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





For the Fiscal Year Ended December 30,
2007





OR





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





















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:





Title of Each
      Class
            Name of Each Exchange
      on Which RegisteredCommon
      Stock
            Nasdaq
      Stock Market LLC





Securities
registered pursuant to Section 12(g) of the Act:  None





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     þ     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, a non-accelerated filer or a smaller reporting
company.  See the definitions of "accelerated filer”, “large
accelerated filer" and “smaller reporting company” in Rule 12b-2 of the
Exchange Act.




Large
accelerated filer  ̈                                                   Accelerated
filer  ̈                                           Non-accelerated
filer ý          Smaller
reporting company  ̈




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 July 1, 2007, the last business day of the
Registrant’s most recently completed second quarter, was $8,146,834. 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 24, 2008:
3,247,016 shares of Common Stock, par value $.01.





DOCUMENTS
INCORPORATED BY REFERENCE





Specified
portions of the Company’s definitive proxy statement in connection with the 2008
Annual Meeting of Shareholders to be held May 28, 2008, 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
            
            PageSpecial 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
            15Part
      IIItem 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
            27Item 8.
            Financial Statements and Supplementary
    Data
            28Item 9.
            Changes in and Disagreements with Accountants on Accounting
      and Financial Disclosure
            28Item 9A.
            Controls and Procedures
            28Item 9B.
            Other Information
            29Part
      IIIItem 10.
            Directors and Executive Officers of the Registrant and
      Corporate Governance
            29Item 11.
            Executive Compensation
            29Item 12.
            Security Ownership of Certain Beneficial Owners and
      Management and Related Shareholder Matters
            29Item 13.
            Certain Relationships and Related Transactions and Director
      Independence
            29Item 14.
            Principal Accountant Fees and Services
            29Part
      IVItem 15.
            Exhibits and Financial Statement
    Schedules
            30




















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 that
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 this 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 full-service
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® and Crazy
Jose’s®.  The Company also operates a burrito fast casual concept
under the name Mission BurritoTM.  The Casa Olé, Monterey,
Tortuga, La Señorita, Crazy Jose’s and Mission Burrito concepts have been in
business for 36, 53, 14, 29, 21 and 11 years, respectively.  Today the
Company operates 58 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 Burrito
restaurants, which are also designed to appeal to a broad range of customers,
are located primarily in the Houston market.  The restaurants offer
fresh, quality food, affordable prices, friendly service and comfortable
surroundings.  The full-service 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 Mission
Burrito restaurants offer freshly made burritos, tacos, quesadillas, soups,
salads, and chips with guacamole and/or chili con queso.   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-theme and the burrito fast casual restaurant markets 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”), which at the time of
the acquisition 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 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 from its
Beaumont-based franchisee and affiliates for a total consideration of
approximately $13.75 million.





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 Burrito restaurants, a burrito fast casual concept, 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 regional, value leader in the Mexican theme segment of the casual
dining marketplace and as a regional player in the burrito fast casual
segment.  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:








4







Ÿ
            Offering
      consistent, high-quality, original recipe Mexican menu items that reflect
      both national and local taste
preferences;





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 the menu items are prepared daily
in the kitchen of each restaurant from original recipes.





The casual dining menus feature a wide
variety of entrees including enchiladas, combination platters, burritos,
fajitas, coastal seafood and other house specialties.  The menus also
include 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 from less than 5% of sales at its more family-oriented
locations to up to 20% in its more casual-oriented dining
locations.  At Company-owned restaurants the dinner menu entrees
presently range in price from $4.99 to $23.99, with most items priced between
$6.65 and $12.99.  Lunch prices at most Company-owned restaurants
presently range from $4.95 to $8.49.





The burrito fast casual menu features a
more limited variety of entrees including burritos (wrapped in flour tortilla or
in a bowl), tacos, quesadillas, soups, salads, chips with guacamole and/or chili
con queso.  The menu entrees presently range in price from $2.75 to
$7.75.  Alcoholic beverages are served as a complement to meals and
represent less than 2% of sales.





Atmosphere and
Layout.  The Company’s full-services restaurants emphasize 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 restaurant’s
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 Company’s two fast-casual Mission
Burrito restaurants are approximately 2,000 and 3,000 square feet,
respectively.  Both restaurants have extensive patios that offer
additional outdoor seating.  The Company has developed a prototype
Mission Burrito design that is approximately 2,750 square feet with an indoor
seating capacity of approximately 80.  The new prototype also includes
a patio that offers additional outdoor seating.  The interior decor
has a casual dining atmosphere that distinguishes it from other burrito
concepts.  The design is sufficiently flexible to accommodate a
variety of available sites and development opportunities; however, the Company
will focus mostly on end-caps of shopping centers, town centers and life style
centers developments.





Growth
Strategy





Over the last four fiscal years, the
Company has focused its energies to assimilate two acquisitions (13 restaurants
bought in 2004 from a franchisee and two Mission Burrito restaurants acquired in
2006), to develop new prototypes for our Casa Olé and Monterey’s restaurants and
to initiate a program of remodeling several of our existing restaurants each
year.










5


In August 2006 the Company acquired two
burrito fast-casual Mission Burrito restaurants located in Houston,
Texas.  The concept was established eleven years ago and has a very
loyal customer base.  Since the Mission Burrito acquisition, the
Company has spent considerable time and attention planning for the future growth
and positioning of the concept.  During fiscal year 2007, the Company
hired a senior vice president to lead the growth of Mission Burrito and a senior
marketing consultant to work exclusively on building the Mission Burrito
brand.  In February 2008, the Company opened its first Mission Burrito
prototype in Katy, Texas.  The restaurant is approximately 2,750 s.f.
and cost approximately $525,000, net of landlord contributions.  To
date, sales have exceeded expectations.





For the foreseeable future, the Company
has decided to focus its growth primarily on Mission Burrito.  If the
new prototype is any indication, the cost of building a Mission Burrito will be
approximately 65% of the cost of building a new Casa Olé
restaurant.  Although it will be a few years before the Company can
measure the actual cash on cash return on investment, based on the prototype
cost and the sales forecast, the Company believes the Mission Burrito concept
will provide a better return on investment than building either Casa Olé or
Monterey’s restaurants.  In fiscal year 2008, the Company plans to
open three Mission Burrito restaurants and lay the groundwork for opening five
in fiscal year 2009.





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, provides 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 goal 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).  Substantial increases in commodity
costs, repair and maintenance and property and casualty insurance premiums 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 fiscal year
2008.  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.





During fiscal year 2008, the Company’s
goal is to improve 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 (see “Franchising”
below).  Although the Company is focused primarily on growing the
Mission Burrito concept, the Company will continue to review potential strategic
acquisitions within the Mexican food restaurant industry that would complement
its 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.






6





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 2007, the Company did not open new
restaurants but did extensively remodel one restaurant and modestly remodeled or
made improvements to three existing restaurants.  The Company plans to
build and open three new Mission Burrito restaurants in fiscal year 2008, as
well as significantly remodel one existing restaurant.





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 Mission Burrito
restaurants in fiscal year 2008.  The anticipated investment for a
2,750 square foot restaurant lease space, including equipment, signage, site
work, furniture, fixtures and decor ranges between $500,000 and
$600,000.  Additionally, training and other pre-opening costs are
anticipated to approximate $25,000 to $35,000 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 $500,000 and $600,000,
there can be no assurance of this.





Restaurant
Operations





Management and
Employees.The management staff of
each casual dining 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 management staff of each Mission
Burrito restaurant is responsible for managing the restaurant's
operations.  Each restaurant operates with a general manager and one
or more assistant managers.  Including managers, restaurants have an
average of 20 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.





7




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 30, 2007, the Company
employed 2,395 people, of whom 2,333 were restaurant personnel at the
Company-owned restaurants and 62 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.





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 2007, the Company spent approximately 3.1%
of restaurant revenues on various forms of advertising and plans to spend a
comparable amount in fiscal year 2008.  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 nine
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
2007, but one company-owned restaurant was sold to Larry Forehand, a Director
and Vice Chairman of the Company’s Board of Directors.  See “Footnote
(10) Related Party Transactions".





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.





8


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 2008 to 2015.  The Company is updating its Franchise
Agreement.  Under the new Franchise Agreements, the termination dates
will range from 2008 to 2018.  There are five franchises that are
currently on a month-to-month basis until we have approved the new Franchise
Agreement.





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".





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.







9





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, fast casual 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.





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.  If the Company fails to comply with existing or future
laws and regulations, it could be subject to governmental or judicial fines or
sanctions.    The Company believes that it is operating in
substantial compliance with applicable laws and regulations that govern its
operations. 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.





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.








10


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 Burrito” 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 furnishes 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.





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.





Cost Pressures
May Adversely Impact Our Net Income.The Company believes
that certain cost pressures impacted net income during fiscal year
2007.  Substantial increases in food commodity prices, repair and
maintenance 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 cost pressures in 2008.  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.





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.  On July 24, 2007, the federal minimum wage
increased from $5.15 to $5.85 per hour.  The Company estimated that
the increase in the federal minimum wage impacted labor cost approximately
$7,000 per week.  Future federal minimum wage increases are scheduled
to increase to $6.55 per hour on July 24, 2008 and to $7.25 per hour on July 24,
2009.  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.





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 Ben E. Keith Company as the primary  distributor
of our ingredients.  Ben E. Keith Company is a privately held
corporation that is part of a cooperative of independent food distributors
(Unipro) located throughout the nation. The Company has an exclusive contract
with Ben E. Keith 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 Ben E. Keith
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.





11


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 2007, 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
2007.  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.





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.





An
Increase In Our Interest Rates May Adversely Impact Net
Income. We are subject to interest rate fluctuations
under the terms of our outstanding bank debt with Wells Fargo Bank,
N.A.   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 30, 2007, the
Company had $6.4 million outstanding on our credit facility with Wells
Fargo.





Our Financial
Covenants Could Adversely Affect Our Ability to Borrow.  Under
our current credit agreement with Wells Fargo Bank, N.A., the Company is subject
to certain reporting requirements and financial covenants, including
requirements that the Company maintain various financial ratios.  As
of December 30, 2007, the Company was in compliance with all debt
covenants.  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”.





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 64.8% of our Common Stock and rights to
acquire Common Stock are beneficially owned or held by Larry N. Forehand, The D3
Family Funds (with which Cara Denver, one of our directors, is affiliated),
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.








12





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.





Changes in
General Economic and Political Conditions Affect Consumer Spending and May Harm
Our Revenues and Operating Results.  With a few exceptions,
most of the restaurant industry’s casual dining segment experienced a slow down
or negative same-store sales and tighter profit margins in 2007.  The
forecast for 2008 continues to be cautious, calling for an economic slow-down or
recession.  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.













13





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.





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 2007, 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 2008 or fiscal
year 2009.  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 2007, the Company subleased a
previously closed restaurant and assigned one lease as part of the sale of one
company-owned restaurant to Larry Forehand, a Director and Vice Chairman of the
Company’s Board of Directors.  See “Footnote (10) Related Party
Transactions".





During fiscal year 2007, the Company
did not open any new restaurants.  The Company did, however,
extensively remodel one existing restaurant and modestly remodeled or made
improvements to three existing restaurants.





14


Restaurant
Locations





At December 30, 2007, the Company had
58 Company-operated restaurants, 18 franchise restaurants and one licensed
restaurant.  As of such date, the Company operated and franchised 42
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
11 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 at December 2007
is summarized below:








Casa OléCompany-operated
            29
            LeasedFranchisee-operated
            17Concept
      total
            46Monterey’s Tex-Mex CaféCompany-operated
            5
            LeasedConcept
      total
            5Monterey’s Little MexicoCompany-operated
            10
            LeasedLicensee-operated
            1Concept
      total
            11Tortuga Coastal CantinaCompany-operated
            4
            LeasedConcept
      total
            4La SeñoritaCompany-operated
            5
            LeasedFranchisee-operated
            1Concept
      total
            6Crazy Jose’sCompany-operated
            3
            LeasedConcept
      total
            3Mission BurritoCompany-operated
            2
            LeasedSystem
      total
            77








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 30, 2007.




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 24, 2008, the closing price of the Company’s Common Stock as  reported
on the Nasdaq Small Cap Market was $5.85.  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 2005 fiscal year.




15





HIGH
            
            LOWFiscal
      Year 2008:First
      Quarter (through March 24, 2008)
            6.51
            
            5.11Fiscal
      Year 2007:First
      Quarter (ended April 1, 2007)
            11.70
            
            9.32Second
      Quarter (ended July 1, 2007)
            9.60
            
            7.60Third
      Quarter (ended September 30, 2007)
            8.37
            
            6.36Fourth
      Quarter (ended December 30, 2007)
            7.57
            
            4.75




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





Performance
Graph





The
following Performance Graph and related information shall not be deemed
“soliciting material” or to be “filed” with the Securities and Exchange
Commission, nor shall such information be incorporated by reference into any
future filing under the Securities Act of 1933 or Securities Exchange Act of
1934, each as amended, except to the extent that the Company specifically
incorporates it by reference into such filing.





The
followingperformance
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 investment of $100 at December 31,
2002.














Holders.As of March 14, 2008, the Company estimates that there were approximately
700 beneficial owners of the Company’s Common Stock, represented by
approximately 46 holders of record, and 3,247,016 shares of Common Stock
outstanding.








16




Issuer
Purchases.The Company did
not repurchase any shares of its Common Stock during the fourth quarter of 2007,
but did purchase 25,290 shares during the first three quarters of fiscal year
2006.  In addition, in July 2007 the Company repurchased 200,000
shares from Larry Forehand, the Company’s former Franchise Director and member
of the Board of Directors, for $8.14 per share pursuant to a purchase agreement
dated June 13, 2007.  In July 2007 the Forehand Limited Partnership,
an entity affiliated with Mr. Forehand, delivered 26,806 shares of Common Stock
(valued at $8.14 per share, the ten-day weighted average stock price at June 12,
2007) to the Company as consideration for the purchase of the assets of the
Company’s Casa Olé restaurant in Stafford, Texas, and entered into a franchise
agreement with the Company with respect to the restaurant.





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.





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)2003
            
            
            2004
            
            
            2005
            
            
            2006
            
            
            2007Income
      Statement Data:Revenues:Restaurant
      sales
            
            $
            49,737
            
            
            $
            73,499
            
            
            $
            76,356
            
            
            $
            80,805
            
            
            $
            81,380Franchise
      fees, royalties and other
            
            
            1,139
            
            
            
            753
            
            
            
            694
            
            
            
            825
            
            
            
            710Business
      interruption
            
            
            --
            
            
            
            --
            
            
            
            534
            
            
            
            60
            
            
            
            --50,876
            
            
            
            74,252
            
            
            
            77,584
            
            
            
            81,690
            
            
            
            82,090Costs
      and expenses:Cost
      of sales
            
            
            13,678
            
            
            
            20,311
            
            
            
            20,757
            
            
            
            22,259
            
            
            
            23,366Restaurant
      operating expenses
            
            
            27,981
            
            
            
            40,414
            
            
            
            42,433
            
            
            
            45,318
            
            
            
            46,550General
      and administrative
            
            
            5,306
            
            
            
            6,587
            
            
            
            6,942
            
            
            
            7,717
            
            
            
            7,472Depreciation
      and amortization
            
            
            1,847
            
            
            
            2,114
            
            
            
            2,653
            
            
            
            3,102
            
            
            
            3,417Asset
      impairments
            
            
            266
            
            
            
            322
            
            
            
            -
            
            
            
            448
            
            
            
            100Gain
      on disposal of assets - Hurricane Rita
            
            
            --
            
            
            
            --
            
            
            
            (472
            )
            
            
            (367
            )
            
            
            --(Gain)
      loss on sale of assets
            
            
            (292
            )
            
            
            180
            
            
            
            368
            
            
            
            30
            
            
            
            20848,786
            
            
            
            69,928
            
            
            
            72,681
            
            
            
            78,507
            
            
            
            81,113Operating
      income
            
            
            2,090
            
            
            
            4,324
            
            
            
            4,903
            
            
            
            3,183
            
            
            
            977Other
      income (expense), net
            
            
            (97
            )
            
            
            (459
            )
            
            
            (404
            )
            
            
            (303
            )
            
            
            (443
            )Income
      before income tax expense
            
            
            1,993
            
            
            
            3,865
            
            
            
            4,499
            
            
            
            2,880
            
            
            
            534Income
      tax expense
            
            
            722
            
            
            
            1,280
            
            
            
            1,486
            
            
            
            901
            
            
            
            79Income
      from continuing operations
            
            
            1,271
            
            
            
            2,585
            
            
            
            3,013
            
            
            
            1,979
            
            
            
            455Discontinued
      OperationsLoss
      from discontinued operations, net of taxes
            
            
            (2,306
            )
            
            
            (824
            )
            
            
            (696
            )
            
            
            (841
            )
            
            
            (106
            )Net
      income (loss)
            
            $
            (1,035
            )
            
            $
            1,761
            
            
            $
            2,317
            
            
            $
            1,138
            
            
            $
            349







17





2003
            
            
            2004
            
            
            2005
            
            
            2006
            
            
            2007Basic
      income (loss) per share:Income
      from continuing operations
            
            $
            0.37
            
            
            $
            0.76
            
            
            $
            0.88
            
            
            $
            0.58
            
            
            $
            0.13Loss
      from discontinued operations
            
            
            (0.68
            )
            
            
            (0.24
            )
            
            
            (0.20
            )
            
            
            (0.25
            )
            
            
            (0.03
            )Net
      income (loss)
            
            $
            (0.31
            )
            
            $
            0.52
            
            
            $
            0.68
            
            
            $
            0.33
            
            
            $
            0.10Diluted
      income (loss) per share:Income
      from continuing operations
            
            $
            0.37
            
            
            $
            0.71
            
            
            $
            0.82
            
            
            $
            0.56
            
            
            $
            0.13Loss
      from discontinued operations
            
            
            (0.68
            )
            
            
            (0.23
            )
            
            
            (0.19
            )
            
            
            ( 0.24
            )
            
            
            ( 0.03
            )Net
      income (loss)
            
            $
            (0.31
            )
            
            $
            0.48
            
            
            $
            0.63
            
            
            $
            0.32
            
            
            $
            0.10Weighted
      average shares – Basic
            
            
            3,384,605
            
            
            
            3,388,489
            
            
            
            3,415,806
            
            
            
            3,402,207
            
            
            
            3,339,280Weighted
      average shares – Diluted
            
            
            3,384,605
            
            
            
            3,634,849
            
            
            
            3,700,876
            
            
            
            3,521,587
            
            
            
            3,430,276





As of the End of Fiscal
    Years2003
            
            
            2004
            
            
            2005
            
            
            2006
            
            
            2007(In
      thousands)Balance
      Sheet Data:Working
      capital (deficit)
            
            $
            (2,669
            )
            
            $
            (1,359
            )
            
            $
            (1,632
            )
            
            $
            (1,928
            )
            
            $
            (911
            )Total
      assets
            
            $
            25,861
            
            
            $
            32,326
            
            
            $
            33,137
            
            
            $
            33,276
            
            
            $
            34,356Long-term
      debt, lesscurrent
      portion
            
            $
            1,775
            
            
            $
            6,000
            
            
            $
            4,500
            
            
            $
            3,800
            
            
            $
            6,400Total
      stockholders’ equity
            
            $
            15,954
            
            
            $
            17,868
            
            
            $
            18,884
            
            
            $
            20,573
            
            
            $
            19,265





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 for an
aggregate of 2,732,705 shares of its Common Stock.  The exchange
transaction was completed in 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 and  La
Señorita.  The Company also operates fast casual burrito restaurants
under the name Mission Burrito.  At December 30, 2007 the Company
operated 58 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 2007, 2006 and 2005 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 2006 and 2005 shown in the accompanying
consolidated financial statements have been reclassified to conform to the 2007
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 2005, 2006 and 2007 relate to the periods ended January 1,
2006, December 31, 2006, and December 30, 2007, respectively.  Fiscal
years 2005, 2006 and 2007, presented herein consisted of 52 weeks.





Results
of Operations





Fiscal
Year 2007 Compared to Fiscal Year 2006 as Adjusted for Discontinued
Operations





Revenues.  The
Company’s revenues for the fiscal year ended December 30, 2007 were up $400,537
or 0.5% to $82.1 million compared with fiscal year 2006.  Restaurant
sales for fiscal year 2007 increased $574,879 or 0.7% to $81.4 million compared
with fiscal year 2006.  The increase in restaurant sales reflects the
full year impact of one restaurant opened in fiscal year 2006 and the
acquisition of Mission Burrito (two restaurants), offset in part by a 1.8%
decline in same-restaurant sales.  For the fourth quarter 2007,
same-store sales were up 0.6%.





Franchise
fees, royalties and other for the fiscal year ended December 30, 2007 was down
$114,721 or 13.9% to $710,394 compared with fiscal year 2006.  Fiscal
year 2006 included the recognition of $80,000 in royalties due to a correction
of understated royalty income over the 16 previous
quarters.   For the fiscal year 2007, franchised-owned same-store
sales, as reported by franchisees, increased approximately 2.97%.





In fiscal
year 2006, the Company recorded $59,621 of business interruption proceeds
related to its Hurricane Rita insurance claim.





Costs and
Expenses.  Costs of sales,
consisting of food, beverage, liquor, supplies and paper costs, increased as a
percent of restaurant sales 120 basis points to 28.7% compared with 27.5% in
fiscal year 2006.  The increase primarily reflects higher commodity
prices, especially produce, cheese and dry goods.  The increase also
reflects a one time adjustment of $100,000 to cost of sales to correct for
rebates the Company mistakenly recorded as its own that should have been paid to
franchisees.





Labor and
other related expenses increased as a percentage of restaurant sales 20 basis
points to 32.5% compared with 32.3% for fiscal year 2006.  The
increase primarily reflects the lingering impact of the first quarter of fiscal
2007, which had labor cost of 33.7%, reflecting hourly labor that wasn’t
scheduled in proportion to declining same-restaurant sales.  Since the
first quarter of 2007, labor cost improved to 32.0% in the second quarter, 32.5%
in the third quarter and 31.7% in the fourth quarter.  Since the first
quarter, labor utilization improvements were approximately the same for all
three quarters.  The second quarter benefited from a one time
adjustment to worker’s compensation insurance and unemployment tax adjustments
related to a policy audit and a refund due to excess funding from the State of
Texas Workforce Commission.





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 2007 as a percentage of restaurant sales 110 basis
points to 24.7% as compared with 23.6% in fiscal year 2006.  The
increase primarily reflects higher property and casualty insurance expense,
which is directly attributable to severe weather associated with the United
State’s Gulf Coast region, higher repair and maintenance expense, rents and
advertising.





General
and administrative expenses consist of expenses associated with corporate and
administrative functions that support restaurant operations.  General
and administrative expenses decreased 30 basis points as a percentage of total
sales to 9.1% compared with 9.4% for fiscal year 2006.  Actual general
and administrative expenses decreased $245,030.  The decrease
primarily reflects lower vested option expense which was partially offset by
higher legal expenses, employee finder fees and consulting fees related to
Sarbanes-Oxley required internal control documentation and testing.







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 4.2% in fiscal
year 2007 as compared with 3.8% in fiscal year 2006.  Actual
depreciation and amortization expense increased $315,720 in fiscal year 2007
compared with fiscal year 2006.  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 2007, the Company
incurred $23,947 in pre-opening expenses related to the reopening of a remodeled
restaurant.  In fiscal year 2006, the Company spent $108,847 in
pre-opening expenses related to the opening of two new restaurants.





Impairment
costs.  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.





During
fiscal year 2007, the Company expensed $99,978 to impair the assets of two
under-performing restaurants.  During fiscal year 2006, the Company
expensed $447,903 to impair the assets of two under-performing
restaurants.  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 the Company’s insurance
claim.  During the second quarter of 2006, the Company finalized
negotiations with its insurance carrier for the hurricane insurance
claim.  Also, 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 2007, the Company
recorded a loss on the sale of assets of $207,517, reflecting the loss from two
remodeled restaurants and from the sale of one under-performing restaurant to
Mr. Forehand, Vice Chairman of the Company, who purchased the assets of the
Company’s Casa Olé restaurant located in Stafford, Texas for an agreed price of
26,806 shares of the Company’s common stock.  The stock was valued at
$8.14 per share, which was the ten-day weighted average stock price as of June
12, 2007, for a total value of $218,205.  The Stafford restaurant
operates under the Company’s uniform franchise agreement and is subject to a
monthly royalty fee.
During fiscal year 2006, the Company recorded a loss of $29,591 due to the
disposition of miscellaneous assets.





Other Income
(Expense).   Net expense increased $139,487 to $442,801 in
fiscal year 2007 compared with a net expense of $303,314 in fiscal year
2006.  Interest expense increased $109,312 to $499,851 in fiscal year
2007 compared with interest expense of $390,539 in fiscal year 2006, reflecting
an increase in outstanding debt.





Income Tax
Expense. The Company’s effective tax rate from continuing operations for
fiscal year 2007 was 14.8% as compared to 31.3% for fiscal year
2006.  In fiscal year 2007, the Company had significantly lower pretax
income from continuing operations compared to fiscal year 2006. In both years,
the permanent differences were approximately the same, resulting in the lower
effective tax rate in fiscal year 2007. Certain permanent differences result in
tax credits.  In fiscal year 2007, the Company was not able to use all
of its current year tax credits, but those tax credits of $268,386 can be
carried forward for an indefinite period to reduce future federal regular income
taxes.





Discontinued
Operations.  In fiscal year 2007, the Company closed one
under-performing restaurant in February, 2007 after its lease expired incurring
losses from discontinued operations, net of taxes, of $106,622 pursuant to
Statement on Financial Accounting Standards No. 146, “Accounting for Costs
Associated with Exit or Disposal Activities”. In fiscal year 2006, the Company
closed four underperforming restaurants incurring losses from discontinued
operations, net of taxes, of $840,804.





20





The
circumstances and testing leading to an impairment charge were determined in
accordance with SFAS No. 144 which requires that property 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 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 $81.7 million compared with fiscal year
2005.  Restaurant sales for fiscal year 2006 increased $4.5 million or
5.8% to $80.8 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 Burrito (two restaurants) in mid 2006, 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 30
basis points to 27.5% 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, which 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 32.3% compared
with 32.5% 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 23.6% as compared with 22.9% 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.  (Mr.
Glowacki subsequently returned to the Company in the second quarter of fiscal
2007.)  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 in December 2006 of Mr. Glowacki’s vested
options.





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.








21


Impairment
costs.During fiscal year 2006,
the Company expensed $447,903 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 the Company’s 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 $29,591.   The loss was
due to the disposition of miscellaneous assets. During fiscal year 2005, the
Company recorded a loss of $367,568 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 31.3% 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 losses from discontinued operations, net
of taxes, of $840,804 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 losses from
discontinued operations, net of taxes, of $696,225.





The
circumstances and testing leading to an impairment charge were determined in
accordance with SFAS No. 144 which requires that property 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 2007 capital
requirements primarily by drawing on its cash reserves and line of
credit.  In fiscal year 2007, the Company had cash flows from
continuing operating activities of $3.8 million, compared with cash flows from
continuing operating activities of $4.9 million in fiscal year 2006 and $6.4
million in fiscal year 2005.  The decrease in cash flows from
continuing operating activities primarily reflects the decrease in operating
income.  Financing activities provided $1.0 million in fiscal year
2007, in which $3.1 million was drawn from the Company’s lines of credit with
$1.6 million used for the July 2007 purchase of 200,000 shares of the Company’s
common stock and $0.5 million used for the prepayment of the Beaumont-based
franchise restaurant seller note, compared to a use of cash of $1.2 million
primarily related to long term debt payments in fiscal year 2006.  As
of December 30, 2007, the Company had a working capital deficit of approximately
$911,000 compared with a working capital deficit of approximately $1.9 million
at December 31, 2006.  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 2007, total cash used for capital
requirements was
approximately $4.2 million, which included the
following:  approximately $475,000 spent for new PosiTouch
point-of-sale register systems, PosiTouch software upgrades and PosiTouch
upgrades for electronic gift card sales; $1.3 million for restaurant remodels;
and approximately $450,000 for new restaurant construction.  All
Company-owned restaurants are now using the PosiTouch system.





22


The
Company did not open any new restaurants during fiscal year 2007, but did sign
two new leases for Mission Burrito restaurants, one of which opened in February
2008 and the other it plans to open in May 2008.  One lease previously
signed for a future Casa Olé restaurant was terminated due to the landlord’s
failure to perform.  During fiscal year 2007, the Company completed an
extensive remodel of one Casa Olé restaurant at a total cost of approximately
$825,000.  Sales for the remodeled Casa Olé restaurant were up over
46.3% since its reopening.




For
fiscal year 2008, the Company plans to develop at least three new Mission
Burrito restaurants and moderately remodel one restaurant.  The
estimated capital needed for fiscal year 2008 for general corporate purposes,
including  remodeling and new restaurant expansion, is approximately
$4.2 million.  The Company anticipates that it will primarily use cash
generated by operating activity during fiscal year 2008 to fund capital
expenditures.





The Company has incurred debt to carry
out acquisitions, to repurchase its common stock, to develop new restaurants and
to remodel existing restaurants, as well as to accommodate other working capital
needs.  During fiscal year 2007, the Company drew $3.1 million, net of
payments on its line of credit, prepaid the remaining seller note of $500,000
from the Beaumont-based franchise restaurant acquisition in 2004, and
repurchased 200,000 shares of the Company’s common stock for $1.6
million.  As of December 30, 2007, the Company had $6.4 million drawn
on its line of credit.





On June
29, 2007 the Company entered into a Credit Agreement (the “Wells Fargo
Agreement”) with Wells Fargo Bank, N.A. (“Wells Fargo”) in order to increase the
revolving loan amount available to the Company from $7.5 million under its then
existing credit facility with Bank of America to $10 million.  The
Wells Fargo Agreement also allows up to $2.0 million in annual stock
repurchases.  In connection with the execution of the Wells Fargo
Agreement, the Company prepaid and terminated its existing credit facility
between the Company and Bank of America.  The Wells Fargo Agreement
provides for a revolving loan of up to $10 million, with an option to increase
the revolving loan by an additional $5 million, for a total of $15
million.  The Wells Fargo Agreement terminates on June 29,
2010.  At the Company’s option, the revolving loan bears an interest
rate equal to either the Wells Fargo’s Base Rate plus a stipulated percentage or
LIBOR plus a stipulated percentage.  Accordingly, the Company is
impacted by changes in the Base Rate and LIBOR.  The Company is
subject to a non-use fee of 0.50% on the unused portion of the revolver from the
date of the Wells Fargo 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
Wells Fargo Bank, N.A.  The Wells Fargo Agreement requires the Company
to maintain certain minimum EBITDA levels, leverage ratios and fixed charge
coverage ratios.  As of December 30, 2007, the Company was in
compliance with all debt covenants and expects to be in full compliance with all
debt covenants during fiscal year 2008.





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 entered into a
repurchase plan designed to comply with Rules 10b5-1 and 10b-18 under the
Securities and Exchange Act of 1934 under which an agent appointed by the
Company determined the time, amount, and price at which purchases of common
stock were made, subject to certain parameters established in advance by the
Company.  Under this program, the Company purchased shares through the
third quarter of fiscal year 2006 at which time the maximum authority was
reached.  The Company presently has no further authority to repurchase
outstanding shares of its common stock under this program.  On June
13, 2007, Mr. Forehand entered into a Stock Purchase Agreement to sell 200,000
shares of his personally-owned common stock back to the Company.  The
stock was valued at $8.14 per share, which was the ten-day weighted average
stock price as of June 12, 2007, and the Company finalized the stock purchase on
July 6, 2007.  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 revolving line of credit under
the Wells Fargo Agreement, funds will be sufficient to meet operating
requirements and to finance routine capital expenditures and new restaurant
growth through the next 12 months.  Unless the Company violates a debt
covenant, the Company’s credit facility with Wells Fargo is not subject to
triggering events that would cause the credit facility to become due sooner than
the maturity dates described in the previous paragraphs.











23





Contractual
Obligations and Commercial Commitments.





The following table summarizes the
Company’s total contractual cash obligations and commercial commitments as of
December 30, 2007, including leases (in excess of one year) signed that are
effective in 2008:




Payments
      Due By PeriodContractual
      Obligation
            
            Total
            
            
            Less
      than
              1
      Year
            
            
            1
      to 3
              Years
            
            
            3
      to 5
              Years
            
            
            More
      Than
              5
      YearsLong-Term
      Debt
            
            $
            6,400,000
            
            
            $
            --
            
            
            $
            6,400,000
            
            
            $
            --
            
            
            $
            --Operating
      Leases
            
            
            48,268,751
            
            
            
            5,699,708
            
            
            
            10,998,198
            
            
            
            10,013,015
            
            
            
            21,557,830Total
      Contractual Cash Obligations
            
            $
            54,668,751
            
            
            $
            5,699,708
            
            
            $
            17,398,198
            
            
            $
            10,013,015
            
            
            $
            21,557,830





The contractual obligation table does
not include interest payments on our long-term debt with Wells Fargo 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 30, 2007.





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.





Management’s Discussion and Analysis of
Financial Condition and Results of Operations discusses the Company’s
consolidated financial statements, which have been prepared in accordance with
accounting principles generally accepted in the United States.  The
preparation of these consolidated financial statements requires management to
make estimates and assumptions that affect the reported amounts of assets and
liabilities, the disclosure of contingent assets and liabilities at the date of
the consolidated financial statements, and the reported amounts of revenues and
expenses during the reporting period.





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 consolidated financial statement purposes. The Company
capitalizes improvements and expenses 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 analyzes
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.





24


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 2007, 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.





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 are 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.





25


Effective January 1, 2007, the Company
adopted FASB Interpretation Number 48, “Accounting for Uncertainty in
Income Taxes” (FIN 48), which is intended to clarify the accounting for
income taxes prescribing a minimum recognition threshold for a tax position
before being recognized in the consolidated financial statements. FIN 48 also
provides guidance on derecognition, measurement, classification, interest and
penalties, accounting in interim periods, disclosure and
transition.  In accordance with the requirements of FIN 48, the
Company evaluated all tax years still subject to potential audit under state and
federal income tax law in reaching its accounting conclusions. As a result, the
Company concluded it did not have any unrecognized tax benefits or any
additional tax liabilities after applying FIN 48 as of the January 1, 2007
adoption date or for the fiscal year ended December 30, 2007.  The
adoption of FIN 48 therefore had no impact on the Company’s consolidated
financial statements.  See Note 4 to our consolidated financial
statements for further discussion.





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 operations. 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.





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 September 2006, the FASB issued
SFAS No. 157, “Fair
Value Measurements” (“SFAS No. 157”). This Statement defines
fair value, establishes a framework for measuring fair value and expands
disclosure of fair value measurements. SFAS No. 157 applies under
other accounting pronouncements that require or permit fair value measurements
and accordingly, does not require any new fair value measurements. Leasing
transactions that are accounted for under SFAS No. 13 “Accounting for Leases” are
excluded from SFAS No. 157. However, this exclusion does not apply to
fair value measurements of assets and liabilities recorded as a result of a
lease transaction but measured pursuant to other pronouncements within the scope
of SFAS No. 157. For non-financial assets and liabilities that are
recognized or disclosed at fair value in the financial statements at least
annually as well as for all financial assets and liabilities,
SFAS No. 157 is effective in financial statements issued for fiscal
years beginning after November 15, 2007. For non-financial assets and
liabilities that are not recognized or disclosed at fair value in the financial
statements on a recurring basis, SFAS No. 157 is effective in
financial statements issued for fiscal years beginning after November 15,
2008.  The adoption of SFAS No. 157 is not expected to have a material
impact on the financial position, results of operations or cash
flows.




In February 2007, the FASB issued SFAS
No. 159, “The Fair Value
Option for Financial Assets and Financial Liabilities – including an amendment
of FASB Statement No. 115.”  SFAS 159 permits entities to
choose to measure many financial instruments and certain other items at fair
value.  The objective is to improve financial reporting by providing entities
with the opportunity to mitigate volatility in reported earnings caused by
measuring related assets and liabilities differently without having to apply
complex hedge accounting provisions.  This Statement is expected to
expand the use of fair value measurement, which is consistent with the Board’s
long-term measurement objectives for accounting for financial
instruments.  SFAS No. 159 becomes effective for the fiscal years
beginning after November 15, 2007.  We do not believe the adoption of
SFAS No. 159 will have a material impact on our consolidated financial position,
cash flows or results of operations.




26





In December 2007, the FASB issued
SFAS No. 141(R), “Business Combinations”
(“SFAS No. 141(R)”),which is a revision of SFAS 141 “Business Combinations”. SFAS No. 141(R)
significantly changes the accounting for business combinations. Under this
statement, an acquiring entity will be required to recognize all the assets
acquired and liabilities assumed in a transaction at the acquisition-date fair
value with limited exceptions. Additionally, SFAS No. 141(R) includes
a substantial number of new disclosure requirements. SFAS No. 141(R)
applies prospectively to business combinations for which the acquisition date is
on or after the beginning of the first annual reporting period beginning on or
after December 15, 2008. Earlier adoption is prohibited. The Company is in
the process of evaluating the impact the adoption of SFAS No. 141(R)
will have on the results of operations and financial condition.  We
currently believe SFAS No. 141(R) will not have a material impact on our
consolidated financial position, cash flows or results of
operations.





In December 2007, the FASB issued
FASB Statement No. 160, “Noncontrolling Interests in
Consolidated Financial Statements — An Amendment of ARB No. 51”
(“SFAS No. 160”), which is an amendment to ARB No. 51
“Consolidated Financial Statements”. SFAS No. 160 establishes new
accounting and reporting standards for the noncontrolling interest in a
subsidiary and for the deconsolidation of a subsidiary. Specifically, this
statement requires the recognition of a noncontrolling interest (minority
interest) as equity in the consolidated financial statements and separate from
the parent’s equity. The amount of net income attributable to the noncontrolling
interest will be included in consolidated net income on the face of the income
statement. SFAS No. 160 clarifies that changes in a parent’s ownership
interest in a subsidiary that do not result in deconsolidation are equity
transactions if the parent retains its controlling financial interest. In
addition, this statement requires that a parent recognize a gain or loss in net
income when a subsidiary is deconsolidated. Such gain or loss will be measured
using the fair value of the noncontrolling equity investment on the
deconsolidation date. SFAS No. 160 also includes expanded disclosure
requirements regarding the interests of the parent and its noncontrolling
interest. SFAS No. 160 is effective for fiscal years, and interim
periods within those fiscal years, beginning on or after December 15, 2008.
Earlier adoption is prohibited. The Company is in the process of evaluating the
impact the adoption of SFAS No. 160 will have on the results of
operations and financial condition.  Presently, there are no
significant noncontrolling interests in any of the Company’s consolidated
subsidiaries.  Therefore, we currently believe the impact of SFAS No.
160, if any, will primarily depend on the materiality of noncontrolling
interests arising in future transactions to which the consolidated financial
statement presentation and disclosure provisions of SFAS No. 160 will
apply.








ITEM
7A.                     QUANTITATIVE
AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK




Effects
of Inflation




Components
of the Company’s operations subject to inflation include food, beverage, lease
and labor costs. The Company’s leases require it to pay taxes, maintenance,
repairs, insurance and utilities, all of which are subject to inflationary
increases. The Company believes inflation has not had a material impact on its
results of operations in recent years.




Commodity
Price Risk




The
Company is exposed to market price fluctuations in beef and other food product
prices. Given the historical volatility of beef and other food product prices,
this exposure can impact the Company’s food and beverage costs. Because the
Company typically sets its menu prices in advance of its beef and other food
product purchases, the Company cannot quickly take into account changing costs
of beef and other food items. To the extent that the Company is unable to pass
the increased costs on to its guests through price increases, the Company’s
results of operations would be adversely affected. The Company currently does
not use financial instruments to hedge its risk to market price fluctuations in
beef or other food product prices.





Interest Rates





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 annual
interest expense by approximately $64,000.




27







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 ANDFINANCIAL
DISCLOSURE





None.





ITEM
9A.                     CONTROLS
AND PROCEDURES




Evaluation of Disclosure Controls and Procedures. We have
established and maintain disclosure controls and procedures that are
designed to ensure that material information relating to us and
our subsidiaries required to be disclosed by us in the reports that we file
or submit under the Securities Exchange Act of 1934 is recorded,
processed, summarized and reported within the time periods specified in the
Securities and Exchange Commission's (“SEC”) rules and forms, and that such
information is accumulated and communicated to our management, including
our chief executive officer and chief financial officer, as appropriate to
allow timely decisions regarding required disclosure. In designing and
evaluating the disclosure controls and procedures, management recognized
that any controls and procedures, no matter how well designed and operated,
can only provide reasonable assurance of achieving the desired
control objectives, and in reaching a reasonable level of assurance,
management necessarily was required to apply its judgment in evaluating the
cost-benefit relationship of possible controls and procedures.





We
carried out an evaluation, under the supervision and with the participation
of our management, including our chief executive officer and
chief financial officer, of the effectiveness of the design and operation
of our disclosure controls and procedures as of the end of the period
covered by this report. Based on that evaluation, the chief executive
officer and chief financial officer concluded that our disclosure controls
and procedures were effective as of the date of such evaluation to provide
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 by the SEC's rules and forms.





Management's Report on Internal
Control over Financial Reporting. Our management is responsible for
establishing and maintaining adequate internal control over financial
reporting. Internal control over financial reporting is a process designed
by, or under the supervision of, our chief executive and chief financial
officers and effected by our board of directors, management and other
personnel to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of financial statements for
external purposes in accordance with U.S. generally accepted
accounting principles and includes those policies and procedures
that:





·
              pertain
      to the maintenance of records that in reasonable detail accurately and
      fairly reflect the transactions and dispositions of our
      assets;





·
              provide
      reasonable assurance that transactions are recorded as necessary to
      permit preparation of financial statements in accordance
      with generally accepted accounting principles, and that our receipts
      and expenditures are being made only in accordance with the
      authorizations of our management and directors;
  and





·
              provide
      reasonable assurance regarding prevention or timely detection
      of unauthorized acquisition, use or disposition of our assets that
      could have a material effect on our financial
    statements.





Because
of inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Projections of any evaluation
of effectiveness to future periods are subject to the risks that controls
may become inadequate because of changes in conditions, or that the degree
of compliance with policies or procedures may deteriorate. However, these
inherent limitations are known features of the financial reporting process.
It is possible to design into the process safeguards to reduce, thought not
eliminate, the risk that misstatements are not prevented or detected on a
timely basis. Management is responsible for establishing and maintaining
adequate internal control over financial reporting for the
company.


28


Management assessed the effectiveness
of the Company’s internal control over financial reporting as of December 30,
2007. In making this assessment, management used the criteria set forth by the
Committee of Sponsoring Organizations of the Treadway Commission in Internal
Control-Integrated Framework. Based on this assessment, our management concluded
that, as of December 30, 2007, our internal control over financial reporting was
effective to provide reasonable assurance regarding the reliability of financial
reporting and the preparation and presentation of financial statements for
external purposes in accordance with generally accepted accounting
principles.


Change in Internal Control Over Financial Reporting. There were no
changes in the our internal control over financial reporting that occurred
during our last fiscal quarter that have materially affected, or are
reasonably likely to materially affect, our internal control over
financial reporting.





ITEM
9B.           OTHER
INFORMATION





None.




PART III




ITEM
10.           DIRECTORS
AND EXECUTIVE OFFICERS OF THE REGISTRANT 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.




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.





























29





PART
IV


ITEM 1 5.                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.





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





†10.13
            
            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).†10.14
            
            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).†10.15
            
            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).10.16
            
            Credit
      Agreement between Mexican Restaurants, Inc. and Wells Fargo Bank, N.A.
      dated June 29, 2007 (incorporated by reference to Exhibit 10.1 to the
      Company’s Form 8-K filed on July 6, 2007 with the Securities and Exchange
      Commission).10.17
            
            Stock
      Purchase Agreement between Mexican Restaurants, Inc. and Forehand Family
      Partnership, Ltd. dated June 13, 2007 (incorporated by reference to
      Exhibit 10.2 to the Company’s Form 10-Q filed on August 14, 2007 with the
      Securities and Exchange Commission).21.1
            
            List
      of subsidiaries of the Company (incorporated by reference to Exhibit 22.1
      of the 1996  Form S-1).*23.1
            
            Consent of UHY LLP, Independent Registered Public
      Accounting Firm.*24.1
            
            Power of Attorney (included on the signature page to this Form
      10-K).*31.1
            
            Certification of Chief Executive
      Officer  pursuant to Section 302 of the Sarbanes-Oxley Act of
      2002.*31.2
            
            Certification of Chief Financial Officer pursuant to
      Section 302 of the Sarbanes-Oxley Act of 2002.#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.










30











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 26, 2008.





MEXICAN RESTAURANTS,
      INC.By:  /s/  Curt
      GlowackiCurt
      Glowacki,President
      and Chief Executive Officer





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
      26, 2008Louis
      P. Neeb/s/
      Larry N. Forehand
            Founder
      and Vice Chairman of the Board of Directors
            March
      26, 2008Larry
      N. Forehand/s/
      Curt Glowacki
            President
      and Chief Executive Officer and Director
            March
      26, 2008Curt
      Glowacki
            (Principal
      Executive Officer)/s/
      Andrew J. Dennard
            Executive
      Vice President and Chief Financial Officer
            March
      26, 2008Andrew
      J. Dennard
            (Principal
      Financial and Accounting Officer)/s/
      Cara Denver
            Director
            March
      26, 2008Cara
      Denver/s/
      Michael D. Domec
            Director
            March
      26, 2008Michael
      D. Domec/s/
      J. J. Fitzsimmons
            Director
            March
      26, 2008J.
      J. Fitzsimmons/s/
      Lloyd Fritzmeier
            Director
            March
      26, 2008Lloyd
      Fritzmeier/s/
      Thomas E. Martin
            Director
            March
      26, 2008Thomas
      E. Martin




31





MEXICAN
RESTAURANTS, INC.





INDEX
TO CONSOLIDATED FINANCIAL STATEMENTS





PageReport of Independent Registered Public Accounting
      Firm
            F-2Consolidated Balance Sheets as of December 31, 2006 and
      December 30, 2007
            F-3Consolidated
      Statements of Operations for each of the years in the three
      fiscal-yearperiod
      ended December 30, 2007
            F-4Consolidated
      Statements of Stockholders' Equity for each of the years inthe
      three fiscal-year period ended December 30, 2007
            F-5Consolidated
      Statements of Cash Flows for each of the years in the
      threefiscal-year
      period ended December 30, 2007
            F-6Notes to Consolidated Financial
    Statements
            F-7







































































































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 30, 2007 and December 31, 2006, and the related
consolidated statements of operations, stockholders' equity and cash flows for
each of the three years in the period ended December 30, 2007.  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.





We were not engaged to examine
management’s assertion about the effectiveness of Mexican Restaurants, Inc.’s
internal control over financial reporting as of December 30, 2007 included in
the accompanying Form 10-K and, accordingly, we do not express an opinion
thereon.





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 30, 2007 and December 31,
2006, and the consolidated results of their operations and their cash flows for
each of the three years in the period ended December 30, 2007 in conformity with
accounting principles generally accepted in the United States of
America.

















/s/ UHY
LLP








Houston,
Texas


March 26,
2008














































F-2


MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES


CONSOLIDATED BALANCE SHEETS


December
31, 2006 and December 30, 2007








Fiscal
      YearsASSETS
            
            2006
            
            
            2007Current
      assets:Cash
            
            $
            653,310
            
            
            $
            1,154,629Royalties
      receivable
            
            
            90,627
            
            
            
            61,233Other
      receivables
            
            
            856,704
            
            
            
            832,790Inventory
            
            
            710,633
            
            
            
            750,516Taxes
      receivable
            
            
            408,787
            
            
            
            372,576Prepaid
      expenses and other current assets
            
            
            851,580
            
            
            
            975,195Total
      current assets
            
            
            3,571,641
            
            
            
            4,146,939Property
      and equipment
            
            
            34,682,615
            
            
            
            37,028,882Less
      accumulated depreciation
            
            
            (17,171,172
            )
            
            
            (19,175,946
            )Net
      property and equipment
            
            
            17,511,443
            
            
            
            17,852,936Goodwill
            
            
            11,403,805
            
            
            
            11,403,805Deferred
      tax assets
            
            
            318,519
            
            
            
            439,985Other
      assets
            
            
            470,284
            
            
            
            512,261$
            33,275,692
            
            
            $
            34,355,926LIABILITIES AND STOCKHOLDERS'
      EQUITYCurrent
      liabilities:Accounts
      payable
            
            $
            2,087,506
            
            
            $
            2,181,873Accrued
      sales and liquor taxes
            
            
            142,787
            
            
            
            130,941Accrued
      payroll and taxes
            
            
            1,440,040
            
            
            
            1,135,326Accrued
      expenses
            
            
            1,389,234
            
            
            
            1,461,141Current
      portion of liabilities associated with leasing and exit
      activities
            
            
            439,682
            
            
            
            148,681Total
      current liabilities
            
            
            5,499,249
            
            
            
            5,057,962Long-term
      debt
            
            
            3,800,000
            
            
            
            6,400,000Other
      liabilities associated with leasing and exit activities, net of current
      portion
            
            
            544,512
            
            
            
            577,582Deferred
      gain
            
            
            1,352,927
            
            
            
            1,144,785Other
      liabilities
            
            
            1,505,760
            
            
            
            1,910,270Total
      liabilities
            
            
            12,702,448
            
            
            
            15,090,599Commitments
      and ContingenciesStockholders'
      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
            
            
            19,041,867
            
            
            
            19,275,067Retained
      earnings
            
            
            12,759,122
            
            
            
            13,107,896Treasury
      stock, cost of 1,272,383 common shares in 2006 and 1,485,689
      commonshares
      in 2007
            
            
            (11,275,072
            )
            
            
            (13,164,963
            )Total
      stockholders' equity
            
            
            20,573,244
            
            
            
            19,265,327$
            33,275,692
            
            
            $
            34,355,926





See accompanying notes to
consolidated financial statements.







F-3


MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES


CONSOLIDATED STATEMENTS OF OPERATIONS


For
the fiscal years ended January 1, 2006, December 31, 2006


and
December 30, 2007








Fiscal
      Years2005
            
            
            2006
            
            
            2007Revenues:
              Restaurant
      sales
            
            $
            76,356,224
            
            
            $
            80,804,886
            
            
            $
            81,379,765Franchise
      fees, royalties and other
            
            
            694,302
            
            
            
            825,115
            
            
            
            710,394Business
      interruption
            
            
            534,163
            
            
            
            59,621
            
            
            
            --77,584,689
            
            
            
            81,689,622
            
            
            
            82,090,159Costs
      and expenses:Cost
      of sales
            
            
            20,757,520
            
            
            
            22,259,123
            
            
            
            23,366,381Labor
            
            
            24,833,620
            
            
            
            26,133,108
            
            
            
            26,428,606Restaurant
      operating expenses
            
            
            17,521,915
            
            
            
            19,076,539
            
            
            
            20,097,179General
      and administrative
            
            
            6,941,683
            
            
            
            7,716,786
            
            
            
            7,471,756Depreciation
      and amortization
            
            
            2,652,732
            
            
            
            3,101,628
            
            
            
            3,417,348Pre-opening
      costs
            
            
            77,942
            
            
            
            108,847
            
            
            
            23,947Impairment
      costs
            
            
            --
            
            
            
            447,903
            
            
            
            99,978Gain
      on disposal of assets – Hurricane Rita
            
            
            (471,622
            )
            
            
            (366,808
            )
            
            
            --Loss
      on sale of property and equipment
            
            
            367,568
            
            
            
            29,591
            
            
            
            207,51772,681,358
            
            
            
            78,506,717
            
            
            
            81,112,712Operating
      income
            
            
            4,903,331
            
            
            
            3,182,905
            
            
            
            977,447Other
      income (expense):Interest
      income
            
            
            3,451
            
            
            
            6,239
            
            
            
            10,715Interest
      expense
            
            
            (521,161
            )
            
            
            (390,539
            )
            
            
            (499,851
            )Other,
      net
            
            
            113,846
            
            
            
            80,986
            
            
            
            46,335(403,864
            )
            
            
            (303,314
            )
            
            
            (442,801
            )Income
      from continuing operations before income taxes
            
            
            4,499,467
            
            
            
            2,879,591
            
            
            
            534,646Income
      tax expense
            
            
            1,486,245
            
            
            
            900,453
            
            
            
            79,250Income
      from continuing operations
            
            
            3,013,222
            
            
            
            1,979,138
            
            
            
            455,396Discontinued
      operations:Income
      (loss) from discontinued operations
            
            
            (331,752
            )
            
            
            (401,603
            )
            
            
            3,090Restaurant
      closure costs
            
            
            (790,708
            )
            
            
            (928,053
            )
            
            
            (175,796
            )Gain
      (loss) on sale of assets
            
            
            (2,563
            )
            
            
            (13,140
            )
            
            
            3,412Loss
      from discontinued operations before income taxes
            
            
            (1,125,023
            )
            
            
            (1,342,796
            )
            
            
            (169,294
            )Income
      tax benefit
            
            
            428,798
            
            
            
            501,992
            
            
            
            62,672Loss
      from discontinued operations
            
            
            (696,225
            )
            
            
            (840,804
            )
            
            
            (106,622
            )Net
      Income
            
            $
            2,316,997
            
            
            $
            1,138,334
            
            
            $
            348,774Basic
      income (loss) per share:Income
      from continuing operations
            
            $
            0.88
            
            
            $
            0.58
            
            
            $
            0.13Loss
      from discontinued operations
            
            
            (0.20
            )
            
            
            (0.25
            )
            
            
            (0.03
            )Net
      income
            
            $
            0.68
            
            
            $
            0.33
            
            
            $
            0.10Diluted
      income (loss) per share:Income
      from continuing operations
            
            $
            0.82
            
            
            $
            0.56
            
            
            $
            0.13Loss
      from discontinued operations
            
            
            (0.19
            )
            
            
            (0.24
            )
            
            
            (0.03
            )Net
      income
            
            $
            0.63
            
            
            $
            0.32
            
            
            $
            0.10Weighted
      average number of shares (basic)
            
            
            3,415,806
            
            
            
            3,402,207
            
            
            
            3,339,280Weighted
      average number of shares (diluted)
            
            
            3,700,876
            
            
            
            3,521,587
            
            
            
            3,430,276





See accompanying notes to consolidated
financial statements.




F-4





MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES


CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY





For
the fiscal years ended


January
1, 2006, December 31, 2006


and
December 30, 2007





Common
      Stock
            
            
            Additional
              Paid-in
              Capital
            
            
            Retained
              Earnings
            
            
            Deferred
              Compensation
            
            
            Treasury
              Stock
            
            
            Total
              Stockholders’
              EquityBalances
      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
            )
            
            
            20,573,244Exercise
      of Stock Options ThroughIssuance
      of Treasury
              Shares
            
            
            --
            
            
            
            (65,785
            )
            
            
            --
            
            
            
            --
            
            
            
            119,610
            
            
            
            53,825Repurchase
      of shares
            
            
            --
            
            
            
            163,296
            
            
            
            --
            
            
            
            --
            
            
            
            (2,009,501
            )
            
            
            (1,846,205
            )Stock
      based Compensation Expense
            
            
            --
            
            
            
            141,347
            
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            141,347Tax
      Shortfall-Options Exercised
            
            
            --
            
            
            
            (5,658
            )
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            (5,658
            )Net
      income
            
            
            --
            
            
            
            --
            
            
            
            348,774
            
            
            
            --
            
            
            
            --
            
            
            
            348,774Balances
      at December 30, 2007
            
            $
            47,327
            
            
            $
            19,275,067
            
            
            $
            13,107,896
            
            
            $
            --
            
            
            $
            (13,164,963
            )
            
            $
            19,265,327


























See
accompanying notes to consolidated financial statements.







F-5


MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES


CONSOLIDATED STATEMENTS OF CASH FLOWS


For
the fiscal years ended January 1, 2006, December 31, 2006 and December 30,
2007





Fiscal
      Years2005
            
            
            2006
            
            
            2007Cash
      flows from operating activities:Net
      income
            
            $
            2,316,997
            
            
            $
            1,138,334
            
            
            $
            348,774Adjustment
      to reconcile net income to net cash provided by operating
      activitiesDepreciation
      and amortization
            
            
            2,652,732
            
            
            
            3,101,628
            
            
            
            3,417,348Deferred
      gain amortization
            
            
            (208,142
            )
            
            
            (208,143
            )
            
            
            (208,142
            )Loss
      from discontinued operations
            
            
            696,225
            
            
            
            840,804
            
            
            
            106,622Impairment
      costs
            
            
            --
            
            
            
            447,903
            
            
            
            99,978Gain
      from insurance proceeds
            
            
            (534,163
            )
            
            
            (59,621
            )
            
            
            --Hurricane
      Rita gain
            
            
            (471,622
            )
            
            
            (366,808
            )
            
            
            --Loss
      on sale of property and equipment
            
            
            367,568
            
            
            
            29,591
            
            
            
            207,517Stock
      based compensation expense
            
            
            6,303
            
            
            
            63,508
            
            
            
            141,347Excess
      tax expense (benefit)--stock based compensation expense
            
            
            --
            
            
            
            (44,923
            )
            
            
            5,658Deferred
      income taxes (benefit)
            
            
            707,683
            
            
            
            19,931
            
            
            
            (233,546
            )Changes
      in assets and liabilities, net of effects of acquisitionsRoyalties
      receivable
            
            
            (91,272
            )
            
            
            86,022
            
            
            
            29,394Other
      receivables
            
            
            (43,507
            )
            
            
            438,055
            
            
            
            13,597Taxes
      receivable/payable
            
            
            776,956
            
            
            
            (566,980
            )
            
            
            30,553Inventory
            
            
            (275,942
            )
            
            
            9,706
            
            
            
            (58,467
            )Prepaid
      expenses and other current assets
            
            
            4,367
            
            
            
            (27,273
            )
            
            
            (146,001
            )Other
      assets
            
            
            4,074
            
            
            
            (25,551
            )
            
            
            (89,363
            )Accounts
      payable
            
            
            17,353
            
            
            
            289,378
            
            
            
            64,084Accrued
      expenses and other liabilities
            
            
            310,068
            
            
            
            (352,654
            )
            
            
            (472,294
            )Deferred
      rent and other long-term liabilities
            
            
            138,772
            
            
            
            103,384
            
            
            
            496,918Total
      adjustments
            
            
            4,057,453
            
            
            
            3,777,957
            
            
            
            3,405,203Net
      cash provided by continuing operations
            
            
            6,374,450
            
            
            
            4,916,291
            
            
            
            3,753,977Net
      cash provided by (used in) discontinued operations
            
            
            (132,211
            )
            
            
            128,572
            
            
            
            (78,768
            )Net
      cash provided by operating activities
            
            
            6,242,239
            
            
            
            5,044,863
            
            
            
            3,675,209Cash
      flows from investing activities:Insurance
      proceeds received from Hurricane Rita loss
            
            
            300,000
            
            
            
            1,211,850
            
            
            
            --Purchase
      of property and equipment
            
            
            (4,499,061
            )
            
            
            (5,121,636
            )
            
            
            (4,203,357
            )Proceeds
      from sale of property and equipment
            
            
            372,691
            
            
            
            765,000
            
            
            
            5,280Business
      Acquisitions, net of cash acquired
            
            
            --
            
            
            
            (742,490
            )
            
            
            --Net
      cash used in continuing operations
            
            
            ( 3,826,370
            )
            
            
            (3,887,276
            )
            
            
            (4,198,077
            )Net
      cash provided by (used in) discontinued operations
            
            
            (113,873
            )
            
            
            (80,242
            )
            
            
            4,020Net
      cash used in investing activities
            
            
            (3,940,243
            )
            
            
            (3,967,518
            )
            
            
            (4,194,057
            )Cash
      flows from financing activities:Net
      borrowings (payment) under line of credit agreement
            
            
            (1,500,000
            )
            
            
            800,000
            
            
            
            3,100,000Purchase
      of treasury stock
            
            
            (1,738,267
            )
            
            
            (261,730
            )
            
            
            (1,628,000
            )Excess
      tax benefit (expense) – stock-based compensation expense
            
            
            --
            
            
            
            44,923
            
            
            
            (5,658
            )Exercise
      of stock options
            
            
            430,544
            
            
            
            704,663
            
            
            
            53,825Payments
      on Long-term debt
            
            
            --
            
            
            
            (2,500,000
            )
            
            
            (500,000
            )Net
      cash provided by (used in) financing activities
            
            
            (2,807,723
            )
            
            
            (1,212,144
            )
            
            
            1,020,167Net
      increase (decrease) in cash
            
            
            (505,727
            )
            
            
            (134,799
            )
            
            
            501,319Cash
      at beginning of year
            
            
            1,293,836
            
            
            
            788,109
            
            
            
            653,310Cash
      at end of year
            
            $
            788,109
            
            
            $
            653,310
            
            
            $
            1,154,629Supplemental
      disclosure of cash flow information:Cash
      paid during the year:Interest
            
            $
            561,972
            
            
            $
            384,242
            
            
            $
            390,298Income
      taxes
            
            $
            297,693
            
            
            $
            1,074,819
            
            
            $
            107,652Non-cash
      financing activities:Repurchase
      of common stock in exchange for certain assets
            
            
            --
            
            
            
            --
            
            
            $
            218,205


See
accompanying notes to consolidated financial statements.







F-6





MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


January
1, 2006, December 31, 2006 and December 30, 2007





(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.





In July 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.”





In April 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.




In
January 2004, the Company purchased 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 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
Fleet National Bank, CNL and the sellers.





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.  The Company spent $329,489 remodeling
the restaurant.





On August
17, 2006, the Company completed its purchase of two Houston-area Mission Burrito
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 2007,
2006, and 2005 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 2006 and 2005 shown in the accompanying
consolidated financial statements have been reclassified to conform to the 2007
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 also franchises the Casa Olé concept
principally in Texas and Louisiana and the La Señorita concept principally in
the State of Michigan.










F-7








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 2007, 2006 and 2005 each consisted of 52
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 consist of
hiring and training employees associated with the opening of a new restaurant
and are expensed as incurred.





(f)  Property and Equipment





Property 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 on a straight-line basis
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 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
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”.





In fiscal
year 2007, the Company recorded asset impairment costs of $99,978 in continuing
operations related to two under-performing restaurants, which were also impaired
in fiscal year 2006.














F-8








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 $928,053 is included in discontinued
operations.  The remaining $447,903 in continuing operations related
to the impairment of the assets of two under-performing restaurants and real
estate broker commissions related to the sale of one subleased restaurant and
adjusted its accrual for two other 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.





(g)  Balance
Sheets of Discontinued Operations





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





2006
            
            
            2007Current
      portion of liabilitiesassociated
      with leasing andexit
      activities
            
            $
            439,682
            
            
            $
            148,681Other
      liabilities associated withleasing
      and exit activities
            
            $
            544,512
            
            
            $
            577,582Total
            
            $
            984,194
            
            
            $
            726,263





Current
liabilities consist primarily of accrued closure costs and the current portion
of rent differential.  Long-term liabilities consist primarily of rent
differential for closed restaurants for which the Company has subleased the
restaurants.  Rent differential represents the difference between the
contractual lease payments made by the Company for closed restaurants and the
amount to be received under subleases to other tenants.





(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 a loss of $29,800 related to the pending sale of the Port
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”.





At December 30, 2007 and December 31,
2006, the consolidated balance sheets each included $11.4 million of goodwill
primarily resulting from the MAC, La Señorita and Beaumont-based franchisee
acquisitions and the 2006 acquisition of Mission Burrito.  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,
December 31, 2006, and December 30, 2007.  Management performed its
goodwill impairment testing for each year and determined that the fair value
exceeded the carrying amount of the reporting unit and that no impairment of
goodwill exists.




F-9




MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)


(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 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 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 revised the existing franchise
tax by substantially changing the tax calculation and expanding the taxpayer
base.





Effective January 1, 2007, the Company
adopted FASB Interpretation Number 48, “Accounting for Uncertainty in
Income Taxes” (FIN 48), which is intended to clarify the accounting for
income taxes prescribing a minimum recognition threshold for a tax position
before being recognized in the consolidated financial statements. FIN 48 also
provides guidance on
derecognition, measurement, classification, interest and penalties, accounting
in interim periods, disclosure and transition.  In accordance with the
requirements of FIN 48, the Company evaluated all tax years still subject to
potential audit under state and
federal income tax law in reaching its accounting conclusions. As a result, the
Company concluded it did not have any unrecognized tax benefits or any
additional tax liabilities after applying FIN 48 as of the January 1, 2007
adoption date or for the fiscal year ended December 30, 2007.  The
adoption of FIN 48 therefore had no impact on the Company’s consolidated
financial statements.  See Note 4 to our consolidated financial
statements for further discussion.






F-10


MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)


(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).





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.  Information related to options granted
in 2007 and 2005 is as follows:





2005
            2007Risk-free
      interest rate
            4.05%
            4.51%
      to 4.74%Expected
      life, in years
            8.1
            7.5Expected
      volatility
            28.3%
            23.6%
      to 29.3%Dividend
      yield
            0%
            0%










F-11








MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)








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.





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 121,472, 104,375 and 13,500 stock
options exercised in fiscal years 2005, 2006 and 2007, respectively (excluding
the options purchased in December, 2006 from the Company’s President and CEO
pursuant to a Separation Agreement).  (See Note 5 (g)).  The
Company received cash in the amount of $430,544, $704,663 and $53,825
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 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.





2005Net
      income (loss) - as reported
            
            $
            2,316,997Less:
      Stock based compensation expense, determined under fair
      valuebased
      method for all awards, net of taxes
            
            
            (85,467
            )Proforma
      net income (loss) – pro forma for SFAS No. 123
            
            $
            2,231,530Net
      income per share basic – as reported
            
            $
            0.68Net
      income per share diluted – as reported
            
            $
            0.63Pro
      forma net income per share basic
            
            $
            0.65Pro
      forma net income per share diluted
            
            $
            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 consolidated
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 consolidated
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 fiscal year 2005, and
$1,211,850 in fiscal year 2006 related to the property damage
claim.  Additionally, the Company received $593,784 for business
interruption proceeds.


F-12
  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 FASB issued SFAS No. 157, “Fair Value Measurements”
(“SFAS No. 157”). This Statement defines fair value, establishes a
framework for measuring fair value and expands disclosure of fair value
measurements. SFAS No. 157 applies under other accounting
pronouncements that require or permit fair value measurements and accordingly,
does not require any new fair value measurements. Leasing transactions that are
accounted for under SFAS No. 13 “Accounting for Leases” are excluded
from SFAS No. 157. However, this exclusion does not apply to fair
value measurements of assets and liabilities recorded as a result of a lease
transaction but measured pursuant to other pronouncements within the scope of
SFAS No. 157. For non-financial assets and liabilities that are
recognized or disclosed at fair value in the financial statements at least
annually as well as for all financial assets and liabilities,
SFAS No. 157 is effective in financial statements issued for fiscal
years beginning after November 15, 2007. For non-financial assets and
liabilities that are not recognized or disclosed at fair value in the financial
statements on a recurring basis, SFAS No. 157 is effective in
financial statements issued for fiscal years beginning after November 15,
2008. The Company adopted SFAS No. 157 on January 1, 2008. The adoption of
SFAS No. 157 is not expected to have a material impact on the financial
position, results of operations or cash flows.





In February 2007, the FASB issued
SFAS No. 159, “The
Fair Value Option for Financial Assets and Financial Liabilities —
including an amendment of FASB Statement No. 115”
(“SFAS No. 159”). This Statement provides an opportunity to improve
financial reporting by providing entities with the opportunity to mitigate
volatility in reported earnings caused by measuring related assets and
liabilities differently without having to apply complex hedge accounting
provisions. SFAS No. 159 becomes effective for the fiscal years beginning after
November 15, 2007.  We do not believe the adoption of SFAS No. 159
will have a material impact on our consolidated financial position, cash flows
or results of operations.





In December 2007, the FASB issued
SFAS No. 141(R), “Business Combinations”
(“SFAS No. 141(R)”),which is a revision of SFAS 141 “Business Combinations”. SFAS No. 141(R)
significantly changes the accounting for business combinations. Under this
statement, an acquiring entity will be required to recognize all the assets
acquired and liabilities assumed in a transaction at the acquisition-date fair
value with limited exceptions. Additionally, SFAS No. 141(R) includes
a substantial number of new disclosure requirements. SFAS No. 141(R)
applies prospectively to business combinations for which the acquisition date is
on or after the beginning of the first annual reporting period beginning on or
after December 15, 2008. Earlier adoption is prohibited. The Company is in
the process of evaluating the impact the adoption of SFAS No. 141(R)
will have on the results of operations and financial condition.  We
currently believe SFAS No. 141(R) will not have a material impact on our
consolidated financial position, cash flows or results of
operations.








In December 2007, the FASB issued
FASB Statement No. 160, “Noncontrolling Interests in
Consolidated Financial Statements — An Amendment of ARB No. 51”
(“SFAS No. 160”), which is an amendment to ARB No. 51 “Consolidated Financial Statements”.
SFAS No. 160 establishes new accounting and reporting standards for
the noncontrolling interest in a subsidiary and for the deconsolidation of a
subsidiary. Specifically, this statement requires the recognition of a
noncontrolling interest (minority interest) as equity in the consolidated
financial statements and separate from the parent’s equity. The amount of net
income attributable to the noncontrolling interest will be included in
consolidated net income on the face of the income statement.
SFAS No. 160 clarifies that changes in a parent’s ownership interest
in a subsidiary that do not result in deconsolidation
are equity transactions if the parent retains its controlling financial
interest. In addition, this statement requires that a parent recognize a gain or
loss in net income when a subsidiary is deconsolidated. Such gain or loss will
be measured using the fair value of the noncontrolling equity investment on the
deconsolidation date. SFAS No. 160 also includes expanded disclosure
requirements regarding the interests of the parent and its noncontrolling
interest. SFAS No. 160 is effective for fiscal years, and interim
periods within those fiscal years, beginning on or after December 15, 2008.
Earlier adoption is prohibited. The Company is in the process of evaluating the
impact the adoption of SFAS No. 160 will have on the results of
operations and financial condition. Presently, there are no significant
noncontrolling interests in any of the Company’s consolidated
subsidiaries.  Therefore, we currently believe the impact of SFAS No.
160, if any, will primarily depend on the materiality of noncontrolling
interests arising in future transactions to which the consolidated financial
statement presentation and disclosure provisions of SFAS No. 160 will
apply.






F-13


MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)


(s)  Reclassifications





Certain reclassifications have been
made at January 1, 2006 and December 31, 2006 to conform with classifications at
December 30, 2007.  These reclassifications have no effect on the
Company’s consolidated net income or financial position as previously
reported.





(t)
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 2005, 2006 and 2007,
the Company recorded advertising expense in continuing operations of $2,203,403,
$2,315,534 and $2,502,848, which represents 2.9%, 2.9% and 3.1% of restaurant
sales from continuing operations, respectively.





(u) Sales Taxes





Sales taxes collected from customers
are excluded from revenues.  The obligation is included in accrued
liabilities until the taxes are remitted to the appropriate taxing
authorities.





(2)  Property and
Equipment





Property and equipment at December 31,
2006 and December 30, 2007 are as follows:





2006
            
            
            2007Land
            
            $
            60,750
            
            
            $
            60,750Vehicles
            
            
            16,874
            
            
            
            16,874Equipment
      and Smallwares
            
            
            20,458,161
            
            
            
            21,625,556Leasehold
      Improvements
            
            
            14,141,859
            
            
            
            14,799,57334,677,644
            
            
            
            36,502,753Less:
      Accumulated Depreciation
            
            
            (17,171,172
            )
            
            
            (19,175,946
            )17,506,472
            
            
            
            17,326,807Construction
      in Progress
            
            
            4,971
            
            
            
            526,129Net
            
            $
            17,511,443
            
            
            $
            17,852,936



















F-14





MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)





(3)  Long-term
Debt





Long-term debt consists of the
following at December 31, 2006 and December 30, 2007:





2006
            
            
            2007Revolving
      Line of Credit
            
            $
            3,300,000
            
            
            $
            6,400,000Other
      long-term debt
            
            
            500,000
            
            
            
            --Total
      long-term debt
            
            
            3,800,000
            
            
            
            6,400,000Less
      current installments
            
            
            --
            
            
            
            --Long-term
      debt, excluding current installments
            
            $
            3,800,000
            
            
            $
            6,400,000





During fiscal year 2007, the Company
borrowed $6,828,000 on its new Wells Fargo Bank line of credit to pay off the
$6,128,000 balance on the then-existing Bank of America line of credit and the
remaining $500,000 seller note to the Beaumont-based franchisee.  The
Company paid down $428,000 on the Wells Fargo line of credit in the fourth
quarter of fiscal year 2007.  As of December 30, 2007, the Company’s
outstanding debt to Wells Fargo Bank was $6.4 million.





During
fiscal year 2006, the Company borrowed on its then-existing 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 March 29, 2007 the Company amended
its credit facility with Bank of America 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.  This revolving line of credit was scheduled to mature on
December 31, 2011.   As of April 1, 2007, the Company was in
compliance with all debt covenants, as amended.  This credit facility
was terminated in June 2007 as described below.







On June 29, 2007 the Company entered into a Credit Agreement (the “Wells Fargo
Agreement”) with Wells Fargo Bank, N.A. (“Wells Fargo”) in order to increase the
revolving loan amount available to the Company from $7.5 million to $10
million.  The Wells Fargo Agreement also allows up to $2.0 million in
annual stock repurchases.  In connection with the execution of the
Wells Fargo Agreement, the Company prepaid and terminated its existing credit
facility between the Company and Bank of America.  The Wells Fargo
Agreement provides for a revolving loan of up to $10 million, with an option to
increase the revolving loan by an additional $5 million, for a total of $15
million.  The Wells Fargo Agreement terminates on June 29,
2010.  At the Company’s option, the revolving loan bears an interest
rate equal to either the Wells Fargo Base Rate plus a stipulated percentage or
LIBOR plus a stipulated percentage.  Accordingly, the Company is
impacted by changes in the Base Rate and LIBOR.  The Company is
subject to a non-use fee of 0.50% on the unused portion of the revolver from the
date of the Wells Fargo 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
Wells Fargo Bank, N.A.  The Wells Fargo Agreement requires the Company
to maintain certain minimum EBITDA levels, leverage ratios and fixed charge
coverage ratios.  As of December 30, 2007, the Company was in
compliance with all debt covenants.




Maturities
      on long-term debt are as follows:Year Ending2008
            $              --2009
            --2010
            6,400,0002011
            --2012
            --Thereafter
            --$6,400,000




F-15





MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)





(4)  Income
Taxes





The provision (benefit) for income
taxes from continuing operations is summarized as follows for fiscal years 2005,
2006 and 2007:





2005
            
            
            2006
            
            
            2007Current:Federal
            
            $
            642,522
            
            
            $
            726,948
            
            
            $
            186,889State
      and local
            
            
            136,040
            
            
            
            153,574
            
            
            
            125,907Deferred
      (benefit)
            
            
            707,683
            
            
            
            19,931
            
            
            
            (233,546
            )$
            1,486,245
            
            
            $
            900,453
            
            
            $
            79,250





The benefit for income taxes from
discontinued operations is summarized as follows for fiscal years 2005, 2006 and
2007:





2005
            
            
            2006
            
            
            2007Current:Federal
            
            $
            66,853
            
            
            $
            341,803
            
            
            $
            141,845State
      and local
            
            
            17,075
            
            
            
            78,013
            
            
            
            32,907Deferred
            
            
            344,870
            
            
            
            82,176
            
            
            
            (112,080
            )$
            428,798
            
            
            $
            501,992
            
            
            $
            62,672





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:








2005
            
            
            2006
            
            
            2007Expected
      tax expenseFederal
            
            $
            1,529,819
            
            
            $
            979,061
            
            
            $
            181,780State tax expense,
      net State and local
            
            
            131,500
            
            
            
            86,621
            
            
            
            66,408Non-deductible
      amortization
            
            
            3,391
            
            
            
            --
            
            
            
            --Tax
      credits
            
            
            (150,645
            )
            
            
            (177,792
            )
            
            
            (179,264
            )Other
            
            
            (27,820
            )
            
            
            12,563
            
            
            
            10,326$
            1,486,245
            
            
            $
            900,453
            
            
            $
            79,250





The tax effects of temporary
differences that give rise to significant portions of deferred tax assets and
liabilities at December 31, 2006 and December 30, 2007 are as
follows:





2006
            
            
            2007Deferred
      tax assets:Sale-leaseback
            
            $
            500,177
            
            
            $
            423,227Tax
      credit carryforwards
            
            
            495,665
            
            
            
            764,051Asset
      impairments
            
            
            987,649
            
            
            
            941,447Accrued
      expenses
            
            
            239,288
            
            
            
            195,585$
            2,222,779
            
            
            $
            2,324,310Deferred
      tax liabilities:Other
            
            $
            (99,808
            )
            
            $
            (65,767
            )Depreciation
      differences
            
            
            (1,804,452
            )
            
            
            (1,818,558
            )$
            (1,904,260
            )
            
            $
            (1,884,325
            )Net
      deferred taxes
            
            $
            318,519
            
            
            $
            439,985







F-16








MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)








At December 30, 2007, 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 30, 2007, the Company has tax credit
carryforwards of $764,051 which are available to reduce future Federal regular
income taxes, if any, over an indefinite period.





The provisions of FIN No. 48 have been
applied to all of our material tax positions taken through the date of adoption
and during the fiscal year ended December 30, 2007.  We have
determined that all of our material tax positions taken in our income tax
returns met the more likely-than-not recognition threshold prescribed by FIN No.
48.  In addition, we have also determined that, based on our judgment,
none of these tax positions meet the definition of “uncertain tax positions” that are
subject to the non-recognition criteria set forth in the new
pronouncement.  In future reporting periods, if any interest or
penalties are imposed in connection with an income tax liability, we expect to
include both of these items in our income tax provision.  We also do
not believe that it is reasonably possible that the amount of our unrecognized
tax benefits will change significantly within the next twelve
months.  The Company is no longer subject to U.S. federal or state
income tax examinations by tax authorities for years before 2004. During fiscal
year 2006, the Internal Revenue Service (IRS) examined the Company’s 2004 U.S.
income tax return, resulting in the IRS sending a final determination notice of
“No Change”, dated June 29, 2006. As a result, the Company concluded it did not
have any unrecognized tax benefits or any additional tax liabilities after
applying FIN 48 as of the January 1, 2007 adoption date or as of the fiscal year
ended December 30, 2007.  The adoption of FIN 48 therefore had no
impact on the Company’s consolidated financial statements.





(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; motivate employees, by making
appropriate awards, to achieve long-range goals; provide incentive compensation
that is competitive with other corporations; and further align the interests of
directors, employees and other participants with those of other shareholders. It
is anticipated that the 350,000 shares authorized for issuance under the 2005
Plan will enable the Company to cover its grant obligations until the end of
fiscal year 2008 if there are no additional grants.  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.





(b) 1996 Long Term Incentive
Plan





The Board of Directors and shareholders
of the Company approved the Mexican Restaurants, Inc. 1996 Long Term Incentive
Plan (the "Incentive Plan").  The Incentive Plan terminated by its
terms on February 29, 2006, and no additional options may be granted
thereunder.  The Incentive Plan authorized 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 was 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 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 are nonqualified
stock options and 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-17








MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)








(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.  However,
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.  Options
granted under the Directors Plan are exercisable in 20% increments and 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 are  nonqualified stock options
and 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.  The Stock Option Plan for Non-Employee Directors terminated
by its terms on December 31, 2005, and no additional options may be granted
thereunder.





(d)1996 Manager’s Stock Option
Plan





The Company adopted the 1996 Manager’s
Stock Option Plan (the “Manager’s Plan”) specifically for its store-level
managers.  The Manager’s Plan authorized 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 was 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
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 are nonqualified stock options and 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. The 1996 Manager’s Stock
Option Plan terminated by its terms on December 31, 2005, and no additional
options may be granted thereunder.





(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-Based
      Compensation





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 qualified for this restricted
stock grant.  Effective December 15, 2006, the Company awarded
restricted stock grants for an aggregate of 25,000 shares to four employees,
with such grants vesting over a five year period, and two of these awards
provided that the Company was to make additional restricted stock grants on the
three following anniversary dates, for an aggregate of 25,000
shares.  During the second quarter of fiscal year 2007, 5,000
restricted shares and 2,500 stock options were forfeited upon the termination of
one of those employees.







F-18


MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)








On May 22, 2007, the Company’s Board of
Directors approved a restricted stock grant of 10,000 shares to its President,
with such grant vesting over a four year period.  This award provided
that the Company was to make additional restricted stock grants on the four
following anniversary dates, for an aggregate of 40,000 shares. Also, restricted
stock grants for an aggregate of 11,000 shares was made to four employees of its
Michigan operations, with such grants vesting over a five year
period.  In addition, the Board approved a stock option grant to the
Company’s President for 50,000 options with a grant date price of
$8.43.  The options vest over a five year period, with no vesting in
the first year and vesting of 10%, 20%, 30% and 40% in the second, third, fourth
and fifth years, respectively.





In August 2007, the Company’s Board of
Directors approved restricted stock grants for an aggregate of 20,000 shares to
two employees, with one 10,000 share grant vesting over five years and the
second 10,000 share grant vesting as follows: 2,000 shares vested on August 30,
2007 with the remaining 8,000 shares vesting at 2,000 shares per year over four
years.   The Company’s Board also approved an aggregate of 25,000
stock options to two employees with such grants vesting over five
years.





On November 13, 2007, the Company’s
Board of Directors approved restricted stock grants aggregating 10,000 shares to
four employees, with such grants vesting over a five year period.  In
addition, the Board approved a stock option grant to an employee for 5,000
options with a grant date price of $6.90.  The options vest over a
five year period.





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 for
which the options were sold over the exercise prices of the
options.





(g)
Stock Options Exercised





During fiscal year 2007, the Company’s
employees and a director exercised stock options for 13,500 shares for which the
Company received proceeds of $53,825.  During fiscal year 2006, the
Company’s employees exercised stock options for 104,375 shares 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 stock options  for
121,472 shares 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.





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 based upon
the difference between $10.50 per share and the per share expense prices for
such options.





(h)  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 $6,303 was recognized in fiscal year
2005.





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.  The Company has purchased the
aggregate amount of shares permitted under the program.  The Wells
Fargo debt agreement will allow the Company to repurchase up to $2,000,000 of
stock repurchases in each year (as long as the repurchase does not cause the
Company to be out of compliance with any debt covenants).














F-19











MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)








(i) Option and
      Warrant Summary
            
            
            
            
            Weighted
      AverageShares
            
            
            Exercise PriceBalance
      at January 2, 2005:
            
            
            976,270
            
            
            $
            6.96Granted
            
            
            260,000
            
            
            $
            12.00Exercised
            
            
            121,472
            
            
            
            3.54Canceled
            
            
            10,750
            
            
            
            5.68Balance
      at January 1, 2006:
            
            
            1,104,048
            
            
            $
            8.54Granted
            
            
            --
            
            
            $
            --Exercised
      -- warrants
            
            
            359,770
            
            
            
            10.90Exercised
      -- options
            
            
            217,278
            
            
            
            5.98Canceled
            
            
            110,000
            
            
            
            7.22Balance
      at December 31, 2006:
            
            
            417,000
            
            
            $
            8.19Granted
            
            
            80,000
            
            
            $
            7.96Exercised
            
            
            13,500
            
            
            
            3.98Canceled
            
            
            93,500
            
            
            
            10.45Balance
      at December 30, 2007:
            
            
            390,000
            
            
            $
            7.75





The 390,000 options outstanding at
December 30, 2007 had exercise prices ranging between $2.50 to $12.00, of which
160,000 of the options had exercise prices of $12.00.   As of
December 30, 2007, 306,375 options were vested and exercisable.





During fiscal year 2007, the Company
granted a total of stock options for 80,000 shares to four management
employees.  The Company did not grant any options or warrants in 2006
and the options for 260,000 shares granted in 2005 were fully vested, of which
80,000 have been cancelled.   As of December 30, 2007, the
Company had unrecognized stock based compensation expense of $808,090 for all
outstanding awards.





(j) 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 year 2005, the effect of dilutive stock options
increased the weighted average shares outstanding by 285,070
shares.  For fiscal year 2005, such stock options and warrants did
affect the determination of diluted income by $0.05 per share; 405,870 options
and warrants were considered antidilutive for fiscal year
2005.   The options and warrants that are considered antidilutive
have a grant price that exceeded the market price as of the end of the 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 excess 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 years 2007 and 2006, the incremental shares
added in the calculation of diluted income per share were 90,996 and 119,380,
which affected the determination of diluted income by approximately $0.00 and
$0.01 per share, respectively.
















F-20





MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)








(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 December 31, 2006 and December 30,
2007 was $1,352,927 and $1,144,785, 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 $6,387,210 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 30, 2007, including long-term leases signed and effective in fiscal
year 2008 are approximately:








Year Ending2008
            
            $
            5,699,7082009
            
            
            5,667,9132010
            
            
            5,330,2852011
            
            
            5,058,3092012
            
            
            4,954,706Thereafter
            
            
            21,557,830$
            48,268,751








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 term.  Future
minimum lease receipts under non-cancelable operating leases with initial or
remaining lease terms in excess of one year as of December 30, 2007 are
approximately:





Year Ending2008
            
            $
            199,9502009
            
            
            113,0402010
            
            
            115,2962011
            
            
            117,5642012
            
            
            119,916Thereafter
            
            
            61,134$
            726,900




F-21





MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)








Total rent expense for restaurant
operating space and equipment amounted to $6,103,154, $6,164,216 and $6,134,555
for the fiscal years 2005, 2006 and 2007, respectively.





(7)
            Accrued
      Expenses and Other Liabilities





Accrued expenses consist of the
following:





2006
            
            
            2007Property
      Tax
            
            $
            751,393
            
            
            $
            643,492Insurance
            
            
            400,321
            
            
            
            450,878Rent
            
            
            129,908
            
            
            
            117,096Interest
            
            
            12,538
            
            
            
            120,865Other
            
            
            95,075
            
            
            
            128,810$
            1,389,234
            
            
            $
            1,461,141





Other liabilities consist of the
following:





2006
            
            
            2007Deferred
      Rent
            
            $
            1,442,260
            
            
            $
            1,843,311Other
            
            
            63,500
            
            
            
            66,958$
            1,505,760
            
            
            $
            1,910,270





(8)
            Acquisition





In January 2004, the Company purchased
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, CNL Franchise Network, LP (“CNL”)
and the sellers of the Beaumont-based franchise
restaurants.   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.  On March 31, 2006, the Company prepaid
$2.5 million in fixed rate notes and on June 29, 2007 the Company prepaid the
remaining $500,000 fixed rate note.





On August 17, 2006, the Company
completed its purchase of two Houston-area Mission Burrito 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










F-22





MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)








(9)
            401(k)
      Plan





Beginning in fiscal year 1998, the
Company established adefined 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 2005, 2006 and 2007.





(10)
            Related
      Party Transactions





On June 12, 2007, the Company’s
Director of Franchise Operations, Mr. Forehand, resigned his position and
entered into a five year employment agreement, which provides for a reduced
operational role with the Company.  He continues to serve as a
Director and as Vice Chairman of the Company’s Board of Directors.





On June 13, 2007, Mr. Forehand entered
into a Stock Purchase Agreement to sell 200,000 shares of his personally-owned
common stock back to the Company.  The stock was valued at $8.14 per
share, which was the ten-day weighted average stock price as of June 12, 2007,
and the Company finalized the stock purchase on July 6, 2007.





On June 15, 2007, Mr. Forehand entered
into an Asset Purchase Agreement to purchase the assets of the Company’s Casa
Olé restaurant located in Stafford, Texas, an under-performing restaurant, for
an agreed price of 26,806 shares of the Company’s common stock.  The
stock was valued at $8.14 per share, which was the ten-day weighted average
stock price as of June 12, 2007, for a total value of $218,205.  The
sale resulted in a loss of $79,015.  The restaurant operations were
taken over by Mr. Forehand after the close of business on July 1,
2007.  The Stafford restaurant operates under the Company’s uniform
franchise agreement and is subject to a monthly royalty fee.  For
fiscal year ended December 30, 2007 the Company recognized royalty income of
$10,254.





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.





(11)
            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 30, 2007, there
were 255,000 performance units outstanding.  The performance units, of
which 165,000 expire August 2010, 25,000 expire December 2011, 55,000 expire
August 2012 and 10,000 expire November 2012, 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.





During the fourth quarter of fiscal
year 2007, the Company made a one time adjustment of $100,000 to cost of sales
to correct for rebates the Company mistakenly recorded as its own that should
have been paid to franchisees.



















F-23














MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)





(12)
            Subsequent
      Events





On February 19, 2008 a fire at a
Company-owned restaurant located in East Texas caused extensive damage to the
interior of the restaurant.  The Company has not yet determined the
amount of the loss and is currently in discussions with its insurance
carrier.





(13)
            Selected
      Quarterly Financial Data
(Unaudited)





The unaudited quarterly results for the
fiscal year ended  December 31, 2006 and December 30, 2007 were as
follows (in thousands, except per share data):





Fiscal
      Year 2006 Quarter EndedDecember 31
            
            
            October 1
            
            
            July 2
            
            
            April 2Revenues
            
            $
            19,813
            
            
            $
            20,241
            
            
            $
            20,850
            
            
            $
            20,786Income
      (loss) from continuing operations,net
      of tax
            
            
            (315
            )
            
            
            454
            
            
            
            1,047
            
            
            
            793Loss
      from discontinued operations, net oftax
            
            
            (694
            )
            
            
            (79
            )
            
            
            (41
            )
            
            
            (27
            )Net
      income (loss)
            
            $
            (1,009
            )
            
            $
            375
            
            
            $
            1,006
            
            
            $
            766Basic
      income per shareIncome
      (loss) from continuing operations
            
            $
            (0.10
            )
            
            $
            0.13
            
            
            $
            0.31
            
            
            $
            0.24Loss
      from discontinued operations
            
            
            (0.20
            )
            
            
            (0.02
            )
            
            
            (0.01
            )
            
            
            (0.01
            )Net
      income (loss)
            
            $
            (0.30
            )
            
            $
            0.11
            
            
            $
            0.30
            
            
            $
            0.23Diluted
      income per shareIncome
      (loss) from continuing operations
            
            $
            (0.10
            )
            
            $
            0.12
            
            
            $
            0.28
            
            
            $
            0.22Loss
      from discontinued operations
            
            
            (0.20
            )
            
            
            (0.02
            )
            
            
            (0.01
            )
            
            
            (0.01
            )Net
      income (loss)
            
            $
            (0.30
            )
            
            $
            0.10
            
            
            $
            0.27
            
            
            $
            0.21





Fiscal
      Year 2007 Quarter EndedDecember 30
            
            
            September 30
            
            
            July 1
            
            
            April 1Revenues
            
            $
            19,843
            
            
            $
            20,887
            
            
            $
            20,870
            
            
            $
            20,490Income
      (loss) from continuing operations, net oftax
            
            
            194
            
            
            
            99
            
            
            
            184
            
            
            
            (21
            )Income
      (loss) from discontinued operations, netof
      tax
            
            
            6
            
            
            
            (10
            )
            
            
            (54
            )
            
            
            (48
            )Net
      income (loss)
            
            $
            200
            
            
            $
            89
            
            
            $
            130
            
            
            $
            (69
            )Basic
      income per shareIncome
      (loss) from continuing operations
            
            $
            0.06
            
            
            $
            0.03
            
            
            $
            0.06
            
            
            $
            (0.01
            )Loss
      from discontinued operations
            
            
            --
            
            
            
            --
            
            
            
            ( 0.02
            )
            
            
            ( 0.01
            )Net
      income (loss)
            
            $
            0.06
            
            
            $
            0.03
            
            
            $
            0.04
            
            
            $
            (0.02
            )Diluted
      income per shareIncome
      (loss) from continuing operations
            
            $
            0.06
            
            
            $
            0.03
            
            
            $
            0.06
            
            
            $
            (0.01
            )Income
      (loss) from discontinued  operations
            
            
            --
            
            
            
            --
            
            
            
            ( 0.02
            )
            
            
            ( 0.01
            )Net
      income  (loss)
            
            $
            0.06
            
            
            $
            0.03
            
            
            $
            0.04
            
            
            $
            (0.02
            )

































.