UNITED
        STATES
 SECURITIES
        AND EXCHANGE COMMISSION
 WASHINGTON,
        D.C. 20549
  **FORM
        10-K**
 
 (Mark
        One)
 
 [X]
              ANNUAL
                  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                  ACT OF
                  1934 [FEE REQUIRED]
 
 **For
        the Fiscal Year Ended December 31, 2006**
 
 OR
 
 []
              TRANSITION
                  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                  ACT OF
                  1934 [NO FEE REQUIRED]
 
 For
        the
        transition period from ___________ to ______________
 
 **Commission
        file number: 0-28234**
 
   
 
 **MEXICAN
        RESTAURANTS, INC.**
 (Exact
        name of registrant as specified in its charter)
 
 **Texas**
              **76-0493269**(State
                  or other jurisdiction of
                incorporation
                  or organization)
              (IRS
                  Employer Identification Number)
 
 **1135
                  Edgebrook, Houston, Texas**
              **77034-1899**(Address
                  of Principal Executive Offices)
              (Zip
                  Code)
 
 Registrant’s
        telephone number, including area code: **713-943-7574**
 
 Securities
        registered pursuant to Section 12(b) of the Act:
 **None**
 
 Securities
        registered pursuant to Section 12(g) of the Act:
 **Common
        Stock, $.01 par value**
 (Title
        of
        class)
 
 Indicate
        by check mark if the registrant is a well-known seasoned issuer, as defined
        in
        Rule 405 of the Securities Act.
 Yes   ̈  No þ
 
 Indicate
        by check mark if the registrant is not required to file reports pursuant
        to
        Section 13 or Section 15(d) of the Act. Yes   ̈  No þ
 
 Indicate
        by check mark whether the Registrant (1) has filed all reports required to
        be
        filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
        the
        preceding 12 months (or for such shorter period that the Registrant was required
        to file such reports), and (2) has been subject to such filing requirements
        for
        the past 90 days.  Yes X  No
        ____
 
 Indicate
        by check mark if disclosure of delinquent filers pursuant to Item 405 of
        Regulation S-K is not contained herein, and will not be contained, to the
        best
        of Registrant’s knowledge, in definitive proxy or information statements
        incorporated by reference in Part III of this Form 10-K or any amendment
        to this
        Form 10-K. [ ]
 
 Indicate
        by check mark whether the Registrant is a large accelerated filer, an
        accelerated filer, or a non-accelerated filer. See definition of "accelerated
        filer and large accelerated filer" in Rule 12b-2 of the Exchange
        Act.
  Large
        accelerated filer  ̈  Accelerated
        filer  ̈  Non-accelerated
        filer ý
  Indicate
        by check mark whether the Registrant is a shell company (as defined by
        Rule 12b-2 of the Act). Yes  ̈  No ý
  
 
 The
        aggregate market value of the Registrant’s Common Stock held by non-affiliates
        of the Registrant, based on the sale trade price of the Common Stock as reported
        by the Nasdaq Small Cap Market on June 30, 2006, the last business day of
        the
        Registrant’s most recently completed second quarter, was $12,660,659 For
        purposes of this computation, all officers, directors and 10% beneficial
        owners
        of the registrant are deemed to be affiliates. Such determination should
        not be
        deemed an admission that such officers, directors or 10% beneficial owners
        are,
        in fact, affiliates of the Registrant.
  Number
        of
        shares outstanding of the Registrant’s Common Stock, as of March 29, 2007:
        3,460,322 shares of Common Stock, par value $.01.
 
 **DOCUMENTS
        INCORPORATED BY REFERENCE**
 
 Specified
        portions of the Company’s definitive proxy statement in connection with the 2007
        Annual Meeting of Shareholders to be held May 22, 2007, to be filed with
        the
        Securities and Exchange Commission pursuant to Regulation 14A, are incorporated
        by reference into Part III of this report.
 
 **Mexican
        Restaurants, Inc.**
 **Table
        of Contents**
 
 **Part
                  I**
              
              **Page**Special
                  Note Regarding Forward-Looking Statements
              3Item
                  1.
              Business
              4Item
                  1A.
              Risk
                  Factors
              11Item
                  1B.
              Unresolved
                  Staff Comments
              14Item
                  2.
              Properties
              14Item
                  3.
              Legal
                  Proceedings
              15Item
                  4.
              Submission
                  of Matters to a Vote of Security Holders
              15**Part
                  II**Item
                  5.
              Market
                  for the Registrant’s Common Equity, Related Shareholder Matters and Issuer
                  Purchases of Equity Securities
              15Item
                  6.
              Selected
                  Financial Data
              17Item
                  7.
              Management’s
                  Discussion and Analysis of Financial Condition and Results of
                  Operations
              18Item
                  7A.
              Quantitative
                  and Qualitative Disclosures about Market Risk
              26Item
                  8.
              Financial
                  Statements and Supplementary Data
              26Item
                  9.
              Changes
                  in and Disagreements with Accountants on Accounting and Financial
                  Disclosure
              26Item
                  9A.
              Controls
                  and Procedures
              26Item
                  9B.
              Other
                  Information
              27**Part
                  III**Item
                  10.
              Directors
                  and Executive Officers of the Registrant and Corporate
                  Governance
              27Item
                  11.
              Executive
                  Compensation
              27Item
                  12.
              Security
                  Ownership of Certain Beneficial Owners and Management and Related
                  Shareholder Matters
              28Item
                  13.
              Certain
                  Relationships and Related Transactions and Director
                  Independence
              28Item
                  14.
              Principal
                  Accountant Fees and Services
              28**Part
                  IV**Item
                  15.
              Exhibits
                  and Financial Statement Schedules
              28
 
 
 
 2
 
 
 **SPECIAL
        NOTE REGARDING FORWARD-LOOKING STATEMENTS**
 
 Certain
        statements in this Form 10-K constitute “forward-looking statements” within the
        meaning of Section 21E of the Securities Exchange Act of 1934, as amended
        of the
        Private Securities Litigation Reform Act of 1995 (the “Reform Act”). Such
        forward-looking statements involve known and unknown risks, uncertainties
        and
        other facts which may cause the actual results, performance or achievements
        of
        Mexican Restaurants, Inc. and its subsidiaries (the “Company”), its restaurants,
        area developers and franchisees to be materially different from any future
        results, performance or achievements expressed or implied by such
        forward-looking statements. Such factors include, among others, the following:
        general economic and business conditions; competition; success of operating
        initiatives; development and operating costs; advertising and promotional
        efforts; brand awareness; adverse publicity; acceptance of new product
        offerings; availability, locations and terms of sites for store development;
        changes in business strategy or development plans; quality of management;
        availability, terms and development of capital; business abilities and judgment
        of personnel; availability of qualified personnel; food, labor and employee
        benefit costs; area developers’ adherence to development schedules; changes in,
        or the failure to comply with government regulations; regional weather
        conditions or weather-related events; construction schedules; and other factors
        referenced in the Form 10-K. The use in this Form 10-K of such words as
“believes”, “anticipates”, “expects”, “intends”, “plans” and similar expressions
        with respect to future activities or other future events or conditions are
        intended to identify forward-looking statements, but are not the exclusive
        means
        of identifying such statements. The success of the Company is dependent on
        the
        efforts of the Company, its employees, its area developers, and franchisees
        and
        the manner in which they operate and develop stores in light of various factors,
        including those set forth above.
 
 Although
        the Company believes that the assumptions underlying the forward-looking
        statements contained herein are reasonable, any of the assumptions could
        be
        inaccurate, and therefore, there can be no assurance that the forward-looking
        statements included in this Form 10-K will prove to be accurate. In light
        of the significant uncertainties inherent in the forward-looking statements
        included herein, the inclusion of such information should not be regarded
        as a
        representation by the Company that its objectives or plans will be achieved.
        Accordingly, readers are cautioned not to place undue reliance on these
        forward-looking statements. In addition, oral statements made by the Company's
        directors, officers and employees to the investment community, media
        representatives and others, depending upon their nature, may also constitute
        forward-looking statements. As with the forward-looking statements included
        in
        this report, these forward-looking statements are by nature inherently
        uncertain, and actual results may differ materially as a result of many factors.
        Further information regarding the risk factors that could affect the Company's
        financial and other results are included as Item 1A of this annual report
        on Form 10-K.
 
 
  3
  
 **PART
        I**
 
 **ITEM
        1.****BUSINESS**
 
 **General**
 
 Mexican
        Restaurants, Inc. (the “Company”) operates and franchises Mexican-theme
        restaurants featuring various elements associated with the casual dining
        experience under the names Casa Olé®, Monterey’s Tex-Mex Café®, Monterey’s
        Little Mexico®, Tortuga Coastal Cantina®, La Señorita®, Crazy Jose’s® and
        Mission Burritos®. The Casa Olé, Monterey, Tortuga, La Señorita, Crazy
        Jose’s and Mission Burritos concepts have been in business for 35, 52, 13, 28,
        20 and 10 years, respectively. Today the Company operates 60 restaurants,
        franchises 18 restaurants and licenses one restaurant in various communities
        across Texas, Louisiana, Oklahoma and Michigan. The Casa Olé, Monterey, La
        Señorita and Crazy Jose’s restaurants are designed to appeal to a broad range of
        customers, and are located primarily in small and medium-sized communities
        and
        in middle-income areas of larger markets. The Tortuga Coastal Cantina and
        Mission Burritos restaurants also are designed to appeal to a broad range
        of
        customers and are located primarily in Houston markets. The restaurants offer
        fresh, quality food, affordable prices, friendly service and comfortable
        surroundings. Menus feature a variety of traditional Mexican and Tex-Mex
        selections, complemented by the Company's own original Mexican-based recipes,
        designed to have broad appeal. The Company believes that the established
        success
        of the Company in existing markets, its focus on middle-income customers,
        and
        the skills of its management team provide significant opportunities to realize
        the value inherent in the Mexican restaurant market and increase revenues
        in
        existing markets.
 
 The
        Company was incorporated under the name “Casa Olé Restaurants, Inc.” under the
        laws of the State of Texas in February 1996, and had its initial public offering
        of Common Stock in April 1996. In May 1999, the Company changed its corporate
        name to Mexican Restaurants, Inc. The Company operates as a holding company
        and
        conducts substantially all of its operations through its subsidiaries. All
        references to the Company include the Company and its subsidiaries, unless
        otherwise stated.
 
 Since
        its
        inception as a public company, the Company has primarily grown through the
        acquisition of other Mexican food restaurant companies. In
        1997,
        the Company purchased all of the outstanding stock of Monterey’s Acquisition
        Corp. (“MAC”). At the time of the acquisition, MAC owned and operated 26
        restaurants in Texas and Oklahoma under the names “Monterey’s Tex-Mex Café,”
“Monterey’s Little Mexico” and “Tortuga Coastal Cantina”.
 
 In
        1999,
        the Company purchased 100% of the outstanding stock of La Señorita Restaurants,
        a Mexican restaurant chain operated in the State of Michigan. At the time
        of the
        acquisition, La Señorita operated five company-owned restaurants, and three
        franchise restaurants.
 
 In January 2004, the Company purchased 13 restaurants and related assets
        from
        its Beaumont-based franchisee and affiliates for a total consideration of
        approximately $13.75 million. The financing for the acquisition was provided
        by
        Fleet National Bank, CNL and the sellers. The restaurants acquired include
        eight
        Casa Olé restaurants located in Southeast Texas, two Casa Olé restaurants
        located in Southwest Louisiana, and three Crazy Jose’s restaurants located in
        Southeast Texas.
 
 In
        October 2004, the Company purchased one franchise restaurant in Brenham,
        Texas
        for approximately $215,000. The restaurant was closed, remodeled and re-opened
        on November 22, 2004.
 
 In
        August
        2006, the Company purchased two Houston-area Mission Burritos restaurants
        and
        related assets for a total consideration of approximately $725,000, excluding
        acquisition costs.
 
 **Strategy
        and Concept**
 
 The
        Company’s objective is to be perceived as a value leader in the Mexican theme
        segment of the casual dining marketplace. To accomplish this objective, the
        Company has developed strategies designed to achieve and maintain high levels
        of
        customer loyalty, frequent patronage and profitability. The key strategic
        elements are:
 
 Ÿ
              Offering
                  consistent, high-quality, original recipe Mexican menu items that
                  reflect
                  both national and local taste
                  preferences;
  4
  Ÿ
              Pricing
                  its menu offerings at levels below many family and casual-dining
                  restaurant concepts;
 
 Ÿ
              Selecting,
                  training and motivating its employees to enhance customer dining
                  experiences and the friendly casual atmosphere of its
                  restaurants;
 
 Ÿ
              Providing
                  customers with the friendly, attentive service typically associated
                  with
                  more expensive casual-dining experiences;
                  and
 
 Ÿ
              Reinforcing
                  the perceived value of the dining experience with a comfortable
                  and
                  inviting Mexican decor.
 
 
 ***Menu.*** The
        Company’s restaurants offer high-quality products with a distinctive, yet mild
        taste profile with mainstream appeal. Fresh ingredients are a critical recipe
        component, and the majority of menu items are prepared daily in the kitchen
        of
        each restaurant from original recipes.
 
 The
        menus
        feature a wide variety of entrees including enchiladas, combination platters,
        burritos, fajitas, coastal seafood and other house specialties. The menu
        also
        includes soup, salads, appetizers and desserts. From time to time the Company
        also introduces new dishes designed to keep the menus fresh. Alcoholic beverages
        are served as a complement to meals and represent a range of less than 5%
        of
        sales at its more family-oriented locations, and up to 20% in its more
        casual-oriented dining locations. At Company-owned restaurants the dinner
        menu
        entrees presently range in price from $4.95 to $15.59, with most items priced
        between $5.99 and $8.99. Lunch prices at most Company-owned restaurants
        presently range from $4.95 to $8.29.
 
 ***Atmosphere
        and Layout.*** The
        Company emphasizes an attractive design for each of its restaurants. The
        typical
        restaurant has an inviting and interesting Mexican exterior. The interior
        decor
        is comfortable Mexican in appearance to reinforce the perceived value of
        the
        dining experience. Stucco, tile floors, carpets, plants and a variety of
        paint
        colors are integral features of each restaurants’ decor. These decor features
        are incorporated in a floor plan designed to provide a comfortable atmosphere.
        The Company’s restaurant designs are sufficiently flexible to accommodate a
        variety of available sites and development opportunities, such as malls,
        end-caps of strip shopping centers and free standing buildings, including
        conversions to the Company’s restaurant design. The restaurant facility is also
        designed to serve a high volume of customers in a relatively limited period
        of
        time. The Company's restaurants typically range in size from approximately
        4,000
        to 5,600 square feet, with an average of approximately 4,500 square feet
        and a
        seating capacity of approximately 180.
 
 The
        two
        fast-casual Mission Burritos restaurants the Company acquired in August 2006
        are
        approximately 2,000 and 3,000 square feet, respectively. Both restaurants
        have
        extensive patios that offer additional outdoor seating. The Company is
        developing a prototype Mission Burritos design that is approximately 2,500
        square feet with an indoor seating capacity of approximately 40 to 60. The
        new
        prototype will also include a patio that offers additional outdoor seating.
 
 **Growth
        Strategy**
 
 Over
        the
        last three fiscal years, the Company has focused its energies to assimilate
        two
        acquisitions (13 restaurants bought in 2004 from a franchisee and two Mission
        Burritos restaurants acquired in 2006), to develop new prototypes for our
        Casa
        Olé and Monterey’s restaurants (opening two new Casa Olé and one new Monterey’s
        restaurants during that period) and to initiate a program of remodeling several
        of our existing restaurants each year. Based on an average investment of
        approximately $650,000 (net of landlord reimbursements), the cash on cash
        return
        for the three new restaurants has averaged approximately 50.0%. Most of the
        remodeled restaurants have resulted in higher average weekly sales and a
        return
        on investment of approximately 10.0%, based on an average investment of
        approximately $285,000. The Company feels it is important for the long term
        viability of the concepts to continue with the remodel program as it competes
        against newer concepts.
 
 In
        August
        2006 the Company acquired two fast-casual Mission Burritos restaurants located
        in Houston, Texas. The concept was established ten years ago and has a very
        loyal customer base. Since the Mission Burritos acquisition, the Company
        has
        spent considerable time and attention planning for the future growth and
        positioning of the concept. In fiscal years 2007 and 2008, the Company plans
        to
        open several Mission Burritos restaurants in the Greater Houston area and
        possibly open Mission Burritos restaurants in other Texas markets. Although
        the
        Company has not built the new Mission Burritos prototype, it anticipates
        that
        its investment will be approximately $250,000 less than the investment for
        Casa
        Olé and Monterey’s.
  5
 The
        Company believes that the unit economics of the various restaurant concepts
        of
        the Company, as well as their value orientation and focus on middle income
        customers, provide significant potential opportunities for growth. The Company’s
        long-standing strategy to capitalize on these growth opportunities has been
        comprised of three key elements:
 
 ***Improve
        Same-Restaurant Sales and Profits*** .
        The
        Company’s first growth opportunity is to improve the sales and controllable
        income of existing restaurants (controllable income consists of restaurant
        sales
        less food and beverage expenses, labor and controllable expenses, such as
        utilities and repair and maintenance expenses, but excludes advertising and
        occupancy expenses). This is accomplished through an emphasis on restaurant
        operations, coupled with improving marketing, purchasing and other
        organizational efficiencies (see “Restaurant Operations” below). During fiscal
        year 2007, the Company expects to focus on improving sales and profitability
        so
        that it can maximize free cash flow, which it will use to pay off debt, remodel
        existing restaurants, build new restaurants, acquire existing franchise
        restaurants and to make repurchases of its common stock when it determines
        such
        repurchases are a prudent use of its capital.
 
 ***Seek
        Strategic Acquisitions.*** Since
        its
        inception as a public company, the Company has primarily grown through the
        acquisition of other Mexican food restaurant companies, making four acquisitions
        since 1996. The Company anticipates it will continue to selectively acquire
        existing franchised restaurants from time to time when such opportunities
        arise,
        as well as actively promote the development of new franchise restaurants
        (see
“Franchising” below). Further, the Company will continue to review potential
        strategic acquisitions within the Mexican food restaurant industry that would
        complement our existing corporate culture.
  ***Increased
        Penetration of Existing Markets.*** The
        Company’s second growth opportunity is, when it believes market conditions
        warrant, to increase the number of restaurants in existing Designated Market
        Areas (“DMAs”) and to expand into contiguous new markets. The DMA concept is a
        mapping tool developed by the A.C. Nielsen Co. that measures the size of
        a
        particular market by reference to communities included within a common
        television market. The Company's objective in increasing the density of
        Company-owned restaurants within existing markets is to improve operating
        efficiencies in such markets and to realize improved overhead absorption.
        In
        addition, the Company believes that increasing the density of restaurants
        in
        both Company-owned and franchised markets will assist it in achieving effective
        media penetration while maintaining or reducing advertising costs as a
        percentage of revenues in the relevant markets. The Company believes that
        careful and prudent site selection within existing markets will avoid
        cannibalization of the sales bases of existing restaurants.
 
 In
        implementing its unit expansion strategy, the Company may use a combination
        of
        franchised and Company-owned restaurants. The number of such restaurants
        developed in any period will vary. The Company believes that a mix of franchised
        and Company-owned restaurants would enable it to realize accelerated expansion
        opportunities, while maintaining majority or sole ownership of a significant
        number of restaurants. Generally, the Company does not anticipate opening
        franchised and Company-owned restaurants within the same market. In seeking
        franchisees, the Company will continue to primarily target experienced
        multi-unit restaurant operators with knowledge of a particular geographic
        market
        and financial resources sufficient to execute the Company's development
        strategy.
 
 The
        restaurant industry is a competitive and fragmented business. Moreover, the
        restaurant industry is characterized by a high initial capital investment.
        Our
        focus is not on new restaurant expansion just to generate additional sales,
        but
        a balanced approach that emphasizes same-restaurant sales growth and selective
        new restaurant development and acquisitions of existing franchise restaurants.
        During fiscal year 2006, the Company opened two new restaurants and remodeled
        seven existing restaurants. The Company plans to build three new restaurants
        in
        fiscal year 2007, as well as significantly remodel one existing restaurant
        and
        moderately remodel four existing restaurants. During fiscal year 2007, the
        Company plans to open at least two additional Mission Burritos restaurants
        in
        the Houston market. If the unit economics of Mission Burritos prove favorable,
        the Company’s plan is to expand further into the Greater Houston area and open
        Mission Burritos in other Texas markets.
 
 6
 **Site
        Selection**
 
 When
        developing new restaurant sites, senior management of the Company devotes
        significant time and resources to analyzing prospective sites for the Company’s
        restaurants. Senior management has also created and utilizes a site selection
        committee, which reviews and approves each site to be developed. In addition,
        the Company conducts customer surveys to define precisely the demographic
        profile of the customer base of each of the Company’s restaurant concepts. The
        Company’s site selection criteria focus on:
 
 1)
            matching
                the customer profile of the respective restaurant concept to the
                profile
                of the population of the target local
                market; 
 2)
            easy
                site accessibility, adequate parking, and prominent visibility of
                each
                site under consideration; 
 3)
            the
                site’s strategic location within the
                marketplace; 
 4)
            the
                site’s proximity to the major concentration of shopping centers within
                the
                market; 
 5)
            the
                site’s proximity to a large employment base to support the lunch segment;
                and 
 6)
            the
                impact of competition from other restaurants in the
                market. 
 The
        Company believes that a sufficient number of suitable sites are available
        for
        contemplated Company and franchise development in existing markets. Based
        on its
        current planning and market information, the Company plans to open three
        new
        restaurants in fiscal year 2007. The anticipated total investment for a 4,800
        to
        5,600 square foot restaurant, including land, building, equipment, signage,
        site
        work, furniture, fixtures and decor ranges between $1.4 and $2.1 million
        (including capitalized lease value). Additionally, training and other
        pre-opening costs are anticipated to approximate $50,000 to $100,000 per
        location. The cost of developing and operating a Company restaurant can vary
        based upon fluctuations in land acquisition and site improvement costs,
        construction costs in various markets, the size of the particular restaurant
        and
        other factors. Although the Company anticipates that development costs
        associated with near-term restaurants will range between $1.4 and $2.1 million,
        there can be no assurance of this. Where possible, the Company uses build
        to
        suit, lease conversion or sale and leaseback transactions in an effort to
        limit
        its cash investment to approximately $550,000 to $850,000 per
        location.
 
 **Restaurant
        Operations**
 
 ***Management
        and Employees.*** **** The
        management staff of each restaurant is responsible for managing the restaurant's
        operations. Each Company-owned restaurant operates with a general manager,
        one
        or more assistant managers and a kitchen manager or a chef. Including managers,
        restaurants have an average of 50 full-time and part-time employees. The
        Company
        historically has spent considerable effort developing its employees, allowing
        it
        to promote from within. As an additional incentive to its restaurant management
        personnel, the Company has a bonus plan in which restaurant managers can
        receive
        monthly bonuses based on a percentage of their restaurants’ controllable
        profits.
 
 The
        Company’s regional supervisors, who report directly to the Company’s Directors
        of Operation, offer support to the store managers. Each supervisor is eligible
        for a monthly bonus based on a percentage of controllable profits of the
        stores
        under their control.
 
 As
        of
        December 31, 2006, the Company employed 2,877 people, of whom 2,824 were
        restaurant personnel at the Company-owned restaurants and 53 were corporate
        personnel. The Company considers its employee relations to be good. Most
        employees, other than restaurant management and corporate personnel, are
        paid on
        an hourly basis. The Company’s employees are not covered by a collective
        bargaining agreement.
 
 ***Training
        and Quality Control.*** The
        Company requires its hourly employees to participate in a formal training
        program carried out at the individual restaurants, with the on-the-job training
        program varying from three days to two weeks based upon the applicable position.
        Managers of both Company-owned and franchised restaurants are trained at
        one of
        the Company's specified training stores by that store's general manager and
        are
        then certified upon completion of a four to six week program that encompasses
        all aspects of restaurant operations as well as personnel management and
        policy
        and procedures, with special emphasis on quality control and customer relations.
        To evaluate ongoing employee service and provide rewards to employees, the
        Company employs a "mystery shopper" program that consists of two anonymous
        visits per month per restaurant. The Company's franchise agreement requires
        each
        franchised restaurant to employ a general manager who has completed the
        Company's training program at one of the Company's specified training stores.
        Compliance with the Company's operational standards is monitored for both
        Company-owned and franchised restaurants by random, on-site visits by corporate
        management, regular inspections by regional supervisors, the ongoing direction
        of a corporate quality control manager and the mystery shopper program.
 
 7
 ***Marketing
        and Advertising.*** The
        Company believes that when media penetration is achieved in a particular
        market,
        investments in radio and television advertising can generate significant
        increases in revenues in a cost-effective manner. During fiscal year 2006,
        the
        Company spent approximately 3.0% of restaurant revenues on various forms
        of
        advertising and plans to spend a comparable amount in fiscal year 2007. Besides
        radio and television, the Company makes use of in-store promotions, involvement
        in community activities, and customer word-of-mouth to maintain their
        performance.
 
 ***Purchasing.*** **** The
        Company strives to obtain consistent quality products at competitive prices
        from
        reliable sources. The Company works with its distributors and other purveyors
        to
        ensure the integrity, quality, price and availability of the various raw
        ingredients. The Company researches and tests various products in an effort
        to
        maintain quality and to be responsive to changing customer tastes. The Company
        operates a centralized purchasing system that is utilized by all of the
        Company-owned restaurants and is available to the Company's franchisees.
        Under
        the Company's franchise agreement, if a franchisee wishes to purchase from
        a
        supplier other than a currently approved supplier, it must first submit the
        products and supplier to the Company for approval. Regardless of the purchase
        source, all purchases must comply with the Company's product specifications.
        The
        Company’s ability to maintain consistent product quality throughout its
        operations depends upon acquiring specified food products and supplies from
        reliable sources. Management believes that all essential food and beverage
        products are available from other qualified sources at competitive
        prices.
 
 **Franchising**
 
 The
        Company currently has 9 franchisees operating a total of 18 restaurants and
        one
        licensee operating one restaurant. Most franchisees operate one or two
        restaurants. No new franchise restaurants were opened during fiscal 2006.
 
 Franchising
        allows the Company to expand the number of stores and penetrate markets more
        quickly and with less capital than developing Company-owned stores. The Company
        has the first right of refusal when a franchisee decides to sell its
        restaurant(s). Historically, the Company has selectively acquired franchisee
        restaurants when reasonably available. At the same time, the Company plans
        to
        expand its base of franchise restaurants.
 
 Franchisees
        are selected on the basis of various factors, including business background,
        experience and financial resources. In seeking new franchisees, the Company
        targets experienced multi-unit restaurant operators with knowledge of a
        particular geographic market and financial resources sufficient to execute
        the
        Company's development schedule. Under the current franchise agreement,
        franchisees are required to operate their stores in compliance with the
        Company's policies, standards and specifications, including matters such
        as menu
        items, ingredients, materials, supplies, services, fixtures, furnishings,
        decor
        and signs. In addition, franchisees are required to purchase, directly from
        the
        Company or its authorized agent, spice packages for use in the preparation
        of
        certain menu items, and must purchase certain other items from approved
        suppliers unless written consent is received from the Company.
 
 ***Franchise
        Agreements.*** ** The
        Company enters into a franchise agreement with each franchisee that grants
        the
        franchisee the right to develop a single store within a specific territory
        at a
        site approved by the Company. The franchisee then has limited exclusive rights
        within the territory. Under the Company's current standard franchise agreement,
        the franchisee is required to pay a franchise fee of $25,000 per restaurant.
        The
        current standard franchise agreement provides for an initial term of
        15 years (with a limited renewal option) and payment of a royalty of 3% to
        5% of gross sales. The termination dates of the Company's franchise
        agreements with its existing franchisees currently range from 2007 to 2015.
 
 Franchise
        agreements are not assignable without the prior written consent of the Company.
        Also, the Company retains rights of first refusal with respect to any proposed
        sales by the franchisee. Franchisees are not permitted to compete with the
        Company during the term of the franchise agreement and for a limited time,
        and
        in a limited area, after the term of the franchise agreement. The enforceability
        and permitted scope of such noncompetition provisions varies from state to
        state. The Company has the right to terminate any franchise agreement for
        certain specific reasons, including a franchisee's failure to make payments
        when
        due or failure to adhere to the Company's policies and standards. Many state
        franchise laws, however, limit the ability of a franchisor to terminate or
        refuse to renew a franchise. See "Item 1. Business—Government
        Regulation".
 
 8
 Prior
        forms of the Company's franchise agreements still in effect may contain terms
        that vary from those described above, including with respect to the payment
        or
        nonpayment of advertising fees and royalties, the term of the agreement,
        and
        assignability, noncompetition and termination provisions.
 
 ***Franchisee
        Training and Support.*** ** Under
        the
        current franchise agreement, each franchisee (or if the franchisee is a business
        organization, a manager designated by the franchisee) is required to personally
        participate in the operation of the franchise. Before opening the franchisee's
        business to the public, the Company provides training at its approved training
        facility for each franchisee's general manager, assistant manager and kitchen
        manager or chef. The Company recommends that the franchisee, if the franchisee
        is other than the general manager, or if a business organization, its chief
        operating officer, attend such training. The Company also provides a training
        team to assist the franchisee in opening its restaurant. The team, supervised
        by
        the Director of Training, will assist and advise the franchisee and/or its
        manager in all phases of the opening operation for a seven to fourteen day
        period. The formal training program required of hourly employees and management,
        along with continued oversight by the Company's quality control manager,
        is
        designed to promote consistency of operations.
 
 ***Area
        Developers.*** ** The
        area
        development agreement is an extension of the standard franchise agreement.
        The
        area development agreement provides area developers with the right to execute
        more than one franchise agreement in accordance with a fixed development
        schedule. Restaurants established under these agreements must be located
        in a
        specific territory in which the area developer will have limited exclusive
        rights. Area developers pay an initial development fee generally equal to
        the
        total initial franchise fee for the first franchise agreement to be executed
        pursuant to the development schedule plus 10% of the initial franchise fee
        for
        each additional franchise agreement to be executed pursuant to the development
        schedule. Generally the initial development fee is not refundable, but will
        be
        applied in the proportions described above to the initial franchise fee payable
        for each franchise agreement executed pursuant to the development schedule.
        New
        area developers
 will
        pay
        monthly royalties for all restaurants established under such franchise
        agreements on a declining scale generally ranging from 5% of gross sales
        for the
        initial restaurant to 3% of gross sales for the fourth restaurant and thereafter
        as additional restaurants are developed. Area development agreements are
        not
        assignable without the prior written consent of the Company. The Company
        will
        retain rights of first refusal with respect to proposed sales of restaurants
        by
        the area developers. Area developers are not permitted to compete with the
        Company. As described above, the enforceability and permitted scope of such
        noncompetition provisions may vary from state to state. If an area developer
        fails to meet its development schedule obligations, the Company can, among
        other
        things, terminate the area development agreement or modify the territory
        in the
        agreement. These termination rights may be limited by applicable state franchise
        laws. The Company is currently seeking new area developers.
 
 **Competition**
 
 The
        restaurant industry is intensely competitive. Competition is based upon a
        number
        of factors, including concept, price, location, quality and service. The
        Company
        competes against a broad range of other family dining concepts, including
        those
        focusing on various other types of ethnic food, as well as local restaurants
        in
        its various markets. The Company also competes against other quick service
        and
        casual dining concepts within the Mexican and Tex-Mex food segment. Many
        of the
        Company's competitors are well established and have substantially greater
        financial and other resources than the Company. Some of the Company's
        competitors may be better established in markets where the Company’s restaurants
        are or may be located. Also, the Company competes for qualified franchisees
        with
        franchisors of other restaurants and various other concepts.
 
 The
        success of a particular restaurant concept is also affected by many other
        factors, including national, regional or local economic and real estate
        conditions, changes in consumer tastes and eating habits, demographic trends,
        weather, traffic patterns, and the type, number and location of competing
        restaurants. In addition, factors such as inflation, increased food, labor
        and
        benefit costs, and the availability of experienced management and hourly
        employees may adversely affect the restaurant industry in general and the
        Company's restaurants in particular.
  9
  **Government
        Regulation**
 
 Each
        restaurant is subject to regulation by federal agencies and to licensing
        and
        regulation by state and local health, sanitation, safety, fire and other
        departments relating to the development and operation of restaurants. These
        include regulations pertaining to the environmental, building and zoning
        requirements in the preparation and sale of food. The Company is also subject
        to
        laws governing the service of alcohol and its relationship with employees,
        including minimum wage requirements, overtime, working conditions and
        immigration requirements. Difficulties or failures in obtaining the required
        construction and operating licenses, permits or approvals could delay or
        prevent
        the opening of a specific new restaurant. The Company believes that it is
        operating in substantial compliance with applicable laws and regulations
        that
        govern its operations.
 
 Alcoholic
        beverage control regulations require each of the Company’s restaurants to apply
        to a state authority and, in certain locations, county or municipal authorities,
        for a license or permit to sell alcoholic beverages on the premises and to
        provide service for extended hours. Typically, licenses must be renewed annually
        and may be revoked or suspended for cause at any time. Alcoholic beverage
        control regulations relate to numerous aspects of the Company's restaurants,
        including minimum age of patrons drinking alcoholic beverages and of employees
        serving alcoholic beverages, training, hours of operation, advertising,
        wholesale purchasing, inventory control and handling, storage and dispensing
        of
        alcoholic beverages. The Company is also subject to "dramshop" statutes that
        generally provide that a person injured by an intoxicated person may seek
        to
        recover damages from an establishment determined to have wrongfully served
        alcoholic beverages to the intoxicated person. The Company carries liquor
        liability coverage as part of its existing comprehensive general liability
        insurance. Additionally, within thirty days of employment by the Company,
        each
        Texas employee of the Company who serves alcoholic beverages is required
        to
        attend an alcoholic seller training program that has been approved by the
        Texas
        Alcoholic Beverage Commission and endorsed by the Texas Restaurant Association
        that endeavors to educate the server to detect and prevent overservice, as
        well
        as underage service, of the customers at the Company’s restaurants.
 
 In
        connection with the sale of franchises, the Company is subject to the United
        States Federal Trade Commission rules and regulations and state laws that
        regulate the offer and sale of franchises and business opportunities. The
        Company is also subject to laws that regulate certain aspects of such
        relationships. To date, the Company has had no claims with respect to its
        programs and, based on the nature of any potential compliance issues identified,
        does not believe that compliance issues associated with its historic franchising
        programs will have a material adverse effect on its results of operations
        or
        financial condition. The Company believes that it is operating in substantial
        compliance with applicable laws and regulations that govern franchising
        programs.
 
 The
        federal Americans with Disabilities Act prohibits discrimination on the basis
        of
        disability in public accommodations and employment. The Company is required
        to
        comply with the Americans with Disabilities Act and regulations relating
        to
        accommodating the needs of the disabled in connection with the construction
        of
        new facilities and with significant renovations of existing facilities.
 
 The
        Company is subject to various local, state and federal laws regulating the
        discharge of pollutants into the environment. The Company believes that it
        conducts its operations in substantial compliance with applicable environmental
        laws and regulations. The Company conducts environmental audits of each proposed
        restaurant site in order to determine whether there is any evidence of
        contamination prior to purchasing or entering into a lease with respect to
        such
        site. To date, the Company's operations have not been materially adversely
        affected by the cost of compliance with applicable environmental
        laws.
 
 **Trademarks,
        Service Marks and Trade Dress**
 
 The
        Company believes its trademarks, service marks and trade dress have significant
        value and are important to its marketing efforts. It has registered the
        trademarks for “Casa Olé”, “Casa Olé Mexican Restaurant”, “Monterey’s Tex-Mex
        Café”, “Monterey’s Little Mexico”, “Tortuga Cantina”, “La Señorita”, “Crazy
        Jose’s” and a pending national registration for “Mission Burritos” ** with the
        U.S. Trademark Office.
 
 **Available
        Information**
  The
        Company is subject to the informational requirements of the Securities Exchange
        Act of 1934, as amended, and in accordance therewith, it files reports, proxy
        and information statements and other information with the Securities and
        Exchange Commission ("SEC"). The Company's annual reports on Form 10-K,
        quarterly reports on Form 10-Q, current reports on Form 8-K, proxy and
        information statements and other information and amendments to those reports
        filed or furnished pursuant to Section 13(a) or 15(d) of the Securities
        Exchange Act of 1934 are available through the Company’s Web site at www.mexicanrestaurantsinc.com .
        Reports
        are available free of charge as soon as reasonably practicable after the
        Company
        electronically files them with, or furnish them to, the SEC. In addition,
        the
        Company's officers and directors file with the SEC initial statements of
        beneficial ownership and statements of change in beneficial ownership of
        the
        Company's securities, which are available on the SEC's Internet site at www.sec.gov .
        The
        Company is not including this or any other information on its Web site as
        part
        of, nor incorporating it by reference into, this Form 10-K or any of its
        other SEC filings. In addition to the Company’s Web site, you may read and copy
        public reports the Company files with or furnishes to the SEC at the SEC's
        Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. You
        may
        obtain information on the operation of the Public Reference Room by calling
        the
        SEC at 1-800-SEC-0330. The SEC maintains an internet site that contains the
        Company's reports, proxy and information statements, and other information
        that
        the Company files electronically with the SEC at www.sec.gov .
  
 10
 **ITEM
        1A.** **RISK
        FACTORS**
 
 You
        should carefully consider the following risk factors as well as the other
        information contained or incorporated by reference in this report, as these
        are
        important factors, among others, that could cause our actual results to differ
        from our expected or historical results. It is not possible to predict or
        identify all such factors. Consequently, you should not consider any such
        list
        to be a complete statement of all of our potential risks or
        uncertainties.
 
 ***Seasonal
        Fluctuations in Sales and Earnings Affect Our Quarterly
        Results.*** **** The
        Company’s sales and earnings fluctuate seasonally. Historically the Company’s
        highest sales and earnings have occurred in the second and third calendar
        quarters, which the Company believes is typical of the restaurant industry
        and
        consumer spending patterns in general. In addition, quarterly results have
        been
        and, in the future are likely to be, substantially affected by the timing
        of new
        restaurant openings. Because of the seasonality of our business and the impact
        of new restaurant openings, results for any calendar quarter are not necessarily
        indicative of the results that may be achieved for a full fiscal year and
        cannot
        be used to indicate financial performance for the entire year.
 
 ***Inflation
        May Adversely Impact Our Net Income.*** **** The
        Company **** believes
        that inflation impacted net income during fiscal year 2006. Substantial
        increases in utility expenses and property and casualty insurance costs had
        a
        marked impact on our operating results to the extent such increases could
        not be
        passed along to customers. There can be no assurance that the Company will
        not
        experience the same inflationary impact in the future. If operating expenses
        increase, our management intends to attempt to recover increased costs by
        increasing prices to the extent deemed advisable in light of competitive
        conditions.
 
 ***An
        Increase In Our Interest Rates May Adversely Impact Net Income.*** Our
        exposure to interest rate fluctuations is limited to our outstanding bank
        debt
        with Bank of America. The interest rate is either the prime rate or LIBOR
        plus a
        stipulated percentage. Accordingly, the Company is impacted by changes in
        the
        prime rate and LIBOR. As of December 31, 2006, the Company had $3.3 million
        outstanding on our credit facility with Bank of America. The Company is in
        compliance with the debt convenants as of December 31, 2006. As of December
        31,
        2006, the Company also had $500,000 in notes which have a fixed interest
        rate of
        7.0% (See Note 3 in the accompanying Consolidated Financial Statements).
        The
        Company prepaid $2.5 million in fixed rate notes on March 31, 2006 by borrowing
        from our Bank of America credit facility.
 
 ***Our
        Financial
        Covenants Could Adversely Affect Our Ability to
        Borrow.*** Under
        our current credit agreement with Bank of America, the Company is subject
        to
        certain reporting requirements and financial covenants, including requirements
        that the Company maintain various financial ratios. As of December 31, 2006,
        the
        Company was in compliance with all debt covenants, as amended on March 29,
        2007
        and made effective December 31, 2006. Although the Company is currently in
        compliance with such financial covenants, an erosion of its business could
        place
        it out of compliance in future periods. Potential remedies for the lender
        if the
        Company is not in compliance include declaring all outstanding amounts
        immediately payable, terminating commitments and enforcing any liens. See
“Note
        3, Long-term Debt, of Notes to Consolidated Financial Statements”.
  ***Increases
        in
        the minimum wage may have a material adverse effect on our business and
        financial results.*** Many
        of
        our employees are subject to various minimum wage requirements. The federal
        minimum  wage
        has
        remained at $5.15 per hour since September 1, 1997 but will very likely be
        increased during 2007. The
        minimum wage increases may have a material adverse effect on our business,
        financial condition, results of operations and cash flows to the extent that the Company
        cannot increase menu prices.
  11
 ***Changes
        in
        food costs could negatively impact our revenues and results of
        operations*** .
        The
        Company’s profitability is dependent in part on our ability to anticipate and
        react to changes in food costs. Other than for a portion of our produce,
        which
        is purchased locally by each restaurant, the Company relies on Glazier Foods
        Company as the primary distributor of our ingredients. Glazier Foods Company
        is
        a family owned company that is part of a cooperative of independent food
        distributors (Unipro) located throughout the nation. The Company has an
        exclusive contract with Glazier Foods Company on terms and conditions which
        it
        believes are consistent with those made available to similarly situated
        restaurant companies. Any increase in distribution prices by Glazier Foods
        Company could cause the Company’s food costs to fluctuate. Additional factors
        beyond the Company’s control, including adverse weather conditions and
        governmental regulation, may affect food costs. The Company may not be able
        to
        anticipate and react to changing food costs through its purchasing practices
        and
        menu price adjustments in the future, and failure to do so could negatively
        impact its revenues and results of operations.
 
 ***Rising
        Insurance Costs Could Negatively Impact Our
        Profitability.*** The
        Company is insured against a variety of uncertainties. While the cost of
        certain
        insurance coverages increased in 2006, it was able to negotiate lower premium
        costs for other insurance coverages, and in general, was able to minimize
        the
        overall increase and impact of all total insurance costs to the Company.
        Nevertheless, the increase in property and casualty premiums did have a negative
        impact on the Company’s profitability in fiscal year 2006. Each year, the
        Company renews its insurance coverages. While the Company tries to be proactive
        in its efforts to control insurance costs, market forces beyond its control
        may
        thwart its ability to manage these costs. The Company expects insurance premiums
        for property and casualty insurance to continue to increase in light of the
        impact of hurricanes on the Texas and Louisiana Gulf Coast.
 
 ***Recent
        Changes in Our Senior Management May Be Disruptive to Our
        Business.*** ** We
        have
        recently experienced significant changes in our senior management.  On
        December 1, 2006,  Lou Neeb agreed to serve and was appointed our interim
        Chief Executive Officer, and Lou Porry has been appointed as our Chief Operating
        Officer (following the departure of Curt Glowacki, our former President and
        CEO,
        in December 2006).  We are conducting a search for a permanent Chief
        Executive Officer.  These changes in our senior management may prove
        disruptive to our business and there may be uncertainty among our investors,
        vendors, employees and others concerning our future direction and
        performance.  If we are unable to identify and retain an effective
        permanent Chief Executive Officer, our results of operations and financial
        condition may be adversely affected.
 
 ***Our
        Small Restaurant Base and Geographic Concentration Make Our Operations More
        Susceptible to Local Economic Conditions.*** The
        results achieved to date by the Company’s relatively small restaurant base may
        not be indicative of the results of a larger number of restaurants in a more
        geographically dispersed area. Because of its relatively small restaurant
        base,
        an unsuccessful new restaurant could have a more significant effect on its
        results of operations than would be the case in a company owning more
        restaurants. Additionally, given the Company’s present geographic concentration
        (all of its company-owned units are currently in Texas, especially along
        the
        Gulf Coast region, and in Oklahoma, Louisiana and Michigan), results of
        operations may be adversely affected by economic or other conditions in the
        region, such as hurricanes, and any adverse publicity in the region relating
        to
        its restaurants could have a more pronounced adverse effect on its overall
        sales
        than might be the case if its restaurants were more broadly
        dispersed.
 
 ***Our
        Management and Directors Hold a Majority of the Common Stock.*** Approximately
        66.0% of our Common Stock and rights to acquire Common Stock are beneficially
        owned or held by Larry N. Forehand, The D3 Family Funds (represented by director
        Cara Denver), Michael D. Domec and Louis P. Neeb, directors and/or executive
        officers or affiliates thereof. As a result, these individuals have substantial
        control over matters requiring shareholder approval, including the election
        of
        directors.
 
 ***Competition
        May Adversely Affect Our Operations and Financial
        Results.*** The
        restaurant industry is highly competitive with respect to price, service,
        restaurant location and food quality, and is often affected by changes in
        consumer tastes, economic conditions, population and traffic patterns. The
        Company competes within each market against other family dining concepts,
        as
        well as quick service and casual dining concepts, for customers, employees
        and
        franchisees. Several of the Company’s competitors operate more restaurants and
        have significantly greater financial resources and longer operating histories
        than the Company does. The Company’s inability to successfully compete with the
        other restaurants in its markets could prevent it from increasing or sustaining
        its revenues and profitability and result in a material adverse effect on
        its
        business, financial condition, results of operations or cash flows.
 
 12
 ***Changes
        in General Economic and Political Conditions Affect Consumer Spending and
        May
        Harm Our Revenues and Operating Results.*** The
        United States experienced an economic expansion throughout most of 2006,
        including Texas where the majority of our restaurants operate. The forecast
        for
        2007 is more cautious, especially for the restaurant casual dining segment,
        in
        which several concepts have been experiencing declining same-store sales
        for the
        last two quarters. A few economic conditions that could impact the economy
        and
        our operating results are: rising fuel and energy costs could reduce consumers’
level of discretionary spending; a decrease in discretionary spending could
        impact the frequency with which our customers choose to dine out or the amount
        they spend on meals while dining out, thereby decreasing our revenues.
        Additionally, the continued responses to the terrorist attacks on the United
        States, possible future terrorist attacks and the conflict in Iraq and its
        aftermath may exacerbate current economic conditions and lead to a weakening
        in
        the economy. Adverse economic conditions and any related decrease in
        discretionary spending by our customers could have an adverse effect on our
        revenues and operating results.
 
 ***Implementing
        Our Growth Strategy May Strain Our Resources*** .
        Our
        ability to expand by adding Company-owned and franchised restaurants will
        depend
        on a number of factors, including the availability of suitable locations,
        the
        ability to hire, train and retain an adequate number of experienced management
        and hourly employees, the availability of acceptable lease terms and adequate
        financing, timely construction of restaurants, the ability to obtain various
        government permits and licenses and other factors, some of which are beyond
        our
        control.
 
 The
        results achieved by our newer restaurants may not be indicative of longer
        term
        performance of older, more established restaurants. The Company cannot be
        assured that any new restaurant that it opens will have similar operating
        results to those of prior restaurants. Further, the opening or acquiring
        of
        additional restaurants in the future will depend in part upon its ability
        to
        generate sufficient funds from operations or to obtain sufficient debt financing
        on favorable terms to support its expansion.
 
 The
        Company may not be able to open its planned new operations on a timely basis,
        if
        at all, and, if opened, these restaurants may not be operated profitably.
        The
        Company has experienced, and expects to continue to experience, delays in
        restaurant openings from time to time. Delays or failures in opening planned
        new
        restaurants could have an adverse effect on its business, financial condition,
        results of operations or cash flows.
 
 The
        opening of additional franchised restaurants will depend, in part, upon the
        ability of existing and future franchisees to obtain financing or investment
        capital adequate to meet their market development obligations. Based on the
        Company’s experience in attempting to grow outside its existing markets, it has
        found there can be limited consumer acceptance and that the cost of such
        efforts
        can have a material adverse impact on its financial results.
 
 ***Shares
        Eligible for Future Sale Could Adversely Impact the Stock Price.*** Sales
        of
        substantial amounts of shares in the public market could adversely affect
        the
        market price of our Common Stock. In any event, the market price of the Common
        Stock could be subject to significant fluctuations in response to our operating
        results and other factors.
 
 ***Litigation
        Could Have a Material Adverse Effect on Our Business.*** From
        time to time the Company is the subject of complaints or litigation from
        guests
        alleging food-borne illness, injury or other food quality, health or operational
        concerns. The Company may be adversely affected by publicity resulting from
        such
        allegations, regardless of whether such allegations are valid or whether
        it is
        liable. The Company is also subject to complaints or allegations from former
        or
        prospective employees from time to time. A lawsuit or claim could result
        in an
        adverse decision against the Company that could have a materially adverse
        effect
        on its business.
 
 The
        Company is subject to state “dramshop” laws and regulations, which generally
        provide that a person injured by an intoxicated person may seek to recover
        damages from an establishment that wrongfully served alcoholic beverages
        to such
        person. Although the Company carries liquor liability coverage as part of
        its
        existing comprehensive general liability insurance, it may still be subject
        to a
        judgment in excess of its insurance coverage and it may not be able to obtain
        or
        continue to maintain such insurance coverage at reasonable costs, or at
        all.
 
 13
 ***Compliance
        with Changing Regulation of Corporate Governance and Public Disclosure May
        Result in Additional Expenses.*** Keeping
        up-to-date and in compliance with changing laws, regulations and standards
        relating to corporate governance and public disclosure, including the
        Sarbanes-Oxley Act of 2002, new SEC regulations and Nasdaq Stock Market rules,
        has required an increased amount of management attention and external resources.
        The Company remains committed to maintaining high standards of corporate
        governance and public disclosure. As a result, it intends to invest all
        reasonably necessary resources to comply with evolving standards, and this
        investment may result in increased general and administrative expenses and
        a
        diversion of management time and attention from revenue-generating activities
        to
        compliance activities.
 
 ***Future
        changes in financial accounting standards may affect our reported results
        of
        operations.*** Changes
        in accounting standards can have a significant effect on our reported results
        and may affect our reporting of transactions completed before the change
        is
        effective. New pronouncements and varying interpretations of pronouncements
        have
        occurred and may occur in the future.
 
 Changes
        to existing rules or differing interpretations with respect to our current
        practices may adversely affect our reported financial results.
 
 **ITEM
        1B.****UNRESOLVED
        STAFF COMMENTS**
 
 None.
 
 **ITEM
        2.****PROPERTIES**
 
 In
        fiscal
        year 2006, the Company's executive offices were located in approximately
        10,015
        square feet of office space in Houston, Texas. The offices are currently
        leased
        by the Company from Gillett Properties, Ltd., under a gross lease (where
        the
        landlord pays utilities and property taxes) expiring in December 2009, with
        rental payments of $11,000 per month. Due to severe foundation and structural
        issues, the Company hired a commercial real estate broker to search for new
        executive office space. The Company anticipates finding and moving into new
        executive offices sometime during fiscal year 2007 or early fiscal year 2008.
        See "Notes to Consolidated Financial Statements—Related Party Transactions." The
        Company believes that its properties are generally well maintained, in good
        condition and adequate for its operations. Further, the Company believes
        that
        suitable additional or replacement space under comparable terms will be
        available if required.
 
 Real
        estate leased for Company-owned restaurants is typically leased under triple
        net
        leases that require the Company to pay real estate taxes and utilities, to
        maintain insurance with respect to the premises and in certain cases to pay
        contingent rent based on sales in excess of specified amounts. Generally
        the
        non-mall locations for the Company-owned restaurants have initial terms of
        10 to 20 years with renewal options.
 
 All
        of
        the Company-owned restaurants are leased. During fiscal year 2006, the Company
        sold for $130,000 a pad site in Port Arthur, Texas and sold for $550,000
        a
        previously closed restaurant located in Chubbuck, Idaho. In fiscal year 2005,
        the Company sold an office building for $360,000, net of closing costs, that
        was
        acquired in 2004 with the Beaumont-based franchisee stores and related assets.
 
 During
        fiscal year 2006, the Company opened two new restaurants and closed four
        under-performing restaurants (two of which the leases expired; one in which
        the
        property was subleased, and one in which the lease will expire in April 2008).
        During fiscal year 2005, the Company opened one new restaurant and closed
        one
        under-performing restaurant that the Company is currently negotiating a
        sublease.
 
 14
 **Restaurant
        Locations**
 
 At
        December 31, 2006, the Company had 60 Company-operated restaurants, 18 franchise
        restaurants and one licensed restaurant. As of such date, the Company operated
        and franchised 43 Casa Olé restaurants in the State of Texas and four in the
        State of Louisiana; operated five Monterey’s Tex-Mex Café restaurants in the
        State of Oklahoma; operated and licensed 12 Monterey’s Little Mexico restaurants
        in the State of Texas; operated four Tortuga Coastal Cantina restaurants
        in the
        State of Texas; operated three Crazy Jose’s in the State of Texas, operated two
        Mission Burritos in the State of Texas and also operated and franchised six
        La
        Señorita restaurants in the State of Michigan. The Company’s portfolio of
        restaurants is summarized below:
 
 **Casa
                  Olé**Company-operated
              30
              LeasedFranchisee-operated
              17**Concept
                  total**
              47**Monterey’s
                  Tex-Mex Café**Company-operated
              5
              Leased**Concept
                  total**
              5**Monterey’s
                  Little Mexico**Company-operated
              11
              LeasedLicensee-operated
              1**Concept
                  total**
              12**Tortuga
                  Coastal Cantina**Company-operated
              4
              Leased**Concept
                  total**
              4**La
                  Señorita**Company-operated
              5
              LeasedFranchisee-operated
              1**Concept
                  total**
              6**Crazy
                  Jose’s**Company-operated
              3
              Leased**Concept
                  total**
              3**Mission
                  Burritos**Company-operated
              2
              Leased**System
                  total**
              79
 
 
 **ITEM
        3.****LEGAL
        PROCEEDINGS**
 
 The
        Company is involved from time to time in litigation relating to claims arising
        from its operations in the normal course of business. Management believes
        that
        the ultimate disposition of all uninsured matters resulting from existing
        litigation will not have a material adverse effect on the Company’s business or
        financial position.
 
 **ITEM
        4.****SUBMISSION
        OF MATTERS TO A VOTE OF SECURITY HOLDERS**
 
 No
        matter
        was submitted to a vote of the shareholders of the Company during the fourth
        quarter of the fiscal year ended December 31, 2006.
 
 **PART
        II**
 
 **ITEM
        5.****MARKET
        FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES
        OF EQUITY SECURITIES**
 
 ***Market
        Information.*** The
        Company’s Common Stock trades on the Nasdaq Small Cap Market tier of The Nasdaq
        Stock Market under the symbol “CASA.” At March 28, 2007, the closing price of
        the Company’s Common Stock as reported on the Nasdaq Small Cap Market was $9.36.
        The following table sets forth the range of quarterly high and low reported
        sale
        prices of the Company’s Common Stock on the Nasdaq Small Cap Market during each
        of the Company’s fiscal quarters since the end of the Company’s 2004 fiscal
        year.
 
 15
 
 
 **HIGH**
              
              **LOW****Fiscal
                  Year 2007:**First
                  Quarter (as of March 28, 2007)
              11.70
              
              9.36**Fiscal
                  Year 2006:**First
                  Quarter (ended April 2, 2006)
              13.33
              
              10.00Second
                  Quarter (ended July 2, 2006)
              13.50
              
              9.14Third
                  Quarter (ended October 1, 2006)
              11.00
              
              9.64Fourth
                  Quarter (ended December 31, 2006)
              11.99
              
              9.90
 
 **Fiscal
                  Year 2005:**First
                  Quarter (ended April 3, 2005)
              10.50
              
              8.50Second
                  Quarter (ended July 3, 2005 )
              10.42
              
              7.79Third
                  Quarter (ended October 2, 2005 )
              10.50
              
              8.69Fourth
                  Quarter (ended January 1, 2006 )
              12.06
              
              9.17
 
 
 The
        following ****** performance
        graph compares the cumulative return of the Common Stock with that of the
        Nasdaq
        Composite Index and the Standard & Poors Small Cap Restaurants Index
        assuming in each case an initial invest of $100 at December 31,
        2001.
















***Holders.*** As
      of
      March 29, 2007, the Company estimates that there were approximately 975
      beneficial owners of the Company’s Common Stock, represented by approximately 50
      holders of record, and 3,460,322 shares of Common Stock
      outstanding.





***Issuer
      Purchases*** .
      The
      Company did not repurchase any shares of its Common Stock during the fourth
      quarter of 2006, but did purchase 25,290 shares during the first three quarters
      of fiscal year 2006.





***Dividends.*** Since
      its 1996 initial public offering, the Company has not paid cash dividends on
      its
      Common Stock. The Company intends to retain earnings of the Company to support
      operations, to finance expansion and pay down its debt, and does not intend
      to
      pay cash dividends on the Common Stock for the foreseeable future. In addition,
      the Company’s current credit agreement prohibits the payment of any cash
      dividends. Any payment of cash dividends in the future will be at the discretion
      of the Board of Directors and will depend upon such factors as earnings levels,
      capital requirements, the Company’s financial condition, the ability to do so
      under then-existing credit agreements and other factors deemed relevant by
      the
      Board of Directors. See Management’s Discussion and Analysis of Financial
      Condition and Results of Operation—Liquidity and Capital Resources) contained in
      Item 7. to this Report.





16


**ITEM
      6.****SELECTED
      FINANCIAL DATA**





The
      selected financial data set forth below should be read in conjunction with
      and
      are qualified by reference to the Consolidated Financial Statements and the
      related Notes thereto included in Item 8. hereof and "Management's Discussion
      and Analysis of Financial Condition and Results of Operations" included in
      Item
      7. hereof.








**Fiscal
                Years**(In
                thousands, except share and per share amounts)**2002**
            
            **2003**
            
            **2004**
            
            **2005**
            
            **2006****Income
                Statement Data:**Revenues:Restaurant
                sales
            
            $
            49,981
            
            $
            50,244
            
            $
            74,035
            
            $
            76,902
            
            $
            81,379Franchise
                fees, royalties and other
            
            
            1,181
            
            
            1,139
            
            
            753
            
            
            694
            
            
            825Business
                interruption
            
            
            105
            
            
            --
            
            
            --
            
            
            534
            
            
            6051,266
            
            
            51,383
            
            
            74,788
            
            
            78,130
            
            
            82,264Costs
                and expenses:Cost
                of sales
            
            
            13,455
            
            
            13,829
            
            
            20,473
            
            
            20,915
            
            
            22,429Restaurant
                operating expenses
            
            
            27,837
            
            
            28,344
            
            
            40,793
            
            
            42,818
            
            
            45,731General
                and administrative
            
            
            5,198
            
            
            5,306
            
            
            6,587
            
            
            6,942
            
            
            7,717Depreciation
                and amortization
            
            
            1,721
            
            
            1,867
            
            
            2,136
            
            
            2,684
            
            
            3,131Asset
                impairments
            
            
            --
            
            
            266
            
            
            322
            
            
            -
            
            
            544Gain
                on disposal of assets - Hurricane Rita
            
            
            --
            
            
            --
            
            
            --
            
            
            (472
            )
            
            (367
            )(Gain)
                loss on sale of assets
            
            
            (28
            )
            
            (292
            )
            
            180
            
            
            368
            
            
            3248,183
            
            
            49,320
            
            
            70,491
            
            
            73,255
            
            
            79,217Operating
                income
            
            
            3,083
            
            
            2,063
            
            
            4,297
            
            
            4,875
            
            
            3,047Other
                income (expense), net
            
            
            (85
            )
            
            (97
            )
            
            (459
            )
            
            (404
            )
            
            (303
            )Income
                before income tax expense
            
            
            2,998
            
            
            1,966
            
            
            3,838
            
            
            4,471
            
            
            2,744Income
                tax expense
            
            
            1,003
            
            
            712
            
            
            1,269
            
            
            1,475
            
            
            849Income
                from continuing operations
            
            
            1,995
            
            
            1,254
            
            
            2,569
            
            
            2,996
            
            
            1,895Discontinued
                OperationsLoss
                from discontinued operations, net of taxes
            
            
            (291
            )
            
            (2,289
            )
            
            (808
            )
            
            (679
            )
            
            (757
            )Net
                income (loss)
            
            $
            1,704
            
            $
            (
                1,035
            )
            $
            1,761
            
            $
            2,317
            
            $
            1,138











17











**2002**
            
            **2003**
            
            **2004**
            
            **2005**
            
            **2006**Basic
                income (loss) per share:Income
                from continuing operations
            
            $
            0
                .57
            
            $
            0.37
            
            $
            0.76
            
            $
            0.88
            
            $
            0.55Loss
                from discontinued operations
            
            
            (0.08
            )
            
            (0.68
            )
            
            (0.24
            )
            
            (0.20
            )
            
            (0.22
            )Net
                income (loss)
            
            $
            0.49
            
            $
            (0.31
            )
            $
            0.52
            
            $
            0.68
            
            $
            0.33Diluted
                income (loss) per share:Income
                from continuing operations
            
            $
            0.56
            
            $
            0.37
            
            $
            0.70
            
            $
            0.81
            
            $
            0.53Loss
                from discontinued operations
            
            
            (0.08
            )
            
            (0.68
            )
            
            (0.22
            )
            
            (0.18
            )
            
            (
                0.21
            )Net
                income (loss)
            
            $
            0.48
            
            $
            (0.31
            )
            $
            0.48
            
            $
            0.63
            
            $
            0.32Weighted
                average shares - Basic
            
            
            3,447,957
            
            
            3,384,605
            
            
            3,388,489
            
            
            3,415,806
            
            
            3,402,207Weighted
                average shares - Diluted
            
            
            3,520,769
            
            
            3,384,605
            
            
            3,634,849
            
            
            3,700,876
            
            
            3,521,587










As
                of the End of Fiscal Years**2002**
            
            **2003**
            
            **2004**
            
            **2005**
            
            **2006**(In
                thousands)**Balance
                Sheet Data:**Working
                capital (deficit)
            
            $
            (2,736
            )
            $
            (2,669
            )
            $
            (1,359
            )
            $
            (1,632
            )
            $
            (1,928
            )Total
                assets
            
            $
            28,983
            
            $
            25,861
            
            $
            32,326
            
            $
            33,137
            
            $
            33,276Long-term
                debt, lesscurrent
                portion
            
            $
            3,400
            
            $
            1,775
            
            $
            6,000
            
            $
            4,500
            
            $
            3,800Total
                stockholders’ equity
            
            $
            16,948
            
            $
            15,954
            
            $
            17,868
            
            $
            18,884
            
            $
            20,573








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





Certain
      statements set forth below under this caption constitute “forward-looking
      statements” within the meaning of the Reform Act. See “Special Note Regarding
      Forward-Looking Statements” above for additional factors relating to such statements.  The
      following discussion and analysis should be read in conjunction with the
      Company’s Consolidated Financial Statements and Notes thereto appearing
      elsewhere in this Report. Additional information concerning factors that could
      cause results to differ materially from those in any forward-looking statements
      is contained under “Item 1A. Risk Factors”.





**General
      Overview**





The
      Company was organized under the laws of the State of Texas in February 1996. ** Pursuant
      to the reorganization of the Company in preparation for its 1996 initial public
      offering of Common Stock, the shareholders of related prior corporations
      contributed to the Company all outstanding shares of capital stock of each
      corporation, and the Company issued to such shareholders in exchange therefor
      an
      aggregate of 2,732,705 shares of its Common Stock. The exchange transaction
      was completed April 1996, and, as a result, the corporations became wholly-owned
      subsidiaries of the Company, and each shareholder of the Company received a
      number of shares of Common Stock in the Company.





The
      Company operates and franchises Mexican-theme restaurants featuring various
      elements associated with the casual dining experience under the names Casa
      Olé,
      Monterey’s Tex-Mex Café, Monterey’s Little Mexico, Tortuga Coastal Cantina,
      Crazy Jose’s, La Señorita and Mission Burritos. At December 31, 2006 the Company
      operated 60 restaurants, franchised 18 restaurants and licensed one restaurant
      in various communities in Texas, Louisiana, Oklahoma and Michigan.





The
      Company's primary source of revenues is the sale of food and beverages at
      Company-owned restaurants. The Company also derives revenues from franchise
      fees, royalties and other franchise-related activities. Franchise fee revenue
      from an individual franchise sale is recognized when all services relating
      to
      the sale have been performed and the restaurant has commenced operation. Initial
      franchise fees relating to area franchise sales are recognized ratably in
      proportion to services that are required to be performed pursuant to the area
      franchise or development agreements and proportionately as the restaurants
      within the area are opened.





18


The
      consolidated statements of income and cash flows for fiscal years 2006, 2005
      and
      2004 have been adjusted to remove the operations of closed restaurants, which
      have been reclassified as discontinued operations. Consequently, the
      consolidated statements of income and cash flows for fiscal years 2005 and
      2004
      shown in the accompanying consolidated financial statements have been
      reclassified to conform to the 2006 presentation. These reclassifications had
      no
      effect on total assets, total liabilities, stockholders’ equity or net
      income.




**Fiscal
      Year**





The
      Company has a 52/53 week fiscal year ending on the Sunday nearest December
      31.
      References in this Report to fiscal 2004, 2005 and 2006 relate to the periods
      ended January 2, 2005, January 1, 2006 and December 31, 2006, respectively.
      Fiscal years 2005 and 2006 presented herein consisted of 52 weeks. Fiscal year
      2004 presented herein consisted of 53 weeks.





**Results
      of Operations**





**Fiscal
      Year 2006 Compared to Fiscal Year 2005 as Adjusted for Discontinued
      Operations**





***Revenues*** **.** The
      Company’s revenues for the fiscal year ended December 31, 2006 were up $4.1
      million or 5.3% to $82.3 million compared with fiscal year 2005. Restaurant
      sales for fiscal year 2006 increased $4.5 million or 5.8% to $81.4 million
      compared with fiscal year 2005. The increase in restaurant sales reflects the
      opening of two new restaurants, the full year impact of one restaurant opened
      in
      fiscal year 2005, and the acquisition of Mission Burritos (two restaurants),
      offset in part by a 0.9% decline in same-restaurant sales.





For
      the
      fourth quarter 2006 same-store sales were down 8%. This compares to the 12%
      same-store sales growth achieved in fourth quarter 2005. The fourth quarter
      of
      2005 was unusual, reflecting the temporary population shifts after Hurricanes
      Rita and Katrina and the relative speed with which the Company was able to
      re-open closed stores after Hurricane Rita. Year-to-date for fiscal 2006, total
      system same-restaurant sales decreased 1.2%, Company-owned same-restaurant
      sales
      decreased 0.9% and franchise-owned same-restaurant sales decreased 1.9% from
      fiscal year 2005.





***Costs
      and Expenses*** *.* Costs of
      sales, consisting of food, beverage, liquor, supplies and paper costs, increased
      as a percent of restaurant sales 40 basis points to 27.6% compared with 27.2%
      in
      fiscal year 2005. The increase primarily reflects the lower than standard cost
      of sales experienced during the fourth quarter of fiscal year 2005, which was
      in
      the aftermath of Hurricane Rita. During the fourth quarter of fiscal 2005
      restaurants re-opened in the hurricane-impacted region with limited menus
      offering primarily low food cost items, that had a significant impact on cost
      of
      sales both for the quarter and year-to-date. On a year-to-date basis, the
      increase reflects to a lesser extent slightly higher produce, meat and poultry
      costs partially offset by lower tortilla costs.





**** Labor
      and
      other related expenses decreased as a percentage of restaurant sales 20 basis
      points to 32.4% compared with 32.6% for fiscal year 2005. The decrease primarily
      reflects a reduction of group health insurance expense. The Company is self
      insured with a stop loss policy and the Company’s experience for fiscal year
      2006 was better than expected.





Restaurant
      operating expenses, which primarily includes rent, property taxes, utilities,
      repair and maintenance, liquor taxes, property insurance, general liability
      insurance and advertising, increased in fiscal year 2006 as a percentage of
      restaurant sales 70 basis points to 23.7% as compared with 23.0% in fiscal
      year
      2005. The increase primarily reflects higher electricity, natural gas, security
      and property and casualty insurance expense. The increase in property and
      casualty insurance is directly attributable to severe weather associated with
      the United State’s Gulf Coast region. Also due to the hurricanes and related
      population shifts, Company restaurants have experienced higher rates of crime.
      In fiscal 2006, the Company spent $115,000 more on restaurant security than
      it
      did in fiscal year 2005.




General
      and administrative expenses consist of expenses associated with corporate and
      administrative functions that support restaurant operations. General and
      administrative expenses increased 50 basis points as a percentage of total
      sales
      to 9.4% compared with 8.9% for fiscal year 2005. The increase reflects the
      cost
      of purchasing the vested options of Curt Glowacki, who resigned as Chief
      Executive Officer on December 15, 2006. Further, to prepare for new restaurant
      growth as well as for management turnover, the Company spent $89,410 more in
      fiscal year 2006 than in fiscal year 2005 for training new managers. And
      finally, the Company spent $31,250 in fiscal year 2006 for executive
      recruitment. Actual general and administrative expenses increased $775,103,
      of
      which $596,764 relates to the purchase of Mr. Glowacki’s vested options.




19


Depreciation
      and amortization expenses include the depreciation of fixed assets and the
      amortization of other assets. Depreciation and amortization expense increased
      as
      a percentage of total revenues 40 basis points to 3.8% in fiscal year 2006
      as
      compared with 3.4% in fiscal year 2005. Actual depreciation and amortization
      expense increased $447,748 in fiscal year 2006 compared with fiscal year 2005.
      The increase reflects additional depreciation expense for remodeled restaurants,
      new restaurants, and the replacement of equipment and leasehold improvements
      in
      various existing restaurants.





During
      fiscal year 2006, the Company incurred $108,847 in pre-opening expenses related
      to the opening of two new restaurants. In fiscal year 2005, the Company spent
      $77,942 in pre-opening expenses related to the opening of one new restaurant
      and
      the remodel of one existing restaurant.





***Impairment
      costs.*** **** During
      fiscal year 2006, the Company expensed $543,777 to impair the assets of three
      under-performing restaurants, one of which was closed after its lease expired
      during the first quarter of fiscal year 2007. The Company also expensed real
      estate broker commissions related to the sale of one subleased restaurant and
      for future broker commissions related to two other subleased restaurants.





***Gain
      on Disposal of Assets - Hurricane Rita.*** On
      September 24, 2005, Hurricane Rita hit the Gulf Coast area, affecting a number
      of the Company’s restaurants in that region. The Company subsequently hired an
      insurance consulting firm to assist management with the filing of its insurance
      claim. During the second quarter of 2006, the Company finalized negotiations
      with its insurance carrier for the hurricane insurance claim. During fiscal
      year
      2006, the Company capitalized $511,236 in asset cost expenditures related to
      damaged property in the consolidated balance sheets, and recognized in the
      consolidated statement of income $366,808 as a gain and $59,621 as business
      interruption revenue from the insurance claim. As of December 31, 2006, the
      Company has collected all receivables related to its hurricane insurance
      claim.





***(Gain)
      Loss on Sale of Assets*** .
      During
      fiscal year 2006, the Company recorded a loss on the sale of assets of $32,282.
      The loss was due to the disposition of miscellaneous assets. During fiscal
      year
      2005, the Company recorded a loss of $367,711 on the disposition of assets
      related to the remodel of existing restaurants, the sale of an office building
      that was acquired in fiscal 2004 in the purchase of the Beaumont-based
      franchisee stores and related assets and the sale of a joint ventured
      restaurant.





***Other
      Income (Expense)*** .
      Net
      expense decreased $100,550 to $303,314 in fiscal year 2006 compared with a
      net
      expense of $403,864 in fiscal year 2005. Interest expense decreased $130,622
      to
      $390,539 in fiscal year 2006 compared with interest expense of $521,161 in
      fiscal year 2005, reflecting a decrease in outstanding debt.





***Income
      Tax Expense.*** The
      Company’s effective tax rate from continuing operations for fiscal year 2006 was
      30.9% as compared to 33.0% for fiscal year 2005. In fiscal year 2006, the
      Company had a lower pretax income from continuing operations compared to fiscal
      year 2005. In both years, the permanent differences were approximately the
      same,
      resulting in a lower effective tax rate in fiscal year 2006.





***Discontinued
      Operations*** .
      In
      fiscal year 2006, the Company closed four under-performing restaurants incurring
      net losses from discontinued operations of $756,339 pursuant to Statement on
      Financial Accounting Standards No. 146, “Accounting for Costs Associated with
      Exit or Disposal Activities”. In fiscal year 2005, the Company closed one
      restaurant incurring net losses from discontinued operations of
      $679,417.





The
      circumstances and testing leading to an impairment charge were determined in
      accordance with SFAS No. 144 which requires that property, plant and equipment
      be reviewed for impairment whenever events or changes in circumstances indicate
      that the carrying amount of an asset may not be recoverable.





**Fiscal
      Year 2005 Compared to Fiscal Year 2004 as Adjusted for Discontinued
      Operations**





***Revenues*** **.** The
      Company’s revenues for the fiscal year ended January 1, 2006 were up $3.4
      million or 4.5% to $78.1 million compared with fiscal year 2004. Restaurant
      sales for fiscal year 2005 increased $2.9 million or 3.9% to $76.9 million
      compared with fiscal year 2004, despite being closed a total of 309 store-days
      during the third and fourth quarters due to the impact of Hurricane Rita. Fiscal
      year 2005 had 52 weeks of revenue compared to 53 weeks of revenue for fiscal
      year 2004, resulting in $1.6 million in additional revenue for fiscal 2004.
      The
      increase in restaurant sales reflects the opening of one new restaurant and
      positive same-restaurant sales. The Company had eight consecutive quarters
      of
      positive same-restaurant sales. For fiscal year 2005, total system
      same-restaurant sales increased 3.8%, Company-owned same restaurant sales
      increased 4.6% and franchise-owned same-restaurant sales increased 1.2% from
      fiscal year 2004.





20


Franchise
      fees, royalties and other decreased $58,991 or 7.8% primarily due to lower
      royalty income resulting from the closure of a Houston-based franchise
      restaurant. In the fourth quarter of fiscal year 2005, the Company recorded
      $534,163 of business interruption proceeds related to the Hurricane Rita
      insurance claim.





***Costs
      and Expenses*** *.* Costs of
      sales, consisting of food, beverage, liquor, supplies and paper costs, decreased
      as a percent of restaurant sales 50 basis points to 27.2% compared with 27.7%
      in
      fiscal 2004. The improvement reflects lower dairy, cheese, meat and poultry
      costs which was partially offset by higher produce, paper and supplies, beverage
      and liquor costs and fuel surcharges. Beverage costs were higher reflecting
      the
      increased sale of bottled products, and liquor costs were higher due to various
      reduced price promotions.





Labor
      and
      other related expenses, as a percentage of restaurant sales, increased 10 basis
      points to 32.6% compared with 32.5% in fiscal year 2004, reflecting higher
      health insurance premiums, training expense and overtime expense associated
      with
      post hurricane labor shortages.





Restaurant
      operating expenses, which primarily includes rent, property taxes, utilities,
      repair and maintenance, liquor taxes, property insurance, general liability
      insurance and advertising, increased in fiscal year 2005 as a percentage of
      restaurant sales 50 basis points to 23.0% as compared with 22.5% in fiscal
      year
      2004. The increase reflects higher electricity, natural gas, water and sewer
      cost, coupons and credit collection expenses.




General
      and administrative expenses consist of expenses associated with corporate and
      administrative functions that support restaurant operations. General and
      administrative expenses as a percentage of total sales increased 10 basis points
      to 8.9% in fiscal year 2005 as compared with 8.8% for fiscal year 2004. Actual
      general and administrative expenses increased $354,876. The increase reflects
      higher legal, audit, health insurance and SEC reporting expenses. Legal expenses
      reflect an unusually high level of litigation expense as the Company
      successfully defended one employee lawsuit and successfully negotiated the
      settlement of another employee lawsuit. Additional legal expenses included
      updating the Uniform Franchise Offering Circular for Casa Olé and legal expenses
      associated with the development and adoption of the Mexican Restaurants, Inc.
      2005 Long Term Incentive Plan (“LTIP”). The higher audit cost reflects last
      year’s KPMG audit and subsequent change to its new auditors. The increase in SEC
      reporting costs was primarily due to the LTIP.





Depreciation
      and amortization expenses include the depreciation of fixed assets and the
      amortization of other assets. Depreciation and amortization expense increased
      as
      a percentage of total revenues 50 basis points to 3.4% in fiscal year 2005
      as
      compared with 2.9% in fiscal year 2004. Actual depreciation and amortization
      expense increased $547,687 in fiscal year 2005 compared with fiscal year 2004.
      The increase reflects additional depreciation expense for remodeled restaurants,
      new restaurants, and the replacement of equipment and leasehold improvements
      in
      various existing restaurants.





During
      fiscal year 2005, the Company incurred $77,942 in pre-opening expenses related
      to the opening of one new restaurant and the re-opening of a remodeled
      restaurant. In fiscal year 2004, the Company spent $34,756 in pre-opening
      expenses related to the remodel of one existing restaurant and the remodel
      of
      one acquired Casa Olé franchise restaurant.





***Impairment
      Costs*** .
      In
      fiscal year 2004, the Company incurred $322,074 of impairment expenses in
      continuing operations related primarily to four Tortuga restaurants that the
      Company wanted to position for re-concept to one of the Company’s other Mexican
      food concepts. Because of improved operating performance, the Company did not
      re-concept the four Tortuga restaurants in fiscal year 2005.





***Gain
      on Disposal of Assets - Hurricane Rita.*** On
      September 24, 2005, Hurricane Rita hit the Gulf Coast area, affecting a number
      of the Company’s restaurants in that region. The Company subsequently hired an
      insurance consulting firm to assist management with the filing of its insurance
      claim. Based on the low range of the consulting firm’s estimate and negotiations
      with the insurance carrier, the Company recorded an insurance claim of $1.6
      million in the fourth quarter of fiscal 2005.





21


The
      consolidated statement of operations ended January 1, 2006, includes a separate
      line item for a gain of $471,622 resulting from assets damaged by Hurricane
      Rita
      and other expenses offset by insurance proceeds for the replacement of assets.
      The Company’s insurers paid $300,000 during the fourth quarter of 2005 and
      $785,028 in the first quarter of 2006 related to the property damage claim.
      Additionally, the Company has recognized $534,163 for estimated business
      interruption proceeds. All insurance proceeds have been collected as of December
      31, 2006.





***(Gain)
      Loss on Sale of Assets*** .
      During
      fiscal year 2005, the Company recorded a loss on the sale of assets of $367,711.
      The loss was primarily due to the disposition of assets related to the remodel
      of existing restaurants, the sale of an office building that was acquired in
      fiscal 2004 in the purchase of the Beaumont-based franchisee stores and related
      assets and the sale of a joint ventured restaurant. During fiscal 2004, the
      Company recorded a loss of $179,948 on the disposition of assets, primarily
      related to the remodel of existing restaurants and sale of a leasehold interest
      of another existing restaurant.





***Other
      Income (Expense)*** .
      Net
      expense decreased $54,915 to $403,864 in fiscal year 2005 compared with a net
      expense of $458,779 in fiscal year 2004. Interest expense decreased $32,210
      to
      $521,161 in fiscal year 2005 compared with interest expense of $553,371 in
      fiscal year 2004, reflecting a decrease in outstanding debt which was partially
      offset by higher interest rates.





***Income
      Tax Expense.*** The
      Company’s effective tax rate from continuing operations for fiscal year 2005 was
      33.0% as compared to fiscal year 2004 of 33.1%. In fiscal year 2005, the Company
      had a higher pretax income from continuing operations compared to fiscal year
      2004. In both years, the permanent differences were approximately the same,
      resulting in a slightly higher effective tax rate in fiscal year
      2005.





***Discontinued
      Operations*** .
      In
      fiscal year 2005, the Company closed one under-performing restaurant incurring
      net losses from discontinued operations of $679,417 pursuant to Statement on
      Financial Accounting Standards No. 146. In fiscal year 2004, the Company closed
      three under-performing restaurants incurring net losses from discontinued
      operations of $807,972.





The
      circumstances and testing leading to an impairment charge were determined in
      accordance with SFAS No. 144 which requires that property, plant and equipment
      be reviewed for impairment whenever events or changes in circumstances indicate
      that the carrying amount of an asset may not be recoverable.





**Liquidity
      and Capital Resources**





The
      Company met fiscal 2006 capital requirements with cash generated by operations
      and with its cash reserves. In fiscal year 2006, the Company's operations
      generated approximately $5.0 million in cash, as compared with $6.2 million
      in fiscal 2005 and $5.7 million in fiscal year 2004, which was a 53-week
      fiscal year. As of December 31, 2006, the Company had a working capital deficit
      of approximately $1.9 million, compared with a working capital deficit of
      approximately $1.6 million at January 1, 2006. The increase in the working
      capital deficit reflects the $1.2 million receivable related to hurricane
      recovery proceeds as of January 1, 2006, which was subsequently collected in
      fiscal 2006 partially offset by the reduction of the current portion of long
      term debt, resulting from the amendment to the Bank of America line of credit.
      A
      working capital deficit is common in the restaurant industry, since restaurant
      companies do not typically require a significant investment in either accounts
      receivable or inventory.





The
      Company's principal capital requirements are the funding of routine capital
      expenditures, new restaurant development or acquisitions and remodeling of
      older
      units. During fiscal year 2006, total cash used for capital requirements was
      approximately $5.1 million ($2.3 million on routine capital expenditures, $1.7
      million for two new restaurants, $0.6 million on remodels and $0.5 million
      for
      hurricane expenditures). In addition, the Company spent an additional $742,490
      in connection with the acquisition of two Mission Burritos restaurants and
      related assets. During fiscal year 2006, the Company received $765,000 from
      the
      sale of a pad site in Port Arthur, Texas, the sale of furniture, fixtures and
      equipment from a previously closed restaurant in Boise, Idaho and the sale
      of
      another previously closed restaurant in Chubbuck, Idaho. The Company opened
      one
      new restaurant in Owasso, Oklahoma near the end of the first quarter of fiscal
      year 2006 and a second new restaurant in Georgetown, Texas during the fourth
      quarter of fiscal year 2006. During fiscal year 2006, the Company closed four
      under-performing restaurants (two of which the leases expired; one in which
      the
      property was subleased, and one in which the lease will expire in April of
      2008).





22


For
      fiscal year 2007, the Company plans to develop at least three new restaurants,
      extensively remodel one restaurant, moderately remodel three other restaurants,
      and invest in new PosiTouch point-of-sale register systems for fifteen
      restaurants. The estimated capital needed for fiscal year 2007 for general
      corporate purposes, including remodeling and new restaurant expansion, is
      approximately $5.3 million. The Company anticipates that it will primarily
      use
      cash generated by operating activity during fiscal year 2007 to fund investing
      activity.





Over
      the last several years, the Company’s debt was incurred to carry out
      acquisitions, to develop new restaurants, and to remodel existing restaurants,
      as well as to accommodate other working capital needs. During
      the first quarter of fiscal year 2006, the Company prepaid $2.5 million of
      the
      Beaumont-based franchise restaurant seller notes by drawing $2.0 million on
      its
      Bank of America revolving line of credit, with the balance paid from cash
      reserves. During fiscal year 2006, the Company borrowed $800,000 on its Bank
      of
      America line of credit. As of December 31, 2006, the Company’s outstanding debt
      to Bank of America was $3.3 million, all on its revolving line of credit and
      its
      outstanding debt on the seller note was $500,000 for a total indebtedness of
      $3.8 million.




On
      March
      29, 2007 the Company amended its credit facility with Bank of America changing
      its credit facility from a $10.0 million credit facility consisting of a $5.0
      million term note (remaining balance $1.5 million) and a $5.0 million revolving
      line of credit to a $7.5 million revolving line of credit, rolling the term
      note
      balance into the newly increased revolving line of credit. The revolving line
      of
      credit matures on December 31, 2011. The amendment allowed for additional
      capital expenditures, revised certain covenant ratios and increased the amount
      of allowable stock or vested option repurchases. The interest rate is either
      the
      prime rate or LIBOR plus a stipulated percentage. Accordingly, the Company
      is
      impacted by changes in the prime rate and LIBOR. The Company is subject to
      a
      non-use fee of 0.75% on the unused portion of the revolver from the date of
      the
      credit agreement. The Company has pledged the stock of its subsidiaries, its
      leasehold interests, its patents and trademarks and its furniture, fixtures
      and
      equipment as collateral for its credit facility with Bank of America. As of
      December 31, 2006, the Company was in compliance with all debt covenants, as
      amended, and expects to be in full compliance with all debt covenants during
      fiscal year 2007. The amendment was signed March 29, 2007 and was effective
      December 31, 2006.





On
      May 9,
      2005, the Company announced its plan to implement a limited stock repurchase
      program in a manner permitted under its bank financing agreement. The Company
      has entered into a repurchase plan designed to comply with Rules 10b5-1 and
      10b-18 under the Securities Exchange Act of 1934 under which an agent appointed
      by the Company determines the time, amount, and price at which purchases of
      common stock are made, subject to certain parameters established in advance
      by
      the Company. During fiscal year 2006, the Company repurchased 25,290 shares
      of
      its common stock for a total price of $261,730 and the Company’s employees
      exercised 104,375 options and the Company received $704,663 in net proceeds.
      In
      addition to the stock repurchases and employee options exercised just described
      above, the Company purchased 102,903 vested options directly from its former
      Chief Executive Officer, who resigned December 15, 2006, for $596,764. The
      transaction was recorded as compensation expense. Under this program, the
      Company has no remaining authority to repurchase outstanding shares of its
      common stock. Shares previously acquired are being held for general corporate
      purposes, including the offset of the dilutive effect on shareholders from
      the
      exercise of stock options.




The
      Company’s management believes that with its operating cash flow and the
      Company’s credit facility with Bank of America, funds will be sufficient to meet
      operating requirements and to finance routine capital expenditures and new
      restaurant growth through the end of the 2007 fiscal year. Unless the Company
      violates a debt covenant, the Company’s credit facility with Bank of America
      will not be subject to triggering events that would cause the credit facility
      to
      become due sooner than the maturity dates described in the previous
      paragraphs.





***Contractual
      Obligations and Commitments.***





The
      following table summarizes the Company’s total contractual cash obligations as
      of December 31, 2006:




**Contractual
                Obligation**
            
            **Total**
            
            **Less
                than**
              **1
                Year**
            
            **1
                to 3**
              **Years**
            
            **3
                to 5**
              **Years**
            
            **More
                Than**
              **5
                Years**Long-Term
                Debt
            
            $
            3,800,000
            
            $
            --
            
            $
            500,000
            
            $
            3,300,000
            
            $
            --Long-Term
                Debt Fixed Interest
            
            
            71,458
            
            
            35,000
            
            
            36,458
            
            
            --
            
            
            --Operating
                Leases
            
            
            49,712,735
            
            
            5,556,932
            
            
            10,537,546
            
            
            9,128,657
            
            
            24,489,600Total
                Contractual Cash Obligations
            
            $
            53,584,193
            
            $
            5,591,932
            
            $
            11,074,004
            
            $
            12,428,657
            
            $
            24,489,600





23


The
      contractual obligation table does not include interest payments on our long-term
      debt with Bank of America (formerly Fleet National Bank) due to the variable
      interest rates under our credit facility and the varying debt balance during
      the
      year. The contractual interest rate for our credit facility is either the prime
      rate or LIBOR base rate plus a stipulated margin. See Note 3 to our consolidated
      financial statements for balances and terms of our credit facility at December
      31, 2006.





***Related
      Parties.*** The
      Company provides accounting and administrative services for the Casa Olé Media
      and Production Funds. The Casa Olé Media and Production Funds are
      not-for-profit, unconsolidated entities used to collect money from company-owned
      and franchise-owned restaurants to pay for the marketing of Casa Olé
restaurants. Each restaurant contributes an agreed upon percentage of its sales
      to the funds.




***Critical
      Accounting Policies.***




Critical
      accounting policies are those that the Company believes are most important
      to
      the portrayal of its financial condition and results of operations and also
      require its most difficult, subjective, or complex judgments. Judgments or
      uncertainties regarding the application of these policies may result in
      materially different amounts being reported under various conditions or using
      different assumptions. The Company considers the following policies to be the
      most critical in understanding the judgment that is involved in preparing its
      consolidated financial statements.





***Property
      and Equipment.***




The
      Company records all property
      and equipment at cost less accumulated depreciation and it selects useful lives
      that reflect the actual economic lives of the underlying assets. The Company
      amortizes leasehold improvements over the shorter of the useful life of the
      asset or the related lease term. It calculates depreciation using the
      straight-line method for financial statement purposes. The Company capitalizes
      improvements and expense repairs and maintenance costs as incurred. It is often
      required to exercise judgment in its decision whether to capitalize an asset
      or
      expense an expenditure that is for maintenance and repairs. The Company’s
      judgments may produce materially different amounts of repair and maintenance
      or
      depreciation expense if different assumptions were used.





The
      Company periodically performs asset impairment analysis of property and
      equipment related to its restaurant locations. It performs these tests when
      it
      experiences a "triggering" event such as a major change in a location's
      operating environment, or other event that might impact its ability to recover
      its asset investment. This process requires the use of estimates and assumptions
      which are subject to a high degree of judgment. If these assumptions change
      in
      the future, the Company may be required to record impairment charges for these
      assets. Also, the Company has a policy of reviewing the financial operations
      of
      its restaurant locations on at least a quarterly basis. Locations that do not
      meet expectations are identified and monitored closely throughout the year.
      Primarily in the fourth quarter, the Company reviews actual results and analyze
      budgets for the ensuing year. If it deems that a location's results will
      continue to be below expectations, it will evaluate alternatives for its
      continued operation. At that time, the Company will perform an asset impairment
      test. If it determines that the asset's carrying value exceeds the future
      undiscounted cash flows, it will record an impairment charge to reduce the
      asset
      to its fair value. Calculation of fair value requires significant estimates
      and
      judgments which could vary significantly based on its assumptions. Upon an
      event
      such as a formal decision for abandonment (restaurant closure), the Company
      may
      record additional impairment charges. Any carryover basis of assets will be
      depreciated over the respective remaining useful lives.





***Goodwill*** .





Goodwill
      and other indefinite lived assets resulted primarily from the Company’s
      acquisition of franchisee-owned restaurants. The most significant acquisitions
      were completed in 1997, 1999, 2004 and 2006. Goodwill and other intangible
      assets with indefinite lives are not subject to amortization. However, such
      assets must be tested for impairment whenever events or changes in circumstances
      indicate that the carrying amount may not be recoverable and at least annually.
      The Company completed the most recent impairment test in December 2006, and
      determined that there were no impairment losses related to goodwill and other
      indefinite lived assets. In assessing the recoverability of goodwill and other
      indefinite lived assets, market values and projections regarding estimated
      future cash flows and other factors are used to determine the fair value of
      the
      respective assets. The estimated future cash flows were projected using
      significant assumptions, including future revenues and expenses. If these
      estimates or related projections change in the future, the Company may be
      required to record impairment charges for these assets.




24


***Leasing
      Activities.***




The
      Company leases all of its restaurant properties. At the inception of the lease,
      the Company evaluates each property and classifies the lease as an operating
      or
      capital lease in accordance with Statement of Financial Accounting Standards
      ("SFAS") No. 13, “ *Accounting
      for Leases* ”.
      It
      exercises significant judgment in determining the estimated fair value of the
      restaurant as well as the discount rate used to discount the minimum future
      lease payments. The term used for this evaluation includes renewal option
      periods only in instances in which the exercise of the renewal option can
      reasonably be assured and failure to exercise such option would result in an
      economic penalty. All of the Company’s restaurant leases are classified as
      operating leases.





The
      Company’s lease term used for straight-line rent expense is calculated from the
      date it takes possession of the leased premises through the lease termination
      date. There is potential for variability in its "rent holiday" period which
      begins on the possession date and ends on the store open date. Factors that
      may
      affect the length of the rent holiday period generally include construction
      related delays. Extension of the rent holiday period due to delays in restaurant
      opening will result in greater rent expensed during the rent holiday
      period.





The
      Company records contingent rent expense based on a percentage of restaurant
      sales, which exceeds minimum base rent, over the periods the liability is
      incurred. The contingent rent expense is recorded prior to achievement of
      specified sales levels if achievement of such amounts is considered probable
      and
      estimable.





***Income
      Taxes.***




The
      Company provides for income taxes based on its estimate of federal and state
      tax
      liabilities. These estimates consider, among other items, effective rates for
      state and local income taxes, allowable tax credits for items such as taxes
      paid
      on reported tip income, estimates related to depreciation and amortization
      expense allowable for tax purposes, and the tax deductibility of certain other
      items, The Company’s estimates are based on the information available to it at
      the time it prepares the income tax provisions. The Company generally files
      its
      annual income tax returns several months after its fiscal year end. Income
      tax
      returns are subject to audit by federal, state, and local governments, generally
      years after the returns are filed. These returns could be subject to material
      adjustments or differing interpretations of the tax laws.





Deferred
      income tax assets and liabilities are recognized for the expected future income
      tax consequences of carryforwards and temporary differences between the book
      and
      tax basis of assets and liabilities. Valuation allowances are established for
      deferred tax assets that arc deemed more likely than not to be realized in
      the
      near term. The Company must assess the likelihood that it will be able to
      recover its deferred tax assets. If recovery is not likely, the Company
      establishes valuation allowances to offset any deferred tax asset recorded.
      The
      valuation allowance is based on its estimates of future taxable income in each
      jurisdiction in which it operates, tax planning strategies, and the period
      over
      which its deferred tax assets will be recoverable. In the event that actual
      results differ from these estimates, the Company may be unable to implement
      certain tax planning strategies or adjust these estimates in future periods.
      As
      the Company updates its estimates, it may need to establish an additional
      valuation allowance which could have a material negative impact on its results
      of operations or financial position, or it could reduce its valuation allowances
      which would have a favorable impact on its results of operations or financial
      position.





***Stock-Based
      Compensation.***




The
      Company accounts for stock-based compensation in accordance with the fair value
      recognition provisions of Statement of Financial Accounting Standards 123
      (revised 2004), Share-Based Payment ("SFAS 123R"). The fair value of each option
      award is estimated on the date of grant using the Black-Scholes option pricing
      model and is affected by assumptions regarding a number of highly complex and
      subjective variables. These variables include, but are not limited to the actual
      and projected employee and director stock option exercise behavior. The use
      of
      an option pricing model also requires the use of a number of complex assumptions
      including expected volatility, risk-free interest rate, expected dividends,
      and
      expected term. Expected volatility is based on the Company’s historical
      volatility. The Company utilizes historical data to estimate option exercise
      and
      employee termination behavior within the valuation model. The risk-free interest
      rate is based on the U.S. Treasury yield curve in effect at the time of grant
      for the expected term of the option. SFAS 123R also requires us to estimate
      forfeitures at the time of grant and revise these estimates, if necessary,
      in
      subsequent periods if actual forfeitures differ from those estimates. The
      Company estimates forfeitures based on its expectation of future experience
      while considering its historical experience. Changes in the subjective
      assumptions can materially affect the estimate of fair value of stock-based
      compensation and consequently, the related amount recognized on the consolidated
      statements of earnings. The Company is also required to establish deferred
      tax
      assets for expense relating to options that would be expected to generate a
      tax
      deduction under their original terms. The recoverability of such assets are
      dependent upon the actual deduction that may be available at exercise and can
      further be impaired by either the expiration of the option or an overall
      valuation reserve on deferred tax assets.





25


The
      Company believes the estimates and assumptions related to these critical
      accounting policies are appropriate under the circumstances; however, should
      future events or occurrences result in unanticipated consequences, there could
      be a material impact on its future financial condition or results of
      operations.





**Impact
      of Recently Issued Standards.**




In
      July
      2006, the FASB issued FASB Interpretation No. 48 ("FIN 48"), Accounting for
      Uncertainty in Income Taxes an interpretation of FASB Statement No. 109, which
      clarifies the accounting for uncertainty in tax positions. FIN 48 prescribes
      a
      recognition threshold and measurement attribute for the financial statement
      recognition and measurement of a tax position taken or expected to be taken
      in a
      tax return. In addition, FIN 48 requires expanded disclosure with respect to
      the
      uncertainty in income taxes and is effective for our first quarter of the 2007
      fiscal year. The Company is currently evaluating the impact, if any, that FIN
      48
      will have on our consolidated financial statements.





In
      September 2006, the FASB issued SFAS No. 157 *,"Fair
      Value Measurements* ”.
      SFAS
      No. 157 clarifies the fair value should be based on the assumptions market
      participants would use when pricing an asset or liability and establishes a
      fair
      value hierarchy that prioritizes the information used to develop those
      assumptions. Under the standard, fair value measurements would be separately
      disclosed by level within the fair value hierarchy. SFAS No. 157 is effective
      for financial statements issued for fiscal years beginning after November 15,
      2007, and interim periods within those fiscal years, with early adoption
      permitted. The Company has not yet determined the impact, if any, that the
      implementation of SFAS No. 157 will have on its consolidated financial
      statements.




**ITEM
      7A.****QUANTITATIVE
      AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**





The
      Company does not have or participate in transactions involving derivative,
      financial and commodity instruments. The Company’s long-term debt bears interest
      at floating market rates, based upon either the prime rate or LIBOR plus a
      stipulated percentage, and therefore it experiences changes in interest expense
      when market interest rates change. Based on amounts outstanding at year-end,
      a
      1% change in interest rates would change interest expense by approximately
      $33,000.





**ITEM
      8.****FINANCIAL
      STATEMENTS AND SUPPLEMENTARY DATA**




The
      Financial Statements and Supplementary Data are set forth herein commencing
      on
      page F-1 of this report.





**ITEM
      9.****CHANGES
      IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
      DISCLOSURE**





None.





**ITEM
      9A.** **CONTROLS
      AND PROCEDURES**




*Disclosure
      Controls Evaluation and Related CEO and CFO Certifications.* The
      Company, with the participation of its principal executive officer ("CEO")
      and
      principal financial officer ("CFO"), conducted an evaluation of the
      effectiveness of the design and operation of the Company's disclosure controls
      and procedures as of the end of the period covered by this annual report on
      Form
      10-K.




26


Certifications
      of the Company's CEO and CFO, required in accordance with Rule 13a-14 of
      the Securities Exchange Act of 1934, as amended ("Exchange Act"), are attached
      as exhibits to this annual report on Form 10-K. This "Controls and
      Procedures" section includes the information concerning the controls evaluation
      referred to in the certifications and it should be read in conjunction with
      the
      certifications for a more complete understanding of the topics
      presented.




*Limitations
      on the Effectiveness of Controls.* The
      Company does not expect that its disclosure controls and procedures will prevent
      or detect all errors and all fraud. A system of controls and procedures, no
      matter how well conceived and operated, can provide only reasonable, not
      absolute, assurance that the objectives of the system are met. Because of the
      limitations in all such systems, no evaluation can provide absolute assurance
      that all control issues and instances of fraud, if any, within the Company
      have
      been detected. Furthermore, the design of any system of controls and procedures
      is based in part upon certain assumptions about the likelihood of future events,
      and there can be no assurance that any design will succeed in achieving its
      stated goals under all potential future conditions, regardless of how unlikely.
      Because of those inherent limitations in a cost-effective system of controls
      and
      procedures, misstatements or omissions due to error or fraud may occur and
      not
      be detected.




*Scope
      of the Controls Evaluation.* The
      evaluation of the Company’s disclosure controls and procedures included a review
      of their objectives and design, the Company's implementation of the controls
      and
      procedures and the effect of the controls and procedures on the information
      generated for use in this annual report on Form 10-K. In the course of the
      evaluation, the Company sought to identify whether it had any data errors,
      control problems or acts of fraud and to confirm that appropriate corrective
      action, including process improvements, were being undertaken if needed. Many
      of
      the components of the Company’s disclosure controls and procedures are also
      evaluated by management. The overall goals of these various evaluation
      activities are to monitor the Company’s disclosure controls and procedures on an
      ongoing basis, and to maintain them as dynamic systems that change as conditions
      warrant.




*Conclusions
      regarding Disclosure Controls.* Based on
      the required evaluation of the Company's disclosure controls and procedures,
      our
      CEO and CFO have concluded that, as of December 31, 2006, the Company
      maintained disclosure controls and procedures that were effective in providing
      reasonable assurance that information required to be disclosed by the Company
      in
      the reports that it files or submits under the Exchange Act is recorded,
      processed, summarized and reported within the time periods specified in the
      SEC's rules and forms, and that such information is accumulated and communicated
      to the Company's management, including its CEO and CFO, as appropriate to allow
      timely decisions regarding required disclosure.




During
      fiscal year 2006, the Company engaged an accounting firm, Calvetti, Ferguson
      & Wagner, P.C. (“CF&W”), to assist us in our obligation under Section
      404 of the Sarbanes-Oxley Act of 2002 to document and test the Company’s
      internal controls. Such documentation and testing should be completed during
      fiscal year 2007. During fiscal year 2006, the Company made no significant
      changes to its internal controls.




**ITEM
      9B.****OTHER
      INFORMATION**





None.





**PART
      III**





**ITEM
      10.****DIRECTORS
      AND EXECUTIVE OFFICERS OF THE REGISTRANT AND CORPORATE
      GOVERNANCE**





The
      information called for by this Item 10 is incorporated herein by reference
      to
      the Company’s definitive proxy statement to be filed with the Securities and
      Exchange Commission pursuant to Regulation 14A not later than 120 days after
      the
      end of the fiscal year covered by this report.








**ITEM
      11.****EXECUTIVE
      COMPENSATION**





The
      information called for by this Item 11 is incorporated herein by reference
      to
      the Company’s definitive proxy statement to be filed with the Securities and
      Exchange Commission pursuant to Regulation 14A not later than 120 days after
      the
      end of the fiscal year covered by this report.





27


**ITEM
      12.****SECURITY
      OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER
      MATTERS**





The
      information called for by this Item 12 is incorporated herein by reference
      to
      the Company’s definitive proxy statement to be filed with the Securities and
      Exchange Commission pursuant to Regulation 14A not later than 120 days after
      the
      end of the fiscal year covered by this report.





**ITEM
      13.****CERTAIN
      RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
      INDEPENDENCE**





The
      information called for by this Item 13 is incorporated herein by reference
      to
      the Company’s definitive proxy statement to be filed with the Securities and
      Exchange Commission pursuant to Regulation 14A not later than 120 days after
      the
      end of the fiscal year covered by this report.





**ITEM
      14.** **PRINCIPAL
      ACCOUNTANT FEES AND SERVICES**





The
      information called for by this Item 14 is incorporated herein by reference
      to
      the Company’s definitive proxy statement to be filed with the Securities and
      Exchange Commission pursuant to Regulation 14A not later than 120 days after
      the
      end of the fiscal year covered by this report.







**PART
      IV**





**ITEM
      15.****EXHIBITS
      AND FINANCIAL STATEMENT SCHEDULES**





(a)
            The
                following documents are filed as part of this
                Report:





1.
            Financial
                Statements:





The
      Financial Statements are listed in the index to Consolidated Financial
      Statements on page F-1 of this Report.





2. Financial Statement Schedules are omitted because they are either not
      applicable or not material.





3.
            The
                following exhibits are filed, furnished or incorporated by reference
                as
                exhibits to this Report as required by Item 601 of Regulation S-K.
                The
                exhibits designated with a cross are management contracts and compensatory
                plans and arrangements required to be filed as exhibits to this report.





Exhibits:





3.1
            Articles
                of Incorporation of the Company, as amended (incorporated by reference
                to
                the corresponding Exhibit number of the Company’s Form 8-K filed on May
                25, 1999 with the Securities and Exchange Commission).‡3.2
            Bylaws
                of the Company.‡4.1
            Specimen
                of Certificate of Common Stock of the Company.4.2
            Articles
                of Incorporation of the Company (see 3.1 above).‡4.3
            Bylaws
                of the Company (see 3.2 above).‡10.1
            Employment
                Agreement by and between the Company and Louis P. Neeb dated
                February 28, 1996.





28








10.2
            Indemnity
                Agreement by and between the Company and Louis P. Neeb dated as of
                April 10, 1996 (incorporated by reference to Exhibit 10.4 of the
                Company’s Form S-1 Registration Statement filed under the Securities Act
                of 1933, dated April 24, 1996, with the Securities and Exchange Commission
                (Registration Number 333-1678) (the “1996 Form
                S-1”)).




10.3
            Indemnity
                Agreement by and between the Company and Larry N. Forehand dated as
                of April 10, 1996 (incorporated by reference to Exhibit 10.5 of the
                1996 Form S-1).10.4
            Indemnity
                Agreement by and between the Company and John C. Textor dated as
                of
                April 10, 1996 (incorporated by reference to Exhibit 10.6 of the 1996
                From S-1).10.5
            Indemnity
                Agreement by and between the Company and Michael D. Domec dated as of
                April 10, 1996 (incorporated by reference to Exhibit 10.8 of the 1996
                Form S-1).10.6
            Indemnity
                Agreement by and between the Company and J. J. Fitzsimmons dated
                as of
                April 10, 1996 (incorporated by reference to Exhibit 10.10 of the
                1996 Form S-1).10.7
            Indemnity
                Agreement by and between the Company and Richard E. Rivera dated as
                of April 10, 1996 (incorporated by reference to Exhibit 10.11 of the
                1996 Form S-1).10.8
            Form
                of the Company's Multi-Unit Development Agreement (incorporated by
                reference to Exhibit 10.14 of the 1996 Form S-1).10.9
            Form
                of the Company's Franchise Agreement (incorporated by reference to
                Exhibit
                10.15 of the 1996 Form S-1).†10.10
            1996
                Long Term Incentive Plan (incorporated by reference to Exhibit 10.16
                of
                the 1996 Form S-1).†10.11
            Mexican
                Restaurants, Inc. 2005 Long Term Incentive Plan (incorporated by
                reference
                to Exhibit 99.1 of the 2005 Form S-8 filed December 1,
                2005).†10.12
            Stock
                Option Plan for Non-Employee Directors (incorporated by reference
                to
                Exhibit 10.17 of the 1996 Form S-1).10.13
            Indemnification
                letter agreement by Larry N. Forehand dated April 10, 1996
                (incorporated by reference to Exhibit 10.35 of the 1996 Form S-1).†10.14
            1996
                Manager’s Stock Option Plan (incorporated by reference to Exhibit 99.2 of
                the Company’s Form S-8 Registration Statement filed under the Securities
                Act of 1933, dated February 24, 1997 filed with the Securities and
                Exchange Commission).


†10.15
            Employment
                Agreement by and between the Company and Andrew J. Dennard dated
                May 20,
                1997 (incorporated by reference to Exhibit 10.45 of the Company’s Form
                10-K Annual Report filed on March 30, 1998 with the Securities and
                Exchange Commission).10.23
            Fleet
                Revolving Credit and Term Loan Agreement between Mexican Restaurants,
                Inc., as the Borrower, and Fleet National Bank, as the Bank, for
                $10,000,000 dated June 29, 2001 and as amended on January 7, 2004
                and
                April 1, 2005 (incorporated by reference to Exhibit 10.22 of the
                Company’s
                Form 10-K Annual Report filed in April, 2005 with the Securities
                and
                Exchange Commission).10.24
            Amendment
                No. 2 to Amended and Restated Revolving Credit and Term Loan Agreement
                dated November 15, 2005 (effective June 30, 2005) between Mexican
                Restaurants, Inc., as the Borrower, and Bank of America, successor
                to
                Fleet National Bank, as the Bank, for $10,000,000 dated June 29,
                2001 and
                as amended on January 7, 2004 and April 1, 2005 (incorporated by
                reference
                to Exhibit 10.24 to the Company’s Form 10-K Annual Report filed on March
                30, 2006 with the Securities and Exchange Commission).†10.25
            Performance
                Unit Agreement by and between Mexican Restaurants, Inc. and Andrew
                Dennard
                dated August 16, 2005 (incorporated by reference to Exhibit 10.25
                to the
                Company’s Form 10-K Annual Report filed on March 30, 2006 with the
                Securities and Exchange Commission).†10.26
            Separation
                Agreement by and between Mexican Restaurants, Inc. and Curt Glowacki
                dated
                December 1, 2006 (incorporated by reference to Exhibit 10.1 to the
                Company’s Form 8-K filed on December 7, 2006 with the Securities and
                Exchange Commission).†10.27
            Performance
                Unit Agreement by and between Mexican Restaurants, Inc. and Louis
                P. Neeb
                dated August 16, 2005 (incorporated by reference to Exhibit 10.27
                to the
                Company’s Form 10-K Annual Report filed on March 30, 2006 with the
                Securities and Exchange Commission).†10.28
            Performance
                Unit Agreement by and between Mexican Restaurants, Inc. and Dennis
                Vegas
                dated August 16, 2005 (incorporated by reference to Exhibit 10.28
                to the
                Company’s Form 10-K Annual Report filed on March 30, 2006 with the
                Securities and Exchange Commission)..*10.29
            Amendment
                No. 3 to Amended and Restated Revolving Credit and Term Loan Agreement
                dated March 29, 2007 between Mexican Restaurants, Inc. as the Borrower,
                and Bank of America, successor to Fleet National Bank, as the Bank,
                for
                $10,000,000 dated June 29, 2001 and as amended on January 7, 2004
                and
                April 1, 2005 and March 29, 2007.21.1
            List
                of subsidiaries of the Company (incorporated by reference to Exhibit
                22.1
                of the Company’s Form S-1 Registration Statement Under the Securities Act
                of 1933, dated April 24, 1996, filed by the Company with the Securities
                and Exchange Commission).*23.1
            Consent
                of UHY LLP, Independent Registered Public Accounting
                Firm.*23.2
            Consent
                of KPMG LLP, Independent Registered Public Accounting
                Firm.*24.1
            Power
                of Attorney (included on the signature page to this Form
                10-K).*31.1
            Certification
                filed pursuant to Rule 13a-14(a) or Rule 15d-14(a).*31.2
            Certification
                filed pursuant to Rule 13a-14(a) or Rule 15d-14(a).#32.1
            Certification
                of Chief Executive Officer furnished pursuant to 18 U.S.C. Section
                1350,
                as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
                2002.#32.2
            Certification
                of Chief Financial Officer furnished pursuant to 18 U.S.C. Section
                1350,
                as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
                2002._____*
            Filed
                herewith.‡
            Incorporated
                by reference to corresponding Exhibit number of the Company’s Form S-1
                Registration Statement under the Securities Act of 1933, dated April
                24,
                1996, with the Securities and Exchange Commission (Registration number
                333-1678) (the “1996 Form S-1”).†
            Management
                contract or compensatory plan or arrangement.#
            Furnished
                herewith.








29





**SIGNATURES**





Pursuant
      to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
      1934, the Registrant has duly caused this report to be signed on its behalf
      by
      the undersigned, thereunto duly authorized on March 30, 2007.





MEXICAN
                RESTAURANTS, INC.*By:
                /s/
                Louis P. Neeb*Louis
                P. Neeb,Chairman
                of the
                Board of Directors





**POWER
      OF ATTORNEY**





KNOW
      ALL
      MEN AND WOMEN BY THESE PRESENTS, that each person whose signature appears below
      constitutes and appoints Louis P. Neeb and Andrew Dennard, and each of them,
      such individual’s true and lawful attorneys-in-fact and agents, with full power
      of substitution and resubstitution, for such individual and in his or her name,
      place and stead, in any and all capacities, to sign any and all amendments
      to
      this Form 10-K under the Securities Exchange Act of 1934, and to file the same,
      with all exhibits thereto, and all documents in connection therewith, with
      the
      Securities and Exchange Commission, granting unto said attorneys-in-fact and
      agents, and each of them, full power and authority to do and perform each and
      every act and thing requisite and necessary to be done in and about the premises
      as fully to all intents and purposes as he or she might or could do in person,
      hereby ratifying and confirming all that said attorneys-in-fact and agents,
      or
      any of them, or their substitute or substitutes, may lawfully do or cause to
      be
      done by virtue hereof.





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





**Signatures**
            **Title**
            **Date***/s/
                Louis P. Neeb*
            Chairman
                of the Board of Directors
            March
                30, 2007Louis
                P. Neeb
            Chief
                Executive Officer(Principal
                Executive Officer)*/s/
                Larry N. Forehand*
            Founder
                and Vice Chairman of the Board of Directors
            March
                30, 2007Larry
                N. Forehand*/s/
                Andrew J. Dennard*
            Exec.
                Vice President and Chief Financial Officer
            March
                30, 2007Andrew
                J. Dennard
            (Principal
                Financial and Accounting Officer)*/s/
                Cara Denver*
            Director
            March
                30, 2007Cara
                Denver*/s/
                Michael D. Domec*
            Director
            March
                30, 2007Michael
                D. Domec*/s/
                J. J. Fitzsimmons*
            Director
            March
                30, 2007J.
                J. Fitzsimmons*/s/
                Curt Glowacki*
            Director
            March
                30, 2007Curt
                Glowacki*/s/
                Thomas E. Martin*
            Director
            March
                30, 2007Thomas
                E. Martin*/s/
                J. Stuart Sargent*
            Director
            March
                30, 2007J.
                Stuart Sargent


























**MEXICAN
      RESTAURANTS, INC.**





**INDEX
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**Page**Report
                of Independent Registered Public Accounting Firm
            F-2Report
                of Independent Registered Public Accounting Firm
            F-3Consolidated
                Balance Sheets as of January 1, 2006 and December 31, 2006
            F-4Consolidated
                Statements of Operations for each of the years in the three fiscal-yearperiod
                ended December 31, 2006
            F-5Consolidated
                Statements of Stockholders' Equity for each of the years inthe
                three fiscal-year period ended December 31, 2006
            F-6Consolidated
                Statements of Cash Flows for each of the years in the threefiscal-year
                period ended December 31, 2006
            F-7Notes
                to Consolidated Financial Statements
            F-8




































































































F-1











**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**











The
      Board
      of Directors and Shareholders


Mexican
      Restaurants, Inc. and Subsidiaries:








We
      have
      audited the accompanying consolidated balance sheets of Mexican Restaurants,
      Inc. and subsidiaries (the “Company”) as of December 31, 2006 and January 1,
      2006, and the related consolidated statements of operations, stockholders'
      equity and cash flows for the years then ended. These consolidated financial
      statements are the responsibility of the Company's management. Our
      responsibility is to express an opinion on these consolidated financial
      statements based on our audits.





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





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the consolidated financial position of Mexican
      Restaurants, Inc. and subsidiaries as of December 31, 2006 and January 1, 2006,
      and the consolidated results of their operations and their cash flows for the
      years then ended, in conformity with U.S. generally accepted accounting
      principles.





As
      discussed in Note 1 to the consolidated financial statements, effective January
      2, 2006 the Company changed its method of accounting for share-based
      compensation.







UHY
      LLP








Houston,
      Texas


March
      30,
      2007
































































F-2







**Report
      of Independent Registered Public Accounting Firm**




The
      Board
      of Directors and Stockholders


Mexican
      Restaurants, Inc.:




We
      have
      audited the accompanying consolidated statement of operations, stockholders’
equity, and cash flows of Mexican Restaurants, Inc. and subsidiaries for the
      year ended January 2, 2005. The consolidated financial statements are the
      responsibility of the Company’s management. Our responsibility is to express an
      opinion on the consolidated financial statements based on our
      audit.





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





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the results of the operations and the cash flows
      of
      Mexican Restaurants, Inc. and subsidiaries for the year ended January 2, 2005,
      in conformity with U.S. generally accepted accounting principles.





KPMG
      LLP


Houston,
      Texas


March
      28,
      2005, except for Note 1(a), as to which the date is March 30, 2007.



































































F-3





**MEXICAN
      RESTAURANTS, INC. AND SUBSIDIARIES**


**CONSOLIDATED
      BALANCE SHEETS**


**January
      1, 2006 and December 31, 2006**








**Fiscal
                Years****ASSETS**
            
            **2005**
            
            **2006**Current
                assets:Cash
            
            $
            788,109
            
            $
            653,310Royalties
                receivable
            
            
            176,649
            
            
            90,627Other
                receivables
            
            
            2,088,035
            
            
            856,704Inventory
            
            
            744,397
            
            
            710,633Taxes
                receivable
            
            
            --
            
            
            408,787Prepaid
                expenses and other current assets
            
            
            833,678
            
            
            851,580Total
                current assets
            
            
            4,630,868
            
            
            3,571,641Property,
                plant and equipment
            
            
            31,511,205
            
            
            34,682,615Less
                accumulated depreciation
            
            
            (15,315,864
            )
            
            (17,171,172
            )Net
                property, plant and equipment
            
            
            16,195,341
            
            
            17,511,443Goodwill
            
            
            10,902,664
            
            
            11,403,805Deferred
                tax assets
            
            
            256,274
            
            
            318,519Property
                held for sale, net
            
            
            625,318
            
            
            --Other
                assets
            
            
            526,804
            
            
            470,284$
            33,137,269
            
            $
            33,275,692**LIABILITIES
                AND STOCKHOLDERS' EQUITY**Current
                liabilities:Current
                installments of long-term debt
            
            $
            1,000,000
            
            $
            --Accounts
                payable
            
            
            1,710,068
            
            
            2,087,506Income
                taxes payable
            
            
            203,116
            
            
            --Accrued
                sales and liquor taxes
            
            
            127,283
            
            
            142,787Accrued
                payroll and taxes
            
            
            1,685,235
            
            
            1,440,040Accrued
                expenses
            
            
            1,536,895
            
            
            1,828,916Total
                current liabilities
            
            
            6,262,597
            
            
            5,499,249Long-term
                debt
            
            
            4,500,000
            
            
            3,800,000Other
                liabilities
            
            
            1,930,056
            
            
            2,050,272Deferred
                gain
            
            
            1,561,070
            
            
            1,352,927Total
                liabilities
            
            
            14,253,723
            
            
            12,702,448Stockholders'
                equity:Preferred
                stock, $0.01 par value, 1,000,000 shares authorized, none
                issued
            
            
            --
            
            
            --Common
                stock, $0.01 par value, 20,000,000 shares authorized, 4,732,705 sharesissued
            
            
            47,327
            
            
            47,327Additional
                paid-in capital
            
            
            19,406,139
            
            
            19,041,867Retained
                earnings
            
            
            11,620,788
            
            
            12,759,122Treasury
                stock, cost of 1,375,728 common shares in 2005 and 1,272,383 commonshares
                in 2006
            
            
            (12,190,708
            )
            
            (11,275,072
            )Total
                stockholders' equity
            
            
            18,883,546
            
            
            20,573,244$
            33,137,269
            
            $
            33,275,692





See
      accompanying notes to consolidated financial statements.
















F-4





**MEXICAN
      RESTAURANTS, INC. AND SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF OPERATIONS**


**For
      the fiscal years ended January 2, 2005, January 1, 2006**


**and
      December 31, 2006**







**Fiscal
                Years********2004**
            
            ******2005**
            
            ******2006**Revenues:
              Restaurant
                sales
            
            $
            74,034,769
            
            $
            76,901,353
            
            $
            81,379,597Franchise
                fees, royalties and other
            
            
            753,293
            
            
            694,302
            
            
            825,115Business
                interruption
            
            
            --
            
            
            534,163
            
            
            59,62174,788,062
            
            
            78,129,818
            
            
            82,264,333Costs
                and expenses:Cost
                of sales
            
            
            20,473,539
            
            
            20,914,871
            
            
            22,429,076Labor
            
            
            24,087,436
            
            
            25,048,534
            
            
            26,358,576Restaurant
                operating expenses
            
            
            16,670,639
            
            
            17,692,164
            
            
            19,263,309General
                and administrative
            
            
            6,586,807
            
            
            6,941,683
            
            
            7,716,786Depreciation
                and amortization
            
            
            2,135,964
            
            
            2,683,651
            
            
            3,131,399Pre-opening
                costs
            
            
            34,756
            
            
            77,942
            
            
            108,847Impairment
                costs
            
            
            322,074
            
            
            --
            
            
            543,777Gain
                on disposal of assets - Hurricane Rita
            
            
            --
            
            
            (471,622
            )
            
            (366,808
            )Loss
                on sale of assets
            
            
            179,948
            
            
            367,711
            
            
            32,28270,491,163
            
            
            73,254,934
            
            
            79,217,244Operating
                income
            
            
            4,296,899
            
            
            4,874,884
            
            
            3,047,089Other
                income (expense):Interest
                income
            
            
            9,711
            
            
            3,451
            
            
            6,239Interest
                expense
            
            
            (553,371
            )
            
            (521,161
            )
            
            (390,539
            )Other,
                net
            
            
            84,881
            
            
            113,846
            
            
            80,986(458,779
            )
            
            (403,864
            )
            
            (303,314
            )Income
                from continuing operations before income taxes
            
            
            3,838,120
            
            
            4,471,020
            
            
            2,743,775Income
                tax expense
            
            
            1,269,174
            
            
            1,474,606
            
            
            849,102Income
                from continuing operations
            
            
            2,568,946
            
            
            2,996,414
            
            
            1,894,673Discontinued
                operations:Loss
                from discontinued operations
            
            
            (547,176
            )
            
            (303,448
            )
            
            (364,352
            )Restaurant
                closure costs
            
            
            (546,506
            )
            
            (790,708
            )
            
            (832,179
            )Loss
                on sale of assets
            
            
            (212,561
            )
            
            (2,420
            )
            
            (10,449
            )Loss
                from discontinued operations before income taxes
            
            
            (1,306,243
            )
            
            (1,096,576
            )
            
            (1,206,980
            )Income
                tax benefit
            
            
            498,271
            
            
            417,159
            
            
            450,641Loss
                from discontinued operations
            
            
            (807,972
            )
            
            (679,417
            )
            
            (756,339
            )Net
                Income
            
            $
            1,760,974
            
            $
            2,316,997
            
            $
            1,138,334Basic
                income (loss) per share:Income
                from continuing operations
            
            $
            0.76
            
            $
            0.88
            
            $
            0.55Loss
                from discontinued operations
            
            
            (0.24
            )
            
            (0.20
            )
            
            (0.22
            )Net
                income
            
            $
            0.52
            
            $
            0.68
            
            $
            0.33Diluted
                income (loss) per share:Income
                from continuing operations
            
            $
            0.70
            
            $
            0.81
            
            $
            0.53Loss
                from discontinued operations
            
            
            (0.22
            )
            
            (0.18
            )
            
            (0.21
            )Net
                income
            
            $
            0.48
            
            $
            0.63
            
            $
            0.32Weighted
                average number of shares (basic)
            
            
            3,388,489
            
            
            3,415,806
            
            
            3,402,207Weighted
                average number of shares (diluted)
            
            
            3,634,849
            
            
            3,700,876
            
            
            3,521,587





See
      accompanying notes to consolidated financial statements .










F-5








**MEXICAN
      RESTAURANTS, INC. AND SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF STOCKHOLDERS' EQUITY**





**For
      the fiscal years ended**


**January
      2, 2005, January 1, 2006**


**and
      December 31, 2006**





**Common****Stock**
            
            **Additional**
              **Paid-in**
              **Capital**
            
            **Retained**
              **Earnings**
            
            **Deferred**
              **Compensation**
            
            **Treasury**
              **Stock**
            
            **Total**
              **Stockholders’**
              **Equity**Balances
                at December 28, 2003
            
            $
            47,327
            
            $
            20,121,076
            
            $
            7,542,817
            
            $
            (47,607
            )
            $
            (11,709,513
            )
            $
            15,954,100Exercise
                of Stock Options
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            111,591
            
            
            111,591Amortization
                of Deferred Compensation
            
            
            --
            
            
            --
            
            
            --
            
            
            41,304
            
            
            --
            
            
            41,304Net
                income
            
            
            --
            
            
            --
            
            
            1,760,974
            
            
            --
            
            
            --
            
            
            1,760,974Balances
                at January 2, 2005
            
            
            47,327
            
            
            20,121,076
            
            
            9,303,791
            
            
            (6,303
            )
            
            (11,597,922
            )
            
            17,867,969Exercise
                of Stock Options ThroughIssuance
                of Treasury Shares
            
            
            --
            
            
            (714,937
            )
            
            --
            
            
            --
            
            
            1,145,481
            
            
            430,544Repurchase
                of shares
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            (1,738,267
            )
            
            (1,738,267
            )Amortization
                of Deferred Compensation
            
            
            --
            
            
            --
            
            
            --
            
            
            6,303
            
            
            --
            
            
            6,303Net
                income
            
            
            --
            
            
            --
            
            
            2,316,997
            
            
            --
            
            
            --
            
            
            2,316,997Balances
                at January 1, 2006
            
            
            47,327
            
            
            19,406,139
            
            
            11,620,788
            
            
            --
            
            
            (12,190,708
            )
            
            18,883,546Exercise
                of Stock Options ThroughIssuance
                of Treasury Shares
            
            
            --
            
            
            (472,703
            )
            
            --
            
            
            --
            
            
            1,177,366
            
            
            704,663Repurchase
                of shares
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            (261,730
            )
            
            (261,730
            )Stock
                based Compensation Expense
            
            
            --
            
            
            63,508
            
            
            --
            
            
            --
            
            
            --
            
            
            63,508Excess
                Tax Benefit-Options Exercised
            
            
            --
            
            
            44,923
            
            
            --
            
            
            --
            
            
            --
            
            
            44,923Net
                income
            
            
            --
            
            
            --
            
            
            1,138,334
            
            
            --
            
            
            --
            
            
            1,138,334Balances
                at December 31, 2006
            
            $
            47,327
            
            $
            19,041,867
            
            $
            12,759,122
            
            $
            --
            
            $
            (11,275,072
            )
            $
            20,573,244






































See
      accompanying notes to consolidated financial statements.













F-6





**MEXICAN
      RESTAURANTS, INC. AND SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**


**For
      the fiscal years ended January 2, 2005, January 1, 2006 and December 31,
      2006**


**Fiscal
                Years****2004**
            
            **2005**
            
            **2006**(Revised.
                See Note 1)**Cash
                flows from operating activities:**Net
                income
            
            $
            1,760,974
            
            $
            2,316,997
            
            $
            1,138,334Adjustment
                to reconcile net income to net cash provided by operating activitiesDepreciation
                and amortization
            
            
            2,135,964
            
            
            2,683,651
            
            
            3,131,399Deferred
                gain amortization
            
            
            (208,185
            )
            
            (208,142
            )
            
            (208,143
            )Loss
                from discontinued operations
            
            
            807,972
            
            
            679,417
            
            
            756,339Impairment
                costs
            
            
            322,074
            
            
            --
            
            
            543,777Hurricane
                Rita gain
            
            
            --
            
            
            (471,622
            )
            
            (366,808
            )Loss
                on sale of property, plant and equipment
            
            
            179,948
            
            
            367,711
            
            
            32,282Stock
                based compensation expense
            
            
            41,304
            
            
            6,303
            
            
            63,508Business
                interruption proceeds
            
            
            --
            
            
            (534,163
            )
            
            (59,621
            )Deferred
                income taxes (benefit)
            
            
            677,164
            
            
            697,550
            
            
            (27,109
            )Changes
                in assets and liabilities, net of effects of acquisitionsRoyalties
                receivable
            
            
            94,140
            
            
            (91,272
            )
            
            86,022Other
                receivables
            
            
            (284,845
            )
            
            (44,729
            )
            
            437,930Taxes
                receivable/payable
            
            
            (228,834
            )
            
            776,956
            
            
            (611,903
            )Inventory
            
            
            6,507
            
            
            (275,666
            )
            
            9,711Prepaids
                and other current assets
            
            
            (143,337
            )
            
            4,179
            
            
            (32,750
            )Other
                assets
            
            
            33,173
            
            
            4,074
            
            
            (25,551
            )Accounts
                payable
            
            
            25,576
            
            
            17,353
            
            
            289,378Accrued
                expenses and other liabilities
            
            
            160,653
            
            
            310,334
            
            
            (347,674
            )Deferred
                rent and other long-term liabilities
            
            
            308,859
            
            
            138,772
            
            
            103,384Total
                adjustments
            
            
            3,928,133
            
            
            4,060,706
            
            
            3,774,171Net
                cash provided by continuing operations
            
            
            5,689,107
            
            
            6,377,703
            
            
            4,912,505Net
                cash provided by (used in) discontinued operations
            
            
            13,883
            
            
            (135,464
            )
            
            132,358Net
                cash provided by operating activities
            
            
            5,702,990
            
            
            6,242,239
            
            
            5,044,863**Cash
                flows from investing activities:**Insurance
                proceeds received from Hurricane Rita loss
            
            
            --
            
            
            300,000
            
            
            1,211,850Purchase
                of property, plant and equipment
            
            
            (2,698,460
            )
            
            (4,512,175
            )
            
            (5,138,048
            )Proceeds
                from sale of property, plant and equipment
            
            
            655,752
            
            
            372,691
            
            
            765,000Business
                Acquisitions, net of cash acquired
            
            
            (6,767,916
            )
            
            --
            
            
            (742,490
            )Net
                cash used in continuing operations
            
            
            (
                8,810,624
            )
            
            (
                3,839,484
            )
            
            (3,903,688
            )Net
                cash used in discontinued operations
            
            
            (301,163
            )
            
            (100,759
            )
            
            (63,830
            )Net
                cash used in investing activities
            
            
            (9,111,787
            )
            
            (3,940,243
            )
            
            (3,967,518
            )**Cash
                flows from financing activities:**Net
                borrowings (payment) under line of credit agreement
            
            
            1,225,000
            
            
            (1,500,000
            )
            
            800,000Purchase
                of treasury stock
            
            
            --
            
            
            (1,738,267
            )
            
            (261,730
            )Excess
                tax benefit - stock-based compensation expense
            
            
            --
            
            
            --
            
            
            44,923Exercise
                of stock options
            
            
            111,591
            
            
            430,544
            
            
            704,663Additions
                to (payments on) Long-term debt
            
            
            3,000,000
            
            
            --
            
            
            (2,500,000
            )Net
                cash provided by (used in) financing activities
            
            
            4,336,591
            
            
            (2,807,723
            )
            
            (1,212,144
            )Net
                increase (decrease) in cash
            
            
            927,794
            
            
            (505,727
            )
            
            (134,799
            )Cash
                at beginning of year
            
            
            366,042
            
            
            1,293,836
            
            
            788,109Cash
                at end of year
            
            $
            1,293,836
            
            $
            788,109
            
            $
            653,310**Supplemental
                disclosure of cash flow information:**Cash
                paid during the year:Interest
            
            $
            494,844
            
            $
            561,972
            
            $
            384,242Income
                taxes
            
            $
            464,532
            
            $
            297,693
            
            $
            1,074,819Non-cash
                financing activities:CNL
                real estate transaction
            
            $
            8,325,000
            
            
            --
            
            
            --




See
      accompanying notes to consolidated financial statements.










F-7





**MEXICAN
      RESTAURANTS, INC. AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**January
      2, 2005, January 1, 2006 and December 31, 2006**





**(1)
      Description of Business and Summary of Significant Accounting
      Policies**





*(a)
      Description of Business*





On
      February 16, 1996, Mexican Restaurants, Inc. (formerly Casa Olé
Restaurants, Inc.) was incorporated in the State of Texas, and on April 24,
      1996, its initial public offering of 2,000,000 shares of Common Stock became
      effective. Mexican Restaurants, Inc. is the holding company for Casa Olé
Franchise Services, Inc. and several subsidiary restaurant operating
      corporations (collectively the “Company”). Casa Olé Franchise Services, Inc. was
      incorporated in 1977, and derives its revenues from the collection of franchise
      fees under a series of protected location franchise agreements and from the
      sale
      of restaurant accessories to the franchisees of those protected location
      franchise agreements. The restaurants feature moderately priced Mexican and
      Tex-Mex food served in a casual atmosphere. The first Casa Olé restaurant was
      opened in 1973.





On
      July
      2, 1997, the Company purchased 100% of the outstanding stock of Monterey’s
      Acquisition Corp. (“MAC”). The Company purchased the shares of common stock for
      $4.0 million, paid off outstanding debt and accrued interest totaling $7.1
      million and funded various other agreed upon items approximating $500,000.
      At
      the time of the acquisition, MAC owned and operated 26 restaurants in Texas
      and
      Oklahoma under the names “Monterey’s Tex-Mex Café,” “Monterey’s Little Mexico”
and “Tortuga Coastal Cantina.”





On
      April
      30, 1999, the Company purchased 100% of the outstanding stock of La Señorita
      Restaurants, a Mexican restaurant chain operated in the State of Michigan.
      The
      Company purchased the shares of common stock of La Señorita for $4.0 million.
      The transaction was funded with the Company’s revolving line of credit with Bank
      of America. At the time of the acquisition, La Señorita operated five
      company-owned restaurants, and three franchise restaurants.





On
      January 7, 2004, the Company completed its purchase of 13 restaurants and
      related assets from its Beaumont-based franchisee, Thomas Harken, and Mr.
      Harken's operating partner, Victor Gonzalez, for a total consideration of
      approximately $13.75 million. The financing for the acquisition was provided
      by
      Fleet National Bank, CNL and the sellers. The restaurants acquired include
      8
      Casa Olé restaurants located in Southeast Texas, 2 Casa Olé restaurants located
      in Southwest Louisiana, and 3 Crazy Jose’s restaurants located in Southeast
      Texas. In the past year these restaurants had combined sales of over $20
      million.





On
      October 14, 2004, the Company completed its purchase of one franchise restaurant
      in Brenham, Texas for approximately $215,000. The restaurant was closed,
      remodeled and re-opened on November 22, 2004. The Company spent $329,489
      remodeling the restaurant.





On
      August
      17, 2006, the Company completed its purchase of two Houston-area Mission
      Burritos restaurants and related assets for a total consideration of
      approximately $725,000, excluding acquisition costs.





The
      consolidated statements of operations and cash flows for fiscal years 2006,
      2005, and 2004 have been adjusted to remove the operations of closed
      restaurants, which have been reclassified as discontinued operations.
      Consequently, the consolidated statements of operations and cash flows for
      the
      fiscal years 2005 and 2004 shown in the accompanying consolidated financial
      statements have been reclassified to conform to the 2006 presentation. These
      reclassifications have no effect on total assets, total liabilities,
      stockholders’ equity or net income.





*(b)
      Principles of Consolidation*





The
      consolidated financial statements include the accounts of Mexican Restaurants,
      Inc. and its wholly-owned subsidiaries, after elimination of all significant
      inter-company transactions. The Company owns and operates various Mexican
      restaurant concepts principally in Texas, Oklahoma, Louisiana and Michigan.
      The
      Company’s three Idaho restaurants were closed on December 30, 2001 and the
      restaurants are either subleased or leased to third parties. The Company also
      franchises the Casa Olé concept principally in Texas and Louisiana and the La
      Señorita concept principally in the State of Michigan.













F-8




**MEXICAN
      RESTAURANTS, INC. AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**






*(c)
      Fiscal Year*





The
      Company maintains its accounting records on a 52/53 week fiscal year ending
      on the Sunday nearest December 31. Fiscal years 2005 and 2006 consisted of
      52
      weeks and fiscal year 2004 consisted of 53 weeks.




*(d)
      Inventory*





Inventory,
      which is comprised of food and beverages, is stated at the lower of cost or
      market. Cost is determined using the first-in, first-out method. Miscellaneous
      restaurant supplies are included in inventory and valued on a specific
      identification basis.





*(e)
      Pre-opening Costs*





Pre-opening
      costs primarily consists of hiring and training employees associated with the
      opening of a new restaurant and are expensed as incurred.





*(f)
      Property, Plant and Equipment*





Property,
      plant and equipment are stated at cost. Depreciation on equipment and vehicles
      is calculated on the straight-line method over the estimated useful lives of
      the
      assets. Leasehold improvements are amortized straight-line over the shorter
      of
      the lease term plus options reasonably assured or estimated useful life of
      the
      assets.





Leasehold
                improvements
            2-25 yearsVehicles
            5 yearsEquipment
            3-15
                years




At
      the
      opening of a new restaurant, the initial purchase of smallwares is capitalized
      as restaurant equipment, but not depreciated. Subsequent purchases of smallwares
      are expensed as incurred.




Significant
      expenditures that add materially to the utility or useful lives of property,
      plant and equipment are capitalized. All other maintenance and repair costs
      are
      charged to current operations. The cost and related accumulated depreciation
      of
      assets replaced, retired or otherwise disposed of are eliminated from the
      property accounts and any gain or loss is reflected as other income and expense.





Property,
      plant and equipment are reviewed for impairment whenever events or changes
      in
      circumstances indicate that the carrying amount of an asset may not be
      recoverable pursuant to Statement of Financial Accounting Standards (SFAS)
      No.
      144, “ *Accounting
      for the Impairment or Disposal of Long-Lived Assets* ”.
      The
      various indicators leading to the testing of these long-lived assets include
      declines in revenues, a current cash flow loss combined with a forecast
      demonstrating continuing cash flow losses, current market conditions and
      competitive intrusion. The service potential of the assets includes assessment
      of future cash-flow-generating capacity, the remaining lives of the assets,
      the
      remaining term of the operating lease and evaluation of future cash flows
      associated with potential capital expenditures. The method for determining
      the
      fair value of impaired assets to be sold is based on its appraised fair market
      value or the value that a third party buyer would be willing to pay.
      Additionally, the Company accounts for restaurant closure costs pursuant to
      SFAS
      No. 146, “ *Accounting
      for Costs Associated with Exit or Disposal Activities* ”.













F-9








**MEXICAN
      RESTAURANTS, INC. AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**








In
      fiscal
      year 2006, the Company recorded asset impairments and restaurant closure costs
      of $1,375,956, of which $832,179 is included in discontinued operations. The
      remaining $543,777 in continuing operations related to the impairment of the
      assets of three under-performing restaurants, one of which was closed after
      its
      lease expired during the first quarter of fiscal year 2007, and real estate
      broker commissions related to the sale of one subleased restaurant and adjusted
      its accrual for two subleased restaurants.





In
      fiscal
      year 2005, the Company recorded asset impairment and restaurant closure costs
      of
      $790,708, all of which is included in discontinued operations related to the
      2005 closure of one restaurant.





In
      fiscal
      year 2004, the Company recorded asset impairment and restaurant closure costs
      of
      $868,580, of which $546,506 is included in discontinued operations. The $322,074
      of asset impairments included in continuing operations related primarily to
      three Tortuga restaurants that the Company wanted to position for re-concept
      to
      one of the Company’s other Mexican food concepts. Because of improved operating
      performance, the Company did not re-concept the three Tortuga restaurants in
      fiscal year 2005, but did close one other Tortuga restaurant in fiscal year
      2006. In addition, two Monterey’s restaurants, which were impaired in 2003 and
      2004, were closed during fiscal year 2006.





*(g)
      Balance Sheets of Discontinued Operations*





The
      following table summarizes the significant remaining assets and liabilities
      of
      discontinued operations:





2005
            
            2006Current
                assets
            
            $
            157,210
            
            $
            42,172Long-term
                assets
            
            
            462,033
            
            
            735Total
                assets
            
            $
            619,243
            
            $
            42,907Current
                liabilities
            
            $
            163,774
            
            $
            326,175Long-term
                liabilities
            
            
            706,339
            
            
            702,705Total
                liabilities
            
            $
            870,113
            
            $
            1,028,880





Current
      liabilities consist primarily of accrued closure costs. Long-term liabilities
      consist primarily of rent differential for closed restaurants for which the
      Company intends to sublease the restaurant.





*(h)
      Property Held for Sale*





Property
      held for sale is separately aggregated in the consolidated balance sheets and
      is
      recorded at the lower of cost or net realizable value. In fiscal year 2006,
      the
      Company sold its building in Chubbock, Idaho to its tenant. In fiscal year
      2005,
      the Company recorded an impairment charge of $29,800 related to the pending
      sale
      of the Pt. Arthur, Texas pad site that was acquired in the 2004 acquisition
      of
      13 restaurants from its Beaumont-based franchisee. The pad site was sold on
      April 4, 2006.





*(i)
      Goodwill and Other Intangible Assets*





Goodwill
      represents the excess of costs over fair value of assets of businesses acquired.
      The Company adopted the provisions of SFAS No. 142, “ *Goodwill
      and Other Intangible Assets”* ,
      as of
      January 1, 2002. Goodwill and intangible assets acquired in a purchase business
      combination and determined to have an indefinite useful life are not amortized,
      but instead tested for impairment at least annually in accordance with the
      provisions of SFAS No. 142. SFAS No. 142 also requires that intangible assets
      with estimable useful lives be amortized over their respective estimated useful
      lives to their estimated residual values, and reviewed for impairment in
      accordance with SFAS No. 144, “ *Accounting
      for Impairment or Disposal of Long-Lived Assets”* .













F-10








**MEXICAN
      RESTAURANTS, INC. AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**





At
      December 31, 2006 and January 1, 2006, the consolidated balance sheets included
      $11.4 million and $10.9 million, respectively of goodwill primarily resulting
      from the MAC, La Señorita and Beaumont-based franchisee acquisitions and the
      2006 acquisition of Mission Burritos. In connection with SFAS No. 142’s
      transitional goodwill impairment evaluation, the Statement required the Company
      to perform an assessment of whether there was an indication that goodwill is
      impaired as of the date of adoption. To accomplish this, the Company was
      required to identify its reporting units and determine the carrying value of
      each reporting unit by assigning the assets and liabilities, including the
      existing goodwill and intangible assets, to those reporting units as of January
      1, 2002. The Company was required to determine the fair value of each reporting
      unit and compare it to the carrying amount of the reporting unit within six
      months of January 1, 2002. To the extent the carrying amount of a reporting
      unit
      exceeded the fair value of the reporting unit, the Company would be required
      to
      perform the second step of the transitional impairment test, as this is an
      indication that the reporting unit goodwill may be impaired. For purposes of
      applying SFAS No. 142 impairment testing, the Company believes it is operating
      in one segment. Although each restaurant is measured and analyzed by Company
      management for performance, since the economic characteristics and operations
      are similar across restaurant concept lines, the reporting unit is considered
      to
      be equivalent to the
      Company’s operating segment. Management evaluated goodwill as required by SFAS
      No. 142 upon its adoption and annually as of January 1, 2006, and December
      31,
      2006. Management performed its goodwill impairment testing for each year and
      determined that the fair value exceeded the carrying amount of the reporting
      units and that no impairment of goodwill exists.




*(j)* *Impairment of Long-Lived Assets*





In
      accordance with Statement of Financial Accounting Standards No. 144,
“ *Accounting
      for the Impairments or Disposal of Long-Lived Assets* ”,
      long-lived assets, such as property, plant, and equipment, and purchased
      intangibles subject to amortization, are reviewed for impairment whenever events
      or changes in circumstances indicate that the carrying amount of an asset may
      not be recoverable. Recoverability of assets to be held and used is measured
      by
      a comparison of the carrying amount of an asset to estimated undiscounted future
      cash flows expected to be generated by the asset. If the carrying amount of
      an
      asset exceeds its estimated future cash flows, an impairment charge is
      recognized by the amount by which the carrying amount of the asset exceeds
      the
      fair value of the asset. Assets to be disposed of would be separately presented
      in the balance sheet and reported at the lower of the carrying amount or fair
      value less costs to sell, and are no longer depreciated. The assets and
      liabilities of a disposed group classified as held for sale would be presented
      separately in the appropriate asset and liability sections of the balance sheet.
      The revenues and expenses, as well as gains, losses, and impairments, from
      those
      assets are reported in the discontinued operations section of the consolidated
      statement of operations for all periods presented.




*(k)
      Deferred Rent Recognition*





The
      Company expenses lease rentals that have escalating rents on a straight line
      basis over the life of each lease pursuant to Statement of Financial Accounting
      Standards No. 13 “ *Accounting
      for Leases”* .
      Most of
      these lease agreements require minimum annual rent payments plus contingent
      rent
      payments based on a percentage of restaurant sales, which exceed the minimum
      base rent. Contingent rent payments, to the extent they exceed minimum payments,
      are accrued over the periods in which the liability is incurred. Incentive
      allowances provided by landlords under leasing arrangements are deferred as
      a
      liability and amortized to income as an adjustment to rent expense over the
      life
      of the lease.





(l *)
      Income Taxes*





Income
      taxes are provided based on the asset and liability method of accounting
      pursuant to Statement of Financial Accounting Standards (SFAS) No. 109,
“ *Accounting
      for Income Taxes”.* The
      Company provides for income taxes based on its estimate of federal and state
      liabilities. These estimates include, among other items, effective rates for
      state and local income taxes, allowable tax credits for items such as taxes
      paid
      on reported tip income, estimates related to depreciation and amortization
      expense allowable for tax purposes, and the tax deductibility of certain other
      items.





The
      Company’s estimates are based on the information available to it at the time
      that it prepares the income tax provision. The Company generally files its
      annual income tax returns several months after its fiscal year-end. Income
      tax
      returns are subject to audit by federal, state, and local governments, generally
      years after the returns are filed. These returns










F-11





**MEXICAN
      RESTAURANTS, INC. AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**





could
      be
      subject to material adjustments or differing interpretations of the tax laws.
      On
      May 19, 2006, the State of Texas passed a new law which revises the existing
      franchise tax by substantially changing the tax calculation and expanding the
      taxpayer base. This new law will take effect on January 1, 2008. If the new
      law
      had been in effect for fiscal 2006, the Company has determined that there would
      have been only a negligible effect on its state tax liability.





*(m)
      Revenue Recognition*





The
      Company records revenue from the sale of food, soft beverages and alcoholic
      beverages as products are sold. Franchise fee revenue from an individual
      franchise sale is recognized when all services relating to the sale have been
      performed and the restaurant has commenced operation. Initial franchise fees
      relating to area franchise sales are recognized ratably in proportion to
      services that are required to be performed pursuant to the area franchise or
      development agreements and proportionately as the restaurants within the area
      are opened. The Company’s current standard franchise agreement also provides for
      a royalty payment which is a percentage of gross sales. Royalty income is
      recognized as incurred.





Revenues
      from gift card sales are recognized upon redemption. Prior to redemption, the
      outstanding balances of all gift cards are included in accounts payable in
      the
      accompanying consolidated balance sheets.




*(n)
      Stock Options*





Effective
      January 2, 2006, the Company adopted SFAS No. 123 (Revised) “ *Share-Based
      Payments* ”
(SFAS
      No.123(R)) utilizing the modified prospective approach. Prior to the adoption
      of
      SFAS No. 123(R), the Company accounted for the equity-based compensation plans
      under the recognition and measurement provisions of Accounting Principles Board
      Opinion No. 25, Accounting for Stock Issued to Employees, and related
      interpretations (the intrinsic value method), and accordingly, did not recognize
      any compensation expense for stock option grants.




Under
      the
      modified prospective approach, SFAS No. 123(R) applies to new awards and to
      unvested awards that were outstanding on January 2, 2006, and those that are
      subsequently modified, repurchased or cancelled. Under the modified prospective
      approach, compensation cost recognized in the fiscal year ended December 31,
      2006 includes compensation cost for all unvested stock-based payments granted
      prior to adoption that vested during 2006, and compensation cost for all
      share-based payments granted subsequent to adoption, based on the grant-date
      fair value estimated in accordance with the provisions of SFAS No. 123(R).
      On
      May 23, 2006, the Company’s Board of Directors approved a restricted stock grant
      of 3,000 shares to each of the outside directors with ten years of service,
      with
      such grants vesting over a four year period. Two of the directors qualify for
      this restricted stock grant. There were no stock option awards granted in fiscal
      year 2006.





The
      fair
      value of each option award is estimated on the date of grant using the
      Black-Scholes-Merton option-pricing model, which uses the assumptions noted
      in
      the following table. Expected volatility is based on historical volatilities
      from stock traded. The Company uses historical data to estimate option exercises
      and employee terminations used in the model. In addition, separate groups of
      employees that have similar historical exercise behavior are considered
      separately. The expected term of options granted is derived using the
“simplified” method as allowed under the provisions of the Securities and
      Exchange Commission’s Staff Accounting Bulletin No. 107 and represents the
      period of time that options granted are expected to be outstanding. Management
      has estimated a forfeiture rate of 4% for these calculations. The risk-free
      interest rate for periods within the contractual life of the option is based
      on
      the U.S. Treasury yield curve in effect at the time of grant.





2005Risk-free
                interest rate
            4.05%Expected
                life,
                in years
            8.1Expected
                volatility
            28.3%Dividend
                yield
            0%





As
      a
      result of adopting SFAS No. 123(R) on January 2, 2006, income before income
      taxes, net income and diluted earnings per share for the year ended December
      31,
      2006, were lower by $63,508, $40,029, and $0.01 per share, respectively, than
      if
      the Company had continued to account for stock-based compensation under APB
      Opinion No. 25.






F-12


**MEXICAN
      RESTAURANTS, INC. AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**








The
      Company receives a tax deduction for certain stock option exercises during
      the
      period the options are exercised, generally for the excess of the price at
      which
      the options were sold over the exercise prices of the options. There were
      30,200, 121,472 and 104,375 stock options exercised (excluding the options
      purchased from the Company’s former President and CEO pursuant to the Separation
      Agreement. (See Note 5 (d)) in 2004, 2005 and 2006, respectively. The Company
      received cash in the amount of $111,591, $430,544 and $704,663, respectively,
      from the exercise of these options.





The
      following table illustrates the effect on net income and earnings per share
      if
      the Company had applied the fair value recognition provisions of SFAS No. 123(R)
      to options granted under the Company’s stock option plans for 2004 and 2005. For
      purposes of this pro forma disclosure, the value of the options is estimated
      using the Black-Scholes-Merton option-pricing model and amortized to expense
      over the options’ vesting periods.








**2004**
            
            **2005**Net
                income (loss) - as reported
            
            $
            1,760,974
            
            $
            2,316,997Less:
                Stock based compensation expense, determined under fair valuebased
                method for all awards, net of taxes
            
            
            (29,380
            )
            
            (85,467
            )Proforma
                net
                income (loss) - pro forma for SFAS No. 123
            
            
            1,731,594
            
            
            2,231,530Net
                income per share basic - as reported
            
            $
            0.52
            
            $
            0.68Net
                income per share diluted - as reported
            
            $
            0.48
            
            $
            0.63Pro
                forma net income per share basic
            
            $
            0.51
            
            $
            0.65Pro
                forma net income per share diluted
            
            $
            0.48
            
            $
            0.60





In
      conjunction with the Company’s 1996 initial public offering, the Company entered
      into warrant agreements with Louis P. Neeb, the Company’s President, and
      Tex-Mex Partners, a limited liability company in which a former member of the
      Board of Directors is a principal. The warrants to purchase 359,770 shares
      of
      common stock (179,885 each to Louis P. Neeb and Tex-Mex Partners), which had
      a
      $10.90 exercise price, were all exchanged on April 24, 2006 under agreements
      with the warrant holders that provided for the delivery of 11,638 shares of
      the
      Company’s common stock to each of Mr. Neeb and Tex-Mex Partners. The exchange
      rate was determined by the difference between a fifteen day simple trading
      average for the Common Stock from March 27, 2006 through April 15, 2006 (which
      average the parties agreed was $12.52) and the exercise price, resulting in
      a
      spread of $1.62, then divided by two.




*(o)
      Use of Estimates*





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





*(p)
      Insurance proceeds*





On
      September 24, 2005, Hurricane Rita hit the Gulf Coast area, affecting a number
      of the Company’s restaurants in that region. The Company subsequently hired an
      insurance consulting firm to assist management with the filing of its insurance
      claim. The final insurance claim was settled with the insurance company for
      losses and damages totaling $2.1 million after deductible.





The
      consolidated statements of operations for the years ended January 1, 2006 and
      December 31, 2006, includes a separate line item for gains of $471,622 and
      $366,808, respectively, resulting from assets damaged by Hurricane Rita and
      other expenses offset by insurance proceeds for the replacement of assets.
      The
      Company’s insurers paid $300,000 in the fourth quarter of 2005, $785,028 in the
      first quarter of 2006 and $426,822 in the fourth quarter of 2006 related to
      the
      property damage claim. Additionally, the Company has received $593,784 for
      business interruption proceeds.




There
      were no insurance claims recorded in 2004.









F-13





**MEXICAN
      RESTAURANTS, INC. AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**








*(q)
      Fair Value of Financial Instruments*





The
      carrying amount of receivables, accounts payable, and accrued expenses
      approximates fair value because of the immediate or short-term maturity of
      these
      financial instruments. The fair value of long-term debt is determined using
      current applicable rates for similar instruments and approximates the carrying
      value of such debt.





*(r)
      Recently Issued Accounting Standards*





In
      September 2006, the Financial Accounting Standards Board (FASB) issued Statement
      of Financial Accounting Standards (“SFAS”) No. 157, “ *Fair
      Value Measurements* ”.
      SFAS
      No. 157 defines fair value, establishes a framework for measuring fair value
      in
      generally accepted accounting principles (GAAP), and expands disclosures about
      fair value measurements. This statement applies under other accounting
      pronouncements that require or permit fair value measurements, the FASB having
      previously concluded in those pronouncements that fair value is the relevant
      measurement attribute. This Statement is effective for financial statements
      issued for fiscal years beginning after November 15, 2007 and interim periods
      within those fiscal years. The Company has not yet completed its evaluation
      of
      the impact of the adoption of SFAS No. 157, but presently it anticipates that
      its adoption will not have a material impact on its consolidated financial
      statements.




In June 2006, the Financial Accounting Standards Board released FASB
      Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes”.
      This Interpretation clarifies the accounting for uncertainty in income taxes
      recognized in a company’s financial statements in accordance with FASB Statement
      No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold
      and measurement attribute for the financial statement recognition and
      measurement of a tax position taken or expected to be taken in a tax return
      when
      it is more likely than not that the position would be sustained upon examination
      by the tax authorities. This Interpretation is effective for fiscal years
      beginning after December 15, 2006. The Company has not yet completed its
      evaluation of the impact of the recognition and measurement requirements of
      FIN
      48 on its existing tax positions, but presently it anticipates that its adoption
      will not have a material impact on its consolidated financial statements. FIN
      48
      also requires expanded disclosures including identification of tax positions
      for
      which it is reasonably possible that total amounts of unrecognized tax benefits
      will significantly change in the next twelve months, a description of tax years
      that remain subject to examination by major tax jurisdiction, a tabular
      reconciliation of the total amount of unrecognized tax benefits at the beginning
      and end of each annual reporting period, the total amount of unrecognized tax
      benefits that, if recognized, would affect the effective tax rate and the total
      amounts of interest and penalties recognized in the statements of operations
      and
      financial position.





*(s)
      Reclassifications*





Certain
      reclassifications have been made at January 2, 2005 and January 1, 2006 to
      conform with classifications at December 31, 2006. These reclassifications
      have
      no effect on the Company’s consolidated net income or financial position as
      previously reported.





(t *)
      Consolidated Statements of Cash Flows*





The
      Company has revised the Consolidated Statements of Cash Flows for 2004 and
      2005
      consistent with 2006 to reconcile net cash provided by operating activities
      from
      net income, instead of net income from continuing operations.





*(u)
      Advertising Expense*





Each
      year, the Company prepares a budget for advertising expenses to promote each
      of
      the Company’s restaurant brands. Prepaid advertising is deferred and amortized
      to expense based on estimates of usage. For fiscal years 2004, 2005 and 2006,
      the Company recorded advertising expense in continuing operations of $2,073,119,
      $2,247,505 and $2,363,303 which represents 2.8%, 2.9% and 2.9% of restaurant
      sales from continuing operations, respectively.













F-14





**MEXICAN
      RESTAURANTS, INC. AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**








**(2)
      Property, Plant and Equipment**





Property,
      plant and equipment at January 1, 2006 and December 31, 2006 are as
      follows:




**2005**
            
            **2006**Land
            
            $
            60,750
            
            $
            60,750Vehicles
            
            
            16,874
            
            
            16,874Equipment
                and
                Smallwares
            
            
            19,415,556
            
            
            20,458,161Leasehold
                Improvements
            
            
            11,988,063
            
            
            14,141,85931,481,243
            
            
            34,677,644Less:
                Accumulated Depreciation
            
            
            (15,315,864
            )
            
            (17,171,172
            )16,165,379
            
            
            17,506,472Construction
                in
                Progress
            
            
            29,962
            
            
            4,971Net
            
            $
            16,195,341
            
            $
            17,511,443








**(3)
      Long-term Debt**





Long-term
      debt consists of the following at January 1, 2006 and December 31,
      2006:





**2005**
            
            **2006**Term
                Note
            
            $
            2,500,000
            
            $
            --Revolving
                Line
                of Credit
            
            
            --
            
            
            3,300,000Other
                long-term debt
            
            
            3,000,000
            
            
            500,000Total
                long-term debt
            
            
            5,500,000
            
            
            3,800,000Less
                current installments
            
            
            (1,000,000
            )
            
            --Long-term
                debt,
                excluding current installments
            
            $
            4,500,000
            
            $
            3,800,000





During fiscal year 2006, the Company borrowed $800,000 on its Bank of America
      line of credit. As of December 31, 2006, the Company’s outstanding debt to Bank
      of America was $3.3 million and its outstanding debt on one seller note issued
      to its former franchisee in January 2004 was $500,000, for a total indebtedness
      of $3.8 million.





On
      January 7, 2004, Bank of America amended its $10.0 million credit facility
      to
      accommodate the acquisition of the Beaumont-based franchise restaurants. Part
      of
      the financing for the acquisition included $3.0 million in notes issued by
      Mexican Restaurants to the sellers. The seller notes pay interest for five
      years, with $1.5 million in principal due on January 7, 2009 and $1.5 million
      in
      principal amortizing over an additional five years. The Company prepaid $2.5
      million of the seller notes on March 31, 2006.




On
      April
      1, 2005, the Company and Bank of America amended the $10.0 million credit
      facility to accommodate the Company’s growth plans. The amendment allows for
      additional capital expenditures, revised certain covenant ratios, increased
      the
      amount of allowable stock repurchases, and extended the maturity date of the
      revolving line of credit to January 7, 2009. Effective June 30, 2005, the
      Company and Bank of America further amended the $10.0 million credit facility
      to
      revise certain ratios affected by Hurricane Rita and the Company’s stock
      repurchase program, and to lower the applicable interest rate
      margins.




On
      March
      29, 2007 the Company amended its credit facility with Bank of America changing
      its credit facility from a $10.0 million credit facility consisting of a $5.0
      million term note (remaining balance $1.5 million) and a $5.0 million













F-15


**MEXICAN
      RESTAURANTS, INC. AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**








revolving
      line of credit to a $7.5 million revolving line of credit, rolling the term
      note
      balance into the newly increased revolving line of credit. The revolving line
      of
      credit matures on December 31, 2011. The amendment allowed for additional
      capital expenditures, revised certain covenant ratios and increased the amount
      of allowable stock or vested option repurchases. The interest rate is either
      the
      prime rate or LIBOR plus a stipulated percentage. Accordingly, the Company
      is
      impacted by changes in the prime rate and LIBOR. The Company is subject to
      a
      non-use fee of 0.75% on the unused portion of the revolver from the date of
      the
      credit agreement. The Company has pledged the stock of its subsidiaries, its
      leasehold interests, its patents and trademarks and its furniture, fixtures
      and
      equipment as collateral for its credit facility with Bank of America. As of
      December 31, 2006, the Company was in compliance with all debt covenants, as
      amended, and expects to be in full compliance with all debt covenants during
      fiscal year 2007. The amendment was signed March 29, 2007 and was made effective
      December 31, 2006. The current portion of long-term debt, in the table above,
      at
      December 31, 2006 reflects the payment terms as amended.








Maturities
                on long-term debt are as follows:Year
                Ending2007
            
            $
            --2008
            
            
            --2009
            
            
            500,0002010
            
            
            --2011
            
            
            3,300,000Thereafter
            
            
            --$
            3,800,000


**(4)
      Income Taxes**





The
      provision (benefit) for income taxes from continuing operations is summarized
      as
      follows for fiscal years 2004, 2005 and 2006:





**2004**
            
            **2005**
            
            **2006**Current:Federal
            
            $
            488,022
            
            $
            641,329
            
            $
            723,495****State
                and local
            
            
            103,988
            
            
            135,727
            
            
            152,716Deferred
                (benefit)
            
            
            677,164
            
            
            697,550
            
            
            (27,109
            )$
            1,269,174
            
            $
            1,474,606
            
            $
            849,102





The
      benefit for income taxes from discontinued operations is summarized as follows
      for fiscal years 2004, 2005 and 2006:








**2004**
            
            **2005**
            
            **2006**Current:Federal
            
            $
            386,561
            
            $
            65,660
            
            $
            338,350State
                and local
            
            
            87,632
            
            
            16,762
            
            
            77,155Deferred
            
            
            24,078
            
            
            334,737
            
            
            35,136$
            498,271
            
            $
            417,159
            
            $
            450,641










The
      actual income tax expense differs from expected income tax expense calculated
      by
      applying the U.S. federal corporate tax rate to income before income tax expense
      from continuing operations as follows:






F-16





**MEXICAN
      RESTAURANTS, INC. AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**





**2004**
            
            **2005**
            
            **2006**Expected
                tax
                expenseFederal
            
            $
            1,304,961
            
            $
            1,520,147
            
            $
            932,883****State
                tax expense, net
            
            
            114,733
            
            
            130,655
            
            
            82,587Non-deductible
                amortization
            
            
            3,391
            
            
            3,391
            
            
            --Tax
                credits
            
            
            (159,005
            )
            
            (151,767
            )
            
            (178,931
            )Other
            
            
            5,094
            
            
            (27,820
            )
            
            12,563$
            1,269,174
            
            $
            1,474,606
            
            $
            849,102








The
      tax
      effects of temporary differences that give rise to significant portions of
      deferred tax assets and liabilities at January 1,2006 and December 31, 2006
      are
      as follows:








**2005**
            
            **2006**Deferred
                tax
                assets:Sale-leaseback
            
            $
            577,128
            
            $
            500,177Tax
                credit carryforwards
            
            
            472,385
            
            
            495,665Asset
                impairments
            
            
            561,794
            
            
            987,649Accrued
                expenses
            
            
            110,351
            
            
            239,288$
            1,721,658
            
            $
            2,222,779Deferred
                tax
                liabilities:Other
            
            $
            (8,160
            )
            $
            (99,808
            )Depreciation
                differences
            
            
            (1,457,224
            )
            
            (1,804,452
            )$
            (1,465,384
            )
            $
            (1,904,260
            )Net
                deferred taxes
            
            $
            256,274
            
            $
            318,519








At
      December 31, 2006, the Company determined that it was more likely than not
      that
      the deferred tax assets would be realized based on the level of historical
      taxable income and projections of future taxable income over the periods in
      which the deferred tax assets are deductible. At December 31, 2006, the Company
      has tax credit carryforwards of $495,665 which are available to reduce future
      Federal regular income taxes, if any, over an indefinite period.





**(5)
      Common Stock, Options and Warrants**




*(a)*
            *2005
                Long Term Incentive Plan*





The
      Board
      of Directors and shareholders of the Company have approved the Mexican
      Restaurants, Inc. 2005 Long Term Incentive Plan (the "2005 Plan"). The 2005
      Plan
      authorizes the granting of up to 350,000 shares of Common Stock in the form
      of
      incentive stock options and non-qualified stock options to key executives and
      other key employees of the Company, including officers of the Company and its
      subsidiaries. The purpose of the 2005 Plan is to benefit and advance the
      interests of the Company by attracting and retaining qualified directors and
      key
      executive and managerial employees; motivating employees, by making appropriate
      awards, to achieve long-range goals; providing incentive compensation that
      is
      competitive with other corporations; and further aligning the interests of
      directors, employees and other participants with those of other shareholders.
      It
      is anticipated that the 350,000 shares proposed to be authorized under the
      2005
      Plan, together with the shares remaining under the 1996 Long Term Incentive
      Plan, will enable the Company to provide sufficient grants of awards for the
      foreseeable future. Also, the inclusion of authority to grant various forms
      of
      equity compensation in addition to stock options, including restricted stock,
      will allow the Company to tailor future awards to the Company’s specific needs
      and circumstances at that time.






F-17


**MEXICAN
      RESTAURANTS, INC. AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**







*(b)
      1996 Long Term Incentive Plan*




The
      Board
      of Directors and shareholders of the Company have approved the Mexican
      Restaurants, Inc. 1996 Long Term Incentive Plan (the "Incentive Plan"). The
      Incentive Plan, as amended, authorizes the granting of up to 500,000 shares
      of
      Common Stock in the form of incentive stock options and non-qualified stock
      options to key executives and other key employees of the Company, including
      officers of the Company and its subsidiaries. The purpose of the Incentive
      Plan
      is to attract and retain key employees, to motivate key employees to achieve
      long-range goals and to further align the interests of key employees with those
      of the other shareholders of the Company. Options granted under the Incentive
      Plan will generally vest and become exercisable at the rate of 10% on the first
      anniversary of the date of grant, 15% on the second anniversary of


the
      date
      of grant, and 25% on each of the third through fifth anniversaries of the date
      of grant. All stock options granted pursuant to the 1996 Long Term Incentive
      Plan will be nonqualified stock options and will remain exercisable until the
      earlier of ten years from the date of grant or no more than 90 days after the
      optionee ceases to be an employee of the Company.





*(c)*  *Stock
      Option Plan for Non-Employee Directors*




The
      Company has adopted the Mexican Restaurants, Inc. Stock Option Plan for
      Non-Employee Directors (the “Directors Plan”) for its outside directors and has
      reserved 200,000 shares of Common Stock for issuance thereunder. The Directors
      Plan provides that each outside director will automatically be granted an option
      to purchase 10,000 shares of Common Stock at the time of becoming a director.
      These options will be exercisable in 20% increments and will vest equally over
      the five-year period from the date of grant. Such options are priced at the
      fair
      market value at the time an individual is elected as a director. Until the
      third
      quarter of fiscal year 2002, each outside director received options to purchase
      1,500 shares of Common Stock quarterly, plus additional options for attendance
      at committee meetings, exercisable at the fair market value of the Common Stock
      at the close of business on the date immediately preceding the date of grant.
      Such annual options will vest at the conclusion of one year, so long as the
      individual remains a director of the Company. All stock options granted pursuant
      to the Directors Plan will be nonqualified stock options and will remain
      exercisable until the earlier of ten years from the date of grant or six months
      after the optionee ceases to be a director of the Company.





As
      of the
      third quarter of fiscal year 2002, compensation for each outside director was
      changed from quarterly options to cash payments of $2,500 per quarter and $1,250
      per board meeting attended. The chairman of the audit committee receives
      compensation of $6,250 per quarter.




During
      fiscal year 2006, the Company’s employees exercised 104,375 stock options in the
      open market. The Company received $704,663 in exchange for 104,375 shares of
      common stock that was previously held as Treasury stock. During fiscal year
      2005, the Company’s employees exercised 121,472 stock options in the open
      market. The Company received $430,544 in exchange for 121,472 shares of common
      stock that was previously held as Treasury stock. During
      fiscal year 2004, one director exercised 30,200 of his options in the open
      market. The Company received $111,591 in exchange for 30,200 shares of common
      stock that was previously held as Treasury stock.





In
      December 2006, in connection with the Separation Agreement with the Company’s
      President and CEO, an aggregate cash payment of $596,764 was made with respect
      to his vested stock options.





*(d)* **** *1996
      Manager’s Stock Option Plan*





The
      Company has adopted the 1996 Manager’s Stock Option Plan (the “Manager’s Plan”)
      specifically for its store-level managers. The Manager’s Plan authorizes the
      granting of up to 200,000 shares of Common Stock in the form of non-qualified
      stock options to store-level managers of the Company. The purpose of the
      Manager’s Plan is to attract, retain and motivate restaurant managers to achieve
      long-range goals and to further align the interests of those employees with
      those of the other shareholders of the Company. Options granted under the
      Manager’s Plan will generally vest and become exercisable at the rate of 10% on
      the first anniversary of the date of grant, 15% on the second anniversary of
      the
      date of grant, and 25% on each of the third through fifth anniversaries of
      the
      date of grant. All stock options granted pursuant to the 1996 Manager’s Stock
      Option Plan will be nonqualified stock options and will remain exercisable
      until
      the earlier of ten years from the date of grant or no more than 90 days after
      the optionee ceases to be an employee of the Company.










F-18


**MEXICAN
      RESTAURANTS, INC. AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**








*(e)*
            *Warrants*





In
      conjunction with the Company’s 1996 initial public offering, the Company entered
      into warrant agreements with Louis P. Neeb and Tex-Mex Partners, a limited
      liability company in which a former member of the Board of Directors is a
      principal. The warrants to purchase 359,770 shares of common stock (179,885
      each
      to Louis P. Neeb and Tex-Mex Partners), which had a $10.90 exercise price,
      were
      all exchanged on April 24, 2006 under agreements with the warrant holders that
      provided for the delivery of 11,638 shares of the Company’s common stock to each
      of Mr. Neeb and Tex-Mex Partners. The exchange rate was determined by the
      difference between a fifteen day simple trading average for the Common Stock
      from March 27, 2006 through April 15, 2006 (which average the parties agreed
      was
      $12.52) and the exercise price, resulting in a spread of $1.62, then divided
      by
      two.





*(f)
      Stock Transactions*





During
      1999 and 2000 the Company authorized the granting of 64,000 shares of restricted
      stock to key executives. The awards were valued at an average of $3.50 per
      share
      and will vest in 20% increments over a five year period from the date of the
      grant. Compensation expense of $41,304 and $6,303 was recognized in fiscal
      years
      2004 and 2005 respectively.





On
      May 9,
      2005, the Company announced its plan to implement a limited stock repurchase
      program in a manner permitted under its bank financing agreement. Under this
      program, the Company could spend up to $1.0 million over the next 12 months
      (not
      to exceed $500,000 in any one quarter) to repurchase outstanding shares of
      its
      common stock. On September 7, 2005, the Company’s Board of Directors approved an
      increase of $1.0 million to its stock repurchase program announced on May 9,
      2005.  During
      fiscal year 2006, the Company repurchased 25,290 shares of common stock for
      $261,730. During fiscal year 2005, the Company repurchased 181,300 shares of
      common stock for $1,738,267. During fiscal year 2004, the Company did not
      repurchase any of its common shares. The Company has purchased the aggregate
      amount of shares permitted under the program.








*(g)
                Option and Warrant Summary*
            
            
            
            Weighted
                AverageShares
            
            Exercise
                PriceBalance
                at January 2, 2005:Granted
            
            
            --
            
            $
            --Exercised
            
            
            30,200
            
            
            3.70Canceled
            
            
            22,500
            
            
            7.36976,270
            
            $
            6.96Balance
                at January 1, 2006:Granted
            
            
            260,000
            
            $
            12.00Exercised
            
            
            121,472
            
            
            3.54Canceled
            
            
            10,750
            
            
            5.681,104,048
            
            $
            8.54Balance
                at December 31, 2006:Granted
            
            
            --
            
            $
            --Exercised
                --
                warrants
            
            
            359,770
            
            
            10.90Exercised
                --
                options
            
            
            217,278
            
            
            5.98Canceled
            
            
            110,000
            
            
            7.22417,000
            
            $
            8.19













F-19








**MEXICAN
      RESTAURANTS, INC. AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**





The
      417,000 options outstanding at December 31, 2006 had exercise prices ranging
      between $2.50 to $12.00, of which 247,000 of the options had exercise prices
      ranging from $8.63 to $12.00. As of December 31, 2006, 403,281 options were
      exercisable at an average price of $8.35.





The
      Company did not grant any options or warrants in 2004 and 2006 and the options
      granted in 2005 were fully vested.





*(h)
      Income Per Share*





Basic
      income per share is based on the weighted average shares outstanding without
      any
      dilutive effects considered. Prior to the adoption of Statement of Financial
      Accounting Standard No. 123-R, diluted income per share recognized the dilution
      from all contingently issuable shares, including options and warrants. For
      fiscal years 2004 and 2005, the effect of dilutive stock options increased
      the
      weighted average shares outstanding by 246,360 and 285,070 shares respectively.
      For fiscal year 2004 and 2005, such stock options and warrants did affect the
      determination of diluted income by $0.04 and $0.05 per share respectively.
      454,570 and 405,870 options and warrants were considered antidilutive for fiscal
      years 2004 and 2005 respectively. The options and warrants that are considered
      antidilutive have a grant price that exceeded the market price as of the end
      of
      each fiscal year.





Since
      the
      adoption of SFAS No. 123-R in fiscal year 2006, diluted income per share is
      calculated using the treasury stock method, which considers unrecognized
      compensation expense as well as the potential windfall tax benefits that reflect
      the current market price and total compensation expense to be recognized under
      SFAS No. 123-R. If the sum of the assumed proceeds, including the unrecognized
      compensation costs calculated under the treasury stock method, exceeds the
      average stock price, those options would be considered antidilutive and
      therefore excluded from the calculation of diluted income per share. For fiscal
      year 2006, the incremental shares added in the calculation of diluted income
      per
      share were 119,380, which affected the determination of diluted income by
      approximately $0.01 per share.




**(6)
      Leases**





The
      Company leases restaurant operating space and equipment under non-cancelable
      operating leases which expire at various dates through January 31,
      2024.





The
      restaurant operating space base agreements typically provide for a minimum
      lease
      rent plus common area maintenance, insurance, and real estate taxes, plus
      additional percentage rent based upon revenues of the restaurant (generally
      2%
      to 7%) and may be renewed for periods ranging from five to twenty-five
      years.





On
      June
      25, 1998, the Company completed a sale-leaseback transaction involving the
      sale
      and leaseback of land, building and improvements of 13 company-owned
      restaurants. The properties were sold for $11.5 million and resulted in a gain
      of approximately $3.5 million that was deferred and is amortized over the terms
      of the leases, which are 15 years each. The deferred gain at January 1, 2006
      and
      December 31, 2006 was $1,561,070 and $1,352,927, respectively. The leases are
      classified as operating leases in accordance with Statement of Financial
      Accounting Standards (SFAS) No. 13 “ *Accounting
      for Leases* ”.
      Subsequent to the original transaction, two leases were sold. The remaining
      11
      leases have a total future minimum lease obligation of approximately $7,475,681
      and are included in the future minimum lease payment schedule
      below.





Future
      minimum lease payments (which includes the two closed restaurants scheduled
      below) under non-cancelable operating leases with initial or remaining lease
      terms in excess of one year as of December 31, 2006 are
      approximately:





















F-20





**MEXICAN
      RESTAURANTS, INC. AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**








Year
                Ending2007
            
            $
            5,556,9322008
            
            
            5,341,2822009
            
            
            5,196,2642010
            
            
            4,737,2672011
            
            
            4,391,390Thereafter
            
            
            24,489,600$
            49,712,735





On
      May 4,
      2006, the Company was released from its lease obligations at one of the three
      Idaho restaurants when the third party operator purchased the building from
      the
      landlord.





The
      two
      remaining Idaho restaurants (which are included in the table above) have been
      subleased to third party restaurant operators. One of the subtenants has two
      five year options to extend its lease. The other subtenant extended its lease
      during 2006 for 77 months which corresponds with the base lease terms. Future
      minimum lease receipts under non-cancelable operating leases with initial or
      remaining lease terms in excess of one year as of December 31, 2006 are
      approximately:





Year
                Ending2007
            
            $
            210,1502008
            
            
            199,9502009
            
            
            113,0402010
            
            
            115,2962011
            
            
            117,564Thereafter
            
            
            181,050$
            937,050





Total
      rent expense for restaurant operating space and equipment amounted to
      $5,964,086, $6,103,154 and $6,164,216 for the fiscal years 2004, 2005 and 2006,
      respectively.





**(7)**
            **Acquisition**





On
      January 7, 2004, the Company completed its purchase of 13 restaurants and
      related assets from its Beaumont-based franchisee for a total consideration
      of
      approximately $13.75 million. The financing for the acquisition was provided
      by
      Bank of America (formerly Fleet National Bank), CNL Franchise Network, LP
      (“CNL”) and the sellers of the Beaumont-based franchise restaurants. Bank of
      America (formerly Fleet National Bank) provided $3.1 million of the acquisition
      financing by amending its existing credit facility with Mexican Restaurants,
      Inc. Six of the acquired restaurants were concurrently sold to CNL for $8.325
      million in a sale-leaseback transaction. The sellers accepted $3.0 million
      in
      notes from Mexican Restaurants, Inc. for the balance of the purchase price.
      The
      Company prepaid $2.5 million in fixed rate notes on March 31, 2006 by borrowing
      from our Bank of America credit facility. The remaining seller note requires
      the
      payment of interest only for five years, with $500,000 principal due on January
      7, 2009.





The
      acquisition was accounted for under SFAS No. 141 and results of operations
      are
      included in the accompanying financial statements from the date of acquisition.
      The assets acquired and liabilities assumed of the acquisition were recorded
      at
      estimated fair values using comparables, appraisals, and records.




A
      summary
      of the assets acquired and liabilities assumed in the acquisition
      follow:










F-21








**MEXICAN
      RESTAURANTS, INC. AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**











Estimated
                fair
                value of assets acquired:Current
                assets
            
            $
            184,601Property
                and
                equipment
            
            
            2,946,365Other
                assets
            
            
            175,000Goodwill
            
            
            3,283,916Total
                assets
            
            $
            6,589,882Less:
                Cash acquired
            
            
            (35,150
            )Net
                assets acquired
            
            $
            6,554,732





On
      October 14, 2004, the Company completed its purchase of one franchise restaurant
      in Brenham, Texas for approximately $215,000, which included $164,509 classified
      as goodwill. The restaurant was closed, remodeled and re-opened on November
      22,
      2004.





On
      August
      17, 2006, the Company completed its purchase of two Houston-area Mission
      Burritos restaurants and related assets for a total consideration of
      approximately $725,000, excluding acquisition costs. The acquisition was
      accounted for under Statement of Financial Accounting Standard No. 141 *Business
      Combinations* and
      results of operations are included in the accompanying financial statements
      from
      the date of acquisition. The assets acquired and liabilities assumed of the
      acquisition were recorded at estimated fair values using comparables,
      appraisals, and other supporting documentation.





A
                summary of the assets acquired and liabilities assumed in the acquisition
                follow:








Estimated
                fair
                value of assets acquired:Current
                assets
            
            $
            19,355Property
                and
                equipment
            
            
            233,500Goodwill
            
            
            501,141Total
                assets
            
            $
            753,996Less:
                Liabilities assumed
            
            
            (906
            )Cash
                acquired
            
            
            (10,600
            )Net
                assets acquired
            
            $
            742,490






**(8)**
            **401(k)
                Plan**





Beginning
      in fiscal year 1998, the Company established a **** defined
      contribution 401(k) plan that covers substantially all full-time employees
      meeting certain age and service requirements. Participating employees may elect
      to defer a percentage of their qualifying compensation as voluntary employee
      contributions. The Company may contribute additional amounts at the discretion
      of management. The Company did not make any contributions to the plan in fiscal
      years 2004, 2005 and 2006.





**(9)**
            **Related
                Party Transactions**





The Company leased its executive offices from a company owned by two
      shareholders of Mexican Restaurants, Inc. Net lease expense related to these
      facilities in fiscal 2004 was $10,416. The building was sold to a non-related
      party on February 20, 2004.




The
      Company provides accounting and administrative services for the Casa Olé Media
      and Production Funds. The Casa Olé Media and Production Funds are
      not-for-profit, unconsolidated entities used to collect money from company
      -owned and franchise-owned restaurants to pay for the marketing of Casa Olé
restaurants. Each restaurant contributes an agreed upon percentage of its sales
      to the funds.







F-22





**MEXICAN
      RESTAURANTS, INC. AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**








**(10)**
            **Contingencies**





The
      Company has litigation, claims and assessments that arise in the normal course
      of business. Management believes that the Company’s financial position or
      results of operations will not be materially affected by such
      matters.





On
      August
      15, 2005, the Company issued performance units under the 2005 Plan. As of
      December 31, 2006, there were 260,000 performance units outstanding. The
      performance units, of which 240,000 expire August 2010 and 20,000 expire
      February 2011, vest upon a Business Combination (as defined in the 2005 Plan)
      and are payable in cash in an amount equal to the product of the number of
      units
      vested and the average of the high and low prices of the Common Stock as of
      the
      last business day preceeding the Business Combination, which average price
      must
      be in excess of $20.00 per share.





**(11)**
            **Selected
                Quarterly Financial Data
                (Unaudited)**





The
      unaudited quarterly results for the fiscal year ended January 1, 2006 and
      December 31, 2006 were as follows (in thousands, except per share
      data):





(Restated)Fiscal
                Year 2005 Quarter Ended**January
                01**
            
            **October
                2**
            
            **July
                3**
            
            **April
                3**Revenues
            
            $
            20,193
            
            $
            19,030
            
            $
            19,638
            
            $
            19,269Income
                from continuing operations
            
            
            1,680
            
            
            89
            
            
            531
            
            
            696Loss
                from discontinued operations
            
            
            (571
            )
            
            (58
            )
            
            (29
            )
            
            (21
            )Net
                income
            
            $
            1,108
            
            $
            31
            
            $
            502
            
            $
            675Basic
                income per shareIncome
                from continuing operations
            
            $
            0.50
            
            $
            0.03
            
            $
            0.16
            
            $
            0.21Loss
                from discontinued operations
            
            
            (
                0.17
            )
            
            (
                0.02
            )
            
            (0.01
            )
            
            (
                0.01
            )Net
                income
            
            $
            0.33
            
            $
            0.01
            
            $
            0.15
            
            $
            0.20Diluted
                income per shareIncome
                from continuing operations
            
            $
            0.46
            
            $
            0.03
            
            $
            0.15
            
            $
            0.19Loss
                from discontinued operations
            
            
            (
                0.16
            )
            
            (0.02
            )
            
            (
                0.01
            )
            
            (
                0.01
            )Net
                income
            
            $
            0.30
            
            $
            0.01
            
            $
            0.14
            
            $
            0.18








(Restated)Fiscal
                Year 2006 Quarter Ended**December
                31**
            
            **October
                1**
            
            **July
                2**
            
            **April
                2**Revenues
            
            $
            19,951
            
            $
            20,379
            
            $
            20,999
            
            $
            20,935Income
                (loss) from continuing operations
            
            
            (382
            )
            
            444
            
            
            1,042
            
            
            790Loss
                from discontinued operations
            
            
            (628
            )
            
            (69
            )
            
            (35
            )
            
            (24
            )Net
                income (loss)
            
            $
            (1,009
            )
            $
            375
            
            $
            1,006
            
            $
            766Basic
                income per shareIncome
                (loss) from continuing operations
            
            $
            (0.12
            )
            $
            0.13
            
            $
            0.31
            
            $
            0.24Loss
                from discontinued operations
            
            
            (0.18
            )
            
            (0.02
            )
            
            (0.01
            )
            
            (0.01
            )Net
                income (loss)
            
            $
            (0.30
            )
            $
            0.11
            
            $
            0.30
            
            $
            0.23Diluted
                income per shareIncome
                (loss) from continuing operations
            
            $
            (0.12
            )
            $
            0.12
            
            $
            0.28
            
            $
            0.22Loss
                from discontinued operations
            
            
            (0.18
            )
            
            (0.02
            )
            
            (0.01
            )
            
            (0.01
            )Net
                income (loss)
            
            $
            (0.30
            )
            $
            0.10
            
            $
            0.27
            
            $
            0.21






F-23