##### Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549



---



FORM 10-K



(Mark One)

| | þ | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
| | - | ------------------------------------------------------------------------------------



| |  | For the fiscal year ended June 28, 2006
| |  | ---------------------------------------



OR



| |  ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
| | - | ----------------------------------------------------------------------------------------



Commission file number 0-21203



DIEDRICH COFFEE, INC.

(Exact Name of Registrant as Specified in Its Charter)



|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 33-0086628                          
|(State or Other Jurisdiction of Incorporation or Organization) |  | (I.R.S. Employer Identification No.)



28 Executive Park,
Suite 200

Irvine, California 92614

(Address of Principal Executive Offices)



Registrants telephone number, including area code

(949) 260-1600



Securities registered pursuant to Section 12(b) of the Act:

None



Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $0.01 par value per share

(Title of Class)



Indicate by check mark if the registrant is a well-known seasoned issuer, as
defined in Rule 405 of the Securities Act.  Yes  [    ]  No  [X]



Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the
Act.  Yes  [    ]  No  [X]



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



Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to
this Form 10-K.  [    ]



Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act.
(Check one):  Large accelerated filer  [    ]    Accelerated filer  [    ]    Non-accelerated filer  [X]



Indicate by check mark if the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act).  Yes  [    ]  No  [X]



The aggregate market value of the registrants common stock held by non-affiliates of the registrant as of December 14, 2005 was $14,462,653.



The number of shares of the registrants common stock
outstanding, as of September 22, 2006 was 5,346,270.



DOCUMENTS INCORPORATED BY REFERENCE



Portions
of the registrants proxy statement for its 2006 annual meeting of stockholders, which will be filed with the Securities and Exchange Commission within 120 days of June 28, 2006, are incorporated by reference into Part III of this Report.



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TABLE OF CONTENTS



|                                           |  |                                                                                                              |  |     
|------------------------------------------ |  | ------------------------------------------------------------------------------------------------------------ |  | ----
|                                           |  |                                                                                                              |  | Page
|A Warning About Forward-Looking Statements |  | 1                                                                                                           
|                                           |  |                                                                                                             
|                                           |  | PART I                                                                                                       |  |     
|                                           |  |                                                                                                             
|Item 1.                                    |  | Business                                                                                                     |  | 1   
|                                           |  |                                                                                                             
|Item 1A.                                   |  | Risk Factors                                                                                                 |  | 13  
|                                           |  |                                                                                                             
|Item 1B.                                   |  | Unresolved Staff Comments                                                                                    |  | 19  
|                                           |  |                                                                                                             
|Item 2.                                    |  | Properties                                                                                                   |  | 19  
|                                           |  |                                                                                                             
|Item 3.                                    |  | Legal Proceedings                                                                                            |  | 20  
|                                           |  |                                                                                                             
|Item 4.                                    |  | Submission of Matters to a Vote of Security Holders                                                          |  | 20  
|                                           |  |                                                                                                             
|                                           |  | PART II                                                                                                      |  |     
|                                           |  |                                                                                                             
|Item 5.                                    |  | Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities |  | 20  
|                                           |  |                                                                                                             
|Item 6.                                    |  | Selected Financial Data                                                                                      |  | 20  
|                                           |  |                                                                                                             
|Item 7.                                    |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                        |  | 22  
|                                           |  |                                                                                                             
|Item 7A.                                   |  | Quantitative and Qualitative Disclosures About Market Risk                                                   |  | 37  
|                                           |  |                                                                                                             
|Item 8.                                    |  | Financial Statements and Supplementary Data                                                                  |  | 38  
|                                           |  |                                                                                                             
|Item 9.                                    |  | Changes in and Disagreements With Accountants on Accounting and Financial Disclosure                         |  | 38  
|                                           |  |                                                                                                             
|Item 9A.                                   |  | Controls and Procedures                                                                                      |  | 39  
|                                           |  |                                                                                                             
|Item 9B.                                   |  | Other Information                                                                                            |  | 39  
|                                           |  |                                                                                                             
|                                           |  | PART III                                                                                                     |  |     
|                                           |  |                                                                                                             
|Item 10.                                   |  | Directors and Executive Officers of the Registrant                                                           |  | 39  
|                                           |  |                                                                                                             
|Item 11.                                   |  | Executive Compensation                                                                                       |  | 39  
|                                           |  |                                                                                                             
|Item 12.                                   |  | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters               |  | 39  
|                                           |  |                                                                                                             
|Item 13.                                   |  | Certain Relationships and Related Transactions                                                               |  | 40  
|                                           |  |                                                                                                             
|Item 14.                                   |  | Principal Accountant Fees and Services                                                                       |  | 40  
|                                           |  |                                                                                                             
|                                           |  | PART IV                                                                                                      |  |     
|                                           |  |                                                                                                             
|Item 15.                                   |  | Exhibits and Financial Statement Schedules                                                                   |  | 40  
|                                           |  |                                                                                                             
|                                           |  | Signatures                                                                                                   |  | 41  
|                                           |  |                                                                                                             
|                                           |  | Financial Statements                                                                                         |  | F-1 
|                                           |  |                                                                                                             
|                                           |  | Index to Exhibits                                                                                            |  | S-1 



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A WARNING ABOUT FORWARD-LOOKING STATEMENTS



We make forward-looking statements in this annual report that are subject to risks and uncertainties. These forward-looking statements include information about possible or assumed future results of our financial condition, operations,
plans, objectives and performance. When we use the words believe, expect, anticipate, estimate or similar expressions, we are making forward-looking statements. Many possible events or factors could
affect our future financial results and performance. This could cause our results or performance to differ materially from those expressed in our forward-looking statements. You should consider these risks when you review this document, along with
the following possible events or factors:



| |  |  | the financial and operating performance of our retail operations;
| | - |  | -----------------------------------------------------------------



| |  |  | the timing and success of the pending sale of retail store locations to Starbucks Corporation;
| | - |  | ----------------------------------------------------------------------------------------------



| |  |  | our ability to maintain profitability over time;
| | - |  | ------------------------------------------------



| |  |  | the successful execution of our growth strategies;
| | - |  | --------------------------------------------------



| |  |  | our franchisees adherence to our practices, policies and procedures;
| | - |  | ---------------------------------------------------------------------



| |  |  | the impact of competition; and
| | - |  | ------------------------------



| |  |  | the availability of working capital.
| | - |  | ------------------------------------



Additional risks and uncertainties are described elsewhere in this report and in detail under Item 1A. Risk Factors. You are cautioned not to place
undue reliance on these forward-looking statements, which reflect managements analysis only as of the date of this annual report. We undertake no obligation to revise or update any forward-looking statements, whether as a result of new
information, future events or changed circumstances. Unless the context requires otherwise, the terms we, us, and our refer to Diedrich Coffee, Inc., a Delaware corporation, and its predecessors and subsidiaries.



PART I



|Item 1. | Business.
|------- | ---------



Overview



Diedrich Coffee, Inc. is a specialty coffee roaster, wholesaler and retailer. We sell brewed, espresso-based and various blended beverages primarily made from our own fresh roasted premium coffee beans, as well as
light food items, whole bean coffee and accessories, through our company operated and franchised retail locations. We also sell whole bean and ground coffee on a wholesale basis through a network of distributors in the Office Coffee Service
(OCS) market and to other wholesale customers, including restaurant chains and other retailers. Our brands include Diedrich Coffee, Gloria Jeans, and Coffee People. As of June 28, 2006, we owned and operated 52 retail
locations, of which up to 40 retail locations may be sold to Starbucks Corporation (as discussed in Recent Developments in the section immediately below and Item 7 OverviewRecent Developments), and franchised 148 other
retail locations under these brands, for a total of 200 retail coffee outlets. Although the specialty coffee industry is presently dominated by a single company, which operates over eight thousand domestic retail locations, we are one of the
nations largest specialty coffee retailers with annual system-wide revenues in excess of $116 million. System-wide revenues include sales from company operated and franchise locations. Our retail units are located in 33 states. As of
June 28, 2006, we also had over 800 wholesale accounts with OCS distributors, chain and independent restaurants, and others. In addition, we operate a large coffee roasting facility in central California that supplies freshly roasted coffee to
our franchise and retail locations and wholesale accounts.



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Our Gloria Jeans coffee stores offer an extensive variety of the finest quality flavored whole bean
coffees, as well as an assortment of coffee related merchandise, accessories, porcelain novelties and gift items, in addition to coffee-based beverages. The critical components for each of our retail locations include high quality, fresh roasted
coffee and superior customer service by knowledgeable employees.



Our Diedrich Coffee brand is differentiated from other specialty coffee companies by roasting our coffee beans with the experience we have gained over several decades. Our roasting recipes take into account the specific variety, origin and
physical characteristics of each coffee bean to maximize its unique flavor. In addition, we seek to differentiate our coffeehouses by offering our customers a broad line of superior tasting coffee products and a high level of personalized customer
service. Our coffeehouses offer a warm, friendly environment specifically designed to encourage guests to enjoy their favorite beverages while lingering with friends and business associates, or relaxing alone in comfort. Ample seating is augmented
by sofas and comfortable chairs to create intimate nooks for meeting and relaxing. Many of our coffeehouses feature local musicians who provide live entertainment from time to time during the week.



Recent Developments



On September 14, 2006, we and Starbucks Corporation, a Washington corporation (Starbucks), entered into an
asset purchase agreement pursuant to which Starbucks has agreed to purchase our leasehold interests in most of the 47 locations where we operate retail stores under the Diedrich Coffee and Coffee People brands (the Company Stores), along
with certain related fixtures and equipment, improvements, prepaid items, and ground lease improvements, and to assume certain liabilities as set forth in the asset purchase agreement (collectively, the Transaction).



Pursuant to the asset purchase agreement, Starbucks will pay us up to
$13,520,000 in cash, which includes payment of $120,000 as consideration for our agreement to a non-compete provision. The actual amount paid by Starbucks under the asset purchase agreement is dependent on which and how many of the Company Stores
are ultimately transferred to Starbucks. Ten percent of the amount paid to us upon transfer of the Company Stores will be deposited into an escrow fund to be held in connection with our indemnification obligations. The closing is expected to occur
approximately 90 days after the date of the asset purchase agreement (the Closing), provided that certain conditions, including that a specified minimum number of Company Stores are transferred to Starbucks at Closing, are met. After the
Closing, we and Starbucks have agreed to use commercially reasonable efforts to transfer certain remaining Company Stores until approximately 150 days after the date of the asset purchase agreement or such other longer period as agreed to by us and
Starbucks.



We and Starbucks have made certain customary
representations, warranties and covenants in the asset purchase agreement. Specifically, we have agreed that, subject to a fiduciary-out provision and payment of a break-up fee, we will not (i) take any action to solicit any
proposal from, (ii) furnish any information to, or (iii) participate in any discussions with, any entity other than Starbucks regarding any transaction involving the Company Stores. Upon termination of the asset purchase agreement under
certain circumstances, including the Companys entry into an alternative transaction involving the Company Stores, we shall pay Starbucks actual fees and expenses incurred in connection with the Transaction up to a maximum amount of
$500,000; provided, however, that Starbucks is entitled to a minimum of $250,000, regardless of its actual fees and expenses. The asset purchase agreement also contains customary indemnification provisions for certain claims and provides for a
basket of $100,000 and a cap of $2,000,000 for breaches of our representations and warranties contained in the asset purchase agreement.



The consummation of the Transaction is subject to certain customary conditions, including: approval of the Transaction by our stockholders; a specified
minimum number of Company Stores transferred to Starbucks at Closing; the receipt by Starbucks of permits and approvals for at least 70% of certain Company Stores that are transferred if the Closing occurs within 90 days of the date of the asset
purchase agreement; receipt of lease extensions of at least 10 years for at least 40% of certain Company Stores that are transferred; and, receipt of



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consents to the assignment of the leases for each of the Company Stores that are transferred, with estoppel provisions being agreed to for at least 50% of
the Company Stores that are transferred. The asset purchase agreement contains customary termination provisions and may be terminated by either us or Starbucks if the Closing does not occur within 150 days from the date of the asset purchase
agreement. We may also terminate the asset purchase agreement if the Closing has not occurred within 90 days, provided that Starbucks has not used commercially reasonable efforts to achieve the Closing.



As part of the asset purchase agreement, we have agreed to a non-compete
provision that for three years after the Closing restricts our ability to operate or have any interest in the ownership or operation of any entity operating any retail specialty coffee stores in any city where a Company Store is presently located.
The non-compete provision applies only to stores opened after the date of the asset purchase agreement and does not apply to (1) any retail stores operated under the Gloria Jeans brand name, (2) wholesale sales to retail
businesses that are not operated by us, or other non-retail businesses, or (3) the conversion of Company-operated stores existing on the date of the asset purchase agreement to franchise stores. We have also agreed that we will not solicit any
Starbucks employee to enter our employment for three years after the Closing.



Sale of International Franchise Operations



On
February 11, 2005, we completed the sale of our Gloria Jeans international franchise operations. Proceeds from the sale of the 338 franchised units were a cash payment of $16,000,000 and notes of $7,020,000 payable over the next six
years. See Managements Discussion and Analysis of Financial Condition and Results of OperationsResults of OperationsSale of International Franchise Operations.



Company Background



Our predecessor company, Carl E. Diedrich & Sons, Inc., commenced operations in Orange County, California in 1972
and changed its name to Diedrich Coffee when its first retail store opened. We incorporated in California in 1985. We remained a small, family operated business with only three retail locations until 1992. We grew rapidly from 1992 to 1996 through
construction of new Diedrich Coffee coffeehouses in Orange County and the acquisition of coffeehouses operated under other brands in Houston, Denver and San Diego, all of which were converted into Diedrich Coffee coffeehouses. In August 1996, we
reincorporated under Delaware law as Diedrich Coffee, Inc., and completed an initial public offering of our common stock in September 1996. On July 7, 1999, we acquired Coffee People, Inc. The Coffee People, Inc. brands included Gloria
Jeans, one of the leaders in the mall coffee store market, Coffee People, based primarily in Portland, Oregon, and Coffee Plantation, based primarily in Phoenix, Arizona. The Coffee Plantation coffeehouses have been sold or closed. We continue
to operate three brands: Diedrich Coffee, Gloria Jeans and Coffee People.



Industry Overview



According to the National
Coffee Association of U.S.A., Inc. (the NCA), in 2006, 178.3 million adults, or 82% of the population over the age of 18, drank coffee daily or occasionally, which represents a 5.9 million-person increase from the 80% of
the population over the age of 18 in 2004. The NCA also reported that daily and occasional consumption of gourmet coffee has increased over the past six years from 9.0% of the adult population in 2000 to over 16.0% of the adult population
in 2006.



The United States coffee market consists of two
distinct product categories:



| | n | commercial ground roast, mass-merchandised coffee; and
| | - | ------------------------------------------------------



| | n | specialty coffees, which include gourmet coffees (premium grade Arabica coffees sold in whole bean and ground form) and premium coffees (upscale coffees mass-marketed by the leading
coffee companies).
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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We believe that several factors have contributed to the increase in demand for gourmet coffee including:



| | n | greater consumer awareness of gourmet coffee as a result of its increasing availability;
| | - | ----------------------------------------------------------------------------------------



| | n | increased quality differentiation over commercial grade coffees by consumers;
| | - | -----------------------------------------------------------------------------



| | n | increased demand for all premium food products, including gourmet coffee, where the differential in price from the commercial brands is small compared to the perceived improvement
in product quality and taste; and
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | n | ease of preparation of gourmet coffees resulting from the increased use of automatic drip coffee makers and home espresso machines.
| | - | -----------------------------------------------------------------------------------------------------------------------------------



Our Business Model



Our business objective is a logical extension of our Mission Statement, which states: We sell great coffee.
Therefore, our objective is to sell coffee, without compromising our commitment to quality. We buy only the finest quality green coffee beans available, fresh roast them with our proprietary recipes and subject them to a rigorous internal quality
control process. We ensure that care is taken at each and every step of the production and distribution process to preserve that quality.



We principally sell our coffee through two distribution channels, and strive to target our resources to increase efficiency and profitability while
growing the business within this framework. These two distribution channels are retail outlets and wholesale distribution. While each of these channels have different customers, cost structures, overhead requirements, competitors, and other
fundamental differences, we believe our commitment to quality is essential to successful growth in both of these areas. Important financial information for each of our business segments can be found in Note 13 to our consolidated financial
statements.



Retail Outlets



Our retail outlet distribution channel can be divided into two sub-channels,
each with its own distinct business model, including differences in revenue and cost structure, overhead, and capital requirements. These two retail sub-channels are company operated retail outlets and franchised retail outlets. Despite the
differences noted above, we view retail outlets as a single distribution channel primarily because our retail customers do not make any distinction between company and franchise operated locations. The critical success factors are, therefore, the
same for each type of retail location, whether company operated or franchisedquality of product, service and atmosphere. The economic model and cost structures are also the same for each type of location at the retail unit level,
notwithstanding their different direct financial impacts on us in our roles as both an operator and franchiser of retail outlets. Furthermore, the potential contribution of any given outlet, as measured by the amount of roasted coffee produced
through our roasting plant, is the same.



Presently, our
largest brand is Gloria Jeans, which consists of retail units located throughout the United States. Over 97% of Gloria Jeans retail units are franchised. Our Diedrich Coffee brand has a higher concentration of company operated
units, with 76% of retail locations operated by us. Diedrich Coffee stores are located primarily in Orange County, California, although there are a number of Diedrich Coffee locations in Los Angeles, San Diego, Denver, and Houston. We also
operate retail coffee outlets under a third brand, Coffee People, all of which except one are currently company operated and located in Oregon.



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The following table summarizes the relative sizes of each of our brands on a unit count basis and changes in unit count
for each brand over the past two years.



|                                |  |                        |  |        |  |                  |   |  |                                                     |   |  |                        |  |        |  |             |   |  |                                                     |   |  |                           
|------------------------------- |  | ---------------------- |  | ------ |  | ---------------- | - |  | --------------------------------------------------- | - |  | ---------------------- |  | ------ |  | ----------- | - |  | --------------------------------------------------- | - |  | --------------------------
|                                |  | Units at June 30, 2004 |  | Opened |  | Closed/ Sold (E) |   |  | Net transfers between the Company and Franchise (A) |   |  | Units at June 29, 2005 |  | Opened |  | Closed/Sold |   |  | Net transfers between the Company and Franchise (B) |   |  | Units at June 28, 2006 (F)
|Gloria Jeans Brand             |  |                        |  |        |  |                  |   |  |                                                     |   |  |                        |  |        |  |             |   |  |                                                     |   |  |                           
|Company Operated                |  | 10                     |  | 1      |  | (1               | ) |  | 1                                                   |   |  | 11                     |  | 1      |  | (1          | ) |  | (6                                                  | ) |  | 5                         
|Franchise  Domestic            |  | 137                    |  | 11     |  | (15              | ) |  | (1                                                  | ) |  | 132                    |  | 16     |  | (15         | ) |  | 6                                                   |   |  | 139                       
|                                |  |                        |  |        |  |                  |   |  |                                                     |   |  |                        |  |        |  |             |   |  |                                                     |   |  |                           
|Franchise  International       |  |                        |  |        |  |                  |   |  |                                                     |   |  |                        |  |        |  |             |   |  |                                                     |   |  |                           
|Australia                       |  | 196                    |  | 46     |  | (242             | ) |  |                                                    |   |  |                       |  |       |  |            |   |  |                                                    |   |  |                          
|Far East/Asia (C)               |  | 19                     |  |       |  | (19              | ) |  |                                                    |   |  |                       |  |       |  |            |   |  |                                                    |   |  |                          
|Mexico                          |  | 17                     |  |       |  | (17              | ) |  |                                                    |   |  |                       |  |       |  |            |   |  |                                                    |   |  |                          
|Other (D)                       |  | 50                     |  | 14     |  | (64              | ) |  |                                                    |   |  |                       |  |       |  |            |   |  |                                                    |   |  |                          
|                                |  |                        |  |        |  |                  |   |  |                                                     |   |  |                        |  |        |  |             |   |  |                                                     |   |  |                           
|Total Franchise  International |  | 282                    |  | 60     |  | (342             | ) |  |                                                    |   |  |                       |  |       |  |            |   |  |                                                    |   |  |                          
|                                |  |                        |  |        |  |                  |   |  |                                                     |   |  |                        |  |        |  |             |   |  |                                                     |   |  |                           
|Subtotal Gloria Jeans          |  | 429                    |  | 72     |  | (358             | ) |  |                                                    |   |  | 143                    |  | 17     |  | (16         | ) |  |                                                    |   |  | 144                       
|                                |  |                        |  |        |  |                  |   |  |                                                     |   |  |                        |  |        |  |             |   |  |                                                     |   |  |                           
|                                |  |                        |  |        |  |                  |   |  |                                                    
|Diedrich Coffee Brand           |  |                        |  |        |  |                  |   |  |                                                     |   |  |                        |  |        |  |             |   |  |                                                     |   |  |                           
|Company Operated                |  | 23                     |  | 3      |  |                 |   |  |                                                    |   |  | 26                     |  | 1      |  |            |   |  | (1                                                  | ) |  | 26                        
|Franchise  Domestic            |  | 7                      |  | 1      |  | (1               | ) |  |                                                    |   |  | 7                      |  | 1      |  | (1          | ) |  | 1                                                   |   |  | 8                         
|                                |  |                        |  |        |  |                  |   |  |                                                     |   |  |                        |  |        |  |             |   |  |                                                     |   |  |                           
|Subtotal Diedrich               |  | 30                     |  | 4      |  | (1               | ) |  |                                                    |   |  | 33                     |  | 2      |  | (1          | ) |  |                                                    |   |  | 34                        
|                                |  |                        |  |        |  |                  |   |  |                                                     |   |  |                        |  |        |  |             |   |  |                                                     |   |  |                           
|                                |  |                        |  |        |  |                  |   |  |                                                    
|Coffee People Brand             |  |                        |  |        |  |                  |   |  |                                                     |   |  |                        |  |        |  |             |   |  |                                                     |   |  |                           
|Company Operated                |  | 23                     |  | 3      |  | (1               | ) |  |                                                    |   |  | 25                     |  | 4      |  | (7          | ) |  | (1                                                  | ) |  | 21                        
|Franchise  Domestic            |  |                       |  |       |  |                 |   |  |                                                    |   |  |                       |  |       |  |            |   |  | 1                                                   |   |  | 1                         
|                                |  |                        |  |        |  |                  |   |  |                                                     |   |  |                        |  |        |  |             |   |  |                                                     |   |  |                           
|Subtotal Coffee People          |  | 23                     |  | 3      |  | (1               | ) |  |                                                    |   |  | 25                     |  | 4      |  | (7          | ) |  |                                                    |   |  | 22                        
|                                |  |                        |  |        |  |                  |   |  |                                                     |   |  |                        |  |        |  |             |   |  |                                                     |   |  |                           
|Total                           |  | 482                    |  | 79     |  | (360             | ) |  |                                                    |   |  | 201                    |  | 23     |  | (24         | ) |  |                                                    |   |  | 200                       
|                                |  |                        |  |        |  |                  |   |  |                                                     |   |  |                        |  |        |  |             |   |  |                                                     |   |  |                           



---



|(A) | Two company operated Gloria Jeans coffeehouses were transferred to franchisees during fiscal year 2005 and three franchisee operated coffeehouses were transferred from
franchisees to the Company.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(B) | Six company operated Gloria Jeans, one company operated Diedrich Coffee, and one company operated Coffee People coffeehouses were transferred to franchisees during fiscal year
2006.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(C) | Includes Japan and Korea.
|--- | -------------------------



|(D) | Includes Guam, Indonesia, Ireland, Turkey, Malaysia, New Zealand, Philippines, United Arab Emirates, Romania, South Africa and Thailand.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------



|(E) | On February 11, 2005, we sold the international franchise rights to 338 Gloria Jean units in exchange for a cash payment of $16,000,000 and notes of $7,020,000 payable over the
next six years, as more fully described in Note 1 to the Consolidated Financial Statements attached herein.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(F) | On September 14, 2006, we and Starbucks Corporation entered into an agreement pursuant to which Starbucks has agreed to purchase our leasehold interests in most of the 47
locations where we operate retail stores under the Diedrich Coffee and Coffee People brands. See Recent Developments above and Item 7 OverviewRecent Developments.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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We recognize the importance of our brands to our success in both the retail and wholesale areas of our
business. We therefore devote considerable energy to maintain distinct brand identities. Our brands are differentiated by coffees offered, other product categories offered, format and type of retail location, advertising message, and trade dress.



Gloria Jeans



Gloria Jeans is a leader in the specialty grade, flavored coffee
market, with 144 coffee stores in 33 states throughout the United States. Many of our Gloria Jeans coffee stores are located in high traffic shopping malls. The consumer traffic pattern in our mall-based stores is driven by mall hours and
dynamics. Our mall-based stores are generally busiest on weekends and during holiday seasons. The typical Gloria Jeans domestic coffee store is staffed with a manager and a staff of 10 to 15 part-time hourly employees who fill the operating
shifts. Gloria Jeans outlets tend to open earlier than most mall stores, but in general, operating hours coincide with mall hours. In addition to coffee beverages and fresh roasted whole bean coffees, Gloria Jeans carries a wide
selection of gift items, coffee accessories, and a small selection of bakery items to complement beverage sales. The Gloria Jeans stores currently sell from 32 to 53 varieties of flavored and non-flavored coffees, with beverage sales
representing approximately 50% of overall sales.



The success
of Gloria Jeans coffee stores in malls depends on three critical components: product quality, product selection, and service.



Product Quality.    Gloria Jeans has been a pioneer in developing high quality, flavored, specialty coffees, and
continues to be a leader in the sale of flavored coffees. Gloria Jeans flavored coffees begin with a top quality, single-origin coffee that is roasted and then coated with proprietary flavorings.



Product Selection.    For those stores in a mall
environment, the shopping experience is integral to a coffee store, and sales of whole bean coffee and coffee-related merchandise tend to represent a large percentage of sales. Offering as many as 53 varieties of flavored coffees, a wide variety of
hot and cold beverages, and a wide selection of gift items is important. A major benefit of mall retailing is its captive consumer base. The primary function of Gloria Jeans marketing is to entice consumers with eye-catching signage and window
displays. A large selection of products helps to attract both new and repeat customers. Once inside a mall, consumers are unlikely to leave to purchase coffee, refreshments or gifts similar to those offered by Gloria Jeans. Mall employees are
also captive consumers and represent an important component of our customer base.



Service.    Friendly and efficient customer service is always critical in any retail setting, and is especially important for those stores in a mall environment, where shoppers are often in
a hurry and have many choices. Because of the opportunity for repeat customers, it is essential that customers receive excellent service.



Diedrich Coffee



Our typical Diedrich Coffee neighborhood coffeehouse is staffed with one or two managers and a staff of 12 to 25 part-time hourly employees who fill the
operating shifts. Additionally, local entertainment is often offered on the weekends to enhance the neighborhood atmosphere. The hours for each coffeehouse are established based upon location and customer demand, but typically are from 6:00 a.m. to
11:00 p.m.



In addition to coffee beverages and fresh roasted
whole bean coffees, all of our Diedrich Coffee coffeehouses offer a limited selection of light food items such as bagels, croissants and pastries, and dessert items, such as cookies and cakes, to complement beverage sales. Our coffeehouses sell more
than 25 different selections of regular and decaffeinated roasted whole bean coffees, and they carry select coffee-related merchandise items. The success of a Diedrich Coffee coffeehouse depends upon three critical components: product quality,
service and ambiance.



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Product Quality.    Our management team includes a number of coffee experts
with years of specialty coffee industry experience in purchasing and roasting coffee and in training our coffeehouse team members. Through these key personnel, we are able to identify and purchase exceptional coffees and roast them to perfection. In
addition they share their expertise with our coffeehouse team members in our training program, Coffee University.



Service.    Our coffeehouses deliver specific consumer benefits that address a wide range of otherwise unmet needs in suburban
neighborhoods in the United States. As a neighborhood coffeehouse, we are the non-alcoholic alternative to the corner pub. Our employees greet regular customers by name and acknowledge all patrons by name at the point of drink pick-up. Although a
large percentage of coffeehouse business is quick morning coffee pick-up, where speed is an important aspect of our overall service, our coffeehouses place an emphasis on hospitality and customer interaction to encourage development of strong
afternoon and evening business. This is complemented by our selection of desserts, pastries and quality, non-caffeinated beverages. Surveys and customer comments indicate that patrons are treated as part of the Diedrich Coffee community and
frequently visit the coffeehouse.



Ambiance.    Our coffeehouses are specifically designed to encourage guests to linger with friends and business associates, or to relax alone in comfort. Ample seating is augmented with sofas and comfortable
chairs to create intimate nooks for meeting and relaxing. A weekly entertainment schedule is provided to encourage patrons to revisit on weekend evenings. A signature element of our full size coffeehouses is a coffee bar, where customers can sit at
a barstool and watch the barista prepare espresso-based drinks, similar to the way patrons in traditional pubs and taverns interact with the bartender and other customers at the bar.



Wholesale Distribution



As of June 28, 2006, we had over 800 coffee wholesale accounts not affiliated with our retail locations, which purchase
coffee from us under both the Diedrich Coffee and Gloria Jeans brands. Our current wholesale accounts are in the OCS (Office Coffee Services) market, chain restaurants, independent restaurants and other hospitality industry accounts and
specialty retailers. Additionally, our franchise agreements require both Gloria Jeans and Diedrich Coffee franchisees to purchase substantially all of their coffee from us, and we record a wholesale gross profit on such sales.



OCS Market



During fiscal 2000, we entered into a licensing agreement with Keurig, Inc.
whereby we utilize Keurigs patented single service coffee brewing technology and its extensive distribution channels within the OCS market. In addition to Keurig single-serve K-Cups®, we sell our premium coffees to OCS distributors in whole bean and ground coffee form
for use in traditional coffee brewing equipment found in most office environments. In addition to being a leader in office-based single-cup brewing choices, Keurig is growing in the home-based brewer area. Keurig brewers are currently sold in over
5,000 retail locations including Macys, Bloomingdales, Target, Linens n Things, and Bed, Bath & Beyond. We are actively participating in this retail channel with the sale of K-cups through many of these retailers and
the sale of at-home brewers and K-cups in most of our company and franchise stores and internet web stores.



On May 2, 2006, Green Mountain Coffee Roasters, Inc. and Keurig, Inc. announced they had agreed to a transaction in which Green Mountain Coffee would
acquire all the outstanding shares of Keurig, Inc. that the Company did not already own. After the acquisition, Keurig would be a wholly-owned subsidiary of Green Mountain Coffee.



We do not anticipate any negative effects to our licensing agreement resulting from Green Mountains acquisition of
Keurig, Inc. There is, however, no assurance that we will be able to extend or renew our licensing agreement with Keurig, in which case, we would lose revenues from this business.



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Chain Restaurants



As specialty coffee has grown in overall popularity, restaurant customers are demanding a high quality cup of coffee as a
supplement to a meal. Our chain accounts include Rubys restaurants, Ruths Chris Steakhouse (California and Arizona locations), Pat and Oscars restaurants, Islands restaurants, and Marie Callenders restaurants. We not only
supply coffee to these customers, but also approve their equipment and train their employees to ensure that the quality of coffee served meets our rigorous quality standards. It is common for our chain restaurant wholesale customers to specify in
their menus that they serve Diedrich Coffee or Gloria Jeans coffee, which provides us with additional exposure to the restaurants patrons.



Other Wholesale Accounts



We also supply coffee on a wholesale basis to a number of smaller, often independent, operators in the restaurant and hospitality industries and to
specialty retailers. These wholesale accounts are typically located in the same geographic areas where our retail outlets have created brand awareness and demand. We are careful to balance the benefit of new wholesale accounts near our existing
retail outlets against the risk of cannibalization of these units. We believe that this risk can be successfully managed. Many of our wholesale accounts, such as hotels, restaurants, golf course snack bars and airport concessions have
their own captive customer base. In such cases, the risk of cannibalization is minimal, since a customer would not likely stop their activity in such locations to visit one of our coffeehouses or mall based coffee stores for a beverage,
and then return to their previous activity at those wholesale customer locations. Additionally, if sales conflicts arise as we develop new retail locations in the future, we can cease selling to then-existing wholesale accounts.



Growth Strategy



Retail Segment Growth.    Under a non-compete provision in the asset purchase agreement
with Starbucks, we are restricted for a period of three years after the asset sale closes in our ability to open any new company-operated or franchised Diedrich Coffee and Coffee People coffeehouses in any city in which Diedrich Coffee or Coffee
People coffeehouses operated on the date that we and Starbucks entered into the asset purchase agreement. The non-compete provision does not restrict our ability to open retail Gloria Jeans stores and does not apply to wholesale sales to
retail businesses that are not operated by us or other non-retail businesses or the conversion of our stores existing on the date of the asset purchase agreement to franchise stores. See Recent Developments above and Item 7
OverviewRecent Developments.



As a result of the
proposed asset sale to Starbucks, we expect any future growth in our retail segment to occur in two ways: via comparable store sales growth in each of our retail brands and from new retail unit growth. We expect that new unit growth in the near term
will be achieved through the development of new Gloria Jeans retail locations, by us and by franchisees. We believe that the resources we recently invested in our Gloria Jeans franchising infrastructure will allow us to resume net growth
in our domestic store count under the Gloria Jeans brand.



Development of new Gloria Jeans retail locations by us will be undertaken on a very selective basis. New company store development will be done primarily for the purpose of facilitating new franchise development. Therefore, increased
development of new retail units by us will likely be accompanied by increased sales of company operated retail units to franchisees. For a variety of reasons, retail units sold by us to franchisees in any given period may not necessarily coincide
precisely with the specific new units developed by us in that same period. Development of new retail units by us is expected to support new franchise development in a number of ways, including opportunistically obtaining control of desirable
locations as they become available, increasing awareness of our specialty coffee brands by real estate developers and landlords of prime retail properties as they develop new retail venues, and by prospective retail coffeehouse customers, improving
the cost effectiveness of architectural plans for new prototypes, leveraging purchasing efficiencies system-wide for new unit equipment and fixtures packages, and increasing awareness among prospective franchisees and their lenders.



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Gloria Jeans Franchise Growth.Since the acquisition of the
Gloria Jeans brand in 1999, we have made a number of modifications to the Gloria Jeans franchising business model to strengthen the Gloria Jeans system. A new form of franchise agreement was adopted which incorporated many
provisions common in other successful franchise systems. Screening of financial qualifications of franchise candidates has been improved in terms of consistency and accuracy. Franchisees are now encouraged to obtain their own master leases directly
from mall owners, rather than subleasing their locations from Gloria Jeans. Franchisees are required to hire their own architects and contractors to develop new Gloria Jeans locations to approved specifications. Our training program has
been completely redesigned in order to improve the quality of store level operations, product quality, and the consistency of brand standards. Although we believe that these and other changes to the Gloria Jeans franchising model will
ultimately result in a stronger Gloria Jeans franchise system, they may result in slower domestic franchise growth in the near term.



Another factor we must overcome in the near term to resume domestic unit growth for Gloria Jeans is a shortage of projects in our new unit
development pipeline, or inventory of new unit deals in progress. This shortage resulted from our focus on improving the foundation for future franchise development during the past several years since we acquired the Gloria Jeans
brand, rather than on opening new retail units. As part of our efforts to strengthen our existing retail base, it was necessary to allow many of the weaker performing locations to close. Additional gaps in the flow of new franchise units resulted
from several periods where our franchise registration status, which is required by law to sell new franchises, was temporarily interrupted during certain periods when our financial position was less stable than it is today, and frequent updates of
our registration were required.



Although there were only five
premature franchise unit closures (closures prior to the natural expiration of the underlying master lease) during the most recent fiscal year, there are an average of approximately 9-12 franchise units which reach their
natural expiration annually, and it may not make economic sense to renew many of these locations based on changes in the retail tenant mix, desirability of the location, increases in rent relative to sales levels, and various other
factors. Therefore, it may be some time before we are able to open enough new domestic retail units to offset the number of closures during the same time period for net growth in domestic retail unit count.



Diedrich Coffee Franchise Growth.On
September 14, 2006, we announced that we had entered into an asset purchase agreement to sell most of our 47 company-owned locations to Starbucks Corporation as part of our plan to narrow the focus of the retail side of the business to our
Gloria Jeans franchise operations. The eight franchisee-owned Diedrich Coffee stores currently opened are not directly affected by the proposed sale transaction or other strategic changes. However, in light of the asset purchase
agreement, we have temporarily suspended our franchise growth strategy for the Diedrich and Coffee People brands.



As part of the agreement, we agreed to a non-compete provision that for three years after the transaction closing restricts our ability to franchise any
new Diedrich or Coffee People coffeehouses in any city where a company store was previously located. The non-compete provision applies only to stores opened after the date of the asset purchase agreement.



As of June 28, 2006, there were no area development agreements giving
any franchisee the right to develop a particular market area. Under the terms of our agreement to sell the Gloria Jeans international operations, we agreed to not compete internationally with the purchaser using the Diedrich or Coffee
People brands. That restriction expires on February 11, 2007.



Wholesale Distribution Growth.    We have taken significant steps to build our wholesale sales organization over the past two years, and we are actively seeking new distribution channels for our products.
We intend to pursue continued growth within our OCS wholesale business by expanding the number of distributors that carry our Keurig Premium Coffee Systemslines of coffees and our whole bean and ground coffee product lines. We also offer our coffees on our internet website, and we believe that this channel of distribution has long-term growth potential.



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Franchise Support Programs



We provide a variety of support services to our franchisees. These services include marketing, product sourcing, volume
purchasing savings, training and business consultation.



We
have established an intensive training program for our franchisees, which includes training on in-store operations, coffee knowledge, merchandising, buying, controls and accounting. Management works closely with franchisee representatives on issues
that affect the operations of stores. Franchisees are surveyed regularly to provide feedback on subjects that affect the operations of their stores.



Marketing



Our primary marketing strategy is to develop the Gloria Jeans brand in the U.S. and Puerto Rico through penetration of new and existing markets via
franchise growth. Our wholesale sales in the OCS market, to chain restaurants, and to other customers also operate to increase the visibility of our brands. Our marketing efforts are based upon the belief that the proprietary roast recipes and our
commitment to quality and freshness deliver a distinctive advantage in our products. We use word-of-mouth, local store marketing and the inviting atmosphere of our mall coffee stores to drive brand awareness and comparable store sales growth. We
also conduct in-store coffee tastings, provide brewed coffee at local neighborhood events, and donate coffee to local charities to increase brand awareness. We also conduct product trials in the communities where our coffeehouses and mall coffee
stores are located.



Product Supply and Roasting



Sourcing.    We are committed to selling
only the finest whole bean coffees and coffee beverages. Coffee beans are an agricultural product grown in over 50 countries in tropical regions of the world. The supply and price of coffee are subject to significant volatility and we depend upon
our relationships with coffee producers, outside trading companies and exporters for our supply of green coffee. Supply and price can be affected by multiple factors in the producing countries, including weather, political and economic conditions.
Although the broader coffee market generally treats coffee as a fungible commodity, the specialty coffee industry focuses on the highest grades of coffee. We purchase premium grade Arabica coffee beans that we believe to be the best available from
each producing region.



Roasting.    We employ a roasting process that varies based upon the variety, quality, origin and physical characteristics of the coffee beans being roasted. Our master roasters are responsible for the
green coffee bean roasting process. They are craftsmen who employ our proprietary roasting formulas while adjusting the formula to take into account the specific attributes of each coffee bean being roasted. Each coffee bean contains aromatic oils
and flavor characteristics that develop from the soil, climate and environment where the bean is grown. The skilled roast master determines and carefully controls the roasting conditions in an effort to maximize the flavor potential of each batch of
coffee. The roast master hears how the roast pops, smells the developing aroma and identifies the right shades of color. He draws upon experience and knowledge to properly adjust airflow, time and temperature while the roast is in progress in order
to optimize each roast.



Freshness.    We are committed to serving our customers beverages and whole bean products from freshly roasted coffee beans. Our coffee is delivered to our retail locations and wholesale customers promptly
to guarantee the freshness of each cup of coffee or package of whole coffee beans sold.



Competition



The specialty coffee market is
intensely competitive and generally highly fragmented. In most markets in which we do retail business either through company or franchise locations, there are numerous competitors in the specialty coffee beverage business, and we expect this
situation to continue. Our whole bean coffee competes



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directly against specialty coffees sold at specialty retailers and a growing number of specialty coffee stores. We believe that our customers choose among
retailers primarily on the basis of product quality, service and convenience and, to a lesser extent, on price.



In our wholesale business, we expect increased competition, both within our primary geographic territory, the Western United States, and in other regions
of the United States, as we expand from our current markets. The specialty coffee market is expected to become even more competitive as regional companies expand and attempt to build brand awareness in new markets. We compete primarily by providing
high quality coffee, easy access to our products and superior customer service, and we believe we differentiate ourselves from many of our larger competitors, who specialize in one primary channel of distribution. We also believe that our product
offering is distinctive because we offer a wide array of coffees, including origins, blends and flavored coffees. Finally, we believe that being an independent roaster allows us to be better focused and react quicker to our wholesale customers
needs as compared to than larger, multi-product competitors. While we believe we currently compete favorably with respect to these factors, there can be no assurance that we will be able to compete successfully in the future.



Foreign Operations



The international Gloria Jeans franchise operations were sold on February 11, 2005. In connection with that sale,
we agreed that we would not compete internationally with the purchaser using our Diedrich Coffee and Coffee People brands for a period of two years. Since that date, we no longer have foreign operations.



Other Factors



The performance of individual coffeehouses or mall coffee stores may also be affected by factors such as traffic patterns
and the type, number and proximity of competing coffeehouses or mall coffee stores. In addition, factors such as inflation, increased coffee bean, food, labor and employee benefit costs and the availability of experienced management and hourly
employees may also adversely affect the specialty coffee retail business in general and our coffeehouses and mall coffee stores in particular.



Seasonality



Historically, we have experienced variations in sales from quarter-to-quarter due to the peak November-December holiday season, as well as from a variety
of other factors, including, but not limited to, general economic trends, the cost of green coffee, competition, marketing programs, weather and special or unusual events.



Intellectual Property



We own several trademarks and service marks that have been registered with the United States Patent and Trademark Office, including Diedrich
Coffee®, Gloria Jeans®, Coffee People®, Motor Moka®, Aero Moka®, Wiener Melange Blend®, Harvest Peak®, and Flor de Apanas®, as well as other
slogans, product names, design marks and logos. In addition, we have applications pending with the United States Patent and Trademark Office for a number of additional marks. We also own registrations and have applications pending in numerous
foreign countries for the protection of the Diedrich Coffee and Coffee People trademark and service mark. These trademark registrations can generally be renewed as long as we continue to use the marks protected by the registrations. The Gloria
Jeans and Diedrich Coffee trademarks are material to our business. On February 11, 2005, we sold Gloria Jeans international franchise operations to Jireh International Pty. Ltd., formerly the Gloria Jeans master franchisee for
Australia, and certain of its affiliates (collectively, Jireh) for $16,000,000 in cash and an additional $7,020,000 payable over the next six years under license, roasting and consulting agreements. After all payments have been made to
us under the license, roasting and consulting agreements, all remaining Gloria Jeans trademarks, including those in the U.S., will be transferred to Jireh. Concurrent with such future transfer, our U.S.-based Gloria Jeans subsidiary will
enter into a perpetual, royalty-free master franchise agreement with Jireh under which we will continue to have exclusive rights to operate, franchise and develop



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Gloria Jeans locations throughout the U.S. and Puerto Rico and to continue our wholesale operations under the Gloria Jeans Coffees brand in these
same markets. We also own a number of common law service marks and trademarks in the United States including Gloria Jeans Coffee Bean. We have also received trademark and service mark protection for the name Coffee People and
related marks in Canada and Japan. We own copyrights on our promotional materials, coffeehouse graphics and operational and training materials. We do not believe that any of these copyrights, valuable as they are, are material to our business.



Employees



At June 28, 2006, we employed 951 people, 570 of whom were employed full-time. None of our employees are represented by
a labor union, and no employees are currently covered by collective bargaining agreements. We consider our relations with our employees to be good. We regularly review our employee benefits, training and other aspects of employment to attract and to
retain valuable employees and managers. Franchise employees are not employees of the Company. Under the asset purchase agreement with Starbucks, all non-management store employees in good standing at the retail stores that are sold to Starbucks will
be offered positions with Starbucks while store managers and assistant managers at those locations will be provided the opportunity to interview for positions with Starbucks.



Government Regulation



In addition to the laws and regulations relating to the food service industry, we are subject to Federal Trade Commission (FTC) regulation and
state laws that regulate the offer and sale of franchises as well as the franchise relationship. The FTCs Trade Regulation Rule relating to Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures
generally requires us to give prospective franchisees a franchise offering circular containing information prescribed by the rule. A number of states have laws that regulate the offer and sale of franchises and the franchisor-franchisee
relationship. These laws generally require registration of the franchise offering with state authorities before making offers or sales and regulate the franchise relationship by, for example:



| |  |  | prohibiting interference with the right of free association among franchisees;
| | - |  | ------------------------------------------------------------------------------



| |  |  | prohibiting discrimination in fees and charges;
| | - |  | -----------------------------------------------



| |  |  | regulating the termination of the relationship by requiring good cause to exist as a basis for the termination, advance notice to the franchisee of the termination, and
an opportunity to cure a default;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | requiring repurchase of inventories in some circumstances;
| | - |  | ----------------------------------------------------------



| |  |  | restricting non-renewal by the franchisor;
| | - |  | ------------------------------------------



| |  |  | limiting restrictions on transfers or inheritance of the franchisees interests; and
| | - |  | ------------------------------------------------------------------------------------



| |  |  | regulating placement of competing units that might adversely affect the franchisees results.
| | - |  | ---------------------------------------------------------------------------------------------



Failure to comply with applicable franchise laws may adversely affect us. Any changes to the FTCs rules, or state
franchise laws, or future court or administrative decisions, could affect our franchise business. There are also extensive federal, state and local government regulations relating to the development and operation of food service outlets, including
laws and regulations relating to: building and seating requirements; the preparation and sale of food; cleanliness; safety in the workplace; and accommodations for the disabled. Our relationship with our employees is also subject to regulation, such
as: minimum wage requirements; anti-discrimination laws; overtime and working conditions; and citizenship requirements.



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Available Information



Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, and other documents that we may file with or furnish to
the SEC from time to time are available on our Internet website, free of charge, as soon as reasonably practicable after the reports are electronically filed with or furnished to the United States Securities and Exchange Commission. These reports
are available at www.diedrich.com under the heading Investor Services. We intend to disclose future amendments to certain provisions of our Code of Conduct, which is available on the www.diedrich.com website, within four business days
following the date of such amendment on our website.



|Item 1A. | Risk factors.
|-------- | -------------



RISK FACTORS AND TRENDS AFFECTING DIEDRICH COFFEE AND ITS BUSINESS



As discussed under Item 1 Recent Developments, and Item 7 OverviewRecent Developments, on
September 14, 2006, we and Starbucks Corporation entered into an asset purchase agreement pursuant to which Starbucks has agreed to purchase our leasehold interests in most of the 47 locations where we operate retail stores under the Diedrich
Coffee and Coffee People brands, along with certain related fixtures and equipment, improvements, prepaid items, and ground lease improvements, and to assume certain liabilities as set forth in the asset purchase agreement. The risk factors
discussing these retail locations that may be sold to Starbucks are pertinent until such locations are sold to Starbucks. If and when the asset sale to Starbucks is consummated, we will update the risk factors set forth below as necessary in our
quarterly reports on Form 10-Q.



The pending sale of certain of our retail
stores to Starbucks Corporation may not be consummated.



On
September 14, 2006, we and Starbucks Corporation entered into an asset purchase agreement pursuant to which Starbucks has agreed to purchase our leasehold interests in most of the 47 locations where we operate retail stores under the Diedrich
Coffee and Coffee People brands, along with certain related fixtures and equipment, improvements, prepaid items, and ground lease improvements, and to assume certain liabilities as set forth in the asset purchase agreement. The asset sale is subject
to stockholder approval and certain other closing conditions. We expect to complete the asset sale in December 2006. However, there is no assurance that the conditions to the completion of the asset sale will be satisfied. If the asset sale is not
completed, we will be subject to several risks, including the following:



| |  |  | our cashflow and financial condition could be adversely affected if we are unable to complete the asset sale;
| | - |  | -------------------------------------------------------------------------------------------------------------



| |  |  | under certain circumstances, including our entry into an alternative transaction involving the retail store locations that are the subject of the asset sale, we are required to pay
Starbucks actual fees and expenses incurred in connection with the asset sale up to a maximum amount of $500,000, with a minimum payment of $250,000 regardless of Starbucks actual fees and expenses;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the current stock price of our common stock may reflect a market assumption that the asset sale will occur, and, thus, a failure to complete the asset sale could result in a
negative perception by the stock market of us generally and a decline in the market price of our common stock; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our retail business could be adversely affected if we are unable to retain key employees, our employees at our retail store locations or attract replacements.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------



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Historical losses from continuing operations may continue and, as a result, the price of our common stock may be
negatively affected.



For the past five fiscal years, we
had net income (loss) from continuing operations of $(7,796,000) for the fiscal year ended June 28, 2006, $(3,315,000) for the fiscal year ended June 29, 2005, $(1,647,000) for the fiscal year ended June 30, 2004, $(2,504,000) for the
fiscal year ended July 3, 2003 and $272,000 for the fiscal year ended July 3, 2002. We could suffer losses in the future, which may negatively affect our stock price.



If we are not able to grow our business, the results of our operations and our financial condition may be adversely impacted.



As of June 28, 2006, we operated 47 Diedrich Coffee
and Coffee People retail locations, which we managed on a day-to-day basis, and had nine franchised Diedrich Coffee and Coffee People coffeehouse locations. We also had 144 Gloria Jeans retail locations, of which 139 were franchised. To grow,
we must:



| |  |  | attract single and multi-store franchisees for our Gloria Jeans brand in the United States;
| | - |  | --------------------------------------------------------------------------------------------



| |  |  | continue to upgrade Gloria Jeans products and programs;
| | - |  | --------------------------------------------------------



| |  |  | expand Diedrich Coffee and Gloria Jeans wholesale sales;
| | - |  | ---------------------------------------------------------



| |  |  | attract franchise area developers for Diedrich Coffee in the United States and internationally after our two-year international non-compete restriction expires;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | obtain (or have our franchise area developers obtain) suitable sites at acceptable costs in highly competitive real estate markets;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------



| |  |  | hire, train and retain qualified personnel;
| | - |  | -------------------------------------------



| |  |  | integrate newly franchised or corporate locations into existing product distribution;
| | - |  | -------------------------------------------------------------------------------------



| |  |  | continue to upgrade inventory control, marketing and information systems; and
| | - |  | -----------------------------------------------------------------------------



| |  |  | impose and maintain strict quality control from green coffee acquisition to the fresh cup of brewed coffee in a customers hand.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------



Implementation of our growth strategy may divert managements attention
from other aspects of our business and place a strain on management, operational and financial resources, and accounting systems. Future inability to grow our business resulting from, among other things, failing to execute any of the above factors
may adversely affect the results of our operations and our financial condition.



Our franchisees could take actions that could harm our business.



Franchisees are independent contractors and are not our employees. We provide training and support to our franchisees, and the terms of our franchise agreements require our franchisees to maintain certain minimum
operating standards; however, the quality of franchised operations may be diminished by any number of factors beyond our control. For example, franchisees may not successfully operate coffeehouses in a manner consistent with our standards and
requirements, or may not hire and train qualified managers or other personnel. In other instances, franchisees may operate their units in conformity with our operating standards and specifications, but may fail to meet their financial obligations to
us under a franchise agreement or a sublease for a location, or to vendors, lenders or other creditors. While we have certain contractual remedies in such instances of default, enforcing our remedies typically requires litigation, and therefore our
image and reputation, and the image and



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reputation of other franchisees, may suffer even if such litigation is successfully concluded. If a significant number of franchisees were to be in default
simultaneously, a larger number of franchise units could be terminated in a given time period than we would be able to re-franchise, or absorb into our company operated unit base, and system-wide sales could significantly decline. If this were to
occur, we might also be unable to meet our obligations to mall landlords for early termination of the 86 master leases for which we are currently liable.



Our growth through franchise area development may not occur as rapidly as we currently anticipate.



Our ability to recruit, retain and contract with qualified franchise area developers has become, and will continue to be,
increasingly important to our operations as we expand. Our franchisees are dependent upon the availability of adequate sources of financing on acceptable terms in order to meet their development obligations, and the credit markets for such franchise
financing have historically been somewhat volatile. Prospective franchise lenders have historically been cautious in their approach to financing smaller or newer, less established retail brands vis-à-vis larger and more established franchised
systems. Such financing may not be available to our franchised area developers, or only available upon disadvantageous terms. Our franchise development strategy may not enhance our results of operations. Failure to execute on our strategy to grow
through franchise area development would harm our business, financial condition and results of operations.



Our operating results may fluctuate significantly, which could have a negative effect on the price of our common stock.



Our operating results will fluctuate from quarter to quarter as the result of a number of factors, including:



| |  |  | comparable store sales results;
| | - |  | -------------------------------



| |  |  | the number, timing, mix and cost of coffeehouse and mall coffee store openings, franchises, acquisitions or closings;
| | - |  | ---------------------------------------------------------------------------------------------------------------------



| |  |  | the level of competition from existing or new competitors in the specialty coffee industry;
| | - |  | -------------------------------------------------------------------------------------------



| |  |  | labor costs for our hourly and management personnel, including increases in federal or state minimum wage requirements;
| | - |  | -----------------------------------------------------------------------------------------------------------------------



| |  |  | changes in consumer preferences; and
| | - |  | ------------------------------------



| |  |  | fluctuations in prices of unroasted coffee.
| | - |  | -------------------------------------------



From time to time in the future, our operating results may fall below the expectations of investors and public market securities analysts. Quarterly
fluctuations, for any reason, could cause our stock price to decline. Also, our business is subject to seasonal fluctuations. The NovemberDecember holiday season generally experiences the highest sales. In contrast, hot weather tends to
depress sales of hot coffee and espresso drinks, especially unseasonably warm weather. Consequently, we will continue to experience significant fluctuations in quarterly results.



In addition, if we were to open additional company owned coffeehouses in the future, we would incur significant pre-opening
expenses, and the new coffeehouses would likely experience an initial period of operating losses. As a result, the opening of a significant number of company owned coffeehouses in a single period would have an adverse effect on our results of
operations. Accordingly, we believe that period-to-period comparisons of our historical or future operating results are not necessarily meaningful, and such comparisons should not be relied upon as indicators of future performance.



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Because we have only one roasting facility, a significant interruption in the operation of this facility could
potentially disrupt our operations.



We have only one
coffee roasting and distribution facility. A significant interruption in the operation of this facility, whether as a result of a natural disaster or other causes, could significantly impair our ability to operate our business on a day-to-day basis.



Future changes in minimum wage requirements could adversely affect our
business, financial condition, results of operations or cash flows.



A number of our employees are subject to minimum wage requirements. Many of our employees work in retail locations located in California and Oregon, and receive salaries equal to those states minimum wage laws, which salaries
currently exceed the federal minimum wage. There can be no assurance that further increases will not be implemented in these or other jurisdictions in which we operate or seek to operate. There can be no assurance that we will be able to pass
additional increases in labor costs through to our customers in the form of price adjustments and, accordingly, such minimum wage increases could have a material adverse effect on our business, financial condition, results of operations or cash
flows.



We or our franchisees may not be able to renew leases or control
rent increases at our retail locations.



All of our 52
company operated coffeehouses are presently on leased premises. Gloria Jeans stores are generally leased by an indirect subsidiary of Coffee People, although in most cases, the franchisees pay their rent directly to their landlord. Upon the
expiration of some of these leases, there is no automatic renewal or option to renew. Consequently, these leases may not be renewed. If they are renewed, rents may increase substantially. Either of these events could adversely affect us. Other
leases are subject to renewal at fair market value, which could involve substantial rent increases, or are subject to renewal with scheduled rent increases, which could result in rents being above fair market value. In addition, at the time of lease
renewal, significant remodeling is typically required. It is possible that we may not have available capital to perform such remodeling.



In addition, franchisees may not renew their franchises at the expiration of the coffeehouse lease term. On average 12 franchise unit lease terms expire
annually. Franchisees may choose not to renew their franchises, which could have a material adverse effect on our results of operations.



Our industry is highly competitive and we may not have the resources to compete effectively.



With low barriers to entry, competition in our industry is expected to increase from national and regional chains, franchise
operators and local specialty coffee stores. Our whole bean coffees compete directly against specialty coffees sold at specialty retailers, variety and discount stores, and a growing number of specialty coffee stores. Many specialty coffee
companies, including Starbucks, Seattles Best Coffee, Bucks County, Brothers Gourmet Coffees and Green Mountain Coffee Roasters sell whole bean coffees through these channels. In our sale of coffee beverages and espresso drinks, we compete
directly against all other specialty grade coffee roasters, coffeehouses, espresso/coffee bars and mall coffee stores, as well as against restaurant and beverage outlets that serve coffee, and a growing number of espresso stands, carts, and stores.
Our competition at this level includes a growing number of specialty coffee retailers, including Starbucks, Barnies, Coffee Beanery Ltd., Caribou Coffee, Peets Coffee, Tullys Coffee and many others. The attractiveness of the
gourmet specialty coffeehouse market may draw additional competitors with substantially greater financial, marketing and operating resources than we have. In addition, we compete to draw customers of standard or commercial coffee, and consumers of
substitute coffee products manufactured by a number of nationwide coffee manufacturers, such as Kraft Foods, Proctor & Gamble and Nestlé, to specialty grade coffee.



We believe that our customers choose among retailers primarily on the basis of product quality, service, coffeehouse
ambiance, convenience, and to a lesser extent, on price. The performance of individual coffeehouses



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or mall coffee stores may also be affected by factors such as traffic patterns and the type, number and proximity of competing coffeehouses or mall coffee
stores. In addition, factors such as inflation, increased coffee bean, food, labor and employee benefit costs, and the availability of experienced management and hourly employees may also adversely affect the specialty coffee retail business in
general and our coffeehouses and mall coffee stores in particular.



Our
company operated retail locations are concentrated in the western region of the United States, and therefore our business is subject to fluctuations if adverse business conditions occur in that region.



Our company operated retail locations are primarily located in the western
region of the United States. Accordingly, we are susceptible to fluctuations in our business caused by adverse economic or other conditions in this region, including natural or other disasters. In addition, some of our competitors have many more
retail locations than we do. Consequently, adverse economic or other conditions in a region, a decline in the profitability of several existing retail locations or the introduction of several unsuccessful new retail locations in a geographic area
could have a more significant effect on our results of operations than would be the case for a company with a larger number of retail locations or with more geographically dispersed retail locations.



Our supply costs may be higher than we expect because of fluctuations in availability and
cost of unroasted coffee.



Increases in the price of green
coffee, or the unavailability of adequate supplies of green coffee of the quality we seek, whether due to the failure of our suppliers to perform, conditions in coffee-producing countries, or otherwise, could have a material adverse effect on our
results of operations. We depend upon both outside brokers and our direct contacts with exporters and growers in countries of origin for our supply of green coffee. Coffee supply and price are subject to significant volatility beyond our control.
Although most coffee trades in the commodity market, coffee of the quality we seek tends to trade on a negotiated basis at a substantial premium above commodity coffee pricing, depending upon the origin, supply and demand at the time of purchase.
Supply and price can be affected by a number of factors in the producing countries, including weather, political and economic conditions. In addition, green coffee prices have been affected in the past, and may be affected in the future, by the
actions of certain organizations and associations, such as the International Coffee Organization or the Association of Coffee Producing Countries. These organizations have historically attempted to establish commodity price controls of green coffee
through agreements that establish export quotas or by restricting coffee supplies worldwide. These organizations, or others, may succeed in raising green coffee prices. Should this happen, we may not be able to maintain our gross margins by raising
prices without affecting demand.



Compliance with health, franchising and
other government regulations applicable to us could have a material adverse affect on our business, financial condition and results of operations.



Each retail location and roasting facility is and will be subject to licensing and reporting requirements by a number of governmental authorities. These
governmental authorities include federal, state and local health, environmental, labor relations, sanitation, building, zoning, fire, safety and other departments that have jurisdiction over the development and operation of our retail locations. Our
activities are also subject to the Americans with Disabilities Act and related regulations, which prohibit discrimination on the basis of disability in public accommodations and employment. Changes in any of these laws or regulations could have a
material adverse affect on our business, financial condition and results of operations. Delays or failures in obtaining or maintaining required construction and operating licenses, permits or approvals could delay or prevent the opening of new
retail locations, or could materially and adversely affect the operation of existing retail locations. In addition, we may not be able to obtain necessary variances or amendments to required licenses, permits or other approvals on a cost-effective
or timely basis in order to construct and develop retail locations in the future.



We are also subject to federal regulation and certain state laws that govern the offer and sale of franchises and the franchisor-franchisee relationship. Many state franchise laws impose substantive requirements on



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franchise agreements, including limitations on non-competition provisions and on provisions concerning the termination or non-renewal of a franchise. Some
states require companies to register certain materials before franchises can be offered or sold in that state. The failure to obtain or retain licenses or registration approvals to sell franchises could delay or preclude franchise sales and
otherwise adversely affect our business, financial condition and results of operations. Additionally, any franchise law violations may give existing and future franchisees a basis to bring claims against us. Franchise law violation claims could
include unfair business practices, negligent misrepresentation, fraud, or statutory franchise investment or relationship violations. Remedies may include damages or rescission of the franchise agreement by the franchisee. These claims may already
exist and their assertion against us could adversely affect our business, financial condition, and results of operations.



The loss of key personnel or our inability to attract and retain qualified personnel could significantly disrupt our business.



Our continued success largely will depend on the efforts and abilities of our
executive officers and other key employees. The loss of services of these individuals could disrupt operations. Although we have employment agreements with each of our executive officers, any of our executive officers can terminate their employment
if he or she chooses to do so. In addition, our success and the success of our franchisees will depend upon our and their ability to attract and retain highly motivated, well-qualified retail operators and other management personnel, as well as a
sufficient number of qualified employees. Qualified individuals needed to fill these positions are in short supply in some geographic areas. Our inability to recruit and retain such individuals may delay the planned openings of new retail locations
or result in higher employee turnover in existing retail locations, which could have a material adverse effect on our business or results of operations.



We could be subject to adverse publicity or claims from our customers.



We may be subject to complaints from or litigation by customers who allege beverage or food-related illness, injuries suffered on the premises or other
quality, health or operational concerns. Adverse publicity resulting from such allegations may materially adversely affect us, regardless of whether such allegations are true or whether we are ultimately held liable. We may also be the subject of
complaints or allegations from current, former or prospective employees from time-to-time. A lawsuit or claim could result in an adverse decision against us that could have a material adverse effect on our business, financial condition and results
of operations.



Changes in consumer preferences or discretionary spending
could negatively affect our results.



Our retail locations
offer specialty coffee beans, brewed coffee beverages, espresso-based beverages, blended drinks and light food items served in a casual setting. Our continued success depends, in part, upon the popularity of these types of coffee-based beverages and
this style of casual dining. Shifts in consumer preferences away from our coffee-based beverages or casual setting could materially adversely affect our future profitability. Also, our success depends to a significant extent on a number of factors
that affect discretionary consumer spending, including economic conditions, disposable consumer income and consumer confidence. Adverse changes in these factors could reduce guest traffic or impose practical limits on pricing, either of which could
adversely affect our business, financial condition, operating results and cash flows.



Our lack of diversification may affect business if demand is reduced.



Our business is primarily centered on one product: fresh specialty grade coffee. To date, our operations have been limited to primarily the purchase and roasting of green coffee beans and the sale of whole bean
coffee, coffee beverages and espresso drinks through our franchise coffee stores, coffeehouses, and wholesale coffee and mail order businesses. Any decrease in demand for coffee would have a material adverse effect on our business, operating results
and financial condition.



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Our failure or inability to enforce our trademarks or trade names could adversely affect our efforts to establish
brand equity.



Our ability to successfully expand our
business will depend in part on our ability to maintain brand equity through the use of our trademarks, service marks, trade dress and other proprietary intellectual property, including our name and logos. We currently hold a number of
trademarks and service marks related to our brands. Some or all of our rights related to our intellectual property may not be enforceable, even if registered, against any prior users of similar intellectual property or our competitors who seek or
intend to utilize similar intellectual property in areas where we operate or intend to conduct operations. If we are unable to successfully enforce our intellectual property rights, we may be unable to capitalize on our efforts to maintain brand
equity. It is possible that we will encounter claims from prior users of similar intellectual property in areas where we operate or intend to conduct operations, including foreign countries. Claims from prior users could limit our operations or
cause us to pay damages or licensing fees to a prior user or registrant of similar intellectual property.



|Item 1B. | Unresolved Staff Comments
|-------- | -------------------------



None.



|Item 2. | Properties.
|------- | -----------



Office Space and Plant



We currently lease approximately 17,620 square feet of office space in Irvine, California and approximately 6,192 square feet of warehouse space in
Irvine, California. The lease for the office space will expire in January 2011 and the lease for the warehouse space will expire in December 2015. We also lease a 66,237 square foot roasting facility located in Castroville, California. The term of
the current lease expires in December 2015, and is renewable, at our option, for a term of 15 additional years. We believe that our facilities are generally adequate for our current needs, and that suitable additional production and
administrative space will be available as needed for the foreseeable future.



Company Operated Locations



As of June 28,
2006, we were a party to leases for a total of 52 company operated retail locations. During fiscal year 2006, we closed eight locations. As discussed under Item 1 Recent Developments, and Item 7 OverviewRecent
Developments, we and Starbucks Corporation entered into an asset purchase agreement pursuant to which Starbucks has agreed to purchase our leasehold interests in most of the 47 locations where we operate retail stores under the Diedrich Coffee
and Coffee People brands.



Our company operated retail
locations on leased premises are subject to varying arrangements specified in property specific leases. For example, some of the leases require a flat rent, subject to regional cost-of-living increases, while others are based upon a percentage of
gross sales. In addition, certain of these leases expire in the near future, and there is no automatic renewal or option to renew. No assurance can be given that leases can be renewed, or if renewed, that rents will not increase substantially,
either of which would adversely affect us. Other leases are subject to renewal at fair market value, which could involve substantial increases or are subject to renewal with a scheduled rent increase, which could result in rents being above fair
market value. In addition, at the time of lease renewal, significant remodeling is typically required. It is possible that we may not have available capital to perform such remodeling.



Franchised Stores



All of our Gloria Jeans locations are operated on leased premises, 139 of which are franchised. A majority of the leased premises presently occupied
by Gloria Jeans franchised outlets are leased by us, and we have entered into sublease agreements with the franchisees on a cost pass-through basis. Gloria Jeans, however,



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remains obligated under the lease in all such cases. As further discussed below under the heading Financial Condition and Liquidity and Capital
ResourcesCommitments and Contractual Obligations, our maximum theoretical future exposure under these leases at June 28, 2006, computed as the sum of all remaining lease payments through the expiration dates of the respective
leases, was $20,168,000. In the future, new franchisees will generally be required to enter into master leases directly with the landlord. This will also be the case when current leases are up for renewal. Gloria Jeans stores are designed to
accommodate locations in various sizes, ranging from 170 square foot kiosk outlets (which sell principally coffee drinks and other beverages) to 2,000 square foot full service stores.



|Item 3. | Legal Proceedings.
|------- | ------------------



In the ordinary course of our business, we may become involved in legal proceedings from time to time. As of September 25, 2006, we were not a party
to any material pending legal proceedings.



|Item 4. | Submission of Matters to a Vote of Security Holders.
|------- | ----------------------------------------------------



None.



PART II



|Item 5. | Market For Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
|------- | -------------------------------------------------------------------------------------------------------------



Our common stock is reported on the Nasdaq Global Market under the symbol
DDRX. The following table sets forth, for the periods indicated, the high and low trading prices for our common stock as reported on the Nasdaq Global Market.



|                                      |  |             |      |     |   |     
|------------------------------------- |  | ----------- | ---- | --- | - | ----
|                                      |  | Price Range
|Period                                |  | High        |      | Low
|Fiscal Year Ended June 29, 2005       |  |             |      |     |   |     
|Twelve Weeks Ended September 22, 2004 |  | $           | 5.60 |     | $ | 4.72
|Twelve Weeks Ended December 15, 2004  |  |             | 5.83 |     |   | 4.24
|Twelve Weeks Ended March 9, 2005      |  |             | 6.12 |     |   | 5.11
|Sixteen Weeks Ended June 29, 2005     |  |             | 5.32 |     |   | 4.01
|                                      |  |            
|Fiscal Year Ended June 28, 2006       |  |             |      |     |   |     
|Twelve Weeks Ended September 21, 2005 |  |             | 9.11 |     |   | 4.78
|Twelve Weeks Ended December 14, 2005  |  |             | 8.55 |     |   | 4.89
|Twelve Weeks Ended March 8, 2006      |  |             | 5.20 |     |   | 4.00
|Sixteen Weeks Ended June 28, 2006     |  |             | 4.95 |     |   | 3.11



At September 22,
2006, there were 5,346,270 shares of our common stock outstanding and 674 stockholders of record. We have not paid dividends on our common stock and do not anticipate paying dividends in the foreseeable future.



|Item 6. | Selected Financial Data.
|------- | ------------------------



Our fiscal year ends on the Wednesday closest to June 30. This reporting schedule generally results in three 12-week quarters and one 16-week quarter
during the fourth fiscal quarter, for a total of 52 weeks. However, due to the alignment of the calendar in 2002, the fiscal year ended July 3, 2002 contains 17 weeks during the fourth fiscal quarter, for a total of 53 weeks. The following
selected financial data may not be indicative of our future results of operations and should be read in conjunction with Managements Discussion and Analysis of Financial Condition and Results of Operations beginning on page 21, and
should be read in conjunction with our consolidated financial statements and related notes.



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On February 11, 2005 we completed the sale of our Gloria Jeans international operations. In
accordance with SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS 144), the financial statements for all periods have been reclassified to report the financial results for those operations
as discontinued operations.



The information set forth below
should be read in conjunction with the consolidated financial statements and related notes and Managements Discussion and Analysis of Financial Condition and Results of Operations included elsewhere in this Form 10-K.



|                                                                          |  |                                       |        |   |                                 |   |        |                                 |  |   |                                |   |  |                                    |        |   |  |   |        |  
|------------------------------------------------------------------------- |  | ------------------------------------- | ------ | - | ------------------------------- | - | ------ | ------------------------------- |  | - | ------------------------------ | - |  | ---------------------------------- | ------ | - |  | - | ------ | -
|                                                                          |  | Fiscal Year ended June 28, 2006 (B)   |        |   | Fiscal Year ended June 29, 2005 |   |        | Fiscal Year ended June 30, 2004 |  |   | Fiscal Year ended July 2, 2003 |   |  | Fiscal Year ended July 3, 2002 (A) |       
|                                                                          |  | (in thousands, except per share data) |       
|Statement of Operations Data:                                             |  |                                       |        |   |                                 |   |        |                                 |  |   |                                |   |  |                                    |        |   |  |   |        |  
|Net revenue:                                                              |  |                                       |        |   |                                 |   |        |                                 |  |   |                                |   |  |                                    |        |   |  |   |        |  
|Retail sales                                                              |  | $                                     | 34,428 |   |                                 | $ | 31,890 |                                 |  | $ | 31,617                         |   |  | $                                  | 33,034 |   |  | $ | 38,658 |  
|Wholesale and other                                                       |  |                                       | 21,244 |   |                                 |   | 16,482 |                                 |  |   | 14,861                         |   |  |                                    | 14,788 |   |  |   | 16,681 |  
|Franchise revenue                                                         |  |                                       | 3,775  |   |                                 |   | 4,166  |                                 |  |   | 4,407                          |   |  |                                    | 4,810  |   |  |   | 5,322  |  
|                                                                          |  |                                       |        |   |                                 |   |        |                                 |  |   |                                |   |  |                                    |        |   |  |   |        |  
|Total net revenue                                                         |  |                                       | 59,447 |   |                                 |   | 52,538 |                                 |  |   | 50,885                         |   |  |                                    | 52,632 |   |  |   | 60,661 |  
|                                                                          |  |                                       |        |   |                                 |   |        |                                 |  |   |                                |   |  |                                    |        |   |  |   |        |  
|Costs and expenses:                                                       |  |                                       |        |   |                                 |   |        |                                 |  |   |                                |   |  |                                    |        |   |  |   |        |  
|Cost of sales and related occupancy costs                                 |  |                                       | 32,440 |   |                                 |   | 26,765 |                                 |  |   | 24,642                         |   |  |                                    | 25,862 |   |  |   | 30,423 |  
|Operating expenses                                                        |  |                                       | 19,947 |   |                                 |   | 17,449 |                                 |  |   | 16,701                         |   |  |                                    | 16,954 |   |  |   | 17,801 |  
|Depreciation and amortization                                             |  |                                       | 2,601  |   |                                 |   | 2,372  |                                 |  |   | 2,315                          |   |  |                                    | 2,169  |   |  |   | 2,474  |  
|General and administrative expenses                                       |  |                                       | 13,546 |   |                                 |   | 11,178 |                                 |  |   | 9,597                          |   |  |                                    | 9,150  |   |  |   | 9,398  |  
|Provision for asset impairment and restructuring costs                    |  |                                       |       |   |                                 |   |       |                                 |  |   | 94                             |   |  |                                    | 2,176  |   |  |   | 542    |  
|Gain on asset disposals                                                   |  |                                       | (58    | ) |                                 |   | (4     | )                               |  |   | (2                             | ) |  |                                    | (868   | ) |  |   | (423   | )
|                                                                          |  |                                       |        |   |                                 |   |        |                                 |  |   |                                |   |  |                                    |        |   |  |   |        |  
|Total costs and expenses                                                  |  |                                       | 68,476 |   |                                 |   | 57,760 |                                 |  |   | 53,347                         |   |  |                                    | 55,443 |   |  |   | 60,215 |  
|                                                                          |  |                                       |        |   |                                 |   |        |                                 |  |   |                                |   |  |                                    |        |   |  |   |        |  
|Operating income (loss) from continuing operations                        |  |                                       | (9,029 | ) |                                 |   | (5,222 | )                               |  |   | (2,462                         | ) |  |                                    | (2,811 | ) |  |   | 446    |  
|Interest income (expense) and other, net                                  |  |                                       | 432    |   |                                 |   | 56     |                                 |  |   | (318                           | ) |  |                                    | (256   | ) |  |   | (537   | )
|                                                                          |  |                                       |        |   |                                 |   |        |                                 |  |   |                                |   |  |                                    |        |   |  |   |        |  
|Loss from continuing operations before income tax benefit                 |  |                                       | (8,597 | ) |                                 |   | (5,166 | )                               |  |   | (2,780                         | ) |  |                                    | (3,067 | ) |  |   | (91    | )
|Income tax benefit                                                        |  |                                       | (801   | ) |                                 |   | (1,851 | )                               |  |   | (1,133                         | ) |  |                                    | (563   | ) |  |   | (363   | )
|                                                                          |  |                                       |        |   |                                 |   |        |                                 |  |   |                                |   |  |                                    |        |   |  |   |        |  
|Income (loss) from continuing operations                                  |  | $                                     | (7,796 | ) |                                 | $ | (3,315 | )                               |  | $ | (1,647                         | ) |  | $                                  | (2,504 | ) |  | $ | 272    |  
|                                                                          |  |                                       |        |   |                                 |   |        |                                 |  |   |                                |   |  |                                    |        |   |  |   |        |  
|Discontinued operations:                                                  |  |                                       |        |   |                                 |   |        |                                 |  |   |                                |   |  |                                    |        |   |  |   |        |  
|Income from discontinued operations, net of income tax                    |  |                                       |       |   |                                 |   | 2,143  |                                 |  |   | 1,898                          |   |  |                                    | 1,146  |   |  |   | 680    |  
|Gain on sale of discontinued operations, net of income tax                |  |                                       |       |   |                                 |   | 15,795 |                                 |  |   |                               |   |  |                                    |       |   |  |   |       |  
|                                                                          |  |                                       |        |   |                                 |   |        |                                 |  |   |                                |   |  |                                    |        |   |  |   |        |  
|Net income (loss)                                                         |  | $                                     | (7,796 | ) |                                 | $ | 14,623 |                                 |  | $ | 251                            |   |  | $                                  | (1,358 | ) |  | $ | 952    |  
|                                                                          |  |                                       |        |   |                                 |   |        |                                 |  |   |                                |   |  |                                    |        |   |  |   |        |  
|Basic and diluted net income (loss) per share (B):                        |  |                                       |        |   |                                 |   |        |                                 |  |   |                                |   |  |                                    |        |   |  |   |        |  
|Income (loss) from continuing operations                                  |  | $                                     | (1.47  | ) |                                 | $ | (0.64  | )                               |  | $ | (0.32                          | ) |  | $                                  | (0.49  | ) |  | $ | 0.05   |  
|Income from discontinued operations, net                                  |  | $                                     |       |   |                                 | $ | 3.44   |                                 |  | $ | 0.37                           |   |  | $                                  | 0.22   |   |  | $ | 0.13   |  
|Net income (loss)                                                         |  | $                                     | (1.47  | ) |                                 | $ | 2.80   |                                 |  | $ | 0.05                           |   |  | $                                  | (0.26  | ) |  | $ | 0.18   |  
|                                                                          |  |                                       |        |   |                                
|Balance Sheet Data:                                                       |  |                                       |        |   |                                 |   |        |                                 |  |   |                                |   |  |                                    |        |   |  |   |        |  
|Working capital                                                           |  | $                                     | 3,618  |   |                                 | $ | 11,203 |                                 |  | $ | 641                            |   |  | $                                  | 1,207  |   |  | $ | 809    |  
|Total assets                                                              |  |                                       | 34,130 |   |                                 |   | 40,313 |                                 |  |   | 25,218                         |   |  |                                    | 26,101 |   |  |   | 27,806 |  
|Long-term debt and obligations under capital leases, less current portion |  |                                       | 309    |   |                                 |   | 328    |                                 |  |   | 1,173                          |   |  |                                    | 2,033  |   |  |   | 2,832  |  
|Total stockholders equity                                                |  | $                                     | 24,267 |   |                                 | $ | 31,522 |                                 |  | $ | 16,475                         |   |  | $                                  | 16,202 |   |  | $ | 17,492 |  



---



|(A) | Includes 53 weeks of operation.
|--- | -------------------------------



|(B) | Includes compensation expense of $403,000 due to the adoption of SFAS 123R.
|--- | ---------------------------------------------------------------------------



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|Item 7. | Managements Discussion and Analysis of Financial Condition and Results of Operations.
|------- | --------------------------------------------------------------------------------------



INTRODUCTION



Managements discussion and analysis of financial condition and results
of operations is provided as a supplement to the accompanying consolidated financial statements and footnotes to help provide an understanding of our financial condition, the changes in our financial condition and the results of operations. Our
discussion is organized as follows:



| |  |  | Overview.    This section provides a general description of our business, as well as recent significant transactions that we believe are important in
understanding the results of operations, as well as to anticipate future trends in those operations.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Results of operations.    This section provides an analysis of our results of operations presented in the accompanying consolidated statements of
operations by comparing the results for fiscal 2006 to fiscal 2005 and comparing the results for fiscal 2005 to fiscal 2004.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Financial condition and liquidity and capital resources.    This section provides an analysis of our cash flows, as well as a discussion of our
outstanding debt and commitments, both firm and contingent, that existed as of June 28, 2006. Included in the discussion of outstanding debt is a discussion of the amount of financial capacity available to fund our future commitments, as well
as a discussion of other financing arrangements.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Critical accounting estimates.    This section discusses those accounting policies that both are considered important to our financial condition and
results, and require significant judgment and estimates on the part of management in their application. In addition, all of our significant accounting policies, including the critical accounting policies, are summarized in Note 1 to the accompanying
consolidated financial statements.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | New accounting pronouncements.    This section discusses new accounting pronouncements, dates of implementation and impact on our accompanying
consolidated financial statements, if any.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



OVERVIEW



Recent Developments



On September 14, 2006, we and Starbucks Corporation entered into an
asset purchase agreement pursuant to which Starbucks has agreed to purchase our leasehold interests in most of the 47 locations where we operate retail stores under the Diedrich Coffee and Coffee People brands, along with certain related fixtures
and equipment, improvements, prepaid items, and ground lease improvements, and to assume certain liabilities as set forth in the asset purchase agreement.



Pursuant to the asset purchase agreement, Starbucks will pay us up to $13,520,000 in cash, which includes payment of $120,000 as consideration for our
agreement to a non-compete provision. The actual amount paid by Starbucks under the asset purchase agreement is dependent on which and how many of the Company Stores are ultimately transferred to Starbucks. Ten percent of the amount paid to us upon
transfer of the Company Stores will be deposited into an escrow fund to be held in connection with our indemnification obligations. The Closing is expected to occur approximately 90 days after the date of the asset purchase agreement, provided that
certain conditions, including that a specified minimum number of Company Stores are transferred to Starbucks at Closing, are met. After the Closing, we and Starbucks have agreed to use commercially reasonable efforts to transfer certain remaining
Company Stores until approximately 150 days after the date of the asset purchase agreement or such other longer period as agreed to by us and Starbucks.



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We and Starbucks have made certain customary representations, warranties and covenants in the asset
purchase agreement. Specifically, we have agreed that, subject to a fiduciary-out provision and payment of a break-up fee, we will not (i) take any action to solicit any proposal from, (ii) furnish any information to, or
(iii) participate in any discussions with, any entity other than Starbucks regarding any transaction involving the Company Stores. Upon termination of the asset purchase agreement under certain circumstances, including the Companys entry
into an alternative transaction involving the Company Stores, we shall pay Starbucks actual fees and expenses incurred in connection with the Transaction up to a maximum amount of $500,000; provided, however, that Starbucks is entitled to a
minimum of $250,000, regardless of its actual fees and expenses. The asset purchase agreement also contains customary indemnification provisions for certain claims and provides for a basket of $100,000 and a cap of $2,000,000 for breaches of our
representations and warranties contained in the asset purchase agreement.



The consummation of the Transaction is subject to certain customary conditions, including: approval of the Transaction by our stockholders; a specified minimum number of Company Stores transferred to Starbucks at
Closing; the receipt by Starbucks of permits and approvals for at least 70% of certain Company Stores that are transferred if the Closing occurs within 90 days of the date of the asset purchase agreement; receipt of lease extensions of at least 10
years for at least 40% of certain Company Stores that are transferred; and, receipt of consents to the assignment of the leases for each of the Company Stores that are transferred, with estoppel provisions being agreed to for at least 50% of the
Company Stores that are transferred. The asset purchase agreement contains customary termination provisions and may be terminated by either us or Starbucks if the Closing does not occur within 150 days from the date of the asset purchase agreement.
We may also terminate the asset purchase agreement if the Closing has not occurred within 90 days, provided that Starbucks has not used commercially reasonable efforts to achieve the Closing.



As part of the asset purchase agreement, we have agreed to a non-compete
provision that for three years after the Closing restricts our ability to operate or have any interest in the ownership or operation of any entity operating any retail specialty coffee stores in any city where a Company Store is presently located.
The non-compete provision applies only to stores opened after the date of the asset purchase agreement and does not apply to (1) any retail stores operated under the Gloria Jeans brand name, (2) wholesale sales to retail
businesses that are not operated by us, or other non-retail businesses, or (3) the conversion of Company-operated stores existing on the date of the asset purchase agreement to franchise stores. We have also agreed that we will not solicit any
Starbucks employee to enter our employment for three years after the Closing.



Business



We are a specialty coffee roaster,
wholesaler and retailer. We sell brewed, espresso based and various blended beverages primarily made from our own fresh roasted premium coffee beans, as well as light food items, whole bean coffee and accessories, through our company operated and
franchised retail locations. We also sell whole bean and ground coffees on a wholesale basis in the Office Coffee Service market and to other wholesale customers, including restaurant chains and other retailers. We roast coffee at our coffee
roasting facility in central California. It supplies freshly roasted coffee to our company operated and franchised retail locations and to our wholesale accounts.



Our brands include Diedrich Coffee, Gloria Jeans, and Coffee People. The Diedrich Coffee and Coffee People brands are
primarily company store operations and the Gloria Jeans brand is primarily a franchised store operation. As of June 28, 2006, we owned and operated 52 retail locations, of which up to 40 retail locations may be sold to Starbucks
Corporation (as discussed in Item 1 Recent Developments, and OverviewRecent Developments in this Item 7), and franchised 148 other retail locations under these brands, for a total of 200 retail coffee outlets. Our
retail units are located in 33 states. As of June 28, 2006, we had over 800 wholesale accounts with Office Coffee Service distributors, chain and independent restaurants, and others. Although the specialty coffee industry is dominated by a
single company with over 8,000 domestic locations, we are one of the nations largest specialty coffee retailers. Our system-wide revenues are more than $116 million. System-wide revenues include sales from company operated and franchise
locations.



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We believe that our company is differentiated from other specialty coffee companies by the quality of our
coffee products, the superior personalized customer service provided to our customers and the warm and friendly ambiance offered by our coffeehouses. We serve our distinctively roasted coffee products in all of our brand locations and an extensive
variety of fine quality flavored whole bean coffees are offered in our Gloria Jeans units. Our roasting recipes take into account the specific variety, origin and physical characteristics of each coffee bean to maximize its unique flavor.



Key Performance Indicators



We have several key indicators that we use to evaluate the performance of our
business. These include same-store sales growth, the number of company operated and franchised stores opened and closed, and the measured relationship of cost of sales and related occupancy costs, operating expenses and general and administrative
expenses to sales.



Same-store sales growth, or comparative
sales growth, is a primary statistic used in the retail industry to measure core revenues. This measure compares sales for all units open for one year or more to the comparable prior year period. We use this measure to evaluate single coffeehouse,
total brand, and total company sales performance. Until recently, comparable sales of our company operated stores and domestic franchised stores had declined, primarily as a result of aging stores, a lack of capital to fund store improvements, and
no new store openings. New stores typically achieve relatively strong comparative sales growth in their early years. Franchised units that are located in malls have also experienced declining sales due to overall declines in mall traffic. Our
ability to open new company operated and franchise stores depends on our success in raising capital and selling franchises. Continuing declines in same store sales could result in store closures, make sales of franchises more difficult and have a
material adverse impact on our future performance. In addition, under a non-compete provision in the asset purchase agreement with Starbucks, we are restricted for a period of three years after the asset sale closes in our ability to open any new
company-operated or franchised Diedrich Coffee and Coffee People coffeehouses in any city in which Diedrich Coffee or Coffee People coffeehouses operated on the date that we and Starbucks entered into the asset purchase agreement. The non-compete
provision does not restrict our ability to open retail Gloria Jeans stores and does not apply to wholesale sales to retail businesses that are not operated by us or other non-retail businesses or the conversion of our stores existing on the
date of the asset purchase agreement to franchise stores. See Item 1 Recent Developments, and OverviewRecent Developments in this Item 7.



The number of operating units opened and closed is also a measure of the health of our brands and our business, although it
is affected by a number of factors, including the availability of capital to finance growth. In recent years the number of domestic units has declined because the number of aging units closing exceeded the number of new units opening. Company
operated stores have deceased and franchised stores have increased. Unlike new company operated stores, new franchised stores do not require our capital. In addition, franchised stores typically make an immediate profit contribution, whereas company
stores generally are not profitable in the first year. Our near-term growth plans focus primarily on franchising new domestic stores. Failure to successfully expand our franchise operations would materially adversely impact our future performance.



We use the relationship between cost of sales and related
occupancy costs and operating expenses to sales to measure the operating efficiency of our individual coffeehouses and to measure the relationship between general and administrative expenses to sales to monitor and control the level of corporate
overhead. Cost of sales and related occupancy costs increased in the current fiscal year due to the higher percentage of the higher cost Keurig K-cup business. In total, wholesale sales which carry a higher costs of goods sold than retail sales,
increased as a percentage of the total retail and wholesale sales mix. Cost of sales and related occupancy costs increased during fiscal 2006 as a result of a higher percentage of higher cost Keurig business in the current year. Operating expenses
as a percentage of sales remained relatively flat compared to prior year. General and administrative expenses have increased as a percentage of sales primarily due in part from increases in overhead costs not associated with retail and wholesale
operations.



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RESULTS OF OPERATIONS



The following table sets forth the percentage relationship to total revenue of certain items included in our statements of
income for the years indicated:



|                                                            |  |                          |    |  |                          |    |  |                         |   
|----------------------------------------------------------- |  | ------------------------ | -- |  | ------------------------ | -- |  | ----------------------- | --
|                                                            |  | Year Ended June 28, 2006 |    |  | Year Ended June 29, 2005 |    |  | Year EndedJune 30, 2004 |   
|Net revenue:                                                |  |                          |    |  |                          |    |  |                         |   
|Retail sales                                                |  | 57.9                     | %  |  | 60.7                     | %  |  | 62.1                    | % 
|Wholesale and other                                         |  | 35.7                     |    |  | 31.4                     |    |  | 29.2                    |   
|Franchise revenue                                           |  | 6.4                      |    |  | 7.9                      |    |  | 8.7                     |   
|                                                            |  |                          |    |  |                          |    |  |                         |   
|Total revenue                                               |  | 100.0                    | %  |  | 100.0                    | %  |  | 100.0                   | % 
|                                                            |  |                          |    |  |                          |    |  |                         |   
|Costs and expenses:                                         |  |                          |    |  |                          |    |  |                         |   
|Cost of sales and related occupancy costs                   |  | 54.6                     | %  |  | 50.9                     | %  |  | 48.4                    | % 
|Operating expenses                                          |  | 33.5                     |    |  | 33.2                     |    |  | 32.8                    |   
|Depreciation and amortization                               |  | 4.4                      |    |  | 4.5                      |    |  | 4.5                     |   
|General and administrative expenses                         |  | 22.8                     |    |  | 21.3                     |    |  | 18.9                    |   
|Provision for asset impairment and restructuring costs      |  |                         |    |  |                         |    |  | 0.2                     |   
|Gain on asset disposals                                     |  | (0.1                     | )  |  |                         |    |  |                        |   
|                                                            |  |                          |    |  |                          |    |  |                         |   
|Total costs and expenses                                    |  | 115.2                    | %  |  | 109.9                    | %  |  | 104.8                   | % 
|                                                            |  |                          |    |  |                          |    |  |                         |   
|Operating loss from continuing operations                   |  | (15.2                    | )% |  | (9.9                     | )% |  | (4.8                    | )%
|Interest income (expense) and other, net                    |  | 0.7                      |    |  | 0.1                      |    |  | (0.6                    | ) 
|                                                            |  |                          |    |  |                          |    |  |                         |   
|Loss from continuing operations before income tax provision |  | (14.5                    | )  |  | (9.8                     | )  |  | (5.4                    | ) 
|Income tax benefit                                          |  | (1.4                     | )  |  | (3.5                     | )  |  | (2.2                    | ) 
|                                                            |  |                          |    |  |                          |    |  |                         |   
|Loss from continuing operations                             |  | (13.1                    | )% |  | (6.3                     | )% |  | (3.2                    | )%
|Discontinued operations:                                    |  |                          |    |  |                          |    |  |                         |   
|Income from discontinued operations, net of income tax      |  |                         |    |  | 4.1                      | %  |  | 3.7                     | % 
|Gain on sale of discontinued operations, net of income tax  |  |                         |    |  | 30.0                     |    |  |                        |   
|                                                            |  |                          |    |  |                          |    |  |                         |   
|Net income (loss)                                           |  | (13.1                    | )% |  | 27.8                     | %  |  | 0.5                     | % 
|                                                            |  |                          |    |  |                          |    |  |                         |   



Sale of International Franchise
Operations



On February 11, 2005, we completed the
sale of our Gloria Jeans international franchise operations to Jireh International Pty. Ltd., formerly the Gloria Jeans master franchisee for Australia, and certain of its affiliates (collectively, Jireh) for $16,000,000 in
cash and an additional $7,020,000 payable over the next six years under license, roasting and consulting agreements. The sale resulted in a gain on the disposal of discontinued operations of $15,795,000, net of $3,139,000 in taxes. The tax expense
associated with the discontinued operations differed from the statutory federal effective tax rate primarily due to changes in the valuation allowance and permanently nondeductible goodwill associated with the discontinued operations.



The sale included immediate transfer of franchise rights to Jireh of 338
Gloria Jeans retail locations outside the U.S. and Puerto Rico, including 242 in Australia. After all payments have been made to us under the license, roasting and consulting agreements, all remaining Gloria Jeans trademarks, including
those in the U.S., will be transferred to Jireh. Concurrent with such future transfer, our U.S.-based Gloria Jeans subsidiary will enter into a perpetual, royalty-free master franchise agreement with Jireh under which we will continue to have
exclusive rights to operate, franchise and develop Gloria Jeans locations throughout the U.S. and Puerto Rico and to continue our wholesale operations under the Gloria Jeans Coffees brand in these same markets.



We agreed to not compete internationally through our Diedrich Coffee and
Coffee People brands for a period of two years from the date of sale. Other than that restriction, our domestic Gloria Jeans outlets, our



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Castroville roasting operations, our wholesale operations and our company operated Diedrich Coffee and Coffee People retail outlets were not significantly
affected by this transaction.



In accordance with SFAS
No. 144, the financial results of Gloria Jeans international franchise operations are reported as discontinued operations for all periods presented.



Results of Operations



Year Ended June 28, 2006 Compared To Year Ended June 29, 2005



Total Revenue.    Our revenue from continuing operations for the year ended June 28, 2006 increased by $6,909,000,
to $59,447,000 from $52,538,000 for the year ended June 29, 2005. This result was the net effect of a 8.0% increase in retail sales, a 28.9% increase in wholesale sales and a 9.4% decrease in domestic franchise revenue. Each component of total
revenue is discussed below.



Retail
Sales.    Our retail sales revenue for the year ended June 28, 2006 increased by $2,538,000, or 8.0%, to $34,428,000 from $31,890,000 for the year ended June 29, 2005. This increase was primarily due to a
company-operated same store sales increase of 3.6%. Retail sales from our internet website also increased by $295,000 from $596,000 in fiscal 2005 to $891,000 in fiscal 2006.



Wholesale Revenue.    Our wholesale sales for the year ended June 28, 2006 increased by
$4,762,000, or 28.9%, to $21,244,000 from $16,482,000 for the year ended June 29, 2005. This increase was primarily the net result of the following factors:



Keurig K-cup and other Third Party Wholesale sales.    Third party
wholesale sales increased $4,890,000, or 46.0% to $15,514,000 led by strong growth in the Keurig K-cup sales which increased by 55.3%.



Roasted coffee sales to franchisees.    Sales of roasted coffee to our franchisees decreased $129,000 for the year ended
June 28, 2006 primarily because of a net decrease of 2.1% same store sales in fiscal 2006 for the Gloria Jeans domestic system which reduced roasted coffee usage.



Franchise Revenue.    Our domestic franchise revenue decreased by $391,000, or 9.4%, to
$3,775,000 for the year ended June 28, 2006 from $4,166,000 for the year ended June 29, 2005. Our franchise revenue consists of initial franchise fees, franchise renewal fees, area development fees and royalties received on sales at
franchised locations. Of the decrease in domestic franchise revenue, $341,000 resulted from a reclassification of certain fees as a reduction of general and administrative marketing expenses. The balance of the decrease in franchise revenue of
$50,000 resulted primarily from a 2.1% negative same stores sales for the Gloria Jeans brand in the current year compared to fiscal 2005.



Cost of Sales and Related Occupancy Costs.    As a percentage of total revenue, these costs increased from 50.9% in
fiscal 2005 to 54.6% in fiscal 2006. Because none of these costs relate to franchise revenue, the most relevant benchmark of these costs is their relationship to total retail and wholesale sales. Using that measure, cost of sales and related
occupancy costs increased as a percentage of total retail and wholesale sales from 55.3% in fiscal 2005 to 58.3% in fiscal 2006. Retail cost of sales increased from 34.8% to 35.5% in the current year whereas wholesale cost of sales increased from
72.2% to 73.4% of wholesale sales in fiscal 2006 due to a higher percentage of higher cost Keurig business in the current year. Wholesale sales that carry a higher cost of goods sold than retail sales, also increased as a percentage of the retail
and wholesale sales mix from 34.1% to 38.2%.



Operating
Expenses.    Operating expenses for the year ended June 28, 2006, as a percentage of retail and wholesale sales, decreased modestly, from 36.1% of retail and wholesale sales in fiscal 2005 to 35.8% in the current
year. Retail operating expenses increased from 47.7% of retail sales in fiscal 2005 to 49.5% in the current year primarily due to increased labor and supervision costs.



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Depreciation and Amortization.    Depreciation and amortization
increased $229,000, or 9.7% to $2,601,000 for the year ended June 28, 2006 from $2,372,000 for the year ended June 29, 2005 and resulted from an increase in capital improvements in the current year and toward the second half of the
previous fiscal year.



General and Administrative
Expenses.    Our general and administrative expense increased by $2,368,000, or 21.2%, to $13,546,000 for the year ended June 28, 2006. As a percentage of revenue, general and administrative expenses increased to
22.8% for the year ended June 28, 2006 from 21.3% for the year ended June 29, 2005. This increase resulted from $1,189,000 of salaries, consulting, and related costs, including $701,000 of salaries resulting from the departures of our
former chief executive officer and vice president of information systems along with the realignment of those respective departments, as well as $263,000 of increase in salaries and consulting related to the companys review of its purchasing
and distribution process. In addition, the Company incurred $225,000 in salaries associated with store supervision, training, and marketing, $121,000 in salaries associated with training and franchise development primarily in an effort to grow our
Gloria Jeans brand, $268,000 in accounting and finance consulting fees primarily related to strategic planning projects and the restatement of the Companys prior year financial statements, all of which was offset by $389,000 from the
elimination of the current year corporate bonus accruals. We also incurred $403,000 of compensation expense for the current year due to the adoption of SFAS 123R Share Based Payment (SFAS 123R), in the first quarter of
the fiscal 2006 along with a net $581,000 increase in legal fees. In addition, the Company incurred $243,000 of additional workers compensation charges from an increase in expected losses, outside services increased by $122,000 primarily from audit
and tax fees expensed in the current fiscal year, but which were related to the 2005 fiscal year end audit and tax returns, and other costs of $138,000 net primarily associated with an increase in credit card processing fees. These increases were
offset by, $131,000 savings in travel due to timing of the Gloria Jeans annual conference and a reduction in overall advertising spending of $177,000 resulting from a change in the classification for coordination fees previously reflected in
franchise income.



Interest Expense and Interest and
Other Income, Net.    Interest and other income, net less Interest Expense totaled $432,000 for the year ended June 28, 2006 while Interest and other income, net les Interest Expense totaled $56,000 for the year
ended June 29, 2005. The increase of $376,000 was primarily due to interest income on the notes receivables from the sale of our international Gloria Jeans franchise operations.



Income Tax Benefit.    We had losses from
continuing operations for the years ended June 28, 2006 and June 29, 2005. In accordance with SFAS No. 109, Accounting for Income Taxes (SFAS 109), the income tax benefit generated by the loss from
continuing operations were $801,000 and $1,851,000 for the years ended June 28, 2006 and June 29, 2005, respectively. Due to the utilization of net operating loss carryforwards in the sale of the Gloria Jeans international franchise
operations and following an Internal Revenue Code Section 382 analysis, as of June 28, 2006, net operating loss carryforwards of $8,721,000 and $7,883,000 for federal and state income tax purposes, respectively are available to be utilized
against future taxable income for years through fiscal 2026, subject to possible annual limitation pertaining to change in ownership rules under the Internal Revenue Code. Due to the uncertainty of future taxable income, deferred tax assets
resulting from the net operating loss carryforwards have been fully reserved.



Results of Discontinued Operations    As a result of the sale of the international Gloria Jeans franchise operations on February 11, 2005 the results from this component of
our business are presented as discontinued operations for the fiscal year ended June 29, 2005 in accordance with SFAS 144. In the year ended June 29, 2005 net income from discontinued operations was $17,938,000, net of $3,457,000 in taxes,
including a gain of $15,795,000, net of $3,139,000 in taxes. The tax expense associated with the discontinued operations differed from the statutory federal effective tax rate primarily due to changes in the valuation allowance and permanently
nondeductible goodwill associated with the discontinued operations.



Year
Ended June 29, 2005 Compared To Year Ended June 30, 2004



Total Revenue.    Our revenue from continuing operations for the year ended June 29, 2005 increased by $1,653,000, to $52,538,000 from $50,885,000 for the year ended June 30, 2004. This result was
the net effect of



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a 0.9% increase in retail sales, a 10.9% increase in wholesale sales and a 5.5% decrease in domestic franchise revenue. Each component of total revenue is
discussed below.



Retail
Sales.    Our retail sales revenue for the year ended June 29, 2005 increased by $273,000, or 0.9%, to $31,890,000 from $31,617,000 for the year ended June 30, 2004. This increase was primarily due to a
company-operated same store sales increase of 4.7%, and a net increase of four company stores since the beginning of the prior year. Retail sales from our internet website also increased by $139,000 from $457,000 in fiscal 2004 to $596,000 in fiscal
2005.



Wholesale Revenue.    Our
wholesale sales for the year ended June 29, 2005 increased by $1,621,000, or 10.9%, to $16,482,000 from $14,861,000 for the year ended June 30, 2004. This increase was primarily the net result of the following factors:



Keurig K-cup and other Third Party Wholesale
sales.    Third party wholesale sales increased $1,878,000, or 21.5% to $10,624,000 led by strong growth in the Keurig K-cup sales which increased by 27.6%.



Roasted coffee sales to franchisees.    Sales of
roasted coffee to our franchisees decreased $219,000 for the year ended June 29, 2005 because of a net decrease of 14 domestic franchise stores since the beginning of the 2004 fiscal year and compounded by negative 3.0% same store sales in
fiscal 2005 for the Gloria Jeans domestic system which reduced roasted coffee usage.



Franchise Revenue.    Our domestic franchise revenue decreased by $241,000, or 5.5%, to $4,166,000 for the year ended June 29, 2005 from $4,407,000 for the year ended June 30,
2004. Our franchise revenue consists of initial franchise fees, franchise renewal fees, area development fees, royalties received on sales at franchised locations, and miscellaneous other franchise revenue, including coordination fees received from
product suppliers. The decrease in domestic franchise revenue was primarily due to the net impact of a 14 store decrease in units as 22 new units opened but 36 closed during the past two fiscal years, and also due to 3.0% negative same store sales
which affected royalties.



Cost of Sales and Related
Occupancy Costs.    As a percentage of total revenue, these costs increased from 48.4% in fiscal 2004 to 50.9% in fiscal 2005. Because none of these costs relate to franchise revenue, the most relevant benchmark of these
costs is their relationship to total retail and wholesale sales. Using that measure, cost of sales and related occupancy costs increased as a percentage of total retail and wholesale sales from 53.0% in fiscal 2004 to 55.3% in fiscal 2005. Retail
cost of sales remained relatively stable, but wholesale cost of sales increased from 69.8% to 72.2% of wholesale sales in fiscal 2005 due to a higher percentage of higher cost Keurig business in the current year. Wholesale sales that carry a higher
cost of goods sold than retail sales, also increased as a percentage of the retail and wholesale sales mix from 32.0% to 34.1%.



Operating Expenses.    Operating expenses for the year ended June 29, 2005, as a percentage of retail and wholesale
sales, increased modestly, increasing from 35.9% of retail and wholesale sales in fiscal 2004 to 36.1% in the current year. Retail operating expenses increased from 47.0% of retail sales in fiscal 2004 to 47.7% in the current year primarily due to
increased labor and supervision costs.



Depreciation and
Amortization.    Depreciation and amortization was relatively stable increasing $57,000, or 2.5% to $2,372,000 for the year ended June 29, 2005.



General and Administrative Expenses.    Our general and administrative expense increased
by $1,581,000, or 16.5%, to $11,178,000 for the year ended June 29, 2005. On a margin basis, general and administrative expenses increased to 21.3% of total revenue for the year ended June 29, 2005 from 18.9% of total revenue for the year
ended June 30, 2004. This unfavorable 2.4% change for the current year was primarily the result of a $614,000 increase in costs related to actual and planned store growths in areas such as marketing, franchise sales, real estate, technology and
development, $292,000 in increased independent audit and financial staffing costs,



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increased cost of Gloria Jeans franchisee meetings of $211,000, and a $260,000 workers compensation refund received in the prior fiscal year period.



Provision for Asset Impairment and Restructuring
Costs.    No provision was required in fiscal 2005. A provision of $94,000 was recorded in the prior year.



Interest Expense and Interest and Other Income, Net.    Interest and other income, net less Interest Expense was an
expense of $318,000 in the year ended June 30, 2004, while Interest and other income, net less Interest Expense totaled $56,000 in the year ended June 29, 2005. This change was due to a lower level of outstanding debt in the current year
and interest income on our increased cash generated from the proceeds on the sale of the international franchise operations.



Income Tax Benefit.    We had losses from continuing operations and income from discontinued operations for the years
ended June 30, 2005 and June 30, 2004. In accordance with SFAS No. 109, the income tax benefits generated by the losses from continuing operations were $1,851,000 and $1,133,000 for the years ended June 29, 2005 and June 30,
2004, respectively. Due to the utilization of net operating loss carryforwards in the sale of the Gloria Jeans international franchise operations and following an Internal Revenue Code Section 382 analysis, as of June 29, 2005, net
operating loss carryforwards for federal income tax purposes of $3,615,000 are available to be utilized against future taxable income for years through fiscal 2024, subject to possible annual limitation pertaining to change in ownership rules under
the Internal Revenue Code. Due to the uncertainty of future taxable income, deferred tax assets resulting from the net operating loss carryforwards have been fully reserved. As of June 29, 2005, there were no net operating loss carryforwards
available for state income tax purposes.



Results of
Discontinued Operations    As a result of the sale of the international Gloria Jeans franchise operations on February 11, 2005 the results from this component of our business are presented as discontinued
operations for the fiscal years ended June 29, 2005 and June 30, 2004 in accordance with SFAS 144. In the year ended June 29, 2005 net income from discontinued operations was $17,938,000, net of $3,457,000 in taxes, including a gain
of $15,795,000, net of $3,139,000 in taxes. The tax expense associated with the discontinued operations differed from the statutory federal effective tax rate primarily due to changes in the valuation allowance and permanently nondeductible goodwill
associated with the discontinued operations. In the year ended June 30, 2004 income from discontinued operations was $1,898,000, net of taxes of $1,161,000.



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FINANCIAL CONDITION AND LIQUIDITY AND CAPITAL RESOURCES



Current Financial Condition



At June 28, 2006, we had working capital of $3,618,000, total capital
lease obligations, deferred rent and deferred compensation of $1,334,000 and $24,267,000 of stockholders equity, compared to a working capital of $11,203,000, total capital lease obligations, deferred rent and deferred compensation of $780,000
and $31,522,000 of stockholders equity at June 29, 2005. As a result of the restructuring of our credit agreements as described in Outstanding Debt and Financing Arrangements below, available credit under our credit agreements
were $5,000,000 and $5,250,000 as of June 28, 2006 and June 29, 2005, respectively.



Cash Flows



The
following is a summary of our cash flows for the three years ended June 28, 2006:



|                                                                 |  |                    |            |   |               |   |             |               |  |   |            |  
|---------------------------------------------------------------- |  | ------------------ | ---------- | - | ------------- | - | ----------- | ------------- |  | - | ---------- | -
|                                                                 |  | Fiscal Years Ended |           
|                                                                 |  | June 28, 2006      |            |   | June 29, 2005 |   |             | June 30, 2004 | 
|Cash flows provided by operating activities:                     |  |                    |            |   |               |   |             |               |  |   |            |  
|Net income (loss)                                                |  | $                  | (7,796,000 | ) |               | $ | 14,623,000  |               |  | $ | 251,000    |  
|Less: Income from discontinued operations, net                   |  |                    |           |   |               |   | (2,143,000  | )             |  |   | (1,898,000 | )
|Gain on disposal of discontinued operations, net                 |  |                    |           |   |               |   | (15,795,000 | )             |  |   |           |  
|                                                                 |  |                    |            |   |               |   |             |               |  |   |            |  
|Loss from continuing operations                                  |  |                    | (7,796,000 | ) |               |   | (3,315,000  | )             |  |   | (1,647,000 | )
|Net non-cash charges to income                                   |  |                    | 3,191,000  |   |               |   | 908,000     |               |  |   | 1,812,000  |  
|Net (increase) decrease in operating assets                      |  |                    | (916,000   | ) |               |   | (2,241,000  | )             |  |   | 173,000    |  
|Net increase in operating liabilities                            |  |                    | 814,000    |   |               |   | 1,942,000   |               |  |   | 541,000    |  
|                                                                 |  |                    |            |   |               |   |             |               |  |   |            |  
|Cash flows provided by (used in) continuing operating activities |  | $                  | (4,707,000 | ) |               | $ | (2,706,000  | )             |  | $ | 879,000    |  
|Cash flows provided by (used in) discontinued operations         |  |                    |           |   |               |   | (201,000    | )             |  |   | 2,877,000  |  
|Cash flows provided by (used in) investing activities            |  |                    | (3,246,000 | ) |               |   | 12,353,000  |               |  |   | (2,438,000 | )
|Cash flows used in financing activities                          |  |                    | 53,000     |   |               |   | (752,000    | )             |  |   | (2,144,000 | )
|                                                                 |  |                    |            |   |               |   |             |               |  |   |            |  
|Net increase (decrease) in cash                                  |  |                    | (7,900,000 | ) |               |   | 8,694,000   |               |  |   | (826,000   | )
|Cash at beginning of year                                        |  |                    | 10,493,000 |   |               |   | 1,799,000   |               |  |   | 2,625,000  |  
|                                                                 |  |                    |            |   |               |   |             |               |  |   |            |  
|Cash at end of year                                              |  | $                  | 2,593,000  |   |               | $ | 10,493,000  |               |  | $ | 1,799,000  |  
|                                                                 |  |                    |            |   |               |   |             |               |  |   |            |  
|Capital commitments at end of year                               |  | $                  | 2,018,000  |   |               | $ | 2,065,000   |               |  | $ | 514,000    |  
|                                                                 |  |                    |            |   |               |   |             |               |  |   |            |  



The decrease in cash
from continuing operations in fiscal year 2006 as compared to fiscal years 2005 and 2004 is more fully enumerated in the consolidated statements of cash flows in the accompanying consolidated financial statements.



Working capital requirements tend to be seasonal, with inventories and
receivables increasing before the holiday season and declining in the post holiday period. Planned new store growth will initially have the effect of increasing working capital requirements and decreasing cash flows provided by operating activities.



Cash flow provided by discontinued operating activities is
primarily the results of international franchise operations before the sale in February 2005.



Cash provided by investing activities for the fiscal year ended June 29, 2005 increased $14,791,000 from cash used of $2,438,000 in fiscal 2004 to cash provided of $12,353,000 in fiscal 2005. The increase is
primarily the result of the sale of international operations for $16,000,000 in cash offset by capital expenditures of $3,665,000.



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The decrease in cash flows used in financing activities is the result of a net reduction of long-term
debt and capital lease obligations from fiscal 2004 to fiscal 2005.



We had capital commitments at the end of the fiscal year 2006 totaling $2,018,000, of which $1,177,000 relates to opening new stores and $841,000 for remodeling, equipment and software upgrades for company operated retail units. We had
capital commitments at the end of the fiscal year 2005 totaling $2,065,000, of which $1,228,000 relates to opening new stores and $837,000 for remodeling, equipment and software upgrades for company operated retail units and the Castroville roasting
facility. Capital commitments at the end of the fiscal year 2004 totaled $514,000 of which $406,000 relates to opening a new store and $108,000 for remodeling and equipment for company operated retail units.



Outstanding Debt and Financing Arrangements



On May 10, 2004, we entered into a $5,000,000 Contingent Convertible
Note Purchase Agreement. The agreement provides for us to, at our election, issue notes with up to an aggregate principal amount of $5,000,000. The notes are to be amortized on a monthly basis at a rate that will repay 60% of the principal amount of
the note by June 30, 2008. The remaining 40% will mature on that date. Interest is payable at three-month LIBOR plus 5.30%, and a facility fee of 1.00% annually is payable on the unused portion of the facility. The agreement contains covenants
among others that limit the amount of indebtedness that we may have outstanding in relation to its tangible net worth. As of June 28, 2006, we were in compliance with all the covenants in the agreement. Notes are convertible into our common
stock only upon certain changes of control. For notes issued and repaid, warrants to purchase shares are to be issued with the same rights and restrictions for exercise as existed for convertibility of the notes at the time of their issuance.
Warrants are exercisable only in the event of a change of control and expire on June 30, 2010. The fair value of warrants issued with respect to notes repaid will be recorded as a discount to debt, at the date of issuance, which will then be
amortized using the effective interest method. Warrants to purchase our common stock will be issued only upon a change in control. The lender under this agreement is a limited partnership of which the chairman of our board of directors serves as the
sole general partner. On May 10, 2004, upon entering into the agreement, we immediately issued a $1,000,000 note under the facility, and used the proceeds of the note and other available cash to repay all outstanding debt with Bank of the West
(BOW). On September 15, 2004, we issued a second note for $1,000,000 under this facility. Both the notes were fully repaid in fiscal year 2005, and thus a total of 455,184 warrants are issuable upon a change in control. We have
issued 4,219 warrants as of June 28, 2006. As of June 28, 2006, we had no borrowings outstanding under the facility and the full amounts are available for borrowing at that date.



On June 30, 2004, we entered into Amendment No. 1 to Contingent
Convertible Note Purchase Agreement (Amendment No. 1), which revised the definition of Availability to mean, on any date, the loan amount less the sum of the principal amounts then outstanding under the Note Purchase
Agreement. Under the original Note Purchase Agreement, availability was calculated using a formula that reduced availability over time.



On November 4, 2005, we entered into a new Credit Agreement with Bank of the West. The agreement provides for a $750,000 letter of credit facility
that expires on October 15, 2006. The letter of credit facility is secured by a deposit account at Bank of the West. As of June 28, 2006, this deposit account had a balance of $583,000, which is shown as restricted cash on the consolidated
balance sheets. As of June 28, 2006, $651,000 of letters of credit was outstanding under the letter of credit facility. The agreement contains covenants that, among other matters, require us to submit financial statements to the bank within
specified time periods. As of June 28, 2006, we were in compliance with all Bank of the West agreement covenants.



On March 31, 2006, we entered into Amendment No. 2 to Contingent Convertible Note Purchase Agreement (Amendment No. 2).
Amendment No. 2: (i) contains a waiver with respect to the default of the Minimum EBITDA Covenant as of March 8, 2006 and removes the Minimum EBITDA from the Note Purchase Agreement; (ii) clarifies that warrants to purchase our
common stock will be issued with respect to repaid principal amounts only upon a change in control; (iii) increases the interest rate applicable to outstanding



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amounts under the credit facility by 2%, to LIBOR plus 5.30%; and (iv) extended the exercise date of all warrants issued or to be issued under the Note
Purchase Agreement by one year, to May 10, 2009 which was subsequently extended as discussed below. The maturity date for any notes issued in the future was unaffected by Amendment No. 2. We were in compliance with all agreement covenants
as amended by Amendment No. 2 as of June 28, 2006.



Subsequent to the fiscal year-end 2006, we issued a note with a principal amount of $1,000,000 on August 23, 2006, pursuant to the $5,000,000 Contingent Convertible Note Purchase Agreement. The interest rate was 10.63% at the time of
the note issuance.



On September 22, 2006, we entered into
Amendment No. 3 to Contingent Convertible Note Purchase Agreement (Amendment No. 3). Amendment No. 3 (i) changes the date specified in the definition of Maturity Date from May 10, 2007 to June 30, 2008; (ii) adjusts the
calculation of monthly payments to reflect the extended maturity date; (iii) removes a condition precedent to each loan that previously required there to be no material adverse effect or event reasonably likely to result in a material adverse effect
before the obligation of the lender to purchase any note arose; (iv) amends the events of default so that an event that has, or is reasonably likely to have, a material adverse effect will not be considered such an event of default; (v) amends the
notice requirements so that the Company is not required to give notice to the lender of any event that is reasonably likely to have a material adverse effect; and (vi) extends the exercise date of all warrants issued or to be issued under the Note
Purchase Agreement to June 30, 2010.



In recent years, we have
experienced recurring operating losses and negative cash flows from operations. We have taken steps to reduce future losses and with positive revenue trends, the cost control measures initiated by us should result in improved financial performance
in the near term. We have announced our plans to strengthen our two core business segments by focusing the resources dedicated to our expanding wholesale business and by narrowing our retail focus to our franchise stores without significant
capital investment. We also announced that we would exit our company operated Diedrich and Coffee People retail locations through the previously disclosed transaction with Starbucks Corporation.



While our management fully expects that the transaction with Starbucks
Corporation will be completed, there are no absolute assurances that this will occur. In the unlikely event that the transaction is not fully completed, the anticipated improvement in our cash flow and financial condition would reflect only the cost
control measures initiated by us and any portion of the transaction that is completed.



Based on the terms of our credit agreements, as amended, our managements expectations that the transaction to exit the company operated Diedrich and Coffee People retail locations will be completed, the focus on
growing the wholesale and franchise business segments, the status of our balance sheet and the overall business outlook for us and the specialty coffee market, our management believes that cash from ongoing operations, the anticipated proceeds from
the sale transaction and funds available to us from our current credit agreements will be sufficient to satisfy our working capital needs at the anticipated operating levels for at least the next twelve months.



Off-Balance Sheet Arrangements



As of June 28, 2006, we did not have any off-balance sheet arrangements,
as defined in Item 303 (a)(4)(ii) of Regulation S-K.



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Commitments and Contractual Obligations



The following is a summary of our contractual obligations and commitments as of June 28, 2006:



|                                                             |  |                        |        |                 |   |           |  |           |        |                   |   |        |  |   |       
|------------------------------------------------------------ |  | ---------------------- | ------ | --------------- | - | --------- |  | --------- | ------ | ----------------- | - | ------ |  | - | ------
|                                                             |  | Payments Due By Period
|                                                             |  | Total                  |        | Less than1 year |   | 1-3 years |  | 3-5 years |        | More than 5 years
|                                                             |  | (In thousands)        
|Capital leases (including interest)                          |  | $                      | 504    |                 | $ | 44        |  | $         | 88     |                   | $ | 88     |  | $ | 284   
|Company operated retail locations and other operating leases |  |                        | 27,463 |                 |   | 4,112     |  |           | 7,421  |                   |   | 5,924  |  |   | 10,006
|Franchise operated retail locations operating leases         |  |                        | 20,168 |                 |   | 4,203     |  |           | 6,037  |                   |   | 4,250  |  |   | 5,678 
|Green coffee commitments                                     |  |                        | 1,874  |                 |   | 1,874     |  |           |       |                   |   |       |  |   |      
|                                                             |  |                        |        |                 |   |           |  |           |        |                   |   |        |  |   |       
|                                                             |  | $                      | 50,009 |                 | $ | 10,233    |  | $         | 13,546 |                   | $ | 10,262 |  | $ | 15,968
|                                                             |  |                        |        |                 |   |           |  |           |        |                   |   |        |  |   |       



We have also entered
into employment agreements with two senior executive officers that provide for severance payments in the event that these individuals are terminated without cause or that they terminate their employment as a result of a constructive termination.
These severance payments range from six months to one years salary. Our Companys maximum liability for severance under the contracts is currently $368,000. Because such amounts are contingent they have not been included in the above
table.



We have obligations under non-cancelable operating
leases for our coffee houses, roasting facility and administrative offices. Lease terms are generally for 10 to 20 years with renewal options and generally require us to pay a proportionate share of real estate taxes, insurance, common area and
other operating costs. Some retail leases provide for contingent rental payments based on sales thresholds. In addition, we are liable on the master leases for 79 Gloria Jeans franchise locations. Under our historical franchising business
model, we executed the master leases for these locations, and entered into subleases on the same terms with our franchisees, which typically pay their rent directly to the landlords. Should any of these franchisees default on their subleases, we
would be responsible for making payments thereunder. Our maximum theoretical future exposure at June 28, 2006, computed as the sum of all remaining lease payments through the expiration dates of the respective leases, was $20,168,000. This
amount does not take into consideration any mitigating measures that we could take to reduce this exposure in the event of default, including re-leasing the locations or terminating the master lease by negotiating a lump sum payment to the landlord
that is less than the sum of all remaining future rents and other amounts payable.



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CRITICAL ACCOUNTING ESTIMATES



The preparation of our consolidated financial statements requires us to make estimates and assumptions that affect the
reported amounts. The estimates and assumptions are evaluated on an ongoing basis and are based on historical experience and on various other factors that are believed to be reasonable. Accounts significantly impacted by estimates and assumptions
include, but are not limited to, franchise receivables, allowance for bad debt reserves, fixed asset lives, goodwill, intangible assets, income taxes, self-insurance and workers compensation reserves, store closure reserves, stock-based
compensation, the valuation allowance for net deferred tax assets and contingencies. We believe that the following represent our critical accounting policies and estimates used in the preparation of our condensed consolidated financial statements.
The following discussion, however, does not list all of our accounting policies and estimates.



Impairment of Property and Equipment and Other Amortizable Long-Lived Assets Held and Used



Each quarter, or upon the occurrence of a triggering event as defined in SFAS No. 144, we evaluate the carrying value of individual stores when the
operating results have reasonably progressed to a point to adequately evaluate the probability of continuing operating losses or a current expectation that a store will be sold or otherwise disposed of before the end of its previously estimated
useful life. In making these judgments, we consider the period of time since the store was opened or remodeled, and the trend of operations and expectations for future sales growth. For stores selected for review, we estimate the future cash flows
from operating the store over its estimated useful life. We make judgments about future same-store sales and the operating expenses and estimated useful life that we would expect with such level of same-store sales.



The most significant assumptions in our analysis are those used when we
estimate a units future cash flows. We generally use the assumptions in our strategic plan and modify them as necessary based on unit specific information. If our assumptions are incorrect, the carrying value of our operating unit assets may
be overstated or understated.



Impairment of Goodwill



At the reporting unit level, goodwill is tested for impairment annually or
whenever an event or circumstance indicates that impairment has likely occurred. We consider the reporting unit level to be the segment level since the components within each segment have similar economic characteristics, including products and
services, production processes, types or classes of customers and distribution methods. The impairment, if any, is measured based on the estimated fair value of the segment. Fair value can be determined based on discounted cash flows or valuations
of similar businesses. Impairment occurs when the carrying amount of goodwill exceeds its estimated fair value.



The most significant assumptions we use in this analysis are those made in estimating future net cash flows. In estimating future cash flows, we consider
historical results as well as the assumptions utilized in our strategic plan for items such as same-store sales, store count growth rates, and the discount rate we consider to be the market discount rate used for acquisitions of similar businesses.



If our assumptions used in performing the impairment test
prove inaccurate, the fair value of the segments may ultimately prove to be significantly higher or lower, thereby causing the carrying value to be less than or to exceed the fair value and indicating impairment has or has not occurred. If our
assumptions are incorrect, the carrying value of our goodwill may be understated or overstated. Our annual impairment measurement date is our fiscal year end.



Estimated Liability for Closing Stores



We make decisions to close stores based on prospects for estimated future profitability and sometimes we are forced to close stores due to circumstances
beyond our control (e.g., a landlords refusal to negotiate a new



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lease). Our management team evaluates each stores performance every period. When stores continue to perform poorly, we consider the demographics of the
location, as well as the likelihood of being able to improve the performance of an unprofitable store. Based on the management teams judgment, we estimate the future net cash flows. If we determine that the store will not, within a reasonable
period of time, operate at break-even cash flow or be profitable, and we are not contractually obligated to continue operating the store, we may close the store. Additionally, franchisees may close stores for which we are the primary lessee. If the
franchisee cannot make payments on the lease, we continue making the lease payments and establish an estimated liability for the closed store if we decide not to operate it as a company operated store. Effective January 1, 2003, we establish
the estimated liability on the actual closure date which is generally the date on which we cease to receive economic benefit from the unit. Prior to the adoption of SFAS No. 146, Accounting for Costs Associated with Exit or Disposal
Activities (SFAS 146), on January 1, 2003, we established the estimated liability when we identified a store for closure, which may or may not have been the actual closure date. We also review the net cash flows to
determine the need to provide for asset impairment.



The
estimated liability for closing stores on properties vacated is generally based on the term of the lease and the lease termination fee that we expect to pay, as well as the estimated maintenance costs that we expect to pay until the lease has been
abated. The amount of the estimated liability is generally the present value of the estimated future payments. The interest rate used to calculate the present value of these liabilities is based on our incremental borrowing rate at the time the
liability is established. The related discount is amortized and shown in provision for asset impairment and restructuring costs or cost of sales and related occupancy, net in our consolidated statements of operations.



A significant assumption used in determining the amount of the estimated
liability for closing stores is the amount of the estimated liability for future lease payments on vacant stores, which we determine based on our assessment of our ability to successfully negotiate early terminations of our lease agreements with the
lessors or to sublease the property. Additionally, we estimate the cost to maintain leased and owned vacant properties until the lease has been abated. If the costs to maintain properties increase, or it takes longer than anticipated to sell
properties or sublease or terminate leases, we may need to record additional estimated liabilities. If the leases on the vacant stores are not terminated or subleased on the terms we used to estimate the liabilities, we may be required to record
losses in future periods. Conversely, if the leases on the vacant stores are terminated or subleased on more favorable terms than we used to estimate the liabilities, we reverse previously established estimated liabilities through the line item in
which it was originally recorded, resulting in an increase in operating income.



Estimated Liability for Self-Insurance and Workers Compensation



We are self-insured for a portion of our current years losses related to workers compensation insurance. We have obtained stop loss insurance for individual workers compensation claims with a
$250,000 deductible per occurrence and a program maximum for all claims of $750,000. Insurance liabilities and reserves are accounted for based on the present value of actuarial estimates of the amount of incurred and unpaid losses, based
approximately on a risk-free interest rate. These estimates rely on actuarial observations of historical claim loss development. Management, in determining the estimated liability, bases the assumptions on the average historical losses on claims we
have incurred. The actual loss development may be better or worse than the development we estimated in conjunction with the actuary. In that event, we will modify the reserve. As a result, if we experience a higher than expected number of claims or
the costs of claims are greater than expected, then we may adjust the expected losses upward and our future self-insurance expenses will rise.



Franchised Operations



We monitor the financial condition of certain franchisees and record provisions for estimated losses on receivables when we believe that our franchisees
are unable to make their required payments to us. Each period we perform an analysis to develop estimated bad debts for each franchisee. We then compare the aggregate result



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of that analysis to the amount recorded in our consolidated financial statements as the allowance for doubtful accounts and adjust the allowance as
appropriate. Over time, our assessment of individual franchisees may change. For instance, we have had franchisees for whom we had estimated a loss equal to the total amount of their receivable, who have paid us in full or established a consistent
record of payments (generally one year) such that we determined an allowance was no longer required.



Depending on the facts and circumstances, there are a number of different actions we or our franchisees may take to resolve franchise collections issues.
These actions may include the purchase of franchise stores by us or by other franchisees, a modification to the franchise agreement, which may include a provision to defer certain royalty payments or reduce royalty rates in the future, a
restructuring of the franchisees business or finances (including the restructuring of leases for which we are the primary or secondary obligee) or, if necessary, the termination of the franchise agreement. The allowance established is based on
our assessment of the most probable course of action that will occur.



In accordance with SFAS No. 146, which we adopted on January 1, 2003, an estimated liability for future lease obligations on stores operated by franchisees for which we are the primary or secondary obligee is established on the
date the franchisee closes the store. Also, we record an estimated liability for subsidized lease payments when we sign a sublease agreement committing us to the subsidy.



The amount of the estimated liability is established using the methodology described in Estimated Liability for
Closing Stores above. Consistent with SFAS No. 146, we have not established an additional estimated liability for potential losses not yet incurred. If sales trends or economic conditions worsen for our franchisees, their financial health
may worsen, our collection rates may decline and we may be required to assume the responsibility for additional lease payments on franchised stores. In addition, entering into restructured franchise agreements may result in reduced franchise royalty
rates in the future.



Stock-Based Compensation



As discussed in the notes to consolidated financial statements, we have
various stock-based compensation plans that provide options for certain employees and outside directors to purchase common shares of stock. Prior to June 30, 2005, we elected to account for stock-based compensation in accordance with Accounting
Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, which utilizes the intrinsic value method of accounting for stock-based compensation, as opposed to using the fair-value method
prescribed in SFAS No. 123, Accounting for Stock-Based Compensation. Because of this election, we were required to make certain disclosures of pro forma net income assuming we had adopted SFAS No. 123. Starting
June 30, 2005, we adopted the provisions of SFAS 123R, which sets accounting requirements for share-based compensation to employees and non-employee directors, including employee stock purchase plans, and requires companies to
recognize in the statement of operations the grant-date fair value of stock options and other equity-based compensation.



We determine the estimated fair value of stock-based compensation on the date of the grant using the Black-Scholes option-pricing model. The Black-Scholes
option-pricing model requires us to apply highly subjective assumptions, including our historical stock price volatility, expected life of the option and the risk-free interest rate. A change in one or more of the assumptions used in the
Black-Scholes option-pricing model may result in a material change to the estimated fair value of the stock-based compensation. See Note 1 of Notes to Consolidated Financial Statements for analysis of the effect of certain changes in assumptions
used to determine the fair value of stock-based compensation.



Valuation
Allowance for Net Deferred Tax Assets and Contingencies



As discussed above, we have recorded a 100% valuation allowance against our net deferred tax assets. If we have been profitable for a number of years and our prospects for the realization of our deferred tax assets are



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more likely than not, we would then reverse our valuation allowance and credit income tax expense. In assessing the prospects for future profitability, many
of the assessments of same-store sales and cash flows discussed above become relevant. When circumstances warrant, we assess the likelihood that our net deferred tax assets will more likely than not be realized from future taxable income. As of
June 28, 2006, our net deferred tax assets and related valuation allowance totaled approximately $5,094,000.



NEW ACCOUNTING PRONOUNCEMENTS



Accounting Pronouncements Not Yet Adopted



In July 2006, the FASB issued Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109, which seeks to
reduce the diversity in practice associated with the accounting and reporting for uncertainty in income tax positions. This Interpretation prescribes a comprehensive model for the financial statement recognition, measurement, presentation and
disclosure of uncertain tax positions taken or expected to be taken in income tax returns. FIN 48 is effective for fiscal years beginning after December 15, 2006. We will adopt the new requirements in our fiscal first quarter of 2008. The
cumulative effects, if any, of adopting FIN 48 will be recorded as an adjustment to retained earnings as of the beginning of the period of adoption. We have not yet determined the impact, if any, of adopting FIN 48 on our consolidated financial
statements.



OTHER MATTERS



Seasonality and Quarterly Results



Our business is subject to seasonal fluctuations as well as economic trends
that affect retailers in general. Historically, our net sales have not been realized proportionately in each quarter, with net sales being the highest during the second fiscal quarter, which includes the November-December holiday season. Hot weather
tends to negatively impact sales. Quarterly results are also affected by the timing of the opening of new stores, which may not occur as anticipated due to events outside our control. As a result of these factors, and of the other contingencies and
risk factors described elsewhere in this report, the financial results for any individual quarter may not be indicative of the results that may be achieved in a full fiscal year.



|Item 7A. | Quantitative and Qualitative Disclosures About Market Risk.
|-------- | -----------------------------------------------------------



Market Risk Sensitive Items Entered Into for Trading Purposes



None.



Market Risk Sensitive Items Entered Into for Other Than Trading Purposes



We have exposure to market risk from two primary sourcesinterest rate
risk and commodity price risk.



Interest Rate Risk



We are exposed to market risk from changes in interest
rates on our outstanding bank debt. At June 28, 2006, we had a $5,000,000 note facility with no outstanding balance, which could be affected by changes in short term interest rates. At fiscal year-end, the interest rate was 10.81%.



Commodity Price Risk



Green coffee, the principal raw material for our products, is subject to
significant price fluctuations caused by a number of factors, including weather, political, and economic conditions. To date, we have not used



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commodity-based financial instruments to hedge against fluctuations in the price of green coffee. To ensure that we have an adequate supply of green coffee,
however, we enter into agreements to purchase green coffee in the future that may or may not be fixed as to price. At June 28, 2006, we had commitments to purchase coffee through fiscal year 2007, totaling $1,874,000 for 1,215,000 pounds of
green coffee, the majority of which were fixed as to price. The coffee scheduled to be delivered to us in fiscal year 2007 pursuant to these commitments will satisfy approximately 25% of our anticipated green coffee requirements for the fiscal year.
Assuming we require approximately 3,364,000 additional pounds of green coffee during fiscal 2007 for which no price has yet been fixed, each $0.01 per pound increase in the price of green coffee could result in $34,000 of additional cost. However,
because the price we pay for green coffee is negotiated with suppliers, we believe that the commodity market price for green coffee would have to increase significantly, by as much as $0.25 per pound, before suppliers would increase the price they
charge us.



|Item 8. | Financial Statements and Supplementary Data.
|------- | --------------------------------------------



The financial statements and supplementary data required by this item are set forth at the end of this Annual Report on Form 10-K beginning on page F-1.



We have agreed to indemnify and hold KPMG LLP harmless against
and from any and all legal costs and expenses incurred by KPMG LLP in successful defense of any legal action or proceeding that arises as a result of KPMG LLPs consent to the incorporation by reference of its audit report on our past financial
statements incorporated by reference herein.



|Item 9. | Changes in and Disagreements With Accountants on Accounting and Financial Disclosure.
|------- | -------------------------------------------------------------------------------------



KPMG LLP (KPMG) was previously our principal accountants. On October 26,
2004, the Audit Committee approved the dismissal of KPMG as our principal accountants upon the acceptance by BDO Seidman, LLP of its appointment to serve in such capacity. The decision to change auditors was recommended and approved by the Audit
Committee.



The audit report of KPMG on our consolidated
financial statements as of and for the fiscal year ended June 30, 2004 did not contain any adverse opinion or disclaimer of opinion, nor were they qualified or modified as to uncertainty, audit scope or accounting principles.



In connection with the audit of the fiscal year ended June 30, 2004 and
the subsequent interim period through October 26, 2004, there were no disagreements or reportable events with KPMG on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedures, which
disagreements if not resolved to KPMGs satisfaction would have caused KPMG to make reference in connection with its opinion to the subject matter of the disagreement or reportable event, except as described below:



In performing its audit of our consolidated financial statements for the year
ended June 30, 2004, KPMG noted a matter involving our internal controls that it considered to be a reportable condition. A reportable condition, which may or may not be determined to be a material weakness, involves matters
relating to significant deficiencies in the design or operation of internal controls that, in KPMGs judgment, could adversely affect our ability to record, process, summarize and report financial data consistent with the assertions of
management in the financial statements. The reportable conditions, which were not considered by us to be material weaknesses, noted that we do not have adequate internal controls over the application of new accounting principles or the application
of existing accounting principles to new transactions. Specifically, KPMG noted that in the fourth quarter of fiscal year 2004 we recognized $113,000 in franchise revenue related to a terminated area development agreement when it should have been
recognized in the first fiscal quarter, which resulted in the



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restatement of our first fiscal quarter results. It also noted that we had not fully addressed the impact of accounting for the warrants associated with the
convertible debt issued in May 2004, and had not timely completed the assessment necessary to implement Financial Accounting Standards Board Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest
Entities. We authorized KPMG to respond fully to the inquiries of BDO Seidman, LLP regarding the events described above.



For the fiscal year ended June 30, 2004 and the subsequent interim period through October 26, 2004, we did not consult with BDO Seidman, LLP
regarding the application of accounting principles to a specified transaction, type of audit opinion that might be rendered on our financial statements, or any other accounting, auditing or reporting matters.



|Item 9A. | Controls and Procedures.
|-------- | ------------------------



Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure
controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange Act)), in connection with the preparation of this Annual Report on Form 10-K, as of
June 28, 2006. Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, also conducted an evaluation of our internal control over financial reporting to determine whether any changes occurred during the
fourth quarter of fiscal 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.



Based on the review described above, our Chief Executive Officer and Chief Financial Officer determined that our disclosure controls and procedures were
effective as of the end of the period covered by this report. There were no changes in our internal control over financial reporting that occurred during the fourth quarter ended June 28, 2006, that have materially affected, or are reasonably
likely to materially affect, our internal control over financial reporting.



|Item 9B. | Other Information.
|-------- | ------------------



None.



PART III



|Item 10. | Directors and Executive Officers of the Registrant.
|-------- | ---------------------------------------------------



The information required by this item is incorporated herein by reference to our definitive proxy statement for our 2006 annual meeting of stockholders,
which will be filed with the Securities and Exchange Commission no later than 120 days after the close of the fiscal year ended June 28, 2006.



|Item 11. | Executive Compensation.
|-------- | -----------------------



The information required by this item is incorporated herein by reference to our definitive proxy statement for our 2006 annual meeting of stockholders,
which will be filed with the Securities and Exchange Commission no later than 120 days after the close of the fiscal year ended June 28, 2006.



|Item 12. | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
|-------- | -----------------------------------------------------------------------------------------------



The information required by this item is incorporated herein by reference to
our definitive proxy statement for our 2006 annual meeting of stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after the close of the fiscal year ended June 28, 2006.



39



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##### Table of Contents

Equity Compensation Plan Information



The following table summarizes the equity compensation plans under which our common stock may be issued as of June 28,
2006.



|                                                       |  |                                                                                             |  |                                                                             |  |                                                                                                                                            
|------------------------------------------------------ |  | ------------------------------------------------------------------------------------------- |  | --------------------------------------------------------------------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------
|                                                       |  | (a)                                                                                         |  | (b)                                                                         |  | (c)                                                                                                                                        
|Plan category                                          |  | Number of securities to be issued upon exercise of outstanding options, warrants and rights |  | Weighted-average exercise price of outstanding options, warrants and rights |  | Number of securities remaining available for future issuance under equity
compensation plans (excluding securities reflected in column (a))
|Equity compensation plans approved by security
holders |  | 941,333 (1)                                                                                 |  | $4.94                                                                       |  | 387,001 (2)                                                                                                                                
|                                                       |  |                                                                                             |  |                                                                             |  |                                                                                                                                            
|Total                                                  |  | 941,333                                                                                     |  | $4.94                                                                       |  | 387,001                                                                                                                                    
|                                                       |  |                                                                                             |  |                                                                             |  |                                                                                                                                            
|                                                       |  |                                                                                             |  |                                                                             |  |                                                                                                                                            



| | (1) | Represents options to purchase shares of our common stock issued under: the Diedrich Coffee, Inc. 2000 Equity Incentive Plan; the Stock Option Plan and Agreement with Roger M.
Laverty; the Diedrich Coffee, Inc. 2000 Non-Employee Directors Stock Option Plan; and the Amended and Restated Diedrich Coffee, Inc. 1996 Stock Incentive Plan.
| | --- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (2) | Represents securities available for issuance under the Diedrich Coffee, Inc. 2000 Equity Incentive Plan.
| | --- | --------------------------------------------------------------------------------------------------------



|Item 13. | Certain Relationships and Related Transactions.
|-------- | -----------------------------------------------



The information required by this item is incorporated herein by reference to our definitive proxy statement for our 2006 annual meeting of stockholders,
which will be filed with the Securities and Exchange Commission no later than 120 days after the close of the fiscal year ended June 28, 2006.



|Item 14. | Principal Accountant Fees and Services.
|-------- | ---------------------------------------



The information required by this item is incorporated herein by reference to our definitive proxy statement for our 2006 annual meeting of stockholders,
which will be filed with the Securities and Exchange Commission no later than 120 days after the close of the fiscal year ended June 28, 2006.



PART IV



|Item 15. | Exhibits and Financial Statement Schedules
|-------- | ------------------------------------------



Financial Statements and Schedules.



The financial statements and schedules required to be filed hereunder are set forth at the end of this Annual Report on Form 10-K beginning on page F-1.



Exhibits.



The Exhibit Index attached hereto is incorporated herein by reference.



40



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##### Table of Contents

SIGNATURES



Pursuant to the
requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.



|                   |  |                       |  |                              
|------------------ |  | --------------------- |  | -----------------------------
|                   |  | DIEDRICH COFFEE, INC.
|                   |  |                      
|September 26, 2006 |  | By:                   |  | /s/ STEPHEN V. COFFEY        
|                   |  |                       |  | Stephen V. Coffey            
|                   |  |                       |  | Chief Executive Officer      
|                   |  |                       |  | (on behalf of the registrant)



Pursuant to the
requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.



|                                       |  |                                                                                         |  |                   
|-------------------------------------- |  | --------------------------------------------------------------------------------------- |  | ------------------
|Signature                              |  | Title                                                                                   |  | Date              
|                                       |  |                                                                                        
|/s/ PAUL HEESCHENPaul Heeschen         |  | Chairman of the Board of Directors                                                      |  | September 26, 2006
|                                       |  |                                                                                        
|/s/ STEPHEN V. COFFEYStephen V. Coffey |  | Chief Executive Officer                                                                 |  | September 26, 2006
|                                       |  |                                                                                        
|/s/ SEAN M. MCCARTHYSean M. McCarthy   |  | Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) |  | September 26, 2006
|                                       |  |                                                                                        
|/s/ LAWRENCE GOELMANLawrence Goelman   |  | Director                                                                                |  | September 26, 2006
|                                       |  |                                                                                        
|/s/ RICHARD SPENCERRichard Spencer     |  | Director                                                                                |  | September 26, 2006
|                                       |  |                                                                                        
|/s/ TIMOTHY J. RYANTimothy J. Ryan     |  | Director                                                                                |  | September 26, 2006
|                                       |  |                                                                                        
|/s/ GREG PALMERGreg Palmer             |  | Director                                                                                |  | September 26, 2006



41



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##### Table of Contents

DIEDRICH COFFEE, INC. AND SUBSIDIARIES



INDEX TO CONSOLIDATED FINANCIAL STATEMENTS



|                                                         |  |     
|-------------------------------------------------------- |  | ----
|                                                         |  | Page
|                                                         | 
|Report of Independent Registered Public Accounting Firms |  |     
|                                                         | 
|BDO Seidman, LLP                                         |  | F-2 
|                                                         | 
|KPMG LLP                                                 |  | F-3 
|                                                         | 
|Consolidated Balance Sheets                              |  | F-4 
|                                                         | 
|Consolidated Statements of Operations                    |  | F-5 
|                                                         | 
|Consolidated Statements of Stockholders Equity          |  | F-6 
|                                                         | 
|Consolidated Statements of Cash Flows                    |  | F-7 
|                                                         | 
|Notes to Consolidated Financial Statements               |  | F-9 
|                                                         | 
|Schedule II  Valuation and Qualifying Accounts          |  | F-32



F-1



---

##### Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



The Board of Directors and Stockholders

Diedrich Coffee, Inc.:



We have audited the accompanying consolidated balance sheets of Diedrich Coffee, Inc. and subsidiaries (the
Company) as of June 28, 2006 and June 29, 2005 and the related consolidated statements of operations, shareholders equity and cash flows for the years then ended. In connection with our audits of the consolidated
financial statements, we also have audited the supplementary information included in Schedule II. These consolidated financial statements and the financial statement schedules are the responsibility of the Companys management. Our
responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.



We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we
plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial
reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of
the Companys internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also
includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.



As more fully described in Note 1 to the consolidated financial statements,
effective June 30, 2005, the Company adopted the provisions of SFAS 123(R), Share-Based Payment.



As described in Note 2, the Company has suffered continuing losses from operations resulting in decreased working capital availability and the Company
management has implemented certain actions and plans including the potential sale of its retail operations to address its financial condition and liquidity.



In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Diedrich
Coffee, Inc. and subsidiaries as of June 28, 2006 and June 29, 2005, and the results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States. Also
in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.



/s/ BDO Seidman, LLP



Costa Mesa, California

August 18, 2006, except as to Note 16,

which is as of September 14, 2006

and Note 2 and last paragraphs

of Notes 7 and 9, which are as of

September 22, 2006



F-2



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##### Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



The Board of Directors and Stockholders

Diedrich Coffee, Inc.:



We have audited the accompanying consolidated statements of operations, stockholders equity and cash flows of Diedrich
Coffee, Inc. and subsidiaries for the year ended June 30, 2004. In connection with our audit of the consolidated financial statements, we have also audited the accompanying financial statement schedule. These consolidated financial statements
and financial statement schedule are the responsibility of the Companys management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audit.



We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement
presentation. We believe that our audit provide a reasonable basis for our opinion.



In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the results of operations and cash flows of Diedrich Coffee, Inc. and subsidiaries for the year ended
June 30, 2004, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole,
presents fairly, in all material respects, the information set forth therein.



/s/ KPMG LLP



Costa Mesa, California

August 20, 2004, except as to paragraphs 3, 4,
5, 6 and 7 of note 1,

which are as of September 22, 2005



F-3



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##### Table of Contents

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS



|                                                                                                                                                          |  |               |             |   |               |   |             |  
|--------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------- | ----------- | - | ------------- | - | ----------- | -
|                                                                                                                                                          |  | June 28, 2006 |             |   | June 29, 2005 |  
|Assets                                                                                                                                                    |  |               |             |   |               |   |             |  
|Current assets:                                                                                                                                           |  |               |             |   |               |   |             |  
|Cash                                                                                                                                                      |  | $             | 2,593,000   |   |               | $ | 10,493,000  |  
|Restricted cash                                                                                                                                           |  |               | 583,000     |   |               |   |            |  
|Accounts receivable, less allowance for doubtful accounts of $1,863,000 at June 28, 2006 and $1,392,000 at June 29,
2005                                  |  |               | 2,829,000   |   |               |   | 2,203,000   |  
|Inventories                                                                                                                                               |  |               | 3,846,000   |   |               |   | 3,426,000   |  
|Income tax refund                                                                                                                                         |  |               | 516,000     |   |               |   | 1,220,000   |  
|Current portion of notes receivable                                                                                                                       |  |               | 1,137,000   |   |               |   | 1,165,000   |  
|Advertising fund assets, restricted                                                                                                                       |  |               | 217,000     |   |               |   | 218,000     |  
|Prepaid expenses                                                                                                                                          |  |               | 426,000     |   |               |   | 489,000     |  
|                                                                                                                                                          |  |               |             |   |               |   |             |  
|Total current assets                                                                                                                                      |  |               | 12,147,000  |   |               |   | 19,214,000  |  
|Property and equipment, net                                                                                                                               |  |               | 9,088,000   |   |               |   | 7,974,000   |  
|Goodwill                                                                                                                                                  |  |               | 8,179,000   |   |               |   | 8,179,000   |  
|Notes receivable                                                                                                                                          |  |               | 3,972,000   |   |               |   | 4,554,000   |  
|Cash surrender value of life insurance policy                                                                                                             |  |               | 391,000     |   |               |   |            |  
|Other assets                                                                                                                                              |  |               | 353,000     |   |               |   | 392,000     |  
|                                                                                                                                                          |  |               |             |   |               |   |             |  
|Total assets                                                                                                                                              |  | $             | 34,130,000  |   |               | $ | 40,313,000  |  
|                                                                                                                                                          |  |               |             |   |               |   |             |  
|Liabilities and Stockholders Equity                                                                                                                      |  |               |             |   |               |   |             |  
|                                                                                                                                                          |  |              
|Current liabilities:                                                                                                                                      |  |               |             |   |               |   |             |  
|Current installments of obligations under capital leases                                                                                                  |  | $             | 19,000      |   |               | $ | 85,000      |  
|Accounts payable                                                                                                                                          |  |               | 2,929,000   |   |               |   | 2,642,000   |  
|Accrued compensation                                                                                                                                      |  |               | 2,481,000   |   |               |   | 2,886,000   |  
|Accrued expenses                                                                                                                                          |  |               | 1,779,000   |   |               |   | 1,366,000   |  
|Franchisee deposits                                                                                                                                       |  |               | 599,000     |   |               |   | 632,000     |  
|Deferred franchise fee income                                                                                                                             |  |               | 104,000     |   |               |   | 91,000      |  
|Advertising fund liabilities                                                                                                                              |  |               | 217,000     |   |               |   | 218,000     |  
|Accrued provision for store closure                                                                                                                       |  |               | 401,000     |   |               |   | 91,000      |  
|                                                                                                                                                          |  |               |             |   |               |   |             |  
|Total current liabilities                                                                                                                                 |  |               | 8,529,000   |   |               |   | 8,011,000   |  
|Obligations under capital leases, excluding current installments                                                                                          |  |               | 309,000     |   |               |   | 328,000     |  
|Deferred rent                                                                                                                                             |  |               | 603,000     |   |               |   | 452,000     |  
|Deferred compensation                                                                                                                                     |  |               | 422,000     |   |               |   |            |  
|                                                                                                                                                          |  |               |             |   |               |   |             |  
|Total liabilities                                                                                                                                         |  |               | 9,863,000   |   |               |   | 8,791,000   |  
|                                                                                                                                                          |  |               |             |   |               |   |             |  
|Commitments and contingencies (Notes 7 and 8)                                                                                                             |  |               |             |   |               |   |             |  
|Stockholders equity:                                                                                                                                     |  |               |             |   |               |   |             |  
|Common stock, $.01 par value; authorized 8,750,000 shares; issued and outstanding 5,308,000 shares at June 28, 2006 and 5,273,000 shares
at June 29, 2005 |  |               | 53,000      |   |               |   | 53,000      |  
|Additional paid-in capital                                                                                                                                |  |               | 59,022,000  |   |               |   | 58,481,000  |  
|Accumulated deficit                                                                                                                                       |  |               | (34,808,000 | ) |               |   | (27,012,000 | )
|                                                                                                                                                          |  |               |             |   |               |   |             |  
|Total stockholders equity                                                                                                                                |  |               | 24,267,000  |   |               |   | 31,522,000  |  
|                                                                                                                                                          |  |               |             |   |               |   |             |  
|Total liabilities and stockholders equity                                                                                                                |  | $             | 34,130,000  |   |               | $ | 40,313,000  |  
|                                                                                                                                                          |  |               |             |   |               |   |             |  



See accompanying
notes to consolidated financial statements.



F-4



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##### Table of Contents

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS



|                                                                                            |  |                          |            |   |                          |   |            |                          |  |   |            |  
|------------------------------------------------------------------------------------------- |  | ------------------------ | ---------- | - | ------------------------ | - | ---------- | ------------------------ |  | - | ---------- | -
|                                                                                            |  | Year Ended June 28, 2006 |            |   | Year Ended June 29, 2005 |   |            | Year Ended June 30, 2004 | 
|Net revenue:                                                                                |  |                          |            |   |                          |   |            |                          |  |   |            |  
|Retail sales                                                                                |  | $                        | 34,428,000 |   |                          | $ | 31,890,000 |                          |  | $ | 31,617,000 |  
|Wholesale and other                                                                         |  |                          | 21,244,000 |   |                          |   | 16,482,000 |                          |  |   | 14,861,000 |  
|Franchise revenue                                                                           |  |                          | 3,775,000  |   |                          |   | 4,166,000  |                          |  |   | 4,407,000  |  
|                                                                                            |  |                          |            |   |                          |   |            |                          |  |   |            |  
|Total revenue                                                                               |  |                          | 59,447,000 |   |                          |   | 52,538,000 |                          |  |   | 50,885,000 |  
|                                                                                            |  |                          |            |   |                          |   |            |                          |  |   |            |  
|Costs and expenses:                                                                         |  |                          |            |   |                          |   |            |                          |  |   |            |  
|Cost of sales and related occupancy costs                                                   |  |                          | 32,440,000 |   |                          |   | 26,765,000 |                          |  |   | 24,642,000 |  
|Operating expenses                                                                          |  |                          | 19,947,000 |   |                          |   | 17,449,000 |                          |  |   | 16,701,000 |  
|Depreciation and amortization                                                               |  |                          | 2,601,000  |   |                          |   | 2,372,000  |                          |  |   | 2,315,000  |  
|General and administrative expenses                                                         |  |                          | 13,546,000 |   |                          |   | 11,178,000 |                          |  |   | 9,597,000  |  
|Provision for asset impairment and restructuring costs                                      |  |                          |           |   |                          |   |           |                          |  |   | 94,000     |  
|Gain on asset disposals                                                                     |  |                          | (58,000    | ) |                          |   | (4,000     | )                        |  |   | (2,000     | )
|                                                                                            |  |                          |            |   |                          |   |            |                          |  |   |            |  
|Total costs and expenses                                                                    |  |                          | 68,476,000 |   |                          |   | 57,760,000 |                          |  |   | 53,347,000 |  
|                                                                                            |  |                          |            |   |                          |   |            |                          |  |   |            |  
|Operating loss from continuing operations                                                   |  |                          | (9,029,000 | ) |                          |   | (5,222,000 | )                        |  |   | (2,462,000 | )
|Interest expense                                                                            |  |                          | (116,000   | ) |                          |   | (223,000   | )                        |  |   | (348,000   | )
|Interest and other income, net                                                              |  |                          | 548,000    |   |                          |   | 279,000    |                          |  |   | 30,000     |  
|                                                                                            |  |                          |            |   |                          |   |            |                          |  |   |            |  
|Loss from continuing operations before income tax benefit                                   |  |                          | (8,597,000 | ) |                          |   | (5,166,000 | )                        |  |   | (2,780,000 | )
|Income tax benefit                                                                          |  |                          | (801,000   | ) |                          |   | (1,851,000 | )                        |  |   | (1,133,000 | )
|                                                                                            |  |                          |            |   |                          |   |            |                          |  |   |            |  
|Loss from continuing operations                                                             |  |                          | (7,796,000 | ) |                          |   | (3,315,000 | )                        |  |   | (1,647,000 | )
|Discontinued operations:                                                                    |  |                          |            |   |                          |   |            |                          |  |   |            |  
|Income from discontinued operations, net of $0, $318,000 and $1,161,000 taxes, respectively |  |                          |           |   |                          |   | 2,143,000  |                          |  |   | 1,898,000  |  
|Gain on sale of discontinued operations, net of $3,139,000 taxes                            |  |                          |           |   |                          |   | 15,795,000 |                          |  |   |           |  
|                                                                                            |  |                          |            |   |                          |   |            |                          |  |   |            |  
|Net income (loss)                                                                           |  | $                        | (7,796,000 | ) |                          | $ | 14,623,000 |                          |  | $ | 251,000    |  
|                                                                                            |  |                          |            |   |                          |   |            |                          |  |   |            |  
|Basic and diluted net income (loss) per share:                                              |  |                          |            |   |                          |   |            |                          |  |   |            |  
|Loss from continuing operations                                                             |  | $                        | (1.47      | ) |                          | $ | (0.64      | )                        |  | $ | (0.32      | )
|                                                                                            |  |                          |            |   |                          |   |            |                          |  |   |            |  
|Income from discontinued operations, net                                                    |  | $                        |           |   |                          | $ | 3.44       |                          |  | $ | 0.37       |  
|                                                                                            |  |                          |            |   |                          |   |            |                          |  |   |            |  
|Net income (loss)                                                                           |  | $                        | (1.47      | ) |                          | $ | 2.80       |                          |  | $ | 0.05       |  
|                                                                                            |  |                          |            |   |                          |   |            |                          |  |   |            |  
|Weighted average and equivalent shares outstanding:                                         |  |                          |            |   |                          |   |            |                          |  |   |            |  
|Basic and diluted                                                                           |  |                          | 5,303,000  |   |                          |   | 5,218,000  |                          |  |   | 5,161,000  |  
|                                                                                            |  |                          |            |   |                          |   |            |                          |  |   |            |  



See accompanying
notes to consolidated financial statements.



F-5



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##### Table of Contents

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY



|                           |  |              |  |        |        |                            |   |                     |  |   |                            |   |  |   |            |  
|-------------------------- |  | ------------ |  | ------ | ------ | -------------------------- | - | ------------------- |  | - | -------------------------- | - |  | - | ---------- | -
|                           |  | Common Stock |  |        |        |                            |   |                     |  |  
|                           |  | Shares       |  | Amount |        | Additional Paid-In Capital |   | Accumulated Deficit |  |   | Total Stockholders Equity |  
|                           |  |              |  |        |       
|Balance, July 2, 2003      |  | 5,161,000    |  | $      | 52,000 |                            | $ | 58,036,000          |  | $ | (41,886,000                | ) |  | $ | 16,202,000 |  
|Stock compensation expense |  |             |  |        |       |                            |   | 22,000              |  |   |                           |   |  |   | 22,000     |  
|Net income                 |  |             |  |        |       |                            |   |                    |  |   | 251,000                    |   |  |   | 251,000    |  
|                           |  |              |  |        |        |                            |   |                     |  |   |                            |   |  |   |            |  
|Balance, June 30, 2004     |  | 5,161,000    |  |        | 52,000 |                            |   | 58,058,000          |  |   | (41,635,000                | ) |  |   | 16,475,000 |  
|Exercise of stock options  |  | 112,000      |  |        | 1,000  |                            |   | 367,000             |  |   |                           |   |  |   | 368,000    |  
|Stock compensation expense |  |             |  |        |       |                            |   | 47,000              |  |   |                           |   |  |   | 47,000     |  
|Common Stock warrants      |  |             |  |        |       |                            |   | 9,000               |  |   |                           |   |  |   | 9,000      |  
|Net income                 |  |             |  |        |       |                            |   |                    |  |   | 14,623,000                 |   |  |   | 14,623,000 |  
|                           |  |              |  |        |        |                            |   |                     |  |   |                            |   |  |   |            |  
|Balance, June 29, 2005     |  | 5,273,000    |  |        | 53,000 |                            |   | 58,481,000          |  |   | (27,012,000                | ) |  |   | 31,522,000 |  
|Exercise of stock options  |  | 35,000       |  |        |       |                            |   | 138,000             |  |   |                           |   |  |   | 138,000    |  
|Stock compensation expense |  |             |  |        |       |                            |   | 403,000             |  |   |                           |   |  |   | 403,000    |  
|Net loss                   |  |             |  |        |       |                            |   |                    |  |   | (7,796,000                 | ) |  |   | (7,796,000 | )
|                           |  |              |  |        |        |                            |   |                     |  |   |                            |   |  |   |            |  
|Balance, June 28, 2006     |  | 5,308,000    |  | $      | 53,000 |                            | $ | 59,022,000          |  | $ | (34,808,000                | ) |  | $ | 24,267,000 |  
|                           |  |              |  |        |        |                            |   |                     |  |   |                            |   |  |   |            |  



See accompanying
notes to consolidated financial statements.



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##### Table of Contents

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS



|                                                                                                   |  |                          |            |   |                          |   |             |                          |  |   |            |  
|-------------------------------------------------------------------------------------------------- |  | ------------------------ | ---------- | - | ------------------------ | - | ----------- | ------------------------ |  | - | ---------- | -
|                                                                                                   |  | Year Ended June 28, 2006 |            |   | Year Ended June 29, 2005 |   |             | Year Ended June 30, 2004 | 
|Cash flows from operating activities:                                                              |  |                          |            |   |                          |   |             |                          |  |   |            |  
|Net income (loss)                                                                                  |  | $                        | (7,796,000 | ) |                          | $ | 14,623,000  |                          |  | $ | 251,000    |  
|Income from discontinued operations                                                                |  |                          |           |   |                          |   | (2,143,000  | )                        |  |   | (1,898,000 | )
|Gain on disposal of discontinued operations, net                                                   |  |                          |           |   |                          |   | (15,795,000 | )                        |  |   |           |  
|                                                                                                   |  |                          |            |   |                          |   |             |                          |  |   |            |  
|Loss from continuing operations:                                                                   |  |                          | (7,796,000 | ) |                          |   | (3,315,000  | )                        |  |   | (1,647,000 | )
|Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: |  |                          |            |   |                          |   |             |                          |  |   |            |  
|Depreciation and amortization                                                                      |  |                          | 2,601,000  |   |                          |   | 2,372,000   |                          |  |   | 2,315,000  |  
|Amortization and write off of loan fees                                                            |  |                          | 32,000     |   |                          |   | 35,000      |                          |  |   | 152,000    |  
|Amortization of note payable discount                                                              |  |                          |           |   |                          |   | 7,000       |                          |  |   |           |  
|Provision for bad debt                                                                             |  |                          | 589,000    |   |                          |   | 213,000     |                          |  |   | 246,000    |  
|Income tax benefit                                                                                 |  |                          | (801,000   | ) |                          |   | (1,851,000  | )                        |  |   | (1,133,000 | )
|Provision for inventory obsolescence                                                               |  |                          | 86,000     |   |                          |   | 89,000      |                          |  |   | 210,000    |  
|Provision for asset impairment and restructuring                                                   |  |                          |           |   |                          |   |            |                          |  |   | 94,000     |  
|Provision for (reversal of) store closure                                                          |  |                          | 401,000    |   |                          |   |            |                          |  |   | (70,000    | )
|Stock compensation expense                                                                         |  |                          | 403,000    |   |                          |   | 47,000      |                          |  |   | 22,000     |  
|Notes receivable issued for franchise fees                                                         |  |                          | (62,000    | ) |                          |   |            |                          |  |   | (22,000    | )
|Gain on disposal of assets                                                                         |  |                          | (58,000    | ) |                          |   | (4,000      | )                        |  |   | (2,000     | )
|Changes in operating assets and liabilities:                                                       |  |                          |            |   |                          |   |             |                          |  |   |            |  
|Accounts receivable                                                                                |  |                          | (1,215,000 | ) |                          |   | (866,000    | )                        |  |   | 172,000    |  
|Inventories                                                                                        |  |                          | (506,000   | ) |                          |   | (714,000    | )                        |  |   | (414,000   | )
|Notes receivable                                                                                   |  |                          | (373,000   | ) |                          |   | (139,000    | )                        |  |   |           |  
|Prepaid expenses                                                                                   |  |                          | 63,000     |   |                          |   | (158,000    | )                        |  |   | 560,000    |  
|Income tax refund                                                                                  |  |                          | 1,505,000  |   |                          |   |            |                          |  |   |           |  
|Other assets                                                                                       |  |                          | (390,000   | ) |                          |   | (364,000    | )                        |  |   | (145,000   | )
|Accounts payable                                                                                   |  |                          | 286,000    |   |                          |   | 498,000     |                          |  |   | 36,000     |  
|Accrued compensation                                                                               |  |                          | 16,000     |   |                          |   | 812,000     |                          |  |   | 767,000    |  
|Accrued expenses                                                                                   |  |                          | 435,000    |   |                          |   | 619,000     |                          |  |   | 6,000      |  
|Deferred franchise fees income and franchisee deposits                                             |  |                          | (20,000    | ) |                          |   | 47,000      |                          |  |   | (66,000    | )
|Accrued provision for store closure                                                                |  |                          | (91,000    | ) |                          |   | (18,000     | )                        |  |   | (246,000   | )
|Deferred rent                                                                                      |  |                          | 188,000    |   |                          |   | (16,000     | )                        |  |   | 44,000     |  
|                                                                                                   |  |                          |            |   |                          |   |             |                          |  |   |            |  
|Net cash provided by (used in) continuing operations                                               |  |                          | (4,707,000 | ) |                          |   | (2,706,000  | )                        |  |   | 879,000    |  
|Net cash provided by (used in) discontinued operations                                             |  |                          |           |   |                          |   | (201,000    | )                        |  |   | 2,877,000  |  
|                                                                                                   |  |                          |            |   |                          |   |             |                          |  |   |            |  
|Net cash provided by (used in) operating activities:                                               |  |                          | (4,707,000 | ) |                          |   | (2,907,000  | )                        |  |   | 3,756,000  |  
|Cash flows from investing activities:                                                              |  |                          |            |   |                          |   |             |                          |  |   |            |  
|Capital expenditures for property and equipment                                                    |  |                          | (3,826,000 | ) |                          |   | (3,665,000  | )                        |  |   | (2,530,000 | )
|Proceeds from sale of discontinued operations                                                      |  |                          |           |   |                          |   | 16,000,000  |                          |  |   |           |  
|Proceeds from disposal of property and equipment                                                   |  |                          | 93,000     |   |                          |   | 31,000      |                          |  |   | 64,000     |  
|Acquisition of retail store                                                                        |  |                          |           |   |                          |   | (80,000     | )                        |  |   |           |  
|Issuance of notes receivable                                                                       |  |                          |           |   |                          |   |            |                          |  |   | (20,000    | )
|Payments received on notes receivable                                                              |  |                          | 1,070,000  |   |                          |   | 67,000      |                          |  |   | 48,000     |  
|Investment in restricted money market account                                                      |  |                          | (583,000   | ) |                          |   |            |                          |  |   |           |  
|                                                                                                   |  |                          |            |   |                          |   |             |                          |  |   |            |  
|Net cash provided by (used in) investing activities                                                |  |                          | (3,246,000 | ) |                          |   | 12,353,000  |                          |  |   | (2,438,000 | )
|                                                                                                   |  |                          |            |   |                          |   |             |                          |  |   |            |  





See accompanying notes to consolidated financial statements.



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##### Table of Contents

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS(Continued)



|                                                    |  |                          |            |   |                          |   |            |                          |  |   |            |  
|--------------------------------------------------- |  | ------------------------ | ---------- | - | ------------------------ | - | ---------- | ------------------------ |  | - | ---------- | -
|                                                    |  | Year Ended June 28, 2006 |            |   | Year Ended June 29, 2005 |   |            | Year Ended June 30, 2004 | 
|Cash flows from financing activities:               |  |                          |            |   |                          |   |            |                          |  |   |            |  
|Payments on long-term debt                          |  |                          |           |   |                          |   | (1,983,000 | )                        |  |   | (2,967,000 | )
|Payments on capital lease obligations               |  |                          | (85,000    | ) |                          |   | (137,000   | )                        |  |   | (177,000   | )
|Exercise of stock options                           |  |                          | 138,000    |   |                          |   | 368,000    |                          |  |   |           |  
|Borrowings under credit agreement                   |  |                          |           |   |                          |   | 1,000,000  |                          |  |   | 1,000,000  |  
|                                                    |  |                          |            |   |                          |   |            |                          |  |   |            |  
|Net cash provided by (used in) financing activities |  |                          | 53,000     |   |                          |   | (752,000   | )                        |  |   | (2,144,000 | )
|                                                    |  |                          |            |   |                          |   |            |                          |  |   |            |  
|Net increase (decrease) in cash                     |  |                          | (7,900,000 | ) |                          |   | 8,694,000  |                          |  |   | (826,000   | )
|Cash at beginning of year                           |  |                          | 10,493,000 |   |                          |   | 1,799,000  |                          |  |   | 2,625,000  |  
|                                                    |  |                          |            |   |                          |   |            |                          |  |   |            |  
|Cash at end of year                                 |  | $                        | 2,593,000  |   |                          | $ | 10,493,000 |                          |  | $ | 1,799,000  |  
|                                                    |  |                          |            |   |                          |   |            |                          |  |   |            |  
|Supplemental disclosure of cash flow information:   |  |                          |            |   |                          |   |            |                          |  |   |            |  
|Cash paid during the period for:                    |  |                          |            |   |                          |   |            |                          |  |   |            |  
|Interest                                            |  | $                        | 83,000     |   |                          | $ | 357,000    |                          |  | $ | 153,000    |  
|                                                    |  |                          |            |   |                          |   |            |                          |  |   |            |  
|Income taxes                                        |  | $                        | 50,000     |   |                          | $ | 2,828,000  |                          |  | $ | 37,000     |  
|                                                    |  |                          |            |   |                          |   |            |                          |  |   |            |  
|Non-cash transactions:                              |  |                          |            |   |                          |   |            |                          |  |   |            |  
|Issuance of notes receivable                        |  | $                        | 66,000     |   |                          | $ | 7,020,000  |                          |  | $ | 42,000     |  
|                                                    |  |                          |            |   |                          |   |            |                          |  |   |            |  



See accompanying
notes to consolidated financial statements.



F-8



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##### Table of Contents

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



1.    Summary of Significant Accounting Policies and Practices



Business



Diedrich Coffee, Inc. is a specialty coffee roaster, wholesaler, retailer and
franchiser whose brands include Diedrich Coffee, Gloria Jeans, and Coffee People. The Company owns and operates 52 retail locations and is the franchiser of 148 retail locations as of June 28, 2006, all of which are located in 33 states.
The Company also has over 800 wholesale accounts with businesses and restaurant chains. In addition, the Company operates a coffee roasting facility in central California that supplies freshly roasted coffee beans to its retail locations and to its
wholesale customers.



Basis of Presentation and Fiscal
Year End



The consolidated financial statements include
the accounts of Diedrich Coffee, Inc. and its wholly owned subsidiaries (the Company). All significant intercompany transactions are eliminated. The Companys fiscal year end is the Wednesday closest to June 30. In fiscal years
2004, 2005 and 2006, this resulted in a 52-week year.



Discontinued Operations



On
February 11, 2005, the Company completed the sale of its Gloria Jeans international franchise operations to Jireh International Pty. Ltd., formerly the Gloria Jeans master franchisee for Australia, and certain of its affiliates
(collectively, Jireh) for $16,000,000 in cash and an additional $7,020,000 payable over the next six years under license, roasting and consulting agreements. The sale resulted in a gain on the disposal of discontinued operations of
$15,795,000, net of $3,139,000 of taxes. The tax expense associated with the discontinued operations differed from the statutory federal effective tax rate primarily due to changes in the valuation allowance and permanently nondeductible goodwill
associated with the discontinued operations.



The sale included
the immediate transfer of related franchise rights to Jireh of 338 Gloria Jeans retail locations outside the U.S. and Puerto Rico, including 242 located in Australia.



The Company was not required to defer any of the gain on the disposal of Gloria Jeans international franchise
operations because all future payments are irrevocable, non-interest bearing and require no ongoing obligation or performance by the Company to receive them.



In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS No. 144),
the financial results of Gloria Jeans international franchise operations are reported as discontinued operations for all periods presented.



The following accounts are reflected in Discontinued Operations:



| |  |  | International franchise royalties, new store fees and roasting fees
| | - |  | -------------------------------------------------------------------



| |  |  | Wholesale revenue and cost of goods sold associated with the sale of coffee to international franchisees
| | - |  | --------------------------------------------------------------------------------------------------------



| |  |  | Bad debt expense related to international franchisees
| | - |  | -----------------------------------------------------



| |  |  | General and administrative costs related to international operations and audit, tax and legal fees relating to the transaction.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------



| |  |  | Gain on sale of the international franchise operations, net of the related tax provision, and
| | - |  | ---------------------------------------------------------------------------------------------



| |  |  | Provision for foreign taxes paid on international revenues
| | - |  | ----------------------------------------------------------



F-9



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##### Table of Contents

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



The financial results included in discontinued operations were as follows:



|                                                                                          |  |                    |  |               |            |               |   |          
|----------------------------------------------------------------------------------------- |  | ------------------ |  | ------------- | ---------- | ------------- | - | ---------
|                                                                                          |  | Fiscal years ended
|                                                                                          |  | June 28, 2006      |  | June 29, 2005 |            | June 30, 2004
|Net revenue                                                                               |  |                   |  | $             | 3,935,000  |               | $ | 3,740,000
|                                                                                          |  |                    |  |               |            |               |   |          
|Earnings from discontinued operations before income taxes                                 |  |                   |  | $             | 2,461,000  |               |   | 3,059,000
|                                                                                          |  |                    |  |               |            |               |   |          
|Earnings from discontinued operations, net of $318,000 and $1,161,000 taxes, respectively |  |                   |  | $             | 2,143,000  |               |   | 1,898,000
|Gain on sale of discontinued operations, net of $3,139,000 of taxes                       |  |                   |  |               | 15,795,000 |               |   |         
|                                                                                          |  |                    |  |               |            |               |   |          
|Total income from discontinued operations, net of tax                                     |  |                   |  | $             | 17,938,000 |               | $ | 1,898,000
|                                                                                          |  |                    |  |               |            |               |   |          



Cash and Cash
Equivalents



The Company considers all highly liquid
investments purchased with an original maturity of three months or less to be cash equivalents. The Company had $0 and $9,500,000 of invested cash at June 28, 2006 and June 29, 2005, respectively.



Accounts Receivable



Trade accounts receivable are recorded at the invoiced amount and do not bear
interest. The allowance for doubtful accounts is based on managements best estimate of the amount of probable credit losses in existing accounts receivable. The Company evaluates its allowance for doubtful accounts based upon knowledge of its
customers and their compliance with credit terms. The evaluation process includes a review of customers accounts on a regular basis. The review process evaluates all account balances with amounts outstanding 90 days and other specific amounts
for which information obtained indicates that the balance may be uncollectible. The allowance for doubtful accounts is adjusted based on such evaluation, with a corresponding provision included in operating expenses. Account balances are charged off
against the allowance when management believes it is probable the receivable will not be recovered. The Company does not have any off-balance-sheet credit exposure related to its customers.



Inventories



Inventories are stated at the lower of cost or market. The cost for
inventories is determined using the first-in, first-out method.



Property and Depreciation



Property and
equipment, including assets under capital leases, are recorded at cost. Depreciation for property and equipment is calculated using the straight-line method over estimated useful lives of three to seven years. Property and equipment held under
capital leases and leasehold improvements are generally amortized using the straight-line method. Property and equipment held under capital leases are generally amortized over the shorter of their estimated useful lives or the term of the related
leases. Leasehold improvements are generally amortized over the shorter of 9 years or the term of the related leases.



Major remodels and improvements are capitalized. Maintenance and repairs that do not improve or extend the life of the respective assets are charged to
expense as incurred.



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##### Table of Contents

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Deferred Financing Costs



Costs related to the issuance of debt are deferred and amortized using a method that approximates the effective interest
method as a component of interest expense over the terms of the respective debt issues.



Store Pre-opening Costs



Direct and incremental costs incurred prior to the opening of a retail coffeehouse location are expensed as incurred.



Fair Value of Financial Instruments



The carrying amounts of cash, accounts receivable, inventories, prepaid expenses, other assets, notes receivable, accounts payable, accrued compensation,
accrued expenses, and franchisee deposits approximate fair value because of the short-term maturity of these financial instruments. The Company believes the carrying amounts of the Companys long-term debt approximates fair value because the
interest rate on these instrument are subject to change with market interest rates and other terms and conditions are consistent with terms currently available to the Company.



Cost of Sales and Related Occupancy Costs



Cost of sales and related occupancy costs include cost of purchased products, inbound freight charges, purchasing and
receiving costs, inspection costs, warehousing costs, internal transfer costs and all other costs of our distribution network and retail store occupancy costs.



Certain lease agreements provide for scheduled rent increases during the lease terms or for rental payments commencing on a date other than the date of
initial occupancy. Rent expense is recorded on a straight-line basis over the respective terms of the leases.



Operating Expenses



Operating expenses include compensation costs that account for over 70% of the total. Other operating expenses include utilities, advertising and
marketing, business insurance, taxes, licenses, fees and bank charges.



General and Administrative Expenses



General and administrative expenses include compensation costs that represent approximately 60% of the total. Other costs include legal, office rent, telephone, consulting and outside services, and Directors and Officers
insurance.



Income Taxes



The Company accounts for income taxes under SFAS No. 109,
Accounting for Income Taxes (SFAS No. 109). This statement requires the recognition of deferred tax assets and liabilities for the future consequences of events that have been recognized in the Companys
financial statements or tax returns. The measurement of the deferred items is based on enacted tax laws. In the event the future consequences of differences between financial reporting bases and the tax bases of the Companys assets and
liabilities result in a deferred tax asset, SFAS No. 109 requires an evaluation of the probability of being able to realize the future benefits indicated by such asset. A valuation allowance related to a deferred tax asset is recorded when it
is more likely than not that some portion or all of the deferred tax asset will not be realized.



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##### Table of Contents

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Net Income (Loss) Per Common Share



Basic earnings per share represents net earnings divided by the
weighted average shares outstanding, excluding all potentially dilutive common shares. Diluted earnings per-share reflects the dilutive effect of all potentially dilutive common shares.



Goodwill



In July 2001, the Financial Accounting Standards Board (FASB)
issued SFAS No. 141, Business Combinations, (SFAS No. 141) and SFAS No. 142, Goodwill and Other Intangible Assets (SFAS No. 142). SFAS No. 141 requires that
the purchase method of accounting be used for all business combinations initiated after June 30, 2001. SFAS No. 141 also specifies criteria intangible assets acquired in a purchase method business combination must meet to be recognized and
reported apart from goodwill. SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead are tested for impairment annually or whenever events or changes in circumstances indicate
that the carrying value may not be recoverable. Factors the Company considers important which could trigger an impairment review include significant underperformance relative to expected historical or projected future operating results, significant
changes in the manner of use of acquired assets or the strategy for the overall business, and significant negative industry or economic trends. The Company has performed annual evaluations of its goodwill since June 30, 2001 in order to
properly state its goodwill (see Notes 6 and 11). No provision for impairment was recorded in fiscal 2004, 2005 and 2006.



Stock Option Plans



On June 30, 2005, the Company adopted the provisions of SFAS No. 123R, Share-Based Payment(SFAS No. 123R).
SFAS 123R sets accounting requirements for share-based compensation to employees and non-employee directors, including employee stock purchase plans, and requires companies to recognize in the statement of operations the grant-date fair
value of stock options and other equity-based compensation.



The Company chose the modified-prospective transition alternatives in adopting SFAS No. 123R. Under the modified-prospective transition method, compensation cost is recognized in financial statements issued subsequent to the date of
adoption for all stock-based payments granted, modified or settled after the date of adoption, as well as for any unvested awards that were granted prior to the date of adoption. Because the Company previously adopted only the pro forma disclosure
provisions of SFAS No. 123 Accounting for Stock-Based Compensation (SFAS No. 123), it will recognize compensation cost relating to the unvested portion of awards granted prior to the date of adoption using
the same estimate of the grant-date fair value and the same attribution method used to determine the pro forma disclosures under SFAS No. 123, except that forfeitures rate will be estimated for all options, as required by SFAS No. 123R.



Awards granted prior to the Companys implementation of
SFAS No. 123R were accounted for under the recognition and measurement principles of APB Opinion 25, Accounting for Stock Issued to Employees, and related interpretations. Accordingly, no stock-based employee compensation cost is
reflected in net loss in the accompanying Consolidated Statements of Operations for the fiscal years ended June 29, 2005 and June 30, 2004 because all options granted under the Companys plans had exercise prices equal to the market
values of the underlying common stock on the date of grant.



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##### Table of Contents

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Pro forma net income (loss) and pro forma net income (loss) per share, as if the fair value-based
method of SFAS No. 123 had been applied in measuring compensation cost for stock-based awards, is as follows:



|                                                                                                                                           |  |                          |            |   |                          |   |          |  
|------------------------------------------------------------------------------------------------------------------------------------------ |  | ------------------------ | ---------- | - | ------------------------ | - | -------- | -
|                                                                                                                                           |  | Year Ended June 29, 2005 |            |   | Year Ended June 30, 2004 |  
|Net income (loss) as reported                                                                                                              |  | $                        | 14,623,000 |   |                          | $ | 251,000  |  
|Add:  Stock based employee compensation expense included in reported net income (loss), net of related tax effects                         |  |                          | 47,000     |   |                          |   | 22,000   |  
|Deduct:  Stock-based employee compensation expense determined under the fair value based method for all awards, net of related tax
effects |  |                          | (528,000   | ) |                          |   | (926,000 | )
|                                                                                                                                           |  |                          |            |   |                          |   |          |  
|Pro forma net income (loss)                                                                                                                |  | $                        | 14,142,000 |   |                          | $ | (653,000 | )
|                                                                                                                                           |  |                          |            |   |                          |   |          |  
|Basic and dilutive net income (loss) per share  as reported                                                                               |  | $                        | 2.80       |   |                          | $ | 0.05     |  
|Basic and dilutive net income (loss) per share  pro forma                                                                                 |  | $                        | 2.71       |   |                          | $ | (0.13    | )



The fair value of each
option award is estimated on the date of grant using a Black-Scholes option valuation model that uses the assumptions noted in the following table. Expected volatility is based on the historical volatility of the price of the Companys stock.
The Company uses historical data to estimate option exercise and employee termination rates within the valuation model. The expected term of options is derived from the output of the option valuation model and represents the period of time that
options are expected to be outstanding. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The fair values of the options were estimated using the
Black-Scholes option-pricing model based on the following weighted average assumptions:



|                        |  |                          |  |                          |  |                         
|----------------------- |  | ------------------------ |  | ------------------------ |  | ------------------------
|                        |  | Year Ended June 28, 2006 |  | Year Ended June 29, 2005 |  | Year Ended June 30, 2004
|Risk free interest rate |  | 4.74%                    |  | 4.00%                    |  | 3.81%                   
|Expected life           |  | 2 years                  |  | 6 years                  |  | 6 years                 
|Expected volatility     |  | 56%                      |  | 44%                      |  | 57%                     
|Expected dividend yield |  | 0%                       |  | 0%                       |  | 0%                      



The Company uses a
forfeiture rate of 4.9% for the fiscal year ended June 28, 2006.



Long-Lived Assets



The Company accounts
for long-lived assets in accordance with the provisions of SFAS No. 144. This requires that long-lived assets be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be
recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to
be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.



Revenue Recognition



Retail and wholesale sales are recorded when payment is tendered at point of
sale for retail, and upon shipment of product for wholesale, respectively. Initial franchise fees are recognized when a franchised coffeehouse begins operations, at which time the Company has performed its obligations related to such fees.

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DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Initial franchise fees are referred to as Front end fees in the table below. Such fees
are collected (if applicable) before the franchised location begins operation, and are nonrefundable. Initial franchise fees apply primarily in the case of domestic franchise development. Franchise royalties are recognized as earned, based upon a
percentage of a franchise coffeehouse sales over time.



The
following table details the various components included in franchise revenue:



|               |  |               |           |               |   |               |  |   |          
|-------------- |  | ------------- | --------- | ------------- | - | ------------- |  | - | ---------
|               |  | June 28, 2006 |           | June 29, 2005 |   | June 30, 2004
|Royalties      |  | $             | 3,362,000 |               | $ | 3,432,000     |  | $ | 3,658,000
|Front end fees |  |               | 413,000   |               |   | 393,000       |  |   | 428,000  
|Other          |  |               |          |               |   | 341,000       |  |   | 321,000  
|               |  |               |           |               |   |               |  |   |          
|Total          |  | $             | 3,775,000 |               | $ | 4,166,000     |  | $ | 4,407,000
|               |  |               |           |               |   |               |  |   |          



Barter
Transaction



In fiscal year 2004, the Company recorded
a charge reducing holiday gift pack inventory to its net realizable value and exchanged $67,000 of this impaired inventory for advertising barter credits valued by the barter provider in excess of the impaired inventory value. The Company recorded
the advertising credits as a prepaid expense at the $67,000 net realizable value of the inventory exchanged. Additionally, in accordance with EITF No. 99-17, Accounting for Advertising Barter Transactions, the Company
accounted for this transaction as a sale, recording revenue and cost of sales of $67,000, leaving no net impact to income (loss). There were no barter transactions during the 2005 and 2006 fiscal years.



Shipping and Handling Costs



Shipping and handling costs are included as a component of cost of sales and
related occupancy costs. A corresponding amount is billed to the Companys wholesale customers, and is included as a component of wholesale and other revenue.



Advertising and Promotion Costs



The following table details the components of advertising and promotion costs:



|                                               |  |                    |           |               |   |               |  |   |          
|---------------------------------------------- |  | ------------------ | --------- | ------------- | - | ------------- |  | - | ---------
|                                               |  | Fiscal Years Ended
|Advertising and Promotion Costs:               |  | June 28, 2006      |           | June 29, 2005 |   | June 30, 2004
|Advertising and promotion payments             |  | $                  | 1,796,000 |               | $ | 2,165,000     |  | $ | 1,926,000
|Less franchisee ad fund contributions          |  |                    | 1,173,000 |               |   | 1,116,000     |  |   | 1,060,000
|                                               |  |                    |           |               |   |               |  |   |          
|Net advertising and promotion payments         |  | $                  | 623,000   |               | $ | 1,049,000     |  | $ | 866,000  
|                                               |  |                    |           |               |   |               |  |   |          
|Included in general and administrative expense |  | $                  | 159,000   |               | $ | 336,000       |  | $ | 140,000  
|Included in operating expenses                 |  |                    | 464,000   |               |   | 713,000       |  |   | 726,000  
|                                               |  |                    |           |               |   |               |  |   |          
|Total advertising and promotion expense        |  | $                  | 623,000   |               | $ | 1,049,000     |  | $ | 866,000  
|                                               |  |                    |           |               |   |               |  |   |          



Total advertising and
promotion costs are for all Company brands sold in company-operated and franchise units. Franchisees are required to contribute 2% of sales to an ad fund that is segregated and designated for advertising. The Company acts as an agent for the
franchisees with regard to these contributions. The Company consolidates the fund into its financial statements on a net basis, whereby contributions from franchisees, when received, are recorded as offsets to the Companys reported advertising
expenses, in accordance with SFAS No. 45,



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DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Accounting for Franchisee Fee Revenue. As discussed in this Note 1 below, in Variable Interest Entities, the Company began to
consolidate the advertising fund as of June 30, 2004, also on a net basis, as required for accounting periods ending after March 15, 2004.



The Company charges advertising costs to expense as incurred.



Store Closures



Effective January 1, 2003, the Company adopted SFAS No. 146, Accounting for Costs Associated with Exit or Disposal
Activities, and now records these estimated costs when they are incurred rather than at the date of a commitment to an exit or disposal plan. Such costs primarily consist of the estimated cost to terminate real estate leases.



|                                    |  |                   |         |                            |   |             |  |   |               |   |  |                |         |   |  |   |        
|----------------------------------- |  | ----------------- | ------- | -------------------------- | - | ----------- |  | - | ------------- | - |  | -------------- | ------- | - |  | - | -------
|                                    |  | Beginning Balance |         | Amounts Charged to Expense |   | Adjustments |  |   | Cash Payments |   |  | Ending Balance
|Accrued provision for store closure |  |                   |         |                            |   |             |  |   |               |   |  |                |         |   |  |   |        
|Year ended June 29, 2005            |  | $                 | 109,000 |                            | $ |            |  | $ |              |   |  | $              | (18,000 | ) |  | $ | 91,000 
|Year ended June 28, 2006            |  | $                 | 91,000  |                            | $ | 401,000     |  | $ | (75,000       | ) |  | $              | (16,000 | ) |  | $ | 401,000



Amounts charged to
expense for the years ended June 29, 2005 and June 28, 2006 were $0 and $401,000, respectively.



Variable Interest Entities



On June 30, 2004 the Company adopted FASB Interpretation No. 46 (revised), Consolidation of Variable Interest Entitiesan
interpretation of Accounting Research Bulletin (ARB) No. 51 (FIN 46R) which addresses the consolidation of entities in which a reporting enterprise has an economic interest but for which the traditional voting
interest approach to consolidation, based on voting rights, is ineffective in identifying where control of the entity lies, or in which the equity investors do not bear the economic risks and rewards of the entity. FIN 46R refers to those entities
as variable interest entities (VIEs). FIN 46R requires the consolidation of VIEs by the primary beneficiary that absorbs a majority of the economic risks and rewards from the VIEs activities.



The Company acquired its franchise operations in 1999. At June 28, 2006,
there were 148 domestic franchise units, all of which are owned by franchisees. The Company, as the franchisor, receives royalty fees on franchise sales, but has no equity interest and does not share in profits or losses of the franchise operation.
The franchisees make the key decisions that impact the success of their operations. The Companys rights are protective in nature and are designed to preserve the value of the brand that it licenses to the franchisee through the franchise
agreement. Of the 148 domestic franchise locations, the Company provides subordinated financial support to the extent that it is the primary lessee on 86 of the coffeehouse leases and subleases the premises to the franchisees on a pass-through basis
on the same terms as the primary lease. The franchisees generally pay rent directly to the primary lease landlord.



The Company calculated the present value of the subordinated financial support provided to each of the franchisees by the lease arrangements and compared
it to the overall subordinated financing support as defined by FIN 46R and determined that for all but six stores the Company was providing less than 50% of the franchisees total subordinated financial support. For the remaining four stores a
further quantitative test of the franchisees equity indicated that it was well above the 10% minimum and that the franchisee would not be considered a VIE. The remaining two stores may be considered a VIE, however, the consolidation of this
franchisee would be immaterial.



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DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



The Company believes its risk of loss is not significant. As a condition to acquire a franchise, the
prospective franchisee is required to have a personal net worth of at least $350,000, an amount believed to be sufficient to absorb possible franchise losses. Each franchisee is personally liable, either through direct ownership of the franchise or
by a personal guarantee if the franchise is operated as a company. The Company looks to the franchisees personal assets to satisfy the franchises obligations, including the lease on which the Company is the primary lessee. This
arrangement has historically insulated the Company from loss. In the rare situation where the franchisees personal assets have been insufficient to meet the obligations of the franchise, the Company has been able to accomplish an early
termination of the lease at a substantial discount to the present value of the rentals for the remaining primary lease term.



The Companys franchise agreements require that the franchisees pay an advertising fund contribution of 2% of franchise sales. These funds are
maintained in a segregated fund and used to pay for franchise brand marketing. All contributions are used solely for brand advertising and none are revenue or income to the Company. The fund is administered by an employee of the Company and is
subject to audit by a franchisee committee. In the event that the advertising fund in not sufficient to pay all outstanding invoices, the Company could be contingently liable for their payment. Accordingly, the Company determined that consolidation
of the fund is appropriate under FIN 46R and adopted it in the quarter ended June 30, 2004. The Company included $217,000 and $218,000 of advertising fund assets, restricted, and advertising fund liabilities in the consolidated balance sheet as
of June 28, 2006 and June 29, 2005, respectively. Advertising fund assets are primarily cash, which is segregated and restricted to use for franchise brand advertising. Advertising fund liabilities consist mainly of accounts payable,
accrued expenses and deferred obligations. As noted in Advertising and Promotion Costs above, the advertising contributions and disbursements are reported in the consolidated statement of operations on a net basis whereby
contributions are recorded as offsets to the Companys reported operating and general and administrative expenses.



Cash Surrender Value of Life Insurance



The change in the cash surrender value (CSV) of company owned life insurance (COLI) contracts, net of insurance premiums paid and
gains realized, is reported in compensation and benefits expense. See Note 15.



Use of Estimates



The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could materially differ from those estimates.



Recent Accounting Pronouncements



In July 2006, the FASB issued Interpretation No. 48 (FIN
48), Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109 (FIN 48) which seeks to reduce the diversity in practice associated with the accounting and reporting for
uncertainty in income tax positions. This Interpretation prescribes a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax
returns. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company will adopt the new requirements in its fiscal first quarter of 2008. The cumulative effects, if any, of adopting FIN 48 will be recorded as an
adjustment to retained earnings as of the beginning of the period of adoption. The Company has not yet determined the impact, if any, of adopting FIN 48 on its consolidated financial statements.



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DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



On October 6, 2005, FASB released FASB Staff Position (FSP) FAS 13-1, Accounting
for Rental Costs Incurred during a Construction Period.This FSP affects companies that are engaged in construction activities on buildings or grounds, which are accounted for as operating leases. The FSP requires companies to expense rental
costs associated with these leases starting on the date that the tenant is given control of the premises. As a result, companies must cease capitalizing rental costs during construction periods. The FSP is effective for the first reporting period
beginning after December 15, 2005, which is the fourth quarter of fiscal 2006 for the Company. Retrospective application is permitted but not required. Our adoption of this FSP in the fourth quarter of fiscal 2006 did not have a material impact
on our financial position, results of operations or cash flows.



Reclassifications



Certain
reclassifications have been made to prior periods to conform to the 2006 presentation.



2.    Liquidity and Management Plans



In recent years, the Company has experienced recurring operating losses and negative cash flows from operations. The Company has taken steps to reduce future losses and with positive revenue trends, the cost control
measures initiated by the Company should result in improved financial performance in the near term. The Company has announced its plans to strengthen its two core business segments by focusing the resources dedicated to its expanding wholesale
business and by narrowing its retail focus to its franchise stores without significant capital investment. The Company also announced that it would exit its company operated Diedrich and Coffee People retail locations through the previously
disclosed transaction with Starbucks Corporation (see Note 16).



While Company management fully expects that the transaction with Starbucks Corporation will be completed, there are no absolute assurances that this will occur. In the unlikely event that the transaction is not fully completed, the
anticipated improvement in the Companys cash flow and financial condition would reflect only the cost control measures initiated by the Company and any portion of the transaction that is completed.



Based on the terms of the Companys credit agreements, as amended (see
Note 7), managements expectations that the transaction to exit the Company operated Diedrich and Coffee People retail locations will be completed, the focus on growing the wholesale and franchise business segments, the status of the
Companys balance sheet and the overall business outlook for the Company and the specialty coffee market, management believes that cash from ongoing operations, the anticipated proceeds from the sale transaction and funds available to the
Company from its current credit agreements will be sufficient to satisfy the working capital needs of the Company at the anticipated operating levels for at least the next twelve months.



3.    Inventories



Inventories consist of the following:



|                                  |  |               |           |               |   |          
|--------------------------------- |  | ------------- | --------- | ------------- | - | ---------
|                                  |  | June 28, 2006 |           | June 29, 2005
|Unroasted coffee                  |  | $             | 1,522,000 |               | $ | 1,481,000
|Roasted coffee                    |  |               | 791,000   |               |   | 643,000  
|Accessory and specialty items     |  |               | 136,000   |               |   | 225,000  
|Other food, beverage and supplies |  |               | 1,397,000 |               |   | 1,077,000
|                                  |  |               |           |               |   |          
|                                  |  | $             | 3,846,000 |               | $ | 3,426,000
|                                  |  |               |           |               |   |          



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DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



4.    Notes Receivable



Notes receivable consist of the following:



|                                                                                                                                                                                                                                                                                                |  |               |            |   |               |   |            |  
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------- | ---------- | - | ------------- | - | ---------- | -
|                                                                                                                                                                                                                                                                                                |  | June 28, 2006 |            |   | June 29, 2005 |  
|Notes receivable bearing interest at rates from 0% to 9.5%, payable in monthly installments varying between $115 and $4,268 and due between January, 2006 and October 1, 2016. Notes are
secured by the assets sold under the asset purchase and sale agreements or general security agreement. |  | $             | 206,000    |   |               | $ | 181,000    |  
|Notes receivable from a corporation discounted at an annual rate of 8.0%, payable annually in installments varying between $1,000,000 and $2,000,000, due between January 31, 2007 and
January 31, 2011.                                                                                        |  |               | 4,903,000  |   |               |   | 5,538,000  |  
|Less: current portion of notes receivable                                                                                                                                                                                                                                                       |  |               | (1,137,000 | ) |               |   | (1,165,000 | )
|                                                                                                                                                                                                                                                                                                |  |               |            |   |               |   |            |  
|Long-term portion of notes receivable                                                                                                                                                                                                                                                           |  | $             | 3,972,000  |   |               | $ | 4,554,000  |  
|                                                                                                                                                                                                                                                                                                |  |               |            |   |               |   |            |  



5.    Property
and Equipment



Property and equipment is summarized as
follows:



|                                          |  |               |             |   |               |   |             |  
|----------------------------------------- |  | ------------- | ----------- | - | ------------- | - | ----------- | -
|                                          |  | June 28, 2006 |             |   | June 29, 2005 |  
|Buildings                                 |  | $             | 365,000     |   |               | $ | 365,000     |  
|Leasehold improvements                    |  |               | 9,195,000   |   |               |   | 7,870,000   |  
|Equipment                                 |  |               | 15,567,000  |   |               |   | 14,621,000  |  
|Furniture and fixtures                    |  |               | 2,330,000   |   |               |   | 1,871,000   |  
|Construction in progress                  |  |               | 224,000     |   |               |   | 604,000     |  
|                                          |  |               |             |   |               |   |             |  
|                                          |  |               | 27,681,000  |   |               |   | 25,331,000  |  
|Accumulated depreciation and amortization |  |               | (18,593,000 | ) |               |   | (17,357,000 | )
|                                          |  |               |             |   |               |   |             |  
|                                          |  | $             | 9,088,000   |   |               | $ | 7,974,000   |  
|                                          |  |               |             |   |               |   |             |  



Property held under
capitalized leases in the amount of $958,000 at June 28, 2006 and June 29, 2005, is included in equipment. Accumulated amortization of such equipment amounted to $680,000 and $653,000 at June 28, 2006 and June 29, 2005,
respectively.



6.    Intangible Assets



On February 1, 2005 the Company purchased a retail location from one
of its franchisees which resulted in goodwill of $80,000.



The
Company did not incur any goodwill impairment adjustments during fiscal years 2006, 2005 and 2004. It is possible that the assumptions used by management related to the evaluation of the Companys goodwill may change or that actual results may
vary significantly from managements estimates. As a result, additional impairment charges may occur.



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DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Goodwill by segment was as follows:



|                     |  |               |           |               |   |          
|-------------------- |  | ------------- | --------- | ------------- | - | ---------
|                     |  | June 28, 2006 |           | June 29, 2005
|Retail Operations    |  | $             | 1,347,000 |               | $ | 1,347,000
|Wholesale Operations |  |               | 6,311,000 |               |   | 6,311,000
|Franchise Operations |  |               | 521,000   |               |   | 521,000  
|                     |  |               |           |               |   |          
|Goodwill             |  | $             | 8,179,000 |               | $ | 8,179,000
|                     |  |               |           |               |   |          



7.     Debt



On May 10, 2004 the Company entered into a $5,000,000
Contingent Convertible Note Purchase Agreement. The agreement provides for the Company to, at its election, issue notes with up to an aggregate principal amount of $5,000,000. The notes are to be amortized on a monthly basis at a rate that will
repay 60% of the principal amount of the note by June 30, 2008. The remaining 40% will mature on that date. Interest is payable at three-month LIBOR plus 5.30%, and a facility fee of 1.00% annually is payable on the unused portion of the
facility. The agreement contains covenants that limit the amount of indebtedness that the Company may have outstanding in relation to its tangible net worth. As of June 28, 2006, the Company was in compliance with all the covenants in the
agreement. Notes are convertible into common stock only upon certain changes of control. For notes issued and repaid, warrants to purchase shares are to be issued with the same rights and restrictions for exercise as existed for convertibility of
the notes at the time of their issuance. Warrants are exercisable only in the event of a change of control and expire on June 30, 2010. The fair value of warrants issued with respect to notes repaid will be recorded as a discount to debt, at
the date of issuance, which will then be amortized using the effective interest method. Warrants to purchase common stock of the Company will be issued only upon a change in control of the Company. The lender under this agreement is a limited
partnership of which the chairman of the Companys board of directors serves as the sole general partner. On May 10, 2004, upon entering into the agreement, the Company immediately issued a $1,000,000 note under the facility, and used the
proceeds of the note and other available cash to repay all outstanding debt with Bank of the West. On September 15, 2004, the Company issued a second note for $1,000,000 under this facility. Both the notes were fully repaid in fiscal year 2005,
and thus a total of 455,184 warrants are issuable upon a change in control. The Company has issued 4,219 warrants as of June 28, 2006. As of June 28, 2006, the Company had no borrowings outstanding under the facility and the full amounts
are available for borrowing at that date.



On June 30,
2004, the Company entered into Amendment No. 1 to Contingent Convertible Note Purchase Agreement (Amendment No. 1) which revised the definition of Availability to mean, on any date, the loan amount less the sum of
the principal amounts then outstanding under the Note Purchase Agreement. Under the original Note Purchase Agreement, availability was calculated using a formula that reduced availability over time.



On November 4, 2005, the Company entered into a new Credit Agreement
with Bank of the West. The agreement provides for a $750,000 letter of credit facility that expires on October 15, 2006. The letter of credit facility is secured by a deposit account at Bank of the West. As of June 28, 2006, this deposit
account had a balance of $583,000, which is shown as restricted cash on the consolidated balance sheets. As of June 28, 2006, $651,000 of letters of credit was outstanding under the letter of credit facility. The agreement contains covenants
that, among other matters, require the Company to submit financial statements to the bank within specified time periods. As of June 28, 2006, the Company was in compliance with all Bank of the West agreement covenants.



On March 31, 2006, the Company entered into Amendment No. 2 to
Contingent Convertible Note Purchase Agreement (Amendment No. 2). Amendment No. 2: (i) contains a waiver with respect to the default of the Minimum EBITDA Covenant as of March 8, 2006 and removes the Minimum EBITDA
from the Note Purchase



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DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Agreement; (ii) clarifies that warrants to purchase common stock of the Company will be issued with respect to repaid principal amounts only upon a
change in control of the Company; (iii) increases the interest rate applicable to outstanding amounts under the credit facility by 2%, to LIBOR plus 5.30%; and (iv) extended the exercise date of all warrants issued or to be issued under
the Note Purchase Agreement by one year, to May 10, 2009, which was subsequently extended as discussed below. The maturity date for any notes issued in the future was unaffected by Amendment No. 2. The Company is in compliance with all
agreement covenants as amended by Amendment No 2.



On September
22, 2006, the Company entered into Amendment No. 3 to Contingent Convertible Note Purchase Agreement (Amendment No. 3). Amendment No. 3 (i) changes the date specified in the definition of Maturity Date from May 10, 2007 to
June 30, 2008; (ii) adjusts the calculation of monthly payments to reflect the extended maturity date; (iii) removes a condition precedent to each loan that previously required there to be no material adverse effect or event reasonably likely to
result in a material adverse effect before the obligation of the lender to purchase any note arose; (iv) amends the events of default so that an event that has, or is reasonably likely to have, a material adverse effect will not be considered such
an event of default; (v) amends the notice requirements so that the Company is not required to give notice to the lender of any event that is reasonably likely to have a material adverse effect; and (vi) extends the exercise date of all warrants
issued or to be issued under the Note Purchase Agreement to June 30, 2010.



8.    Commitments and Contingencies



Lease Commitments



As of June 28,
2006, the Company leases warehouse and office space in Irvine, California, and Castroville, California, as well as 52 retail locations. The leases expire at various dates through November 2017. The leases for four of the coffeehouse locations are
guaranteed by an officer or director of the Company. Certain of the coffeehouse leases require the payment of property taxes, normal maintenance and insurance on the properties and additional rents based on percentages of sales in excess of various
specified retail sales levels. Contingent rent expense was insignificant for all periods presented.



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DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Future minimum lease payments under non-cancelable operating leases, franchise-system operating
leases and capital leases, and minimum future sublease rentals expected to be received as of June 28, 2006, are as follows:



|                                                                 |  |                |          |   |                                     |   |                                                 |  |                                                       |            |                               |   |            |  |   |          
|---------------------------------------------------------------- |  | -------------- | -------- | - | ----------------------------------- | - | ----------------------------------------------- |  | ----------------------------------------------------- | ---------- | ----------------------------- | - | ---------- |  | - | ---------
|Year Ending June                                                 |  | Capital Leases |          |   | Non-Cancelable Operating Leases (D)
|                                                                 |  |                |          |   | Total                               |   | Company operated retail locations and other (A) |  | Gloria Jeans Franchise operated retail locations (B) |            | Other subleased locations (C)
|2007                                                             |  | $              | 44,000   |   |                                     | $ | 8,315,000                                       |  | $                                                     | 3,659,000  |                               | $ | 4,203,000  |  | $ | 453,000  
|2008                                                             |  |                | 44,000   |   |                                     |   | 7,189,000                                       |  |                                                       | 3,486,000  |                               |   | 3,373,000  |  |   | 330,000  
|2009                                                             |  |                | 44,000   |   |                                     |   | 6,269,000                                       |  |                                                       | 3,351,000  |                               |   | 2,664,000  |  |   | 254,000  
|2010                                                             |  |                | 44,000   |   |                                     |   | 5,546,000                                       |  |                                                       | 3,085,000  |                               |   | 2,312,000  |  |   | 149,000  
|2011                                                             |  |                | 44,000   |   |                                     |   | 4,629,000                                       |  |                                                       | 2,566,000  |                               |   | 1,938,000  |  |   | 125,000  
|Thereafter                                                       |  |                | 285,000  |   |                                     |   | 15,685,000                                      |  |                                                       | 9,708,000  |                               |   | 5,678,000  |  |   | 299,000  
|                                                                 |  |                |          |   |                                     |   |                                                 |  |                                                       |            |                               |   |            |  |   |          
|                                                                 |  |                | 505,000  |   |                                     | $ | 47,633,000                                      |  | $                                                     | 25,855,000 |                               | $ | 20,168,000 |  | $ | 1,610,000
|                                                                 |  |                |          |   |                                     |   |                                                 |  |                                                       |            |                               |   |            |  |   |          
|Less: amount representing interest (8% to 15%)                   |  |                | (177,000 | ) |                                     |   |                                                 |  |                                                       |            |                               |   |            |  |   |          
|                                                                 |  |                |          |   |                                     |   |                                                 |  |                                                       |            |                               |   |            |  |   |          
|Present value of minimum lease payments                          |  |                | 328,000  |   |                                     |   |                                                 |  |                                                       |            |                               |   |            |  |   |          
|Less current installments                                        |  |                | (19,000  | ) |                                     |   |                                                 |  |                                                       |            |                               |   |            |  |   |          
|                                                                 |  |                |          |   |                                     |   |                                                 |  |                                                       |            |                               |   |            |  |   |          
|Obligations under capital leases, excluding current installments |  | $              | 309,000  |   |                                     |   |                                                 |  |                                                       |            |                               |   |            |  |   |          
|                                                                 |  |                |          |   |                                     |   |                                                 |  |                                                       |            |                               |   |            |  |   |          



| | (A) | Includes Irvine and Castroville office and warehouse space and company operated retail locations.
| | --- | -------------------------------------------------------------------------------------------------



| | (B) | The Company is liable on the master leases for 79 Gloria Jeans franchise locations. Under the Companys historical franchising business model, the Company executed the
master leases for these locations, and entered into subleases on the same terms with its franchisees, which typically pay their rent directly to the landlords. Should any of these franchisees default on their subleases, the Company would be
responsible for making payments under the master lease. The Companys maximum theoretical future exposure at June 28, 2006, computed as the sum of all remaining lease payments through the expiration dates of the respective leases, was
$20,168,000. This amount does not take into consideration any mitigating measures that the Company could take to reduce this exposure in the event of default, including re-leasing the locations or terminating the master lease by negotiating a lump
sum payment to the landlord less than the sum of all remaining future rents and other amounts payable.
| | --- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (C) | The Company has leased and subleased land and buildings to others including Diedrich franchisees. Many of these leases provide for fixed payments with contingent rents when sales
exceed certain levels, while others provide for monthly rentals based on a percentage of sales. The Company directly pays the rents on these master leases, and collects associated rent amounts directly from its sublessees.
| | --- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (D) | Some leases provide for CPI increases in renewals.
| | --- | --------------------------------------------------



Rent expense under operating leases approximated $5,245,000, $4,537,000, and $4,238,000 for the years ended June 28, 2006, June 29, 2005,
and June 30, 2004, respectively.



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##### Table of Contents

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Purchase Commitments



At June 28, 2006, the Company had commitments to purchase coffee through fiscal year 2007, totaling $1,874,000 for
1,215,000 pounds of green coffee, the majority of which were fixed as to price. Such contracts are generally short-term in nature, and the Company believes that their cost approximates fair market value.



Capital Commitments



At June 28, 2006, the Company had capital commitments of $2,018,000
comprised of $1,177,000 for opening new stores and $841,000 for remodels, equipment and software upgrades.



Guarantees and Indemnifications



The Company guarantees the performance of its subsidiary franchisor obligations and also indemnifies franchisees for costs incurred in defending the
Companys trademarks and tradenames.



Contingencies



In the ordinary course of its business, the Company
may become involved in legal proceedings from time to time. The Company is not aware of any pending legal proceedings which in the opinion of management, based in part on advice from legal counsel, would significantly adversely affect the
Companys consolidated financial position or results of operations.



9.    Stockholders Equity



Stock Options



On October 20, 2000,
the Companys board of directors authorized the adoption of the Diedrich Coffee, Inc. 2000 Equity Incentive Plan (the 2000 Equity Incentive Plan) and the concurrent discontinuation of the option grants under the Diedrich Coffee,
Inc. Amended and Restated 1996 Stock Incentive Plan and the Diedrich Coffee, Inc. 1996 Non-Employee Directors Stock Option Plan. The Companys stockholders approved the 2000 Equity Incentive Plan on October 16, 2000. A total of 1,087,500
shares of the Companys common stock may be issued under the 2000 Equity Incentive Plan, as amended. The board of directors determines the number of shares, terms and exercise periods for awards under the 2000 Equity Incentive Plan on a case by
case basis, except for automatic annual grants of options to non-employee directors. Options generally vest ratably over three years and expire ten years from the date of grant. The exercise price of options is generally equivalent to the fair
market value of the Companys common stock on the date of grant.



During fiscal 2004, the Company issued Marty Lynch, the Companys former CFO, and Sean McCarthy, the CFO (held the position as Vice President Controller in 2004), 150,000 and 20,000, respectively, options to purchase shares of the
Companys common stock at a per share price of $3.38 and $3.69, respectively, which were below market value. The options were granted under the 2000 Equity Incentive Plan previously approved by stockholders. The Company recognized $22,000 in
compensation expense related to these options in accordance with the provisions of APB 25.



During fiscal 2005, the Company issued Paul Heeschen, Lawrence Goelman, Peter Churm, Richard Spencer and Randy Powell, as members of the Companys Board of Directors, 15,000 options each to purchase shares of the
Companys common stock at a per share price of $4.65, which was below market value. The options were granted under the 2000 Equity Incentive Plan previously approved by stockholders. In 2005, the Company recognized $47,000 in compensation
expense related to these options in accordance with the provisions of APB 25.



F-22



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##### Table of Contents

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Information regarding the Companys stock options is summarized below:



|                                                               |  |         |          |   |                                 |   |      
|-------------------------------------------------------------- |  | ------- | -------- | - | ------------------------------- | - | -----
|                                                               |  | Options |          |   | Weighted Average Exercise Price
|Number of options authorized for future grant at June 28, 2006 |  |         | 361,084  |   |                                 |   |      
|                                                               |  |         |          |   |                                 |   |      
|Outstanding at July 2, 2003                                    |  |         | 748,867  |   |                                 | $ | 5.85 
|Granted                                                        |  |         | 245,000  |   |                                 | $ | 3.52 
|Exercised                                                      |  |         |         |   |                                 |   |     
|Forfeited                                                      |  |         | (24,625  | ) |                                 | $ | 5.13 
|                                                               |  |         |          |   |                                 |   |      
|Outstanding at June 30, 2004                                   |  |         | 969,242  |   |                                 | $ | 5.27 
|Granted                                                        |  |         | 102,500  |   |                                 | $ | 4.63 
|Exercised                                                      |  |         | (111,666 | ) |                                 | $ | 3.29 
|Forfeited                                                      |  |         | (22,459  | ) |                                 | $ | 12.32
|                                                               |  |         |          |   |                                 |   |      
|Outstanding at June 29, 2005                                   |  |         | 937,617  |   |                                 | $ | 5.27 
|                                                               |  |         |          |   |                                 |   |      
|Granted                                                        |  |         | 150,000  |   |                                 | $ | 4.82 
|Exercised                                                      |  |         | (35,000  | ) |                                 | $ | 3.93 
|Forfeited                                                      |  |         | (111,284 | ) |                                 | $ | 7.87 
|                                                               |  |         |          |   |                                 |   |      
|Outstanding at June 28, 2006                                   |  |         | 941,333  |   |                                 | $ | 4.94 
|                                                               |  |         |          |   |                                 |   |      
|Weighted-average fair value of options granted:                |  |         |          |   |                                 |   |      
|Year ended June 30, 2004                                       |  | $       | 3.05     |   |                                 |   |      
|Year ended June 29, 2005                                       |  | $       | 4.76     |   |                                 |   |      
|Year ended June 28, 2006                                       |  | $       | 2.39     |   |                                 |   |      
|Options exercisable:                                           |  |         |          |   |                                 |   |      
|At June 30, 2004                                               |  |         | 521,239  |   |                                 |   |      
|At June 29, 2005                                               |  |         | 654,448  |   |                                 |   |      
|At June 28, 2006                                               |  |         | 786,332  |   |                                 |   |      



The following table
summarizes information about stock options outstanding at June 28, 2006:



|                        |  |                                     |  |                                         |  |                                 |       |                                         |         |                                 |   |      
|----------------------- |  | ----------------------------------- |  | --------------------------------------- |  | ------------------------------- | ----- | --------------------------------------- | ------- | ------------------------------- | - | -----
|                        |  | Options Outstanding                 |  | Options Exercisable                    
|Range of Exercise
Price |  | Number Outstanding At June 28, 2006 |  | Weighted Average Remaining Life (Years) |  | Weighted Average Exercise Price |       | Number Exercisable At June 28, 2006 (1) |         | Weighted Average Exercise Price
|$ 2.16 - $ 3.38         |  | 177,500                             |  | 6.92                                    |  | $                               | 3.27  |                                         | 177,500 |                                 | $ | 3.27 
|$ 3.44 - $ 3.44         |  | 200,000                             |  | 6.82                                    |  |                                 | 3.44  |                                         | 200,000 |                                 |   | 3.44 
|$ 3.69 - $ 3.97         |  | 227,833                             |  | 6.13                                    |  |                                 | 3.81  |                                         | 221,166 |                                 |   | 3.82 
|$ 4.14 - $ 4.65         |  | 227,500                             |  | 8.92                                    |  |                                 | 4.50  |                                         | 94,166  |                                 |   | 4.52 
|$ 5.00 - $ 41.00        |  | 108,500                             |  | 3.73                                    |  |                                 | 13.71 |                                         | 93,500  |                                 |   | 14.88
|                        |  |                                     |  |                                         |  |                                 |       |                                         |         |                                 |   |      
|                        |  | 941,333                             |  | 6.83                                    |  |                                 | 4.94  |                                         | 786,332 |                                 |   | 5.00 
|                        |  |                                     |  |                                         |  |                                 |       |                                         |         |                                 |   |      



---

|(1) | The weighted average remaining life for the options exercisable at June 28, 2006 was 6.3 years at June 28, 2006.
|--- | ----------------------------------------------------------------------------------------------------------------



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##### Table of Contents

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Stock option-based compensation expense included in the statement of operations for the fiscal year
ended June 28, 2006 was approximately $403,000. As of June 28, 2006, there was approximately $234,000 of total unrecognized stock option-based compensation cost related to options granted under our plans that will be recognized over a
weighted average period of 1.9 years. The total intrinsic value of options exercised during the year ended June 28, 2006 was approximately $100,000.



A summary of option activity under our stock option plans for the year ended June 28, 2006 is as follows:



|                                  |  |          |   |  |                                         
|--------------------------------- |  | -------- | - |  | ----------------------------------------
|Unvested Options                  |  | Options  |   |  | Weighted-AverageGrant-Date FairValue ($)
|Unvested options at June 29, 2005 |  | 283,000  |   |  | 3.92                                    
|Granted                           |  | 135,000  |   |  | 4.82                                    
|Vested                            |  | (240,000 | ) |  | 3.90                                    
|Forfeited                         |  | (23,000  | ) |  | 4.48                                    
|Unvested options at June 28, 2006 |  | 155,000  |   |  | 4.64                                    



The total fair value
of vested options during the year ended June 28, 2006 was $937,000.



Stock Purchase Warrants



On May 8, 2001, in connection with the sale of 2,000,000 shares of Company common stock, the Company issued warrants to Sequoia Enterprises, L.P., of which the Companys chairman, Paul C. Heeschen, is the general partner, to
purchase 250,000 shares of the Companys common stock at a price of $4.80 per share. Other investors also received warrants to purchase an additional 250,000 shares at a price of $4.80 per share. The warrants were exercisable immediately upon
issuance and expire on May 8, 2011. At June 28, 2006, all 500,000 warrants were outstanding.



The terms of the Contingent Convertible Note Purchase Agreement (see Note 7) provide that upon a change of control, outstanding Notes are convertible into
shares of the Companys common stock at a price that is equal to the greater of the price of the stock on the date that Note is issued or 85% of the average price paid per share of common stock by a person who engages in a transaction that
results in a change of control, as defined in the Agreement. The Notes are convertible only if and when a change of control event occurs. As Notes are paid, the Agreement provides that warrants are to be issued. The warrants are exercisable on
substantially the same terms as the Notes are convertible. The warrants are also only exercisable if and when a change of control event occurs. The price of the Companys common stock on May 10, 2004, the date that the first $1,000,000
Note was issued, was $3.95 per share. The price of the Companys common stock on September 15, 2004, the date that the second $1,000,000 Note was issued, was $4.95 per share. Since both the Notes were fully paid off in fiscal year 2005, a
total of 455,184 warrants are issuable. The Company has issued 4,219 warrants at June 28, 2006.



On March 31, 2006, the Company entered into Amendment No. 2 to Contingent Convertible Note Purchase Agreement. Amendment No. 2 contains
among other things, clarification that warrants to purchase common stock of the Company will be issued with respect to repaid principal amounts only upon a change in control of the Company. This amendment also extended the exercise date of all
warrants issued or to be issued under the Note Purchase Agreement by one year, to May 10, 2009.



On September 22, 2006, the Company entered into Amendment No. 3 to Contingent Convertible Note Purchase Agreement. Amendment No. 3 extends the exercise
date of all warrants issued or to be issued under the Note Purchase Agreement to June 30, 2010.



F-24



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##### Table of Contents

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



10.    Income Taxes



The components of income tax benefit from continuing operations are as follows:



|          |  |                          |          |   |                          |   |            |                          |  |   |            |  
|--------- |  | ------------------------ | -------- | - | ------------------------ | - | ---------- | ------------------------ |  | - | ---------- | -
|          |  | Year Ended June 28, 2006 |          |   | Year Ended June 29, 2005 |   |            | Year Ended June 30, 2004 | 
|Current:  |  |                          |          |   |                          |   |            |                          |  |   |            |  
|Federal   |  | $                        | (552,000 | ) |                          | $ | (1,578,000 | )                        |  | $ | (1,040,000 | )
|State     |  |                          | (249,000 | ) |                          |   | (273,000   | )                        |  |   | (93,000    | )
|          |  |                          |          |   |                          |   |            |                          |  |   |            |  
|          |  |                          | (801,000 | ) |                          |   | (1,851,000 | )                        |  |   | (1,133,000 | )
|          |  |                          |          |   |                          |   |            |                          |  |   |            |  
|Deferred: |  |                          |          |   |                          |   |            |                          |  |   |            |  
|Federal   |  |                          |         |   |                          |   |           |                          |  |   |           |  
|State     |  |                          |         |   |                          |   |           |                          |  |   |           |  
|          |  |                          |          |   |                          |   |            |                          |  |   |            |  
|          |  | $                        | (801,000 | ) |                          | $ | (1,851,000 | )                        |  | $ | (1,133,000 | )
|          |  |                          |          |   |                          |   |            |                          |  |   |            |  



Deferred income taxes
reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting and income tax purposes. The significant components of deferred tax assets and liabilities are as follows:



|                                    |  |               |            |   |               |   |            |  
|----------------------------------- |  | ------------- | ---------- | - | ------------- | - | ---------- | -
|                                    |  | June 28, 2006 |            |   | June 29, 2005 |  
|Deferred tax assets:                |  |               |            |   |               |   |            |  
|Net operating loss carryforwards    |  | $             | 3,399,000  |   |               | $ | 1,229,000  |  
|Intangible assets                   |  |               | 119,000    |   |               |   | 136,000    |  
|Property and equipment              |  |               | 2,634,000  |   |               |   | 2,584,000  |  
|Accrued expenses                    |  |               | 1,019,000  |   |               |   | 883,000    |  
|Accrued provision for store closure |  |               |           |   |               |   | 35,000     |  
|Other                               |  |               | 736,000    |   |               |   | 340,000    |  
|                                    |  |               |            |   |               |   |            |  
|Total gross deferred tax assets     |  |               | 7,907,000  |   |               |   | 5,207,000  |  
|Less: valuation allowance           |  |               | (5,094,000 | ) |               |   | (2,631,000 | )
|                                    |  |               |            |   |               |   |            |  
|Deferred tax liabilities:           |  |               |            |   |               |   |            |  
|Installment gain and other          |  |               | (2,813,000 | ) |               |   | (2,576,000 | )
|                                    |  |               |            |   |               |   |            |  
|Net deferred tax assets             |  | $             |           |   |               | $ |           |  
|                                    |  |               |            |   |               |   |            |  



A reconciliation of
the statutory federal income tax rate with the Companys effective income tax provision (benefit) rate for continuing operations is as follows:



|                                           |  |                          |    |  |                          |    |  |                          |   
|------------------------------------------ |  | ------------------------ | -- |  | ------------------------ | -- |  | ------------------------ | --
|                                           |  | Year Ended June 28, 2006 |    |  | Year Ended June 29, 2005 |    |  | Year Ended June 30, 2004 |   
|Federal statutory rate                     |  | (34.0                    | )% |  | (34.0                    | )% |  | (34.0                    | )%
|State income taxes, net of Federal benefit |  | (1.9                     | )  |  | (3.6                     | )  |  | (3.0                     | ) 
|Goodwill and other non-deductible costs    |  | 0.1                      |    |  |                         |    |  | 0.7                      |   
|Net operating loss utilization             |  |                         |    |  | 29.3                     |    |  | (3.3                     | ) 
|Valuation allowance                        |  | 22.6                     |    |  | (30.1                    | )  |  |                         |   
|Other                                      |  | 3.9                      |    |  | 2.6                      |    |  | (1.2                     | ) 
|                                           |  |                          |    |  |                          |    |  |                          |   
|                                           |  | (9.3                     | )% |  | (35.8                    | )% |  | (40.8                    | )%
|                                           |  |                          |    |  |                          |    |  |                          |   



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##### Table of Contents

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Due to the uncertainty of future taxable income, deferred tax assets resulting from these net
operating losses have been fully reserved. Due to the utilization of net operating loss carryforwards in the sale of the Gloria Jeans international franchise operations and following a Section 382 analysis, as of June 28, 2006, net
operating loss carryforwards of $8,721,000 and $7,883,000 for federal and state income tax purposes, respectively are available to be utilized against future taxable income for years through fiscal 2026, subject to possible annual limitation
pertaining to change in ownership rules under the Internal Revenue Code. Due to the uncertainty of future taxable income, deferred tax assets resulting from these net operating loss carryforwards have been fully reserved are available to be utilized
against future taxable income for years through fiscal 2026, subject to possible annual limitation under the Internal Revenue Code.



In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred
tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled
reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based upon the level of historical taxable income and projections for future taxable income over the periods which the
deferred tax assets are deductible, management believes it is not more likely than not that the Company will not realize the benefits of these deductible differences, and thus has recorded a valuation allowance against the entire deferred tax asset
balance. As of June 28, 2006 and June 29, 2005, the valuation allowance was $5,094,000 and $2,631,000, respectively. The change in the valuation allowance during 2006 was an increase of $2,463,000.



11.    Impairment and Restructuring Charges



The Company recorded an asset impairment charge of $94,000 in fiscal 2004 to
reduce the carrying value associated with one of its coffeehouses. This was comprised of a charge of $90,000 to write down the carrying amount of one Company operated coffeehouse, and a charge of $4,000 to terminate a lease obligation on a subleased
location. No provision was required in fiscal 2005 and 2006.



12.    Earnings Per Share



The following table sets forth the computation of basic and diluted net income per share from continuing operations:



|                                                                |  |                         |            |   |                         |   |            |                         |  |   |            |  
|--------------------------------------------------------------- |  | ----------------------- | ---------- | - | ----------------------- | - | ---------- | ----------------------- |  | - | ---------- | -
|                                                                |  | Year EndedJune 28, 2006 |            |   | Year EndedJune 29, 2005 |   |            | Year EndedJune 30, 2004 | 
|Numerator:                                                      |  |                         |            |   |                         |   |            |                         |  |   |            |  
|Net loss from continuing operations                             |  | $                       | (7,796,000 | ) |                         | $ | (3,315,000 | )                       |  | $ | (1,647,000 | )
|                                                                |  |                         |            |   |                         |   |            |                         |  |   |            |  
|Denominator:                                                    |  |                         |            |   |                         |   |            |                         |  |   |            |  
|Basic weighted average shares outstanding                       |  |                         | 5,303,000  |   |                         |   | 5,218,000  |                         |  |   | 5,161,000  |  
|Effect of dilutive securities                                   |  |                         |           |   |                         |   |           |                         |  |   |           |  
|                                                                |  |                         |            |   |                         |   |            |                         |  |   |            |  
|Diluted adjusted weighted average shares                        |  |                         | 5,303,000  |   |                         |   | 5,218,000  |                         |  |   | 5,161,000  |  
|                                                                |  |                         |            |   |                         |   |            |                         |  |   |            |  
|Basic and diluted net loss per share from continuing operations |  | $                       | (1.47      | ) |                         | $ | (0.64      | )                       |  | $ | (0.32      | )
|                                                                |  |                         |            |   |                         |   |            |                         |  |   |            |  



F-26



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##### Table of Contents

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



For the years ended June 28, 2006, June 29, 2005 and June 30, 2004, employee
stock options of 941,000, 938,000, and 912,000, respectively, and warrants of 500,000 for each year (as described in note 9), were excluded from the computation of diluted earnings per share as their impact would have been anti-dilutive. The 451,000
stock purchase warrants outstanding in 2006 and 2005 and the 4,200 stock purchase warrants outstanding in 2004, pursuant to terms of the Convertible Note Purchase Agreement were excluded from the computation of diluted earnings per share for the
fiscal years ended June 28, 2006, June 29, 2005 and June 30, 2004 as their impact would have been anti-dilutive. The weighted average strike price of anti-dilutive securities for the years ended June 28, 2006, June 29,
2005 and June 30, 2004 was $5.00, $5.85 and $6.70, respectively.



The following table sets forth the computation of basic and diluted net income per share:



|                                                      |  |                          |            |   |                          |   |                          |  |   |          
|----------------------------------------------------- |  | ------------------------ | ---------- | - | ------------------------ | - | ------------------------ |  | - | ---------
|                                                      |  | Year Ended June 28, 2006 |            |   | Year Ended June 29, 2005 |   | Year Ended June 30, 2004
|Numerator:                                            |  |                          |            |   |                          |   |                          |  |   |          
|Net income (loss)                                     |  | $                        | (7,796,000 | ) |                          | $ | 14,623,000               |  | $ | 251,000  
|                                                      |  |                          |            |   |                          |   |                          |  |   |          
|Denominator:                                          |  |                          |            |   |                          |   |                          |  |   |          
|Basic and diluted weighted average shares outstanding |  |                          | 5,303,000  |   |                          |   | 5,218,000                |  |   | 5,161,000
|                                                      |  |                          |            |   |                          |   |                          |  |   |          
|Basic and diluted net income (loss) per share         |  | $                        | (1.47      | ) |                          | $ | 2.80                     |  | $ | 0.05     
|                                                      |  |                          |            |   |                          |   |                          |  |   |          



13.    Segment
Information



The Company has three reportable segments,
retail operations, wholesale operations and franchise operations. The Company evaluates performance of its operating segments based on income before provision for asset impairment and restructuring costs, income taxes, interest expense, depreciation
and amortization, and general and administrative expenses.



The
retail operations segment includes only company-operated retail units. Revenues are derived from sales of products and services by the units. Retail segment profit before tax is net of cost of goods sold and related occupancy costs, retail-operating
expenses and specifically identified general and administrative costs.



The wholesale operations segment sells coffee products to company stores, franchisees, and third parties. Reported revenues for the wholesale segment include sales to franchisees and third parties, but sales to company-operated retail units
are eliminated in consolidation. Wholesale segment profit before tax includes a manufacturing profit on all sales, including those to company-operated retail units, but inter-company profit in retail unit inventories is eliminated at each period
end. Wholesale segment profit before tax also is net of specifically identified selling, general and administrative expenses as well as costs of the Companys coffee roasting facility.



The franchise operations segment revenues include franchise store opening
fees, franchise renewal and various service fees, roasting fees and royalty fees. Franchise segment profit before tax is net of specifically identified operating, general and administrative expenses.



F-27



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##### Table of Contents

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Summarized financial information of continuing operations of the Companys reportable segments
is shown in the following table. The other total assets consist of corporate cash, corporate notes receivable, corporate prepaid expenses, and corporate property, plant and equipment. The other component of segment profit before tax includes
corporate general and administrative expenses, provision for asset impairment and restructuring costs, depreciation and amortization expense, and interest expense.



|                                 |  |                                       |        |   |                      |   |                      |  |       |       |  |       |         |   |  |   |        |  
|-------------------------------- |  | ------------------------------------- | ------ | - | -------------------- | - | -------------------- |  | ----- | ----- |  | ----- | ------- | - |  | - | ------ | -
|                                 |  | Retail Operations                     |        |   | Wholesale Operations |   | Franchise Operations |  | Other |       |  | Total |        
|                                 |  | (in thousands, except per share data) |       
|Year ended June 28, 2006         |  |                                       |        |   |                      |   |                      |  |       |       |  |       |         |   |  |   |        |  
|Total revenue                    |  | $                                     | 34,428 |   |                      | $ | 21,244               |  | $     | 3,775 |  | $     |        |   |  | $ | 59,447 |  
|Interest expense                 |  |                                       | 26     |   |                      |   |                     |  |       | 3     |  |       | 87      |   |  |   | 116    |  
|Depreciation and amortization    |  |                                       | 1,756  |   |                      |   | 519                  |  |       |      |  |       | 326     |   |  |   | 2,601  |  
|Segment profit (loss) before tax |  |                                       | (728   | ) |                      |   | 2,772                |  |       | 2,405 |  |       | (13,046 | ) |  |   | (8,597 | )
|Total assets as of June 28, 2006 |  | $                                     | 9,115  |   |                      | $ | 13,742               |  | $     | 1,798 |  | $     | 9,475   |   |  | $ | 34,130 |  
|Year ended June 29, 2005         |  |                                       |        |   |                      |   |                      |  |       |       |  |       |         |   |  |   |        |  
|Total revenue                    |  | $                                     | 31,890 |   |                      | $ | 16,482               |  | $     | 4,166 |  | $     |        |   |  | $ | 52,538 |  
|Interest expense                 |  |                                       | 34     |   |                      |   |                     |  |       | 21    |  |       | 168     |   |  |   | 223    |  
|Depreciation and amortization    |  |                                       | 1,505  |   |                      |   | 588                  |  |       |      |  |       | 279     |   |  |   | 2,372  |  
|Segment profit (loss) before tax |  |                                       | 375    |   |                      |   | 2,019                |  |       | 3,657 |  |       | (11,217 | ) |  |   | (5,166 | )
|Total assets as of June 29, 2005 |  | $                                     | 8,499  |   |                      | $ | 12,277               |  | $     | 2,635 |  | $     | 16,902  |   |  | $ | 40,313 |  
|Year ended June 30, 2004         |  |                                       |        |   |                      |   |                      |  |       |       |  |       |         |   |  |   |        |  
|Total revenue                    |  | $                                     | 31,617 |   |                      | $ | 14,861               |  | $     | 4,407 |  | $     |        |   |  | $ | 50,885 |  
|Interest expense                 |  |                                       | 31     |   |                      |   |                     |  |       | 38    |  |       | 279     |   |  |   | 348    |  
|Depreciation and amortization    |  |                                       | 1,366  |   |                      |   | 578                  |  |       |      |  |       | 371     |   |  |   | 2,315  |  
|Segment profit (loss) before tax |  |                                       | 935    |   |                      |   | 2,284                |  |       | 4,051 |  |       | (10,050 | ) |  |   | (2,780 | )
|Total assets as of June 30, 2004 |  | $                                     | 6,366  |   |                      | $ | 11,797               |  | $     | 4,269 |  | $     | 2,786   |   |  | $ | 25,218 |  



Intercompany sales
from wholesale operations to retail operations of $ 2,607,000 for fiscal 2004, $2,819,000 for fiscal 2005 and $3,220,000 for fiscal 2006 have been eliminated.



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DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



14.    Selected Quarterly Financial Data (Unaudited)



The quarterly results of operations for the years ended June 28, 2006
and June 29, 2005 were as follows:



|                                                      |  |                                       |        |   |                |   |        |               |  |   |                |   |  |   |        |  
|----------------------------------------------------- |  | ------------------------------------- | ------ | - | -------------- | - | ------ | ------------- |  | - | -------------- | - |  | - | ------ | -
|                                                      |  | First Quarter                         |        |   | Second Quarter |   |        | Third Quarter |  |   | Fourth Quarter |  
|                                                      |  | (in thousands, except per share data) |       
|Fiscal 2006                                           |  |                                       |        |   |                |   |        |               |  |   |                |   |  |   |        |  
|Total revenue                                         |  | $                                     | 12,180 |   |                | $ | 14,943 |               |  | $ | 14,049         |   |  | $ | 18,275 |  
|Operating loss from continuing operations             |  |                                       | (2,020 | ) |                |   | (1,464 | )             |  |   | (1,898         | ) |  |   | (3,647 | )
|Net loss                                              |  |                                       | (1,552 | ) |                |   | (1,442 | )             |  |   | (1,684         | ) |  |   | (3,118 | )
|Basic and diluted income (loss) per share             |  |                                       | (0.29  | ) |                |   | (0.27  | )             |  |   | (0.32          | ) |  |   | (0.59  | )
|Fiscal 2005                                           |  |                                       |        |   |                |   |        |               |  |   |                |   |  |   |        |  
|Total revenue                                         |  | $                                     | 11,214 |   |                | $ | 13,442 |               |  | $ | 11,624         |   |  | $ | 16,258 |  
|Operating loss from continuing operations             |  |                                       | (1,301 | ) |                |   | (265   | )             |  |   | (877           | ) |  |   | (2,779 | )
|Loss from continuing operations                       |  |                                       | (1,344 | ) |                |   | (315   | )             |  |   | (873           | ) |  |   | (2,634 | )
|Income (loss) from discontinued operations before tax |  |                                       | 883    |   |                |   | 841    |               |  |   | 19,851         |   |  |   | (180   | )
|Net income (loss)                                     |  |                                       | (468   | ) |                |   | 522    |               |  |   | 15,601         |   |  |   | (1,032 | )
|Basic and diluted income (loss) per share             |  |                                       | (0.09  | ) |                |   | 0.10   |               |  |   | 2.99           |   |  |   | (0.20  | )



Quarterly operating
results are not necessarily representative of operations for a full year for various reasons, including the seasonal nature of the Companys business, which may affect sales volume and food costs. All quarters have 12-week accounting periods,
except the fourth quarter, which has a 16-week accounting period.



On February 11, 2005, the Company completed the sale of its Gloria Jeans international franchise operations. The sale resulted in a gain on the disposal of discontinued operations of $15,795,000, net of $3,139,000 in taxes (see
Note 1). The tax expense associated with the discontinued operations differed from the statutory federal effective tax rate primarily due to changes in the valuation allowance and permanently nondeductible goodwill associated with the discontinued
operations.



15.    Employee Benefit Plans



401(k) Plan



The Company has a 401(k) Plan that covers eligible employees. The
contributions to this plan were $53,000, $55,000 and $44,000 for the fiscal years 2006, 2005 and 2004, respectively.



Deferred Compensation Plan



Effective December 15, 2005, the Company amended its non-qualified deferred compensation plan. Under the amended plan, participants may elect to
defer, on a pre-tax basis, a portion (from 0% to 100%) of their base salary, service bonus, and performance-based compensation. Any amounts deferred by a participant will be credited to the participants deferred compensation account. The plan
further provides that the Company may



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DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



make discretionary contributions to a plan participants deferred compensation account. Each plan participant will be vested in the amounts held in the
plan participants deferred compensation account as follows: (i) one hundred percent (100%) vested at all times with respect to all amounts of deferred compensation; and (ii) one hundred percent (100%) vested at all times
with respect to all employer discretionary contributions. The Company made no discretionary contributions to plan participants accounts for the year ended June 28, 2006.



The plan also provides that any amounts deferred under the plan may not be distributed to a plan participant until the
earlier of: (i) the plan participants separation from service with the Company; (ii) the Plan participants retirement from the Company; (iii) the plan participants disability; (iv) the plan participants
death; (v) the occurrence of a change in control of the Company; (vi) the occurrence of an unforeseeable emergency, as defined in the plan; or (vii) such other date as set forth in the plan participants deferral election,
including a date that occurs prior to the plan participants separation from service with the Company. Any amounts distributed to a plan participant will be paid in a form specified by the plan participant, or in the form of either a lump sum
payment in an amount equal to the plan participants deferred compensation account balance or equal annual installments of the plan participants deferred compensation account balance over a period not to exceed (i) 20 years in the
case of a distribution due to separation from service, death or disability or (ii) five years in the case of a distribution for educational expenses.



The Company has purchased a company-owned life insurance (COLI) contract insuring two of the participants in the deferred compensation plan.
The policy is held in a trust to provide additional benefit security for the deferred compensation plan. The assets in the trust are owned by the Company and are subject to claims of its creditors. The gross cash surrender value of these contracts
as of June 28, 2006 was $391,000 as shown in the accompanying consolidated balance sheets. Total life insurance policy death benefits payable were $14,864,000 at June 28, 2006. Management intends to use the future death benefits from these
insurance contracts to fund the deferred compensation arrangements; however, there may not be a direct correlation between the timing of the future cash receipts and disbursements under these arrangements.



16.    Recent Developments



On September 14, 2006, the Company and Starbucks Corporation entered
into an asset purchase agreement pursuant to which Starbucks has agreed to purchase the Companys leasehold interests in most of the 47 locations where the Company operates retail stores under the Diedrich Coffee and Coffee People brands, along
with certain related fixtures and equipment, improvements, prepaid items, and ground lease improvements, and to assume certain liabilities as set forth in the asset purchase agreement.



Pursuant to the asset purchase agreement, Starbucks will pay the Company up to $13,520,000 in cash, which includes payment
of $120,000 as consideration for the Companys agreement to a non-compete provision. The actual amount paid by Starbucks under the asset purchase agreement is dependent on which and how many of the Company Stores are ultimately transferred to
Starbucks. Ten percent of the amount paid to the Company upon transfer of the Company Stores will be deposited into an escrow fund to be held in connection with the Companys indemnification obligations. The Closing is expected to occur
approximately 90 days after the date of the asset purchase agreement, provided that certain conditions, including that a specified minimum number of Company Stores are transferred to Starbucks at Closing, are met. After the Closing, the Company and
Starbucks have agreed to use commercially reasonable efforts to transfer certain remaining Company Stores until approximately 150 days after the date of the asset purchase agreement or such other longer period as agreed to by the Company and
Starbucks.



The Company and Starbucks have made certain
customary representations, warranties and covenants in the asset purchase agreement. Specifically, they have agreed that, subject to a fiduciary-out provision and payment

of a break-up fee, the Company will not (i) take any action to solicit any proposal from, (ii) furnish any



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##### Table of Contents

DIEDRICH COFFEE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



information to, or (iii) participate in any discussions with, any entity other than Starbucks regarding any transaction involving the Company Stores.
Upon termination of the asset purchase agreement under certain circumstances, including the Companys entry into an alternative transaction involving the Company Stores, the Company shall pay Starbucks actual fees and expenses incurred in
connection with the Transaction up to a maximum amount of $500,000; provided, however, that Starbucks is entitled to a minimum of $250,000, regardless of its actual fees and expenses. The asset purchase agreement also contains customary
indemnification provisions for certain claims and provides for a basket of $100,000 and a cap of $2,000,000 for breaches of the Companys representations and warranties contained in the asset purchase agreement.



The consummation of the transaction is subject to certain customary
conditions, including: approval of the transaction by the Companys stockholders; a specified minimum number of Company Stores transferred to Starbucks at Closing; the receipt by Starbucks of permits and approvals for at least 70% of certain
Company Stores that are transferred if the Closing occurs within 90 days of the date of the asset purchase agreement; receipt of lease extensions of at least 10 years for at least 40% of certain Company Stores that are transferred; and, receipt of
consents to the assignment of the leases for each of the Company Stores that are transferred, with estoppel provisions being agreed to for at least 50% of the Company Stores that are transferred. The asset purchase agreement contains customary
termination provisions and may be terminated by either the Company or Starbucks if the Closing does not occur within 150 days from the date of the asset purchase agreement. The Company may also terminate the asset purchase agreement if the Closing
has not occurred within 90 days, provided that Starbucks has not used commercially reasonable efforts to achieve the Closing.



As part of the asset purchase agreement, the Company has agreed to a non-compete provision that for three years after the Closing restricts the
Companys ability to operate or have any interest in the ownership or operation of any entity operating any retail specialty coffee stores in any city where a Company Store is presently located. The non-compete provision applies only to stores
opened after the date of the asset purchase agreement and does not apply to (1) any retail stores operated under the Gloria Jeans brand name, (2) wholesale sales to retail businesses that are not operated by the Company,
or other non-retail businesses, or (3) the conversion of Company-operated stores existing on the date of the asset purchase agreement to franchise stores. The Company has also agreed that it will not solicit any Starbucks employee to enter the
Companys employment for three years after the Closing.



No assurances can be given that the asset purchase will be completed according to the foregoing terms, if at all.



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##### Table of Contents

DIEDRICH COFFEE, INC. AND SUBSIDIARIES



SCHEDULE II  VALUATION AND QUALIFYING ACCOUNTS



|                         |  |                                |           |                         |   |                                                |  |                      |   |  |                          |          |   |  |   |          
|------------------------ |  | ------------------------------ | --------- | ----------------------- | - | ---------------------------------------------- |  | -------------------- | - |  | ------------------------ | -------- | - |  | - | ---------
|                         |  | Balance at Beginning of Period |           | Provisions (Recoveries) |   | Additional Provisions Obtained in Acquisitions |  | Accounts Written Off |   |  | Balance at End of Period
|Allowance for Bad Debt:  |  |                                |           |                         |   |                                                |  |                      |   |  |                          |          |   |  |   |          
|Year ended June 30, 2004 |  | $                              | 1,375,000 |                         | $ | 253,000                                        |  | $                    | 0 |  | $                        | (473,000 | ) |  | $ | 1,155,000
|                         |  |                                |           |                         |   |                                                |  |                      |   |  |                          |          |   |  |   |          
|Year ended June 29, 2005 |  | $                              | 1,155,000 |                         | $ | 829,000                                        |  | $                    | 0 |  | $                        | (592,000 | ) |  | $ | 1,392,000
|                         |  |                                |           |                         |   |                                                |  |                      |   |  |                          |          |   |  |   |          
|Year ended June 28, 2006 |  | $                              | 1,392,000 |                         | $ | 589,000                                        |  | $                    | 0 |  | $                        | (118,000 | ) |  | $ | 1,863,000
|                         |  |                                |           |                         |   |                                                |  |                      |   |  |                          |          |   |  |   |          



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##### Table of Contents

DIEDRICH COFFEE, INC.



INDEX TO
EXHIBITS



|            |  |                                                                                                                                                                                                                   
|----------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                                                       
|2.1         |  | Agreement and Plan of Merger, dated March 16, 1999, among Diedrich Coffee, Inc., CP Acquisition Corp., a wholly owned subsidiary of Diedrich Coffee, Inc., and Coffee People,
Inc.(1)                             
|            | 
|3.1         |  | Restated Certificate of Incorporation of the Company, dated May 11, 2001(2)                                                                                                                                       
|            | 
|3.2         |  | Bylaws of the Company(3)                                                                                                                                                                                          
|            | 
|4.1         |  | Specimen Stock Certificate(4)                                                                                                                                                                                     
|            | 
|4.2         |  | Purchase Agreement for Series A Preferred Stock dated as of December 11, 1992 by and among Diedrich Coffee, Inc., Martin R. Diedrich, Donald M. Holly, SNV Enterprises, and D.C.H.,
LP(5)                         
|            | 
|4.3         |  | Purchase Agreement for Series B Preferred Stock dated as of June 29, 1995 by and among Diedrich Coffee, Inc., Martin R. Diedrich, Steven A. Lupinacci, Redwood Enterprises VII, LP, and
Diedrich Partners I, LP(5)
|            | 
|4.4         |  | Form of Conversion Agreement in connection with the conversion of Series A and Series B Preferred Stock into Common Stock(3)                                                                                      
|            | 
|4.5         |  | Form of Warrant, dated May 8, 2001(2)                                                                                                                                                                             
|            | 
|4.6         |  | Registration Rights Agreement, dated May 8, 2001(2)                                                                                                                                                               
|            | 
|4.7         |  | Form of Common Stock and Option Purchase Agreement with Franchise Mortgage Acceptance Company, dated as of April 3, 1998(6)                                                                                       
|            | 
|10.1        |  | Form of Indemnification Agreement(5)                                                                                                                                                                              
|            | 
|10.2        |  | Diedrich Coffee, Inc. 2000 Equity Incentive Plan(19)*                                                                                                                                                             
|            | 
|10.3        |  | Diedrich Coffee, Inc. 2000 Non-Employee Directors Stock Option Plan(8)*                                                                                                                                           
|            | 
|10.4        |  | Amended and Restated Diedrich Coffee, Inc. 1996 Stock Incentive Plan(9)*                                                                                                                                          
|            | 
|10.5        |  | Diedrich Coffee, Inc. 1996 Non-Employee Directors Stock Option Plan(10)*                                                                                                                                          
|            | 
|10.6        |  | Reserved.                                                                                                                                                                                                         
|            | 
|10.7        |  | Form of Diedrich Coffee Franchise Agreement(18)                                                                                                                                                                   
|            | 
|10.8        |  | Form of Gloria Jeans Franchise Agreement(18)                                                                                                                                                                     
|            | 
|10.9        |  | Form of Area Development Agreement(18)                                                                                                                                                                            
|            | 
|10.10       |  | Employment Agreement with Roger M. Laverty, dated April 24, 2003(13)*                                                                                                                                             
|            | 
|10.11       |  | Stock Option Plan and Agreement with Roger M. Laverty, dated April 24, 2003(13)*                                                                                                                                  



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##### Table of Contents

|      |  |                                                                                                                                                             
|----- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.12 |  | Employment Agreement with Martin A. Lynch, dated March 26, 2004(7)*                                                                                         
|      | 
|10.13 |  | Employment Agreement with Matthew McGuinness, effective March 13, 2000(16)*                                                                                 
|      | 
|10.14 |  | Employment Letter regarding the employment of Pamela Britton, dated February 6, 2001(18)*                                                                   
|      | 
|10.15 |  | Employment Letter regarding the employment of Carl Mount dated October 29, 1999(17)*                                                                        
|      | 
|10.16 |  | Separation Agreement by and between Diedrich Coffee, Inc. and Philip G. Hirsch dated January 3, 2003(13)*                                                   
|      | 
|10.17 |  | Contingent Convertible Note Purchase Agreement, dated May 10, 2004 (includes form of convertible promissory note and form of warrant)(24)                   
|      | 
|10.18 |  | Standard Industrial/Commercial Multi-Tenant Lease Agreement by and between The Westphal Family Trust and Diedrich Coffee, Inc., dated September 10, 2003(14)
|      | 
|10.19 |  | Office Space Lease Agreement by and between The Irvine Company and Diedrich Coffee, Inc., dated August 1, 2003(14)                                          
|      | 
|10.20 |  | Amendment No. 1 to Contingent Convertible Note Purchase Agreement dated June 30, 2004                                                                       
|      | 
|10.21 |  | Amendment No. 2 to Contingent Convertible Note Purchase Agreement dated March 31, 2006(22)                                                                  
|      | 
|10.22 |  | Mutual Release Agreement by and between Diedrich Coffee, Inc. and Roger M. Laverty, dated December 13, 2005(20)*                                            
|      | 
|10.23 |  | Engagement Agreement by and between Diedrich Coffee, Inc. and Stephen V. Coffey, dated December 14, 2005(20)*                                               
|      | 
|10.24 |  | Letter Agreement with Sean M. McCarthy, effective January 1, 2006(21)*                                                                                      
|      | 
|10.25 |  | Agreement of Purchase and Sale of Assets by and between Starbucks Corporation, Diedrich Coffee, Inc. and Coffee People, Inc.                                
|      | 
|10.26 |  | Form of Separation Agreement and Release with Martin Diedrich, effective October 28, 2004(23)*                                                              
|      | 
|10.27 |  | Credit Agreement with Bank of the West dated November 4, 2005(25)                                                                                           
|      | 
|10.28 |  | Amendment No. 3 to Contingent Convertible Note Purchase Agreement dated September 22, 2006                                                                  
|      | 
|21.1  |  | List of Subsidiaries(16)                                                                                                                                    
|      | 
|23.1  |  | Consent of Independent Registered Public Accounting Firm  BDO Seidman, LLP                                                                                 
|      | 
|23.2  |  | Consent of Independent Registered Public Accounting Firm  KPMG LLP                                                                                         
|      | 
|31.1  |  | Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                         
|      | 
|31.2  |  | Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                         
|      | 
|32.1  |  | Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                         
|      | 
|32.2  |  | Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                         



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##### Table of Contents

---



| | * | Management contract or compensatory plan or arrangement
| | - | -------------------------------------------------------



| | (1) | Previously filed as Appendix A to Diedrich Coffees Registration Statement on Form S-4, filed with the Securities and Exchange Commission on April 23, 1999.
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (2) | Previously filed as an exhibit to Diedrich Coffees Current Report on Form 8-K, filed with the Securities and Exchange Commission on May 16, 2001.
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------



| | (3) | Previously filed as an exhibit to Diedrich Coffees Registration Statement on Form S-1/A (Registration No. 333-08633), filed with the Securities and Exchange Commission on
August 28, 1996 and declared effective on September 11, 1996.
| | --- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (4) | Previously filed as an exhibit to Diedrich Coffees Registration Statement on Form S-3 (Registration No. 333-66744), filed with the Securities and Exchange Commission on
August 3, 2001.
| | --- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (5) | Previously filed as an exhibit to Diedrich Coffees Registration Statement on Form S-1 (Registration No. 333-08633), filed with the Securities and Exchange Commission on
July 24, 1996 and declared effective on September 11, 1996.
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (6) | Previously filed as an exhibit to Diedrich Coffees Annual Report on Form 10-K for the fiscal year ended January 28, 1998, filed with the Securities and Exchange
Commission on April 28, 1998.
| | --- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (7) | Previously filed as an exhibit to Diedrich Coffees Quarterly Report on Form 10-Q for the period ended March 10, 2004, filed with the Securities and Exchange Commission on
April 26, 2004.
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (8) | Previously filed as an exhibit to Diedrich Coffees Registration Statement on Form S-8, filed with the Securities and Exchange Commission on November 21, 2000.
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (9) | Previously filed as an exhibit to Diedrich Coffees Quarterly Report on Form 10-Q for the period ended September 22, 1999, filed with the Securities and Exchange
Commission on November 5, 1999.
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (10) | Previously filed as an exhibit to Diedrich Coffees Registration Statement on Form S-1/A (Registration No. 333-08633), filed with the Securities and Exchange Commission on
August 12, 1996 and declared effective on September 11, 1996.
| | ---- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (11) | Previously filed as an exhibit to Diedrich Coffees Annual Report on Form 10-K for the fiscal year ended July 3, 2002, filed with the Securities and Exchange Commission on
October 1, 2002.
| | ---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (12) | Previously filed as an exhibit to Diedrich Coffees Quarterly Report on Form 10-Q for the period ended December 18, 2002, filed with the Securities and Exchange Commission
on January 31, 2003.
| | ---- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (13) | Previously filed as an exhibit to Diedrich Coffees Quarterly Report on Form 10-Q for the period ended March 12, 2003, filed with the Securities and Exchange Commission on
April 28, 2003.
| | ---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (14) | Previously filed as an exhibit to Diedrich Coffees Annual Report on Form 10-K for the fiscal year ended July 2, 2003, filed with the Securities and Exchange Commission on
September 30, 2003.
| | ---- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (15) | Previously filed as an exhibit to Diedrich Coffees Annual Report on Form 10-K for the fiscal year ended June 27, 2001, filed with the Securities and Exchange Commission
on September 25, 2001.
| | ---- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

| | (16) | Previously filed as an exhibit to Diedrich Coffees Annual Report on Form 10-K for the fiscal year ended June 28, 2000, filed with the Securities and Exchange Commission
on September 27, 2000.
| | ---- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (17) | Previously filed as an exhibit to Diedrich Coffees Quarterly Report on Form 10-Q for the period ended September 20, 2000, filed with the Securities and Exchange
Commission on November 6, 2000.
| | ---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (18) | Previously filed as an exhibit to Diedrich Coffees Quarterly Report on Form 10-Q for the period ended September 24, 2003, filed with the Securities and Exchange
Commission on November 7, 2003.
| | ---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (19) | Previously filed as an exhibit to Diedrich Coffees Quarterly Report on Form 10-Q for the period ended December 17, 2003, filed with the Securities and Exchange Commission
on January 30, 2004.
| | ---- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (20) | Previously filed as an exhibit to Diedrich Coffees Current Report on Form 8-K, filed with the Securities and Exchange Commission on December 16, 2005.
| | ---- | -------------------------------------------------------------------------------------------------------------------------------------------------------



| | (21) | Previously filed as an exhibit to Diedrich Coffees Current Report on Form 8-K, filed with the Securities and Exchange Commission on January 5, 2006.
| | ---- | -----------------------------------------------------------------------------------------------------------------------------------------------------



| | (22) | Previously filed as an exhibit to Diedrich Coffees Current Report on Form 8-K, filed with the Securities and Exchange Commission on March 31, 2006.
| | ---- | ----------------------------------------------------------------------------------------------------------------------------------------------------



| | (23) | Previously filed as an exhibit to Diedrich Coffees Current Report on Form 8-K, filed with the Securities and Exchange Commission on November 3, 2004.
| | ---- | ------------------------------------------------------------------------------------------------------------------------------------------------------



| | (24) | Previously filed with this Annual Report on Form 10-K for the fiscal year ended June 30, 2004, filed with the Securities and Exchange Commission on September 28, 2004.
| | ---- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (25) | Previously filed as an exhibit to Diedrich Coffees Quarterly Report on Form 10-Q for the period ended March 8, 2006, filed with the Securities and Exchange Commission on
April 21, 2006.
| | ---- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

EXHIBIT INDEX



|            |  |                                                                                                                             
|----------- |  | ----------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                 
|10.20       |  | Amendment No. 1 to Contingent Convertible Note Purchase Agreement dated June 30, 2004                                       
|            | 
|10.25       |  | Agreement of Purchase and Sale of Assets by and between Starbucks Corporation, Diedrich Coffee, Inc. and Coffee People, Inc.
|            | 
|10.28       |  | Amendment No. 3 to Contingent Convertible Note Purchase Agreement dated September 22, 2006                                  
|            | 
|23.1        |  | Consent of Independent Registered Public Accounting Firm  BDO Seidman, LLP                                                 
|            | 
|23.2        |  | Consent of Independent Registered Public Accounting Firm  KPMG LLP                                                         
|            | 
|31.1        |  | Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                         
|            | 
|31.2        |  | Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                         
|            | 
|32.1        |  | Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                         
|            | 
|32.2        |  | Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002