UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

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

For the quarterly period ended March 9, 2005

OR

¨ 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 x  NO ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ¨  No x

As of June 13, 2005, there were 5,272,789 shares of common stock of the registrant outstanding.

DIEDRICH COFFEE, INC.

INDEX

	Page Number
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	22
Item 4. Controls and Procedures	22
PART II – OTHER INFORMATION
Item 1. Legal Proceedings	23
Item 6. Exhibits	24
Signatures	27

i

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements.

DIEDRICH COFFEE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(UNAUDITED)

	March 9, 2005			June 30, 2004
Assets
Current assets:
Cash	$	17,998,000		$	1,799,000
Accounts receivable, less allowance for doubtful accounts of $1,393,000 at March 9, 2005 and $990,000 at June 30, 2004		2,315,000			2,337,000
Inventories		3,086,000			2,815,000
Current portion of notes receivable		1,185,000			81,000
Advertising fund assets, restricted		414,000			370,000
Prepaid expenses		790,000			341,000
Total current assets		25,788,000			7,743,000
Property, plant and equipment, net		7,347,000			7,111,000
Goodwill		8,179,000			10,190,000
Notes receivable, net of $1,594,000 of deferred interest, excluding current installments		4,459,000			153,000
Other assets		445,000			445,000
Total assets	$	46,218,000		$	25,642,000
Liabilities and Stockholders’ Equity
Current liabilities:
Current installments of obligations under capital leases	$	122,000		$	160,000
Current installments of long-term debt		425,000			200,000
Accounts payable		2,621,000			2,144,000
Accrued compensation		2,569,000			2,074,000
Accrued expenses		849,000			732,000
Income taxes payable		3,376,000			—
Franchisee deposits		638,000			611,000
Deferred franchise fee income		135,000			702,000
Advertising fund liabilities		414,000			370,000
Accrued provision for store closure		89,000			109,000
Total current liabilities		11,238,000			7,102,000
Obligations under capital leases, excluding current installments		319,000			390,000
Long term debt, less unamortized discount of $8,000 at March 9, 2005 and $0 at June 30, 2004, excluding current installments		1,288,000			783,000
Deferred rent		471,000			490,000
Common stock warrants		9,000			—
Total liabilities		13,325,000			8,765,000
Commitments and contingencies (notes 3, 4 and 7)
Stockholders’ equity:
Common stock, $0.01 par value; authorized 8,750,000 shares; issued and outstanding 5,272,000 shares at March 9, 2005 and 5,161,000 at June 30, 2004		52,000			52,000
Additional paid-in capital		58,422,000			58,058,000
Accumulated deficit		(25,581,000	)		(41,233,000	)
Total stockholders’ equity		32,893,000			16,877,000
Total liabilities and stockholders’ equity	$	46,218,000		$	25,642,000

See accompanying notes to condensed consolidated financial statements

1

DIEDRICH COFFEE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

	Twelve Weeks Ended March 9, 2005			Twelve Weeks Ended March 10, 2004			Thirty-six Weeks Ended March 9, 2005			Thirty-six Weeks Ended March 10, 2004 (Restated)
Net revenue:
Retail sales	$	7,115,000		$	7,281,000		$	21,801,000		$	21,725,000
Wholesale and other		3,427,000			3,224,000			11,374,000			10,714,000
Franchise revenue		1,082,000			1,168,000			3,107,000			3,179,000
Total net revenue		11,624,000			11,673,000			36,282,000			35,618,000
Costs and expenses:
Cost of sales and related occupancy costs		5,807,000			5,616,000			17,913,000			17,257,000
Operating expenses		3,799,000			3,866,000			11,584,000			11,548,000
Depreciation and amortization		563,000			513,000			1,697,000			1,541,000
General and administrative expenses		2,334,000			2,323,000			7,547,000			6,793,000
Provision for asset impairment and restructuring		—			—			—			94,000
(Gain) loss on asset disposals		(2,000	)		5,000			(14,000	)		5,000
Total costs and expenses		12,501,000			12,323,000			38,727,000			37,238,000
Operating loss		(877,000	)		(650,000	)		(2,445,000	)		(1,620,000	)
Interest expense		(52,000	)		(67,000	)		(145,000	)		(203,000	)
Interest and other income, net		56,000			9,000			55,000			17,000
Loss from continuing operations before income tax provision		(873,000	)		(708,000	)		(2,535,000	)		(1,806,000	)
Income tax provision		—			1,000			—			1,000
Net loss from continuing operations		(873,000	)		(709,000	)		(2,535,000	)		(1,807,000	)
Discontinued operations:
Income from operations of discontinued operations, net of $1,000, $9,000, $12,000 and $19,000 tax, respectively		916,000			640,000			2,629,000			2,094,000
Gain on sale of discontinued operations, net of $3,376,000 taxes		15,558,000			—			15,558,000			—
Net income (loss)	$	15,601,000		$	(69,000	)	$	15,652,000		$	287,000
Basic net income (loss) per share:
Loss from continuing operations	$	(0.17	)	$	(0.14	)	$	(0.49	)	$	(0.35	)
Income from discontinued operations, net	$	3.16		$	0.12		$	3.50		$	0.41
Net income (loss)	$	2.99		$	(0.01	)	$	3.01		$	0.06
Diluted net income (loss) per share:
Loss from continuing operations	$	(0.17	)	$	(0.14	)	$	(0.49	)	$	(0.35	)
Income from discontinued operations, net	$	3.07		$	0.12		$	3.17		$	0.40
Net income (loss)	$	2.91		$	(0.01	)	$	2.73		$	0.06
Weighted average and equivalent shares outstanding:
Basic		5,214,000			5,161,000			5,194,000			5,161,000
Diluted		5,368,000			5,161,000			5,734,000			5,189,000

See accompanying notes to condensed consolidated financial statements

2

DIEDRICH COFFEE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

	Thirty-six Weeks Ended March 9, 2005			Thirty-six Weeks Ended March 10, 2004 (Restated)
Cash flows from operating activities:
Net income	$	15,652,000		$	287,000
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		1,697,000			1,541,000
Amortization of loan fees		23,000			64,000
Amortization of note payable discount		1,000			—
Provision for bad debt		596,000			253,000
Provision for inventory obsolescence		69,000			176,000
Provision for asset impairment		—			90,000
Benefit from store closure		—			(70,000	)
Gain on sale of discontinued operations, net		(18,934,000	)		—
(Gain) loss on asset disposals		(14,000	)		5,000
Changes in operating assets and liabilities:
Accounts receivable		(574,000	)		(232,000	)
Inventories		(354,000	)		(140,000	)
Prepaid expenses		(449,000	)		240,000
Notes receivable		(27,000	)		—
Other assets		(405,000	)		(95,000	)
Accounts payable		477,000			(78,000	)
Accrued compensation		495,000			530,000
Accrued expenses		116,000			(4,000	)
Income taxes payable		3,376,000			—
Franchisee deposits		27,000			(23,000	)
Deferred franchise fee income		(567,000	)		132,000
Accrued provision for store closure		(20,000	)		(218,000	)
Deferred rent		(19,000	)		12,000
Net cash provided by operating activities		1,166,000			2,470,000
Cash flows from investing activities:
Capital expenditures for property, plant and equipment		(1,942,000	)		(1,706,000	)
Proceeds from disposal of property, plant and equipment		31,000			8,000
Proceeds from sale of discontinued operations		16,000,000			—
Acquisition of goodwill		(80,000	)		—
Principal payments on notes receivable		30,000			26,000
Net cash provided by (used in) investing activities		14,039,000			(1,672,000	)
Cash flows from financing activities:
Proceeds from exercise of common stock options, net of tax		364,000			—
Release of restricted cash		—			(957,000	)
Borrowings under credit agreement		1,000,000			—
Payments on long-term debt		(261,000	)		(958,000	)
Payments on capital lease obligations		(109,000	)		(116,000	)
Net cash provided by (used in) financing activities		994,000			(2,031,000	)
Net increase (decrease) in cash		16,199,000			(1,233,000	)
Cash at beginning of period		1,799,000			2,625,000
Cash at end of period	$	17,998,000		$	1,392,000
Supplemental disclosures of cash flow information:
Non-cash transactions:
Value of common stock warrants recorded as debt discount	$	8,000		$	—
Cash paid during the period for:
Interest	$	120,000		$	133,000
Income taxes	$	12,000		$	20,000

See accompanying notes to condensed consolidated financial statements

3

DIEDRICH COFFEE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH 9, 2005

(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 12, 2004.

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.

Restatement of Unaudited Condensed Consolidated Financial Statements

The Company restated its previously issued unaudited condensed consolidated financial statements for the first three quarters of the previous fiscal year. As part of the Company’s accounting activities during its year-end audit, the Company determined that an adjustment was required to recognize $113,000 of additional franchise revenue in the first quarter of fiscal 2004 under an area development agreement that had terminated in that quarter. The Company originally recorded this franchise revenue in the fourth quarter of fiscal 2004. As a consequence, a correction of reported year-to-date income for its second and third quarters of fiscal year 2004 was also required. This adjustment had no effect on reported revenues or earnings for the 2004 fiscal year. The net effect of all of the adjustments was to increase first fiscal quarter 2004 revenue and earnings by $113,000 and to reduce fourth fiscal quarter 2004 revenue and earnings by the same amount. This adjustment increased basic and diluted net income per share by $0.02, $0.02 and $0.03 in the first, second and third quarters of fiscal 2004, respectively.

On April 1, 2005, the Company completed a review of its lease accounting procedures and concluded that these procedures were in error and that prior year period financial statements required restatement. The Company publicly announced that information on April 1, 2005. The results of the review were provided to the Company’s former independent auditor which had rendered opinions on the affected prior period financial statements, but it has been unable to complete its re-audit of the prior periods in time for the filing of this quarterly report. The Company anticipates that its former independent auditor will complete its re-audit in the fourth quarter of the Company’s current fiscal year. Based on most current data, but subject to the completion of the ongoing audit by the Company’s former auditor, the Company expects that the cumulative effect of the restatements for prior year accounting errors, when recorded, will be an increase of prior reported earnings of $0.01 per share in fiscal 2004, an increase of prior reported loss of $0.02 per share in fiscal 2003 and a reduction of prior reported earnings of $0.06 per share in fiscal 2002 and a reduction of shareholders equity at June 30, 2004 of approximately $498,000. Subject to the review by the Company’s former and current independent auditors for their applicable period, earnings for the current and prior year third quarters, and for the first three quarters of each year, are not expected to change as a result of the restatement.

Recent Accounting Pronouncements

On June 30, 2004, the Company completed its adoption of FASB Interpretation No. 46 (revised), “Consolidation of Variable Interest Entities — an interpretation of Accounting Research Bulletin (“ARB”) No. 51” (“FIN 46R”), which was issued in January 2003 and which is effective for all reporting periods ending after March 15, 2004.

FIN 46R addresses the consolidation of entities in which a reporting enterprise has an economic interest, but for which the traditional voting interest approach to consolidation, based on voting rights, is ineffective in identifying where control of the entity lies, or in which the equity investors do not bear the economic risks and rewards of the entity. FIN 46R refers to those entities as variable interest entities (“VIEs”). FIN 46R requires the consolidation of VIEs by the primary entity that absorbs a majority of the economic risks and rewards from the activities of the VIE.

The principal entities in which the Company possesses a variable interest are franchisees. The Company does not possess any ownership interests in its franchisees, but it provides financial support to a number of franchisees by serving as the primary obligor on lease obligations for properties in which the franchisees operate their business. There are also some franchised coffeehouses that are VIEs in which the Company holds a significant variable interest, but which the Company does not consolidate because the Company is not the primary entity that absorbs a majority of the economic risks and rewards from the activities of the franchised coffeehouse. The adoption of FIN 46R did not result in the consolidation of any franchise entities.

4

The Company utilizes a segregated advertising fund to administer contributions received from its franchisees for advertising programs. Upon the adoption of FIN 46R, the Company consolidated the advertising fund. The Company has included $414,000 of advertising fund assets, restricted and advertising fund liabilities in the accompanying unaudited condensed consolidated balance sheet as of March 9, 2005. The advertising contributions and disbursements are reported in the unaudited condensed consolidated statement of operations on a net basis whereby contributions from franchisees are recorded as offsets to the Company’s reported general and administrative expenses.

In December 2004, the FASB reissued Statement of Financial Accounting Standard (“SFAS”) No. 123 as SFAS No. 123R, “Share Based Compensation.” Under SFAS No. 123R, public entities will be required to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award and recognize the cost over the period during which an employee is required to render services in exchange for the award. Additionally, SFAS No. 123R will require entities to record compensation expense for employee stock purchase plans that may not have previously been considered compensatory under the existing rules. SFAS No. 123R will be effective for annual reporting periods beginning on or after June 15, 2005. The Company has not yet determined the impact that adopting SFAS No. 123R will have on its results of operations.

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs,” which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material. SFAS No. 151 will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company has not yet determined the impact that adopting SFAS No. 151 will have on its results of operations.

Income Taxes

The Company accounts for income taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and for operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income in the period that includes the enactment date.

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 materially differ from those estimates.

Stock Option Plans

The Company currently applies the intrinsic value-method of accounting prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations (“APB No. 25”), in accounting for employee stock options. Accordingly, compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. 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 loss and pro forma net loss per share, as if the fair value-based method of SFAS No. 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 9, 2005			March 10, 2004			March 9, 2005			March 10, 2004 (Restated)
Net income (loss)	$	15,601,000		$	(69,000	)	$	15,652,000		$	287,000
SFAS No. 123 option expense		(102,000	)		(268,000	)		(432,000	)		(654,000	)
Pro forma net income (loss)	$	15,499,000		$	(337,000	)	$	15,220,000		$	(367,000	)
Basic income (loss) per share – as reported	$	2.99		$	(0.01	)	$	3.01		$	0.06
Diluted income (loss) per share – as reported	$	2.91		$	(0.01	)	$	2.73		$	0.06
Basic income (loss) per share – pro forma	$	2.97		$	(0.07	)	$	2.93		$	(0.07	)
Diluted income (loss) per share – pro forma	$	2.89		$	(0.07	)	$	2.65		$	(0.07	)

5

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

	TWELVE WEEKS ENDED				THIRTY-SIX WEEKS ENDED
Pro Forma	March 9, 2005		March 10, 2004		March 9, 2005		March 10, 2004
Risk free interest rate	3.81	%	2.57	%	3.81	%	2.57	%
Expected life	6 years		6 years		6 years		6 years
Expected volatility	40	%	99	%	43	%	99	%
Expected dividend yield	0	%	0	%	0	%	0	%

Reclassifications

Certain reclassifications have been made to the March 10, 2004 unaudited condensed consolidated financial statements to conform to the March 9, 2005 presentation.

2. INVENTORIES

Inventories consist of the following:

	March 9, 2005		June 30, 2004
Unroasted coffee	$	1,300,000	$	1,067,000
Roasted coffee		526,000		632,000
Accessory and specialty items		181,000		198,000
Other food, beverage and supplies		1,079,000		918,000
Total inventory	$	3,086,000	$	2,815,000

3. LONG-TERM DEBT

Long-term debt consists of the following:

	March 9, 2005			June 30, 2004
Note payable bearing interest at a rate of LIBOR plus 3.30% and payable in monthly installments of $35,417 with balance due on May 10, 2007. Note is unsecured. Net of $8,000 unamortized discount.	$	1,713,000		$	983,000
Less: current installments		(425,000	)		(200,000	)
Long-term debt, excluding current installments	$	1,288,000		$	783,000

On May 10, 2004, the Company entered into a $5,000,000 Contingent Convertible Note Purchase Agreement. The agreement provides for the Company, at its election, to issue notes to the lender, Sequoia Enterprises L.P., with up to an aggregate principal amount of $5,000,000. The notes are amortized on a monthly basis at a rate that will repay 60% of the principal amount of the note by May 10, 2007. The remaining 40% will mature on that date. Interest is payable at LIBOR plus 3.30%, and a facility fee of 1.00% annually is payable on the unused portion of the facility. The agreement contains covenants that limit the amount of indebtedness that the Company may have outstanding in relation to its tangible net worth and that require the Company to maintain a specified minimum dollar value of EBITDA for the trailing four fiscal quarters, among others. As of March 9, 2005, the Company was in compliance with all debt covenants. Notes are convertible into the Company’s common stock only upon certain changes of control. In addition, as principal payments are made, the Company will issue the lender warrants to purchase shares of common stock. The number of warrants that the Company will issue will directly correlate to the amount of notes issued and repaid. The issued warrants will expire on May 10, 2008. The lender under this agreement is a limited partnership of which the chairman of the Company’s board of directors serves as the sole general partner. On May 10, 2004, upon entering into the agreement, the Company immediately issued a $1,000,000 note, and used the proceeds of the note and other available cash to repay all outstanding debt with Bank of the West (“BOW”). On September 15, 2004, the Company issued an additional $1,000,000 note under this facility.

In connection with the issuance of the two $1,000,000 notes issued under the Contingent Convertible Note Purchase Agreement on May 10, 2004 and September 15, 2004, the Company will issue a total of 253,164 and 202,020 warrants to purchase shares of common stock, respectively, as principal payments are made. The warrants are classified as debt instruments in accordance with Emerging Issues Task Force Issue No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.” The estimated fair value of the warrants on the date of issuance, $5,000 and $4,000, respectively, was

recorded as a discount to the face value of the notes issued and as a common stock warrants liability in the accompanying unaudited condensed consolidated balance sheet. As of March 9, 2005, the Company had issued 4,219 warrants.

6

On May 10, 2004, the Company also entered into an Amended and Restated Credit Agreement with BOW. The agreement provides for a working capital facility of $250,000 and a letter of credit facility of $750,000. On March 9, 2005, no debt was outstanding under the working capital facility and $576,000 of letters of credit were outstanding under the letter of credit facility. With respect to the working capital facility, the Company may elect to pay interest on amounts outstanding at the BOW reference rate plus 1.00% or LIBOR plus 3.25%. Borrowings and issuance of letters of credit under the BOW facility are secured by substantially all of the Company’s assets. Letters of credit issued under the letter of credit facility are subject to an annual fee of 2.00% of the face amount. The agreement contains covenants that limit the amount of indebtedness that the Company may have outstanding in relation to its tangible net worth and that require the Company to maintain a specified minimum dollar value of EBITDA for the trailing four fiscal quarters, among others. As of March 9, 2005, the Company was in compliance with all debt covenants. The working capital and letter of credit facilities expire on October 15, 2005.

Maturities of long-term debt, net of unamortized discount of $8,000, for years subsequent March 9, 2005 are as follows:

Payments due by period
12 months	$	425,000
13-24 months		425,000
25-36 months		863,000
Total long-term debt	$	1,713,000

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. These 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 June 30, 2004	$	425,000	$	36,000	$	(106,000	)	$	(246,000	)	$	109,000
Thirty-six Weeks ended March 9, 2005	$	109,000	$	—	$	—		$	(20,000	)	$	89,000

For the thirty-six weeks ended March 9, 2005, no expenses related to the provision for store closure were incurred. The Company made cash payments in the amount of $20,000 for rent expense at an impaired location.

7

5. EARNINGS PER SHARE

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

	Twelve Weeks Ended March 9, 2005			Twelve Weeks Ended March 10, 2004			Thirty-six Weeks Ended March 9, 2005			Thirty-six Weeks Ended March 10, 2004 (Restated)
Numerator:
Net loss from continuing operations	$	(873,000	)	$	(709,000	)	$	(2,535,000	)	$	(1,807,000	)
Denominator:
Basic weighted average shares outstanding		5,214,000			5,161,000			5,194,000			5,161,000
Effect of dilutive securities		—			—			—			—
Diluted adjusted weighted average shares		5,214,000			5,161,000			5,194,000			5,161,000
Basic and diluted net loss per share from continuing operations	$	(0.17	)	$	(0.14	)	$	(0.49	)	$	(0.35	)

For computation of net income per share from continuing operations, all 877,000 options outstanding as of March 9, 2005 were excluded from the calculation of diluted net loss per share for the twelve weeks and thirty-six weeks ended March 9, 2005 because their inclusion would have been anti-dilutive. In addition, all 504,000 outstanding warrants to purchase shares of common stock during the twelve weeks and thirty-six weeks ended March 9, 2005 were excluded from the calculation of diluted net loss per share for the twelve weeks and thirty-six weeks ended March 9, 2005 because their inclusion would have been anti-dilutive. All 972,000 outstanding options and all 527,000 outstanding warrants to purchase shares of common stock as of March 10, 2004 were excluded from the calculation of diluted net loss per share for the twelve weeks and thirty-six weeks ended March 10, 2004 because their inclusion would have been anti-dilutive.

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

	Twelve Weeks Ended March 9, 2005		Twelve Weeks Ended March 10, 2004			Thirty-six Weeks Ended March 9, 2005		Thirty-six Weeks Ended March 10, 2004 (Restated)
Numerator:
Net income (loss)	$	15,601,000	$	(69,000	)	$	15,652,000	$	287,000
Denominator:
Basic weighted average shares outstanding		5,214,000		5,161,000			5,194,000		5,161,000
Effect of dilutive securities		154,000		—			540,000		28,000
Diluted adjusted weighted average shares		5,368,000		5,161,000			5,734,000		5,189,000
Basic net income (loss) per share	$	2.99	$	(0.01	)	$	3.01	$	0.06
Diluted net income (loss) per share	$	2.91	$	(0.01	)	$	2.73	$	0.06

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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 (loss) before income taxes.

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

	TWELVE WEEKS ENDED						THIRTY-SIX WEEKS ENDED
	March 9, 2005			March 10, 2004			March 9, 2005			March 10, 2004 (Restated)
Revenue:
Retail	$	7,115,000		$	7,281,000		$	21,801,000		$	21,725,000
Wholesale		3,427,000			3,224,000			11,374,000			10,714,000
Franchise		1,082,000			1,168,000			3,107,000			3,179,000
Total revenue	$	11,624,000		$	11,673,000		$	36,282,000		$	35,618,000
Interest expense:
Retail	$	6,000		$	8,000		$	17,000		$	22,000
Franchise		4,000			6,000			17,000			27,000
Corporate		42,000			53,000			111,000			154,000
Total interest expense	$	52,000		$	67,000		$	145,000		$	203,000
Depreciation and amortization:
Retail	$	366,000		$	304,000		$	1,121,000		$	837,000
Wholesale		135,000			149,000			392,000			414,000
Franchise		—			—			—			—
Corporate		62,000			60,000			184,000			290,000
Total depreciation and amortization	$	563,000		$	513,000		$	1,697,000		$	1,541,000
Segment loss from continuing operations before income tax provision:
Retail	$	96,000		$	189,000		$	506,000		$	807,000
Wholesale		382,000			397,000			1,780,000			1,652,000
Franchise		1,001,000			1,099,000			2,846,000			2,814,000
Corporate		(2,352,000	)		(2,393,000	)		(7,667,000	)		(7,079,000	)
Total segment loss from continuing operations before income tax provision	$	(873,000	)	$	(708,000	)	$	(2,535,000	)	$	(1,806,000	)

	March 9, 2005		June 30, 2004
Identifiable assets:
Retail	$	6,494,000	$	5,521,000
Wholesale		6,097,000		5,487,000
Franchise		947,000		1,657,000
Corporate		24,501,000		2,787,000
Tangible assets		38,039,000		15,452,000
Goodwill - Retail		1,347,000		1,267,000
Goodwill - Wholesale		6,310,000		6,311,000
Goodwill - Franchise		522,000		2,612,000
Total assets	$	46,218,000	$	25,642,000

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7. LEASE CONTINGENCIES

The Company is liable on the master leases for 86 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 9, 2005, computed as the sum of all remaining lease payments through the expiration dates of the respective leases, was $18,210,000. 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. DISCONTINUED OPERATIONS

On February 11, 2005, the Company completed the sale of its Gloria Jean’s international franchise operations to Jireh International Pty. Ltd., formerly the Gloria Jean’s master franchisee for Australia, and certain of its affiliates (collectively, “Jireh”) for $16,000,000 in cash and an additional $7,020,000 payable over the next six years under license, roasting and consulting agreements. The sale resulted in a gain on the disposal of discontinued operations of $15,558,000, net of $3,376,000 taxes.

The sale included immediate transfer to Jireh of 338 Gloria Jean’s retail locations outside the U.S. and Puerto Rico, including 242 in Australia. After all payments have been made to the Company under the license, roasting and consulting agreements, all remaining Gloria Jean’s trademarks, including those in the U.S., will be transferred to Jireh. Concurrent with such future transfer, the Company’s U.S.-based Gloria Jean’s subsidiary will enter into a perpetual, royalty-free master franchise agreement with Jireh under which the Company will continue to have exclusive rights to operate, franchise and develop Gloria Jean’s locations throughout the U.S. and Puerto Rico and to continue its wholesale operations under the Gloria Jean’s Coffees brand in these same markets.

The Company has agreed to not compete internationally through its Diedrich Coffee and Coffee People brands for a period of two years from the date of sale. Other than that restriction, the Company’s domestic Gloria Jean’s outlets, its Castroville roasting operations, its wholesale operations and its company operated Diedrich Coffee and Coffee People retail outlets were not significantly affected by this transaction.

In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the financial results of Gloria Jean’s international franchise operations are reported as discontinued operations for all periods presented.

The financial results included in discontinued operations were as follows:

	TWELVE WEEKS ENDED				THIRTY-SIX WEEKS ENDED
	March 9, 2005		March 10, 2004		March 9, 2005		March 10, 2004 (Restated)
Net revenue	$	1,780,000	$	827,000	$	3,910,000	$	2,557,000
Earnings from discontinued operations before income taxes	$	917,000	$	649,000	$	2,641,000	$	2,113,000
Earnings from discontinued operations, net of $1,000 and $9,000 tax, respectively, for the twelve weeks ended and net of $12,000 and $19,000 tax, respectively, for the thirty-six weeks ended	$	916,000	$	640,000	$	2,629,000	$	2,094,000
Gain on sale of discontinued operations, net of $3,376,000 taxes		15,558,000		—		15,558,000		—
Total income (loss) from discontinued operations, net of tax	$	16,474,000	$	640,000	$	18,187,000	$	2,094,000

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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. A number of events and 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 report, along with the following possible events or factors:

• the financial and operating performance of our retail operations;

• our ability to maintain profitability over time;

• 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.

Additional 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 June 30, 2004 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.

INTRODUCTION

Management’s discussion and analysis of financial condition and results of operations is provided as a supplement to the accompanying unaudited condensed consolidated financial statements and footnotes to help provide an understanding of our financial condition, the changes in our financial condition and our results of operations. Our discussion is organized as follows:

• Overview. This section provides a general description of our business and recent significant transactions that we believe are important in understanding our results of operations. This section also contains a discussion of trends in our operations and key performance indicators that we use to evaluate business results.

• Results of operations. This section provides an analysis of our results of operations presented in the accompanying unaudited condensed consolidated statements of operations by comparing the results for the twelve and thirty-six weeks ended March 9, 2005 to the results for the twelve and thirty-six weeks ended March 10, 2004, respectively.

• Financial condition, liquidity and capital resources. This section provides an analysis of our cash flows, and a discussion of our outstanding debt and commitments, both firm and contingent, that existed as of March 9, 2005. Included in the discussion of outstanding debt is a discussion of our financial capacity to fund our future commitments and a discussion of other financing arrangements.

• Critical accounting estimates. This section contains a discussion of those accounting policies that we believe are important to our financial condition and results and that require significant judgment and estimates on the part of management in their application. In addition, all of our significant accounting policies, including the critical accounting policies, are summarized in Note 1 to the accompanying unaudited condensed consolidated financial statements.

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OVERVIEW

Sale of International Franchise Operations

On February 11, 2005, we announced that we had sold our international Gloria Jean’s operations to our former Australian master franchisee, Jireh International Pty. Ltd., and certain of its affiliates. Proceeds were $16,000,000 in cash and an additional $7,020,000 in payments to be received over the next six years under license, roasting and consulting agreements. The proceeds, net of costs of the transaction and net book value of assets sold, primarily goodwill related to the international operations, resulted in a gain of $15,558,000, or $2.71 per share, on a diluted basis, for the thirty-six weeks ended March 9, 2005.

Business

We are 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 in the Office Coffee Service market and to other wholesale customers, including restaurant chains and other retailers. We roast coffee at our coffee roasting facility in central California. It supplies freshly roasted coffee to our company operated and franchised retail locations and to our wholesale accounts.

Our brands include Diedrich Coffee, Gloria Jean’s and Coffee People. The Diedrich Coffee and Coffee People brands are primarily company store operations and the Gloria Jean’s brand is primarily a franchised store operation. As of March 9, 2005, we owned and operated 55 retail locations and franchised 142 other retail locations under these brands, for a total of 197 retail coffee outlets. As of March 9, 2005, our retail units were located in 33 states and we had over 460 wholesale accounts with Office Coffee Service distributors, chain and independent restaurants and others. Although the specialty coffee industry is dominated by a single company which has more than 8,000 locations, we are one of the nation’s largest specialty coffee retailers.

We believe that we are differentiated from other specialty coffee companies by the quality of our coffee products, the superior personalized customer service that we provide to our customers and the warm and friendly ambiance that our coffeehouses offer. We serve our distinctively roasted coffee products in all of our brand locations and an extensive variety of fine quality flavored whole bean coffees are offered in our Gloria Jean’s brand stores. Our roasting recipes take into account the specific variety, origin and physical characteristics of each coffee bean to maximize its unique flavor.

A table summarizing the relative sizes of each of our brands, on a unit count basis, and changes in unit count for each brand for fiscal 2004 and fiscal 2005 through the quarter ended March 9, 2005, is set forth below:

	Units at July 2, 2003	Opened	Closed		Net transfers between the Company and Franchise		Units at June 30, 2004	Opened	Closed		Sold (A)		Net transfers between the Company and Franchise		Units at March 9, 2005
Gloria Jean’s Brand
Company Operated	11	—	(3	)	2		10	1	(1	)	—		(2	)	8
Franchise – Domestic	143	10	(14	)	(2	)	137	8	(12	)	—		2		135
Franchise – International
Australia	142	55	(1	)	—		196	46	—		(242	)	—		—
Far East/Asia (B)	18	4	(3	)	—		19	—	—		(19	)	—		—
Mexico	15	3	(1	)	—		17	—	(3	)	(14	)	—		—
Other (C)	31	21	(2	)	—		50	14	(1	)	(63	)	—		—
Total Franchise - International	206	83	(7	)	—		282	60	(4	)	(338	)	—		—
Subtotal Gloria Jean’s	360	93	(24	)	—		429	69	(17	)	(338	)	—		143
Diedrich Coffee Brand
Company Operated	25	—	(2	)	—		23	—	—		—		—		23
Franchise – Domestic	10	—	(3	)	—		7	1	(1	)	—		—		7
Subtotal Diedrich	35	—	(5	)	—		30	1	(1	)	—		—		30
Coffee People Brand
Company Operated	22	1	—		—		23	1	—		—		—		24
Total	417	94	(29	)	—		482	71	(18	)	(338	)	—		197

(A) On February 11, 2005, in connection with the sale of our international Gloria Jean’s operations, we sold 338 retail locations to Jireh International Pty. Ltd. and certain of its affiliates.

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(B) Includes Japan and Korea.

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

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 are highest during our 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.

Key Performance Indicators

We use several key indicators to evaluate the performance of our business. These indicators include same-store sales growth, the number of company operated and franchised stores opened and closed, and the measured relationship of cost of sales and related occupancy costs, operating expenses and general and administrative expenses to sales.

Same-store sales growth, or comparative sales growth, is a primary statistic used in the retail industry to measure core revenues. This measure compares sales for all units open for one year or more to the comparable prior year period. We use this measure to evaluate single coffeehouse, total brand and total company sales performance. Until recently, comparable sales of our company operated stores and domestic franchised stores had declined, primarily as a result of aging stores, a lack of capital to fund store improvements, and no new store openings. New stores typically achieve relatively strong comparative sales growth in their early years. Franchised units that are located in shopping malls have also experienced declining sales due to overall declines in mall traffic.

The number of operating units opened and closed is also a measure of the health of our brands and our business, although it is affected by a number of factors, including the availability of capital to finance growth. In recent years, the number of domestic units has declined because the number of aging units closed exceeded the number of new units opened. Also, company operated stores have declined and franchised stores have increased. Unlike new company operated stores, new franchised stores do not require our capital. In addition, franchised stores typically make an immediate profit contribution, whereas company stores generally are not profitable in the first year. Domestic franchises historically generated more profit than international franchises because the domestic royalty fees are higher and because all domestic franchisees are required to purchase their coffee from us.

We use the relationship between cost of sales and related occupancy costs and operating expenses to sales to measure the operating efficiency of our individual coffeehouses and to measure the relationship between general and administrative expenses to sales to monitor and control the level of corporate overhead. In recent years, cost of sales and related occupancy costs have declined and gross margins have improved, primarily because wholesale sales, which have higher gross margins than retail sales, have become a higher percentage of our overall sales mix. Operating expenses have increased in the past two years as a result of dedicating more in-store labor and supervision to our retail stores. General and administrative expenses have increased as a percentage of sales due to staffing for accelerated growth and to the effect of continuing declines in sales on a relatively fixed expense base.

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Results of Operations.

Twelve weeks ended March 9, 2005 compared with the twelve weeks ended March 10, 2004

Restatement of Prior Period Condensed Consolidated Financial Statements. In the fourth quarter of fiscal year 2004, we restated our previously issued unaudited condensed consolidated financial statements for the first three quarters of the previous fiscal year. As part of our accounting activities during our year-end audit, we determined that an adjustment was required to recognize $113,000 of additional franchise revenue in the first quarter of fiscal 2004 under an area development agreement that had terminated in that quarter. We originally recorded this franchise revenue in the fourth quarter of fiscal 2004. As a consequence, a correction of reported year-to-date income for our second and third quarters of fiscal year 2004 was also required. This adjustment had no effect on reported revenues or earnings for the 2004 fiscal year. The net effect of all of the adjustments was to increase first fiscal quarter 2004 revenue and earnings by $113,000 and to reduce fourth fiscal quarter 2004 revenue and earnings by the same amount. This adjustment increased basic and diluted net income per share by $0.02, $0.02 and $0.03 in the first, second and third quarters of fiscal 2004, respectively.

On April 1, 2005, we completed a review of our lease accounting procedures and concluded that these procedures were in error and that prior year period financial statements required restatement. We publicly announced that information on April 1, 2005. The results of the review were provided to our former independent auditor which had rendered opinions on the affected prior period financial statements, but it has been unable to complete its re-audit of the prior periods in time for the filing of this quarterly report. We anticipate that our former independent auditor will complete its re-audit in the fourth quarter of our current fiscal year. Based on most current data, but subject to the completion of the ongoing audit by our former auditor, we expect that the cumulative effect of the restatements for prior year accounting errors, when recorded, will be an increase of prior reported earnings of $0.01 per share in fiscal 2004, an increase of prior reported loss of $0.02 per share in fiscal 2003 and a reduction of prior reported earnings of $0.06 per share in fiscal 2002 and a reduction of shareholders equity at June 30, 2004 of approximately $498,000. Subject to the review by the Company’s former and current independent auditors for their applicable period, earnings for the current and prior year third quarters, and for the first three quarters of each year, are not expected to change as a result of the restatement.

Total Revenue. Total revenue for the twelve weeks ended March 9, 2005 decreased by $49,000, or 0.4%, to $11,624,000 from $11,673,000 for the twelve weeks ended March 10, 2004. Each component of total revenue is discussed below.

Retail sales for the twelve weeks ended March 9, 2005 decreased by $166,000, or 2.3%, to $7,115,000 from $7,281,000 for the prior year period. This decrease is primarily the net result of a $630,000 decrease in sales due to the sale of seven company operated units and the closure of five company operated units since the beginning of the third quarter of the prior fiscal year, partially offset by a $242,000 increase in sales related to new store openings, a $186,000, or 2.8%, increase in same store sales and a $36,000, or 35.4%, increase in e-commerce retail sales.

Wholesale sales increased $203,000, or 6.3%, to $3,427,000 for the twelve weeks ended March 9, 2005 from $3,224,000 for the prior year period. Wholesale sales to third party customers increased by $405,000, or 23.4%, primarily due to strong performance in the Keurig “K-cup” line that increased sales by $414,000, or 26.2%, in the third fiscal quarter of fiscal 2005. Wholesale sales of roasted coffee to our franchisees decreased $202,000, or 18.0%, primarily due to timing differences of coffee orders and an eight unit decrease in the number of domestic franchise stores when compared to the prior year period.

Franchise revenue decreased from the prior year quarter by $86,000, or 7.4%, to $1,082,000. Domestic franchise royalties declined by $19,000, or 2.1%, to $901,000 as a result of a reduction of eight domestic franchise units when compared to the prior year period. Domestic franchise and coordination fees decreased by $67,000 to $182,000 as a result of opening three domestic franchise units in the current year quarter versus four domestic franchise units in the previous year quarter.

Cost of Sales and Related Occupancy Costs. Cost of sales and related occupancy costs for the twelve weeks ended March 9, 2005 increased $191,000, to $5,807,000 from $5,616,000 in the prior year period. Because little of these costs relate to franchise revenue, the most relevant benchmark of these costs is their relationship to total retail and wholesale sales. Using that measure, cost of sales and related occupancy costs increased to 55.1% of retail and wholesale sales for the twelve weeks ended March 9, 2005 from 53.5% in the twelve weeks ended March 10, 2004. This unfavorable margin basis point variance was primarily due to cost of sales in the wholesale segment. Wholesale cost of sales, as a percentage of wholesale sales, increased by 2.5% in the current year quarter due to higher Keurig sales, which carry a higher cost of goods sold. Occupancy costs as a percentage of retail and wholesale sales were relatively flat year over year.

Operating Expenses. Operating expenses for the twelve weeks ended March 9, 2005 decreased $67,000, or 1.7%, from the prior year period to $3,799,000. On a margin basis, operating expenses decreased in the retail and wholesale segments from 36.8% of sales in last year’s third fiscal quarter to 36.0% in the current fiscal quarter.

Depreciation and Amortization. Depreciation and amortization expense remained relatively flat with an increase of $50,000 in the current year quarter, to $563,000 compared to $513,000 in the prior year fiscal quarter.

14

General and Administrative Expenses. General and administrative expenses remained relatively flat at $2,334,000 for the current quarter compared to $2,323,000 for the prior year fiscal quarter. As a percentage of revenue, general and administrative expenses increased to 20.1% in the third quarter of fiscal 2005 from 19.9% in the prior year quarter. During the quarter, there were increases in marketing expenses of $136,000, increases in consulting expenses of $93,000 and an increase of $108,000 in the provision for management incentive compensation payable upon achievement of 2005 budgetary and personal achievement goals. These increases were offset by a decrease in legal fees of $323,000 over the prior year quarter, of which $225,000 of the decrease relate to items classified as discontinued operations for the current quarter.

Interest Expense and other, net. Net interest expense decreased $62,000, to $4,000 of income in the current year quarter from $58,000 of expense in the prior year quarter. This decrease is primarily related to a $17,000 decrease in loan fee amortization in the current year quarter, due to a decrease in loan fees because we entered into a new debt agreement during the fourth quarter of fiscal 2004, and a $55,000 increase in interest income related to interest earned on our proceeds from the sale of our Gloria Jean’s international operations.

Gain on Sale of International Operations; Discontinued Operations. We sold our international Gloria Jean’s operations on February 11, 2005. Proceeds from the sale were $16,000,000 in cash and an additional $7,020,000 in payments to be received over the next six years under license, roasting and consulting agreements. Proceeds, net of costs of the transaction and net book value of assets sold, primarily consisting of goodwill related to the international operations, net of tax of $3,376,000, resulted in a book gain of $15,558,000, or $2.90 per share, on a diluted basis, for the twelve weeks ended March 9, 2005. The tax provision on book gain resulted in a tax rate lower than statutory tax rates due to the use of net operating loss carryovers from prior years. We currently account for our international Gloria Jean’s units as discontinued operations. Excluding the gain on the sale, discontinued operations for the current year quarter earned $916,000, or $0.17 per share, on a diluted basis, compared to $640,000, or $0.12 per share, in the prior year quarter.

Income Tax Provision. Net operating losses generated in the current year from continuing operations resulted in no federal and state tax liability for continuing operations for the twelve weeks ended March 9, 2005. The fluctuation in expense from continuing operations between the twelve weeks ended March 9, 2005 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 number of states. The tax provision for the gain on sale of discontinued operations totaled $3,376,000. The tax rate on discontinued operations differed from the expected statutory rate due to the use of net operating loss carryovers from the current year and prior years, including the release of $3,857,000 of valuation allowance related to the use of prior years net operating losses. However, utilization of the net operating loss carryovers from prior years is limited under Internal Revenue Code Section 382, which pertains to changes in ownership. Due to the uncertainty of future taxable income, deferred tax assets resulting from these net operating losses have been fully reserved. As of March 9, 2005, net operating loss carryforwards for federal and state income tax purposes of approximately $25,000,000 and $13,000,000, respectively, are available to be utilized against future taxable income for years through fiscal 2024 for federal and fiscal 2014 for state, subject to annual limitations pertaining to ownership changes under Internal Revenue Code Section 382, as previously discussed.

Thirty-six weeks ended March 9, 2005 compared with the thirty-six weeks ended March 10, 2004

Restatement of Prior Period Condensed Consolidated Financial Statements. In the fourth quarter of fiscal year 2004, we restated our previously issued unaudited condensed consolidated financial statements for the first three quarters of the previous fiscal year. As part of our accounting activities during our year-end audit, we determined that an adjustment was required to recognize $113,000 of additional franchise revenue in the first quarter of fiscal 2004 under an area development agreement that had terminated in that quarter. We originally recorded this franchise revenue in the fourth quarter of fiscal 2004. As a consequence, a correction of reported year-to-date income for our second and third quarters of fiscal year 2004 was also required. This adjustment had no effect on reported revenues or earnings for the 2004 fiscal year. The net effect of all of the adjustments was to increase first fiscal quarter 2004 revenue and earnings by $113,000 and to reduce fourth fiscal quarter 2004 revenue and earnings by the same amount. This adjustment increased basic and diluted net income per share by $0.02, $0.02 and $0.03 in the first, second and third quarters of fiscal 2004, respectively.

On April 1, 2005, we completed a review of our lease accounting procedures and concluded that these procedures were in error and prior year period financial statements required restatement. We publicly announced that information on April 1, 2005. The results of the review were provided to our former independent auditor which had rendered opinions on the affected prior period financial statements, but it has been unable to complete its re-audit of the prior periods in time for the filing of this quarterly report. We anticipate that our former independent auditor will complete its re-audit in the fourth quarter of our current fiscal year. Based on most current data, but subject to the completion of the ongoing audit by our former auditor, we expect that the cumulative effect of the restatements for prior year accounting errors, when recorded, will be an increase of prior reported earnings of $0.01 per share in fiscal 2004, an increase of prior reported loss of $0.02 per share in fiscal 2003 and a reduction of prior reported earnings of $0.06 per share in fiscal 2002 and a reduction of shareholders equity at June 30, 2004 of approximately $498.000. Subject to the review by the Company’s former and independent current auditors for their applicable period, earnings for the current and prior year third quarters, and for the first three quarters of each year, are not expected to change as a result of the restatement.

Total Revenue. Total revenue for the thirty-six weeks ended March 9, 2005 increased by $664,000, or 1.9%, to $36,282,000 from $35,618,000 for the thirty-six weeks ended March 10, 2004. Each component of total revenue is discussed below.

15

Retail sales for the thirty-six weeks ended March 9, 2005 increased by $76,000, or 0.3%, to $21,801,000 from $21,725,000 for the prior year period. This increase is the net result of a $881,000, or 5.0%, increase in same store sales, a $101,000, or 31.5%, increase in e-commerce retail sales and a $548,000 increase in sales from newly opened units, partially offset by a decrease of $1,454,000 due to the sale of seven company operated units and the closure of six company operated units since the beginning of the prior fiscal year.

Wholesale sales increased $660,000, or 6.2%, to $11,374,000 for the thirty-six weeks ended March 9, 2005, from $10,714,000 for the prior year period. The increase is primarily due to higher wholesale sales to third party customers of $1,107,000, or 22.6%, primarily due to strong performance in the Keurig “K-cup” line that increased sales by $1,062,000, or 23.9%. This increase is offset primarily by a decrease in wholesale sales of roasted coffee to our franchisees of $450,000, or 9.5%, resulting primarily from the timing differences of coffee orders and a eight unit net decrease in the number of domestic franchise stores when compared to the prior year period.

Franchise revenue decreased from the prior year period by $72,000, or 2.3%, to $3,107,000. Domestic franchise royalties declined by $162,000, or 6.0%, as a result of a net reduction of eight domestic franchise units since the beginning of fiscal 2004. Area development and coordination fees increased by $90,000 as a result of opening eight domestic franchise units in the current year and an increase in store renewal fees in the current year period.

Cost of Sales and Related Occupancy Costs. Cost of sales and related occupancy costs for the thirty-six weeks ended March 9, 2005 increased $656,000, or 3.8%, to $17,913,000 from $17,257,000 in the prior year period. Because little of these costs relate to franchise revenue, the most relevant benchmark of these costs is their relationship to total retail and wholesale sales. Using that measure, cost of sales and related occupancy costs increased to 54.0% of retail and wholesale sales for the thirty-six weeks ended March 9, 2005 from 53.2% in the thirty-six weeks ended March 10, 2004. This increase is primarily due to an increase in Kerug sales, which carry a higher cost of goods sold.

Operating Expenses. Operating expenses for the thirty-six weeks ended March 9, 2005 increased $36,000, or 0.3%, from the prior year period to $11,584,000. On a margin basis, operating expenses remained relatively consistent in the retail and wholesale segments at 34.9% of sales in the current and 35.6% in the prior year periods. Franchise operating expense decreased $148,000 in the current period, which was attributable to a lower bad debt provision required in the current quarter.

Depreciation and Amortization. Depreciation and amortization increased by $156,000 to $1,697,000 for the thirty-six weeks ended March 9, 2005 from the prior year period. This increase is primarily due to an increase in our retail store depreciation expense in the current year, which related to our store remodel project that commenced during the prior year.

General and Administrative Expenses. General and administrative expenses increased by $754,000, or 11.1%, to $7,547,000 for the thirty-six weeks ended March 9, 2005, from the prior year period. As a percentage of revenue, general and administrative expenses increased to 20.8% in the first thirty-six weeks of fiscal 2005 from 19.1% in the prior year period. Approximately $696,000 of the increase in expense was incurred in the areas of franchise development, field supervision, construction, management information systems and recruiting fees, all of which are designed to support the planned acceleration of company operated and franchised store growth. The increase also included a $235,000 increase in the provision for management incentive compensation payable upon achievement of 2005 budgetary and personal achievement goals and a $141,000 increase in legal and audit fees.

Interest Expense and other, net. Interest expense and other, net decreased by $96,000 to $90,000 of expense for the thirty-six weeks ended March 9, 2005 from the prior year period. This decrease is primarily related to a $41,000 decrease in loan fee amortization in the current year, due to a decrease in loan fees because we entered into a new debt agreement during the fourth quarter of fiscal 2004, and a $56,000 increase in interest income related to interest earned on our proceeds from the sale of our Gloria Jean’s international operations.

Gain on Sale of International Operations; Discontinued Operations. We sold our international Gloria Jean’s operations on February 11, 2005. Proceeds from the sale were $16,000,000 in cash and an additional $7,020,000 in payments to be received over the next six years under license, roasting and consulting agreements. Proceeds, net of costs of the transaction and net book value of assets sold, primarily consisting of goodwill related to the international operations, net of tax of $3,376,000, resulted in a book gain of $15,558,000, or $2.71 per share, on a diluted basis, for the thirty-six weeks ended March 9, 2005. The tax provision on book gain resulted in a tax rate lower than statutory tax rates due to our use of net operating loss carryovers from prior years. We currently account for our international Gloria Jean’s units as discontinued operations. For the first three quarters of the current year, discontinued operations, excluding the gain on the sale, earned $2,629,000, or $0.46 per share, on a diluted basis, compared to $2,094,000, or $0.40 per share, for the first three quarters of fiscal year 2004.

        Income Tax Provision. Net operating losses generated in the current year from continuing operations resulted in no federal and state tax liability for continuing operations for the thirty-six weeks ended March 9, 2005. The fluctuation in expense from continuing operations between the thirty-six weeks ended March 9, 2005 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 number of states. The tax provision for the gain on sale of discontinued operations totaled $3,376,000. The tax rate on discontinued operations differed from the expected statutory rate due to the use of net operating loss carryovers from the current year and prior years, including the release of $3,857,000 of valuation allowance related to the use of prior years net operating losses. However, utilization of the net operating loss carryovers from prior years is limited under Internal Revenue Code Section 382, which pertains to changes in ownership. Due to the uncertainty of future taxable income, deferred tax assets resulting from prior years net operating losses have been fully reserved. As of March 9, 2005, net operating loss carryforwards for federal and state income tax purposes of approximately $25,000,000 and $13,000,000, respectively, are available to be utilized against future taxable income for years through fiscal 2024 for federal and fiscal 2014 for state, subject to annual limitations pertaining to ownership change under Internal Revenue Code Section 382, as previously discussed.

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Financial Condition, Liquidity and Capital Resources.

Current Financial Condition. At March 9, 2005, we had cash of $17,998,000 as compared to $1,799,000 at June 30, 2004, and we had working capital of $14,550,000, as compared to working capital of $641,000 at June 30, 2004. Total outstanding capital lease obligations and total long-term debt increased from $1,533,000 at June 30, 2004 to $2,154,000 at the end of the current year fiscal quarter. From June 30, 2004 to March 9, 2005, stockholder’s equity increased from $16,877,000 to $32,893,000.

Cash Flows. Cash provided by operating activities for the thirty-six weeks ended March 9, 2005 totaled $1,166,000 as compared with $2,470,000 for the thirty-six weeks ended March 10, 2004. This decrease is the net result of a number of factors more fully enumerated in the Unaudited Condensed Consolidated Statement of Cash Flows in the accompanying financial statements.

Net cash provided by investing activities for the thirty-six weeks ended March 9, 2005 totaled $14,039,000 as compared with net cash used of $1,672,000 for the thirty-six weeks ended March 10, 2004. During the thirty-six weeks ended March 9, 2005, $1,942,000 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 $30,000 of payments received on notes receivable and $31,000 of proceeds received from sales of property and equipment. Additionally, we received $16,000,000 in cash proceeds for the sale of our discontinued operations and purchased $80,000 of goodwill in the acquisition of a coffeehouse.

Net cash provided by financing activities for the thirty-six weeks ended March 9, 2005 totaled $994,000 as compared to $2,031,000 in net cash used in financing activities for the thirty-six weeks ended March 10, 2004. In the first quarter of fiscal 2005, we borrowed $1,000,000 under our contingent convertible note purchase agreement.

Outstanding Debt and Financing Arrangements. On May 10, 2004, we entered into a $5,000,000 Contingent Convertible Note Purchase Agreement. The agreement provides for us, at our election, to issue notes to the lender, Sequoia Enterprises L.P., up to an aggregate principal amount of $5,000,000. The notes are amortized on a monthly basis at a rate that will repay 60% of the principal amount of each note by May 10, 2007. The remaining 40% will mature on that date. Interest is payable at LIBOR plus 3.30%, and a facility fee of 1.00% annually is payable on the unused portion of the facility. The agreement contains covenants that limit the amount of indebtedness that we may have outstanding in relation to our tangible net worth and that require us to maintain a specified minimum dollar value of earnings before interest, tax, depreciation and amortization for the trailing four fiscal quarters, among others. Notes are convertible into our common stock only upon certain changes of control. In addition, as principal payments are made, we will issue the lender warrants to purchase shares of common stock. The number of warrants that we will issue will directly correlate to the amount of notes issued and repaid. The issued warrants will expire on May 10, 2008. The lender under this agreement is a limited partnership of which the chairman of our board of directors serves as the sole general partner. On May 10, 2004, upon entering into the agreement, we immediately issued a $1,000,000 note under the facility and used the proceeds from that note and other available cash to repay all outstanding debt with Bank of the West. On September 15, 2004, we issued another $1,000,000 note under the facility. As of March 9, 2005, $1,713,000 was outstanding under the facility. As of March 9, 2005, we were in compliance with all debt covenants.

In connection with the issuance of the two $1,000,000 notes issued under the Contingent Convertible Note Purchase Agreement on May 10, 2004 and September 15, 2004, we will issue a total of 253,164 and 202,020 warrants to purchase shares of common stock, respectively, as principal payments are made. The warrants are classified as debt instruments in accordance with Emerging Issues Task Force Issue No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.” The estimated fair value of the warrants on the date of issuance, $5,000 and $4,000, respectively, was recorded as a discount to the face value of the notes issued and as a liability in the accompanying unaudited condensed consolidated balance sheet. As of March 9, 2005, we have issued 4,219 warrants.

On May 10, 2004, we also entered into an Amended and Restated Credit Agreement with Bank of the West. The agreement provides for a working capital facility of $250,000 and a letter of credit facility of $750,000. On March 9, 2005, no debt was outstanding under the working capital facility and $576,000 of letters of credit were outstanding under the letter of credit facility. With respect to the working capital facility, we may elect to pay interest on amounts outstanding at the Bank of the West reference rate plus 1.00% or LIBOR plus 3.25%. Borrowings and issuance of letters of credit under the Bank of the West facility are secured by substantially all of our assets. Letters of credit issued under the letter of credit facility are subject to an annual fee of 2.00% of the face amount. The agreement contains covenants that limit the amount of indebtedness that we may have outstanding in relation to our tangible net worth and that require us to maintain a specified minimum dollar value of EBITDA for the trailing four fiscal quarters, among others. As of March 9, 2005, we were in compliance with all debt covenants. The working capital and letter of credit facilities expire on October 15, 2005.

Based upon the terms of our credit agreements, our recent operating performance and business outlook, and status of our balance sheet, we believe that cash from operations, cash and cash equivalents, and funds available under our credit

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agreements will be sufficient to satisfy our working capital needs at the anticipated operating levels for at least the next twelve months.

Off-balance sheet arrangements. We utilize a segregated advertising fund to administer contributions received from our franchisees for advertising programs. Upon the adoption of FIN 46R, we consolidated the advertising fund. We have included $414,000 of advertising fund assets, restricted and advertising fund liabilities in the accompanying unaudited condensed consolidated balance sheet as of March 9, 2005. The advertising contributions and disbursements are reported in the unaudited condensed consolidated statement of operations on a net basis whereby contributions from franchisees are recorded as offsets to the Company’s reported general and administrative expenses.

Other Commitments. The following represents a comprehensive list of our contractual obligations and commitments as of March 9, 2005:

	Payments Due by Year
	Total		1 year		2 years		3 years		4 years		5 years		Thereafter
	(In thousands)
Note payable	$	1,713	$	425	$	425	$	863	$	—	$	—	$	—
Capital leases		441		122		22		24		25		27		221
Company operated retail locations and other operating leases		13,118		3,409		2,331		1,889		1,641		1,259		2,589
Franchise operated retail locations operating leases		18,210		1,619		4,025		3,242		2,627		1,902		4,795
Green coffee commitments		2,151		2,151		—		—		—		—		—
	$	35,633	$	7,726	$	6,803	$	6,018	$	4,293	$	3,188	$	7,605

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 86 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 9, 2005, computed as the sum of all remaining lease payments through the expiration dates of the respective leases, was $18,210,000. 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.

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Critical Accounting Estimates

The preparation of our unaudited 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 we believe 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 the critical accounting policies and estimates that we use in the preparation of our unaudited 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 (for example, 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 management’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 (“SFAS”) No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” 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 unaudited condensed consolidated statements of earnings.

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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 to 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 year’s 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 our 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 unaudited 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, in the past, we have had some franchisees which we had determined required an estimated loss equal to the total amount of the receivable, but which have paid us in full or established a consistent record of payments (generally one year) such that we subsequently determined that 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 is based on our assessment of the most probable course of action that will occur.

In accordance with SFAS No. 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 above under the heading “Estimated Liability for Closing Stores.” Consistent with SFAS No. 146, we have not established an additional estimated liability for potential losses not yet incurred. If sales trends or 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.

Stock-Based Compensation

As discussed in the Notes to Unaudited 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 Accounting Principles Board 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.” 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 Unaudited Condensed Consolidated Financial Statements for analysis of the effect of certain changes in assumptions used to determine the fair value of stock-based compensation).

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In December of 2004, the Financial Accounting Standards Board reissued SFAS No. 123 as SFAS No. 123R, “Share Based Compensation.” Under SFAS No. 123R, public entities will be required to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award and recognize the cost over the period during which an employee is required to render services in exchange for the award. Additionally, SFAS No. 123R will require entities to record compensation expense for employee stock purchase plans that may not have previously been considered compensatory under the existing rules. SFAS No. 123R will be effective for annual reporting periods beginning on or after June 15, 2005. We have not yet determined the impact that adopting SFAS No. 123R will have on our results of operations.

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 9, 2005, our net deferred tax assets were fully reserved wtih a related valuation allowance that totaled approximately $11,000,000.

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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 debt. At March 9, 2005, we had a $5,000,000 loan facility, with an outstanding balance of $1,713,000 at an interest rate of 5.87%, and a $250,000 working capital facility, with no outstanding balance, each of which could be affected by changes in short term interest rates. At March 9, 2005, a hypothetical 100 basis point increase in the adjusted rate would result in additional interest expense of approximately $17,000 on an annualized basis.

Commodity Price Risk. The supply and price of green coffee, the principal raw material for our products, are subject to significant volatility. Although most coffee trades in the commodity market, coffee of the quality that we seek tends to trade on a negotiated basis at a substantial premium above commodity coffee prices, depending upon the supply and demand at the time of purchase. Supply and price can be affected by a number of factors in the producing countries, including weather, political and economic conditions. In addition, green coffee prices have been affected in the past, and may be affected in the future, by the actions of certain organizations and associations that have historically attempted to influence commodity prices of green coffee through agreements establishing export quotas or restricting coffee supplies worldwide.

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. As of March 9, 2005, we had commitments to purchase coffee through fiscal year 2006 totaling $2,151,000 for 1,276,000 pounds of green coffee, some of which commitments were fixed as to price. The coffee scheduled to be delivered to us in the next twelve months pursuant to these commitments will satisfy approximately 38% of our anticipated green coffee requirements for the next twelve months. Assuming we require approximately 2,071,000 additional pounds of green coffee during the next twelve months for which no price has yet been fixed, each $0.01 per pound increase in the price of green coffee could result in approximately $21,000 of additional cost.

Another ingredient that we used extensively in our products is fluid milk. Fluid milk prices in the United States rose significantly in 2004. We continue to monitor published dairy prices on the related commodities markets, but cannot predict with any certainty whether future prices that we will pay for dairy products.

Our ability to raise sales prices in response to rising coffee or milk prices may be limited, and our profitability could be adversely affected if prices were to rise substantially.

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 our disclosure controls and procedures. Based on that evaluation, because of the material weakness described below, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were not effective as of March 9, 2005.

(b) As reported in our Current Report on Form 8-K, dated April 1, 2005, which was amended on April 8, 2005, in the course of a review of our lease accounting policies, we became aware that our accounting policies for leases may not have been consistent with United States generally accepted accounting principles (“GAAP”). After investigating the matter, our management and the Audit Committee of the Board of Directors concluded that our disclosure controls and procedures as of the end of the period covered by this report were not effective because there was a material weakness in our controls over the selection, monitoring, implementation and review of our lease accounting policies. We remediated the material weakness in internal control over financial reporting and the ineffectiveness of our disclosure controls and procedures by reviewing and changing our accounting policies for leases to conform to GAAP, training our accounting staff regarding the policy changes and increasing management oversight of our compliance with such policies.

Other than to remediate the material weakness described above, there were no changes in our internal controls over financial reporting during the quarter ended March 9, 2005 that materially affected, or were reasonably likely to materially affect, our internal control over financial reporting.

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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. As of and for the thirty-six week period ending March 9, 2005, we were not a party to any material legal proceedings.

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Item 6. 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 Diedrich Coffee, Inc., dated May 11, 2001 (2)
3.2	Bylaws of Diedrich Coffee, Inc. (3)
4.1	Specimen Common 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 Common Stock and Option Purchase Agreement with Franchise Mortgage Acceptance Company, dated as of April 3, 1998 (7)
10.1	Form of Indemnification Agreement (5)
10.2	Diedrich Coffee, Inc. 2000 Equity Incentive Plan (8)*
10.3	Diedrich Coffee, Inc. 2000 Non-Employee Directors Stock Option Plan (9)*
10.4	Amended and Restated Diedrich Coffee, Inc. 1996 Stock Incentive Plan (10)*
10.5	Diedrich Coffee, Inc. 1996 Non-Employee Directors Stock Option Plan (11)*
10.6	Form of Diedrich Coffee, Inc. Franchise Agreement (12)
10.7	Form of Gloria Jean’s Franchise Agreement (12)
10.8	Form of Diedrich Coffee, Inc. Area Development Agreement (12)
10.9	Amended and Restated Credit Agreement with Bank of the West, effective May 10, 2004 (13)
10.10	Security Agreement, dated September 3, 2002, by and between Diedrich Coffee, Inc. and Bank of the West d/b/a/ United California Bank (14)
10.11	Form of Supplemental Security Agreement (Trademarks) (14)
10.12	Form of Guaranty (14)
10.13	Form of Guarantor Security Agreement (14)
10.14	Employment Agreement with Roger M. Laverty, dated April 24, 2003 (15)*
10.15	Stock Option Plan and Agreement with Roger M. Laverty, dated April 24, 2003 (15)*
10.16	Employment Agreement with Martin A. Lynch, dated March 26, 2004 (16)*
10.17	Employment Agreement with Matthew McGuinness, effective March 13, 2000 (18)*

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10.18	Employment Letter regarding the employment of Pamela Britton, dated February 6, 2001 (12)*
10.19	Employment Letter regarding the employment of Carl Mount, dated October 29, 1999 (19)*
10.20	Separation Agreement by and between Diedrich Coffee, Inc. and Philip G. Hirsch (15)*
10.21	Form of Separation Agreement and Release with Martin Diedrich, effective October 28, 2004 (20)*
10.22	Standard Industrial/Commercial Multi-Tenant Lease Agreement by and between The Westphal Family Trust and Diedrich Coffee, Inc., dated September 10, 2003 (21)
10.23	Office Space Lease Agreement by and between The Irvine Company and Diedrich Coffee, Inc., dated August 1, 2003 (21)
10.24	Contingent Convertible Note Purchase Agreement, dated May 10, 2004 (includes form of convertible promissory note and form of warrant) (13)
10.25	Asset Purchase Agreement, dated December 5, 2004, by and among, among others, Diedrich Coffee, Inc. and Jireh International Pty. Ltd. (17)
10.26	Roasting License Agreement, dated February 10, 2005 (22)
10.27	Consulting Agreement, dated February 10, 2005 (22)
10.28	Trademark License Agreement, dated February 10, 2005 (22)
10.29	1997 Non-Employee Director Stock Option Plan and Agreement (23)*
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.

(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 23, 1996.

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

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(7) 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.

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

(9) 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.

(10) 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.

(11) 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.

(12) 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.

(13) Previously filed as an exhibit to Diedrich Coffee’s Annual Report on Form 10-K for the fiscal year ended June 30, 2004, filed with the Securities and Exchange Commission on September 28, 2004.

(14) 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.

(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 Quarterly Report on Form 10-Q for the period ended March 10, 2004, filed with the Securities and Exchange Commission on April 26, 2004.

(17) Previously filed as an exhibit to Diedrich Coffee’s Current Report on Form 8-K, filed with the Securities and Exchange Commission on December 6, 2004.

(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 Current Report on Form 8-K, filed with the Securities and Exchange Commission on November 3, 2004.

(21) 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.

(22) Previously filed as an exhibit to Diedrich Coffee’s Quarterly Report on Form 8-K, filed with the Securities and Exchange Commission on February 16, 2005.

(23) Previously filed as an exhibit to Diedrich Coffee’s Annual Report on Form 10-K405/A for the fiscal year ended January 27, 1999, filed with the Securities and Exchange Commission on June 8, 1999.

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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: June 14, 2005	DIEDRICH COFFEE, INC.
	/s/ Roger M. Laverty
	Roger M. Laverty
	President and Chief Executive Officer
	(On behalf of the registrant)
	/s/ Martin A. Lynch
	Martin A. Lynch
	Executive Vice President and Chief Financial Officer
	(Principal financial officer)

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