**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**(Mark One)**
| **ý**                                             | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT  OF 1934** |
|--------------------------------------------------------|-----------------------------------------------------------------------------------------------------|
|                                                   |
| **For the quarterly period ended  June 29, 2004** |
|                                                   |
| **OR**                                                 |
|                                                   |
| **o**                                                  | **TRANSITION  REPORT UNDER SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934**       |
|                                                   |
| **Commission File Number 0-27148**                     |

 

**New World Restaurant Group, Inc**.

(Name of Registrant as Specified in itsCharter)

 
| **Delaware**                                                    |   | **13-3690261**                        |   |
|-----------------------------------------------------------------|--------|---------------------------------------|--------|
| (State or other jurisdiction  of Incorporation or Organization) |   | (I.R.S. Employer  Identification No.) |   |
|                                                            |   |                                  |   |
| **1687 Cole Blvd., Golden, Colorado  80401**               |   |
| (Address of principal executive offices,  including zip code)   |
|                                                            |
| **(303) 568-8000**                                              |
| (Registrant’s telephone number, including  area code)      |

 
| Securities registered pursuant to  Section 12(b) of the Act: |
|-------------------------------------------------------------------|
| **None**                                                          |
|                                                              |
| Securities registered pursuant to  Section 12(g) of the Act: |
| **Common Stock, $.001 par value**                                 |

 

Indicate by check mark whether the registrant (1)has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90 days.  Yes ý  No o

 

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

 

As of August 5, 2004, 9,842,385 shares ofCommon Stock of the registrant were outstanding.

 

 

----

 

**NEW WORLD RESTAURANT GROUP, INC.**

 

June 29, 2004

 

TABLE OF CONTENTS

 
| **Part I**.  **Financial Information** |                                                                                        |
|---------------------------------------------|---------------------------------------------------------------------------------------------|
|                                        |                                                                                        |   |
| Item  1.                                    | Financial Statements:                                                                       |   |
|                                        |                                                                                        |   |
|                                        |                                                                                        | Consolidated Balance Sheets, June 29, 2004 (unaudited) and  December 30, 2003 |   |
|                                        |                                                                                        |   |   |
|                                        |                                                                                        | Consolidated Statements of Operations, for  the thirteen and twenty-six weeks ended June 29, 2004 and July 1,  2003 (unaudited) |   |
|                                        |                                                                                        |   |   |
|                                        |                                                                                        | Consolidated Statements of Cash Flows, for  the twenty-six weeks ended June 29, 2004 and July 1, 2003  (unaudited) |   |
|                                        |                                                                                        |   |   |
|                                        |                                                                                        | Consolidated Statement of Changes in  Stockholders’ Equity (Deficit), for the twenty-six weeks ended June 29,  2004 (unaudited) |   |
|                                        |                                                                                        |   |   |
|                                        |                                                                                        | Notes to the Consolidated Financial  Statements |   |
|                                        |                                                                                        |   |
| Item 2.                                     | Management’s Discussion and Analysis of Financial Condition and  Results of Operations |   |
|                                        |                                                                                        |   |
| Item 3.                                     | Quantitative and Qualitative Disclosures  about Market Risk                                 |   |
|                                        |                                                                                        |   |
| Item 4.                                     | Controls and Procedures                                                                     |   |
|                                        |                                                                                        |   |
| **Part II. Other Information**              |                                                                                        |
|                                        |                                                                                        |   |
| Item  1.                                    | Legal  Proceedings                                                                          |   |
|                                        |                                                                                        |   |
| Item 2.                                     | Changes in Securities and Use of Proceeds                                                   |   |
|                                        |                                                                                        |   |
| Item 4.                                     | Submission of Matters to a Vote of Security  Holders                                        |   |
|                                        |                                                                                        |   |
| Item 6.                                     | Exhibits and Reports on Form 8-K                                                            |   |

 

2

----

 

**NEW WORLD RESTAURANT GROUP, INC.**

**CONSOLIDATEDBALANCE SHEETS**

**AS OF JUNE 29, 2004 AND DECEMBER 30, 2003**

(inthousands, except share information)

 
|                                                                                                                                                                       |   | **June 29,  2004** |    | **December 30,  2003** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|---------|-----------------------------|--------|
|                                                                                                                                                                       |   | **(Unaudited)**         |    |                        |   |
| **ASSETS**                                                                                                                                                                 |   |                    |    |                        |   |
| Current assets:                                                                                                                                                            |   |                    |    |                        |   |
| Cash and cash equivalents                                                                                                                                                  |   | $                       | 10,323  |                        | $      | 9,575 |   |
| Restricted cash                                                                                                                                                            |   | 1,158                   |    | 1,815                       |   |
| Franchise and other receivables, net of  allowance of $2,947 and $3,310                                                                                                    |   | 5,995                   |    | 5,842                       |   |
| Inventories                                                                                                                                                                |   | 4,807                   |    | 4,831                       |   |
| Prepaid expenses and other current assets                                                                                                                                  |   | 2,328                   |    | 2,650                       |   |
| Total current assets                                                                                                                                                       |   | 24,611                  |    | 24,713                      |   |
|                                                                                                                                                                       |   |                    |    |                        |   |
| Restricted cash long-term                                                                                                                                                  |   | 3,037                   |    | 3,036                       |   |
| Property, plant and equipment, net                                                                                                                                         |   | 63,234                  |    | 67,800                      |   |
| Trademarks and other intangibles, net                                                                                                                                      |   | 81,389                  |    | 85,431                      |   |
| Goodwill                                                                                                                                                                   |   | 4,875                   |    | 4,875                       |   |
| Debt issuance costs and other assets                                                                                                                                       |   | 8,262                   |    | 9,170                       |   |
| Total assets                                                                                                                                                               |   | $                       | 185,408 |                        | $      | 195,025 |   |
|                                                                                                                                                                       |   |                    |    |                        |   |
| **LIABILITIES AND  STOCKHOLDERS’ DEFICIT**                                                                                                                            |   |                    |    |                        |   |
| Current liabilities:                                                                                                                                                       |   |                    |    |                        |   |
| Accounts payable                                                                                                                                                           |   | $                       | 7,849   |                        | $      | 8,189 |   |
| Accrued expenses                                                                                                                                                           |   | 37,250                  |    | 37,871                      |   |
| Short term debt and current portion of  long-term debt                                                                                                                     |   | 1,105                   |    | 2,105                       |   |
| Current portion of obligations under  capital leases                                                                                                                       |   | 57                      |    | 180                         |   |
| Total current liabilities                                                                                                                                                  |   | 46,261                  |    | 48,345                      |   |
|                                                                                                                                                                       |   |                    |    |                        |   |
| Senior notes and other long-term debt                                                                                                                                      |   | 161,120                 |    | 161,120                     |   |
| Obligations under capital leases                                                                                                                                           |   | 29                      |    | 29                          |   |
| Other liabilities                                                                                                                                                          |   | 10,135                  |    | 10,397                      |   |
| 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                                                                                                                                                          |   | 274,545                 |    | 276,891                     |   |
|                                                                                                                                                                       |   |                    |    |                        |   |
| Stockholders’ deficit:                                                                                                                                                |   |                    |    |                        |   |
| Common stock, $.001 par value; 15,000,000  shares authorized; 9,842,385 and 9,841,828 shares issued and outstanding                                                        |   | 10                      |    | 10                          |   |
| Additional paid-in capital                                                                                                                                                 |   | 175,620                 |    | 175,585                     |   |
| Accumulated deficit                                                                                                                                                        |   | (264,767                | )       | (257,461                    | )      |
| Total stockholders’ deficit                                                                                                                                           |   | (89,137                 | )       | (81,866                     | )      |
| Total liabilities and stockholders’ deficit                                                                                                                           |   | $                       | 185,408 |                        | $      | 195,025 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

3

----

 

**NEW WORLD RESTAURANT GROUP, INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**FOR THE THIRTEEN AND TWENTY-SIX WEEKS ENDED JUNE 29,2004 AND JULY 1, 2003**

 

**(UNAUDITED)**

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

 
|                                                                     |   | **Thirteen  weeks ended:** |   | **Twenty-six  weeks ended:** |   |
|--------------------------------------------------------------------------|--------|----------------------------|--------|------------------------------|--------|
|                                                                     |   | **June 29,  2004**    |   | **July 1,  2003**       |   | **June 29,  2004** |   | **July 1,  2003** |   |
| Revenues:                                                                |   |                       |   |                         |   |   |   |   |   |
| Retail sales                                                             |   | $                          | 87,596 |                         | $      | 90,878 |   | $ | 172,219 |   | $ | 179,328 |   |
| Manufacturing revenues                                                   |   | 4,944                      |   | 5,754                        |   | 10,357 |   | 11,178 |   |
| Franchise and license related revenues                                   |   | 1,624                      |   | 1,117                        |   | 2,784 |   | 2,454 |   |
|                                                                     |   |                       |   |                         |   |   |   |   |   |
| Total revenues                                                           |   | 94,164                     |   | 97,749                       |   | 185,360 |   | 192,960 |   |
|                                                                     |   |                       |   |                         |   |   |   |   |   |
| Cost of sales:                                                           |   |                       |   |                         |   |   |   |   |   |
| Retail costs                                                             |   | 73,403                     |   | 77,385                       |   | 143,490 |   | 150,339 |   |
| Manufacturing costs                                                      |   | 4,442                      |   | 5,082                        |   | 9,020 |   | 10,123 |   |
|                                                                     |   |                       |   |                         |   |   |   |   |   |
| Total cost of sales                                                      |   | 77,845                     |   | 82,467                       |   | 152,510 |   | 160,462 |   |
|                                                                     |   |                       |   |                         |   |   |   |   |   |
| Gross profit                                                             |   | 16,319                     |   | 15,282                       |   | 32,850 |   | 32,498 |   |
|                                                                     |   |                       |   |                         |   |   |   |   |   |
| Operating expenses:                                                      |   |                       |   |                         |   |   |   |   |   |
| General and administrative expenses                                      |   | 8,000                      |   | 10,604                       |   | 16,818 |   | 20,858 |   |
| Depreciation and amortization                                            |   | 5,344                      |   | 7,092                        |   | 10,582 |   | 14,297 |   |
| Adjustment of integration and  reorganization cost                       |   | (39                        | )      | —                       |   | (799 | ) | — |   |
|                                                                     |   |                       |   |                         |   |   |   |   |   |
| Income (loss) from operations                                            |   | 3,014                      |   | (2,414                       | )      | 6,249 |   | (2,657 | ) |
|                                                                     |   |                       |   |                         |   |   |   |   |   |
| Other expense (income):                                                  |   |                       |   |                         |   |   |   |   |   |
| Interest expense, net                                                    |   | 5,904                      |   | 9,975                        |   | 11,703 |   | 18,271 |   |
| Cumulative change in the fair value of  derivatives                      |   | —                     |   | 727                          |   | — |   | 70 |   |
| Loss (gain) on sale, disposal or  abandonment of assets, net             |   | 1,712                      |   | (202                         | )      | 1,713 |   | (385 | ) |
| Other income                                                             |   | (36                        | )      | (119                         | )      | (100 | ) | (186 | ) |
|                                                                     |   |                       |   |                         |   |   |   |   |   |
| Loss before income taxes                                                 |   | (4,566                     | )      | (12,795                      | )      | (7,067 | ) | (20,427 | ) |
|                                                                     |   |                       |   |                         |   |   |   |   |   |
| Provision for state income taxes                                         |   | (184                       | )      | (320                         | )      | (239 | ) | (430 | ) |
|                                                                     |   |                       |   |                         |   |   |   |   |   |
| Net loss                                                                 |   | (4,750                     | )      | (13,115                      | )      | (7,306 | ) | (20,857 | ) |
|                                                                     |   |                       |   |                         |   |   |   |   |   |
| Dividends and accretion on Preferred Stock                               |   | —                     |   | (9,821                       | )      | — |   | (14,424 | ) |
|                                                                     |   |                       |   |                         |   |   |   |   |   |
| Net loss available to common stockholders                                |   | $                          | (4,750 | )                            | $      | (22,936 | ) | $ | (7,306 | ) | $ | (35,281 | ) |
|                                                                     |   |                       |   |                         |   |   |   |   |   |
| Net loss per common share – Basic and  Diluted                      |   | $                          | (0.48  | )                            | $      | (14.28 | ) | $ | (0.74 | ) | $ | (22.55 | ) |
|                                                                     |   |                       |   |                         |   |   |   |   |   |
| Weighted average number of common shares  outstanding: Basic and Diluted |   | 9,842,293                  |   | 1,606,665                    |   | 9,842,061 |   | 1,564,909 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

4

----

 

**NEW WORLD RESTAURANT GROUP, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**FOR THE TWENTY-SIX WEEKS ENDED JUNE 29, 2004 ANDJULY 1, 2003**

 

**(UNAUDITED)**

(inthousands)

 
|                                                                             |   | **Twenty-six  weeks ended:** |   |
|----------------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                             |   | **June 29,  2004**      |   | **July 1,  2003** |   |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                            |   |                         |   |   |   |
| Net loss                                                                         |   | $                            | (7,306 | ) | $ | (20,857 | ) |
| Adjustments to reconcile net loss to net  cash provided by operating activities: |   |                         |   |   |   |
| Depreciation and amortization                                                    |   | 10,582                       |   | 14,297 |   |
| Stock based compensation expense                                                 |   | 35                           |   | — |   |
| Loss on disposal of assets                                                       |   | 1,713                        |   | — |   |
| Adjustments of integration and  reorganization costs                             |   | (799                         | )      | — |   |
| Cumulative change in fair value of  derivatives                                  |   | —                       |   | 70 |   |
| Amortization of debt issuance and debt  discount costs                           |   | 908                          |   | 2,212 |   |
| Notes issued as paid in kind for interest  on Bridge Loan                        |   | —                       |   | 510 |   |
| Issuance of standstill warrants                                                  |   | —                       |   | 1,238 |   |
| Greenlight interest                                                              |   | —                       |   | 1,025 |   |
| Changes in operating assets and  liabilities:                                    |   |                         |   |   |   |
| Franchise and other receivables                                                  |   | (153                         | )      | 573 |   |
| Accounts payable and accrued expenses                                            |   | (162                         | )      | 8,307 |   |
| Other assets and liabilities                                                     |   | 617                          |   | (6,156 | ) |
|                                                                             |   |                         |   |   |   |
| Net cash provided by operating activities                                        |   | 5,435                        |   | 1,219 |   |
|                                                                             |   |                         |   |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                            |   |                         |   |   |   |
| Purchase of property and equipment                                               |   | (3,687                       | )      | (3,494 | ) |
|                                                                             |   |                         |   |   |   |
| Net cash used in investing activities                                            |   | (3,687                       | )      | (3,494 | ) |
|                                                                             |   |                         |   |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                            |   |                         |   |   |   |
| Proceeds (repayments) of line of credit,  net                                    |   | (1,000                       | )      | 937 |   |
|                                                                             |   |                         |   |   |   |
| Net cash provided by (used in) financing  activities                             |   | (1,000                       | )      | 937 |   |
|                                                                             |   |                         |   |   |   |
| Net increase (decrease) in cash                                                  |   | 748                          |   | (1,338 | ) |
| Cash and cash equivalents, beginning of  period                                  |   | 9,575                        |   | 10,705 |   |
|                                                                             |   |                         |   |   |   |
| Cash and cash equivalents, end of period                                         |   | $                            | 10,323 |   | $ | 9,367 |   |
|                                                                             |   |                         |   |   |   |
| SUPPLEMENTAL CASH FLOW INFORMATION:                                              |   |                         |   |   |   |
| Cash paid for interest                                                           |   | $                            | 10,280 |   | $ | 7,669 |   |
|                                                                             |   |                         |   |   |   |
| Cash paid for income taxes                                                       |   | $                            | 165    |   | $ | 320 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

5

----

 

**NEW WORLD RESTAURANT GROUP, INC.**

**CONSOLIDATEDSTATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT)**

**FOR THE TWENTY-SIX WEEKS ENDED JUNE 29, 2004**

 

**(UNAUDITED)**

(inthousands, except share information)

 
|                                      |   |              |   |       |   | **Additional  Paid In  Capital** |   | **Accumulated  Deficit  Amount** |   | **Total** |     |
|-------------------------------------------|--------|-------------------|--------|------------|--------|----------------------------------|--------|----------------------------------|--------|-----------|----------|
|                                      |   | **Common  Stock** |   |       |   |                             |
|                                      |   | **Shares**        |   | **Amount** |   |                             |   |                             |
| Balance, December 30, 2003           |   | 9,841,828         |   | $          | 10     |                             | $      | 175,585                          |   | $         | (257,461 | ) | $ | (81,866 | ) |
| Net loss                                  |   | —            |   | —     |   | —                           |   | (7,306                           | )      | (7,306    | )        |
| Stock based compensation expense          |   |              |   |       |   | 35                               |   |                             |   | 35        |     |
| Common stock issued upon warrant exercise |   | 557               |   | —     |   | —                           |   | —                           |   | —    |     |
|                                      |   |              |   |       |   |                             |   |                             |   |      |     |
| Balance, June 29, 2004               |   | 9,842,385         |   | $          | 10     |                             | $      | 175,620                          |   | $         | (264,767 | ) | $ | (89,137 | ) |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

6

----

 

**NEWWORLD RESTAURANT GROUP, INC.**

 

Notes to Consolidated FinancialStatements(Unaudited)

 

Thirteen and twenty-six weeksended June 29, 2004 and July 1, 2003

 

**1.****    ****Basis ofPresentation**

 

The accompanyingconsolidated financial statements of New World Restaurant Group, Inc. and itswholly-owned subsidiaries (collectively, “the Company”) have been preparedpursuant to the rules and regulations of the Securities and Exchange Commission(“SEC”). The Company owns, franchises or licenses various restaurant conceptsunder the brand names of Einstein Bros. Bagels (“Einstein Bros.”), Noah’s NewYork Bagels (“Noah’s”), Manhattan Bagel Company (“Manhattan”), Chesapeake BagelBakery (“Chesapeake”), New World Coffee (“New World”), and Willoughby’s Coffeeand Tea (“Willoughby’s”). Our business is subject to seasonaltrends. Generally, our revenues in the first fiscal quarter are somewhat lowerthan in the other three fiscal quarters.

 

Theaccompanying consolidated financial statements as of June 29, 2004 andDecember 30, 2003 and for the thirteen and twenty-six weeks endedJune 29, 2004 and July 1, 2003 have been prepared without audit (except for the balance sheetinformation as of December 30, 2003, which is derived from our audited financialstatements). The information furnished herein reflects all adjustments(consisting only of normal recurring accruals and adjustments), which are, inour opinion, necessary to fairly state the interim operating results for therespective periods.  However, these operating results are not necessarilyindicative of the results expected for the full fiscal year.  Certaininformation and footnote disclosures normally included in annual financialstatements prepared in accordance with generally accepted accounting principlesin the United States have been omitted pursuant to SEC rules and regulations.The notes to the consolidated financial statements (unaudited) should be readin conjunction with the notes to the consolidated financial statements containedin our annual report on Form 10-K for the fiscal year ended December 30,2003. We believe that the disclosures are sufficient for interim financialreporting purposes.

 

Certain reclassificationshave been made to conform previously reported data to the current presentation.These reclassifications have no effect on net income or financialposition as previously reported.

 

7

----

 

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

 

Statement of Financial Accounting Standards (SFAS) No. 142provides that goodwill and other indefinite-lived intangibles should not beamortized, but be subject to an annual assessment for impairment, or morefrequently if circumstances indicate potential impairment, through a comparisonof fair value to its carrying amount. The two-step approach to assess goodwillimpairment requires that we first compare the estimated fair value of eachreporting unit that houses goodwill to the carrying amount of the unit’s assetsand liabilities, including its goodwill and intangible assets. If the fairvalue of the reporting unit is below its carrying amount, then the second stepof the impairment test is performed, in which the current fair value of theunit’s assets and liabilities will determine the current implied fair value ofthe unit’s goodwill. The impairment tests relating to goodwill and indefinite-livedtrademarks are performed as of year-end, unless events and circumstancesindicate otherwise. During the thirteen weeks ended June 29, 2004, we beganan evaluation of whether each of our brands should be a part of our overallstrategic business plan. As a result of this evaluation, we determined thatcertain brands no longer fit strategically. Accordingly, we performed animpairment analysis and determined that no impairment of these brands existedat June 29, 2004. We also performed a longevity analysis of certain brandsand determined that certain trademarks had an estimated remaining useful lifeof 4 years. These trademarks were previously treated as a non-amortizingintangible and accordingly were reclassified as an amortizing intangible atJune 29, 2004. Additionally, we recorded $129,000 in amortization expensespecifically related to these trademarks for the thirteen weeks ended June 29,2004.

 

Goodwill represents theexcess of cost over fair value of net assets acquired in the acquisition ofManhattan Bagel Company, Inc.

 

Trademarks and otherintangibles consists of the following (in thousands of dollars):

 
|                                        |   | **June 29,  2004** |   | **December 30,  2003** |   |
|---------------------------------------------|--------|-------------------------|--------|-----------------------------|--------|
| Amortizing intangibles:                     |   |                    |   |                        |   |
| Trade secrets                               |   | $                       | 5,385  |                        | $      | 5,385 |   |
| Trademarks                                  |   | 2,062                   |   | —                      |   |
| Patents-manufacturing process               |   | 33,741                  |   | 33,741                      |   |
|                                        |   | 41,188                  |   | 39,126                      |   |
| Less accumulated amortization               |   | (23,605                 | )      | (19,563                     | )      |
| Total amortizing intangibles, net           |   | $                       | 17,583 |                        | $      | 19,563 |   |
|                                        |   |                    |   |                        |   |
| Non-amortizing intangibles:                 |   |                    |   |                        |   |
| Trademarks                                  |   | 63,806                  |   | 65,868                      |   |
|                                        |   |                    |   |                        |   |
| Total trademarks and other intangibles, net |   | $                       | 81,389 |                        | $      | 85,431 |   |

 

8

----

 

**3.****    ****Debt**

 

Debt consists of the following(in thousands of dollars):

 
|                                                        |   | **June 29,  2004** |    | **December 30,  2003** |   |
|-------------------------------------------------------------|--------|-------------------------|---------|-----------------------------|--------|
|                                                        |   |                    |    |                        |   |
| $160  Million Indenture (a)                                 |   | $                       | 160,000 |                        | $      | 160,000 |   |
| AmSouth  Revolver (b)                                       |   | 3⁄4                  |    | 1,000                       |   |
| Chesapeake  Bagel Bakery Note Payable (c)                   |   | 825                     |    | 825                         |   |
| New  Jersey Economic Development Authority Note Payable (d) |   | 1,400                   |    | 1,400                       |   |
|                                                        |   | 162,225                 |    | 163,225                     |   |
| Less  current portion of debt                               |   | (1,105                  | )       | (2,105                      | )      |
|                                                        |   |                    |    |                        |   |
| Long-term  debt                                             |   | $                       | 161,120 |                        | $      | 161,120 |   |

 

----

**(a)****  ****$160 MillionIndenture**

 

On July 8, 2003, weissued $160 million of 13% senior secured notes maturing on July 1, 2008(“$160 Million Indenture”) in a private placement.

 

The $160 Million Indentureis guaranteed, fully and unconditionally, jointly and severally, by us and allpresent and future subsidiaries of ours and is collateralized by substantiallyall of our assets in which we have an interest. Pursuant to an IntercreditorAgreement, the $160 Million Indenture is subordinate to the AmSouth Revolver asdescribed below.

 

The $160 Million Indenture contains certain covenants, which, among others,include certain financial covenants such as limitations on capital expendituresand minimum EBITDA as defined in the agreement. These covenants are measured ona rolling twelve-month period and fiscal quarter basis, respectively. This debtcontains usual and customary default provisions. As of June 29, 2004, wewere in compliance with all our financial and operating covenants.

 

Interest payments under the $160 Million Indenture are payable inarrears at the rate of 13% per year on July 1 and January 1,commencing January 1, 2004. The notes are redeemable, at our option, inwhole or in part at any time after July 1, 2004 at the followingredemption prices (as expressed in percentages of the principal amount):

 

| **Year**            |   | **Percentage** |   |
|---------------------|--------|----------------|--------|
| 2004                |   | 104.0          | %      |
| 2005                |   | 103.0          | %      |
| 2006                |   | 102.0          | %      |
| 2007                |   | 101.0          | %      |
| 2008 and thereafter |   | 100.0          | %      |

 

Debt issuance costs are capitalized and amortized using the effectiveinterest method over the term of the $160 Million Indenture.

 

9

----

 

**(b)****  ****AmSouth Revolver**

 

Also on July 8, 2003,we entered into a three-year, $15 million senior secured revolving creditfacility with AmSouth Bank (“AmSouth Revolver”). The AmSouth Revolver has beensubsequently amended to make technical corrections, clarify ambiguous terms andprovide for increased limits with respect to letters of credit.

 

The AmSouth Revolver iscollateralized by substantially all of our assets in which we have an interestand is senior to the $160 Million Indenture pursuant to an Intercreditor Agreement.

 

The AmSouth Revolver contains certain covenants, which, among others,include certain financial covenants such as limitations on capitalexpenditures, operating lease obligations, minimum EBITDA as defined in theagreement, operating cash flow coverage ratio and minimum net worth. Thesecovenants are measured on a rolling twelve-month period at each fiscal quarteror annually at year-end. Additional covenant restrictions exist if the totalborrowings, including outstanding letters of credit exceed $10.0 million.This debt also contains usual and customary default provisions. As ofJune 29, 2004, we are in compliance with all of our financial andoperating covenants.

 

Interest payments under the AmSouth Revolver are payable in arrears onthe first of each month. The net borrowings under the AmSouth Revolver bear aninterest rate equal to the base rate plus an applicable margin with the baserate being the AmSouth Bank “prime rate” and the applicable margin being basedon our fixed charge coverage ratio with a minimum and maximum applicable marginof 0.5% and 2.5% respectively. As of June 29, 2004, the prime interestrate under the AmSouth Revolver was 4.0%.

 

We are required to pay an unused credit line fee of 0.50% per annum onthe average daily unused amount. The unused line fee is payable monthly inarrears. Additionally, we are required to pay a letter of credit fee based onthe average daily undrawn face amount for each letter of credit issued, of anapplicable margin being based on our fixed charge coverage ratio with a minimumand maximum applicable margin of 2.0% and 4.5% respectively. Letters of creditreduce our availability under the AmSouth Revolver. At June 29, 2004, wehad $5.0 million letters of credit outstanding. The letters of credit expire onvarious dates during 2005, are automatically renewable for one additional yearand are payable upon demand in the event that we fail to pay certain workerscompensation claims. Our availability under the AmSouth Revolver was $10.0million at June 29, 2004.

 

Debt issuance costs are capitalized and amortized using the effectiveinterest method over the term of the AmSouth Revolver.

 

**(c)****   Chesapeake Bagel Bakery NotePayable**

 

As a part of the acquisition of the assets of Chesapeake Bagel Bakery,we entered into a note payable to the seller. The note provides for quarterlypayments of interest only at 10%. The note is due in full on August 31,2004 and is secured by the assets of Chesapeake Bagel Bakery.

 

**(d)****   New Jersey****EconomicDevelopment Authority Note Payable**

 

In December 1998, Manhattan Bagel Company, Inc. entered into anote payable in the principal amount of $2,800,000 with the New Jersey EconomicDevelopment Authority (“NJEDA”) at an interest rate of 9% per annum. Principalis paid annually and interest is paid quarterly. The note matures onDecember 1, 2008 and is secured by the assets of Manhattan Bagel Company,Inc.

 

10

----

 

On July 3, 2003, we placed an advanced funding of the note inescrow to enact a debt defeasance as allowed for in the agreement. Thisadvanced funding is shown as restricted cash and the note is included in bothcurrent portion and long-term portion of debt in the June 29, 2004 and December 30, 2003consolidated balance sheets in accordance with the payment terms. Thisclassification will continue until the note is fully paid from the escrowamount proceeds. The escrow has a maturity date of December 1, 2008.

 

**4.****    ****Net Loss PerCommon Share**

 

Wecompute basic net loss per common share by dividing the net loss for the periodby the weighted average number of shares of common stock outstanding (which includes shares contingently issuable for little orno consideration) during the period. There were 1,434,993 and 1,393,236 sharescontingently issuable included in the weighted average number of shares ofcommon stock outstanding during the thirteen and twenty six weeks endedJuly 1, 2003, respectively.

 

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

 

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

 

 
|                                                                                                                             |   | **Thirteen weeks ended:** |   | **Twenty-six weeks ended:** |   |
|----------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------|--------|-----------------------------|--------|
|                                                                                                                             |   | **June 29,  2004**   |   | **July 1,  2003**      |   | **June 29,  2004** |   | **July 1,  2003** |   |
|                                                                                                                             |   |                      |   |                        |   |   |   |   |   |
| Weighted  average shares outstanding                                                                                             |   | 9,842,293                 |   | 1,606,665                   |   | 9,842,061 |   | 1,564,909 |   |
|                                                                                                                             |   |                      |   |                        |   |   |   |   |   |
| Net  loss available to common stockholders (in thousands of dollars)                                                             |   | $                         | (4,750 | )                           | $      | (22,936 | ) | $ | (7,306 | ) | $ | (35,281 | ) |
|                                                                                                                             |   |                      |   |                        |   |   |   |   |   |
| Basic  and diluted net loss per share                                                                                            |   | $                         | (0.48  | )                           | $      | (14.28 | ) | $ | (0.74 | ) | $ | (22.55 | ) |
|                                                                                                                             |   |                      |   |                        |   |   |   |   |   |
| Outstanding  options and warrants that were not included in the diluted calculation  because their effect would be anti-dilutive |   | 1,856,125                 |   | 102,214                     |   | 1,856,125 |   | 102,214 |   |

 

11

----

 

**5.****    ****Stock BasedCompensation**

 

Weapply the intrinsic value-based method of accounting prescribed by AccountingPrinciples Board (APB) Opinion No. 25, *Accounting for Stock Issued to Employees*, and relatedinterpretations, in accounting for our fixed award stock options to ouremployees. As such, compensation expense is recorded only if the current marketprice of the underlying common stock exceeded the exercise price of the optionon the date of grant. We apply the fair value-based of accounting as prescribedby Statements of Financial Accounting Standards (SFAS) Nos. 123 and 148, *Accounting for Stock-Based Compensation*inaccounting for our fixed award stock options to our consultants. Under SFASNos. 123 and 148, compensation expense is recognized based on the fair value ofstock options granted.  Had compensationcost for stock options granted to employees been determined on the basis offair value as computed using the assumptions herein, net loss and loss pershare would have been increased to the following pro forma amounts (inthousands of dollars, except per share amounts):

 
|                                                                     |   | **Thirteen weeks ended:** |   | **Twenty-six weeks ended:** |   |
|--------------------------------------------------------------------------|--------|---------------------------|--------|-----------------------------|--------|
|                                                                     |   | **June 29,  2004**   |   | **July 1,  2003**      |   | **June 29,  2004** |   | **July 1,  2003** |   |
|                                                                     |   |                      |   |                        |   |   |   |   |   |
| Net  loss available to common stockholders, as reported                  |   | $                         | (4,750 | )                           | $      | (22,936 | ) | $ | (7,306 | ) | $ | (35,281 | ) |
| Deduct:  stock based compensation determined under the fair value method |   | (222                      | )      | (45                         | )      | (444 | ) | (90 | ) |
| Pro  forma net loss available to common stockholders                     |   | $                         | (4,972 | )                           | $      | (22,981 | ) | $ | (7,750 | ) | $ | (35,371 | ) |
|                                                                     |   |                      |   |                        |   |   |   |   |   |
| Basic  and diluted loss per common share:                                |   |                      |   |                        |   |   |   |   |   |
|                                                                     |   |                      |   |                        |   |   |   |   |   |
| As  reported                                                             |   | $                         | (0.48  | )                           | $      | (14.28 | ) | $ | (0.74 | ) | $ | (22.55 | ) |
|                                                                     |   |                      |   |                        |   |   |   |   |   |
| Pro  forma                                                               |   | $                         | (0.51  | )                           | $      | (14.30 | ) | $ | (0.79 | ) | $ | (22.60 | ) |

 

Compensationcost of options granted for the SFAS No. 123 pro forma amounts disclosedabove was estimated using the Black-Scholes option-pricing model with thefollowing assumptions:

 
|                                         |   | **Thirteen weeks ended:** |   | **Twenty-six weeks ended:** |   |
|----------------------------------------------|--------|---------------------------|--------|-----------------------------|--------|
|                                         |   | **June 29,  2004**   |   | **July 1,  2003**      |   | **June 29,  2004** |   | **July 1,  2003** |   |
| Expected  life of options from date of grant |   | 4.0 years                 |   | 4.0 years                   |   | 4.0 years |   | 4.0 years |   |
| Risk-free  interest rate                     |   | 3.1                       | %      | 3.0                         | %      | 3.1 | % | 3.0 | % |
| Volatility                                   |   | 100.0                     | %      | 100.0                       | %      | 100.0 | % | 100.0 | % |
| Assumed  dividend yield                      |   | 0.0                       | %      | 0.0                         | %      | 0.0 | % | 0.0 | % |

 

12

----

 

**6.****    ****Litigation,Commitments and Contingencies**

 

*Guarantees*

 

Inthe past, we would sometimes guarantee leases for the benefit of certain of ourfranchisees. The lease guarantees extend through 2008. Under the guarantees, wemay be required by the lessor to make all of the remaining monthly rentalpayments or property tax and common area maintenance payments if the franchiseedoes not make the required payments in a timely manner. However, we believethat most, if not all, of the franchised locations could be subleased to thirdparties minimizing our potential exposure. Additionally, we haveindemnification agreements with our franchisees under which the franchiseeswould be obligated to reimburse us for any amounts paid under such guarantees.As of June 29, 2004, our maximum exposure under these contingentliabilities was approximately $2.0 million.

 

*Employment Related*

 

On July 31, 2002, Tristan Goldstein, a former store manager, and ValerieBankhordar, a current store manager, filed a putative class action againstEinstein and Noah Corp. (“ENC”) in the Superior Court for the State ofCalifornia, County of San Francisco. The plaintiffs allege that ENC failed topay overtime wages to managers and assistant managers of its California storeswho were improperly designated as exempt employees in violation of Californiawage and hour laws and Business Profession Code Section 17200. DuringApril 2004, we reached an agreement in principle for the settlement oflitigation with the plaintiffs, subject to court approval. Amounts representingour estimate to settle this litigation were previously recorded during thequarter ended December 30, 2003.

 

On March 31, 2003, Jerold E. Novack, our former Chief FinancialOfficer and Secretary, filed a complaint in the United States District Courtfor the District of New Jersey against us, Anthony D. Wedo, our former Chairmanand Chief Executive Officer, and William J. Nimmo, a former member of our boardof directors.  The complaint purports tostate claims for breach of plaintiff’s employment contract, breach of Messrs.Wedo and Nimmo’s fiduciary duties to plaintiff, defamation, andviolation of the New Jersey Conscientious Employee Protection Act, and inaddition seeks a declaration that the termination of plaintiff “for cause” wasinvalid.  We have answered and filedcounterclaims against Mr. Novack and on January 20, 2004, the Courtgranted the Company’s motion to dismiss the breach of fiduciary duty claims. OnJuly 9, 2004, both the plaintiffs and defendants filed motions for summaryjudgment. Arguments on motions are scheduled for September 7, 2004. Atthis time, it is not possible to reasonably estimate the possible loss or rangeof loss, if any.

 

On June 4, 2003, R. Ramin Kamfar, our former Chairman of the Boardand Chief Executive Officer, filed an action in the United States DistrictCourt for the Southern District of New York against us and Anthony D. Wedo, ourformer Chairman and Chief Executive Officer, alleging causes of action forbreach of contract, defamation, declaratory relief and punitive damages. Webelieve that the claims of Mr. Kamfar are without merit. We have answered andfiled counterclaims against Mr. Kamfar, including claims for breach of fiduciaryduty, fraud, and breach of contract. Motions for summary judgment were filed on July 15, 2004. At thistime, it is not possible to reasonably estimate the possible loss or range ofloss, if any.

 

13

----

 

*Investigations*

 

On April 3, 2002, the Securities and Exchange Commission notifiedus that the Commission was conducting an investigation into the resignation ofour former Chairman, R. Ramin Kamfar, and the termination for cause of ourformer Chief Financial Officer, Jerold Novack, and the delay in filing ourForm 10-K for 2001. We have cooperated fully with the investigation aswell as with a Department of Justice inquiry relating to these issues. Further,several of the former and present officers and directors have requested that weadvance reasonable legal expenses on their respective behalves to the extentany of them is or has been requested to provide information to the Commissionin connection with its investigation. We are fulfilling our obligations asrequired by applicable law and our By-Laws. At this time, it is not possible toreasonably estimate the possible loss or range of loss, if any.

 

On August 7, 2003, supplemented on November 25, 2003 andJanuary 9, 2004, we received a subpoena for documents from the Office ofthe Attorney General of the State of New York requesting information primarilyrelated to whether our subsidiary, Manhattan Bagel Company, Inc., qualified fora net worth exemption from franchise registration in light of the restatement of the Company’sfinancial results for 2000 and 2001, the facts and circumstances leading to theresignation of the Company’s former Chief Executive Officer and the terminationof our former Chief Financial Officer and others, and issues relating to costof bagel dough. We have responded to these requests and have notreceived any further inquiries in this regard for the past six months. DuringJuly 2004, the Attorney General’s Office informed us that our UniformFranchise Offering Circular (UFOC) application for registration (the franchiseregistration) of Manhattan and Chesapeake has been processed and approved forregistration.

 

*Financial Impact of Litigation*

 

We are engaged in various other legal proceedings and have certainunresolved claims pending. The ultimate liability, if any, for the aggregateamounts claimed cannot be determined at this time. However, we believe basedupon consultation with legal counsel that there are no other matters pending orthreatened which are expected to have a material adverse effect, individuallyor in the aggregate, on our consolidated financial condition or results ofoperations.

 

*Insurance**Programs*

 

We are self-insured for a substantial portion of our current and prioryears’ coverage including workers’ compensation, employment practices liabilityand general liability (collectively, “insurance losses”). To mitigate thepotential cost of our exposures for certain of the insurance losses, we makeannual decisions to self-fund the risks of loss up to defined maximum peroccurrence retentions on a policy-by-policy basis. We then purchase insurancecoverage, up to a certain limit, for losses that exceed the self-insurance peroccurrence or aggregate retention. The insurers’ maximum aggregate loss limitsare significantly above our actuarially determined probable losses; therefore,we believe the likelihood of losses exceeding the insurers’ maximum aggregatedloss limits is remote. We are also self-insured for healthcare claims foreligible participating employees subject to certain deductibles andlimitations. We have accounted for our liabilities related to the insurancelosses and healthcare claims, including reported and incurred but not reportedclaims, based on information provided by actuaries.

 

We believe that we have recorded reserves adequate to cover ourinsurance losses based upon information we have today. Due to the inherentvolatility of actuarially determined insurance loss estimates, it is reasonablypossible that we could experience changes in estimated losses, which could bematerial to our consolidated financial position or results of operations.

 

14

----

 

**7.****    ****Adjustment ofIntegration and Reorganization Cost**

 

The adjustment of integration and reorganization cost primarilyrepresents an adjustment to previously recorded liabilities associated with theclosing and corporate consolidation of our Eatontown facilities during 2002.During April 2004, we reached an agreement with the landlord of ourEatontown facility to settle outstanding litigation. Previously recordedintegration and reorganization estimates associated with closing this facilitywere adjusted down by $700,000 during the thirteen weeks ended March 30,2004 as a result of this settlement.

 

**8.****    ****Loss on Disposalor Abandonment of Assets**

 

During the thirteen and twenty-six weeks ended June 29, 2004, werecorded a loss of $1.7 million, primarily due the disposal of menu boards as aresult of our new menu offerings and due to the abandonment of leaseholdimprovements related to closed restaurants and our administrative facilitieslocated in New Jersey.

 

**9.****    ****Potential Sale ofAssets of Willoughby’s Coffee & Tea**

 

On June 22, 2004, weentered into a letter of intent to sale the assets of Willoughby’s to anindependent third party.  TheWilloughby’s business consists of a coffee roasting plant, two retail locationsand an office space. Assets of the sale include, but are not limited to:

 

•      The “Willoughby’s Coffee & Tea” trade name, trademark andlogo,

•      The “Serious Coffee” trademark,

•      The willoughbyscoffee.com domain name and existing website,

•      All property and equipment of Willoughby’s, and

•      Cash in drawer, accounts receivable, and inventory at allWilloughby’s locations.

 

Under the terms ofagreement, we will sell the assets for a total sales price of $426,000 to bereceived in cash, subject to post-closing adjustments for changes from May 25,2004 to closing in inventory, accounts receivable and cash in drawer.Additionally, we may be entitled to post-closing payments of up to $100,000contingent upon the landlord’s option to terminate the lease at one of ourretail locations. In connection with the sale of Willoughby’s, we intend toexecute a two-year supply agreement to purchase coffee from the buyer for our NewWorld stores. The sale is expected to close by the end of August 2004.

 

We have consideredStatement of Financial Accounting Standard No. 144, *Accounting for the Impairment or Disposal of Long-Lived Assets.*Wehave determined that the revenues, cost of sales, other operating expenses andthe net book value of the assets related to the sale of the coffee roastingplant and two retail locations included in the Willoughby’s business areimmaterial in relation to our Einstein Bros., Noah and Manhattan restaurants,as well as the financial statements taken as a whole. Accordingly, we have notpresented discontinued operations in the accompanying consolidated statementsof operations for the thirteen and twenty-six weeks ended June 29, 2004and July 1, 2003, respectively, nor have we reflected assets as held forsale in the accompanying consolidated balance sheets as of June 29,2004.  We have determined that net bookvalue of the assets is less than the sales price and accordingly, no impairmentexists at June 29, 2004.

 

**10.**** ****Recent AccountingPronouncements**

 

We have evaluated all recent accounting pronouncements and believe suchpronouncements do not have a material effect on our financial statements.

 

15

----

 

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

 

The following discussionand analysis supplements the management’s discussion and analysis in our AnnualReport on Form 10-K for the year ended December 30, 2003 and presumes thatreaders have read or have access to the discussion and analysis in our AnnualReport. The following discussion and analysis includes historical and certainforward-looking information that should be read together with the accompanyingConsolidated Financial Statements, related footnotes and the discussion belowof certain risks and uncertainties that could cause future operating results todiffer materially from historical results or from the expected resultsindicated by forward looking statements.

 

**Business Overview**

 

We are a leader in the quick casual segment of the restaurant industry.With 720 locations in 33 states and in the District of Columbia as ofJune 29, 2004, we operate and license locations primarily under theEinstein Bros. and Noah’s brand names, and franchise locations primarily underthe Manhattan and Chesapeake brand names. We also operate a dough productionfacility. We operate as a single business segment with a focus on ourcompany-operated restaurants. Our manufacturing and franchise operations areeither supportive or ancillary to our main business focus.

 

Our financial focus is on long term, sustainable growth in free cashflow. Free cash flow represents net cash provided by operations less purchasesof fixed assets. In achieving free cash flow, we are more capable of payingdown debt, saving cash for future use and building shareholder equity. We alsobelieve free cash flow will allow us the opportunity to pursue newopportunities, acquire other businesses, or pay dividends. Increasing ouroperating profit and efficiently managing working capital and capitalexpenditures primarily drive free cash flow.

 

The restaurant industry, in which we compete, is intensely competitivewith respect to food quality, price, service, convenience, location andconcept. The industry is often affected by changes in consumer tastes, economicconditions, demographic trends, traffic patterns, the type, number and locationof competing food retailers and products and disposable purchasing power.

 

In measuring our overall growth and progress, we focus on various keyperformance indicators. Such key performance indicators include: same-storesales growth, number of restaurant openings and closings, number of franchiseand licensed locations opened, restaurant level and concept level margins, cashgenerated from operations and free cash flow. Our progress against some ofthese key performance indicators is discussed throughout the Management’sDiscussion and Analysis.

 

**Significant Known Events, Trends orUncertainties Expected to Impact 2004 Results**

 

The following factors impact comparability of operating performance orcould impact comparisons for the remainder of 2004.

 

*Economic Trends*

 

We anticipate that our business will be affected by general economictrends that affect retailers in general. While we have not operated during aperiod of high inflation, we believe based on industry experience that we wouldgenerally be able to pass on increased costs resulting from inflation to ourconsumers. Our business may be affected by other factors, including increasesin the commodity prices of flour, butter and/or green coffee, existing andadditional competition, marketing programs, weather and variations in thenumber of company-owned or licensed location openings.

 

16

----

 

Although few, if any, employees are paid at the minimum wage, anincrease in the minimum wage may create pressure to increase the pay scale forour employees, which would increase our labor costs and those of ourfranchisees and licensees.

 

*Revenue Trends*

 

**Due to the increasing competitive pressure of the restaurant industry,we currently are experiencing and believe we will continue to experience lowerretail sales until such time as we can make the planned modifications to ourcustomer service system, menu offerings and the “look and feel” of ourcompany-operated restaurants. We believe that our plans to revitalize ourrestaurant concepts in late 2004 and beyond may address issues in each of theseareas that have negatively affected sales. Additionally, recent dietary trendsand negative publicity on products high in carbohydrate content may have hadand may continue to have an adverse impact on our sales. We believe that we areaddressing these trends with modifications to our menus. In addition, theplanned modifications of our menu offerings include pricing increases, as wellas limited time offerings of seasonal menu items. We anticipate that theseplanned price changes will have the effect of increasing our average check infuture periods.**

 

*Expense Trends*

 

Currently, the restaurant industry is experiencing increases in thecost of dairy and other raw ingredients, as well as increases in energy costs.During the current fiscal quarter, we saw the impact of such increases in ourfood costs, utility bills and transportation charges and we believe this trendwill continue through the remainder of the year. These increases directlyimpact the profitability of company-owned locations, manufacturing operationsand distribution channels. While we have purchase commitments for our dairy andother raw ingredients that mitigate immediate increases in food costs, ourpurchase commitments are not long-term in nature. Accordingly, in the nearfuture we may experience degradation in our profit margins until such time aswe are able to pass on increased costs to our consumers.

 

*Revitalization of our Restaurant Concepts*

 

We intend to begin revitalization of our Einstein Bros.company-operated restaurants in late 2004. The planned modifications includechanges to our customer service system, menu offerings and the “look and feel”of our company-operated restaurants. We have two prototypes scheduled to openduring the fourth quarter of this year. We will operate the two prototypes forapproximately 90 days before commencing a staggered rollout on amarket-by-market basis. By the end of the current fiscal year, we anticipatethe completion of our first market. It is our intention to thoroughly study thefinancial and operating performance of the two prototypes in order to determinemodifications necessary, if any, to our menu offerings and/or the physicallayout of our restaurants for future prototypes.

 

*Store Portfolio Strategy*

 

From time to time, we close restaurants that are performing poorly, werelocate restaurants to a new site within the same trade area or we consolidatetwo or more of our existing units into a single unit. Generally, the closurescoincide with the expiration of an existing lease and result in little or noimpairment charges.

 

During the second quarter ended 2004, we completed our evaluation ofthe Willoughby’s brand, determined that it did not fit within our overallstrategic plan and identified a buyer to purchase the business. The Willoughby’s business consistsof a coffee roasting plant, two retail locations and office space.  Under the terms of agreement, we will sellthe assets for a total purchase price of $426,000 to be received in cash,subject to post-closing adjustments for changes from May 25, 2004 to closing ininventory, accounts receivable and cash in drawer. Additionally, we may beentitled to post-closing payments of up to $100,000 contingent upon thelandlord’s option to terminate the lease at one of our retail locations.

 

17

----

 

In connection with thesale of Willoughby’s, we intend to execute a two-year supply agreement topurchase coffee from the buyer for our New World Coffee outlets. The sale isexpected to close by the end of August 2004.

 

We have determined thatthe revenues, cost of sales, other operating expenses and the net book value ofthe assets related to the sale of the coffee roasting plant and two retaillocations included in the Willoughby’s business are immaterial in relation toour Einstein Bros., Noah and Manhattan restaurants, as well as the financialstatements taken as a whole. Accordingly, we have not presented discontinuedoperations in the accompanying consolidated statements of operations for thethirteen and twenty-six weeks ended June 29, 2004 and July 1, 2003,respectively, nor have we reflected assets as held for sale in the accompanyingconsolidated balance sheets as of June 29, 2004.

 

The following table details the total restaurants open at the end ofthe respective second quarter:

 

|                                     |   | **Company  owned** |   | **Licensed** |   | **Franchised** |   | **Total** |   |
|------------------------------------------|--------|--------------------|--------|--------------|--------|----------------|--------|-----------|--------|
| **Einstein Bros.:**                      |   |               |   |         |   |           |   |      |   |
| 2004                                     |   | 371                |   | 46           |   | —         |   | 417       |   |
| 2003                                     |   | 371                |   | 25           |   | —         |   | 396       |   |
| **Noah’s:**                         |   |               |   |         |   |           |   |      |   |
| 2004                                     |   | 80                 |   | 3            |   | —         |   | 83        |   |
| 2003                                     |   | 83                 |   | 3            |   | —         |   | 86        |   |
| **Manhattan:**                           |   |               |   |         |   |           |   |      |   |
| 2004                                     |   | —             |   | —       |   | 165            |   | 165       |   |
| 2003                                     |   | —             |   | —       |   | 192            |   | 192       |   |
| **Chesapeake:**                          |   |               |   |         |   |           |   |      |   |
| 2004                                     |   | —             |   | —       |   | 37             |   | 37        |   |
| 2003                                     |   | —             |   | —       |   | 46             |   | 46        |   |
| **New World  Coffee/Willoughby’s:** |   |               |   |         |   |           |   |      |   |
| 2004                                     |   | 8                  |   | —       |   | 10             |   | 18        |   |
| 2003                                     |   | 8                  |   | —       |   | 11             |   | 19        |   |
| **Total Restaurants:**                   |   |               |   |         |   |           |   |      |   |
| 2004                                     |   | 459                |   | 49           |   | 212            |   | 720       |   |
| 2003                                     |   | 462                |   | 28           |   | 249            |   | 739       |   |

 

We believe we have a strong platform for growth through store licensingof our Einstein and Noah’s brands. During the latter half of 2003, we beganexpansion of our licensed stores and we intend to continue our expansion byopening approximately 30 licensed store locations by the end of 2004. Thelicensing program is available to qualified foodservice operators and typicallyrequires an upfront license fee that is fully earned at the time the licenseecommences operations. Stores are developed on college campuses, hospitals,airports, military installations and other locations. The licensed stores aregenerally opened during the third and fourth calendar quarters consistent withthe timing of many government and higher education projects and federalfunding. We typically receive continuing royalties on sales from each licensedstore location. Our licensees are not required to buy all of their proprietaryproducts directly from us, but rather their product sources must be approved byus.

 

Our Manhattan and Chesapeake brands primarily represent our franchisebase. Our franchised locations generate a recurring revenue stream throughroyalty payments on sales from each franchised location. Our franchisee baseprovides us with the ability to grow our brands with minimal commitment ofcapital by us, and creates a built-in customer base for our manufacturingoperations. Duringthe thirteen weeks ended June 29, 2004, we began an evaluation of therationale for each of our brands with a view toward determining whether thebrand should be a part of our overall strategic business plan.

 

18

----

 

**Results of Operations**

 

The following table sets forth, for the periods indicated, certainamounts included in our Consolidated Statements of Operations, the relativepercentage that those amounts represent to total revenue (unless otherwiseindicated), and the percentage change in those amounts from period to period.All percentages are calculated using actual amounts rounded to the nearestthousand.

 
|                                                            |   | **For the  thirteen weeks ended** |   | **Increase**              |   | **For the  twenty-six weeks ended** |   | **Increase**           |   |
|-----------------------------------------------------------------|--------|-----------------------------------|--------|---------------------------|--------|-------------------------------------|--------|------------------------|--------|
|                                                            |   | **(in  thousands)**               |   | **(percent  of revenue)** |   | **(Decrease)**                      |   | **(in  thousands)**    |   | **(percent  of revenue)** |   | **(Decrease)** |   |
|                                                            |   | **June 29,  2004**           |   | **July 1,  2003**    |   | **June 29,  2004**             |   | **July 1,  2003** |   | **2004  vs. 2003** |   | **June 29,  2004** |   | **July 1,  2003** |   | **June 29,  2004** |   | **July 1,  2003** |   | **2004  vs. 2003** |   |
| **Revenues:**                                                   |   |                              |   |                      |   |                                |   |                   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Retail sales**                                                |   | 87,596                            |   | 90,878                    |   | 93.0                                | %      | 93.0                   | %      | -3.6 | % | 172,219 |   | 179,328 |   | 92.9 | % | 92.9 | % | -4.0 | % |
| **Manufacturing revenues**                                      |   | 4,944                             |   | 5,754                     |   | 5.3                                 | %      | 5.9                    | %      | -14.1 | % | 10,357 |   | 11,178 |   | 5.6 | % | 5.8 | % | -7.3 | % |
| **Franchise and license related revenues**                      |   | 1,624                             |   | 1,117                     |   | 1.7                                 | %      | 1.1                    | %      | 45.4 | % | 2,784 |   | 2,454 |   | 1.5 | % | 1.3 | % | 13.4 | % |
|                                                            |   |                              |   |                      |   |                                |   |                   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Total revenues**                                              |   | 94,164                            |   | 97,749                    |   | 100.0                               | %      | 100.0                  | %      | -3.7 | % | 185,360 |   | 192,960 |   | 100.0 | % | 100.0 | % | -3.9 | % |
|                                                            |   |                              |   |                      |   |                                |   |                   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Cost of sales:**                                              |   |                              |   |                      |   |                                |   |                   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Retail costs**                                                |   | 73,403                            |   | 77,385                    |   | 78.0                                | %      | 79.2                   | %      | -5.1 | % | 143,490 |   | 150,339 |   | 77.4 | % | 77.9 | % | -4.6 | % |
| **Manufacturing costs**                                         |   | 4,442                             |   | 5,082                     |   | 4.7                                 | %      | 5.2                    | %      | -12.6 | % | 9,020 |   | 10,123 |   | 4.9 | % | 5.2 | % | -10.9 | % |
|                                                            |   |                              |   |                      |   |                                |   |                   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Total cost of sales**                                         |   | 77,845                            |   | 82,467                    |   | 82.7                                | %      | 84.4                   | %      | -5.6 | % | 152,510 |   | 160,462 |   | 82.3 | % | 83.2 | % | -5.0 | % |
|                                                            |   |                              |   |                      |   |                                |   |                   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Gross profit:**                                               |   |                              |   |                      |   |                                |   |                   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Retail**                                                      |   | 14,193                            |   | 13,493                    |   | 15.1                                | %      | 13.8                   | %      | 5.2 | % | 28,729 |   | 28,989 |   | 15.5 | % | 15.0 | % | -0.9 | % |
| **Manufacturing**                                               |   | 502                               |   | 672                       |   | 0.5                                 | %      | 0.7                    | %      | -25.3 | % | 1,337 |   | 1,055 |   | 0.7 | % | 0.5 | % | 26.7 | % |
| **Franchise and license**                                       |   | 1,624                             |   | 1,117                     |   | 1.7                                 | %      | 1.1                    | %      | 45.4 | % | 2,784 |   | 2,454 |   | 1.5 | % | 1.3 | % | 13.4 | % |
| **Total gross profit**                                          |   | 16,319                            |   | 15,282                    |   | 17.3                                | %      | 15.6                   | %      | 6.8 | % | 32,850 |   | 32,498 |   | 17.7 | % | 16.8 | % | 1.1 | % |
|                                                            |   |                              |   |                      |   |                                |   |                   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **General and administrative expenses**                         |   | 8,000                             |   | 10,604                    |   | 8.5                                 | %      | 10.8                   | %      | -24.6 | % | 16,818 |   | 20,858 |   | 9.1 | % | 10.8 | % | -19.4 | % |
|                                                            |   |                              |   |                      |   |                                |   |                   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Depreciation and amortization**                               |   | 5,344                             |   | 7,092                     |   | 5.7                                 | %      | 7.3                    | %      | -24.6 | % | 10,582 |   | 14,297 |   | 5.7 | % | 7.4 | % | -26.0 | % |
| **Adjustment of integration and reorganization cost**           |   | (39                               | )      | —                    |   | 0.0                                 | %      | 0.0                    | %      |   | *  | (799 | ) | — |   | -0.4 | % | 0.0 | % |   | * |
|                                                            |   |                              |   |                      |   |                                |   |                   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Income (loss) from operations**                               |   | 3,014                             |   | (2,414                    | )      | 3.2                                 | %      | -2.5                   | %      |   | * | 6,249 |   | (2,657 | ) | 3.4 | % | -1.4 | % |   | * |
|                                                            |   |                              |   |                      |   |                                |   |                   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Other expense (income):**                                     |   |                              |   |                      |   |                                |   |                   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Interest expense, net**                                       |   | 5,904                             |   | 9,975                     |   | 6.3                                 | %      | 10.2                   | %      | -40.8 | % | 11,703 |   | 18,271 |   | 6.3 | % | 9.5 | % | -35.9 | % |
|                                                            |   |                              |   |                      |   |                                |   |                   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Cumulative change in the fair value of derivatives**          |   | —                            |   | 727                       |   | 0.0                                 | %      | 0.7                    | %      |   | * | — |   | 70 |   | 0.0 | % | 0.0 | % |   | * |
|                                                            |   |                              |   |                      |   |                                |   |                   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Loss (gain) on sale, disposal or abandonment of assets, net** |   | 1,712                             |   | (202                      | )      | 1.8                                 | %      | -0.2                   | %      |   | * | 1,713 |   | (385 | ) | 0.9 | % | -0.2 | % |   | * |
| **Other income**                                                |   | (36                               | )      | (119                      | )      | 0.0                                 | %      | -0.1                   | %      | -69.7 | % | (100 | ) | (186 | ) | -0.1 | % | -0.1 | % | -46.2 | % |
|                                                            |   |                              |   |                      |   |                                |   |                   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Loss before income taxes**                                    |   | (4,566                            | )      | (12,795                   | )      | -4.8                                | %      | -13.1                  | %      | -64.3 | % | (7,067 | ) | (20,427 | ) | -3.8 | % | -10.6 | % | -65.4 | % |

 

----

* not meaningful

 

We operate as a single business segment with a focus on ourcompany-operated restaurants. Our manufacturing and franchise operations areeither supportive or ancillary to our main business focus.

 

19

----

 

***Revenues***

 

**Total revenues for the thirteen and twenty-six weeks endedJune 29, 2004 were consistent with our expectations. Our total revenuesdecreased 3.7% and 3.9% for the thirteen and twenty-six weeks endedJune 29, 2004, respectively, when compared to the same periods in fiscal2003. The decreases primarily resulted from the dollar decline in retail sales(e.g. company-operated store sales which represents the most significantcomponent of revenue).  Our retailcomparable store sales decrease of 3.7% and 4.3% for the thirteen andtwenty-six weeks ended June 29, 2004, respectively, consisted of a 7.3%and 6.3% reduction in transactions partially offset by a 3.9% and 2.2% increasein average check primarily related to both an increase in menu pricing and ashift in product mix to higher priced items. We consider comparable store salesto represent sales at stores that were 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 and as “comp sales” within the restaurantindustry.**

** **

***Gross Profit***

 

Our total gross profit improved 6.8% and 1.1% for the thirteen andtwenty-six weeks ended June 29, 2004, respectively, when compared to thesame periods in fiscal 2003. The improvement was primarily due to improvementsin our retail costs of sales. Our retail margins improved by 5.2% for the thirteenweeks ended June 29, 2004 when compared to the same period in fiscal 2003.All store-level operating expenses other than depreciation, amortization andtaxes impact our retail margins. The improvement we have experienced isprimarily attributable to our decision to reduce marketing expenditures as wefocus on modifications to our customer service system, menu offerings and the“look and feel” of our company-operated restaurants. We will continue toimplement solutions that improve our margins but expect this trend to level outduring the next two quarters, as many of our store-level cost reductioninitiatives will have been in place for approximately one year.  Additionally during the thirteen weeks endedJune 29, 2004, we experienced reductions in our group insurance claimsratings and we also incurred lower costs for regularly scheduled storemaintenance.

 

***Other Expenses***

 

**Our general and administrative expenses decreased 24.6% and 19.4% forthe thirteen and twenty-six weeks ended June 29, 2004, respectively, whencompared to the same periods in fiscal 2003. The decline in general andadministrative expenses is primarily due to reduced spending fornon-capitalizable legal and consulting expenses associated with our debtrefinancing and equity recapitalization, and the re-audit of our 2000 and 2001financial results that occurred during 2003.**

 

Our depreciation and amortization expenses decreased 24.6% and 26.0%for the thirteen and twenty-six weeks ended June 29, 2004, respectively,when compared to the same periods in fiscal 2003. The decreases in depreciationand amortization expense are primarily due to a portion of our asset basebecoming fully depreciated during the fiscal year 2004. In the near future, weanticipate spending additional capital on existing stores, which would resultin a corresponding increase in our depreciable asset base, and thusdepreciation expense. Over the past several years, former management did notinvest significant capital in our store equipment due to limited availabilityof resources and covenant restrictions under our former credit facilities.During the current year, we have placed greater emphasis on the requirements ofour existing company-operated stores. For additional information, see thediscussion under “Liquidity and Capital Resources.”

 

The adjustment of integration and reorganization cost primarilyrepresents an adjustment to previously recorded liabilities associated with theclosing and corporate consolidation of our Eatontown facilities during 2002.During April 2004, we reached an agreement with the landlord of ourEatontown facility to settle outstanding litigation.

 

20

----

 

Previously recorded integration and reorganization estimates associatedwith closing this facility were adjusted down by $700,000 during the thirteenweeks ended March 30, 2004 as a result of this settlement.

 

Interest expensedecreased 40.8% and 35.9% for the thirteen and twenty-six weeks endedJune 29, 2004, respectively, when compared to the same periods in fiscal2003. The primary cause of the decline in interest expense is the result of thedebt refinancing that occurred during the third quarter of fiscal 2003. As aresult of the debt refinancing, our interest rate on our primary debt facilitydeclined from 19% to 13% per year.

 

During the thirteen andtwenty-six weeks ended June 29, 2004, we recorded a loss of $1.7 million,primarily due the disposal of menu boards as a result of our new menu offeringsand due to the abandonment of leasehold improvements related to closedrestaurants and our administrative facilities located in New Jersey.

 

**Liquidity and Capital Resources**

 

We have historically relied upon our major preferred and commonstockholders to provide us with supplemental financing at times when our cashflows from operations have been insufficient to cover our capital requirementsor the requirements of other debt. The restaurant industry is predominantly acash business where cash is received at the time of the transaction. We have aminimal amount of accounts receivable, which are predominantly from ourfranchisees, licensees and distributors. Additionally, our investment ininventory is minimal since our products are perishable. Our accounts payableare on terms that we believe are consistent with those of other companieswithin the industry.

 

The primary driver of our operating cash flow is our restaurantoperations, specifically the gross margin from our company-operatedrestaurants. Therefore, we focus on the elements of those operations includingcomparable store sales to ensure a steady stream of operating profits thatenable us to meet our cash obligations. On a weekly basis, we review ourcompany-operated store performance compared with the same period in the prioryear and our operating plan. We are continuously identifying and implementingcost reduction initiatives, not only at the store operations level, but alsowithin other disciplines such as supply chain, manufacturing operations andoverhead. Examples of these cost reduction initiatives include:

 

•      Menu optimization to removeand/or modify inefficient products and thus reduce waste;

 

•      Upgrade/deployment oftechnology to enable more accurate sales identification and tracking of dailyvolumes and cost of products sold thereby identifying opportunities to improvestore margins and reduce waste;

 

•      Reduction of the variouselements of cost that were historically non-recurring in nature.

 

During fiscal year 2004, we anticipate the majority of our capitalexpenditures will be focused on the following: (1) requirements of our existing company-operated stores, primarilyequipment replacement and new computer hardware, (2) upgrades and remodelingcosts associated with the revitalization of our concept, (3) a modest amount ofnew company-operated store development related to approximately four to six newstore openings, (4) a modest amount of capital spent on our manufacturingoperations and (5) additional capital for our support center in Golden,Colorado, primarily related to spending on information technology upgrades andmaintenance.

 

Based upon our projections for fiscal 2004 and beyond, we believe thatthe cash flow from operations coupled with the continued availability of ourAmSouth Revolver will be adequate to fund our operations, capital expendituresand required debt and interest repayments for the foreseeable future.

 

Our AmSouth Revolver is a $15 million senior secured revolving credit facility, whichmatures on July 8, 2006. At June 29, 2004, our unused credit facilitytotaled $10.0 million, net of outstanding letters of credit of $5.0 million.

 

21

----

 

Our credit facilitycontains financial covenants relating to the maintenance of leverage andcoverage ratios. The credit facility also contains affirmative and negativecovenants including, among other things, limitations on certain additionalindebtedness, capital expenditures and minimum EBITDA as defined in theagreement. We were in compliance with all covenants at June 29, 2004 anddo not anticipate that the covenants will impact our ability to borrow underour credit facility for its remaining term.

 

Ifat some point in the future we require additional financing, no assurance canbe given that any additional financing would be available on acceptable terms,or at all.  If we are unable to obtain additional financing, we maybe required to further reduce costs associated with our current infrastructure, decreasespending on marketing and advertising campaigns, curtail research anddevelopment programs and/or halt all other discretionary spending programs, anyof which could further reduce sales and adversely affect liquidity andoperations.

 

At June 29, 2004, we had unrestricted cash of $10.3 millionand short-term restricted cash of $1.2 million. We reduced our workingcapital deficit to $21.7 million at June 29, 2004 compared with aworking capital deficit of $23.6 million at December 30, 2003.Additionally, we experienced an improvement of $6.6 million in our cash operatingperformance (defined as net loss as adjusted for non-cash charges). We believethis improvement is a direct result of our ability to better manage fixed andvariable elements of our cost of sales and an overall reduction in spendingdollars for general and administrative purposes. We also generated $1.7 millionin free cash flow during the twenty-six weeks ended June 29, 2004.

 

Cash operating performance and free cash flow are not intended torepresent cash flow from operations in accordance with accounting principlesgenerally accepted in the United States (GAAP) and should not be used as anindicator of operating performance or to cash flow as a measure of liquidity.Rather, our cash operating performance and free cash flow are a basis uponwhich we measure our financial performance, as well as our ability to pay downdebt, save cash for future use and build shareholder equity. We also believethat the presentation of these calculations provides meaningful non-GAAPfinancial measures to help investors understand and compare business trendamong different reporting periods on a consistent basis. Cash operatingperformance and free cash flow are not necessarily comparable to othersimilarly titled measures of other companies due to the potential inconsistenciesin the method of calculation.

 
|                                                           |   | **Twenty-six  weeks ended** |   |
|----------------------------------------------------------------|--------|-----------------------------|--------|
|                                                           |   | **June 29,  2004**     |   | **July 1,  2003** |   |
| **Reconciliation of  Net Loss to Cash Operating Performance:** |   |                        |   |   |   |
| Net loss                                                       |   | $                           | (7,306 | ) | $ | (20,857 | ) |
| Adjustments for non-cash charges:                              |   |                        |   |   |   |
| Depreciation and amortization                                  |   | 10,582                      |   | 14,297 |   |
| Stock-based compensation expense                               |   | 35                          |   | — |   |
| Loss on disposal of assets                                     |   | 1,713                       |   | — |   |
| Adjustments of integration and  reorganization costs           |   | (799                        | )      | — |   |
| Cumulative change in fair value of  derivatives                |   | —                      |   | 70 |   |
| Amortization of debt issuance and debt  discount costs         |   | 908                         |   | 2,212 |   |
| Notes issued as paid in kind for interest  on Bridge Loan      |   | —                      |   | 510 |   |
| Issuance of standstill warrants                                |   | —                      |   | 1,238 |   |
| Greenlight non-cash interest                                   |   | —                      |   | 1,025 |   |
| Cash Operating Performance                                     |   | $                           | 5,133  |   | $ | (1,505 | ) |

 

22

----

 
|                                                                                |   | **Twenty-six  weeks ended** |   |
|-------------------------------------------------------------------------------------|--------|-----------------------------|--------|
|                                                                                |   | **June 29,  2004**     |   | **July 1,  2003** |   |
| **Reconciliation of  Net Cash Provided by Operating Activities to Free Cash Flow:** |   |                        |   |   |   |
| Net cash provided by operating activities                                           |   | $                           | 5,435  |   | $ | 1,219 |   |
| Less: purchases of fixed assets                                                     |   | (3,687                      | )      | (3,494 | ) |
| Free Cash Flow                                                                      |   | $                           | 1,748  |   | $ | (2,275 | ) |

 

During the twenty-six weeks ended June 29, 2004, operationsgenerated $5.4 million of cash compared to $1.2 million during thetwenty-six weeks ended July 1, 2003. We believe we will continue to seeimprovements in our company operated store cash operating performance duringthe next quarter. Due to the timing of the cash interest payment under our $160Million Indenture, which is due January 1 and July 1, we anticipateconsuming cash from operations during the first and third fiscal quarters ofeach year. During the second and fourth fiscal quarters of each year, weanticipate generating cash from operations. Historically, our fourth quarter isour strongest quarter for generating cash due to seasonality and gift cardpromotions. We believe the cash generated during the twenty-six weeks endedJune 29, 2004 and December 28, 2004, along with the availabilityunder our AmSouth Revolver will be adequate to satisfy our cash obligations.

 

During the twenty-six weeks ended June 29, 2004, we used$3.7 million of cash to purchase additional property and equipment whichincluded $1.0 million for new stores, $1.9 million for replacement and newequipment at our existing company-operated stores, $0.3 million for ourmanufacturing operations and $0.5 million for general corporate purposes.

 

During the twenty-sixweeks ended June 29, 2004, we used $1.0 million of cash to reduce ourdebt outstanding on the AmSouth Revolver.

 

***ContractualObligations***

 

There were no material changes to our contractual obligations duringthe twenty-six weeks ended June 29, 2004. For information regarding ourcontractual obligations at December 30, 2003, see our Annual Report onForm 10-K for the fiscal year ended December 30, 2003.

 

***Guarantees***

 

Inthe past, we would sometimes guarantee leases for the benefit of certain of ourfranchisees. The lease guarantees extend through 2008. Under the guarantees, wemay be required by the lessor to make all of the remaining monthly rentalpayments or property tax and common area maintenance payments if the franchiseedoes not make the required payments in a timely manner. However, we believethat most, if not all, of the franchised locations could be subleased to thirdparties minimizing our potential exposure. Additionally, we haveindemnification agreements with our franchisees under which the franchiseeswould be obligated to reimburse us for any amounts paid under such guarantees.As of June 29, 2004, our maximum exposure under this contingent liabilitywas approximately $2.0 million.

###### ** **

23

----

 

***Insurance Programs***

 

We are self-insured for a substantial portion of our current and prioryears’ coverage including workers’ compensation, employment practices liabilityand general liability (collectively, “insurance losses”). To mitigate thepotential cost of our exposures for certain of the insurance losses, we makeannual decisions to self-fund the risks of loss up to defined maximum peroccurrence retentions on a policy-by-policy basis. We then purchase insurancecoverage, up to a certain limit, for losses that exceed the self-insurance peroccurrence or aggregate retention. The insurers’ maximum aggregate loss limitsare significantly above our actuarially determined probable losses; therefore,we believe the likelihood of losses exceeding the insurers’ maximum aggregatedloss limits is remote.

 

We are also self-insured for healthcare claims for eligibleparticipating employees subject to certain deductibles and limitations. We haveaccounted for our liabilities related to the insurance losses and healthcareclaims, including reported and incurred but not reported claims, based oninformation provided by actuaries.

 

We believe that we have recorded reserves adequate to cover ourinsurance losses based upon information we have today. Due to the inherentvolatility of actuarially determined insurance loss estimates, it is reasonablypossible that we could experience changes in estimated losses, which could bematerial to our consolidated financial position or results of operations.

 

### ***Risk Factors***

####  

You should consider each of the following factors as well as otherinformation in the Quarterly Report in evaluating our business and prospects.The risks and uncertainties described below are not the only ones we face.Additional risks and uncertainties not presently known to us or that wecurrently consider immaterial may also impair our business operations. If anyof these risks actually occur, our business and financial results could beharmed and the trading price of our common stock could decline. You should alsorefer to the other information set forth in the Quarterly Report and in ourAnnual Report on Form 10-K for the fiscal year ended December 30, 2003,including our consolidated financial statements and the related notes.

 

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

 

Our successdepends on part on our ability to understand our customers’ needs. We believesuccessful deployment of our current business strategy will address customers’needs and contribute to overall company growth. If we improperly perceivecustomers’ needs and/or are not successful in implementing any or all of theinitiatives of our business strategy, it could have a material adverse effecton our business, results of operations, and financial condition.

 

*We have and expect to continue to have asubstantial amount of debt.*

 

We have a high level of debt and are highly leveraged. In addition, wemay, subject to certain restrictions, incur substantial additional indebtednessin the future. Our high level of debt, among other factors, could:

 

•      make it difficult for us tosatisfy our obligations under our indebtedness;

 

•      limit our ability to obtainadditional financing for working capital, capital expenditures, acquisitionsand general corporate purposes;

 

•      increase our vulnerabilityto downturns in our business or the economy generally;

 

24

----

 

•      limit our ability towithstand competitive pressures from our less leveraged competitors; and

 

•      harm us because a failure byus to comply with the covenants in the instruments and agreements governing ourindebtedness could result in an event of default that, if not cured or waived,could result in all of our indebtedness becoming immediately due and payable,which could render us insolvent.

 

*We may not be able to generate sufficientcash flow to make payments on our indebtedness.*

 

Economic, financial, competitive, legislative and other factors beyondour control may affect our ability to generate cash flow from operations tomake payments on our indebtedness and to fund necessary working capital. Asignificant reduction in operating cash flow would likely increase the need foralternative sources of liquidity. If we are unable to generate sufficient cashflow to make payments on our debt, we will have to pursue one or morealternatives, such as reducing or delaying capital expenditures, refinancingour debt, selling assets or raising equity. We may not be able to accomplishany of these alternatives on satisfactory terms, if at all, and even ifaccomplished, they may not yield sufficient funds to service our debt.

 

*We are vulnerable to changes in consumerpreferences and economic conditions that could harm our financial results.*

 

Food service businesses are often affected by changes in consumertastes, dietary trends, national, regional and local economic conditions anddemographic trends. Factors such as traffic patterns, local demographics andthe type, number and location of competing restaurants may adversely affect theperformance of individual locations. Shifts in consumer preferences away fromour type of cuisine and/or the quick casual dining style could have a materialadverse affect on our results of operations. We believe that the trend towardconsumption of food low in carbohydrate content may have had and may continueto have a negative impact on our sales and revenues. In addition, inflation andincreased food and energy costs may harm the restaurant industry in general andour locations in particular. Adverse changes in any of these factors couldreduce consumer traffic or impose practical limits on pricing, which could harmour business prospects, financial condition, operating results and cash flow.Our continued success will depend in part on our ability to anticipate,identify and respond to changing consumer preferences and economic conditions.

 

*There is intense competition in therestaurant industry.*

 

Our industry is intensely competitive and there are manywell-established competitors with substantially greater financial and otherresources than we have. In addition to current competitors, one or more newmajor competitors with substantially greater financial, marketing and operatingresources could enter the market at any time and compete directly against us.In addition, in virtually every major metropolitan area in which we operate orexpect to enter, local or regional competitors already exist.

 

*We are vulnerable to fluctuations in thecost, availability and quality of our raw ingredients.*

 

The cost, availability and quality of the ingredients we use to prepareour food are subject to a range of factors, many of which are beyond ourcontrol. Fluctuations in economic and political conditions, weather and demandcould adversely affect the cost of our ingredients. We have limited controlover fluctuations in the price of commodities, and we may not be able to passthrough any cost increases to our customers. We are dependent on frequentdeliveries of fresh ingredients, thereby subjecting us to the risk of shortagesor interruptions in supply. All of these factors could adversely affect ourbusiness and financial results.

 

25

----

 

*We heavily depend onour suppliers and distributors.*

 

We currently purchase our raw materials from various suppliers. Wepurchase a majority of our frozen bagel dough from one supplier. Though to datewe have not experienced significant difficulties with our suppliers, ourreliance on our suppliers subjects us to a number of risks, including possibledelays or interruption in supplies, diminished control over quality and apotential lack of adequate raw material capacity. Any disruption in the supplyor degradation in the quality of the materials provided by our suppliers couldhave a material adverse effect on our business, operating results and financialcondition. In addition, such disruptions in supply or degradations in qualitycould have a long-term detrimental impact on our efforts to develop a strongbrand identity and a loyal consumer base.

 

We depend on our network of six regional custom distributors todistribute frozen bagel dough and other materials to our locations. If any oneor more of these distributors fails to perform as anticipated, or if there isany disruption in any of our distribution relationships for any reason, itcould have a material adverse effect on our business, financial condition andresults of operations.

 

*Increasing labor costs could adversely affectour continued profitability.*

 

We are dependent upon an available labor pool of unskilled employees,many of whom are hourly employees whose wages may be affected by an increase inthe federal or state minimum wage. Numerous proposals have been made onfederal, state and local levels to increase minimum wage levels. Although few,if any, of our employees are paid at the minimum wage level, an increase in theminimum wage may create pressure to increase the pay scale for our employees,which would increase our labor costs and those of our franchisees andlicensees. A shortage in the labor pool or other general inflationary pressuresor changes could also increase labor costs. In addition, changes in labor lawsor reclassifications of employees from management to hourly employees couldaffect our labor cost. For example, new federal overtime regulations under theFair Labor Standards Act, which go into effect on August 23, 2004, mayimpact the classification of several of our positions. We are continuing toevaluate the specific impact of these changes. An increase in labor costs couldhave a material adverse effect on our income from operations and decrease ourprofitability and cash available to service our debt obligations if we areunable to recover these increases by raising the prices we charge ourcustomers.

 

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

 

We are from time to time the subject of complaints or litigation fromour consumers alleging illness, injury or other food quality, health oroperational concerns. Adverse publicity resulting from these allegations maymaterially adversely affect us, regardless of whether the allegations are validor whether we are liable. In addition, employee claims against us based on,among other things, discrimination, harassment or wrongful termination maydivert financial and management resources that would otherwise be used tobenefit our future performance. We have been subject to claims from time totime, and although these claims have not historically had a material impact onour operations, a significant increase in the number of these claims or thenumber that are successful could materially adversely affect our business,prospects, financial condition, operating results or cash flows.

 

*We rely in part on our franchisees.*

 

We rely in part on our franchisees and the manner in which they operatetheir locations to develop and promote our business. Although we have developedcriteria to evaluate and screen prospective franchisees, franchisees may nothave the business acumen or financial resources necessary to operate successfulfranchises in their franchise areas. The failure of franchisees to operatefranchises successfully could have a material adverse effect on us, our abilityto collect royalties, our reputation, our brands and our ability to attractprospective franchisees.

 

26

----

 

*We face risksassociated with government regulation.*

 

Each of our locations is subject to licensing and regulation by thehealth, sanitation, safety, labor, building and fire agencies of the respectivestates and municipalities in which it is located. A failure to comply with oneor more regulations could result in the imposition of sanctions, including theclosing of facilities for an indeterminate period of time, or third-partylitigation, any of which could have a material adverse effect on us and ourresults of operations.

 

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

 

Under various federal, state and local laws, an owner or operator ofreal estate may be liable for the costs of removal or remediation of certainhazardous or toxic substances on or in such property. Such liability may beimposed without regard to whether the owner or operator knew of, or wasresponsible for, the presence of such hazardous or toxic substances. Althoughwe are not aware of any environmental conditions that require remediation by usunder federal, state or local law at our properties, we have not conducted acomprehensive environmental review of our properties or operations. We may nothave identified all of the potential environmental liabilities at ourproperties, and any such liabilities that are identified in the future may havea material adverse effect on our financial condition.

 

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

 

We believe that our trademarks, service marks and other proprietaryrights are important to our success and our competitive position. Accordingly,we devote substantial resources to the establishment and protection of ourtrademarks, service marks and proprietary rights. However, the actions taken byus may be inadequate to prevent imitation of our products and concepts byothers or to prevent others from claiming violations of their trademarks andproprietary rights by us. In addition, others may assert rights in ourtrademarks, service marks and other proprietary rights.

 

*We have a majoritystockholder.*

 

Greenlight Capital, L.L.C. and its affiliates beneficially ownapproximately 97 percent of our common stock. As a result, Greenlight hassufficient voting power, without the vote of any other stockholders, todetermine what matters will be submitted for approval by our stockholders, toapprove actions by written consent without the approval of any otherstockholders, to elect all of our board of directors, and to determine whethera change in control of our company occurs. Greenlight’s interests on matterssubmitted 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.  One of our directors is a current employeeof Greenlight. The remaining five directors are not affiliated with Greenlight.

 

27

----

 

Our common stock is not currently listed on any stock exchange orNasdaq. As a result, we are not subject to corporate governance rules recentlyadopted by the New York Stock Exchange, American Stock Exchange and Nasdaqrequiring a majority of directors to be independent and requiring compensationand nominating committees that are composed solely of independent directors.However, we are subject to rules requiring that the audit committee consistentirely of independent directors. Under the rules of these stock exchanges andNasdaq, if a single stockholder holds more that 50% of the voting power of alisted company, that company is considered a controlled company, and except forthe rules relating to independence of the audit committee, is exempt from theabove-mentioned independence rules. Since Greenlight beneficially ownsapproximately 97% of our common stock, we may take advantage of the controlledcompany exemption if our common stock becomes listed on an exchange or Nasdaqin the future. As a result, our stockholders do not have, and may never havethe protections that these rules are intended to provide.

 

*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 stock are sold in thepublic market, the market price of our common stock could fall.  The perception among investors that thesesales will occur could also produce this effect.  Our majority stockholder Greenlight beneficially ownsapproximately 97 percent of our common stock and sales by Greenlight or aperception that Greenlight will sell could cause a decrease in the market priceof our common stock. Additionally, holders of outstanding warrants may convertand sell the underlying shares in the public market. Pursuant to ourobligations under registration rights agreements, we are currently registering957,872 shares of common stock underlying certain warrants, of which Greenlightowns warrants to purchase approximately 493,683 shares of our common stock.Sales of shares or a perception that there will be sales of the underlyingshares could also cause a decrease in the market price of our common stock.

 

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

 

Our common stock is currently trading on the “pink sheets” under thesymbol “NWRG.PK.”  Before changing oursymbol on October 20, 2003, our common stock traded on the “pink sheets”under the symbol “NWCI.PK.”  Since ourcommon stock is not listed on Nasdaq, Amex or the New York Stock Exchange,holders of our common stock may find that the liquidity of our common stock isimpaired – not only in the number of securities that can be bought and sold,but also through delays in the timing of transactions, reduction in securityanalysts’ and the news media’s coverage of us, and lower prices for oursecurities than might otherwise be attained.

 

Securities that are not listed on a stock exchange, the Nasdaq NationalMarket or the Nasdaq SmallCap Market are subject to an SEC rule that imposesspecial requirements on broker-dealers who sell those securities to personsother than their established customers and accredited investors. Thebroker-dealer must determine that the security is suitable for the purchaserand must obtain the purchaser’s written consent prior to the sale. Theserequirements may make it more difficult for you to sell our stock than thestock of some other companies. It may also affect our ability to raise morecapital if and when necessary.

 

Before May 22, 2002, our common stock was quoted on the OTCBulletin Board under the symbol “NWCI.OB.” On May 22, 2002, our commonstock was removed from the eligible list on the OTC Bulletin Board for afailure to comply with NASD Rule 6530, which resulted from our failure to timelyfile our Form 10-K for the year ended January 1, 2002.  Before November 27, 2001, our commonstock was quoted on the Nasdaq National Market under the symbol “NWCI.”  Effective November 27, 2001, NASDAQdelisted our common stock from the Nasdaq National Market due to corporategovernance violations and public interest concerns.

 

28

----

 

**Item 3.  Qualitative and QuantitativeDisclosures About Market Risk**

 

Through June 29, 2004, our results of operations, financial positionand cash flows have not been materially affected by changes in the relativevalues of non-U.S. currencies to the U.S. dollar. We do not use derivativefinancial instruments to limit our foreign currency risk exposure sincevirtually all of our business is conducted in the United States.

 

Our debt as of June 29, 2004 is principally comprised of the $160Million Indenture due July 1, 2008 and the AmSouth Revolver. A 100 basispoint increase in market interest rates would have an immaterial effect on ourborrowing costs, since the interest rate on the $160 Million Indenture isfixed. The interest rate on the AmSouth Revolver does fluctuate with changes inthe prime rate, but is minor in relation to interest expense in our results ofoperations and financial condition.

 

**Item 4.  Controls and Procedures**

 

Our chief executive officer and our principal financial officer haveevaluated the effectiveness of our “disclosure controls and procedures” (asdefined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as ofJune 29, 2004. Based on that evaluation, our chief executive officer andour principal financial officer have concluded that our disclosure controls andprocedures were effective to provide reasonable assurance that information thatwe are required to disclose in reports that we file with the SEC is recorded,processed, summarized and reported within the time periods specified by theExchange Act rules.

 

It should be noted that any system of controls, however well designedand operated, can provide only reasonable assurance regarding management’scontrol objectives. In addition, the design of any control system is based inpart upon certain assumptions about the likelihood of future events. Because ofthese and other inherent limitations of control systems, there can be noassurance that any design will succeed in achieving its stated goals under allpotential future conditions, regardless of how remote.

 

During the fiscal quarter ended June 29, 2004, there were nochanges to our internal control over financial reporting which were identifiedin connection with the evaluation of our disclosure controls and proceduresrequired by the Exchange Act rules and which have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

29

----

 

**PART II - OTHERINFORMATION**

**NEWWORLD RESTAURANT GROUP, INC.**

**JUNE 29,2004**

 

**Item 1.****    Legal Proceedings.**

 

Information regarding legalproceedings is incorporated by reference from Note 6 to our ConsolidatedFinancial Statements set forth in Part I of this report.

 

**Item2.****    Changes in Securities and Use ofProceeds**

 

During the thirteen weeks ended June 29, 2004, wereceived consideration of $568 and issued 557 shares of our common stock uponthe exercise of certain warrants granted by us subject to registration rightsagreements. We issued these warrants to the warrant holder in a privatefinancing transaction related to our issuance of increasing rate notes whichwere repaid in July 2003.

 

**Item4.****    Submission of Matters to a Vote ofSecurity Holders**

 

The Company’s ProxyStatement dated April 6, 2004 for the Annual Meeting of Shareholders heldon May 20, 2004, as filed with Securities and Exchange Commission onApril 8, 2004 is incorporated herein by reference.

 

1)     The Annual Meeting ofShareholders of the Company was held on May 20, 2004.

2)     Each of the nominees, asdescribed in the Proxy Statement reference above, was elected a director tohold office until the next Annual Meeting of Shareholders or until hissuccessor is elected and qualified.

 

| **Name**                   |   | **Vote For** |   | **Votes  Against  or Withheld** |   |
|----------------------------|--------|--------------|--------|---------------------------------|--------|
| John S. Clark, II          |   | 9,799,470    |   | 4,171                           |   |
| E. Nelson Heumann          |   | 9,799,470    |   | 4,171                           |   |
| Frank C. Meyer             |   | 9,799,470    |   | 4,171                           |   |
| Paul J.B. Murphy, III      |   | 9,799,470    |   | 4,171                           |   |
| S. Garrett Stonehouse, Jr. |   | 9,799,470    |   | 4,171                           |   |
| Leonard Tannenbaum         |   | 9,799,471    |   | 4,171                           |   |

 

3)     The following matter wasalso voted upon at the meeting and approved by the shareholders:

 

a)     Proposal to approve theExecutive Employee Incentive Plan

 

| **Votes For** |   | **Votes  Against** |   | **Abstentions** |   |
|---------------|--------|--------------------|--------|-----------------|--------|
| 9,587,428     |   | 7,763              |   | 2,553           |   |

 

b)    Proposal to approve theStock Option Plan for Independent Directors

 

| **Votes For** |   | **Votes  Against** |   | **Abstentions** |   |
|---------------|--------|--------------------|--------|-----------------|--------|
| 9,585,688     |   | 9,706              |   | 2,350           |   |

 

c)     Proposal to ratify the appointment of Grant ThorntonLLP as independent auditors for the fiscal year ending December 28, 2004

 

| **Votes For** |   | **Votes  Against** |   | **Abstentions** |   |
|---------------|--------|--------------------|--------|-----------------|--------|
| 9,800,921     |   | 1,672              |   | 1,048           |   |

 

30

----

 

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

 

(a)   Exhibits

 

31.1         Certification by ChiefExecutive Officer pursuant to Exchange Act Rule 13a-15(e), as adopted pursuantto Section 302 of the Sarbanes-Oxley Act of 2002

 

31.2         Certification by ChiefFinancial Officer pursuant to Exchange Act Rule 13a-15(e), as adopted pursuantto Section 302 of the Sarbanes-Oxley Act of 2002

 

32.1         Certification by ChiefExecutive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuantto Section 906 of the Sarbanes-Oxley Act of 2002

 

32.2         Certification by ChiefFinancial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuantto Section 906 of the Sarbanes-Oxley Act of 2002

 

(b)   Reports on Form 8-K filed during the quarter endedJune 29, 2004:

 

A report on Form 8-K dated May10, 2004 under Items 5 and 7, was filed with the Securities and ExchangeCommission on May 13, 2004. The Form 8-K furnished a copy of the Company’spress release and conference call script relating to financial results for thethirteen weeks ended March 30, 2004.

 

31

----

 

**Signatures**

 

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

 

 
|   |                | NEW WORLD RESTAURANT GROUP, INC.                          |   |
|--------|---------------------|-----------------------------------------------------------|--------|
|   |                |                                                      |   |
|   |                |                                                      |   |
| Date:  | August 5, 2004 | By: /s/ PAUL J. B. MURPHY, III                       |   |
|   |                | Paul J.B. Murphy, III                                     |   |
|   |                | Chairman and Chief Executive Officer                      |   |
|   |                |                                                      |   |
| Date:  | August 5, 2004 | By: /s/ RICHARD P. DUTKIEWICZ                             |   |
|   |                | Richard P. Dutkiewicz                                     |   |
|   |                | Chief Financial Officer and Principal  Accounting Officer |   |

 

32

----