**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-Q**
| **(Mark One)**                                      |
|-----------------------------------------------------|
| **x**                                               | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
|                                                |
| **For the  quarterly period ended October 3, 2006** |
|                                                |
| **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 ofRegistrant as Specified in its Charter)

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

 

**1687 Cole Blvd., Golden, Colorado80401**

(Address ofprincipal executive offices, including zip code)

**(303) 568-8000**

(Registrant’stelephone number, including area code)

Securities registeredpursuant to Section 12(b) of the Act:

**None**

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

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer or anon-accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Actof 1934). 
| Large  accelerated filer o | Accelerated  filer o | Non-accelerated  filer x |
|----------------------------|----------------------|--------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theSecurities Exchange Act of 1934). Yes o Nox

As of November 8, 2006,10,593,085 shares of Common Stock of the registrant were outstanding.

 

----

**NEW WORLDRESTAURANT GROUP, INC.**

October 3, 2006

TABLE OF CONTENTS
| **Part I. Financial  Information** | ** **                                                                                                                                       |
|------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------|
|                               |                                                                                                                                             |   |
| Item 1.                            | Financial  Statements:                                                                                                                           |   |
|                               |                                                                                                                                             |   |
|                               | Consolidated Balance Sheets (unaudited), October 3,  2006 and January 3, 2006                                                                    |   |
|                               |                                                                                                                                             |   |
|                               | Consolidated Statements of Operations (unaudited), for  the third quarter and year to date periods ended  October 3, 2006 and September 27, 2005 |   |
|                               |                                                                                                                                             |   |
|                               | Consolidated Statements of Cash Flows (unaudited), for  the year to date periods ended October 3, 2006 and September 27, 2005                    |   |
|                               |                                                                                                                                             |   |
|                               | Consolidated Statement of Changes in Stockholders’  Deficit (unaudited), for the year to date period ended October 3, 2006                  |   |
|                               |                                                                                                                                             |   |
|                               | Notes to the Consolidated Financial Statements  (unaudited)                                                                                      |   |
|                               |                                                                                                                                             |   |
| Item 2.                            | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                      |   |
|                               |                                                                                                                                             |   |
| Item 3.                            | Quantitative  and Qualitative Disclosures about Market Risk                                                                                      |   |
|                               |                                                                                                                                             |   |
| Item 4.                            | Controls  and Procedures                                                                                                                         |   |
|                               |                                                                                                                                             |   |
| **Part  II. Other Information**    | ** **                                                                                                                                       |
|                               |                                                                                                                                             |   |
| Item 1.                            | Legal  Proceedings                                                                                                                               |   |
|                               |                                                                                                                                             |   |
| Item 1A.                           | Risk Factors                                                                                                                                     |   |
|                               |                                                                                                                                             |   |
| Item 6.                            | Exhibits                                                                                                                                         |   |

 

2

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**NEW WORLD RESTAURANT GROUP, INC.**

**CONSOLIDATED BALANCE SHEETS**

**AS OF OCTOBER 3, 2006 AND JANUARY 3, 2006**

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

**(unaudited)**
| ** **                                                                                                                                                                  | ** ** | **October 3,** | ** ** | **January 3,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|---------------------|------------|
| ** **                                                                                                                                                                  | ** ** | **2006**            | ** ** | **2006**            | ** ** |
| **ASSETS**                                                                                                                                                                  | ** ** | ** **          | ** ** | ** **          | ** ** |
| Current assets:                                                                                                                                                             |       |                |       |                |       |
| Cash and cash  equivalents                                                                                                                                                  |       | $                   | 4,234      |                | $          | 1,556 |   |
| Restricted cash                                                                                                                                                             |       | 2,202               |       | 2,554               |       |
| Franchise and  other receivables, net of allowance of $629 and $480, respectively                                                                                           |       | 5,858               |       | 5,506               |       |
| Inventories                                                                                                                                                                 |       | 4,943               |       | 5,072               |       |
| Prepaid expenses  and other current assets                                                                                                                                  |       | 4,809               |       | 4,506               |       |
| Total current  assets                                                                                                                                                       |       | 22,046              |       | 19,194              |       |
|                                                                                                                                                                        |       |                |       |                |       |
| Restricted cash  long-term                                                                                                                                                  |       | 579                 |       | 595                 |       |
| Property, plant  and equipment, net                                                                                                                                         |       | 33,285              |       | 33,359              |       |
| Trademarks and  other intangibles, net                                                                                                                                      |       | 63,806              |       | 67,717              |       |
| Goodwill                                                                                                                                                                    |       | 4,875               |       | 4,875               |       |
| Debt issuance  costs and other assets, net                                                                                                                                  |       | 5,579               |       | 5,184               |       |
|                                                                                                                                                                        |       |                |       |                |       |
| Total assets                                                                                                                                                                |       | $                   | 130,170    |                | $          | 130,924 |   |
|                                                                                                                                                                        |       |                |       |                |       |
| **LIABILITIES AND STOCKHOLDERS’  DEFICIT**                                                                                                                             | ** ** | ** **          | ** ** | ** **          | ** ** |
| Current  liabilities:                                                                                                                                                       |       |                |       |                |       |
| Accounts payable                                                                                                                                                            |       | $                   | 5,188      |                | $          | 5,848 |   |
| Accrued expenses                                                                                                                                                            |       | 27,303              |       | 24,789              |       |
| Short term debt  and current portion of long-term debt                                                                                                                      |       | 3,130               |       | 280                 |       |
| Current portion  of obligations under capital leases                                                                                                                        |       | 66                  |       | 19                  |       |
| Total current  liabilities                                                                                                                                                  |       | 35,687              |       | 30,936              |       |
|                                                                                                                                                                        |       |                |       |                |       |
| Senior notes and  other long-term debt, net of discount                                                                                                                     |       | 167,290             |       | 160,560             |       |
| Obligations  under capital leases                                                                                                                                           |       | 115                 |       | 29                  |       |
| Other  liabilities                                                                                                                                                          |       | 8,438               |       | 8,610               |       |
| Mandatorily  redeemable, Series Z Preferred Stock, $.001 par value, $1,000 per share  liquidation value; 2,000,000 shares authorized; 57,000 shares issued and  outstanding |       | 57,000              |       | 57,000              |       |
| Total  liabilities                                                                                                                                                          |       | 268,530             |       | 257,135             |       |
|                                                                                                                                                                        |       |                |       |                |       |
| Commitments and  contingencies                                                                                                                                              |       |                |       |                |       |
|                                                                                                                                                                        |       |                |       |                |       |
| Stockholders’  deficit:                                                                                                                                                |       |                |       |                |       |
| Common stock,  $.001 par value; 25,000,000 shares authorized; 10,593,085 and 10,065,072  shares issued and outstanding                                                      |       | 11                  |       | 10                  |       |
| Additional  paid-in capital                                                                                                                                                 |       | 176,682             |       | 176,018             |       |
| Unamortized  stock compensation                                                                                                                                             |       | —              |       | (68                 | )          |
| Accumulated  deficit                                                                                                                                                        |       | (315,053            | )          | (302,171            | )          |
| Total  stockholders’ deficit                                                                                                                                           |       | (138,360            | )          | (126,211            | )          |
|                                                                                                                                                                        |       |                |       |                |       |
| Total liabilities and  stockholders’ deficit                                                                                                                           |       | $                   | 130,170    |                | $          | 130,924 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

3

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**NEW WORLD RESTAURANT GROUP, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**FOR THE THIRD QUARTER AND YEAR TO DATE PERIODS ENDEDOCTOBER 3, 2006 AND SEPTEMBER 27, 2005**

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

**(unaudited)**
| ** **                                                              | ** ** | **Third quarter ended:** | ** ** | **Year to date ended:** | ** ** |
|-------------------------------------------------------------------------|------------|------------------------------------|------------|----------------------------------------|------------|
| ** **                                                              | ** ** | **October 3,**                | ** ** | **September 27,**                 | ** ** | **October 3,** | ** ** | **September 27,** | ** ** |
| ** **                                                              | ** ** | **2006**                           | ** ** | **2005**                               | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues:                                                               |       |                               |       |                                   |       |   |   |   |   |
| Restaurant sales                                                        |       | $                                  | 89,213     |                                   | $          | 87,937 |   | $ | 271,300 |   | $ | 265,912 |   |
| Manufacturing  revenues                                                 |       | 5,052                              |       | 5,270                                  |       | 15,126 |   | 14,905 |   |
| Franchise and  license related revenues                                 |       | 1,487                              |       | 1,575                                  |       | 4,358 |   | 4,373 |   |
|                                                                    |       |                               |       |                                   |       |   |   |   |   |
| Total revenues                                                          |       | 95,752                             |       | 94,782                                 |       | 290,784 |   | 285,190 |   |
|                                                                    |       |                               |       |                                   |       |   |   |   |   |
| Cost of sales:                                                          |       |                               |       |                                   |       |   |   |   |   |
| Restaurant costs                                                        |       | 72,187                             |       | 73,941                                 |       | 219,677 |   | 219,141 |   |
| Manufacturing  costs                                                    |       | 5,445                              |       | 4,980                                  |       | 15,952 |   | 13,880 |   |
|                                                                    |       |                               |       |                                   |       |   |   |   |   |
| Total cost of sales                                                     |       | 77,632                             |       | 78,921                                 |       | 235,629 |   | 233,021 |   |
|                                                                    |       |                               |       |                                   |       |   |   |   |   |
| Gross profit                                                            |       | 18,120                             |       | 15,861                                 |       | 55,155 |   | 52,169 |   |
|                                                                    |       |                               |       |                                   |       |   |   |   |   |
| Operating expenses:                                                     |       |                               |       |                                   |       |   |   |   |   |
| General and  administrative expenses                                    |       | 9,750                              |       | 8,868                                  |       | 30,038 |   | 26,857 |   |
| Depreciation and  amortization                                          |       | 2,640                              |       | 5,798                                  |       | 14,238 |   | 19,583 |   |
| Loss on sale,  disposal or abandonment of assets, net                   |       | 193                                |       | 104                                    |       | 206 |   | 269 |   |
| Charges of  integration and reorganization cost                         |       | —                             |       | 1                                      |       | — |   | 6 |   |
| Impairment  charges and other related costs                             |       | 51                                 |       | 205                                    |       | 134 |   | 1,484 |   |
|                                                                    |       |                               |       |                                   |       |   |   |   |   |
| Income from operations                                                  |       | 5,486                              |       | 885                                    |       | 10,539 |   | 3,970 |   |
| Other expense (income):                                                 |       |                               |       |                                   |       |   |   |   |   |
| Interest  expense, net                                                  |       | 4,749                              |       | 5,805                                  |       | 14,670 |   | 17,497 |   |
| Prepayment  penalty upon redemption of $160 Million Notes               |       | —                             |       | —                                 |       | 4,800 |   | — |   |
| Write-off of  debt issuance costs upon redemption of $160 Million Notes |       | —                             |       | —                                 |       | 3,956 |   | — |   |
| Other                                                                   |       | (15                                | )          | (106                                   | )          | (5 | ) | (232 | ) |
|                                                                    |       |                               |       |                                   |       |   |   |   |   |
| Income (loss) before  income taxes                                      |       | 752                                |       | (4,814                                 | )          | (12,882 | ) | (13,295 | ) |
|                                                                    |       |                               |       |                                   |       |   |   |   |   |
| Provision for income  taxes                                             |       | —                             |       | —                                 |       | — |   | — |   |
|                                                                    |       |                               |       |                                   |       |   |   |   |   |
| Net income (loss)                                                       |       | $                                  | 752        |                                   | $          | (4,814 | ) | $ | (12,882 | ) | $ | (13,295 | ) |
|                                                                    |       |                               |       |                                   |       |   |   |   |   |
| Net income (loss) per  common share – Basic                        |       | $                                  | 0.07       |                                   | $          | (0.49 | ) | $ | (1.25 | ) | $ | (1.35 | ) |
| Net income (loss) per  common share – Diluted                      |       | $                                  | 0.07       |                                   | $          | (0.49 | ) | $ | (1.25 | ) | $ | (1.35 | ) |
|                                                                    |       |                               |       |                                   |       |   |   |   |   |
| Weighted average number  of common shares outstanding:                  |       |                               |       |                                   |       |   |   |   |   |
| Basic                                                                   |       | 10,593,085                         |       | 9,868,623                              |       | 10,276,464 |   | 9,859,407 |   |
| Diluted                                                                 |       | 11,036,527                         |       | 9,868,623                              |       | 10,276,464 |   | 9,859,407 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

4

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**NEW WORLD RESTAURANT GROUP, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**FOR THE YEAR TO DATE PERIODS ENDED OCTOBER 3, 2006 ANDSEPTEMBER 27, 2005**

**(in thousands)**

**(unaudited)**
| ** **                                                                       | ** ** | **October 3,** | ** ** | **September 27,** | ** ** |
|----------------------------------------------------------------------------------|------------|---------------------|------------|------------------------|------------|
| ** **                                                                       | ** ** | **2006**            | ** ** | **2005**               | ** ** |
| OPERATING ACTIVITIES:                                                            |       | (12,882             | )          | (13,295                | )          |
| Net loss                                                                         |       |                |       |                   |       |
| Adjustments to  reconcile net loss to net cash provided by operating activities: |       |                |       |                   |       |
| Depreciation and  amortization                                                   |       | 14,238              |       | 19,583                 |       |
| Stock based  compensation expense                                                |       | 546                 |       | 52                     |       |
| Loss, net of  gains, on disposal of assets                                       |       | 206                 |       | 269                    |       |
| Impairment  charges and other related costs                                      |       | 134                 |       | 1,484                  |       |
| Integration and  reorganization costs                                            |       | —              |       | 6                      |       |
| Provision for  (recovery of) losses on accounts receivable, net                  |       | 158                 |       | (78                    | )          |
| Amortization of  debt issuance and debt discount costs                           |       | 620                 |       | 1,386                  |       |
| Write-off of  debt issuance costs                                                |       | 3,956               |       | —                 |       |
| Accretion of  paid-in-kind interest                                              |       | 1,113               |       | —                 |       |
| Changes in  operating assets and liabilities:                                    |       |                |       |                   |       |
| Franchise and  other receivables                                                 |       | (509                | )          | 938                    |       |
| Accounts payable  and accrued expenses                                           |       | 1,832               |       | (7,587                 | )          |
| Other assets and  liabilities                                                    |       | 9                   |       | 3                      |       |
|                                                                             |       |                |       |                   |       |
| Net cash  provided by operating activities                                       |       | 9,421               |       | 2,761                  |       |
|                                                                             |       |                |       |                   |       |
| INVESTING ACTIVITIES:                                                            |       |                |       |                   |       |
| Purchase of property  and equipment                                              |       | (10,570             | )          | (5,775                 | )          |
| Proceeds from the sale  of equipment                                             |       | 165                 |       | 97                     |       |
|                                                                             |       |                |       |                   |       |
| Net cash used in  investing activities                                           |       | (10,405             | )          | (5,678                 | )          |
|                                                                             |       |                |       |                   |       |
| FINANCING ACTIVITIES:                                                            |       |                |       |                   |       |
| Proceeds from line of  credit                                                    |       | 24                  |       | 5,445                  |       |
| Repayments of line of  credit                                                    |       | (24                 | )          | (5,460                 | )          |
| Repayment of other  borrowings                                                   |       | —              |       | (14                    | )          |
| Payments under capital  lease obligations                                        |       | (34                 | )          | —                 |       |
| Repayment of notes  payable                                                      |       | (160,000            | )          | —                 |       |
| Borrowings under First  Lien                                                     |       | 80,000              |       | —                 |       |
| Repayments under First  Lien                                                     |       | (950                | )          | —                 |       |
| Borrowing under Second  Lien                                                     |       | 65,000              |       | —                 |       |
| Borrowings under  Subordinated Note                                              |       | 24,375              |       | —                 |       |
| Proceeds upon stock  option and warrant exercises                                |       | 187                 |       | 21                     |       |
| Debt issuance costs                                                              |       | (4,916              | )          | —                 |       |
|                                                                             |       |                |       |                   |       |
| Net cash  provided by (used in) financing activities                             |       | 3,662               |       | (8                     | )          |
|                                                                             |       |                |       |                   |       |
| Net increase (decrease)  in cash and cash equivalents                            |       | 2,678               |       | (2,925                 | )          |
| Cash and cash  equivalents, beginning of period                                  |       | 1,556               |       | 9,752                  |       |
| Cash and cash equivalents, end of period                                         |       | $                   | 4,234      |                   | $          | 6,827 |   |
|                                                                                  |            |                     |            |                        |            |  |  |

 

Theaccompanying notes are an integral part of these consolidated financial statements.

5

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**NEW WORLD RESTAURANT GROUP, INC.**

**CONSOLIDATEDSTATEMENT OF CHANGES IN STOCKHOLDERS’ DEFICIT**

**FOR THE YEAR TO DATE PERIOD ENDED OCTOBER 3, 2006**

(inthousands, except share information)

(unaudited)
| ** **                                      | ** ** | ** **            | ** ** | ** **       | ** ** | **Additional** | ** ** | **Unamortized**  | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|------------------|------------|----------------|------------|------------------|------------|-----------------|------------|------------|------------|
| ** **                                      | ** ** | **Common Stock** | ** ** | **Paid In** | ** ** | **Stock**      | ** ** | **Deficit**      | ** ** | ** **      | ** ** |
| ** **                                      | ** ** | **Shares**            | ** ** | **Amount**       | ** ** | **Capital**    | ** ** | **Compensation** | ** ** | **Amount**      | ** ** | **Total**  | ** ** |
|                                            |       |                  |       |             |       |           |       |             |       |            |       |       |       |
| Balance, January 3, 2006                        |       | 10,065,072            |       | $                | 10         |           | $          | 176,018          |       | $               | (68        | )          | $          | (302,171 | ) | $ | (126,211 | ) |
| Net  loss                                       |       | —                |       | —           |       | —         |       | —           |       | (12,882         | )          | (12,882    | )          |
| Common  stock issued upon stock option exercise |       | 45,151                |       | —           |       | 132            |       | —           |       |            |       | 132        |       |
| Common  stock issued upon warrant exercise      |       | 482,862               |       | 1                |       | 54             |       | —           |       |            |       | 55         |       |
| Impact  of adoption of SFAS 123R                |       |                  |       |             |       | (68            | )          | 68               |       |            |       | —     |       |
| Stock  based compensation expense               |       | —                |       | —           |       | 546            |       | —           |       | —          |       | 546        |       |
|                                            |       |                  |       |             |       |           |       |             |       |            |       |       |       |
| Balance, October 3, 2006                        |       | 10,593,085            |       | $                | 11         |           | $          | 176,682          |       | $               | —     |       | $          | (315,053 | ) | $ | (138,360 | ) |

 

Theaccompanying notes are an integral part of this consolidated financialstatement.

6

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**NEW WORLD RESTAURANT GROUP, INC.**

Notes toConsolidated Financial Statements (Unaudited)

Quarter and Year to Date periods ended October 3, 2006 andSeptember 27, 2005

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

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”). As of October 3, 2006, the Company owns, franchises or licenses variousrestaurant concepts under the brand names of Einstein Bros. Bagels (“EinsteinBros.”), Noah’s New York Bagels (“Noah’s”), Manhattan Bagel Company (“Manhattan”),Chesapeake Bagel Bakery (“Chesapeake”) and New World Coffee (“New World”). Ourbusiness is subject to seasonal trends. Generally, our revenues and results ofoperations in the first fiscal quarter are somewhat lower than in the otherthree fiscal quarters, while revenues in the fourth fiscal quarter tend to bethe most significant.

The accompanying consolidated financial statements as of October 3, 2006 and for thequarter and year to date periods ended October 3, 2006 and September 27, 2005 havebeen prepared without audit. The balance sheet information as of January 3,2006 has been derived from our audited financial statements. The informationfurnished herein reflects all adjustments (consisting only of normal recurringaccruals and adjustments), which are, in our opinion, necessary to fairly statethe interim operating results for the respective periods.  However, theseoperating results are not necessarily indicative of the results expected forthe full fiscal year.  Certain information and footnote disclosuresnormally included in annual financial statements prepared in accordance with generallyaccepted accounting principles in the United States have been omitted pursuantto SEC rules and regulations. The notes to the consolidated financialstatements (unaudited) should be read in conjunction with the notes to theconsolidated financial statements contained in our annual report on Form 10-Kfor the fiscal year ended January 3, 2006. We believe that the disclosures aresufficient for interim financial reporting purposes.

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

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

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

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

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

7

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Our stock-based compensation cost for the thirdquarter of 2006 and 2005 was $139,000 and $17,000, respectively and has beenincluded in general and administrative expenses. For the year to date periodended October 3, 2006 and September 27, 2005, stock based compensation expensewas $546,000 and $52,000, respectively. The impact of adoption of SFAS No. 123Rhad the effect of reducing our income per share by $0.01 and increasing ourloss per share by $0.05 for third quarter and year to date period ended October3, 2006, respectively. No tax benefits were recognized for these costs due toour recurring cumulative losses. Results for fiscal year 2005 have not beenrestated. Had compensation cost for stock options granted to employees beendetermined on the basis of fair value as computed using the assumptions herein,net loss and loss per share would have been increased to the following proforma amounts (in thousands of dollars, except per share amounts):
|                                                | ** ** | **Quarter ended:** | ** ** | **Year to date:** | ** ** |
|------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                     | ** ** | **Sept 27,**       | ** ** | **Sept 27,**           | ** ** |
| ** **                                     | ** ** | **2005**                | ** ** | **2005**                    | ** ** |
| Net loss, as  reported                         |       | $                       | (4,814     | )                           | $          | (13,295 | ) |
| Deduct: fair  value based compensation expense |       | (199                    | )          | (538                        | )          |
| Pro forma net  loss                            |       | $                       | (5,013     | )                           | $          | (13,833 | ) |
| Basic and  diluted loss per common share:      |       |                    |       |                        |       |
| As reported                                    |       | $                       | (0.49      | )                           | $          | (1.35 | ) |
| Pro forma                                      |       | $                       | (0.51      | )                           | $          | (1.40 | ) |

 

The fair value of stock options is estimated using theBlack-Scholes option-pricing model with the following weighted averageassumptions:
|                                              | ** ** | **Third quarter ended:** | ** ** | **Year to date ended:** | ** ** |
|----------------------------------------------|------------|------------------------------------|------------|----------------------------------------|------------|
| ** **                                   | ** ** | **Oct 3,**                    | ** ** | **Sept 27,**                      | ** ** | **Oct 3,** | ** ** | **Sept 27,** | ** ** |
| ** **                                   | ** ** | **2006**                           | ** ** | **2005**                               | ** ** | **2006** | ** ** | **2005** | ** ** |
| Expected life of  options from date of grant |       | 4.0 years                          |       | *                                      |       | 4.0 years |   | 4.0 years |   |
| Risk-free  interest rate                     |       | 4.8                                | %          | *                                      |       | 4.4 - 4.8 | % | 3.6 - 3.9 | % |
| Volatility                                   |       | 100.0                              | %          | *                                      |       | 100.0 | % | 100.0 | % |
| Assumed dividend yield                       |       | 0.0                                | %          | *                                      |       | 0.0 | % | 0.0 | % |

 

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* There were no stock options granted during thirdquarter ended September 27, 2005.

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

8

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**StockOption Plans**

*1994 and 1995 Plans*

Our 1994 Stock Plan (1994 Plan) provided for thegranting to employees of incentive stock options and for the granting toemployees and consultants of non-statutory stock options and stock purchaserights. On November 21, 2003, the board of directors terminated theauthority to issue any additional options under the 1994 Plan. At October 3,2006, options to purchase 17 shares of common stock at an exercise price of$210.71 per share and a remaining contractual life of 0.73 years remainedoutstanding under this plan.

Our 1995 Directors’Stock Option Plan (Directors’ Option Plan) provided for the automatic grant ofnon-statutory stock options to non-employee directors of the Company. OnDecember 19, 2003, our board of directors terminated the authority toissue any additional options under the Directors’ Option Plan. At October 3,2006, options to purchase 2,324 shares of common stock at a weighted averageexercise price of $32.43 per share and a weighted average remaining contractuallife of 5.9 years remained outstanding under this plan.

*2003Executive Employee Incentive Plan*

On November 21,2003, our board of directors adopted the Executive Employee Incentive Plan,amended on December 19, 2003 (2003 Plan). The 2003 Plan provides for grantingincentive stock options to employees and granting non-statutory stock optionsto employees and consultants. Unless terminated sooner, the 2003 Plan willterminate automatically in December 2013. The board of directors has theauthority to amend, modify or terminate the 2003 Plan, subject to any requiredapproval by our stockholders under applicable law or upon advice of counsel. Nosuch action may affect any options previously granted under the 2003 Planwithout the consent of the holders. There are 1,150,000 shares issuable pursuantto options granted under the 2003 Plan. Options are granted with an exerciseprice equal to the fair market value on the date of grant, have a contractuallife of ten years and typically vest over a three-year service period.Generally, 50% of options granted vest based solely upon the passage of time.We recognize compensation costs for these awards using a graded vestingattribution method over the requisite service period. The remaining 50% ofoptions granted vest based on service and performance conditions. Options thatdo not vest due to the failure to achieve specific financial performancecriteria are forfeited. Options to purchase approximately 263,179 shares of ourcommon stock, which are not yet exercisable, are subject to company performanceconditions. We recognize compensation costs for performance based options overthe requisite service period when conditions for achievement become probable.We expect that all of the non-vested awards at October 3, 2006 will vest basedon company performance. As of October 3, 2006, there were 217,916 sharesreserved for future issuance under the 2003 Plan.

*2004Stock Option Plan for Independent Directors*

On December 19,2003, our board of directors adopted the Stock Option Plan for IndependentDirectors, effective January 1, 2004, (2004 Directors’ Plan). Our board ofdirectors may amend, suspend, or terminate the 2004 Directors’ Plan at anytime, provided, however, that no such action may adversely affect anyoutstanding option without the option holders consent. A total of 200,000shares of common stock have been reserved for issuance under the 2004 Directors’Plan. The 2004 Directors’ Plan provides for the automatic grant ofnon-statutory stock options to independent directors on January 1 of each yearand a prorated grant of options for any director elected during the year.Options are granted with an exercise price equal to the fair market value onthe date of grant, become exercisable six months after the grant date and areexercisable for 5 years from the date of grant unless earlier terminated. As ofOctober 3, 2006, there were 64,192 shares reserved for future issuance underthe 2004 Directors’ Plan.

9

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Transactionsduring the year to date period ending October 3, 2006 were as follows:
|                                          | ** ** | ** **  | ** ** | **Weighted** | ** ** | **Weighted**          | ** ** | ** **    | ** ** |
|------------------------------------------|------------|-------------|------------|--------------|------------|-----------------------|------------|---------------|------------|
| ** **                               | ** ** | **Number**  | ** ** | **Average**  | ** ** | **Average**           | ** ** | **Aggregate** | ** ** |
| ** **                               | ** ** | **of**      | ** ** | **Exercise** | ** ** | **Remaining**         | ** ** | **Intrinsic** | ** ** |
| ** **                               | ** ** | **Options** | ** ** | **Price**    | ** ** | **Life (Years)** | ** ** | **Value**     | ** ** |
| Outstanding,  January 4, 2006            |       | 997,152     |       | $            | 3.31       |                  |       |          |       |   |
| Granted                                  |       | 152,500     |       | $            | 4.50       |                  |       |          |       |   |
| Exercised                                |       | (45,151     | )          | $            | 2.92       |                  |       |          |       |   |
| Forfeited                                |       | (79,419     | )          | $            | 2.64       |                  |       |          |       |   |
| Outstanding,  October 3, 2006            |       | 1,025,082   |       | $            | 3.58       |                  | 7.39       |          | $          | 5,045,260 |   |
| Exercisable and Vested,  October 3, 2006 |       | 498,705     |       | $            | 3.61       |                  | 6.30       |          | $          | 2,438,354 |   |

 
|                                     | ** ** | ** **  | ** ** | **Weighted**        | ** ** |
|-------------------------------------|------------|-------------|------------|---------------------|------------|
| ** **                          | ** ** | **Number**  | ** ** | **Average**         | ** ** |
| ** **                          | ** ** | **of**      | ** ** | **Grant Date** | ** ** |
| ** **                          | ** ** | **Options** | ** ** | **Fair Value** | ** ** |
| Non-vested  shares, January 4, 2006 |       | 643,915     |       | $                   | 2.13       |   |
| Granted                             |       | 152,500     |       | $                   | 4.50       |   |
| Vested                              |       | (190,619    | )          | $                   | 2.12       |   |
| Forfeited                           |       | (79,419     | )          | $                   | 2.64       |   |
| Non-vested shares,  October 3, 2006 |       | 526,377     |       | $                   | 2.50       |   |

 

At October 3,2006, we have approximately $0.4 million of total unrecognized compensationcost related to non-vested awards granted under our option plans, which weexpect to recognize over a weighted average period of ten months. Totalcompensation costs related to the options outstanding as of October 3, 2006will be fully recognized by first quarter of fiscal 2009.

**Warrants**

As of October 3,2006, there were 332 warrants outstanding and exercisable to purchase shares ofour common stock. These warrants have an exercise price of $316.67 and expireon October 25, 2006.

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**3.****             ****Supplemental Cash FlowInformation**
|                                                           | ** ** | **Oct 3,**                              | ** ** | **Sept 27,** | ** ** |
|-----------------------------------------------------------|------------|----------------------------------------------|------------|-------------------|------------|
| ** **                                                | ** ** | **2006**                                     | ** ** | **2005**          | ** ** |
| ** **                                                | ** ** | **(in thousands of dollars)** | ** ** |
| Cash paid during  the year to date period ended:          |       |                                         |       |              |       |
| Interest                                                  |       | $                                            | 11,820     |              | $          | 21,411 |   |
| Prepayment penalty upon redemption of $160 Million  Notes |       | $                                            | 4,800      |              | $          | — |   |
|                                                      |       |                                         |       |              |       |
| Non-cash  investing activities:                           |       |                                         |       |              |       |
| Non-cash purchase of equipment through capital  leasing   |       | $                                            | 168        |              | $          | — |   |

 

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

Inventories, which consist of food, beverage, papersupplies and bagel ingredients, are stated at the lower of cost or market, withcost being determined by the first-in, first-out method. Inventories consist ofthe following:
|                   | ** ** | **October 3,**                          | ** ** | **January 3,** | ** ** |
|-------------------|------------|----------------------------------------------|------------|---------------------|------------|
| ** **        | ** ** | **2006**                                     | ** ** | **2006**            | ** ** |
| ** **        | ** ** | **(in thousands of dollars)** | ** ** |
| Finished goods    |       | $                                            | 3,847      |                | $          | 3,883 |   |
| Raw materials     |       | 1,096                                        |       | 1,189               |       |
|              |       |                                         |       |                |       |
| Total inventories |       | $                                            | 4,943      |                | $          | 5,072 |   |

 

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

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

Goodwill and otherintangible assets with indefinite lives are not subject to amortization but aretested for impairment annually or more frequently if events or changes incircumstances indicate that the asset might be impaired. SFAS No. 142, Goodwilland Other Intangible Assets, requires a two-step approach for testingimpairment of goodwill. For goodwill, the fair value of each reportingunit is compared to its carrying value to determine whether an indication ofimpairment exists. If impairment is indicated, the fair value of the reportingunit’s goodwill is determined by allocating the unit’s fair value to its assetsand liabilities (including any unrecognized intangible assets) as if thereporting unit had been acquired in a business combination. For otherindefinite lived intangibles, the fair value is compared to the carrying value.The amount ofimpairment for goodwill and other intangible assets is measured as the excessof its carrying amount over its fair value. Intangible assets not subject toamortization consist primarily of the Einstein Bros. and Manhattan trademarks.

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

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

 

During the year todate period ended October 3, 2006, there were no events or changes incircumstances that indicated that our intangible assets might be impaired ormay not be recoverable.

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

Senior notes andother long-term debt consist of the following (in thousands of dollars):
|                                                                | ** ** | **October 3,** | ** ** | **January 3,** | ** ** |
|----------------------------------------------------------------|------------|---------------------|------------|---------------------|------------|
| ** **                                                     | ** ** | **2006**            | ** ** | **2006**            | ** ** |
|                                                           |       |                |       |                |       |
| $80 Million  First Lien Term Loan                              |       | $                   | 79,050     |                | $          | — |   |
| $65 Million  Second Lien Term Loan                             |       | 65,000              |       | —              |       |
| $25 Million  Subordinated Note                                 |       | 25,530              |       | —              |       |
| $160 Million  Notes                                            |       | —              |       | 160,000             |       |
| New Jersey  Economic Development                               |       |                |       |                |       |
| Authority Note Payable                                         |       | 840                 |       | 840                 |       |
|                                                           |       | $                   | 170,420    |                | $          | 160,840 |   |
| Less current  portion of senior notes and other long-term debt |       | 3,130               |       | 280                 |       |
| Senior notes and  other long-term debt                         |       | $                   | 167,290    |                | $          | 160,560 |   |

 

**Debt Redemption andRefinancing**

On February 28,2006, we completed the refinancing of the AmSouth Revolver and $160Million Notes. Our newdebt obligations consist of the following:

·                  $15 million revolving creditfacility (Revolving Facility);

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

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

·                  $25 million subordinated note(Subordinated Note).

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

**Revolving Facility**

The RevolvingFacility has a maturity date of March 31, 2011 and provides for interest basedupon the prime rate or LIBOR plus a margin. The margin may increase or decreaseup to 0.25% based upon our consolidated leverage ratio as defined in theagreement. The initial margin is at prime plus 2.00% or LIBOR plus 3.00%. Thisfacility may be used in whole or in part for letters of credit.  As of October 3, 2006, the stated interestrate under the Revolving Facility was at prime plus 2.00%, or 10.25%.

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

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We are required to pay an unused credit line fee of0.5% per annum on the average daily unused amount. The unused line fee ispayable quarterly in arrears. Additionally, we are required to pay a letter ofcredit fee based on the ending daily undrawn face amount for each letter ofcredit issued, of an applicable margin being based on our consolidated leverageratio with a minimum and maximum applicable margin of 2.75% and 3.25%,respectively, plus a 0.5% arranger fee payable quarterly. Letters of creditreduce our availability under the Revolving Facility. At October 3, 2006, wehad $6.9 million in letters of credit outstanding. The letters of credit expireon various dates during 2007, are automatically renewable for one additionalyear and are payable upon demand in the event that we fail to pay theunderlying obligation. Our availability under the Revolving Facility was $8.1million at October 3, 2006.

The RevolvingFacility contains usual and customary covenants including consolidated leverageratios, fixed charge coverage ratios, limitations on capital expenditures, etc.The ratio covenants are based on a Consolidated EBITDA calculation (asdefined in our loan agreement) and are measured on a twelve month period endingon the last day of each fiscal quarter. The loan is guaranteed by our material subsidiaries.  The Revolving Facility and the relatedguarantees are secured by a first priority security interest in all of ourassets and our material subsidiaries, including a pledge of 100% of ourinterest in all shares of capital stock (or other ownership or equityinterests) of each material subsidiary.  Asof October 3, 2006, we were in compliance with all our financial and operatingcovenants.

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

**First Lien Term Loan**

The First LienTerm Loan has a maturity date of March 31, 2011 and provides for a floatinginterest rate based upon the prime rate or LIBOR plus a margin. The margin mayincrease or decrease 0.25% based upon our consolidated leverage ratio asdefined in the agreement. The initial margin is at prime plus 2.00% and/orLIBOR plus 3.00% and is payable in arrears quarterly and/or at the LIBOR date,dependent upon the rate in effect. As of October 3, 2006, the stated interestrate under the First Lien Term Loan was 8.45%, which represents a weightedaverage of 6-Month LIBOR plus 3.00%, or 8.45%, 3-Month LIBOR plus 3.00%, or8.37%, and prime plus 2.00%, or 10.25%. The effective interest rate sinceinception was 8.36%.  The facility isfully amortizing with annual aggregate principal reductions payable inquarterly installments over the term of the loan as follows:
| For the 2006 fiscal year ending  January 2, 2007  | $  1.425 million |
|---------------------------------------------------|----------------------------|
| For the 2007 fiscal year ending January 1, 2008   | $  3.325 million |
| For the 2008 fiscal year ending December 30, 2008 | $  5.950 million |
| For the 2009 fiscal year ending December 29, 2009 | $11.250 million            |
| For the 2010 fiscal year ending December 28, 2010 | $32.150 million            |
| For the 2011 fiscal quarter ending March 29, 2011 | $25.900 million            |

 

In addition to therepayment schedule discussed above, the First Lien Term Loan also requiresadditional principal reductions based upon a percentage of excess cash flow asdefined in the loan agreement in any fiscal year. The First Lien Term Loan alsoprovides us the opportunity to repay the Second Lien Term Loan or theSubordinated Note with the proceeds of a capital stock offering provided thatcertain consolidated leverage ratios are met.

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

14

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The First LienTerm Loan has usual and customary covenants including consolidated leverageratios, fixed charge coverage ratios, limitations on capital expenditures, etc.The ratio covenants are based on a Consolidated EBITDA calculation (asdefined in our loan agreement) and are measured on a twelve month period endingon the last day of each fiscal quarter. The loan is guaranteed by our material subsidiaries.  The First Lien Term Loan and the relatedguarantees are secured by a first priority security interest in all of ourassets and our material subsidiaries, including a pledge of 100% of ourinterest in all shares of capital stock (or other ownership or equityinterests) of each material subsidiary.  Asof October 3, 2006, we were in compliancewith all our financial and operating covenants.

Approximately $2.2 million in debt issuance costs havebeen capitalized and are being amortized using the effective interest methodover the term of the First Lien Term Loan.

**Second Lien Term Loan**

The Second LienTerm Loan has a maturity date of February 28, 2012 and provides for a floatinginterest rate based upon the prime rate plus 5.75% or LIBOR plus 6.75%.Interest is payable in arrears on a quarterly basis. As of October 3, 2006, thestated interest rate under the Second Lien Term Loan was at LIBOR plus 6.75%,or 12.21% and the effective interest rate since inception was 11.82%.  The Second Lien Term Loan has a prepaymentpenalty of 2.0% and 1.0% of the amount of any such optional prepayment thatoccurs prior to the first or second anniversary date, respectively. The SecondLien Term Loan requires principal reductions based upon a percentage of excesscash flow (as defined in the credit agreement) in any fiscal year and is alsosubject to certain mandatory prepayment provisions. In the event that we havenot extended the maturity date of the Series Z to a date that is on or afterJuly 26, 2012 or redeemed the Series Z by March 30, 2009, then the Second LienTerm Loan will mature on March 30, 2009.

The Second LienTerm Loan has usual and customary covenants including consolidated leverageratios, fixed charge coverage ratios, limitations on capital expenditures, etc.The ratio covenants are based on a Consolidated EBITDA calculation (asdefined in our loan agreement) and are measured on a twelve month period endingon the last day of each fiscal quarter. The loan is guaranteed by our material subsidiaries.  The Second Lien Term Loan and the relatedguarantees are secured by a second priority security interest in all our assetsand our material subsidiaries, including a pledge of 100% of our interest inall shares of capital stock (or other ownership or equity interests) of eachmaterial subsidiary.  As ofOctober 3, 2006, we were in compliance with all our financial and operating covenants.

Approximately $1.7 million in debt issuance costs havebeen capitalized and are being amortized using the effective interest methodover the term of the Second Lien Term Loan.

**Subordinated Note**

The SubordinatedNote has a maturity date of February 28, 2013, carries a fixed interest rate of13.75% per annum and requires a quarterly cash interest payment in arrears at6.5% and quarterly paid-in kind interest that is added to the principal balanceoutstanding at 7.25%. As of October 3, 2006, the effective interest rate sinceinception was 14.13%. The Subordinated Note is held by Greenlight Capital andits affiliates (collectively referred to as Greenlight). Based on an originalissue discount of 2.5%, proceeds of approximately $24.4 million were loaned tothe Company. The Subordinated Note is subject to certain mandatory prepaymentprovisions. In the event that we have not extended the maturity date of theSeries Z to a date that is on or after July 26, 2013 or redeemed the Series Zby June 29, 2009, then the Subordinated Note will mature on June 29, 2009.

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The SubordinatedNote has usual and customary covenants including consolidated leverage ratios,fixed charge coverage ratios, limitations on capital expenditures, etc. Theloan is guaranteed by our material subsidiaries.   The Subordinated Note is unsecured.  As of October 3, 2006, we were incompliance with all our financial and operating covenants.

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

**$160 Million Notes**

On July 8, 2003,we issued $160 million of 13% senior secured notes maturing on July 1, 2008 (“$160Million Notes”). On February 28, 2006, the $160 Million Notes werereplaced with $170 million in new term loans as discussed above. Debt issuancecosts were capitalized and amortized using the effective interest method overthe term of the $160 Million Notes. During the first quarter ended April 4, 2006, debt issuance costs werewritten off in the amount of $3.8 million.

**AmSouth Revolver**

On July 8, 2003,we entered into a three-year, $15 million senior secured revolving creditfacility with AmSouth Bank (“AmSouth Revolver”). On February 28, 2006,the AmSouth Revolver was replaced with a new $15 million revolving creditfacility as discussed above..  Debtissuance costs were capitalized and amortized using the effective interestmethod over the term of the AmSouth Revolver. During the first quarter ended April 4, 2006, debt issuance costs werewritten off to interest expense in the amount of $0.2 million.

**New Jersey Economic Development Authority NotePayable**

In December 1998, Manhattan Bagel Company, Inc.entered into a note payable in the principal amount of $2,800,000 with the NewJersey Economic Development Authority (“NJEDA”) at an interest rate of 9% perannum. Principal is paid annually and interest is paid quarterly. The notematures on December 1, 2008 and is secured by the assets of Manhattan BagelCompany, Inc.

On July 3, 2003, we placed an advanced funding ofthe note in escrow to enact a debt defeasance as allowed for in the agreement.This advanced funding is shown as restricted cash and the note is included inboth current portion and long-term portion of debt in the October 3, 2006 andJanuary 3, 2006 consolidated balance sheets in accordance with the paymentterms. This classification will continue until the note is fully paid from theescrow amount proceeds.

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**7.****             ****Net Income (Loss) Per CommonShare**

In accordance with SFAS No. 128, Earnings per Share,we compute basic net income (loss) per common share by dividing the net income(loss) for the period by the weighted average number of shares of common stockoutstanding during the period.

Diluted net income per share is computed by dividingthe net income for the period by the weighted average number of shares ofcommon stock and potential common stock equivalents outstanding during theperiod using the treasury stock method. Potential common stock equivalentsinclude incremental shares of common stock issuable upon the exercise of stockoptions and warrants. Potential common stock equivalents are excluded from thecomputation of diluted net income (loss) per share when their effect isanti-dilutive.

The following table summarizes the weighted averagenumber of common shares outstanding, and the computation of basic and dilutednet income (loss) per common share for the periods indicated (in thousands ofdollars, except share and per share data):
| ** **                                            | ** ** | **Quarter ended:** | ** ** | **Year to date period ended:** | ** ** |
|-------------------------------------------------------|------------|-------------------------|------------|----------------------------------------------------|------------|
| ** **                                            | ** ** | **October 3,**     | ** ** | **September 27,**                             | ** ** | **October 3,** | ** ** | **September 27,** | ** ** |
| ** **                                            | ** ** | **2006**                | ** ** | **2005**                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                  |       |                    |       |                                               |       |   |   |   |   |
| Net income  (loss) (a)                                |       | $                       | 752        |                                               | $          | (4,814 | ) | $ | (12,882 | ) | $ | (13,295 | ) |
|                                                  |       |                    |       |                                               |       |   |   |   |   |
| Basic weighted  average shares outstanding (b)        |       | 10,593,085              |       | 9,868,623                                          |       | 10,276,464 |   | 9,859,407 |   |
| Dilutive effect  of stock options                     |       | 443,442                 |       | —                                             |       | — |   | — |   |
| Diluted weighted  average shares outstanding (c) |       | 11,036,527              |       | 9,868,623                                          |       | 10,276,464 |   | 9,859,407 |   |
| Basic earnings  (loss) per share (a)/(b)              |       | $                       | 0.07       |                                               | $          | (0.49 | ) | $ | (1.25 | ) | $ | (1.35 | ) |
| Diluted earnings  (loss) per share (a)/(c)            |       | $                       | 0.07       |                                               | $          | (0.49 | ) | $ | (1.25 | ) | $ | (1.35 | ) |
|                                                  |       |                    |       |                                               |       |   |   |   |   |
| Antidilutive stock  options and warrants              |       | 2,673                   |       | 1,841,062                                          |       | 1,025,414 |   | 1,841,062 |   |

 

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

We record deferredtax assets and liabilities based on the difference between the financialstatement and income tax basis of assets and liabilities using the enactedstatutory tax rate in effect for the year differences are expected to betaxable or refunded. Deferred income tax expenses or credits are based on thechanges in the asset or liability from period to period. Future tax benefitsare subject to a valuation allowance when we conclude that our deferred incometax assets may not be realized from the results of operations. We consider thescheduled reversal of deferred tax liabilities, projected future taxable incomeand tax planning strategies in making this assessment.

Cumulative net operating losses generated in thecurrent year from continuing operations resulted in no federal and state incometax liability for the third quarter and year to date periods ended 2006 and2005. Due to the uncertainty of future taxable income, deferred tax assetsresulting from these net operating losses have been fully reserved. To date we have incurredsubstantial net losses that have created significant net operating losscarryforwards (NOL’s) for tax purposes. Our NOL’s are one of our deferredincome tax assets. Over the past two years, we have reduced our net losses substantiallyfrom prior years. Due to improved operations, reduction in our depreciation andamortization expense, and a savings from the reduction in the interest rate onour debt facility, we achieved net income for the third quarter ended October3, 2006.

In accordance withSFAS 109, Accounting for Income Taxes, we will assess the continuing need for avaluation allowance that results from uncertainty regarding our ability torealize the benefits of our deferred tax assets. The ultimate realization of deferredincome tax assets is dependent upon generation of future taxable income duringthe periods in which those temporary differences become deductible. During thethird quarter ended October 3, 2006, we achieved net income. As we continue tomove closer toward achieving net income on an annual basis, we will reviewvarious qualitative and quantitative data, including events within therestaurant industry, the cyclical nature of our business, our future forecastsand historical trending. If we conclude that our prospects for the realizationof our deferred tax assets are more likely than not, we will then reduce ourvaluation allowance as appropriate and credit income tax expense afterconsidering the following factors:

·                  The level of historical taxable incomeand projections for future taxable income over periods in which the deferredtax assets would be deductible, and

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

The amount of thedeferred tax asset considered realizable, however, could be reduced ifestimates of future taxable income during the carryforward periods are reduced.As of October 3, 2006, net operating loss carryforwards of $158 millionwere available to be utilized against future taxable income for years throughfiscal 2026, subject to annual limitations.

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

In accordance withSFAS No. 144, Accounting for the Impairment or Disposal of Long Lived Assets,impairment losses are recorded on long-lived assets on arestaurant-by-restaurant basis whenever impairment indicators are determined tobe present. We consider a history of cash flow losses to be the primaryindicator of potential impairment for individual restaurants. We determinewhether a restaurant is impaired based on expected undiscounted future cashflows, considering location, local competition, current restaurant managementperformance, existing pricing structure and alternatives available for thesite. If impairment exists, the amount of impairment is measured as the excessof the carrying amount of the asset over its fair value as determined utilizingthe estimated discounted future cash flows or the expected proceeds, net ofcosts to sell, upon sale of the asset.

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During the thirdquarter and year to date period ended October 3, 2006, we recorded $51,000 and$134,000, respectively in impairment charges related to company-owned stores.During the third quarter and year to date period ended September 27, 2005, werecorded $100,000 and $200,000, respectively in impairment charges related tocompany-owned restaurants.  In addition,during the third quarter and year to date period ended September 27, 2005 werecorded $100,000 and $1.3 million, respectively in impairment charges relatedto our Chesapeake trademarks.

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

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

On September 14, 2004, Atlantic Mutual InsuranceCompany brought an action in the Superior Court of New Jersey Law Division:Morris County, against the Company, certain of its former officers anddirectors and insurers seeking declaratory judgment on insurance coverageissues in previously resolved litigation against Jerold Novack and RaminKamfar, former officers. This lawsuit was settled in February 2006. The Companyfiled a claim against National Union, the Company’s officer and directorsliability insurer for the applicable time period, asserting that certainsettled claims were an insured loss under the Company’s policy with NationalUnion.  The Company and National Unionrecently settled the issue.

*Guarantees*

Prior to 2001, we would occasionally guarantee leasesfor the benefit of certain of our franchisees. None of the guarantees have beenmodified since their inception and we have since discontinued this practice.Current franchisees are the primary lessees under the vast majority of theseleases. Under the lease guarantees, we may be required by the lessor to makeall of the remaining monthly rental payments or property tax and common areamaintenance payments if the franchisee does not make the required payments in atimely manner. However, we believe that most, if not all, of the franchisedrestaurants could be subleased to third parties minimizing our potentialexposure. Additionally, we have indemnification agreements with our franchiseesunder which the franchisees would be obligated to reimburse us for any amountspaid under such guarantees. Historically, we have not been required to makesuch payments in significant amounts. We record a liability for our exposureunder the guarantees in accordance with SFAS No. 5, “Accounting forContingencies,” following a probability related approach. Minimum future rentalpayments remaining under these leases were approximately $0.9 million as ofOctober 3, 2006. We believe the ultimate disposition of these matters will nothave a material adverse effect on our financial position or results ofoperations.

*Insurance*

We are insured for losses related to health, generalliability and workers’ compensation under large deductible policies. Theinsurance liability represents an estimate of the ultimate cost of claims incurredand unpaid as of the balance sheet date. The estimated liability is establishedbased on actuarial estimates, is discounted at 10% based upon a discreteanalysis of actual claims and historical data and is reviewed on a quarterlybasis to ensure that the liability is appropriate. If actual trends, includingthe severity or frequency of claims, differ from our estimates our financialresults could be favorably or unfavorably impacted.  The estimated liability is included inaccrued expenses in our consolidated balance sheets.

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

On October 6, 2005, the FASB released FASB StaffPosition (“FSP”) 13-1, Accounting for Rental Costs Incurred during aConstruction Period. FSP 13-1 is effective for the first reporting periodbeginning after December 15, 2005 and requires that rental costs associatedwith ground or building operating leases incurred during a construction periodbe recognized as rental expense allocated on a straight-line basis over thelease term. This accounting is consistent with our historical and currentpractice.

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

In September 2006, the Securities and ExchangeCommission (SEC) issued Staff Accounting Bulletin No. 108 (SAB 108). Due todiversity in practice among registrants, SAB 108 expresses SEC staff viewsregarding the process by which misstatements in financial statements areevaluated for purposes of determining whether financial statement restatementis necessary. SAB 108 is effective for fiscal years ending after November 15,2006, and early application is encouraged. We do not believe SAB 108 will havea material impact on our results from operations or financial position.

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

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

E. Nelson Heumannis the chairman of our board of directors and is a current employee ofGreenlight Capital, Inc.  Greenlight andits affiliates beneficially own approximately 94 percent of our common stock ona fully diluted basis. As a result, Greenlight has sufficient voting powerwithout the vote of any other stockholders to determine what matters will besubmitted for approval by our stockholders, to approve actions by writtenconsent without the approval of any other stockholders, to elect all of ourboard of directors, and among other things, to determine whether a change incontrol of our company occurs.

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

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

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During the year to date period ended October 3, 2006,we issued 429,645 shares of our common stock to Greenlight in connection withcashless exercises of certain warrants previously granted by us. Greenlightsurrendered 56,953 shares of common stock to us in connection with suchcashless exercises. We issued these warrants in private financing transactionsthat occurred between 2000 and 2003.

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

During the year to date period ended October 3, 2006,we received consideration of $6,183 and issued 6,057 shares of our common stockin connection with the exercises of certain warrants previously granted by usto Mr. Tannenbaum and BET. We issued these warrants in private financingtransactions that occurred between 2000 and 2003.

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**ITEM2.  MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

The following discussion and analysis supplements themanagement’s discussion and analysis in our Annual Report on Form 10-K for the yearended January 3, 2006 and presumes that readers have read or have access to thediscussion and analysis in our Annual Report. The following discussion andanalysis includes historical and certain forward-looking information thatshould be read together with the accompanying consolidated financialstatements, related footnotes and the discussion below of certain risks anduncertainties that could cause future operating results to differ materiallyfrom historical results or from the expected results indicated by forwardlooking statements.

**Critical AccountingPolicies and Estimates**

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

Effective January 4, 2006, we adopted the provisionsof SFAS No. 123R using the modified prospective transition method. Prior to theadoption of SFAS No. 123R, we applied the intrinsic value-based method of accountingprescribed by APB No. 25 and related interpretations, in accounting forour fixed award stock options to our employees. As such, compensation expensewas recorded only if the current market price of the underlying common stockexceeded the exercise price of the option on the date of grant. We applied thefair value basis of accounting as prescribed by SFAS No. 123**in accounting for our fixed award stock options to ourconsultants. Under SFAS No. 123, compensation expense was recognized based onthe fair value of stock options granted.

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

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We use theBlack-Scholes model to estimate the fair value of our option awards. TheBlack-Scholes model requires estimates of the expected term of the option, aswell as future volatility and the risk-free interest rate. Our stockoptions generally vest over a period of 6 months to 3 years and havecontractual terms to exercise of 5 to 10 years. The expected term of options isbased upon evaluations of historical and expected future exercise behavior. Therisk-free interest rate is based on the US Treasury rates at the date of grantwith maturity dates approximately equal to the expected life at the grant date.Implied volatility is based on the mean reverting average of our stock’shistorical volatility and that of an industry peer group.  The use of meanreversion is supported by evidence of a correlation between stock pricevolatility and a company’s leverage combined with the effects mandatoryprincipal payments will have on our capital structure, as defined under our newdebt facility. We have not historically issued any dividends and are precludedfrom doing so under our debt covenants.

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

Estimates of share-based compensation expenses do havean impact on our financial statements, but these expenses are based on theaforementioned option valuation model and will never result in the payment ofcash by us. For this reason, and because we do not view share-basedcompensation as related to our operational performance, we exclude estimatedshare-based compensation expense when evaluating our performance.

There were no other material changes in our criticalaccounting policies since the filing of our 2005 Form 10-K. As discussed in our2005 Form 10-K, the preparation of the consolidated financial statements inconformity with accounting principles generally accepted in the United Statesrequires management to make certain estimates and assumptions that affect theamount of reported assets and liabilities and disclosure of contingent assetsand liabilities at the date of the consolidated financial statements andrevenues and expenses during the periods reported. Actual results may differfrom those estimates.

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**Company Overview**

We believe we are a leading fast-casual restaurantchain specializing in high-quality foods for breakfast and lunch in a caféatmosphere with a neighborhood emphasis. As of October 3, 2006, we own,operate, franchise or license 604 restaurants primarily under the EinsteinBros., Noah’s and Manhattan brands. Einstein Bros. is a national fast-casualrestaurant chain, and Noah’s and Manhattan are regional fast-casual restaurantchains operated on the West Coast and in the Northeast, respectively.

Our product offerings include fresh-baked goods bakedon site, made-to-order sandwiches on a variety of bagels and breads, gourmetsoups and salads, decadent desserts, premium coffees and other café beverages.Our manufacturing and commissary operations prepare consistent, high-qualityingredients and we deliver them to our restaurants through our network ofindependent distributors. While the primary purpose of these operations is tosupport our restaurants, we also have sales to other third parties.

**Significant Events, Trends or UncertaintiesExpected to Impact 2006 Results**

The following factors represent current trends oruncertainties that may impact operating performance or could cause reportedfinancial information not to be indicative of future operating results orfuture financial condition.

*Restaurant Base*

Since 2003, as part of our efforts to improvefinancial performance, we completed a thorough evaluation of our restaurantbase.  At the end of 2003, we had 736restaurants across 33 states and the District of Columbia.  Since that time, we have closed 51company-owned restaurants and 140 franchised and licensed restaurants.  The majority of the closed company-ownedrestaurants were either located in inferior real estate locations, had averageannual unit volumes (AUVs) below $600,000 or were unprofitable or marginallyprofitable.  Substantially all of thefranchises that closed either:

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

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

·                  Were restaurantsoperating under our non-core brands, Chesapeake Bagel Bakery and New WorldCoffee.

We have identified approximately 30 company-ownedrestaurants that we anticipate closing over the next three years as theirleases expire. Generally, these restaurants have an annual AUV below $550,000and contribute negligible cash flow.

We intend to open five restaurants in 2006.  For the year to date period ended October 3,2006, we have opened 2 restaurants, including an Einstein Bros. in Boca Raton,FL and a Noah’s in Mercer Island, WA. Additionally, on October 14, 2006 weopened an Einstein Bros. restaurant in Chicago. We anticipate opening an Einstein Bros. restaurant in Phoenix and a Noah’srestaurant in Portland, which are projected to open during the fourth quarterof fiscal 2006. In addition to these openings, we are in the process ofidentifying several other potential locations for restaurant openings in 2007and 2008. We are focusing our efforts on key markets that include Portland,Seattle, Atlanta, Chicago, Las Vegas, Phoenix, Washington, D.C. and the stateof Florida.

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The following table details the number of restaurants opened and closedduring the third quarter and year-to-date periods, total restaurants open atthe end of the third quarter, and total restaurants projected to open and closeduring the fourth quarter of Fiscal 2006:
|                                         | ** ** | **Third Quarter** | ** ** | **Year-to-Date** | ** ** | **Projected** | ** ** |
|-----------------------------------------|------------|------------------------|------------|------------------|------------|---------------|------------|
| ** **                              | ** ** | **Activity**           | ** ** | **Activity**     | ** ** | **Activity**  | ** ** |
| ** **                              | ** ** | **Fiscal**             | ** ** | **Fiscal**       | ** ** | **Fiscal**    | ** ** | **Fiscal** | ** ** | **Fourth Quarter** | ** ** |
| ** **                              | ** ** | **2006**               | ** ** | **2005**         | ** ** | **2006**      | ** ** | **2005** | ** ** | **2006** | ** ** |
| **Einstein  Bros Bagels**               | ** ** | ** **             | ** ** | ** **       | ** ** | ** **    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Company-owned beginning balance         |       | 353                    |       | 365              |       | 360           |       | 371 |   |   |   |
| Opened restaurants                      |       | —                 |       | —           |       | 1             |       | 3 |   | 2 |   |
| Closed restaurants                      |       | (9                     | )          | (4               | )          | (17           | )          | (13 | ) | (4 | ) |
| **Company-owned ending balance**        | ** ** | **344**                | ** ** | **361**          | ** ** | **344**       | ** ** | **361** | ** ** | ** ** | ** ** |
|                                    |       |                   |       |             |       |          |       |   |   |   |   |
| Licensed beginning balance              |       | 70                     |       | 57               |       | 67            |       | 54 |   |   |   |
| Opened restaurants                      |       | 13                     |       | 10               |       | 18            |       | 14 |   | 12 |   |
| Closed restaurants                      |       | —                 |       | (2               | )          | (2            | )          | (3 | ) | — |   |
| **Licensed ending balance**             | ** ** | **83**                 | ** ** | **65**           | ** ** | **83**        | ** ** | **65** | ** ** | ** ** | ** ** |
|                                    |       |                   |       |             |       |          |       |   |   |   |   |
| **Noah’s**                         | ** ** | ** **             | ** ** | ** **       | ** ** | ** **    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Company-owned beginning balance         |       | 72                     |       | 75               |       | 73            |       | 78 |   |   |   |
| Opened restaurants                      |       | 1                      |       | —           |       | 1             |       | — |   | 1 |   |
| Closed restaurants                      |       | —                 |       | (1               | )          | (1            | )          | (4 | ) | (1 | ) |
| **Company-owned ending balance**        | ** ** | **73**                 | ** ** | **74**           | ** ** | **73**        | ** ** | **74** | ** ** | ** ** | ** ** |
|                                    |       |                   |       |             |       |          |       |   |   |   |   |
| Licensed beginning balance              |       | 3                      |       | 3                |       | 3             |       | 3 |   |   |   |
| Opened restaurants                      |       | 1                      |       | —           |       | 1             |       | — |   | — |   |
| Closed restaurants                      |       | (1                     | )          | —           |       | (1            | )          | — |   | — |   |
| **Licensed ending balance**             | ** ** | **3**                  | ** ** | **3**            | ** ** | **3**         | ** ** | **3** | ** ** | ** ** | ** ** |
|                                    |       |                   |       |             |       |          |       |   |   |   |   |
| **Manhattan**                           | ** ** | ** **             | ** ** | ** **       | ** ** | ** **    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Franchised beginning balance            |       | 105                    |       | 127              |       | 109           |       | 145 |   |   |   |
| Opened restaurants                      |       | —                 |       | —           |       | 2             |       | — |   | — |   |
| Closed restaurants                      |       | (13                    | )          | (9               | )          | (19           | )          | (27 | ) | (11 | ) |
| **Franchised ending balance**           | ** ** | **92**                 | ** ** | **118**          | ** ** | **92**        | ** ** | **118** | ** ** | ** ** | ** ** |
|                                    |       |                   |       |             |       |          |       |   |   |   |   |
| **Chesapeake**                          | ** ** | ** **             | ** ** | ** **       | ** ** | ** **    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Franchised beginning balance            |       | 5                      |       | 24               |       | 8             |       | 27 |   |   |   |
| Opened restaurants                      |       | —                 |       | —           |       | —        |       | — |   | — |   |
| Closed restaurants                      |       | —                 |       | (12              | )          | (3            | )          | (15 | ) | — |   |
| **Franchised ending balance**           | ** ** | **5**                  | ** ** | **12**           | ** ** | **5**         | ** ** | **12** | ** ** | ** ** | ** ** |
|                                    |       |                   |       |             |       |          |       |   |   |   |   |
| **New  World Coffee/Willoughby’s** | ** ** | ** **             | ** ** | ** **       | ** ** | ** **    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Company-owned beginning balance         |       | 2                      |       | 2                |       | 2             |       | 4 |   |   |   |
| Opened restaurants                      |       | —                 |       | —           |       | —        |       | — |   | — |   |
| Closed restaurants                      |       | —                 |       | —           |       | —        |       | (2 | ) | — |   |
| **Company-owned ending balance**        | ** ** | **2**                  | ** ** | **2**            | ** ** | **2**         | ** ** | **2** | ** ** | ** ** | ** ** |
|                                    |       |                   |       |             |       |          |       |   |   |   |   |
| Franchised beginning balance            |       | 3                      |       | 5                |       | 4             | ** ** | **7** | ** ** | ** ** | ** ** |
| Opened restaurants                      |       | —                 |       | —           |       | —        |       | — |   | — |   |
| Closed restaurants                      |       | (1                     | )          | (1               | )          | (2            | )          | (3 | ) | — |   |
| **Franchised ending balance**           | ** ** | **2**                  | ** ** | **4**            | ** ** | **2**         | ** ** | **4** | ** ** | ** ** | ** ** |
|                                    |       |                   |       |             |       |          |       |   |   |   |   |
| **Consolidated  Total**                 | ** ** | ** **             | ** ** | ** **       | ** ** | ** **    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total beginning balance                 |       | 613                    |       | 658              |       | 626           |       | 689 |   |   |   |
| Opened restaurants                      |       | 15                     |       | 10               |       | 23            |       | 17 |   | 15 |   |
| Closed restaurants                      |       | (24                    | )          | (29              | )          | (45           | )          | (67 | ) | (16 | ) |
| **Total  ending balance**               | ** ** | **604**                | ** ** | **639**          | ** ** | **604**       | ** ** | **639** | ** ** | ** ** | ** ** |

 

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*Revenue*

Over 93% of our revenue is generated by restaurant sales at ourEinstein Bros. and Noah’s company-owned restaurants.  Restaurant sales also include catering saleswhere the food is prepared at the restaurant and either delivered to or heldfor pick-up by the guest.  The keyfactors that affect our restaurant sales in the aggregate are the number ofrestaurants in operation for the period, the AUV of the restaurant, and thechange in comparable store sales.  Inaddition to AUV, we measure the change in comparable store sales on a weeklybasis.

The majority of our growth in comparable store sales has been throughan increase in our average check. This increase has been achieved through acombination of multiple initiatives including: system-wide price increases,regional price increases in markets with a higher cost of living and suggestiveselling by our restaurant personnel to add-on higher priced items.

We will continue to focus on our core strengths in bagels, thebreakfast daypart, and on quality, speed of service, order accuracy and guestinteraction. Prospectively, our focus towards sales growth will includecontinued improvements in our service system, local store marketing, and theintroduction of new menu items.  For example,during the third quarter of 2006, we introduced frozen beverages and freshbaked pretzels.  We also intend to expandour existing catering programs, increase customer awareness of our retailproducts, emphasize bundling products such as “Sweeten the Deal,” (adding on abeverage and a bakery product, such as a cookie) and highlight favorite itemssuch as our egg sandwiches. These initiatives are aimed at increasing averagecheck and transaction counts in our restaurants.

We are also in the process of refining our restaurant layout, orderingsystem and order fulfillment process. These changes will be customized to bestutilize the unique layouts in our existing restaurant base. On a prospectivebasis, we intend to standardize our restaurant design to ensure a consistentguest experience that embodies our heritage of guest and associate interactionwithout compromising speed and efficiency.

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

Franchise and license revenue consists of a license or franchise fee atthe inception of the agreement and ongoing royalty payments based on apercentage of the restaurant’s sales. The principal factors affecting franchiseand license revenue are the number of franchised and licensed restaurants aswell as the level of sales at those restaurants.

*Expenses*

Food, beverage and packaging costs represent one of the largestelements of cost at our company-owned restaurants. The most important factorthat affects the cost of these products is the underlying cost of theagricultural commodities such as flour, cheese, coffee, turkey and otherproducts.  In order to mitigate theimpact of rising commodity costs, we enter agreements with our suppliers to fixthe cost of these products for a specified period of time that is generally oneyear or less. We do not engage in the practice of buying futures contracts andtherefore we do not have derivative accounting. Packaging and distributioncosts are primarily affected by the cost of oil because petroleum basedmaterial is often used to package products for distribution. Although we havegenerally been able to increase our retail prices at our company-ownedrestaurants to offset the increased costs of these items, we may not be able todo this in the future.

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Compared to 2005, dairy and coffee prices in 2006 have slightlydecreased. We expect the costs to remain relatively stable for the remainder of2006. Commodity costs for flour continue to rise during 2006 as compared to2005. Flour represents the most significant raw ingredient we purchase andworld-wide wheat production for 2006 has been below projections due to poorcrop yields. We expect to see continued pressure throughout the end of thisyear and continuing into 2007. We have experienced increases in the cost ofother ingredients such as corn syrup due to the ethanol production demand oncorn.

Compensation costs reflect the hourly wages, salary, bonus, taxes andinsurance that we pay our associates at each restaurant. Compensation coststend to vary by geographic region based upon the labor market, local minimumwages, and the supply and demand of workers. Also, compensation costs tend tobe semi-variable in nature and increase or decrease somewhat based upon thevolume of products sold. Due to competition for personnel, limited availabilityin the labor pool, and changes in the federal overtime regulations, weanticipate that we may experience an increase in hourly wages during theremainder of 2006 contingent upon the number of overtime hours worked. Additionally,we are aware of increases in state minimum hourly wage rates in most of thestates in which we operate that are effective beginning January 1, 2007. Wecontinue to make improvements in labor efficiencies that may help to offset aportion of the increases in labor costs.

Other operating costs consist of utilities, restaurant and othersupplies, repairs and maintenance, laundry and uniforms, bank charges and othercosts related to the operation of the company-owned restaurant. Certain ofthese costs generally tend to be fixed in nature and are only modestly impactedby changes in the volume of products sold. Utilities, distribution costs andother expenses impacted by fuel price fluctuations are not fixed and arecontingent upon contract rates negotiated by third parties outside of ourcontrol. Many of our contracts are re-priced quarterly based on the priorquarter’s market fluctuations resulting in a delayed effect upon on operatingcosts. During 2005 and part of 2006, we experienced increases in the cost forenergy. Our distribution partners and common freight carriers passed on fuelsurcharges to us during 2004, 2005 and part of 2006. During periods ofuncertainty and significant market fluctuations, we cannot be certain of theimpact on our future operating results. If we are unable to leverage costincreases with operating efficiencies or price increases, it may negativelyimpact our operating results. Conversely, decreases in fuel prices willpositively impact our utilities, distribution costs and other related expenses.

Non-operating expenses include rent, common area costs, property taxesand insurance, liability insurance, delivery fees and allocated marketingexpenses.  We exclude depreciation andamortization expense from company-owned restaurant expenses. Changes in thesecosts are generally the result of changes in our rent and other relatedfacility costs.  Accordingly, these costsare predominantly fixed in nature and are modestly impacted by changes in thevolume of products sold. Certain states and local governments have increasedboth the rate and nature of taxes on businesses in their regions. Theseincreased taxes include real estate and property taxes, state and local incometaxes, and various employment taxes.

Manufacturing costs are comprised of raw materials such as flour, dairyproducts and meats, compensation costs and the related taxes and employeebenefits, rents, supplies and repairs and maintenance. These costs are directlyrelated to the manufacturing revenue they produce. Operating results from ourmanufacturing operations represents third-party sales and can be significantlyimpacted by fixed overhead costs such as rent, utilities, property taxes andmanager salaries and fluctuating commodity costs.

Changes in any of the aforementioned categories could directly impactthe profitability of our company-owned restaurants, manufacturing operations ordistribution channels. Increases in any of these expense trends in the nearfuture may contribute to degradation in our profit margins until such time aswe are able to pass on increased costs to our consumers.

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*Consumer Spending Habits and Impact of Inflation*

Our results depend on consumer spending, which is influenced byconsumer confidence and disposable income. In particular, the effects of highergasoline prices, an increase in minimum balances payable on consumer debt andincreasing interest rates among other things, may impact discretionary consumerspending in restaurants. Accordingly, we believe we experience declines in comparablestore sales during economic downturns or during periods of economic uncertaintylike interest rate speculation, unemployment rates, and real estate marketconditions. Any material decline in the amount of discretionary spending couldhave a material adverse effect on our sales and income.

We have experienced only a modest impact from inflation as evidenced bya slight increase in the level of consumer prices. However, the impact ofinflation on labor, food and occupancy costs could, in the future, significantlyaffect our operations. We pay many of our employees hourly rates slightly abovethe applicable federal, state or municipal “living wage” rates. Food costs as apercentage of sales have been somewhat stable due to procurement efficienciesand menu price adjustments, although no assurance can be made that ourprocurement will continue to be efficient or that we will be able to raise menuprices in the future. Costs for construction, taxes, repairs, maintenance andinsurance all impact our occupancy costs. We believe that our current strategy,which is to seek to maintain operating margins through a combination of menuprice increases, cost controls, efficient purchasing practices and carefulevaluation of property and equipment needs, has been an effective tool fordealing with inflation.

28

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**Results of Operations**

This table sets forth, for the periods indicated,certain amounts included in our consolidated statements of operations, therelative percentage that those amounts represent to total revenue (unlessotherwise indicated), and the percentage change in those amounts from period toperiod. All percentages are calculated using actual amounts rounded to thenearest thousand.  
| ** **                                                              | ** ** | **Third quarter ended:**           | ** ** | **Increase**           | ** ** | **Third quarter ended:**            | ** ** | **Year to date ended:**       | ** ** | **Increase**           | ** ** | **Year to date ended:**        | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------------------------|------------|------------------------|------------|-----------------------------------------------|------------|----------------------------------------------|------------|------------------------|------------|-----------------------------------------------|------------|
| ** **                                                              | ** ** | **(in thousands of dollars)** | ** ** | **(Decrease)**         | ** ** | **(percent of total revenue)** | ** ** | **(in thousands of dollars)** | ** ** | **(Decrease)**         | ** ** | **(percent of total revenue)** | ** ** |
| ** **                                                              | ** ** | **October 3,**                          | ** ** | **September 27,** | ** ** | **2006**                                      | ** ** | **October 3,**                          | ** ** | **September 27,** | ** ** | **October 3,**                           | ** ** | **September 27,** | ** ** | **2006** | ** ** | **October 3,** | ** ** | **September 27,** | ** ** |
| ** **                                                              | ** ** | **2006**                                     | ** ** | **2005**               | ** ** | **vs. 2005**                             | ** ** | **2006**                                     | ** ** | **2005**               | ** ** | **2006**                                      | ** ** | **2005** | ** ** | **vs. 2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues:                                                               |       |                                         |       |                   |       |                                          |       |                                         |       |                   |       |                                          |       |   |   |   |   |   |   |   |   |
| Restaurant  sales                                                       |       | 89,213                                       |       | 87,937                 |       | 1.5                                           | %          | 93.2                                         | %          | 92.8                   | %          | 271,300                                       |       | 265,912 |   | 2.0 | % | 93.3 | % | 93.2 | % |
| Manufacturing  revenues                                                 |       | 5,052                                        |       | 5,270                  |       | (4.1                                          | )%         | 5.3                                          | %          | 5.6                    | %          | 15,126                                        |       | 14,905 |   | 1.5 | % | 5.2 | % | 5.2 | % |
| Franchise  and license related revenues                                 |       | 1,487                                        |       | 1,575                  |       | (5.6                                          | )%         | 1.6                                          | %          | 1.7                    | %          | 4,358                                         |       | 4,373 |   | (0.3 | )% | 1.5 | % | 1.5 | % |
| Total revenues                                                          |       | 95,752                                       |       | 94,782                 |       | 1.0                                           | %          | 100.0                                        | %          | 100.0                  | %          | 290,784                                       |       | 285,190 |   | 2.0 | % | 100.0 | % | 100.0 | % |
|                                                                    |       |                                         |       |                   |       |                                          |       |                                         |       |                   |       |                                          |       |   |   |   |   |   |   |   |   |
| Cost of sales:                                                          |       |                                         |       |                   |       |                                          |       |                                         |       |                   |       |                                          |       |   |   |   |   |   |   |   |   |
| Restaurant  costs                                                       |       | 72,187                                       |       | 73,941                 |       | (2.4                                          | )%         | 75.4                                         | %          | 78.0                   | %          | 219,677                                       |       | 219,141 |   | 0.2 | % | 75.5 | % | 76.8 | % |
| Manufacturing  costs                                                    |       | 5,445                                        |       | 4,980                  |       | 9.3                                           | %          | 5.7                                          | %          | 5.3                    | %          | 15,952                                        |       | 13,880 |   | 14.9 | % | 5.5 | % | 4.9 | % |
| Total cost of sales                                                     |       | 77,632                                       |       | 78,921                 |       | (1.6                                          | )%         | 81.1                                         | %          | 83.3                   | %          | 235,629                                       |       | 233,021 |   | 1.1 | % | 81.0 | % | 81.7 | % |
|                                                                    |       |                                         |       |                   |       |                                          |       |                                         |       |                   |       |                                          |       |   |   |   |   |   |   |   |   |
| Gross profit:                                                           |       |                                         |       |                   |       |                                          |       |                                         |       |                   |       |                                          |       |   |   |   |   |   |   |   |   |
| Retail                                                                  |       | 17,026                                       |       | 13,996                 |       | 21.6                                          | %          | 17.8                                         | %          | 14.8                   | %          | 51,623                                        |       | 46,771 |   | 10.4 | % | 17.8 | % | 16.4 | % |
| Manufacturing                                                           |       | (393                                         | )          | 290                    |       | *                                             |       | (0.4                                         | )%         | 0.3                    | %          | (826                                          | )          | 1,025 |   | * |   | (0.3 | )% | 0.4 | % |
| Franchise  and license                                                  |       | 1,487                                        |       | 1,575                  |       | (5.6                                          | )%         | 1.6                                          | %          | 1.7                    | %          | 4,358                                         |       | 4,373 |   | (0.3 | )% | 1.5 | % | 1.5 | % |
| Total  gross profit                                                     |       | 18,120                                       |       | 15,861                 |       | 14.2                                          | %          | 18.9                                         | %          | 16.7                   | %          | 55,155                                        |       | 52,169 |   | 5.7 | % | 19.0 | % | 18.3 | % |
|                                                                    |       |                                         |       |                   |       |                                          |       |                                         |       |                   |       |                                          |       |   |   |   |   |   |   |   |   |
| Operating expenses:                                                     |       |                                         |       |                   |       |                                          |       |                                         |       |                   |       |                                          |       |   |   |   |   |   |   |   |   |
| General  and administrative expenses                                    |       | 9,750                                        |       | 8,868                  |       | 9.9                                           | %          | 10.2                                         | %          | 9.4                    | %          | 30,038                                        |       | 26,857 |   | 11.8 | % | 10.3 | % | 9.4 | % |
| Depreciation  and amortization                                          |       | 2,640                                        |       | 5,798                  |       | (54.5                                         | )%         | 2.8                                          | %          | 6.1                    | %          | 14,238                                        |       | 19,583 |   | (27.3 | )% | 4.9 | % | 6.9 | % |
| Loss  on sale, disposal or abandonment of assets, net                   |       | 193                                          |       | 104                    |       | 85.6                                          | %          | 0.2                                          | %          | 0.1                    | %          | 206                                           |       | 269 |   | (23.4 | )% | 0.1 | % | 0.1 | % |
| Impairment  charges and other related costs                             |       | 51                                           |       | 206                    |       | (75.2                                         | )%         | 0.1                                          | %          | 0.2                    | %          | 134                                           |       | 1,490 |   | (91.0 | )% | 0.0 | % | 0.5 | % |
| Income from operations                                                  |       | 5,486                                        |       | 885                    |       | 519.9                                         | %          | 5.7                                          | %          | 0.9                    | %          | 10,539                                        |       | 3,970 |   | 165.5 | % | 3.6 | % | 1.4 | % |
| Other expense (income):                                                 |       |                                         |       |                   |       |                                          |       |                                         |       |                   |       |                                          |       |   |   |   |   |   |   |   |   |
| Interest  expense, net                                                  |       | 4,749                                        |       | 5,805                  |       | (18.2                                         | )%         | 5.0                                          | %          | 6.1                    | %          | 14,670                                        |       | 17,497 |   | (16.2 | )% | 5.0 | % | 6.1 | % |
| Prepayment  penalty upon redemption of $160 Million Notes               |       | —                                       |       | —                 |       | *                                             |       | 0.0                                          | %          | 0.0                    | %          | 4,800                                         |       | — |   | * |   | 1.7 | % | 0.0 | % |
| Write-off  of debt issuance costs upon redemption of $160 Million Notes |       | —                                       |       | —                 |       | *                                             |       | 0.0                                          | %          | 0.0                    | %          | 3,956                                         |       | — |   | * |   | 1.4 | % | 0.0 | % |
| Other,  net                                                             |       | (15                                          | )          | (106                   | )          | *                                             |       | (0.0                                         | )%         | (0.1                   | )%         | (5                                            | )          | (232 | ) | * |   | (0.0 | )% | (0.1 | )% |
| Net income (loss)                                                       |       | 752                                          |       | (4,814                 | )          | (115.6                                        | )%         | 0.8                                          | %          | (5.1                   | )%         | (12,882                                       | )          | (13,295 | ) | (3.1 | )% | (4.4 | )% | (4.7 | )% |

 

----

* not meaningful

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*Restaurant Operations*

**While our comparable store salesfor the third quarter ended 2006 were slightly better than the overall industry*,* our restaurant sales were below our expectations.Restaurant sales improved 1.5% and 2.0% when compared to the third quarter andyear to date periods ended 2005, respectively. Our comparable store salesincrease of 3.2% consisted of a 5.7% increase in average check partially offsetby a 2.3% reduction in transactions during the third quarter ended October 3,2006. We also experienced a 4.3% increase in comparable store sales for theyear to date period ended October 3, 2006 that consisted of a 6.2% increase inaverage check partially offset by a 1.7% reduction in transactions. Theincrease in average check was related to a system-wide price increase, a slightshift in product mix to higher priced items, and suggestive selling techniquesencouraging our “Sweeten the Deal” bundling offer and our “Hate to Wait”promotion (a pre-packaged baker’s dozen of bagels with cream cheese).Comparable store sales represent sales at restaurants open for one full yearand have not been relocated or closed during the current year.   Comparable store sales include company-ownedrestaurants only and represent the change in period-over-period sales for thecomparable restaurant base.  A restaurantbecomes comparable in its 12**th full month ofoperation. Comparable store sales are also referred to as “same-store” sales oras “comp sales” within the restaurant industry.   

**The following table summarizes theelements of comparable store sales for each quarter in fiscal 2005 and 2006:**
|                              | ** ** | **Comparable**       | ** ** |
|------------------------------|------------|----------------------|------------|
| **Period**                   | ** ** | **Store Sales** | ** ** |
| Third quarter,  fiscal 2005  |       | 6.0                  | %          |
| Fourth quarter,  fiscal 2005 |       | 3.9                  | %          |
| First quarter,  fiscal 2006  |       | 6.2                  | %          |
| Second quarter,  fiscal 2006 |       | 3.6                  | %          |
| Third quarter, fiscal  2006  |       | 3.2                  | %          |

 

We believe we canimprove our transaction counts and bring further awareness to our brand byfocusing on improvements in the operation of our restaurants includinginitiatives in customer service (accuracy, friendliness and speed of service),overall restaurant appearance and further development of catering programs inselected markets. In addition, we are introducing our new seasonal menu,enhancing our local store marketing and implementing employee level contests topromote suggestive selling during the fourth quarter of fiscal 2006. 

Our restaurantgross profit increased 21.6% and 10.4% for the third quarter and year to dateperiods ended October 3, 2006, respectively, when compared to the comparableperiods in 2005. Our restaurant margins are impacted by various store-leveloperating expenses such as the cost of products sold, salaries and benefits, insurance,supplies, repair and maintenance expenses, advertising, rent, utilities andproperty taxes. Because certain elements of cost of sales such as rent,utilities, property taxes and manager salaries are fixed in nature, incrementalsales positively impact gross profit. Depreciation, amortization and incometaxes do not impact our store contribution margins. 

During the thirdquarter of 2006, the increase in restaurant sales over the comparable periodcontributed approximately $0.3 million of store contribution margin related tothe increased sales. Our margins were also favorably impacted by a reduction inmarketing expense of $2.1 million, $0.4 million in decreased workers’compensation loss reserves and group insurance IBNR (incurred but not reported)estimates, $0.3 million for improvements in labor utilization, offset by $0.1million in additional bonus wages payable due to improved operatingperformance.

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During the year todate period ended October 3, 2006, the increase in restaurant sales over thecomparable period contributed approximately $4.3 million of store contributionmargin related to the increased sales. Our margins were also favorably impactedby approximately $1.0 million for improvements in labor utilization and $0.7million savings in real estate taxes that included the settlement of a realestate tax dispute, $0.7 million reduction in marketing expense, $0.3 milliondue to the timing of repair and maintenance expenditures, offset by $0.9million in increased workers’ compensation loss reserves, $0.8 million inincreased energy and utility costs and $0.4 million in wages payable due toimproved operating performance. 

*ManufacturingOperations*

Our manufacturingoperations predominately support our company-owned restaurants and generate revenuefrom the sale of food products to franchisees, licensees and third-partydistributors. For the third quarter and year to date periods ended October 3,2006 and September 27, 2005, our manufacturing margins represented less than1.0% of total revenues. Our manufacturing margins are impacted by variousmanufacturing-level operating expenses such as the cost of products sold,salaries and benefits, insurance, supplies, repair and maintenance expenses,rent, utilities and property taxes. Margins from our manufacturing operationsrepresent third-party sales and can be significantly impacted by fixed overheadcosts such as rent, utilities, property taxes and manager salaries andfluctuating commodity costs. All inter-company transactions have been eliminatedduring consolidation. 

During the thirdquarter and year to date period ended October 3, 2006, our manufacturingoperations experienced negative margins primarily due to increases in rawmaterials and freight costs and incremental start-up costs associated with newproducts and customers. During the fourth quarter of 2006, we plan to increaseprices to third party customers. Additionally, we plan to begin operating twonew commissary locations which, we believe, will increase future capacity,enabling us to become more operationally efficient in the future. We believethese initiatives will positively impact our manufacturing operations. 

*Franchiseand License Operations*

Revenues for thefranchised and licensed operations consist primarily of initial fees androyalty income earned as a result of operation of franchise and licenserestaurants.  Overall, franchisee andlicensee royalty income decreased approximately $0.1 million during the thirdquarter of 2006 as compared to the same quarter of 2005.  The third quarter of 2006 included animprovement in revenue of approximately $0.2 million predominately due toimproved comparable sales in the Manhattan and Einstein Bros. brands and anincrease in number of Einstein Bros. licensee restaurants. During the thirdquarter of fiscal 2005, we recognized approximately $0.3 million in acceleratedroyalties due to an early termination of a franchise agreement. 

*Generaland Administrative Expenses*

**General and administrative expensesinclude corporate and administrative functions that support our company-ownedrestaurants as well as our manufacturing and franchise and licenseoperations.  These costs include employeewages, taxes and related benefits, travel costs, information systems,recruiting and training costs, corporate rent, and general insurance costs.**

**Our general and administrativeexpenses increased 9.9%, or $0.9 million, for the third quarter of 2006 whencompared to the third quarter of 2005. Contributing to the increase wasapproximately $0.3 million in increased severance, salary, and other wagerelated expenses, $0.3 million in increased management training wages, anincrease of $0.2 million in bonus wages payable to corporate office staff dueto improved operating performance, $0.1 million in relocation expense for newmanagement, and $0.1 million in stock based compensation expense. Theseincreases are offset with a decrease of $0.2 million in group insurance IBNRestimates.**

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General andadministrative expenses increased 11.8%, or $3.2 million, for the year to dateperiod ended October 3, 2006 when compared to the year to date period endedSeptember 27, 2005. Contributing to the increase was approximately $0.5 millionin stock based compensation expense, $0.4 million in bonus wages payable tocorporate office staff due to improved operating performance, $0.4 million inincreased travel and management development expenses, $0.3 million in expensesrelated to the costs of transitioning to a new distributor, $0.4 million inmanagement training wages, $0.2 million in relocation expense for newmanagement, $0.1 million in increased salary related expenses and $0.2 millionin additional consulting and contract labor fees. Additionally, we incurredapproximately $0.7 million for our first annual leadership summits for ourEinstein Bros. and Noah’s general managers and our Manhattan Bagel franchisees.

*Depreciation and Amortization*

Depreciation andamortization are periodic non-cash charges that represent the reduction inusefulness and value of our tangible and intangible assets.  The majority of our depreciation andamortization relates to equipment and leasehold improvements located in ourcompany-owned restaurants. Depreciation and amortization expenses decreased54.5%, or $3.2 million, for the third quarter of 2006 when compared to thethird quarter of 2005. Depreciation and amortization expenses decreased 27.3%,or $5.3 million, for the year to date period ended October 3, 2006 whencompared to the year to date period ended September 27, 2005.  The decrease is primarily due to all of our amortizing intangibleassets becoming fully amortized and a substantial portion of our other assetsbecoming fully depreciated within the second and third quarters of fiscal 2006.Depreciation and amortizationexpense is predominately related to the assets of Einstein/Noah Bagel Corp.that we acquired in bankruptcy proceedings in June 2001. Based on our currentpurchases of capital assets, our existing base of assets, and our projectionsfor new purchases of fixed assets, we believe our annual rate of depreciationexpense will approximate $12 million to $15 million in the near term.

*Loss on the Disposal, Sale orAbandonment of Assets*

Loss on the disposal,sale or abandonment of assets represents the excess of proceeds received, if any,over the net book value of an asset. We establish estimated useful lives forour assets, which range from 3 to 8 years, and depreciate using thestraight-line method. Leasehold improvements are limited to the lesser of theuseful life or the noncancelable lease term. The useful lives of the assets arebased upon our expectations of the period of time that the asset will be usedto generate revenue. We periodically review the assets for changes incircumstances, which may impact their useful lives.

*Impairment Charges and otherRelated Costs*

Impairment losses arenon-cash charges recorded on long-lived assets, goodwill, trademarks and ourother intangible assets. Generally, an indicator of impairment would includesignificant change in an asset’s ability to generate positive cash flow in thefuture or in the fair value of an asset. Whenever impairment indicators aredetermined to be present, the amount of impairment is measured as the excess ofthe carrying amount of the asset over its fair value. During the third quarterand year to date period ended October 3, 2006, we recorded $51,000 and $0.1million, respectively in impairment charges related to company-ownedrestaurants. During the third quarter and year to date period ended September27, 2005, we recorded $0.1 million and $0.2 million, respectively in impairmentcharges related to company-owned restaurants. In addition, during the third quarter and year to date period endedSeptember 27, 2005 we recorded $0.1 million and $1.3 million, respectively in impairmentcharges related to our Chesapeake trademarks.

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*Interest Expense*

On February 28, 2006, wecompleted a debt refinancing that redeemed our $160 Million Notes and retiredour $15 million AmSouth Revolver. We replaced this debt with $170 million in newterm loans and a $15 million revolving credit facility effectively reducing oureffective interest rate from 13.9% to a weighted-average effective interestrate of 9.9% as of October 3, 2006. During the first quarter ended 2006, wewrote off $4.0 million of debt issuance costs and paid a 3% redemption premiumon the $160 Million Notes in the amount of $4.8 million. During the thirdquarter and year to date period ended 2006, we incurred $4.7 million and $14.7million, respectively, in net interest expense compared to $5.8 million and$17.5 million in the respective 2005 periods. 

*Net Income (Loss) and IncomeTaxes*

Cumulative net operatinglosses generated in the current year from continuing operations resulted in nofederal and state income tax liability for the third quarter and year to dateperiods ended 2006 and 2005. Due to the uncertainty of future taxable income,deferred tax assets resulting from these net operating losses have been fullyreserved. Todate we have incurred substantial net losses that have created significant netoperating loss carryforwards (NOL’s) for tax purposes. Our NOL’s are one of ourdeferred income tax assets. Over the past two years, we have reduced our netlosses substantially from prior years. Due to improved operations and as aresult of a reduction in our depreciation and amortization expense, as well asa savings from the reduction in the interest rate on our debt facility, weachieved net income of $0.8 million for the third quarter ended October 3,2006. 

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

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

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

The amount of the deferred tax asset considered realizable, however,could be reduced if estimates of future taxable income during the carryforwardperiods are reduced. As of October 3, 2006, net operating losscarryforwards of $158 million were available to be utilized against futuretaxable income for years through fiscal 2026, subject to annual limitations. 

**Liquidityand Capital Resources**

The restaurant industryis predominantly a cash business where cash is received at the time of thetransaction. We believe we will generate sufficient cash flow and havesufficient availability under our revolving credit facility to fund operations,capital expenditures and required debt and interest payments. Our inventoryturns frequently since our products are perishable. Accordingly, our investmentin inventory is minimal. Our accounts payable are on terms that we believe areconsistent with those of other companies within the industry. 

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

33

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*2006 Debt Redemption andRefinancing*

On February 28, 2006, wecompleted the refinancing of the AmSouth Revolver and $160 Million Notes. Ournew financing consists of a:

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

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

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

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

Each of the loansrequires the payment of interest in arrears on a quarterly basis commencing onMarch 31, 2006. Additionally, the First Lien Term Loan requires quarterlyscheduled minimum principal reductions commencing June 30, 2006. In the eventthat we have not extended the maturity date of the Mandatorily RedeemableSeries Z Preferred Stock (Series Z) to a date that is on or after July 26, 2012(July 26, 2013 for the Subordinated Note) or redeemed the Series Z by variousdates in 2008 and 2009, then each of the loans have various acceleratedmaturity dates beginning in December 2008. For an additional discussionregarding our new debt facility, see Note 6 to our consolidated financialstatements included in Part I of this report.

*Working Capital Deficit and CashFlows*

As of October 3, 2006, wehad unrestricted cash of $4.2 million, restricted cash of $2.8 million and nooutstanding borrowings under the Revolving Facility. However, we have $6.9million in letters of credit outstanding under our Revolving Facility atOctober 3, 2006.  Our working capitaldeficit increased to $13.6 million at October 3, 2006 from $11.7 million at January3, 2006, primarily due to the short-term classification of principal paymentsdue under our First Lien Term Loan. Due to increased profitability at ourcompany-owned restaurants and the timing of operational receipts and payments,net cash generated by operating activities was $9.4 million for the year todate period ended October 3, 2006 compared to $2.8 million for the year to dateperiod ended September 27, 2005. Cash provided by operations for the year todate period ended October 3, 2006 includes a $4.8 million cash prepaymentpenalty incurred upon redemption of the $160 Million Notes. 

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

During the year to dateperiod ended October 3, 2006, we used approximately $10.6 million of cash topurchase additional property and equipment that included $1.2 million for newrestaurants, $2.0 million for remodeling existing restaurants, $3.7 million forreplacement and new equipment at our existing company-owned restaurants, $2.3million for our manufacturing operations and $1.4 million for general corporatepurposes. We anticipate that the majority of our capital expenditures forfiscal 2006 will be focused on our refresh and remodel strategy that includesupdates of restaurant interiors and design flow. In addition, we plan toacquire additional equipment for new menu items and improvements in the speedof service, particularly during the morning day-part. We also plan to open 5new company-owned restaurants during 2006 at an average capital investment ofapproximately $0.4 million to $0.5 million per restaurant.  For the year to date period ended October 3,2006, we have opened 2 restaurants, including an Einstein’s Bros. in BocaRaton, FL and a Noah’s in Mercer Island, WA Additionally, on October 14, 2006,we opened an Einstein Bros. restaurant in Chicago.  We anticipate opening an Einstein Bros.restaurant in Phoenix and a Noah’s restaurant in Portland, which are projectedto open during the fourth quarter of fiscal 2006.

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As a result of ourrefinancing of our $160 Million Notes with $170 million in new term loans inFebruary 2006, we borrowed $169.4 million in term loans and incurredapproximately $5.0 million in debt issuance costs. Upon closing of our new debtfacility, we began amortizing these costs and the debt issuance costs relatedto our $160 Million Notes and AmSouth Revolver were written-off.

*Contractual Obligations*

The following tablesummarizes the amounts of payments due under specified contractual obligationsas of October 3, 2006: 
|                                                  | ** ** | **Payments Due by Period**    | ** ** |
|--------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                     | ** ** | **2007 to  2009** | ** ** | **2010 to  2011** | ** ** | **2012 and  thereafter** | ** ** | **Total** | ** ** |
| ** **                                       | ** ** | **(in thousands of dollars)** | ** ** |
| Accounts payable  and accrued expenses           |       | $                                            | 32,491     |   | $ | — |   | $ | — |   | $ | — |   | $ | 32,491 |   |
| Debt                                             |       | 755                                          |       | 21,085 |   | 58,050 |   | 105,795 |   | $ | 185,685 |   |
| Estimated  interest expense on our Debt Facility |       | 4,241                                        |       | 48,658 |   | 26,279 |   | 4,987 |   | $ | 84,165 |   |
| Manditorily  Redeemable Series Z                 |       | —                                       |       | 57,000 |   | — |   | — |   | $ | 57,000 |   |
| Minimum lease  payments under capital leases     |       | 66                                           |       | 115 |   | — |   | — |   | $ | 181 |   |
| Minimum lease  payments under operating leases   |       | 6,654                                        |       | 44,585 |   | 12,482 |   | 2,391 |   | $ | 66,112 |   |
| Purchase  obligations (a)                        |       | 4,827                                        |       | — |   | — |   | — |   | $ | 4,827 |   |
| Other long-term  obligations (b)                 |       | —                                       |       | 1,344 |   | 832 |   | 4,907 |   | $ | 7,083 |   |
| Total                                            |       | $                                            | 49,034     |   | $ | 172,787 |   | $ | 97,643 |   | $ | 118,080 |   | $ | 437,544 |   |

 

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

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

*Insurance*

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

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**Off-Balance Sheet Arrangements**

*Guarantees*

Prior to 2001, we wouldoccasionally guarantee leases for the benefit of certain of our franchisees.None of the guarantees have been modified since their inception and we havesince discontinued this practice. Current franchisees are the primary lesseesunder the vast majority of these leases. Under the lease guarantees, we may berequired by the lessor to make all of the remaining monthly rental payments orproperty tax and common area maintenance payments if the franchisee does notmake the required payments in a timely manner. However, we believe that most,if not all, of the franchised restaurants could be subleased to third partiesminimizing our potential exposure. Additionally, we have indemnificationagreements with our franchisees under which the franchisees would be obligatedto reimburse us for any amounts paid under such guarantees. Historically, wehave not been required to make such payments in significant amounts. We recorda liability for our exposure under the guarantees in accordance with SFAS No.5, “Accounting for Contingencies,” following a probability related approach.Minimum future rental payments remaining under these leases were approximately$0.9 million as of October 3, 2006. We believe the ultimate disposition ofthese matters will not have a material adverse effect on our financial positionor results of operations.

*Letters of Credit*

We have $6.9 million inletters of credit outstanding under our Revolving Facility at October 3, 2006.The letters of credit expire on various dates during 2007, are automaticallyrenewable for one additional year and are payable upon demand in the event thatwe fail to pay the underlying obligation.

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

During the third quarterand year to date periods ended October 3, 2006 and September 27, 2005, ourresults of operations, financial position and cash flows have not beenmaterially affected by changes in the relative values of non-U.S. currencies tothe U.S. dollar. We do not use derivative financial instruments to limit ourforeign currency risk exposure since virtually all of our business is conductedin the United States.

Our debt as of October 3,2006 was principally comprised of the Revolving Facility, First Lien Term Loan,Second Lien Term Loan, and Subordinated Note as further discussed in Note 6 tothe consolidated financial statements included in Part I of this document. Forfixed rate debt, interest rate changes affect the fair market value of suchdebt but do not impact earnings or cash flows. Conversely for variable ratedebt, including borrowings under our Revolving Facility, First Lien Term Loanand Second Lien Term Loan, interest rate changes generally do not affect thefair market value of such debt, but do impact future earnings and cash flows,assuming other factors are held constant. A 100 basis point increase inshort-term effective interest rates would increase our net loss byapproximately $1.5 million annually, assuming no change in the size orcomposition of debt at October 3, 2006. Currently, the interest rates on ourFirst Lien Term Loan, Second Lien Term Loan and Revolving Facility arepredominately at LIBOR rates plus an applicable margin through short-term fixedrate financing. The estimated increase in interest expense incorporates thefixed interest financing into its assumptions.

We purchase certaincommodities such as butter, cheese, coffee and flour. These commodities aregenerally purchased based upon market prices established with vendors. Ourpurchase arrangements may contain contractual features that limit the pricepaid by establishing certain price floors or caps. We do not use financialinstruments to hedge commodity prices because our purchase arrangements helpcontrol the ultimate cost paid and any commodity price aberrations aregenerally short-term in nature.

This market riskdiscussion contains forward-looking statements. Actual results may differmaterially from this discussion based upon general market conditions andchanges in domestic and global financial markets.

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**Item4.  Controls and Procedures**

An evaluation was carriedout under the supervision and with the participation of company management,including our chief executive officer and chief financial officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures (as defined in rule 13a-15(e) under the Securities Exchange Actof 1934, as amended) as of October 3, 2006. Based upon that evaluation, ourchief executive officer and our chief financial officer have concluded that thedesign and operation of our disclosure controls and procedures were effectivein timely making known to them material information relating to the Companyrequired to be disclosed in reports that we file or submit under the ExchangeAct rules.

It should be noted thatany system of controls, however well designed and operated, can provide onlyreasonable assurance regarding management’s control objectives. In addition,the design of any control system is based in part upon certain assumptions aboutthe likelihood of future events. Because of these and other inherentlimitations of control systems, there can be no assurance that any design willsucceed in achieving its stated goals under all potential future conditions,regardless of how remote.

During the quarter endedOctober 3, 2006, there were no changes to our internal controls over financialreporting that were identified in connection with the evaluation of ourdisclosure controls and procedures required by the Exchange Act rules and that havematerially affected, or are reasonably likely to materially affect, ourinternal controls over financial reporting.

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**PART II - OTHER INFORMATION**

**NEW WORLDRESTAURANT GROUP, INC.**

**Item 1. LegalProceedings**

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

**Item 1A. Risk Factors**

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

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

*Failure to protect food suppliesand adhere to food safety standards could result in food-borne illnesses and/orinjuries to our customers.*

Food safety is the mostsignificant risk to any company that operates in the restaurant industry. It isthe focus of increased government regulatory initiatives at the local, stateand federal levels. To limit our exposure to the risk of food contamination, wevigorously emphasize and enforce food safety policies in all of our restaurantsand at our commissaries and manufacturing plant. These policies are designed towork cooperatively with programs established by health agencies at all levelsof government authority, including the federal Hazard Analysis of CriticalControl Points (HACCP) program. In addition, we make use of ServSafe Training,a nationally recognized program developed by the National RestaurantAssociation. The ServSafe program provides accurate, up-to-date science-basedinformation to all levels of restaurant workers on all aspects of foodhandling, from receiving and storing to preparing and serving. All restaurantmanagers are required to be certified in ServSafe Training and are required tobe re-certified every three to five years.

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Failure to protect our food supply or enforce foodsafety policies such as proper food temperatures and adherence to shelf lifedates, could result in food-borne illnesses and/or injuries to our customers.Instances of food-borne illness, including listeriosis, salmonella and e-coli,whether or not traced to our restaurants, could reduce demand for our menuofferings. If any of our customers become ill from consuming our products, theaffected restaurants may be forced to close. An instance of food contaminationoriginating from one of our restaurants, our commissaries or our manufacturingplant could have far-reaching effects, as the contamination would affectsubstantially all of our restaurants. In addition, product contamination orrecalls, in general, such as the recent warning by the FDA and illnessesrelated to fresh spinach, may cause our customers to cease frequenting ourrestaurants based on fear of such illnesses.

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

Numerous factors including changes in consumer tastesand discretionary spending priorities often affect restaurants.  Shifts in consumer preferences away from ourtype of cuisine and/or the fast-casual style could have a material adverseeffect on our results of operations. Dietary trends, such as the consumption of food low in carbohydratecontent, have in the past and may, in the future, negatively impact our sales.

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

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

Our success depends in part on our ability tounderstand and satisfy our guests’ needs. We believe successful deployment of our current business strategy willaddress guests’ needs and contribute to overall company growth.  Our business strategy consists of severalinitiatives:

·                  expanding themenu offerings at our company-owned restaurants;

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

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

·                  continuingto develop our manufacturing and commissary operations to increase third-partysales.

Our ability to achieve any or all of these initiativesis uncertain.  Our success in developingnew menu offerings and refreshing our restaurants is dependent in part on ourability to predict and satisfy consumer preferences.  Our success in growing our business throughopening new company-owned restaurants is dependent on a number of factors,including our ability to: find suitable locations, reach acceptable leaseterms, have adequate capital, train appropriate staff and properly manage thenew restaurant.  Our success inincreasing third-party sales is dependent on identifying new opportunities andnegotiating profitable arrangements with third-party purchasers.  If we are not successful in implementing anyor all of the initiatives of our business strategy, it could have a materialadverse effect on our business, results of operations, and financial condition.

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

The level of growth in comparable store salessignificantly affects our sales growth and will be a critical factor affectingprofit growth. The profit margin driven by comparable store sales enables fixedcosts to be spread over a higher sales base. Our ability to increase comparablestore sales depends in part on our ability to successfully implement ourinitiatives to increase throughput, such as increasing the speed at which ouremployees serve each customer, and to build customer awareness of our menuofferings. Factors such as traffic patterns, local demographics and the type, numberand location of competing restaurants may adversely affect the performance ofindividual restaurants. It is possible that we will not achieve our targetedcomparable store sales growth or that the change in comparable store salescould be negative and could adversely impact our sales and profit growth.  We expect quarterly comparable restaurantsales increases to decline throughout the year as sequential comparisons becomemore difficult.

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

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

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

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

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

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

The cost, availability and quality of the ingredientswe use to prepare our food are subject to a range of factors, many of which arebeyond our control. Fluctuations in economic and political conditions, weatherand demand could adversely affect the cost of our ingredients. For example,flour represents the most significant raw ingredient we purchase and world-widewheat production for 2006 has been below projections due to poor crop yields.We expect to see continued pressure throughout the end of this year andcontinuing into 2007.  We have limitedcontrol over these changes in the price and quality of commodities, since we donot have any long-term pricing agreements for these ingredients.  We may not be able to pass through any futurecost increases by increasing menu prices, as we have done in the past. We andour franchisees and licensees are dependent on frequent deliveries of freshingredients, thereby subjecting us to the risk of shortages or interruptions insupply.  All of these factors couldadversely affect our business, reputation and financial results.

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

Adverse weather conditions could seriously affectregions in which our company-owned, franchised and licensed restaurants arelocated or regions that produce raw ingredients for our restaurants.  If adverse weather conditions affect ourrestaurants, we could experience closures, repair and restoration costs, foodspoilage, and other significant reopening costs as well as increased food costsand delayed supply shipments, any of which would adversely affect our business.

The effects of hurricanes and other adverse weatherconditions are likely to affect supply of and costs for raw ingredients andnatural resources, near-term construction costs for our new restaurants as wellas sales in our restaurants going forward. If we are not able to anticipate or react to changing costs of food andother raw materials by adjusting our purchasing practices or menu prices, ouroperating margins would likely deteriorate.

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

We currently purchase our raw materials from varioussuppliers; however, we have only one supplier for each of our key ingredients.We purchase a majority of our frozen bagel dough from a single supplier, whoutilizes our proprietary processes and on whom we are dependent upon in theshort-term.  All of our remaining frozenbagel dough is produced at our dough manufacturing facility in Whittier, CA.  Additionally, we purchase all of our creamcheese from a single source, and we have a single supplier for our coffee.Although to date we have not experienced significant difficulties with oursuppliers, our reliance on a single supplier for each of our key ingredientssubjects us to a number of risks, including possible delays or interruption insupplies, diminished control over quality and a potential lack of adequate rawmaterial capacity. Any disruption in the supply or degradation in the qualityof the materials provided by our suppliers could have a material adverse effecton our business, operating results and financial condition. In addition, anysuch disruptions in supply or degradations in quality could have a long-termdetrimental impact on our efforts to maintain a strong brand identity and aloyal consumer base.

Our contract with our supplier of frozen bagel doughexpires at the end of 2006 and we are in the process of negotiating a new5-year contract. If we are unable to reach a new agreement to supply frozenbagel dough on favorable terms, our frozen bagel dough costs could increasewhich would have a negative impact on our results from operations.

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

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

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

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

We are dependent upon an available labor pool ofassociates, many of whom are hourly employees whose wages may be affected by anincrease in the federal, state or municipal “living wage” rates. Numerousproposals have been made on federal, state and local levels to increase minimumwage levels. Although few, if any, of our associates are paid at the minimumwage level, an increase in the minimum wage may create pressure to increase thepay scale for our associates, which would increase our labor costs and those ofour franchisees and licensees. We are aware of increases in state minimumhourly wage rates in most of the states in which we operate that are effectivebeginning January 1, 2007. A shortage in the labor pool or other generalinflationary pressures or changes could also increase labor costs. In addition,changes in labor laws or reclassifications of associates from management tohourly employees could affect our labor cost. An increase in labor costs couldhave a material adverse effect on our income from operations and decrease ourprofitability and cash flows if we are unable to recover these increases byraising the prices we charge our customers.

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

We have a high level of debt and are highly leveraged.As of October 3, 2006, we had $170 million in term loans outstanding. Inaddition, we may, subject to certain restrictions, incur substantial additionalindebtedness in the future.  Our highlevel of debt, among other things, could:

·                  makeit difficult for us to satisfy our obligations under our indebtedness;

·                  limitour ability to obtain additional financing for working capital, capitalexpenditures, acquisitions and general corporate purposes;

·                  increaseour vulnerability to downturns in our business or the economy generally; and

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

Economic, financial, competitive, legislative andother factors beyond our control may affect our ability to generate cash flowfrom operations to make payments on our indebtedness and to fund necessaryworking capital. A significant reduction in operating cash flow would likelyincrease the need for alternative sources of liquidity. If we are unable togenerate sufficient cash flow to make payments on our debt, we will have topursue one or more alternatives, such as reducing or delaying capitalexpenditures, refinancing our debt on terms that are not favorable to us,selling assets or issuing additional equity securities. We may not be able toaccomplish any of these alternatives on satisfactory terms, if at all, and evenif accomplished, they may not yield sufficient funds to service our debt.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

*We have a majority stockholder.*

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

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

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

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

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

Our common stock is currently trading on the ‘‘pinksheets’’ under the symbol ‘‘NWRG.PK.’’ Since our common stock is not listed onNasdaq, Amex or the New York Stock Exchange, holders of our common stock mayfind that the liquidity of our common stock is limited—not only in the numberof securities that can be bought and sold, but also through delays in thetiming of transactions, lack of security analysts’ and the news media’scoverage of us, and lower prices for our securities than might otherwise beattained.

Securities that are not listed on a stock exchange,the Nasdaq National Market or the Nasdaq SmallCap Market are subject to an SECrule that imposes special requirements on broker-dealers who sell thosesecurities to persons other than their established customers and accreditedinvestors. The broker-dealer must determine that the security is suitable forthe purchaser and must obtain the purchaser’s written consent prior to thesale. These requirements may make it more difficult for stockholders to sellour stock than the stock of some other companies. It may also affect ourability to raise more capital if and when necessary.

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**Item 6.  Exhibits**

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

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

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

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

**Signatures**

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

 

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