|                               |   |   |
|                               | Consolidated  Balance Sheets (unaudited), July 4, 2006 and January 3, 2006 |   |
|                               |   |   |
|                               | Consolidated  Statements of Operations (unaudited), for the second quarter and year to date  periods ended July 4, 2006 and June 28, 2005 |   |
|                               |   |   |
|                               | Consolidated  Statements of Cash Flows (unaudited), for the year to date periods ended July  4, 2006 and June 28, 2005 |   |
|                               |   |   |
|                               | Consolidated  Statement of Changes in Stockholders’ Deficit (unaudited), for the year to  date period ended July 4, 2006 |   |
|                               |   |   |
|                               | Notes  to the Consolidated Financial Statements (unaudited) |   |
|                               |   |   |
| Item 2.                            | Management’s Discussion  and Analysis of Financial Condition and Results of Operations |   |
|                               |   |   |
| Item 3.                            | Quantitative  and Qualitative Disclosures about Market Risk |   |
|                               |   |   |
| Item 4.                            | Controls and Procedures |   |
|                               |   |
| **Part II. Other Information**     |
|                               |   |
| Item 1.                            | Legal Proceedings |   |
|                               |   |   |
| Item 1A.                           | Risk Factors |   |
|                               |   |   |
| Item 2.                            | Unregistered  Sales of Equity Securities and Use of Proceeds |   |
|                               |   |   |
| Item 4.                            | Submission of  Matters to a Vote of Security Holders |   |
|                               |   |   |
| Item 5.                            | Other Information |   |
|                               |   |   |
| Item 6.                            | Exhibits |   |

 

2

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**NEW WORLD RESTAURANT GROUP, INC.**

**CONSOLIDATED BALANCE SHEETS**

**AS OF JULY 4, 2006 AND JANUARY 3, 2006**

**(in thousands, except share information)**

**(unaudited)**

 
| ** **                                                                                                                                                                  | ** ** | **July 4,** | ** ** | **January 3,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------|------------|---------------------|------------|
| ** **                                                                                                                                                                  | ** ** | **2006**         | ** ** | **2006**            | ** ** |
| **ASSETS**                                                                                                                                                                  | ** ** | ** **       | ** ** | ** **          | ** ** |
| Current assets:                                                                                                                                                             |       |             |       |                |       |
| Cash and cash  equivalents                                                                                                                                                  |       | $                | 4,738      |                | $          | 1,556 |   |
| Restricted cash                                                                                                                                                             |       | 2,404            |       | 2,554               |       |
| Franchise and  other receivables, net of allowance of $595 and $480, respectively                                                                                           |       | 4,941            |       | 5,506               |       |
| Inventories                                                                                                                                                                 |       | 4,742            |       | 5,072               |       |
| Prepaid expenses  and other current assets                                                                                                                                  |       | 4,988            |       | 4,506               |       |
| Total current  assets                                                                                                                                                       |       | 21,813           |       | 19,194              |       |
|                                                                                                                                                                        |       |             |       |                |       |
| Restricted cash  long-term                                                                                                                                                  |       | 579              |       | 595                 |       |
| Property, plant  and equipment, net                                                                                                                                         |       | 30,964           |       | 33,359              |       |
| Trademarks and  other intangibles, net                                                                                                                                      |       | 63,806           |       | 67,717              |       |
| Goodwill                                                                                                                                                                    |       | 4,875            |       | 4,875               |       |
| Debt issuance  costs and other assets, net                                                                                                                                  |       | 5,761            |       | 5,184               |       |
|                                                                                                                                                                        |       |             |       |                |       |
| Total assets                                                                                                                                                                |       | $                | 127,798    |                | $          | 130,924 |   |
|                                                                                                                                                                        |       |             |       |                |       |
| **LIABILITIES AND STOCKHOLDERS’  DEFICIT**                                                                                                                             | ** ** | ** **       | ** ** | ** **          | ** ** |
| Current  liabilities:                                                                                                                                                       |       |             |       |                |       |
| Accounts payable                                                                                                                                                            |       | $                | 5,275      |                | $          | 5,848 |   |
| Accrued expenses                                                                                                                                                            |       | 25,694           |       | 24,789              |       |
| Short term debt  and current portion of long-term debt                                                                                                                      |       | 2,655            |       | 280                 |       |
| Current portion  of obligations under capital leases                                                                                                                        |       | 59               |       | 19                  |       |
| Total current  liabilities                                                                                                                                                  |       | 33,683           |       | 30,936              |       |
|                                                                                                                                                                        |       |             |       |                |       |
| Senior notes and  other long-term debt, net of discount                                                                                                                     |       | 167,752          |       | 160,560             |       |
| Obligations  under capital leases                                                                                                                                           |       | 110              |       | 29                  |       |
| Other  liabilities                                                                                                                                                          |       | 8,503            |       | 8,610               |       |
| 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                                                                                                                                                          |       | 267,048          |       | 257,135             |       |
|                                                                                                                                                                        |       |             |       |                |       |
| Commitments and  contingencies                                                                                                                                              |       |             |       |                |       |
|                                                                                                                                                                        |       |             |       |                |       |
| Stockholders’  deficit:                                                                                                                                                |       |             |       |                |       |
| Common stock,  $.001 par value; 25,000,000 shares authorized; 10,593,085 and 10,065,072  shares issued and outstanding                                                      |       | 11               |       | 10                  |       |
| Additional  paid-in capital                                                                                                                                                 |       | 176,544          |       | 176,018             |       |
| Unamortized  stock compensation                                                                                                                                             |       | —           |       | (68                 | )          |
| Accumulated  deficit                                                                                                                                                        |       | (315,805         | )          | (302,171            | )          |
| Total  stockholders’ deficit                                                                                                                                           |       | (139,250         | )          | (126,211            | )          |
|                                                                                                                                                                        |       |             |       |                |       |
| Total  liabilities and stockholders’ deficit                                                                                                                           |       | $                | 127,798    |                | $          | 130,924 |   |

The accompanyingnotes are an integral part of these consolidated financial statements.

3

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**NEW WORLD RESTAURANT GROUP, INC.**

**CONSOLIDATED STATEMENTS OFOPERATIONS**

**FOR THE SECOND QUARTER AND YEAR TO DATE PERIODS ENDED JULY 4,2006 AND JUNE 28, 2005**

**(in thousands, except earnings per share and related shareinformation)**

**(unaudited)**

 
| ** **                                                              | ** ** | **Second quarter ended:** | ** ** | **Year to date ended:** | ** ** |
|-------------------------------------------------------------------------|------------|-------------------------------------|------------|----------------------------------------|------------|
| ** **                                                              | ** ** | **July 4,**                    | ** ** | **June 28,**                      | ** ** | **July 4,** | ** ** | **June 28,** | ** ** |
| ** **                                                              | ** ** | **2006**                            | ** ** | **2005**                               | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues:                                                               |       |                                |       |                                   |       |   |   |   |   |
| Restaurant sales                                                        |       | $                                   | 91,507     |                                   | $          | 91,116 |   | $ | 182,087 |   | $ | 177,975 |   |
| Manufacturing revenues                                                  |       | 4,960                               |       | 4,641                                  |       | 9,981 |   | 9,635 |   |
| Franchise and license related revenues                                  |       | 1,489                               |       | 1,356                                  |       | 2,964 |   | 2,798 |   |
|                                                                    |       |                                |       |                                   |       |   |   |   |   |
| Total revenues                                                          |       | 97,956                              |       | 97,113                                 |       | 195,032 |   | 190,408 |   |
|                                                                    |       |                                |       |                                   |       |   |   |   |   |
| Cost of sales:                                                          |       |                                |       |                                   |       |   |   |   |   |
| Restaurant costs                                                        |       | 73,964                              |       | 73,770                                 |       | 147,490 |   | 145,200 |   |
| Manufacturing costs                                                     |       | 5,502                               |       | 4,193                                  |       | 10,507 |   | 8,900 |   |
|                                                                    |       |                                |       |                                   |       |   |   |   |   |
| Total cost of  sales                                                    |       | 79,466                              |       | 77,963                                 |       | 157,997 |   | 154,100 |   |
|                                                                    |       |                                |       |                                   |       |   |   |   |   |
| Gross profit                                                            |       | 18,490                              |       | 19,150                                 |       | 37,035 |   | 36,308 |   |
|                                                                    |       |                                |       |                                   |       |   |   |   |   |
| Operating  expenses:                                                    |       |                                |       |                                   |       |   |   |   |   |
| General and administrative expenses                                     |       | 9,727                               |       | 9,309                                  |       | 20,288 |   | 17,994 |   |
| Depreciation and amortization                                           |       | 5,594                               |       | 7,077                                  |       | 11,598 |   | 13,785 |   |
| Loss (gain) on sale, disposal or abandonment of  assets, net            |       | (8                                  | )          | 161                                    |       | 13 |   | 165 |   |
| Impairment charges and other related costs                              |       | 7                                   |       | 1,182                                  |       | 83 |   | 1,279 |   |
|                                                                    |       |                                |       |                                   |       |   |   |   |   |
| Income from  operations                                                 |       | 3,170                               |       | 1,421                                  |       | 5,053 |   | 3,085 |   |
| Other expense  (income):                                                |       |                                |       |                                   |       |   |   |   |   |
| Interest expense, net                                                   |       | 4,712                               |       | 5,773                                  |       | 9,921 |   | 11,692 |   |
| Prepayment penalty upon redemption of $160 Million  Notes               |       | —                              |       | —                                 |       | 4,800 |   | — |   |
| Write-off of debt issuance costs upon redemption of  $160 Million Notes |       | —                              |       | —                                 |       | 3,956 |   | — |   |
| Other                                                                   |       | —                              |       | (69                                    | )          | 10 |   | (126 | ) |
|                                                                    |       |                                |       |                                   |       |   |   |   |   |
| Loss before  income taxes                                               |       | (1,542                              | )          | (4,283                                 | )          | (13,634 | ) | (8,481 | ) |
| Provision for  income taxes                                             |       | —                              |       | —                                 |       | — |   | — |   |
|                                                                    |       |                                |       |                                   |       |   |   |   |   |
| Net loss                                                                |       | $                                   | (1,542     | )                                      | $          | (4,283 | ) | $ | (13,634 | ) | $ | (8,481 | ) |
|                                                                    |       |                                |       |                                   |       |   |   |   |   |
| Net loss per  common share – Basic and Diluted                     |       | $                                   | (0.15      | )                                      | $          | (0.43 | ) | $ | (1.35 | ) | $ | (0.86 | ) |
|                                                                    |       |                                |       |                                   |       |   |   |   |   |
| Weighted average  number of common shares outstanding:                  |       |                                |       |                                   |       |   |   |   |   |
| Basic and Diluted                                                       |       | 10,171,236                          |       | 9,860,886                              |       | 10,118,154 |   | 9,854,799 |   |

The accompanyingnotes are an integral part of these consolidated financial statements.

4

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**NEW WORLD RESTAURANT GROUP, INC.**

**CONSOLIDATED STATEMENTS OF CASHFLOWS**

**FOR THE YEAR TO DATE PERIODS ENDED JULY 4, 2006 AND JUNE 28,2005**

**(in thousands)**

**(unaudited)**

 
| ** **                                                                       | ** ** | **July 4,** | ** ** | **June 28,** | ** ** |
|----------------------------------------------------------------------------------|------------|------------------|------------|-------------------|------------|
| ** **                                                                       | ** ** | **2006**         | ** ** | **2005**          | ** ** |
| OPERATING  ACTIVITIES:                                                           |       |             |       |              |       |
| Net loss                                                                         |       | $                | (13,634    | )                 | $          | (8,481 | ) |
| Adjustments to  reconcile net loss to net cash provided by operating activities: |       |             |       |              |       |
| Depreciation and amortization                                                    |       | 11,598           |       | 13,785            |       |
| Stock based compensation expense                                                 |       | 408              |       | 34                |       |
| Loss, net of gains, on disposal of assets                                        |       | 13               |       | 165               |       |
| Impairment charges and other related costs                                       |       | 83               |       | 1,279             |       |
| Integration and reorganization costs                                             |       | —           |       | 5                 |       |
| Provision for (recovery of) losses on accounts  receivable, net                  |       | 132              |       | (138              | )          |
| Amortization of debt issuance and debt discount  costs                           |       | 419              |       | 924               |       |
| Write-off of debt issuance costs                                                 |       | 3,956            |       | —            |       |
| Accretion of paid-in-kind interest                                               |       | 643              |       | —            |       |
| Changes in operating assets and liabilities:                                     |       |             |       |              |       |
| Restricted cash                                                                  |       | (166             | )          | (2,040            | )          |
| Franchise and other receivables                                                  |       | 433              |       | 1,572             |       |
| Accounts payable and accrued expenses                                            |       | 332              |       | (1,016            | )          |
| Other assets and liabilities                                                     |       | 61               |       | 1,976             |       |
|                                                                             |       |             |       |              |       |
| Net cash provided by operating activities                                        |       | 4,278            |       | 8,065             |       |
|                                                                             |       |             |       |              |       |
| INVESTING  ACTIVITIES:                                                           |       |             |       |              |       |
| Purchase of  property and equipment                                              |       | (5,400           | )          | (4,082            | )          |
| Proceeds from  the sale of equipment                                             |       | 153              |       | 92                |       |
|                                                                             |       |             |       |              |       |
| Net cash used in investing activities                                            |       | (5,247           | )          | (3,990            | )          |
|                                                                             |       |             |       |              |       |
| FINANCING  ACTIVITIES:                                                           |       |             |       |              |       |
| Proceeds from  line of credit                                                    |       | 24               |       | 5,430             |       |
| Repayments of  line of credit                                                    |       | (24              | )          | (5,445            | )          |
| Repayment of  other borrowings                                                   |       | —           |       | (10               | )          |
| Payments under  capital lease obligations                                        |       | (20              | )          | —            |       |
| Repayment of  notes payable                                                      |       | (160,000         | )          | —            |       |
| Borrowings under  First Lien                                                     |       | 80,000           |       | —            |       |
| Repayments under  First Lien                                                     |       | (475             | )          |              |       |
| Borrowing under  Second Lien                                                     |       | 65,000           |       | —            |       |
| Borrowings under  Subordinated Note                                              |       | 24,375           |       | —            |       |
| Proceeds upon  stock option and warrant exercises                                |       | 187              |       | 21                |       |
| Debt issuance  costs                                                             |       | (4,916           | )          | —            |       |
|                                                                             |       |             |       |              |       |
| Net cash provided by (used in) financing activities                              |       | 4,151            |       | (4                | )          |
|                                                                             |       |             |       |              |       |
| Net increase in  cash and cash equivalents                                       |       | 3,182            |       | 4,071             |       |
| Cash and cash  equivalents, beginning of period                                  |       | 1,556            |       | 9,752             |       |
| Cash and cash  equivalents, end of period                                        |       | $                | 4,738      |              | $          | 13,823 |   |

The accompanyingnotes are an integral part of these consolidated financial statements.

5

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**NEW WORLD RESTAURANT GROUP, INC.**

**CONSOLIDATED STATEMENT OF CHANGESIN STOCKHOLDERS’ DEFICIT**

**FOR THE YEAR TO DATE PERIOD ENDED JULY 4, 2006**

(inthousands, except share information)

(unaudited)
| ** **                                     | ** ** | ** **            | ** ** | ** **       | ** ** | **Additional** | ** ** | **Unamortized**  | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|------------------|------------|----------------|------------|------------------|------------|-----------------|------------|------------|------------|
| ** **                                     | ** ** | **Common Stock** | ** ** | **Paid In** | ** ** | **Stock**      | ** ** | **Deficit**      | ** ** | ** **      | ** ** |
| ** **                                     | ** ** | **Shares**            | ** ** | **Amount**       | ** ** | **Capital**    | ** ** | **Compensation** | ** ** | **Amount**      | ** ** | **Total**  | ** ** |
|                                           |       |                  |       |             |       |           |       |             |       |            |       |       |       |
| Balance, January  3, 2006                      |       | 10,065,072            |       | $                | 10         |           | $          | 176,018          |       | $               | (68        | )          | $          | (302,171 | ) | $ | (126,211 | ) |
| Net loss                                       |       | —                |       | —           |       | —         |       | —           |       | (13,634         | )          | (13,634    | )          |
| Common stock issued upon stock option exercise |       | 45,151                |       | —           |       | 132            |       | —           |       |            |       | 132        |       |
| Common stock issued upon warrant exercise      |       | 482,862               |       | 1                |       | 54             |       | —           |       |            |       | 55         |       |
| Impact of adoption of SFAS 123R                |       |                  |       |             |       | (68            | )          | 68               |       |            |       | —     |       |
| Stock based compensation expense               |       | —                |       | —           |       | 408            |       | —           |       | —          |       | 408        |       |
|                                           |       |                  |       |             |       |           |       |             |       |            |       |       |       |
| Balance, April  4, 2006                        |       | 10,593,085            |       | $                | 11         |           | $          | 176,544          |       | $               | —     |       | $          | (315,805 | ) | $ | (139,250 | ) |

The accompanyingnotes are an integral part of these consolidated financial statements.

6

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**NEW WORLD RESTAURANT GROUP, INC.**

Notes toConsolidated Financial Statements (Unaudited)

Quarter and Yearto Date periods ended July 4, 2006 and June 28, 2005

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

The accompanying consolidated financial statements ofNew World Restaurant Group, Inc. and its wholly-owned subsidiaries(collectively, the Company) have been prepared pursuant to the rules andregulations of the Securities and Exchange Commission (“SEC”). As of July 4,2006, the Company owns, franchises or licenses various restaurant conceptsunder the brand names of Einstein Bros. Bagels (“Einstein Bros.”), EinsteinBros. 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 to seasonal trends. Generally, ourrevenues and results of operations in the first fiscal quarter are somewhatlower than in the other three fiscal quarters.

The accompanying consolidated financial statements as of July 4, 2006 and for thequarter and year to date periods ended July 4, 2006 and June 28, 2005 havebeen prepared without audit. The balance sheet information as of January 3,2006 has been derived from our audited financial statements. The informationfurnished herein reflects all adjustments (consisting only of normal recurringaccruals and adjustments), which are, in our opinion, necessary to fairly statethe interim operating results for the respective periods.  However, theseoperating results are not necessarily indicative of the results expected forthe full fiscal year.  Certain information and footnote disclosuresnormally included in annual financial statements prepared in accordance withgenerally accepted accounting principles in the United States have been omittedpursuant to 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 January 3, 2006. We believe that the disclosures aresufficient for interim financial reporting purposes.

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

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

In December 2004, the Financial Accounting StandardsBoard (FASB) issued Statement of Financial Accounting Standard (SFAS) No. 123R,Share-Based Payment.  SFAS No. 123R is arevision of SFAS No. 123, Accounting for Stock-Based Compensation, andsupersedes Accounting Principles Board Opinion (APB) No. 25, Accounting forStock Issued to Employees and its related implementation guidance. SFAS No.123R focuses primarily on accounting for transactions in which an entityobtains employee services in share-based payment transactions. The Statementrequires entities to recognize compensation expense for awards of equityinstruments to employees based on the grant-date fair value of those awards(with limited exceptions).

Effective January 4, 2006, we adopted the provisionsof SFAS No. 123R using the modified prospective transition method. Prior to theadoption of SFAS No. 123R, we applied the intrinsic value-based method ofaccounting prescribed by APB No. 25 and related interpretations, inaccounting for our fixed award stock options to our employees. As such,compensation expense was recorded only if the current market price of theunderlying common stock exceeded the exercise price of the option on the dateof grant. We applied the fair value-basis of accounting as prescribed by SFASNo. 123**in accounting for our fixed award stockoptions to our consultants. Under SFAS No. 123, compensation expense wasrecognized based on the fair value of stock options granted.

Because we previously adopted only the pro formadisclosure provisions of SFAS No. 123, we will recognize compensation cost,over the requisite service period, relating to the unvested portion of awardsgranted prior to the date of adoption using the same estimate of the grant-datefair value and the same attribution method used to determine the pro formadisclosures under SFAS No. 123, except that forfeiture rates have beenestimated for all options, as required by SFAS No. 123R.

7

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Our stock-based compensation cost for the secondquarter of 2006 and 2005 was $192,000 and $17,000, respectively and has beenincluded in general and administrative expenses. For the year to date periodended July 4, 2006 and June 28, 2005, stock based compensation expense was$408,000 and $34,000, respectively. The impact of adoption of SFAS No. 123R hadthe effect of increasing our loss per share by $0.02 and $0.04 for secondquarter and year to date period ended July 4, 2006, respectively. No taxbenefits were recognized for these costs due to our recurring losses. Resultsfor fiscal year 2005 have not been restated. Had compensation cost for stockoptions granted to employees been determined on the basis of fair value ascomputed using the assumptions herein, net loss and loss per share would havebeen increased to the following pro forma amounts (in thousands of dollars,except per share amounts):

|                                                | ** ** | **Quarter ended:** | ** ** | **Year to date:** | ** ** |
|------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                     | ** ** | **June 28,**       | ** ** | **June 28,**           | ** ** |
| ** **                                     | ** ** | **2005**                | ** ** | **2005**                    | ** ** |
| Net loss, as  reported                         |       | $                       | (4,283     | )                           | $          | (8,481 | ) |
| Deduct: fair  value based compensation expense |       | (296                    | )          | (449                        | )          |
| Pro forma net  loss                            |       | $                       | (4,579     | )                           | $          | (8,930 | ) |
| Basic and  diluted loss per common share:      |       |                    |       |                        |       |
| As reported                                    |       | $                       | (0.43      | )                           | $          | (0.86 | ) |
| Pro forma                                      |       | $                       | (0.46      | )                           | $          | (0.91 | ) |

The fair value of stockoptions is estimated using the Black-Scholes option-pricing model with thefollowing weighted average assumptions:

|                                              | ** ** | **Second quarter ended:** | ** ** | **Year to date ended:** | ** ** |
|----------------------------------------------|------------|-------------------------------------|------------|----------------------------------------|------------|
| ** **                                   | ** ** | **July 4,**                    | ** ** | **June 28,**                      | ** ** | **July 4,** | ** ** | **June 28,** | ** ** |
| ** **                                   | ** ** | **2006**                            | ** ** | **2005**                               | ** ** | **2006** | ** ** | **2005** | ** ** |
| Expected life of  options from date of grant |       |                                | *          | 4.0 years                              |       | 4.0 years |   | 4.0 years |   |
| Risk-free  interest rate                     |       |                                | *          | 3.7 - 3.9                              | %          | 4.35 | % | 3.6 - 3.9 | % |
| Volatility                                   |       |                                | *          | 100.0                                  | %          | 100.0 | % | 100.0 | % |
| Assumed dividend  yield                      |       |                                | *          | 0.0                                    | %          | 0.0 | % | 0.0 | % |

 

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*There were no stock options granted during second quarter ended July 4, 2006.

The expected term of options is based upon evaluationsof historical and expected future exercise behavior. The risk-free interestrate is based on the US Treasury rates at the date of grant with maturity datesapproximately equal to the expected life at the grant date. Implied volatilityis based on the mean reverting average of our stock’s historical volatility andthat of an industry peer group. The use of mean reversion is supported byevidence of a correlation between stock price volatility and a company’sleverage combined with the effects mandatory principal payments will have onour capital structure, as defined under our new debt facility. We have nothistorically issued any dividends and are precluded from doing so under ourdebt covenants.

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**Stock Option Plans**

*1994 and 1995 Plans*

Our 1994 Stock Plan (1994Plan) provided for the granting to employees of incentive stock options and forthe granting to employees and consultants of non-statutory stock options andstock purchase rights. On November 21, 2003, the board of directorsterminated the authority to issue any additional options under the 1994 Plan.At July 4, 2006, options to purchase 17 shares of common stock at an exerciseprice of $210.71 per share and a remaining contractual life of 0.98 yearsremained outstanding under this plan.

Our 1995 Directors’ Stock Option Plan (Directors’Option Plan) provided for the automatic grant of non-statutory stock options tonon-employee directors of the Company. On December 19, 2003, our board ofdirectors terminated the authority to issue any additional options under theDirectors’ Option Plan. At July 4, 2006, options to purchase 2,324 shares ofcommon stock at a weighted average exercise price of $32.43 per share and aweighted average remaining contractual life of 4.65 years remained outstandingunder this plan.

*2003 Executive Employee Incentive Plan*

On November 21, 2003, our board of directors adoptedthe Executive Employee Incentive Plan, amended on December 19, 2003 (2003Plan). The 2003 Plan provides for granting incentive stock options to employeesand granting non-statutory stock options to employees and consultants. Unlessterminated sooner, the 2003 Plan will terminate automatically in December 2013.The board of directors has the authority to amend, modify or terminate the 2003Plan, subject to any required approval by our stockholders under applicable lawor upon advice of counsel. No such action may affect any options previouslygranted under the 2003 Plan without the consent of the holders. There are1,150,000 shares issuable pursuant to options granted under the 2003 Plan.Options are granted with an exercise price equal to the fair market value onthe date of grant, have a contractual life of ten years and typically vest overa three-year service period. Generally, 50% of options granted vest basedsolely upon the passage of time. We recognize compensation costs for theseawards using a graded vesting attribution method over the requisite serviceperiod. The remaining 50% of options granted vest based on service andperformance conditions. Options that do not vest due to the failure to achievespecific financial performance criteria are forfeited. Options to purchaseapproximately 257,342 shares of our common stock, which are not yetexercisable, are subject to company performance conditions. We recognizecompensation costs for performance based options over the requisite serviceperiod when conditions for achievement become probable. We expect that all ofthe non-vested awards at July 4, 2006 will vest based on company performance.As of July 4, 2006, there were 229,584 shares reserved for future issuanceunder the 2003 Plan.

*2004 Stock Option Plan for Independent Directors*

On December 19, 2003, our board of directors adoptedthe Stock Option Plan for Independent Directors, effective January 1, 2004,(2004 Directors’ Plan). Our board of directors may amend, suspend, or terminatethe 2004 Directors’ Plan at any time, provided, however, that no such actionmay adversely affect any outstanding option without the option holders consent.A total of 200,000 shares of common stock have been reserved for issuance underthe 2004 Directors’ Plan. The 2004 Directors’ Plan provides for the automaticgrant of non-statutory stock options to independent directors on January 1 ofeach year and a prorated grant of options for any director elected during theyear. Options are granted with an exercise price equal to the fair market valueon the date of grant, become exercisable six months after the grant date andare exercisable for 5 years from the date of grant unless earlier terminated.As of July 4, 2006, there were 64,192 shares reserved for future issuance underthe 2004 Directors’ Plan.

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Transactions during the year to date period endingJuly 4, 2006 were as follows:
|                                       | ** ** | ** **  | ** ** | **Weighted** | ** ** | **Weighted**          | ** ** | ** **    | ** ** |
|---------------------------------------|------------|-------------|------------|--------------|------------|-----------------------|------------|---------------|------------|
| ** **                            | ** ** | **Number**  | ** ** | **Average**  | ** ** | **Average**           | ** ** | **Aggregate** | ** ** |
| ** **                            | ** ** | **of**      | ** ** | **Exercise** | ** ** | **Remaining**         | ** ** | **Intrinsic** | ** ** |
| ** **                            | ** ** | **Options** | ** ** | **Price**    | ** ** | **Life (Years)** | ** ** | **Value**     | ** ** |
| Outstanding,  January 4, 2006         |       | 997,152     |       | $            | 3.31       |                  |       |          |       |   |
| Granted                               |       | 117,500     |       | $            | 4.50       |                  |       |          |       |   |
| Exercised                             |       | (45,151     | )          | $            | 2.92       |                  |       |          |       |   |
| Forfeited                             |       | (56,087     | )          | $            | 2.48       |                  |       |          |       |   |
| Outstanding,  July 4, 2006            |       | 1,013,414   |       | $            | 3.54       |                  | 7.61       |          | $          | 1,480,970 |   |
| Exercisable and Vested,  July 4, 2006 |       | 498,705     |       | $            | 3.61       |                  | 6.59       |          | $          | 692,887 |   |

 

|                                     | ** ** | ** **  | ** ** | **Weighted**        | ** ** |
|-------------------------------------|------------|-------------|------------|---------------------|------------|
| ** **                          | ** ** | **Number**  | ** ** | **Average**         | ** ** |
| ** **                          | ** ** | **of**      | ** ** | **Grant Date** | ** ** |
| ** **                          | ** ** | **Options** | ** ** | **Fair Value** | ** ** |
| Non-vested  shares, January 4, 2006 |       | 643,915     |       | $                   | 2.13       |   |
| Granted                             |       | 117,500     |       | $                   | 4.50       |   |
| Vested                              |       | (190,619    | )          | $                   | 2.12       |   |
| Forfeited                           |       | (56,087     | )          | $                   | 2.48       |   |
| Non-vested shares, July  4, 2006    |       | 514,709     |       | $                   | 2.45       |   |

At July 4, 2006, we haveapproximately $0.5 million of total unrecognized compensation cost related tonon-vested awards granted under our option plans, which we expect to recognizeover a weighted average period of ten months. Total compensation costs relatedto the options outstanding as of July 4, 2006 will be fully recognized by firstquarter of fiscal 2009.

**Warrants**

As of July 4, 2006, there were 332 remaining warrantsoutstanding and exercisable to purchase shares of our common stock. Thesewarrants have an exercise price of $316.67 and expire on October 25, 2006.

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**3.****             ****Supplemental Cash FlowInformation**

|                                                           | ** ** | **July 4,**                             | ** ** | **June 28,** | ** ** |
|-----------------------------------------------------------|------------|----------------------------------------------|------------|-------------------|------------|
| ** **                                                | ** ** | **2006**                                     | ** ** | **2005**          | ** ** |
| ** **                                                | ** ** | **(in thousands of dollars)** | ** ** |
| Cash paid during  the year to date period ended:          |       |                                         |       |              |       |
| Interest                                                  |       | $                                            | 7,718      |              | $          | 10,809 |   |
| Prepayment penalty upon redemption of $160 Million  Notes |       | $                                            | 4,800      |              | $          | — |   |
|                                                      |       |                                         |       |              |       |
| Non-cash  investing activities:                           |       |                                         |       |              |       |
| Non-cash purchase of equipment through capital  leasing   |       | $                                            | 141        |              | $          | — |   |

**4.****             ****Inventories**

Inventories, whichconsist of food, beverage, paper supplies and bagel ingredients, are stated atthe lower of cost or market, with cost being determined by the first-in,first-out method. Inventories consist of the following: 
|                    | ** ** | **July 4,**                             | ** ** | **January 3,** | ** ** |
|--------------------|------------|----------------------------------------------|------------|---------------------|------------|
| ** **         | ** ** | **2006**                                     | ** ** | **2006**            | ** ** |
| ** **         | ** ** | **(in thousands of dollars)** | ** ** |
| Finished goods     |       | $                                            | 3,510      |                | $          | 4,558 |   |
| Raw materials      |       | 1,232                                        |       | 514                 |       |
| Total  inventories |       | $                                            | 4,742      |                | $          | 5,072 |   |

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**5.****             ****Goodwill, Trademarks and OtherIntangibles**

Intangible assetsinclude both goodwill and identifiable intangibles arising from the allocationof the purchase prices of assets acquired. Goodwill represents the excess ofcost over fair value of net assets acquired in the acquisition of Manhattan.Other intangibles consist mainly of trademarks, trade secrets and patents.

Goodwill and otherintangible assets with indefinite lives are not subject to amortization but aretested for impairment annually or more frequently if events or changes incircumstances indicate that the asset might be impaired. SFAS No. 142, Goodwilland Other Intangible Assets, requires a two-step approach for testingimpairment of goodwill. For goodwill, the fair value of each reporting unit iscompared to its carrying value to determine whether an indication of impairmentexists. If impairment is indicated, 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. For other indefinite livedintangibles, the fair value is compared to the carrying value. The amount ofimpairment for goodwill and other intangible assets is measured as the excess ofits carrying amount over its fair value. Intangible assets not subject toamortization consist primarily of the Einstein Bros. and Manhattan trademarks.

Intangible assetswith lives restricted by contractual, legal or other means are amortized overtheir useful lives and consist primarily of patents used in our manufacturingprocess. Amortization expense is calculated using the straight-line method overthe estimated useful lives of approximately 5 years.  Intangible assets subject to amortization arereviewed for impairment whenever events or changes in circumstances indicatethat the carrying amount of an asset may not be recoverable, in accordance withSFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets.

Trademarks andother intangibles consist of the following (in thousands of dollars):

|                                              | ** ** | **July 4,** | ** ** | **January 3,** | ** ** |
|----------------------------------------------|------------|------------------|------------|---------------------|------------|
| ** **                                   | ** ** | **2006**         | ** ** | **2006**            | ** ** |
| Amortizing  intangibles:                     |       |             |       |                |       |
| Trade secrets                                |       | $                | 5,385      |                | $          | 5,385 |   |
| Trademarks                                   |       | —           |       | 1,082               |       |
| Patents-manufacturing  process               |       | 33,741           |       | 33,741              |       |
|                                         |       | 39,126           |       | 40,208              |       |
| Less accumulated  amortization:              |       |             |       |                |       |
| Trade secrets                                |       | 5,385            |       | 4,847               |       |
| Trademarks                                   |       | —           |       | 1,082               |       |
| Patents-manufacturing  process               |       | 33,741           |       | 30,368              |       |
|                                         |       | 39,126           |       | 36,297              |       |
| Total amortizing  intangibles, net           |       | —           |       | $                   | 3,911      |   |
|                                         |       |             |       |                |       |
| Non-amortizing intangibles:                  |       |             |       |                |       |
| Trademarks                                   |       | 63,806           |       | 63,806              |       |
| Total trademarks and  other intangibles, net |       | $                | 63,806     |                | $          | 67,717 |   |

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During the year to date period ended July 4, 2006, there were noevents or changes in circumstances that indicated that our intangible assets mightbe impaired or may not be recoverable.

**6.****             ****Senior Notes and Other Long-TermDebt**

Senior notes andother long-term debt consist of the following (in thousands of dollars):

|                                                                | ** ** | **July 4,** | ** ** | **January 3,** | ** ** |
|----------------------------------------------------------------|------------|------------------|------------|---------------------|------------|
| ** **                                                     | ** ** | **2006**         | ** ** | **2006**            | ** ** |
|                                                           |       |             |       |                |       |
| $80 Million  First Lien Term Loan                              |       | $                | 79,525     |                | $          | — |   |
| $65 Million  Second Lien Term Loan                             |       | 65,000           |       | —              |       |
| $25 Million  Subordinated Note                                 |       | 25,042           |       | —              |       |
| $160 Million  Notes                                            |       | —           |       | 160,000             |       |
| New Jersey  Economic Development                               |       |             |       |                |       |
| Authority Note Payable                                         |       | 840              |       | 840                 |       |
|                                                           |       | $                | 170,407    |                | $          | 160,840 |   |
| Less current  portion of senior notes and other long-term debt |       | 2,655            |       | 280                 |       |
| Senior notes and  other long-term debt                         |       | $                | 167,752    |                | $          | 160,560 |   |

**Debt Redemption andRefinancing**

On February 28,2006, we completed the refinancing of the AmSouth Revolver and $160 MillionNotes. Our new debt obligations consist of the following:

·                  $15 million revolving creditfacility (Revolving Facility);

·                  $80 million first lien term loan(First Lien Term Loan);

·                  $65 million second lien term loan(Second Lien Term Loan); and

·                  $25 million subordinated note(Subordinated Note).

Proceeds from the new debt facility were used to repaythe $160 Million Notes plus a 3% redemption premium of $4.8 million and accruedand unpaid interest to the redemption date.

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**Revolving Facility**

The RevolvingFacility has a maturity date of March 31, 2011 and provides for interest basedupon the prime rate or LIBOR plus a margin. The margin may increase or decreaseup to 0.25% based upon our consolidated leverage ratio as defined in theagreement. The initial margin is at prime plus 2.00% or LIBOR plus 3.00%. Thisfacility may be used in whole or in part for letters of credit.  As of July 4, 2006, the stated interest rateunder the Revolving Facility was at prime plus 2.00%, or 10.25%.

In the event thatwe have not extended the maturity date of the Mandatorily Redeemable Series ZPreferred Stock (Series Z) to a date that is on or after July 26, 2012 orredeemed the Series Z by December 30, 2008, then the Revolving Facility willmature on December 30, 2008.

We are required to pay an unused credit line fee of0.5% per annum on the average daily unused amount. The unused line fee ispayable quarterly in arrears. Additionally, we are required to pay a letter ofcredit fee based on the ending daily undrawn face amount for each letter ofcredit issued, of an applicable margin being based on our consolidated leverageratio with a minimum and maximum applicable margin of 2.75% and 3.25%,respectively, plus a 0.5% arranger fee payable quarterly. Letters of creditreduce our availability under the Revolving Facility. At July 4, 2006, we had$6.9 million in letters of credit outstanding. The letters of credit expire onvarious dates during 2007, are automatically renewable for one additional yearand are payable upon demand in the event that we fail to pay the underlyingobligation. Our availability under the Revolving Facility was $8.1 million atJuly 4, 2006.

The Revolving Facility contains usual and customarycovenants including consolidated leverage ratios, fixed charge coverage ratios,limitations on capital expenditures, etc. The ratio covenants are based on aConsolidated EBITDA calculation (as defined in our loan agreement) and aremeasured on a twelve month period ending on the last day of each fiscal quarter.The loan is guaranteed by our material subsidiaries.  The Revolving Facility and the relatedguarantees are secured by a first priority security interest in all of ourassets and our material subsidiaries, including a pledge of 100% of ourinterest in all shares of capital stock (or other ownership or equityinterests) of each material subsidiary. As of July 4, 2006, we were in compliance with all our financial andoperating covenants.

Approximately $0.4 million in debt issuance costs havebeen capitalized and are being amortized using the straight-line method overthe term of the Revolving Facility.

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**First Lien Term Loan**

The First LienTerm Loan has a maturity date of March 31, 2011 and provides for a floatinginterest rate based upon the prime rate or LIBOR plus a margin. The margin mayincrease or decrease 0.25% based upon our consolidated leverage ratio asdefined in the agreement. The initial margin is at prime plus 2.00% and/orLIBOR plus 3.00% and is payable in arrears quarterly and/or at the LIBOR date,dependent upon the rate in effect. As of July 4, 2006, the stated interest rateunder the First Lien Term Loan was 7.99%, which represents a weighted averageof LIBOR plus 3.00%, or 7.98% and prime plus 2.00%, or 10.25%. The effectiveinterest rate was 8.59%.  The facility isfully amortizing with annual aggregate principal reductions payable inquarterly installments over the term of the loan as follows:

| For the 2006 fiscal year ending  January 2, 2007  |   | $ | 1.425 million  |   |
|---------------------------------------------------|--------|---|----------------|--------|
| For the 2007 fiscal year ending January 1, 2008   |   | $ | 3.325 million  |   |
| For the 2008 fiscal year ending December 30, 2008 |   | $ | 5.950 million  |   |
| For the 2009 fiscal year ending December 29, 2009 |   | $ | 11.250 million |   |
| For the 2010 fiscal year ending December 28, 2010 |   | $ | 32.150 million |   |
| For the 2011 fiscal quarter ending March 29, 2011 |   | $ | 25.900 million |   |

In addition to the repayment schedule discussed above, the FirstLien Term Loan also requires additional principal reductions based upon apercentage of excess cash flow as defined in the loan agreement in any fiscalyear. The First Lien Term Loan also provides us the opportunity to repay theSecond Lien Term Loan or the Subordinated Note with the proceeds of a capitalstock offering provided that certain consolidated leverage ratios are met.

In the event thatwe have not extended the maturity date of the Series Z to a date that is on orafter July 26, 2012 or redeemed the Series Z by December 30, 2008, then theFirst Lien Term Loan will mature on December 30, 2008.

The First Lien Term Loan has usual and customarycovenants including consolidated leverage ratios, fixed charge coverage ratios,limitations on capital expenditures, etc. The ratio covenants are based on aConsolidated EBITDA calculation (as defined in our loan agreement) and aremeasured on a twelve month period ending on the last day of each fiscalquarter. The loan is guaranteed by our material subsidiaries.  The First Lien Term Loan and the relatedguarantees are secured by a first priority security interest in all of ourassets and our material subsidiaries, including a pledge of 100% of ourinterest in all shares of capital stock (or other ownership or equityinterests) of each material subsidiary. As of July 4, 2006, we were in compliance with all our financial andoperating covenants.

Approximately $2.1 million in debt issuance costs havebeen capitalized and are being amortized using the effective interest methodover the term of the First Lien Term Loan.

**Second Lien Term Loan**

The Second LienTerm Loan has a maturity date of February 28, 2012 and provides for a floatinginterest rate based upon the prime rate plus 5.75% or LIBOR plus 6.75%.Interest is payable in arrears on a quarterly basis. As of July 4, 2006, thestated interest rate under the Second Lien Term Loan was at LIBOR plus 6.75%,or 11.73% and the effective interest rate was 12.22%.  The Second Lien Term Loan has a prepaymentpenalty of 2.0% and 1.0% of the amount of any such optional prepayment thatoccurs prior to the first or second anniversary date, respectively. The SecondLien Term Loan requires principal reductions based upon a percentage of excesscash flow (as defined in the credit agreement) in any fiscal year and is alsosubject to certain mandatory prepayment provisions. In the event that we havenot extended the maturity date of the Series Z to a date that is on or afterJuly 26, 2012 or redeemed the Series Z by March 30, 2009, then the Second LienTerm Loan will mature on March 30, 2009.

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The Second Lien Term Loan has usual and customary covenantsincluding consolidated leverage ratios, fixed charge coverage ratios,limitations on capital expenditures, etc. The ratio covenants are based on aConsolidated EBITDA calculation (as defined in our loan agreement) and aremeasured on a twelve month period ending on the last day of each fiscalquarter. The loan is guaranteed by our material subsidiaries.  The Second Lien Term Loan and the relatedguarantees are secured by a second priority security interest in all our assetsand our material subsidiaries, including a pledge of 100% of our interest inall shares of capital stock (or other ownership or equity interests) of eachmaterial subsidiary.  As of July 4, 2006,we were in compliance with all our financial and operating covenants.

Approximately $1.7million in debt issuance costs have been capitalized and are being amortizedusing the effective interest method over the term of the Second Lien Term Loan.

**Subordinated Note**

The SubordinatedNote has a maturity date of February 28, 2013, carries a fixed interest rate of13.75% per annum and requires a quarterly cash interest payment in arrears at6.5% and quarterly paid-in kind interest that is added to the principal balanceoutstanding at 7.25%. As of July 4, 2006, the effective interest rate was14.60%. The Subordinated Note is held by Greenlight Capital and its affiliates(collectively referred to as Greenlight). Based on an original issue discountof 2.5%, proceeds of approximately $24.4 million were loaned to the Company.The Subordinated Note is subject to certain mandatory prepayment provisions. Inthe event that we have not extended the maturity date of the Series Z to a datethat is on or after July 26, 2013 or redeemed the Series Z by June 29, 2009,then the Subordinated Note will mature on June 29, 2009.

The Subordinated Note has usual and customarycovenants including consolidated leverage ratios, fixed charge coverage ratios,limitations on capital expenditures, etc. The loan is guaranteed by ourmaterial subsidiaries.   The SubordinatedNote is unsecured.  As of July 4, 2006,we were in compliance with all our financial and operating covenants.

Approximately $0.7 million in debt issuance costs havebeen capitalized and are being amortized using the effective interest methodover the term of the Subordinated Note. The debt discount of $625,000 isaccretive to the Subordinated Note and is amortized to interest expense usingthe effective interest method over the term of the Subordinated Note.

**$160 Million Notes**

On July 8, 2003,we issued $160 million of 13% senior secured notes maturing on July 1, 2008(“$160 Million Notes”). On February 28, 2006, the $160 Million Notes werereplaced with $170 million in new term loans as discussed above.

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

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The $160 Million Notescontained certain covenants, which, among others, included certain financialcovenants such as limitations on capital expenditures and minimum EBITDA asdefined in the agreement. The covenants also precluded the declaration andpayment of dividends or other distributions to holders of our common stock.These covenants were measured on a rolling twelve-month period and fiscalquarter basis, respectively. This debt contained usual and customary defaultprovisions.

Interest payments underthe $160 Million Notes were payable in arrears at the rate of 13% per year onJuly 1 and January 1, commencing January 1, 2004. The notes were redeemable, atour option, in whole or in part at any time after July 1, 2004 at the followingredemption prices (as expressed in percentages of the principal amount):

| Commencing on July 1, | ** ** | **Percentage** | ** ** |
|--------------------------------------|------------|----------------|------------|
| 2004                                 |       | 104.0          | %          |
| 2005                                 |       | 103.0          | %          |
| 2006                                 |       | 102.0          | %          |
| 2007                                 |       | 101.0          | %          |
| 2008 and thereafter                  |       | 100.0          | %          |

Debt issuancecosts were capitalized and amortized using the effective interest method overthe term of the $160 Million Notes. During the first quarter ended April 4, 2006, debt issuance costs werewritten off in the amount of $3.8 million.

**AmSouthRevolver**

On July 8, 2003, weentered into a three-year, $15 million senior secured revolving credit facilitywith AmSouth Bank (“AmSouth Revolver”). On February 28, 2006, the AmSouthRevolver was replaced with a new $15 million revolving credit facility as discussedabove.

The AmSouth Revolver wascollateralized by substantially all of our assets in which we had an interestand was senior to the $160 Million Notes pursuant to an IntercreditorAgreement.

The AmSouth Revolvercontained certain covenants, which, among others, included certain financialcovenants such as limitations on capital expenditures, operating leaseobligations, minimum EBITDA as defined in the agreement, operating cash flowcoverage ratio and minimum net worth. The covenants also precluded thedeclaration and payment of dividends or other distributions to holders of ourcommon stock. These covenants were measured on a rolling twelve-month period ateach fiscal quarter or annually at year-end. Additional covenant restrictionsexisted if the total borrowings, including outstanding letters of creditexceeded $10.0 million. This debt also contained usual and customarydefault provisions.

Interest payments underthe AmSouth Revolver were payable in arrears on the first of each month. Thenet borrowings under the AmSouth Revolver bore an interest rate equal to thebase rate plus an applicable margin with the base rate being the AmSouth Bank“prime rate” and the applicable margin being based on our fixed charge coverageratio with a minimum and maximum applicable margin of 0.5% and 2.5%respectively.

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We were required to payan unused credit line fee of 0.50% per annum on the average daily unusedamount. The unused line fee was payable monthly in arrears. Additionally, wewere required to pay a letter of credit fee based on the average daily undrawnface amount for each letter of credit issued, of an applicable margin beingbased on our fixed charge coverage ratio with a minimum and maximum applicablemargin of 2.0% and 4.5% respectively. Letters of credit reduced ouravailability under the AmSouth Revolver.

Debt issuance costs werecapitalized and amortized using the effective interest method over the term ofthe AmSouth Revolver.  During the firstquarter ended April 4, 2006, debt issuance costs were written off to interestexpense in the amount of $0.2 million.

**NewJersey Economic Development Authority Note Payable**

In December 1998,Manhattan Bagel Company, Inc. entered into a note payable in the principalamount of $2,800,000 with the New Jersey Economic Development Authority(“NJEDA”) at an interest rate of 9% per annum. Principal is paid annually andinterest is paid quarterly. The note matures on December 1, 2008 and is securedby the assets of Manhattan Bagel Company, Inc.

On July 3,2003, we placed an advanced funding of the note in escrow to enact a debtdefeasance as allowed for in the agreement. This advanced funding is shown asrestricted cash and the note is included in both current portion and long-termportion of debt in the July 4, 2006 and January 3, 2006 consolidated balancesheets in accordance with the payment terms. This classification will continueuntil the note is fully paid from the escrow amount proceeds.

**7.****             ****Net Loss Per Common Share**

In accordance with SFAS No. 128, Earnings per Share,we compute basic net loss per common share by dividing the net loss for theperiod by the weighted average number of shares of common stock outstandingduring the period.

Diluted net loss per share is computed by dividing thenet loss for the period by the weighted average number of shares of commonstock and potential common stock equivalents outstanding during the period, ifdilutive. Potential common stock equivalents include incremental shares ofcommon stock issuable upon the exercise of stock options and warrants. Theeffects of potential common stock equivalents have not been included in thecomputation of diluted net loss per share as their effect is anti-dilutive.

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The following table summarizes the weighted averagenumber of common shares outstanding, as well as sets forth the computation ofbasic and diluted net loss per common share for the periods indicated (inthousands of dollars, except per share data):
|                                       | ** ** | **Quarter ended:** | ** ** | **Year to date period ended:** | ** ** |
|---------------------------------------|------------|-------------------------|------------|----------------------------------------------------|------------|
| ** **                            | ** ** | **July 4,**        | ** ** | **June 28,**                                  | ** ** | **July 4,** | ** ** | **June 28,** | ** ** |
| ** **                            | ** ** | **2006**                | ** ** | **2005**                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                  |       |                    |       |                                               |       |   |   |   |   |
| Weighted average  shares outstanding  |       | 10,171,236              |       | 9,860,886                                          |       | 10,118,154 |   | 9,854,799 |   |
|                                  |       |                    |       |                                               |       |   |   |   |   |
| Net loss                              |       | $                       | (1,542     | )                                                  | $          | (4,283 | ) | $ | (13,634 | ) | $ | (8,481 | ) |
|                                  |       |                    |       |                                               |       |   |   |   |   |
| Basic and  diluted net loss per share |       | $                       | (0.15      | )                                                  | $          | (0.43 | ) | $ | (1.35 | ) | $ | (0.86 | ) |

Stock options andwarrants to purchase an aggregate of 1,013,746 and 2,200,243 shares of commonstock were outstanding as of July 4, 2006 and June 28, 2005, respectively.These stock options and warrants were not included in the computation ofdiluted earnings per share because their effect would have been anti-dilutive.

**8.****             ****Income Taxes**

We record deferredtax assets and liabilities based on the difference between the financialstatement and income tax basis of assets and liabilities using the enactedstatutory tax rate in effect for the year differences are expected to betaxable or refunded. Deferred income tax expenses or credits are based on thechanges in the asset or liability from period to period. Future tax benefitsare subject to a valuation allowance when we are unable to conclude that ourdeferred income tax assets will more likely than not be realized from theresults of operations. We consider the scheduled reversal of deferred tax liabilities,projected future taxable income and tax planning strategies in making thisassessment. Based on our history of losses and the uncertainty of futuretaxable income, we believe it more likely than not that we will not realizebenefits of these deductible differences as of July 4, 2006.  Accordingly, deferred tax assets resultingfrom these net operating losses have been fully reserved.

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To date we haveincurred substantial net losses that have created significant net operatingloss carryforwards (NOL’s) for tax purposes. Our NOL’s are one of our deferredincome tax assets. Over the past two years, we have reduced our net lossessubstantially from prior years. In the near term, we believe our income fromoperations will benefit from the reduction in our depreciation and amortizationexpense, as well as a savings from the reduction in the interest rate on ourdebt facility for the following reasons:

·                  Depreciation and amortizationexpense is predominately related to the assets of Einstein and Noah Corporationthat we acquired in bankruptcy proceedings in June 2001. The majority of theseassets and all of our amortizing intangibles became fully depreciated oramortized in July 2006. Accordingly, on a prospective basis, our depreciationand amortization expense will decrease substantially. Based on our currentpurchases of capital assets, our existing base of assets, and our projectionsfor new purchases of fixed assets, we believe our annual rate of depreciationexpense will approximate $12 million to $15 million in the near term.

·                  As further discussed in Note 6, onFebruary 28, 2006 we completed a debt refinancing that redeemed our $160Million Notes and retired our $15 million AmSouth Revolver. We replaced it with$170 million in new term loans and a $15 million revolving credit facilityeffectively reducing our effective interest rate from 13.9% to aweighted-average effective interest rate of 10.2% as of July 4, 2006. Assumingno significant change in the volume or composition of debt at July 4, 2006, webelieve the refinancing will reduce our annual cost of borrowing by $3.0million or more per year based on current LIBOR rates.

In accordance withSFAS 109, Accounting for Income Taxes, we will assess the continuing need for avaluation allowance that results from uncertainty regarding our ability torealize the benefits of our deferred tax assets. The ultimate realization ofdeferred income tax assets is dependent upon generation of future taxableincome during the periods in which those temporary differences becomedeductible. As we move closer toward achieving net income, we will reviewvarious qualitative and quantitative data, including events within therestaurant industry, the cyclical nature of our business, our future forecastsand historical trending. If we conclude that our prospects for the realizationof our deferred tax assets are more likely than not, we will then reduce ourvaluation allowance as appropriate and credit income tax expense afterconsidering the following factors:

·                  The level of historical taxableincome and projections for future taxable income over periods in which thedeferred tax assets would be deductible, and

·                  Achievement of approximately twoyears of net income before tax, with a carryback and carryforward review of ourperformance over the same period of time in which profits have been sustained.

The amount of thedeferred tax asset considered realizable, however, could be reduced ifestimates of future taxable income during the carryforward periods are reduced.As of July 4, 2006, net operating loss carryforwards of $164.5 million wereavailable to be utilized against future taxable income for years through fiscal2026, subject to annual limitations.

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**9.****             ****Impairment Charges**

In accordance withSFAS 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 primary indicatorof potential impairment for individual restaurant locations. We determinewhether a restaurant location is impaired based on expected undiscounted futurecash flows, considering location, local competition, current restaurantmanagement performance, existing pricing structure and alternatives availablefor the site. If impairment exists, the amount of impairment is measured as theexcess of the carrying amount of the asset over its fair value as determinedutilizing the estimated discounted future cash flows or the expected proceeds,net of costs to sell, upon sale of the asset.

During the secondquarter and year to date period ended July 4, 2006, we recorded $7,000 and$83,000, respectively in impairment charges related to company-owned stores.During the second quarter and year to date period ended June 28, 2005, werecorded approximately $1.2 million and $1.3 million, respectively inimpairment charges related to our Chesapeake trademarks.

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

We are subject to claims and legal actions in theordinary course of our business, including claims by or against ourfranchisees, licensees and employees or former employees and/or contractdisputes. We do not believe that an adverse outcome in any currently pending orthreatened matter would have a material adverse effect on our business, resultsof operations or financial condition.

On September 14, 2004, Atlantic Mutual InsuranceCompany brought an action in the Superior Court of New Jersey Law Division:Morris County, against the Company, certain of its former officers anddirectors and insurers seeking declaratory judgment on insurance coverageissues in previously resolved litigation against Jerold Novack and RaminKamfar, former officers. Mr. Kamfar cross-claimed against us, claiming a rightto be indemnified for expenses. The Company, Mr. Kamfar, Atlantic MutualInsurance Company and Lexington Insurance Company settled the lawsuit inFebruary 2006. The resolution of this lawsuit did not have a material effect onour consolidated financial condition or results of operations. Because theCompany asserts that the advancement and indemnity claims are an insured lossunder the Company’s policy with National Union, the Company has filed anarbitration proceeding against National Union, the Company’s officers anddirectors liability insurer for the applicable time period.

*Guarantees*

Prior to 2001, we would occasionally guarantee leasesfor the benefit of certain of our franchisees. None of the guarantees have beenmodified since their inception and we have since discontinued this practice.Current franchisees are the primary lessees under the vast majority of theseleases. Under the lease guarantees, we may be required by the lessor to makeall of the remaining monthly rental payments or property tax and common areamaintenance payments if the franchisee does not make the required payments in atimely manner. However, we believe that most, if not all, of the franchisedlocations could be subleased to third parties minimizing our potentialexposure. Additionally, we have indemnification agreements with our franchiseesunder which the franchisees would be obligated to reimburse us for any amountspaid under such guarantees. Historically, we have not been required to makesuch payments in significant amounts. We record a liability for our exposureunder the guarantees in accordance with SFAS No. 5, “Accounting forContingencies,” following a probability related approach. Minimum future rentalpayments remaining under these leases were approximately $0.9 million as ofJuly 4, 2006. We believe the ultimate disposition of these matters will nothave a material adverse effect on our financial position or results ofoperations.

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*Insurance*

We are insured for losses related to health, generalliability and workers’ compensation under large deductible policies. Theinsurance 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.  The estimated liability is included inaccrued expenses in our consolidated balance sheets.

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

On October 6, 2005, the FASB released FASB Staff Position (“FSP”) 13-1, Accounting for Rental Costs Incurred during a Construction Period. FSP 13-1 is effective for the first reporting period beginning after December 15, 2005 and requires that rental costs associated with ground or building operating leases incurred during a construction period be recognized as rental expense allocated on a straight-line basis over the lease term. This accounting is consistent with our historical and current practice.

In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 is an interpretation of FASB Statement No. 109, “Accounting for Income Taxes,” and it seeks to reduce the diversity in practice associated with certain aspects of measurement and recognition in accounting for income taxes. FIN 48 prescribes a recognition threshold and measurement criterion for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return, among other items. In addition, FIN 48 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition with respect to uncertainty in income taxes. FIN 48 is effective for fiscal years beginning after December 15, 2006. We are currently evaluating the impact, if any, that FIN 48 will have on our financial statements.

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

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

E. Nelson Heumannis the chairman of our board of directors and is a current employee ofGreenlight Capital, Inc.  Greenlight andits affiliates beneficially own approximately 95 percent of our common stock ona fully diluted basis. As a result, Greenlight has sufficient voting powerwithout the vote of any other stockholders to determine what matters will besubmitted for approval by our stockholders, to approve actions by writtenconsent without the approval of any other stockholders, to elect all of ourboard of directors, and among other things, to determine whether a change incontrol of our company occurs.

Greenlight owned$35.0 million of our $160 Million Notes when we called the Notes for redemptionin January 2006. The Notes were redeemed from the proceeds of our refinancingin February 2006 as further described in Note 6.

We entered intothe Subordinated Note with Greenlight as further described in Note 6. TheSubordinated Note has a maturity date of February 28, 2013, carries a fixedinterest rate of 13.75% per annum and requires a quarterly cash interestpayment in arrears at 6.5% and quarterly paid-in kind interest that is added tothe principal balance outstanding at 7.25%.

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During the quarter ended July 4, 2006, we issued429,645 shares of our common stock to Greenlight in connection with cashlessexercises of certain warrants previously granted by us. Greenlight surrendered56,953 shares of common stock to us in connection with such cashless exercises.We issued these warrants in private financing transactions that occurredbetween 2000 and 2003.

LeonardTannenbaum, a director, is a limited partner and 10% owner in BET. BETpurchased $7.5 million of our $160 Million Notes and Mr. Tannenbaum purchasedan additional $0.5 million of our $160 Million Notes in the market. In January2006, Mr. Tannenbaum and BET’s Notes were called for redemption and wereredeemed from the proceeds of our refinancing in February 2006 as furtherdescribed in Note 6.

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**ITEM 2.  MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

Thefollowing discussion and analysis supplements the management’s discussion andanalysis in our Annual Report on Form 10-K for the year ended January 3, 2006and presumes that readers have read or have access to the discussion andanalysis in our Annual Report. The following discussion and analysis includeshistorical and certain forward-looking information that should be read togetherwith the accompanying consolidated financial statements, related footnotes andthe discussion 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.

### **CriticalAccounting Policies and Estimates**

In December 2004, the Financial Accounting StandardsBoard (FASB) issued Statement of Financial Accounting Standard (SFAS) No. 123R,Share-Based Payment.  SFAS No. 123R is arevision of SFAS No. 123, Accounting for Stock-Based Compensation, andsupersedes Accounting Principles Board Opinion (APB) No. 25, Accounting forStock Issued to Employees and its related implementation guidance. SFAS No.123R focuses primarily on accounting for transactions in which an entityobtains employee services in share-based payment transactions. The Statementrequires entities to recognize compensation expense for awards of equityinstruments to employees based on the fair value of those awards on the date ofgrant (with limited exceptions).

Effective January 4, 2006, we adopted the provisionsof SFAS No. 123R using the modified prospective transition method. Prior to theadoption of SFAS No. 123R, we applied the intrinsic value-based method ofaccounting prescribed by APB No. 25 and related interpretations, inaccounting for our fixed award stock options to our employees. As such,compensation expense was recorded only if the current market price of theunderlying common stock exceeded the exercise price of the option on the dateof grant. We applied the fair value basis of accounting as prescribed by SFASNo. 123**in accounting for our fixed award stockoptions to our consultants. Under SFAS No. 123, compensation expense wasrecognized based on the fair value of stock options granted.

Historically, we adopted only the pro forma disclosureprovisions of SFAS No. 123. Upon adoption of SFAS No. 123R, we will recognizecompensation costs relating to the unvested portion of awards granted prior tothe date of adoption using the same estimates and attributions used todetermine the pro forma disclosures under SFAS No. 123, except that forfeiturerates will be estimated for all options, as required by SFAS No. 123R.

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We use theBlack-Scholes model to estimate the fair value of our option awards. TheBlack-Scholes model requires estimates of the expected term of the option, aswell as future volatility and the risk-free interest rate. Our stock optionsgenerally vest over a period of 6 months to 3 years and have contractual termsto exercise of 5 to 10 years. The expected term of options is based uponevaluations of historical and expected future exercise behavior. The risk-freeinterest rate is based on the US Treasury rates at the date of grant withmaturity dates approximately equal to the expected life at the grant date.Implied volatility is based on the mean reverting average of our stock’shistorical volatility and that of an industry peer group.  The use of mean reversion is supported byevidence of a correlation between stock price volatility and a company’sleverage combined with the effects mandatory principal payments will have onour capital structure, as defined under our new debt facility. We have nothistorically issued any dividends and are precluded from doing so under ourdebt covenants.

Option pricingmodels were developed for use in estimating the value of traded options thathave no vesting or hedging restrictions, are fully transferable and do notcause dilution. Because our share-based payments have characteristicssignificantly different from those of freely traded options, and becausechanges in the subjective input assumptions can materially affect our estimatesof fair values, in our opinion, existing valuation models, including theBlack-Scholes model, may not provide reliable measures of the fair values ofour share-based compensation. Consequently, there is a risk that our estimatesof the fair values of our share-based compensation awards on the grant datesmay differ from the actual values realized upon the exercise, expiration, earlytermination or forfeiture of those share-based payments in the future. Certainshare-based payments, such as employee stock options, may expire worthless orotherwise result in zero intrinsic value as compared to the fair valuesoriginally estimated on the grant date and reported in our financialstatements. Alternatively, value may be realized from these instruments that issignificantly in excess of the fair values originally estimated on the grantdate and reported in our financial statements. Although the fair value of ourshare-based awards is determined in accordance with SFAS 123R and theSecurities and Exchange Commission’s Staff Accounting Bulletin No. 107 (SAB107) using an option-pricing model, that value may not be indicative of thefair value observed in a willing buyer/willing seller market transaction.

Estimatesof share-based compensation expenses do have an impact on our financialstatements, but these expenses are based on the aforementioned option valuationmodel and will never result in the payment of cash by us. For this reason, andbecause we do not view share-based compensation as related to our operationalperformance, we exclude estimated share-based compensation expense whenevaluating our performance.

Therewere no other material changes in our critical accounting policies since thefiling of our 2005 Form 10-K. As discussed in our 2005 Form 10-K, thepreparation of the consolidated financial statements in conformity withaccounting principles generally accepted in the United States requiresmanagement to make certain estimates and assumptions that affect the amount ofreported assets and liabilities and disclosure of contingent assets andliabilities at the date of the consolidated financial statements and revenuesand expenses during the periods reported. Actual results may differ from thoseestimates.

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**Company Overview**

We believe we are a leading fast-casual restaurantchain specializing in high-quality foods for breakfast and lunch in a caféatmosphere with a neighborhood emphasis. As of July 4, 2006, we own, operate,franchise or license 613 restaurants primarily under the Einstein Bros., Noah’sand Manhattan brands. Einstein Bros. is a national fast-casual restaurantchain, and Noah’s and Manhattan are regional fast-casual restaurant chainsoperated on the West Coast and in the Northeast, respectively.

Our product offerings include fresh-baked goods bakedon site, made-to-order sandwiches on a variety of bagels and breads, gourmetsoups and salads, decadent desserts, premium coffees and other café beverages.Our manufacturing and commissary operations prepare consistent, high-qualityingredients and we deliver them to our restaurants through our network ofindependent distributors. These operations support our main business focus,restaurant operations, by exposing our brands to new product channels as wellas enabling sales of our products to third parties.

**SignificantEvents, Trends or Uncertainties Expected to Impact 2006 Results**

The following factorsrepresent current trends or uncertainties that may impact operating performanceor could cause reported financial information not to be indicative of futureoperating results or future financial condition.

*Restaurant Base*

Since 2003, as part ofour efforts to improve financial performance, we completed a thorough evaluationof our restaurant base. At the end of 2003, we had 736 restaurants across 33states and the District of Columbia. Since that time, we have closed 46 company-owned restaurants and 126franchised and licensed restaurants.  Themajority of the closed company-owned restaurants were either located ininferior real estate locations, had average annual unit volumes (AUVs) below$600,000 or were unprofitable or marginally profitable.  Substantially all of the franchises thatclosed either:

·                  Involved thefailure of the franchisee to conform with the requirements of the franchiseagreement;

·                  Weregeographically located outside Manhattan’s core Northeast market; or

·                  Wererestaurants operating under our non-core brands, Chesapeake Bagel Bakery andNew World Coffee.

We have identifiedapproximately 30 company-owned restaurants that we anticipate closing over thenext three years as their leases expire. Generally, these restaurants have anannual AUV below $550,000 and contribute negligible cash flow.

Our operating plan callsfor us to open five to seven restaurants in 2006. In addition to theseopenings, we are in the process of identifying several other potentiallocations for restaurant openings in 2007 and 2008. We are focusing our effortson key markets that include Atlanta, Chicago, Las Vegas, Phoenix, Washington,D.C. and the State of Florida.

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The following tabledetails the total restaurants open at the end of the respective second quarter:
|                             | ** ** | **Company** | ** ** | ** **   | ** ** | ** **     | ** ** | ** ** | ** ** |
|-----------------------------|------------|-------------|------------|--------------|------------|----------------|------------|------------|------------|
| ** **                  | ** ** | **owned**   | ** ** | **Licensed** | ** ** | **Franchised** | ** ** | **Total**  | ** ** |
| **Einstein  Bros. Bagels:** | ** ** | ** **  | ** ** | ** **   | ** ** | ** **     | ** ** | ** ** | ** ** |
| 2006                        |       | 353         |       | 70           |       | —         |       | 423        |       |
| 2005                        |       | 365         |       | 57           |       | —         |       | 422        |       |
| **Noah’s:**            | ** ** | ** **  | ** ** | ** **   | ** ** | ** **     | ** ** | ** ** | ** ** |
| 2006                        |       | 72          |       | 3            |       | —         |       | 75         |       |
| 2005                        |       | 75          |       | 3            |       | —         |       | 78         |       |
| **Manhattan:**              | ** ** | ** **  | ** ** | ** **   | ** ** | ** **     | ** ** | ** ** | ** ** |
| 2006                        |       | —      |       | —       |       | 105            |       | 105        |       |
| 2005                        |       | —      |       | —       |       | 127            |       | 127        |       |
| **Chesapeake:**             | ** ** | ** **  | ** ** | ** **   | ** ** | ** **     | ** ** | ** ** | ** ** |
| 2006                        |       | —      |       | —       |       | 5              |       | 5          |       |
| 2005                        |       | —      |       | —       |       | 24             |       | 24         |       |
| **New  World Coffee:**      | ** ** | ** **  | ** ** | ** **   | ** ** | ** **     | ** ** | ** ** | ** ** |
| 2006                        |       | 2           |       | —       |       | 3              |       | 5          |       |
| 2005                        |       | 2           |       | —       |       | 5              |       | 7          |       |
| **Total  Restaurants:**     | ** ** | ** **  | ** ** | ** **   | ** ** | ** **     | ** ** | ** ** | ** ** |
| 2006                        |       | 427         |       | 73           |       | 113            |       | 613        |       |
| 2005                        |       | 442         |       | 60           |       | 156            |       | 658        |       |

*Revenue*

Over 93% of our revenueis generated by restaurant sales at our Einstein Bros. and Noah’s company-ownedrestaurants.  Restaurant sales alsoinclude catering sales where the food is prepared at the restaurant and eitherdelivered to or held for pick-up by the guest. The key factors that affect our restaurant sales in the aggregate arethe number of restaurants in operation for the period, the AUV of therestaurant, and the change in comparable store sales.  In addition to AUV, we measure the change incomparable store sales on a weekly basis.

The majority of ourgrowth in comparable store sales has been through an increase in our averagecheck. This increase has been achieved through a combination of multipleinitiatives including: system-wide price increases, regional price increases inmarkets with a higher cost of living and suggestive selling by our restaurantpersonnel to add-on higher priced items.

We will continue to focuson our core strengths in bagels, the breakfast daypart, and on quality, speedof service, order accuracy and guest interaction. Prospectively, our focustowards sales growth will include the introduction of new menu items, localstore marketing and continued improvements in our service system. We alsointend to expand our existing catering programs, increase customer awareness ofour retail products, emphasize bundling products such as “Sweeten the Deal,”(adding on a beverage and a bakery product, such as a cookie) and highlightfavorite items such as our egg sandwiches. These initiatives are aimed atincreasing transaction counts in our restaurants.

We are also in theprocess of refining our store layout, ordering system and order fulfillmentprocess. These changes will be customized to best utilize the unique layouts inour existing restaurant base. On a prospective basis, we intend to standardizeour restaurant design to ensure a consistent guest experience that embodies ourheritage of guest and associate interaction without compromising speed andefficiency.

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Our manufacturing revenueis primarily derived from the sale of frozen bagel dough to our franchisees,licensees and third party accounts such as Costco. We also generatemanufacturing revenue from the sale of cream cheese and coffee to ourfranchisees, and the sale of all food products distributed through ourcommissaries to our licensees.  In late2005, we entered into agreements to commence selling salad kits and other deliproducts to the conventional grocery channel through our commissary network.The principal factors affecting manufacturing and commissary revenue are: thenumber of franchised and licensed locations that purchase frozen bagel doughand commissary products from us; sales of our products in existing franchisedand licensed locations; and sales to third parties, including conventionalgrocery chains and warehouse clubs.

Franchise and licenserevenue consists of a license or franchise fee at the inception of theagreement and ongoing royalty payments based on a percentage of therestaurant’s sales. The principal factors affecting franchise and licenserevenue are the number of franchised and licensed locations as well as thelevel of sales at those locations.

*Expenses*

Food, beverage andpackaging costs represent one of the largest elements of cost at ourcompany-owned restaurants. The most important factor that affects the cost ofthese products is the underlying cost of the agricultural commodities such asflour, cheese, coffee, turkey and other products.  In order to manage the cost of theseproducts, we enter agreements with our suppliers to fix the cost of theseproducts for a specified period of time that is generally one year or less. Wedo not engage in the practice of buying futures contracts and therefore we donot have derivative accounting. Packaging and distribution costs are primarilyaffected by the cost of oil.  Although wehave generally been able to increase our retail prices at our company-ownedrestaurants to offset the increased costs of these items, we may not be able todo this in the future.

We experienced slightdecreases in dairy prices during 2005, but the decrease was offset by increasesin commodity costs for coffee, flour and packaging. Flour represents the mostsignificant raw ingredient we purchase and we believe the cost of thiscommodity, as well as others, will continue to increase during the remainder of2006. Additionally, we believe the cost of produce may increase as a result ofthe damage to crops caused by hurricanes and other adverse weather-relatedevents.

Compensation costs reflectthe hourly wages, salary, bonus, taxes and insurance that we pay our associatesat each restaurant. Compensation costs tend to vary by geographic region basedupon the labor market, local minimum wages, and the supply and demand ofworkers. Also, compensation costs tend to be semi-variable in nature andincrease or decrease somewhat based upon the volume of products sold. Due tocompetition for personnel, limited availability in the labor pool, and changesin the federal overtime regulations, we anticipate we may experience anincrease in hourly wages during the remainder of 2006 contingent upon thenumber of overtime hours worked. We continue to make improvements in laborefficiencies that may help to offset increases in labor costs.

Other operating costsconsist of utilities, restaurant and other supplies, repairs and maintenance,laundry and uniforms, bank charges and other costs related to the operation ofthe company-owned restaurant. These costs generally tend to be fixed in natureand are only modestly impacted by changes in the volume of products sold.Rising energy costs and the increasing costs of other natural resources affectour utility bills and the cost of distribution to our restaurants.  We experienced increases in the cost forenergy during 2005 and 2006 and believe such costs will continue to increase onaverage during the remainder of 2006. Our distribution partners and common freight carriers passed on fuelsurcharges to us during 2004 and 2005. During late 2005, we negotiated contract terms with a new distributionpartner.  As a result, we experiencedincreased distribution costs beginning in the fourth quarter of 2005 that willcontinue throughout 2006.

Non-operating expensesinclude rent, common area costs, property taxes and insurance, liabilityinsurance, delivery fees and allocated marketing expenses.  We exclude depreciation and amortizationexpense from company-owned restaurant expenses. Changes in these costs aregenerally the result of changes in our rent and other related facilitycosts.  Accordingly, these costs arepredominantly fixed in nature and are modestly impacted by changes in thevolume of products sold. Certain states and local governments have increasedboth the rate and nature of taxes on businesses in their regions. Theseincreased taxes include real estate and property taxes, state and local incometaxes, and various employment taxes.

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Manufacturing costs arecomprised of raw materials such as flour, dairy products and meats,compensation costs and the related taxes and employee benefits, rents, suppliesand repairs and maintenance. These costs are directly related to themanufacturing revenue they produce. The profit derived from our manufacturingoperations represents third-party sales and can be significantly impacted byfixed overhead costs such as rent, utilities, property taxes and managersalaries and fluctuating commodity costs.

Changes in any of theaforementioned categories could directly impact the profitability of ourcompany-owned locations, manufacturing operations or distribution channels.Increases in any of these expense trends in the near future may contribute todegradation in our profit margins until such time as we are able to pass onincreased costs to our consumers.

*Consumer Spending Habits and Impactof Inflation*

Our results depend onconsumer spending, which is influenced by general economic conditions, such asrising fuel and energy costs, and the availability of discretionary income.Accordingly, we believe we experience declines in comparable store sales duringeconomic downturns or during periods of economic uncertainty like interest ratespeculation, unemployment rates, real estate market conditions and economicgrowth. Any material decline in the amount of discretionary spending could havea material adverse effect on our sales and income.

We have not experienced asignificant overall impact from inflation. However, the impact of inflation onlabor, food and occupancy costs could, in the future, significantly affect ouroperations. We pay many of our employees hourly rates slightly above theapplicable federal, state or municipal “living wage” rates. Food costs as apercentage of sales have been somewhat stable due to procurement efficienciesand menu price adjustments, although no assurance can be made that ourprocurement will continue to be efficient or that we will be able to raise menuprices in the future. Costs for construction, taxes, repairs, maintenance andinsurance all impact our occupancy costs. We believe that our current strategy,which is to seek to maintain operating margins through a combination of menuprice increases, cost controls, efficient purchasing practices and carefulevaluation of property and equipment needs, has been an effective tool fordealing with inflation.

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**Results of Operations**

This table setsforth, for the periods indicated, certain amounts included in our consolidatedstatements of operations, the relative percentage that those amounts representto total revenue (unless otherwise indicated), and the percentage change inthose amounts from period to period. All percentages are calculated usingactual amounts rounded to the nearest thousand.
| ** **                                                              | ** ** | **Second quarter ended:**          | ** ** | **Increase**      | ** ** | **Second quarter ended:**           | ** ** | **Year to date ended:**       | ** ** | **Increase**      | ** ** | **Year to date ended:**        | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------------------------|------------|-------------------|------------|-----------------------------------------------|------------|----------------------------------------------|------------|-------------------|------------|-----------------------------------------------|------------|
| ** **                                                              | ** ** | **(in thousands of dollars)** | ** ** | **(Decrease)**    | ** ** | **(percent of total revenue)** | ** ** | **(in thousands of dollars)** | ** ** | **(Decrease)**    | ** ** | **(percent of total revenue)** | ** ** |
| ** **                                                              | ** ** | **July 4,**                             | ** ** | **June 28,** | ** ** | **2006**                                      | ** ** | **July 4,**                             | ** ** | **June 28,** | ** ** | **July 4,**                              | ** ** | **June 28,** | ** ** | **2006** | ** ** | **July 4,** | ** ** | **June 28,** | ** ** |
| ** **                                                              | ** ** | **2006**                                     | ** ** | **2005**          | ** ** | **vs. 2005**                             | ** ** | **2006**                                     | ** ** | **2005**          | ** ** | **2006**                                      | ** ** | **2005** | ** ** | **vs. 2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues:                                                               |       |                                         |       |              |       |                                          |       |                                         |       |              |       |                                          |       |   |   |   |   |   |   |   |   |
| Restaurant  sales                                                       |       | 91,507                                       |       | 91,116            |       | 0.4                                           | %          | 93.4                                         | %          | 93.8              | %          | 182,087                                       |       | 177,975 |   | 2.3 | % | 93.4 | % | 93.5 | % |
| Manufacturing  revenues                                                 |       | 4,960                                        |       | 4,641             |       | 6.9                                           | %          | 5.1                                          | %          | 4.8               | %          | 9,981                                         |       | 9,635 |   | 3.6 | % | 5.1 | % | 5.1 | % |
| Franchise  and license related revenues                                 |       | 1,489                                        |       | 1,356             |       | 9.8                                           | %          | 1.5                                          | %          | 1.4               | %          | 2,964                                         |       | 2,798 |   | 5.9 | % | 1.5 | % | 1.5 | % |
| Total revenues                                                          |       | 97,956                                       |       | 97,113            |       | 0.9                                           | %          | 100.0                                        | %          | 100.0             | %          | 195,032                                       |       | 190,408 |   | 2.4 | % | 100.0 | % | 100.0 | % |
|                                                                    |       |                                         |       |              |       |                                          |       |                                         |       |              |       |                                          |       |   |   |   |   |   |   |   |   |
| Cost of sales:                                                          |       |                                         |       |              |       |                                          |       |                                         |       |              |       |                                          |       |   |   |   |   |   |   |   |   |
| Restaurant  costs                                                       |       | 73,964                                       |       | 73,770            |       | 0.3                                           | %          | 75.5                                         | %          | 76.0              | %          | 147,490                                       |       | 145,200 |   | 1.6 | % | 75.6 | % | 76.3 | % |
| Manufacturing  costs                                                    |       | 5,502                                        |       | 4,193             |       | 31.2                                          | %          | 5.6                                          | %          | 4.3               | %          | 10,507                                        |       | 8,900 |   | 18.1 | % | 5.4 | % | 4.7 | % |
| Total cost of sales                                                     |       | 79,466                                       |       | 77,963            |       | 1.9                                           | %          | 81.1                                         | %          | 80.3              | %          | 157,997                                       |       | 154,100 |   | 2.5 | % | 81.0 | % | 80.9 | % |
|                                                                    |       |                                         |       |              |       |                                          |       |                                         |       |              |       |                                          |       |   |   |   |   |   |   |   |   |
| Gross profit:                                                           |       |                                         |       |              |       |                                          |       |                                         |       |              |       |                                          |       |   |   |   |   |   |   |   |   |
| Retail                                                                  |       | 17,543                                       |       | 17,346            |       | 1.1                                           | %          | 17.9                                         | %          | 17.9              | %          | 34,597                                        |       | 32,775 |   | 5.6 | % | 17.7 | % | 17.2 | % |
| Manufacturing                                                           |       | (542                                         | )          | 448               |       |                                          | *          | (0.6                                         | )%         | 0.5               | %          | (526                                          | )          | 735 |   |   | * | (0.3 | )% | 0.4 | % |
| Franchise  and license                                                  |       | 1,489                                        |       | 1,356             |       | 9.8                                           | %          | 1.5                                          | %          | 1.4               | %          | 2,964                                         |       | 2,798 |   | 5.9 | % | 1.5 | % | 1.5 | % |
| Total gross profit                                                      |       | 18,490                                       |       | 19,150            |       | (3.4                                          | )%         | 18.9                                         | %          | 19.7              | %          | 37,035                                        |       | 36,308 |   | 2.0 | % | 19.0 | % | 19.1 | % |
|                                                                    |       |                                         |       |              |       |                                          |       |                                         |       |              |       |                                          |       |   |   |   |   |   |   |   |   |
| Operating expenses:                                                     |       |                                         |       |              |       |                                          |       |                                         |       |              |       |                                          |       |   |   |   |   |   |   |   |   |
| General  and administrative expenses                                    |       | 9,727                                        |       | 9,309             |       | 4.5                                           | %          | 9.9                                          | %          | 9.6               | %          | 20,288                                        |       | 17,994 |   | 12.7 | % | 10.4 | % | 9.5 | % |
| Depreciation  and amortization                                          |       | 5,594                                        |       | 7,077             |       | (21.0                                         | )%         | 5.7                                          | %          | 7.3               | %          | 11,598                                        |       | 13,785 |   | (15.9 | )% | 5.9 | % | 7.2 | % |
| Loss  (gain) on sale, disposal or abandonment of assets, net            |       | (8                                           | )          | 161               |       |                                          | *          | (0.0                                         | )%         | 0.2               | %          | 13                                            |       | 165 |   |   | * | 0.0 | % | 0.1 | % |
|                                                                    |       |                                         |       |              |       |                                          |       |                                         |       |              |       |                                          |       |   |   |   |   |   |   |   |   |
| Impairment  charges and other related costs                             |       | 7                                            |       | 1,182             |       | (99.4                                         | )%         | 0.0                                          | %          | 1.2               | %          | 83                                            |       | 1,279 |   | (93.5 | )% | 0.0 | % | 0.7 | % |
| Income from operations                                                  |       | 3,170                                        |       | 1,421             |       | 123.1                                         | %          | 3.2                                          | %          | 1.5               | %          | 5,053                                         |       | 3,085 |   | 63.8 | % | 2.6 | % | 1.6 | % |
| Other expense (income):                                                 |       |                                         |       |              |       |                                          |       |                                         |       |              |       |                                          |       |   |   |   |   |   |   |   |   |
| Interest  expense, net                                                  |       | 4,712                                        |       | 5,773             |       | (18.4                                         | )%         | 4.8                                          | %          | 5.9               | %          | 9,921                                         |       | 11,692 |   | (15.1 | )% | 5.1 | % | 6.1 | % |
| Prepayment  penalty upon redemption of $160 Million Notes               |       | —                                       |       | —            |       |                                          | *          | 0.0                                          | %          | 0.0               | %          | 4,800                                         |       | — |   |   | * | 2.5 | % | 0.0 | % |
| Write-off  of debt issuance costs upon redemption of $160 Million Notes |       | —                                       |       | —            |       |                                          | *          | 0.0                                          | %          | 0.0               | %          | 3,956                                         |       | — |   |   | * | 2.0 | % | 0.0 | % |
| Other,  net                                                             |       | —                                       |       | (69               | )          |                                          | *          | 0.0                                          | %          | (0.1              | )%         | 10                                            |       | (126 | ) |   | * | 0.0 | % | (0.1 | )% |
| Net loss                                                                |       | (1,542                                       | )          | (4,283            | )          | (64.0                                         | )%         | (1.6                                         | )%         | (4.4              | )%         | (13,634                                       | )          | (8,481 | ) | 60.8 | % | (7.0 | )% | (4.5 | )% |

 

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* not meaningful

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*Restaurant Operations*

**Whileour comparable store sales for the second quarter ended 2006 were slightlybetter than the overall industry, our restaurant sales were below ourexpectations. Restaurant sales improved 0.4% and 2.3% when compared to thesecond quarter and year to date periods ended 2005, respectively. Ourcomparable store sales increase of 3.6% consisted of a 6.0% increase in averagecheck partially offset by a 2.3% reduction in transactions during the secondquarter ended July 4, 2006. We also experienced a 4.9% increase in comparablestore sales for the year to date period ended July 4, 2006 that consisted of a6.1% increase in average check partially offset by a 1.2% reduction intransactions. The increase in average check was primarily related to asystem-wide price increase coupled with a slight shift in product mix to higherpriced items, including our “Sweeten the Deal” bundling offer (adding on abeverage and a bakery product such as a cookie). Comparable store salesrepresent sales at restaurants open for one full year and have not beenrelocated or closed during the current year. Comparable store sales are alsoreferred to as “same-store” sales or as “comp sales” within the restaurantindustry.**

**The followingtable summarizes the elements of comparable store sales for each quarter infiscal 2005 and for the first and second quarters ended 2006:**

|                              | ** ** | **Comparable**       | ** ** |
|------------------------------|------------|----------------------|------------|
| **Period**                   | ** ** | **Store Sales** | ** ** |
| First quarter,  fiscal 2005  |       | 4.6                  | %          |
| Second quarter,  fiscal 2005 |       | 6.3                  | %          |
| Third quarter,  fiscal 2005  |       | 5.9                  | %          |
| Fourth quarter,  fiscal 2005 |       | 3.9                  | %          |
| First quarter,  fiscal 2006  |       | 6.2                  | %          |
| Second quarter, fiscal  2006 |       | 3.6                  | %          |

 

We believe we can improve our transaction counts andbring further awareness to our brand by focusing on improvements in theoperation of our restaurants including initiatives in customer service(accuracy, friendliness and speed of service), overall restaurant appearanceand further development of catering programs in selected markets.

Our restaurant gross profit increased 1.1% and 5.6%for the second quarter and year to date periods ended July 4, 2006,respectively, when compared to the comparable periods in 2005. This improvementwas primarily driven by an increase in revenues. Our restaurant margins areimpacted by various store-level operating expenses such as the cost of productssold, salaries and benefits, insurance, supplies, repair and maintenanceexpenses, advertising, rent, utilities and property taxes. Because certainelements of cost of sales such as rent, utilities, property taxes and managersalaries are fixed in nature, incremental sales positively impact gross profit.Depreciation, amortization and income taxes do not impact our storecontribution margins.

During the second quarter of 2006, the increase inrestaurant sales over the comparable period contributed approximately $0.3million of store contribution margin related to the increased sales. Ourmargins were also favorably impacted by approximately by $0.6 million savingsin real estate taxes that included the settlement of a real estate tax disputeand $0.2 million for improvements in labor utilization, offset by $0.5 millionin increased workers’ compensation loss reserves and $0.4 million in additionalmarketing expenses.

During the year to date period ended July 4, 2006, theincrease in restaurant sales over the comparable period contributedapproximately $2.9 million of store contribution margin related to theincreased sales. Our margins were also favorably impacted by approximately $0.7million for improvements in labor utilization and $0.7 million savings in realestate taxes that included the settlement of a real estate tax dispute, offsetby $1.4 million in additional marketing expenses and $1.1 million in increasedworkers’ compensation loss reserves.

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*Manufacturing Operations*

Our manufacturing operations predominately support ourcompany-owned stores and generate revenue from the sale of food products tofranchisees, licensees and third-party distributors. For the second quarter andyear to date periods ended July 4, 2006 and June 28, 2005, our manufacturingmargins represented less than 1.0% of total revenues. Our manufacturing marginsare impacted by various manufacturing-level operating expenses such as the costof products sold, salaries and benefits, insurance, supplies, repair andmaintenance expenses, rent, utilities and property taxes. Margins from ourmanufacturing operations represents third-party sales and can be significantlyimpacted by fixed overhead costs such as rent, utilities, property taxes andmanager salaries and fluctuating commodity costs. All inter-companytransactions have been eliminated during consolidation.

During the second quarter ended July 4, 2006, ourmanufacturing operations experienced negative margins primarily due toincreases in raw materials and freight costs and incremental start-up costsassociated with a new products and customers. We anticipate that this trendwill continue to occur until such time that we are able to pass along a priceincrease to our third party customers or the commodity pressures lessen orcease to exist.

*Franchise and License Operations*

Revenues for the franchised and licensed operationsconsist primarily of initial fees and royalty income earned as a result ofoperation of franchise and license restaurants. The improvement in franchise and license related revenue ispredominately driven by slight increases in comparable store sales in ourManhattan Bagel franchise and Einstein Bros. licensed locations.

*General and Administrative Expenses*

**Generaland administrative expenses include corporate and administrative functions thatsupport our company-owned restaurants as well as our manufacturing andfranchise and license revenue streams. These costs include employee wages, taxes and related benefits, travelcosts, information systems, recruiting and training costs, corporate rent, andgeneral insurance costs.**

**Ourgeneral and administrative expenses increased 4.5%, or $0.4 million, for thesecond quarter of 2006 when compared to the second quarter of 2005.Contributing to the increase was approximately $0.2 million in increased traveland management development expenses and $0.2 million in stock basedcompensation expense.**

General and administrative expenses increased 12.7%,or $2.3 million, for the year to date period ended July 4, 2006 when comparedto the year to date period ended June 28, 2005. Contributing to the increasewas approximately $0.3 million in bonus wages payable to corporate office staffdue to improved operating performance, $0.3 million in additional consultingand contract labor fees, $0.4 million in stock based compensation expense, $0.3million in increased travel and management development expenses and $0.3million in expenses related to the costs of transitioning to a new distributor.Additionally, we incurred approximately $0.7 million for our first annualleadership summits for our Einstein Bros. and Noah’s general managers and ourManhattan Bagel franchisees.

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*Depreciation and Amortization*

Depreciation and amortization are periodic non-cashcharges that represent the reduction in usefulness and value of our tangibleand intangible assets.  The majority ofour depreciation and amortization relates to equipment and leaseholdimprovements located in our company-owned restaurants. Depreciation andamortization expenses decreased 21.0%, or $1.5 million, for the second quarterof 2006 when compared to the second quarter of 2005. The decrease is primarilydue to a portion of our asset base becoming fully depreciated. Depreciation and amortizationexpense is predominately related to the assets of Einstein/Noah Bagel Corp.that we acquired in bankruptcy proceedings in June 2001. On a prospectivebasis, we expect depreciation and amortization costs will decrease due to allof our amortizing intangible assets becoming fully amortized at July 4, 2006,and a substantial portion of our other assets becoming fully depreciated atJuly 4, 2006.  Based on our current purchasesof capital assets, our existing base of assets, and our projections for newpurchases of fixed assets, we believe our annual rate of depreciation expensewill approximate $12 million to $15 million in the near term.

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

Loss (gain) on the disposal, sale or abandonment ofassets represents the excess of proceeds received, if any, over the net bookvalue of an asset. We establish estimated useful lives for our assets, whichrange from 3 to 8 years, and depreciate using the straight-line method.Leasehold improvements are limited to the lesser of the useful life or thenoncancelable lease term. The useful lives of the assets are based upon ourexpectations of the period of time that the asset will be used to generaterevenue. We periodically review the assets for changes in circumstances, whichmay impact their useful lives.

*Impairment Charges and other Related Costs*

Impairment losses are non-cash charges recorded onlong-lived assets, goodwill, trademarks and our other intangible assets. Generally,an indicator of impairment would include significant change in an asset’sability to generate positive cash flow in the future or in the fair value of anasset. Whenever impairment indicators are determined to be present, the amountof impairment is measured as the excess of the carrying amount of the assetover its fair value. During the second quarter and year to date period endedJuly 4, 2006, we recorded $7,000 and $83,000, respectively in impairmentcharges related to company-owned stores. During the second quarter and year todate periods ended June 28, 2005, we recorded approximately $1.2 million and$1.3 million, respectively in impairment charges related to our Chesapeaketrademarks.

*Interest Expense*

On February 28, 2006, we completed a debt refinancingthat redeemed our $160 Million Notes and retired our $15 million AmSouthRevolver. We replaced this debt with $170 million in new term loans and a $15million revolving credit facility effectively reducing our effective interestrate from 13.9% to a weighted-average effective interest rate of 10.2% as ofJuly 4, 2006. During the first quarter ended 2006, we wrote off $4.0 million ofdebt issuance costs and paid a 3% redemption premium on the $160 Million Notesin the amount of $4.8 million. During the second quarter and year to dateperiod ended 2006, we incurred $4.7 million and $9.9 million, respectively, innet interest expense compared to $5.8 million and $11.7 million in therespective 2005 periods.

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*Net Lossand Income Taxes*

Net operatinglosses generated in the current year from continuing operations resulted in nofederal and state income tax liability for the second quarter and year to dateperiods ended 2006 and 2005. Due to the uncertainty of future taxable income,deferred tax assets resulting from these net operating losses have been fullyreserved. Todate we have incurred substantial net losses that have created significant netoperating loss carryforwards (NOL’s) for tax purposes. Our NOL’s are one of ourdeferred income tax assets. Over the past two years, we have reduced our netlosses substantially from prior years. In the near term, we believe our incomefrom operations will benefit from the reduction in our depreciation andamortization expense, as well as a savings from the reduction in the interestrate on our debt facility as previously discussed.

In accordance with SFAS 109, Accounting for Income Taxes, we willassess the continuing need for a valuation allowance that results fromuncertainty regarding our ability to realize the benefits of our deferred taxassets. The ultimate realization of deferred income tax assets is dependentupon generation of future taxable income during the periods in which thosetemporary differences become deductible. As we move closer toward achieving netincome, we will review various qualitative and quantitative data, includingevents within the restaurant industry, the cyclical nature of our business, ourfuture forecasts and historical trending. If we conclude that our prospects forthe realization of our deferred tax assets are more likely than not, we willthen reduce our valuation allowance as appropriate and credit income taxexpense after considering the following factors:

·                  The level of historical taxableincome and projections for future taxable income over periods in which thedeferred tax assets would be deductible, and

·                  Achievement of approximately twoyears of net income before tax, with a carryback and carryforward review of ourperformance over the same period of time in which profits have been sustained.

The amount of the deferredtax asset considered realizable, however, could be reduced if estimates offuture taxable income during the carryforward periods are reduced. As of July4, 2006, net operating loss carryforwards of $164.5 million were available tobe utilized against future taxable income for years through fiscal 2026,subject to annual limitations.

**Liquidity and Capital Resources**

The restaurant industry is predominantly a cashbusiness where cash is received at the time of the transaction. We believe wewill generate sufficient cash flow and have sufficient availability under ourrevolving credit facility to fund operations, capital expenditures and requireddebt and interest payments. Our inventory turns frequently since our productsare perishable. Accordingly, our investment in inventory is minimal. Ouraccounts payable are on terms that we believe are consistent with those ofother companies within the industry.

The primary driver of ouroperating cash flow is our restaurant operations, specifically the gross marginfrom our company-owned restaurants. Therefore, we focus on the elements ofthose operations including comparable store sales and cash flows to ensure asteady stream of operating profits that enable us to meet our cash obligations.On a weekly basis, we review our company-owned store performance compared withthe same period in the prior year and our operating plan.

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*2006 Debt Redemption and Refinancing*

On February 28, 2006, we completed the refinancing ofthe AmSouth Revolver and $160 Million Notes. Our new financing consists of a:

·                  $15million revolving credit facility (Revolving Facility) maturing on March 31,2011;

·                  $80million first lien term loan (First Lien Term Loan) maturing on March 31, 2011;

·                  $65million second lien term loan (Second Lien Term Loan) maturing on February 28,2012; and

·                  $25million subordinated note (Subordinated Note) maturing on February 28, 2013.

Each of the loans requires the payment of interest inarrears on a quarterly basis commencing on March 31, 2006. Additionally, theFirst Lien Term Loan requires quarterly scheduled minimum principal reductionscommencing June 30, 2006. In the event that we have not extended the maturitydate of the Mandatorily Redeemable Series Z Preferred Stock (Series Z) to adate that is on or after July 26, 2012 (July 26, 2013 for the SubordinatedNote) or redeemed the Series Z by various dates in 2008 and 2009, then each ofthe loans have various accelerated maturity dates beginning in December 2008.For an additional discussion regarding our new debt facility, see Note 6 to ourconsolidated financial statements included in Part I of this report.

*Working Capital Deficit and CashFlows*

As of July 4,2006, we had unrestricted cash of $4.7 million, restricted cash of $3.0 millionand no outstanding borrowings under the Revolving Facility. Our working capitaldeficit increased to $11.9 million at July 4, 2006 from $11.7 million atJanuary 3, 2006, primarily due to the short-term classification of principalpayments due under our First Lien Term Loan. Due to increased profitability,the timing of operational receipts and payments, and the inclusion of $4.0million in a prepayment penalty incurred upon redemption of the $160 MillionNotes as reflected in our net loss, net cash of $4.2 million was provided byoperating activities for the year to date period ended July 4, 2006 compared tonet cash of $8.1 million for the year to date period ended June 28, 2005.

Based upon ourprojections for 2006 and beyond, we believe that our various sources ofcapital, including availability under existing debt facilities, ability toraise additional financing, and cash flow from operating activities ofcontinuing operations, are adequate to finance operations as well as the repaymentof current debt obligations. If we are unable to generate sufficient cash flowto make payments on our debt, we may have to pursue one or more alternatives,such as reducing or delaying capital expenditures, refinancing our debt onterms that are not favorable to us or selling assets. We may not be able toaccomplish any of these alternatives on satisfactory terms, if at all, and evenif accomplished, they may not yield sufficient funds to service our debt.

During the year to date period ended July 4, 2006, weused approximately $5.4 million of cash to purchase additional property andequipment that included $0.7 million for new stores, $1.4 million forremodeling existing stores, $2.0 million for replacement and new equipment atour existing company-owned stores, $0.4 million for our manufacturingoperations and less than $0.9 million for general corporate purposes. Weanticipate that the majority of our capital expenditures for fiscal 2006 willbe focused on our refresh and remodel strategy that includes updates ofrestaurant interiors and design flow. In addition, we plan to acquireadditional equipment for new menu items and improvements in the speed ofservice, particularly during the morning day-part. We also plan to open 5 to 7new company-owned restaurants during 2006 at an average capital investment ofapproximately $400,000 to $500,000 per location.

As a result of our refinancing of our $160 MillionNotes with $170 million in new term loans in February 2006, we borrowed $169.4million in term loans and incurred approximately $5.0 million in debt issuancecosts. Upon closing of our new debt facility, we began amortizing these costsand the debt issuance costs related to our $160 Million Notes and AmSouthRevolver were written-off.

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*Contractual Obligations*

The following table summarizes the amounts of paymentsdue under specified contractual obligations as of July 4, 2006:

|                                                  | ** ** | **Payments Due by Period**    | ** ** |
|--------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                     | ** ** | **2007 to  2009** | ** ** | **2010 to  2011** | ** ** | **2012 and  thereafter** | ** ** | **Total** | ** ** |
| ** **                                       | ** ** | **(in thousands of dollars)** | ** ** |
| Accounts payable  and accrued expenses           |       | $                                            | 30,969     |   | $ | — |   | $ | — |   | $ | — |   | $ | 30,969 |   |
| Debt                                             |       | 1,230                                        |       | 21,085 |   | 58,050 |   | 105,795 |   | 186,160 |   |
| Estimated  interest expense on our Debt Facility |       | 8,158                                        |       | 47,266 |   | 25,536 |   | 4,934 |   | 85,894 |   |
| Manditorily  Redeemable Series Z                 |       | —                                       |       | 57,000 |   | — |   | — |   | 57,000 |   |
| Minimum lease  payments under capital leases     |       | 59                                           |       | 110 |   | — |   | — |   | 169 |   |
| Minimum lease  payments under operating leases   |       | 25,889                                       |       | 37,998 |   | 8,811 |   | 2,151 |   | 74,849 |   |
| Purchase  obligations (a)                        |       | 8,139                                        |       | — |   | — |   | — |   | 8,139 |   |
| Other long-term  obligations (b)                 |       | —                                       |       | 1,365 |   | 832 |   | 4,979 |   | 7,176 |   |
| Total                                            |       | $                                            | 74,444     |   | $ | 164,824 |   | $ | 93,229 |   | $ | 117,859 |   | $ | 450,356 |   |

 

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(a) Purchaseobligations consist of non-cancelable minimum purchases of frozen dough andcertain other raw ingredients that are used in our products.

(b) Otherlong-term obligations primarily consist of the remaining liability related tominimum future purchase commitments with a supplier that advanced us $10.0million in 1996.

*Insurance*

We are insured forlosses related to health, general liability and workers’ compensation underlarge deductible policies. The insurance liability represents an estimate ofthe ultimate cost of claims incurred and unpaid as of the balance sheet date.The estimated liability is established based on actuarial estimates, isdiscounted at 10% based upon a discrete analysis of actual claims andhistorical data and is reviewed on a quarterly basis to ensure that theliability is appropriate. If actual trends, including the severity or frequencyof claims, differ from our estimates our financial results could be favorablyor unfavorably impacted.  The estimatedliability is included in accrued expenses in our consolidated balance sheets.

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**Off-BalanceSheet Arrangements**

*Guarantees*

Prior to 2001, wewould occasionally guarantee leases for the benefit of certain of ourfranchisees. None of the guarantees have been modified since their inceptionand we have since discontinued this practice. Current franchisees are theprimary lessees under the vast majority of these leases. Under the leaseguarantees, we may be required by the lessor to make all of the remainingmonthly rental payments or property tax and common area maintenance payments ifthe franchisee does not make the required payments in a timely manner. However,we believe that most, if not all, of the franchised locations could besubleased to third parties minimizing our potential exposure. Additionally, wehave indemnification agreements with our franchisees under which thefranchisees would be obligated to reimburse us for any amounts paid under suchguarantees. Historically, we have not been required to make such payments insignificant amounts. We record a liability for our exposure under theguarantees in accordance with SFAS No. 5, “Accounting for Contingencies,”following a probability related approach. Minimum future rental paymentsremaining under these leases were approximately $0.9 million as of July 4,2006. We believe the ultimate disposition of these matters will not have amaterial adverse effect on our financial position or results of operations.

*Letters of Credit*

We have $6.9 million in letters of credit outstandingunder our Revolving Facility at July 4, 2006. The letters of credit expire onvarious dates during 2007, are automatically renewable for one additional yearand are payable upon demand in the event that we fail to pay the underlyingobligation.

**Item3.  Qualitative and Quantitative Disclosures About Market Risk**

During the second quarter and year to date periodsended July 4, 2006 and June 28, 2005, our results of operations, financialposition and cash flows have not been materially affected by changes in therelative values of non-U.S. currencies to the U.S. dollar. We do not usederivative financial instruments to limit our foreign currency risk exposuresince virtually all of our business is conducted in the United States.

Our debt as of July 4, 2006 was principally comprisedof the Revolving Facility, First Lien Term Loan, Second Lien Term Loan, andSubordinated Note as further discussed in Note 6 to the consolidated financialstatements included in Part I of this document. For fixed rate debt, interestrate changes affect the fair market value of such debt but do not impactearnings or cash flows. Conversely for variable rate debt, including borrowingsunder our Revolving Facility, First Lien Term Loan and Second Lien Term Loan,interest rate changes generally do not affect the fair market value of suchdebt, but do impact future earnings and cash flows, assuming other factors areheld constant. A 100 basis point increase in short-term effective interestrates would increase our net loss by approximately $1.5 million annually,assuming no change in the size or composition of debt at July 4, 2006.Currently, the interest rates on our First Lien Term Loan, Second Lien TermLoan and Revolving Facility are predominately at LIBOR rates plus an applicablemargin through short-term fixed rate financing. The estimated increase ininterest expense incorporates the fixed interest financing into its assumptions.

We purchase certain commodities such as butter,cheese, coffee and flour. These commodities are generally purchased based uponmarket prices established with vendors. Our purchase arrangements may containcontractual features that limit the price paid by establishing certain pricefloors or caps. We do not use financial instruments to hedge commodity pricesbecause our purchase arrangements help control the ultimate cost paid and anycommodity price aberrations are generally short-term in nature.

This market risk discussion contains forward-lookingstatements. Actual results may differ materially from this discussion basedupon general market conditions and changes in domestic and global financialmarkets.

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**Item 4.  Controls and Procedures**

An evaluation was carried out under the supervisionand with the participation of company management, including our chief executiveofficer and chief financial officer, of the effectiveness of the design andoperation of our disclosure controls and procedures (as defined inrule 13a-15(e) under the Securities Exchange Act of 1934, as amended) asof July 4, 2006. Based upon that evaluation, our chief executive officer andour chief financial officer have concluded that the design and operation of ourdisclosure controls and procedures were effective in timely making known tothem material information relating to the Company required to be disclosed inreports that we file or submit under the Exchange Act rules.

It should be noted that any system of controls,however well designed and operated, can provide only reasonable assuranceregarding management’s control objectives. In addition, the design of anycontrol system is based in part upon certain assumptions about the likelihoodof future events. Because of these and other inherent limitations of controlsystems, there can be no assurance that any design will succeed in achievingits stated goals under all potential future conditions, regardless of howremote.

During the quarter ended July 4, 2006, there were nochanges to our internal controls over financial reporting that were identifiedin connection with the evaluation of our disclosure controls and proceduresrequired by the Exchange Act rules and that have materially affected, or arereasonably likely to materially affect, our internal controls over financialreporting.

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**PART II -OTHER INFORMATIONNEW WORLD RESTAURANT GROUP, INC.**

**Item 1.    Legal Proceedings**

Information regardinglegal proceedings is incorporated by reference from Note 10 to our ConsolidatedFinancial Statements set forth in Part I of this report.

### ***Item 1A. Risk Factors***

We wish to cautionour readers that the following important factors, among others, could cause theactual results to differ materially from those indicated by forward-lookingstatements made in this report and from time to time in news releases, reports,proxy statements, registration statements and other written communications, aswell as verbal forward-looking statements made from time to time byrepresentatives of the company. Such forward-looking statements involve risksand uncertainties that may cause our actual results, performance orachievements to be materially different from any future performance orachievements expressed or implied by these forward-looking statements. Factorsthat might cause actual events or results to differ materially from thoseindicated by these forward-looking statements may include matters such asfuture economic performance, restaurant openings or closings, operatingmargins, the availability of acceptable real estate locations, the sufficiencyof our cash balances and cash generated from operating and financing activitiesfor our future liquidity and capital resource needs, and other matters, and aregenerally accompanied by words such as: believes, anticipates, estimates,predicts, expects, and similar expressions that convey the uncertainty offuture events or outcomes. An expanded discussion of some of these risk factorsfollows.

***RiskFactors Relating to Our Business and Our Industry***

*Changes in consumer preferences and discretionaryspending priorities could harm our financial results.*

Numerous factors including changes in consumer tastesand discretionary spending priorities often affect restaurants.  Shifts in consumer preferences away from ourtype of cuisine and/or the fast-casual style could have a material adverseeffect on our results of operations. Dietary trends, such as the consumption of food low in carbohydratecontent, have in the past and may, in the future, negatively impact our sales.  In addition, instances of food-borne illness,including “mad cow” disease, salmonella and e-coli, whether or not traced toour restaurants, could reduce demand for our menu offerings.

Changes in our guests’ spending habits could also havea material adverse effect on our sales. A variety of factors could affect discretionary consumer spending,including national, regional and local economic conditions, inflation, consumerconfidence and energy costs.  Adversechanges in any of these factors could reduce consumers’ discretionary spendingwhich in turn could reduce our guest traffic or average check.  Adverse changes to consumer preferences orconsumer discretionary spending, each of which could be affected by manydifferent factors which are out of our control, could harm our businessprospects, financial condition, operating results and cash flows.  Our continued success will depend in part onour ability to anticipate, identify and respond to changing consumer preferencesand economic conditions.

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

Our success depends in part on our ability to understand and satisfyour guests’ needs.  We believe successfuldeployment of our current business strategy will address guests’ needs andcontribute to overall company growth. Our business strategy consists of several initiatives:

·                  expanding themenu offerings at our company-owned restaurants;

·                  increasing theprofitability of our existing restaurants through our brand refresh strategy;

·                 growing ourbusiness through opening new company-owned, franchised and licensedrestaurants; and

·                 continuing todevelop our manufacturing and commissary operations to increase third-partysales.

Our ability to achieve any or all of these initiatives isuncertain.  Our success in developing newmenu offerings and refreshing our stores is dependent in part on our ability topredict and satisfy consumer preferences. Our success in growing our business through opening new company-ownedrestaurants is dependent on a number of factors, including our ability to: findsuitable locations, reach acceptable lease terms, have adequate capital, trainappropriate staff and properly manage the new location.  Our success in increasing third-party salesis dependent on identifying new opportunities and negotiating profitablearrangements with third-party purchasers. If we are not successful in implementing any or all of the initiativesof our business strategy, it could have a material adverse effect on ourbusiness, results of operations, and financial condition.

*Our sales and profit growth could be adverselyaffected if comparable store sales are less than we expect.*

The level of growth in comparable store salessignificantly affects our sales growth and will be a critical factor affectingprofit growth. The profit margin driven by comparable store sales enables fixedcosts to be spread over a higher sales base. Our ability to increase comparablestore sales depends in part on our ability to successfully implement ourinitiatives to increase throughput, such as increasing the speed at which ouremployees serve each customer, and to build customer awareness of our menuofferings. Factors such as traffic patterns, local demographics and the type,number and location of competing restaurants may adversely affect theperformance of individual locations. It is possible that we will not achieveour targeted comparable store sales growth or that the change in comparablestore sales could be negative and could adversely impact our sales and profitgrowth.

*Competition in the restaurant industry is intense,and we may fall short of our revenue and profitability targets if we are unableto compete successfully.*

Our industry is highly competitive and there are manywell-established competitors with substantially greater financial and otherresources than we have. Although we operate in the fast-casual segment of therestaurant industry, we also consider restaurants in the fast-food andfull-service segments to be our competitors. In addition to currentcompetitors, one or more new major competitors with substantially greaterfinancial, marketing and operating resources could enter the market at any timeand compete directly against us. Also, in virtually every major metropolitanarea in which we operate or expect to enter, local or regional competitorsalready exist. This may make it more difficult to obtain real estate andadvertising space, and to retain customers and personnel.

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*We occupy our company-owned restaurants underlong-term non-cancelable leases, and we may be unable to renew leases at theend of their lease periods or obtain new leases on acceptable terms.*

We do not own any real property, and all of ourcompany-owned restaurants are located in leased premises. Many of our currentleases are non-cancelable and typically have terms ranging from five to tenyears with two three- to five-year renewal options for total terms ofapproximately 15 to 20 years. We believe that leases that we enter into in thefuture likely will also be long-term and non-cancelable and have similarrenewal options.  Most of our leasesprovide that the landlord may increase the rent over the term of the lease, andrequire us to pay our proportionate share of the cost of insurance, taxes,maintenance and utilities.  If we close arestaurant, we generally remain committed to perform our obligations under theapplicable lease, which would include, among other things, payment of the baserent for the balance of the lease term. Our obligation to continue making rental payments in respect of leasesfor closed restaurants could have a material adverse effect on our business andresults of operations.

Alternatively, at the end of the lease term and anyrenewal period for a restaurant, we may be unable to renew the lease withoutsubstantial additional cost, if at all. If we are unable to renew our restaurant leases, we may be forced toclose or relocate a restaurant, which could subject us to construction andother costs and risks, and could have a material adverse effect on our businessand results of operations.  For example,closing a restaurant, even during the time of relocation, will reduce the salesthat the restaurant would have contributed to our revenues.  Additionally, the revenue and profit, if any,generated at a relocated restaurant may not equal the revenue and profitgenerated at the existing restaurant.  Wealso face competition from both restaurants and other specialty retailers forsuitable sites for new restaurants.  As aresult, we may not be able to secure or renew leases for adequate sites atacceptable rent levels.

*Fluctuations in the cost, availability and qualityof our raw ingredients and natural resources such as energy affect our resultsof operations.*

The cost, availability and quality of the ingredientswe use to prepare our food are subject to a range of factors, many of which arebeyond our control. Fluctuations in economic and political conditions, weatherand demand could adversely affect the cost of our ingredients. For example,prices for agricultural commodities such as cheese and butter increasedsubstantially during 2004, and the price for flour, the most significant rawingredient we purchase, has and we expect will continue to increase during theremainder of 2006.  In addition, risingenergy costs and the increasing costs of other natural resources, which weexperienced in 2005 and expect to continue during 2006, affect our utilitybills, the cost of packaging that is derived from petroleum products and thecost of distribution to our restaurants.      Wehave limited control over these changes in the price and quality ofcommodities, since we do not have any long-term pricing agreements for theseingredients.  We may not be able to passthrough any future cost increases by increasing menu prices, as we have done inthe past. We and our franchisees and licensees are dependent on frequentdeliveries of fresh ingredients, thereby subjecting us to the risk of shortagesor interruptions in supply.  All of thesefactors could adversely affect our business, reputation and financial results.

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*Our operations may be negatively impacted byadverse weather conditions.*

Adverse weather conditions could seriously affectregions in which our company-owned, franchised and licensed restaurants arelocated or regions that produce raw ingredients for our restaurants.  If adverse weather conditions affect ourrestaurants, we could experience closures, repair and restoration costs, foodspoilage, and other significant reopening costs as well as increased food costsand delayed supply shipments, any of which would adversely affect ourbusiness.  For example, due to extensivedamage caused by Hurricanes Katrina and Rita, many of our company-owned locationsin Florida and one licensed location in Louisiana were temporarily closed.  We incurred labor and capital costs relatedto the reopening of our company-owned restaurants.

The effects of hurricanes and other adverse weatherconditions are likely to affect supply of and costs for raw ingredients andnatural resources, near-term construction costs for our new restaurants as wellas sales in our restaurants going forward. Specifically, Hurricanes Katrina and Rita damaged tomato and othercrops, drove prices of food products higher, resulted in increased diesel andgasoline costs and affected consumer confidence.  If we are not able to anticipate or react tochanging costs of food and other raw materials by adjusting our purchasingpractices or menu prices, our operating margins would likely deteriorate.

*We have single suppliers for most of our keyingredients, and the failure of any of these suppliers to perform could harmour business.*

We currently purchase our raw materials from varioussuppliers; however, we have only one supplier for each of our key ingredients.We purchase a majority of our frozen bagel dough from a single supplier, whoutilizes our proprietary processes and on whom we are dependent upon in theshort-term.  All of our remaining frozenbagel dough is produced at our dough manufacturing facility in Whittier,CA.  Additionally, we purchase all of ourcream cheese from a single source, and we have a single supplier for ourcoffee. Although to date we have not experienced significant difficulties withour suppliers, our reliance on a single supplier for each of our keyingredients subjects us to a number of risks, including possible delays orinterruption in supplies, diminished control over quality and a potential lackof adequate raw material capacity. Any disruption in the supply or degradationin the quality of the materials provided by our suppliers could have a materialadverse effect on our business, operating results and financial condition. Inaddition, any such disruptions in supply or degradations in quality could havea long-term detrimental impact on our efforts to maintain a strong brandidentity and a loyal consumer base.

Other than our contract with our supplier of frozenbagel dough, we do not have written contracts or long-term arrangements withany of our suppliers.  This contractexpires at the end of 2006. If we are unable to reach a new agreement to supplyfrozen bagel dough on favorable terms, our frozen bagel dough costs couldincrease which would have a negative impact on our results from operations.

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*Failure of our distributors to perform adequatelyor any disruption in our distributor relationships could adversely affect ourbusiness and reputation.*

We depend on our network of distributors to distributefrozen bagel dough and other products and materials to our company-owned,franchised and licensed locations. Any failure by one or more of ourdistributors to perform as anticipated, or any disruption in any of ourdistribution relationships for any reason, would subject us to a number ofrisks, including inadequate products delivered to our restaurants, diminishedcontrol over quality of products delivered, and increased operating costs toprevent delays in deliveries.  Any ofthese events could harm our relationships with our franchisees or licensees, ordiminish the reputation of our menu offerings or our brands in themarketplace.  In addition, a negativechange in the volume of products ordered from our distributors by ourcompany-owned, franchised and/or licensed locations could increase ourdistribution costs. These risks could have a material adverse effect on ourbusiness, financial condition and results of operations.

During late 2005, we negotiated contract terms with anew distribution partner. We have experienced some transition issues at one newdistribution center during 2006, but at this time we do not believe theseissues will have a material adverse effect on our results of operations. We arecurrently working with this distributor to resolve these issues.

*Increasing labor costs could adversely affect ourresults of operations and cash flows.*

We are dependent upon an available labor pool ofassociates, many of whom are hourly employees whose wages may be affected by anincrease in the federal, state or municipal “living wage” rates. Numerousproposals have been made on federal, state and local levels to increase minimumwage levels. Although few, if any, of our associates are paid at the minimumwage level, an increase in the minimum wage may create pressure to increase thepay scale for our associates, which would increase our labor costs and those ofour franchisees and licensees. A shortage in the labor pool or other generalinflationary pressures or changes could also increase labor costs. In addition,changes in labor laws or reclassifications of associates from management tohourly employees could affect our labor cost. An increase in labor costs couldhave a material adverse effect on our income from operations and decrease ourprofitability and cash flows if we are unable to recover these increases byraising the prices we charge our customers.

*We may not be able to generate sufficient cash flowto make payments on our substantial amount of debt.*

We have a high level of debt and are highly leveraged.As of July 4, 2006, we had $170 million in term loans outstanding. In addition,we may, subject to certain restrictions, incur substantial additionalindebtedness in the future.  Our highlevel of debt, among other things, 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.

Economic, financial, competitive, legislative andother factors beyond our control may affect our ability to generate cash flowfrom operations to make payments on our indebtedness 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 issuing additional equity securities. We may not be able toaccomplish any of these alternatives on satisfactory terms, if at all, and evenif accomplished, they may not yield sufficient funds to service our debt.

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*We must comply with certain covenants inherent inour debt agreements to avoid defaulting under those agreements.*

Our debt agreements contain certain covenants, which,among others, include certain financial covenants such as limitations oncapital expenditures, maintenance of the business, use of proceeds on sales ofassets and consolidated leverage and fixed charge coverage ratios as defined inthe agreements. The covenants also preclude the declaration and payment ofdividends or other distributions to holders of our common stock. We are subjectto multiple economic, financial, competitive, legal and other risks that arebeyond our control and could harm our future financial results. Any adverseeffect on our business or financial results could affect our ability tomaintain compliance with our debt covenants, and any failure by us to complywith these covenants could result in an event of default. If we were to defaultunder our covenants and such default were not cured or waived, our indebtednesscould become immediately due and payable, which could render us insolvent.

*We face the risk of adverse publicity andlitigation in connection with our operations.*

We are from time to time the subject of complaints orlitigation from our consumers alleging illness, injury or other food quality,health or operational concerns. Adverse publicity resulting from theseallegations may materially adversely affect us, regardless of whether theallegations are valid or whether we are liable. In addition, employee claimsagainst us based on, among other things, discrimination, harassment or wrongfultermination may divert financial and management resources that would otherwisebe used to benefit our future performance. We have been subject to claims fromtime to time, and although these claims have not historically had a materialimpact on our operations, a significant increase in the number of these claimsor the number that are successful could materially adversely affect ourbusiness, prospects, financial condition, operating results or cash flows.

*A regional or global health pandemic could severelyaffect our business.*

A health pandemic is a disease that spreads rapidlyand widely by infection and affects many individuals in an area or populationat the same time. In 2004, 2005 and 2006, Asian and European countriesexperienced outbreaks of avian flu and it is possible that it will continue tomigrate to the United States where our restaurants are located. If a regionalor global health pandemic were to occur, depending upon its duration andseverity, our business could be severely affected. We have positioned ourselvesas a “neighborhood atmosphere” between home and work where people can gathertogether for human connection and high quality food. Customers might avoidpublic gathering places in the event of a health pandemic, and local, regionalor national governments might limit or ban public gathering places to halt ordelay the spread of disease. A regional or global pandemic might also adverselyimpact our business by disrupting or delaying production and delivery ofproducts and materials in our supply chain and causing staff shortages in ourrestaurants. The impact of a health pandemic might be disproportionatelygreater on us than on other companies that depend less on the gathering ofpeople in a neighborhood atmosphere.

*Our franchisees and licensees may not help usdevelop our business as we expect, or could actually harm our business.*

We rely in part on our franchisees and licensees andthe manner in which they operate their locations to develop and promote ourbusiness. Although we have developed criteria to evaluate and screenprospective candidates, the candidates may not have the business acumen orfinancial resources necessary to operate successful locations in theirrespective areas. In addition, franchisees and licensees are subject tobusiness risks similar to what we face such as competition, consumeracceptance, fluctuations in the cost, availability and quality of rawingredients, and increasing labor costs. The failure of franchisees andlicensees to operate successfully could have a material adverse effect on us,our reputation, our ability to collect royalties, our brands and our ability toattract prospective candidates. As we move into offering franchises for ourEinstein Bros. Bagel brand, our reliance on our franchisees is expected toincrease in proportion to growth of the franchisee base. We are still in theplanning stages with respect to franchising our Einstein Bros. brand, and havenot yet made any formal offers of franchise area development agreements forthis brand.  We may not be able toidentify franchisees that meet our criteria, or to enter into franchise areadevelopment agreements with prospective franchisee candidates that weidentify.  As a result, our franchiseprogram for the Einstein Bros. brand may not grow at the rate we currentlyexpect, or at all.

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*Government regulation could increase our costs orresult in fines or other penalties against us.*

Each of our locations is subject to licensing andregulation by the health, sanitation, safety, labor, building and fire agenciesof the respective states and municipalities in which it is located. A failureto comply with one or more regulations could result in the imposition ofsanctions, including the closing of facilities for an indeterminate period oftime, or third-party litigation, any of which could have a materialadverse effect on us and our results of operations.

In addition, our franchising operations are subject toregulation by the Federal Trade Commission. Our franchisees and we must alsocomply with state franchising laws and a wide range of other state and localrules and regulations applicable to our business. The failure to comply withfederal, state and local rules and regulations would have an adverse effect onour franchisees and us.

Under various federal, state and local laws, an owneror operator of real estate may be liable for the costs of removal orremediation of certain hazardous or toxic substances on or in such property.Such liability may be imposed without regard to whether the owner or operatorknew of, or was responsible for, the presence of such hazardous or toxicsubstances. Although we are not aware of any environmental conditions thatrequire remediation by us under federal, state or local law at our properties,we have not conducted a comprehensive environmental review of our properties oroperations. We may not have identified all of the potential environmentalliabilities at our properties, and any such liabilities that are identified inthe future may have a material adverse effect on our financial condition.

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

We believe that our trademarks, service marks andother proprietary rights are important to our success and our competitiveposition. Accordingly, we devote substantial resources to the establishment andprotection of our trademarks, service marks and proprietary rights. However,the actions we take may be inadequate to prevent imitation of our products andconcepts by others or to prevent others from claiming violations of theirtrademarks and proprietary rights by us. In addition, others may assert rightsin our trademarks, service marks and other proprietary rights.

***Risk Factors Relating toOur Common Stock***

*We have a majority stockholder.*

Greenlight Capital, L.L.C. and its affiliatesbeneficially own approximately 94 percent of our common stock. As a result,Greenlight has sufficient voting power, without the vote of any otherstockholders, to determine what matters will be submitted for approval by ourstockholders, to approve actions by written consent without the approval of anyother stockholders, to elect all of our board of directors, and to determinewhether a change in control of our company occurs. Greenlight’s interests onmatters submitted to stockholders may be different from those of other stockholders.Greenlight is not involved in our day-to-day operations, but Greenlight hasvoted its shares to elect our current board of directors. The chairman of ourboard of directors is a current employee of Greenlight.

Our common stock is not currently listed on any stockexchange or Nasdaq. As a result, we are not subject to corporate governancerules adopted by the New York Stock Exchange, American Stock Exchange andNasdaq requiring a majority of directors to be independent and requiringcompensation and nominating committees that are composed solely of independentdirectors. However, we are subject to rules requiring that the audit committeeconsist entirely of independent directors. Under the rules of these stockexchanges and Nasdaq, if a single stockholder holds more that 50% of the votingpower of a listed company, that company is considered a controlled company, andexcept for the rules relating to independence of the audit committee, is exemptfrom the above-mentioned independence rules. Since Greenlight beneficially ownsapproximately 94 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, andmay never have, the protections that these rules are intended to provide.

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*Future sales of shares of our common stock by ourstockholders could cause our stock price to fall.*

If a substantial number of shares of our common stockare sold in the public market, the market price of our common stock couldfall.  The perception among investorsthat these sales will occur could also produce this effect.  Our majority stockholder Greenlightbeneficially owns approximately 94 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. Salesof shares or a perception that there will be sales of the underlying sharescould also cause a decrease in the market price of our common stock.

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

Our common stock is currently trading on the ‘‘pink sheets’’ under thesymbol ‘‘NWRG.PK.’’ Since our common stock is not listed on Nasdaq, Amex or theNew York Stock Exchange, holders of our common stock may find that theliquidity of our common stock is limited—not only in the number of securitiesthat can be bought and sold, but also through delays in the timing oftransactions, lack of security analysts’ and the news media’s coverage of us,and lower prices for our securities than might otherwise be attained.

Securities that are notlisted on a stock exchange, the Nasdaq National Market or the Nasdaq SmallCapMarket are subject to an SEC rule that imposes special requirements onbroker-dealers who sell those securities to persons other than theirestablished 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.

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**Item 2.  Unregistered Sales of EquitySecurities and Use of Proceeds**

During the secondquarter ended July 4, 2006, we received total consideration of $55,000 andissued 53,217 shares of our common stock in connection with the exercises ofcertain warrants previously granted by us subject to a number of investors,including Greenlight. Additionally we issued 429,645 shares of our common stockto Greenlight upon Greenlight’s cashless exercises of certain warrants.Greenlight surrendered 56,953 shares of common stock to us in connection withsuch cashless exercises. We had issued all of these warrants to warrant holdersin private financing transactions that occurred between 2000 and 2003.

Common stockissued in each warrant exercise was offered and sold by us in reliance upon theexemption from registration under Section 4(2) of the Securities Act, relatingto sales by an issuer not involving a public offering. The sales of securities weremade without the use of an underwriter. All recipients either received adequateinformation about us or had access, through relationships with us, toinformation about us. We have registered these shares of common stock forresale pursuant to our obligation to do so under registration rights agreementsentered into with the warrant holders.

**Item 4.Submission of Matters to a Vote of Security Holders**

(a)                                  TheAnnual Meeting of Shareholders of the Company was held on May 9, 2006. TheCompany’s Proxy Statement dated April 6, 2006, as filed with the Securities andExchange Commission on April 10, 2006, is incorporated herein by reference.

(b)                                 Eachof the nominees, as described in the Proxy Statement referenced above, wasre-elected as a director to hold office until the next Annual Meeting ofShareholders or until his successor is elected and qualified.

| Nominee Name           | ** ** | **Votes For** | ** ** | **Votes Against  or Withheld** | ** ** |
|-----------------------------|------------|--------------------|------------|------------------------------------------|------------|
| Michael W.  Arthur          |       | 9,837,460          |       | 2,011                                    |       |
| E. Nelson  Heumann          |       | 9,837,459          |       | 2,012                                    |       |
| James W. Hood               |       | 9,837,460          |       | 2,011                                    |       |
| Frank C. Meyer              |       | 9,837,460          |       | 2,011                                    |       |
| Paul J.B. Murphy  III       |       | 9,837,459          |       | 2,012                                    |       |
| S. Garrett  Stonehouse, Jr. |       | 9,837,460          |       | 2,011                                    |       |
| Leonard Tannenbaum          |       | 9,836,487          |       | 2,984                                    |       |

 

(c)                                  Thefollowing matters were also voted upon at the meeting and approved by theShareholders:

1.               Proposalto approve an increase in the number of common shares the Company is authorizedto issue from 15,000,000 to 25,000,000

| Votes For | ** ** | **Votes Against** | ** ** | **Abstentions** | ** ** |
|----------------|------------|------------------------|------------|-----------------|------------|
| 9,810,727      |       | 28,582                 |       | 162             |       |

 

2.               Proposalto ratify the appointment of Grant Thornton LLP as independent auditors for thefiscal year ending January 2, 2007

| Votes For | ** ** | **Votes Against** | ** ** | **Abstentions** | ** ** |
|----------------|------------|------------------------|------------|-----------------|------------|
| 9,838,822      |       | 570                    |       | 79              |       |

 

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**Item 5.  Other Information**

(a)                                  Duringthe second quarter ended July 4, 2006, we received total consideration of$55,000 and issued 53,217 shares of our common stock in connection with theexercises of certain warrants previously granted by us subject to a number ofinvestors, including Greenlight. Additionally we issued 429,645 shares of ourcommon stock to Greenlight upon Greenlight’s cashless exercises of certainwarrants. Greenlight surrendered 56,953 shares of common stock to us inconnection with such cashless exercises. We had issued all of these warrants towarrant holders in private financing transactions that occurred between 2000and 2003.

Common stock issued in each warrant exercise wasoffered and sold by us in reliance upon the exemption from registration underSection 4(2) of the Securities Act, relating to sales by an issuer notinvolving a public offering. The sales of securities were made without the useof an underwriter. All recipients either received adequate information about usor had access, through relationships with us, to information about us. We haveregistered these shares of common stock for resale pursuant to our obligationto do so under registration rights agreements entered into with the warrantholders.

**Item6.  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 adopted pursuantto Section 906 of the Sarbanes-Oxley Act of 2002

**Signatures**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
|   |            | NEW WORLD RESTAURANT GROUP, INC.                         |
|--------|-----------------|----------------------------------------------------------|
|   |            |                                                     |
|   |            |                                                     |
| Date:  | August 10, 2006 | By:                                                      | /s/ PAUL J. B. MURPHY, III |
|   |            | Paul J.B. Murphy, III                                    |
|   |            | Chief Executive Officer                                  |
|   |            |                                                     |
| Date:  | August 10, 2006 | By:                                                      | /s/ RICHARD P. DUTKIEWICZ |
|   |            | Richard P. Dutkiewicz                                    |
|   |            | Chief Financial Officer and Principal Accounting Officer |

 

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