**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,DC 20549**

 

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**FORM 10-Q**

 

**ý****          ****QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 28,2006**

 

**o****         ****TRANSITION REPORT PURSUANTTO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**CommissionFile Number 000-29643**

 

**GRANITECITY FOOD & BREWERY LTD.**

(Exact Name of Registrantas Specified in Its Charter)

 

| **Minnesota**                      | ** ** | **41-1883639**       |
|------------------------------------|------------|----------------------|
| (State or Other  Jurisdiction      |       | (I.R.S. Employer     |
| of Incorporation  or Organization) |       | Identification  No.) |

 

**5402Parkdale Drive, Suite 101****Minneapolis, Minnesota 55416****(952) 215-0660**

(Address ofPrincipal Executive Offices and Issuer’sTelephone Number, including Area Code)

 

Indicate by check markwhether the registrant: (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.

 

Yes  ý    No  o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and large acceleratedfiler” in Rule 12b-2 of the Exchange Act. (Check one):

 

| Large  accelerated filer  o |   | Accelerated  filer  o |   | Non-accelerated  filer  ý |
|---------------------------------------|--------|---------------------------------|--------|------------------------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

 

Yes  o    No  ý

 

Asof May 8, 2006, the issuer had outstanding 13,226,526 shares of common stock.

 

 

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**TABLE OFCONTENTS**

 
| **PART I**            | ** ** | **FINANCIAL INFORMATION** |                                                                                                             |
|-----------------------|------------|---------------------------|------------------------------------------------------------------------------------------------------------------|
|                  |       |                      |                                                                                                             |
|                  | ITEM 1     |                      | Financial Statements                                                                                             |   |
|                  |       |                      |                                                                                                             |   |
|                  |       |                      | Condensed Consolidated  Balance Sheets as of March 28, 2006 and December 27, 2005                                |   |
|                  |       |                      |                                                                                                             |   |
|                  |       |                      | Condensed Consolidated  Statements of Operations for the thirteen weeks ended March 28, 2006 and  March 29, 2005 |   |
|                  |       |                      |                                                                                                             |   |
|                  |       |                      | Condensed Consolidated  Statements of Cash Flows for the thirteen weeks ended March 28, 2006 and  March 29, 2005 |   |
|                  |       |                      |                                                                                                             |   |
|                  |       |                      | Notes to Condensed  Consolidated Financial Statements                                                            |   |
|                  |       |                      |                                                                                                             |   |
|                  | ITEM 2     |                      | Management’s Discussion and  Analysis of Financial Condition and Results of Operations.                     |   |
|                  |       |                      |                                                                                                             |   |
|                  | ITEM 3     |                      | Quantitative and Qualitative  Disclosures About Market Risk                                                      |   |
|                  |       |                      |                                                                                                             |   |
|                  | ITEM 4     |                      | Controls and Procedures                                                                                          |   |
|                  |       |                      |                                                                                                             |   |
| **PART II**           | ** ** | **OTHER INFORMATION**     |                                                                                                             |
|                  |       |                      |                                                                                                             |   |
|                  | ITEM  1    |                      | Legal  Proceedings                                                                                               |   |
|                  |       |                      |                                                                                                             |   |
|                  | ITEM  1A   |                      | Risk  Factors                                                                                                    |   |
|                  |       |                      |                                                                                                             |   |
|                  | ITEM  2    |                      | Unregistered  Sales of Equity Securities and Use of Proceeds                                                     |   |
|                  |       |                      |                                                                                                             |   |
|                  | ITEM  3    |                      | Defaults  upon Senior Securities                                                                                 |   |
|                  |       |                      |                                                                                                             |   |
|                  | ITEM  4    |                      | Submission  of Matters to a Vote of Security Holders                                                             |   |
|                  |       |                      |                                                                                                             |   |
|                  | ITEM  5    |                      | Other  Information                                                                                               |   |
|                  |       |                      |                                                                                                             |   |
|                  | ITEM  6    |                      | Exhibits                                                                                                         |   |
|                  |       |                      |                                                                                                             |   |
| **SIGNATURES**        |       |
|                  |       |
| **INDEX TO EXHIBITS** |       |
|                       |            |                           |                                                                                                                  |  |  |

 

i

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**PARTI**                  FINANCIAL INFORMATION

** **

**ITEM1  Financial Statements**

 

**GRANITECITY FOOD & BREWERY LTD.**

# **CONDENSED CONSOLIDATED BALANCE SHEETS**

**(Unaudited)**

 
| ** **                                                                                                                                      | ** ** | **March 28,  2006** | ** ** | **December 27,  2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|------------------------|------------|
| **ASSETS:**                                                                                                                                     |       |                |       |                   |       |
| Current assets:                                                                                                                                 |       |                |       |                   |       |
| Cash                                                                                                                                            |       | $                   | 6,312,647  |                   | $          | 9,836,231 |   |
| Inventory                                                                                                                                       |       | 302,073             |       | 243,180                |       |
| Prepaids and  other                                                                                                                             |       | 171,780             |       | 218,960                |       |
| Total current  assets                                                                                                                           |       | 6,786,500           |       | 10,298,371             |       |
|                                                                                                                                            |       |                |       |                   |       |
| Property and  equipment, net                                                                                                                    |       | 41,782,860          |       | 33,767,282             |       |
| Intangible  assets and other                                                                                                                    |       | 420,051             |       | 416,937                |       |
| Total assets                                                                                                                                    |       | $                   | 48,989,411 |                   | $          | 44,482,590 |   |
|                                                                                                                                            |       |                |       |                   |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY:**                                                                                                  |       |                |       |                   |       |
| Current  liabilities:                                                                                                                           |       |                |       |                   |       |
| Accounts payable                                                                                                                                |       | $                   | 2,462,271  |                   | $          | 1,007,437 |   |
| Accrued expenses                                                                                                                                |       | 2,693,489           |       | 3,156,455              |       |
| Deferred rent,  current portion                                                                                                                 |       | 87,534              |       | 76,437                 |       |
| Long-term debt,  current portion                                                                                                                |       | 241,357             |       | 241,747                |       |
| Capital lease  obligations, current portion                                                                                                     |       | 769,119             |       | 679,738                |       |
| Total current  liabilities                                                                                                                      |       | 6,253,770           |       | 5,161,814              |       |
|                                                                                                                                            |       |                |       |                   |       |
| Deferred rent,  net of current portion                                                                                                          |       | 1,310,764           |       | 1,119,458              |       |
| Long-term debt,  net of current portion                                                                                                         |       | 2,202,991           |       | 2,262,180              |       |
| Capital lease  obligations, net of current portion                                                                                              |       | 23,338,498          |       | 18,585,630             |       |
| Total  liabilities                                                                                                                              |       | 33,106,023          |       | 27,129,082             |       |
|                                                                                                                                            |       |                |       |                   |       |
| Shareholders’  equity:                                                                                                                     |       |                |       |                   |       |
| Common stock,  $0.01 par value, 90,000,000 shares authorized; 13,226,526 shares issued and  outstanding at March 28, 2006 and December 27, 2005 |       | 132,265             |       | 132,265                |       |
| Additional  paid-in capital                                                                                                                     |       | 28,057,009          |       | 27,881,089             |       |
| Accumulated  deficit                                                                                                                            |       | (12,305,886         | )          | (10,659,846            | )          |
| Total  shareholders’ equity                                                                                                                |       | 15,883,388          |       | 17,353,508             |       |
|                                                                                                                                            |       |                |       |                   |       |
| Total  liabilities and shareholders’ equity                                                                                                |       | $                   | 48,989,411 |                   | $          | 44,482,590 |   |

 

See notes tocondensed consolidated financial statements.

 

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**GRANITECITY FOOD & BREWERY LTD.**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                              | ** ** | **Thirteen Weeks Ended** | ** ** |
|---------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                              | ** ** | **March 28,  2006**           | ** ** | **March 29,  2005** | ** ** |
|                                                    |       |                               |       |   |   |
| Restaurant  revenues                                    |       | $                                  | 11,892,319 |   | $ | 7,870,335 |   |
|                                                    |       |                               |       |   |   |
| Cost of sales:                                          |       |                               |       |   |   |
| Food, beverage  and retail                              |       | 3,514,935                          |       | 2,355,388 |   |
| Labor                                                   |       | 4,161,563                          |       | 2,713,753 |   |
| Direct  restaurant operating                            |       | 1,698,782                          |       | 1,046,637 |   |
| Occupancy                                               |       | 681,655                            |       | 436,178 |   |
| Total cost of  sales                                    |       | 10,056,935                         |       | 6,551,956 |   |
|                                                    |       |                               |       |   |   |
| Pre-opening                                             |       | 811,802                            |       | 7,713 |   |
| General and  administrative                             |       | 1,455,060                          |       | 952,353 |   |
| Depreciation and  amortization                          |       | 752,456                            |       | 444,396 |   |
|                                                    |       |                               |       |   |   |
| Operating loss                                          |       | (1,183,934                         | )          | (86,083 | ) |
|                                                    |       |                               |       |   |   |
| Interest:                                               |       |                               |       |   |   |
| Income                                                  |       | 32,050                             |       | 38,261 |   |
| Expense                                                 |       | (498,029                           | )          | (323,989 | ) |
| Other income  (expense), net                            |       | 3,873                              |       | (10,843 | ) |
| Net other  expense                                      |       | (462,106                           | )          | (296,571 | ) |
|                                                    |       |                               |       |   |   |
| Net loss                                                |       | $                                  | (1,646,040 | ) | $ | (382,654 | ) |
|                                                    |       |                               |       |   |   |
| Loss per common  share, basic and diluted               |       | $                                  | (0.12      | ) | $ | (0.03 | ) |
|                                                    |       |                               |       |   |   |
| Weighted average  shares outstanding, basic and diluted |       | 13,226,526                         |       | 11,614,276 |   |

 

See notes tocondensed consolidated financial statements.

 

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**GRANITECITY FOOD & BREWERY LTD.**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

** **
| ** **                                                                                 | ** ** | **Thirteen Weeks Ended** | ** ** |
|--------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                 | ** ** | **March 28,  2006**           | ** ** | **March 29,  2005** | ** ** |
|                                                                                       |       |                               |       |   |   |
| Cash flows from  operating activities:                                                     |       |                               |       |   |   |
| Net loss                                                                                   |       | $                                  | (1,646,040 | ) | $ | (382,654 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities:               |       |                               |       |   |   |
| Depreciation and  amortization                                                             |       | 752,456                            |       | 444,396 |   |
| Stock option  compensation expense                                                         |       | 180,101                            |       | 6,390 |   |
| (Gain)/loss on  disposal of asset                                                          |       | (3,873                             | )          | 10,843 |   |
| Deferred rent                                                                              |       | 202,403                            |       | (7,500 | ) |
| Decrease  (increase) in:                                                                   |       |                               |       |   |   |
| Inventory                                                                                  |       | (58,893                            | )          | — |   |
| Prepaids and  other                                                                        |       | 47,180                             |       | 111,985 |   |
| Increase  (decrease) in:                                                                   |       |                               |       |   |   |
| Accounts payable                                                                           |       | 151,297                            |       | (212,564 | ) |
| Accrued expenses                                                                           |       | (443,296                           | )          | (463,136 | ) |
| Net cash used in  operating activities                                                     |       | (818,665                           | )          | (492,240 | ) |
|                                                                                       |       |                               |       |   |   |
| Cash flows from  investing activities:                                                     |       |                               |       |   |   |
| Purchase of:                                                                               |       |                               |       |   |   |
| Property and  equipment                                                                    |       | (2,416,940                         | )          | (861,704 | ) |
| Intangible  assets and other                                                               |       | (11,668                            | )          | (4,113 | ) |
| Net cash used in  investing activities                                                     |       | (2,428,608                         | )          | (865,817 | ) |
|                                                                                       |       |                               |       |   |   |
| Cash flows from  financing activities:                                                     |       |                               |       |   |   |
| Payments on  capital lease obligations                                                     |       | (212,551                           | )          | (133,702 | ) |
| Payments on long  term-debt                                                                |       | (59,579                            | )          | (55,863 | ) |
| Payment of  dividends                                                                      |       | —                             |       | (41,068 | ) |
| (Cost  incurred)/proceeds from issuance of stock                                           |       | (4,181                             | )          | 31,350 |   |
| Net cash used in  financing activities                                                     |       | (276,311                           | )          | (199,283 | ) |
|                                                                                       |       |                               |       |   |   |
| Net decrease in  cash                                                                      |       | (3,523,584                         | )          | (1,557,340 | ) |
| Cash, beginning                                                                            |       | 9,836,231                          |       | 9,297,247 |   |
| Cash, ending                                                                               |       | $                                  | 6,312,647  |   | $ | 7,739,907 |   |
|                                                                                       |       |                               |       |   |   |
| Supplemental  disclosure of non-cash investing and financing activities:                   |       |                               |       |   |   |
| Land and  buildings acquired under capital lease agreements                                |       | $                                  | 5,054,800  |   | $ | 650,000 |   |
| Equipment and  intangibles purchased and included in accounts payable and accrued expenses |       | $                                  | 1,283,867  |   | $ | 9,923 |   |

 

See notes tocondensed consolidated financial statements.

 

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**GRANITECITY FOOD & BREWERY LTD.**

 

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

Thirteen weeksended March 28, 2006 and March 29, 2005

 

**1.****     Basisof Presentation**

 

GraniteCity Food & Brewery Ltd. (the “Company”) develops and operates casualdining restaurants featuring on-premise breweries known as Granite City Food& Brewery® in selected markets throughout the Midwest. The theme is casualdining with a wide variety of menu items that are prepared fresh daily,combined with freshly brewed hand-crafted beers made on-premise. The Companyproduces its beer using a process called Fermentus InterruptusTM, which isintended to maintain high beer quality while enhancing overall profitability byreducing unit-level brewing costs. The first restaurant, located in St. Cloud,Minnesota, opened in July 1999. Subsequently, the Company opened twelveadditional restaurants that are reflected in these financial statements: SiouxFalls, South Dakota; Fargo, North Dakota; Des Moines, Cedar Rapids andDavenport, Iowa; Lincoln, Nebraska; Maple Grove and Eagan, Minnesota; Wichita,Kansas City and Olathe, Kansas, and Kansas City, Missouri.

 

TheCompany’s current expansion strategy focuses on development of restaurants inmarkets where management believes the Company’s concept will have broad appealand attractive restaurant-level economics.

 

Theaccompanying unaudited condensed consolidated financial statements have beenprepared in accordance with accounting principles generally accepted in theUnited States of America and regulations of the Securities and ExchangeCommission. Accordingly, they do not include all the information and footnotesrequired by U.S. generally accepted accounting principles for completefinancial statements. In the opinion of management, all adjustments, consistingof normal recurring adjustments, which are necessary for a fair statement ofits financial position as of March 28, 2006 and the results of operations forthe interim periods ended March 28, 2006 and March 29, 2005 have been included.

 

Thebalance sheet at December 27, 2005 has been derived from the audited financialstatements at that date, but does not include all of the information and notesrequired by generally accepted accounting principles for complete financialstatements. Certain information and note disclosures normally includedin the Company’s annual financial statements have been condensed or omitted. Thesecondensed financial statements should be read in conjunction with the financialstatements and notes thereto included in the Company’s Annual Report on Form10-KSB for the fiscal year ended December 27, 2005, filed with the Securitiesand Exchange Commission on March 27, 2006.

 

The results of operationsfor the thirteen weeks ended March 28, 2006 are not necessarily indicative ofthe results to be expected for the entire year.

 

**2.****     Summaryof Significant Accounting Policies**

 

Stock-Based Compensation:

OnDecember 16, 2004, the FASB issued Statement of Financial AccountingStandards (“SFAS”) No. 123 (revised 2004) (“SFAS 123(R)”), *Share-Based Payment*, which is a revisionof SFAS 123, *Accounting for Stock-BasedCompensation*. SFAS 123(R) supersedes Accounting PrinciplesBoard (“APB”) Opinion No. 25, *Accounting for StockIssued to Employees,*and amends SFAS No. 95, *Statement of Cash Flows*. Generally, SFAS 123(R)requires all share-based payments to employees, including grants of employeestock options, to be recognized in the income statement based on their fairvalues determined at the date of grant. On April 14, 2005, the Securitiesand Exchange Commission adopted a new rule that amended the compliance datesfor SFAS 123(R). The Company adopted SFAS 123(R) using the modifiedprospective method effective

 

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December28, 2005, the first day of its 2006 fiscal year.

 

Inall prior periods, the Company accounted for stock-based compensation awards toemployees using the intrinsic value method prescribed by APB Opinion No. 25and, as such, generally recognized no compensation cost for employee stockoptions. Accordingly, the adoption of SFAS 123(R)’s fair value method affectsthe Company’s results of operations, although it does not affect the Company’soverall financial position. If the Company had been accounting for stock-basedcompensation under SFAS 123(R) during the first quarter of fiscal year2005, the impact of that standard would have approximated the impact of SFAS 123as described in the pro forma disclosure set forth below:

 
| ** **                                                                                                                                  | ** ** | **Thirteen Weeks Ended  March 29,  2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| Net loss:                                                                                                                                   |       |                                      |       |
| As reported                                                                                                                                 |       | $                                         | (382,654   | ) |
| Less: Total  stock-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |       | $                                         | (189,080   | ) |
| Pro forma                                                                                                                                   |       | $                                         | (571,734   | ) |
|                                                                                                                                        |       |                                      |       |
| Net loss per common share                                                                                                                   |       |                                      |       |
| Basic and  diluted as reported                                                                                                              |       | $                                         | (0.03      | ) |
| Basic and  diluted pro forma                                                                                                                |       | $                                         | (0.05      | ) |

 

The fair value of optionsat date of grant was estimated using the Black-Scholes option-pricing modelwith the following assumptions for the first quarter of 2005: (a) no dividendyield, (b) 37.6% expected volatility, (c) expected life of options of five toten years and (d) a risk-free interest rate of 3.6% to 4.5%.

 

During the first quarterof 2006, the Company granted an aggregate of 115,000 options, estimating thefair value of such options using the Black-Scholes option-pricing model withthe following assumptions: (a) no dividend yield, (b) 41.4% to 43.6% expectedvolatility, (c) expected life of options of five to ten years and (d) arisk-free interest rate of 4.35% to 4.53%. The Company recorded totalstock-based compensation expense of $180,101 in the first quarter of fiscalyear 2006. See Note 4 for future discussion of the Company’s stock-basedcompensation.

 

Accounting for Leases:

On October 6, 2005, the FASB issued StaffPosition No. FAS 13-1, *Accountingfor Rental Costs Incurred During a Construction Period*. Generally,the staff position requires companies to expense rental costs incurred during aconstruction period. The Company was required to adopt FASB Staff PositionNo. FAS 13-1 beginning in fiscal year 2006, and as a result, included$221,957 of such rental costs in pre-opening expense during the first quarterof fiscal year 2006. Prior to the adoption of FASB Staff Position No. FAS 13-1,the Company did not expense rental costs during the construction period, but rathercapitalized such costs as then permitted under GAAP. The Company believes the adoptionof the staff position will increase average per-unit pre-opening costs by $50,000to $125,000 depending upon the lease term and length of construction period.

 

Principlesof consolidation and presentation:

The Company’s consolidated financial statementsinclude the accounts and operations of the Company and its subsidiarycorporations under which its Kansas locations are operated. Fifty-one percentof the stock of each of the subsidiary corporations is owned by a Granite Cityrestaurant manager and the Company owns the remainder of the stock of eachcorporation. Each manager-owner of the stock of these entities has entered intoa buy-sell agreement with each corporation providing, among other things, thattransfer of the shares is restricted and that the shareholder must sell hisshares to the corporation upon certain events, including

 

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termination of employment or any event whichdisqualifies the manager from owning the shares under applicable laws andregulations of the state. The Company has entered into a master agreement witheach separate corporation that permits the operation of the restaurants andleases to each corporation the Company’s property and facilities. Each corporationpays all of its operating expenses and obligations, and the Company retains, asconsideration for the operating arrangements and the lease of property andfacilities, the net profit from its operations. The Company has determined thatthe foregoing ownership structure will cause these separate corporations to betreated as variable interest entities in which the Company has a controllingfinancial interest for the purpose of FASB Interpretation 46 (R), Consolidationof Variable Interest Entities (FIN46R). As such, the corporations areconsolidated with the Company’s financial statements and the Company’sfinancial statements do not reflect a minority ownership in those separatecorporations. All references to the Company in these financial statementsrelate to the consolidated entity.

 

Reclassification:

Certain reclassifications have been made to thefinancial statements for the first quarter of 2005 in order for them to conformto the presentation of the financial statements for the first quarter of 2006. Thesereclassifications have no effect on the accumulated deficit or net losspreviously reported.

 

**3.****     Commitmentand Contingencies**

 

WestWichita, Kansas lease:

In January 2006, the Company entered into a 20-yearnet lease relating to the restaurant it plans to open in West Wichita, Kansasunder the same terms specified in the multi-site development agreement theCompany has entered into with Dunham Capital Management L.L.C. (“Dunham”), itscommercial developer. The restaurant is being constructed for the Company on abuild-to-suit basis and the annual rent will be equal to 10.5% of theconstruction cost including land cost. The land portion of this lease will beclassified as an operating lease because the fair value of the land is morethan 25% of the property to be leased. The building portion of this lease willbe classified as a capital lease because its present value will be greater than90% of the estimated fair value at the beginning of the lease. The Company willbe responsible for any real-estate taxes and all operating costs. The term of thelease will commence when operations begin. The lease may be extended at theCompany’s option for up to five additional five-year periods on the same termsand conditions, except the rent may increase based on a formula using theConsumer Price Index during any such extension, or the Company may purchase thepremises for the fair market value during the last year of the original term. Rentalcosts associated with the operating lease that are incurred during theconstruction period will be recognized as pre-opening costs, and included inincome from continuing operations.

 

St. Louis Park, Minnesota:

In March 2006, the Company entered into a 10-yearnet lease relating to the restaurant it plans to open in St. Louis Park,Minnesota. The lease includes land and an existing building of approximately7,250 square feet which the Company will convert into a Granite City Food &Brewery restaurant. Annual rent is $148,625 per year plus percentage rent basedupon restaurant sales and the Company will be responsible for any real-estatetaxes and all operating costs. The term of the lease commenced March 17, 2006and may be extended at the Company’s option for up to three additionalfive-year periods on the same terms and conditions, except the base rent willincrease approximately $1.00 per square foot during each such extension. Rentalcosts associated with the operating lease that are incurred during theconstruction period will be recognized as pre-opening costs, and included inincome from continuing operations. The Company paid approximately $663,000 inlease acquisition costs for this property.

 

**4.****    ****Stock-Based Compensation**

 

In July 1997, the Companyadopted the 1997 Stock Option Plan for employees and non-employees, includingconsultants to the Company, to purchase the Company’s common stock at anexercise price that equals or exceeds the fair market value on the date ofgrant. The number of shares authorized for issuance under the plan as of March28, 2006 was 400,000, of which 35,500 shares remained available for futureissuance. Although vesting

 

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schedules may vary,option grants under this plan generally vest evenly over a four-year period andoptions are exercisable for no more than ten years from the date of grant.

 

The Company has reserved590,000 shares of common stock for issuance under the 1997 Director StockOption Plan, of which 163,500 remained available for issuance at March 28, 2006.Under this plan, the Company automatically grants an option to each outsidedirector on the date such person becomes a director for the purchase of 15,000shares of common stock and thereafter on each successive anniversary of thegrant of the first option for the purchase of 15,000 shares. Each option vestsone year after the option is granted and is exercisable for five years from thedate of grant. Options are granted at fair market value.

 

In August 2002, theCompany adopted the 2002 Equity Incentive Plan for employees, prospectiveemployees, officers and members of the Company’s board of directors, as well asconsultants and advisors to the Company, to purchase shares of the Company’scommon stock at an exercise price that equals or exceeds the fair market valueon the date of grant. The number of shares authorized for issuance as of March28, 2006 was 1,558,839, of which 555,839 shares remained available for futureissuance. Although vesting schedules may vary, option grants under this plangenerally vest evenly over a four-year period and options are exercisable forno more than ten years from the date of grant.

 

Asummary of the status of the Company’s stock options as of March 28, 2006 ispresented below:

 
| **Fixed Options**                                             | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|--------------------------------------------------------------------|------------|------------|------------|--------------------------------------------|------------|---------------------------------------------------------|------------|---------------------------------|------------|
| Outstanding at  December 27, 2005                                  |       | 1,590,000  |       | $                                          | 3.58       |                                                    | 6.7 years  |                            |       |   |
| Granted                                                            |       | 115,000    |       | 4.30                                       |       | 9.2 years                                               |       |                            |       |
| Exercised                                                          |       | —     |       | —                                     |       | —                                                  |       |                            |       |
| Forfeited                                                          |       | —     |       | —                                     |       | —                                                  |       |                            |       |
| Outstanding at  March 28, 2006                                     |       | 1,705,000  |       | $                                          | 3.62       |                                                    | 6.7 years  |                            | $          | 1,636,320 |   |
|                                                               |       |       |       |                                       |       |                                                    |       |                            |       |
| Options  exercisable at December 27, 2005                          |       | 1,015,750  |       | $                                          | 3.29       |                                                    | 5.9 years  |                            |       |   |
| Options  exercisable at March 28, 2006                             |       | 1,116,336  |       | $                                          | 3.32       |                                                    | 5.8 years  |                            | $          | 1,381,874 |   |
|                                                               |       |       |       |                                       |       |                                                    |       |                            |       |
| Weighted-average  fair value of options granted during the quarter |       | $          | 4.30       |                                       |       |                                                    |       |                            |       |   |
|                                                                    |            |            |            |                                            |            |                                                         |            |                                 |            |  |  |  |

 

The aggregate intrinsic value in the table aboverepresents the total pretax intrinsic value (the difference between the closingprice of the Company’s stock on March 28, 2006 and the exercise price,multiplied by the number of in-the-money options) that would have been receivedby the option holders had all option holders exercised their options on March28, 2006. As of March 28, 2006, there was approximately $871,302 of totalunrecognized compensation cost related to unvested share-based compensationarrangements, of which $678,169 is expected to be recognized during theremainder of fiscal year 2006, $180,840 in fiscal year 2007 and $12,293 infiscal year 2008.

 

**ITEM 2****   Management’s Discussion and Analysis of FinancialCondition and Results of Operations**

 

*This discussion and analysis contains variousnon-historical forward-looking statements within the meaning of Section 21E ofthe Exchange Act. Although we believe that, in making any such statement, ourexpectations are based on reasonable assumptions, any such statement may beinfluenced by factors that could cause actual outcomes and results to bematerially different from those projected. When used in the following discussion,the words “anticipates,” “believes,” “expects,” “intends,” “plans,” “estimates”and similar expressions, as they relate to us or our management, are intendedto identify such forward-looking statements. You are cautioned not to placeundue reliance on such forward-looking statements, which are qualified in theirentirety by the cautions and risks described herein. Please refer to our AnnualReport on Form 10-KSB for the fiscal year*

 

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*endedDecember 27, 2005, filed with the Securities and Exchange Commission on March27, 2006, for additional factors known to us that may cause actual results tovary.*

 

**Overview**

 

We operate thirteen casual dining restaurantsfeaturing on-premises breweries under the name Granite City Food & Brewery®.With the exception of the building at our Fargo location, we lease the land andbuilding at each of our restaurants. The location of each restaurant and themonth and year of its opening appear in the following chart:

 
| **Unit** | ** ** | **Location**               | ** ** | **Opened** |
|----------|------------|----------------------------|------------|------------|
| 1        |       | St. Cloud,  Minnesota      |       | Jun-99     |
| 2        |       | Sioux Falls,  South Dakota |       | Dec-00     |
| 3        |       | Fargo, North  Dakota       |       | Nov-01     |
| 4        |       | Des Moines, Iowa           |       | Sep-03     |
| 5        |       | Cedar Rapids,  Iowa        |       | Nov-03     |
| 6        |       | Davenport, Iowa            |       | Jan-04     |
| 7        |       | Lincoln,  Nebraska         |       | May-04     |
| 8        |       | Maple Grove,  Minnesota    |       | Jun-04     |
| 9        |       | Wichita, Kansas            |       | Jul-05     |
| 10       |       | Eagan, Minnesota           |       | Sep-05     |
| 11       |       | Kansas City,  Missouri     |       | Nov-05     |
| 12       |       | Kansas City,  Kansas       |       | Jan-06     |
| 13       |       | Olathe, Kansas             |       | Mar-06     |

 

We developed the foregoing restaurants using proceedsfrom the sale of our securities, building and equipment leases, debt andequipment financing and cash flow from operations. We built units 4-9 and 11-13based upon the prototype we developed in early 2003. Unit 10, our Eaganrestaurant, was a conversion of an existing restaurant. With the exception ofunits 1-3, we developed all of our units under our multi-site developmentagreement with a commercial developer that provides us with assistance in siteselection, construction management and financing for new restaurants. Underthis agreement, we lease the land and building of each new restaurant from ourdeveloper.

 

Our worthouse, located in Ellsworth, Iowa, facilitates the initialstage of our brewing process— the production of non-alcoholic wort— using ourpatent-pending brewing process called Fermentus InterruptusTM. We believe that FermentusInterruptus and the use of a centrally located worthouse improves the economicsof microbrewing as it eliminates the initial stages of brewing and storage atmultiple locations, thereby reducing equipment and development costs at newrestaurant locations. Additionally, having a common starting point for theproduction of wort creates consistency of taste for our product from unit tounit. The wort produced at our worthouse is transported via truck to the fermentationvessels at each of our restaurants where the brewing process is completed. Webelieve that our current worthouse has the capacity to service 30 to 35restaurant locations.

 

The training of each of our managers takes place under the instructionof four, full-time dedicated trainers at Granite City University, locatedwithin our Maple Grove restaurant. Our eight-week training program consists ofboth “hands on” as well as classroom training for all aspects of management. Allsalaries of our managers in training and our trainers as well as all relatedcosts incurred at Granite City University are recorded as a component ofcorporate general and administrative costs.

 

Our new store opening team, which consists of three experiencedrestaurant managers, is responsible for the opening of each of our newrestaurants. Generally, this team arrives at a new restaurant site two to threemonths in advance of the restaurant opening date and coordinates all staffingand training matters for that new

 

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restaurant.We believe that a dedicated team delivers a more disciplined opening processand ensures adherence to our company’s exacting standards and culture.

 

We believe that our operating results will fluctuate significantlybecause of several factors, including the timing of new restaurant openings andrelated expenses, profitability of new restaurants, changes in food and laborcosts, increases or decreases in comparable restaurant sales, general economicconditions, consumer confidence in the economy, changes in consumerpreferences, competitive factors, the skill and experience of ourrestaurant-level management teams and weather conditions.

 

We expect the timing of newrestaurant openings to have a significant impact on restaurant revenues andcosts. We believe we will incur the most significant portion of pre-openingcosts associated with a new restaurant within the two months immediatelypreceding, and the month of, the opening of such restaurant.

 

The thirteen weeks ended March28, 2006 included 151 restaurant weeks, which is the sum of the actual numberof weeks each restaurant operated. The thirteen weeks ended March 29, 2005included 104 restaurant weeks. The source of these additional 47 restaurant weeksis shown in the following chart: 

 
| **Location**                | ** ** | **First Quarter 2006  Weeks of Operation** | ** ** | **First Quarter 2005  Weeks of Operation** | ** ** |
|-----------------------------|------------|--------------------------------------------|------------|--------------------------------------------|------------|
| Wichita, Kansas             |       | 13                                         |       | 0                                          |       |
| Eagan, Minnesota            |       | 13                                         |       | 0                                          |       |
| Kansas City, Missouri       |       | 13                                         |       | 0                                          |       |
| Kansas City, Kansas         |       | 8                                          |       | 0                                          |       |
| Additional Restaurant Weeks |       | 47                                         |       | 0                                          |       |

 

Because we continue toexpand our operations and open new restaurants at various times throughout theyear, we provide this statistical measure to enhance the comparison of revenuesfrom period to period as changes occur in the number of units we are operating.

 

Our restaurant revenues arecomprised almost entirely of the sales of food and beverages. The sale ofretail items, such as cigarettes and promotional items, typically representsless than one percent of total revenue. Product costs include the costs offood, beverages and retail items. Labor costs include direct hourly andmanagement wages, taxes and benefits for restaurant employees. Direct restaurantoperating costs include restaurant supplies, marketing costs, utilities,repairs and maintenance and other related costs. Occupancy costs include renton our operating leases, real estate taxes and insurance. Pre-opening costsconsist of direct costs related to hiring and training the initial restaurantworkforce, the salaries and related costs of our dedicated new store openingteam, rental costs incurred during the construction period, and other directcosts associated with opening new restaurants. General and administrativeexpenses are comprised of expenses associated with all corporate andadministrative functions that support existing operations which includemanagement and staff salaries, employee benefits, travel, information systems,training, market research, professional fees, supplies, corporate rent andexcess worthouse production costs. Depreciation and amortization includesdepreciation on capital expenditures at the restaurant and corporate levels andamortization of intangibles that do not have indefinite lives. Other income andexpense represents the cost of interest expense on debt and capital leases,interest income on invested assets and gain/loss on disposal of assets.

 

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**Results of Operations**

 

The following table compares operating resultsexpressed as a percentage of total revenue for the thirteen weeks ended March28, 2006 and March 29, 2005.

 
| ** **                    | ** ** | **Thirteen Weeks Ended** | ** ** |
|-------------------------------|------------|--------------------------|------------|
| ** **                    | ** ** | **March 28,  2006**      | ** ** | **March 29,  2005** | ** ** |
|                          |       |                     |       |   |   |
| Restaurant revenues           |       | 100.0                    | %          | 100.0 | % |
|                          |       |                     |       |   |   |
| Cost of sales:                |       |                     |       |   |   |
| Food, beverage  and retail    |       | 29.6                     |       | 29.9 |   |
| Labor                         |       | 35.0                     |       | 34.5 |   |
| Direct  restaurant operating  |       | 14.3                     |       | 13.3 |   |
| Occupancy                     |       | 5.7                      |       | 5.5 |   |
| Total cost of  sales          |       | 84.6                     |       | 83.2 |   |
|                          |       |                     |       |   |   |
| Pre-opening                   |       | 6.8                      |       | 0.1 |   |
| General and administrative    |       | 12.2                     |       | 12.1 |   |
| Depreciation and amortization |       | 6.3                      |       | 5.6 |   |
|                          |       |                     |       |   |   |
| Operating loss                |       | (10.0                    | )          | (1.1 | ) |
|                          |       |                     |       |   |   |
| Interest:                     |       |                     |       |   |   |
| Income                        |       | 0.3                      |       | 0.5 |   |
| Expense                       |       | (4.2                     | )          | (4.1 | ) |
| Other income (expense), net   |       | 0.0                      |       | (0.1 | ) |
| Net other  expense            |       | (3.9                     | )          | (3.8 | ) |
|                          |       |                     |       |   |   |
| Net loss                      |       | (13.8                    | )%         | (4.9 | )% |

 

Certain percentageamounts do not sum due to rounding.

 

**Resultsof Operations for the Thirteen Weeks Ended March 28, 2006 and March 29, 2005**

 

**Revenue**

 

We generated $11,892,319 and $7,870,335 of revenuesduring the first quarter of 2006 and 2005, respectively. The thirteen weeks endedMarch 28, 2006 included 151 restaurant weeks, which is the sum of the actualnumber of weeks each restaurant operated. The thirteen weeks ended March 29,2005 included 104 restaurant weeks. Average weekly sales increased from $75,676to $78,757 per week in the first quarter of 2006 compared to the first quarterof 2005 while comparable restaurant sales, which include restaurants inoperation over 18 months, increased 5.4% in the first quarter of 2006 over thefirst quarter of 2005. The increase in sales of 51.1% for the first quarter ofthe fiscal year 2006 over the first quarter of fiscal year 2005 was the resultof 47 additional restaurant weeks in 2006 and the increase in comparablerestaurant sales.

 

We anticipate that restaurant revenues will vary fromquarter to quarter. We anticipate seasonal fluctuations in restaurant revenuesdue in part to increased outdoor seating and generally favorable weatherconditions at our locations during the summer months. We expect the timing ofnew restaurant openings to cause fluctuations in restaurant revenues. Additionally,consumer confidence in the economy and changes in consumer preferences mayaffect our future revenues.

 

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**Restaurant Costs**

 

***Food and Beverage***

 

Our food and beverage costs decreased 0.3% as apercentage of revenue from 29.9% in the first quarter of 2005 to 29.6% in thefirst quarter of 2006 due primarily to more experienced staff members generatingless waste, as well as lower per-unit product prices due to higher volumecompany-wide purchasing.

 

We expect that our food andbeverage costs will vary going forward due to numerous variables, includingseasonal changes in food and beverage costs and guest preferences. Weperiodically create new menu offerings and introduce new craft brewed beersbased upon guest preferences. Although such menu modifications may temporarilyresult in increased food and beverage cost, we believe we are able to offsetsuch increases with our weekly specials which provide variety and value to ourguests. Our varieties of craft brewed beer, which we believe we can produce atlower cost than beers we purchase for resale, also enable us to keep our foodand beverage costs low while fulfilling guest requests and building customerloyalty. As we open additional restaurants, we believe we will experienceincreased purchasing power, partially offsetting food and beverage costincreases, and maintain or reduce our food and beverage costs as a percentageof revenue. Additionally, as we add new restaurants, we believe our brewingprocess, Fermentus Interruptus, will allow us to keep our high quality beerproducts intact while leveraging our fixed production costs, thereby enhancingoverall company profitability.

 

***Labor***

 

Our labor costs expressed as a percentage of revenue increased0.5% from 34.5% in the first quarter of 2005 to 35.0% in the first quarter of2006 due primarily to increases in hourly labor as minimum wages increasedand we had to compete more aggressively for management and hourly employees atour new restaurants.

 

We expect that labor costswill vary as we add new restaurants. Minimum wage laws, local labor laws andpractices, as well as unemployment rates vary from state to state and willaffect our labor costs, as will hiring and training expenses at our new restaurants.We believe that retaining good employees and more experienced staff ensureshigh quality guest service and reduces hiring and training costs.

 

***Direct Restaurant Operating***

 

Our direct restaurant operating expenses increased 1.0%as a percentage of revenues from 13.3% in the first quarter of 2005 to 14.3% inthe first quarter of 2006. Operating supplies, repairs and maintenance, promotionsand restaurant-level administrative expense represent the majority of ourdirect restaurant operating expenses, a portion of which is fixed or indirectlyvariable. The increase in direct restaurant operating expenses was dueprimarily to an increase in expenses related to credit card acceptance, repairand maintenance and utilities.

 

***Occupancy***

 

Our occupancy costs, which include rent on ouroperating leases, common area maintenance, property taxes and insurance,increased 0.2% as a percentage of revenues from 5.5% in the first quarter of2005 to 5.7% in the first quarter of 2006. This increase was due primarily toincreased rent and property taxes. Our occupancy costs do not include paymentson the portion of each restaurant lease which is classified as a capital lease.Under Financial Accounting Standards Board (FASB) Statement No. 13, *Accounting For Leases,* these payments are classified aspayments of principal and interest. Such payments aggregated approximately $549,000and $316,000 during the first quarters of 2006 and 2005, respectively.

 

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**Pre-**Opening

 

Pre-opening costs, which areexpensed as incurred, consist of expenses related to hiring and training the initial restaurantworkforce, wages and expenses of our dedicated new store opening teams, rentalcosts incurred during the construction period and certain other direct costsassociated with opening new restaurants. Pre-opening costs in thefirst quarter of 2006 related primarily to our Kansas City and Olathe, Kansas restaurantswhich we opened January 31, 2006 and March 28, 2006, respectively. In fiscalyear 2006, we included $107,043 and $114,914 of rental costs incurred duringconstruction periods for Kansas City and Olathe, Kansas, respectively, inpre-opening expense in accordance with FASB Staff Position No. FAS 13-1, *Accounting for Rental Costs Incurred during a Construction Period*(FSPFAS 13-1). Based upon the costs of labor, travel, lodging, training and rent incurredprior to opening, we expect pre-opening expenses to average between $400,000and $425,000 per unit, of which we anticipate approximately $50,000 to $125,000to be construction-period rent. Pre-opening costs are primarily incurred in themonth of, and two months prior to, the restaurant opening.

 

**General and Administrative**

 

Generaland administrative expenses include all salaries and benefits associated withour corporate staff that is responsible for overall restaurant quality, futureexpansion into new locations, financial controls and reporting, restaurantmanagement recruiting, training at Granite City University, excess capacitycosts related to our worthouse that we opened in June 2005, and salaries andexpenses of our new store opening team when it is not dedicated to a particularrestaurant opening. Other general and administrative expenses also includeadvertising, professional fees, office administration, centralized accountingsystem costs, and travel by our corporate management to the restaurantlocations.

 

Generaland administrative expenses increased $502,707 from $952,353 in the first quarterof 2005 to $1,455,060 in the first quarter of 2006. Of such increase, approximate$285,000 represented payroll costs due to the increase in our corporate staffin the areas of accounting, IT, Granite City University, the worthouse and ournew store opening team. Professional fees, including consulting,marketing, legal, accounting and investor relations, were approximately$108,300 higher in the first quarter of 2006 than in the first quarter of 2005.

 

InDecember 2004, the FASB issued Statement of Financial Accounting Standards (“SFAS”)No. 123 (revised 2004) (“SFAS 123(R)”), *Share-Based Payment*, which is a revision of SFAS 123, *Accounting for Stock-Based Compensation*. Generally,effective with the first day of fiscal year 2006, SFAS 123(R) requires allshare-based payments to employees, including grants of employee stock options,to be recognized in the income statement based on their fair values determinedat the date of grant. In all prior periods, we accounted for stock-basedcompensation awards to employees using the intrinsic value method prescribed byAPB Opinion No. 25 and, as such, generally recognized no compensation cost foremployee stock options. In the first quarter of 2006, our general andadministrative expenses included approximately $180,100 in non-cash stock-basedcompensation expense. We made no change to our method of valuing stock optionsor to such options’ vesting schedules.

 

Weexpect that general and administrative costs will continue to fluctuate as apercentage of restaurant revenues in the near term as we build ourinfrastructure to adequately sustain operations through further expansion. Aswe continue to expand our restaurant chain, we expect general andadministrative expenses will decrease as a percentage of revenues in the longterm.

 

**Depreciation andAmortization**

 

Depreciation and amortization expense increased $308,060during the first quarter of 2006 compared to the same period in 2005, dueprincipally to the additional depreciation related to the newly openedrestaurants. As a percentage of revenues, depreciation expense increased 0.7% inthe first quarter of 2006.

 

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**Other Income and Expense**

 

Interest expense relatedto capital leases increased $177,523 from $273,919 during the first quarter of2005 to $451,442 during the first quarter of 2006 due to the increase incapital leases as a result of four additional restaurants. Interest expenserelated to long-term debt and interest income related to unused cash decreased$3,483 and $6,211, respectively, during the first quarter of 2006 compared tothe first quarter of 2005 due to the reduction of principal on such debt andthe reduction of cash on hand. As we remodeled our three older restaurants to mirror the prototypeunits in the first quarter of 2005, we recorded a $10,843 loss on assets whichhad not been fully depreciated. During the first quarter of 2006, werecognized a gain on disposal of assets of $3,873 due primarily to the sale of unusedassets at our test kitchen. Managementexpects net interest expense will increase as we pursue further expansion.

 

**Liquidity and Capital Resources**

 

We have funded our capital requirements sinceinception through sales of securities, building and equipment leases, debtfinancing and cash flow from operations. As of March 28, 2006, we had$6,312,647 of cash and $532,730 of net working capital compared to $9,836,231 ofcash and $5,136,557 of net working capital at December 27, 2005.

 

During the quarter ended March 28, 2006, we used $818,665of net cash in operating activities, $2,428,608 in net cash to purchaseequipment and other assets primarily for our new restaurants and those underconstruction, and made payments aggregating $272,130 on our debt and capitallease obligations. Additionally, during the first quarter of 2006, we paid expensesrelated to the issuance of our common stock of $4,181.

 

During the quarter ended March 29, 2005, we used$492,240 of net cash in operating activities, $865,817 in net cash to purchaseequipment and other assets primarily for our wort production facility and ourWichita restaurant, and made payments aggregating $189,565 on our debt andcapital lease obligations. Additionally, during the first quarter of 2005, wepaid cash dividends to shareholders of our preferred stock aggregating $41,068and received net cash of $31,350 from the issuance of our common stock upon theexercise of options.

 

Using the proceeds from thesale of our securities, debt and equipment financing and cash flows fromoperations, we intend to continue expansion in markets where we believe ourconcept will have broad appeal and attractive restaurant-level economics. Weplan to continue using our prototypical model as we open future restaurantsunder our multi-site development agreement; however, where appropriate, we willconvert existing restaurants to our Granite City concept. Additionally, weintend to explore alternative restaurant designs to reduce the cost of ourinitial capital investment and we may alter our prototypical model to meetvarious state and local regulatory requirements, including, but not limited to,pollution control requirements, liquor license ordinances and smokingregulations.

 

Based upon our existingprototype, we anticipate that pre-opening costs, the initial purchase offurniture, fixtures and equipment and our restaurant design costs will requirean investment by us of approximately $1.0 million to $1.6 million for each newrestaurant. We anticipate that our new restaurants will require an investmentby our developer of approximately $3.5 million to $4.5 million each for landand building. We expect these costs will vary from one market to another basedon real estate values, zoning regulations, labor markets and other variables.

 

In January 2006, weopened a restaurant in Kansas City, Kansas. We are leasing this property fromour developer under a 20-year lease agreement. Our annual lease payments are $404,250with $262,500 classified as a capital lease and the remaining $141,750 classifiedas an operating lease. We have the option to extend this lease for up to fiveadditional five-year periods or to purchase the restaurant real estate for itsfair market value during the last year of the original term.

 

In March 2006, weopened a restaurant in Olathe, Kansas. We are leasing this property from ourdeveloper under a 20-year lease agreement. This is the tenth restaurant we haveopened in cooperation with our

 

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developer. Our annuallease payments are $414,750 with $268,254 classified as a capital lease and theremaining $146,496 classified as an operating lease. We have the option toextend this lease for up to five additional five-year periods or to purchasethe restaurant real estate for its fair market value during the last year ofthe original term.

 

In March 2006, wecommenced leasing a property in St. Louis Park, Minnesota under a 10-year leaseagreement. Our annual lease payments will be $148,625 per year pluspercentage rent based upon restaurant sales. This lease may be extended at our option for up to threeadditional five-year periods. We paid approximately $663,000 in leaseacquisitions costs for this property.

 

Withour existing capital resources, cash generated from operations and the proceedsfrom at least $3.0 million in additional debt and/or equipment financing thatwe are currently pursuing, we believe that we will have sufficient funds tocomplete our 2006 openings and provide sufficient working capital for ouroperations. If we do not generate the cash needed from operations and/or arenot able to obtain sufficient debt and/or equipment financing, we may have toreduce or delay our planned fourth quarter 2006 openings. We will requirefurther funding to open additional restaurants. We are continually evaluatingour development plans and we are exploring options relative to the pace of ourgrowth. Further, our liquidity will be affected by our need to refinance aballoon payment of approximately $1.3 million due in February 2007 on a loanassociated with our Fargo restaurant’s building. If we do not have enough fundsbased upon our capital resources, anticipated equipment financing and expectedcash flows from operations, we may be required to obtain additional financingthrough the sale of securities and/or increase our borrowings. We may not beable to accomplish either of these alternatives on terms acceptable to us, orat all.

 

**Commitments and Contingent Liabilities**

 

*Development Agreement:*

 

We have entered into a development agreement with Dunham CapitalManagement L.L.C. (“Dunham”) for the development of restaurants. Dunham iscontrolled by Donald A. Dunham, Jr., who is an affiliate of Granite Partners, abeneficial owner of less than 2% of our securities. The agreement gives Dunhamthe right to develop, construct and lease up to 22 restaurants for us prior toDecember 31, 2012. Dunham also has the right to sell the underlying land andbuilding to third parties or assign our leases. As of March 28, 2006, Dunhamhad sold two of our restaurants sites to third parties. We are not bound toauthorize the construction of restaurants during the term of the developmentagreement, but generally cannot use another developer to develop or own arestaurant as long as the development agreement is in effect. We can useanother developer if Dunham declines to build a particular restaurant, if theagreement is terminated because of a default by Dunham, or if our company issold or merged into another company. In the case of a merger or sale of ourcompany, the development agreement may be terminated. As of March 28, 2006, tenrestaurants, namely units 4-13, have been constructed for us under thisdevelopment agreement.

 

The development agreement provides for a cooperative process betweenDunham and our company for the selection of restaurant sites and thedevelopment of restaurants on those sites, scheduling for the development andconstruction of each restaurant once a location is approved, and controls onthe costs of development and construction using bidding and guaranteed maximumcost concepts. The development agreement provides that restaurants will beleased to us on the basis of a triple net lease. The rental rate of each leasewill be calculated using a variable formula which is based on approved andspecified costs of development and construction and an indexed interest rate. Generally,the land portion of each lease is classified as an operating lease because thefair value of the land is more than 25% of the property to be leased. Thebuilding portion of the lease is classified as a capital lease because itspresent value is greater than 90% of the estimated fair value at the beginningof the lease. The term of each lease is 20 years and may be extended at ouroption for up to five additional five-year periods, or we may purchase therestaurant real estate for the fair market value during the last year of theoriginal term.

 

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*Operating and Capital Leases:*

 

As of March 28, 2006, we operated 13 restaurants, 12 under land andbuilding lease agreements and one under a land lease as we own the building atthat location. Under three of the leases, we are required to pay additionalpercentage rent based upon restaurant sales.

 

Of the 12 restaurants we operated under land and building leaseagreements, 10 originated with our developer. Of these 12 leases, one expiresin 2019, one in 2020, two in 2023, three in 2024, three in 2025 and theremaining two expire in 2026, all with renewable options for additional periods.The land portion of these leases is classified as an operating lease becausethe fair value of the land was more than 25% of the leased property at theinception of each lease. The building portion of these leases is classified asa capital lease because its present value was greater than 90% of the estimatedfair value at the beginning of the lease. As of March 28, 2006, futureobligations relating to the land portion of these 12 leases aggregated $28,678,347plus percentage rent. The scheduled rent increases for the land during the lifeof each lease are recognized on a straight-line basis. Future obligationsrelating to the building portion of these 12 leases aggregated $46,631,618 asof March 28, 2006.

 

In 2001, we entered into a 20-year operating lease for the land uponwhich we built our Fargo restaurant. As of March 28, 2006, future obligationsunder the terms of this lease aggregated $1,125,800 plus percentage rent.

 

In December 2004, we entered into a land and building lease agreementfor a facility to be used for wort production. This ten-year lease commencedFebruary 1, 2005, and is classified as a capital lease as it contains a bargainpurchase option. As of March 28, 2006, future obligations under the terms ofthis lease aggregated $763,204.

 

In August 2005, we entered into a 38-month lease agreement for officespace for our corporate offices. The lease commenced October 1, 2005. Annualrent is $38,666, with scheduled annual increases throughout the term of thelease. Such scheduled rent increases are recognized on a straight-line basisover the term of the lease. Future obligations under the terms of this leaseaggregated $104,785 at March 28, 2006.

 

In November 2005, we entered into an agreement for a facility inMinneapolis, Minnesota which we use as a test kitchen. Obligations under thisthree-year lease agreement began November 1, 2005. The agreement calls forannual rent of $42,000 and has an option for a three-year renewal. Futureobligations under this lease aggregated $108,500 at March 28, 2006.

 

As of March 28, 2006, we had additional capital lease obligationsoutstanding aggregating $349,918 for equipment leases expiring in 2008.

 

We have entered into a 20-year net lease with our developer for arestaurant under construction in West Wichita, Kansas that we anticipateopening later in 2006. Once opened, this will be the eleventh we have opened incooperation with our developer. The annual rent for the lease will be equal to10.5% of the sum of the construction cost and land cost. Additionally, we haveentered into a 10-year net lease for a restaurant in St. Louis Park, Minnesota.The annual rent for that lease will be $148,625 plus percentage rent. The termsof these leases will commence when operations begin at each location.

 

Our developer, in cooperation with our chief executive officer,continues to explore opportunities for the development of additional restaurantsites, and where necessary, enters into letters of intent or leases to securesuch sites on our behalf. As of March 28, 2006, our developer had entered intotwo additional leases and one letter of intent for restaurants we anticipateopening in 2006 and two letters of intent for restaurant sites we anticipate openingin 2007.

 

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*Personal Guaranties:*

 

Two of our directors and one former director have personally guaranteedcertain of our leases and loan agreements. In connection with the $1.5 millionloan we obtained in July 2001 to finance our Fargo restaurant, we entered intoan agreement concerning guaranty which provides, among other things, that suchguarantors will be indemnified from any liabilities they may incur by reason oftheir guaranties of our indebtedness. The agreement contains various covenants,one of which requires us to use our best efforts to obtain a release of oneindividual’s guarantee obligation by January 1, 2006. As of March 28, 2006, wehad not obtained a release of such obligation, and as such have been paying hima monthly guarantee fee in the amount of $1,000. Additionally, at a meetingheld in March 2004, our board of directors agreed to compensate our Presidentand Chief Executive Officer for his personal guaranties of equipment loansentered into in August 2003 and January 2004. The amount of annual compensationis 3% of the balance of such loans. This amount is calculated and accrued basedon the weighted average daily balances of such loans at the end of each monthlyaccounting period. During the first quarters of 2006 and 2005, we accrued $8,242and $9,677 of such fees, respectively, and paid $15,000 and $0 of such fees,respectively.

 

*Employment Agreement:*

 

In June 2005, we entered into a three-year employment agreement withSteven J. Wagenheim, our President and Chief Executive Officer, who is also adirector of our company. The agreement provided for a minimum base salary of$225,000, commencing January 1, 2005, cash incentive compensation for 2005ranging from $0 to $125,550 based on performance, and a stock option for thepurchase of 150,000 shares of common stock. In February 2006, we amended thecompensatory arrangements under the agreement by adopting our 2006 CEOCompensation Plan. This plan provides for a base salary of $275,000, commencingJanuary 1, 2006, cash incentive compensation for 2006 ranging from $0 to$167,400 based on performance, and a stock option for the purchase of 100,000shares of common stock. In addition to annual compensation terms and otherprovisions, the agreement includes change in control provisions that wouldentitle him to receive severance pay equal to 18 months of salary if there is achange in control of our company and his employment terminates.

 

In August 2005, we entered into an at-will employment agreement withour Chief Financial Officer which became effective September 13, 2005. Theemployment agreement provides for a minimum base salary of $215,000 per year,performance-based cash bonus of up to $75,000 per year for years 2005 and 2006,and a stock option for the purchase of 175,000 shares of common stock. Amongother provisions, the employment agreement includes change in controlprovisions that would entitle him to receive severance pay equal to 12 monthsof base salary and a pro-rata portion of any bonus earned as of the date oftermination if there is a change in control of our company and his employmentterminates.

 

*Summary of Contractual Obligations:*

 

The following table summarizes our obligations under contractualagreements as of March 28, 2006 and the time frame within which payments onsuch obligations are due. This table does not include amounts related topercentage rent, as such future amounts are not determinable. In addition,whether we would incur any additional expense on our employment agreementsdepends upon the existence of a change in control of the company. Therefore, nopercentage rent nor severance expense has been included in the following table.

 

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| ** **                                       | ** ** | **Payments due by period** | ** ** |
|--------------------------------------------------|------------|----------------------------|------------|
| **Contractual Obligations**                      | ** ** | **Total**                  | ** ** | **Less than 1  year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More than 5  years** | ** ** |
| Long-term debt, principal                        |       | $                          | 2,444,348  |   | $ | 182,167 |   | $ | 1,773,595 |   | $ | 477,557 |   | $ | 11,029 |   |
| Interest on  long-term debt                      |       | 278,079                    |       | 137,339 |   | 109,309 |   | 31,374 |   | 57 |   |
| Capital lease  obligations, including interest   |       | 47,744,739                 |       | 2,113,800 |   | 5,455,361 |   | 5,270,435 |   | 34,905,143 |   |
| Operating lease  obligations, including interest |       | 30,017,431                 |       | 1,315,201 |   | 3,503,336 |   | 3,369,586 |   | 21,829,308 |   |
| Loan guarantee                                   |       | 98,557                     |       | 42,184 |   | 42,284 |   | 14,089 |   | — |   |
| Total obligations                                |       | $                          | 80,583,154 |   | $ | 3,790,691 |   | $ | 10,883,885 |   | $ | 9,163,041 |   | $ | 56,745,537 |   |

 

Based on our working capital position at March28, 2006, we believe we have sufficient working capital to meet our currentobligations.

 

**CriticalAccounting Policies**

 

Thisdiscussion and analysis is based upon our consolidated financial statements,which were prepared in conformity with generally accepted accounting principles.These principles require management to make estimates and assumptions thataffect the amounts reported in the consolidated financial statements andaccompanying notes. We believe our estimates and assumptions are reasonable;however, actual results and the timing of the recognition of such amounts coulddiffer from those estimates. We have identified the following criticalaccounting policies and estimates utilized by management in the preparation ofour financial statements:

 

*Property and equipment*

 

The cost of property and equipment is depreciatedover the estimated useful lives of the related assets ranging from three to 20years. The cost of leasehold improvements is depreciated over the initial termof the related lease, which is generally 20 years. Depreciation is computed onthe straight-line method for financial reporting purposes and acceleratedmethods for income tax purposes. Amortization of assets acquired under capitallease is included in depreciation expense. We review property and equipment, includingleasehold improvements, for impairment when events or circumstances indicatethese assets might be impaired pursuant to Statement of Financial AccountingStandard (SFAS) No. 144. We base this assessment upon the carrying value versusthe fair market value of the asset and whether or not that difference isrecoverable. Such assessment is performed on a restaurant-by-restaurant basisand includes other relevant facts and circumstances including the physicalcondition of the asset.

 

Ouraccounting policies regarding property and equipment include certain managementjudgments regarding the estimated useful lives of such assets and thedetermination as to what constitutes enhancing the value of or increasing thelife of existing assets. These judgments and estimates may produce materiallydifferent amounts of depreciation and amortization expense than would bereported if different assumptions were used.

 

We continually reassess our assumptions andjudgments and make adjustments when significant facts and circumstances dictate.Historically, actual results have not been materially different than theestimates we have made.

 

*Stock-Based Compensation*

 

Wehave granted stock options to certain employees and non-employee directors. Weaccount for stock-based compensation in accordance with the fair valuerecognition provisions of SFAS 123(R). Under such provisions, stock-basedcompensation is measured at the grant date based on the value of the award andis recognized as expense over the vesting period. Determining the fair value ofstock-based compensation at the

 

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grantdate requires judgment, including but not limited to the expected volatility ofour stock. If actual results differ significantly from these estimates,stock-based compensation expense and our results of operations could bematerially impacted.

 

**Seasonality**

 

We expect that our sales and earnings will fluctuatebased on seasonal patterns. We anticipate that our highest sales and earningswill occur in the second and third quarters due to the milder climate andavailability of outdoor seating during those quarters in our existing andproposed markets.

 

**Inflation**

 

Theprimary inflationary factors affecting our operations are food, supplies andlabor costs. A large number of our restaurant personnel are paid at rates basedon the applicable minimum wage, and increases in the minimum wage directlyaffect our labor costs. In the past, we have been able to minimize the effectof these increases through menu price increases and other strategies. To date,inflation has not had a material impact on our operating results.

 

**ITEM3****                  ****Qualitative andQuantitative Disclosures about Market Risk**

 

Our company isexposed to market risk from changes in interest rates on debt and changes incommodity prices.

 

*Changesin Interest Rate:*

 

In February 2007, we will have a balloon payment due of approximately$1,325,000 on the loan we obtained from an independent financial institution inJuly 2001. Currently, this loan bears a fixed interest rate of 8.75%. If itbecomes necessary to refinance such balloon balance, we may not be able tosecure financing at the same interest rate. The effect of a higher interestrate would depend upon the negotiated financing terms.

 

*Changesin Commodity Prices:*

 

Manyof the food products we purchase are affected by commodity pricing and are,therefore, subject to unpredictable price volatility. These commodities aregenerally purchased based upon market prices established with vendors. Extremefluctuations in commodity prices and/or long-term changes could have an adverseaffect on us. Although SYSCO Corporation is our primary supplier of food,substantially all of the food and supplies we purchase are available fromseveral sources, which helps to control commodity price risks. Additionally, wehave the ability to increase menu prices, or vary the menu items offered, in responseto a food product price increases. If, however, competitive circumstances limitour menu price flexibility, margins could be negatively impacted.

 

Our company does notenter into derivative contracts either to hedge existing risks or forspeculative purposes.

 

**ITEM4****                  ****Controls and Procedures**

 

Wemaintain a system of disclosure controls and procedures that is designed toensure that information required to be disclosed in our Exchange Act reports isrecorded, processed, summarized and reported within the time periods specifiedin the SEC’s rules and forms, and that such information is accumulated andcommunicated to our management, including our Chief Executive Officer and ChiefFinancial Officer, as appropriate, to allow timely decisions regarding requireddisclosures.

 

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Underthe supervision and with the participation of our management, including ourChief Executive Officer and Chief Financial Officer, we conducted an evaluationof our disclosure controls and procedures (as defined in Exchange Act Rules13a-15(e) and 15d-15(e)). Based on this evaluation, our Chief Executive Officerand our Chief Financial Officer concluded that, as of March 28, 2006, ourdisclosure controls and procedures were effective.

 

There were no changes in our internal control overfinancial reporting that occurred during the quarter ended March 28, 2006 thathave materially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

**PART II********OTHER INFORMATION**

 
| **ITEM 1**  | ** ** | **Legal  Proceedings**                                           |
|-------------|------------|------------------------------------------------------------------|
|        |       |                                                             |
|        |       | Not applicable.                                                  |
|        |       |                                                             |
| **ITEM 1A** | ** ** | **Risk  Factors**                                                |
|        |       |                                                             |
|        |       | Not applicable.                                                  |
|        |       |                                                             |
| **ITEM 2**  | ** ** | **Unregistered  Sales of Equity Securities and Use of Proceeds** |
|        |       |                                                             |
|        |       | Not  applicable.                                                 |
|        |       |                                                             |
| **ITEM 3**  | ** ** | **Defaults  upon Senior Securities**                             |
|        |       |                                                             |
|        |       | Not applicable.                                                  |
|        |       |                                                             |
| **ITEM 4**  | ** ** | **Submission  of Matters to a Vote of Security Holders**         |
|        |       |                                                             |
|        |       | Not applicable.                                                  |
|        |       |                                                             |
| **ITEM 5**  | ** ** | **Other  Information**                                           |
|        |       |                                                             |
|        |       | Not applicable.                                                  |
|        |       |                                                             |
| **ITEM 6**  | ** ** | **Exhibits**                                                     |
|        |       |                                                             |
|        |       | See “Index to  Exhibits.”                              |

 

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**SIGNATURES**

 

Pursuant to the requirements of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned thereunto duly authorized.

 
|   |          | GRANITE CITY FOOD &  BREWERY LTD. |
|--------|---------------|---------------------------------------|
|   |          |                                  |
|   |          |                                  |
| Date:  | May  12, 2006 | By:                                   | /s/ Daniel H. Bauer |   |
|   |          |                                  | Daniel H. Bauer |
|   |          |                                  | Chief Financial Officer |

 

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**INDEX TO EXHIBITS**

 
| **Exhibit Number** | ** ** | **Description**                                                                                                                                                                                               |
|--------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|               |       |                                                                                                                                                                                                          |
| 31.1               |       | Certification by  Steven J. Wagenheim, President and Chief Executive Officer of the Company,  pursuant to Exchange Act Rule 13a-14(a), as adopted pursuant to Section 302  of the Sarbanes-Oxley Act of 2002. |
|               |       |                                                                                                                                                                                                          |
| 31.2               |       | Certification by  Daniel H. Bauer, Chief Financial Officer of the Company, pursuant to Exchange  Act Rule  13a-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of  2002.                  |
|               |       |                                                                                                                                                                                                          |
| 32.1               |       | Certification by  Steven J. Wagenheim, President and Chief Executive Officer of the Company,  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906  of the Sarbanes-Oxley Act of 2002.      |
|               |       |                                                                                                                                                                                                          |
| 32.2               |       | Certification  by Daniel H. Bauer, Chief Financial Officer of the Company, pursuant to 18  U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002.                        |

 

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