**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-K**

**(Mark One):**

**x**                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe fiscal year ended January 3, 2006**

**OR**

**o**                                 TRANSITIONREPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe transition period from            to            .**

**CommissionFile Number 0-27148**

**NEW WORLD RESTAURANT GROUP, INC.**

(Exact Name of Registrantas Specified in its Charter)

| **Delaware**                                                                   | **13-3690261**                                                                                          |
|--------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
| (State or Other  Jurisdiction                                                  | (I.R.S. Employer                                                                                        |
| of Incorporation  or Organization)                                             | Identification  No.)                                                                                    |
| **1687 Cole Blvd., Golden, Colorado 80401**                                    | **(303) 568-8000**                                                                                      |
| (Address of  Principal Executive Offices) (Zip Code)                           | (Registrant’s  telephone number, including area code)                                              |
| Securities  registered pursuant to Section 12(b) of the Act:**None** | Securities  registered pursuant to Section 12(g) of the Act:**Common Stock, $.001 par value** |

 

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act. Yes o   No x

Indicateby check mark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Exchange Act. Yes o   No x

Indicateby check mark whether the registrant: (1) has filed all reports requiredto be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes o   No x

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to thebest of the registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-Kor any amendments of this Form 10-K. Yes o   No x

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the ExchangeAct.

Large accelerated filer o      Accelerated filer o      Non-accelerated filer x

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes o   No x

Theaggregate market value of the common stock held by non-affiliates of theregistrant computed by reference to the closing sale price as reported on the “pinksheets” as of June 28, 2005 was $629,312.

As ofFebruary 28, 2006, 10,065,072 shares of common stock of the registrantwere outstanding.

**DOCUMENTSINCORPORATED BY REFERENCE**

Theinformation required by Part III is incorporated herein by reference fromthe registrant’s definitive proxy statement for the 2006 annual meeting ofstockholders, which will be filed with the SEC within 120 days after theclose of the 2005 fiscal year.

 

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**NEWWORLD RESTAURANT GROUP, INC.FORM 10-KTABLE OF CONTENTS**

| **PART I**  |       |
|------------------|------------|
| ITEM 1.     |       | BUSINESS |   | 2 |   |
| ITEM  1A.        |       | RISK  FACTORS |   | 9 |   |
| ITEM 1B.         |       | UNRESOLVED STAFF COMMENTS |   | 14 |   |
| ITEM 2.     |       | PROPERTIES |   | 15 |   |
| ITEM 3.     |       | LEGAL  PROCEEDINGS |   | 17 |   |
| ITEM 4.     |       | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS |   | 18 |   |
| **PART II** |       |
| ITEM 5.     |       | MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED  STOCKHOLDER MATTERS |   | 18 |   |
| ITEM 6.     |       | SELECTED  FINANCIAL DATA |   | 19 |   |
| ITEM 7.     |       | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL  CONDITION AND RESULTS OF OPERATIONS |   | 21 |   |
| ITEM 7A.    |       | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT  MARKET RISK  |   | 36 |   |
| ITEM 8.     |       | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA |   | 37 |   |
| ITEM 9.     |       | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON  ACCOUNTING AND FINANCIAL DISCLOSURES |   | 73 |   |
| ITEM 9A.    |       | CONTROLS AND PROCEDURES |   | 73 |   |
| ITEM  9B.        |       | OTHER  INFORMATION |   | 73 |   |
| **PART III**     |       |
| ITEM 10.         | ** ** | DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT |   | 74 |   |
| ITEM 11.         | ** ** | EXECUTIVE COMPENSATION |   | 74 |   |
| ITEM 12.         | ** ** | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS  AND MANAGEMENT |   | 74 |   |
| ITEM 13.         | ** ** | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS |   | 74 |   |
| ITEM 14.         | ** ** | PRINCIPAL ACCOUNTANT FEES AND SERVICES |   | 74 |   |
| **PART IV** |       |
| ITEM 15.    |       | EXHIBITS AND FINANCIAL STATEMENT SCHEDULES |   | 75 |   |

 

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**PART I**

**ITEM 1.**                BUSINESS

***General***

New World Restaurant Group, Inc. was organized asa Delaware corporation in November 1992. We are a leader in the quickcasual segment of the restaurant industry specializing in high-quality foodsfor breakfast and lunch in a café atmosphere with a neighborhood emphasis. Weoperate and license locations primarily under the Einstein Bros. and Noah’sbrand names, and franchise locations primarily under the Manhattan Bagel brandname. We also operate a dough production facility. We view our primary businessas operating, franchising and licensing strong restaurant brands in themarketplace. Our manufacturing operations are supportive to our main businessfocus but allow us to leverage our inherent cost structure via third party businessand enhancement of our brands through new product channels.

In our early years, we operated and franchisedspecialty coffee cafés in the northeastern United States under the brand namesof New World Coffee (New World) and Willoughby’s Coffee and Tea (Willoughby’s).In addition to coffee, we also served fresh, high quality gourmet foods andpastries. Our business strategy in those years was to be a franchisor and growthrough acquisitions. With the acquisition of Manhattan Bagel Company, Inc.(Manhattan) in 1998 and Chesapeake Bagel Bakery (Chesapeake) in 1999, we becamea significant franchisor of bagel restaurants and, to a lesser extent, ofcoffee cafés.

In 2001, our strategyevolved to include company-operated restaurants as well as franchised andlicensed locations as we completed the acquisition of substantially all of theassets (the Einstein Acquisition) of Einstein/Noah Bagel Corp. (ENBC) and itsmajority-owned subsidiary, Einstein/Noah Bagel Partners, L.P., whichoperated 2 brands: Einstein Bros. Bagels (Einstein Bros.) and Noah’s New YorkBagels (Noah’s). The Einstein Acquisition in 2001 was accomplished by issuing asubstantial amount of short-term debt and mandatorily redeemable preferredequity, which have since been refinanced and restructured. In 2004, we began anevaluation of our brands and their significance and contributions to ouroverall strategic business plan. As a result of this evaluation, we sold theassets of Willoughby’s to the original founders and in 2005, we formed an exitstrategy related to the Chesapeake brand.

***Restaurant Concepts***

*Einstein Bros.Bagels and Einstein Bros. Café (Einstein Bros.)*

Einstein Bros. is a national, quick casual restaurantchain. Einstein Bros. offers a menu that specializes in high-quality foods forbreakfast and lunch, including fresh baked bagels and hot breakfast sandwiches,cream cheese and other spreads, specialty coffees and teas, creative soups,salads and sandwiches, and other unique menu offerings. The average EinsteinBros. location is approximately 2,200 square feet in size with approximately 40seats and is generally located in a neighborhood or regional shopping center.We use sophisticated fixtures and materials in the brand’s design to create arestaurant environment that is consumer friendly, inviting and reflective ofthe brand’s personality and strong neighborhood identity, and which visuallyreinforces the distinctive difference between the brand’s quick casualpositioning and that of quick service restaurants.

In addition to our core bagel offerings and expandedbreakfast menu, our Einstein Bros. Café offers a more extensive lunch menu witha culinary focus on innovative items using fresh and high quality ingredients.Menu offerings include hand crafted gourmet sandwiches, hearty soups,innovative salads, fresh baked goods, premium coffees and other café beverages.The restaurant’s layout is conducive to meetings, family meals, and groupsdining out together. During 2004, we opened our first Einstein Bros. Café. Wecurrently have eight locations operating under the Café concept in the Denverand Colorado Springs, Colorado markets. Six of the eight locations werepreviously Einstein Bros. Bagel restaurants and were converted into EinsteinBros. Cafés. Based on consumer response, we are incorporating some of the 

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proven elements from theEinstein Bros. Cafe concept into the remodeling of several Einstein Bros. Bagelrestaurants. With the resurgence in our Einstein Bros. Bagel restaurants, weare focusing our efforts to ensure that we enhance our guest’s experience,increase the speed of service, and maintain a common theme in our EinsteinBros. Bagel brand while maintaining the neighborhood feel of the restaurants.As we move forward, our growth plans are to open Einstein Bros. Bagel restaurantsthat reflect elements of our Einstein Bros. Café in-store design.

During the fiscal yearsended 2005, 2004 and 2003, Einstein Bros. company-owned restaurants generatedapproximately 82%, 82% and 81% of our retail sales, respectively.

*Noah’s*

Noah’s is a quick casualrestaurant principally located on the West Coast. Noah’s offers a menu thatspecializes in high-quality foods for breakfast and lunch, including freshbaked goods, made-to-order deli style sandwiches, including such favorites aspastrami, corned beef and roast beef on fresh breads and bagels baked onlocation daily, hearty soups, innovative salads, desserts, five fresh-brewedpremium coffees daily and other café beverages. The average Noah’s location isapproximately 1,800 square feet in size with approximately 12 seats and islocated in urban neighborhoods or regional shopping centers. We use elaboratetile work and wood accents in the brand’s design to create an environmentreminiscent of a Lower East Side New York deli, which reinforces the brand’surban focus with an emphasis on the authenticity of a New York deli experience.During the fiscal years ended 2005, 2004 and 2003, Noah’s company-ownedrestaurants generated approximately 17%, 17% and 18% of our retail sales,respectively.

*Manhattan*

Our Manhattan brandrepresents the majority of our franchise operations and is predominatelyoperated in the Northeast. The locations offer over 20 varieties of fresh bakedbagels, as well as bagel sticks and bialys and up to 15 flavors of cream cheese,a variety of breakfast and lunch sandwiches, salads, soups, coffees and cafébeverages, soft drinks and desserts. The average Manhattan location isapproximately 1,400 to 2,400 square feet with 24 to 50 seats and is primarilylocated in urban neighborhoods or regional shopping centers. Manhattanrestaurants are designed to combine the authentic atmosphere of a bagel bakerywith the comfortable setting of a neighborhood meeting place.

*Chesapeake*

Our Chesapeake brand isoperated on the Mid-Atlantic Coast. Chesapeake locations offer a menu thatspecializes in bagels and an extensive array of cream cheese flavors. Thelocations also offer breakfast and lunch sandwiches, soups, salads, coffees andcafé beverages, soft drinks and desserts.

*New World Coffee*

Our New World Coffee brandis operated in the northeastern United States. The locations offer up to 30varieties and blends of fresh roasted coffee, in brewed and whole bean format,a broad range of Italian-style beverages, along with a variety of menuitems to complement the beverage offerings.

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***Business Focus***

We have developed a focused growth strategy thatpositions us to continue to enhance our competitive position and results ofoperations over the near term. The salient features of this strategy include:

*Renewed Focus on the GuestExperience Using a Three-Pronged Approach.**  *We believe that we can expand upon our leadershipposition in the breakfast day-part by selling the finest bagels and coffee andby providing our guest a unique experience that is “anything but routine.” Ourapproach will focus on:

·       People—Establisha baseline on the level of training and service expectations. We recognize theneeds of “Generation Y” associates and we are developing programs formotivating and retaining these associates to ensure a superior guestexperience;

·       Product—Weare developing new menu items that solidify our breakfast daypart, increasespeed of service and address the “on the go” lifestyles of our guests. We willutilize our catering program to grow awareness and trial for our lunchbusiness; and

·       Place—Weare developing operational improvements to enhance the speed of service whilemaintaining our heritage of guest interaction with our associates. We plan tocontinue to refresh and/or remodel our stores to standardize our trade dresswhile maintaining our neighborhood feel.

*Significantlyupgrade our Management and Field Associate Training Programs.*   Inearly 2006, we completed Leadership summits for our Einstein Bros. and Noah’sGeneral Managers and our Manhattan Bagel Franchisees. These summits focused onthe key operational initiatives we plan to deploy in 2006 along with specifictraining on associate motivation, suggestive selling techniques, and othermethods aimed at enhancing the guest experience. We have initiated a programthat provides economic incentives for our training stores and General Managersto provide a consistent training experience for our new General Managers andAssistant Managers. Finally, we have developed training programs for our storelevel associates that ensure each associate is assigned a mentor during theirorientation period.

*LeverageCore Competencies into New Revenue Streams.*   Webelieve that we have a number of opportunities to develop multiple channelsoutside of our traditional retail locations. These alternatives can generateincremental revenues, enhance the brands’ visibility and improve customerconvenience. In particular, grocery and warehouse club channels areincreasingly seeking strong customer brands to help drive their sales ofbagels, breads and salads. We have established various supplier relationshipswith Costco Wholesale Corporation, Target Corporation and HEB, a leadingindependently owned food retailer with stores throughout Texas and Mexico.These products are sold either through a private label program or under theEinstein Bros. or Noah’s brand. We hope to attract alternative retail customersbased on Einstein Bros. substantial brand equity and superior food quality andfreshness.

*BrandGrowth through Franchising.*   Through storefranchising to qualified area developer candidates, we believe that we canincrease our geographic footprint and customer recognition while enjoying avaluable royalty stream with minimal incremental capital expenditures. In December 2005,we filed a Uniform Franchise Offering Circular (UFOC) for the Einstein Bros.brand. We intend to commence offering franchise area development agreements toqualified parties beginning in the second half of 2006. The area developmentagreements grant the right to operate an agreed-upon number of Einstein Bros.restaurants in a defined geographic region for a specified period of time.

We currently have a franchise base primarily in ourManhattan brand that generates a recurring revenue stream through royaltypayments. We look for franchisee candidates with appropriate operationalexperience and financial stability, including specific net worth and liquidityrequirements. We typically receive continuing royalties on sales from eachfranchise store location. Our Manhattan franchisees are not required to buy allof their non-proprietary products directly from us, but rather their productsources must 

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be approved by us. Webelieve that active involvement in and management of restaurant operations byfranchisees will result in a successful franchise strategy.

*Focuson Site Selection Process.**  *Weconsider our site selection process critical to our long-term success. Our siteselection process focuses on identifying markets, trade areas and specificsites based on several factors, including visibility, ready accessibility(particularly for morning and lunch time traffic), parking, signage andadaptability of any current structures. We then determine the availability ofthe site and the related costs. Our site selection strategy emphasizesco-tenant out parcel, end-cap and in-line locations in neighborhood shoppingcenters and power centers with easy access from high-traffic roads.

*Focuson Advertising Tactics.**  *Wealso consider our advertising and media strategy critical to our long-termsuccess. Our advertising and media strategy focuses on multi-dimensional mediatactics integrating print, traffic radio, broadcast, outdoor, public relationsand local store marketing to support our high revenue markets. Company operatedand franchised locations are generally required to contribute to the respectivebrand’s marketing fund, which provides the locations with marketing support,including in-store point-of-purchase and promotional materials. Print and othermass media advertising is utilized to increase consumer interest and buildsales.

*ImproveFree Cash Flow.**  *Ourfinancial focus is on long term, sustainable growth in free cash flow. Freecash flow represents net cash provided by operations less the investment in ourfacilities and fixed assets. By achieving free cash flow, we will be morecapable of paying down debt, saving cash for future use and buildingshareholder value. We also believe free cash flow may give us the ability topursue new opportunities and/or acquire other businesses. Increasing ouroperating profit and efficiently managing working capital and capitalexpenditures primarily drive free cash flow.

In measuring ouroverall growth and progress, we focus on various key performance indicators.Such key performance indicators include:

·       same-storesales growth, comprised of average check and transactions,

·       restaurantlevel and concept level margins,

·       cashgenerated from operations,

·       adjustedEBITDA (as defined in our loan agreements),

·       numberof company-owned restaurant openings and closings, and

·       numberof franchise and licensed restaurant openings and closings.

Our progress toward someof these key performance indicators is discussed throughout Item 7, Management’sDiscussion and Analysis.

***Sourcing, Manufacturing & Distribution***

We believe thatcontrolling the manufacture and distribution of our key products is animportant element in ensuring both quality and profitability. To support thisstrategy, we have developed proprietary formulations, invested in processingtechnology and manufacturing capacity, and aligned ourselves with strategic suppliers.

*Bagel Dough, CreamCheese and Coffee*

We have significant know-how and technical expertisefor manufacturing and freezing mass quantities of raw dough to produce ahigh-quality product more commonly associated with smaller bakeries. We believethis system enables locations to provide consumers with a variety ofconsistent, superior products. 

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We currently operate abagel dough manufacturing facility in Whittier, CA and have a supply contractwith Harlan Bakeries, Inc. in Avon, Indiana that produces bagel dough toour specifications.

Our cream cheese and other cheese products arepurchased exclusively from a single source. Our cream cheese is manufactured tospecification utilizing our proprietary recipes.

All of our coffee is purchased through a third partyprovider and is sold at our Einstein Bros. and Noah’s locations.

Though to date we have notexperienced significant difficulties with our suppliers, our reliance on alimited number of suppliers subjects us to a number of risks, includingpossible delays or interruption in supplies, diminished control over qualityand a potential lack of adequate raw material capacity.

*Purchasing*

Our purchasing programsprovide our company-owned restaurants and our franchised and licensed locationswith high quality ingredients at competitive prices from reliable sources.Consistent product specifications, as well as purchasing guidelines, ensurefreshness and quality. Because we utilize fresh ingredients in most of our menuofferings, inventory at our distributors and company-owned restaurants ismaintained at modest levels. We negotiate short-term and long-term priceagreements and contracts depending on supply and demand for our products andcommodity pressures. These agreements can range in duration from two months tothree years.

*Commissaries*

We believe that ourcommissary system that processes bulk raw ingredients used at our company-operatedrestaurants and licensed locations provides a competitive advantage. Ourcommissaries assure consistent quality, supply fresh products and improveefficiencies by reducing labor and inventory requirements. We focus our growthin areas that allow us to continue to gain efficiencies through leveraging thefixed cost of our current commissary structure. We distribute commissary productsprimarily through our regional distribution partners and locally in certainmarkets through a fleet of temperature-controlled trucks operated by ourpersonnel.

*Distribution*

We currently utilize a network of independentdistributors to distribute frozen dough and other materials to our locations.By contracting with distributors, we are able to eliminate investment indistribution systems and to focus our managerial and financial resources on ourretail operations. We contract for virtually all food products and supplies forour company-owned restaurant operations, including frozen dough, creamcheese, coffee, meats and paper goods and our vendors deliver the products toour distributors for delivery to each location. The individual locations orderdirectly from the distributors one to three times per week.

During late 2005, wenegotiated contract terms with a new distribution partner. We have experiencedsome transition issues at certain locations during 2006 but at this time, we donot believe this will have an adverse effect on our results of operations. Weare currently working with this distributor to resolve these issues.

***Trademarks and Service Marks***

Our rights in ourtrademarks and service marks (marks) are a significant part of our business. Weare the owners of the federal registration of the “Einstein Bros.,” “Noah’s NewYork Bagels,” “Manhattan Bagel,” “Chesapeake Bagel Bakery” and “New WorldCoffee” marks. Some of our marks are also registered in several foreigncountries. We are aware of a number of companies that use various 

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combinationsof words in our marks, some of which may have senior rights to ours for suchuse, but we do not consider any of these uses, either individually or in theaggregate, to materially impair the use of our marks. It is our policy todefend our marks and the associated value from encroachment by others. Themarks listed above represent the brands of the retail outlets that we own,license or franchise. We also own numerous other marks related to our business.

***General Economic Trends***

We anticipate that our business will be affected bygeneral economic trends that affect retailers in general. While we have notoperated during a period of high inflation, we believe based on industryexperience that we would generally be able to pass on increased costs resultingfrom inflation to our consumers. Our business may be affected by other factors,including increases in the commodity prices of flour, butter, cheese, coffee,dairy and/or fresh produce, energy costs, existing and additional competition,marketing programs, weather and variations in the number of company-owned orlicensed location openings and closings.

Although few, if any,associates are paid at the minimum wage, an increase in the minimum wage maycreate pressure to increase the pay scale for our associates, which wouldincrease our labor costs and those of our franchisees and licensees.

***Seasonality and Quarterly Results***

Our business is subject toseasonal fluctuations. Significant portions of our net revenues and profits arerealized during the fourth quarter of the fiscal year, which includes the December holidayseason. Because of the seasonality of the business and the industry, resultsfor any quarter are not necessarily indicative of the results that may be achievedfor the full fiscal year.

***Competition***

The restaurant industry is intensely competitive. Theindustry is often affected by changes in demographics, consumers’ eating habitsand preferences, local and national economic conditions affecting consumer spendinghabits, population trends and local traffic patterns.

We experience competition from numerous sources in ourtrade areas. Our restaurants compete based on customers’ needs for breakfast,lunch and afternoon “chill-out” (the period after lunch and before dinner). Ourcompetitors are different for each day-part in which we offer our products. Thecompetitive factors include brand awareness, advertising effectiveness,location and attractiveness of facilities, environment, quality and speed ofcustomer service, price, quality and value of products offered. Certain of ourcompetitors may have substantially greater financial, marketing and operatingresources. We compete in the quick casual segment of the restaurant industry,but we also consider other players in the quick service, specialty food, quickcasual dining and full service restaurants to be our competitors. Our primarycompetitors include specialty food and casual dining restaurants includingnational, regional and locally owned restaurants.

We also face competitionfrom both restaurants and other specialty retailers for suitable sites for newrestaurants and qualified personnel to operate both new and existingrestaurants. There can be no assurance that we will be able to secure or renewleases for adequate sites at acceptable rent levels or that we will be able toattract a sufficient number of qualified personnel.

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***Government Regulation***

Each of our locations is subject to licensing andregulation by a number of governmental authorities, which include health,safety, labor, sanitation, building and fire agencies in the state ormunicipality in which the restaurant is located. A failure to comply with oneor more regulations could result in the imposition of sanctions, including theclosing of locations for an indeterminate period of time or third-partylitigation. Our manufacturing, commissary and distribution facilities arelicensed and subject to regulation by either federal, state or local health andfire codes, and the operation of our trucks are subject to Department ofTransportation regulations. We are also subject to federal and stateenvironmental regulations.

Our franchise operationsare subject to Federal Trade Commission (FTC) regulation and various statelaws, which regulate the offer and sale of franchises. Several state laws alsoregulate substantive aspects of the franchisor-franchisee relationship.The FTC requires us to furnish to prospective franchisees a franchise offeringcircular containing prescribed information. Some states in which we mightconsider franchising also regulate the sale of franchises and requireregistration of the franchise offering circular with state authorities. Ourability to sell franchises in those states is dependent upon obtaining approvalof our UFOC by those authorities.

***Associates***

As of January 3,2006, we had 7,830 associates, of whom 7,538 were restaurant personnel, 76 wereplant and support services personnel, and 216 were corporate personnel. Mostrestaurant personnel work part-time and are paid on an hourly basis. We havenever experienced a work stoppage and our associates are not representedby a labor organization. We believe that we have good working relationshipswith our associates.

***Executive Officers***

Setforth below is information with respect to our executive officers:

| **Name**              | ** ** | ** ** | ** ** | **Age**                               | ** ** | **Position** |
|-----------------------|------------|------------|------------|---------------------------------------|------------|--------------|
| Paul J.B. Murphy III  |       | 51         |       | Chief Executive Officer  and Director |
| Daniel J. Dominguez   |       | 60         |       | Chief Operating Officer               |
| Richard P. Dutkiewicz |       | 50         |       | Chief Financial Officer               |
| Jill B.W. Sisson      |       | 58         |       | General Counsel and Secretary         |

 

*PaulJ.B. Murphy III*was appointed Chief Executive Officerand Acting Chairman in October 2003. He served as Acting Chairman until October 2004.Mr. Murphy joined us in December 1997 as Senior Vice President—Operationsand had served as Executive Vice President—Operations since March 1998. Mr. Murphywas appointed our Chief Operating Officer in June 2002. From July 1996until December 1997, Mr. Murphy was Chief Operating Officer of one ofour former area developers. From August 1992 until July 1996, Mr. Murphywas Director of Operations of R&A Foods, L.L.C., an area developer ofBoston Chicken. Mr. Murphy has a B.A. degree from Washington and LeeUniversity.

*DanielJ. Dominguez*was appointed Chief Operating Officer in December 2005.Mr. Dominguez joined us in November 1995 and served as Senior VicePresident of Operations for Noah’s New York Bagels since April 1998. From1995 to April 1998, Mr. Dominguez served as the Director ofOperations for Einstein Bros. Midwest. Prior to joining us, Mr. Dominguezwas Executive Vice President of JB Patt America, Beverly Hills, CA, dba Koo KooRoo Restaurants, from July 1994 to October 1995. From May 1987to July 1994, he was the Divisional Vice President of Food Services forCarter Hawley Hale in San Francisco, CA. From November 1976 to May 1987he was the Vice President of Operations for Bakers Square Restaurants in California.

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*RichardP. Dutkiewicz*joined us in October 2003 as ChiefFinancial Officer. From May 2003 to October 2003, Mr. Dutkiewiczwas Vice President—Information Technology of Sirenza Microdevices, Inc., apublicly traded telecommunications component manufacturer located inBroomfield, Colorado. In May 2003, Sirenza Microdevices, Inc.acquired Vari-L Company, Inc., a publicly traded telecommunicationscomponent manufacturer. From January 2001 to May 2003, Mr. Dutkiewiczwas Vice President—Finance, Chief Financial Officer of Vari-L Company, Inc.From April 1995 to January 2001, Mr. Dutkiewicz was VicePresident—Finance, Chief Financial Officer, Secretary and Treasurer of ColemanNatural Products, Inc., located in Denver, Colorado, a leading supplier ofbranded natural beef in the United States. Mr. Dutkiewicz’s previousexperience includes senior financial management positions at TetradCorporation, MicroLithics Corporation and various divisions of UnitedTechnologies Corporation. Mr. Dutkiewicz was an Audit Manager at KPMG LLP.Mr. Dutkiewicz received a BBA degree from Loyola University of Chicago andis a member of the American Institute of Certified Public Accountants,Financial Executives International and the Association for Corporate Growth.

*Jill B. W. Sisson*joinedus as a consultant in December 2003. She most recently served as GeneralCounsel and Secretary of Graphic Packaging International Corporation, aNYSE-listed packaging company, from September 1992 until its merger withRiverwood Holding, Inc. in August 2003. From 1974 to September 1992,she engaged in private law practice in Denver, Colorado. She received her J.D.degree from the University of Colorado Law School in 1974.

***Available Information***

We are subject to the informational requirements ofthe Exchange Act. We therefore file periodic reports, proxy statements andother information with the SEC. Such reports may be obtained by visiting thePublic Reference Room of the SEC at 450 Fifth Street, NW, Washington, D.C.20549, or by calling the SEC at 1-800-SEC-0330. In addition,the SEC maintains an internet site (www.sec.gov) that contains reports, proxyand information statements and other information regarding issuers that fileelectronically.

Additionally, copies of our reports on Forms 10-K,10-Q and 8-K and any amendments to such reports are available forviewing and copying at our internet site (www.nwrgi.com), free of charge, assoon as reasonably practicable after filing such material with, or furnishingit to the SEC.

We also make available onour website and in print to any shareholder who requests it, the Charters forour Audit and Compensation Committees, as well as the Code of Conduct thatapplies to all directors, officers, and associates of our company. Amendmentsto these documents or waivers related to the Code of Conduct will be madeavailable on our website as soon as reasonably practicable after theirexecution.

**ITEM 1A.**        RISKFACTORS

We wish to caution ourreaders that the following important factors, among others, could cause the actualresults to differ materially from those indicated by forward-looking statementsmade in this report and from time to time in news releases, reports, proxystatements, registration statements and other written communications, as wellas verbal forward-looking statements made from time to time by representativesof the company. Such forward-looking statements involve risks and uncertaintiesthat may cause our actual results, performance or achievements to be materiallydifferent from any future performance or achievements expressed or implied bythese forward-looking statements. Factors that might cause actual events orresults to differ materially from those indicated by these forward-lookingstatements may include matters such as future economic performance, restaurantopenings or closings, operating margins, the availability of acceptable realestate locations, the sufficiency of our cash balances and cash generated fromoperating and financing activities for our future liquidity and capitalresource needs, and other matters, and are generally accompanied by words suchas: believes, anticipates, estimates, predicts, expects, and similarexpressions that convey the uncertainty of future events or outcomes. Anexpanded discussion of some of these risk factors follows.

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*We may not besuccessful in implementing any or all of the initiatives of our businessstrategy.*

Our success depends inpart on our ability to understand our customers’ needs. We believe successfuldeployment of our current business strategy will address customers’ needs andcontribute to overall company growth. While we believe our brand refreshstrategy will strengthen the performance of our Einstein Bros. brand, itssuccess is dependent upon customer acceptance of new menu offerings and pricings,the look and feel of the restaurant, and the new service system and otherfactors, many of which are outside our control. In addition, the availabilityof capital and opportunities to make modifications to existing restaurants willbe significant factors in the success of our business strategy. If weimproperly perceive customers’ needs and/or are not successful in implementingany or all of the initiatives of our business strategy, it could have amaterial adverse effect on our business, results of operations, and financialcondition.

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

Food service businesses are often affected by changesin consumer tastes, dietary trends, national, regional and local economicconditions and demographic trends. Factors such as traffic patterns, localdemographics and the type, number and location of competing restaurants mayadversely affect the performance of individual locations. Shifts in consumerpreferences away from our type of cuisine and/or the quick casual style couldhave a material adverse effect on our results of operations.

Dietary trends, such asthe consumption of food low in carbohydrate content may negatively impact oursales. In addition, inflation and increased food and energy costs may harm therestaurant industry in general and our locations in particular. Adverse changesin any of these factors could reduce consumer traffic or impose practicallimits on pricing, which could harm our business prospects, financialcondition, operating results and cash flow. Our continued success will dependin part on our ability to anticipate, identify and respond to changing consumerpreferences and economic conditions.

*There is competition in the restaurant industry forpersonnel, real estate, advertising space, and customers, among other things.*

Our industry is highlycompetitive and there are many well-established competitors with substantiallygreater financial and other resources than we have. In addition to currentcompetitors, one or more new major competitors with substantially greaterfinancial, marketing and operating resources could enter the market at any timeand compete directly against us. In addition, in virtually every majormetropolitan area in which we operate or expect to enter, local or regionalcompetitors already exist. This may make it more difficult to obtain realestate and advertising space, and to retain customers and personnel.

*We are vulnerableto fluctuations in the cost, availability and quality of our raw ingredients.*

The cost, availability andquality of the ingredients we use to prepare our food are subject to a range offactors, many of which are beyond our control. Fluctuations in economic andpolitical conditions, weather and demand could adversely affect the cost of ouringredients. We have limited control over fluctuations in the price and qualityof commodities, and we may not be able to pass through any cost increases toour customers. We are dependent on frequent deliveries of fresh ingredients,thereby subjecting us to the risk of shortages or interruptions in supply. Allof these factors could adversely affect our business and financial results.

*We heavily dependon our suppliers.*

We currently purchase ourraw materials from various suppliers. We purchase a majority of our frozenbagel dough from Harlan Bakeries, Inc. (who utilizes our proprietaryprocesses) and on which we are 

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dependentupon in the short-term. Additionally, we purchase all of our cream cheese froma single source. Though to date we have not experienced significantdifficulties with our suppliers, our reliance on a limited number of supplierssubjects us to a number of risks, including possible delays or interruption insupplies, diminished control over quality and a potential lack of adequate rawmaterial capacity. Any disruption in the supply or degradation in the qualityof the materials provided by our suppliers could have a material adverse effecton our business, operating results and financial condition. In addition, anysuch disruptions in supply or degradations in quality could have a long-termdetrimental impact on our efforts to develop and maintain a strong brandidentity and a loyal consumer base.

*We heavily dependon our distributors.*

We depend on our network of distributors to distributefrozen bagel dough and other products and materials to our locations. If anyone or more of our distributors fails to perform as anticipated, or if there isany disruption in any of our distribution relationships for any reason, itsubjects us to a number of risks, including inadequate products delivered toour company-owned, franchised and licensed locations, diminished control overquality of products delivered, and increased operating costs to prevent delaysin deliveries. These risks could have a material adverse effect on ourbusiness, financial condition and results of operations.

During late 2005, wenegotiated contract terms with a new distribution partner. We have experiencedsome transition issues at certain locations during 2006 but at this time, we donot believe this will have an adverse effect on our results of operations. Weare currently working with this distributor to resolve these issues.

*Increasing laborcosts could adversely affect our continued profitability.*

We are dependent upon anavailable labor pool of associates, many of whom are hourly employees whosewages may be affected by an increase in the federal or state minimum wage.Numerous proposals have been made on federal, state and local levels toincrease minimum wage levels. Although few, if any, of our associates are paidat the minimum wage level, an increase in the minimum wage may create pressureto increase the pay scale for our associates, which would increase our laborcosts and those of our franchisees and licensees. A shortage in the labor poolor other general inflationary pressures or changes could also increase laborcosts. In addition, changes in labor laws or reclassifications of associatesfrom management to hourly employees could affect our labor cost. An increase inlabor costs could have a material adverse effect on our income from operationsand decrease our profitability and cash available to service our debtobligations if we are unable to recover these increases by raising the priceswe charge our customers.

*We face the risk ofadverse publicity and litigation in connection with our operations.*

We are from time to timethe subject of complaints or litigation from our consumers alleging illness,injury or other food quality, health or operational concerns. Adverse publicityresulting from these allegations may materially adversely affect us, regardlessof whether the allegations are valid or whether we are liable. In addition,employee claims against us based on, among other things, discrimination,harassment or wrongful termination may divert financial and managementresources that would otherwise be used to benefit our future performance. Wehave been subject to claims from time to time, and although these claims havenot historically had a material impact on our operations, a significantincrease in the number of these claims or the number that are successful couldmaterially adversely affect our business, prospects, financial condition,operating results or cash flows.

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*A regional orglobal health pandemic could severely affect our business.*

A health pandemic is adisease that spreads rapidly and widely by infection and affects manyindividuals in an area or population at the same time. If a regional or globalhealth pandemic were to occur, depending upon its duration and severity, ourbusiness could be severely affected. We have positioned ourselves as a “neighborhoodatmosphere” between home and work where people can gather together for humanconnection and high quality food. Customers might avoid public gathering placesin the event of a health pandemic, and local, regional or national governmentsmight limit or ban public gathering places to halt or delay the spread ofdisease. A regional or global pandemic might also adversely impact our businessby disrupting or delaying production and delivery of products and materials inour supply chain and causing staff shortages in our restaurants. The impact ofa health pandemic might be disproportionately greater on us than on othercompanies that depend less on the gathering of people in a neighborhoodatmosphere.

*We rely in part onour franchisees and licensees.*

We rely in part on ourfranchisees and licensees and the manner in which they operate their locationsto develop and promote our business. Although we have developed criteria toevaluate and screen prospective candidates, the candidates may not have thebusiness acumen or financial resources necessary to operate successfullocations in their respective areas. In addition, franchisees and licensees aresubject to business risks similar to what we face such as competition, consumeracceptance, fluctuations in the cost, availability and quality of rawingredients, and increasing labor costs. The failure of franchisees andlicensees to operate successfully could have a material adverse effect on us,our reputation, our ability to collect royalties, our brands and our ability toattract prospective candidates. As we move into offering franchises for ourEinstein Bros. Bagel brand, our reliance on our franchisees is expected toincrease in proportion to growth of the franchisee base.

*We face risksassociated with government regulation.*

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

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

Under various federal,state and local laws, an owner or operator of real estate may be liable for thecosts of removal or remediation of certain hazardous or toxic substances on orin such property. Such liability may be imposed without regard to whether theowner or operator knew of, or was responsible for, the presence of suchhazardous or toxic substances. Although we are not aware of any environmentalconditions that require remediation by us under federal, state or local law atour properties, we have not conducted a comprehensive environmental review ofour properties or operations. We may not have identified all of the potentialenvironmental liabilities at our properties, and any such liabilities that areidentified in the future may have a material adverse effect on our financialcondition.

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

We believe that ourtrademarks, service marks and other proprietary rights are important to oursuccess and our competitive position. Accordingly, we devote substantialresources to the establishment 

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andprotection of our trademarks, service marks and proprietary rights. However,the actions we take may be inadequate to prevent imitation of our products andconcepts by others or to prevent others from claiming violations of theirtrademarks and proprietary rights by us. In addition, others may assert rightsin our trademarks, service marks and other proprietary rights.

*We have and expectto continue to have a substantial amount of debt.*

We have a highlevel of debt and are highly leveraged. In addition, we may, subject to certainrestrictions, incur substantial additional indebtedness in the future. Our highlevel of debt, among other factors, could:

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

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

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

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

·       harm us because a failureby us to comply with the covenants in the instruments and agreements governingour indebtedness could result in an event of default that, if not cured orwaived, could result in all of our indebtedness becoming immediately due andpayable, which could render us insolvent.

*We must comply with certain covenants inherent in ourdebt agreements to avoid defaulting under those agreements.*

Our debt agreementscontain certain covenants, which, among others, include certain financialcovenants such as limitations on capital expenditures, maintenance of thebusiness, use of proceeds on sales of assets and minimum Adjusted EBITDA asdefined in the agreements. The covenants also preclude the declaration andpayment of dividends or other distributions to holders of our common stock. Weare subject to multiple economic, financial, competitive, legal and other risksthat are beyond our control and could harm our future financial results. Anyadverse effect on our business or financial results could affect our ability tomaintain compliance with our debt covenants. A failure by us to comply with thecovenants in the instruments and agreements governing our indebtedness couldresult in an event of default that, if not cured or waived, could result in allof our indebtedness becoming immediately due and payable, which could render usinsolvent.

*We may not be ableto generate sufficient cash flow to make payments on our indebtedness.*

Economic, financial,competitive, legislative and other factors beyond our control may affect ourability to generate cash flow from operations to make payments on ourindebtedness and to fund necessary working capital. A significant reduction inoperating cash flow would likely increase the need for alternative sources ofliquidity. If we are unable to generate sufficient cash flow to make paymentson our debt, we will have to pursue one or more alternatives, such as reducingor delaying capital expenditures, refinancing our debt on terms that are notfavorable to us, selling assets or raising equity. We may not be able toaccomplish any of these alternatives on satisfactory terms, if at all, and evenif accomplished, they may not yield sufficient funds to service our debt.

*We have a majoritystockholder.*

Greenlight Capital, L.L.C. and its affiliatesbeneficially own approximately 95 percent of our common stock. As a result,Greenlight has sufficient voting power, without the vote of any otherstockholders, to determine what matters will be submitted for approval by ourstockholders, to approve actions by written 

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consent without theapproval of any other stockholders, to elect all of our board of directors, andto determine whether a change in control of our company occurs. Greenlight’sinterests on matters submitted to stockholders may be different from those ofother stockholders. Greenlight is not involved in our day-to-day operations,but Greenlight has voted its shares to elect our current board of directors.The chairman of our board of directors is a current employee of Greenlight.

Our common stock is notcurrently listed on any stock exchange or Nasdaq. As a result, we are notsubject to corporate governance rules adopted by the New York StockExchange, American Stock Exchange and Nasdaq requiring a majority of directorsto be independent and requiring compensation and nominating committees that arecomposed solely of independent directors. However, we are subject to rules requiringthat the audit committee consist entirely of independent directors. Under the rules ofthese stock exchanges and Nasdaq, if a single stockholder holds more that 50%of the voting power of a listed company, that company is considered acontrolled company, and except for the rules relating to independence ofthe audit committee, is exempt from the above-mentioned independence rules.Since Greenlight beneficially owns approximately 95 percent of our commonstock, we may take advantage of the controlled company exemption if our commonstock becomes listed on an exchange or Nasdaq in the future. As a result, ourstockholders currently do not have, and may never have, the protections thatthese rules are intended to provide.

*Future sales ofshares of our common stock by our stockholders could cause our stock price tofall.*

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

*Holders may find itdifficult to effect transactions in our common stock.*

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

Securities that are notlisted on a stock exchange, the Nasdaq National Market or the Nasdaq SmallCapMarket are subject to an SEC rule that imposes special requirements onbroker-dealers who sell those securities to persons other than theirestablished customers and accredited investors. The broker-dealer mustdetermine that the security is suitable for the purchaser and must obtain thepurchaser’s written consent prior to the sale. These requirements may make itmore difficult for stockholders to sell our stock than the stock of some othercompanies. It may also affect our ability to raise more capital if and whennecessary.

**ITEM 1B.**       UNRESOLVEDSTAFF COMMENTS

None

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**ITEM 2.**                PROPERTIES

Thefollowing table details the total restaurants open at the end of the respectivefiscal year:

| ** **                               | ** ** | **Company** | ** ** | ** **   | ** ** | ** **     | ** ** | ** ** | ** ** |
|------------------------------------------|------------|-------------|------------|--------------|------------|----------------|------------|------------|------------|
| ** **                               | ** ** | **owned**   | ** ** | **Licensed** | ** ** | **Franchised** | ** ** | **Total**  | ** ** |
| **Einstein Bros. Bagels:**               | ** ** |        | ** ** | ** **   |       |           | ** ** | ** ** |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| 2005                                     |       |        | 352        | ** **   |       |           | 67         | ** ** |       |   | — | ** ** |   |   | 419 | ** ** |   |
| 2004                                     |       |        | 366        | ** **   |       |           | 54         | ** ** |       |   | — | ** ** |   |   | 420 | ** ** |   |
| 2003                                     |       |        | 373        | ** **   |       |           | 38         | ** ** |       |   | — | ** ** |   |   | 411 | ** ** |   |
| **Einstein Bros. Cafe:**                 | ** ** |        | ** ** | ** **   |       |           | ** ** | ** ** |       |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| 2005                                     |       |        | 8          | ** **   |       |           | —     | ** ** |       |   | — | ** ** |   |   | 8 | ** ** |   |
| 2004                                     |       |        | 5          | ** **   |       |           | —     | ** ** |       |   | — | ** ** |   |   | 5 | ** ** |   |
| 2003                                     |       |        | —     | ** **   |       |           | —     | ** ** |       |   | — | ** ** |   |   | — | ** ** |   |
| **Noah’s:**                         |       |        |       | ** **   |       |           |       | ** ** |       |   |   | ** ** |   |   |   | ** ** |   |
| 2005                                     |       |        | 73         | ** **   |       |           | 3          | ** ** |       |   | — | ** ** |   |   | 76 | ** ** |   |
| 2004                                     |       |        | 78         | ** **   |       |           | 3          | ** ** |       |   | — | ** ** |   |   | 81 | ** ** |   |
| 2003                                     |       |        | 83         | ** **   |       |           | 3          | ** ** |       |   | — | ** ** |   |   | 86 | ** ** |   |
| **Manhattan:**                           |       |        |       | ** **   |       |           |       | ** ** |       |   |   | ** ** |   |   |   | ** ** |   |
| 2005                                     |       |        | —     | ** **   |       |           | —     | ** ** |       |   | 109 | ** ** |   |   | 109 | ** ** |   |
| 2004                                     |       |        | —     | ** **   |       |           | —     | ** ** |       |   | 145 | ** ** |   |   | 145 | ** ** |   |
| 2003                                     |       |        | —     | ** **   |       |           | —     | ** ** |       |   | 178 | ** ** |   |   | 178 | ** ** |   |
| **Chesapeake:**                          |       |        |       | ** **   |       |           |       | ** ** |       |   |   | ** ** |   |   |   | ** ** |   |
| 2005                                     |       |        | —     | ** **   |       |           | —     | ** ** |       |   | 8 | ** ** |   |   | 8 | ** ** |   |
| 2004                                     |       |        | —     | ** **   |       |           | —     | ** ** |       |   | 27 | ** ** |   |   | 27 | ** ** |   |
| 2003                                     |       |        | —     | ** **   |       |           | —     | ** ** |       |   | 42 | ** ** |   |   | 42 | ** ** |   |
| **New World Coffee/Willoughby’s*:** |       |        |       | ** **   |       |           |       | ** ** |       |   |   | ** ** |   |   |   | ** ** |   |
| 2005                                     |       |        | 2          | ** **   |       |           | —     | ** ** |       |   | 4 | ** ** |   |   | 6 | ** ** |   |
| 2004                                     |       |        | 4          | ** **   |       |           | —     | ** ** |       |   | 8 | ** ** |   |   | 12 | ** ** |   |
| 2003                                     |       |        | 8          | ** **   |       |           | —     | ** ** |       |   | 11 | ** ** |   |   | 19 | ** ** |   |
| **Total Restaurants:**                   |       |        |       | ** **   |       |           |       | ** ** |       |   |   | ** ** |   |   |   | ** ** |   |
| 2005                                     |       |        | 435        | ** **   |       |           | 70         | ** ** |       |   | 121 | ** ** |   |   | 626 | ** ** |   |
| 2004                                     |       |        | 453        | ** **   |       |           | 57         | ** ** |       |   | 180 | ** ** |   |   | 690 | ** ** |   |
| 2003                                     |       |        | 464        | ** **   |       |           | 41         | ** ** |       |   | 231 | ** ** |   |   | 736 | ** ** |   |

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*                    On October 6,2004, we sold Willoughby’s. TheWilloughby’s business consisted of a coffee roasting plant, three retaillocations and office space.

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As of January 3,2006, our company-owned facilities, franchisees and licensees operated invarious states and the District of Columbia as follows:

| ** **            | ** ** | **Company** | ** ** | **Licensed/** | ** ** | ** **     | ** ** |
|-----------------------|------------|-------------|------------|---------------|------------|----------------|------------|
| **Location**          | ** ** | ** **  | ** ** | **Owned**     | ** ** | **Franchised** | ** ** | **Total** | ** ** |
| Alabama               |       |        | —     |          |       |           | 2          |   |   |   | 2 |   |   |
| Arizona               |       |        | 22         |          |       |           | 2          |   |   |   | 24 |   |   |
| California            |       |        | 81         |          |       |           | 12         |   |   |   | 93 |   |   |
| Colorado              |       |        | 32         |          |       |           | 3          |   |   |   | 35 |   |   |
| Connecticut           |       |        | 1          |          |       |           | —     |   |   |   | 1 |   |   |
| Delaware              |       |        | 2          |          |       |           | 3          |   |   |   | 5 |   |   |
| District of  Columbia |       |        | 1          |          |       |           | 3          |   |   |   | 4 |   |   |
| Florida               |       |        | 50         |          |       |           | 21         |   |   |   | 71 |   |   |
| Georgia               |       |        | 13         |          |       |           | 9          |   |   |   | 22 |   |   |
| Illinois              |       |        | 30         |          |       |           | 5          |   |   |   | 35 |   |   |
| Indiana               |       |        | 10         |          |       |           | 1          |   |   |   | 11 |   |   |
| Kansas                |       |        | 9          |          |       |           | —     |   |   |   | 9 |   |   |
| Louisiana*            |       |        | —     |          |       |           | —     |   |   |   | — |   |   |
| Maryland              |       |        | 11         |          |       |           | —     |   |   |   | 11 |   |   |
| Massachusetts         |       |        | 2          |          |       |           | 1          |   |   |   | 3 |   |   |
| Michigan              |       |        | 17         |          |       |           | 4          |   |   |   | 21 |   |   |
| Minnesota             |       |        | 9          |          |       |           | 3          |   |   |   | 12 |   |   |
| Mississippi           |       |        | —     |          |       |           | 1          |   |   |   | 1 |   |   |
| Missouri              |       |        | 14         |          |       |           | —     |   |   |   | 14 |   |   |
| Nevada                |       |        | 9          |          |       |           | —     |   |   |   | 9 |   |   |
| New Hampshire         |       |        | 1          |          |       |           | —     |   |   |   | 1 |   |   |
| New Jersey            |       |        | 4          |          |       |           | 36         |   |   |   | 40 |   |   |
| New Mexico            |       |        | 5          |          |       |           | —     |   |   |   | 5 |   |   |
| New York              |       |        | 2          |          |       |           | 9          |   |   |   | 11 |   |   |
| North Carolina        |       |        | 2          |          |       |           | 4          |   |   |   | 6 |   |   |
| Ohio                  |       |        | 13         |          |       |           | 6          |   |   |   | 19 |   |   |
| Oregon                |       |        | 6          |          |       |           | 1          |   |   |   | 7 |   |   |
| Pennsylvania          |       |        | 15         |          |       |           | 37         |   |   |   | 52 |   |   |
| South Carolina        |       |        | —     |          |       |           | 4          |   |   |   | 4 |   |   |
| Tennessee             |       |        | —     |          |       |           | 1          |   |   |   | 1 |   |   |
| Texas                 |       |        | 25         |          |       |           | 6          |   |   |   | 31 |   |   |
| Utah                  |       |        | 19         |          |       |           | —     |   |   |   | 19 |   |   |
| Virginia              |       |        | 14         |          |       |           | 15         |   |   |   | 29 |   |   |
| Washington            |       |        | 4          |          |       |           | —     |   |   |   | 4 |   |   |
| Wisconsin             |       |        | 12         |          |       |           | 2          |   |   |   | 14 |   |   |
| Total                 |       |        | 435        |          |       |           | 191        |   |   |   | 626 |   |   |
|                       |            |             |            |               |            |                |            |  |  |  |  |  |  |  |  |

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*                    As of January 3,2006, our licensed location in Louisiana was temporarily closed due to damagecaused by Hurricane Katrina. It re-opened for business during mid-January 2006.

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Informationwith respect to our headquarters, training, production and commissaryfacilities is presented below:

| **Location**        | ** ** | ** **                                   | ** ** | **Facility**   | ** ** | **Size** |
|---------------------|------------|----------------------------------------------|------------|----------------|------------|----------|
| Golden, CO(1)       |       | Headquarters, Support  Center, Test Kitchen  |       | 46,802 sq. ft. |
| Hamilton, NJ (2)    |       | Franchise Support  Center, Training Facility |       | 6,637 sq. ft.  |
| Whittier, CA(3)     |       | Production Facility                          |       | 54,640 sq. ft. |
| Walnut Creek, CA(4) |       | Administration Office—Noah’s       |       | 2,190 sq. ft.  |
| Carrolton, TX(5)    |       | USDA Approved Commissary                     |       | 5,000 sq. ft.  |
| Orlando, FL(6)      |       | USDA Approved Commissary                     |       | 7,422 sq. ft.  |
| Denver, CO(7)       |       | USDA Approved Commissary                     |       | 9,200 sq. ft.  |

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(1)          This facility is leasedthrough May 31, 2007.

(2)          This facility is leasedthrough October 31, 2008.

(3)          This facility is leasedwith an initial lease term through November 30, 2006 with two five-yearextension options.

(4)          This facility is leasedthrough February 29, 2008.

(5)          This facility iscurrently under a month-to-month lease.

(6)          This facility is leasedthrough October 31, 2010.

(7)          Thisfacility is leased through October 13, 2008.

**ITEM 3.**                LEGALPROCEEDINGS

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

On July 31, 2002, Tristan Goldstein and ValerieBankhordar, former restaurant managers, filed a putative class action againstEinstein and Noah Corp. (“ENC”) in the Superior Court for the State ofCalifornia, County of San Francisco for failure to pay overtime wages tomanagers and assistant managers of the California Noah’s restaurants. In April 2004,we agreed to settle the litigation, which agreement was subsequently approvedby the court in January 2006. Amounts representing our estimate to settlethis litigation were previously recorded in general and administrative expensesduring fiscal 2003, were paid subsequent to fiscal year-end 2005 and did nothave a material adverse effect on our consolidated financial condition or resultsof operations.

On September 14,2004, Atlantic Mutual Insurance Company brought an action in the Superior Courtof New Jersey Law Division: Morris County, against the Company, certain of itsformer officers and directors and insurers seeking declaratory judgment oninsurance coverage issues in previously resolved litigation against JeroldNovack and Ramin Kamfar, former officers. Mr. Kamfar cross-claimed againstus, claiming a right to be indemnified for expenses. The Company, Mr. Kamfar,Atlantic Mutual Insurance Company and Lexington Insurance Company settled thelawsuit in February 2006. The resolution of this lawsuit did not have amaterial effect on our consolidated financial condition or results ofoperations. Because the Company asserts that the advancement and indemnityclaims are an insured loss under the Company’s policy with National Union, theCompany has filed an arbitration proceeding against National Union, the Company’sofficers and directors liability insurer for the applicable time period.

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**ITEM 4.**                SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

No items were submitted toa vote of security holders in the fourth quarter of the fiscal year ended January 3,2006.

**PART II**

**ITEM 5.**                MARKETFOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Ourcommon stock is quoted on the Pink Sheets OTC market under the symbol “NWRG.PK”.The following table sets forth the high and low bid information for our commonstock for each fiscal quarter during the periods indicated. Bid informationquoted reflects inter-dealer prices without retail mark-up, markdown orcommission and may not necessarily represent actual transactions.

| **Year ended January 3, 2006:** | ** ** | **High** | ** ** | **Low** | ** ** |
|-----------------------------------------------------|------------|----------|------------|---------|------------|
| First Quarter                                       |       | $        | 4.25       |    | $          | 2.00 |   |
| Second Quarter                                      |       | $        | 4.35       |    | $          | 2.00 |   |
| Third Quarter                                       |       | $        | 3.50       |    | $          | 1.50 |   |
| Fourth Quarter                                      |       | $        | 6.03       |    | $          | 2.50 |   |

 

| **Year ended December 28, 2004:** | ** ** | **High** | ** ** | **Low** | ** ** |
|-------------------------------------------------------|------------|----------|------------|---------|------------|
| First Quarter                                         |       | $        | 8.00       |    | $          | 3.00 |   |
| Second Quarter                                        |       | $        | 4.99       |    | $          | 2.50 |   |
| Third Quarter                                         |       | $        | 2.98       |    | $          | 1.75 |   |
| Fourth Quarter                                        |       | $        | 3.10       |    | $          | 1.60 |   |

 

As of March 6, 2006, there were 385 holders ofrecord of our common stock. This number does not include individualstockholders who own common stock registered in the name of a nominee undernominee security listings.

We have not declared orpaid any cash dividends on our common stock since our inception. We do notintend to pay any cash dividends in the foreseeable future, and we areprecluded from paying cash dividends on our common stock under our financingagreements.

***Sales of Unregistered Securities***

During the fiscal year of 2005, we receivedconsideration of $221,000 and issued 216,359 shares of our common stock uponthe exercise of certain warrants granted by us subject to registration rightsagreements. We issued these warrants to the warrant holders in private financingtransactions related to our issuance of increasing rate notes that were repaidin July 2003. Securities issued were offered and sold in reliance upon theexemption from registration under Section 4(2) of the Securities Act,relating to sales by an issuer not involving a public offering. The sales ofsecurities were made without the use of an underwriter. The recipients of thesecurities represented their intention to acquire the securities for investmentonly and not with a view to or for sale in connection with any distributionthereof in the absence of an effective registration statement and restrictivelegends were affixed to the share certificates issued. We have filed aregistration statement for the resale of shares underlying the warrants.

18

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**ITEM 6.**                SELECTEDFINANCIAL DATA

Thefollowing selected financial data for each fiscal year was extracted or derivedfrom our consolidated financial statements which have been audited by GrantThornton LLP, our independent registered public accounting firm.

| ** **                                                          | ** ** | **Fiscal years ended(1):**                                                       | ** ** |
|---------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
| ** **                                                          | ** ** | **Jan 3, 2006**                                                                  | ** ** | **Dec 28, 2004** | ** ** | **Dec 30, 2003** | ** ** | **Dec 31, 2002** | ** ** | **Jan 1, 2002** | ** ** |
| ** **                                                          | ** ** | **(53 wks)**                                                                          | ** ** | **(52 wks)** | ** ** | **(52 wks)** | ** ** | **(52 wks)** | ** ** | **(52 wks)** | ** ** |
| ** **                                                          | ** ** | **(in thousands of dollars, except per share amounts)** | ** ** |
| **Results of Operations**                                           |       |                                                                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Revenues                                                            |       |                                                                                       | $          |   389,093 |   |   |   | $ |   373,860 |   |   |   | $ | 383,306 |   |   |   | $ | 398,650 |   |   |   | $ | 234,175 |   |   |
| Cost of sales                                                       |       |                                                                                       | 315,391    |   |   |   | 306,661 |   |   |   | 317,690 |   |   |   | 321,506 |   |   |   | 189,403 |   |   |
| Gross margin                                                        |       |                                                                                       | 73,702     |   |   |   | 67,199 |   |   |   | 65,616 |   |   |   | 77,144 |   |   |   | 44,772 |   |   |
| Gross margin as percent of sales                                    |       |                                                                                       | 18.9       | % |   |   | 18.0 | % |   |   | 17.1 | % |   |   | 19.4 | % |   |   | 19.1 | % |   |
| General and administrative expenses                                 |       |                                                                                       | 36,096     |   |   |   | 32,755 |   |   |   | 41,794 |   |   |   | 42,640 |   |   |   | 28,647 |   |   |
| Depreciation and amortization                                       |       |                                                                                       | 26,316     |   |   |   | 27,848 |   |   |   | 34,013 |   |   |   | 35,047 |   |   |   | 18,260 |   |   |
| Loss (gain) on sale, disposal or abandonment of assets,  net   |       |                                                                                       | 314        |   |   |   | 1,557 |   |   |   | (558 | ) |   |   | — |   |   |   | — |   |   |
| Charges for integration and reorganization costs               |       |                                                                                       | 5          |   |   |   | (869 | ) |   |   | 2,132 |   |   |   | 4,194 |   |   |   | 4,432 |   |   |
| Impairment charge                                                   |       |                                                                                       | 1,603      |   |   |   | 450 |   |   |   | 5,292 |   |   |   | — |   |   |   | 3,259 |   |   |
| Income (loss) from operations                                       |       |                                                                                       | 9,368      |   |   |   | 5,458 |   |   |   | (17,057 | ) |   |   | (4,737 | ) |   |   | (9,826 | ) |   |
| Interest expense, net(2)                                            |       |                                                                                       | 23,698     |   |   |   | 23,196 |   |   |   | 34,184 |   |   |   | 42,883 |   |   |   | 47,104 |   |   |
| Cumulative change in the fair value of derivatives             |       |                                                                                       | —     |   |   |   | — |   |   |   | (993 | ) |   |   | (233 | ) |   |   | (57,680 | ) |   |
| Gain on sale of debt securities                                     |       |                                                                                       | —     |   |   |   | — |   |   |   | (374 | ) |   |   | (2,537 | ) |   |   | (241 | ) |   |
| Loss on exchange of Series F due to Equity Recap          |       |                                                                                       | —     |   |   |   | — |   |   |   | 23,007 |   |   |   | — |   |   |   | — |   |   |
| Loss on extinguishment of Greenlight obligation                     |       |                                                                                       | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 16,641 |   |   |
| Permanent impairment in the value of investment in  debt securities |       |                                                                                       | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 5,805 |   |   |
| Other expense (income)                                              |       |                                                                                       | (312       | ) |   |   | (284 | ) |   |   | (172 | ) |   |   | (322 | ) |   |   | 131 |   |   |
| Loss before income taxes                                            |       |                                                                                       | (14,018    | ) |   |   | (17,454 | ) |   |   | (72,709 | ) |   |   | (44,528 | ) |   |   | (21,586 | ) |   |
| Provision (benefit) for state income taxes                     |       |                                                                                       | —     |   |   |   | (49 | ) |   |   | 812 |   |   |   | 366 |   |   |   | 167 |   |   |
| Net loss                                                            |       |                                                                                       | (14,018    | ) |   |   | (17,405 | ) |   |   | (73,521 | ) |   |   | (44,894 | ) |   |   | (21,753 | ) |   |
| Dividends and accretion on Preferred Stock                     |       |                                                                                       | —     |   |   |   | — |   |   |   | (14,423 | ) |   |   | (27,594 | ) |   |   | (58,520 | ) |   |
| Net loss available to common stockholders                           |       |                                                                                       | $          | (14,018 | ) |   |   | $ | (17,405 | ) |   |   | $ | (87,944 | ) |   |   | $ | (72,488 | ) |   |   | $ | (80,273 | ) |   |
| Net loss per  share—basic and diluted                          |       |                                                                                       | $          | (1.42 | ) |   |   | $ | (1.77 | ) |   |   | $ | (22.71 | ) |   |   | $ | (55.18 | ) |   |   | $ | (133.43 | ) |   |

 

19

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| ** **                                                                                                                       | ** ** | **As of:**                                                                            | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                       | ** ** | **Jan 3, 2006**                                                                  | ** ** | **Dec 28, 2004** | ** ** | **Dec 30, 2003** | ** ** | **Dec 31, 2002** | ** ** | **Jan 1, 2002** | ** ** |
| ** **                                                                                                                       | ** ** | **(in thousands of dollars, except per share amounts)** | ** ** |
| **Balance Sheet**                                                                                                                |       |                                                                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash and cash equivalents                                                                                                        |       |                                                                                       | $          | 1,556 |   |   |   | $ | 9,752 |   |   |   | $ | 9,575 |   |   |   | $ | 10,705 |   |   |   | $ | 15,478 |   |   |
| Property, plant and equipment, net                                                                                               |       |                                                                                       | 33,359     |   |   |   | 41,855 |   |   |   | 54,513 |   |   |   | 73,780 |   |   |   | 98,064 |   |   |
| Total assets                                                                                                                     |       |                                                                                       | 130,924    |   |   |   | 158,456 |   |   |   | 181,738 |   |   |   | 203,174 |   |   |   | 280,203 |   |   |
| Short-term debt and current portion of long-term debt                                                                            |       |                                                                                       | 280        |   |   |   | 295 |   |   |   | 2,105 |   |   |   | 150,872 |   |   |   | 168,394 |   |   |
| Mandatorily redeemable Series Z preferred stock,  $.001 par value, $1,000 per share liquidation value(3)          |       |                                                                                       | 57,000     |   |   |   | 57,000 |   |   |   | 57,000 |   |   |   | — |   |   |   | — |   |   |
| Long-term debt                                                                                                                   |       |                                                                                       | 160,560    |   |   |   | 160,840 |   |   |   | 161,120 |   |   |   | 11,011 |   |   |   | 12,119 |   |   |
| Mandatorily redeemable Series F preferred stock,  $.001 par value, $1,000 per share liquidation value (temporary equity)(3) |       |                                                                                       | —     |   |   |   | — |   |   |   | — |   |   |   | 84,932 |   |   |   | 57,338 |   |   |
| Total stockholders’ equity (deficit)                                                                                        |       |                                                                                       | (126,211   | ) |   |   | (112,483 | ) |   |   | (95,153 | ) |   |   | (96,146 | ) |   |   | (30,096 | ) |   |
| **Other  Financial Data:**                                                                                                       |       |                                                                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Depreciation and amortization                                                                                                    |       |                                                                                       | $          | 26,316 |   |   |   | $ | 27,848 |   |   |   | $ | 34,013 |   |   |   | $ | 35,047 |   |   |   | $ | 18,260 |   |   |
| Capital expenditures                                                                                                             |       |                                                                                       | 10,264     |   |   |   | 9,393 |   |   |   | 6,921 |   |   |   | 5,172 |   |   |   | 3,757 |   |   |
| Number of locations at end of period                                                                                             |       |                                                                                       | 626        |   |   |   | 690 |   |   |   | 736 |   |   |   | 747 |   |   |   | 770 |   |   |
| Franchised and licensed                                                                                                          |       |                                                                                       | 191        |   |   |   | 237 |   |   |   | 272 |   |   |   | 287 |   |   |   | 287 |   |   |
| Company-owned and operated                                                                                                       |       |                                                                                       | 435        |   |   |   | 453 |   |   |   | 464 |   |   |   | 460 |   |   |   | 483 |   |   |
| Increase  (decrease) in comp store sales(4)                                                                                      |       |                                                                                       | 5.2        | % |   |   | (1.9 | )% |   |   | (3.5 | )% |   |   | 1.9 | % |   |   | 2.5 | % |   |

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(1)           We have a 52/53-week fiscal year ending on theTuesday closest to December 31. Fiscal years 2004, 2003, 2002 and 2001which ended on December 28, 2004, December 30, 2003, December 31,2002 and January 1, 2002, respectively, contained 52 weeks, while fiscalyear 2005, which ended on January 3, 2006, contained 53 weeks.

(2)           Interest expense is comprised of interest paid orpayable in cash and non-cash interest expense resulting from the amortizationof debt discount, notes paid-in-kind, debt issuance costs and the amortizationof warrants issued in connection with debt financings.

(3)           As more fully described in the notes to theconsolidated financial statements, the adoption of Statement ofFinancial Accounting Standard (SFAS) No. 150 resulted in the Series Z Preferred Stock beingpresented as a liability rather than the historical mezzanine presentation of theSeries F.

(4)           Comparable store sales represent sales at restaurantsthat were open for one full year and have not been relocated or closed duringthe current year. Comparable store sales are also referred to as “same-store”sales and as “comp sales” within the restaurant industry.

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**ITEM 7.**                MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

***Quickservice Industry Overview***

According to the Restaurant Industry Operations Report2004, published in 2005 by the National Restaurant Association and Deloitte,quickservice sales growth continues to strengthen fueled by an improvingeconomy. Growth in quickservice restaurant sales outpaced full servicerestaurants. Part of the reason for the stronger growth of quickservicerestaurants was lessened competition from grocery and convenience stores, aswell as from consumers’ decreased use of takeout from other types ofrestaurants. Growth in the quickservice segment will continue to be driven byconsumers’ demands for value and convenience. Even as they make convenience andspeed a top priority, customers also appear to be looking for new tastes andenhanced décor in quickservice restaurants. Part of the recent growth inquickservice restaurants sales is driven by the growing popularity of the “quickcasual” or “fast casual” restaurants. These restaurants tend to do theirhighest sales volume at lunch and have higher check averages (typically in therange of $6.50 to $9.50) than traditional quickservice restaurants. They arecharacterized by food flavor profiles more in line with casual dining offeringsand décor that tends to deviate from the design of the more traditionalquickservice restaurant establishments. Quickservice menus show a trend towardadding more items for nutrition conscious customers to supplement the alreadyvast selection of menu items available. Research from the National RestaurantAssociation indicates that consumers may be interested in even more choices,including fresh fruit, fresh vegetables, main-dish salads and other items.

According to Fast CasualMagazine, it wasn’t long ago that you had to look up the definition of “fastcasual” to understand the meaning of this unique restaurant concept that is ahybrid of the fast-food and traditional sit-down eating experiences. Not onlyis fast-casual food delivered in a fast, high-quality dining experience, butfast casuals also have been in the fast lane of growth—the entire fast casualsegment is expected to exceed $70 billion in 2006, with more than 300 brandsfueling a new restaurant explo­sion.

***Company Overview***

We are a leader in thequick casual segment of the restaurant industry. We specialize in high-qualityfoods for breakfast and lunch in a café atmosphere with a neighborhoodemphasis. Our product offerings include fresh baked bagels and hot breakfastsandwiches, cream cheese and other spreads, specialty coffees and teas,creative soups, salads and sandwiches, among other things. We operate andlicense locations primarily under the Einstein Bros. and Noah’s brand names,and franchise locations primarily under the Manhattan brand name. We alsooperate a dough production facility. We view our primary business as operating,franchising and licensing strong restaurant brands in the marketplace. Ourmanufacturing operations are supportive to our main business focus but allow usto leverage our inherent cost structure via third party business andenhancement of our brands through new product channels.

***Financing Transactions***

Debt Financing—On July 8,2003, we issued $160 million in aggregate principal amount of 13% seniorsecured notes due in 2008 ($160 Million Notes) to replace our $140 million inaggregate principal amount of senior secured increasing rate notes due in 2003.On that same date, we also entered into a three-year, $15 million senior securedrevolving credit facility with AmSouth Bank (AmSouth Revolver).

EquityRecapitalization—In September 2003, we completed an equityrecapitalization with our preferred stockholders, who held a substantialportion of our common stock. Among other things, our Mandatorily Redeemable Series FPreferred Stock was eliminated. In exchange, we issued 57,000 shares of ourMandatorily Redeemable Series Z Preferred Stock (Series Z) to HalpernDenny Fund III, L.P. (Halpern Denny) and we issued 9,380,843 shares of ourcommon stock to Greenlight Capital and affiliates (Greenlight).

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Debt Redemption and Refinancing—On February 28, 2006, wecompleted a debt refinancing that redeemed our $160 Million Notes and retiredour $15 million AmSouth Revolver. Our new debt obligations consist of thefollowing:

·       $15 million revolving creditfacility;

·       $80 million first lien term loan;

·       $65 million second lien term loan;and

·       $25 million subordinated term loan.

$15 MillionRevolving Credit Facility—the Revolving Facility has a maturity date of March 31,2011 and provides for interest based upon the prime rate or LIBOR plus amargin. The margin may increase or decrease up to 0.25% based upon ourconsolidated leverage ratio as defined in the agreement. The initial margin isat prime plus 2.00% or LIBOR plus 3.00%. This facility may be used in whole orin part for letters of credit.

$80 Million First Lien Term Loan—the FirstLien Term Loan has a maturity date of March 31, 2011 and provides for afloating interest rate based upon the prime rate or LIBOR plus a margin. Themargin may increase or decrease 0.25% based upon our consolidated leverageratio as defined in the agreement. The initial margin is prime plus 2.00% orLIBOR plus 3.00%. The facility is fully amortizing with quarterly principalreductions and interest payments over the term of the loan as follows:

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

 

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

In the event thatwe have not extended the maturity date of the Series Z to a date that ison or after July 26, 2012 or redeemed the Series Z by December 30,2008, then the Revolving Facility and the First Lien Term Loan will mature on December 30,2008.

$65 Million SecondLien Term Loan—the Second Lien Term Loan has a maturity date of February 28,2012 and provides for a floating interest rate based upon the prime rate plus5.75% or LIBOR plus 6.75%. Interest is payable in arrears on a quarterly basis.The Second Lien Term Loan has a prepayment penalty of 2.0% and 1.0% of theamount of any such optional prepayment that occurs prior to the first or secondanniversary date, respectively. The Second Lien Term Loan requires principalreductions based upon a percentage of excess cash flow (as defined in thecredit agreement) in any fiscal year and is also subject to certain mandatoryprepayment provisions. In the event that we have not extended the maturity dateof the Series Z to a date that is on or after July 26, 2012 orredeemed the Series Z by March 30, 2009, then the Second Lien TermLoan will mature on March 30, 2009.

$25 MillionSubordinated Term Loan—the Subordinated Term Loan has a maturity date of February 28,2013, carries a fixed interest rate of 13.75% per annum and requires aquarterly cash interest payment in arrears at 6.5% and quarterly paid-in kindinterest that is added to the principal balance 

22

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outstanding at 7.25%. The Subordinated Term Loan is held byaffiliates of Greenlight Capital. Based on an original issue discount of 2.5%,proceeds of approximately $24.4 million were loaned to the Company. TheSubordinated Term Loan is subject to certain mandatory prepayment provisions.In the event that we have not extended the maturity date of the Series Zto a date that is on or after July 26, 2013 or redeemed the Series Zby June 29, 2009, then the Subordinated Term Loan will mature on June 29,2009.

All the loans haveusual and customary covenants including consolidated leverage ratios, fixedcharge coverage ratios, limitations on capital expenditures, etc. The loans areall guaranteed by our material subsidiaries. The Revolving Facility and theFirst Lien Term Loan and the related guarantees are secured by a first prioritysecurity interest in all of our assets and our material subsidiaries, includinga pledge of 100% of our interest in all shares of capital stock (or otherownership or equity interests) of each material subsidiary. The Second LienTerm Loan and the related guarantees are secured by a second priority securityinterest in all our assets and our material subsidiaries, including a pledge of100% of our interest in all shares of capital stock (or other ownership orequity interests) of each material subsidiary. The Subordinated Term Loan isunsecured.

As a result of this refinancing, and based upon LIBOR rates in effectas of February 28, 2006, our average cash interest rate is expected toimprove to approximately 10.2% as compared with 13.0% on the debt it replaced.Cash flow savings from the refinancing is expected to result in cash savings ofapproximately $5.2 million per year based upon LIBOR rates in effect as of February 28,2006.

***Trends and/or Uncertainties***

The following factorsrepresent currently known trends or uncertainties that may impact thecomparability of operating performance or could cause reported financialinformation not to be necessarily indicative of future operating results orfuture financial condition.

*Revenue*

We intend to emphasize ourcore strengths in bagels and the breakfast day-part and focus on quality, speedof service, order accuracy and customer interaction. We also intend to expandour existing catering programs, increase customer awareness of our retailproducts, emphasize bundling products such as “Sweeten the Deal,” (adding on abeverage and a bakery product, such as a cookie) and highlight favoriteproducts such as our egg sandwiches. We believe these initiatives willpositively impact check averages and drive transaction counts in futureperiods.

*Expenses*

Our expenses aregenerally affected by the following major categories:

·       Changingprices for agricultural commodities,

·       Risingenergy costs and increasing costs of other natural resources,

·       Increasinglabor costs, and

·       Increasingtax rates and costs of compliance with regulatory requirements.

In fiscal 2004, prices for agricultural commoditiessuch as dairy, cheese and butter increased substantially. We experienced slightdecreases in dairy prices during 2005, but the decrease was offset by increasesin commodity costs for coffee, flour and packaging. Flour represents the most significantraw ingredient we purchase and we believe the cost of this commodity, as wellas others, will continue to increase in 2006.

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Rising energy costs and the increasing costs of othernatural resources affect our utility bills, the cost of packaging that isderived from petroleum products and the cost of distribution to ourrestaurants. We experienced increases in the cost for energy and packagingmaterials during 2005 and believe such costs will continue to increase onaverage during 2006. Our distribution partners and common freight carrierspassed on fuel surcharges to us during fiscal 2004 and 2005. During late 2005,we negotiated contract terms with a new distribution partner. As a result, weexperienced increased distribution costs beginning in the fourth quarter of2005 that will continue throughout 2006.

Due to competition for personnel, limited availabilityin the labor pool, and changes in the federal overtime regulations, weanticipate that we may experience an increase in hourly wages during 2006contingent upon the number of overtime hours worked. We continue to makeimprovements in labor efficiencies that may help to offset increases in laborcosts.

Certain states and local governments have increasedboth the rate and nature of taxes on businesses in their regions in an effortto offset budget shortfalls. These increased taxes include real estate andproperty taxes, state and local income taxes, and various employment taxes.

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

*Impact of Inflation*

We have not experienced a significant overall impactfrom inflation. As operating expenses increase, we recover increased coststhrough pricing increases, to the extent permitted by competition. We alsoreview and implement alternative products or processes.

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***Results ofOperations for Fiscal Years 2005, 2004 and 2003***

| ** **                                                    | ** ** | **For the years ended:**      | ** ** | **% Increase/  (Decrease)** | ** ** | **For the years ended:** | ** ** |
|---------------------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------|------------|-----------------------------------------|------------|
| ** **                                                    | ** ** | **(in thousands of dollars)** | ** ** | **2005**                         | ** ** | **2004**                                | ** ** | **(percent of total revenue)** | ** ** |
| ** **                                                    | ** ** | **2005**                                     | ** ** | **2004**                         | ** ** | **2003**                                | ** ** | **vs. 2004** | ** ** | **vs. 2003** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                    | ** ** | **(53 wks)**                            | ** ** | **(52 wks)**                | ** ** | **(52 wks)**                       | ** ** | ** ** | ** ** | ** ** | ** ** | **(53 wks)** | ** ** | **(52 wks)** | ** ** | **(52 wks)** | ** ** |
| Revenues:                                                     |       |                                         |       |                             |       |                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Retail sales                                                  |       | $                                            | 363,044    |                             | $          | 347,786                                 |       | $ | 356,225 |   |   | 4.4 | % |   |   | (2.4 | )% |   |   | 93.3 | % |   |   | 93.0 | % |   |   | 92.9 | % |   |
| Manufacturing revenues                                        |       | 20,118                                       |       | 20,122                           |       | 21,457                                  |       |   | (0.0 | )% |   |   | (6.2 | )% |   |   | 5.2 | % |   |   | 5.4 | % |   |   | 5.6 | % |   |
| Franchise and license related revenues                        |       | 5,931                                        |       | 5,952                            |       | 5,624                                   |       |   | (0.4 | )% |   |   | 5.8 | % |   |   | 1.5 | % |   |   | 1.6 | % |   |   | 1.5 | % |   |
| Total revenues                                                |       | 389,093                                      |       | 373,860                          |       | 383,306                                 |       |   | 4.1 | % |   |   | (2.5 | )% |   |   | 100.0 | % |   |   | 100.0 | % |   |   | 100.0 | % |   |
| Cost of sales (percentage  of corresponding revenue stream):  |       |                                         |       |                             |       |                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Retail costs                                                  |       | 296,610                                      |       | 288,736                          |       | 297,934                                 |       |   | 2.7 | % |   |   | (3.1 | )% |   |   | 81.7 | % |   |   | 83.0 | % |   |   | 83.6 | % |   |
| Manufacturing costs                                           |       | 18,781                                       |       | 17,925                           |       | 19,756                                  |       |   | 4.8 | % |   |   | (9.3 | )% |   |   | 93.4 | % |   |   | 89.1 | % |   |   | 92.1 | % |   |
| Total cost of sales                                           |       | 315,391                                      |       | 306,661                          |       | 317,690                                 |       |   | 2.8 | % |   |   | (3.5 | )% |   |   | 81.1 | % |   |   | 82.0 | % |   |   | 82.9 | % |   |
| Gross profit (percentage  of corresponding revenue stream):   |       |                                         |       |                             |       |                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Retail                                                        |       | 66,434                                       |       | 59,050                           |       | 58,291                                  |       |   | 12.5 | % |   |   | 1.3 | % |   |   | 18.3 | % |   |   | 17.0 | % |   |   | 16.4 | % |   |
| Manufacturing                                                 |       | 1,337                                        |       | 2,197                            |       | 1,701                                   |       |   | (39.1 | )% |   |   | 29.2 | % |   |   | 6.6 | % |   |   | 10.9 | % |   |   | 7.9 | % |   |
| Franchise and license                                         |       | 5,931                                        |       | 5,952                            |       | 5,624                                   |       |   | (0.4 | )% |   |   | 5.8 | % |   |   | 100.0 | % |   |   | 100.0 | % |   |   | 100.0 | % |   |
| Total gross profit                                            |       | 73,702                                       |       | 67,199                           |       | 65,616                                  |       |   | 9.7 | % |   |   | 2.4 | % |   |   | 18.9 | % |   |   | 18.0 | % |   |   | 17.1 | % |   |
| General and administrative expenses                           |       | 36,096                                       |       | 32,755                           |       | 41,794                                  |       |   | 10.2 | % |   |   | (21.6 | )% |   |   | 9.3 | % |   |   | 8.8 | % |   |   | 10.9 | % |   |
| Depreciation and amortization                                 |       | 26,316                                       |       | 27,848                           |       | 34,013                                  |       |   | (5.5 | )% |   |   | (18.1 | )% |   |   | 6.8 | % |   |   | 7.4 | % |   |   | 8.9 | % |   |
| Loss (gain) on sale, disposal or abandonment of  assets, net  |       | 314                                          |       | 1,557                            |       | (558                                    | )          |   | (79.8 | )% |   |   | * |   |   |   | 0.1 | % |   |   | 0.4 | % |   |   | (0.1 | )% |   |
| Charges (adjustments) of integration and  reorganization cost |       | 5                                            |       | (869                             | )          | 2,132                                   |       |   | * |   |   |   | * |   |   |   | 0.0 | % |   |   | (0.2 | )% |   |   | 0.6 | % |   |
| Impairment charges and other related costs                    |       | 1,603                                        |       | 450                              |       | 5,292                                   |       |   | * |   |   |   | (91.5 | )% |   |   | 0.4 | % |   |   | 0.1 | % |   |   | 1.4 | % |   |
| Income (loss) from operations                                 |       | 9,368                                        |       | 5,458                            |       | (17,057                                 | )          |   | 71.6 | % |   |   | (132.0 | )% |   |   | 2.4 | % |   |   | 1.5 | % |   |   | (4.4 | )% |   |
| Other expense (income):                                       |       |                                         |       |                             |       |                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest expense, net                                         |       | 23,698                                       |       | 23,196                           |       | 34,184                                  |       |   | 2.2 | % |   |   | (32.1 | )% |   |   | 6.1 | % |   |   | 6.2 | % |   |   | 8.9 | % |   |
| Cumulative change in the fair value of derivatives            |       | —                                       |       | —                           |       | (993                                    | )          |   | * |   |   |   | * |   |   |   | 0.0 | % |   |   | 0.0 | % |   |   | (0.3 | )% |   |
| Gain on investment in debt securities                         |       | —                                       |       | —                           |       | (374                                    | )          |   | * |   |   |   | * |   |   |   | 0.0 | % |   |   | 0.0 | % |   |   | (0.1 | )% |   |
| Loss on exchange of Series F Preferred Stock             |       | —                                       |       | —                           |       | 23,007                                  |       |   | * |   |   |   | * |   |   |   | 0.0 | % |   |   | 0.0 | % |   |   | 6.0 | % |   |
| Other                                                         |       | (312                                         | )          | (284                             | )          | (172                                    | )          |   | 9.9 | % |   |   | 65.1 | % |   |   | (0.1 | )% |   |   | (0.1 | )% |   |   | (0.0 | )% |   |
| Loss before income taxes                                      |       | (14,018                                      | )          | (17,454                          | )          | (72,709                                 | )          |   | (19.7 | )% |   |   | (76.0 | )% |   |   | (3.6 | )% |   |   | (4.7 | )% |   |   | (19.0 | )% |   |
| Provision (benefit) for state income taxes                    |       | —                                       |       | (49                              | )          | 812                                     |       |   | * |   |   |   | * |   |   |   | 0.0 | % |   |   | (0.0 | )% |   |   | 0.2 | % |   |
| Net loss                                                      |       | (14,018                                      | )          | (17,405                          | )          | (73,521                                 | )          |   | (19.5 | )% |   |   | (76.3 | )% |   |   | (3.6 | )% |   |   | (4.7 | )% |   |   | (19.2 | )% |   |
| Dividends and accretion on Preferred Stock                    |       | —                                       |       | —                           |       | (14,423                                 | )          |   | * |   |   |   | * |   |   |   | 0.0 | % |   |   | 0.0 | % |   |   | (3.8 | )% |   |
| Net loss available  to common stockholders                    |       | $                                            | (14,018    | )                                | $          | (17,405                                 | )          | $ | (87,944 | ) |   | (19.5 | )% |   |   | (80.2 | )% |   |   | (3.6 | )% |   |   | (4.7 | )% |   |   | (22.9 | )% |   |

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*                     not meaningful

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*Revenues*

Total revenues for fiscal 2005 were slightly below ourexpectations predominantly due to lower manufacturing revenues, license feesand a lower level of increased transactions at our company operated restaurantsbut represented positive sales performance over prior years. Total revenueimproved 4.1% during fiscal 2005 compared to fiscal 2004. This improvement wasprimarily attributable to an increase in retail sales. During fiscal 2005, wederived 93.3% of our total revenue from our company-operated restaurants. Ourcompany operated retail sales increased 2.4% when calculated on a comparative 53-weekbasis for both fiscal 2005 and 2004. Retail comparable store sales increased5.2% for fiscal 2005 due to an increase of 5.4% in check average offset by 0.2%decrease in transactions. Comparable store sales represent sales at restaurantsthat were open for one full year and have not been relocated or closed duringthe current year. Comparable store sales are also referred to as “same-store”sales and as “comp sales” within the restaurant industry.

Total revenues for fiscal 2004 were consistent withour expectations. Total revenues decreased 2.5% for fiscal 2004 compared tofiscal 2003. The decrease in total revenue primarily resulted from the declinein company operated retail sales. Retail comparable store sales decreased 1.9%for fiscal 2004 due to a reduction in transactions of 5.4% partially offset byan increase of 3.8% in check average.

Throughoutfiscal 2004, the trend of lower comparable store sales began to reverse andultimately became positive during the fourth quarter of 2004. The followingtable summarizes the elements of comparable store sales for each quarter infiscal 2004 and 2005:

| ** **        | ** ** | **Comparable**       | ** ** | **Average** | ** ** | ** **       | ** ** |
|-------------------|------------|----------------------|------------|-------------|------------|------------------|------------|
| ** **        | ** ** | **Store Sales** | ** ** | **Check**   | ** ** | **Transactions** | ** ** |
| Fiscal Year 2004: |       |                 |       |        |       |             |       |   |   |   |   |   |   |
| First Quarter     |       |                 | (4.8       | )%          |       |             | 0.7        | % |   |   | (5.5 | )% |   |
| Second Quarter    |       |                 | (3.7       | )%          |       |             | 3.9        | % |   |   | (7.3 | )% |   |
| Third Quarter     |       |                 | (1.6       | )%          |       |             | 5.0        | % |   |   | (6.3 | )% |   |
| Fourth Quarter    |       |                 | 2.6        | %           |       |             | 5.2        | % |   |   | (2.5 | )% |   |
| Fiscal Year 2005: |       |                 |       |        |       |             |       |   |   |   |   |   |   |
| First Quarter     |       |                 | 4.6        | %           |       |             | 6.4        | % |   |   | (1.7 | )% |   |
| Second Quarter    |       |                 | 6.3        | %           |       |             | 6.0        | % |   |   | 0.3 | % |   |
| Third Quarter     |       |                 | 5.9        | %           |       |             | 5.5        | % |   |   | 0.4 | % |   |
| Fourth Quarter    |       |                 | 3.9        | %           |       |             | 3.8        | % |   |   | 0.1 | % |   |

 

We believe the positivetrend in comparable store sales is a result of price increases coupled with ashift in the product mix to higher priced items, improvements in the operationof our restaurants including initiatives in customer service and overall storeappearance, the introduction of new menu items, further development of cateringprograms in selected markets, and advertising campaigns that were initiated inthe fourth quarter of fiscal 2004 and second and third quarters of fiscal 2005that strengthened consumer awareness.

*Gross Profit*

Our total gross profit during fiscal 2005 demonstratescontinuing improvement over prior years due to careful monitoring of the impactof price increases and the cost of products sold using theoretical food costmodels. The dollar change in our total gross profit improved 9.7% during fiscal2005 compared to fiscal 2004. The improvement was primarily driven by anincrease of 12.5% in our company-operated retail margins, which contributes themost significant component of total gross profit. Our retail margins areimpacted by various store-level operating expenses such as the cost of productssold, salaries and benefits, insurance, supplies, repair and maintenanceexpenses, advertising, rent, utilities and property taxes. 

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Similarly, ourmanufacturing margins are impacted by various manufacturing-level operatingexpenses such as the cost of products sold, salaries and benefits, insurance,supplies, repair and maintenance expenses, rent, utilities and property taxes.Depreciation, amortization and income taxes do not impact our retail ormanufacturing margins.

Because certain elements of cost of sales such asrent, utilities, property taxes and manager salaries are fixed in nature,incremental sales positively impact gross profit. During fiscal year 2005, theincrease in company operated retail sales over the comparable periodcontributed approximately $11.7 million of store contribution margin related tothe increased sales. This margin increase was partially offset by approximately$1.6 million in additional marketing expenses, $2.0 million in additionalbonuses payable to restaurant managers due to improved operating performance and$0.7 million in increased bank charges and credit card fees.

Our total gross profit improved 2.4% for fiscal 2004compared to fiscal 2003. The improvement was primarily due to improvements inour retail costs of sales. Our retail margins improved by 1.3% in fiscal 2004as compared to fiscal 2003. For fiscal 2004, approximately $8.2 million of theimprovement we experienced was attributable to our decision to temporarilyreduce marketing expenditures as we focused on modifications to our customerservice system, menu offerings and the “look and feel” of our company-operatedrestaurants. Additionally, we experienced an improvement in labor utilizationand reductions in group insurance and workers’ compensation claims ofapproximately $1.1 million, offset by increases of approximately $2.4 millionin commodity costs.

Our manufacturingoperations are ancillary to our company-operated stores. For the fiscal yearsended 2005 and 2004, our manufacturing margins represented less than 1.0% oftotal revenues. The profit derived from our manufacturing operations representsthird-party sales and can be significantly impacted by fixed overhead costssuch as rent, utilities, property taxes and manager salaries and fluctuatingcommodity costs.

*Other Expenses*

Our general and administrative expenses increased10.2% during fiscal 2005 when compared to the same period in 2004.Approximately $2.4 million was the result of an increase in salaries andbonuses to corporate office staff and management due to improved operating performance.Also contributing to the increase was approximately $0.6 million in travel,$0.4 million in severance wages, $0.5 million in additional accrued vacationwages payable in future periods, $0.3 million in additional recruiting andrelocation expenses, offset by approximately $1.1 million in reduced legalspending for matters that were resolved in early 2005.

General and administrative expenses decreased 21.6%during fiscal 2004 when compared to the preceding fiscal year. The decline infiscal 2004 general and administrative expenses is primarily due to reducedspending of $3.9 million for non-capitalizable legal and consulting expensesthat were related to our 2003 debt refinancing and equity recapitalization, andthe re-audit of our 2000 and 2001 financial results that occurred during 2003,which did not recur in 2004. Additionally, in 2004, bad debt expense decreased$1.8 million due to improved collection efforts and management of franchiseereceivables.

Depreciation and amortization expenses decreased 5.5%and 18.1% during fiscal 2005 and 2004, respectively, when compared to thepreceding fiscal year. The decrease in depreciation and amortization expense isprimarily due to a portion of our asset base becoming fully depreciated.

During fiscal 2004, we recorded a loss on disposal orabandonment of assets of approximately $120,000 due to the disposal of menuboards as a result of our new menu offerings and approximately $1.5 milliondue to the abandonment of leasehold improvements related to closed restaurantsand our 

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administrative facilitieslocated in New Jersey. The loss on disposal or abandonment of assets was offsetby a gain of approximately $90,000 on the sale of the assets of Willoughby’s.

Charges (adjustments) of integration andreorganization cost for fiscal 2004 primarily represents adjustments topreviously recorded liabilities associated with the closing and consolidationof our Eatontown facilities during 2002. During April 2004, we reached anagreement with the landlord of our Eatontown facility to settle outstandinglitigation. Previously recorded integration and reorganization estimatesassociated with closing this facility were adjusted to reflect a reduction ofthe prior year’s accrued cost of $0.7 million. The charge in fiscal 2003 reflectsan increase in the estimated liability associated with closing certainfacilities as part of our reorganization partially offset by an adjustment froman estimated reorganization liability recorded in 2002.

During fiscal 2005, we recorded approximately $1.3million in impairment charges related to the Chesapeake trademarks. We alsorecorded approximately $0.2 million in impairment charges related tocompany-owned stores and approximately $0.1 million in exit costs from thedecision to close one restaurant. During fiscal 2004, we recorded $0.5 millionin impairment charges for long-lived asset impairments and exit costs from thedecision to close two restaurants and to write down the assets ofunder-performing restaurants. During fiscal 2003, we recorded a charge ofapproximately $5.3 million due to the reduced value of certain trademarksassociated with our Manhattan and Chesapeake brands and the value of franchiseeterritory rights for our Manhattan brand. There was no impairment of intangibleassets in fiscal 2004.

During fiscal 2005, net interest expense increased2.2% when compared to fiscal 2004 primarily due to the 53-week basis.Calculated on a comparative 53-week basis for both fiscal 2005 and 2004,interest expense remained flat. Net interest expense decreased 32.1% duringfiscal 2004 when compared to the preceding fiscal year as a result ofrefinancing our debt in July 2003 in which the stated interest rate on ourprimary debt facility declined from 18% to 13% per year.

As a result of the equity recapitalization in September 2003,we no longer have contingently issuable warrants and all issued warrants areclassified as permanent equity. The cumulative change in fair value ofderivatives during fiscal 2003 is due to the change in the fair value ofwarrants classified as a derivative liability based on the underlying fairvalue of common stock to which they are indexed and, for contingently-issuablewarrants classified as a derivative liability, the estimated probability ofissuance and other pertinent factors.

In fiscal 2003, we recognized a gain on the investmentin debt securities of $0.4 million from our investment in theEinstein/Noah Bagel Corp. 7.25% Convertible Debentures due 2004. The proceedsfrom the bankruptcy court were in excess of our original estimates.

In September 2003, we completed an equityrecapitalization with our preferred stockholders, who held a substantialportion of our common stock. Among other things, our Mandatorily Redeemable Series FPreferred Stock was eliminated. In exchange, we issued 57,000 shares of Series ZMandatorily Redeemable Preferred Stock to Halpern Denny Fund III, L.P. and weissued 9,380,843 shares of our common stock to Greenlight Capital andaffiliates. The exchange of the Halpern Denny interest resulted in a reductionof our effective dividend rate and as a result of this and other factors, weaccounted for this transaction as troubled debt restructuring. This exchangedid not result in a gain from troubled debt restructuring. The exchange of theGreenlight interest into common shares was recorded at fair value, whichresulted in a loss upon exchange of approximately $23.0 million reflected infiscal 2003.

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***Financial Condition, Liquidity and Capital Resources***

The restaurant industry is predominantly a cashbusiness where cash is received at the time of the transaction. We generatesufficient cash flow and we have sufficient availability under our revolving creditfacility to fund operations, capital expenditures and required debt andinterest payments. Our inventory turns frequently since our products areperishable. Accordingly, our investment in inventory is minimal. Our accountspayable are on terms that we believe are consistent with those of othercompanies within the industry.

The primary driverof our operating cash flow is our restaurant operations, specifically the grossmargin from our company-operated restaurants. Therefore, we focus on theelements of those operations including comparable store sales and cash flows toensure a steady stream of operating profits that enable us to meet our cashobligations. On a weekly basis, we review our company-operated storeperformance compared with the same period in the prior year and our operatingplan. We are continuously identifying and implementing initiatives to increaserevenue as well as reduce costs, not only at the store operations level, butalso within other disciplines such as supply chain, manufacturing operationsand overhead. During 2005, we continued to identify and implement theseinitiatives, including but not limited to:

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

·       refinementof merchandising to drive sales of higher margin items;

·       newrevenue initiatives related to our manufacturing and commissary operations;

·       expansionof our catering program;

·       menuoptimization to remove and/or modify slow moving products and thus reduce waste;

·       reductionsin cost of goods sold through purchasing efficiencies;

·       afocus on labor costs and efficiencies; and

·       refinement of programs thatmonitor theoretical food cost.

*AmSouth Revolverand $160 Million Notes*

Our AmSouth Revolver was a $15 million senior securedrevolving credit facility, with a maturity date of July 8, 2006. On January 3,2006, our unused credit facility totaled approximately $7.9 million, net ofoutstanding letters of credit of $7.1 million. Our credit facility containedfinancial covenants relating to the maintenance of leverage and coverageratios. The credit facility also contained affirmative and negative covenantsincluding, among other things, limitations on certain additional indebtedness,capital expenditures and minimum EBITDA as defined in the AmSouth agreement. Wewere in compliance with all covenants at January 3, 2006 and did notanticipate that the covenants would have impacted our ability to borrow underour credit facility for its remaining term.

On July 8, 2003, we issued $160 million inaggregate principal amount of 13% senior secured notes due in 2008 ($160Million Notes) to replace our $140 million in aggregate principal amount ofsenior secured increasing rate notes due in 2003. The $160 Million Notes containedcertain covenants, which, among others, included certain financial covenantssuch as limitations on capital expenditures and minimum EBITDA as defined inthe agreement. The covenants also precluded the declaration and payment ofdividends or other distributions to holders of our common stock. We were incompliance with all covenants at January 3, 2006.

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

·       $15million revolving credit facility maturing on March 31, 2011;

·       $80million first lien term loan maturing on March 31, 2011;

·       $65million second lien term loan maturing on February 28, 2012; and,

·       $25million subordinated term loan maturing on February 28, 2013.

Each of the loans requires the payment of interest inarrears on a quarterly basis commencing on March 31, 2006. Additionally,the $80 million First Lien Term Loan requires quarterly scheduled minimumprincipal reductions commencing June 30, 2006. In the event that we havenot extended the maturity date of the Series Z to a date that is on orafter July 26, 2012 (July 26, 2013 for the Subordinated Term Loan) orredeemed the Series Z by various dates in 2008 and 2009, then each of theloans have various accelerated maturity dates beginning in December 2008.For an additional discussion regarding our new debt facility, see Note 27 toour consolidated financial statements included in Item 8 of this report.

Based upon our projectionsfor fiscal 2006 and beyond, we believe that the cash flow from operationscoupled with the availability under our new financing will be adequate to fundour operations, capital expenditures and required debt and interest repaymentsfor the foreseeable future.

*Working Capital*

On January 3, 2006,we had unrestricted cash of $1.6 million and restricted cash of $3.2 million.On December 28, 2004, we had unrestricted cash of $9.8 million, restrictedcash of $3.8 million and nothing borrowed under our AmSouth Revolver. Wereduced our working capital deficit to $11.7 million in fiscal 2005 compared toa working capital deficit of $18.7 million in fiscal 2004. The timing of our January 1semi-annual interest payment of $10.4 million under our $160 Million Notes andthe payment of monthly rent (reflected in prepaid expenses) negatively impactedour cash balance at January 3, 2006.

*OperatingActivities*

During fiscal 2005, operations generated $2.1 millionof cash compared to $11.1 million in fiscal 2004. Generally, our cash fromoperations has included two semi-annual interest payments of $10.4 million, or$20.8 million in the aggregate, related to our $160 Million Notes. Fiscal year2005 includes $31.2 million representing three cash interest payments. Wecontinue to see improvements in our cash flow from operations and believe thatsuch cash flow will be adequate to fund operating costs.

Due to the timing ofinterest payments under our $160 Million Notes, which were due January 1and July 1 and approximated $10.4 million on a semi-annual basis, we generallyconsumed cash from operations during the first and third fiscal quarters ofeach year. During the second and fourth fiscal quarters of each year, wegenerally generated cash from operations. Historically, our fourth quarter isour strongest quarter for generating cash due to seasonality and gift cardpromotions. Under our new credit facility and based on LIBOR rates in effect asof February 28, 2006, we estimate that our cash interest expense willdecrease by approximately $5.2 million on an annual basis.

*InvestingActivities*

During fiscal 2005, we used approximately $10.3million of cash to purchase additional property and equipment that included$1.2 million for new stores, $2.3 million for remodeling existing stores, $4.3million for replacement and new equipment at our existing company-operatedstores, $0.9 million for our manufacturing operations and less than $1.6million for general corporate purposes.

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During fiscal 2004, we used $9.4 million of cash topurchase additional property and equipment that included $1.2 million for newrestaurants, $5.8 million for replacement and new equipment at our existingcompany-operated restaurants, $0.8 million for our manufacturing operations and$1.6 million for general corporate purposes.

We anticipate that themajority of our capital expenditures for fiscal 2006 will be focused on ourrefresh and remodel strategy that includes updates of restaurant interiors andimprovements to service through new menu boards. In addition, we plan toacquire additional equipment for new menu items and improvements in the speedof service, particularly during the morning day-part. We also plan to open 10new company-owned restaurants during 2006 at an average capital investment ofapproximately $400,000 per location.

*Financing Activities*

During fiscal 2005, we used cash of approximately $0.3million to repay our obligations under the New Jersey Economic DevelopmentAuthority Note Payable (as further discussed in Note 10 to our consolidatedfinancial statements included in Item 8 of this report), offset byapproximately $0.2 million in proceeds received from the exercise of warrantsissued in connection with a private financing transaction related to ourissuance of increasing rate notes that were repaid in July 2003.

During fiscal 2004, we used $1.0 million of cash toreduce our debt outstanding on the AmSouth Revolver, approximately $0.8 millionto repay our obligations under the Chesapeake Bagel Bakery Note Payable andapproximately $0.3 million to repay our obligations under the New JerseyEconomic Development Authority Note Payable (as further discussed in Note 10 toour consolidated financial statements included in Item 8 of this report).

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

***Contractual Obligations***

Thefollowing table summarizes the amounts of payments due under specifiedcontractual obligations as of January 3, 2006:

| ** **                                     | ** ** | **Payments Due by Period**    | ** ** |
|------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                     | ** ** | **2006**                                     | ** ** | **2007 to  2009** | ** ** | **2010 to  2011** | ** ** | **2012 and  thereafter** | ** ** | **Total** | ** ** |
| ** **                                     | ** ** | **(in thousands of dollars)** | ** ** |
| Accounts payable  and accrued expenses         |       | $                                            | 30,637     |   | $ | — |   | $ | — |   |   | $ | — |   |   | $ | 30,637 |   |
| Debt(a)                                        |       | 280                                          |       | 160,560 |   | — |   |   | — |   |   | 160,840 |   |
| Interest expense  on $160 Million Notes(a)     |       | 20,800                                       |       | 31,200 |   | — |   |   | — |   |   | 52,000 |   |
| Manditorily  Redeemable Series Z          |       | —                                       |       | 57,000 |   | — |   |   | — |   |   | 57,000 |   |
| Minimum lease  payments under capital leases   |       | 19                                           |       | 29 |   | — |   |   | — |   |   | 48 |   |
| Minimum lease  payments under operating leases |       | 23,973                                       |       | 28,264 |   | 4,980 |   |   | 2,151 |   |   | 59,368 |   |
| Purchase  obligations(b)                       |       | 9,072                                        |       | — |   | — |   |   | — |   |   | 9,072 |   |
| Other long-term  obligations(c)                |       | —                                       |       | 1,448 |   | 832 |   |   | 5,095 |   |   | 7,375 |   |
| Total                                          |       | $                                            | 84,781     |   | $ | 278,501 |   | $ | 5,812 |   |   | $ | 7,246 |   |   | $ | 376,340 |   |

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(a)           On January 27,2006, the $160 Million Notes maturing on July 1, 2008 were called forredemption. On February 28, 2006, the $160 Million Notes were replacedwith $170 million in new term loans. Borrowings from the new debt facility wereused to repay the $160 Million Notes plus a 3% 

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redemption premium andaccrued and unpaid interest to the redemption date. Additionally, debt issuancecosts related to our $160 Million Notes and AmSouth Revolver were written off.Our $170 million in new term loans mature on various dates beginning in2011. In the event that we have not extended the maturity date of the Series Zto a date that is on or after July 26, 2012 (July 26, 2013 for theSubordinated Term Loan) or redeemed the Series Z by various dates in 2008and 2009, then each of the loans have various accelerated maturity datesbeginning in December 2008. Under our new credit facility and based onLIBOR rates in effect as of February 28, 2006, we estimate that our cashinterest expense will decrease by approximately $5.2 million on an annualbasis. For an additional discussion regarding our new debt facility, see Note27 to our consolidated financial statements included in Item 8 of this report.

(b)          Purchase obligationsconsist of non-cancelable minimum purchases of frozen dough from HarlanBakeries, Inc. and certain other raw ingredients that are used in ourproducts.

(c)           Other long-termobligations primarily consist of the remaining liability related to minimumfuture purchase commitments with a supplier that advanced us $10.0 million in1996.

We also had $7.1 million in letters of creditoutstanding under our AmSouth Revolver at January 3, 2006. The letters ofcredit expired on various dates during 2006, were automatically renewable forone additional year and were payable upon demand in the event that we fail topay certain workers compensation claims. Upon funding of our new financing on February 28,2006, the existing letters of credit were surrendered and replaced with newletters of credit totaling $6.9 million. The new letters of credit expire onvarious dates during 2007.

Effective October 6, 2004, we executed a two-yearsupply agreement to purchase coffee for our New World Coffee cafés. Theagreement provided for agreed-upon pricing at cost plus a minimal mark-up andno minimum purchase commitment. Accordingly, we have not included any estimatesof payments due in the contractual obligations table above.

Thefollowing schedule details the amounts of payments due under our new debtfacility as of February 28, 2006 based on the original maturity dates. Inthe event that we have not extended the maturity date of the Series Z to adate that is on or after July 26, 2012 (July 26, 2013 for theSubordinated Term Loan) or redeemed the Series Z by various dates in 2008and 2009, then each of the loans have various accelerated maturity datesbeginning in December 2008.

| ** **                                    | ** ** | **Payments Due by Period**    | ** ** |
|-----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                    | ** ** | **2006**                                     | ** ** | **2007 to  2009** | ** ** | **2010 to  2011** | ** ** | **2012 and  thereafter** | ** ** | **Total** | ** ** |
| ** **                                    | ** ** | **(in thousands of dollars)** | ** ** |
| Revolving Credit  Facility                    |       | $                                            | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| First Lien Term  Facility                     |       | 1,425                                        |       | 20,525 |   | 58,050 |   | — |   | 80,000 |   |
| Second Lien Term  Facility                    |       | —                                       |       | — |   | — |   | 65,000 |   | 65,000 |   |
| Unsecured  Subordinated Term Loan Facility    |       | —                                       |       | — |   | — |   | 25,000 |   | 25,000 |   |
| Estimated  interest expense on the term loans |       | 13,116                                       |       | 41,988 |   | 27,082 |   | 20,540 |   | 102,726 |   |
| Total                                         |       | $                                            | 14,541     |   | $ | 62,513 |   | $ | 85,132 |   | $ | 110,540 |   | $ | 272,726 |   |

 

***Off-Balance Sheet Guarantees***

Prior to 2001, we wouldoccasionally guarantee leases for the benefit of certain of our franchisees.None of the guarantees have been modified since their inception and we havesince discontinued this practice. Current franchisees are the primary lesseesunder the vast majority of these leases. Under the lease guarantees, we may berequired by the lessor to make all of the remaining monthly rental payments orproperty tax and common area maintenance payments if the franchisee does notmake the required payments in a timely manner. However, we believe that most,if not all, of the franchised locations could be 

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subleasedto third parties reducing our potential exposure. Additionally, we haveindemnification agreements with our franchisees under which the franchiseeswould be obligated to reimburse us for any amounts paid under such guarantees.Historically, we have not been required to make such payments in significantamounts. We record a liability for our exposure under the guarantees inaccordance with SFAS No. 5, Accounting for Contingencies (SFAS No. 5),following a probability related approach. In the event that trends change inthe future, our financial results could be impacted. As of January 3,2006, we had outstanding guarantees of indebtedness under certain leases ofapproximately $0.6 million. Approximately $90,000 is reflected in accruedexpenses in our consolidated balance sheet at January 3, 2006 for probablelosses related to these guarantees.

***Non-GAAP Financial Measures***

Adjusted EBITDA is a typical non-GAAP measurement forcompanies that issue debt and a measure used by our lenders. Adjusted EBITDA,as defined in our Indenture Agreement relating to the $160 Million Notes and therevolving credit facility with AmSouth Bank (collectively referred to herein asour loan agreements) represents earnings before interest, taxes, depreciationand amortization, and is further adjusted by various items including: (1) integrationand reorganization charges and credits, (2) cumulative change in fairvalue of derivatives, (3) gain/loss on the investment, sale, disposal orexchange of assets, (4) impairment and other related charges and (5) otherexpense (income). Adjusted EBITDA may also be further adjusted by certainlegal, financing and advisory fees, acquisition and integration expenses, andother charges. Our loan agreements required that Adjusted EBITDA be measured ona twelve month period ending on the last day of each fiscal quarter and begreater than $33 million. We present Adjusted EBITDA because it related to acovenant contained in each of our loan agreements which was material to us, ourfinancial condition and liquidity. If we did not comply with the AdjustedEBITDA covenant, an Event of Default (as defined in our loan agreements) wouldoccur and, subject to the applicable notice and cure periods, the lenders coulddeclare all amounts outstanding immediately due and payable and pursue allavailable remedies for payment of such amounts. As of January 3, 2006, wewere in compliance with the Adjusted EBITDA covenants under our AmSouthRevolver and $160 Million Notes.

Data regarding Adjusted EBITDA is provided asadditional information to help our bondholders understand our compliance withthe Adjusted EBITDA covenant. We also believe Adjusted EBITDA is useful to ourbondholders as an indicator of earnings available to service debt. AdjustedEBITDA is not a recognized term under GAAP and does not purport to be analternative to income (loss) from operations, an indicator of cash flow fromoperations or a measure of liquidity. Because not all companies calculateAdjusted EBITDA identically, this presentation may not be comparable tosimilarly titled measures of other companies. We believe Adjusted EBITDA is amore meaningful indicator of earnings available to service debt when certaincharges (such as the gain or loss from the disposal of assets, impairment ofassets and cumulative change in the fair value of derivatives) are excluded fromincome (loss) from continuing operations. Adjusted EBITDA is not intended to bea measure of free cash flow for management’s discretionary use, as it does notconsider certain cash requirements such as interest expense, income taxes, debtservice payments and cash costs arising from integration and reorganizationactivities.

On February 28, 2006, we completed therefinancing of the AmSouth Revolver and $160 Million Notes. Our new financinghas the usual and customary covenants including an Adjusted EBITDA covenantconsistent with the aforementioned definition.

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Thefollowing tables reconcile Adjusted EBITDA to net loss and cash flows used inoperating activities:

| ** **                                                    | ** ** | **First quarter ended:** | ** ** | **Second quarter ended:** | ** ** | **Third quarter ended:** | ** ** | **Fourth quarter ended:** | ** ** | **Year ended:** | ** ** |
|---------------------------------------------------------------|------------|------------------------------------|------------|-------------------------------------|------------|------------------------------------|------------|-------------------------------------|------------|----------------------|------------|
| ** **                                                    | ** ** | **Mar 29,**                   | ** ** | **Mar 30,**                    | ** ** | **Jun 28,**                   | ** ** | **Jun 29,**                    | ** ** | **Sept 27,**    | ** ** | **Sept 28,** | ** ** | **Jan 3,** | ** ** | **Dec 28,** | ** ** | **Jan 3,** | ** ** | **Dec 28,** | ** ** |
| ** **                                                    | ** ** | **2005**                           | ** ** | **2004**                            | ** ** | **2005**                           | ** ** | **2004**                            | ** ** | **2005**             | ** ** | **2004** | ** ** | **2006** | ** ** | **2004** | ** ** | **2006** | ** ** | **2004** | ** ** |
| **Reconciliation of Net Loss to Adjusted EBITDA:**            |       |                               |       |                                |       |                               |       |                                |       |                 |       |   |   |   |   |   |   |   |   |   |   |
| Net loss                                                      |       | $                                  | (4,198     | )                                   | $          | (4,130                             | )          | $                                   | (4,283     | )                    | $          | (6,224 | ) | $ | (4,814 | ) | $ | (4,952 | ) | $ | (723 | ) | $ | (2,099 | ) | $ | (14,018 | ) | $ | (17,405 | ) |
| Adjustments  as defined in the loan agreements:               |       |                               |       |                                |       |                               |       |                                |       |                 |       |   |   |   |   |   |   |   |   |   |   |
| Interest expense, net                                         |       | 5,919                              |       | 5,799                               |       | 5,773                              |       | 5,904                               |       | 5,805                |       | 5,723 |   | 6,201 |   | 5,770 |   | 23,698 |   | 23,196 |   |
| Taxes                                                         |       | —                             |       | 55                                  |       | —                             |       | 184                                 |       | —               |       | (147 | ) | — |   | (141 | ) | — |   | (49 | ) |
| Depreciation and amortization                                 |       | 6,708                              |       | 6,819                               |       | 7,077                              |       | 7,058                               |       | 5,798                |       | 7,005 |   | 6,733 |   | 6,966 |   | 26,316 |   | 27,848 |   |
| Loss (gain) on sale, disposal or abandonment of  assets, net  |       | 4                                  |       | (7                                  | )          | 161                                |       | 1,472                               |       | 104                  |       | (70 | ) | 45 |   | 162 |   | 314 |   | 1,557 |   |
| Charges (adjustments) of integration and  reorganization cost |       | 5                                  |       | (760                                | )          | —                             |       | (39                                 | )          | 1                    |       | (44 | ) | (1 | ) | (26 | ) | 5 |   | (869 | ) |
| Impairment charges and other related costs                    |       | 97                                 |       | —                              |       | 1,182                              |       | —                              |       | 205                  |       | 402 |   | 119 |   | 48 |   | 1,603 |   | 450 |   |
| Other expense (income)                                        |       | (57                                | )          | (63                                 | )          | (69                                | )          | (36                                 | )          | (106                 | )          | (98 | ) | (80 | ) | (87 | ) | (312 | ) | (284 | ) |
| Certain legal, financing and advisory fees                    |       | —                             |       | 75                                  |       | 526                                |       | 688                                 |       | 99                   |       | 494 |   | 6 |   | 338 |   | 631 |   | 1,595 |   |
| Certain corporate expenses                                    |       | —                             |       | 225                                 |       | —                             |       | —                              |       | —               |       | 174 |   | — |   | 219 |   | — |   | 618 |   |
| Certain other charges                                         |       | —                             |       | 25                                  |       | 700                                |       | —                              |       | 25                   |       | — |   | 27 |   | — |   | 752 |   | 25 |   |
| Adjusted EBITDA                                               |       | $                                  | 8,478      |                                | $          | 8,038                              |       | $                                   | 11,067     |                 | $          | 9,007 |   | $ | 7,117 |   | $ | 8,487 |   | $ | 12,327 |   | $ | 11,150 |   | $ | 38,989 |   | $ | 36,682 |   |

 

| ** **                                                                       | ** ** | **First quarter ended:** | ** ** | **Second quarter ended:** | ** ** | **Third quarter ended:** | ** ** | **Fourth quarter ended:** | ** ** | **Year ended:** | ** ** |
|----------------------------------------------------------------------------------|------------|------------------------------------|------------|-------------------------------------|------------|------------------------------------|------------|-------------------------------------|------------|----------------------|------------|
| ** **                                                                       | ** ** | **Mar 29,**                   | ** ** | **Mar 30,**                    | ** ** | **Jun 28,**                   | ** ** | **Jun 29,**                    | ** ** | **Sept 27,**    | ** ** | **Sept 28,** | ** ** | **Jan 3,** | ** ** | **Dec 28,** | ** ** | **Jan 3,** | ** ** | **Dec 28,** | ** ** |
| ** **                                                                       | ** ** | **2005**                           | ** ** | **2004**                            | ** ** | **2005**                           | ** ** | **2004**                            | ** ** | **2005**             | ** ** | **2004** | ** ** | **2006** | ** ** | **2004** | ** ** | **2006** | ** ** | **2004** | ** ** |
| **Reconciliation of Net Cash Used in Operating  Activities to Adjusted EBITDA:** |       |                               |       |                                |       |                               |       |                                |       |                 |       |   |   |   |   |   |   |   |   |   |   |
| Net cash generated by (used in) operating activities                        |       | $                                  | (6,288     | )                                   | $          | (4,175                             | )          | $                                   | 14,353     |                 | $          | 9,610 |   | $ | (5,304 | ) | $ | (5,853 | ) | $ | (686 | ) | $ | 11,528 |   | $ | 2,075 |   | $ | 11,110 |   |
| Adjustments  as defined in the loan agreements:                                  |       |                               |       |                                |       |                               |       |                                |       |                 |       |   |   |   |   |   |   |   |   |   |   |
| Changes in operating assets and liabilities                                      |       | 9,292                              |       | 6,560                               |       | (9,784                             | )          | (6,768                              | )          | 7,138                |       | 8,860 |   | 7,258 |   | (6,087 | ) | 13,904 |   | 2,565 |   |
| Reduction in (provision for) losses on accounts receivable                  |       | 91                                 |       | —                              |       | 47                                 |       | (94                                 | )          | (60                  | )          | (172 | ) | 80 |   | 89 |   | 158 |   | (177 | ) |
| Amortization of debt issue costs                                                 |       | (462                               | )          | (462                                | )          | (462                               | )          | (446                                | )          | (462                 | )          | (479 | ) | (462 | ) | (462 | ) | (1,848 | ) | (1,849 | ) |
| Stock based compensation expense                                                 |       | (17                                | )          | —                              |       | (17                                | )          | (35                                 | )          | (18                  | )          | (16 | ) | (17 | ) | (17 | ) | (69 | ) | (68 | ) |
| Interest expense, net                                                            |       | 5,919                              |       | 5,799                               |       | 5,773                              |       | 5,904                               |       | 5,805                |       | 5,723 |   | 6,201 |   | 5,770 |   | 23,698 |   | 23,196 |   |
| Other income                                                                     |       | (57                                | )          | (64                                 | )          | (69                                | )          | (36                                 | )          | (106                 | )          | (97 | ) | (80 | ) | (87 | ) | (312 | ) | (284 | ) |
| Provision (benefit) for state income taxes                                       |       | —                             |       | 55                                  |       | —                             |       | 184                                 |       | —               |       | (147 | ) | — |   | (141 | ) | — |   | (49 | ) |
| Certain legal, financing and advisory fees                                       |       | —                             |       | 75                                  |       | 526                                |       | 688                                 |       | 99                   |       | 494 |   | 6 |   | 338 |   | 631 |   | 1,595 |   |
| Certain corporate expenses                                                       |       | —                             |       | 225                                 |       | —                             |       | —                              |       | —               |       | 174 |   | — |   | 219 |   | — |   | 618 |   |
| Certain other charges                                                            |       | —                             |       | 25                                  |       | 700                                |       | —                              |       | 25                   |       | — |   | 27 |   | — |   | 752 |   | 25 |   |
| Adjusted EBITDA                                                                  |       | $                                  | 8,478      |                                | $          | 8,038                              |       | $                                   | 11,067     |                 | $          | 9,007 |   | $ | 7,117 |   | $ | 8,487 |   | $ | 12,327 |   | $ | 11,150 |   | $ | 38,989 |   | $ | 36,682 |   |

 

***Recent Accounting Pronouncements***

In December 2004, the FASB issued SFAS No. 123(revised 2004) entitled Share-Based Payment (SFAS No. 123R). SFAS No. 123Raddresses the accounting for share-based payment transactions in which anenterprise receives employee services in exchange for a) equity instruments ofthe enterprise or b) liabilities that are based on the fair value of theenterprise’s equity instruments or that may be settled by the issuance of suchequity instruments. The Statement eliminates the ability to account forshare-based compensation transactions using APB Opinion No. 25, Accountingfor Stock Issued to Employees (APB No. 25), and generally would requireinstead that such transactions be accounted for using a fair-value-basedmethod. This Statement is to be implemented at the beginning of the next fiscalyear that begins after June 15, 2005. Based on options granted and variousassumptions used to calculate stock based compensation expense as of January 3,2006, we believe that the adoption will result in an increase in expense ofapproximately $0.6 million and $0.1 million during fiscal 2006 and 2007,respectively. If actual events differ from our assumptions used to calculatethe expense or if we grant additional options, our financial results could beimpacted.

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In May 2005, the FASB issued SFAS No. 154,Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20,Accounting Changes, and SFAS No. 3, Reporting Accounting Changes inInterim Financial Statements. SFAS No. 154 changes the requirements forthe accounting for and reporting of a change in accounting principle.Previously, most voluntary changes in accounting principles were requiredrecognition via a cumulative effect adjustment within net income of the periodof the change. SFAS No. 154 requires retrospective application to priorperiods’ financial statements, unless it is impracticable to determine eitherthe period-specific effects or the cumulative effect of the change. SFAS No. 154is effective for accounting changes made in fiscal years beginning after December 15,2005; however, the Statement does not change the transition provisions of anyexisting accounting pronouncements.

We have considered allother recently issued accounting pronouncements and do not believe that theadoption of such pronouncements will have a material impact on our consolidatedfinancial statements.

***Critical Accounting Policies and Estimates***

The discussion and analysis of our financial conditionand results of operations are based upon our consolidated financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States of America. The preparation of these consolidatedfinancial statements requires us to make estimates and judgments that affectthe reported amounts of assets, liabilities, revenues and expenses. On anon-going basis, we evaluate our estimates based on historical experience and onvarious other assumptions that are believed to be reasonable under thecircumstances, the results of which form the basis for making judgments aboutthe carrying value of assets and liabilities that are not readily apparent fromother sources. Actual results may differ from these estimates under differentassumptions or conditions.

We believe the followingcritical accounting policies impact our more significant judgments andestimates used in the preparation of our consolidated financial statements. Oursignificant accounting policies are discussed in Note 2 to our consolidatedfinancial statements set forth in Item 8 of this report.

*Impairment ofLong-Lived Assets*

We review property and equipment and amortizingintangible assets for impairment when events or circumstances indicate that thecarrying amount of a restaurant’s assets may not be recoverable. We test forimpairment using historical cash flows and other relevant facts andcircumstances as the primary basis for our estimate of future cash flows.Relevant facts and circumstances may include, but are not limited to, localcompetition in the area, the ability of existing restaurant management, thenecessity of tiered pricing structures and the impact that refreshing ourrestaurants may have on our estimates. This process requires the use ofestimates and assumptions, which are subject to high degree of judgment. In theevent that these estimates and assumptions change in the future, we may berequired to record impairment charges for these assets.

At least annually, weutilize independent valuation experts to assist us in assessing therecoverability of goodwill and other intangible assets not subject to amortizationrelated to our restaurant concepts. These impairment tests require us toestimate the fair values of our restaurant concepts by making assumptionsregarding future profits and cash flows, expected growth rates, terminalvalues, discount rates and other factors. In the event that these assumptionschange in the future, we may be required to record impairment charges for theseassets.

*Insurance Reserves*

We are insured for certainlosses related to health, general liability and workers’ compensation underlarge deductible policies. The insurance liability represents an estimate ofthe ultimate cost of claims 

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incurredand unpaid as of the balance sheet date. The estimated liability is establishedand discounted at 10% based upon analysis of historical data and actuarialestimates and is reviewed on a quarterly basis to ensure that the liability isappropriate. If actual trends, including the severity or frequency of claimsdiffer from our estimates, our financial results could be favorably or unfavorablyimpacted.

*Guarantees*

Prior to 2001, we wouldoccasionally guarantee leases for the benefit of certain of our franchisees.None of the guarantees have been modified since their inception and we havesince discontinued this practice. Current franchisees are the primary lesseesunder the vast majority of these leases. Under the lease guarantees, we may berequired by the lessor to make all of the remaining monthly rental payments orproperty tax and common area maintenance payments if the franchisee does notmake the required payments in a timely manner. However, we believe that most,if not all, of the franchised locations could be subleased to third partiesminimizing our potential exposure. Additionally, we have indemnificationagreements with our franchisees under which the franchisees would be obligatedto reimburse us for any amounts paid under such guarantees. Historically, wehave not been required to make such payments in significant amounts. We recorda liability for our exposure under the guarantees in accordance with SFAS No. 5,“Accounting for Contingencies,” following a probability related approach. Inthe event that trends change in the future, our financial results could beimpacted.

**ITEM 7A.**        QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

For the fiscal years ended 2005 and 2004, our resultsof operations, financial position and cash flows have not been materiallyaffected by changes in the relative values of non-U.S. currencies to the U.S.dollar. We do not use derivative financial instruments to limit our foreigncurrency risk exposure since virtually all of our business is conducted in theUnited States.

Our debt as of January 3, 2006 and December 28,2004 was principally comprised of the $160 Million Notes due July 1, 2008and the AmSouth Revolver. A 100 basis point increase in market interest rateswould have had an immaterial effect on our borrowing costs, since the interestrate on the $160 Million Notes was fixed. The interest rate on the AmSouthRevolver fluctuated with changes in the prime rate, but was immaterial inrelation to interest expense under the $160 Million Notes and in our results ofoperations and financial condition.

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

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

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**ITEM8.**                FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

| Audited Annual Financial Statements                                                                                                                      | ** ** | **Page** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| Report of Independent Registered Public Accounting  Firm                                                                                                                |       |     | 38         |   |   |
| Consolidated  Balance Sheets as of January 3, 2006 and December 28, 2004                                                                                      |       |     | 39         |   |   |
| Consolidated Statements of Operations for the Years  Ended January 3, 2006, December 28, 2004 and December 30, 2003                                      |       |     | 40         |   |   |
| Consolidated Statements of Changes in Stockholders’  Equity (Deficit) for the Years Ended January 3, 2006, December 28,  2004 and December 30, 2003 |       |     | 41         |   |   |
| Consolidated Statements of Cash Flows for the Years  Ended January 3, 2006, December 28, 2004 and December 30, 2003                                      |       |     | 42         |   |   |
| Notes to Consolidated Financial Statements                                                                                                                              |       |     | 43         |   |   |

 

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

Board of DirectorsNew World Restaurant Group, Inc.

We have audited the accompanying consolidated balancesheets of New World Restaurant Group, Inc. and Subsidiaries as of January 3,2006 and December 28, 2004, and the related consolidated statements ofoperations, changes in stockholders’ equity (deficit) and cash flows for eachof the three years in the period ended January 3, 2006. These financialstatements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audits to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement. The Company is not required to have, nor were we engagedto perform an audit of its internal control over financial reporting. Ouraudits included consideration of internal control over financial reporting as abasis for designing audit procedures that are appropriate in the circumstances,but not for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting. Accordingly, we express nosuch opinion. An audit also includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements, assessingthe accounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above, present fairly, in all material respects, the financialposition of New World Restaurant Group, Inc. and Subsidiaries as of January 3,2006 and December 28, 2004, and the results of their operations, and theircash flows for each of the three years in the period ended January 3,2006, in conformity with accounting principles generally accepted in the UnitedStates of America.

Our audit was conductedfor the purpose of forming an opinion on the basic financial statements takenas a whole. Schedule II is presented for purposes of additional analysis and isnot a required part of the basic financial statements. This schedule has beensubjected to the auditing procedures applied in the audit of the basicfinancial statements and in our opinion, is fairly stated in all materialrespects in relation to the basic financial statements taken as a whole.

/s/ GRANT THORNTON LLP

Denver, ColoradoFebruary 28, 2006

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**NEW WORLD RESTAURANT GROUP, INC.CONSOLIDATED BALANCE SHEETSAS OF JANUARY 3, 2006 AND DECEMBER 28, 2004(in thousands, except share information)**

| ** **                                                                                                                                                                      | ** ** | **January 3,** | ** ** | **December 28,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                      | ** ** | **2006**            | ** ** | **2004**              | ** ** |
| **ASSETS**                                                                                                                                                                      | ** ** | ** **          | ** ** |                  | ** ** | ** ** |   |
| Current assets:                                                                                                                                                                 |       |                |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                       |       | $                   | 1,556      |                  |       | $ | 9,752 |   |   |
| Restricted cash                                                                                                                                                                 |       | 2,554               |       |                  | 1,269      |   |   |
| Franchise and other receivables, net of allowance of  $480 and $2,475                                                                                                           |       | 5,506               |       |                  | 7,123      |   |   |
| Inventories                                                                                                                                                                     |       | 5,072               |       |                  | 4,941      |   |   |
| Prepaid expenses and other current assets                                                                                                                                       |       | 4,506               |       |                  | 1,643      |   |   |
| Total current assets                                                                                                                                                            |       | 19,194              |       |                  | 24,728     |   |   |
| Restricted cash long-term                                                                                                                                                       |       | 595                 |       |                  | 2,526      |   |   |
| Property, plant and equipment, net                                                                                                                                              |       | 33,359              |       |                  | 41,855     |   |   |
| Trademarks and other intangibles, net                                                                                                                                           |       | 67,717              |       |                  | 77,219     |   |   |
| Goodwill                                                                                                                                                                        |       | 4,875               |       |                  | 4,875      |   |   |
| Debt issuance costs and other assets                                                                                                                                            |       | 5,184               |       |                  | 7,253      |   |   |
| Total assets                                                                                                                                                                    |       | $                   | 130,924    |                  |       | $ | 158,456 |   |   |
| **LIABILITIES AND STOCKHOLDERS’  DEFICIT**                                                                                                                                 | ** ** | ** **          | ** ** |                  | ** ** | ** ** |   |
| Current  liabilities:                                                                                                                                                           |       |                |       |                  |       |   |   |
| Accounts payable                                                                                                                                                                |       | $                   | 5,848      |                  |       | $ | 8,243 |   |   |
| Accrued expenses                                                                                                                                                                |       | 24,789              |       |                  | 34,836     |   |   |
| Short term debt and current portion of long-term  debt                                                                                                                          |       | 280                 |       |                  | 295        |   |   |
| Current portion of obligations under capital leases                                                                                                                             |       | 19                  |       |                  | 16         |   |   |
| Total current liabilities                                                                                                                                                       |       | 30,936              |       |                  | 43,390     |   |   |
| Senior notes and other long-term debt                                                                                                                                           |       | 160,560             |       |                  | 160,840    |   |   |
| Obligations under capital leases                                                                                                                                                |       | 29                  |       |                  | 31         |   |   |
| Other liabilities                                                                                                                                                               |       | 8,610               |       |                  | 9,678      |   |   |
| Mandatorily redeemable, Series Z Preferred  Stock, $.001 par value, $1,000 per share liquidation value; 2,000,000 shares authorized;  57,000 shares issued and outstanding |       | 57,000              |       |                  | 57,000     |   |   |
| Total liabilities                                                                                                                                                               |       | 257,135             |       |                  | 270,939    |   |   |
| Commitments and  contingencies                                                                                                                                                  |       |                |       |                  |       |   |   |
| Stockholders’  deficit:                                                                                                                                                    |       |                |       |                  |       |   |   |
| Common stock, $.001 par value; 15,000,000 shares authorized;  10,065,072 and 9,848,713 shares issued and outstanding                                                            |       | 10                  |       |                  | 10         |   |   |
| Additional paid-in capital                                                                                                                                                      |       | 176,018             |       |                  | 175,797    |   |   |
| Unamortized stock compensation                                                                                                                                                  |       | (68                 | )          |                  | (137       | ) |   |
| Accumulated deficit                                                                                                                                                             |       | (302,171            | )          |                  | (288,153   | ) |   |
| Total stockholders’ deficit                                                                                                                                                |       | (126,211            | )          |                  | (112,483   | ) |   |
| Total liabilities  and stockholders’ deficit                                                                                                                               |       | $                   | 130,924    |                  |       | $ | 158,456 |   |   |

 

The accompanying notes are an integral part of these consolidated financial statements.

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**NEW WORLD RESTAURANT GROUP, INC.CONSOLIDATED STATEMENTSOF OPERATIONSFOR THE YEARS ENDED JANUARY 3, 2006, DECEMBER 28, 2004 AND DECEMBER 30, 2003(in thousands, except earnings per share and related share information)**

| ** **                                                        | ** ** | **January 3,** | ** ** | **December 28,** | ** ** | **December 30,** | ** ** |
|-------------------------------------------------------------------|------------|---------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                        | ** ** | **2006**            | ** ** | **2004**              | ** ** | **2003**              | ** ** |
| Revenues:                                                         |       |                |       |                  |       |                  |       |   |   |   |   |
| Retail sales                                                      |       | $                   | 363,044    |                  |       | $                     | 347,786    |   |   |   | $ | 356,225 |   |   |
| Manufacturing revenues                                            |       | 20,118              |       |                  | 20,122     |                  |       |   | 21,457 |   |   |
| Franchise and license related revenues                            |       | 5,931               |       |                  | 5,952      |                  |       |   | 5,624 |   |   |
| Total revenues                                                    |       | 389,093             |       |                  | 373,860    |                  |       |   | 383,306 |   |   |
| Cost of sales:                                                    |       |                |       |                  |       |                  |       |   |   |   |   |
| Retail costs                                                      |       | 296,610             |       |                  | 288,736    |                  |       |   | 297,934 |   |   |
| Manufacturing costs                                               |       | 18,781              |       |                  | 17,925     |                  |       |   | 19,756 |   |   |
| Total cost of  sales                                              |       | 315,391             |       |                  | 306,661    |                  |       |   | 317,690 |   |   |
| Gross profit                                                      |       | 73,702              |       |                  | 67,199     |                  |       |   | 65,616 |   |   |
| Operating expenses:                                               |       |                |       |                  |       |                  |       |   |   |   |   |
| General and administrative expenses                               |       | 36,096              |       |                  | 32,755     |                  |       |   | 41,794 |   |   |
| Depreciation and amortization                                     |       | 26,316              |       |                  | 27,848     |                  |       |   | 34,013 |   |   |
| Loss (gain) on sale, disposal or abandonment of  assets, net |       | 314                 |       |                  | 1,557      |                  |       |   | (558 | ) |   |
| Charges (adjustments) of integration and reorganization cost |       | 5                   |       |                  | (869       | )                     |       |   | 2,132 |   |   |
| Impairment charges and other related costs                        |       | 1,603               |       |                  | 450        |                  |       |   | 5,292 |   |   |
| Income (loss)  from operations                                    |       | 9,368               |       |                  | 5,458      |                  |       |   | (17,057 | ) |   |
| Other expense (income):                                           |       |                |       |                  |       |                  |       |   |   |   |   |
| Interest expense, net                                             |       | 23,698              |       |                  | 23,196     |                  |       |   | 34,184 |   |   |
| Cumulative change in the fair value of derivatives                |       | —              |       |                  | —     |                  |       |   | (993 | ) |   |
| Gain on investment in debt securities                             |       | —              |       |                  | —     |                  |       |   | (374 | ) |   |
| Loss on exchange of Series F Preferred Stock                 |       | —              |       |                  | —     |                  |       |   | 23,007 |   |   |
| Other                                                             |       | (312                | )          |                  | (284       | )                     |       |   | (172 | ) |   |
| Loss before  income taxes                                         |       | (14,018             | )          |                  | (17,454    | )                     |       |   | (72,709 | ) |   |
| Provision  (benefit) for state income taxes                       |       | —              |       |                  | (49        | )                     |       |   | 812 |   |   |
| Net loss                                                          |       | (14,018             | )          |                  | (17,405    | )                     |       |   | (73,521 | ) |   |
| Dividends and  accretion on Preferred Stock                       |       | —              |       |                  | —     |                  |       |   | (14,423 | ) |   |
| Net loss  available to common stockholders                        |       | $                   | (14,018    | )                     |       | $                     | (17,405    | ) |   |   | $ | (87,944 | ) |   |
| Net loss per  common share—Basic and Diluted                 |       | $                   | (1.42      | )                     |       | $                     | (1.77      | ) |   |   | $ | (22.71 | ) |   |
| Weighted average number  of common shares outstanding:            |       |                |       |                  |       |                  |       |   |   |   |   |
| Basic and Diluted                                                 |       | 9,878,665           |       |                  | 9,842,414  |                  |       |   | 3,873,284 |   |   |

 

The accompanying notes are an integral part of these consolidated financial statements.

40

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**NEW WORLD RESTAURANT GROUP, INC.CONSOLIDATED STATEMENTOF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT)FOR THE YEARS ENDED JANUARY 3, 2006, DECEMBER 28, 2004 AND DECEMBER 30, 2003(in thousands, except share information)**

| ** **                                                | ** ** | ** **            | ** ** | ** **       | ** ** | **Additional** | ** ** | **Unamortized**  | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
|-----------------------------------------------------------|------------|-----------------------|------------|------------------|------------|----------------|------------|------------------|------------|-----------------|------------|------------|------------|
| ** **                                                | ** ** | **Common Stock** | ** ** | **Paid In** | ** ** | **Stock**      | ** ** | **Deficit**      | ** ** | ** **      | ** ** |
| ** **                                                | ** ** | **Shares**            | ** ** | **Amount**       | ** ** | **Capital**    | ** ** | **Compensation** | ** ** | **Amount**      | ** ** | **Total**  | ** ** |
| Balance,  December 31, 2002                          |       | 847,413               |       |             | $          | 1              |       |             | $          | 86,657          |       |       | $          | — |   |   |   | $ | (182,804 | ) |   | $ | (96,146 | ) |
| Net loss                                                  |       | —                |       |             | —     |           |       | —           |       |            | —     |       |       |   | (73,521 | ) |   | (73,521 | ) |
| Conversion of Series F to common stock          |       | 9,380,843             |       |             | 9          |           |       | 84,704           |       |            | —     |       |       |   | — |   |   | 84,713 |   |
| Conversion of common stock and warrants to  Series Z |       | (386,428              | )          |             | —     |           |       | (762             | )          |            | —     |       |       |   | — |   |   | (762 | ) |
| Issuance of warrants in financing transactions            |       | —                |       |             | —     |           |       | 4,986            |       |            | —     |       |       |   | — |   |   | 4,986 |   |
| Dividends and accretion on preferred stock                |       | —                |       |             | —     |           |       | —           |       |            | —     |       |       |   | (14,423 | ) |   | (14,423 | ) |
| Balance,  December 30, 2003                          |       | 9,841,828             |       |             | $          | 10             |       |             | $          | 175,585         |       |       | $          | — |   |   |   | $ | (270,748 | ) |   | $ | (95,153 | ) |
| Net loss                                                  |       | —                |       |             | —     |           |       | —           |       |            | —     |       |       |   | (17,405 | ) |   | (17,405 | ) |
| Common stock issued upon exercise of warrants             |       | 6,885                 |       |             | —     |           |       | 7                |       |            | —     |       |       |   | — |   |   | 7 |   |
| Stock compensation expense of options granted             |       | —                |       |             | —     |           |       | 205              |       |            | (205       | )          |       |   | — |   |   | — |   |
| Amortization of stock compensation expense                |       | —                |       |             | —     |           |       | —           |       |            | 68         |       |       |   | — |   |   | 68 |   |
| Balance,  December 28, 2004                          |       | 9,848,713             |       |             | $          | 10             |       |             | $          | 175,797         |       |       | $          | (137 | ) |   |   | $ | (288,153 | ) |   | $ | (112,483 | ) |
| Net loss                                                  |       | —                |       |             | —     |           |       | —           |       |            | —     |       |       |   | (14,018 | ) |   | (14,018 | ) |
| Common stock issued upon exercise of warrants             |       | 216,359               |       |             | —     |           |       | 221              |       |            | —     |       |       |   | — |   |   | 221 |   |
| Amortization of stock compensation expense                |       | —                |       |             | —     |           |       | —           |       |            | 69         |       |       |   | — |   |   | 69 |   |
| Balance, January 3,  2006                            |       | 10,065,072            |       |             | $          | 10             |       |             | $          | 176,018         |       |       | $          | (68 | ) |   |   | $ | (302,171 | ) |   | $ | (126,211 | ) |

 

The accompanying notes are an integral part of these consolidated financial statements.

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**NEW WORLD RESTAURANT GROUP, INC.CONSOLIDATED STATEMENTSOF CASH FLOWSFOR THE YEARS ENDED JANUARY 3, 2006, DECEMBER 28, 2004 AND DECEMBER 30, 2003(in thousands)**

| ** **                                                                            | ** ** | **January 3,** | ** ** | **December 28,** | ** ** | **December 30,** | ** ** |
|---------------------------------------------------------------------------------------|------------|---------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                                            | ** ** | **2006**            | ** ** | **2004**              | ** ** | **2003**              | ** ** |
| **OPERATING ACTIVITIES:**                                                             |       |                |       |                  |       |                  |       |   |   |   |   |
| Net loss                                                                              |       | $                   | (14,018    | )                     |       | $                     | (17,405    | ) |   |   | $ | (73,521 | ) |   |
| Adjustments to reconcile net loss to net cash  provided by operating activities: |       |                |       |                  |       |                  |       |   |   |   |   |
| Depreciation and  amortization                                                        |       | 26,316              |       |                  | 27,848     |                  |       |   | 34,013 |   |   |
| Stock based compensation  expense                                                     |       | 69                  |       |                  | 68         |                  |       |   | — |   |   |
| Loss, net of gains, on  disposal of assets                                            |       | 314                 |       |                  | 1,557      |                  |       |   | (558 | ) |   |
| Impairment charges and  other related costs                                           |       | 1,603               |       |                  | 450        |                  |       |   | 5,292 |   |   |
| Charges (adjustments) of  integration and reorganization costs                        |       | 5                   |       |                  | (869       | )                     |       |   | 2,132 |   |   |
| Provision for (recovery  of) losses on accounts receivable, net                       |       | (158                | )          |                  | 177        |                  |       |   | 1,815 |   |   |
| Amortization of debt  issuance and debt discount costs                                |       | 1,848               |       |                  | 1,849      |                  |       |   | 3,138 |   |   |
| Gain on investment in  debt securities                                                |       | —              |       |                  | —     |                  |       |   | (374 | ) |   |
| Cumulative change in  fair value in derivatives                                       |       | —              |       |                  | —     |                  |       |   | (993 | ) |   |
| Notes issued as paid in  kind for interest on Bridge Loan                             |       | —              |       |                  | —     |                  |       |   | 395 |   |   |
| Issuance of standstill  and step-up warrants                                          |       | —              |       |                  | —     |                  |       |   | 3,132 |   |   |
| Greenlight interest                                                                   |       | —              |       |                  | —     |                  |       |   | 1,025 |   |   |
| Loss on exchange of  Series F Preferred Stock                                    |       | —              |       |                  | —     |                  |       |   | 23,007 |   |   |
| Reduction in Bridge Loan                                                              |       | —              |       |                  | —     |                  |       |   | (500 | ) |   |
| Changes in operating assets and liabilities:                                          |       |                |       |                  |       |                  |       |   |   |   |   |
| Franchise and other  receivables                                                      |       | 1,775               |       |                  | (1,593     | )                     |       |   | (1,688 | ) |   |
| Accounts payable and  accrued expenses                                                |       | (12,565             | )          |                  | (2,112     | )                     |       |   | 8,516 |   |   |
| Other assets and  liabilities                                                         |       | (3,114              | )          |                  | 1,140      |                  |       |   | (2,816 | ) |   |
| Net cash provided by  operating activities                                            |       | 2,075               |       |                  | 11,110     |                  |       |   | 2,015 |   |   |
| **INVESTING ACTIVITIES:**                                                             |       |                |       |                  |       |                  |       |   |   |   |   |
| Purchase of property and  equipment                                                   |       | (10,264             | )          |                  | (9,393     | )                     |       |   | (6,921 | ) |   |
| Proceeds from the sale  of equipment                                                  |       | 180                 |       |                  | 543        |                  |       |   | 558 |   |   |
| Proceeds from investment  in debt securities                                          |       | —              |       |                  | —     |                  |       |   | 374 |   |   |
| Net cash used in  investing activities                                                |       | (10,084             | )          |                  | (8,850     | )                     |       |   | (5,989 | ) |   |
| **FINANCING ACTIVITIES:**                                                             |       |                |       |                  |       |                  |       |   |   |   |   |
| Proceeds from line of  credit                                                         |       | 5,455               |       |                  | 18,120     |                  |       |   | 6,020 |   |   |
| Repayments of line of  credit                                                         |       | (5,470              | )          |                  | (19,105    | )                     |       |   | (11,020 | ) |   |
| Repayment of other  borrowings                                                        |       | (312                | )          |                  | (1,105     | )                     |       |   | (1,131 | ) |   |
| Proceeds from issuance  of $160 Million Indenture                                     |       | —              |       |                  | —     |                  |       |   | 160,000 |   |   |
| Repayment of $140  Million Facility                                                   |       | —              |       |                  | —     |                  |       |   | (140,000 | ) |   |
| Advance funding of NJEDA  (restricted cash)                                           |       | —              |       |                  | —     |                  |       |   | (1,684 | ) |   |
| Debt issuance costs                                                                   |       | (81                 | )          |                  | —     |                  |       |   | (8,571 | ) |   |
| Proceeds upon warrant  exercise                                                       |       | 221                 |       |                  | 7          |                  |       |   | — |   |   |
| Net cash provided by  (used in) financing activities                                  |       | (187                | )          |                  | (2,083     | )                     |       |   | 3,614 |   |   |
| Net increase (decrease)  in cash                                                      |       | (8,196              | )          |                  | 177        |                  |       |   | (360 | ) |   |
| Cash and cash  equivalents, beginning of period                                       |       | 9,752               |       |                  | 9,575      |                  |       |   | 9,935 |   |   |
| Cash and cash equivalents, end of period                                              |       | $                   | 1,556      |                  |       | $                     | 9,752      |   |   |   | $ | 9,575 |   |   |

 

The accompanying notes are an integral part of these consolidated financial statements.

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements**

**1.   DESCRIPTIONOF BUSINESS AND BASIS OF PRESENTATION**

The consolidatedfinancial statements of New World Restaurant Group, Inc. and itswholly-owned subsidiaries (collectively, the Company) have been prepared in conformitywith accounting principles generally accepted in the United States of America.All inter-company accounts and transactions have been eliminated inconsolidation. TheCompany owns, franchises or licenses various restaurant concepts under thebrand names of Einstein Bros. Bagels and Einstein Bros. Café (collectivelyknown as Einstein Bros.), Noah’s New York Bagels (Noah’s), Manhattan BagelCompany (Manhattan), Chesapeake Bagel Bakery (Chesapeake) and New World Coffee(New World).

We have a 52/53-week fiscal year ending on theTuesday closest to December 31. Fiscal year 2004 and 2003, which ended on December 28,2004 and December 30, 2003, respectively, contained 52 weeks, while fiscalyear 2005, which ended on January 3, 2006, contained 53 weeks.

Certain reclassifications have been made to conform previouslyreported data to the current presentation. These reclassifications haveno effect on net income or financial position as previously reported.

**2.   SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES**

**Use of Estimates**

The preparation of theconsolidated financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires us to makeestimates and assumptions that affect reported amounts of assets andliabilities, disclosure of contingent assets and liabilities at the date of thefinancial statements, and the reported amounts of revenues, costs and expensesduring the reporting period. Actual results could differ from the estimates.

**Revenue Recognition**

We record revenue from the sale of food and beverageas products are sold. Our manufacturing revenues are recorded at the time ofshipment to customers. Initial fees received from a franchisee or licensee toestablish a new location are recognized as income when we have performed ourobligations required to assist the franchisee or licensee in opening a newlocation, which is generally at the time the franchisee or licensee commencesoperations. Continuing royalties, which are a percentage of the net sales offranchised and licensed locations, are accrued as income each month. Proceedsfrom the sale of gift cards are recorded as deferred revenue and recognized asincome when redeemed by the holder.

During fiscal year 2005,we began selling bagels through our manufacturing operations outside of theUnited States to a wholesaler and a distributor who take possession in theUnited States. As the product is shipped FOB domestic dock, there are nointernational risk of loss or foreign exchange currency issues. Approximately$2.2 million of international sales are included in manufacturing revenues.

**Cash and Cash Equivalents**

Cash and cash equivalentsconsist of cash on hand and highly liquid instruments with original maturitiesof three months or less when purchased. Amounts in-transit from credit cardprocessors are also considered cash equivalents because they are bothshort-term and highly liquid in nature and are typically converted to cashwithin three days of the sales transaction.

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**Propertyand Equipment**

Propertyand equipment is recorded at cost. Furniture and equipment are depreciatedusing the straight-line method over the estimated useful life of the asset,which ranges from 3 to 8 years. Leasehold improvements are amortized using thestraight-line method. The depreciable lives for our leasehold improvements,which are subject to a lease, are limited to the lesser of the useful life orthe noncancelable lease term. In circumstances where we would incur an economicpenalty by not exercising one or more option periods, we include one or moreoption periods when determining the depreciation period. In eithercircumstance, our policy requires consistency when calculating the depreciationperiod, in classifying the lease, and in computing straight-line rent expense.

In accordance with Statement of FinancialAccounting Standard (SFAS) No. 144, Accounting for the Impairment orDisposal of Long Lived Assets (SFAS No. 144), impairment losses arerecorded on long-lived assets on a restaurant-by-restaurant basis wheneverimpairment indicators are determined to be present. We consider a history ofcash flow losses to be the primary indicator of potential impairment forindividual restaurant locations. We determine whether a restaurant location isimpaired based on expected undiscounted future cash flows, consideringlocation, local competition, current restaurant management performance,existing pricing structure and alternatives available for the site. Ifimpairment exists, the amount of impairment is measured as the excess of thecarrying amount of the asset over its fair value as determined utilizing theestimated discounted future cash flows or the expected proceeds, net of coststo sell, upon sale of the asset.

**Duringfiscal 2005, we recorded approximately $0.2 million in impairment chargesrelated to company-owned stores and approximately $0.1 million in exit costsfrom the decision to close one restaurant. During fiscal 2004, we recorded $0.5million in impairment charges for long-lived asset impairments and exit costsfrom the decision to close two restaurants and to write down the assets ofunder-performing restaurants.**

**Goodwill, Trademarks and Other Intangibles**

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

Goodwilland other intangible assets with indefinite lives are not subject toamortization but are tested for impairment annually or more frequently ifevents or changes in circumstances indicate that the asset might be impaired.SFAS No. 142, Goodwill and Other Intangible Assets (SFAS No. 142),requires a two-step approach for testing impairment of goodwill. For goodwill,the fair value of each reporting unit is compared to its carrying value todetermine whether an indication of impairment exists. If impairment isindicated, the fair value of the reporting unit’s goodwill is determined byallocating the unit’s fair value to its assets and liabilities (including anyunrecognized intangible assets) as if the reporting unit had been acquired in abusiness combination. For other indefinite lived intangibles, the fair value iscompared to the carrying value. The amount of impairment for goodwill and otherintangible assets is measured as the excess of its carrying amount over itsfair value. Intangible assets not subject to amortization consist primarily ofthe Einstein Bros. and Manhattan trademarks.

Intangibleassets with lives restricted by contractual, legal or other means are amortizedover their useful lives and consist primarily of patents used in ourmanufacturing process. Amortization expense is calculated using thestraight-line method over the estimated useful lives of approximately 5 years. Intangibleassets subject to amortization are reviewed for impairment whenever events orchanges in 

44

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

circumstances indicate that the carrying amount of anasset may not be recoverable, in accordance with SFAS No. 144.

During the second quarter of fiscal 2004, we began anevaluation of whether each of our brands should be a part of our overallstrategic business plan. As a result of this evaluation, we determined that theChesapeake brand did not fit within our long-term business model. Accordingly,we performed an interim impairment analysis and determined that no impairmentexisted. We also performed a longevity analysis and determined that the brandhad an estimated useful life of four years. The trademarks were previouslytreated as a non-amortizing intangible and were reclassified to an amortizingintangible at June 29, 2004. During the second quarter of fiscal 2005, were-visited the long term strategic fit of Chesapeake utilizing therecommendations of a third party consultant previously engaged to presentviable alternatives for the brand. Based upon the consultant’s recommendations,we began forming an exit strategy that we believed could be completed withinone year. Because there had been a change in circumstances, it was necessary toreview the asset for impairment. The analysis indicated that the carryingamount of the Chesapeake trademarks was greater than its fair value andaccordingly we recorded an impairment charge of $1.2 million during the quarterended June 28, 2005. As we continued to work with our remainingfranchisees on an exit strategy, we also continued to review the carryingamount of the Chesapeake trademarks in relation to their fair value. Werecorded an additional $0.1 million in impairment charges related to theChesapeake trademarks. As of January 3, 2006, there is no remaining valuereflected in our consolidated financial statements related to the Chesapeaketrademarks and we anticipate completion of our exit strategy during fiscal year2006. Our ability to execute an exit strategy is dependent upon the agreementand cooperation of our franchisees and we cannot provide any assurance that wewill be successful in fully completing an exit strategy.

For the fiscal years ended2005, 2004 and 2003, we engaged an independent valuation expert to assist us inperforming an impairment analysis of the goodwill and indefinite livedintangible assets related to our Einstein Bros. and Manhattan brands. At January 3,2006 and December 28, 2004, there was no indication of impairment in ourgoodwill and indefinite lived intangible assets. At December 30, 2003,there was an indication that the carrying amounts of certain indefinite livedassets exceeded their fair values and accordingly we recorded an impairmentcharge of $4.9 million related to our Manhattan and Chesapeake trademarks. Theimpairments for both Manhattan and Chesapeake were related to declining cashflows for those brands and our expectation that the trend of lower sales willcontinue in future years. In addition to the trademark impairment, we alsowrote-off the value of previously reacquired Manhattan franchise territoryrights of $0.4 million.

**Insurance Reserves**

We are insured for lossesrelated to health, general liability and workers’ compensation under largedeductible policies. The insurance liability represents an estimate of theultimate cost of claims incurred and unpaid as of the balance sheet date. Theestimated liability is established based on actuarial estimates, is discountedat 10% based upon a discrete analysis of actual claims and historical data andis reviewed on a quarterly basis to ensure that the liability is appropriate.The estimated liability is included in accrued expenses in our consolidatedbalance sheets.

**Guarantees**

Prior to 2001, we would occasionally guarantee leasesfor the benefit of certain of our franchisees. None of the guarantees have beenmodified since their inception and we have since discontinued this 

45

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

practice. Currentfranchisees are the primary lessees under the vast majority of these leases.Under the lease guarantees, we may be required by the lessor to make all of theremaining monthly rental payments or property tax and common area maintenancepayments if the franchisee does not make the required payments in a timelymanner. However, we believe that most, if not all, of the franchised locationscould be subleased to third parties reducing our potential exposure.Additionally, we have indemnification agreements with our franchisees underwhich the franchisees would be obligated to reimburse us for any amounts paidunder such guarantees. Historically, we have not been required to make suchpayments in significant amounts. We record a liability for our exposure underthe guarantees in accordance with SFAS No. 5, “Accounting forContingencies,” following a probability related approach. In the event thattrends change in the future, our financial results could be impacted. As of January 3,2006, we had outstanding guarantees of indebtedness under certain leases ofapproximately $600,000. Approximately $90,000 is reflected in accrued expensesin our consolidated balance sheet at January 3, 2006.

**Fair Value of Financial Instruments**

Asof January 3, 2006 and December 28, 2004, our financial instrumentsconsist of cash equivalents, accounts receivable, accounts payable and debt.The fair value of accounts receivable and accounts payable approximate their carryingvalue, due to their short-term maturities. The fair value of debt and notespayable is estimated to approximate their carrying value by comparing the termsof existing instruments to the terms offered by lenders for similar borrowingswith similar credit ratings. As of January 3, 2006, the fair value of the$160 Million Notes approximated $176.5 million as the notes were traded at apremium. The fair value of the $160 Million Notes approximated its carryingvalue at December 28, 2004 as the notes were traded at par in the market.

The Mandatorily Redeemable Series Z PreferredStock (Series Z) is recorded in the accompanying consolidated balancesheets at its full face value of $57.0 million, which represents the totalrequired future cash payment. The current fair value of the Series Z,which was determined by using the remaining term of the Series Z and theeffective dividend rate from the Certificate of Designation, is estimated to be$33.2 million and $28.5 million at January 3, 2006 and December 28,2004, respectively.

**Concentrationsof Risk**

We purchase a majority of our frozen bagel dough fromHarlan Bakeries, Inc. (who utilizes our proprietary processes) and onwhich we are dependent upon in the short-term. Additionally, we purchase all ofour cream cheese from a single source. Though to date we have not experiencedsignificant difficulties with our suppliers, our reliance on a limited numberof suppliers subjects us to a number of risks, including possible delays orinterruption in supplies, diminished control over quality and a potential lackof adequate raw material capacity. Any disruption in the supply or degradationin the quality of the materials provided by our suppliers could have a materialadverse effect on our business, operating results and financial condition. Inaddition, any such disruptions in supply or degradations in quality could havea long-term detrimental impact on our efforts to develop a strong brandidentity and a loyal consumer base.

**AdvertisingCosts**

We expense advertising costs as incurred. Advertisingcosts were $6.6 million, $4.5 million and $12.9 million for the fiscalyears ended 2005, 2004 and 2003, respectively, and are included in retail costsof sales in the consolidated statements of operations.

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**Income Taxes**

We record deferred tax assets andliabilities based on the difference between the financial statement and incometax basis of assets and liabilities using the enacted statutory tax rate ineffect for the year differences are expected to be taxable or refunded. Deferredincome tax expenses or credits are based on the changes in the asset orliability from period to period. The recorded deferred tax assets are reviewedfor impairment on a quarterly basis by reviewing our internal estimates forfuture net income. If we determine it to be more likely than not that therecovery of the asset is in question in the immediate, foreseeable future, werecord a valuation allowance. On January 3, 2006 and December 28,2004, we recorded a full valuation allowance against our net deferred taxasset. We will continue to record valuation allowances against additionaldeferred tax assets until such time that recoverability of such assets isdemonstrated.

The provision(benefit) for income taxes reflected in our consolidated statements ofoperations represents minimum state taxes payable.

**NetLoss per Common Share**

Inaccordance with SFAS No. 128, “Earnings per Share,” we compute basic netloss per common share by dividing the net loss for the period by the weightedaverage number of shares of common stock outstanding during the period (whichincludes warrants exercisable for a nominal price of $0.01 per share on apre-split basis prior to our equity recapitalization further described in Note13).

Dilutednet loss per share is computed by dividing the net loss for the period by theweighted average number of shares of common stock and potential common stockequivalents outstanding during the period, if dilutive. Potential common stockequivalents include incremental shares of common stock issuable upon theexercise of stock options and warrants. The effects of potential common stockequivalents have not been included in the computation of diluted net loss pershare as their effect is anti-dilutive.

The following tablesummarizes the weighted average number of common shares outstanding, as well assets forth the computation of basic and diluted net loss per common share forthe periods indicated (in thousands of dollars, except share and per sharedata):

| ** **                                                                                      | ** ** | **For the years ended:** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                                      | ** ** | **January 3,**                     | ** ** | **December 28,** | ** ** | **December 30,** | ** ** |
| ** **                                                                                      | ** ** | **2006**                                | ** ** | **2004** | ** ** | **2003** | ** ** |
| Weighted average  shares outstanding                                                            |       | 9,878,665                               |       |   | 9,842,414 |   |   |   | 3,873,284 |   |   |
| Net loss  available to common stockholders                                                      |       | $                                       | (14,018    | ) |   | $ | (17,405 | ) |   |   | $ | (87,944 | ) |   |
| Basic and diluted  net loss per share                                                           |       | $                                       | (1.42      | ) |   | $ | (1.77 | ) |   |   | $ | (22.71 | ) |   |
| Shares contingently  issuable included in the weighted average number of shares of common stock |       | —                                  |       |   | — |   |   |   | 604,298 |   |   |

 

Stock options and warrants to purchase an aggregate of1,737,113, 1,764,372 and 1,832,679 shares of common stock were outstanding asof January 3, 2006, December 28, 2004 and December 30, 2003,respectively. These stock options and warrants were not included in thecomputation of diluted earnings per share because their effect would have beenanti-dilutive.

47

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**Stock-Based Compensation**

Weapply the intrinsic value-based method of accounting prescribed by AccountingPrinciples Board (APB) Opinion No. 25, Accounting for Stock Issued toEmployees (APB No. 25), and related interpretations, in accounting for ourfixed award stock options to our associates. As such, compensation expense isrecorded only if the current market price of the underlying common stockexceeded the exercise price of the option on the date of grant. We apply thefair value-basis of accounting as prescribed by SFAS No. 123, Accountingfor Stock-Based Compensation (SFAS No. 123) in accounting for our fixedaward stock options to our consultants. Under SFAS No. 123, compensationexpense is recognized based on the fair value of stock options granted.

Hadcompensation cost for stock options granted to associates been determined onthe basis of fair value using the following assumptions, net loss and loss pershare would have been increased to the following pro forma amounts (inthousands of dollars, except per share amounts):

| ** **                                      | ** ** | **For the year ended:** | ** ** |
|-------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                      | ** ** | **January 3,**                    | ** ** | **December 28,** | ** ** | **December 30,** | ** ** |
| ** **                                      | ** ** | **2006**                               | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net loss, as  reported                          |       | $                                      | (14,018    | ) |   | $ | (17,405 | ) |   |   | $ | (87,944 | ) |   |
| Deduct: fair  value based compensation expense  |       | (1,164                                 | )          |   | (544 | ) |   |   | (10 | ) |   |
| Pro forma net  loss                             |       | (15,182                                | )          |   | (17,949 | ) |   |   | (87,954 | ) |   |
| Basic and diluted loss  per common share:       |       |                                   |       |   |   |   |   |   |   |   |   |
| As reported                                     |       | $                                      | (1.42      | ) |   | $ | (1.77 | ) |   |   | $ | (22.71 | ) |   |
| Pro forma                                       |       | $                                      | (1.54      | ) |   | $ | (1.82 | ) |   |   | $ | (22.71 | ) |   |
| Assumptions:                                    |       |                                   |       |   |   |   |   |   |   |   |   |
| Expected life of  options from date of grant    |       | 4 years                                |       |   | 4 years |   |   |   | 4 years |   |   |
| Risk-free  interest rate                        |       | 3.55 - 4.44                            | %          |   | 2.7 - 3.4 | % |   |   | 3.0 | % |   |
| Volatility                                      |       | 100.0                                  | %          |   | 100.0 | % |   |   | 100.0 | % |   |
| Assumed dividend  yield                         |       | 0.0                                    | %          |   | 0.0 | % |   |   | 0.0 | % |   |
| Weighted average fair  value of options granted |       | $                                      | 1.85       |   |   | $ | 2.21 |   |   |   | $ | 2.84 |   |   |

 

**Recent Accounting Pronouncements**

In December 2004, the FASB issued SFAS No. 123(revised 2004) entitled “Share-Based Payment” that addresses the accounting forshare-based payment transactions in which an enterprise receives employeeservices in exchange for a) equity instruments of the enterprise or b)liabilities that are based on the fair value of the enterprise’s equityinstruments or that may be settled by the issuance of such equity instruments.The Statement eliminates the ability to account for share-based compensationtransactions using APB No. 25 and generally would require instead thatsuch transactions be accounted for using a fair-value-based method. ThisStatement is to be implemented at the beginning of the next fiscal year thatbegins after June 15, 2005. Based on options granted and variousassumptions used to calculate stock based compensation expense as of January 3,2006, we believe that the adoption will result in an increase in expense ofapproximately $0.6 million and $0.1 million during fiscal 2006 and 2007,respectively. If actual events differ from our assumptions used to calculatethe expense or if we grant additional options, our financial results could beimpacted.

In May 2005, the FASB issued SFAS No. 154,Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20,Accounting Changes, and SFAS No. 3, Reporting Accounting 

48

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

Changes in InterimFinancial Statements. SFAS No. 154 changes the requirements for theaccounting for and reporting of a change in accounting principle. Previously,most voluntary changes in accounting principles were required recognition via acumulative effect adjustment within net income of the period of the change.SFAS No. 154 requires retrospective application to prior periods’financial statements, unless it is impracticable to determine either theperiod-specific effects or the cumulative effect of the change. SFAS No. 154is effective for accounting changes made in fiscal years beginning after December 15,2005; however, the Statement does not change the transition provisions of anyexisting accounting pronouncements.

We have considered allother recently issued accounting pronouncements and do not believe that theadoption of such pronouncements will have a material impact on our consolidatedfinancial statements.

**3.   RESTRICTED CASH**

Restrictedcash consisted of the following:

| ** **                                          | ** ** | **January 3,**                           | ** ** | **December 28,** | ** ** |
|-----------------------------------------------------|------------|-----------------------------------------------|------------|-----------------------|------------|
| ** **                                          | ** ** | **2006**                                      | ** ** | **2004**              | ** ** |
| ** **                                          | ** ** | **(in thousands of dollars:)** | ** ** |
| Advertising  Funds(a)                               |       |                                          | $          | 533                   |       |   |   | $ | 851 |   |   |
| New Jersey  Economic Development Authority(b)       |       |                                          | 950        |                  |       |   | 1,307 |   |   |
| Worker’s  Compensation Insurance Collateral(c) |       |                                          | —     |                  |       |   | 1,600 |   |   |
| Distributor  Collateral(d)                          |       |                                          | 1,500      |                  |       |   | — |   |   |
| Other(e)                                            |       |                                          | 166        |                  |       |   | 37 |   |   |
|                                                |       |                                          | 3,149      |                  |       |   | 3,795 |   |   |
| Less current  portion of long-term restricted cash  |       |                                          | 2,554      |                  |       |   | 1,269 |   |   |
| Long-term restricted  cash                          |       |                                          | $          | 595                   |       |   |   | $ | 2,526 |   |   |

----

(a)           We act as custodian forcertain funds paid by our franchisees that are earmarked as advertising fundcontributions.

(b)          On July 3, 2003, weplaced in escrow an advanced refunding of the New Jersey Economic DevelopmentAuthority (NJEDA) note dated December 1, 1998 to enact a debt defeasanceas allowed for in the agreement. The NJEDA funds are included in both currentportion and long-term portion of restricted cash as of the January 3, 2006and December 28, 2004 balance sheet dates in accordance with payment termsof the note. We anticipate this classification will continue until the NJEDAnote is fully paid from the escrow amount proceeds. The NJEDA note has amaturity date of December 1, 2008. See Note 10 for additional information.

(c)           We had restricted cashheld as collateral for a letter of credit supporting our worker’s compensationinsurance claims. The insurance company could access this collateral in theevent that we did not reimburse them for claims paid on our behalf. In 2005,our bank no longer required the letter of credit to be cash collateralized.

(d)          We have restricted cashheld as collateral for a letter of credit issued to one of our distributors. Ourdistributor could access the letter of credit in the event that we fail to paythem for products delivered to our company-owned restaurants.

(e)           Wealso have various restricted cash accounts for the benefit of taxing and othergovernment authorities.

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**4.   FRANCHISE AND OTHER RECEIVABLES**

The majority of our receivables are due from ourfranchisees, distributors and trade customers. Credit is extended based on ourevaluation of the customer’s financial condition and, generally, collateral isnot required. Accounts receivable are due within 7-30 days and arestated at amounts due from customers net of an allowance for doubtful accounts.Accounts outstanding longer than the contractual payment terms are consideredpast due. We determine our allowance by considering a number of factors, includingthe length of time trade accounts receivable are past due, our previous lossand payment history, the customer’s current ability to pay its obligation tous, and the condition of the general economy and the industry as a whole. Wewrite off accounts receivable when they become uncollectible, and paymentssubsequently received on such receivables are credited to the allowance fordoubtful accounts.

Franchiseand other receivables consist of the following:

| ** **                            | ** ** | **January 3,**                          | ** ** | **December 28,** | ** ** |
|---------------------------------------|------------|----------------------------------------------|------------|-----------------------|------------|
| ** **                            | ** ** | **2006**                                     | ** ** | **2004**              | ** ** |
| ** **                            | ** ** | **(in thousands of dollars)** | ** ** |
| Trade receivables                     |       |                                         | $          | 2,296                 |       |   |   | $ | 1,725 |   |   |
| Franchisee and  licensee receivables  |       |                                         | 984        |                  |       |   | 3,367 |   |   |
| Vendor rebates(a)                     |       |                                         | 2,130      |                  |       |   | 3,196 |   |   |
| Other                                 |       |                                         | 576        |                  |       |   | 1,310 |   |   |
|                                  |       |                                         | 5,986      |                  |       |   | 9,598 |   |   |
| Less allowance  for doubtful accounts |       |                                         | 480        |                  |       |   | 2,475 |   |   |
| Total receivables                     |       |                                         | $          | 5,506                 |       |   |   | $ | 7,123 |   |   |

----

(a)           Vendorrebates represent a rebate earned at the time products are purchased and arenot contingent upon any level of purchases or period of time. Vendor rebatesare recorded as a reduction to cost of sales when products are sold.

**5.   INVENTORIES**

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

| ** **        | ** ** | **January 3,**                          | ** ** | **December 28,** | ** ** |
|-------------------|------------|----------------------------------------------|------------|-----------------------|------------|
| ** **        | ** ** | **2006**                                     | ** ** | **2004**              | ** ** |
| ** **        | ** ** | **(in thousands of dollars)** | ** ** |
| Finished goods    |       |                                         | $          | 4,558                 |       |   |   | $ | 4,545 |   |   |
| Raw materials     |       |                                         | 514        |                  |       |   | 396 |   |   |
| Total inventories |       |                                         | $          | 5,072                 |       |   |   | $ | 4,941 |   |   |

 

50

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**6.   PROPERTYAND EQUIPMENT**

Propertyand equipment consists of the following:

| ** **                         | ** ** | **January 3,**                          | ** ** | **December 28,** | ** ** |
|------------------------------------|------------|----------------------------------------------|------------|-----------------------|------------|
| ** **                         | ** ** | **2006**                                     | ** ** | **2004**              | ** ** |
| ** **                         | ** ** | **(in thousands of dollars)** | ** ** |
| Leasehold  improvements            |       | $                                            | 49,744     |                  |       | $ | 49,186 |   |   |
| Store and  manufacturing equipment |       | 66,810                                       |       |                  | 61,373     |   |   |
| Furniture and  fixtures            |       | 1,193                                        |       |                  | 1,095      |   |   |
| Office and computer  equipment     |       | 11,044                                       |       |                  | 10,404     |   |   |
| Vehicles                           |       | 115                                          |       |                  | 41         |   |   |
|                               |       | 128,906                                      |       |                  | 122,099    |   |   |
| Less accumulated  depreciation     |       | 95,547                                       |       |                  | 80,244     |   |   |
| Property and equipment,  net       |       | $                                            | 33,359     |                  |       | $ | 41,855 |   |   |

 

Depreciationexpense was $18.1 million, $19.6 million and $26.2 million for the fiscal yearsended January 3, 2006, December 28, 2004 and December 30, 2003,respectively.

As of January 3, 2006 and December 28, 2004,manufacturing equipment with a net book value of approximately $4.4 million and$5.1 million, respectively, was located at the plant of Harlan Bakeries, Inc.,our frozen bagel dough supplier.

**7.   TRADEMARKS AND OTHER INTANGIBLES**

Trademarks and other intangibles consist of the following as of:

| ** **                                  | ** ** | **January 3,**                          | ** ** | **December 28,** | ** ** |
|---------------------------------------------|------------|----------------------------------------------|------------|-----------------------|------------|
| ** **                                  | ** ** | **2006**                                     | ** ** | **2004**              | ** ** |
| ** **                                  | ** ** | **(in thousands of dollars)** | ** ** |
| Amortizing intangibles:                     |       |                                         |       |                  |       |   |   |   |   |
| Trade secrets                               |       |                                         | $          | 5,385                 |       |   |   | $ | 5,385 |   |   |
| Trademarks                                  |       |                                         | 1,082      |                  |       |   | 2,400 |   |   |
| Patents—manufacturing  process         |       |                                         | 33,741     |                  |       |   | 33,741 |   |   |
|                                        |       |                                         | 40,208     |                  |       |   | 41,526 |   |   |
| Less accumulated amortization:              |       |                                         |       |                  |       |   |   |   |   |
| Trade secrets                               |       |                                         | 4,847      |                  |       |   | 3,770 |   |   |
| Trademarks                                  |       |                                         | 1,082      |                  |       |   | 725 |   |   |
| Patents—manufacturing  process         |       |                                         | 30,368     |                  |       |   | 23,618 |   |   |
|                                        |       |                                         | 36,297     |                  |       |   | 28,113 |   |   |
| Total amortizing  intangibles, net          |       |                                         | $          | 3,911                 |       |   |   | $ | 13,413 |   |   |
| Non-amortizing intangibles:                 |       |                                         |       |                  |       |   |   |   |   |
| Trademarks                                  |       |                                         | 63,806     |                  |       |   | 63,806 |   |   |
| Total trademarks and other intangibles, net |       |                                         | $          | 67,717                |       |   |   | $ | 77,219 |   |   |

 

Certain trademarks were previously treatedas a non-amortizing intangible and were reclassified as an amortizingintangible at June 29, 2004. See Note 2 for additional information.

Intangibleamortization expense totaled approximately $8.2 million, $8.2 million and $7.8million for the fiscal years ended 2005, 2004 and 2003, respectively. Theremaining aggregate amortization expense of $3.9 million is to be fullyamortized during fiscal year 2006.

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**8.   DEBTISSUANCE COSTS AND OTHER ASSETS**

Debtissuance costs and other assets consist of the following:

| ** **                                   | ** ** | **January 3,**                          | ** ** | **December 28,** | ** ** |
|----------------------------------------------|------------|----------------------------------------------|------------|-----------------------|------------|
| ** **                                   | ** ** | **2006**                                     | ** ** | **2004**              | ** ** |
| ** **                                   | ** ** | **(in thousands of dollars)** | ** ** |
| Security deposits                            |       |                                         | $          | 993                   |       |   |   | $ | 1,296 |   |   |
| Debt issuance  costs, net of amortization(a) |       |                                         | 4,110      |                  |       |   | 5,957 |   |   |
| Debt issuance  costs(b)                      |       |                                         | 81         |                  |       |   | — |   |   |
| Total debt issue costs  and other assets     |       |                                         | $          | 5,184                 |       |   |   | $ | 7,253 |   |   |

----

(a)           This asset representscosts incurred related to our $160 Million Notes and AmSouth Revolver.

(b)          This asset represents costsincurred as of January 3, 2006 related to the issuance of $170 million innew term loans and $15 million new revolving credit facility in February 2006as further described in Note 27. Upon closing of our new debt facility, webegan amortizing these costs and the debt issuance costs related to our $160Million Notes and AmSouth Revolver were written-off.

Direct costs incurred forthe issuance of debt under the $160 Million Notes have been capitalized andamortized using the effective interest method over the term of the debt. Debtissuance costs related to the AmSouth Revolver have been capitalized andamortized using the straight-line method over the term of the debt. In theevent that the debt is retired prior to the maturity date, debt issuance costs willbe expensed in the period that the debt is retired. The amortization of debtissuance costs is included in interest expense in the consolidated statementsof operations. Amortization expense of approximately $1.8 million, $1.8 millionand $3.1 million was recorded for the fiscal years ended 2005, 2004 and 2003,respectively.

**9.   ACCRUED EXPENSES**

Accruedexpenses consist of the following:

| ** **                      | ** ** | **January 3,** | ** ** | **December 28,** | ** ** |
|---------------------------------|------------|---------------------|------------|-----------------------|------------|
| ** **                      | ** ** | **2006**            | ** ** | **2004**              | ** ** |
| Payroll and  related bonuses    |       |                | $          | 13,064                |       |   |   | $ | 12,450 |   |   |
| Interest                        |       |                | 181        |                  |       |   | 10,249 |   |   |
| Integration and  reorganization |       |                | —     |                  |       |   | 21 |   |   |
| Gift cards                      |       |                | 2,745      |                  |       |   | 2,476 |   |   |
| Other                           |       |                | 8,799      |                  |       |   | 9,640 |   |   |
| Total accrued expenses          |       |                | $          | 24,789                |       |   |   | $ | 34,836 |   |   |

 

52

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**10.   SENIORNOTES AND OTHER LONG-TERM DEBT**

Senior notes and other long-term debtconsist of the following:

| ** **                                              | ** ** | **January 3,** | ** ** | **December 28,** | ** ** |
|---------------------------------------------------------|------------|---------------------|------------|-----------------------|------------|
| ** **                                              | ** ** | **2006**            | ** ** | **2004**              | ** ** |
| $160 Million  Indenture                                 |       | $                   | 160,000    |                  |       | $ | 160,000 |   |   |
| AmSouth Revolver                                        |       | —              |       |                  | 15         |   |   |
| New Jersey  Economic Development Authority Note Payable |       | 840                 |       |                  | 1,120      |   |   |
|                                                    |       | 160,840             |       |                  | 161,135    |   |   |
| Less current  portion of debt                           |       | 280                 |       |                  | 295        |   |   |
| Long-term debt                                          |       | $                   | 160,560    |                  |       | $ | 160,840 |   |   |

 

**$160 Million Notes**

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

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

The $160 Million Notes contain certain covenants,which, among others, include certain financial covenants such as limitations oncapital expenditures and minimum EBITDA as defined in the agreement. Thecovenants also preclude the declaration and payment of dividends or otherdistributions to holders of our common stock. These covenants are measured on arolling twelve month period and fiscal quarter basis, respectively. This debtcontains usual and customary default provisions. As of January 3, 2006, wewere in compliance with all of the financial and operating covenants.

Interestpayments under the $160 Million Notes are payable in arrears at the rate of 13%per year on July 1 and January 1, commencing January 1, 2004.The notes are redeemable, at our option, in whole or in part at any time after July 1,2004 at the following redemption prices (as expressed in percentages of theprincipal amount):

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

 

**AmSouth Revolver**

On July 8,2003, we entered into a three-year, $15 million senior secured revolving creditfacility with AmSouth Bank (“AmSouth Revolver”). The AmSouth Revolver wassubsequently amended to make technical corrections, clarify ambiguous terms andprovide for increased limits with respect to letters of credit. On February 11,2005, the AmSouth Revolver was amended again to increase our letter of creditsub-facility from $5 million to $7.5 million.

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

The AmSouthRevolver is collateralized by substantially all of our assets in which we havean interest and is senior to the $160 Million Notes pursuant to anIntercreditor Agreement.

The AmSouth Revolver contains certain covenants,which, among others, include certain financial covenants such as limitations oncapital expenditures, operating lease obligations, minimum EBITDA as defined inthe agreement, operating cash flow coverage ratio and minimum net worth. Thecovenants also preclude the declaration and payment of dividends or otherdistributions to holders of our common stock. These covenants are measured on arolling twelve-month period at each fiscal quarter or annually at year-end.Additional covenant restrictions exist if the total borrowings, includingoutstanding letters of credit exceed $10.0 million. This debt also containsusual and customary default provisions. As of January 3, 2006, we are incompliance with all of the financial and operating covenants.

Interest payments under the AmSouth Revolver arepayable in arrears on the first of each month. The net borrowings under theAmSouth Revolver bear an interest rate equal to the base rate plus anapplicable margin with the base rate being the AmSouth Bank “prime rate” andthe applicable margin based on our fixed charge coverage ratio with a minimumand maximum applicable margin of 0.5% and 2.5%, respectively. As of January 3,2006 and December 28, 2004, the interest rate on the borrowingsoutstanding under the AmSouth Revolver was 7.75% and 6.25%, respectively.

We are required to pay anunused credit line fee of 0.50% per annum on the average daily unused amount.The unused line fee is payable monthly in arrears. Additionally, we arerequired to pay a letter of credit fee, based on the average daily undrawn faceamount for each letter of credit issued, of an applicable margin being based onour fixed charge coverage ratio with a minimum and maximum applicable margin of2.0% and 4.5% respectively. Letters of credit reduce our availability under theAmSouth Revolver. At January 3, 2006, we had $7.1 million in letters ofcredit outstanding. The letters of credit expire on various dates during 2006,are automatically renewable for one additional year and are payable upon demandin the event that we fail to pay certain workers compensation claims. Ouravailability under the AmSouth Revolver was approximately $7.9 million at January 3,2006.

**NewJersey Economic Development Authority Note Payable**

In December 1998, Manhattan entered into a notepayable in the principal amount of $2.8 million with the New Jersey EconomicDevelopment Authority (NJEDA) at an interest rate of 9% per annum. Principal ispaid annually and interest is paid quarterly. The note matures on December 1,2008 and is secured by the assets of Manhattan.

On July 3, 2003, we placed an advanced funding ofthe note in escrow to enact a debt defeasance as allowed for in the agreement.This advanced funding is shown as restricted cash and the note is included inboth current portion and long-term portion of debt in the January 3, 2006and December 28, 2004 consolidated balance sheets in accordance with thepayment terms. This classification will continue until the note is fully paidfrom the escrow amount proceeds.

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

Oursenior notes and other long-term debt obligations for the three years followingJanuary 3, 2006 are as follows:

| **Fiscal year (in thousands of dollars):** | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------|------------|------------|------------|------------|------------|
| 2006                                                                |       | $          | 280        |       |
| 2007                                                                |       | 280        |       |
| 2008                                                                |       | 160,280    |       |
|                                                                |       | $          | 160,840    |       |

 

**Debt Redemption and Refinancing**

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

·       $15million revolving credit facility maturing on March 31, 2011;

·       $80million first lien term loan maturing on March 31, 2011;

·       $65million second lien term loan maturing on February 28, 2012; and,

·       $25million subordinated term loan maturing on February 28, 2013.

Each of the loans requiresthe payment of interest in arrears on a quarterly basis commencing on March 31,2006. Additionally, the $80 million First Lien Term Loan requires quarterly scheduledminimum principal reductions commencing June 30, 2006. In the event thatwe have not extended the maturity date of the Series Z to a date that ison or after July 26, 2012 (July 26, 2013 for the Subordinated TermLoan) or redeemed the Series Z by various dates in 2008 and 2009, theneach of the loans have various accelerated maturity dates beginning in December 2008.For an additional discussion regarding our new debt facility, see Note 27.

**11.   LEASES**

**Capital Leases**

We lease certain equipmentunder capital leases. Included in property and equipment are the asset valuesof $63,000 and $51,000 and the related accumulated amortization of $16,000 and$5,000 at January 3, 2006 and December 28, 2004, respectively.Amortization of assets under capital leases is included in depreciation andamortization expense.

**Operating Leases**

We lease office space,restaurant space and certain equipment under operating leases having terms thatexpire at various dates through fiscal 2017. Our restaurant leases have renewalclauses of 1 to 20 years at our option and, in some cases, have provisions forcontingent rent based upon a percentage of gross sales, as defined in theleases. Rent expense for fiscal 2005, 2004 and 2003 was approximately $27.1million, $27.9 million and $27.8 million, respectively. Contingent rentincluded in rent expense for fiscal 2005, 2004 and 2003 was approximately$140,000, $130,000 and $130,000, respectively.

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**Future Minimum Lease Payments**

As of January 3,2006, future minimum lease payments under capital and operating leases were asfollows (in thousands of dollars):

| ** **                                    | ** ** | **Capital** | ** ** | **Operating** | ** ** |
|-----------------------------------------------|------------|-------------|------------|---------------|------------|
| **Fiscal year:**                         | ** ** | **Leases**  | ** ** | **Leases**    | ** ** |
| 2006                                          |       |        | $          | 23            |       |   |   | $ | 23,973 |   |   |
| 2007                                          |       |        | 20         |          |       |   | 14,294 |   |   |
| 2008                                          |       |        | 10         |          |       |   | 8,011 |   |   |
| 2009                                          |       |        | —     |          |       |   | 5,959 |   |   |
| 2010                                          |       |        | —     |          |       |   | 3,766 |   |   |
| 2011 and thereafter                           |       |        | —     |          |       |   | 3,365 |   |   |
| Total minimum lease payments                  |       |        | 53         |          |       |   | $ | 59,368 |   |   |
| Less imputed interest (average rate of 4.75%) |       |        | 5          |          |       |   |   |   |   |
| Present value of minimum lease payments       |       |        | 48         |          |       |   |   |   |   |
| Less current installments                     |       |        | 19         |          |       |   |   |   |   |
| Future minimum  rental payments, net          |       |        | $          | 29            |       |   |   |   |   |   |

 

**12.   OTHER LONG-TERM LIABILITIES**

Otherlong-term liabilities consist of the following (in thousands of dollars):

| ** **                        | ** ** | **January 3,** | ** ** | **December 28,** | ** ** |
|-----------------------------------|------------|---------------------|------------|-----------------------|------------|
| ** **                        | ** ** | **2006**            | ** ** | **2004**              | ** ** |
| Vendor  contractual agreements(a) |       |                | $          | 7,175                 |       |   |   | $ | 7,804 |   |   |
| Guaranteed  franchisee debt(b)    |       |                | 42         |                  |       |   | 394 |   |   |
| Deferred rent                     |       |                | 1,234      |                  |       |   | 1,480 |   |   |
| Other                             |       |                | 159        |                  |       |   | — |   |   |
|                              |       |                | $          | 8,610                 |       |   |   | $ | 9,678 |   |   |

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(a)           A strategic supplier ofours provided advance funding in the amount of $10.0 million to us in 1996 aspart of a contract to continue buying products from the supplier. The contractterminates upon fulfillment of contractual purchase volumes. The accounting forthis contract is to recognize a reduction of cost of goods sold based on thevolume of purchases of the vendor’s product.

(b)          Inconnection with our acquisition of Manhattan, we agreed to guarantee certainloans to franchisees made by two financial institutions. We evaluate the fairvalue of such liability at each balance sheet date. As of January 3, 2006and December 28, 2004, the fair value of the liability reflected above isthe probable and estimable loss related to such loans pursuant to agreementswith the financial institutions regarding the established caps on ourobligation. This represents our best estimate of future pay-outs we will makeunder these guarantees.

**13.   2003DEBT REFINANCING AND EQUITY RECAPITALIZATION**

During 2000 and 2001, we engaged in several financingtransactions to acquire the bonds of Einstein/Noah Bagel Corp. (ENBC), whichdeclared Chapter 11 bankruptcy on April 27, 2000. In 2001, we completedthe acquisition of substantially all of the assets (the Einstein Acquisition)of ENBC and its 

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

majority-owned subsidiary,Einstein/Noah Bagel Partners, L.P. which operated 2 brands: Einstein Bros.Bagels and Noah’s New York Bagels. The Einstein Acquisition in 2001 wasaccomplished by issuing a substantial amount of short-term debt and mandatorilyredeemable preferred equity. The maturity date on the debt and the redemptiondate of certain preferred stock issuances ranged from one to three years. Thedebt and preferred stock agreements required the issuance of additionalwarrants and payment of dividends in the event that they were not redeemedwithin a certain period. Such debt and preferred stock and warrant agreementswere referred to as the Increasing Rate Notes or $140 Million Facility, theStandstill Agreements, the Bond Purchase Agreement, the Bridge Loan, and theMandatorily Redeemable Series F Preferred Stock (Series F) andWarrant Agreements.

In connection with the aforementioned debt andpreferred stock issuances, we issued freestanding warrants and rights toreceive additional warrants based either on the passage of time or upon theoccurrence (or non-occurrence) of certain contingent future events(contingently-issuable warrants). We determined that the contingently-issuablewarrants could not be classified within stockholders’ equity based on theapplication of the criteria in EITF Issue 00-19, “Accounting forDerivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock,” and accordingly classified those warrants as a liabilityin the balance sheet. Furthermore, those warrants classified as a liabilitywere subject to the provisions of SFAS No. 133, “Accounting for Derivativeand Hedging Activities.” The warrants were carried at fair value based upon theunderlying fair value of the common stock to which they were indexed, theestimated probability of issuance and other pertinent factors and were adjustedto fair value at each measurement date. Changes in the fair value ofderivatives were recognized in earnings. During fiscal year 2003, we recorded acumulative change in the fair value of derivatives resulting in a $1.0 milliongain. As a result of the equity recapitalization as described below, we nolonger have contingently issuable warrants and all warrants issued have beenclassified as permanent equity. During the 2003, freestanding warrants thatwere issued based on the passage of time were valued based upon the underlyingfair value of the common stock to which they were indexed and recorded inadditional paid-in-capital with a charge to interest expense.

We previously held an investment in debt securitieswhich included ENBC 7.25% Convertible Debentures due 2004 (Einstein Bonds). TheEinstein Bonds were classified as available for sale and recorded at fair valuewith changes in fair value reported in stockholders’ deficit. During fiscalyear 2003, we received proceeds of $0.4 million for the debentures from thebankruptcy court that exceeded the carrying value of the asset. Accordingly, werecorded a gain on our investment in debt securities of $0.4 million.

The proceeds received of $36.7 million relating to ourinvestment in the Einstein Bonds were used to repay a portion of the BridgeLoan, which bore interest at an initial rate of 14% per annum and increased by0.35% on the fifteenth day of each month beginning July 15, 2002. TheBridge Loan was secured by the Einstein Bonds. We issued Series F to paythe remaining balance of the Bridge Loan. Additionally, we issued Series Fto pay the Bond Purchase Agreement in full. The Bond Purchase Agreementprovided for guaranteed accretion of 15% per year, increasing to 17% on January 17,2002 and an additional 2% each six months thereafter. The Series F wasentitled to an annual cash dividend equal to 17% per annum increasing 100 basispoints per month until the Series F was redeemed. Warrants to purchaseshares of our common stock were also issued in connection with this transactionand have since been reclassified as permanent equity as a result of the equityrecapitalization.

On July 8,2003, we issued $160 million of 13% senior secured notes due 2008 as furtherexplained in Note 10. We used the net proceeds, among other things, torefinance the Increasing Rate Notes. The 

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

Increasing Rate Notes bore interest at an initial rateof 13%, increasing 100 basis points each quarter commencing September 15,2001 to a maximum rate of 18%. Also on July 8, 2003, we entered into theAmSouth Revolver.

On June 26,2003, our board of directors approved an equity restructuring agreement betweenus and the holders of all our preferred stock and a substantial portion of ourfully diluted common stock. These entities included: Greenlight Capital, L.P.,Greenlight Capital Qualified, L.P., Greenlight Capital Offshore, Ltd.,Brookwood New World Investors, L.L.C. and NWCI Holdings, LLC. These entitiesare collectively referred to as Greenlight in this filing. Additionally, wealso agreed to the equity recapitalization with Halpern Denny Fund III, L.P.(Halpern Denny). Certain of these entities also held a portion of theIncreasing Rate Notes.

On September 24, 2003, our stockholders approvedthe equity recapitalization, which included the following transactions:

·       We issued Halpern Denny57,000 shares of Series Z Preferred Stock, par value $0.001 per share (Series Z)in exchange for 56,237.994 shares of Series F, par value $0.001 per share,23,264,107 shares of common stock and warrants to purchase 13,711,054 shares ofcommon stock; and

·       Each stockholder received0.6610444 new shares of common stock for every share of common stock held bysuch stockholder pursuant to a 1.6610444-for-one forward stock split inorder to effect the transaction contemplated by the equity recapitalization;

·       The per share exerciseprice and the number of shares of common stock issuable upon the exercise ofeach outstanding option or warrant (other than warrants that were issued inconnection with the Increasing Rate Notes pursuant to the Warrant Agreementdated June 19, 2001, as amended between the Bank of New York, as warrantagent and us) were adjusted to reflect the forward stock split;

·       Immediately following theforward stock split, but before the one-for-one hundred reverse stock splitdiscussed below, we issued Greenlight 938,084,289 shares of common stock inexchange for 61,706.237 shares of Series F. These shares of Series Fincluded: i) shares originally issued as Series F, ii) shares convertedinto Series F from the $10 million contribution plus accrued interestresulting from the Bond Purchase Agreement, and iii) shares converted into Series Ffrom the Bridge Loan.

Followingthe closing of the equity recapitalization, Greenlight beneficially owned 92%of our common stock on a fully diluted basis and warrants issued pursuant tothe Warrant Agreement represented approximately 4.3% of our common stock on afully diluted basis.

In addition to approving the equity recapitalization,our stockholders also approved the following amendments to our RestatedCertificate of Incorporation:

·       effect aone-for-one-hundred reverse stock split following the consummation of thetransactions as contemplated by the equity recapitalization;

·       reduce the number of sharesof common stock authorized for issuance following the consummation of theeffectiveness of the reverse stock split;

·       eliminate theclassification of our board of directors; and

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements**

·       allowour stockholders to take action by written consent of the holders of 80% of ourcapital stock entitled to vote on such action.

The 1.6610444-for-one forward stock split andthe one-for-one hundred reverse stock split have been retroactively reflectedin the accompanying consolidated financial statements and footnotes for allperiods presented.

The exchange of the Halpern Denny interest for Series Zresulted in a reduction of our effective dividend rate to that required by the Series Fand as a result of this and other factors, we accounted for this transaction astroubled debt restructuring as required by SFAS No. 15, Accounting byDebtors and Creditors for Troubled Debt Restructurings. Since a portion of thisexchange included the receipt of our common stock and warrants previously heldby Halpern Denny, we did not recognize a gain from troubled debt restructuring.

The exchange of the Greenlight interest into commonshares was recorded at fair value (the closing price of our common stock on September 24,2003). Because fair value exceeded the negotiated conversion price of theGreenlight conversion of Series F into our common stock, we recorded aloss on the exchange of approximately $23.0 million.

In connection with theequity recapitalization and because certain debt agreements were not redeemedwithin a certain period, we issued step-up warrants to prevent further dilutionand entered into Standstill Agreements with holders of our Increasing RateNotes. Under the terms of the Standstill Agreements, we agreed to issueadditional warrants to purchase shares of our common stock. The StandstillAgreements prevented the call of the debt until such time as we completed theequity recapitalization. For the year ended December 30, 2003, we recorded$3,132 in interest expense related to the standstill and step-up warrantsrepresenting the fair value of our stock on the date of issuance.

**14.   MANDATORILYREDEEMABLE SERIES Z PREFERRED STOCK**

The majorprovisions of our Mandatorily Redeemable Series Z Preferred Stock (Series Z)are as follows:

·       2,000,000shares authorized;

·       parvalue of $0.001 per share;

·       mandatoryredemption upon the earlier of (i) a merger or change of control or (ii) June 30,2009;

·       sharesare non-voting (except for certain limited voting rights with respect tospecified events);

·       liquidationvalue is $1,000 per share;

·       anannual dividend rate equal to 250 basis points higher than the highest ratepaid on our funded indebtedness is payable if the shares are not redeemed bythe redemption date; and

·       sharesmay be redeemed in whole or in part at an earlier date at our discretion.

The Series Z isrecorded in the accompanying consolidated balance sheets at its full face valueof $57.0 million as a result of the accounting under troubled debtrestructuring as discussed in Note 13. The $57.0 million represents the totalcash payable upon liquidation.

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

**15.   STOCKHOLDERS’ EQUITY**

**Common Stock**

We are authorized to issueup to 15 million shares of common stock, par value $0.001 per share. As of January 3,2006 and December 28, 2004, there were 10,065,072 and 9,848,713 sharesoutstanding, respectively.

**Series AJunior Participating Preferred Stock**

In June 1999, ourboard of directors authorized the issuance of a Series A juniorparticipating preferred stock in the amount of 700,000 shares. Thisauthorization was made in accordance with the Stockholder Protection RightsPlan discussed below. There are currently no issued shares.

**Stockholder Protection Rights Plan**

We maintain a StockholderProtection Rights Plan (the Plan). Upon implementation of the Plan in June 1999,our Board declared a dividend distribution of one right on each outstandingshare of common stock, as well as on each share later issued. Each right willallow stockholders to buy one one-hundredth of a share of Series A juniorparticipating preferred stock at an exercise price of $10.00. The rights becomeexercisable if an individual or group acquires 15% or more of common stock, orif an individual or group announces a tender offer for 15% or more of commonstock. The Board can redeem the rights at $0.001 per right at any time beforeany person acquires 15% or more of the outstanding common stock. In the eventan individual (the “Acquiring Person”) acquires 15% or more of the outstandingcommon stock, each right will entitle its holder to purchase, at the right’sexercise price, one one-hundredth of a share of Series A junior participatingpreferred stock, which is convertible into common stock at one-half of the thenvalue of the common stock, or to purchase such common stock directly if thereare a sufficient number of shares of common stock authorized. Our Board has theability to exclude any Acquiring Person from the provision of the stockholdersrights plan, resulting in such Acquiring Person’s purchase of our common stocknot triggering the plan. Rights held by the Acquiring Person are void and willnot be exercisable to purchase shares at the bargain purchase price. If we areacquired in a merger or other business combination transaction, each right willentitle its holder to purchase, at the right’s then-current exercise price, anumber of the acquiring company’s common shares having a market value at thattime of twice the right’s exercise price.

**16.   STOCK OPTION AND WARRANT PLANS**

**1994 and 1995 Plans**

Our 1994 Stock Plan (1994 Plan) provided for thegranting to employees of incentive stock options and for the granting toemployees and consultants of non-statutory stock options and stock purchaserights. On November 21, 2003, the board of directors terminated theauthority to issue any additional options under the 1994 Plan. At January 3,2006, options to purchase 17 shares of common stock at an exercise price of$210.71 per share and a remaining contractual life of 1.48 years remainedoutstanding under this plan.

Our 1995 Directors’ StockOption Plan (Directors’ Option Plan) provided for the automatic grant ofnon-statutory stock options to non-employee directors of the Company. On December 19,2003, our board of directors terminated the authority to issue any additionaloptions under the Directors’ Option Plan. At 

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

January 3,2006, options to purchase 1,328 shares of common stock at a weighted averageexercise price of $49.08 per share and a weighted average remaining contractuallife of 3.15 years remained outstanding under this plan.

**2003Executive Employee Incentive Plan**

On November 21, 2003,our board of directors adopted the Executive Employee Incentive Plan, amendedon December 19, 2003 (2003 Plan). The 2003 Plan provides for grantingincentive stock options to employees and granting non-statutory stock optionsto employees and consultants. Unless terminated sooner, the 2003 Plan willterminate automatically in December 2013. The board of directors has theauthority to amend, modify or terminate the 2003 Plan, subject to any requiredapproval by our stockholders under applicable law or upon advice of counsel. Nosuch action may affect any options previously granted under the 2003 Planwithout the consent of the holders. There are 1,150,000 shares issuablepursuant to options granted under the 2003 Plan. Options typically vest in partbased upon the passage of time and, in part, upon our financial performance.Options that do not vest due to the failure to achieve specific financialperformance criteria are forfeited. Options to purchase approximately 424,208shares of our common stock, which are not yet exercisable, are subject tocompany performance and are treated as variable options. We expect that all ofthe non-vested awards at January 3, 2006 will eventually vest based oncompany performance. As of January 3, 2006, there were 260,001 sharesreserved for future issuance under the 2003 Plan.

**2004Stock Option Plan for Independent Directors**

On December 19, 2003,our board of directors adopted the Stock Option Plan for Independent Directors,effective January 1, 2004, (2004 Directors’ Plan). Our board of directorsmay amend, suspend, or terminate the 2004 Directors’ Plan at any time,provided, however, that no such action may adversely affect any outstandingoption without the option holders consent. A total of 200,000 shares of commonstock have been reserved for issuance under the 2004 Directors’ Plan. The 2004Directors’ Plan provides for the automatic grant of non-statutory stock optionsto independent directors on January 1 of each year and a prorated grant ofoptions for any director elected during the year. Options become exercisablesix months after the grant date and are exercisable for 5 years from thedate of grant unless earlier terminated. As of January 3, 2006, there were94,192 shares reserved for future issuance under the 2004 Directors’ Plan.

**Option Activity**

Transactionsduring fiscal 2005, 2004 and 2003 were as follows:

| ** **                      | ** ** | **Number of Options** | ** ** | **Weighted Average Exercise Price** | ** ** | ** ** |
|---------------------------------|------------|---------------------------------|------------|----------------------------------------------------|------------|------------|
| ** **                      | ** ** | **2005**                        | ** ** | **2004**                                           | ** ** | **2003**   | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | ** ** |
| Outstanding,  beginning of year |       | 803,341                         |       | 878,345                                            |       | 86,647     |   | $ | 3.95 |   | $ | 4.12 |   | $ | 17.46 |   |   |
| Granted                         |       | 606,308                         |       | 45,000                                             |       | 877,495    |   | 2.62 |   | 3.25 |   | 4.05 |   |   |
| Exercised                       |       | —                          |       | —                                             |       | —     |   | — |   | — |   | — |   |   |
| Forfeited                       |       | (412,497                        | )          | (120,004                                           | )          | (85,797    | ) | 3.52 |   | 3.00 |   | 16.89 |   |   |
| Outstanding, end  of year       |       | 997,152                         |       | 803,341                                            |       | 878,345    |   | $ | 3.31 |   | $ | 3.95 |   | $ | 4.12 |   |   |
| Exercisable, end of year        |       | 353,237                         |       | 32,341                                             |       | 2,345      |   | $ | 3.82 |   | $ | 5.92 |   | $ | 33.99 |   |   |

 

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

Thefollowing table summarizes information about stock options outstanding at January 3,2006:

| ** **                                  | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|---------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| **Range of Exercise Prices** | ** ** | ** **                   | ** ** | **Number of  Options**  | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Life (Years)** | ** ** | **Number of  Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $2.25 – $4.00                          |       |                         | 903,307    |                         |       |   | $ | 3.12 |   |   |   | 8.28 |   |   |   | 351,892 |   |   | $ | 3.64 |   |
| $4.01 – $10.00                         |       |                         | 93,330     |                         |       |   | 4.59 |   |   |   | 7.19 |   |   |   | 830 |   |   | 14.57 |   |
| $100.00 – $241.00                      |       |                         | 515        |                         |       |   | 110.04 |   |   |   | 3.82 |   |   |   | 515 |   |   | 110.04 |   |
|                                        |       |                         | 997,152    |                         |       |   | $ | 3.31 |   |   |   | 8.18 |   |   |   | 353,237 |   |   | $ | 3.82 |   |
|                                             |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Warrants**

As of January 3,2006, we have 739,961 warrants outstanding and exercisable to purchase sharesof our common stock. The warrants have exercise prices ranging from $0.60 to$663.00 per share, of which 737,449 are exercisable at $1.20 or less per share,and have an expiration date of June 20, 2006. Such warrants were issued inconnection with financings and certain other services (see Note 13 for furtherinformation regarding the accounting, conversion and valuation of warrants).Transactions during fiscal 2005, 2004 and 2003 were as follows:

| ** **                                  | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Outstanding at  beginning of year           |       | 961,391  |       | 968,337  |       | 659,328  |       |
| Issued                                      |       | —   |       | —   |       | 541,027  |       |
| Exercised                                   |       | (216,359 | )          | (6,885   | )          | —   |       |
| Converted                                   |       | —   |       | —   |       | (227,747 | )          |
| Forfeited                                   |       | (5,071   | )          | (61      | )          | (4,271   | )          |
| Outstanding and  exercisable at end of year |       | 739,961  |       | 961,391  |       | 968,337  |       |

 

**17.   SAVINGSPLAN**

We sponsor a qualifieddefined contribution retirement plan covering eligible employees of New WorldRestaurant Group (the 401(k) Plan). Employees, excluding officers, areeligible to participate in the plan if they meet certain compensation andeligibility requirements. The 401(k) Plan allows participating employeesto defer the receipt of a portion of their compensation and contribute suchamount to one or more investment options. We have accrued a discretionary matchof approximately 35% of the participants’ elective contribution for 2005. Ourcontribution to the plan was $0.3 million, $0.3 million and $0.2 million for2005, 2004 and 2003, respectively. Employer contributions vest at the rate of100% after three years of service.

**18.   INTEGRATIONAND REORGANIZATION COSTS**

**2001 Restructuring**

During the quarter ended July 3, 2001, weimplemented a plan to consolidate our two dough manufacturing facilities on theWest Coast, eliminate duplicative labor lines of assembly, and terminatecertain lease obligations inclusive of several restaurant and other locations.We initially recorded a restructuring accrual of approximately $4.4 millionassociated with this restructuring plan. Approximately 

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

$1.0 million of thischarge represented a write-off of equipment and leasehold improvements thatwere either abandoned or deemed unusable by us.

The following table presents the activity and balancesrelated to the 2001 restructuring accrual:

 

| ** **                                | ** ** | **Facility  Consolidation  Costs** | ** ** | **Severance  Costs** | ** ** | **Contract  Termination   and Other   Costs** | ** ** | **Store Lease  Termination** | ** ** | **Total** | ** ** |
|-------------------------------------------|------------|------------------------------------|------------|----------------------|------------|--------------------------------------------------------------|------------|-----------------------------------|------------|-----------|------------|
| Initial accrual                           |       |                               | $          | 379                  |       |                                                         |       | $                                 | 151        |      |       |   | $ | 233 |   |   |   | $ | 2,629 |   |   | $ | 3,392 |   |
| Application of  costs against the accrual |       |                               | —     |                 |       |                                                         | —     |                              |       |      | (204       | ) |   |   | (293 | ) |   | (497 | ) |
| Adjustments to  the accrual               |       |                               | —     |                 |       |                                                         | —     |                              |       |      | 29         |   |   |   | 12 |   |   | 41 |   |
| Balance at  January 1, 2002          |       |                               | $          | 379                  |       |                                                         |       | $                                 | 151        |      |       |   | $ | 58 |   |   |   | $ | 2,348 |   |   | $ | 2,936 |   |
| Application of  costs against the accrual |       |                               | (68        | )                    |       |                                                         | (229       | )                                 |       |      | (94        | ) |   |   | (907 | ) |   | (1,298 | ) |
| Adjustments to  the accrual               |       |                               | —     |                 |       |                                                         | 85         |                              |       |      | 43         |   |   |   | (702 | ) |   | (574 | ) |
| Balance at  December 31, 2002        |       |                               | $          | 311                  |       |                                                         |       | $                                 | 7          |      |       |   | $ | 7 |   |   |   | $ | 739 |   |   | $ | 1,064 |   |
| Application of  costs against the accrual |       |                               | (266       | )                    |       |                                                         | —     |                              |       |      | (14        | ) |   |   | (229 | ) |   | (509 | ) |
| Adjustments to  the accrual               |       |                               | (32        | )                    |       |                                                         | (7         | )                                 |       |      | 7          |   |   |   | (181 | ) |   | (213 | ) |
| Balance at  December 30, 2003        |       |                               | $          | 13                   |       |                                                         |       | $                                 | —     |      |       |   | $ | — |   |   |   | $ | 329 |   |   | $ | 342 |   |
| Application of  costs against the accrual |       |                               | (15        | )                    |       |                                                         | —     |                              |       |      | —     |   |   |   | (168 | ) |   | (183 | ) |
| Adjustments to  the accrual               |       |                               | 2          |                 |       |                                                         | —     |                              |       |      | —     |   |   |   | (140 | ) |   | (138 | ) |
| Balance at  December 28, 2004        |       |                               | $          | —               |       |                                                         |       | $                                 | —     |      |       |   | $ | — |   |   |   | $ | 21 |   |   | $ | 21 |   |
| Application of  costs against the accrual |       |                               | —     |                 |       |                                                         | —     |                              |       |      | —     |   |   |   | (26 | ) |   | (26 | ) |
| Adjustments to  the accrual               |       |                               | —     |                 |       |                                                         | —     |                              |       |      | —     |   |   |   | 5 |   |   | 5 |   |
| Balance at  January 3, 2006          |       |                               | $          | —               |       |                                                         |       | $                                 | —     |      |       |   | $ | — |   |   |   | $ | — |   |   | $ | — |   |

 

**2002 Restructuring**

During the quarter ended October 1, 2002, weimplemented a plan to shut down our dough manufacturing facilities on the EastCoast. During the quarter ended December 31, 2002, we implemented a planto terminate the lease obligation for the Eatontown location. We vacated theEatontown location in the last week of 2002. When initiated, the restructuringplans were expected to take approximately one year to complete, subject to ourability to sublease the Eatontown facility. We ultimately recorded a $4.8million charge associated with the restructuring plans in 2002. Approximately$2.2 million of this charge represented a write-off of equipment and leaseholdimprovements that were either abandoned or deemed unusable by us. In the fourthquarter of fiscal 2003, we became aware that the Eatontown facility was in theprocess of being sold and that the landlord had engaged a valuation expert todetermine the total cost associated with our vacating the facility. Based uponthe results of this study, we adjusted our initial charge to our estimate ofthe ultimate liability on the Eatontown facility. During April 2004, wereached an agreement with the landlord of the Eatontown facility to settleoutstanding litigation. Previously recorded integration and reorganizationestimates associated with closing this facility were adjusted to reflect areduction of the prior year’s accrued cost of $0.7 million.

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

Thefollowing table presents the activity and balances related to the 2002restructuring accrual:

| ** **                                | ** ** | **Facility  Consolidation  Costs** | ** ** | **Severance  Costs** | ** ** | **Contract  Termination   and Other   Costs** | ** ** | **Total** | ** ** |
|-------------------------------------------|------------|------------------------------------|------------|----------------------|------------|--------------------------------------------------------------|------------|-----------|------------|
| Initial accrual                           |       |                               | $          | 1,447                |       |                                                         |       | $         | 787        |   |   |   | $ | 300 |   |   | $ | 2,534 |   |
| Application of  costs against the accrual |       |                               | —     |                 |       |                                                         | (662       | )         |       |   | (168 | ) |   | (830 | ) |
| Balance at  December 31, 2002        |       |                               | $          | 1,447                |       |                                                         |       | $         | 125        |   |   |   | $ | 132 |   |   | $ | 1,704 |   |
| Application of  costs against the accrual |       |                               | (160       | )                    |       |                                                         | (90        | )         |       |   | (68 | ) |   | (318 | ) |
| Adjustments to  the accrual               |       |                               | 2,413      |                 |       |                                                         | (35        | )         |       |   | (33 | ) |   | 2,345 |   |
| Balance at  December 30, 2003        |       |                               | $          | 3,700                |       |                                                         |       | $         | —     |   |   |   | $ | 31 |   |   | $ | 3,731 |   |
| Application of  costs against the accrual |       |                               | (3,000     | )                    |       |                                                         | —     |      |       |   | — |   |   | (3,000 | ) |
| Adjustments to  the accrual               |       |                               | (700       | )                    |       |                                                         | —     |      |       |   | (31 | ) |   | (731 | ) |
| Balance at  December 28, 2004        |       |                               | $          | —               |       |                                                         |       | $         | —     |   |   |   | $ | — |   |   | $ | — |   |

 

**19.   LOSS(GAIN) ON SALE, DISPOSAL OR ABANDONMENT OF ASSETS**

**Duringfiscal 2004, we recorded a loss on disposal or abandonment of assets ofapproximately $0.1 million due to the disposal of menu boards as a result ofour new menu offerings and approximately $1.5 million due to the abandonment ofleasehold improvements related to closed restaurants and our administrativefacilities located in New Jersey. The loss on disposal or abandonment of assetswas offset by a gain of approximately $90,000 on the sale of the assets ofWilloughby’s as further described below.**

**20.   SALEOF WILLOUGHBY’S COFFEE AND TEA**

Effective October 6, 2004, we executed an AssetPurchase Agreement and sold the assets of Willoughby’s to the original founders.The Willoughby’s business consisted of a coffee roasting plant, three retaillocations and an office space.

Components of theasset sale included, but were not limited to:

·       The“Willoughby’s Coffee & Tea” trade name, trademark and logo,

·       The“Serious Coffee” trademark,

·       Thewilloughbyscoffee.com domain name and existing website,

·       Allproperty and equipment of Willoughby’s, and

·       Cashin drawer, accounts receivable, and inventory at all Willoughby’s locations.

Under the terms of agreement, we sold the assets for atotal sales price of approximately $0.4 million, which was received in cash. Inconnection with the sale of Willoughby’s, we also executed a two-year supplyagreement to purchase coffee for our New World Coffee cafés from the buyer.

 

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

We have considered SFAS No. 144in our determination that the revenues, cost of sales, other operating expensesand the net book value of the assets related to the sale of the coffee roastingplant and three retail locations included in the Willoughby’s business wereimmaterial in relation to our Einstein Bros., Noah and Manhattan restaurants,as well as the consolidated financial statements taken as a whole. Accordingly,we have not presented discontinued operations in the accompanying consolidatedstatements of operations, nor have we reflected assets as held for sale in theaccompanying consolidated balance sheet as of December 28, 2004. Werecognized a gain from the sale of approximately $90,000 during the year ended December 28,2004.

**21.   INCOME TAXES**

Theprovision for income taxes consists of the following:

| ** **                                 | ** ** | **2005**                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------|------------|----------------------------------------------|------------|----------|------------|----------|------------|
| ** **                                 | ** ** | **(in thousands of dollars)** | ** ** |
| Current                                    |       |                                         |       |     |       |     |       |   |   |
| Federal                                    |       |                                         | $          | —   |       |     | $          | — |   | $ | — |   |
| State                                      |       |                                         | —     |     |       | (49      | )          | 812 |   |
| Total current income tax expense (benefit) |       |                                         | —     |     |       | (49      | )          | 812 |   |
| Deferred                                   |       |                                         |       |     |       |     |       |   |   |
| Federal                                    |       |                                         | —     |     |       | —   |       | — |   |
| State                                      |       |                                         | —     |     |       | —   |       | — |   |
| Total deferred income tax benefit          |       |                                         | —     |     |       | —   |       | — |   |
| Total income tax benefit (expense)         |       |                                         | $          | —   |       |     | $          | (49 | ) | $ | 812 |   |

 

Areconciliation between the reported provision for income taxes and the amountcomputed by applying the statutory federal income tax rate of 35% to lossbefore income taxes is as follows:

| ** **                          | ** ** | **2005**                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------|------------|----------------------------------------------|------------|----------|------------|----------|------------|
| ** **                          | ** ** | **(in thousands of dollars)** | ** ** |
| Expected tax  benefit at 35%        |       | $                                            | (4,906     | )        | $          | (6,109   | )          | $ | (25,448 | ) |
| State net of  federal benefit       |       | (390                                         | )          | (611     | )          | (1,601   | )          |
| Loss on  extinguishment of debt     |       | —                                       |       | —   |       | 8,052    |       |
| Other, net                          |       | 705                                          |       | (469     | )          | 2,303    |       |
| Change in  valuation allowance      |       | 4,591                                        |       | 7,140    |       | 17,506   |       |
| Total benefit (provision) for taxes |       | $                                            | —     |     | $          | (49      | )          | $ | 812 |   |

 

65

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

Theincome tax effects of temporary differences that give rise to significantportions of deferred tax assets as of January 3, 2006 and December 28,2004 are as follows:

| ** **                       | ** ** | **2005**                                     | ** ** | **2004** | ** ** |
|----------------------------------|------------|----------------------------------------------|------------|----------|------------|
| ** **                       | ** ** | **(in thousands of dollars)** | ** ** |
| Deferred tax  assets             |       |                                         |       |     |       |
| Operating loss carryforwards     |       | $                                            | 59,958     |     | $          | 57,412 |   |
| Capital loss carryforwards       |       | 1,237                                        |       | 1,237    |       |
| Accrued expenses                 |       | 1,317                                        |       | 2,424    |       |
| Allowances for doubtful accounts |       | 183                                          |       | 893      |       |
| Other assets                     |       | 58                                           |       | 32       |       |
| Property, plant and equipment    |       | 15,852                                       |       | 12,016   |       |
| Total gross deferred tax asset   |       | 78,605                                       |       | 74,014   |       |
| Less valuation allowance         |       | (78,605                                      | )          | (74,014  | )          |
| Total deferred tax liability     |       | $                                            | —     |     | $          | — |   |

 

For income tax purposes, at January 3, 2006, wehad net operating loss carryforwards of approximately $157 million, expiring atvarious dates through 2025. The utilization of approximately $103 million ofthe aforementioned net operating loss carryforwards is subject to an annuallimitation under the provisions of Section 382 of the Internal RevenueCode.

At this time, we believeit is more likely than not that our net deferred tax asset will not berealized. Accordingly, a valuation allowance has been recorded against thedeferred tax asset at January 3, 2006 and December 28, 2004. Shouldwe conclude that the deferred tax asset is, at least in part, realizable, thevaluation allowance will be reversed to the extent of such expectedrealizability.

**22.   SUPPLEMENTALCASH FLOW INFORMATION**

| ** **                                                          | ** ** | **2005**                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------------------------|------------|----------------------------------------------|------------|----------|------------|----------|------------|
| ** **                                                          | ** ** | **(in thousands of dollars)** | ** ** |
| Cash paid during  the period for:                                   |       |                                         |       |     |       |     |       |
| Interest                                                            |       | $                                            | 32,084     |     | $          | 21,166   |       | $ | 17,284 |   |
| Non-cash investing and financing activities:                        |       |                                         |       |     |       |     |       |
| Non-cash dividends and accretion on preferred stock                 |       | $                                            | —     |     | $          | —   |       | $ | 14,423 |   |
| Conversion of Bridge Loan and Bond Purchase  Agreement              |       |                                         |       |     |       |     |       |
| to Mandatorily Redeemable Series F preferred  stock            |       | $                                            | —     |     | $          | —   |       | $ | 18,588 |   |
| Conversion of Mandatorily Redeemable Series F                  |       |                                         |       |     |       |     |       |
| to Mandatorily Redeemable Series Z preferred  stock            |       | $                                            | —     |     | $          | —   |       | $ | 57,000 |   |
| Conversion of Mandatorily Redeemable Series F  to common stock |       | $                                            | —     |     | $          | —   |       | $ | 61,706 |   |
| Non-cash warrant issuance                                           |       | $                                            | —     |     | $          | —   |       | $ | 1,854 |   |
| Non-cash option issuance                                            |       | $                                            | —     |     | $          | 205      |       | $ | — |   |
| Non-cash purchase of equipment through capital  leasing             |       | $                                            | 33         |     | $          | 51       |       | $ | — |   |

 

**23.   RELATED PARTY TRANSACTIONS**

Several of ourstockholders or former stockholders, including BET Associates LP (BET), HalpernDenny, Greenlight Capital, LLC and certain of their affiliates (Greenlight),have been involved in our 

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

financings,refinancings, have purchased our debt and equity securities and were involvedin our equity recapitalization as further described in Note 13. Below, we havesummarized related party transactions involving these investors during the2005, 2004 and 2003 fiscal years.

*Greenlight Capital,LLC and its affiliates*

E. Nelson Heumann is the chairman of our board ofdirectors and is a current employee of Greenlight. Greenlight and itsaffiliates beneficially own approximately 95 percent of our common stock on afully diluted basis. As a result, Greenlight has sufficient voting powerwithout the vote of any other stockholders to determine what matters will besubmitted for approval by our stockholders, to approve actions by written consentwithout the approval of any other stockholders, to elect all of our board ofdirectors, and among other things, to determine whether a change in control ofour company occurs.

In July 2003, Greenlight purchased all of theoutstanding Einstein/Noah Bagel Corp. 7.25% Convertible Debentures due 2004from Jefferies. Greenlight also purchased $35.0 million of our $160 MillionNotes. Upon consummation of the equity recapitalization, we issued 4,337.481shares of Series F to Greenlight in full payment of the outstanding BridgeLoan. The shares of Series F were converted into common stock in theequity recapitalization.

In 2003, pursuant to the equity recapitalization, wereimbursed Greenlight for legal fees and disbursements incurred in connectionwith their investment in our company and the equity restructuring in the amountof $0.2 million.

In January 2006, wecalled for redemption the investment Greenlight held in our $160 Million Notes.The notes were redeemed from the proceeds our refinancing in February 2006as further described in Note 27.

*Leonard Tannenbaum,MYMF Capital LLC and BET*

Leonard Tannenbaum, a director, was the ManagingDirector of MYFM Capital LLC until July 2004. In July 2004, Mr. Tannenbaumfounded Fifth Street Capital LLC and is the managing partner. He is also alimited partner and 10% owner in BET. His father-in-law is Bruce Toll, anaffiliate of BET. On May 30, 2002, we entered into a Loan and SecurityAgreement (the facility) with BET, which provided for $75.0 million revolvingloan facility at 11% interest. The facility was secured by substantially all ofour assets. In February 2003, we executed an amendment to the facility toextend the maturity of the facility from March 31, 2003 to June 1,2003. From February 1, 2003 to June 1, 2003, the interest rateincreased from 11% to 13% per annum. BET and MYFM Capital LLC received anextension fee of $0.2 million in connection with the amendment, payable atmaturity, and an additional $0.1 million because the facility was not paid infull by June 2, 2003. After June 1, 2003, the interest rate forborrowings under the facility was 15% per annum, and MYFM Capital LLC receiveda $30,000 fee for entering into a standstill agreement with us. The facilitywas repaid with the proceeds of issuance of the $160 Million Facility in July 2003,and BET received $3,000 for reimbursement of legal fees and expenses. BETpurchased $7.5 million of our $160 Million Notes and Mr. Tannenbaumpurchased an additional $0.5 million of our $160 Million Notes in the market.

In January 2006, wecalled for redemption the investment BET and Mr. Tannenbaum held in our$160 Million Notes. The notes were redeemed from the proceeds our refinancingin February 2006 as further described in Note 27.

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

*Halpern Denny*

In 2003, pursuant to theequity recapitalization, we reimbursed Halpern Denny for legal fees anddisbursements incurred in connection with their investment in our company andthe equity restructuring in the amounts of $0.2 million.

*Jill B.W. Sisson*

On December 8, 2003,we entered into a consulting agreement with Ms. Jill B. W. Sisson toprovide legal, consulting and advisory services to us and to serve as GeneralCounsel and Secretary. The agreement provided that Ms. Sisson be paid$15,833 per month and, on December 19, 2003, was granted options topurchase 75,000 shares of common stock pursuant to the 2003 Plan. The optionsvest in part, upon length of service and in part, upon the achievement ofspecified financial goals by us. In addition, Ms. Sisson is eligible toreceive annual additional premium compensation based upon our performance andpersonal performance and has subsequently received an increase to $18,750 permonth. Ms. Sisson will also be reimbursed for reasonable and necessaryout-of-pocket expenses. The agreement provides for non-solicitation of ouremployees for a year after termination of the agreement, and can be terminatedby either party upon 30 days notice.

**24.   PURCHASE COMMITMENTS**

We have obligations withcertain of our major suppliers of raw materials (primarily frozen bagel doughand cream cheese) for minimum purchases both in terms of quantity and pricingon an annual basis. Furthermore, from time to time, we will commit to thepurchase price of certain commodities that are related to the ingredients used forthe production of our bagels. On a periodic basis, we review the relationshipof these purchase commitments to our business plan, general market trends andour assumptions in our operating plans. If these commitments are deemed to bein excess of the market, we will expense the excess purchase commitment to costof sales, in the period in which the shortfall is determined. The total of ourfuture purchase obligations at January 3, 2006 was approximately $9.1million.

**25.   LITIGATION**

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

On July 31, 2002, Tristan Goldstein and ValerieBankhordar, former restaurant managers, filed a putative class action againstEinstein and Noah Corp. (“ENC”) in the Superior Court for the State ofCalifornia, County of San Francisco for failure to pay overtime wages tomanagers and assistant managers of the California Noah’s restaurants. In April 2004,we agreed to settle the litigation, which agreement was subsequently approvedby the court in January 2006. Amounts representing our estimate to settlethis litigation were previously recorded in general and administrative expensesduring fiscal 2003, were paid subsequent to fiscal year-end 2005 and did nothave a material adverse effect on our consolidated financial condition orresults of operations.

On September 14,2004, Atlantic Mutual Insurance Company brought an action in the Superior Courtof New Jersey Law Division: Morris County, against the Company, certain of itsformer officers and 

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

directorsand insurers seeking declaratory judgment on insurance coverage issues inpreviously resolved litigation against Jerold Novack and Ramin Kamfar, formerofficers. Mr. Kamfar cross-claimed against us, claiming a right to beindemnified for expenses. The Company, Mr. Kamfar, Atlantic MutualInsurance Company and Lexington Insurance Company settled the lawsuit in February 2006.The resolution of this lawsuit did not have a material effect on ourconsolidated financial condition or results of operations. Because the Companyasserts that the advancement and indemnity claims are an insured loss under theCompany’s policy with National Union, the Company has filed an arbitrationproceeding against National Union, the Company’s officers and directorsliability insurer for the applicable time period.

**26.   QUARTERLYRESULTS OF OPERATIONS (UNAUDITED)**

Thefollowing table summarizes the unaudited consolidated quarterly results ofoperations for fiscal 2005 and 2004:

| ** **                                 | ** ** | **Fiscal year 2005:**                                                            | ** ** |
|--------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
| ** **                                 | ** ** | **1st Quarter**                                                                       | ** ** | **2nd Quarter** | ** ** | **3rd Quarter** | ** ** | **4th Quarter** | ** ** |
| ** **                                 | ** ** | **(13 wks)**                                                                          | ** ** | **(13 wks)** | ** ** | **(13 wks)** | ** ** | **(14 wks)** | ** ** |
| ** **                                 | ** ** | **(in thousands of dollars, except per share amounts)** | ** ** |
| Revenue                                    |       |                                                                                       | $          | 93,295 |   |   |   | $ | 97,113 |   |   |   | $ | 94,782 |   |   |   | $ | 103,903 |   |   |
| Income from  operations                    |       |                                                                                       | $          | 1,664 |   |   |   | $ | 1,421 |   |   |   | $ | 885 |   |   |   | $ | 5,398 |   |   |
| Net loss                                   |       |                                                                                       | $          | (4,198 | ) |   |   | $ | (4,283 | ) |   |   | $ | (4,814 | ) |   |   | $ | (723 | ) |   |
| Net loss  available to common shareholders |       |                                                                                       | $          | (4,198 | ) |   |   | $ | (4,283 | ) |   |   | $ | (4,814 | ) |   |   | $ | (723 | ) |   |
| Basic and diluted  loss per share          |       |                                                                                       | $          | (0.43 | ) |   |   | $ | (0.43 | ) |   |   | $ | (0.49 | ) |   |   | $ | (0.07 | ) |   |

 

| ** **                                 | ** ** | **Fiscal year 2004:**                                                            | ** ** |
|--------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
| ** **                                 | ** ** | **1st Quarter**                                                                       | ** ** | **2nd Quarter** | ** ** | **3rd Quarter** | ** ** | **4th Quarter** | ** ** |
| ** **                                 | ** ** | **(13 wks)**                                                                          | ** ** | **(13 wks)** | ** ** | **(13 wks)** | ** ** | **(14 wks)** | ** ** |
| ** **                                 | ** ** | **(in thousands of dollars, except per share amounts)** | ** ** |
| Revenue                                    |       |                                                                                       | $          | 91,196 |   |   |   | $ | 94,164 |   |   |   | $ | 91,179 |   |   |   | $ | 97,321 |   |   |
| Income (loss)  from operations             |       |                                                                                       | $          | 1,661 |   |   |   | $ | (172 | ) |   |   | $ | 526 |   |   |   | $ | 3,443 |   |   |
| Net loss                                   |       |                                                                                       | $          | (4,130 | ) |   |   | $ | (6,224 | ) |   |   | $ | (4,952 | ) |   |   | $ | (2,099 | ) |   |
| Net loss  available to common shareholders |       |                                                                                       | $          | (4,130 | ) |   |   | $ | (6,224 | ) |   |   | $ | (4,952 | ) |   |   | $ | (2,099 | ) |   |
| Basic and diluted loss  per share          |       |                                                                                       | $          | (0.42 | ) |   |   | $ | (0.63 | ) |   |   | $ | (0.50 | ) |   |   | $ | (0.21 | ) |   |

 

**27.   SUBSEQUENTEVENT—DEBT REDEMPTION AND REFINANCING**

Debt Redemption and Refinancing—On February 28, 2006, wecompleted a debt refinancing that redeemed our $160 Million Notes and retiredour $15 million AmSouth Revolver. Our new debt obligations consist of thefollowing:

·       $15 million revolving creditfacility;

·       $80 million first lien term loan;

·       $65 million second lien term loan;and

·       $25 million subordinated term loan.

$15 MillionRevolving Credit Facility—the Revolving Facility has a maturity date of March 31,2011 and provides for interest based upon the prime rate or LIBOR plus amargin. The margin may increase or decrease up to 0.25% based upon ourconsolidated leverage ratio as defined in the agreement. The initial 

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

margin is at prime plus 2.00% or LIBOR plus 3.00%. This facilitymay be used in whole or in part for letters of credit.

$80 Million First Lien Term Loan—the FirstLien Term Loan has a maturity date of March 31, 2011 and provides for afloating interest rate based upon the prime rate or LIBOR plus a margin. Themargin may increase or decrease 0.25% based upon our consolidated leverageratio as defined in the agreement. The initial margin is prime plus 2.00% orLIBOR plus 3.00%. The facility is fully amortizing with quarterly principalreductions and interest payments over the term of the loan as follows:

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

 

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

In the event thatwe have not extended the maturity date of the Series Z to a date that ison or after July 26, 2012 or redeemed the Series Z by December 30,2008, then the Revolving Facility and the First Lien Term Loan will mature on December 30,2008.

$65 Million SecondLien Term Loan—the Second Lien Term Loan has a maturity date of February 28,2012 and provides for a floating interest rate based upon the prime rate plus5.75% or LIBOR plus 6.75%. Interest is payable in arrears on a quarterly basis.The Second Lien Term Loan has a prepayment penalty of 2.0% and 1.0% of theamount of any such optional prepayment that occurs prior to the first or secondanniversary date, respectively. The Second Lien Term Loan requires principalreductions based upon a percentage of excess cash flow (as defined in thecredit agreement) in any fiscal year and is also subject to certain mandatoryprepayment provisions. In the event that we have not extended the maturity dateof the Series Z to a date that is on or after July 26, 2012 orredeemed the Series Z by March 30, 2009, then the Second Lien TermLoan will mature on March 30, 2009.

$25 MillionSubordinated Term Loan—the Subordinated Term Loan has a maturity date of February 28,2013, carries a fixed interest rate of 13.75% per annum and requires aquarterly cash interest payment in arrears at 6.5% and quarterly paid-in kindinterest that is added to the principal balance outstanding at 7.25%. TheSubordinated Term Loan is held by affiliates of Greenlight Capital. Based on anoriginal issue discount of 2.5%, proceeds of approximately $24.4 million wereloaned to the Company. The Subordinated Term Loan is subject to certainmandatory prepayment provisions. In the event that we have not extended thematurity date of the Series Z to a date that is on or after July 26,2013 or redeemed the Series Z by June 29, 2009, then the SubordinatedTerm Loan will mature on June 29, 2009.

All the loans haveusual and customary covenants including consolidated leverage ratios, fixedcharge coverage ratios, limitations on capital expenditures, etc. The loans areall guaranteed by our material subsidiaries. The Revolving Facility and theFirst Lien Term Loan and the related guarantees are secured 

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**NEW WORLD RESTAURANT GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued)**

by a first priority security interest in all of our assets and ourmaterial subsidiaries, including a pledge of 100% of our interest in all sharesof capital stock (or other ownership or equity interests) of each materialsubsidiary. The Second Lien Term Loan and the related guarantees are secured bya second priority security interest in all our assets and our materialsubsidiaries, including a pledge of 100% of our interest in all shares ofcapital stock (or other ownership or equity interests) of each materialsubsidiary. The Subordinated Term Loan is unsecured.

As a result ofthis refinancing, and based upon LIBOR rates in effect as of February 28,2006, our average cash interest rate is expected to improve to approximately10.2% as compared with 13.0% on the debt it replaced.

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**NEW WORLD RESTAURANT GROUP, INC.Schedule II—Valuation and Qualifying Accounts(in thousands of dollars)**

| ** **                                         | ** ** | **Balance at** | ** ** | ** **       | ** ** | ** **        | ** ** | **Balance at** | ** ** |
|----------------------------------------------------|------------|---------------------|------------|------------------|------------|-------------------|------------|---------------------|------------|
| ** **                                         | ** ** | **beginning**       | ** ** | ** **       | ** ** | ** **        | ** ** | **end**             | ** ** |
| ** **                                         | ** ** | **of period**  | ** ** | **Additions(a)** | ** ** | **Deductions(b)** | ** ** | **of period**  | ** ** |
| For the fiscal year  ended December 30, 2003: |       |                |       |             |       |              |       |                |       |   |   |   |   |   |   |   |   |
| Allowance for doubtful accounts                    |       |                | $          | 4,611            |       |              |       | 1,815               |       |   |   | (3,116 | ) |   |   | $ | 3,310 |   |   |
| Restructuring reserve                              |       |                | $          | 2,768            |       |              |       | 2,420               |       |   |   | (1,115 | ) |   |   | $ | 4,073 |   |   |
| Valuation allowance for deferred taxes             |       |                | $          | 49,368           |       |              |       | 17,506              |       |   |   | — |   |   |   | $ | 66,874 |   |   |
| For the fiscal year  ended December 28, 2004: |       |                |       |             |       |              |       |                |       |   |   |   |   |   |   |   |   |
| Allowance for doubtful accounts                    |       |                | $          | 3,310            |       |              |       | 177                 |       |   |   | (1,012 | ) |   |   | $ | 2,475 |   |   |
| Restructuring reserve                              |       |                | $          | 4,073            |       |              |       | (869                | )          |   |   | (3,183 | ) |   |   | $ | 21 |   |   |
| Valuation allowance for deferred taxes             |       |                | $          | 66,874           |       |              |       | 7,140               |       |   |   | — |   |   |   | $ | 74,014 |   |   |
| For the fiscal year  ended January 3, 2006:   |       |                |       |             |       |              |       |                |       |   |   |   |   |   |   |   |   |
| Allowance for doubtful accounts                    |       |                | $          | 2,475            |       |              |       | (158                | )          |   |   | (1,837 | ) |   |   | $ | 480 |   |   |
| Restructuring reserve                              |       |                | $          | 21               |       |              |       | 5                   |       |   |   | (26 | ) |   |   | $ | — |   |   |
| Valuation  allowance for deferred taxes            |       |                | $          | 74,014           |       |              |       | 4,591               |       |   |   | — |   |   |   | $ | 78,605 |   |   |

----

Notes:

(a)           Amounts charged tocosts and expenses.

(b)          Bad debt write-offs andcharges to reserves.

See accompanying report of independent registered public accounting firm

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**ITEM 9.**                CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES

None

**ITEM 9A.**        CONTROLSAND PROCEDURES

An evaluation was carried out under the supervisionand with the participation of company management, including our chief executiveofficer and chief financial officer, of the effectiveness of the design andoperation of our disclosure controls and procedures (as defined in Rule 13a-15(e) underthe Securities Exchange Act of 1934, as amended) as of January 3, 2006.Based upon that evaluation, our chief executive officer and our chief financialofficer have concluded that the design and operation of our disclosure controlsand procedures were effective in timely making known to them materialinformation relating to the Company required to be disclosed in reports that wefile or submit under the Exchange Act rules.

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

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

**ITEM 9B.**       OTHERINFORMATION

None

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**PART III**

**ITEM 10.**         DIRECTORSAND EXECUTIVE OFFICERS OF THE REGISTRANT

Information relating to Directors required by Item 10will be included in our 2006 Proxy Statement, which will be filed within 120days after the close of the 2005 fiscal year, and is hereby incorporated byreference.

Information relating to compliance with Section 16(a) requiredby Item 10 will included in our 2006 Proxy Statement, which will be filedwithin 120 days after the close of the 2005 fiscal year, and is herebyincorporated by reference.

Information regardingexecutive officers is included in Part I of this Form 10-K, aspermitted by General Instruction G(3).

**ITEM 11.**         EXECUTIVECOMPENSATION

This information will beincluded in our 2006 Proxy Statement, which will be filed within 120 days afterthe close of the 2005 fiscal year, and is hereby incorporated by reference.

**ITEM 12.**         SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

This information will beincluded in our 2006 Proxy Statement, which will be filed within 120 days afterthe close of the 2005 fiscal year, and is hereby incorporated by reference.

**ITEM 13.**         CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS

This information will beincluded in our 2006 Proxy Statement, which will be filed within 120 days afterthe close of the 2005 fiscal year, and is hereby incorporated by reference.

**ITEM 14.**         PRINCIPALACCOUNTANT FEES AND SERVICES

This information will be included in our 2006 ProxyStatement, which will be filed within 120 days after the close of the 2005fiscal year, and is hereby incorporated by reference.

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**PART IV**

**ITEM 15.**         EXHIBITSAND FINANCIAL STATEMENT SCHEDULES

(1)          Financial Statements

See the Index toConsolidated Financial Statements included on Page 37 for a list of thefinancial statements included in this Form 10-K.

(2)          Financial StatementSchedules

See Page 72for Schedule II—Valuation and Qualifying Accounts. All other financialstatement schedules are omitted because they are not required or are notapplicable.

(3)          Exhibits

| No.   | ** ** | Description                                                                                                                                                                                         | ** ** | ** ** |
|-------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
| 3.1   |       | Restated Certificate of Incorporation(3)                                                                                                                                                            |
| 3.11  |       | Amendment to Restated Certificate of  Incorporation(10)                                                                                                                                             |
| 3.12  |       | Amendment to Restated Certificate of  Incorporation(11)                                                                                                                                             |
| 3.13  |       | Amendment to Restated Certificate of  Incorporation(12)                                                                                                                                             |
| 3.14  |       | Amendment to Restated Certificate of  Incorporation(13)                                                                                                                                             |
| 3.15  |       | Amendment to Restated Certificate of  Incorporation(14)                                                                                                                                             |
| 3.16  |       | Amendment to Restated Certificate of  Incorporation(15)                                                                                                                                             |
| 3.2   |       | Third Amended By-laws(1)                                                                                                                                                                            |
| 3.3   |       | Amendments to By-laws(7)                                                                                                                                                                            |
| 4.1   |       | Specimen Common Stock Certificate of Registrant(18)                                                                                                                                                 |
| 4.2   |       | New World Restaurant Group, Inc. Certificate of  Designation, Preferences and Rights of Series Z Preferred Stock(9)                                                                       |
| 10.1  |       | 1994 Stock Plan(1)+                                                                                                                                                                                 |
| 10.2  |       | Directors’ Option Plan(1)+                                                                                                                                                                     |
| 10.3  |       | Executive Employee Incentive Plan(20)+                                                                                                                                                              |
| 10.4  |       | Amendment to Executive Employee Incentive Plan (21)+                                                                                                                                                |
| 10.5  |       | Stock Option Plan for Independent Directors(22)+                                                                                                                                                    |
| 10.6  |       | Amendment to Stock Option Plan for Independent  Directors (23)+                                                                                                                                     |
| 10.7  |       | Consulting Agreement between Registrant and Jill  B.W. Sisson effective as of December 8, 2003(18)+                                                                                            |
| 10.8  |       | Rights Agreement between Registrant and American  Stock Transfer & Trust Company, as Rights Agent dated as of  June 7, 1999(2)                                                        |
| 10.9  |       | Amendment No. 1 to Warrant Agreement dated as  of March 15, 2002 between Registrant and The Bank of New York, as  successor in interest to the United States Trust Company of New York(8) |
| 10.10 |       | Escrow Deposit Agreement dated as of June 10,  2003, between Registrant and The Bank of New York, as Trustee(8)                                                                                |
| 10.11 |       | Indenture dated as of July 8, 2003, by and  among Registrant, the Subsidiary Guarantors and The Bank of New York, as  Trustee(8)                                                               |
| 10.12 |       | 144A Global Note (including guarantees thereon) by  and among Registrant, the Subsidiary Guarantors and The Bank of New York, as  Trustee(8)                                                        |
| 10.13 |       | IAI Global Note (including guarantees thereon) by  and among Registrant, the Subsidiary Guarantors and The Bank of New York, as  Trustee(8)                                                         |
| 10.14 |       | Pledge and Security Agreement dated as of  July 8, 2003, by and among Registrant, the Subsidiary Guarantors and The  Bank of New York, as Trustee(8)                                           |

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| 10.15 |   | Patent Security Agreement dated as of July 8,  2003, by and among Registrant and the Subsidiary Guarantors, in favor of The  Bank of New York, as Collateral Agent(8)                                                                                                                                                             |
|-------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.16 |   | Trademark Security Agreement dated as of  July 8, 2003, between Registrant and The Bank of New York, as Collateral  Agent(8)                                                                                                                                                                                                      |
| 10.17 |   | Trademark Security Agreement dated as of  July 8, 2003, between Chesapeake Bagel Franchise Corp. and The Bank of  New York, as Collateral Agent(8)                                                                                                                                                                                |
| 10.18 |   | Trademark Security Agreement dated as of  July 8, 2003, between Einstein/Noah Bagel Partners, Inc. and The  Bank of New York, as Collateral Agent(8)                                                                                                                                                                         |
| 10.19 |   | Trademark Security Agreement dated as of  July 8, 2003, between Einstein and Noah Corp. and The Bank of New York,  as Collateral Agent(8)                                                                                                                                                                                         |
| 10.20 |   | Trademark Security Agreement dated as of  July 8, 2003, between Manhattan Bagel Company, Inc. and The Bank of  New York, as Collateral Agent(8)                                                                                                                                                                              |
| 10.21 |   | Loan and Security Agreement dated as of July 8,  2003, by and among Registrant and certain of its Subsidiaries (as therein  defined), as Borrower(s) and Guarantors, AmSouth Bank, as Agent, AmSouth  Bank and the financial institutions named therein, as Lenders, and AmSouth  Capital Corp., as Administrative Agent(16) |
| 10.22 |   | Security Agreement and Mortgage—Trademarks and  Patents dated as of July 8, 2003, by and among Registrant, the  Subsidiary Guarantors and the Bank of New York, as Trustee(16)                                                                                                                                               |
| 10.23 |   | Pledge Agreement dated as of July 8, 2003, by  and among Registrant and certain of its Subsidiaries, as Pledgors in favor of  AmSouth Bank, as Agent(16)                                                                                                                                                                          |
| 10.24 |   | Intercreditor Agreement dated as of July 8,  2003, by and among Registrant, the Subsidiary Guarantors, AmSouth Bank and  the Bank of New York as Trustee(16)                                                                                                                                                                      |
| 10.25 |   | Amendment Agreement with AmSouth Bank dated  December 30, 2003(17)                                                                                                                                                                                                                                                                |
| 10.26 |   | Second Amendment Agreement with AmSouth Bank dated  February 9, 2004(18)                                                                                                                                                                                                                                                          |
| 10.27 |   | Registration Rights Agreement dated as of  July 8, 2003, between Registrant, the Subsidiary Guarantors and  Jefferies & Company, Inc.(8)                                                                                                                                                                            |
| 10.28 |   | Form of Common Stock Purchase Warrant issued to  Halpern Denny, BET and Brookwood(4)                                                                                                                                                                                                                                              |
| 10.29 |   | Form of Common Stock Purchase Warrant issued to  the Greenlight Entities(4)                                                                                                                                                                                                                                                       |
| 10.30 |   | Registration Rights Agreement dated as of  January 17, 2001, by and among the Registrant, Greenlight Capital, L.P.,  Greenlight Capital Qualified, L.P. and Greenlight Capital Offshore, Ltd.(4)                                                                                                                                  |
| 10.31 |   | Form of Common Stock Purchase Warrant issued to  Halpern Denny(5)                                                                                                                                                                                                                                                                 |
| 10.32 |   | Amended and Restated Registration Rights Agreement  dated as of January 18, 2001, by and among the Registrant, Halpern  Denny, BET and Brookwood(4)                                                                                                                                                                               |
| 10.33 |   | Amendment No. 1 to Amended and Restated  Registration Rights Agreement dated as of January 18, 2001, by and among  the Registrant, Halpern Denny, BET and Brookwood(5)                                                                                                                                                       |
| 10.34 |   | Amendment No. 2 to Registration Rights  Agreement dated as of June 19, 2001, by and among the Registrant,  Halpern Denny, BET and Brookwood(6)                                                                                                                                                                               |
| 10.35 |   | Form of Common Stock Purchase Warrant issued to  Halpern Denny, Greenlight Capital and Special Situations(6)                                                                                                                                                                                                                      |
| 10.36 |   | Warrant Agreement dated as of June 19, 2001, by  and among the Registrant, Jefferies & Co. and the United States  Trust Company of New York (6)                                                                                                                                                                          |
| 10.37 |   | Registration Rights Agreement dated as of  June 19, 2001, by and between the Registrant and Jefferies &  Co.(6)                                                                                                                                                                                                          |
| 10.38 |   | Third Amendment Agreement with AmSouth Bank dated  February 11, 2005(19)                                                                                                                                                                                                                                                          |

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| 10.39 |   | Second Amended and Restated Project and Approved  Supplier Agreement dated as of April 28, 2002 and Letter Agreement,  effective as of December 14, 2004, dated February 23, 2005, by and  among New World Restaurant Group, Inc., Einstein and Noah Corp.,  Manhattan Bagel Company, Inc., and Harlan Bagel Supply Company, LLC,  Harlan Bakeries, Inc., Hal P. Harlan, Hugh P. Harlan and Doug H. Harlan  (Certain information contained in this exhibit has been omitted and filed  separately with the Commission pursuant to a confidential treatment request  under Rule 24b-2)(19) |
|-------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.40 |   | First Lien Credit Agreement dated January 26,  2006, among the Registrant, Bear, Stearns & Co. Inc. (“Bear  Stearns”), as sole lead arranger, Wells Fargo Foothill, Inc., as  administrative agent and the other lenders from time to time parties  thereto(24)                                                                                                                                                                                                                                                                                                                                 |
| 10.41 |   | Second Lien Credit Agreement dated January 26,  2006, among the Registrant; Bear Stearns, as sole lead arranger, Bear Stearns  Corporate Lending Inc., as administrative agent, and the other lenders from  time to time parties thereto(24)                                                                                                                                                                                                                                                                                                                                                                            |
| 10.42 |   | Subordinated Credit Agreement dated January 26,  2006, among the Registrant, Greenlight Capital, L.P., Greenlight Capital  Qualified, L.P. and any other lenders from time to time parties thereto(24)                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 21.1  |   | List of Subsidiaries*                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 31.1  |   | Certification of Principal Executive Officer of the  Registrant pursuant to Section 906 of the Sarbanes-Oxley Act of  2002, with respect to the Registrant’s Annual Report on Form 10-K  for the year ended January 3, 2006*                                                                                                                                                                                                                                                                                                                                                                             |
| 31.2  |   | Certification of Principal Financial Officer of the  Registrant pursuant to Section 906 of the Sarbanes-Oxley Act of  2002, with respect to the Registrant’s Annual Report on Form 10-K  for the year ended January 3, 2006*                                                                                                                                                                                                                                                                                                                                                                             |
| 32.1  |   | Certification of Principal Executive Officer  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act*                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 32.2  |   | Certification of Principal Financial Officer  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act*                                                                                                                                                                                                                                                                                                                                                                                                                                                              |

----

*                    Filed orfurnished herewith.

+                    Managementcontract.

(1)          Incorporated byreference from Registrant’s Registration Statement on Form SB-2 (33-95764).

(2)          Incorporated byreference from Registrant’s Current Report on Form 8-K dated June 7,1999.

(3)          Incorporated byreference from Registrant’s Current Report on Form 8-K dated September 7,1999.

(4)          Incorporated byreference from Registrant’s Current Report on Form 8-K dated January 17,2001.

(5)          Incorporated byreference from Registrant’s Current Report on Form 8-K dated March 29,2001.

(6)          Incorporated byreference from Registrant’s Current Report on Form 8-K dated July 3,2001.

(7)          Incorporated byreference from Registrant’s Annual Report on Form 10-K for theFiscal Year Ended December 31, 2002, filed on May 14, 2003.

(8)          Incorporated byreference from Registrant’s Form S-4 Registration Statement (File No. 333-107894),filed on August 12, 2003.

(9)          Incorporated byreference from Registrant’s Schedule 14A, filed on September 10, 2003included as schedule 1 to annex B.

(10)   Incorporated by reference fromRegistrant’s Schedule 14A, filed on September 10, 2003 included as annex D.

77

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(11)   Incorporated by reference fromRegistrant’s Schedule 14A, filed on September 10, 2003 included as annex E.

(12)   Incorporated by reference fromRegistrant’s Schedule 14A, filed on September 10, 2003 included as annex F.

(13)   Incorporated by reference fromRegistrant’s Schedule 14A, filed on September 10, 2003 included as annex G.

(14)   Incorporated by reference fromRegistrant’s Schedule 14A, filed on September 10, 2003 included as annex H.

(15)   Incorporated by reference fromRegistrant’s Schedule 14A, filed on September 10, 2003 included as annex I.

(16)   Incorporated by reference fromRegistrant’s Form S-4 Registration Statement (File No. 333-107894),filed on September 19, 2003.

(17)   Incorporated by reference fromRegistrant’s Current Report on Form 8-K, filed on January 5,2004.

(18)   Incorporated by reference fromRegistrant’s Annual Report on Form 10-K for the Fiscal Year Ended December 30,2003, filed on March 26, 2004.

(19)   Incorporated by reference fromRegistrant’s Annual Report on Form 10-K for the Fiscal Year Ended December 28,2004, filed on March 11, 2005.

(20)   Incorporated by reference fromRegistrant’s Schedule 14A, filed on April 29, 2005 included as annex A.

(21)   Incorporated by reference fromRegistrant’s Schedule 14A, filed on April 29, 2005 included as annex B.

(22)   Incorporated by reference fromRegistrant’s Schedule 14A, filed on April 29, 2005 included as annex C.

(23)   Incorporated by reference fromRegistrant’s Schedule 14A, filed on April 29, 2005 included as annex D.

(24)   Incorporated by reference fromRegistrant’s Current Report on Form 8-K, filed on February 1,2006.

78

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

|                            |   |   |   | NEW WORLD RESTAURANT  GROUP, INC. |
|----------------------------|--------|--------|--------|----------------------------------------|
| Date: March 10,  2006 |   | By:    |   | /s/ Paul J.B.  Murphy, III        |
|                       |   |   |   | Paul J. B. Murphy, III            |
|                       |   |   |   | Chief Executive Officer                |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities indicated on March 10, 2006.

|                                      | **Signature** | ** **                                       | ** ** |  | **Title** | ** ** |
|--------------------------------------|---------------|--------------------------------------------------|------------|--|-----------|------------|
| /s/ Paul J.B.  Murphy, III      |          | President, Chief  Executive Officer and Director |
| Paul J.B. Murphy, III           |          | (Principal Executive  Officer)                   |
| /s/  Richard P. Dutkiewicz      |          | Chief Financial  Officer                         |
| Richard P.  Dutkiewicz          |          | (Principal Financial and  Accounting Officer)    |
| /s/ Michael W.  Arthur               |          | Director                                         |
| Michael W. Arthur                    |          |                                             |
| /s/ E. Nelson  Heumann               |          | Director                                         |
| E. Nelson Heumann                    |          |                                             |
| /s/ James W. Hood                    |          | Director                                         |
| James W. Hood                        |          |                                             |
| /s/ Frank C.  Meyer                  |          | Director                                         |
| Frank C. Meyer                       |          |                                             |
| /s/ S. Garrett  Stonehouse, Jr. |          | Director                                         |
| S. Garrett  Stonehouse, Jr.     |          |                                             |
| /s/ Leonard  Tannenbaum              |          | Director                                         |
| Leonard Tannenbaum                   |          |                                             |

 

 

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