UNITED
STATES
 SECURITIES
AND EXCHANGE COMMISSION
 WASHINGTON,
D.C.  20549
 
 FORM
10-K
 
 [ X ]
              ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934
 
 For the Fiscal Year Ended December 28,
2008
 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 "large accelerated filer”,
“accelerated filer" and “smaller reporting company” in Rule 12b-2 of the
Exchange Act.  (Check one):
  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 June 27, 2008, the last business day of the
Registrant’s most recently completed second quarter, was $4,310,469. 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 December 28, 2008:
3,251,641 shares of Common Stock, par value $.01.
 
 Documents
Incorporated By Reference
 
 Specified
portions of the Registrant’s definitive proxy statement in connection with the
2009 Annual Meeting of Shareholders to be held May 27, 2009, 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.
 Form
10-K
 Table
of Contents
 
 Part
      I
                
                PageSpecial Note Regarding Forward-Looking
      Statements
                3Item 1.
                Business
                4Item 1A.
                Risk Factors
                11Item 1B.
                Unresolved Staff Comments
                13Item 2.
                Properties
                13Item 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.(T)
                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
                30Item 14.
                Principal Accountant Fees and Services
                30Part
      IVItem 15.
                Exhibits and Financial Statement
    Schedules
                30Signatures
                
                32
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 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 and terms 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 at the time when made, 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®.  We also
operate 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 37, 54, 15, 30, 22
and 12 years, respectively.  Today, we operate 61 restaurants,
franchise 18 restaurants and license 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
our 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.   We believe that our established success in existing
markets, focus on middle-income customers, and the skills of our 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.
 
 Our 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, we changed the 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.
 
 Strategy
and Concept
 
 Our 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, we have developed strategies
designed to achieve and maintain high levels of customer loyalty, frequent
patronage and profitability.  The key strategic elements
are:
 
 Ÿ
              Offering
      consistent, high-quality, original recipe Mexican menu items that reflect
      both national and local taste
preferences;
 
 Ÿ
              Pricing
      our menu offerings at levels below many family and casual-dining
      restaurant concepts;
 
 Ÿ
              Selecting,
      training and motivating our employees to enhance customer dining
      experiences and the friendly casual atmosphere of our
      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.Our
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 we
also introduce new dishes designed to keep the menus fresh.  Alcoholic
beverages are served as a complement to meals and
as a percentage of sales represent a range from less than 5% at our more
family-oriented locations to up to 21% in our more casual-oriented dining
locations.  At Company-owned restaurants the dinner menu entrees
presently range in price from $4.99 to $15.99, with most items priced between
$6.95 and $10.99.  Lunch prices at most Company-owned restaurants
presently range from $4.95 to $7.99.
 
 4
 The burrito fast casual menu features a
more limited variety of entrees including burritos (wrapped in a 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 3% of sales.
 
 Atmosphere and
Layout.  Our full-service restaurants emphasize an attractive
design for each of our 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.  Our 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 our restaurant
design.  The restaurant facility is also designed to serve a high
volume of customers in a relatively limited period of time.  Our
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 persons.
 
 Our six fast-casual Mission Burrito
restaurants are between approximately 2,000 and 3,000 square
feet.  Several of the restaurants have extensive patios that offer
additional outdoor seating.  We have developed a prototype Mission
Burrito design that is approximately 2,750 square feet with an indoor seating
capacity of approximately 80 persons.  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, we will focus
mostly on end-caps of shopping centers, town centers and lifestyle centers
developments.
 
 Growth
Strategy
 Over the last five years, we have
focused our 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, Monterey’s and Mission Burrito
restaurants and to initiate a program of remodeling several of our existing
restaurants each year.
 
 In August 2006 we acquired two burrito
fast-casual Mission Burrito restaurants located in Houston,
Texas.  The concept, established twelve years ago, has a very loyal
customer base.  Since the Mission Burrito acquisition, we have spent
considerable time and attention planning for the future growth and positioning
of the concept.  Beginning in fiscal year 2007, we 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.  During fiscal year 2008, we opened four Mission Burrito
restaurants in the Greater Houston Metropolitan Area.  On January 24,
2009, we closed one of our Mission Burrito restaurants seven months after it
opened after concluding that the real estate was not conducive to the fast
casual burrito segment.  The average net cost of building the four
Mission Burrito restaurants was $622,000, net of landlord
contributions.
 
 For the foreseeable future, we have
decided to focus our growth primarily on Mission Burrito.  The average
cost to build a Mission Burrito restaurant is approximately 65% of the cost of
building a new Casa Olé restaurant.  Although it will be a few years
before we can measure the actual return on investment, based on the average cost
and the sales forecast, we believe the Mission Burrito concept will provide a
better return on investment than building either Casa Olé or Monterey’s
restaurants.  Due to the combined effects of Hurricanes Gustav and Ike
and the current economic recession, we will focus on a slower rate of growth for
Mission Burrito to fine tune the concept and so that we can rebuild our cash
flow and pay down debt.  In fiscal year 2009, we plan to open one
Mission Burrito restaurant and lay the groundwork for future restaurant
expansion in fiscal year 2010 and beyond.
 
 We believe that the unit economics of
the various restaurant concepts, as well as their value orientation and focus on
middle income customers, provides significant potential opportunities for
growth.  Our long-standing strategy to capitalize on these growth
opportunities has been comprised of three key elements:
 
 
   5
  
 Improve
Same-Restaurant Sales and Profits.  Our 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).  In fiscal year 2008, substantial
increases in commodity prices, utilities and group health 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 we will
not experience the same inflationary impact in fiscal year 2009.  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 2009, our goal is to
improve sales and profitability so that we can maximize free cash flow, which we
will use to pay off debt, remodel one existing restaurant, and build one new
Mission Burrito restaurant.  Although we do not anticipate the
following transactions in fiscal year 2009, we reserve the right to acquire
existing franchise restaurants and to make repurchases of our Common Stock when
we determine such repurchases are a prudent use of our capital.
  Increased
Penetration of Existing Markets.  Our second growth opportunity
is, when we believe 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.  Our 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, we
believe that increasing the density of restaurants in both Company-owned and
franchised markets will assist us in achieving effective media penetration while
maintaining or reducing advertising costs as a percentage of revenues in the
relevant markets.  We believe that careful and prudent site selection
within existing markets will avoid cannibalization of the sales bases of
existing restaurants.
 
 In implementing our unit expansion
strategy, we may use a combination of franchised and Company-owned
restaurants.  The number of such restaurants developed in any period
will vary.  We believe that a mix of franchised and Company-owned
restaurants would enable us to realize accelerated expansion opportunities,
while maintaining majority or sole ownership of a significant number of
restaurants.  Generally, we do not anticipate opening franchised and
Company-owned restaurants within the same market.  In seeking
franchisees, we will continue to primarily target experienced multi-unit
restaurant operators with knowledge of a particular geographic market and
financial resources sufficient to execute our development strategy.
 
 The restaurant industry is a
competitive and fragmented business.  Moreover, the restaurant
industry is characterized by a high initial capital investment.  Our
focus is not on new restaurant expansion just to generate additional sales, but
a balanced approach that emphasizes same-restaurant sales growth and selective
new restaurant development and acquisitions of existing franchise
restaurants.  During fiscal year 2008, we opened four Mission Burrito
restaurants, modestly remodeled one existing restaurant and rebuilt two
restaurants that had been damaged by fire.  We plan to build and open
one new Mission Burrito restaurant in fiscal year 2009, as well as significantly
remodel one existing restaurant.
 
 Seek Strategic
Acquisitions.Since our inception as a public company,
we have primarily grown through the acquisition of other Mexican food restaurant
companies, making four acquisitions since 1996.  We anticipate we will
continue to selectively acquire existing franchised restaurants from time to
time when such opportunities arise (see “Franchising”
below).  Although we are focused primarily on growing the Mission
Burrito concept, we will continue to review potential strategic acquisitions
within the Mexican food restaurant industry that would complement our existing
corporate culture.
 
 Site
Selection
 
 When developing new restaurant sites,
our senior management 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, we conduct customer
surveys to define precisely the demographic profile of the customer base of each
of our restaurant concepts.  Our 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.
 
 6
 We believe that a sufficient number of
suitable sites are available for contemplated Company and franchise development
in existing markets.  Based on our current planning and market
information, we plan to open one new Mission Burrito restaurant in fiscal year
2009.  The anticipated investment for a 2,750 square foot restaurant
lease space, including equipment, signage, site work, furniture, fixtures and
decor ranges between $550,000 and $650,000, net of landlord
contributions.  Additionally, training and other pre-opening costs are
anticipated to be approximately $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 we anticipate that development costs associated
with near-term restaurants will range between $550,000 and $650,000, 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 40 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.
 
 We historically have spent considerable
effort developing our employees, allowing us to promote from
within.  As an additional incentive to our restaurant management
personnel, we have a bonus plan in which restaurant managers can receive monthly
bonuses based on a percentage of their restaurants’ controllable
profits.
 
 Our regional supervisors, who report
directly to the Company’s Directors of Operations, 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 28, 2008, we employed
2,378 people, of whom 2,332 were restaurant personnel at the Company-owned
restaurants and 46 were corporate personnel.  We consider our employee
relations to be good.  Most employees, other than restaurant
management and corporate personnel, are paid on an hourly basis.  Our
employees are not covered by a collective bargaining agreement.
 
 Training and
Quality Control.  We require our 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 our 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.  The
Company's franchise agreement requires each franchised restaurant to employ a
general manager who has completed our training program at one of our specified
training stores.  Compliance with our 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.  We believe 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 2008, we spent approximately 2.5% of
restaurant revenues on various forms of advertising and plan to spend 2.7% of
restaurant revenues in fiscal year 2009.  Besides radio and
television, we make use of in-store promotions, involvement in community
activities, and customer word-of-mouth to maintain their
performance.
 
  7
 Purchasing.We strive to obtain
consistent quality products at competitive prices from reliable
sources.  We work with our distributors and other purveyors to ensure
the integrity, quality, price and availability of the various raw
ingredients.  We research and test various products in an effort to
maintain quality and to be responsive to changing customer tastes.  We
operate a centralized purchasing system that is utilized by all of the
Company-owned restaurants and is available to our franchisees.  Under
our franchise agreements, if franchisees wish to purchase from a supplier other
than a currently approved supplier, they must first submit the products and
supplier to us for approval.  Regardless of the purchase source, all
purchases must comply with the Company's product specifications.  Our
ability to maintain consistent product quality throughout our 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
 
 We currently have eight Casa Olé
franchisees and one La Senorita franchisee operating a total of 18 restaurants
and one licensee operating one Monterey’s Little Mexico
restaurant.  Most franchisees operate one or two
restaurants.  No new franchise restaurants were opened during fiscal
2008.  In 2007 one company-owned restaurant was sold to Larry
Forehand, a director and Vice Chairman of the Company’s Board of
Directors.  See “Notes to Consolidated Financial Statements, Footnote
(10) ‘Related Party Transactions’”.
 
 Franchising allows us to expand the
number of stores and penetrate markets more quickly and with less capital than
developing Company-owned stores.  We have the first right of refusal
when a franchisee decides to sell its restaurant(s).  Historically, we
have selectively acquired franchisee restaurants when reasonably
available.  At the same time, we plan to expand our base of franchise
restaurants.
 
 Franchisees are selected on the basis
of various factors, including business background, experience and financial
resources.  In seeking new franchisees, we target experienced
multi-unit restaurant operators with knowledge of a particular geographic market
and financial resources sufficient to execute our 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 our authorized agent, spice packages for use in the
preparation of certain menu items, and must purchase certain other items from
approved suppliers unless written consent is received from the
Company.
 
 Franchise
Agreements.We enter 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
us.  The franchisee then has limited exclusive rights within the
territory.  Under our 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 our
franchise agreements with its existing franchisees currently range from 2009 to
2019.  We are updating our Franchise Agreement.  Under the
new Franchise Agreements, the termination dates will range from 2009 to
2024.  There are six franchises that are currently on a month-to-month
basis until we have approved the new Franchise Agreement.
 
 Franchise agreements are not assignable
without our prior written consent.  Also, we retain rights of first
refusal with respect to any proposed sales by the
franchisee.  Franchisees are not permitted to compete with us 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.  We have 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 our 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 our 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.
 
 8
 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, we provide training at its approved
training facility for each franchisee's
general manager, assistant manager and kitchen manager or chef.  We
recommend that the franchisee, if the franchisee is other than the general
manager, or if a business organization, its chief operating officer, attend such
training.  We also provide 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 our 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 our prior written consent.  We 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
us.  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.  We currently have two area
developers and are seeking new area developers.
 
 Competition
 
 The restaurant industry is intensely
competitive.  Competition is based upon a number of factors, including
concept, price, location, quality and service.  We compete 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.  We also compete against other quick service, fast casual and
casual dining concepts within the Mexican and Tex-Mex food
segment.  Many of our competitors are well established and have
substantially greater financial and other resources than
us.   Some of our competitors may be better established in
markets where our restaurants are, or may be, located.  Also, we
compete 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 our 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.  We are also subject to laws governing
the service of alcohol and our relationship with employees, including minimum
wage requirements, overtime, working conditions and immigration
requirements.  If we fail to comply with existing or future laws and
regulations, we could be subject to governmental or judicial fines or
sanctions.    We believe that we are operating in
substantial compliance with applicable laws and regulations that govern our
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.
 
 9
 Alcoholic beverage control regulations
require each of our 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 our 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.  We are 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.  We carry liquor liability
coverage as part of our existing comprehensive general liability
insurance.  Additionally, within thirty days of employment by the
Company, each of our Texas employees 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
over-service, as well as underage service, of the customers at our
restaurants.
 
 In connection with the sale of
franchises, we are 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. We are also subject to laws that regulate certain
aspects of such relationships.  To date, we have had no claims with
respect to its programs and, based on the nature of any potential compliance
issues identified, do not believe that compliance issues associated with our
historic franchising programs will have a material adverse effect on our results
of operations or financial condition.  We believe that we are
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.  We are 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.
 
 We are subject to various local, state
and federal laws regulating the discharge of pollutants into the
environment.  We believe that we conduct our operations in substantial
compliance with applicable environmental laws and regulations.  We
conduct 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, our
operations have not been materially adversely affected by the cost of compliance
with applicable environmental laws.
 
 Trademarks,
Service Marks and Trade Dress
 
 We believe our trademarks, service
marks and trade dress have significant value and are important to our marketing
efforts.  We have registered the trademarks for “Casa Olé”, “Casa Olé
Mexican Restaurant”, “Monterey’s Tex-Mex Café”, “Monterey’s Little Mexico”,
“Tortuga Cantina”,  “La Señorita” and “Crazy Jose’s.” We have a federal
registration for Mission Burritos Fresh Food Fast & design and a pending
federal application for Mission Burrito More Choices. More Flavor. &
design.  We also have a Texas state registration for the wordmark Mission
Burritos.
 
 Available
Information
  We are subject to the informational
requirements of the Securities Exchange Act of 1934, as amended, and in
accordance therewith, we file reports, proxy and information statements and
other information with the Securities and Exchange Commission
("SEC").  Our 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 our Web site at
www.mexicanrestaurantsinc.com.  Reports are available free of charge
as soon as reasonably practicable after we electronically file them with, or
furnish them to, the SEC.  In addition, our 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.  We are not including this
or any other information on our 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 our Web site, you may read and copy public
reports we file with or furnish 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
we file electronically with the SEC at www.sec.gov.
 
 
 
  10
  
 
 ITEM
1A.                      RISK
FACTORS
 
 You should carefully consider the
following risk factors as well as the other information contained or
incorporated by reference in this report, as these are important factors, among
others, that could cause our actual results to differ from our expected or
historical results.  It is not possible to predict or identify all
such factors and these factors are based on management’s current knowledge and
estimates of factors affecting our operations, both known and
unknown.  Consequently, you should not consider any such list to be a
complete statement of all of our potential risks or uncertainties.
 
 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 2008.  The
forecast for 2009 continues to be cautious, calling for a continuation of the
current economic recession.  A few economic conditions that could
impact the economy and our operating results are: rising unemployment, the
economic recession and the subsequent decline in household wealth 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.  A return to rising fuel and energy costs could reduce
consumers’ level of discretionary spending.  Additionally, the
continued responses to the terrorist attacks on the United States, possible
future terrorist attacks and the conflict in Iraq and Afghanistan and its
aftermath may exacerbate current economic conditions and lead to a further
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.
 
 Our Small
Restaurant Base and Geographic Concentration Make Our Operations More
Susceptible to Local Economic Conditions and the Economic Downturn May Adversely
Impact Our Results.The results achieved to date by our
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 our 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 our present geographic concentration
(all of our 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.  Also, the ongoing financial crisis and economic downturn
could result in material decreases in discretionary spending by consumers, which
in turn could materially and adversely affect our business and results of
operations.
 
 Cost Pressures
May Adversely Impact Our Net Income. Webelieve that certain
cost pressures impacted net income during fiscal year
2008.  Substantial increases in food commodity prices, utilities and
group health insurance 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 we will not experience similar cost pressures in
2009.  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, 2008, the federal minimum wage
increased from $5.85 to $6.55 per hour.  We estimated that the
increase in the federal minimum wage impacted our labor cost by approximately
$2,000 per week.  Future federal minimum wage increases are scheduled
to increase 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 we cannot
increase menu prices.
 
 Changes in food
costs could negatively impact our revenues and results of
operations.  Our 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, we rely
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. We have an exclusive contract with Ben E. Keith Company
on terms and conditions which we believe are consistent with those made
available to similarly situated restaurant companies.  Any increase in
distribution prices by Ben E. Keith Company could cause our food costs to
fluctuate.  Additional factors beyond our control, including adverse
weather conditions and governmental regulation, may affect food
costs.  We may not be able to anticipate and react to changing food
costs through our purchasing practices and menu price adjustments in the future,
and failure to do so could negatively impact our revenues and results of
operations.
  11
 Rising Insurance
Costs Could Negatively Impact Our Profitability.  We are
insured against a variety of uncertainties.  We also provided group
health insurance to certain of our employees and cover approximately 65% of the
cost.  While the cost of certain insurance coverages increased in
2008, we were able to negotiate lower premium costs for other insurance
coverages, and in general, were able to minimize the overall increase and impact
of all total insurance costs to the Company.  For example, a decrease
in property and casualty premiums did have a positive impact on our
profitability in fiscal year 2008.  However, the increase in group
health insurance costs did have a negative impact on our profitability in fiscal
year 2008.  Each year, we renew our insurance
coverages.  Although we try to be proactive in our efforts to control
insurance costs, market forces beyond our control may thwart our ability to
manage these costs.  We expect insurance premiums for property and
casualty insurance to increase in light of the impact of recent hurricanes on
the Texas and Louisiana Gulf Coast.
 
 Seasonal
Fluctuations in Sales and Earnings Affect Our Quarterly
Results.Our sales and earnings fluctuate
seasonally.  Historically, our highest sales and earnings have
occurred in the second and third calendar quarters, which we believe 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, we are impacted by changes in the
prime rate and LIBOR.  As of December 28, 2008, we had $7.5 million
outstanding on our credit facility with Wells Fargo.
 
 Our Financial
Covenants Could Adversely Affect Our Ability to
Borrow.   Under the Wells Fargo Agreement, we are required
to maintain certain minimum EBITDA levels, leverage ratios and fixed charge
coverage ratios.  Due to the impact of Hurricanes Gustav and Ike in the
third quarter of fiscal year 2008, which resulted in approximately $1.15 million
in lost sales, we increased our debt by $1.0 million to $7.5 million.  As a
result of the lost sales, we failed to satisfy our minimum EBITDA covenant for
the twelve month period as of the third quarter of fiscal year 2008.  We
requested and received from Wells Fargo a waiver to this covenant for the third
quarter of fiscal year 2008, and as of December 28, 2008, received an amendment
to the covenant permanently removing the requirement to maintain certain minimum
EBITDA levels.
 
 Although we are currently in compliance
with such financial covenants as amended, an erosion of our business could place
us out of compliance in future periods.  Potential remedies for the
lender if we are 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”.
 
 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.   We compete within each market against other family
dining concepts, as well as quick service and casual dining concepts, for
customers, employees and franchisees.  Several of our competitors
operate more restaurants and have significantly greater financial resources and
longer operating histories than we do.  If we are unable to
successfully compete with the other restaurants in our markets, this could
prevent us from increasing or sustaining our revenues and profitability and
result in a material adverse effect on our business, financial condition,
results of operations or cash flows.
 
 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.
 
 We may
not be able to open our planned new operations on a timely basis, if at all,
and, if opened, these restaurants may not be operated profitably.  We
have experienced, and expect 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 our business, financial condition,
results of operations or cash flows.
 
 
  12
  
 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.
 
 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, we are the subject of complaints or litigation from guests alleging
food-borne illness, injury or other food quality, health or operational
concerns.  We may be adversely affected by publicity resulting from
such allegations, regardless of whether such allegations are valid or whether
the Company is liable.  We are 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 us that could have
a materially adverse effect on our business.
 
 We are 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 we carry liquor
liability coverage as part of our existing comprehensive general liability
insurance, we may still be subject to a judgment in excess of our insurance
coverage and we 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.  We remain committed to maintaining
high standards of corporate governance and public disclosure.  As a
result, we intend 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 2008, our executive
offices were located in approximately 10,015 square feet of office space in
Houston, Texas.  The offices are currently leased by us 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.  We hired a commercial real estate broker to search for new
executive office space and anticipate finding and moving into new executive
offices sometime during fiscal year 2009.  We believe that our
properties are generally well maintained, in good condition and adequate for our
operations.  Further, we believe that suitable additional or
replacement space under comparable terms will be available if
required.
 
 
 13
  Real estate leased for Company-owned
restaurants is typically leased under triple net leases that require us 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 restaurant
sites are leased.  During fiscal year 2007, we 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 our
Board of Directors.  See “Footnote (10) Related Party
Transactions”.
 
 During
fiscal year 2008, we opened four new Mission Burrito restaurants and closed one
underperforming Mission Burrito restaurant subsequent to year-end.  We
modestly remodeled one existing restaurant and rebuilt two restaurants that had
been damaged by fires.
 
 Restaurant
Locations
 
 At December 28, 2008, we had 61
Company-operated restaurants, 18 franchise restaurants and one licensed
restaurant.  As of such date, we 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
three Tortuga Coastal Cantina restaurants in the State of Texas; operated three
Crazy Jose’s in the State of Texas; operated six Mission Burritos in the State
of Texas; and  operated and franchised six La Señorita restaurants in
the State of Michigan.  Our portfolio of restaurants at December 28,
2008 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
                    
                    
                    3
                    
                    LeasedConcept
      total
                    
                    
                    3La SeñoritaCompany-operated
                    
                    
                    5
                    
                    LeasedFranchisee-operated
                    
                    
                    1Concept
      total
                    
                    
                    6Crazy Jose’sCompany-operated
                    
                    
                    3
                    
                    LeasedConcept
      total
                    
                    
                    3Mission BurritoCompany-operated
                    
                    
                    6
                    
                    LeasedSystem
      total
                    
                    
                    80
 
 
 
 14
 
 
 ITEM
3.                      LEGAL
PROCEEDINGS
 
 We are involved from time to time in
litigation relating to claims arising from our 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 our 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 28, 2008.
 
 
 PART
II
 
 ITEM
      5.
              MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER
      MATTERS AND ISSUER PURCHASES OF EQUITY
  SECURITIES
 
 Market
Information.Our Common Stock trades on the Nasdaq Small Cap Market tier
of The Nasdaq Stock Market under the symbol “CASA.”  At March 23,
2009, the closing price of our Common Stock as reported on the Nasdaq Small Cap
Market was $2.54.  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 our fiscal quarters since the end of our
2006 fiscal year.
 
 
 HIGH
                    
                    
                    LOWFiscal
      Year 2009:First
      Quarter (through March 23, 2009)
                    
                    $
                    2.57
                    
                    
                    $
                    1.75Fiscal
      Year 2008:First
      Quarter (ended March 30, 2008)
                    
                    $
                    6.51
                    
                    
                    $
                    5.11Second
      Quarter (ended June 29, 2008)
                    
                    $
                    5.88
                    
                    
                    $
                    3.35Third
      Quarter (ended September 28, 2008)
                    
                    $
                    5.65
                    
                    
                    $
                    3.75Fourth
      Quarter (ended December 28, 2008)
                    
                    $
                    5.39
                    
                    
                    $
                    1.36
 
 Fiscal
      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
 
 
 15
 Performance
Graph
 
 The
following Performance Graph and related information shall not be deemed
“soliciting material” or to be “filed” with the SEC, 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,
2003.
  
 
 
  
  Holders.As of March 23, 2009, we estimate that there were approximately 600
beneficial owners of our Common Stock, represented by approximately 50 holders
of record, and 3,251,641 shares of Common Stock outstanding.
 
 Issuer
Purchases.We did not
repurchase any shares of our Common Stock during 2008.
 
 Dividends.  Since
our 1996 initial public offering, we have not paid cash dividends on our Common
Stock.  We intend to retain earnings of the Company to support
operations, to finance expansion and pay down our debt, and do not intend to pay
cash dividends on the Common Stock for the foreseeable future.  In
addition, our 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, our financial condition, the ability to
do so under then-existing credit agreements and other factors deemed relevant by
the Board of Directors.  See Management’s Discussion and Analysis of
Financial Condition and Results of Operation—Liquidity and Capital Resources)
contained in Item 7 to this Report.
 
 16
 ITEM
6.                      SELECTED
FINANCIAL DATA
 
 The selected financial data set forth
below should be read in conjunction with and are qualified by reference to the
Consolidated Financial Statements and the related Notes thereto included in Item
8, hereof and "Management's Discussion and Analysis of Financial Condition and
Results of Operations" included in Item 7, hereof.
  Fiscal Years(In
      thousands, except share and per share amounts)2004
                  
                  
                  2005
                  
                  
                  2006
                  
                  
                  2007
                  
                  
                  2008Income
      Statement Data:Revenues:Restaurant
      sales
                  
                  $
                  73,499
                  
                  
                  $
                  76,356
                  
                  
                  $
                  80,805
                  
                  
                  $
                  81,380
                  
                  
                  $
                  80,915Franchise
      fees, royalties and other
                  
                  
                  753
                  
                  
                  
                  694
                  
                  
                  
                  825
                  
                  
                  
                  710
                  
                  
                  
                  637Business
      interruption
                  
                  
                  --
                  
                  
                  
                  534
                  
                  
                  
                  60
                  
                  
                  
                  --
                  
                  
                  
                  31874,252
                  
                  
                  
                  77,584
                  
                  
                  
                  81,690
                  
                  
                  
                  82,090
                  
                  
                  
                  81,870Costs
      and expenses:Cost
      of sales
                  
                  
                  20,311
                  
                  
                  
                  20,757
                  
                  
                  
                  22,259
                  
                  
                  
                  23,366
                  
                  
                  
                  23,651Restaurant
      operating expenses
                  
                  
                  40,414
                  
                  
                  
                  42,433
                  
                  
                  
                  45,318
                  
                  
                  
                  46,550
                  
                  
                  
                  46,696General
      and administrative
                  
                  
                  6,587
                  
                  
                  
                  6,942
                  
                  
                  
                  7,717
                  
                  
                  
                  7,472
                  
                  
                  
                  7,640Depreciation
      and amortization
                  
                  
                  2,114
                  
                  
                  
                  2,653
                  
                  
                  
                  3,102
                  
                  
                  
                  3,417
                  
                  
                  
                  3,568Goodwill
      impairment
                  
                  
                  --
                  
                  
                  
                  --
                  
                  
                  
                  --
                  
                  
                  
                  --
                  
                  
                  
                  5,130Impairment
      and restaurant closure costs
                  
                  
                  322
                  
                  
                  
                  --
                  
                  
                  
                  448
                  
                  
                  
                  100
                  
                  
                  
                  774Gain
      on involuntary disposals
                  
                  
                  --
                  
                  
                  
                  (472
                  )
                  
                  
                  (367
                  )
                  
                  
                  --
                  
                  
                  
                  (685
                  )Loss
      on sale of other property and equipment
                  
                  
                  180
                  
                  
                  
                  368
                  
                  
                  
                  30
                  
                  
                  
                  208
                  
                  
                  
                  20669,928
                  
                  
                  
                  72,681
                  
                  
                  
                  78,507
                  
                  
                  
                  81,113
                  
                  
                  
                  86,980Operating
      income (loss)
                  
                  
                  4,324
                  
                  
                  
                  4,903
                  
                  
                  
                  3,183
                  
                  
                  
                  977
                  
                  
                  
                  (5,110
                  )Other
      expense, net
                  
                  
                  (459
                  )
                  
                  
                  (404
                  )
                  
                  
                  (303
                  )
                  
                  
                  (443
                  )
                  
                  
                  (388
                  )Income
      (loss) before income taxes
                  
                  
                  3,865
                  
                  
                  
                  4,499
                  
                  
                  
                  2,880
                  
                  
                  
                  534
                  
                  
                  
                  (5,498
                  )Income
      tax (expense) benefit
                  
                  
                  (1,280
                  )
                  
                  
                  (1,486
                  )
                  
                  
                  (901
                  )
                  
                  
                  (79
                  )
                  
                  
                  1,478Income
      (loss) from continuing operations
                  
                  
                  2,585
                  
                  
                  
                  3,013
                  
                  
                  
                  1,979
                  
                  
                  
                  455
                  
                  
                  
                  (4,020
                  )Discontinued
      OperationsIncome
      (loss) from discontinued operations, netof
      taxes
                  
                  
                  (824
                  )
                  
                  
                  (696
                  )
                  
                  
                  (841
                  )
                  
                  
                  (106
                  )
                  
                  
                  33Net
      income (loss)
                  
                  $
                  1,761
                  
                  
                  $
                  2,317
                  
                  
                  $
                  1,138
                  
                  
                  $
                  349
                  
                  
                  $
                  (3,987
                  )
   2004
                  
                  
                  2005
                  
                  
                  2006
                  
                  
                  2007
                  
                  
                  2008Basic
      income (loss) per share:Income
      (loss) from continuing operations
                  
                  $
                  0.76
                  
                  
                  $
                  0.88
                  
                  
                  $
                  0.58
                  
                  
                  $
                  0.13
                  
                  
                  $
                  (1.23
                  )Income
      (loss) from discontinued operations
                  
                  
                  (0.24
                  )
                  
                  
                  (0.20
                  )
                  
                  
                  (0.25
                  )
                  
                  
                  (0.03
                  )
                  
                  
                  0.01Net
      income (loss)
                  
                  $
                  0.52
                  
                  
                  $
                  0.68
                  
                  
                  $
                  0.33
                  
                  
                  $
                  0.10
                  
                  
                  $
                  (1.22
                  )Diluted
      income (loss) per share:Income
      (loss) from continuing operations
                  
                  $
                  0.71
                  
                  
                  $
                  0.82
                  
                  
                  $
                  0.56
                  
                  
                  $
                  0.13
                  
                  
                  $
                  (1.23
                  )Income
      (loss) from discontinued operations
                  
                  
                  (0.23
                  )
                  
                  
                  (0.19
                  )
                  
                  
                  ( 0.24
                  )
                  
                  
                  ( 0.03
                  )
                  
                  
                  0.01Net
      income (loss)
                  
                  $
                  0.48
                  
                  
                  $
                  0.63
                  
                  
                  $
                  0.32
                  
                  
                  $
                  0.10
                  
                  
                  $
                  (1.22
                  )Weighted
      average shares – Basic
                  
                  
                  3,388,489
                  
                  
                  
                  3,415,806
                  
                  
                  
                  3,402,207
                  
                  
                  
                  3,339,280
                  
                  
                  
                  3,255,503Weighted
      average shares – Diluted
                  
                  
                  3,634,849
                  
                  
                  
                  3,700,876
                  
                  
                  
                  3,521,587
                  
                  
                  
                  3,430,276
                  
                  
                  
                  3,255,503
 
  As of the End of Fiscal
    Years2004
                  
                  
                  2005
                  
                  
                  2006
                  
                  
                  2007
                  
                  
                  2008(In
      thousands)Balance
      Sheet Data:Working
      capital deficit
                  
                  $
                  (1,359
                  )
                  
                  $
                  (1,632
                  )
                  
                  $
                  (1,928
                  )
                  
                  $
                  (911
                  )
                  
                  $
                  (847
                  )Total
      assets
                  
                  $
                  32,326
                  
                  
                  $
                  33,137
                  
                  
                  $
                  33,276
                  
                  
                  $
                  34,356
                  
                  
                  $
                  31,503Long-term
      debt, less  current portion
                  
                  $
                  6,000
                  
                  
                  $
                  4,500
                  
                  
                  $
                  3,800
                  
                  
                  $
                  6,400
                  
                  
                  $
                  7,500Total
      stockholders’ equity
                  
                  $
                  17,868
                  
                  
                  $
                  18,884
                  
                  
                  $
                  20,573
                  
                  
                  $
                  19,265
                  
                  
                  $
                  15,486
 
 
 17
 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 other sections of this Annual report on Form 10-K,
including 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.  Through our
subsidiaries, we operate and franchise 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.  We also operate
fast casual burrito restaurants under the name Mission Burrito.  At
December 28, 2008 we operated 61 restaurants, franchised 18 restaurants and
licensed one restaurant in various communities in Texas, Louisiana, Oklahoma and
Michigan.
 
 Our primary source of revenues is the
sale of food and beverages at Company-owned restaurants.  We also
derive 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.
 
 The consolidated statements of
operations and cash flows for fiscal years 2007 and 2006 have been adjusted to
remove the operations of closed restaurants, which have been reclassified as
discontinued operations.  There were no discontinued operations in
2008.
 
 Fiscal
Year
 
 We have a 52/53 week fiscal year ending
on the Sunday nearest December 31.  References in this Report to
fiscal 2008, 2007 and 2006 relate to the periods ended December 28, 2008,
December 30, 2007, and December 31, 2006, respectively.  Fiscal years
2008, 2007 and 2006, presented herein consisted of 52 weeks.
 
 Results
of Operations
 
 Fiscal
Year 2008 Compared to Fiscal Year 2007 as Adjusted for Discontinued
Operations
 
 Revenues.  Our
revenues for the fiscal year ended December 28, 2008 were down $221,131 or 0.3%
to $81.9 million compared with fiscal year 2007.  Restaurant sales for
fiscal year 2008 decreased $465,227 or 0.6% to $80.9 million compared
with fiscal year 2007.  We lost approximately $1.15 million in
restaurant sales from the impact of Hurricanes Gustav and
Ike.  Restaurant sales were also impacted by approximately $900,000
due to restaurant fires at two stores.  The decrease also reflects the
sale of the Stafford, Texas Casa Olé restaurant in July of 2007.  An
increase in same-store sales partially offset the above mentioned decreases,
along with the addition of four Mission Burrito fast casual
restaurants.  For the 52-week period ended December 28, 2008,
excluding the lost sales from the hurricanes and fires from the same-store sales
comparison (only stores open in both periods are included in same-store sales
amounts), Company-owned same-restaurant sales increased approximately
1.5%.  The same-store sales trend prior to the two hurricanes was up
0.3%.  Franchised-owned same-restaurant sales, as reported by
franchisees, and reflecting the lost hurricane sales, increased approximately
1.2% over the same 52-week period ended December 28, 2008.
 
 18
 Franchise
fees, royalties and other for the fiscal year ended December 28, 2008 was down
$73,621 or 10.4% to $636,773 compared with fiscal year 2007 because other
miscellaneous revenues of a nonrecurring nature were realized in fiscal year
2007.
 
 In fiscal
year 2008, we recorded $317,717 of business interruption proceeds related to
claims for two restaurant fires and Hurricane Ike store closures.
 
 Costs and
Expenses.  Costs of sales,
consisting of food, beverage, liquor, supplies and paper costs, increased 50
basis points as a percent of restaurant sales to 29.2% compared with 28.7% in
fiscal year 2007.  The increase primarily reflects higher commodity
prices, especially cheese, produce, tortillas, supplies and paper costs, and
higher food discounts to customers.  In March and again in September
of 2008, we raised menu prices at most of the concepts in an effort to offset
some of the rise in commodity costs.
 
 Labor and
other related expenses increased as a percentage of restaurant sales 20 basis
points to 32.7% compared with 32.5% for fiscal year 2007.  Higher
group health insurance expense impacted restaurant labor 10 basis
points.  Hourly back-of-house labor and management costs increased 60
basis points, primarily due to lost sales from Hurricanes Gustav and Ike, while
hourly front-of-house labor improved 50 basis points during fiscal year
2008.
 
 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 2008 as a percentage of restaurant sales 10 basis
points to 24.8% as compared with 24.7% in fiscal year 2007.  The
increase primarily reflects a lower level of sales due to Hurricanes Gustav and
Ike.  Electricity and natural gas costs also
increased.  Favorable electricity contracts on approximately 60% of
our restaurants expired in August of 2008, resulting in higher electric costs
per kilowatt hour thereafter.  We have signed short-term, three-month
contracts until such time management believes that a lower, longer term contract
can be obtained.  The price of electricity in Texas is primarily tied
to the price of natural gas, which has been on a downward trend over the last
three months.  These increases were partially offset by lower
advertising expense, as we pulled commercial advertising immediately after
Hurricane Ike and during the 2008 presidential campaign season.
 
 General
and administrative expenses consist of expenses associated with corporate and
administrative functions that support restaurant operations.  General
and administrative expenses increased 20 basis points as a percentage of total
sales to 9.3% compared with 9.1% for fiscal year 2007.  The increase,
as a percentage of total revenue, reflects, in part, a lower level of sales due
to Hurricanes Gustav and Ike. Actual general and administrative expenses
increased $167,908 in fiscal year 2008 compared with fiscal year
2007.  The increase primarily reflects higher relocation expense,
banking fees, legal expenses, consulting fees related to marketing for Mission
Burrito concept development, and consulting fees related to Sarbanes-Oxley
compliance, all of which were partially offset by reductions in general and
administrative salaries and bonuses, and lower manager-in-training
expenses.
 
 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 20 basis points to 4.4% in fiscal
year 2008 as compared with 4.2% in fiscal year 2007.  Actual
depreciation and amortization expense increased $150,405 in fiscal year 2008
compared with fiscal year 2007.  The increase reflects additional
depreciation expense for remodeled restaurants, new restaurants, and the
replacement of equipment and leasehold improvements in various existing
restaurants.
 
 
 19
  During fiscal year 2008, we incurred
$166,655 in pre-opening expenses related to the opening of four new Mission
Burrito restaurants.  In fiscal year 2007, we spent $23,947 in
pre-opening expenses related to the re-opening of remodeled
restaurants.
 
 Goodwill
Impairment.  Goodwill represents the excess of costs over fair
value of assets of businesses acquired.  We 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.  At year end 2008, management determined that the fair value did
not exceed the carrying amount of the reporting unit and recorded an impairment
of approximately $5.1 million.
 
 Impairment and
Restaurant Closure 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 2008, we expensed $773,789 to impair the assets of one closed
restaurant, one under-performing restaurant earmarked for closure once its lease
expires in fiscal year 2009 and two other under-performing restaurants, and for
broker commissions related to two subleased restaurant sites in
Idaho.  During fiscal year 2007, we expensed $99,978 to impair the
assets of two under-performing restaurants.
 
 Gain on
Involuntary Disposals  The consolidated statements of
operations for the period ended December 28, 2008 includes a separate line item
for gain on involuntary disposals which includes a gain of $685,137 resulting
primarily from the write-off of assets damaged by two restaurant fires, offset
by insurance proceeds for the replacement of assets.  The first fire
occurred on February 19, 2008 at our Casa Olé restaurant located in Vidor, Texas
which re-opened July 7, 2008.  The second fire occurred July 28, 2008
at our Casa Olé restaurant located in Pasadena, Texas which re-opened October
25, 2008.  The gain on involuntary disposals was partially offset by
losses from Hurricanes Gustav and Ike.  We recorded net losses of
$60,991 resulting primarily from spoiled inventory caused by temporary
electricity outages at 35 Company-owned restaurants after Hurricane Ike made
landfall on September 13, 2008.
 
 During
fiscal year 2008, our insurers have paid $739,969 and we have recorded a
receivable of $241,757 related to property damage.  We have spent
$1,167,418 as of December 28, 2008 for the replacement of assets related to the
two fires and the two hurricanes.
 
 The
consolidated statements of operations for period ended December 28, 2008
includes a separate line item for revenues for business interruption insurance
proceeds as follows:  $248,717 related to the two restaurant fires and
$69,000 related to the hurricanes.
 
 Loss on Sale of
Other Property and Equipment.During fiscal year ended
December 28, 2008, we recorded losses of $206,447 primarily related to the
disposal of restaurant assets during the conversion of an existing restaurant
into a Mission Burrito restaurant.
 
 Other Income
(Expense).   Net expense decreased $54,950 to $387,851 in
fiscal year 2008 compared with a net expense of $442,801 in fiscal year
2007.  Interest expense decreased $72,109 to $427,742 in fiscal year
2008 compared with interest expense of $499,851 in fiscal year 2007, reflecting
a decrease in interest rates.
 
 Income Tax
Expense. Our effective tax rate from continuing operations for fiscal
year 2008 was a benefit of 26.89% as compared to 14.8% of expense for fiscal
year 2007.  In fiscal year 2008, we had a pretax net loss from
continuing operations compared to pretax net income in fiscal year
2007.  We recorded a receivable of approximately $128,000 in 2008 for
an expected income tax refund for carrying back the 2008 net operating loss to
an amended 2006 income tax return.  The permanent differences in 2008
were approximately $1.5 million higher as compared to the permanent differences
in 2007 because of the goodwill impairment.  Since the tax deduction
for goodwill is limited to its net tax value, the difference between
the net tax value and net book value contributed to the decrease in the
effective tax rate.  Certain other permanent differences result in tax
credits.  In fiscal year 2008, we were not able to use any of our
current year tax credits, but tax credits of $291,383 can be carried forward for
a twenty year period to reduce future federal regular income taxes.
 
 20
 Discontinued
Operations.  During the fiscal year ended December 28, 2008, we
recorded closure income of $46,226, all of which is included in discontinued
operations.  The closure income related to the revision by management
of the estimated repair and maintenance costs, utility costs and property taxes
associated with restaurants closed in prior years and actual repairs performed
in third quarter 2008.  No stores were permanently closed in fiscal
year 2008.
 
 Fiscal
Year 2007 Compared to Fiscal Year 2006 as Adjusted for Discontinued
Operations
 
 Revenues.  Our
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.
 
 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, we recorded $59,621 of business interruption proceeds related to our
Hurricane Rita insurance claim.
 
 Costs and
Expenses.  Costs of sales,
consisting of food, beverage, liquor, supplies and paper costs, increased 120
basis points as a percent of restaurant sales 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 we mistakenly recorded as our 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
year 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
States’ 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.
 
 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.
 
 
 21
 During fiscal year 2007, we incurred
$23,947 in pre-opening expenses related to the reopening of a remodeled
restaurant.  In fiscal year 2006, we 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, we expensed $99,978 to impair the assets of two
under-performing restaurants.  During fiscal year 2006, we expensed
$447,903 to impair the assets of two under-performing restaurants.  We
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 our restaurants in that
region.  We subsequently hired an insurance consulting firm to assist
management with the filing of our insurance claim.  During the second
quarter of 2006, we finalized negotiations with our insurance carrier for the
hurricane insurance claim.  Also, during fiscal year 2006, we
capitalized $511,236 in asset cost expenditures related to damaged property in
the consolidated balance sheets, and recognized in the consolidated statement of
operations $366,808 as a gain and $59,621 as business interruption revenue from
the insurance claim.  As of December 31, 2006, we have collected all
receivables related to our hurricane insurance claim.
 
 Loss on
Sale of Other Property and Equipment.During fiscal year
2007, we 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 our Casa Olé restaurant located in Stafford, Texas for an agreed price
of 26,806 shares of our 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 our uniform franchise agreement and is subject to a monthly royalty
fee.
During fiscal year 2006, we recorded a loss of $29,591 due to the disposition of
miscellaneous assets.
 
 Other
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. Our 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, we 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, we were not able to use all of our
current year tax credits, but 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, we 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 of Financial Accounting Standards No. 146, “Accounting for Costs Associated
with Exit or Disposal Activities”. In fiscal year 2006, we closed four
underperforming restaurants incurring losses from discontinued operations, net
of taxes, of $840,804.
 
 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.   See “Notes to Consolidated Financial Statements,
Footnotes (1) ‘Description of Business and Summary of Significant Accounting
Policies’ and (10) ‘Related Party Transactions’.”
 
  22
 
 
 Liquidity
and Capital Resources
 
 We
financed our capital expenditure requirements for the fiscal year ended December
28, 2008 primarily by drawing on our revolving line of credit and drawing on our
cash reserves.  In fiscal year 2008, we had cash flow provided by
operating activities of approximately $3.0 million, compared with cash flow
provided by operating activities of approximately $3.7 million in fiscal year
2007 and cash flow provided by operating activities of approximately $5.0
million in fiscal year 2006.  The decrease in cash flows from
operating activities reflects the decrease in operating income, primarily due to
the impact of Hurricanes Gustav and Ike during the third quarter of fiscal year
2008.  During fiscal year 2008, we made a net draw of $1.1 million on
our line of credit, $1 million of which related directly to the impact of
Hurricanes Gustav and Ike.  During fiscal year 2007, financing
activities provided $1.0 million, in which $3.1 million was drawn from our lines
of credit with $1.6 million used for the July 2007 purchase of 200,000 shares of
our common stock and $0.5 million used for the prepayment of the Beaumont-based
franchise restaurant seller note.  As of December 28, 2008, we had a
working capital deficit of $846,905 compared with a working capital deficit of
$911,023 at December 30, 2007 and $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.
 
 Our
principal capital requirements are the funding of routine capital expenditures,
new restaurant development or acquisitions and remodeling of older
units.  During fiscal year 2008, total cash used for capital
requirements was approximately $5.3 million, which included approximately $1.8
million spent for routine capital expenditures, approximately $2.2 million for
new restaurant development, approximately $0.9 million spent to reconstruct two
restaurants damaged by fires, approximately $0.3 million to reconstruct from
hurricane damage, and approximately $0.1 million spent  on
remodels.  We opened four Mission Burrito restaurants during fiscal
year 2008, for a total of six Mission Burrito restaurants. We closed one Mission
Burrito restaurant on January 24, 2009 after seven months of
operations.  We attribute the closure to a poor real estate
location.  We expect to begin construction on our seventh Mission
Burrito restaurant in the second quarter of fiscal year 2009.  Due to
the recent economic downturn and the impact of Hurricanes Gustav and Ike, we do
not expect to enter into any further lease obligations to develop Mission
Burrito restaurants for fiscal year 2009.  We plan to resume our
development of Mission Burrito in fiscal year 2010 and beyond.
 
 In June
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 us from $7.5 million under our then-existing credit
facility with Bank of America to $10 million.   In connection
with the execution of the Wells Fargo Agreement, we prepaid and terminated our
then-existing credit facility with 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 our option, the revolving loan bears an interest rate equal
to 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.  We are 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 Wells Fargo Agreement also allows up to $2.0 million
in annual stock repurchases.  We have pledged the stock of our
subsidiaries, our leasehold interests, our patents and trademarks and our
furniture, fixtures and equipment as collateral for our credit facility with
Wells Fargo.  As of December 28, 2008, total debt outstanding under
the Wells Fargo Agreement was $7.5 million.
 
 Under the Wells Fargo Agreement, we are
required to maintain certain minimum EBITDA levels, leverage ratios and fixed
charge coverage ratios.  Due to the impact of Hurricanes Gustav and Ike in
the third quarter of fiscal year 2008, which resulted in approximately $1.15
million in lost sales, we increased our debt by $1.0 million to $7.5
million.  As a result of the lost sales, we failed to satisfy our
minimum EBITDA covenant under the Wells Fargo agreement for the twelve month
period as of the third quarter of fiscal year 2008.  We requested and
received from Wells Fargo a waiver to this covenant.  We received an
amendment to the agreement effective as of December 28, 2008, eliminating the
minimum EBITDA requirement and adding limits on our growth capital
expenditures.
 
 Although
the Wells Fargo Agreement permits us to implement a share repurchase program
under certain conditions, we currently have no repurchase program in
effect.  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.
 
 Our management believes that with our
operating cash flow and our 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 we violate a debt covenant, our credit facility
with Wells Fargo, as amended, 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.  Our future cash requirements and the
adequacy of available funds will depend on many factors,
including the pace of expansion, real estate markets, site locations and the
nature of the arrangements negotiated with landlords. We believe that our
current cash balances, together with anticipated cash flows from operations and
funds anticipated to be available from our credit facility, will be sufficient
to satisfy our working capital and capital expenditure requirements on a
short-term and long-term basis. Changes in our operating plans, acceleration of
our expansion plans, lower than anticipated sales, increased expenses, failure
to maintain financial covenants under our credit facility, financial and
non-financial covenant requirements or other events may cause us to seek
additional financing sooner than anticipated. Additional financing may not be
available on acceptable terms, or at all. Failure to obtain additional financing
as needed could have a material adverse effect on our business and results of
operations.
 
 23
 Contractual
Obligations and Commercial Commitments.
 
 The following table summarizes our
total contractual cash obligations and commercial commitments as of December 28,
2008, including leases (in excess of one year) signed that are effective in
2009:
  Payments
      Due By PeriodContractual
      Obligation
                  
                  Total
                  
                  
                  Less
      than
                    1
      Year
                  
                  
                  1
      to 3
                    Years
                  
                  
                  3
      to 5
                    Years
                  
                  
                  More
      Than
                    5
      YearsLong-Term
      Debt (principal only)
                  
                  $
                  7,500,000
                  
                  
                  $
                  --
                  
                  
                  $
                  7,500,000
                  
                  
                  $
                  --
                  
                  
                  $
                  --Operating
      Leases
                  
                  
                  43,686,115
                  
                  
                  
                  5,849,011
                  
                  
                  
                  10,835,971
                  
                  
                  
                  9,157,555
                  
                  
                  
                  17,843,578Total
      Contractual Cash Obligations
                  
                  $
                  51,186,115
                  
                  
                  $
                  5,849,011
                  
                  
                  $
                  18,335,971
                  
                  
                  $
                  9,157,555
                  
                  
                  $
                  17,843,578
 
 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 “Notes to Consolidated Financial Statements, ‘Footnote
(3) Long-Term Debt’” for balances and terms of our credit facility at December
28, 2008.
 
 Related Parties.
 
 We provide 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
sales to the funds.
 
 Critical Accounting
Policies.
 
 Our Management’s Discussion and
Analysis of Financial Condition and Results of Operations discusses our
consolidated financial statements, which have been prepared in accordance with
accounting principles generally accepted in the United States of
America.  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 we believe are most important to the portrayal of our financial condition
and results of operations and also require our 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. We consider the following policies to
be the most critical in understanding the judgment that is involved in preparing
the consolidated financial statements.
 
 Property
and Equipment.
  We record all property and equipment at
cost less accumulated depreciation and we select useful lives that reflect the
actual economic lives of the underlying assets.  We amortize leasehold
improvements over the shorter of the useful life of the asset or the related
lease term. We calculate depreciation using the straight-line method for
consolidated financial statement purposes. We capitalize improvements and
expense repairs and maintenance costs as incurred. We are often required to
exercise judgment in our decision whether to capitalize an asset or expense an
expenditure that is for maintenance and repairs. Our judgments may produce
materially different amounts of repair and maintenance or depreciation expense
if different assumptions were used.
  24
 We
periodically perform asset impairment analysis of property and equipment related
to our restaurant locations. We perform these tests when we experience a
"triggering" event such as a major change in a location's operating environment,
or other event that might impact our ability to recover our 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, we may be
required to record impairment charges for these assets. Also, we have a policy
of reviewing the financial operations of our 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, we review actual results and analyze budgets for the ensuing
year.  If we deem that a location's results will continue to be below
expectations, we will evaluate alternatives for its continued
operation.  At that time, we will perform an asset impairment test. If
we determine that the asset's carrying value exceeds the future undiscounted
cash flows, we 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 our assumptions. Upon an event such as a
formal decision for abandonment (restaurant closure), we may record additional
impairment charges. Any carryover basis of assets will be depreciated over the
respective remaining useful lives.
 
 Goodwill.
 
 Goodwill and other indefinite lived
assets resulted from our acquisition of franchisee-owned and third-party owned
restaurants.  Our 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.  We completed the most recent impairment test as of December
2008, and determined that there were impairment losses related to
goodwill.  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, we may be required to record additional impairment charges for these
assets.
 
 Leasing Activities.
 
 We lease all of our restaurant
properties. At the inception of the lease, we evaluate each property and
classify the lease as an operating or capital lease in accordance with Statement
of Financial Accounting Standards ("SFAS") No. 13, “Accounting for
Leases”.  We exercise 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 our restaurant leases are classified
as operating leases.
 
 Our lease term used for straight-line
rent expense is calculated from the date we take possession of the leased
premises through the lease termination date. There is potential for variability
in the "rent holiday" period which begins on the possession date and ends on the
store opening 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
expense during the rent holiday period.
 
 We record 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.
 
 We provide for income taxes based on
our 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.  Our estimates are based
on the information available to us at the time we prepare the income tax
provisions. We generally file our annual income tax returns several months after
our 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. We must
assess the likelihood
that we will be able to recover our deferred tax assets. If recovery is not
likely, we establish valuation allowances to offset any deferred tax asset
recorded. The valuation allowance is based on our estimates of future taxable
income in each jurisdiction in which we operate, tax planning strategies, and
the period over which our deferred tax assets will be recoverable. In the event
that actual results differ from these estimates, we may be unable to implement
certain tax planning strategies or adjust these estimates in future periods. As
we update our estimates, we may need to establish an additional valuation
allowance, which could have a material negative impact on our results of
operations or financial position, or we could reduce our valuation allowances,
which would have a favorable impact on our results of operations or financial
position.
 
 25
 Effective January 1, 2007, we adopted
Financial Accounting Standards Board (“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, we
evaluated all tax years still subject to potential audit under state and federal
income tax law in reaching our accounting conclusions. As a result, we concluded
we 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 our consolidated financial statements.  See Note (4) to our
consolidated financial statements for further discussion.
 
 Stock-Based Compensation.
 
 We account for stock-based compensation
in accordance with the fair value recognition provisions of SFAS 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 our historical
volatility.  We utilize 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. We estimate forfeitures based on our expectation of future experience
while considering our 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.  We are 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.
 
 We believe 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 our future
financial condition or results of operations.
 
 Impact
of Recently Issued Standards.
 
 In October 2008, the FASB issued FASB
Staff Position (“FSP”) No. 157-3, “Determining the Fair Value of a
Financial Asset When the Market for That Asset Is Not
Active”  This FSP clarifies the application of FASB Statement
No. 157, “Fair Value
Measurements”, when the market for a financial asset is
inactive.  Specifically, FSP 157-3 clarifies how (1) management’s
internal assumptions should be considered in measuring fair value when
observable data are not present, (2) observable market information from an
inactive market should be taken into account, and (3) the use of broker quotes
or pricing services should be considered in assessing the relevance of
observable and unobservable data to measure fair value.  FSP 157-3
shall be effective upon issuance, including prior periods for which financial
statements have not been issued.  The implementation of FSP 157-3 is
not expected to have a material impact on the Company’s consolidated statement
of financial position, results of operations or cash flows.
 
 In
June 2008, the FASB issued FASB FSP Emerging Issues Task Force
(EITF) No. 03-6-1, “Determining Whether Instruments
Granted in Share-Based Payment Transactions Are Participating
Securities.” Under the FSP, unvested share-based payment awards that
contain rights to receive nonforfeitable dividends (whether paid or unpaid) are
participating securities, and should be included in the two-class method of
computing EPS. The FSP is effective for fiscal years beginning after
December 15, 2008, and interim periods within those years, and is not
expected to have a material impact on our earnings per share.
 
 26
 In May 2008, the FASB issued Statements
of Financial Accounting Standards (“SFAS No. 162, “The Hierarchy of Generally Accepted
Accounting Principles” (“SFAS 162”).  SFAS No. 162 identifies
the sources of accounting principles and the framework for selecting the
principles used in the preparation of financial statements of nongovernmental
entities that are presented in conformity with Generally Accepted Accounting
Principles (“GAAP”) in the United States.  This statement became
effective on November 15, 2008 which was 60 days following the SEC’s approval of
the Public Company Accounting Oversight Board amendments to AU Section 411,“The Meaning of Present Fairly in
Conformity with Generally Accepted Accounting Principles”in September
2008.  We
believe SFAS No. 162 will not have a material impact on our results of
operations and financial condition.
 
 In April 2008, the FASB issued FSP FAS
142-3, “Determination of the
Useful Life of Intangible Assets” (“FSP 142-3”).  FSP 142-3
amends the factors that should be considered in developing renewal or extension
assumptions used to determine the useful life of a recognized intangible asset
under SFAS No. 142, “Goodwill
and Other Intangible Assets” (“SFAS 142”).  This change is
intended to improve the consistency between the useful life of a recognized
intangible asset under SFAS 142 and the period of expected cash flows used to
measure the fair value of the asset under SFAS 141(R) and other
GAAP.  The requirement for determining the useful lives must be
applied prospectively to intangible assets acquired after the effective date and
the disclosure requirements must be applied prospectively to all intangible
assets recognized as of, and subsequent to, the effective date.  FSP
142-3 is effective for financial statements issued for fiscal years beginning
after December 15, 2008.  We believe FSP FAS 142-3 will not have a
material impact on our results of operations and financial
condition.
 
 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 adoption of this statement may
have an impact on the accounting for any acquisition the Company may make after
December 28, 2008.
 
 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 a 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. We are in the process of evaluating the impact
the adoption of SFAS No. 160 will have on our results of operations
and financial condition. Presently, there are no significant noncontrolling
interests in any of our 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 our operations subject to inflation include food, beverage, lease and labor
costs. Our leases require us to pay taxes, maintenance, repairs, insurance and
utilities, all of which are subject to inflationary increases. We believe
inflation has had a material impact on our results of operations in recent
years.
   27
   Commodity
Price Risk
  We are
exposed to market price fluctuations in beef, chicken, pork, dairy products,
produce, tortillas and other food product prices. Given the historical
volatility of these product prices, this exposure can impact our food and
beverage costs. Because we typically set our menu prices in advance of these
product purchases, we cannot quickly take into account changing
costs.  To the extent that we are unable to pass the increased costs
on to our guests through price increases, our results of operations would be
adversely affected. We currently do not use financial instruments to hedge our
risk to market price fluctuations in food product prices.
 
 Interest
Rates
 
 We do not
have or participate in any transactions involving derivative, financial and
commodity instruments.  Our long-term debt bears interest at floating
market rates, based upon either the prime rate or LIBOR plus a stipulated
percentage, and therefore we experience changes in interest expense when market
interest rates change.  Based on amounts outstanding at 2008 fiscal
year-end, a 1% change in interest rates would change annual interest expense by
approximately $75,000.
 
 ITEM
      8.
              FINANCIAL STATEMENTS AND SUPPLEMENTARY
  DATA
 
 The Consolidated Financial Statements
and Supplementary Data are set forth herein commencing on page F-1 of this
Annual Report.
 
 ITEM
9.              
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING ANDFINANCIAL
DISCLOSURE
 
 None.
 
 ITEM
9A(T).      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 SEC’s 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 was required to apply 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 us in the reports that we file or submit 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 consolidated financial statements for external
purposes in accordance with generally accepted accounting principles in the
United States 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 consolidated financial statements in accordance with
      generally accepted accounting principles in the United States, 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 consolidated financial
  statements.
 28
 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 implement into
the process safeguards to reduce, though 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.
 
 Management assessed the effectiveness
of our internal control over financial reporting as of December 28, 2008. 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 28, 2008, our internal control over financial reporting was
effective to provide reasonable assurance regarding the reliability of financial
reporting and the preparation and presentation of consolidated financial
statements for external purposes in accordance with generally accepted
accounting principles in the United States.
 
 Change in Internal Control Over
Financial Reporting.  There were no changes in 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 our definitive proxy statement with
respect to our Annual Meeting of Shareholders to be held on May 27, 2009, to be
filed with the SEC 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 our definitive proxy statement with
respect to our Annual Meeting of Shareholders to be held on May 27, 2009, to be
filed with the SEC 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 our 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
 
 
 
 
 ITEM
      13.
              CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
      INDEPENDENCE
 
 The information called for by this Item
13 is incorporated herein by reference to our definitive proxy statement with
respect to our Annual Meeting of Shareholders to be held on May 27, 2009, 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 our definitive proxy statement with
respect to our Annual Meeting of Shareholders to be held on May 27, 2009, to be
filed with the Securities and Exchange Commission pursuant to Regulation 14A not
later than 120 days after the end of the fiscal year covered by this
report.
 
 
 PART
IV
 
 ITEM
      15.
              EXHIBITS AND CONSOLIDATED FINANCIAL STATEMENT
      SCHEDULES
 
 (a)
              The
      following documents are filed as part of this
  Report:
 
 1.
              Consolidated
      Financial Statements:
 
 The
Consolidated Financial Statements are listed in the index to Consolidated
Financial Statements on page F-1 of this Report.
 
 2.   Consolidated
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 April 2,
2001.
 
 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”)).
 
 
 
 
 30
 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.*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.
 
 
 
 31
 
 
 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, 2009.
 
 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, 2009Louis
      P. Neeb/s/
      Larry N. Forehand
                  Founder
      and Vice Chairman of the Board of Directors
                  March
      26, 2009Larry
      N. Forehand/s/
      Curt Glowacki
                  President
      and Chief Executive Officer and Director
                  March
      26, 2009Curt
      Glowacki
                  (Principal
      Executive Officer)/s/
      Andrew J. Dennard
                  Executive
      Vice President and Chief Financial Officer
                  March
      26, 2009Andrew
      J. Dennard
                  (Principal
      Financial and Accounting Officer)/s/
      Cara Denver
                  Director
                  March
      26, 2009Cara
      Denver/s/
      Michael D. Domec
                  Director
                  March
      26, 2009Michael
      D. Domec/s/
      J. J. Fitzsimmons
                  Director
                  March
      26, 2009J.
      J. Fitzsimmons/s/
      Lloyd Fritzmeier
                  Director
                  March
      26, 2009Lloyd
      Fritzmeier/s/
      Thomas E. Martin
                  Director
                  March
      26, 2009Thomas
      E. Martin
  32
  
 MEXICAN
RESTAURANTS, INC.
 
 INDEX
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 PageReport of Independent Registered Public Accounting
      Firm
                  F-2Consolidated Balance Sheets as of December 30, 2007 and
      December 28, 2008
                  F-3Consolidated
      Statements of Operations for each of the years in the three
      fiscal-yearperiod
      ended December 28, 2008
                  F-4Consolidated
      Statements of Stockholders' Equity for each of the years
      inthe
      three fiscal-year period ended December 28, 2008
                  F-5Consolidated
      Statements of Cash Flows for each of the years in the
      threefiscal-year
      period ended December 28, 2008
                  F-6Notes to Consolidated Financial
    Statements
                  F-7
 
 
  
 
 
  F-1
  
 
 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING
FIRM
 
 
 
 The Board
of Directors and Stockholders
 Mexican
Restaurants, Inc. and Subsidiaries:
 
 
 We have audited the accompanying
consolidated balance sheets of Mexican Restaurants, Inc. and subsidiaries (the
“Company”) as of December 28, 2008 and December 30, 2007, and the related
consolidated statements of operations, stockholders' equity and cash flows for
each of the three years in the period ended December 28, 2008.  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). 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 28, 2008 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 28, 2008 and December 30,
2007, and the consolidated results of their operations and their cash flows for
each of the three years in the period ended December 28, 2008, in conformity
with accounting principles generally accepted in the United States of
America.
 
 
 
 
 
 /s/ UHY
LLP
 
 
 Houston,
Texas
 March 26,
2009
 
 
 
 
  F-2
  
 
 MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES
 CONSOLIDATED BALANCE SHEETS
 December
30, 2007 and December 28, 2008
 
 
 Fiscal
      YearsASSETS
                  
                  2007
                  
                  
                  2008Current
      assets:Cash
                  
                  $
                  1,154,629
                  
                  
                  $
                  891,206Royalties
      receivable
                  
                  
                  61,233
                  
                  
                  
                  144,196Other
      receivables
                  
                  
                  832,790
                  
                  
                  
                  1,229,907Inventory
                  
                  
                  750,516
                  
                  
                  
                  769,543Income
      taxes receivable
                  
                  
                  372,576
                  
                  
                  
                  194,856Prepaid
      expenses and other current assets
                  
                  
                  975,195
                  
                  
                  
                  979,268Total
      current assets
                  
                  
                  4,146,939
                  
                  
                  
                  4,208,976Property
      and equipment, net
                  
                  
                  17,852,936
                  
                  
                  
                  18,626,554Goodwill
                  
                  
                  11,403,805
                  
                  
                  
                  6,273,705Deferred
      tax assets
                  
                  
                  439,985
                  
                  
                  
                  1,976,427Other
      assets
                  
                  
                  512,261
                  
                  
                  
                  417,503Total
      Assets
                  
                  $
                  34,355,926
                  
                  
                  $
                  31,503,165LIABILITIES AND STOCKHOLDERS'
      EQUITYCurrent
      liabilities:Accounts
      payable
                  
                  $
                  2,181,873
                  
                  
                  $
                  2,505,587Accrued
      sales and liquor taxes
                  
                  
                  130,941
                  
                  
                  
                  145,562Accrued
      payroll and taxes
                  
                  
                  1,135,326
                  
                  
                  
                  1,032,934Accrued
      expenses
                  
                  
                  1,461,141
                  
                  
                  
                  1,300,607Current
      portion of liabilities associated with leasing and exit
      activities
                  
                  
                  148,681
                  
                  
                  
                  71,191Total
      current liabilities
                  
                  
                  5,057,962
                  
                  
                  
                  5,055,881Long-term
      debt
                  
                  
                  6,400,000
                  
                  
                  
                  7,500,000Liabilities
      associated with leasing and exit activities, net of current
      portion
                  
                  
                  577,582
                  
                  
                  
                  533,487Deferred
      gain
                  
                  
                  1,144,785
                  
                  
                  
                  936,642Other
      liabilities
                  
                  
                  1,910,270
                  
                  
                  
                  1,990,879Total
      liabilities
                  
                  
                  15,090,599
                  
                  
                  
                  16,016,889Commitments
      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,
      3,247,016 and 3,251,641 shares outstanding at 12/30/07 and
      12/28/08,respectively
                  
                  
                  47,327
                  
                  
                  
                  47,327Additional
      paid-in capital
                  
                  
                  19,275,067
                  
                  
                  
                  19,442,049Retained
      earnings
                  
                  
                  13,107,896
                  
                  
                  
                  9,120,885Treasury
      stock at cost, 1,485,689 and 1,481,064 common shares, at
      12/30/07and
      12/28/08, respectively
                  
                  
                  (13,164,963
                  )
                  
                  
                  (13,123,985
                  )Total
      stockholders’ equity
                  
                  
                  19,265,327
                  
                  
                  
                  15,486,276Total
      Liabilities and Stockholders’ Equity
                  
                  $
                  34,355,926
                  
                  
                  $
                  31,503,165
 
 See accompanying notes to
consolidated financial statements.
 
   F-3
  MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES
 CONSOLIDATED STATEMENTS OF OPERATIONS
 For
the fiscal years ended December 31, 2006, December 30, 2007
 and
December 28, 2008
 
 
 Fiscal
      Years2006
                              
                              
                              2007
                              
                              
                              2008Revenues:
                                Restaurant
      sales
                              
                              $
                              80,804,886
                              
                              
                              $
                              81,379,765
                              
                              
                              $
                              80,914,538Franchise
      fees, royalties and other
                              
                              
                              825,115
                              
                              
                              
                              710,394
                              
                              
                              
                              636,773Business
      interruption
                              
                              
                              59,621
                              
                              
                              
                              --
                              
                              
                              
                              317,71781,689,622
                              
                              
                              
                              82,090,159
                              
                              
                              
                              81,869,028Costs
      and expenses:Cost
      of sales
                              
                              
                              22,259,123
                              
                              
                              
                              23,366,381
                              
                              
                              
                              23,651,208Labor
                              
                              
                              26,133,108
                              
                              
                              
                              26,428,606
                              
                              
                              
                              26,482,900Restaurant
      operating expenses
                              
                              
                              19,076,539
                              
                              
                              
                              20,097,179
                              
                              
                              
                              20,046,135General
      and administrative
                              
                              
                              7,716,786
                              
                              
                              
                              7,471,756
                              
                              
                              
                              7,639,665Depreciation
      and amortization
                              
                              
                              3,101,628
                              
                              
                              
                              3,417,348
                              
                              
                              
                              3,567,753Pre-opening
      costs
                              
                              
                              108,847
                              
                              
                              
                              23,947
                              
                              
                              
                              166,655Goodwill
      impairment
                              
                              
                              --
                              
                              
                              
                              --
                              
                              
                              
                              5,130,100Other
      impairment and restaurant closure costs
                              
                              
                              447,903
                              
                              
                              
                              99,978
                              
                              
                              
                              773,789Gain
      on involuntary disposals
                              
                              
                              (366,808
                              )
                              
                              
                              --
                              
                              
                              
                              (685,137
                              )Loss
      on sale of other property and equipment
                              
                              
                              29,591
                              
                              
                              
                              207,517
                              
                              
                              
                              206,44778,506,717
                              
                              
                              
                              81,112,712
                              
                              
                              
                              86,979,515Operating
      income (loss)
                              
                              
                              3,182,905
                              
                              
                              
                              977,447
                              
                              
                              
                              (5,110,487
                              )Other
      income (expense):Interest
      income
                              
                              
                              6,239
                              
                              
                              
                              10,715
                              
                              
                              
                              5,260Interest
      expense
                              
                              
                              (390,539
                              )
                              
                              
                              (499,851
                              )
                              
                              
                              (427,742
                              )Other,
      net
                              
                              
                              80,986
                              
                              
                              
                              46,335
                              
                              
                              
                              34,631(303,314
                              )
                              
                              
                              (442,801
                              )
                              
                              
                              (387,851
                              )Income
      (loss) from continuing operations before income taxes
                              
                              
                              2,879,591
                              
                              
                              
                              534,646
                              
                              
                              
                              (5,498,338
                              )Income
      tax (expense) benefit
                              
                              
                              (900,453
                              )
                              
                              
                              (79,250
                              )
                              
                              
                              1,478,367Income
      (loss) from continuing operations
                              
                              
                              1,979,138
                              
                              
                              
                              455,396
                              
                              
                              
                              (4,019,971
                              )Discontinued
      operations:Income
      (loss) from discontinued operations
                              
                              
                              (401,603
                              )
                              
                              
                              3,090
                              
                              
                              
                              --Restaurant
      closure income (expense)
                              
                              
                              (928,053
                              )
                              
                              
                              (175,796
                              )
                              
                              
                              46,226Gain
      (loss) on sale of assets
                              
                              
                              (13,140
                              )
                              
                              
                              3,412
                              
                              
                              
                              --Income
      (loss) from discontinued operations before income taxes
                              
                              
                              (1,342,796
                              )
                              
                              
                              (169,294
                              )
                              
                              
                              46,226Income
      tax (expense) benefit
                              
                              
                              501,992
                              
                              
                              
                              62,672
                              
                              
                              
                              (13,266
                              )Income
      (loss) from discontinued operations
                              
                              
                              (840,804
                              )
                              
                              
                              (106,622
                              )
                              
                              
                              32,960Net
      income (loss)
                              
                              $
                              1,138,334
                              
                              
                              $
                              348,774
                              
                              
                              $
                              (3,987,011
                              )Basic
      income (loss) per share:Income
      (loss) from continuing operations
                              
                              $
                              0.58
                              
                              
                              $
                              0.13
                              
                              
                              $
                              (1.23
                              )Income
      (loss) from discontinued operations
                              
                              
                              (0.25
                              )
                              
                              
                              (0.03
                              )
                              
                              
                              0.01Net
      income (loss)
                              
                              $
                              0.33
                              
                              
                              $
                              0.10
                              
                              
                              $
                              (1.22
                              )Diluted
      income (loss) per share:Income
      (loss) from continuing operations
                              
                              $
                              0.56
                              
                              
                              $
                              0.13
                              
                              
                              $
                              (1.23
                              )Income
      (loss) from discontinued operations
                              
                              
                              (0.24
                              )
                              
                              
                              (0.03
                              )
                              
                              
                              0.01Net
      income (loss)
                              
                              $
                              0.32
                              
                              
                              $
                              0.10
                              
                              
                              $
                              (1.22
                              )Weighted
      average number of shares (basic)
                              
                              
                              3,402,207
                              
                              
                              
                              3,339,280
                              
                              
                              
                              3,255,503Weighted
      average number of shares (diluted)
                              
                              
                              3,521,587
                              
                              
                              
                              3,430,276
                              
                              
                              
                              3,255,503
 
 See accompanying notes to consolidated
financial statements.
 
   F-4
  
 MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES
 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
 
 
 For
the fiscal years ended
 December
31, 2006, December 30, 2007
 and
December 28, 2008
 
 Common
      Stock
                
                
                Additional
                  Paid-in
                  Capital
                
                
                Retained
                  Earnings
                
                
                Treasury
                  Stock
                
                
                Total
                  Stockholders’
                  EquityBalances
      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
                )
                
                
                19,265,327Exercise
      of Stock Options ThroughIssuance
      of Treasury Shares
                
                
                --
                
                
                
                (25,223
                )
                
                
                --
                
                
                
                40,978
                
                
                
                15,755Stock
      based Compensation Expense
                
                
                --
                
                
                
                191,720
                
                
                
                --
                
                
                
                --
                
                
                
                191,720Excess
      Tax Benefit-Options Exercised
                
                
                --
                
                
                
                485
                
                
                
                --
                
                
                
                --
                
                
                
                485Net
      loss
                
                
                --
                
                
                
                --
                
                
                
                (3,987,011
                )
                
                
                --
                
                
                
                (3,987,011
                )Balances
      at December 28, 2008
                
                $
                47,327
                
                
                $
                19,442,049
                
                
                $
                9,120,885
                
                
                $
                (13,123,985
                )
                
                $
                15,486,276
 
 
 See
accompanying notes to consolidated financial statements.
 
 
 
 
 
 
 
   F-5
  MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES
 CONSOLIDATED STATEMENTS OF CASH FLOWS
 For
the fiscal years ended December 31, 2006, December 30, 2007 and December 28,
2008
 
 Fiscal
      Years2006
                    
                    
                    2007
                    
                    
                    2008Cash
      flows from operating activities:Net
      income (loss)
                    
                    $
                    1,138,334
                    
                    
                    $
                    348,774
                    
                    
                    $
                    (3,987,011
                    )Adjustments
      to reconcile net income (loss) to net cash provided by operating
      activities:Depreciation
      and amortization
                    
                    
                    3,101,628
                    
                    
                    
                    3,417,348
                    
                    
                    
                    3,567,753Deferred
      gain amortization
                    
                    
                    (208,143
                    )
                    
                    
                    (208,142
                    )
                    
                    
                    (208,143
                    )Income
      (loss) from discontinued operations
                    
                    
                    840,804
                    
                    
                    
                    106,622
                    
                    
                    
                    (32,960
                    )Goodwill
      impairment
                    
                    
                    --
                    
                    
                    
                    --
                    
                    
                    
                    5,130,100Other
      impairment and restaurant closure costs
                    
                    
                    447,903
                    
                    
                    
                    99,978
                    
                    
                    
                    773,789Gain
      on involuntary disposals
                    
                    
                    (366,808
                    )
                    
                    
                    --
                    
                    
                    
                    (685,137
                    )Loss
      on sale of other property and equipment
                    
                    
                    29,591
                    
                    
                    
                    207,517
                    
                    
                    
                    206,447Stock
      based compensation expense
                    
                    
                    63,508
                    
                    
                    
                    141,347
                    
                    
                    
                    191,720Excess
      tax expense (benefit)--stock based compensation expense
                    
                    
                    (44,923
                    )
                    
                    
                    5,658
                    
                    
                    
                    (485
                    )Deferred
      income tax expense (benefit)
                    
                    
                    19,931
                    
                    
                    
                    (233,546
                    )
                    
                    
                    (1,445,240
                    )Changes
      in operating assets and liabilities, net of effects of
      acquisitionsRoyalties
      receivable
                    
                    
                    86,022
                    
                    
                    
                    29,394
                    
                    
                    
                    (82,964
                    )Other
      receivables
                    
                    
                    378,434
                    
                    
                    
                    13,597
                    
                    
                    
                    (155,360
                    )Income
      taxes receivable
                    
                    
                    (566,980
                    )
                    
                    
                    30,553
                    
                    
                    
                    87,003Inventory
                    
                    
                    9,706
                    
                    
                    
                    (58,467
                    )
                    
                    
                    (175,776
                    )Prepaid
      and other current assets
                    
                    
                    (27,273
                    )
                    
                    
                    (146,001
                    )
                    
                    
                    (4,073
                    )Other
      assets
                    
                    
                    (25,551
                    )
                    
                    
                    (89,363
                    )
                    
                    
                    52,207Accounts
      payable
                    
                    
                    289,378
                    
                    
                    
                    64,084
                    
                    
                    
                    248,137Accrued
      expenses
                    
                    
                    (578,145
                    )
                    
                    
                    (283,194
                    )
                    
                    
                    (293,076
                    )Liabilities
      associated with leasing and exit activities
                    
                    
                    229,449
                    
                    
                    
                    (285,781
                    )
                    
                    
                    (121,585
                    )Deferred
      rent and other long-term liabilities
                    
                    
                    99,426
                    
                    
                    
                    593,599
                    
                    
                    
                    (29,551
                    )Total
      adjustments
                    
                    
                    3,777,957
                    
                    
                    
                    3,405,203
                    
                    
                    
                    7,022,806Net
      cash provided by continuing operations
                    
                    
                    4,916,291
                    
                    
                    
                    3,753,977
                    
                    
                    
                    3,035,795Net
      cash provided by (used in) discontinued operations
                    
                    
                    128,572
                    
                    
                    
                    (78,768
                    )
                    
                    
                    32,960Net
      cash provided by operating activities
                    
                    
                    5,044,863
                    
                    
                    
                    3,675,209
                    
                    
                    
                    3,068,755Cash
      flows from investing activities:Insurance
      proceeds received from involuntary disposals
                    
                    
                    1,211,850
                    
                    
                    
                    --
                    
                    
                    
                    739,969Purchase
      of property and equipment
                    
                    
                    (5,121,636
                    )
                    
                    
                    (4,203,357
                    )
                    
                    
                    (5,322,618
                    )Proceeds
      from landlord for lease buildout
                    
                    
                    --
                    
                    
                    
                    --
                    
                    
                    
                    110,160Proceeds
      from sale of property and equipment
                    
                    
                    765,000
                    
                    
                    
                    5,280
                    
                    
                    
                    24,071Business
      Acquisitions, net of cash acquired
                    
                    
                    (742,490
                    )
                    
                    
                    --
                    
                    
                    
                    --Net
      cash used in continuing operations
                    
                    
                    (3,887,276
                    )
                    
                    
                    (4,198,077
                    )
                    
                    
                    (4,448,418
                    )Net
      cash provided by (used in) discontinued operations
                    
                    
                    (80,242
                    )
                    
                    
                    4,020
                    
                    
                    
                    --Net
      cash used in investing activities
                    
                    
                    (3,967,518
                    )
                    
                    
                    (4,194,057
                    )
                    
                    
                    (4,448,418
                    )Cash
      flows from financing activities:Borrowings
      under line of credit agreement
                    
                    
                    2,600,000
                    
                    
                    
                    3,878,000
                    
                    
                    
                    2,260,000Payments
      under line of credit agreement
                    
                    
                    (1,800,000
                    )
                    
                    
                    (778,000
                    )
                    
                    
                    (1,160,000
                    )Purchase
      of treasury stock
                    
                    
                    (261,730
                    )
                    
                    
                    (1,628,000
                    )
                    
                    
                    --Excess
      tax benefit (expense) – stock-based compensation expense
                    
                    
                    44,923
                    
                    
                    
                    (5,658
                    )
                    
                    
                    485Exercise
      of stock options
                    
                    
                    704,663
                    
                    
                    
                    53,825
                    
                    
                    
                    15,755Payments
      on long-term debt
                    
                    
                    (2,500,000
                    )
                    
                    
                    (500,000
                    )
                    
                    ----Net
      cash provided by (used in) financing activities
                    
                    
                    (1,212,144
                    )
                    
                    
                    1,020,167
                    
                    
                    
                    1,116,240Net
      increase (decrease) in cash
                    
                    
                    (134,799
                    )
                    
                    
                    501,319
                    
                    
                    
                    (263,424
                    )Cash
      at beginning of year
                    
                    
                    788,109
                    
                    
                    
                    653,310
                    
                    
                    
                    1,154,629Cash
      at end of year
                    
                    $
                    653,310
                    
                    
                    $
                    1,154,629
                    
                    
                    $
                    891,206Supplemental
      disclosure of cash flow information:Cash
      paid during the year:Interest
                    
                    $
                    384,242
                    
                    
                    $
                    390,298
                    
                    
                    $
                    505,364Income
      taxes
                    
                    $
                    1,074,819
                    
                    
                    $
                    107,652
                    
                    
                    $
                    93,680Non-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
 December
31, 2006, December 30, 2007 and December 28, 2008
 
 (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.  We purchased the shares of
common stock of La Señorita for $4.0 million.  The transaction was
funded with our 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.  We 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 2008,
2007, and 2006 have been adjusted to remove the operations of closed
restaurants, which have been reclassified as discontinued
operations.  No restaurants were closed during
2008.  However, the consolidated statements of operations and cash
flows for the fiscal years 2007 and 2006 shown in the accompanying consolidated
financial statements have been reclassified to reflect store closures during
2007.  These reclassifications have no effect on total assets, total
liabilities, stockholders’ equity or net income.
 
 (b) Concentration of Credit
Risks
 
 The Company maintains a banking
relationship with Wells Fargo Bank.  Wells Fargo provides the Company
with a credit facility as well as treasury services.  Consequently,
the majority of the Company’s cash concentration held by Wells Fargo Bank is
insured to the current maximum Federal Deposit Insurance Corporation’s
limit.
 
 (c) 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.  We own and operate various Mexican restaurant concepts
principally in Texas, Oklahoma, Louisiana and Michigan.  We also
franchise the Casa Olé concept principally in Texas and Louisiana and the La
Señorita concept in the State of Michigan.
  
 
 F-7
 
 MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 
 (d) Fiscal Year
 
 We maintain our accounting records on a
52/53 week fiscal year ending on the Sunday nearest December
31.  Fiscal years 2008, 2007 and 2006 each consisted of 52
weeks.
 
 (e)  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.
 
 (f)  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.
 
 (g)  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
                        2-23 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 an appraised fair market value or the
value that a third party buyer would be willing to pay.  Additionally,
we account for restaurant closure costs pursuant to SFAS No. 146, “Accounting for Costs Associated with
Exit or Disposal Activities”.
 
 In fiscal
year 2008, we recorded asset impairment and restaurant closure costs of $773,789
in continuing operations related to four under-performing
restaurants.  Two of these stores have been impaired each year since
fiscal year 2006 and the other two became impaired during 2008.  One
of the stores was subsequently closed in fiscal year 2009.
 
  
 F-8
 MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 
 In fiscal
year 2007, we recorded asset impairment costs of $99,978 in continuing
operations related to two under-performing restaurants, which were also impaired
in fiscal year 2006.
 
 In fiscal
year 2006, we 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 accruals for two other subleased restaurants.
 
 (h)  Balance
Sheets of Discontinued Operations
 
 The
following table summarizes the significant remaining liabilities of discontinued
operations:
 
 2007
                      
                      
                      2008Current
      portion of liabilitiesassociated
      with leasing andexit
      activities
                      
                      $
                      148,681
                      
                      
                      $
                      71,191Other
      liabilities associated withleasing
      and exit activities
                      
                      $
                      577,582
                      
                      
                      $
                      533,487Total
                      
                      $
                      726,263
                      
                      
                      $
                      604,678
 
 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 we have subleased the
restaurants.  Rent differential represents the difference between the
contractual lease payments we made for closed restaurants and the amount to be
received under subleases to other tenants.
 
 (i)  Goodwill
and Other Intangible Assets
 
 Goodwill represents the excess of costs
over fair value of assets of businesses acquired.  We 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 28, 2008, the consolidated
balance sheet included approximately $6.3 million of goodwill primarily
resulting from the MAC, La Señorita, Beaumont-based franchisee, and Mission
Burrito acquisitions.  For purposes of applying SFAS No. 142
impairment testing, we believe we operate 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 December 31, 2006,
December 30, 2007, and December 28, 2008.  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 existed at year end 2006 and 2007.  However, at year end
2008, management determined that the fair value did not exceed the carrying
amount of the reporting unit and recorded an impairment charge of approximately
$5.1 million.
 
 
 
 
  
 F-9
 
 
 MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 
 (j)    Impairment
of Long-Lived Assets
 
 In
accordance with SFAS 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
consolidated 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
consolidated 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
 
 We expense lease rentals that have
escalating rents on a straight line basis over the life of each lease pursuant
to SFAS 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 SFAS No. 109, “Accounting for Income
Taxes”.We provide for income taxes based on estimates 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.
 
 Our estimates are based on the
information available to us at the time that we prepare the income tax
provision.  We generally file our annual income tax returns several
months after our fiscal year-end.  Income tax returns are subject to
an 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.  In May
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, we 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, we
evaluated all tax years still subject to potential audit under state and federal
income tax law in reaching our accounting conclusions. As a result, we concluded
that we 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 years ended December 30, 2007 and December 28, 2008.  The
adoption of FIN 48 therefore has had no impact on our 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
 
 We record 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 operations.  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.  Our 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, we 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), we 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.
 
 The fair value of each option award is
estimated on the date of grant using the Black-Scholes option-pricing model,
which uses the assumptions noted in the following table.  Expected
volatility is based on historical volatilities from stock traded.  We
use 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 is as follows:
 
 2007Risk-free
      interest rate
                  4.51%
      to 4.74%Expected
      life, in years
                  7.5Expected
      volatility
                  23.6%
      to 29.3%Dividend
      yield
                  0%
 
 We receive 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 104,375, 13,500, and 4,625 stock options
exercised in fiscal years 2006, 2007, and 2008, respectively (excluding the
options purchased in December 2006 from the Company’s President and CEO pursuant
to a Separation Agreement).  (See Note 5 (g)).  We received
cash in the amount of $704,663, $53,825, and $15,755 respectively, from the
exercise of these options.
 
 In conjunction with the Company’s 1996 initial public offering, we 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.
 
  
 F-11
 MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 
 (o)
              Use
      of Estimates
 
 The preparation of consolidated
financial statements in conformity with generally accepted accounting principles
in the United States 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
 
 The consolidated statements of
operations for the years ended December 31, 2006 and December 28, 2008, includes
a separate line item for gains of $366,808 and $685,137, respectively, resulting
from assets damaged by Hurricane Rita in late 2005 and by two restaurant fires
and Hurricane Ike in 2008.  The gains resulted from the loss of
damaged assets offset by insurance proceeds for the replacement of those
assets.  As of December 31, 2006 and December 28, 2008, we received
$1,211,850 and $739,969, respectively from our insurance carriers for property
damages.  The consolidated statements of operations for the years
ended December 31, 2006 and December 28, 2008, also includes a separate line
item for business interruption insurance proceeds of $59,621 and $317,717,
respectively, related to the same events.
 
 (q)  Fair Value
Measurements
 
 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.
 
 We
adopted SFAS No. 157, “Fair
Value Measurements” on December 31, 2007 (“SFAS 157”), for our
consolidated financial assets and consolidated financial
liabilities.  As permitted by FASB Staff Position No. 157-2, we
adopted SFAS 157 for our nonfinancial assets and nonfinancial liabilities on
December 29, 2008.  SFAS 157 defines fair value, provides guidance for
measuring fair value, and requires certain disclosures.  FSP 157-2
amends SFAS 157 to delay the effective date of the application of SFAS 157 to
fiscal years beginning after November 15, 2008 for all nonfinancial assets and
nonfinancial liabilities.  Nonfinancial assets and nonfinancial
liabilities for which we have not applied the provisions of SFAS 157 include
those measured at fair value in goodwill impairment testing and those initially
measured at fair value in a business combination, and fair value measurement
used in long-lived assets under SFAS 144.
 
 SFAS 157
discusses valuation techniques, such as the market approach (comparable market
prices), the income approach (present value of future income or cash flow), and
the cost approach (cost to replace the service capacity of an asset or
replacement cost).  The statement utilizes a fair value hierarchy that
prioritizes the inputs to valuation techniques used to measure fair value into
three broad levels.  The following is a brief description of those
three levels:
 
 ·
              Level
      1:  Observable inputs such as quoted prices (unadjusted) in
      active markets for identical assets or
  liabilities.
 ·
              Level
      2:  Inputs other than quoted prices that are observable for the
      asset or liability, either directly or indirectly.  These
      include quoted prices for similar assets or liabilities in active markets
      and quoted prices for identical or similar assets or liabilities in
      markets that are not active.
 ·
              Level
      3:  Unobservable inputs that reflect the reporting entity’s own
      assumptions.
 
 The
adoption of this statement did not have a material impact on our consolidated
financial statements.  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 became effective for the fiscal years beginning after
November 15, 2007.  We adopted SFAS No. 159 on December 31, 2007,
which did not have a material impact on our consolidated financial position,
results of operations or cash flows as we did not elect the fair value option
for any other financial instruments.
 
  
 F-12
 MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 
 (r)
Recently Issued Accounting Standards
 
 In October 2008, the FASB issued FASB
Staff Position (FSP) No. 157-3, “Determining the Fair Value of a
Financial Asset When the Market for That Asset Is Not
Active.”  This FSP clarifies the application of FASB Statement
No. 157, “Fair Value Measurements”, in a market that is not active and provides
an example to illustrate key considerations in determining the fair value of a
financial asset when the market for that financial asset is not
active.  This FSP shall be effective upon issuance, including prior
periods for which financial statements have not been issued.  Such
adoption has not had a material effect on our consolidated statement of
financial position, results of operations or cash flows.
 
 In
June 2008, the FASB issued FASB Staff Position (FSP) Emerging
Issues Task Force (EITF) No. 03-6-1, “Determining Whether Instruments
Granted in Share-Based Payment Transactions Are Participating
Securities.” Under the FSP, unvested share-based payment awards that
contain rights to receive nonforfeitable dividends (whether paid or unpaid) are
participating securities, and should be included in the two-class method of
computing EPS. The FSP is effective for fiscal years beginning after
December 15, 2008, and interim periods within those years, and is not
expected to have a material impact on our earnings per share.
 
 In May
2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted
Accounting Principles” (“SFAS 162”).  SFAS No. 162 identifies
the sources of accounting principles and the framework for selecting the
principles used in the preparation of financial statements of nongovernmental
entities that are presented in conformity with Generally Accepted Accounting
Principles (“GAAP”) in the United States.  This statement will be
effective 60 days following the SEC’s approval of the Public Company Accounting
Oversight Board amendments to AU Section 411, “The Meaning of Present Fairly in
Conformity with Generally Accepted Accounting Principles.”  We
believe SFAS No. 162 will not have a material impact on our results of
operations and financial condition.
 
 In April 2008, the FASB issued FSP FAS
142-3, “Determination of the
Useful Life of Intangible Assets” (“FSP 142-3”).  FSP 142-3
amends the factors that should be considered in developing renewal or extension
assumptions used to determine the useful life of a recognized intangible asset
under SFAS No. 142, “Goodwill
and Other Intangible Assets” (“SFAS 142”).  This change is
intended to improve the consistency between the useful life of a recognized
intangible asset under SFAS 142 and the period of expected cash flows used to
measure the fair value of the asset under SFAS 141(R) and other
GAAP.  The requirement for determining the useful lives must be
applied prospectively to intangible assets acquired after the effective date and
the disclosure requirements must be applied prospectively to all intangible
assets recognized as of, and subsequent to, the effective date.  FSP
142-3 is effective for financial statements issued for fiscal years beginning
after December 15, 2008.  We believe FSP 142-3 will not have a
material impact on our results of operations and financial
condition.
 
 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 adoption of this statement may have an
impact on the accounting for any acquisition the Company may make after December
28, 2008.
 
 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
      F-13
 MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 is
effective for fiscal years, and interim periods within those fiscal years,
beginning on or after December 15, 2008. Earlier adoption is prohibited. We
are in the process of evaluating the impact the adoption of
SFAS No. 160 will have on our results of operations and financial
condition. Presently, there are no significant noncontrolling interests in any
of our 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.
 
 (s) Advertising Expense
 
 Each year, we prepare a budget for
advertising expenses to promote each of our restaurant
brands.  Prepaid advertising is deferred and amortized to expense
based on estimates of usage.  For fiscal years 2006, 2007, and 2008,
we recorded advertising expense in continuing operations of $2,315,534,
$2,502,848, and $2,047,367 which represents 2.9%, 3.1%, and 2.5% of restaurant
sales from continuing operations, respectively.
 
 (t) 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 30,
2007 and December 28, 2008 are as follows:
 
 2007
                    
                    
                    2008Land
                    
                    $
                    60,750
                    
                    
                    $
                    60,750Vehicles
                    
                    
                    16,874
                    
                    
                    
                    16,874Equipment
      and Smallwares
                    
                    
                    21,625,556
                    
                    
                    
                    23,348,746Leasehold
      Improvements
                    
                    
                    14,799,573
                    
                    
                    
                    17,019,44236,502,753
                    
                    
                    
                    40,445,812Less:
      Accumulated Depreciation
                    
                    
                    (19,175,946
                    )
                    
                    
                    (21,827,592
                    )17,326,807
                    
                    
                    
                    18,618,220Construction
      in Progress
                    
                    
                    526,129
                    
                    
                    
                    8,334Net
                    
                    $
                    17,852,936
                    
                    
                    $
                    18,626,554
 
 (3)  Long-term
Debt
 
 Long-term debt consists of the
following at December 30, 2007 and December 28, 2008:
 
 2007
                    
                    
                    2008Revolving
      Line of Credit
                    
                    $
                    6,400,000
                    
                    
                    $
                    7,500,000Less
      current installments
                    
                    
                    --
                    
                    
                    
                    --Long-term
      debt, excluding current installments
                    
                    $
                    6,400,000
                    
                    
                    $
                    7,500,000
 
 During fiscal year 2008, the Company
borrowed $2,260,000 on its Wells Fargo Bank line of credit for working capital,
of which approximately $1.15 million was a direct result of lost sales due to
Hurricanes Gustav and Ike in the third quarter.  We paid down
$1,160,000 on the Wells Fargo Bank line of credit in the first and second
quarters.  As of December 28, 2008, our outstanding debt to Wells
Fargo Bank was $7.5 million.
  
 F-14
 MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
  Under the
Wells Fargo Agreement, we are required to maintain certain minimum EBITDA
levels, leverage ratios and fixed charge coverage ratios.  Due to the
impact of Hurricanes Gustav and Ike in the third quarter of fiscal year 2008,
which resulted in approximately $1.15 million in lost sales, we increased our
debt by $1.0 million to $7.5 million.  As a result of the
lost sales, the Company failed to satisfy its minimum EBITDA covenant under the
Wells Fargo agreement for the twelve month period as of the third quarter of
fiscal year 2008.  We requested and received from Wells Fargo a waiver to
this covenant for the third quarter.  We subsequently received an
amendment to the covenant effective December 28, 2008 eliminating the minimum
EBITDA requirement and adding limits on our growth capital
expenditures.  Under the amendment, we must limit our capital
expenditures for new restaurant development or acquisitions to $1.0 million in
fiscal year 2009 and $1.2 million in fiscal year 2010.
 
 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 us 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, we prepaid and terminated our 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 our 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, we are impacted by changes in the
Base Rate and LIBOR.  We are 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.
 
 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.  We
paid down $428,000 on the Wells Fargo Bank line of credit in the fourth quarter
of fiscal year 2007.  As of December 30, 2007, our outstanding debt to
Wells Fargo Bank was $6.4 million.
  Maturities
on long-term debt are as follows:
  Year Ending2009
                        
                        $
                        --2010
                        
                        
                        7,500,0002011
                        
                        
                        --2012
                        
                        
                        --Thereafter
                        
                        
                        --$
                        7,500,000
 
 (4)  Income
Taxes
 
 The benefit (expense) for income taxes
from continuing operations is summarized as follows for fiscal years 2006, 2007
and 2008:
 
 2006
                    
                    
                    2007
                    
                    
                    2008Current:Federal
                    
                    $
                    (726,948
                    )
                    
                    $
                    (186,889
                    )
                    
                    $
                    127,612State
      and local
                    
                    
                    (153,574
                    )
                    
                    
                    (125,907
                    )
                    
                    
                    (94,485
                    )Deferred
                    
                    
                    (19,931
                    )
                    
                    
                    233,546
                    
                    
                    
                    1,445,240$
                    (900,453
                    )
                    
                    $
                    (79,250
                    )
                    
                    $
                    1,478,367
   F-15




MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS -- (Continued)




The benefit (expense) for income taxes
from discontinued operations is summarized as follows for fiscal years 2006,
2007 and 2008:
  
 2006
                    
                    
                    2007
                    
                    
                    2008Current:Federal
                    
                    $
                    341,803
                    
                    
                    $
                    141,845
                    
                    
                    
                    --State
      and local
                    
                    
                    78,013
                    
                    
                    
                    32,907
                    
                    
                    
                    --Deferred
                    
                    
                    82,176
                    
                    
                    
                    (112,080
                    )
                    
                    
                    (13,266
                    )$
                    501,992
                    
                    
                    $
                    62,672
                    
                    
                    $
                    (13,266
                    )
 
 The
actual income tax benefit (expense) differs from expected income tax benefit
(expense) calculated by applying the U.S. federal corporate tax rate to income
(loss) before income tax expense from continuing operations as
follows:
 
 2006
                    
                    
                    2007
                    
                    
                    2008Expected
      tax benefit(expense)
                    
                    $
                    (979,061
                    )
                    
                    $
                    (181,780
                    )
                    
                    $
                    1,866,984State tax expense,
      net
                    
                    
                    (86,621
                    )
                    
                    
                    (66,408
                    )
                    
                    
                    (65,778
                    )Non-deductible
      amortization
                    
                    
                    --
                    
                    
                    
                    --
                    
                    
                    
                    (521,350
                    )Tax
      credits
                    
                    
                    177,792
                    
                    
                    
                    179,264
                    
                    
                    
                    192,682Other
                    
                    
                    (12,563
                    )
                    
                    
                    (10,326
                    )
                    
                    
                    5,829$
                    (900,453
                    )
                    
                    $
                    (79,250
                    )
                    
                    $
                    1,478,367
 
 The tax effects of temporary
differences that give rise to significant portions of deferred tax assets and
liabilities at December 30, 2007 and December 28, 2008 are as
follows:
 
 2007
                        
                        
                        2008Deferred
      tax assets:Sale-leaseback
                        
                        $
                        423,227
                        
                        
                        $
                        318,458Tax
      credit carryforwards
                        
                        
                        764,051
                        
                        
                        
                        1,266,271Asset
      impairments
                        
                        
                        941,447
                        
                        
                        
                        1,040,220NOL’s
                        
                        
                        --
                        
                        
                        
                        10,553Accrued
      expenses
                        
                        
                        195,585
                        
                        
                        
                        106,434$
                        2,324,310
                        
                        
                        $
                        2,741,936Deferred
      tax liabilities:Other
                        
                        $
                        (65,767
                        )
                        
                        $
                        (12,975
                        )Goodwill
      amortization differences
                        
                        
                        (1,392,789
                        )
                        
                        
                        (381,331
                        )Depreciation
      differences
                        
                        
                        (425,769
                        )
                        
                        
                        (371,203
                        )$
                        (1,884,325
                        )
                        
                        $
                        (765,509
                        )Net
      deferred taxes
                        
                        $
                        439,985
                        
                        
                        $
                        1,976,427
 
 At December 28, 2008, we 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 28, 2008, we have federal tax credit
carryforwards of approximately $1.3 million and state NOL carryforwards of
approximately $16,000 both of which are available to reduce future Federal
regular income taxes, if any, over a 20-year 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 28, 2008.  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 our 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, we concluded we 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 during the fiscal years ended December 30, 2007 and December
28, 2008.
   
 F-16
 MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
  (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").  On May 28, 2008, the shareholders
approved an amendment to the 2005 Plan to increase the number of shares
authorized for issuance by 75,000 shares, from 350,000 shares to 425,000
shares.  The amended 2005 Plan authorizes the granting of up to
425,000 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
425,000 shares authorized for issuance under the 2005 Plan will enable us to
cover our grant obligations until the end of fiscal year 2009 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 us to tailor future awards to our 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.
 
 (c)  Stock Option Plan for Non-Employee
Directors
 
 We have adopted the Mexican
Restaurants, Inc. Stock Option Plan for Non-Employee Directors (the “Directors
Plan”) for our outside directors and have 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.
 
 
 F-17
 MEXICAN RESTAURANTS, INC. AND
SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 
 (d)1996 Manager’s Stock Option
Plan
 
 We adopted the 1996 Manager’s Stock
Option Plan (the “Manager’s Plan”) specifically for our 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, we 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 our 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, our 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.
 
 On May 22, 2007, our 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 we
were 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 were 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, our 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, our Board of
Directors approved restricted stock grants aggregating 10,000 shares to four
employees, with such grants vesting over a five-year period.  During
the second quarter of fiscal year 2008, 2,500 restricted shares were forfeited
upon the termination of one of those employees.
 
  
 
 F-18
 
 
 MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 
 On November 13, 2007, the Board also
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.
 
 On May 22, 2008, restricted stock
grants in the amount of 10,000 shares to the Company’s President were granted
pursuant to the May 22, 2007 agreement, with such shares vesting over a
four-year period.
 
 On May 28, 2008, our Board of Directors
approved restricted stock grants to one Board member for 3,000 shares, vesting
over three years, and one consultant for 2,000 shares, vesting over two
years.
 
 On December 15, 2008, restricted stock
grants in the amount of 10,000 shares to two employees were granted pursuant to
the December 15, 2006 agreement, with such shares vesting over a five-year
period.
 
 We
receive 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 2006, our 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.
 
 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.
 
 During fiscal year 2007, our employees
and a director exercised stock options for 13,500 shares for which the Company
received proceeds of $53,825.
 
 During fiscal year 2008, our employees
exercised stock options for 4,625 shares for which we received proceeds of
$15,755.
 
 (h)  Stock
Transactions
 
 On May 9, 2005, we announced our plan to implement a limited stock repurchase
program in a manner permitted under our bank financing
agreement.  During fiscal year 2006, the Company repurchased 25,290
shares of common stock for $261,730.  During fiscal year 2005, we
repurchased 181,300 shares of common stock for $1,738,267.  We have
purchased the aggregate amount of shares permitted under the
program.  The Wells Fargo debt agreement will allow us to repurchase
up to $2,000,000 of stock repurchases in each year (as long as the repurchase
does not cause us 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 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
                    
                    
                    
                    7.75Granted
                    
                    
                    --
                    
                    
                    
                    --Exercised
                    
                    
                    4,625
                    
                    
                    
                    3.41Canceled
                    
                    
                    12,000
                    
                    
                    
                    4.91Balance
      at December 28, 2008:
                    
                    
                    373,375
                    
                    
                    $
                    7.89
 
 The 373,375 options outstanding at
December 28, 2008 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 28, 2008, 299,375 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.  We did not grant any options or warrants in 2006 or
2008.    As of December 28, 2008, we had unrecognized stock
based compensation expense of $176,945 for all outstanding stock option
awards.  No warrants remain outstanding as of December 28,
2008.
 
 (j) Restricted stock
summary
 
 Weighted
      AverageShares
                    
                    
                    Fair ValueRestricted
      shares outstanding at January 1, 2006:
                    
                    
                    --Granted
                    
                    
                    26,000
                    
                    
                    $
                    10.91Vested
                    
                    
                    --
                    
                    
                    
                    --Forfeited
                    
                    
                    --
                    
                    
                    
                    --Restricted
      shares outstanding at December 31, 2006:
                    
                    
                    26,000
                    
                    
                    
                    10.91Granted
                    
                    
                    61,000
                    
                    
                    
                    7.31Vested
                    
                    
                    (7,500
                    )
                    
                    
                    10.02Forfeited
                    
                    
                    --
                    
                    
                    
                    --Restricted
      shares outstanding at December 30, 2007:
                    
                    
                    79,500
                    
                    
                    
                    8.01Granted
                    
                    
                    25,000
                    
                    
                    
                    3.62Vested
                    
                    
                    (17,700
                    )
                    
                    
                    8.49Forfeited
                    
                    
                    (2,500
                    )
                    
                    
                    6.90Restricted
      shares outstanding at December 28, 2008:
                    
                    
                    84,300
                    
                    
                    $
                    6.85
 
 The restricted share awards were valued
from $2.00 to $12.27 per share based on the grant date stock price and vest over
2 to 5 years.  As of December 28, 2008, we had unrecognized stock
based compensation expense of $514,863 for all outstanding restricted share
awards.
   F-20
 MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 
 (k) Income Per
Share
 
 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 stock options
and restricted stock shares would be considered antidilutive and therefore
excluded from the calculation of diluted income per share. Diluted loss per
share for fiscal year 2008 excludes 53,769 incremental shares which were
outstanding during the period but were anti-dilutive.  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.  Diluted earnings (loss) per share for fiscal year 2006,
2007, and 2008 excludes 226,000 stock options and restricted stock shares at a
weighted-average price of $12.01, 305,500 stock options and restricted stock
shares at a weighted-average price of $10.24, and 321,800 stock options and
restricted stock shares at a weighted-average price of $9.88, respectively,
which were outstanding during the period but were anti-dilutive.
 
 (6)  Leases
 
 We lease 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, we 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 30, 2007 and December 28,
2008 was $1,144,785 and $936,642, respectively.  The leases are
classified as operating leases in accordance with 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 $5,276,972 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 28, 2008, including long-term leases signed and effective in fiscal
year 2009 are approximately:
 
 Year Ending2009
                      
                      $
                      5,849,0112010
                      
                      
                      5,553,9742011
                      
                      
                      5,281,9972012
                      
                      
                      5,189,7752013
                      
                      
                      3,967,780Thereafter
                      
                      
                      17,843,578$
                      43,686,115
 
 On May 4, 2006, we were released from
our 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 28, 2008 are approximately:
    
 
 F-21
 
 MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 
 
 Year Ending2009
                      
                      $
                      191,7892010
                      
                      
                      115,2962011
                      
                      
                      117,5642012
                      
                      
                      119,9162013
                      
                      
                      61,134$
                      605,699
 
 
 Total rent expense for restaurant
operating space and equipment amounted to $6,164,216, $6,134,555 and $6,319,855
for the fiscal years 2006, 2007 and 2008, respectively.
 
 (7)
              Accrued
      Expenses and Other Liabilities
 
 Accrued expenses consist of the
following:
 
 2007
                      
                      
                      2008Property
      Tax
                      
                      $
                      643,492
                      
                      
                      $
                      681,953Insurance
                      
                      
                      450,878
                      
                      
                      
                      322,192Rent
                      
                      
                      117,096
                      
                      
                      
                      149,630Interest
                      
                      
                      120,865
                      
                      
                      
                      25,022Other
                      
                      
                      128,810
                      
                      
                      
                      121,810$
                      1,461,141
                      
                      
                      $
                      1,300,607
 
 Other liabilities consist of the
following:
 
 2007
                    
                    
                    2008Deferred
      Rent
                    
                    $
                    1,843,311
                    
                    
                    $
                    1,941,920Other
                    
                    
                    66,958
                    
                    
                    
                    48,959$
                    1,910,270
                    
                    
                    $
                    1,990,879
 
 (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, we prepaid $2.5
million in fixed rate notes and on June 29, 2007 we 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 SFAS No.
141 “Business
Combinations”, and results of operations are included in the accompanying
consolidated 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.
 
  
 F-22
 
 MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 
 
 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
 
 
 (9)
              401(k)
      Plan
 
 Beginning in fiscal year 1998, we
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.  We may contribute additional amounts at the discretion
of management.  We did not make any contributions to the plan in
fiscal years 2006, 2007 and 2008.
 
 (10)
              Related
      Party Transactions
 
 On June 12, 2007, our 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 our 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 we 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, a then-currently 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 our
uniform franchise agreement and is subject to a monthly royalty
fee.  For the fiscal years ended December 28, 2008 and December 30,
2007 we recognized royalty income of $22,816 and $10,254,
respectively.
 
 We provide 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
sales to the funds.  As of December 28, 2008, the Casa Olé Media Fund
owed us approximately $46,000 for a cash advance which was repaid in full in
January 2009.
 
 (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.
 
 
 
  
 
 F-23
 MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 
 On August 15, 2005, we issued
performance units under the 2005 Plan.  As of December 30, 2007, there
were 255,000 performance units outstanding.  The performance units
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.  On May 28, 2008, we issued 60,000 performance
units under the 2005 Plan.  The performance unit agreements were
amended in October 2008 to all contain concurrent vesting dates of May 28,
2013.  As of December 28, 2008, there were 315,000 performance units
outstanding.
 
 During the fourth quarter of fiscal
year 2007, we made a one time adjustment of $100,000 to cost of sales to correct
for rebates we mistakenly recorded as our own that should have been paid to
franchisees.
 
 (12)
              Subsequent
      Events
 
 On January 25, 2009, we closed one
underperforming company-owned restaurant.  Asset impairments of
$430,928 related to this store were recognized in continuing operations for
fiscal year 2008.
 
 (13)
              Selected
      Quarterly Financial Data
(Unaudited)
 
 The unaudited quarterly results for the
fiscal year ended December 30, 2007 and December 28, 2008 were as follows (in
thousands, except per share data):
 
 
 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
                    )
 
 
  
   F-24
  
 
 MEXICAN
RESTAURANTS, INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 
 
 Fiscal
      Year 2008 Quarter EndedDecember 28
                    
                    
                    September 28
                    
                    
                    June 29
                    
                    
                    March 30Revenues
                    
                    $
                    20,522
                    
                    
                    $
                    19,957
                    
                    
                    $
                    20,987
                    
                    
                    $
                    20,403Income
      (loss) from continuing operations, net oftax
                    
                    
                    (3,933
                    )(1)
                    
                    
                    (481
                    )
                    
                    
                    359
                    
                    
                    
                    37Income
      (loss) from discontinued operations, netof
      tax
                    
                    
                    16
                    
                    
                    
                    (24
                    )
                    
                    
                    --
                    
                    
                    
                    39Net
      income (loss)
                    
                    $
                    (3,917
                    )
                    
                    $
                    (505
                    )
                    
                    $
                    359
                    
                    
                    $
                    76Basic
      income per shareIncome
      (loss) from continuing operations
                    
                    $
                    (1.20
                    )
                    
                    $
                    (0.14
                    )
                    
                    $
                    0.11
                    
                    
                    $
                    0.01Loss
      from discontinued operations
                    
                    
                    --
                    
                    
                    
                    (0.01
                    )
                    
                    
                    --
                    
                    
                    
                    0.01Net
      income (loss)
                    
                    $
                    (1.20
                    )
                    
                    $
                    (0.15
                    )
                    
                    $
                    0.11
                    
                    
                    $
                    0.02Diluted
      income per shareIncome
      (loss) from continuing operations
                    
                    $
                    (1.20
                    )
                    
                    $
                    (0.14
                    )
                    
                    $
                    0.11
                    
                    
                    $
                    0.01Income
      (loss) from discontinued  operations
                    
                    
                    --
                    
                    
                    
                    (0.01
                    )
                    
                    
                    --
                    
                    
                    
                    0.01Net
      income  (loss)
                    
                    $
                    (1.20
                    )
                    
                    $
                    (0.15
                    )
                    
                    $
                    0.11
                    
                    
                    $
                    0.02
 
 (1)
              Impairment
      charges of approximately $4.3 million, net of a tax benefit of
      approximately $1.4 million, were recognized related to goodwill and
      property and equipment.
 
 
 
 
 
 
 
    
 F-25