UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 10, 2004

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

For the transition period from to

Commission file number 0-21203

DIEDRICH COFFEE, INC.

(Exact Name of Registrant as Specified in Its Charter)

DELAWARE		33-0086628
(State or Other Jurisdiction of Incorporation or Organization)		(IRS Employer Identification No.)

28 EXECUTIVE PARK, SUITE 200 IRVINE, CALIFORNIA 92614
(Address of Principal Executive Offices, Including Zip Code)

(949) 260-1600
(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES ý NO o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES o NO ý

As of April 21, 2004 there were 5,161,260 shares of common stock of the registrant outstanding.

DIEDRICH COFFEE, INC.
INDEX

PART I – FINANCIAL INFORMATION

Item 1.	Financial Statements

		Condensed Consolidated Balance Sheets (Unaudited)	1

		Condensed Consolidated Statements of Operations (Unaudited)	2

		Condensed Consolidated Statements of Cash Flows (Unaudited)	3

		Notes to Condensed Consolidated Financial Statements (Unaudited)	4

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		11

Item 3.	Quantitative and Qualitative Disclosures About Market Risk		21

Item 4.	Controls and Procedures		22

PART II – OTHER INFORMATION

Item 1.	Legal Proceedings		22

Item 6.	Exhibits and Reports on Form 8-K		22

Signatures			27

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements.

DIEDRICH COFFEE, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)

	March 10, 2004			July 2, 2003

Assets
Current assets:
Cash	$	1,392,000		$	2,625,000
Accounts receivable, less allowance for doubtful accounts of $1,181,000 at March 10, 2004 and $1,375,000 at July 2, 2003	2,433,000			2,454,000
Inventories	2,575,000			2,611,000
Current portion of notes receivable	71,000			58,000
Prepaid expenses	661,000			901,000
Total current assets	7,132,000			8,649,000
Restricted cash	957,000			—
Property and equipment, net	7,118,000			7,052,000
Goodwill	10,190,000			10,190,000
Notes receivable, excluding current portion	143,000			182,000
Other assets	496,000			469,000
Total assets	$	26,036,000		$	26,542,000

Liabilities and Stockholders’ Equity
Current liabilities:
Current installments of obligations under capital leases	$	171,000		$	185,000
Current installments of long-term debt	1,517,000			1,459,000
Accounts payable	2,030,000			2,108,000
Accrued compensation	1,837,000			1,307,000
Accrued expenses	734,000			738,000
Franchisee deposits	648,000			671,000
Deferred franchise fee income	794,000			549,000
Accrued provision for store closure	137,000			425,000
Total current liabilities	7,868,000			7,442,000
Obligations under capital leases, excluding current installments	440,000			542,000
Long term debt, excluding current installments	475,000			1,491,000
Deferred rent	490,000			478,000
Total liabilities	9,273,000			9,953,000
Stockholders’ equity:
Common stock, $0.01 par value; authorized 8,750,000 shares; issued and outstanding 5,161,000 shares at March 10, 2004 and July 2, 2003	52,000			52,000
Additional paid-in capital	58,036,000			58,036,000
Accumulated deficit	(41,325,000		)	(41,499,000		)
Total stockholders’ equity	16,763,000			16,589,000
Commitments and contingencies (notes 3, 4 and 7)
Total liabilities and stockholders’ equity	$	26,036,000		$	26,542,000

See accompanying notes to condensed consolidated financial statements.

DIEDRICH COFFEE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

	Twelve Weeks Ended March 10, 2004			Twelve Weeks Ended March 12, 2003			Thirty-Six Weeks Ended March 10, 2004			Thirty-Six Weeks Ended March 12, 2003
Net revenue:
Retail sales	$	7,281,000		$	7,474,000		$	21,725,000		$	23,661,000
Wholesale and other	3,407,000			3,052,000			11,114,000			11,250,000
Franchise revenue	1,812,000			1,531,000			5,223,000			4,461,000
Total revenue	12,500,000			12,057,000			38,062,000			39,372,000

Costs and expenses:
Cost of sales and related occupancy costs	5,750,000			5,906,000			17,601,000			18,907,000
Operating expenses	3,868,000			3,898,000			11,550,000			12,092,000
Depreciation and amortization	513,000			421,000			1,541,000			1,327,000
General and administrative expenses	2,365,000			2,166,000			6,891,000			6,397,000
Provision for asset impairment and restructuring costs	—			(49,000		)	94,000			57,000
(Gain) loss on asset disposals	5,000			(117,000		)	5,000			(119,000		)
Total costs and expenses	12,501,000			12,225,000			37,682,000			38,661,000

Operating income (loss)	(1,000		)	(168,000		)	380,000			711,000

Interest expense	(67,000		)	(55,000		)	(203,000		)	(217,000		)

Interest and other income, net	9,000			9,000			17,000			33,000

Income (loss) before income tax provision	(59,000		)	(214,000		)	194,000			527,000

Income tax provision	10,000			5,000			20,000			44,000

Net income (loss)	$	(69,000	)	$	(219,000	)	$	174,000		$	483,000

Net income (loss) per share – basic and diluted	$	(0.01)		$	(0.04	)	$	0.03		$	0.09

Number of shares used in per share computations:
Basic	5,161,000			5,161,000			5,161,000			5,161,000
Diluted	5,161,000			5,161,000			5,189,000			5,196,000

See accompanying notes to condensed consolidated financial statements.

DIEDRICH COFFEE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

	Thirty-Six Weeks Ended March 10, 2004			Thirty-Six Weeks Ended March 12, 2003
Cash flows from operating activities:
Net income	$	174,000		$	483,000
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	1,541,000			1,327,000
Amortization of loan fees	64,000			58,000
Provision for bad debt	253,000			228,000
Provision for inventory obsolescence	176,000			49,000
Provision for asset impairment and restructuring	90,000			57,000
Provision for (benefit from) store closure	(70,000		)	36,000
Stock compensation expense	—			56,000
(Gain) loss on disposal of assets	5,000			(119,000		)
Changes in operating assets and liabilities:
Accounts receivable	(232,000		)	(725,000		)
Inventories	(140,000		)	(52,000		)
Prepaid expenses	240,000			(122,000		)
Other assets	(95,000		)	(146,000		)
Accounts payable	(78,000		)	27,000
Accrued compensation	530,000			(93,000		)
Accrued expenses	(4,000		)	53,000
Accrued provision for store closure	(218,000		)	(150,000		)
Deferred franchise fee income and franchisee deposits	222,000			124,000
Deferred rent	12,000			(10,000		)
Net cash provided by operating activities	2,470,000			1,081,000
Cash flows from investing activities:
Capital expenditures for property and equipment	(1,706,000		)	(613,000		)
Proceeds from disposal of property and equipment	8,000			278,000
Payments received on notes receivable	26,000			31,000
Net cash used in investing activities	(1,672,000		)	(304,000		)
Cash flows from financing activities:
Restricted cash	(957,000		)	—
Payments on long-term debt	(958,000		)	(826,000		)
Payments on capital lease obligations	(116,000		)	(128,000		)
Net cash used in financing activities	(2,031,000		)	(954,000		)

Net decrease in cash	(1,233,000		)	(177,000		)
Cash at beginning of period	2,625,000			2,233,000
Cash at end of period	$	1,392,000		$	2,056,000

Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest	$	133,000		$	155,000
Income taxes	$	20,000		$	46,000

See accompanying notes to condensed consolidated financial statements.

DIEDRICH COFFEE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 10, 2004
(UNAUDITED)

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The unaudited condensed consolidated financial statements of Diedrich Coffee, Inc. and its subsidiaries (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America, as well as the instructions to Form 10-Q and Article 10 of Regulation S-X. These statements should be read in conjunction with the consolidated financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K/A filed on October 3, 2003.

In the opinion of management, all adjustments (consisting of normal, recurring adjustments and accruals) considered necessary for a fair presentation have been included. Operating results for interim periods are not necessarily indicative of the results expected for a full year.

Use of Estimates

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

Stock Option Plans

The Company applies the intrinsic value-method of accounting prescribed by Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations, in accounting for employee stock options. As such, compensation expense would be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” as amended, established accounting and disclosure requirements using a fair value-based method of accounting for stock-based employee compensation plans. The Company has adopted the disclosure provisions of SFAS No. 123 and continues to follow APB no. 25 for stock-based employee compensation.

Pro forma net income (loss) and pro forma net income (loss) per share, as if the fair value-based method of SFAS 123 had been applied in measuring compensation cost for stock-based awards, is as follows:

	TWELVE WEEKS ENDED						THIRTY-SIX WEEKS ENDED
Pro Forma	March 10, 2004			March 12, 2003			March 10, 2004			March 12, 2003
Net income (loss)	$	(69,000)		$	(219,000)		$	174,000		$	483,000
Stock based employee compensation expense included in reported net income (loss)	—			56,000			—			56,000
Deduct: Stock-based employee compensation expense determined under the fair value based method for all awards, net of related tax effects	(268,000		)	(141,000		)	(654,000		)	(369,000		)
Pro forma net income (loss)	$	(337,000	)	$	(304,000	)	$	(480,000	)	$	170,000
Basic and diluted income (loss) per share	$	(0.07)		$	(0.06	)	$	(0.09	)	$	0.03

The fair values of the options granted were estimated using the Black-Scholes option-pricing model based on the following weighted average assumptions:

	TWELVE AND THIRTY-SIX WEEKS ENDED
	March 10, 2004		March 12, 2003

Risk free interest rate	2.57	%	2.57	%
Expected life	6 years		6 years
Expected volatility	99	%	99	%
Expected dividend yield	0	%	0	%

Barter Transaction

At the end of the 2003 holiday period, in the Company’s second fiscal quarter, the Company recorded an impairment charge reducing holiday gift pack inventory to its net realizable value. During the current quarter, the Company exchanged $67,000 of this impaired inventory for advertising barter credits valued by the barter provider in excess of the impaired inventory value. The Company recorded the advertising credits as a prepaid expense at the $67,000 impaired net realizable value of the inventory exchanged. Additionally, in accordance with Emerging Issues Task Force No. 99-17, “Accounting for Advertising Barter Transactions,” the Company accounted for this transaction as a sale, recording revenue and cost of sales of $67,000, leaving no net impact to income (loss).

Reclassifications

Certain reclassifications have been made to the March 12, 2003 condensed consolidated financial statements to conform to the March 10, 2004 presentation.

2. INVENTORIES

Inventories consist of the following:

	March 10, 2004		July 2, 2003
Unroasted coffee	$	905,000	$	1,034,000
Roasted coffee	562,000		572,000
Accessory and specialty items	121,000		163,000
Other food, beverage and supplies	987,000		842,000
	$	2,575,000	$	2,611,000

3. LONG-TERM DEBT

Long-term debt consists of the following:

	March 10, 2004			July 2, 2003
Term Loan
Note payable bearing interest at a rate of 3.25% over LIBOR, or 4.45%, as of March 10, 2004, and payable in monthly installments of $100,000 plus interest. Due March 31, 2005. Note is secured by the assets of the Company and the stock of its subsidiaries.	$	1,200,000		$	2,000,000
Packaging Equipment Note
Note payable bearing interest at a rate of 5.77% as of March 10, 2004 and payable in monthly installments of $26,000 plus interest. Due August 28, 2006. Note is secured by coffee packaging equipment and a restricted cash balance of $792,000 at March 10, 2004.	792,000			950,000
	1,992,000			2,950,000
Less: current installments	(1,517,000		)	(1,459,000		)
Long-term debt, excluding current installments	$	475,000		$	1,491,000

On September 3, 2002, the Company entered into a credit agreement (the “Credit Agreement”) with United California Bank, doing business as Bank of the West (“BOW”). Two notes payable issued under the Credit Agreement are currently outstanding. In addition, under the Credit Agreement, the Company has a revolving working capital and letter of credit facility.

The Company’s obligations under the Credit Agreement are secured by all of the Company’s assets, including the stock of each of its subsidiaries (each of which has guaranteed the Company’s obligations under the Credit Agreement), as well as all intangible assets it owns, including the intellectual property and trademark assets that the Company and its subsidiaries own.

In addition to the equipment purchased with the proceeds of the note, the Packaging Equipment Note is secured by a restricted cash balance on deposit with BOW equal to the lesser of $800,000 or the outstanding principal balance of the equipment term loan. The restricted cash balance was $792,000 on March 10, 2004.

The Credit Agreement also provides the Company with a $675,000 revolving working capital and letter of credit facility, subject to a number of restrictions. The Company’s working capital facility draws and letters of credit are limited to a combined maximum of $675,000 outstanding at any time. Furthermore, draw-downs against the working capital facility are subject to a sub-limit of $500,000, and letters of credit are subject to a sub-limit of $250,000. The Company is permitted to draw funds against the working capital facility throughout the fiscal year and may repay amounts that it borrows under the working capital facility at any time. Therefore, the Company may be able to re-borrow such funds on a revolving basis (subject to restrictions). The letter of credit facility matures on October 15, 2004 and the working capital facility matured on April 15, 2004. The working capital facility was not renewed upon its April 15, 2004 maturity, and there were no outstanding amounts under this facility as of March 10, 2004. Any payments made by BOW with regard to any letter of credit issued under the letter of credit facility must be repaid by the Company immediately upon the date of such payment by BOW. As of March 10, 2004, BOW had issued one letter of credit under this facility for $179,000.

In October 2003, BOW provided the Company with an additional facility for issuance of up to $250,000 of letters of credit. The new facility provides that issued letters of credit are to be secured by restricted cash balances of an equal amount maintained on deposit with BOW. As of March 10, 2004, BOW had issued two letters of credit for a total of $165,000 under this facility. The restricted cash balance was $165,000 on March 10, 2004.

The Company is subject to a number of restrictions under the Credit Agreement, as amended. These include limitations on the Company’s ability to sell assets, make capital expenditures, incur additional indebtedness, permit new liens upon the Company’s assets, and pay dividends on or repurchase its common stock. The Company must also maintain compliance with agreed-upon financial covenants that require the Company to maintain a specified minimum dollar value level of tangible net worth, maintain a specified minimum dollar value level of EBITDA for the trailing four fiscal quarters and certain minimum ratios of cash flow to debt service obligations, maintain a specified minimum level of profitability, limit the amount of indebtedness it may have outstanding in relation to its tangible net worth, and require the Company to maintain restricted cash balances on deposit with BOW equal to the lesser of $800,000 or the outstanding principal balance of its equipment term loan. As of March 10, 2004 the Company was in compliance with these covenants.

Maturities of long-term debt for periods subsequent to March 10, 2004 are as follows:

Periods
12 months	$	1,517,000
13-24 months	317,000
25-36 months	158,000
Total long-term debt	$	1,992,000

4. ACCRUED PROVISION FOR STORE CLOSURE

Prior to January 1, 2003, the estimated cost associated with closing under-performing stores was accrued in the period in which the store was identified for closure by management under a plan of termination. Effective January 1, 2003, the Company adopted SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” and now records these estimated costs when they are incurred rather than at the date of a commitment to an exit or disposal plan. Such costs primarily consist of the estimated cost to terminate real estate leases.

	Beg Balance			Amounts Charged to Expense		Adjustments			Cash Payments			End Balance
Fiscal year ended July 2, 2003	$	581,000		$	193,000	$	(116,000	)	$	(233,000	)	$	425,000

Thirty-six weeks ended March 10, 2004	$		425,000	$	36,000	$	(106,000	)	$	(218,000	)	$	137,000

For the thirty-six weeks ended March 10, 2004, the $36,000 charged to expense was comprised of a $31,000 charge to cost of sales and related occupancy costs, a $4,000 charge to the provision for asset impairment, and a $1,000 charge to general and administrative expense. These charges primarily related to negotiated lease settlements finalized during the first quarter of fiscal 2004. Also included in the provision for store closure was a benefit of $106,000, which reduced cost of sales and related occupancy costs due to a favorable lease settlement of a closed location.

5. EARNINGS PER SHARE

The following table sets forth the computation of basic and diluted net income per share:

	Twelve Weeks Ended March 10, 2004			Twelve Weeks Ended March 12, 2003			Thirty-Six Weeks Ended March 10, 2004		Thirty-Six Weeks Ended March 12, 2003
Numerator:
Net income (loss)	$	(69,000	)	$	(219,000	)	$	174,000	$	483,000
Denominator:
Basic weighted average shares outstanding	5,161,000			5,161,000			5,161,000		5,161,000

Effect of dilutive securities	—			—			28,000		35,000

Diluted adjusted weighted average shares	5,161,000			5,161,000			5,189,000		5,196,000

Basic and diluted net income (loss) per share	$	(0.01	)	$	(0.04	)	$	0.03	$	0.09

Of the 972,000 options outstanding as of March 10, 2004, all 972,000 were excluded from the calculation of diluted net loss per share for the twelve weeks ended March 10, 2004 as their inclusion would have been anti-dilutive. The calculation of diluted net income per share for the thirty-six weeks ended March 10, 2004 excluded 527,000 options, because the exercise price exceeded the market price. Further, all the 518,000 warrants to purchase shares of common stock outstanding during the twelve weeks and thirty-six weeks ended March 10, 2004 were excluded from the calculation of diluted net income per share as their inclusion would have been anti-dilutive for the twelve weeks ended March 10, 2004 and because the exercise price exceeded the market price for the thirty-six weeks ended March 10, 2004. For the twelve weeks ended March 12, 2003 all 581,000 options were excluded from the calculation of diluted net loss per share, as their inclusion would have been anti-dilutive. During the thirty-six weeks ended March 12, 2003, 358,000 options were excluded from the calculation of diluted net income per share, because the exercise price exceeded the market price. Further, all of the 730,000 warrants to purchase shares of common stock outstanding during the twelve and the thirty-six weeks ended March 12, 2003, were excluded from the calculation of diluted net income (loss) per share as their inclusion would have been anti-dilutive for the twelve weeks ended March 12, 2003 and because the exercise price exceeded the market price for the thirty-six weeks ended March 12, 2003.

6. SEGMENT AND RELATED INFORMATION

The Company has three reportable segments: retail operations, wholesale operations and franchise operations. The Company evaluates performance of its operating segments based on income before income taxes.

Summarized financial information concerning the Company’s reportable segments is shown in the following table. Other identifiable assets consist of corporate cash, corporate notes receivable, corporate prepaid expenses, and corporate property and equipment. The other component of segment profit (loss) before tax includes corporate general and administrative expenses, depreciation and amortization expense and interest expense.

					TWELVE WEEKS ENDED								THIRTY-SIX WEEKS ENDED
					March 10, 2004				March 12, 2003				March 10, 2004			March 12, 2003
Revenue:
Retail					$	7,281,000			$	7,474,000			$	21,725,000		$	23,661,000
Wholesale					3,407,000				3,052,000				11,114,000			11,250,000
Franchise					1,812,000				1,531,000				5,223,000			4,461,000

Total revenue					$	12,500,000			$	12,057,000			$	38,062,000		$	39,372,000

Interest expense:
Retail					$	8,000			$	9,000			$	22,000		$	28,000
Franchise					6,000				10,000				27,000			38,000
Other					53,000				36,000				154,000			151,000

Total interest expense					$	67,000			$	55,000			$	203,000		$	217,000

Depreciation and amortization:
Retail					$	306,000			$	285,000			$	836,000		$	913,000
Wholesale					148,000				70,000				414,000			216,000
Franchise					1,000				4,000				4,000			13,000
Other					58,000				62,000				287,000			185,000

Total depreciation and amortization					$	513,000			$	421,000			$	1,541,000		$	1,327,000

Segment profit (loss) before income tax provision:
Retail					$	196,000			$	454,000			$	812,000		$	1,250,000
Wholesale					444,000				142,000				1,754,000			1,431,000
Franchise					1,736,000				1,322,000				4,846,000			4,425,000
Other					(2,435,000			)	(2,132,000			)	(7,218,000		)	(6,579,000		)

Total segment profit (loss) before income tax provision					$	(59,000		)	$	(214,000		)	$	194,000		$	527,000

					March 10, 2004				July 2, 2003
	Identifiable assets:
		Retail			$		5,642,000		$		5,567,000
		Wholesale			5,446,000				5,584,000
		Franchise			1,378,000				1,373,000
		Other			3,380,000				3,828,000

				Tangible assets	15,846,000				16,352,000

	Goodwill - Retail				1,267,000				1,267,000
	Goodwill - Wholesale				6,311,000				6,311,000
	Goodwill - Franchise				2,612,000				2,612,000

			Total assets		$		26,036,000		$		26,542,000

7. LEASE CONTINGENCIES

We are liable on the master leases for 118 franchise locations. Under the Company’s historical franchising business model, the Company executed the master leases for these locations and entered into subleases on the same terms with its franchisees, which typically pay their rent directly to the landlords. If any of these franchisees default on their subleases, the Company would be required to make all payments under the master leases. The Company’s maximum theoretical future exposure at March 10, 2004, computed as

the sum of all remaining lease payments through the expiration dates of the respective leases, was $20,900,000. This amount does not take into consideration any mitigating measures that the Company could take to reduce this exposure in the event of default, including re-leasing the locations or terminating the master lease by negotiating a lump sum payment to the landlord in an amount that is less than the sum of all remaining future rents.

8. SELF-INSURANCE

Effective October 1, 2003, the Company became self-insured for workers compensation with a $250,000 deductible per occurrence and a program maximum for all claims of $750,000.

Item 2. Management’s Discussion And Analysis Of Financial Condition And Results Of Operations.

A Warning About Forward Looking Statements.

We make forward-looking statements in this quarterly report that are subject to risks and uncertainties. These forward-looking statements include information about possible or assumed future results of our financial condition, operations, plans, objectives and performance. Additionally, when we use the words “believe,” “expect,” “anticipate,” “estimate” or similar expressions, we are making forward-looking statements. Many possible events or factors could affect our future financial results and performance. This could cause our results or performance to differ materially from those expressed in our forward-looking statements. You should consider these risks when you review this document, along with the following possible events or factors:

• the financial and operating performance of our retail operations;

• our ability to maintain profitability over time;

• our ability to perform within the terms of our credit agreement;

• the successful execution of our growth strategies;

• our franchisees’ adherence to our practices, policies and procedures;

• the impact of competition; and

• the availability of working capital.

Foreseeable risks and uncertainties are described elsewhere in this report and in detail under the caption “Risk Factors and Trends Affecting Diedrich Coffee and Its Business” in our Annual Report on Form 10-K/A for the fiscal year ended July 2, 2003 and in other reports that we file with the Securities and Exchange Commission. We undertake no obligation to publicly release the results of any revision of the forward-looking statements. Unless otherwise indicated, “we,” “us,” “our,” and similar terms refer to Diedrich Coffee, Inc.

General.

Diedrich Coffee, Inc. is a specialty coffee roaster, wholesaler and retailer. We sell brewed, espresso-based and various blended beverages primarily made from our own fresh roasted premium coffee beans, as well as light food items, whole bean coffee, and accessories through our Company operated and franchised retail locations. We also sell whole bean and ground coffees on a wholesale basis through a network of distributors in the office coffee service (“OCS”) market, and to other wholesale customers, including restaurant chains and other retailers. Our brands include Diedrich Coffee, Gloria Jean’s Coffees and Coffee People. As of March 10, 2004, Diedrich Coffee owned and operated 58 retail locations and franchised 415 other retail locations under these brands, for a total of 473 retail coffee outlets. Our retail units are located in 35 states and 13 foreign countries. As of March 10, 2004, we also have over 460 wholesale accounts with OCS distributors, chain and independent restaurants and others. In addition, we operate a large coffee roasting facility in central California that supplies freshly roasted coffee to our retail locations and wholesale accounts.

Retail Outlets

Our retail outlet distribution channel can be divided into two sub-channels, each with its own distinct business model, including differences in revenue and cost structure, overhead, and capital requirements. These two retail sub-channels are Company operated retail outlets and franchised retail outlets. We view retail outlets as a single distribution channel, despite the differences noted above, primarily because our retail customers do not make any distinction between Company and franchise

operated locations. The critical success factors are, therefore, the same for each type of retail location, whether Company operated or franchised: quality of product, service, and atmosphere. The economic model and cost structures are also the same for each type of location at the retail unit level, notwithstanding their different direct financial impacts on us in our roles as both an operator and franchiser of retail outlets. Furthermore, the potential contribution of any given outlet to which we provide coffee, as measured by the amount of roasted coffee produced through our roasting plant, is the same.

Presently, our largest brand is Gloria Jean’s and approximately 97% of Gloria Jean’s retail units are franchised. Gloria Jean’s retail units are located throughout the United States and in 13 foreign countries. Our Diedrich Coffee brand has a higher concentration of Company operated units, with 78% of retail locations operated by us. Diedrich Coffee units are located primarily in Orange County, California, although there are a number of Diedrich locations in Denver, Houston, and elsewhere in the United States. We also operate retail coffee outlets under a third brand, Coffee People, which are 100% Company operated at this time. Our Coffee People outlets are all located in Portland, Oregon.

A table summarizing the relative sizes of each of our brands, on a unit count basis, and changes in unit count for each over the thirty-six weeks ended March 10, 2004, is set forth below:

	Units at July 3, 2002	Opened	Closed		Net transfers between the Company and Franchise		Units at July 2, 2003	Opened	Closed		Net transfers between the Company and Franchise		Units at March 10, 2004
Gloria Jean’s Brand
Company Operated	18	—	(1	)	(6	)	11	—	(1	)	2		12
Franchise – Domestic	155	4	(22	)	6		143	8	(10	)	(2	)	139
Franchise – International
Australia	76	66	—		—		142	46	—		—		188
Far East/Asia (1)	16	3	(1	)	—		18	1	(1	)	—		18
Mexico	12	4	(1	)	—		15	3	(1	)	—		17
Other (2)	36	4	(9	)	—		31	17	(2	)	—		46
Total Franchise - International	140	77	(11	)	—		206	67	(4	)	—		269
Subtotal Gloria Jean’s	313	81	(34	)	—		360	75	(15	)	—		420

Diedrich Coffee Brand
Company Operated	25	—	—		—		25	—	(1	)	—		24
Franchise – Domestic	12	—	(2	)	—		10	—	(3	)	—		7
Subtotal Diedrich	37	—	(2	)	—		35	—	(4	)	—		31

Coffee People Brand
Company Operated	27	—	(5	)	—		22	—	—		—		22
Total	377	81	(41	)	—		417	75	(19	)	—		473

(1) Includes Japan and Korea.

(2) Includes Guam, Indonesia, Ireland, Turkey, Malaysia, New Zealand, Philippines, United Arab Emirates and Thailand.

Wholesale Distribution

We currently have over 460 wholesale accounts not affiliated with our retail locations that purchase coffee from us under both the Diedrich Coffee and Gloria Jean’s brands. Our current wholesale accounts are in the office coffee supply market, chain restaurants, independent restaurants, other hospitality industry enterprises and specialty retailers. Additionally, except for our franchisees in Australia and Mexico, our franchise agreements require both Diedrich Coffee and Gloria Jean’s franchisees to purchase substantially all of their coffee from us.

Seasonality and Quarterly Results

Our business is subject to seasonal fluctuations as well as economic trends that affect retailers in general. Historically, our net sales have not been realized proportionately in each quarter, with net sales being the highest during the second fiscal quarter, which includes the November – December holiday season. Hot weather tends to reduce sales. Quarterly results are affected by the timing of the opening of new stores, which may not occur as anticipated due to events outside our control. As a result of these factors, the financial results for any individual quarter may not be indicative of the results that may be achieved in a full fiscal year.

Results of Operations.

Twelve Weeks Ended March 10, 2004 Compared with the Twelve Weeks Ended March 12, 2003

Total Revenue. Total revenue for the twelve weeks ended March 10, 2004 increased by $443,000, or 3.7%, to $12,500,000 from $12,057,000 for the twelve weeks ended March 12, 2003. This increase was attributable to increases in wholesale and other sales and franchise revenue, offset by a decrease in retail sales. Each component is discussed below.

The mix of Company owned and franchised stores and the mix of domestic and international stores continues to change. Since the beginning of the third fiscal quarter of fiscal 2003, Company owned stores have declined by a net of four units and franchised stores have increased by a net of 71 units. Domestic stores have declined by a net of 24 units and international stores have grown by 91 units. These changes impact our retail sales and franchise revenue results because, among other matters, sales and operating expenses are reported for Company stores, but only fees earned under franchise agreements are reported for franchise units. In addition, domestic franchise fees are at higher rates than international franchise fees, and coffee is sold to domestic franchise stores, but generally not to international stores. Therefore, although the new store growth is much stronger in international franchises, per store franchise fees increase more slowly than domestic per store franchise fees and manufacturing sales and profitability is generally not affected by the new international store growth.

Retail sales for the twelve weeks ended March 10, 2004 decreased by $193,000, or 2.6%, to $7,281,000 from $7,474,000 in the prior year period. This decrease primarily represented the net impact of several factors. First, the number of Company stores decreased in the current year versus the earlier period because of the closure or sale of six Company operated locations since the beginning of the prior year period. The reduction in retail sales from the sale or closure of these six coffeehouses was approximately $610,000. This decrease was partially offset by a $184,000 increase in newly opened or transferred store sales, a $37,000 increase in sales from our internet website, and a 2.4% increase in comparable store sales for Company operated units increased retail sales by $196,000.

Wholesale revenue increased $355,000, or 11.6%, for the twelve weeks ended March 10, 2004, to $3,407,000 from $3,052,000 in the prior year period. This increase was primarily the combined result of the following factors:

Wholesale revenue from franchisees. Sales to our franchisees increased $81,000, or 6.6%, for the twelve weeks ended March 10, 2004. Gloria Jean’s domestic franchise comparable store sales increased 0.6% for the quarter and wholesale revenue from franchisees increased $23,000 due to sales of our impaired holiday gift pack inventory during the current quarter. At the end of the 2003 holiday period, in our second quarter, we recorded an impairment charge reducing holiday gift pack inventory to its net realizable value. During the current quarter, we exchanged $67,000 of this impaired inventory for advertising barter credits valued by the barter provider in excess of the impaired inventory value. We recorded the advertising credits as a prepaid expense at the $67,000 impaired net realizable value of the inventory exchanged. Additionally, we accounted for this transaction as a sale, recording revenue and cost of sales of $67,000, leaving no net impact to earnings. These increases were partially offset by a decline in the sales of roasted coffee due to a net 20 unit decrease in the number of domestic franchises compared to the beginning of the prior year quarter.

Keurig “K-cup” and other OCS sales. Keurig and other office coffee service sales increased by $321,000 to $1,737,000 for the twelve weeks ended March 10, 2004, a 22.7% increase over the prior year quarter, due to an increase in the number of K-cup customers.

Coffee sales to independent and chain restaurants and specialty retailers. Wholesale coffee sales to independent and chain restaurants and other specialty retailers decreased by $35,000, or 8.8%, versus the prior year quarter because we de-emphasized this less profitable wholesale segment.

Franchise revenue increased by $281,000, or 18.4%, for the twelve weeks ended March 10, 2004 to $1,812,000 from $1,531,000 in the prior year period. Franchise revenue consists of initial franchise fees, franchise renewal fees, royalties received on sales at franchised locations, and miscellaneous other franchise revenue, including coordination fees received from product suppliers. The increase in franchise revenue was the net impact of several factors. International royalties increased by $203,000 primarily due to strong growth in Australia during the current fiscal quarter. Additionally, area development fees increased by $211,000 primarily due to domestic and international store openings during the current fiscal quarter. These increases were partially offset by a $127,000 decline in domestic royalties and a $6,000 decline in coordination fees due to the net decrease of 20 domestic franchise units in the current quarter compared to the beginning of the prior year quarter.

Cost of Sales and Related Occupancy Costs. Cost of sales and related occupancy costs for the twelve weeks ended March 10, 2004 decreased 2.6% to $5,750,000 from $5,906,000 in the prior year period. On a margin basis, cost of sales and related occupancy costs declined from 56.1% of total retail and wholesale sales for the twelve weeks ended March 12, 2003 to 53.8% for the twelve weeks ended March 10, 2004. This favorable 2.3 margin improvement was due to the net impact of a favorable 1.3 margin basis point change in cost of sales and a favorable 1.0 margin basis point change in occupancy costs. Both cost of sales and occupancy costs experienced a margin basis point improvement primarily due to the sale or closure of six Company stores since the beginning of last year’s third quarter. The closed stores’ cost of sales and occupancy costs were, on a margin basis, approximately 1.0% higher than the remaining store group. Additionally, cost of sales also improved $71,000 in the wholesale segment as a result of our exiting the unprofitable grocery channel this year.

Operating Expenses. Operating expenses for the twelve weeks ended March 10, 2004 declined by $30,000, or 0.8%, to $3,868,000 from $3,898,000 in the prior year period. Retail operating expenses as a percentage of retail sales increased from 43.3% in the prior year quarter to 47.0% in the current year quarter. The percentage increase was primarily due to a planned increase in additional in-store and supervisory labor, and increases in utility and insurance costs. Wholesale operating expenses, as a percentage of wholesale sales, declined from 15.8% in the prior year third quarter to 12.3% in the current year quarter primarily due to the decision to withdraw from the grocery store distribution channel and focus on more profitable opportunities. Franchise operating expense, as a percentage of franchise revenue, declined from 11.9% in the prior year to 1.3% in the current year, primarily due to lower bad debt provisions in the current year quarter.

Depreciation and Amortization. Depreciation and amortization increased by $92,000 to $513,000 for the twelve weeks ended March 10, 2004 from $421,000 for the twelve weeks ended March 12, 2003. This increase was primarily due to the depreciation of the Keurig packaging equipment purchased during fiscal 2003, and the facility improvement program underway in the current year.

General and Administrative Expenses. General and administrative expenses increased by $199,000, or 9.2%, to $2,365,000 for the twelve weeks ended March 10, 2004 from $2,166,000 for the prior year quarter. On a margin basis, general and administrative expenses increased to 18.9% of total revenue in the third quarter of fiscal 2004 from 17.9% in the year ago quarter. This 1.0 unfavorable margin basis point change was primarily related to $189,000 of salary and bonus increases due to the addition of an Executive Vice President of Development, a Director of Operations, and the fact that the Chief Executive Officer position was not filled for part of the prior year period.

Provision for Asset Impairment and Restructuring Costs. In the prior year quarter, we reversed $49,000 in closed store lease reserves associated with a closed coffeehouse in Arizona. There were no asset impairment or restructuring charges in the current year quarter.

Gain (loss) on Asset Disposals. In the third quarter of our last fiscal year, a $5,000 loss on asset disposals and $122,000 gain on the sale of a closed coffeehouse, resulted in a net gain of $117,000. In the current year quarter there was a loss of $5,000 on asset disposals.

Interest Expense and Other, Net. Interest expense and other, net increased $12,000 from $46,000 in last year’s third quarter to $58,000 in the current year quarter, primarily due to increased loan fee amortization.

Income Tax Provision. Net operating losses generated in previous years resulted in no federal income tax liability and only a nominal amount of state income tax expense for the twelve weeks ended March 10, 2004 and the prior year period. Due to the uncertainty of future taxable income, deferred tax assets resulting from these net operating losses have been fully reserved. The slight fluctuation in expense between the twelve weeks ended March 10, 2004 versus the prior year period is due to changes in state income taxes owed in conjunction with the portfolio of Company operated Gloria Jean’s units, which are located in a variety of states. As of March 10, 2004 net operating loss carryforwards for federal and state income tax purposes of $30,305,000 and $19,340,000, respectively, are available to be utilized against future taxable income for years through fiscal 2024 for federal and fiscal 2014 for state, subject to possible annual limitations pertaining to change in ownership rules under the Internal Revenue Code. For the twelve weeks ended March 10, 2004, our valuation allowance decreased $931,000.

Thirty-six Weeks Ended March 10, 2004 Compared with the Thirty-six Weeks Ended March 12, 2003

Total Revenue. Total revenue for the thirty-six weeks ended March 10, 2004 decreased by $1,310,000, or 3.3%, to $38,062,000 from $39,372,000 for the thirty-six weeks ended March 12, 2003. This decline was attributable to decreases in retail and wholesale sales, partially offset by an increase in franchise revenue. Each component is discussed below.

The mix of Company owned and franchised stores and the mix of domestic and international stores continues to change. Since the beginning of the prior fiscal year, Company stores have declined by a net of 12 units and franchised stores have increased by a net of 108 units. Domestic stores have declined by a net of 33 units and international stores have grown by a net of 129 units. These changes impact our retail sales and franchise revenue results because, among other matters, sales and operating expenses are reported for Company stores, but only fees earned under franchise agreements are reported for franchise units. In addition, domestic franchise fees are at higher rates than international franchise fees, and coffee is sold to domestic franchise stores, but generally not to international stores. Therefore, although the new store growth is much stronger in international franchises, per store franchise fees increase more slowly than domestic per store franchise fees and manufacturing sales and profitability is generally not affected by the new international store growth.

Retail sales for the thirty-six weeks ended March 10, 2004 decreased by $1,936,000, or 8.2%, to $21,725,000 from $23,661,000 for the prior year period. This decrease primarily represented the combined impact of two factors. First, the number of Company stores decreased in the current year because of the sale or closure of 14 Company operated locations since the beginning of the prior fiscal year. The reduction in retail sales from the sale or closure of these 14 coffeehouses was approximately $2,426,000. This decrease was partially offset by a $249,000 increase in newly opened or transferred store sales, a $138,000 increase in sales from our internet website, and a 0.1% increase in comparable store sales for Company operated units increased retail sales by $103,000.

Wholesale revenue decreased $136,000, or 1.2%, to $11,114,000 for the thirty-six weeks ended March 10, 2004 from $11,250,000 for the prior year period. This decrease was primarily the combined result of the following factors:

Wholesale revenue from franchisees. Sales of roasted coffee to our franchisees decreased $699,000, or 12.0%, for the thirty-six weeks ended March 10, 2004 primarily because of a net 21 unit reduction in the number of domestic franchises compared to the prior year, along with negative year-to-year same store sales for Gloria Jean’s domestic franchise units of 0.6%. These decreases were partially offset by a barter transaction that we entered into during the third quarter of our current fiscal year. At the end of the 2003 holiday period, in our second fiscal quarter, we recorded an impairment charge reducing holiday gift pack inventory to its net realizable value. During the current quarter, we exchanged $67,000 of this impaired inventory for advertising barter credits valued by the barter provider in excess of the impaired inventory value. We recorded the advertising credits as a prepaid expense at the $67,000 impaired net realizable value of the inventory exchanged. Additionally, we accounted for this transaction as a sale, recording revenue and cost of sales of $67,000, leaving no net impact to earnings.

Keurig “K-cup” and other OCS sales. Keurig and other office coffee service sales increased by $648,000 to $4,900,000 for the thirty-six weeks ended March 10, 2004, from $4,252,000 in the prior year period, a 15.2% increase. This increase is primarily due to an increase in the number of Keurig K-cup customers.

Coffee sales to independent and chain restaurants and specialty retailers. Wholesale coffee sales to independent and chain restaurants and other specialty retailers decreased by $80,000, or 6.8%, versus the prior year period because of our decreased focus on this less profitable segment.

Franchise revenue increased by $762,000, or 17.1%, to $5,223,000 for the thirty-six weeks ended March 10, 2004 from $4,461,000 for the prior year period. The increase in franchise revenue is due to several factors. Initial franchise fees and franchise renewal and transfer fees increased approximately $371,000 for the thirty-six weeks ended March 10, 2004 versus the prior year, primarily as a result of strong international growth and a dissolution settlement of $150,000 for the Malaysia franchise agreement. International franchise royalties increased $567,000 and coordination fees increased $11,000 over the prior year period, due to strong international growth. Domestic royalties decreased $187,000 primarily because of the net 21 unit reduction in domestic franchise stores and negative same store sales for Gloria Jean’s franchise units of 0.9% in the current year. Negative year-to-year same store sales were primarily due to the weak sales of the holiday gift pack inventories.

Cost of Sales and Related Occupancy Costs. Cost of sales and related occupancy costs for the thirty-six weeks ended March 10, 2004 were $17,601,000, a decrease of 6.9% on a 5.9% decline in retail and wholesale sales. On a margin basis, cost of sales and related occupancy costs decreased from 54.2% of total retail and wholesale sales to 53.6% in the current year. This 0.6 favorable margin basis point change was due to the net impact of a favorable 0.3 margin basis point change in cost of sales, in addition to a favorable 0.3 margin basis point change in occupancy costs. Both cost of sales and occupancy costs experienced a margin basis point improvement primarily due to the sale or closure of 14 Company stores since the beginning of last the last fiscal year. The closed stores’ cost of sales and occupancy costs were higher than the remaining store group. Additionally, cost of sales also improved in the wholesale segment as a result of our exiting the unprofitable grocery channel this year.

Operating Expenses. Operating expenses for the thirty-six weeks ended March 10, 2004 declined by $542,000, or 4.5%, to $11,550,000 from $12,092,000 in the prior year period. Retail operating expenses as a percentage of retail sales increased from 44.2% in the prior year to 46.9% in the current year. This was largely due to planned additional in-store and supervisory labor, as well as increases in utility and insurance costs. Wholesale operating expenses, as a percentage of wholesale sales, declined from 13.4% in the prior year to 10.2% in the current fiscal year. Year to year wholesale bad debt expense decreased $149,000, due to a bad debt charge in the prior year of $186,000 related to the bankruptcy of a major wholesale distributor. Wholesale operating expenses also decreased in the current year by $189,000 as a result of our withdrawal from the unprofitable grocery store distribution channel. Franchise operating expense increased $110,000 in the current year, due to an increase in franchise bad debt expense, as prior year franchise bad debt reserves were reduced due to favorable collections on reserved accounts. Effective October 1, 2003, we became self-insured for workers compensation with a $250,000 deductible per occurrence and a program maximum for all claims of $750,000. This change had no material impact in the current year periods.

Depreciation and Amortization. Depreciation and amortization increased by $214,000 to $1,541,000 for the thirty-six weeks ended March 10, 2004. This increase was primarily due to the depreciation of the Keurig packaging equipment purchased during fiscal 2003 and the facility improvement program underway in the current year.

General and Administrative Expenses. General and administrative expenses increased by $494,000, or 7.7%, to $6,891,000 for the thirty-six weeks ended March 10, 2004. On a margin basis, general and administrative expenses increased to 18.1% of total revenue in the first three quarters of fiscal 2004 from 16.2% in the prior year period. This 1.9 unfavorable margin basis point change was primarily due to $431,000 of increased salary and bonus costs. The salary and bonus increases included the addition of an Executive Vice President of Development, a Director of Operations and the fact that the Chief Executive Officer position was not filled for part of the prior year period.

Provision for Asset Impairment and Restructuring Costs. The thirty-six weeks ended March 10, 2004 included a $90,000 charge as a result of the early termination of a Diedrich Coffee coffeehouse lease and a $4,000 provision related to the closure of one coffeehouse. Prior year results included a $106,000 provision to reduce the carrying value of one coffeehouse, partially offset by a $49,000 reversal of closed store lease reserves associated with a closed coffeehouse in Arizona.

Gain (Loss) on Asset Disposals. Gain (loss) on asset disposals changed by $124,000 in the current year period resulting in a $5,000 loss on asset disposals, compared to a $119,000 gain on the sale of a coffee house in the prior year period.

Interest Expense and Other, Net. Interest expense and other, net increased from $184,000 in the prior year to $186,000 for the thirty-six weeks ended March 10, 2004. Interest expense decreased $14,000, primarily due to a $408,000 reduction in our long term debt principle balance, which was partially offset by increased loan fee amortization during the current year. Interest and other income decreased $16,000, primarily due to the revision of our outstanding note receivable agreements in the current year.

Income Tax Provision. Net operating losses generated in previous years resulted in no federal income tax liability and only a nominal amount of state income tax expense for the thirty-six weeks ended March 10, 2004 and the prior year period. Due to the uncertainty of future taxable income, deferred tax assets resulting from these net operating losses have been fully reserved. The slight fluctuation in expense between the thirty-six weeks ended March 10, 2004 versus the prior year period is due to changes in state income taxes owed in conjunction with the portfolio of Company operated Gloria Jean’s units, which are located in a variety of states. As of March 10, 2004, net operating loss carryforwards for federal and state income tax purposes of $30,305,000 and $19,340,000, respectively, are available to be utilized against future taxable income for years through fiscal 2024 for federal and fiscal 2014 for state, subject to possible annual limitations pertaining to change in ownership rules under the Internal Revenue Code. For the thirty-six weeks ended March 10, 2004, our valuation allowance decreased $1,032,000.

Financial Condition, Liquidity and Capital Resources.

Current Financial Condition. At March 10, 2004, we had negative working capital of $736,000, compared to working capital of $1,207,000 at July 2, 2003. This decrease was primarily due to a $792,000 restricted cash requirement imposed by the third amendment to our Credit Agreement with Bank of the West, in addition to the $165,000 restricted cash requirement related to our outstanding letter of credit facility, as discussed in more detail in Note 3 to the Condensed Consolidated Financial Statements.

On December 2, 2003, at the annual meeting of stockholders, the stockholders approved a proposal to enter into a transaction pursuant to which we may borrow up to $5 million from Sequoia Enterprises, LP (the “Lender”). Our Chairman, Paul Heeschen, is the sole general partner of the Lender. The Company is currently documenting the terms of a Contingent Convertible Note Purchase Agreement (the “Agreement”) which will provide for the issuance of one or more unsecured contingent convertible promissory notes (the “Notes”) with an aggregate principal amount not to exceed $5 million. At our election, for a period of three years, we may issue to the Lender on the effective date of the Agreement, or on the first day of any fiscal quarter, one or more Notes having a minimum principal amount of $300,000 up to an aggregate principal amount of $5 million. Interest on the Notes will accrue at a rate equal to LIBOR plus 3.30% per annum calculated on the basis of a 360 day year and actual days elapsed. We will be required to make payments to the Lender monthly on the first day of each month. Each monthly payment will be equal to the sum of (a) all accrued interest on each of the outstanding Notes for the prior month, plus (b) 1.67% of the outstanding aggregate principal amount of the Notes, plus (c) a commitment fee equal to 0.0833% of the difference between $5 million and the principal amount of all issued Notes. The principal amount of the Notes plus any accrued and unpaid interest will be due on the earlier of a change in control or the third

anniversary of the effective date of the Agreement. The Agreement will contain customary financial covenants, including a restriction regarding the amount of additional debt we may incur, and customary events of default.

The Notes will be convertible into our common stock upon the occurrence of a change in control. In addition, upon repayment of the amount of indebtedness evidenced by the Notes, we will be obligated to issue the Lender warrants to purchase shares of our common stock, which warrants will be exercisable upon the occurrence of a change in control. Any warrants issued by us will only be exercisable immediately prior to a change of control and will expire and no longer be exercisable on the fourth

anniversary of the effective date of the Agreement. Additional details regarding the terms of the proposed facility can be found in the proxy statement for our 2003 annual meeting of stockholders.

Based upon the terms of the contingent convertible note purchase agreement, the existing BOW Credit Agreement, our recent operating performance and business outlook, and status of our balance sheet, we believe that cash on hand, cash from operations, and funds available under our current and expected credit facilities will be sufficient to satisfy our working capital requirements for at least the next twelve months.

Cash Flows. Cash provided by operating activities for the thirty-six weeks ended March 10, 2004 totaled $2,470,000 as compared with $1,081,000 for the thirty-six weeks ended March 12, 2003. This improvement is the net result of many factors more fully enumerated in the Unaudited Condensed Consolidated Statement of Cash Flows in the accompanying financial statements.

Net cash used in investing activities for the thirty-six weeks ended March 10, 2004 totaled $1,672,000 as compared with $304,000 used for the thirty-six weeks ended March 12, 2003. During the thirty-six weeks ended March 10, 2004, $1,706,000 was used to invest in property and equipment in our store remodel project, our Castroville roasting facility and our home office facility. These expenditures were partially offset by $26,000 of payments received on notes receivable and $8,000 in proceeds from disposal of property and equipment.

Net cash used in financing activities for the thirty-six weeks ended March 10, 2004 totaled $2,031,000 as compared to $954,000 in net cash used in financing activities for the thirty-six weeks ended March 12, 2003. During the thirty-six weeks ended March 10, 2004, $957,000 of cash was restricted in accordance with the $792,000 restricted cash requirement imposed by the third BOW amendment, in addition to the $165,000 restricted cash requirement related to our outstanding letter of credit facility, as discussed above. For both periods, the net cash used in financing activities consisted of repayment of long-term debt and capital leases.

Outstanding Debt and Financing Arrangements. We have a $675,000 revolving working capital and letter of credit facility. The total borrowings under the working capital facility and letters of credit are limited to a combined maximum of $675,000 outstanding at any time. Letters of credit are subject to a sub-limit of $250,000. We also have an additional $250,000 letter of credit facility. At March 10, 2004, there were two letters of credit in the amounts of $179,000 and $165,000 outstanding under the two letter of credit facilities, and no draws against the working capital facility.

For additional information regarding our banking relationship and further details of the revolving working capital and letter of credit facility please refer to the accompanying Unaudited Condensed Consolidated Financial Statements and related notes.

Other Commitments. The following represents a comprehensive list of our contractual obligations and commitments as of March 10, 2004:

	Payments Due by Period
	Total		12 months		13-24 months		25-36 months		37-48 months		49-60 months		Thereafter
	(In thousands)
Note payable	$	1,992	$	1,517	$	317	$	158	$	—	$	—	$	—
Capital leases	611		171		122		22		23		25		248
Company operated retail locations and other operating leases	15,708		3,968		3,193		2,265		1,757		1,476		3,049
Franchise operated retail locations operating leases	20,900		5,515		4,231		3,237		2,611		1,810		3,496
Green coffee commitments	2,575		1,230		1,345		—		—		—		—
	$	41,786	$	12,401	$	9,208	$	5,682	$	4,391	$	3,311	$	6,793

We have obligations under non-cancelable operating leases for our coffee houses, roasting facility and administrative offices. Lease terms are generally for periods of 10 to 20 years with renewal options, and generally require us to pay a proportionate share of real estate taxes, insurance, common area, and other operating costs. Some retail leases provide for contingent rental payments based on sales thresholds. In addition, we are liable on the master leases for 118 franchise locations. Under our historical franchising business model, we executed the master leases for these locations and entered into subleases on the same terms with our franchisees, which typically pay their rent directly to the landlords. If any of these franchisees default on their subleases, we would be required to make all payments under the master leases. Our maximum theoretical future exposure at March 10, 2004, computed as the sum of all remaining lease payments through the expiration dates of the respective leases, was $20,900,000. This amount does not take into consideration any mitigating measures that we could take to reduce this exposure in the event of default, including re-leasing the locations or terminating the master lease by negotiating a lump sum payment to the landlord in an amount that is less than the sum of all remaining future rents.

Critical Accounting Estimates.

The preparation of our condensed consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts. The estimates and assumptions are evaluated on an ongoing basis and are based on historical experience and on various other factors that are believed to be reasonable. Accounts significantly impacted by estimates and assumptions include, but are not limited to, franchise receivables, allowance for bad debt reserves, fixed asset lives, goodwill, intangible assets, income taxes, self-insurance and workers’ compensation reserves, store closure reserves, stock-based compensation, the valuation allowance for net deferred tax assets and contingencies. We believe that the following represent our critical accounting policies and estimates used in the preparation of our condensed consolidated financial statements. The following discussion, however, does not list all of our accounting policies and estimates.

Impairment of Property and Equipment and Other Amortizable Long-Lived Assets Held and Used

Each quarter we evaluate the carrying value of individual stores when the operating results have reasonably progressed to a point to adequately evaluate the probability of continuing operating losses or a current expectation that a store will be sold or otherwise disposed of before the end of its previously estimated useful life. In making these judgments, we consider the period of time since the store was opened or remodeled, and the trend of operations and expectations for future sales growth. For stores selected for review, we estimate the future estimated cash flows from operating the store over its estimated useful life. We make judgments about future same-store sales and the operating expenses and estimated useful life that we would expect with such level of same-store sales.

The most significant assumptions in our analysis are those used when we estimate a unit’s future cash flows. We generally use the assumptions in our strategic plan and modify them as necessary based on unit specific information. If our assumptions are incorrect, the carrying value of our operating unit assets may be overstated or understated.

Impairment of Goodwill

At the reporting unit level, goodwill is tested for impairment annually or whenever an event or circumstance indicates that it is more likely than not an impairment may have occurred. We consider the reporting unit level to be the segment level since the components within each segment have similar economic characteristics, including products and services, production processes, types or classes of customers and distribution methods. The impairment, if any, is measured based on the estimated fair value of the segment. Fair value can be determined based on discounted cash flows or valuations of similar businesses. Impairment occurs when the carrying amount of goodwill exceeds its estimated fair value.

The most significant assumptions we use in this analysis are those made in estimating future cash flows. In estimating future cash flows, we consider historical results as well as the assumptions utilized in our strategic plan for items such as same-store sales, store count growth rates, and the discount rate we consider to be the market discount rate used for acquisitions of similar businesses.

If our assumptions used in performing the impairment test prove inaccurate, the fair value of the segments may ultimately prove to be significantly lower, thereby causing the carrying value to exceed the fair value and indicating an impairment has occurred. If our assumptions are incorrect, the carrying value of our goodwill may be understated or overstated. Our annual impairment measurement date is our fiscal year end.

Estimated Liability for Closing Stores

We make decisions to close stores based on prospects for estimated future profitability and sometimes we are forced to close stores due to circumstances beyond our control (e.g., a landlord’s refusal to negotiate a new lease). Our management team evaluates each store’s performance every period. When stores continue to perform poorly, we consider the demographics of the location, as well as the likelihood of being able to improve the performance of an unprofitable store. Based on the management team’s judgment, we estimate the future cash flows. If we determine that the store will not, within a reasonable period of time, operate at break-even cash flow or be profitable, and we are not contractually obligated to continue operating the store, we may close the store. Additionally, franchisees may close

stores for which we are the primary lessee. If the franchisee cannot make payments on the lease, we continue making the lease payments and establish an estimated liability for the closed store if we decide not to operate it as a Company operated store. Effective January 1, 2003, we establish the estimated liability on the actual closure date. Prior to the adoption of Statement of Financial Accounting Standards No. 146, Accounting for Costs Associated with Exit or Disposal Activities (“SFAS 146”) on January 1, 2003, we established the estimated liability when we identified a store for closure, which may or may not have been the actual closure date.

The estimated liability for closing stores on properties vacated is generally based on the term of the lease and the lease termination fee we expect to pay, as well as estimated maintenance costs until the lease has been abated. The amount of the estimated liability established is generally the present value of these estimated future payments. The interest rate used to calculate the present value of these liabilities is based on our incremental borrowing rate at the time the liability is established. The related discount is amortized and shown in provision for asset impairment and restructuring costs, net in our condensed consolidated statements of earnings.

A significant assumption used in determining the amount of the estimated liability for closing stores is the amount of the estimated liability for future lease payments on vacant stores, which we determine based on our assessment of our ability to successfully negotiate early terminations of our lease agreements with the lessors or sublease the property. Additionally, we estimate the cost to maintain leased and owned vacant properties until the lease has been abated. If the costs to maintain properties increase, or it takes longer than anticipated to sell properties or sublease or terminate leases, we may need to record additional estimated liabilities. If the leases on the vacant stores are not terminated or subleased on the terms we used to estimate the liabilities, we may be required to record losses in future periods. Conversely, if the leases on the vacant stores are terminated or subleased on more favorable terms than we used to estimate the liabilities, we reverse previously established estimated liabilities, resulting in an increase in operating income.

Estimated Liability for Self-Insurance

Effective October 1, 2003, we became self-insured for a portion of our current years’ losses related to workers’ compensation insurance. We have obtained stop loss insurance for individual workers’ compensation claims with a $250,000 deductible per occurrence and a program maximum for all claims of $750,000. Insurance liabilities and reserves are accounted for based on the present value of actuarial estimates of the amount of incurred and unpaid losses, based approximately on a risk-free interest rate. These estimates rely on actuarial observations of historical claim loss development. The actuary, in determining the estimated liability, bases the assumptions on the average historical losses on claims we have incurred. The actual loss development may be better or worse than the development we estimated in conjunction with the actuary. In that event, we will modify the reserve. As such, if we experience a higher than expected number of claims or the costs of claims rise more than expected, then we may, in conjunction with the actuary, adjust the expected losses upward and our future self-insurance expenses will rise.

Franchised Operations

We monitor the financial condition of certain franchisees and record provisions for estimated losses on receivables when we believe that our franchisees are unable to make their required payments to us. Each period we perform an analysis to develop estimated bad debts for each franchisee. We then compare the aggregate result of that analysis to the amount recorded in our condensed consolidated financial statements as the allowance for doubtful accounts and adjust the allowance as appropriate. Over time, our assessment of individual franchisees may change. For instance, we have had some franchisees, who in the past we had determined required an estimated loss equal to the total amount of the receivable, who have paid us in full or established a consistent record of payments (generally one year) such that we determined an allowance was no longer required.

Depending on the facts and circumstances, there are a number of different actions we and/or our franchisees may take to resolve franchise collections issues. These actions may include the purchase of franchise stores by us or by other franchisees, a modification to the franchise agreement which may include a provision to defer certain royalty payments or reduce royalty rates in the future, a restructuring of the franchisee’s business and/or finances (including the restructuring of leases for which we are the primary or secondary obligee) or, if necessary, the termination of the franchise agreement. The allowance established is based on our assessment of the most probable course of action that will occur.

In accordance with SFAS 146, which we adopted on January 1, 2003, an estimated liability for future lease obligations on stores operated by franchisees for which we are the primary or secondary obligee is established on the date the franchisee closes the store. Also, we record an estimated liability for subsidized lease payments when we sign a sublease agreement committing us to the subsidy.

The amount of the estimated liability is established using the methodology described in “Estimated Liability for Closing Stores” above. Consistent with SFAS 146, we have not established an additional estimated liability for potential losses not yet incurred. If sales trends/economic conditions worsen for our franchisees, their financial health may worsen, our collection rates may decline and we may be required to assume the responsibility for additional lease payments on franchised stores. Entering into restructured franchise agreements may result in reduced franchise royalty rates in the future (see discussion above).

Stock-Based Compensation

As discussed in the Notes to Condensed Consolidated Financial Statements, we have various stock-based compensation plans that provide options for certain employees and outside directors to purchase common shares of stock. We have elected to account for stock-based compensation in accordance with APB Opinion No. 25, “Accounting for Stock Issued to Employees,” which utilizes the intrinsic value method of accounting for stock-based compensation, as opposed to using the fair-value method prescribed in SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”). Because of this election, we are required to make certain disclosures of pro forma net income assuming we had adopted SFAS No. 123. We determine the estimated fair value of stock-based compensation on the date of the grant using the Black-Scholes option-pricing model. The Black-Scholes option-pricing model requires the input of highly subjective assumptions, including the historical stock price volatility, expected life of the option and the risk-free interest rate. A change in one or more of the assumptions used in the Black-Scholes option-pricing model may result in a material change to the estimated fair value of the stock-based compensation (see Note 1 of Notes to Condensed Consolidated Financial Statements for analysis of the effect of certain changes in assumptions used to determine the fair value of stock-based compensation).

Valuation Allowance for Net Deferred Tax Assets

As discussed above, we have recorded a 100% valuation allowance against our net deferred tax assets. If we have been profitable for a number of years and our prospects for the realization of our deferred tax assets are more likely than not, we would then reverse our valuation allowance and credit income tax expense. In assessing the prospects for future profitability, many of the assessments of same-store sales and cash flows discussed above become relevant. When circumstances warrant, we assess the likelihood that our net deferred tax assets will more likely than not be realized from future taxable income. As of March 10, 2004, our net deferred tax assets and related valuation allowance totaled approximately $13,608,000.

Item 3. Quantitative And Qualitative Disclosures About Market Risk.

Market Risk Sensitive Items Entered Into for Trading Purposes.

None.

Market Risk Sensitive Items Entered Into for Other Than Trading Purposes.

Interest Rate Risk. We are exposed to market risk from changes in interest rates on our outstanding bank debt. At March 10, 2004, we had $1,200,000 in bank debt that was tied to changes in short term interest rates. At the end of our third fiscal quarter of fiscal 2004, the interest rate was the LIBOR rate plus 3.25%, or 4.45%. The rate can be fixed over periods ranging from one to six months, at our discretion. At March 10, 2004, a hypothetical 100 basis point increase in the adjusted LIBOR rate would result in additional interest expense of $12,000 on an annualized basis.

Commodity Price Risk. Green coffee, the principal raw material for our products, is subject to significant price fluctuations caused by a number of factors, including weather, political, and economic conditions. To date, we have not used commodity based financial instruments to hedge against fluctuations in the price of coffee. To ensure that we have an adequate supply of coffee, however, we enter into agreements to purchase green coffee in the future that may or may not be fixed as to price. At March 10, 2004, we had commitments to purchase coffee through fiscal year 2005 totaling $2,575,000 for 2,134,000 pounds of green coffee, some of which commitments were fixed as to price. The coffee scheduled to be delivered to us in this fiscal year pursuant to these commitments will satisfy approximately 93% of our anticipated green coffee requirements for this fiscal year. Assuming we require approximately 85,000 additional pounds of green coffee during 2004 for which no price has yet been fixed, each $0.01 per pound increase in the price of green coffee could result in approximately $9,000 of additional cost. However, because the price we pay for green coffee is negotiated with suppliers, we believe that the commodity market price for green coffee would have to increase significantly, by as much as $0.25 per pound, before suppliers would increase the price they charge us.

Item 4. Controls and Procedures.

(a) As of the end of the period covered by this quarterly report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective in timely alerting them to material information relating to Diedrich Coffee (including our subsidiaries) required to be included in our periodic SEC filings.

(b) There was no significant change in our internal control over financial reporting that occurred during our most recent fiscal quarter that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II - OTHER INFORMATION

Item 1. Legal Proceedings.

In the ordinary course of our business, we may become involved in legal proceedings from time to time. During the thirty-six week period ending March 10, 2004, we were not a party to any material legal proceedings.

Item 6. Exhibits and Reports on Form 8-K.

(a) Exhibits.

Set forth below is a list of the exhibits included as part of this quarterly report.

Exhibit No.		Description
2.1		Agreement and Plan of Merger, dated March 16, 1999, among Diedrich Coffee, Inc., CP Acquisition Corp., a wholly owned subsidiary of Diedrich Coffee, Inc., and Coffee People, Inc.(1)

3.1		Restated Certificate of Incorporation of the Company, dated May 11, 2001(2)

3.2		Bylaws of the Company(3)

4.1		Specimen Stock Certificate(4)

4.2		Purchase Agreement for Series A Preferred Stock dated as of December 11, 1992 by and among Diedrich Coffee, Inc., Martin R. Diedrich, Donald M. Holly, SNV Enterprises, and D.C.H., LP(5)

4.3		Purchase Agreement for Series B Preferred Stock dated as of June 29, 1995 by and among Diedrich Coffee, Inc., Martin R. Diedrich, Steven A. Lupinacci, Redwood Enterprises VII, LP, and Diedrich Partners I, LP(5)

4.4		Form of Conversion Agreement in connection with the conversion of Series A and Series B Preferred Stock into Common Stock(3)

4.5		Common Stock and Warrant Purchase Agreement, dated March 14, 2001(6)

4.6		Form of Warrant, dated May 8, 2001(2)

4.7		Registration Rights Agreement, dated May 8, 2001(2)

4.8		Form of Warrant Agreement with Nuvrty, Inc., Ocean Trust, and Grandview Trust(7)

4.9		Form of Common Stock and Option Purchase Agreement with Franchise Mortgage Acceptance Company, dated as of April 3, 1998(8)

10.1		Form of Indemnification Agreement(5)

10.2		Diedrich Coffee, Inc. 2000 Equity Incentive Plan(21)*

10.3		Diedrich Coffee, Inc. 2000 Non-Employee Directors Stock Option Plan(10)*

10.4		Amended and Restated Diedrich Coffee, Inc. 1996 Stock Incentive Plan(11)*

10.5		Diedrich Coffee, Inc. 1996 Non-Employee Directors Stock Option Plan(12)*

10.6		Reserved.

10.7		Form of Diedrich Coffee Franchise Agreement(20)

10.8		Form of Gloria Jean’s Franchise Agreement(20)

10.9		Form of Area Development Agreement(20)

10.10		Credit Agreement, dated September 3, 2002, by and between Diedrich Coffee, Inc. and Bank of the West d/b/a/ United California Bank(13)

10.11		Form of Guaranty(13)

10.12		Form of Guarantor Security Agreement(13)

10.13		Form of Supplemental Security Agreement (Trademarks)(13)

10.14		Security Agreement, dated September 3, 2002, by and between Diedrich Coffee, Inc. and Bank of the West d/b/a/ United California Bank(13)

10.15		First Amendment to Credit Agreement by and between Diedrich Coffee, Inc. and Bank of the West, effective December 17, 2002(14)

10.16		Second Amendment to Credit Agreement by and between Diedrich Coffee, Inc. and Bank of the West, effective March 11, 2003(15)

10.17		Third Amendment to Credit Agreement by and between Diedrich Coffee, Inc. and Bank of the West, effective July 1, 2003(16)

10.18		Fourth Amendment to Credit Agreement by and between Diedrich Coffee, Inc. and Bank of the West, effective October 1, 2003 (20)

10.19		Reserved.

10.20		Employment Agreement with Roger M. Laverty, dated April 24, 2003(15)*

10.21		Stock Option Plan and Agreement with Roger M. Laverty, dated April 24, 2003(15)*

10.22		Employment Agreement with Martin A. Lynch, dated March 26, 2004*

10.23		Form of Employment Agreement with Martin R. Diedrich, dated June 29, 2001(17)*

10.24		Employment Agreement with Matthew McGuinness, effective March 13, 2000(18)*

10.25		Employment Letter regarding the employment of Pamela Britton, dated February 6, 2001(20)*

10.26		Employment Letter regarding the employment of Michael Zorehkey, dated February 3, 2000(20)*

10.27		Employment Letter regarding the employment of Carl Mount dated October 29, 1999(19)*

10.28		Separation Agreement by and between Diedrich Coffee, Inc. and Philip G. Hirsch(15)*

10.29		Reserved.

10.30		Standard Industrial/Commercial Multi-Tenant Lease Agreement by and between The Westphal Family Trust and Diedrich Coffee, Inc., dated September 10, 2003(16)

10.31		Office Space Lease Agreement by and between The Irvine Company and Diedrich Coffee, Inc., dated August 1, 2003(16)

10.32		Reserved.

31.1		Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2		Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1		Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2		Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

* Management contract or compensatory plan or arrangement

(1) Previously filed as Appendix A to Diedrich Coffee’s Registration Statement on Form S-4, filed with the Securities and Exchange Commission on April 23, 1999.

(2) Previously filed as an exhibit to Diedrich Coffee’s Current Report on Form 8-K, filed with the Securities and Exchange Commission on May 16, 2001.

(3) Previously filed as an exhibit to Diedrich Coffee’s Registration Statement on Form S-1/A (Registration No. 333-08633), filed with the Securities and Exchange Commission on August 28, 1996 and declared effective on September 11, 1996.

(4) Previously filed as an exhibit to Diedrich Coffee’s Registration Statement on Form S-3 (Registration No. 333-66744), filed with the Securities and Exchange Commission on August 3, 2001.

(5) Previously filed as an exhibit to Diedrich Coffee’s Registration Statement on Form S-1 (Registration No. 333-08633), filed with the Securities and Exchange Commission on July 24, 1996 and declared effective on September 11, 1996.

(6) Previously filed as Appendix B to Diedrich Coffee’ Definitive Proxy Statement, filed with the Securities and Exchange Commission on April 12, 2001.

(7) Previously filed as an exhibit to Diedrich Coffee’s Quarterly Report on Form 10-Q for the period ended October 29, 1997, filed with the Securities and Exchange Commission on December 11, 1997.

(8) Previously filed as an exhibit to Diedrich Coffee’s Annual Report on Form 10-K for the fiscal year ended January 28, 1998, filed with the Securities and Exchange Commission on April 28, 1998.

(9) Reserved.

(10) Previously filed as an exhibit to Diedrich Coffee’s Registration Statement on Form S-8, filed with the Securities and Exchange Commission on November 21, 2000.

(11) Previously filed as an exhibit to Diedrich Coffee’s Quarterly Report on Form 10-Q for the period ended September 22, 1999, filed with the Securities and Exchange Commission on November 5, 1999.

(12) Previously filed as an exhibit to Diedrich Coffee’s Registration Statement on Form S-1/A (Registration No. 333-08633), filed with the Securities and Exchange Commission on August 12, 1996 and declared effective on September 11, 1996.

(13) Previously filed as an exhibit to Diedrich Coffee’s Annual Report on Form 10-K for the fiscal year ended July 3, 2002, filed with the Securities and Exchange Commission on October 1, 2002.

(14) Previously filed as an exhibit to Diedrich Coffee’s Quarterly Report on Form 10-Q for the period ended December 18, 2002, filed with the Securities and Exchange Commission on January 31, 2003.

(15) Previously filed as an exhibit to Diedrich Coffee’s Quarterly Report on Form 10-Q for the period ended March 12, 2003, filed with the Securities and Exchange Commission on April 28, 2003.

(16) Previously filed as an exhibit to Diedrich Coffee’s Annual Report on Form 10-K for the fiscal year ended July 2, 2003, filed with the Securities and Exchange Commission on September 30, 2003.

(17) Previously filed as an exhibit to Diedrich Coffee’s Annual Report on Form 10-K for the fiscal year ended June 27, 2001, filed with the Securities and Exchange Commission on September 25, 2001.

(18) Previously filed as an exhibit to Diedrich Coffee’s Annual Report on Form 10-K for the fiscal year ended June 28, 2000, filed with the Securities and Exchange Commission on September 27, 2000.

(19) Previously filed as an exhibit to Diedrich Coffee’s Quarterly Report on Form 10-Q for the period ended September 20, 2000, filed with the Securities and Exchange Commission on November 6, 2000.

(20) Previously filed as an exhibit to Diedrich Coffee’s Quarterly Report on Form 10-Q for the period ended September 24, 2003, filed with the Securities and Exchange Commission on November 7, 2003.

(21) Previously filed as an exhibit to Diedrich Coffee’s Quarterly Report on Form 10-Q for the period ended December 17, 2003, filed with the Securities and Exchange Commission on January 30, 2004.

(b) Reports on Form 8-K.

On January 28, 2004 we furnished a Current Report on Form 8-K to report the financial results of our second fiscal quarter.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	Date: April 22, 2004	DIEDRICH COFFEE, INC.


		/s/ Roger M. Laverty
		Roger M. Laverty
		President and Chief Executive Officer
		(Principal Executive Officer)


		/s/ Martin A. Lynch
		Martin A. Lynch
		Executive Vice President and Chief Financial Officer
		(Principal Financial and Accounting Officer)

Exhibit 10.22

DIEDRICH COFFEE, INC.
EMPLOYMENT AGREEMENT

This Employment Agreement (this “Agreement”) is entered into as of March 26, 2004 by and between Martin A. Lynch (“Executive”) and Diedrich Coffee, Inc., a Delaware corporation (the “Company”).

WHEREAS, the Company has retained Executive to provide personal services to the Company in exchange for certain compensation and benefits;

WHEREAS, Executive began working for the Company on October 1, 2003; and

WHEREAS, the Company and Executive mutually desire to memorialize the terms of Executive’s employment with the Company by entering into this Agreement.

NOW, THEREFORE, in consideration of the mutual promises and covenants contained herein, it is hereby agreed by and between the parties hereto as follows:

1. Employment by the Company.

1.1 Title and Responsibilities. Subject to terms set forth herein, the Company agrees to employ Executive as its Chief Financial Officer and Executive Vice President and Executive hereby accepts such employment. During his employment with the Company, Executive will devote his best efforts and substantially all of his business time and attention (except for vacation periods as set forth herein and reasonable periods of illness or other incapacity permitted by the Company’s general employment policies) to the business of the Company.

1.2 Executive Position. Executive will continue to serve in an executive capacity and shall perform such duties as are customarily associated with his title, consistent with the bylaws of the Company and as reasonably required by the Company’s Board of Directors (the “Board”).

1.3 Company Employment Policies. The employment relationship between the parties shall also be governed by the general employment policies and practices of the Company, including those relating to protection of confidential information and assignment of inventions, except that if the terms of this Agreement differ from or are in conflict with the Company’s general employment policies or practices, this Agreement shall control.

2. Compensation.

2.1 Salary. Executive shall receive for services to be rendered hereunder an annualized base salary of two hundred twenty thousand dollars ($220,000), payable on a biweekly basis in accordance with the normal payroll practices of the Company (including deductions, withholdings and collections as required by law). Executive will be considered for annual increases in base salary in accordance with Company policy and subject to review and approval by the Compensation Committee of the Board (the “Compensation Committee”).

2.2 Bonus. Executive shall be eligible to participate in the Company’s executive level bonus plan throughout the duration of Executive’s employment with the Company.

(a) Executive’s Performance. The amount of Executive’s bonus will depend upon Executive’s performance with respect to certain measurable goals to be established in an executive bonus plan for each fiscal year to be developed by the Chief Executive Officer and other officers of the Company within sixty (60) days after the beginning of such fiscal year and then approved by the Compensation Committee no later than ninety (90) days after the beginning of such fiscal year.

(b) Company Profitability. The amount of Executive’s bonus will also depend on attainment by the Company of its planned financial objectives for the bonus year.

(c) Determination of Bonus. The amount of Executive’s bonus will be determined after the close of the Company’s fiscal year and after the Company has received its audited financial statement for such fiscal year. To be eligible to receive a bonus, Executive must remain in employment with the Company throughout the entire fiscal year.

(d) No Guaranteed Bonus. Notwithstanding the foregoing, no bonus is guaranteed to Executive. Any bonus is subject to the approval of the Board, which retains the authority to review, grant, deny or revise any bonus in its sole discretion.

(e) Target Bonus. The target bonus for Executive shall be fifty percent (50%) of his base salary. This target may be adjusted upward to reflect additional bonus to be paid for achievement of strategic transactions apart from base business objectives. At Executive’s election, any bonus payable to Executive may be paid in whole or in part through a grant of shares of the Company’s common stock.

(f) Withholding. Any cash bonus paid to Executive shall be subject to such withholdings as may be required by law.

2.3 Stock Options. Executive will be entitled to receive non-qualified options to purchase up to 150,000 shares of common stock of the Company (the “Options”) under the Diedrich Coffee, Inc. 2000 Equity Incentive Plan on the terms and subject to the conditions of the Memorandum of Option Grant delivered to Executive. Pursuant to the terms of the Memorandum of Option Grant, 25% of the Options will vest every six months until all of the Options have vested, and have an exercise price of $3.38 per share.

2.4 Automobile Allowance. Executive will be entitled to receive an automobile allowance equal to seven hundred fifty dollars ($750) per month, paid on a biweekly basis, in reimbursement of all expenses associated with the operation, maintenance and use of a vehicle for business purposes.

2.5 Standard Company Benefits and Vacation. Executive shall be entitled to those benefits provided to the Company’s executives generally and for which he is eligible pursuant to the terms and conditions of the relevant plans. Executive shall be entitled to four (4) weeks of paid vacation per year.

2.6 Business Expenses. The Company shall promptly reimburse Executive for all reasonable and necessary business expenses incurred by Executive in connection with the business of the Company and the performance of his duties under this Agreement, subject to Executive providing the company with reasonable documentation thereof. It is agreed that Executive shall be reimbursed for mid-week lodging expense in Orange County, California.

2.7 Excise Tax. If any payments or transfers of property to be made to Executive hereunder are subject, in whole or in part, to the excise tax imposed by Section 4999 of the Internal Revenue Code of 1986 (the “Excise Tax”) and application of Section 280G of such Code, and can be avoided by an appropriate stockholder vote pursuant to Section 280G(b)(5)(A) of the Code, the Company and Executive agree that, if requested by Executive at least 15 days prior to the date that proxy materials are first submitted to the Securities and Exchange Commission or mailed to stockholders, the Company will (i) include in any such proxy materials information appropriate to submit the benefits provided to Executive under this Agreement to stockholder vote and (ii) recommend approval of any such proposal.

3. Confidential Information, Rights and Duties.

3.1 Agreement.

(a) Confidential Information.

(i) Executive specifically agrees that he shall not at any time, either during or subsequent to the term of his employment with the Company, in any fashion, form or manner, either directly or indirectly, unless expressly consented to in writing by the Company, use, divulge, disclose or communicate to any person or entity any confidential information of any kind, nature or description concerning any matters affecting or relating to the business of the Company, including, but not limited to: the Company’s sales and marketing methods, programs and related data, or other written records used in the Company’s business; the Company’s computer processes, programs and codes; the names, addresses, buying habits or practices of any of its clients or customers; compensation paid to other employees and independent contractors and other terms of this employment or contractual relationships; or any other confidential information of, about or concerning the business of the Company, its manner of operations, or other data of any kind, nature or description. The parties to this Agreement hereby stipulate that, as between them, the above information and items are important, material and confidential trade secrets that affect the successful conduct of the Company’s business and its good will, and that any breach of any term of this section is a material breach of this Agreement. All equipment, notebooks, documents, memoranda, reports, files, samples, books, correspondence, lists or other written and graphic records, and the like, including tangible or intangible computer programs, records and data, affecting or relating to the business of the Company, which the Executive might prepare, use, construct, observe, posses or control, shall be and shall remain the Company’s sole property.

(ii) For purposes of this Agreement, the term “confidential information” shall not include any information that: (A) has been made public by the Company (other than by acts of Executive in violation of this Agreement or other obligation of confidentiality); (B) is developed by Executive independently of any information the Executive learns in the course of fulfilling his duties hereunder; or (C) Executive is legally compelled to

disclose; provided that (1) Executive is advised by written opinion of the Executive’s counsel, who shall be reasonably satisfactory to the Company, that he is legally required to disclose such information and (2) Executive notifies the Company of such proposed disclosure in as far in advance of its disclosure as is practicable and uses his best efforts to obtain assurances that confidential treatment will be accorded to such information.

(b) Non-Interference. Any wrongful interference with the Company’s business, property, confidential information, trade secrets, clients, customers, employees or independent contractors by the Executive or any of Executive’s agents during or after the term of Executive’s employment shall be treated and acknowledged by the parties as a material breach of this Agreement. If such interference occurs at a time that Executive is employed by the Company, such interference shall be grounds for the Company to terminate Executive for Cause.

3.2 Remedies. Executive’s duties under this Section 3 shall survive termination of Executive’s employment with the Company. Executive acknowledges that a remedy at law for any breach or threatened breach by Executive of the provisions of this Section 3 would be inadequate, and Executive therefore agrees that the Company shall be entitled to injunctive relief in case of any such breach or threatened breach.

4. Outside Activities.

4.1 Activities. Except with the prior written consent of the Chief Executive Officer, Executive will not during his employment with the Company undertake or engage in any other employment, occupation or business enterprise, other than ones in which Executive is a passive investor. Executive may engage in civic and not-for-profit activities so long as such activities do not materially interfere with the performance of his duties hereunder. It is acknowledged by the Company and Executive that Executive’s membership on two boards of directors of publicly listed, non-competing companies will not materially interfere with the performance of his duties hereunder and that such positions are deemed approved by the Company.

4.2 Investments and Interests. Executive agrees not to acquire, assume or participate in, directly or indirectly, any material position, investment or interest known by him to be adverse or antagonistic to the Company, its business or prospects, financial or otherwise.

4.3 Non-Competition. During his employment by the Company, except on behalf of the Company, Executive will not directly or indirectly, whether as an officer, director, stockholder, partner, proprietor, associate, representative, consultant, or in any capacity whatsoever engage in, become financially interested in, be employed by or have any business connection with any other person, corporation, firm, partnership or other entity whatsoever which were known by him to compete directly with the Company, throughout the world, in any line of business engaged in (or planned to be engaged in) by the Company.

5. Termination Of Employment.

5.1 Termination With or Without Cause.

(a) At-Will Employment. Executive’s relationship with the Company is at-will. The Company shall have the right to terminate Executive’s employment with the Company at any time with or without Cause and with or without notice.

(b) Definition of Cause. For purposes of this Agreement and the Memorandum of Option Grant, “Cause” is defined as the occurrence of one or more of the following: (i) Executive is convicted of or pleads guilty or no lo contendere to a felony or any crime involving moral turpitude; (ii) Executive breaches this Agreement or any Agreement entered into with the Company in a manner that materially and adversely affects the Company; (iii) Executive commits willful misconduct that materially and adversely impacts the Company; or (iv) Executive fails, after receipt of written notice and after receiving a period of at least fifteen (15) days following such notice, to follow the direction of the Board of Directors and perform his obligations hereunder.

(c) Termination for Cause. If Executive is terminated with Cause, the Company shall pay Executive the compensation and benefits otherwise payable to Executive under Section 2.1 through the date of termination. Executive’s rights under the Company’s benefit plans of general application shall be determined under the provisions of those plans. All other compensation from and after such termination shall cease (except for those benefits that must be continued pursuant to applicable law or by the terms of such benefit plans), and Executive shall not be entitled to any severance pay or other payment or compensation whatsoever upon such termination.

5.2 Voluntary Termination; Death or Disability.

(a) Voluntary Termination. Executive may voluntarily terminate his employment with the Company at any time, after which no further compensation will be paid to Executive, except as specifically set forth herein.

(b) Death or Disability. The Executive’s employment under this Agreement shall terminate immediately and without notice by the Company upon the death or disability of the Executive. In the event of Executive’s termination due death or disability, he will not be entitled to severance pay, pay in lieu of notice or any other such compensation. For purposes of this Agreement and the Memorandum of Option Grant, the Executive will be deemed to have a disability if he becomes physically or mentally incapacitated or disabled or otherwise unable to fully discharge his duties hereunder for a period of 60 consecutive calendar days or for 120 days in any 360-day period.

(c) No Severance Pay. In the event of Executive’s death or disability or if Executive voluntarily terminates his employment other than due to a Constructive Termination, he will not be entitled to severance pay, pay in lieu of notice or any other such compensation.

(d) Definition of Constructive Termination. For purposes of this Agreement and the Memorandum of Option Grant, “Constructive Termination” shall mean any one of the following events which occurs on or after the date of this Agreement: (i) reduction of the Executive’s annual base salary; (ii) a material reduction in Executive’s duties or a reduction in Executive’s title; (iii) a relocation of Executive’s office to a location outside of Los Angeles

County or Orange County, California; (iv) any material breach by the Company of its obligations under this Agreement; or (v) any failure by the Company to obtain the assumption of this Agreement by any successor or assign of the Company.

5.3 Severance Benefits.

(a) Severance Payment. In the event the Company terminates Executive’s employment without Cause or if Executive terminates his employment due to a Constructive Termination, and provided that Executive timely executes a release as described in Section 8 hereof, Executive shall be entitled to a severance payment equal to: (i) 25% of Executive’s then existing base salary (exclusive of bonus or any other benefits) if such termination occurs on or prior to March 31, 2004; (ii) 50% of Executive’s then existing base salary (exclusive of bonus or any other benefits) if such termination occurs after March 31, 2004 and on or prior to September 30, 2004; or (iii) 100% of Executive’s then existing base salary (exclusive of bonus or any other benefits) if such termination occurs after September 30, 2004.

(b) Stock Options. In the event the Company terminates Executive’s employment without Cause or if Executive terminates his employment due to a Constructive Termination, Executive’s outstanding stock options shall be treated as provided in the documents governing such stock option grants.

(c) Healthcare Coverage. If Executive has been employed by the Company for more than one year, he may elect to continue his medical coverage under COBRA. Assuming Executive exercises his right to continued medical benefits in accordance with COBRA, the Company will pay the premiums for Executive’s COBRA coverage as they become due (including the premiums for any dependent coverage he elects) until the earlier of: (i) the date Executive accepts full time employment and/or becomes covered under another plan; (ii) the date he is otherwise no longer eligible for COBRA coverage; or (iii) twelve (12) months after the effective date of separation. This Section 5.3(c) shall not apply if Executive’s employment is terminated due to death or disability.

5.4 Cessation. If Executive violates any provision of Sections 3, 7 or 8 of this Agreement, any severance payments or other benefits being provided to Executive will cease immediately, and Executive will not be entitled to any further compensation from the Company.

6. Change Of Control.

6.1 Definition of Change of Control. For purposes of this Agreement and the Memorandum of Option Grant, “Change of Control” means the occurrence of any of the following: (i) a sale of all or substantially all of the assets of the Company to any other person or entity (other than an affiliate of the Company); (ii) a merger or consolidation involving the Company in which the Company is not the surviving corporation and the stockholders of the Company immediately prior to the completion of such transaction hold, directly or indirectly, less than fifty percent (50%) of the beneficial ownership (within the meaning of Rule 13d-3 promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), or comparable successor rules) of the securities of the surviving corporation (excluding any stockholders who possessed a beneficial ownership interest in the surviving corporation prior to the completion of such transaction); or (iii) an acquisition by any person, entity or group within

the meaning of Section 13(d) or 14(d) of the Exchange Act or any comparable successor provisions (excluding any Affiliate of the Company or any employee benefit plan, or related trust, sponsored or maintained by the Company) of the beneficial ownership (within the meaning of Rule 13d-3 promulgated under the Exchange Act, or comparable successor rules) of securities of the Company representing at least fifty percent (50%) of the combined voting power entitled to vote in the election of directors.

6.2 Change of Control Termination. Notwithstanding Section 5.3(a) to the contrary, in the event Executive’s employment with the Company terminates other than (a) for Cause or (b) due to death, disability or voluntary termination by the Executive, and such termination occurs sixty (60) days prior to or twelve (12) months after such Change of Control (a “Change of Control Termination”), then Executive shall be eligible to receive, upon timely execution of a release as described in Section 8 hereof, (i) a severance payment in cash equal to 100% of Executive’s then existing base salary (exclusive of bonus or any other benefits) and (ii) the benefits set forth in the Memorandum of Option Grant.

7. Noninterference.

While employed by the Company, and for two (2) years immediately following the termination date of Executive’s employment, Executive agrees not to interfere with the business of the Company.

7.1 Employees. Executive shall not solicit, attempt to solicit, induce, or otherwise cause any employee of the Company to terminate his or her employment in order to become an employee, consultant or independent contractor to or for any competitor of the Company.

7.2 Customers. Executive shall not directly or indirectly solicit (for a business competitive with the Company) the business of any customer of the Company which at the time of termination or one (1) year immediately prior thereto was listed on the Company’s customer list.

8. Release.

In exchange for the benefits and other consideration under this Agreement to which Executive would not otherwise be entitled, Executive shall enter into and execute a release substantially in the form attached hereto as Exhibit A (the “Release”) upon his termination of employment. Unless the Release is executed by Executive and delivered to the Company within twenty-one (21) days after the termination of Executive’s employment with the Company, Executive shall not receive any severance benefits provided under this Agreement or under the Memorandum of Option Grant. Additionally, unless the Release is executed by Executive and delivered to the Company within twenty-one (21) days after the termination of Executive’s employment with the Company (and such release is not revoked), any acceleration of Executive’s options as provided in the Memorandum of Option Grant shall not be effective.

9. General Provisions.

9.1 Notices. Any notices provided hereunder must be in writing and shall be deemed effective upon the earlier of personal delivery (including personal delivery by facsimile

transmission) or the third day after mailing by first class mail, to the Company at its primary office location and to Executive at his address as listed on the Company payroll.

9.2 Severability. Whenever possible, each provision of this Agreement and the Memorandum of Option Grant will be interpreted in such manner as to be effective and valid under applicable law, but if any provision of this Agreement or the Memorandum of Option Grant is held to be invalid, illegal or unenforceable in any respect under any applicable law or rule in any jurisdiction, such invalidity, illegality or unenforceability will not affect any other provision or any other jurisdiction, but this Agreement or the Memorandum of Option Grant, as the case may be, will be reformed, construed and enforced in such jurisdiction as if such invalid, illegal or unenforceable provisions had never been contained herein or therein.

9.3 Waiver. If either party should waive any breach of any provisions of this Agreement, he or it shall not thereby be deemed to have waived any preceding or succeeding breach of the same or any other provision of this Agreement.

9.4 Complete Agreement. This Agreement, together with the Memorandum of Option Grant, constitutes the entire agreement between Executive and the Company and it is the complete, final, and exclusive embodiment of their agreement and supersedes any prior agreement written or otherwise between Executive and the Company with regard to this subject matter. It is entered into without reliance on any promise or representation other than those expressly contained herein or therein, and it cannot be modified or amended except in a writing signed by an officer of the Company.

9.5 Counterparts. This Agreement may be executed in separate counterparts, any one of which need not contain signatures of more than one party, but all of which taken together will constitute one and the same agreement or plan.

9.6 Headings. The headings of the sections hereof and of the Memorandum of Option Grant are inserted for convenience only and shall not be deemed to constitute a part hereof or thereof nor to affect the meaning thereof.

9.7 Successors and Assigns. This Agreement is intended to bind and inure to the benefit of and be enforceable by Executive and the Company and their respective successors, assigns, heirs, executors and administrators, except that Executive may not assign any of his duties hereunder or thereunder and he may not assign any of his rights hereunder or thereunder without the written consent of the Company.

9.8 Attorney Fees. If either party hereto brings any action to enforce his or its rights hereunder, the prevailing party in any such action shall be entitled to recover his or its reasonable attorneys’ fees and costs incurred in connection with such action.

9.9 Arbitration. To provide a mechanism for rapid and economical dispute resolution, Executive and the Company agree that any and all disputes, claims, or causes of action, in law or equity, arising from or relating to this Agreement (including the Release) and the Memorandum of Option Grant or their respective enforcement, performance, breach, or interpretation, will be resolved, to the fullest extent permitted by law, by final, binding, and confidential arbitration before a single arbitrator held in Irvine, California and conducted by Judicial Arbitration & Mediation Services/Endispute (“JAMS”), under its then-existing Rules

and Procedures. The parties shall be entitled to conduct adequate discovery, and they may obtain all remedies available to the parties as if the matter had been tried in court. The arbitrator shall issue a written decision which specifies the findings of fact and conclusions of law on which the arbitrator’s decision is based. Judgment upon the award rendered by the arbitrator may be entered by any court having jurisdiction thereof. Unless otherwise required by law, the arbitrator will award reasonable expenses (including reimbursement of the assigned arbitration costs) to the prevailing party. Nothing in this Section 9.9 or in this Agreement or the Memorandum of Option Grant is intended to prevent either Executive or the Company from obtaining injunctive relief in court to prevent irreparable harm pending the conclusion of any such arbitration.

9.10 Governing Law. All questions concerning the construction, validity and interpretation of this Agreement will be governed by the law of the State of California as applied to contracts made and to be performed entirely within California, excluding the rules on conflicts of law.

IN WITNESS WHEREOF, the parties have executed this Agreement on the day and year first above written.

DIEDRICH COFFEE, INC.		EXECUTIVE


By:	/s/ Roger M. Laverty	/s/ Martin A. Lynch
	Roger M. Laverty	Martin A. Lynch
	Chief Executive Officer

EXHIBIT A

RELEASE AGREEMENT

I understand that my position with Diedrich Coffee, Inc. (the “Company”) terminated effective , 20 (the “Separation Date”). The Company has agreed that if I choose to sign this Agreement, the Company will pay me severance benefits (minus the standard withholdings and deductions) pursuant to the terms of the Employment Agreement entered into as of the 26 day of March 2004 between myself and the Company. I understand that I am not entitled to this severance payment unless I sign this Agreement. I understand that in addition to this severance, the Company will pay me all of my accrued salary and vacation, to which I am entitled by law regardless of whether I sign this release.

In consideration for the severance payment I am receiving under this Agreement, I agree not to use or disclose any of the Company’s proprietary information without written authorization from the Company, to immediately return all Company property and documents (including all embodiments of proprietary information) and all copies thereof in my possession or control, and to release the Company and its current and former officers, directors, agents, attorneys, employees, shareholders, and affiliates from any and all claims, liabilities, demands, causes of action, attorneys’ fees, damages, or obligations of every kind and nature, whether they are known or unknown, arising at any time prior to the date I sign this Agreement. This general release includes, but is not limited to: all federal and state statutory and common law claims, claims related to my employment or the termination of my employment or related to breach of contract, tort, wrongful termination, discrimination, wages or benefits, or claims for any form of compensation. This release is not intended to release any claims I have or may have against any of the released parties for (a) indemnification as a director, officer, agent or employee under applicable law, charter document or agreement, (b) severance and other termination benefits specifically provided for in my Employment Agreement and the Memorandum of Option Grant which constitute a part of the consideration for this release, (c) health or other insurance benefits based on claims already submitted or which are covered claims properly submitted in the future, (d) vested rights under pension, retirement or other benefit plans, or (e) in respect of events, acts or omissions occurring after the date of this Release Agreement. In releasing claims unknown to me at present, I am waiving all rights and benefits under Section 1542 of the California Civil Code, and any law or legal principle of similar effect in any jurisdiction: “A general release does not extend to claims which the creditor does not know or suspect to exist in his favor at the time of executing the release, which if known by him must have materially affected his settlement with the debtor.”

I acknowledge that I am knowingly and voluntarily waiving and releasing any rights I may have under the federal Age Discrimination in Employment Act of 1967, as amended (“ADEA”). I also acknowledge that the consideration given for the waiver in the above paragraph is in addition to anything of value to which I was already entitled. I have been advised by this writing, as required by the ADEA that: (a) my waiver and release do not apply to any claims that may arise after my signing of this Agreement; (b) I should consult with an attorney prior to executing this release, (c) I have twenty-one (21) days within which to consider this release (although I may choose to voluntarily execute this release earlier); (d) I have seven (7) days following the execution of this release to revoke the Agreement; and (e) this Agreement will not

be effective until the eighth day after this Agreement has been signed both by me and by the Company.

This Agreement constitutes the complete, final and exclusive embodiment of the entire agreement between the Company and me with regard to the subject matter hereof. I am not relying on any promise or representation by the Company that is not expressly stated herein. This Agreement may only be modified by a writing signed by both me and a duly authorized officer of the Company.

I accept and agree to the terms and conditions stated above:

/s/ Martin A. Lynch
Martin A. Lynch

Dated: April 22, 2004	/s/ Roger M. Laverty
	Name: Roger M. Laverty
	Title: President and Chief Executive Officer

Dated: April 22, 2004	/s/ Martin A. Lynch
	Name: Martin A. Lynch
	Title: Executive Vice President and Chief Financial Officer