**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

| **(Mark One)**                                                                                                    |
|-------------------------------------------------------------------------------------------------------------------|
| **ý****QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                              |
| **For the  quarterly period ended April 4, 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 of  Registrant 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, Colorado 80401**                                                                      |
| (Address of  principal executive offices, including zip code)                                                     |
|                                                                                                              |
| **(303)  568-8000**                                                                                               |
| (Registrant’s  telephone number, including area code)                                                        |
|                                                                                                              |
| Securities  registered pursuant to Section 12(b) of the Act:                                            |
| **None**                                                                                                          |

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days. Yes ý  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 ExchangeAct of 1934). 
| Large  accelerated filer o |   | Accelerated  filer o |   | Non-accelerated  filer ý |
|----------------------------|--------|----------------------|--------|-------------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theSecurities Exchange Act of 1934). Yes o  No ý

 

As of May 5, 2006,10,087,963 shares of Common Stock of the registrant were outstanding.

 

 

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**NEW WORLDRESTAURANT GROUP, INC.**

 

April 4, 2006

 

TABLE OF CONTENTS

 
| **Part I**. **Financial  Information** | ** **                                                                                                                 |
|---------------------------------------------|----------------------------------------------------------------------------------------------------------------------------|
|                                        |                                                                                                                       |
|  Item 1.                               | Financial Statements:                                                                                                      |   |
|                                        |                                                                                                                       |   |
|                                        | Consolidated Balance Sheets (unaudited), April 4, 2006 and January 3,  2006                                      |   |
|                                        |                                                                                                                       |   |
|                                        | Consolidated Statements of Operations (unaudited), for the first  quarter ended April 4, 2006 and March 29, 2005 |   |
|                                        |                                                                                                                       |   |
|                                        | Consolidated Statements of Cash Flows (unaudited), for the first  quarter ended April 4, 2006 and March 29, 2005 |   |
|                                        |                                                                                                                       |   |
|                                        | 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 APRIL 4, 2006 AND JANUARY 3, 2006**

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

**(unaudited)**

 
| ** **                                                                                                                                                                       | ** ** | **April 4,  2006** | ** ** | **January 3,  2006** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|---------------------------|------------|
| **ASSETS**                                                                                                                                                                       |       |                    |       |                      |       |
| Current  assets:                                                                                                                                                                 |       |                    |       |                      |       |
| Cash and  cash equivalents                                                                                                                                                       |       | $                       | 3,847      |                      | $          | 1,556 |   |
| Restricted  cash                                                                                                                                                                 |       | 2,643                   |       | 2,554                     |       |
| Franchise  and other receivables, net of allowance of $591 and $480, respectively                                                                                                |       | 4,982                   |       | 5,506                     |       |
| Inventories                                                                                                                                                                      |       | 4,966                   |       | 5,072                     |       |
| Prepaid  expenses and other current assets                                                                                                                                       |       | 5,121                   |       | 4,506                     |       |
| Total  current assets                                                                                                                                                            |       | 21,559                  |       | 19,194                    |       |
|                                                                                                                                                                             |       |                    |       |                      |       |
| Restricted  cash long-term                                                                                                                                                       |       | 595                     |       | 595                       |       |
| Property,  plant and equipment, net                                                                                                                                              |       | 31,867                  |       | 33,359                    |       |
| Trademarks  and other intangibles, net                                                                                                                                           |       | 65,761                  |       | 67,717                    |       |
| Goodwill                                                                                                                                                                         |       | 4,875                   |       | 4,875                     |       |
| Debt  issuance costs and other assets, net                                                                                                                                       |       | 5,791                   |       | 5,184                     |       |
| Total assets                                                                                                                                                                     |       | $                       | 130,448    |                      | $          | 130,924 |   |
|                                                                                                                                                                             |       |                    |       |                      |       |
| **LIABILITIES  AND STOCKHOLDERS’ DEFICIT**                                                                                                                                  |       |                    |       |                      |       |
| Current  liabilities:                                                                                                                                                            |       |                    |       |                      |       |
| Accounts  payable                                                                                                                                                                |       | $                       | 5,658      |                      | $          | 5,848 |   |
| Accrued  expenses                                                                                                                                                                |       | 26,711                  |       | 24,789                    |       |
| Short term  debt and current portion of long-term debt                                                                                                                           |       | 2,180                   |       | 280                       |       |
| Current  portion of obligations under capital leases                                                                                                                             |       | 59                      |       | 19                        |       |
| Total  current liabilities                                                                                                                                                       |       | 34,608                  |       | 30,936                    |       |
|                                                                                                                                                                             |       |                    |       |                      |       |
| Senior notes  and other long-term debt, net of discount                                                                                                                          |       | 168,042                 |       | 160,560                   |       |
| Obligations  under capital leases                                                                                                                                                |       | 126                     |       | 29                        |       |
| Other  liabilities                                                                                                                                                               |       | 8,742                   |       | 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                                                                                                                                                               |       | 268,518                 |       | 257,135                   |       |
| Commitments  and contingencies                                                                                                                                                   |       |                    |       |                      |       |
| Stockholders’  deficit:                                                                                                                                                     |       |                    |       |                      |       |
| Common  stock, $.001 par value; 15,000,000 shares authorized; 10,065,072 and  10,065,072 shares issued and outstanding                                                           |       | 10                      |       | 10                        |       |
| Additional  paid-in capital                                                                                                                                                      |       | 176,183                 |       | 176,018                   |       |
| Unamortized  stock compensation                                                                                                                                                  |       | —                  |       | (68                       | )          |
| Accumulated  deficit                                                                                                                                                             |       | (314,263                | )          | (302,171                  | )          |
| Total  stockholders’ deficit                                                                                                                                                |       | (138,070                | )          | (126,211                  | )          |
| Total  liabilities and stockholders’ deficit                                                                                                                                |       | $                       | 130,448    |                      | $          | 130,924 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

3

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**NEW WORLD RESTAURANT GROUP, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**FOR THE FIRST QUARTER ENDED APRIL 4, 2006 AND MARCH 29,2005**

**(in thousands, except earnings per share and relatedshare information)**

**(unaudited)**

 
| ** **                                                              | ** ** | **April 4,  2006** | ** ** | **March 29,  2005** | ** ** |
|-------------------------------------------------------------------------|------------|-------------------------|------------|--------------------------|------------|
| Revenues:                                                               |       |                    |       |                     |       |
| Retail sales                                                            |       | $                       | 90,580     |                     | $          | 86,859 |   |
| Manufacturing  revenues                                                 |       | 5,021                   |       | 4,994                    |       |
| Franchise  and license related revenues                                 |       | 1,475                   |       | 1,442                    |       |
|                                                                    |       |                    |       |                     |       |
| Total  revenues                                                         |       | 97,076                  |       | 93,295                   |       |
| Cost of  sales:                                                         |       |                    |       |                     |       |
| Retail costs                                                            |       | 73,526                  |       | 71,430                   |       |
| Manufacturing  costs                                                    |       | 5,005                   |       | 4,707                    |       |
|                                                                    |       |                    |       |                     |       |
| Total cost  of sales                                                    |       | 78,531                  |       | 76,137                   |       |
|                                                                    |       |                    |       |                     |       |
| Gross profit                                                            |       | 18,545                  |       | 17,158                   |       |
|                                                                    |       |                    |       |                     |       |
| Operating  expenses:                                                    |       |                    |       |                     |       |
| General and  administrative expenses                                    |       | 10,561                  |       | 8,680                    |       |
| Depreciation  and amortization                                          |       | 6,004                   |       | 6,708                    |       |
| Loss on  sale, disposal or abandonment of assets, net                   |       | 21                      |       | 4                        |       |
| Integration  and reorganization cost                                    |       | —                  |       | 5                        |       |
| Impairment  charges and other related costs                             |       | 76                      |       | 97                       |       |
|                                                                    |       |                    |       |                     |       |
| Income from  operations                                                 |       | 1,883                   |       | 1,664                    |       |
|                                                                    |       |                    |       |                     |       |
| Other  expense (income):                                                |       |                    |       |                     |       |
| Interest  expense, net                                                  |       | 5,209                   |       | 5,919                    |       |
| 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                                                                   |       | 10                      |       | (57                      | )          |
|                                                                    |       |                    |       |                     |       |
| Loss before  income taxes                                               |       | (12,092                 | )          | (4,198                   | )          |
|                                                                    |       |                    |       |                     |       |
| Provision  for income taxes                                             |       | —                  |       | —                   |       |
|                                                                    |       |                    |       |                     |       |
| Net loss                                                                |       | $                       | (12,092    | )                        | $          | (4,198 | ) |
|                                                                    |       |                    |       |                     |       |
| Net loss per  common share – Basic and Diluted                     |       | $                       | (1.20      | )                        | $          | (0.43 | ) |
|                                                                    |       |                    |       |                     |       |
| Weighted average  number of common shares outstanding:                  |       |                    |       |                     |       |
| Basic and  Diluted                                                      |       | 10,065,072              |       | 9,848,713                |       |

 

The accompanying notes are an integral part ofthese consolidated financial statements.

 

4

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**NEW WORLD RESTAURANT GROUP, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**FOR THE FIRST QUARTER ENDED APRIL 4, 2006 AND MARCH 29,2005**

**(in thousands)**

**(unaudited)**

 
| ** **                                                                                 | ** ** | **April 4,  2006** | ** ** | **March 29,  2005** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-------------------------|------------|--------------------------|------------|
| **OPERATING  ACTIVITIES:**                                                                 |       |                    |       |                     |       |
| Net loss                                                                                   |       | $                       | (12,092    | )                        | $          | (4,198 | ) |
| Adjustments  to reconcile net loss to net cash provided by (used in) operating activities: |       |                    |       |                     |       |
| Depreciation  and amortization                                                             |       | 6,004                   |       | 6,708                    |       |
| Stock based  compensation expense                                                          |       | 216                     |       | 17                       |       |
| Loss, net of  gains, on disposal of assets                                                 |       | 21                      |       | 4                        |       |
| Impairment  charges and other related costs                                                |       | 76                      |       | 97                       |       |
| Integration  and reorganization costs                                                      |       | —                  |       | 5                        |       |
| Provision  for (recovery of) losses on accounts receivable, net                            |       | 128                     |       | (91                      | )          |
| Amortization  of debt issuance and debt discount costs                                     |       | 227                     |       | 462                      |       |
| Write-off of  debt issuance costs                                                          |       | 3,956                   |       | —                   |       |
| Changes in  operating assets and liabilities:                                              |       |                    |       |                     |       |
| Franchise  and other receivables                                                           |       | 396                     |       | 1,638                    |       |
| Accounts  payable and accrued expenses                                                     |       | 1,732                   |       | (9,960                   | )          |
| Other assets  and liabilities                                                              |       | (528                    | )          | (970                     | )          |
|                                                                                       |       |                    |       |                     |       |
| Net cash  provided by (used in) operating activities                                       |       | 136                     |       | (6,288                   | )          |
|                                                                                       |       |                    |       |                     |       |
| **INVESTING  ACTIVITIES:**                                                                 |       |                    |       |                     |       |
| Purchase of  property and equipment                                                        |       | (2,559                  | )          | (2,178                   | )          |
| Proceeds  from the sale of equipment                                                       |       | 48                      |       | 75                       |       |
|                                                                                       |       |                    |       |                     |       |
| Net cash  used in investing activities                                                     |       | (2,511                  | )          | (2,103                   | )          |
|                                                                                       |       |                    |       |                     |       |
| **FINANCING  ACTIVITIES:**                                                                 |       |                    |       |                     |       |
| Proceeds  from line of credit                                                              |       | 11                      |       | 5,415                    |       |
| Repayments  of line of credit                                                              |       | (11                     | )          | (5,430                   | )          |
| Repayment of  other borrowings                                                             |       | —                  |       | (5                       | )          |
| Payments  under capital lease obligations                                                  |       | (4                      | )          | —                   |       |
| Repayment of  notes payable                                                                |       | (160,000                | )          | —                   |       |
| Borrowings under  First Lien                                                               |       | 80,000                  |       | —                   |       |
| Borrowing  under Second Lien                                                               |       | 65,000                  |       | —                   |       |
| Borrowings  under Subordinated Note                                                        |       | 24,375                  |       | —                   |       |
| Debt  issuance costs                                                                       |       | (4,705                  | )          | —                   |       |
|                                                                                       |       |                    |       |                     |       |
| Net cash  provided by (used in) financing activities                                       |       | 4,666                   |       | (20                      | )          |
|                                                                                       |       |                    |       |                     |       |
| Net increase  (decrease) in cash and cash equivalents                                      |       | 2,291                   |       | (8,411                   | )          |
| Cash and  cash equivalents, beginning of period                                            |       | 1,556                   |       | 9,752                    |       |
| Cash and  cash equivalents, end of period                                                  |       | $                       | 3,847      |                     | $          | 1,341 |   |

 

The accompanying notes are an integral part ofthese consolidated financial statements.

 

5

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**NEW WORLD RESTAURANT GROUP, INC.**

 

Notesto Consolidated Financial Statements (Unaudited)

 

Quarter ended April 4, 2006 and March 29, 2005

 

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

 

Theaccompanying consolidated financial statements of New World Restaurant Group, Inc.and its wholly-owned subsidiaries (collectively, the Company) have beenprepared pursuant to the rules and regulations of the Securities andExchange Commission (“SEC”). As of April 4, 2006, the Company owns,franchises or licenses various restaurant concepts under the brand names ofEinstein Bros. Bagels (“Einstein Bros.”), Einstein Bros. Café, Noah’s New YorkBagels (“Noah’s”), Manhattan Bagel Company (“Manhattan”), Chesapeake BagelBakery (“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.

 

The accompanying consolidated financialstatements asof April 4, 2006 and for the quarters ended April 4, 2006 and March 29,2005 have been prepared without audit. The balance sheet information asof January 3, 2006 has been derived from our audited financial statements.The information furnished herein reflects all adjustments (consisting only ofnormal recurring accruals and adjustments), which are, in our opinion,necessary to fairly state the interim operating results for the respectiveperiods. However, these operating results are not necessarily indicative of theresults expected for the full fiscal year. Certain information and footnotedisclosures normally included in annual financial statements prepared inaccordance with generally accepted accounting principles in the United Stateshave been omitted pursuant to SEC rules and regulations. The notes to theconsolidated financial statements (unaudited) should be read in conjunctionwith the notes to the consolidated financial statements contained in our annualreport on Form 10-K for the fiscal year ended January 3, 2006. Webelieve that the disclosures are sufficient for interim financial reportingpurposes.

 

Certain reclassifications have been made toconform previously 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 FinancialAccounting Standards Board (FASB) issued Statement of Financial AccountingStandard (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, Accountingfor Stock Issued to Employees and its related implementation guidance. SFAS No. 123Rfocuses primarily on accounting for transactions in which an entity obtainsemployee services in share-based payment transactions. The Statement requiresentities to recognize compensation expense for awards of equity instruments toemployees based on the grant-date fair value of those awards (with limitedexceptions).

 

Effective January 4, 2006, we adoptedthe provisions of SFAS No. 123R using the modified prospective transitionmethod. Prior to the adoption of SFAS No. 123R, we applied the intrinsicvalue-based method of accounting prescribed by APB No. 25 and relatedinterpretations, in accounting for our fixed award stock options to ouremployees. As such, compensation expense was recorded only if the currentmarket price of the underlying common stock exceeded the exercise price of theoption on the date of grant. We applied the fair value-basis of accounting asprescribed by SFAS No. 123**in accountingfor our fixed award stock options to our consultants. Under SFAS No. 123,compensation expense was recognized based on the fair value of stock optionsgranted. 

 

Because we previously adopted only the proforma disclosure provisions of SFAS No. 123, we will recognizecompensation cost, over the requisite service period, relating to the unvestedportion of awards granted prior to the date of adoption using the same estimateof the grant-date fair value and the same attribution method used to determinethe pro forma disclosures under SFAS No. 123, except that forfeiture rateshave been estimated for all options, as required by SFAS No. 123R. 

 

6

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Our stock-based compensation cost for firstquarter of 2006 and 2005 was $216,000 and $17,000, respectively and has beenincluded in general and administrative expenses. The impact of adoption of SFAS123R had the effect of increasing our loss per share by $0.02 for first quarter2006. No tax benefits were recognized for these costs due to our recurringlosses. Results for the 2005 first quarter have not been restated. Hadcompensation cost for stock options granted to employees been determined on thebasis of fair value as computed using the assumptions herein, net loss and lossper share would have been increased to the following pro forma amounts (inthousands of dollars, except per share amounts): 

 

| ** **                                     | ** ** | **Quarter ended:**  | ** ** |
|------------------------------------------------|------------|--------------------------|------------|
| ** **                                     | ** ** | **March 29,  2005** | ** ** |
| Net loss, as  reported                         |       | $                        | (4,198     | ) |
| Deduct: fair  value based compensation expense |       | (153                     | )          |
| Pro forma  net loss                            |       | (4,351                   | )          |
| Basic and  diluted loss per common share:      |       |                     |       |
| As reported                                    |       | $                        | (0.43      | ) |
| Pro forma                                      |       | $                        | (0.44      | ) |

 

The fair value of stock options is estimatedusing the Black-Scholes option-pricing model with the following weightedaverage assumptions:

 
| ** **                                   | ** ** | **Quarter ended:** | ** ** |
|----------------------------------------------|------------|-------------------------|------------|
| ** **                                   | ** ** | **April 4,  2006** | ** ** | **March 29,  2005** | ** ** |
| Expected  life of options from date of grant |       | 4.0 years               |       | 4.0 years |   |
| Risk-free  interest rate                     |       | 4.35                    | %          | 3.55 | % |
| Volatility                                   |       | 100.0                   | %          | 100.0 | % |
| Assumed  dividend yield                      |       | 0.0                     | %          | 0.0 | % |

 

The expected term of options is based uponevaluations of historical and expected future employee 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 with consideration given to an evolving capitalstructure brought about by a series of de-levering mandatory prepayments underour new debt facility as further explained in Note 6. We have nothistorically issued any dividends and are precluded from doing so under ourdebt covenants.

 

7

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**Stock Option Plans**

 

*1994 and 1995 Plans*

 

Our 1994 Stock Plan (1994 Plan) provided forthe granting 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 April 4,2006, options to purchase 17 shares of common stock at an exercise price of$210.71 per share and a remaining contractual life of 1.48 years remainedoutstanding under this plan. 

 

Our 1995 Directors’ Stock Option Plan(Directors’ Option Plan) provided for the automatic grant of non-statutorystock options to non-employee directors of the Company. On December 19,2003, our board of directors terminated the authority to issue any additionaloptions under the Directors’ Option Plan. At April 4, 2006, options topurchase 1,328 shares of common stock at a weighted average exercise price of$49.08 per share and a weighted average remaining contractual life of 3.15years remained outstanding under this plan.

 

*2003 Executive Employee Incentive Plan*

 

On November 21, 2003, our board of directorsadopted the Executive Employee Incentive Plan, amended on December 19, 2003(2003 Plan). The 2003 Plan provides for granting incentive stock options toemployees and granting non-statutory stock options to employees and consultants.Unless terminated sooner, the 2003 Plan will terminate automatically inDecember 2013. The board of directors has the authority to amend, modify orterminate the 2003 Plan, subject to any required approval by our stockholdersunder applicable law or upon advice of counsel. No such action may affect anyoptions previously granted under the 2003 Plan without the consent of theholders. There are 1,150,000 shares issuable pursuant to options granted underthe 2003 Plan. Options are granted with an exercise price equal to the fairmarket value on the date of grant, have a contractual life of ten years andtypically vest over a three-year service period. Generally, 50% of optionsgranted vest based solely upon the passage of time. We recognize compensationcosts for these awards using a graded vesting attribution method over therequisite service period. The remaining 50% of options granted vest based onservice and performance conditions. Options that do not vest due to the failureto achieve specific financial performance criteria are forfeited. Options topurchase approximately 431,695 shares of our common stock, which are not yetexercisable, are subject to company performance conditions. We recognizecompensation costs for performance based options over the requisite serviceperiod when conditions for achievement become probable. We expect that all ofthe non-vested awards at April 4, 2006 will vest based on company performance.As of April 4, 2006, there were 260,986 shares reserved for future issuance underthe 2003 Plan.

 

*2004 Stock Option Plan for IndependentDirectors*

 

On December 19, 2003, our board ofdirectors adopted the Stock Option Plan for Independent Directors, effective January 1,2004, (2004 Directors’ Plan). Our board of directors may amend, suspend,or terminate the 2004 Directors’ Plan at any time, provided, however, that nosuch action may adversely affect any outstanding option without the optionholders consent. A total of 200,000 shares of common stock have been reservedfor issuance under the 2004 Directors’ Plan. The 2004 Directors’ Plan providesfor the automatic grant of non-statutory stock options to independent directorson January 1 of each year and a prorated grant of options for any directorelected during the year. Options are granted with an exercise price equal tothe fair market value on the date of grant, become exercisable six months afterthe grant date and are exercisable for 5 years from the date of grant unlessearlier terminated. As of April 4, 2006, there were 94,192 shares reservedfor future issuance under the 2004 Directors’ Plan.

 

8

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Thirteen week period ended March 30, 2004 and April 1,2003

 

Transactions during thefirst quarter of fiscal 2006 were as follows:

 

| ** **                         | ** ** | **Number  of  Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Life (Years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|------------------------------------|------------|-------------------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------|------------|
| Outstanding,  January 4, 2006 |       | 997,152                 |       | $                                      | 3.31       |                                                |       |                            |       |   |
| Granted                            |       | 117,500                 |       | 4.50                                   |       |                                                |       |                            |       |
| Exercised                          |       | —                  |       | —                                 |       |                                                |       |                            |       |
| Forfeited                          |       | (102,500                | )          | 2.46                                   |       |                                                |       |                            |       |
| Outstanding,  April 4, 2006   |       | 1,012,152               |       | $                                      | 3.53       |                                                | 7.92       |                            | $          | 5,521,947 |   |
| Exercisable,  April 4, 2006   |       | 353,237                 |       | $                                      | 3.82       |                                                | 6.72       |                            | $          | 1,825,437 |   |

 

| ** **                         | ** ** | ** **  | ** ** | **Weighted**   | ** ** |
|------------------------------------|------------|-------------|------------|----------------|------------|
| ** **                         | ** ** | **Number**  | ** ** | **Average**    | ** ** |
| ** **                         | ** ** | **of**      | ** ** | **Grant Date** | ** ** |
| ** **                         | ** ** | **Options** | ** ** | **Fair Value** | ** ** |
| Non-vested shares, January 4, 2006 |       | 643,915     |       | $              | 2.13       |   |
| Granted                            |       | 117,500     |       | $              | 3.19       |   |
| Vested                             |       | —      |       | $              | —     |   |
| Forfeited                          |       | (102,500    | )          | $              | 1.73       |   |
| Non-vested shares, April 4, 2006   |       | 658,915     |       | $              | 2.39       |   |

 

 

At April 4, 2006, we have approximately$0.7 million of total unrecognized compensation cost related to non-vestedawards granted under our option plans, which we expect to recognize over aweighted average period of ten months. Total compensation costs related to theoptions outstanding as of April 4, 2006 will be fully recognized by firstquarter of fiscal 2009.

 

9

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Quarter ended April 4,2006 and March 29, 2005

 

**3.****             ****Supplemental Cash Flow Information**

 

 

| ** **                                                | ** ** | **April 4,**                            | ** ** | **March 29,** | ** ** |
|-----------------------------------------------------------|------------|----------------------------------------------|------------|--------------------|------------|
| ** **                                                | ** ** | **2006**                                     | ** ** | **2005**           | ** ** |
| ** **                                                | ** ** | **(in thousands of dollars)** | ** ** |
| Cash paid  during the period for:                         |       |                                         |       |               |       |
| Interest                                                  |       | $                                            | 3,570      |               | $          | 10,583 |   |
| Prepayment  penalty upon redemption of $160 Million Notes |       | $                                            | 4,800      |               | $          | — |   |
|                                                      |       |                                         |       |               |       |
| Non-cash  investing activities:                           |       |                                         |       |               |       |
| Non-cash  purchase of equipment through capital leasing   |       | $                                            | 141        |               | $          | — |   |

 

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

 

Inventories, which consist of food, beverage,paper supplies and bagel ingredients, are stated at the lower of cost ormarket, with cost being determined by the first-in, first-out method.Inventories consist of the following: 

 

| ** **         | ** ** | **April 4,**                            | ** ** | **January 3,** | ** ** |
|--------------------|------------|----------------------------------------------|------------|---------------------|------------|
| ** **         | ** ** | **2006**                                     | ** ** | **2006**            | ** ** |
| ** **         | ** ** | **(in thousands of dollars)** | ** ** |
| Finished  goods    |       | $                                            | 3,619      |                | $          | 4,558 |   |
| Raw  materials     |       | 1,347                                        |       | 514                 |       |
| Total  inventories |       | $                                            | 4,966      |                | $          | 5,072 |   |

 

10

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

 

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

 

Goodwilland other intangible assets with indefinite lives are not subject toamortization but are tested for impairment annually or more frequently ifevents or changes in circumstances indicate that the asset might be impaired.SFAS No. 142, Goodwill and Other Intangible Assets, requires a two-stepapproach for testing impairment of goodwill. For goodwill, thefair value of each reporting unit is compared to its carrying value to determinewhether an indication of impairment exists. If impairment is indicated, thefair value of the reporting unit’s goodwill is determined by allocating theunit’s fair value to its assets and liabilities (including any unrecognizedintangible assets) as if the reporting unit had been acquired in a businesscombination. For other indefinite lived intangibles, the fair value is comparedto the carrying value. Theamount of impairment for goodwill and other intangible assets is measured asthe excess of its carrying amount over its fair value. Intangible assets notsubject to amortization consist primarily of the Einstein Bros. and Manhattantrademarks. 

 

Intangibleassets with lives restricted by contractual, legal or other means are amortizedover their useful lives and consist primarily of patents used in ourmanufacturing process. Amortization expense is calculated using thestraight-line method over the estimated useful lives of approximately 5 years. Intangibleassets subject to amortization are reviewed for impairment whenever events orchanges in circumstances indicate that the carrying amount of an asset may notbe recoverable, in accordance with SFAS No. 144, Accounting for theImpairment or Disposal of Long-Lived Assets.

 

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

 
| ** **                                   | ** ** | **April 4,  2006** | ** ** | **January 3,  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                               |       | 5,117                   |       | 4,847                     |       |
| Trademarks                                   |       | —                  |       | 1,082                     |       |
| Patents-manufacturing  process               |       | 32,054                  |       | 30,368                    |       |
|                                         |       | 37,171                  |       | 36,297                    |       |
| Total  amortizing intangibles, net           |       | $                       | 1,955      |                      | $          | 3,911 |   |
|                                         |       |                    |       |                      |       |
| Non-amortizing  intangibles:                 |       |                    |       |                      |       |
| Trademarks                                   |       | 63,806                  |       | 63,806                    |       |
| Total  trademarks and other intangibles, net |       | $                       | 65,761     |                      | $          | 67,717 |   |

 

11

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Duringthe first quarter of 2006, there were no events or changes in circumstances thatindicated that our intangible assets might be impaired or may not berecoverable. 

 

Theremaining aggregate amortization expense of $1.96 million is to be fullyamortized during the second quarter of fiscal year 2006.

 

**6.****                ****Senior Notes and Other Long-Term Debt**

 

Seniornotes and other long-term debt consists of the following (in thousands ofdollars):

 
| ** **                                                     | ** ** | **April 4,  2006** | ** ** | **January 3,  2006** | ** ** |
|----------------------------------------------------------------|------------|-------------------------|------------|---------------------------|------------|
|                                                           |       |                    |       |                      |       |
| $80 Million  First Lien Term Loan                              |       | $                       | 80,000     |                      | $          | — |   |
| $65 Million  Second Lien Term Loan                             |       | 65,000                  |       | —                    |       |
| $25 Million  Subordinated Note                                 |       | 24,382                  |       | —                    |       |
| $160 Million  Notes                                            |       | —                  |       | 160,000                   |       |
| New Jersey  Economic Development Authority Note Payable        |       | 840                     |       | 840                       |       |
|                                                           |       | $                       | 170,222    |                      | $          | 160,840 |   |
| Less current  portion of senior notes and other long-term debt |       | 2,180                   |       | 280                       |       |
| Senior notes  and other long-term debt                         |       | $                       | 168,042    |                      | $          | 160,560 |   |

 

**Debt Redemption and Refinancing**

 

On February 28, 2006, we completed therefinancing of the AmSouth Revolver and $160 Million Notes. Our new debt obligations consistof 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 usedto repay the $160 Million Notes plus a 3% redemption premium of $4.8 millionand accrued and unpaid interest to the redemption date.

 

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**RevolvingFacility**

 

TheRevolving Facility has a maturity date of March 31, 2011 and provides forinterest based upon the prime rate or LIBOR plus a margin. The margin may increaseor decrease up to 0.25% based upon our consolidated leverage ratio as definedin the agreement. The initial margin is at prime plus 2.00% or LIBOR plus3.00%. This facility may be used in whole or in part for letters ofcredit. As of April 4, 2006, the stated interest rate under the RevolvingFacility was at prime plus 2.00%, or 9.75%.

 

Inthe event that we have not extended the maturity date of the MandatorilyRedeemable Series Z Preferred Stock (Series Z) to a date that is onor after July 26, 2012 or redeemed the Series Z by December 30,2008, then the Revolving Facility will mature on December 30, 2008.

 

We are required to pay an unused credit linefee of 0.5% per annum on the average daily unused amount. The unused line feeis payable quarterly in arrears. Additionally, we are required to pay a letterof credit fee based on the ending daily undrawn face amount for each letter of creditissued, of an applicable margin being based on our consolidated leverage ratiowith a minimum and maximum applicable margin of 2.75% and 3.25%, respectively,plus a 0.5% arranger fee payable quarterly. Letters of credit reduce ouravailability under the Revolving Facility. At April 4, 2006, we had $6.8letters of credit outstanding. The letters of credit expire on various datesduring 2007, are automatically renewable for one additional year and arepayable upon demand in the event that we fail to pay certain workers’compensation claims. Our availability under the Revolving Facility was $8.2million at April 4, 2006. 

 

TheRevolving Facility contains usual and customary covenants includingconsolidated leverage ratios, fixed charge coverage ratios, limitations oncapital expenditures, etc. The ratio covenants are based on a ConsolidatedEBITDA calculation (as defined in our loan agreement) and are measured on atwelve month period ending on the last day of each fiscal quarter. The loan is guaranteed by ourmaterial subsidiaries. The Revolving Facility and the related guarantees aresecured by a first priority security interest in all of our assets and ourmaterial subsidiaries, including a pledge of 100% of our interest in all sharesof capital stock (or other ownership or equity interests) of each materialsubsidiary. As of April 4, 2006, we were in compliance with all ourfinancial and operating covenants. 

 

Approximately $0.4 million in debt issuancecosts have been capitalized and are being amortized using the straight-linemethod over the term of the Revolving Facility.

 

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**First LienTerm Loan**

 

TheFirst Lien Term Loan has a maturity date of March 31, 2011 and providesfor a floating interest rate based upon the prime rate or LIBOR plus a margin.The margin may increase or decrease 0.25% based upon our consolidatedleverage ratio as defined in the agreement. The initial margin is prime plus2.00% or LIBOR plus 3.00% and is payable in arrears quarterly or at the LIBORdate, dependent upon the rate in effect. As of April 4, 2006, the statedinterest rate under the First Lien Term Loan was at LIBOR plus 3.00%, or 7.98%and the effective interest rate was 8.51%. The facility is fully amortizingwith quarterly principal reductions 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 |

 

Inaddition to the repayment schedule discussed above, the First Lien TermLoan also requires additional principal reductions based upon a percentage ofexcess cash flow as defined in the loan agreement in any fiscal year. The FirstLien Term Loan also provides us the opportunity to repay the Second Lien TermLoan or the Subordinated Note with the proceeds of a capital stock offeringprovided that certain consolidated leverage ratios are met.

 

Inthe event that we have not extended the maturity date of the Series Z to adate that is on or after July 26, 2012 or redeemed the Series Zby December 30, 2008, then the First Lien Term Loan will matureon December 30, 2008.

 

TheFirst Lien Term Loan has usual and customary covenants including consolidatedleverage ratios, fixed charge coverage ratios, limitations on capitalexpenditures, etc. The ratio covenants are based on a ConsolidatedEBITDA calculation (as defined in our loan agreement) and are measured on atwelve month period ending on the last day of each fiscal quarter. The loan is guaranteed by ourmaterial subsidiaries. The First Lien Term Loan and the related guarantees aresecured by a first priority security interest in all of our assets and ourmaterial subsidiaries, including a pledge of 100% of our interest in all sharesof capital stock (or other ownership or equity interests) of each materialsubsidiary. As of April 4, 2006, we were in compliance with all ourfinancial and operating covenants. 

 

Approximately $2.1 million in debt issuancecosts have been capitalized and are being amortized using the effectiveinterest method over the term of the First Lien Term Loan.

 

**SecondLien Term Loan**

 

TheSecond Lien Term Loan has a maturity date of February 28, 2012 andprovides for a floating interest rate based upon the prime rate plus 5.75% orLIBOR plus 6.75%. Interest is payable in arrears on a quarterly basis. As of April 4,2006, the stated interest rate under the Second Lien Term Loan was 11.73% andthe effective interest rate was 12.21%. The Second Lien Term Loan has aprepayment penalty of 2.0% and 1.0% of the amount of any such optionalprepayment that occurs prior to the first or second anniversary date,respectively. The Second Lien Term Loan requires principal reductions basedupon a percentage of excess cash flow (as defined in the credit agreement) inany fiscal year and is also subject to certain mandatory prepayment provisions.In the event that we have not extended the maturity date of the Series Zto a date that is on or after July 26, 2012 or redeemed the Series Zby March 30, 2009, then the Second Lien Term Loan will mature on March 30,2009.

 

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TheSecond Lien Term Loan has usual and customary covenants including consolidatedleverage ratios, fixed charge coverage ratios, limitations on capitalexpenditures, etc. The ratio covenants are based on a ConsolidatedEBITDA calculation (as defined in our loan agreement) and are measured on atwelve month period ending on the last day of each fiscal quarter. The loan is guaranteed by our materialsubsidiaries. The Second Lien Term Loan and the related guarantees are securedby a second priority security interest in all our assets and our materialsubsidiaries, including a pledge of 100% of our interest in all shares ofcapital stock (or other ownership or equity interests) of each materialsubsidiary. As of April 4, 2006, we were in compliance with all ourfinancial and operating covenants. 

 

Approximately $1.7 million in debt issuancecosts have been capitalized and are being amortized using the effectiveinterest method over the term of the Second Lien Term Loan.

 

**SubordinatedNote**

 

TheSubordinated Note has a maturity date of February 28, 2013, carries afixed interest 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%. As of April 4, 2006, theeffective interest rate was 14.53%. The Subordinated Note is held by GreenlightCapital and its affiliates (collectively referred to as Greenlight). Based onan original issue discount of 2.5%, proceeds of approximately $24.4 millionwere loaned to the Company. The Subordinated Note is subject to certainmandatory prepayment provisions. In the event that we have not extended thematurity date of the Series Z to a date that is on or after July 26,2013 or redeemed the Series Z by June 29, 2009, then the SubordinatedNote will mature on June 29, 2009.

 

TheSubordinated Note has usual and customary covenants including consolidatedleverage ratios, fixed charge coverage ratios, limitations on capitalexpenditures, etc. The loan is guaranteed by our material subsidiaries. TheSubordinated Note is unsecured. As of April 4, 2006, we werein compliance with all our financial and operating covenants. 

 

Approximately $0.7 million in debt issuancecosts have been capitalized and are being amortized using the effectiveinterest method over the term of the Subordinated Note. The debt discount of$625,000 is accretive to the Subordinated Note and is amortized to interestexpense using the effective interest method over the term of the SubordinatedNote.

 

**$160Million Notes**

 

OnJuly 8, 2003, we issued $160 million of 13% senior secured notes maturingon July 1, 2008 (“$160 Million Notes”). On February 28,2006, the $160 Million Notes were replaced with $170 million in new term loansas discussed above. 

 

The$160 Million Notes were guaranteed, fully and unconditionally, jointly andseverally, by us and all present and future subsidiaries of ours and werecollateralized by substantially all of our assets in which we had an interest.Pursuant to an Intercreditor Agreement, the $160 Million Notes were subordinateto the AmSouth Revolver as described below. 

 

15

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The $160 Million Notes contained certaincovenants, which, among others, included certain financial covenants such aslimitations on capital expenditures and minimum EBITDA as defined in theagreement. The covenants also precluded the declaration and payment ofdividends or other distributions to holders of our common stock. Thesecovenants were measured on a rolling twelve-month period and fiscal quarterbasis, respectively. This debt contained usual and customary defaultprovisions. 

 

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

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

 

Debt issuance costs were capitalized andamortized using the effective interest method over the term of the $160 MillionNotes. During the first quarter ended April 4, 2006, debt issuance costswere written off in the amount of $3.8 million.

 

**AmSouthRevolver**

 

OnJuly 8, 2003, we entered into a three-year, $15 million senior securedrevolving credit facility with AmSouth Bank (“AmSouth Revolver”). OnFebruary 28, 2006, the AmSouth Revolver was replaced with a new $15million revolving credit facility as discussed above.

 

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

 

The AmSouth Revolver contained certaincovenants, which, among others, included certain financial covenants such aslimitations on capital expenditures, operating lease obligations, minimumEBITDA as defined in the agreement, operating cash flow coverage ratio andminimum net worth. The covenants also precluded the declaration and payment ofdividends or other distributions to holders of our common stock. Thesecovenants were measured on a rolling twelve-month period at each fiscal quarteror annually at year-end. Additional covenant restrictions existed if the totalborrowings, including outstanding letters of credit exceeded$10.0 million. This debt also contained usual and customary defaultprovisions. 

 

Interest payments under the AmSouth Revolverwere payable in arrears on the first of each month. The net borrowings underthe AmSouth Revolver bore an interest rate equal to the base rate plus anapplicable margin with the base rate being the AmSouth Bank “prime rate” andthe applicable margin being based on our fixed charge coverage ratio with aminimum and maximum applicable margin of 0.5% and 2.5% respectively.

 

16

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We were required to pay an unused credit linefee of 0.50% per annum on the average daily unused amount. The unused line feewas payable monthly in arrears. Additionally, we were required to pay a letterof credit fee based on the average daily undrawn face amount for each letter ofcredit issued, of an applicable margin being based on our fixed charge coverageratio with a minimum and maximum applicable margin of 2.0% and 4.5%respectively. Letters of credit reduced our availability under the AmSouthRevolver. 

 

Debt issuance costs were capitalized andamortized using the effective interest method over the term of the AmSouthRevolver. During the first quarter ended April 4, 2006, debt issuancecosts were written off to interest expense in the amount of $0.2 million.

 

**New Jersey Economic Development AuthorityNote Payable**

 

In December 1998, Manhattan BagelCompany, Inc. entered into a note payable in the principal amount of$2,800,000 with the New Jersey Economic Development Authority (“NJEDA”) at aninterest rate of 9% per annum. Principal is paid annually and interest is paidquarterly. The note matures on December 1, 2008 and is secured by theassets of Manhattan Bagel Company, Inc. 

 

On July 3, 2003, we placed an advancedfunding of the note in escrow to enact a debt defeasance as allowed for in theagreement. This advanced funding is shown as restricted cash and the note isincluded in both current portion and long-term portion of debt in the April 4,2006 and January 3, 2006 consolidated balance sheets in accordance withthe payment terms. This classification will continue until the note is fullypaid from the escrow amount proceeds. 

 

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

 

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

 

Diluted net loss per share is computed bydividing the net loss for the period by the weighted average number of sharesof common stock and potential common stock equivalents outstanding during theperiod, if dilutive. Potential common stock equivalents include incrementalshares of common stock issuable upon the exercise of stock options andwarrants. The effects of potential common stock equivalents have not beenincluded in the computation of diluted net loss per share as their effect isanti-dilutive. 

 

17

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The following table summarizes the weightedaverage number of common shares outstanding, as well as sets forth thecomputation of basic and diluted net loss per common share for the periodsindicated (in thousands of dollars, except per share data):

 
| ** **                           | ** ** | **Quarter ended:** | ** ** |
|--------------------------------------|------------|--------------------|------------|
| ** **                           | ** ** | **April 4,**  | ** ** | **March 29,** | ** ** |
| ** **                           | ** ** | **2006**           | ** ** | **2005** | ** ** |
| Weighted average shares outstanding  |       | 10,065,072         |       | 9,848,713 |   |
|                                 |       |               |       |   |   |
| Net loss                             |       | $                  | (12,092    | ) | $ | (4,198 | ) |
|                                 |       |               |       |   |   |
| Basic and diluted net loss per share |       | $                  | (1.20      | ) | $ | (0.43 | ) |

 

Stock options and warrants to purchase an aggregateof 1,750,941, and 1,726,154 shares of common stock were outstanding as of April 4,2006 and March 29, 2005 respectively. These stock options and warrantswere not included in the computation of diluted earnings per share becausetheir effect would have been anti-dilutive.

 

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

 

Werecord deferred tax assets and liabilities based on the difference between thefinancial statement and income tax basis of assets and liabilities using theenacted statutory tax rate in effect for the year differences are expected tobe taxable or refunded. Deferred income tax expenses or credits are based onthe changes in the asset or liability from period to period. Future taxbenefits are subject to a valuation allowance when we are unable to concludethat our deferred income tax assets will more likely than not be realized fromthe results of operations. We consider the scheduled reversal of deferred taxliabilities, projected future taxable income and tax planning strategies inmaking this assessment. Based on our history of losses and the uncertainty offuture taxable income, we believe it more likely than not that we will notrealize benefits of these deductible differences as of April 4, 2006.Accordingly, deferred tax assets resulting from these net operating losses havebeen fully reserved. 

 

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Todate we have incurred substantial net losses that have created significant netoperating loss carryforwards (NOL’s) for tax purposes. Our NOL’s are one of ourdeferred income tax assets. Over the past two years, we have reduced our netlosses substantially from prior years. In the near term, we believe our incomefrom operations will benefit from the reduction in our depreciation andamortization expense, as well as a savings from the reduction in the interestrate on our debt facility for the following reasons:

 

•                  Depreciation and amortizationexpense is predominately related to the assets of Einstein and Noah Corporationthat we acquired in bankruptcy proceedings in June 2001. The majority ofthese assets and all of our amortizing intangibles will become fullydepreciated or amortized in July 2006. Accordingly, on a prospectivebasis, our depreciation and amortization expense will decrease substantially.Based on our current run rates for capital expenditures, our existing base ofassets, and our projections for new purchases of fixed assets, we believe ourannual rate of depreciation expense will approximate $12 million to $15 millionin the near term. 

 

•                  As further discussed in Note 6, on February 28,2006 we completed a debt refinancing that redeemed our $160 Million Notes andretired our $15 million AmSouth Revolver. We replaced it with $170 million innew term loans and a $15 million revolving credit facility effectively reducingour effective interest rate from 13.9% to a weighted-average effective interestrate of 10.2% as of April 4, 2006. Assuming no significant changein the volume or composition of debt at April 4, 2006, we believe therefinancing will reduce our annual cost of borrowing by $3.0 million or moreper year based on current LIBOR rates. 

 

Inaccordance with SFAS 109, Accounting for Income Taxes, we will assess thecontinuing need for a valuation allowance that results from uncertainty regardingour ability to realize the benefits of our deferred tax assets. The ultimaterealization of deferred income tax assets is dependent upon generation offuture taxable income during the periods in which those temporary differencesbecome deductible. As we move closer toward achieving net income, we willreview various qualitative and quantitative data, including events within therestaurant industry, the cyclical nature of our business, our future forecastsand historical trending. Upon conclusion that our prospects for the realizationof our deferred tax assets are more likely than not, we would 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 the deferredtax asset considered realizable, however, could be reduced if estimates offuture taxable income during the carryforward periods are reduced. Asof April 4, 2006, net operating loss carryforwards of $164.4 million wereavailable to be utilized against future taxable income for years through fiscal2026, subject to annual limitations.

 

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

 

Inaccordance with SFAS No. 144, Accounting for the Impairment or Disposal ofLong Lived Assets, impairment losses are recorded on long-lived assets on arestaurant-by-restaurant basis whenever impairment indicators are determined tobe present. We consider a history of cash flow losses to be the primaryindicator of potential impairment for individual restaurant locations. Wedetermine whether a restaurant location is impaired based on expectedundiscounted future cash flows, considering location, local competition, currentrestaurant management performance, existing pricing structure and alternativesavailable for the site. If impairment exists, the amount of impairment ismeasured as the excess of the carrying amount of the asset over its fair valueas determined utilizing the estimated discounted future cash flows or theexpected proceeds, net of costs to sell, upon sale of the asset. During thefirst quarter ended April 4, 2006, we recorded $76,000 in impairmentcharges related to company-owned stores. 

 

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

 

We are subject to claims and legal actions inthe ordinary 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 MutualInsurance Company brought an action in the Superior Court of New Jersey LawDivision: Morris County, against the Company, certain of its former officersand directors and insurers seeking declaratory judgment on insurance coverageissues in previously resolved litigation against Jerold Novack and RaminKamfar, former officers. Mr. Kamfar cross-claimed against us, claiming aright to be indemnified for expenses. The Company, Mr. Kamfar, AtlanticMutual Insurance Company and Lexington Insurance Company settled the lawsuit inFebruary 2006. The resolution of this lawsuit did not have a materialeffect on our consolidated financial condition or results of operations.Because the Company asserts that the advancement and indemnity claims are aninsured loss under the Company’s policy with National Union, the Company has filedan arbitration proceeding against National Union, the Company’s officers anddirectors liability insurer for the applicable time period.

 

*Guarantees*

 

Prior to 2001, we would occasionallyguarantee leases for the benefit of certain of our franchisees. None of theguarantees have been modified since their inception and we have sincediscontinued this practice. Current franchisees are the primary lessees underthe vast majority of these leases. Under the lease guarantees, we may berequired by the lessor to make all of the remaining monthly rental payments orproperty tax and common area maintenance payments if the franchisee does notmake the required payments in a timely manner. However, we believe that most,if not all, of the franchised locations could be subleased to third partiesminimizing our potential exposure. Additionally, we have indemnificationagreements with our franchisees under which the franchisees would be obligatedto reimburse us for any amounts paid under such guarantees. Historically, wehave not been required to make such payments in significant amounts. We recorda liability for our exposure under the guarantees in accordance with SFAS No. 5,“Accounting for Contingencies,” following a probability related approach. Inthe event that trends change in the future, our financial results could beimpacted. As of April 4, 2006, we had outstanding guarantees ofindebtedness under certain leases of approximately $0.5 million. Approximately$78,000 is reflected in our accrued expenses in our consolidated balance sheetat April 4, 2006 for probable losses related to these guarantees. 

 

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*Insurance*

 

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

 

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

 

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

 

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 Heumann is the chairman of our board of directors and is a currentemployee of Greenlight Capital, Inc. Greenlight and its affiliates beneficially own approximately 95 percentof our common stock on a fully diluted basis. As a result, Greenlight hassufficient voting power without the vote of any other stockholders to determinewhat matters will be submitted for approval by our stockholders, to approveactions by written consent without the approval of any other stockholders, toelect all of our board of directors, and among other things, to determinewhether a change in control of our company occurs.

 

Greenlightowned $35.0 million of our $160 Million Notes when we called the Notes forredemption in January 2006. The Notes were redeemed from the proceeds ofour refinancing in February 2006 as further described in Note 6.

 

Weentered into the Subordinated Note with Greenlight as further described in Note6. The Subordinated Note has a maturity date of February 28, 2013, carriesa fixed interest rate of 13.75% per annum and requires a quarterly cashinterest payment in arrears at 6.5% and quarterly paid-in kind interest that isadded to the principal balance outstanding at 7.25%.

 

LeonardTannenbaum, a director, is a limited partner and 10% owner in BET. BETpurchased $7.5 million of our $160 Million Notes and Mr. Tannenbaumpurchased an additional $0.5 million of our $160 Million Notes in the market.In January 2006, Mr. Tannenbaum and BET’s Notes were called forredemption and were redeemed from the proceeds of our refinancing in February 2006as further described in Note 6.

 

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

 

The following discussion and analysis supplements the management’sdiscussion and analysis in our Annual Report on Form 10-K for the yearended January 3, 2006 and presumes that readers have read or have accessto the discussion and analysis in our Annual Report. The following discussionand analysis 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 Accounting Policy and Estimate***

### * *

In December 2004, theFinancial Accounting Standards Board (FASB) issued Statement of Financial AccountingStandard (SFAS) No. 123R, Share-Based Payment.  SFAS No. 123R is a revision of SFAS No. 123,Accounting for Stock-Based Compensation, and supersedes Accounting PrinciplesBoard Opinion (APB) No. 25, Accounting for Stock Issued to Employees andits related implementation guidance. SFAS No. 123R focuses primarily onaccounting for transactions in which an entity obtains employee services inshare-based payment transactions. The Statement requires entities to recognizecompensation expense for awards of equity instruments to employees based on thefair value of those awards on the date of grant (with limited exceptions).

 

Effective January 4, 2006, we adopted the provisions of SFAS No. 123Rusing the modified prospective transition method. Prior to the adoption of SFASNo. 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 basedon the fair value of stock options granted.

 

Because we previously adopted only the pro forma disclosure provisionsof SFAS No. 123, we will recognize compensation cost, over the requisiteservice period, relating to the unvested portion of awards granted prior to thedate of adoption using the same estimate of the grant date fair value and thesame attribution method used to determine the pro forma disclosures under SFAS No. 123,except that forfeiture rates have be estimated for all options, as required bySFAS No. 123R.

 

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We use the Black-Scholesmodel to estimate the fair value of our option awards. The Black-Scholes modelrequires estimates of the expected term of the option, as well as futurevolatility and the risk-free interest rate. Our stock optionsgenerally vest over a period of 6 months to 3 years and have contractual termsto exercise of 5 to 10 years. The expected term of options is based uponevaluations of historical and expected future employee 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 with consideration given to an evolving capitalstructure brought about by a series of de-levering mandatory prepayments underour new debt facility as further explained in Note 6 to the consolidatedfinancial statements. We have not historically issued any dividends andare precluded from doing so under our debt covenants.

 

The fair value of stock options is estimated using the Black-Scholesoption-pricing model with the following weighted average assumptions:

 
| ** **                                   | ** ** | **Quarter ended:** | ** ** |
|----------------------------------------------|------------|--------------------|------------|
| ** **                                   | ** ** | **April 4,**  | ** ** | **March 29,** | ** ** |
| ** **                                   | ** ** | **2006**           | ** ** | **2005** | ** ** |
| Expected  life of options from date of grant |       | 4.0 years          |       | 4.0 years |   |
| Risk-free  interest rate                     |       | 4.35               | %          | 3.55 | % |
| Volatility                                   |       | 100.0              | %          | 100.0 | % |
| Assumed  dividend yield                      |       | 0.0                | %          | 0.0 | % |

 

Option pricing models weredeveloped for use in estimating the value of traded options that have novesting or hedging restrictions, are fully transferable and do not causedilution. Because our share-based payments have characteristics significantlydifferent from those of freely traded options, and because changes in thesubjective input assumptions can materially affect our estimates of fairvalues, 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 grantdate and reported in our financial statements. There is currently nomarket-based mechanism or other practical application to verify the reliabilityand accuracy of the estimates stemming from these valuation models, nor isthere a means to compare and adjust the estimates to actual values. Althoughthe fair value of employee share-based awards is determined in accordance withSFAS 123R and the Securities and Exchange Commission’s StaffAccounting Bulletin No. 107 (SAB 107) using an option-pricingmodel, that value may not be indicative of the fair value observed in a willingbuyer/willing seller market transaction.

 

Estimates of share-based compensation expenses do have animpact 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.

 

23

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***Company Overview***

 

We believe we are a leader in the fast casual segment of the restaurantindustry. We specialize in high-quality foods for breakfast and lunch in a casualatmosphere with a neighborhood emphasis. Our product offerings include freshbaked bagels and hot breakfast sandwiches, cream cheese and other spreads,specialty coffees and teas, creative soups, salads and sandwiches, among otherthings. We operate and license locations primarily under the Einstein Bros. andNoah’s brand names, and franchise locations primarily under the Manhattan brandname. We also operate a dough production facility. We view our primary businessas operating, franchising and licensing strong restaurant brands in themarketplace. Our manufacturing operations support our main business focus butallow us to leverage our inherent cost structure by sales to third parties andto enhance our brands through new product channels.

 

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

 

The following factors represent current trends or uncertainties thatmay impact operating performance or could cause reported financial informationnot to be indicative of future operating results or future financial condition.

 

*Revenue*

 

We will continue to focus on our core strengths in bagels, thebreakfast daypart, and on quality, speed of service, order accuracy andcustomer interaction. We also intend to expand our existing catering programs,increase customer awareness of our retail products, emphasize bundling productssuch as “Sweeten the Deal,” (adding on a beverage and a bakery product, such asa cookie) and highlight favorite products such as our egg sandwiches. Webelieve these initiatives will positively impact check averages and drivetransaction counts in future periods.

 

*Expenses*

 

Our expenses are generally affected by the following major categories:

 

•      Changingprices for agricultural commodities;

•      Risingenergy and packaging costs;

•      Increasinglabor costs; and

•      Increasingtax rates and costs of compliance with regulatory requirements.

 

We experienced slight decreases in dairy prices during 2005, but thedecrease was offset by increases in commodity costs for coffee, flour andpackaging. Flour represents the most significant raw ingredient we purchase andwe believe the cost of this commodity, as well as others, will continue toincrease in 2006. Additionally, we believe the cost of produce may increase asa result of the damage to crops caused by hurricanes and other adverseweather-related events.

 

Rising energy costs affect our utility bills, distribution costs andpackaging costs, because of their dependence upon petroleum products.  We experienced increases in the cost forenergy and packaging materials during 2005 and believe such costs will continueto increase on average during 2006. During late 2005, we negotiated contractterms with a new distribution partner. As a result, we experienced increased distribution costs beginning inthe fourth quarter of 2005 that will continue throughout 2006.

 

Due to competition for personnel, limited availability in the laborpool, and changes in the federal overtime regulations, we anticipate we mayexperience an increase in hourly wages during 2006 contingent upon the numberof overtime hours worked. We continue to make improvements in laborefficiencies that may help to offset increases in labor costs.

 

Certain states and local governments have increased both the rate andnature of taxes on businesses in their regions. These increased taxes includereal estate and property taxes, state and local income taxes, and variousemployment taxes.

 

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Changes in any of the aforementioned categories could directly impactthe profitability of our company-owned locations, 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.

 

*Impact of Inflation*

 

We have not experienced a significant overall impact from inflation.However, the impact of inflation on labor, food and occupancy costs could, inthe future, significantly affect our operations. We pay many of our employeeshourly rates slightly above the applicable federal or state minimum wage. Foodcosts as a percentage of sales have been somewhat stable due to procurementefficiencies and menu price adjustments, although no assurance can be made thatour procurement will continue to be efficient or that we will be able to raisemenu prices in the future. Costs for construction, taxes, repairs, maintenanceand insurance all impact our occupancy costs. We believe that our currentstrategy, which is to seek to maintain operating margins through a combinationof menu price increases, cost controls, efficient purchasing practices andcareful evaluation of property and equipment needs, has been an effective toolfor dealing with inflation.

 

**Properties**

 

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

 
| ** **              | ** ** | **Company** | ** ** | ** **   | ** ** | ** **     | ** ** | ** ** | ** ** |
|-------------------------|------------|-------------|------------|--------------|------------|----------------|------------|------------|------------|
| ** **              | ** ** | **owned**   | ** ** | **Licensed** | ** ** | **Franchised** | ** ** | **Total**  | ** ** |
| **Einstein  Bros. :**   | ** ** | ** **  | ** ** | ** **   | ** ** | ** **     | ** ** | ** ** | ** ** |
| 2006                    |       | 358         |       | 69           |       | —         |       | 427        |       |
| 2005                    |       | 370         |       | 57           |       | —         |       | 427        |       |
| **Noah’s:**        | ** ** | ** **  | ** ** | ** **   | ** ** | ** **     | ** ** | ** ** | ** ** |
| 2006                    |       | 72          |       | 3            |       | —         |       | 75         |       |
| 2005                    |       | 76          |       | 3            |       | —         |       | 79         |       |
| **Manhattan:**          | ** ** | ** **  | ** ** | ** **   | ** ** | ** **     | ** ** | ** ** | ** ** |
| 2006                    |       | —      |       | —       |       | 107            |       | 107        |       |
| 2005                    |       | —      |       | —       |       | 138            |       | 138        |       |
| **Chesapeake:**         | ** ** | ** **  | ** ** | ** **   | ** ** | ** **     | ** ** | ** ** | ** ** |
| 2006                    |       | —      |       | —       |       | 6              |       | 6          |       |
| 2005                    |       | —      |       | —       |       | 25             |       | 25         |       |
| **New  World Coffee:**  | ** ** | ** **  | ** ** | ** **   | ** ** | ** **     | ** ** | ** ** | ** ** |
| 2006                    |       | 2           |       | —       |       | 4              |       | 6          |       |
| 2005                    |       | 3           |       | —       |       | 7              |       | 10         |       |
| **Total  Restaurants:** | ** ** | ** **  | ** ** | ** **   | ** ** | ** **     | ** ** | ** ** | ** ** |
| 2006                    |       | 432         |       | 72           |       | 117            |       | 621        |       |
| 2005                    |       | 449         |       | 60           |       | 170            |       | 679        |       |

 

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**Results of Operations**

 

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

 
| ** **                                                              | ** ** | ** **                       | ** ** | ** **     | ** ** | **Increase**                     | ** ** | ** ** | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------------|------------|----------------|------------|----------------------------------|------------|------------|------------|------------|------------|
| ** **                                                              | ** ** | **For the first quarter ended:** | ** ** | **(Decrease)** | ** ** | **For the first quarter ended:** | ** ** |
| ** **                                                              | ** ** | **(in thousands of dollars)**    | ** ** | **2006**       | ** ** | **(percent of total revenue)**   | ** ** |
| ** **                                                              | ** ** | **2006**                         | ** ** | **2005**       | ** ** | **vs. 2005**                     | ** ** | **2006**   | ** ** | **2005**   | ** ** |
| Revenues:                                                               |       |                             |       |           |       |                             |       |       |       |       |       |
| Retail sales                                                            |       | 90,580                           |       | 86,859         |       | 4.3                              | %          | 93.3       | %          | 93.1       | %          |
| Manufacturing revenues                                                  |       | 5,021                            |       | 4,994          |       | 0.5                              | %          | 5.2        | %          | 5.4        | %          |
| Franchise and license related revenues                                  |       | 1,475                            |       | 1,442          |       | 2.3                              | %          | 1.5        | %          | 1.5        | %          |
| Total revenues                                                          |       | 97,076                           |       | 93,295         |       | 4.1                              | %          | 100.0      | %          | 100.0      | %          |
|                                                                    |       |                             |       |           |       |                             |       |       |       |       |       |
| Cost of sales:                                                          |       |                             |       |           |       |                             |       |       |       |       |       |
| Retail costs                                                            |       | 73,526                           |       | 71,430         |       | 2.9                              | %          | 75.7       | %          | 76.6       | %          |
| Manufacturing costs                                                     |       | 5,005                            |       | 4,707          |       | 6.3                              | %          | 5.2        | %          | 5.0        | %          |
| Total cost of sales                                                     |       | 78,531                           |       | 76,137         |       | 3.1                              | %          | 80.9       | %          | 81.6       | %          |
|                                                                    |       |                             |       |           |       |                             |       |       |       |       |       |
| Gross profit:                                                           |       |                             |       |           |       |                             |       |       |       |       |       |
| Retail                                                                  |       | 17,054                           |       | 15,429         |       | 10.5                             | %          | 17.6       | %          | 16.5       | %          |
| Manufacturing                                                           |       | 16                               |       | 287            |       | (94.4                            | )%         | 0.0        | %          | 0.3        | %          |
| Franchise and license                                                   |       | 1,475                            |       | 1,442          |       | 2.3                              | %          | 1.5        | %          | 1.5        | %          |
| Total gross profit                                                      |       | 18,545                           |       | 17,158         |       | 8.1                              | %          | 19.1       | %          | 18.4       | %          |
|                                                                    |       |                             |       |           |       |                             |       |       |       |       |       |
| General and administrative expenses                                     |       | 10,561                           |       | 8,680          |       | 21.7                             | %          | 10.9       | %          | 9.3        | %          |
| Depreciation and amortization                                           |       | 6,004                            |       | 6,708          |       | (10.5                            | )%         | 6.2        | %          | 7.2        | %          |
| Loss on sale, disposal or abandonment of  assets, net                   |       | 21                               |       | 4              |       |                             | *          | 0.0        | %          | 0.0        | %          |
| Integration and reorganization cost                                     |       | —                           |       | 5              |       |                             | *          | 0.0        | %          | 0.0        | %          |
| Impairment charges and other related costs                              |       | 76                               |       | 97             |       | (21.6                            | )%         | 0.1        | %          | 0.1        | %          |
| Income from operations                                                  |       | 1,883                            |       | 1,664          |       | 13.2                             | %          | 1.9        | %          | 1.8        | %          |
| Other expense (income):                                                 |       |                             |       |           |       |                             |       |       |       |       |       |
| Interest expense, net                                                   |       | 5,209                            |       | 5,919          |       | (12.0                            | )%         | 5.4        | %          | 6.3        | %          |
| Prepayment penalty upon redemption of $160  Million Notes               |       | 4,800                            |       | —         |       |                             | *          | 4.9        | %          | 0.0        | %          |
| Write-off of debt issuance costs upon  redemption of $160 Million Notes |       | 3,956                            |       | —         |       |                             | *          | 4.1        | %          | 0.0        | %          |
| Other, net                                                              |       | 10                               |       | (57            | )          |                             | *          | 0.0        | %          | (0.1       | )%         |
| Net loss                                                                |       | (12,092                          | )          | (4,198         | )          | 188.0                            | %          | (12.5      | )%         | (4.5       | )%         |

 

----

* not meaningful

 

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*Retail Operations*

 

**Retail revenues for the first quarter ended2006 were slightly above our expectations. Revenue improved 4.3% when comparedto the first quarter ended 2005. Our comparable store sales increase of 6.2%consisted of a 6.3% increase in average check partially offset by a 0.1%reduction in transactions. The increase in average check was primarily relatedto a system-wide price increase coupled with a slight shift in product mix tohigher priced items, including our “Sweeten the Deal” bundling offer (adding ona beverage and a bakery product such as a cookie). Comparable store salesrepresent sales at restaurants open for one full year and have not beenrelocated or closed during the current year. Comparable store sales are alsoreferred to as “same-store” sales or as “comp sales” within the restaurantindustry.**

 

**The following table summarizes the elementsof comparable store sales for each quarter in fiscal 2005 and the first quarterended 2006:**

 
| ** **                   | ** ** | **Comparable**  | ** ** | **Average** | ** ** | ** **       | ** ** |
|------------------------------|------------|-----------------|------------|-------------|------------|------------------|------------|
| **Period**                   | ** ** | **Store Sales** | ** ** | **Check**   | ** ** | **Transactions** | ** ** |
| First  quarter, fiscal 2005  |       | 4.6             | %          | 6.4         | %          | (1.7             | )%         |
| Second  quarter, fiscal 2005 |       | 6.3             | %          | 6.0         | %          | 0.3              | %          |
| Third  quarter, fiscal 2005  |       | 5.9             | %          | 5.5         | %          | 0.4              | %          |
| Fourth  quarter, fiscal 2005 |       | 3.9             | %          | 3.8         | %          | 0.1              | %          |
| First  quarter, fiscal 2006  |       | 6.2             | %          | 6.3         | %          | (0.1             | )%         |

 

**We believe we can improve our transactioncounts and bring further awareness to our brand by focusing on improvements inthe operation of our restaurants including initiatives in customer service(accuracy, friendliness and speed of service), overall store appearance andfurther development of catering programs in selected markets.**

** **

Our retail gross profit increased 10.5% for the first quarter ended2006 when compared to the first quarter 2005 primarily driven by an increase inrevenues. Our retail margins are impacted by various store-level operatingexpenses 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. During the first quarter of 2006, theincrease in company owned retail sales over the comparable period contributedapproximately $3.4 million of store contribution margin related to theincreased sales. This margin increase was partially offset by approximately$1.0 million in additional marketing expenses, $0.2 million in additionalbonuses payable to restaurant managers due to improved operating performanceand $0.6 million in additional workers’ compensation charges. Depreciation,amortization and income taxes do not impact our retail margins.

 

We continually review the performance of each of our restaurants indeciding whether to provide additional capital and other resources to thatrestaurant. Additionally, we review market level and individual site levelmodels to allow for strategic growth and portfolio rationalization decisionsbased on sound metrics. These models were built based on consumer researchconducted at our company owned Einstein Bros. locations and externaldemographic, psychographic and competitive databases. We consider variousfactors such as local market conditions, distribution and supply chainchannels, competition, comparable store sales, store-level cash flows andexisting lease terms. Based on the store-level considerations, we then reviewthe economic and financial costs of exiting poorly performing locations (wherethe leases permit cessation of operations) or sub-leasing the location to athird party. We also consider the long-term options of locations that performat break-even or slightly above break-even. As a result of our strategic review, we have deliberately reduced ourstore count based on business decisions supported by quantitative data in an effortto improve our overall profitability. We also believe these efforts willidentify markets for future store growth, allow us to better focus our time andresources, re-invest in our existing business and contribute to long-termsustainable growth in free cash flow (cash generated from operations lesscapital expenditures).

 

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*Manufacturing Operations*

 

Our manufacturing operations predominately support our company-operatedstores and generate revenue from the sale of food products to franchisees,licensees and third-party distributors. For the first quarter of 2006 and 2005,our manufacturing margins represented less than 1.0% of total revenues. Ourmanufacturing margins are impacted by various manufacturing-level operatingexpenses such as the cost of products sold, salaries and benefits, insurance,supplies, repair and maintenance expenses, rent, utilities and property taxes.The profit derived from our manufacturing operations represents third-partysales and can be significantly impacted by fixed overhead costs such as rent,utilities, property taxes and manager salaries and fluctuating commodity costs.All inter-company transactions have been eliminated during consolidation.

 

*Franchise and License Operations*

 

Revenues for the franchised and licensed segment consist primarily ofinitial fees and royalty income earned as a result of operation of franchiseand license restaurants.  The improvementin franchise and license related revenue is predominately driven by slightincreases in comparable store sales in our Manhattan Bagel franchise andEinstein Bros. licensed locations.

 

*Other Operating Expenses*

 

**Our general and administrative expensesincreased 21.7%, or $1.9 million, for the first quarter of 2006 when comparedto the first quarter of 2005. Contributing to the increase was approximately$0.1 million in bonus wages payable to corporate office staff due to improvedoperating performance, $0.2 million in severance, and $0.2 million in expensesrelated to the costs of transitioning to a new distributor. Additionally, weincurred approximately $0.5 million for our first annual leadership summits forour Einstein Bros. and Noah’s general managers and our Manhattan Bagelfranchisees. The first quarter of 2005 included a one-time benefit of approximately$0.2 million from the reversal of a prior period charge to bad debt expense dueto stronger than previously forecasted collections on franchise receivables.**

** **

Due to the adoption of SFAS 123R and applying the modified prospectivetransition method in the first quarter of 2006, we recorded $0.2 million instock based compensation expense which is included in general andadministrative expenses. Prior to the adoption of SFAS No. 123R, weapplied the intrinsic value-based method of accounting for which nocompensation expense was recorded as the current market price of the underlyingcommon stock was equal to or less than the exercise price of the option on thedate of grant.

 

Depreciation and amortization expenses decreased 10.5%, or $0.7million, for the first quarter of 2006 when compared to the first quarter of2005. The decrease is primarily due to a portion of our asset base becomingfully depreciated. Depreciation and amortization expense is predominately related tothe assets of Einstein/Noah Bagel Corp. that we acquired in bankruptcyproceedings in June 2001. The majority of these assets and all of ouramortizing intangibles will become fully depreciated or amortized in July 2006.Accordingly, on a prospective basis, our depreciation and amortization expensewill decrease substantially. Based on our current run rates for capitalexpenditures, our existing base of assets, and our projections for newpurchases of fixed assets, we believe our annual rate of depreciation expensewill approximate $12 million to $15 million in the near term.

 

On February 28, 2006, we completed a debt refinancing thatredeemed our $160 Million Notes and retired our $15 million AmSouth Revolver.We replaced this debt with $170 million in new term loans and a $15 million revolvingcredit facility effectively reducing our effective interest rate from 13.9% toa weighted-average effective interest rate of 10.2% as of April 4, 2006.For the first quarter ended 2006, we incurred $5.2 million in net interestexpense compared to $5.9 million in 2005. In addition, we wrote off $4.0 million of debt issuance costs and paid a3% redemption premium on the $160 Million Notes in the amount of $4.8 million.

 

Net operating losses generated in the current year from continuingoperations resulted in no federal and state income tax liability for the firstquarters 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. 

 

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Our NOL’s are one of ourdeferred income tax assets. Over the past two years, we have reduced our netlosses substantially from prior years. In the near term, we believe our incomefrom operations will benefit from the reduction in our depreciation andamortization expense, as well as a savings from the reduction in the interestrate on our debt facility as previously discussed.

 

In accordance with SFAS109, Accounting for Income Taxes, we will assess the continuing need for avaluation allowance that results from uncertainty regarding our ability torealize the benefits of our deferred tax assets. The ultimate realization ofdeferred income tax assets is dependent upon generation of future taxableincome during the periods in which those temporary differences becomedeductible. As we move closer toward achieving net income, we will review variousqualitative and quantitative data, including events within the restaurantindustry, the cyclical nature of our business, our future forecasts andhistorical trending. Upon conclusion that our prospects for the realization ofour deferred tax assets are more likely than not, we would then reduce ourvaluation allowance as appropriate and credit income tax expense afterconsidering the following factors:

 

•      The level of historical taxable income and projections for futuretaxable income over periods in which the deferred tax assets would bedeductible, and

 

•      Achievement of approximately two years of net income before tax,with a carryback and carryforward review of our performance over the sameperiod of time in which profits have been sustained.

 

The amount of the deferredtax asset considered realizable, however, could be reduced if estimates offuture taxable income during the carryforward periods are reduced. Asof April 4, 2006, net operating loss carryforwards of $164.4 million wereavailable to be utilized against future taxable income for years through fiscal2026, subject to annual limitations.

 

**Liquidity andCapital Resources**

 

The restaurant industry is predominantly a cash business where cash isreceived at the time of the transaction. We believe we will generate sufficientcash flow and have sufficient availability under our revolving credit facilityto fund operations, capital expenditures and required debt and interestpayments. Our inventory turns frequently since our products are perishable. Accordingly,our investment in inventory is minimal. Our accounts payable are on terms thatwe believe are consistent with those of other companies within the industry.

 

The primary driver of our operating cash flow is our restaurantoperations, specifically the gross margin from our company-operatedrestaurants. Therefore, we focus on the elements of those operations includingcomparable store sales and cash flows to ensure a steady stream of operatingprofits that enable us to meet our cash obligations. On a weekly basis, wereview our company-operated store performance compared with the same period inthe prior year and our operating plan. We are continuously identifying andimplementing initiatives to increase revenue as well as reduce costs, not onlyat the store operations level, but also within other disciplines such as supplychain, manufacturing operations and overhead. During 2006, we are focusing onthe following initiatives:

 

•      newrevenue initiatives related to our manufacturing and commissary operations;

•      expansionof our catering program;

•      afocus on labor costs and efficiencies;

•      priceincreases on certain menu items based upon competitive analysis and the cost ofunderlying ingredients;

•      refinementof merchandising to drive sales of higher margin items;

•      menuoptimization to remove and/or modify slow moving products and thus reducewaste;

•      reductionsin cost of goods sold through purchasing efficiencies; and

•      refinementof programs that monitor theoretical food cost.

 

29

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*Debt Facility*

 

On February 28, 2006, we completed the refinancing of the AmSouthRevolver and $160 Million Notes. Our new 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 loans requires the payment of interest in arrears on aquarterly basis commencing on March 31, 2006. Additionally, the First LienTerm Loan requires quarterly scheduled minimum principal reductions commencing June 30,2006. In the event that we have not extended the maturity date of theMandatorily Redeemable Series Z Preferred Stock (Series Z) to a datethat is on or after July 26, 2012 (July 26, 2013 for the SubordinatedNote) or redeemed the Series Z by various dates in 2008 and 2009, theneach of the loans have various accelerated maturity dates beginning in December 2008.For an additional discussion regarding our new debt facility, see Note 6 to ourconsolidated financial statements included in Part I of this report.

 

*Working Capital Deficit and Cash Flows*

 

Our working capital deficit increased to $13.0 million at April 4,2006 from $11.7 million at January 3, 2006, primarily due to short termclassification of principal payments due under our First Lien Term Loan. Due toincreased profitability and the timing of operational receipts and payments,net cash of $0.1 million was provided by operating activities for the firstquarter of fiscal 2006 compared to net cash of $6.3 million used in operatingactivities during the same period in fiscal 2005. Based upon our projectionsfor 2006 and beyond, we believe that our various sources of capital, includingavailability under existing debt facilities, ability to raise additionalfinancing, and cash flow from operating activities of continuing operations,are adequate to finance operations as well as the repayment of current debtobligations. If we are unable to generate sufficient cash flow to make paymentson our debt, we may have to pursue one or more alternatives, such as reducingor delaying capital expenditures, refinancing our debt on terms that are notfavorable to us or selling assets. We may not be able to accomplish any ofthese alternatives on satisfactory terms, if at all, and even if accomplished,they may not yield sufficient funds to service our debt.

 

During first quarter of 2006, we used approximately $2.6 million ofcash to purchase additional property and equipment that included $0.3 millionfor new stores, $0.6 million for remodeling existing stores, $1.1 million forreplacement and new equipment at our existing company-operated stores, $0.2million for our manufacturing operations and less than $0.4 million for generalcorporate purposes. We anticipate that the majority of our capital expendituresfor fiscal 2006 will be focused on our refresh and remodel strategy thatincludes updates of restaurant interiors and design flow. In addition, we planto acquire additional equipment for new menu items and improvements in thespeed of service, particularly during the morning day-part. We also plan toopen 5 to 7 new company-owned restaurants during 2006 at an average capitalinvestment of approximately $400,000 to $500,000 per location.

 

As a result of our refinancing of our $160 Million Notes with $170million in new term loans in February 2006, we borrowed $169.4 million interm loans and incurred approximately $5.0 million in debt issuance costs. Uponclosing of our new debt facility, we began amortizing these costs and the debtissuance costs related to our $160 Million Notes and AmSouth Revolver werewritten-off.

 

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*ContractualObligations*

 

There were no material changes to our contractual obligations duringthe first quarter of 2006. For information regarding our contractualobligations at January 3, 2006, see our Annual Report on Form 10-Kfor the fiscal year ended January 3, 2006.

 

*Insurance*

 

We are insured for losses related to health, general liability andworkers’ compensation under large deductible policies. The insurance liabilityrepresents an estimate of the ultimate cost of claims incurred and unpaid as ofthe balance sheet date. The estimated liability is established based onactuarial estimates, is discounted at 10% based upon a discrete analysis ofactual claims and historical data and is reviewed on a quarterly basis toensure that the liability is appropriate. If actual trends, including theseverity 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.

 

**Off-Balance Sheet Arrangements**

 

*Guarantees*

 

Prior to 2001, we would occasionally guarantee leases for the benefitof certain of our franchisees. None of the guarantees have been modified sincetheir inception and we have since discontinued this practice. Currentfranchisees are the primary lessees under the vast majority of these leases.Under the lease guarantees, we may be required by the lessor to make all of theremaining monthly rental payments or property tax and common area maintenancepayments if the franchisee does not make the required payments in a timelymanner. However, we believe that most, if not all, of the franchised locationscould be subleased to third parties minimizing our potential exposure.Additionally, we have indemnification agreements with our franchisees underwhich the franchisees would be obligated to reimburse us for any amounts paidunder such guarantees. Historically, we have not been required to make suchpayments in significant amounts. We record a liability for our exposure underthe guarantees in accordance with SFAS No. 5, “Accounting forContingencies,” following a probability related approach. In the event thattrends change in the future, our financial results could be impacted. As of April 4,2006, we had outstanding guarantees of indebtedness under certain leases ofapproximately $0.5 million. Approximately $78,000 is reflected in our accruedexpenses in our consolidated balance sheet at April 4, 2006 for probablelosses related to these guarantees.

 

*Letters of Credit*

 

We have $6.9 million in letters of creditoutstanding under our Revolving Facility at April 4, 2006. The letters ofcredit expire on various dates during 2007, are automatically renewable for oneadditional year and are payable upon demand in the event that we fail to paycertain workers compensation claims.

 

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**Item 3.  Qualitative andQuantitative Disclosures About Market Risk**

 

During the first quarter ended 2006 and 2005, our results ofoperations, financial position and cash flows have not been materially affectedby changes in the relative values of non-U.S. currencies to the U.S. dollar. Wedo not use derivative financial instruments to limit our foreign currency riskexposure since virtually all of our business is conducted in the United States.

 

Our debt as of April 4, 2006 was principally comprised of theRevolving Facility, First Lien Term Loan, Second Lien Term Loan, andSubordinated Note as further discussed in Note 6 to the consolidated financialstatements included in Part I of this document. For fixed rate debt,interest rate changes affect the fair market value of such debt but do notimpact earnings or cash flows. Conversely for variable rate debt, includingborrowings under our Revolving Facility, First Lien Term Loan and Second LienTerm Loan, interest rate changes generally do not affect the fair market valueof such debt, but do impact future earnings and cash flows, assuming otherfactors are held constant. A 100 basis point increase in short-term effectiveinterest rates would increase our net loss by approximately $1.5 millionannually, assuming no change in the volume or composition of debt at April 4,2006. Currently, the interest rates on our First Lien Term Loan, Second LienTerm Loan and Revolving Facility are at LIBOR rates plus an applicable marginthrough short-term fixed rate financing. The estimated increase in interestexpense incorporates the fixed interest financing into its assumptions.

 

We purchase certain commodities such as butter, cheese, coffee andflour. These commodities are generally purchased based upon market pricesestablished with vendors. Our purchase arrangements may contain contractualfeatures that limit the price paid by establishing certain price floors orcaps. We do not use financial instruments to hedge commodity prices because ourpurchase arrangements help control the ultimate cost paid and any commodityprice aberrations are generally short-term in nature.

 

This market risk discussion contains forward-looking statements. Actualresults may differ materially from this discussion based upon general marketconditions and changes in domestic and global financial markets.

 

**Item 4.  Controls and Procedures**

 

An evaluation was carried out under the supervision and with theparticipation of company management, including our chief executive officer andchief financial officer, of the effectiveness of the design and operation ofour disclosure controls and procedures (as defined in rule 13a-15(e) underthe Securities Exchange Act of 1934, as amended) as of April 4, 2006.Based upon that evaluation, our chief executive officer and our chief financialofficer have concluded that the design and operation of our disclosure controlsand procedures were effective in timely making known to them materialinformation relating to the Company required to be disclosed in reports that wefile or submit under the Exchange Act rules.

 

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

 

During the quarter ended April 4, 2006, there were no changes toour internal controls over financial reporting that were identified inconnection with the evaluation of our disclosure controls and proceduresrequired by the Exchange Act rules and that have materially affected, orare reasonably likely to materially affect, our internal controls overfinancial reporting.

 

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**PART II - OTHER INFORMATION**

**NEW WORLD RESTAURANT GROUP, INC.**

 

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

 

Information regarding legal proceedings is incorporated by referencefrom Note 10 to our Consolidated Financial Statements set forth in Part Iof this report.

 

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

### * *

We wish to caution our readers that the following important factors,among others, could cause the actual results to differ materially from thoseindicated by forward-looking statements made in this report and from time totime in news releases, reports, proxy statements, registration statements andother written communications, as well as verbal forward-looking statements madefrom time to time by representatives of the company. Such forward-lookingstatements involve risks and uncertainties that may cause our actual results,performance or achievements to be materially different from any futureperformance or achievements expressed or implied by these forward-lookingstatements. Factors that might cause actual events or results to differmaterially from those indicated by these forward-looking statements may includematters such as future economic performance, restaurant openings or closings,operating margins, the availability of acceptable real estate locations, thesufficiency of our cash balances and cash generated from operating andfinancing activities for our future liquidity and capital resource needs, andother matters, and are generally accompanied by words such as: believes,anticipates, estimates, predicts, expects, and similar expressions that conveythe uncertainty of future events or outcomes. An expanded discussion of some ofthese risk factors follows.

 

*We may not be successful inimplementing any or all of the initiatives of our business strategy.*

 

Our success depends in part on our ability to understand our customers’needs. We believe successful deployment of our current business strategy willaddress customers’ needs and contribute to overall company growth. While webelieve our brand refresh strategy will strengthen the performance of ourEinstein Bros. brand, its success is dependent upon customer acceptance of newmenu offerings and pricings, the look and feel of the restaurant, and the newservice system and other factors, many of which are outside our control. Inaddition, the availability of capital and opportunities to make modificationsto existing restaurants will be significant factors in the success of ourbusiness strategy. If we improperly perceive customers’ needs and/or are notsuccessful in implementing any or all of the initiatives of our businessstrategy, it could have a material adverse effect on our business, results ofoperations, and financial condition.

 

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

 

Food service businesses are often affected by changes in consumer tastes,dietary trends, national, regional and local economic conditions anddemographic trends. Factors such as traffic patterns, local demographics andthe type, number and location of competing restaurants may adversely affect theperformance of individual locations. Shifts in consumer preferences away fromour type of cuisine and/or the quick casual style could have a material adverseeffect on our results of operations.

 

Dietary trends, such as the consumption of food low in carbohydratecontent may negatively impact our sales. In addition, inflation and increasedfood and energy costs may harm the restaurant industry in general and ourlocations in particular. Adverse changes in any of these factors could reduceconsumer traffic or impose practical limits on pricing, which could harm ourbusiness prospects, financial condition, operating results and cash flow. Ourcontinued success will depend in part on our ability to anticipate, identifyand respond to changing consumer preferences and economic conditions.

 

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

 

The level of growth in comparable store sales significantly affects oursales growth and will be a critical factor affecting profit growth. The profitmargin driven by comparable store sales enables fixed costs to be spread over ahigher sales base. Our ability to increase comparable store sales depends inpart on our ability to successfully implement our initiatives to increasethroughput, such as increasing the speed at which our employees serve eachcustomer, and to build customer awareness of our menu offerings. It is possiblethat we will not achieve our targeted comparable store sales growth or that thechange in comparable store sales could be negative and could adversely impactour sales and profit growth.

 

*There is competition in the restaurantindustry for personnel, real estate, advertising space, and customers, amongother things.*

 

Our industry is highly competitive and there are many well-establishedcompetitors with substantially greater financial and other resources than wehave. In addition to current competitors, one or more new major competitorswith substantially greater financial, marketing and operating resources couldenter the market at any time and compete directly against us. In addition, invirtually every major metropolitan area in which we operate or expect to enter,local or regional competitors already exist. This may make it more difficult toobtain real estate and advertising space, and to retain customers andpersonnel.

 

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

 

The cost, availability and quality of the ingredients we use to prepareour food are subject to a range of factors, many of which are beyond ourcontrol. Fluctuations in economic and political conditions, weather and demandcould adversely affect the cost of our ingredients. We have limited controlover fluctuations in the price and quality of commodities, and we may not beable to pass through any cost increases to our customers. We are dependent onfrequent deliveries of fresh ingredients, thereby subjecting us to the risk ofshortages or interruptions in supply. All of these factors could adverselyaffect our business and financial results.

 

*Our operations may be negatively impacted byadverse weather conditions and we may incur significant expenses related to therecovery of our temporarily damaged operations.*

 

Due to extensive damage caused by Hurricanes Katrina and Rita, many ofour company-owned locations in Florida and one licensed location in Louisianawere temporarily closed. We incurred labor and capital costs related to thereopening of our company-owned restaurants. To the extent that adverse weatherconditions impact regions in which our company-owned, licensed or franchisedrestaurants are located, we could experience closures, delayed shipments,repair and restoration costs, food spoilage, increased food costs and othersignificant reopening costs, thereby adversely affecting our business. Forexample, hurricanes in some parts of the United States damaged tomato crops anddrove prices higher. We may not be able to anticipate or react to changing foodcosts by adjusting our purchasing practices or menu prices, which could causeour operating margins to deteriorate. The hurricanes also resulted in higherdiesel and gasoline costs, affected consumer confidence and are likely toaffect supply and distribution costs and near-term construction costs for ournew stores and may affect our sales going forward.

 

*We heavily depend on our suppliers.*

 

We currently purchase our raw materials from various suppliers. Wepurchase a majority of our frozen bagel dough from Harlan Bakeries, Inc.,who utilizes our proprietary processes and on whom we are dependent upon in theshort-term. Additionally, we purchase all of our cream cheese from a singlesource. Although to date we have not experienced significant difficulties withour suppliers, our reliance on a limited number of suppliers subjects us to anumber of risks, including possible delays or interruption in supplies,diminished control over quality and a potential lack of adequate raw materialcapacity. Any disruption in the supply or degradation in the quality of thematerials provided by our suppliers could have a material adverse effect on ourbusiness, operating results and financial condition. In addition, any suchdisruptions 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.

 

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Our contract with Harlan Bakeries, Inc. expires at the end of 2006and we have an option to renew this contract. We have issued a request for proposal from Harlan Bakeries, Inc.and other international and domestic vendors for our frozen bagel dough. If wecannot negotiate the same or lower pricing with our selected vendor, our frozenbagel dough costs could increase and have a negative impact on our results fromoperations.

 

*We heavily depend on our distributors.*

 

We depend on our network of distributors to distribute frozen bageldough and other products and materials to our locations. If any one or more ofour distributors fails to perform as anticipated, or if there is any disruptionin any of our distribution relationships for any reason, it subjects us to anumber of risks, including inadequate products delivered to our company-owned,franchised and licensed locations, diminished control over quality of productsdelivered, and increased operating costs to prevent delays in deliveries. Inaddition, a decrease in the volume of products ordered from our distributors byour company-owned, franchised and/or licensed locations could increase our perproduct distribution costs. These risks could have a material adverse effect onour business, financial condition and results of operations.

 

During late 2005, we negotiated contract terms with a new distributionpartner. We have experienced some transition issues at one new distributioncenter during 2006, but at this time we do not believe these issues will havean adverse effect on our results of operations. We are currently working withthis distributor to resolve these issues.

 

*Increasing labor costs could adversely affectour continued profitability.*

 

We are dependent upon an available labor pool of associates, many ofwhom are hourly employees whose wages may be affected by an increase in thefederal or state minimum wage. Numerous proposals have been made on federal,state and local levels to increase minimum wage levels. Although few, if any,of our associates are paid at the minimum wage level, an increase in theminimum wage may create pressure to increase the pay scale for our associates,which would increase our labor costs and those of our franchisees andlicensees. A shortage in the labor pool or other general inflationary pressuresor changes could also increase labor costs. In addition, changes in labor lawsor reclassifications of associates from management to hourly employees couldaffect our labor cost. An increase in labor costs could have a material adverseeffect on our income from operations and decrease our profitability and cashavailable to service our debt obligations if we are unable to recover theseincreases by raising the prices we charge our customers.

 

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

 

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

 

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*A regional or global health pandemic couldseverely affect our business.*

 

A health pandemic is a disease that spreads rapidly and widely byinfection and affects many individuals in an area or population at the sametime. In 2004 and 2005, Asian and European countries experienced outbreaks ofavian flu and it is possible that it will continue to migrate to the UnitedStates where our restaurants are located. If a regional or global healthpandemic were to occur, depending upon its duration and severity, our businesscould be severely affected. We have positioned ourselves as a “neighborhoodatmosphere” between home and work where people can gather together for humanconnection and high quality food. Customers might avoid public gathering placesin the event of a health pandemic, and local, regional or national governmentsmight limit or ban public gathering places to halt or delay the spread ofdisease. A regional or global pandemic might also adversely impact our businessby disrupting or delaying production and delivery of products and materials inour supply chain and causing staff shortages in our restaurants. The impact ofa health pandemic might be disproportionately greater on us than on othercompanies that depend less on the gathering of people in a neighborhoodatmosphere.

 

*We rely in part on our franchisees andlicensees.*

 

We rely in part on our franchisees and licensees and the manner inwhich they operate their locations to develop and promote our business.Although we have developed criteria to evaluate and screen prospectivecandidates, the candidates may not have the business acumen or financialresources necessary to operate successful locations in their respective areas.In addition, franchisees and licensees are subject to business risks similar towhat we face such as competition, consumer acceptance, fluctuations in thecost, availability and quality of raw ingredients, and increasing labor costs.The failure of franchisees and licensees to operate successfully could have amaterial adverse effect on us, our reputation, our ability to collectroyalties, our brands and our ability to attract prospective candidates. As wemove into offering franchises for our Einstein Bros. Bagel brand, our relianceon our franchisees is expected to increase in proportion to growth of thefranchisee base.

 

*We face risks associated with governmentregulation.*

 

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

 

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

 

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

 

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*We may notbe able to protect our trademarks, service marks and other proprietary rights.*

 

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

 

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

 

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

 

•      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;

•      limitour ability to withstand competitive pressures from our less leveragedcompetitors; and

•      harmus because a failure by us to comply with the covenants in the instruments andagreements governing our indebtedness could result in an event of default that,if not cured or waived, could result in all of our indebtedness becomingimmediately due and payable, which could render us insolvent.

 

*We must comply with certain covenantsinherent in our debt agreements to avoid defaulting under those agreements.*

 

Our debt agreements contain certain covenants, which, among others,include certain financial covenants such as limitations on capitalexpenditures, maintenance of the business, use of proceeds on sales of assetsand consolidated leverage and fixed charge coverage ratios as defined in theagreements. 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. A failure by us to comply with thecovenants in the instruments and agreements governing our indebtedness couldresult in an event of default that, if not cured or waived, could result in allof our indebtedness becoming immediately due and payable, which could render usinsolvent.

 

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

 

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

 

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*We have amajority stockholder.*

 

Greenlight Capital, L.L.C. and its affiliates beneficially ownapproximately 95 percent of our common stock. As a result, Greenlight hassufficient voting power, without the vote of any other stockholders, todetermine what matters will be submitted for approval by our stockholders, toapprove actions by written consent without the approval of any otherstockholders, to elect all of our board of directors, and to determine whethera change in control of our company occurs. Greenlight’s interests on matterssubmitted to stockholders may be different from those of other stockholders.Greenlight is not involved in our day-to-day operations, but Greenlight hasvoted its shares to elect our current board of directors. The chairman of ourboard of directors is a current employee of Greenlight.

 

Our common stock is not currently listed on any stock exchange orNasdaq. As a result, we are not subject to corporate governance rules adoptedby the New York Stock Exchange, American Stock Exchange and Nasdaq requiring amajority of directors to be independent and requiring compensation andnominating committees that are composed solely of independent directors.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, isexempt from the above-mentioned independence rules. Since Greenlightbeneficially owns approximately 95 percent of our common stock, we may takeadvantage of the controlled company exemption if our common stock becomeslisted on an exchange or Nasdaq in the future. As a result, our stockholderscurrently do not have, and may never have, the protections that these rules areintended to provide.

 

*Future sales of shares of ourcommon stock by our stockholders could cause our stock price to fall.*

 

If a substantial number of shares of our common stock are sold in thepublic market, the market price of our common stock could fall.  The perception among investors that thesesales will occur could also produce this effect.  Our majority stockholder Greenlightbeneficially owns approximately 95 percent of our common stock and sales byGreenlight or a perception that Greenlight will sell could cause a decrease inthe market price of our common stock. Additionally, holders of outstandingwarrants may convert and sell the underlying shares in the public market.Pursuant to our obligations under registration rights agreements, we registered957,872 shares of common stock underlying certain warrants, of which Greenlightowns warrants to purchase approximately 493,683 shares of our common stock.Sales of shares or a perception that there will be sales of the underlyingshares could also cause a decrease in the market price of our common stock.

 

*Holders may find it difficult to effecttransactions in 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 impaired—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 NationalMarket or the Nasdaq SmallCap Market are subject to an SEC rule thatimposes special requirements on broker-dealers who sell those securities topersons other than their established customers and accredited investors. Thebroker-dealer must determine that the security is suitable for the purchaserand must obtain the purchaser’s written consent prior to the sale. Theserequirements may make it more difficult for stockholders to sell our stock thanthe stock of some other companies. It may also affect our ability to raise morecapital if and when necessary.

 

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**Item 6.  Exhibits**

 

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

 

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

 

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

 

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

 

**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:  | May 11, 2006 | By:                                                      | /s/ PAUL J. B. MURPHY, III |
|   |              | Paul J.B. Murphy, III                               |
|   |              | Chief Executive Officer                                  |
|   |              |                                                     |
| Date:  | May 11, 2006 | By:                                                      | /s/ RICHARD P. DUTKIEWICZ |
|   |              | Richard P. Dutkiewicz                                    |
|   |              | Chief Financial Officer and Principal Accounting Officer |
|   |              |                                                     |

 

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