10-Q

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 8, 2006

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 a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated Filer  ¨ Accelerated Filer  ¨ Non-Accelerated Filer  x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES ¨    NO x

As of April 17, 2006, there were 5,307,789 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	20
Item 4.	Controls and Procedures	21
PART II – OTHER INFORMATION
Item 1.	Legal Proceedings	21
Item 4.	Submission of Matters to a Vote of Security Holders	21
Item 6.	Exhibits	22
Signatures		25

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PART I - FINANCIAL INFORMATION

Item 1. Financial Statements.

DIEDRICH COFFEE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

	March 8, 2006			June 29, 2005
	(Unaudited)
Assets
Current assets:
Cash	$	4,286,000		$	10,493,000
Restricted cash		578,000			—
Accounts receivable, less allowance for doubtful accounts of $1,372,000 at March 8, 2006 and $1,392,000 at June 29, 2005		3,527,000			2,203,000
Inventories		3,163,000			3,426,000
Income tax refund		158,000			1,220,000
Current portion of notes receivable		1,155,000			1,165,000
Advertising fund assets, restricted		242,000			218,000
Prepaid expenses		740,000			489,000
Total current assets		13,849,000			19,214,000
Property and equipment, net		10,010,000			7,974,000
Goodwill		8,179,000			8,179,000
Notes receivable		3,800,000			4,554,000
Cash surrender value of life insurance policy		372,000			—
Other assets		400,000			392,000
Total assets	$	36,610,000		$	40,313,000
Liabilities and Stockholders’ Equity
Current liabilities:
Current installments of obligations under capital leases	$	19,000		$	85,000
Accounts payable		3,613,0000			2,642,000
Accrued compensation		1,839,000			2,886,000
Accrued expenses		1,714,000			1,366,000
Franchisee deposits		546,000			632,000
Deferred franchise fee income		65,000			91,000
Advertising fund liabilities		242,000			218,000
Accrued provision for store closure		—			91,000
Total current liabilities		8,038,000			8,011,000
Obligations under capital leases, excluding current installments		314,000			328,000
Deferred rent		599,000			452,000
Deferred compensation		390,000			—
Total liabilities		9,341,000			8,791,000
Commitments and contingencies (notes 4 and 7)
Stockholders’ equity:
Common stock, $0.01 par value; authorized 8,750,000 shares; 5,308,000 and 5,273,000 shares issued and outstanding at March 8, 2006 and June 29, 2005, respectively		53,000			53,000
Additional paid-in capital		58,905,000			58,481,000
Accumulated deficit		(31,689,000	)		(27,012,000	)
Total stockholders’ equity		27,269,000			31,522,000
Total liabilities and stockholders’ equity	$	36,610,000		$	40,313,000

See accompanying notes to condensed consolidated financial statements.

1

DIEDRICH COFFEE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

	Twelve Weeks Ended March 8, 2006			Twelve Weeks Ended March 9, 2005			Thirty-six Weeks Ended March 8, 2006			Thirty-six Weeks Ended March 9, 2005
Net revenue:
Retail sales	$	7,975,000		$	7,115,000		$	24,007,000		$	21,801,000
Wholesale and other		5,102,000			3,427,000			14,496,000			11,374,000
Franchise revenue		972,000			1,082,000			2,668,000			3,107,000
Total net revenue		14,049,000			11,624,000			41,171,000			36,282,000
Costs and expenses:
Cost of sales and related occupancy costs		7,713,000			5,806,000			22,152,000			17,904,000
Operating expenses		4,299,000			3,801,000			12,927,000			11,590,000
Depreciation and amortization		617,000			563,000			1,775,000			1,697,000
General and administrative expenses		3,313,000			2,333,000			9,677,000			7,550,000
(Gain) loss on asset disposals		5,000			(2,000	)		22,000			(14,000	)
Total costs and expenses		15,947,000			12,501,000			46,553,000			38,727,000
Operating loss		(1,898,000	)		(877,000	)		(5,382,000	)		(2,445,000	)
Interest expense		(25,000	)		(52,000	)		(85,000	)		(145,000	)
Interest and other income, net		118,000			56,000			406,000			55,000
Loss from continuing operations before income tax provision		(1,805,000	)		(873,000	)		(5,061,000	)		(2,535,000	)
Income tax benefit		(121,000	)		(340,000	)		(384,0000	)		(973,000	)
Net loss from continuing operations		(1,684,000	)		(533,000	)		(4,677,000	)		(1,562,000	)
Discontinued operations:
Income from discontinued operations, net of $341,000 and $985,000 of taxes, respectively		—			576,000			—			1,656,000
Gain on sale of discontinued operations, net of $3,376,000 taxes		—			15,558,000			—			15,558,000
Net (loss) income	$	(1,684,000	)	$	15,601,000		$	(4,677,000	)	$	15,652,000
Basic and diluted net (loss) income per share:
Loss from continuing operations	$	(0.32	)	$	(0.10	)	$	(0.88	)	$	(0.30	)
Income from discontinued operations, net	$	—		$	3.09		$	—		$	3.31
Net (loss) income	$	(0.32	)	$	2.99		$	(0.88	)	$	3.01
Weighted average and equivalent shares outstanding:
Basic and diluted		5,303,000			5,214,000			5,300,000			5,194,000

See accompanying notes to condensed consolidated financial statements.

2

DIEDRICH COFFEE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

	Thirty-six Weeks Ended March 8, 2006			Thirty-six Weeks Ended March 9, 2005
Cash flows from operating activities:
Net (loss) income	$	(4,677,000	)	$	15,652,000
Gain from discontinued operations		—			(15,558,000	)
Income from discontinued operations		—			(1,656,000	)
Loss from continuing operations:		(4,677,000	)		(1,562,000	)
Adjustments to reconcile net income to net cash (used in) provided by operating activities:
Depreciation and amortization		1,775,000			1,697,000
Amortization of loan fees		23,000			23,000
Amortization of note payable discount		—			1,000
Provision for bad debt		96,000			140,000
Income tax benefit		1,062,000			—
Provision for inventory obsolescence		24,000			69,000
Stock compensation expense		287,000			—
Notes receivable issued		(35,000	)		—
Gain (loss) on disposals of assets		22,000			(14,000	)
Changes in operating assets and liabilities:
Accounts receivable		(1,420,000	)		(837,000	)
Inventories		239,000			(354,000	)
Prepaid expenses		(251,000	)		(449,000	)
Notes receivable		(239,000	)		(27,000	)
Other assets		(408,000	)		(405,000	)
Accounts payable		971,000			477,000
Accrued compensation		(657,000	)		495,000
Accrued expenses		348,000			116,000
Franchisee deposits		(86,000	)		27,000
Deferred franchise fee income		(26,000	)		(1,204,000	)
Accrued provision for store closure		(91,000	)		(20,000	)
Deferred rent		152,000			(19,000	)
Net cash used in operating activities		(2,891,000	)		(1,846,000	)
Net cash provided by discontinued operations		—			3,012,000
Net cash (used in) provided by operating activities		(2,891,000	)		1,166,000
Cash flows used in investing activities:
Capital expenditures for property and equipment		(3,876,000	)		(1,942,000	)
Proceeds from disposal of property and equipment		43,000			31,000
Proceeds from sale of discontinued operations		—			16,000,000
Goodwill resulting from acquisition		—			(80,000	)
Principal payments on notes receivable		1,038,000			30,000
Investment in restricted money market account		(578,000	)		—
Net cash (used in) provided by investing activities		(3,373,000	)		14,039,000
Cash flows provided by financing activities:
Exercise of stock options		137,000			364,000
Borrowings under credit agreement		—			1,000,000
Payments on long-term debt		—			(261,000	)
Payments on capital lease obligations		(80,000	)		(109,000	)
Net cash provided by financing activities		57,000			994,000
Net (decrease) increase in cash		(6,207,000	)		16,199,000
Cash at beginning of period		10,493,000			1,799,000
Cash at end of period	$	4,286,000		$	17,998,000
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	$	57,000		$	120,000
Income taxes	$	61,000		$	12,000

See accompanying notes to condensed consolidated financial statements.

3

DIEDRICH COFFEE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 8, 2006

(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 for the year ended June 29, 2005.

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.

Discontinued Operations

On February 10, 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 included the immediate transfer of related franchise rights to Jireh of 338 Gloria Jean’s retail locations outside the U.S. and Puerto Rico, including 242 in Australia.

In accordance with Statement of Financial Accounting Standards (“SFAS”) 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. There was no activity related to discontinued operations for the thirty-six weeks ended March 8, 2006.

The following accounts are reflected in Discontinued Operations:

• International franchise royalties, new store fees and roasting fees

• Wholesale revenue and cost of goods sold associated with the sale of coffee to international franchisees

• Bad debt expense related to international franchisees

• General and administrative costs related to international operations and audit, tax and legal fees relating to the transaction

• Gain on sale of the international franchise operations, net of the related tax provision

• Provision for foreign taxes paid on international revenues

Recent Accounting Pronouncements

On October 6, 2005, the Financial Accounting Standards Board (“FASB”) released FASB Staff Position (“FSP”) FAS 13-1, Accounting for Rental Costs Incurred during a Construction Period. This FSP affects companies that are engaged in construction activities on buildings or grounds, which are accounted for as operating leases. The FSP requires companies to expense rental costs associated with these leases starting on the date that the tenant is given control of the premises. As a result, companies must cease capitalizing rental costs during construction periods. The FSP is effective for the first reporting period beginning after December 15, 2005, which is the fourth quarter of fiscal 2006 for the Company. Retrospective application is permitted but not required. The Company has not yet determined what impact the adoption of FSP FAS 13-1 will have on its results of operations. The Company believes that the adoption of FSP FAS 13-1 will not have a material impact on its financial position, results of operations or cash flows.

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. In the event the future consequences of differences between financial reporting bases and the tax bases of the Company’s assets and liabilities result in a deferred tax asset, SFAS 109, Accounting for Income Taxes, requires an evaluation of

4

the probability of being able to realize the future benefits indicated by such asset. A valuation allowance related to a deferred tax asset is recorded when it is more likely than not that some portion or all of the deferred tax asset will not be realized.

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-Based Compensation

On October 20, 2000, the Company’s board of directors authorized the adoption of the Diedrich Coffee, Inc. 2000 Equity Incentive Plan (the “2000 Equity Incentive Plan”) and the concurrent discontinuation of the option grants under the Diedrich Coffee, Inc. Amended and Restated 1996 Stock Incentive Plan and the Diedrich Coffee, Inc. 1996 Non-Employee Directors Stock Option Plan. The Company’s stockholders approved the 2000 Equity Incentive Plan on November 29, 2000. A total of 1,087,500 shares of the Company’s common stock may be issued under the 2000 Equity Incentive Plan, as amended. The board of directors determines the number of shares, terms and exercise periods for awards under the 2000 Equity Incentive Plan on a case by case basis, except for automatic annual grants of options to non-employee directors. Options generally vest ratably over three years and expire ten years from the date of grant. The exercise price of options is generally equivalent to the fair market value of the Company’s common stock on the date of grant.

On June 30, 2005, the Company adopted the provisions of SFAS 123R, Share-Based Payment (“SFAS 123R”). SFAS 123R sets accounting requirements for “share-based” compensation to employees and non-employee directors, including employee stock purchase plans, and requires companies to recognize in the statement of operations the grant-date fair value of stock options and other equity-based compensation.

The Company chose the modified-prospective transition alternatives in adopting SFAS 123R. Under the modified-prospective transition method, compensation cost is recognized in financial statements issued subsequent to the date of adoption for all stock-based payments granted, modified or settled after the date of adoption, as well as for any unvested awards that were granted prior to the date of adoption. Because the Company previously adopted only the pro forma disclosure provisions of SFAS 123, it will recognize compensation cost relating to the unvested portion of awards granted prior to the date of adoption using the same estimate of the grant-date fair value and the same attribution method used to determine the pro forma disclosures under SFAS 123, except that forfeitures rate will be estimated for all options, as required by SFAS 123R.

The fair value of each option award is estimated on the date of grant using a Black-Scholes option valuation model that uses the assumptions noted in the following table. Expected volatility is based on the historical volatility of the price of the Company’s stock. The Company uses historical data to estimate option exercise and employee termination rates within the valuation model. The expected term of options is derived from the output of the option valuation model and represents the period of time that options are expected to be outstanding. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The fair values of the options were estimated using the Black-Scholes option-pricing model based on the following weighted average assumptions:

	TWELVE WEEKS ENDED				THIRTY-SIX WEEKS ENDED
	March 8, 2006		March 9, 2005		March 8, 2006		March 9, 2005
Risk free interest rate	4.47	%	3.81	%	4.47	%	3.81	%
Expected life	2 years		6 years		2 years		6 years
Expected volatility	66	%	40	%	70	%	43	%
Expected dividend yield	0	%	0	%	0	%	0	%
Forfeiture rate	4.30	%	0	%	4.30	%	0	%

5

A summary of option activity under our stock option plans for the thirty-six weeks ended March 8, 2006 is as follows:

	Number of options		Weighted average exercise price		Weighted average remaining contractual term (years)	Aggregate intrinsic value ($)
Options outstanding at June 29, 2005	938,000		$	5.27
Plus: Options granted	120,000			4.97
Less:
Options exercised	(35,000	)		3.97
Options canceled or expired	(50,000	)		7.22
Options outstanding at March 8, 2006	973,000		$	5.18	6.9	$	—
Options exercisable at March 8, 2006	722,000		$	5.50	6.3	$	—

Stock-based compensation expense included in the statement of operations for the twelve weeks ended March 8, 2006 was approximately $111,000 and for the thirty-six weeks ended March 8, 2006 was approximately $287,000. As of March 8, 2006, there were approximately $410,000 of total unrecognized stock-based compensation cost related to options granted under our plans that will be recognized over a weighted average period of 1.6 years. The total intrinsic value of options exercised during the thirty-six weeks ended March 8, 2006 was approximately $100,000. No options were exercised in the twelve weeks ended March 8, 2006.

A summary of the status of the Company’s unvested options as of March 8, 2006, and changes during the thirty-six weeks ended March 8, 2006, is presented below:

Unvested Options	Options		Weighted - Average Grant-Date Fair Value ($)
Unvested options at June 29, 2005	283,000		3.92
Granted	120,000		4.89
Vested	(102,000	)	(2.60	)
Forfeited	(50,000	)	(7.16	)
Unvested options at March 8, 2006	251,000		4.27

The total fair value of vested options during the thirty-six weeks ended March 8, 2006 was $177,000.

Awards granted prior to the Company’s implementation of SFAS 123R were accounted for under the recognition and measurement principles of APB Opinion 25, Accounting for Stock Issued to Employees, and related interpretations. Accordingly, no stock-based employee compensation cost is reflected in net loss in the accompanying Unaudited Condensed Consolidated Statements of Operations for the twelve weeks and thirty-six weeks ended March 9, 2005 because all options granted under the Company’s plans had exercise prices equal to the market value of the underlying common stock on the date of grant.

Pro forma net income and net income per share, as if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based compensation for periods presented prior to the Company’s adoption of SFAS 123R, are as follows:

Pro Forma net income	TWELVE WEEKS ENDED March 9, 2005			THIRTY-SIX WEEKS ENDED March 9, 2005
Net income	$	15,601,000		$	15,562,000
Deduct: Stock-based compensation expense determined under the fair value based method for all awards, net of related tax effects		(102,000	)		(432,000	)
Pro forma net income	$	15,499,000		$	15,220,000
Basic and diluted income per share – as reported	$	2.99		$	3.01
Basic and diluted income per share – pro forma	$	2.97		$	2.93

Cash Surrender Value of Life Insurance

The change in the cash surrender value (“CSV”) of company owned life insurance (“COLI”) contracts, net of insurance premiums paid and gains realized, is reported in compensation and benefits expense. See Note 10.

Reclassifications

Certain reclassifications have been made to the March 9, 2005 unaudited condensed consolidated financial statements to conform to the March 8, 2006 presentation.

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2. INVENTORIES

Inventories consist of the following:

	March 8, 2006		June 29, 2005
Unroasted coffee	$	958,000	$	1,481,000
Roasted coffee		639,000		643,000
Accessory and specialty items		201,000		225,000
Other food, beverage and supplies		1,365,000		1,077,000
Total inventory	$	3,163,000	$	3,426,000

3. NOTES RECEIVABLE

In November 2005, the Company received a non-interest bearing note from a franchisee in exchange for franchise fees in the amount of $7,500. The note is due and payable in full on December 1, 2006.

In November 2005, the Company received a note bearing an annual interest rate of 8% in exchange for point-of-sale equipment in the amount of $7,286. The note is being repaid in monthly installments and due on or before November 14, 2007.

In September 2005, the Company received a non-interest bearing note from a franchisee in exchange for franchise fees in the amount of $20,000. The note was due and payable in full on January 1, 2006. As agreed between the Company and the franchisee, the debt will be rolled into a new area development agreement that is currently being negotiated with the franchisee.

In February 2005, the Company sold its international franchise operations for $16,000,000 in cash and $7,020,000 in notes receivable payable over the next six years under license, roasting and consulting agreements. See Note 1 to the condensed consolidated financial statements.

Notes receivable consist of the following:

	March 8, 2006			June 29, 2005
Notes receivable bearing interest at rates from 0% to 9.0%, payable in monthly installments of between $284 and $4,268 and due between January 2006 and November 2007. Notes are secured by the assets sold under the asset purchase and sale agreements or general security agreement.	$	164,000		$	181,000
Notes receivable from a corporation discounted at an annual rate of 8.0%, payable annually in installments of between $1,000,000 and $2,000,000, due between January 2007 and January 2011.		4,791,000			5,538,000
Less: current portion of notes receivable		(1,155,000	)		(1,165,000	)
Long-term portion of notes receivable	$	3,800,000		$	4,554,000

4. ACCRUED PROVISION FOR STORE CLOSURE

As required by SFAS 146, Accounting for Costs Associated with Exit or Disposal Activities, the Company records estimated costs for store closures 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 29, 2005	$	109,000	$	—	$	—		$	(18,000	)	$	91,000
Thirty-six weeks ended March 8, 2006	$	91,000	$	—	$	(75,000	)	$	(16,000	)	$	—

For the thirty-six weeks ended March 8, 2006, the Company adjusted the store closure accrual due to the transfer of a corporate store to a franchisee. The Company made cash payments in the amount of $16,000 for rent expense at an impaired store location.

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5. EARNINGS PER SHARE

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

	Twelve Weeks Ended March 8, 2006			Twelve Weeks Ended March 9, 2005			Thirty-six Weeks Ended March 8, 2006			Thirty-six Weeks Ended March 9, 2005
Numerator:
Net loss from continuing operations	$	(1,684,000	)	$	(533,000	)	$	(4,677,000	)	$	(1,562,000	)
Denominator:
Basic weighted average shares outstanding		5,303,000			5,214,000			5,300,000			5,194,000
Effect of dilutive securities		—			—			—			—
Diluted adjusted weighted average shares		5,303,000			5,214,000			5,300,000			5,194,000
Basic and diluted net loss per share from continuing operations	$	(0.32	)	$	(0.10	)	$	(0.88	)	$	(0.30	)

For computation of net loss per share from continuing operations, all 973,000 and 952,000 options outstanding as of March 8, 2006 and March 9, 2005, respectively, were excluded from the calculation of diluted net loss per share because their inclusion would have been anti-dilutive. In addition, all 504,000 outstanding warrants to purchase shares of common stock as of March 8, 2006 and March 9, 2005 were excluded from the calculation of diluted net loss per share because their inclusion would have been anti-dilutive

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

	Twelve Weeks Ended March 8, 2006			Twelve Weeks Ended March 9, 2005		Thirty-six Weeks Ended March 8, 2006			Thirty-six Weeks Ended March 9, 2005
Numerator:
Net income (loss)	$	(1,684,000	)	$	15,601,000	$	(4,677,000	)	$	15,652,000
Denominator:
Basic weighted average shares outstanding		5,303,000			5,214,000		5,300,000			5,194,000
Effect of dilutive securities		—			—		—			—
Diluted adjusted weighted average shares		5,303,000			5,214,000		5,300,000			5,194,000
Basic and diluted net income (loss) per share	$	(0.32	)	$	2.99	$	(0.88	)	$	3.01

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.

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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, interest income and interest expense.

	TWELVE WEEKS ENDED						THIRTY-SIX WEEKS ENDED
	March 8, 2006			March 9, 2005			March 8, 2006			March 9, 2005
Revenue:
Retail	$	7,975,000		$	7,115,000		$	24,007,000		$	21,801,000
Wholesale		5,102,000			3,427,000			14,496,000			11,374,000
Franchise		972,000			1,082,000			2,668,000			3,107,000
Total revenue	$	14,049,000		$	11,624,000		$	41,171,000		$	36,282,000
Interest expense:
Retail	$	7,000		$	6,000		$	20,000		$	17,000
Franchise					4,000			3,000			17,000
Corporate		18,000			42,000			62,000			111,000
Total interest expense	$	25,000		$	52,000		$	85,000		$	145,000
Depreciation and amortization:
Retail	$	451,000		$	360,000		$	1,175,000		$	1,121,000
Wholesale		89,000			135,000			377,000			392,000
Franchise		—			—			—			—
Corporate		77,000			68,000			223,000			184,000
Total depreciation and amortization	$	617,000		$	563,000		$	1,775,000		$	1,697,000
Segment income (loss) from continuing operations before income tax benefit:
Retail	$	(83,000	)	$	96,000		$	43,000		$	506,000
Wholesale		697,000			382,000			2,078,000			1,780,000
Franchise		775,000			1,001,000			2,193,000			2,846,000
Corporate		(3,194,000	)		(2,352,000	)		(9,375,000	)		(7,667,000	)
Total segment loss from continuing operations before income tax provision	$	(1,805,000	)	$	(873,000	)	$	(5,061,000	)	$	(2,535,000	)

	March 8, 2006		June 29, 2005
Identifiable assets:
Retail	$	9,108,000	$	7,152,000
Wholesale		7,055,000		5,966,000
Franchise		1,174,000		2,114,000
Corporate		11,094,000		16,902,000
Tangible assets		28,431,000		32,134,000
Goodwill - Retail		1,347,000		1,347,000
Goodwill - Wholesale		6,311,000		6,311,000
Goodwill - Franchise		521,000		521,000
Total assets	$	36,610,000	$	40,313,000

7. LEASE CONTINGENCIES

The Company is liable on the master real property leases for 78 Gloria Jean’s franchise locations. Under the Company’s franchising business model, the Company from time to time executes the master lease for locations and enters 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 lease. The Company’s maximum theoretical future exposure at March 8, 2006, computed as the sum of all remaining lease payments through the expiration dates of the respective leases, was $19,608,000. 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 location 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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8. OUTSTANDING FINANCING ARRANGEMENTS AND RESTRICTED CASH

On May 10, 2004, the Company entered into a $5,000,000 Contingent Convertible Note Purchase Agreement (the “Note Purchase Agreement”). The agreement allows the Company, at its 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 was initially payable at LIBOR plus 3.30%, and a facility fee of 1.00% annually is payable on the unused portion of the facility. The Note Purchase Agreement contains covenants that, among other matters, limit the amount of indebtedness that the Company may have outstanding in relation to its tangible net worth and that originally required the Company to maintain a specified minimum dollar value of earnings before interest, tax, depreciation and amortization for the trailing four fiscal quarters (the “Minimum EBITDA Covenant”). The notes are convertible into the Company’s common stock only upon certain changes of control. For notes issued and repaid, warrants to purchase shares are issued with the same rights and restrictions for exercise as existed for convertibility of the notes at the time of their issuance. Warrants are exercisable only in the event of a change of control and were to expire on May 10, 2008. The lender under this agreement is the Company’s largest single stockholder and the chairman of the Company’s board of directors serves as the sole general partner of this limited partnership.

On May 10, 2004, upon entering into the Note Purchase Agreement, the Company 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, the Company issued a second note for $1,000,000 under this facility. The price of the Company’s common stock on May 10, 2004, the date that the first $1,000,000 note was issued, was $3.95 per share. The price of the Company’s common stock on September 15, 2004, the date the second $1,000,000 note was issued, was $4.95 per share. Both the notes were fully repaid in fiscal year 2005, and thus a total of 455,184 warrants are issuable upon a change in control. The Company has issued 4,219 warrants as of March 8, 2006. As of March 8, 2006, the Company had no borrowings outstanding under the facility.

On June 30, 2004, the Company entered into Amendment No. 1 to Contingent Convertible Note Purchase Agreement (“Amendment No. 1”) which revised the definition of “Availability” to mean, on any date, the loan amount less the sum of the principal amounts then outstanding under the Note Purchase Agreement. Under the original Note Purchase Agreement, availability was calculated using a formula that reduced availability over time.

As a result of cumulative losses over the last three quarters, the Company was not in compliance with all agreement covenants for the current quarter. On March 31, 2006, the Company entered into Amendment No. 2 to Contingent Convertible Note Purchase Agreement (“Amendment No. 2”). Amendment No. 2: (i) contains a waiver with respect to the existing default of the Minimum EBITDA Covenant and removes the Minimum EBITDA from the Note Purchase Agreement; (ii) clarifies that warrants to purchase common stock of the Company will be issued with respect to repaid principal amounts only upon a change in control of the Company; (iii) increases the interest rate applicable to outstanding amounts under the credit facility by 2%, to LIBOR plus 5.30%; and (iv) extends the exercise date of all warrants issued or to be issued under the Note Purchase Agreement by one year, to May 10, 2009. The maturity date for any notes issued in the future was unaffected by Amendment No. 2. The Company is in compliance with all agreement covenants as amended by Amendment No. 2 for the quarter ended March 8, 2006.

On October 15, 2005, the Amended and Restated Credit Agreement with Bank of the West expired. On November 4, 2005, the Company entered into a new Credit Agreement with Bank of the West. The agreement provides for a $750,000 letter of credit facility that expires on October 15, 2006. The letter of credit facility is secured by a deposit account at Bank of the West. As of March 8, 2006, this deposit account had a balance of $578,000, which is shown as restricted cash on the consolidated balance sheets. As of March 8, 2006, $651,000 of letters of credit were outstanding under the letter of credit facility. The agreement contains covenants that, among other matters, require the Company to submit financial statements to the bank within specified time periods. As of March 8, 2006, the Company was in compliance with all Bank of the West agreement covenants.

9. DISCONTINUED OPERATIONS

On February 10, 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 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 brand in these same markets.

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The Company has agreed to not compete internationally through its Diedrich Coffee or 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 144, 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 8, 2006		March 9, 2005		March 8, 2006		March 9, 2005
Net revenue	$	—	$	1,780,000	$	—	$	3,910,000
Earnings from discontinued operations before income taxes	$	—	$	917,000	$	—	$	2,641,000
Earnings from discontinued operations, net of $341,000 tax for the twelve weeks ended March 9, 2005 and net of $985,000 tax for the thirty-six weeks ended March 9, 2005	$	—	$	576,000	$	—	$	1,656,000
Gain on sale of discontinued operations, net of $3,376,000 tax				15,558,000				15,558,000
Total income from discontinued operations, net of tax	$	—	$	16,134,000	$	—	$	17,214,000

10. EMPLOYEE BENEFIT PLANS

401(k) Plan

The Company maintains a 401(k) Salary Deferral Plan (the “401(k) Plan”) whereby eligible employees may voluntarily contribute up to 20% of compensation, subject to certain statutory limits. The Company may match a percentage of employee contributions at its discretion. Employer matching contributions relating to the 401(k) Plan totaled $13,000 and $38,000 for the twelve and thirty-six weeks ended March 8, 2006, respectively, and $11,000 and $28,000 for the twelve and thirty-six weeks ended March 9, 2005, respectively.

Deferred Compensation Plan

Effective December 15, 2005, the Company amended its non-qualified deferred compensation plan. Under the amended plan, participants may elect to defer, on a pre-tax basis, a portion (from 0% to 100%) of their base salary, service bonus, and performance-based compensation. Any amounts deferred by a participant will be credited to the participant’s deferred compensation account. The plan further provides that the Company may make discretionary contributions to a plan participant’s deferred compensation account. Each plan participant will be vested in the amounts held in the plan participant’s deferred compensation account as follows: (i) one hundred percent (100%) vested at all times with respect to all amounts of deferred compensation; and (ii) one hundred percent (100%) vested at all times with respect to all employer discretionary contributions. The Company made no discretionary contributions to plan participants’ accounts for the twelve and thrity-six weeks ended March 8, 2006.

The plan also provides that any amounts deferred under the plan may not be distributed to a plan participant until the earlier of: (i) the plan participant’s separation from service with the Company; (ii) the Plan participant’s retirement from the Company; (iii) the plan participant’s disability; (iv) the plan participant’s death; (v) the occurrence of a change in control of the Company; (vi) the occurrence of an unforeseeable emergency, as defined in the plan; or (vii) such other date as set forth in the plan participant’s deferral election, including a date that occurs prior to the plan participant’s separation from service with the Company. Any amounts distributed to a plan participant will be paid in a form specified by the plan participant, or in the form of either a lump sum payment in an amount equal to the plan participant’s deferred compensation account balance or equal annual installments of the plan participant’s deferred compensation account balance over a period not to exceed (i) 20 years in the case of a distribution due to separation from service, death or disability or (ii) five years in the case of a distribution for educational expenses.

During the fiscal quarter ended March 8, 2006, the Company purchased a company-owned life insurance (“COLI”) contract insuring one of the participants in the deferred compensation plan. The policy is held in a trust to provide additional benefit security for the deferred compensation plan. The assets in the trust are owned by the Company and are subject to claims of its creditors. The gross cash surrender value of these contracts as of March 8, 2006 was $372,000 as shown in the accompanying consolidated balance sheets. Total death benefits payable were $10,347,000 at March 8, 2006. Management intends to use the future death benefits from these insurance contracts to fund the deferred compensation arrangements; however, there may not be a direct correlation between the timing of the future cash receipts and disbursements under these arrangements.

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 for the fiscal year ended June 29, 2005 and in other reports that we file with the Securities and Exchange Commission. We undertake no obligation to revise or update any forward-looking statements whether as a result of new information, future events or changed circumstances. Unless otherwise indicated, “we,” “us,” “our,” and similar terms refer to Diedrich Coffee, Inc. and its subsidiaries.

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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 8, 2006 to the results for the twelve and thirty-six weeks ended March 9, 2005.

• 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 8, 2006. 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 the 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.

OVERVIEW

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 8, 2006, we owned and operated 57 retail locations and franchised 145 other retail locations under these brands, for a total of 202 retail coffee outlets. As of March 8, 2006, 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 with more than 10,000 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.

Recent Developments

On January 25, 2006, we announced that Peter Churm had rejoined our board of directors.

On January 3, 2006, we announced the appointment of Sean M. McCarthy to serve as our Chief Financial Officer following the planned retirement of Martin A. Lynch on January 1, 2006.

On December 14, 2005, we announced the appointment of Stephen V. Coffey to serve as our Chief Executive Officer following the resignation of Roger M. Laverty on December 13, 2005.

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Sale of International Franchise Operations

On February 10, 2005, we sold our international Gloria Jean’s operations to our former Australian master franchisee, Jireh International Pty. Ltd., and certain of its affiliates. From this sale, we received $16,000,000 in cash and expect to receive a total of $7,020,000 over the next six years under license, roasting and consulting agreements. Through March 8, 2006, we had received $1,000,000 of these payments.

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 thirty-six weeks ended March 8, 2006, is set forth below:

	Units at June 30, 2004	Opened	Closed/Sold (A)		Net transfers between the Company and Franchise		Units at June 29, 2005	Opened	Closed		Net transfers between the Company and Franchise		Units at March 8, 2006
Gloria Jean’s Brand
Company Operated	10	1	(1	)	1		11	1	(1	)	(3	)	8
Franchise – Domestic	137	11	(15	)	(1	)	132	13	(13	)	3		135
Total Company Operated and Franchise-Domestic	147	12	(16	)	—		143	14	(14	)	—		143
Franchise – International
Australia	196	46	(242	)	—		—	—	—		—		—
Far East/Asia (B)	19	—	(19	)	—		—	—	—		—		—
Mexico	17	—	(17	)	—		—	—	—		—		—
Other (C)	50	14	(64	)	—		—	—	—		—		—
Total Franchise - International	282	60	(342	)	—		—	—	—		—		—
Subtotal Gloria Jean’s	429	72	(358	)	—		143	14	(14	)	—		143
Diedrich Coffee Brand
Company Operated	23	3	—		—		26	1	—		(1	)	26
Franchise – Domestic	7	1	(1	)	—		7	1	—		1		9
Subtotal Diedrich	30	4	(1	)	—		33	2	—		—		35
Coffee People Brand
Company Operated	23	3	(1	)	—		25	4	(5	)	(1	)	23
Franchise – Domestic	—	—	—		—		—	—	—		1		1
Subtotal Coffee People	23	3	(1	)	—		25	4	(5	)	—		24
Total	482	79	(360	)	—		201	20	(19	)	—		202

(A) On February 10, 2005, in connection with the sale of our international Gloria Jean’s operations, we sold the franchise rights to 338 Gloria Jean’s retail locations to Jireh International Pty. Ltd. and certain of its affiliates.

(B) Includes Japan and Korea.

(C) Includes Guam, Indonesia, Ireland, Turkey, Malaysia, New Zealand, Philippines, United Arab Emirates, Romania, South Africa 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.

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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 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. 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.

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. Recently, cost of sales and related occupancy costs have increased and gross margins have decreased primarily as a result of the increase in the number of company operated retail locations and Keurig related wholesale sales, which have lower gross margins than other wholesale sales, and have become a higher percentage of our overall revenue 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.

RESULTS OF OPERATIONS

Twelve weeks ended March 8, 2006 compared with the twelve weeks ended March 9, 2005

Total Revenue. Total revenue for the twelve weeks ended March 8, 2006 increased by $2,425,000, or 20.9%, to $14,049,000 from $11,624,000 for the twelve weeks ended March 9, 2005. Each component of total revenue is discussed below.

Retail Sales. Retail sales for the twelve weeks ended March 8, 2006 increased by $860,000, or 12.1%, to $7,975,000 from $7,115,000 for the prior year period. This increase was primarily due to a net increase of two company operated stores since March 9, 2005 and to company operated same store sales increase of 5.7%. Retail sales from our internet website also increased by $93,000, or 67.4%, to $231,000 for the twelve weeks ended March 8, 2006 from $138,000 for the twelve weeks ended March 9, 2005.

Wholesale Revenue. Our wholesale sales for the twelve weeks ended March 8, 2006 increased by $1,675,000, or 48.9%, to $5,102,000 from $3,427,000 for the twelve weeks ended March 9, 2005. This increase was primarily the net result of the following factors:

Keurig “K-cup” and other Third Party Wholesale sales. Third party wholesale sales for the twelve weeks ended March 8, 2006 increased by $1,524,000, or 60.8%, to $4,029,000 from $2,505,000 for the twelve weeks ended March 9, 2005 led by a 70.2% growth in Keurig “K-cup” sales.

Roasted coffee sales to franchisees. Sales of roasted coffee to our franchisees increased $152,000 for the twelve weeks ended March 8, 2006 due primarily to the timing of holiday shipments to franchisees in the current year period and relatively flat same store sales in the twelve weeks ended March 8, 2006.

Franchise Revenue. Our franchise revenue consists of initial franchise fees, franchise renewal fees, area development fees, and royalties received on sales at franchised locations. Franchise revenue decreased by $110,000, or 10.2%, to $972,000 for the twelve weeks ended March 8, 2006 from $1,082,000 for the twelve weeks ended March 9, 2005. Of the decline, $60,000 was due to a reclassification of certain fees as a reduction of general and administrative marketing expenses. The balance of the decline, $50,000, was due primarily to higher average sales volumes in the new franchise stores opened since the beginning of the prior year and relatively flat same store sales in the twelve weeks ended March 8, 2006.

Cost of Sales and Related Occupancy Costs. Cost of sales and related occupancy costs for the twelve weeks ended March 8, 2006 increased $1,907,000, or 32.8%, to $7,713,000 from $5,806,000 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 59.0% of retail and wholesale sales for the twelve weeks ended March 8, 2006 from 55.1% in the twelve weeks ended March 9, 2005. Retail cost of sales increased from 34.5% to 37.0% due in part to an increase in roasted coffee costs and a higher percentage of higher cost whole bean coffee sales. Wholesale cost of sales increased from 72.7% to 74.2% primarily due to a higher percentage of higher cost Keurig business for the twelve weeks ended March 8, 2006. Occupancy costs for the twelve weeks ended March 8, 2006 increased $115,000, or 13.4%, to $975,000 from $860,000 in the prior year period primarily due to the higher rents associated with new retail stores and lease renewals at existing retail stores.

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Operating Expenses. Operating expenses for the twelve weeks ended March 8, 2006, as a percentage of retail and wholesale sales, decreased from 36.1% of retail and wholesale sales for the twelve weeks ended March 9, 2005 to 32.9% for the twelve weeks ended March 8, 2006 due primarily to the increase in third party wholesale sales and lower workers compensation expenses.

Depreciation and Amortization. Depreciation increased by $54,000 to $617,000 for the twelve weeks ended March 8, 2006 from the prior year fiscal quarter due mostly to capital assets that have been acquired as part of new store construction.

General and Administrative Expenses. Our general and administrative expenses increased by $980,000, or 42.0%, to $3,313,000 for the twelve weeks ended March 8, 2006. As a percentage of total revenue, general and administrative expenses increased from 20.0% for the twelve weeks ended March 9, 2005 to 23.6% for the twelve weeks ended March 8, 2006. An increase of $374,000 was attributed to salaries, temporary help, consulting and related costs primarily in the areas of franchise sales, training, construction and store supervision, and includes $96,000 of severance expense resulting from the departure of our former vice president of information systems, partially offset by a reduced provision for corporate bonuses. We also incurred a $111,000 increase in stock-based compensation expense due to the adoption of SFAS 123R in the first quarter of fiscal 2006, as well as net $481,000 increase in legal fees. These expenses were offset by a $73,000 decrease for the Gloria Jean’s brand resulting from a change in the classification for coordination fees previously reflected in franchise income.

Interest Expense and Other, Net. Interest expense, interest income and other income, net was a net income of $4,000 in the twelve weeks ended March 9, 2005 and was a net income of $93,000 in the twelve weeks ended March 8, 2006. This change was due to interest income on the proceeds from the sale of our international Gloria Jean’s franchise operations and a reduction of interest expense.

Income Tax Benefit. We had losses from continuing operations and income from discontinued operations for the twelve weeks ended March 9, 2005. In accordance with SFAS 109 Accounting for Income Taxes, the income tax benefit generated by the loss from continuing operations was $340,000 for the twelve weeks ended March 9, 2005. Tax expense for the twelve weeks ended March 8, 2006 includes an adjustment to increase the year-to-date tax benefit by $69,000. The tax benefit was generated primarily due to net operating loss carry-backs to offset taxable income reported for the year ended June 29, 2005. Due to the uncertainty of future taxable income, deferred tax assets resulting from the net operating loss carry-forwards have been fully reserved.

Results of Discontinued Operations. As a result of the sale of the international Gloria Jean’s franchise operations on February 10, 2005, the results from this component of our business are presented as discontinued operations for the fiscal twelve weeks ended March 9, 2005 in accordance with SFAS 144 Accounting for the Impairment or Disposal of Long-Lived Assets. For the twelve weeks ended March 9, 2005, income from discontinued operations was $576,000, net of $341,000 in taxes.

Thirty-six weeks ended March 8, 2006 compared with the thirty-six weeks ended March 9, 2005

Total Revenue. Total revenue for the thirty-six weeks ended March 8, 2006 increased by $4,889,000, or 13.5%, to $41,171,000 from $36,282,000 for the thirty-six weeks ended March 9, 2005. Each component of total revenue is discussed below.

Retail Sales. Retail sales for the thirty-six weeks ended March 8, 2006 increased by $2,206,000, or 10.1%, to $24,007,000 from $21,801,000 for the prior year period. This increase was primarily due to company operated same store sales increase of 3.8% and includes a $200,000, or 47.3%, increase in e-commerce retail sales.

Wholesale Revenue. Our wholesale sales for the thirty-six weeks ended March 8, 2006 increased by $3,122,000, or 27.4%, to $14,496,000 from $11,374,000 for the thirty-six weeks ended March 9, 2005. This increase was primarily the net result of the following factors:

Keurig “K-cup” and other Third Party Wholesale sales. Third party wholesale sales for the thirty-six weeks ended March 8, 2006 increased by $3,118,000, or 43.9%, to $10,225,000 from $7,107,000 for the thirty-six weeks ended March 9, 2005 led by a 54.3% growth in the Keurig “K-cup” sales.

Roasted coffee sales to franchisees. Sales of roasted coffee to our franchisees remained flat for the thirty-six weeks ended March 8, 2006 increasing by $5,000 compared to same quarter prior year due to 2.4% negative same store sales for the three quarters of fiscal 2006 for the Gloria Jean’s franchise system which reduced roasted coffee usage, and was offset in part by the timing of holiday shipments to franchisees in the current year period.

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Franchise Revenue. Our franchise revenue consists of initial franchise fees, franchise renewal fees, area development fees, and royalties received on sales at franchised locations. Our franchise revenue decreased by $439,000, or 14.1%, to $2,668,000 for the thirty-six weeks ended March 8, 2006 from $3,107,000 for the thirty-six weeks ended March 9, 2005. Of the decline, $241,000 was due to a reclassification of certain fees as a reduction of general and administrative marketing expenses. The balance of the decline, $198,000, was due to a decline in franchise royalties and franchise fee revenue, primarily resulting from to declining same store sales at franchise locations along with fewer new store openings compared to prior year.

Cost of Sales and Related Occupancy Costs. Cost of sales and related occupancy costs for the thirty-six weeks ended March 8, 2006 increased $4,248,000, or 23.7%, to $22,152,000 from $17,904,000 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 57.5% of retail and wholesale sales for the thirty-six weeks ended March 8, 2006 from 54.0% in the thirty-six weeks ended March 9, 2005. The increase is primarily due to a higher percentage of higher cost Keurig business which increased wholesale cost of sales from 69.6% to 72.4% for the thirty-six weeks ended March 8, 2006. Occupancy costs for the thirty-six weeks ended March 8, 2006 increased $443,000, or 17.4%, to $2,982,000 from $2,539,000 in the prior year period primarily due to the higher rents associated with new retail stores and lease renewals at existing retail stores.

Operating Expenses. Operating expenses for the thirty-six weeks ended March 8, 2006 as a percentage of retail and wholesale sales decreased from 34.9% of retail and wholesale sales for the thirty-six weeks ended March 9, 2005 to 33.6% for the thirty-six weeks ended March 8, 2006 due primarily to the increase in third party wholesale sales and lower workers compensation expense.

Depreciation and Amortization. Depreciation and amortization increased by $78,000 to $1,775,000 for the thirty-six weeks ended March 8, 2006 from the prior year period due mostly to capital assets that have been acquired as part of new store construction.

General and Administrative Expenses. General and administrative expenses increased by $2,127,000, or 28.2%, to $9,677,000 for the thirty-six weeks ended March 8, 2006 from the prior year period. As a percentage of revenue, general and administrative expenses increased to 23.5% in the first thirty-six weeks of fiscal 2006 from 20.8% in the prior year period. This increase resulted from $1,015,000 of salaries, temporary help, consulting and related costs, including $419,000 of expense resulting from the departures of our former chief executive officer and vice president of information systems, $296,000 related to salaries associated with construction, training and franchise development primarily related to efforts to grow our Gloria Jean’s brand, and $235,000 related to salaries associated with store supervision, training, and marketing primarily related to efforts to grow our Diedrich and Coffee People brands. We also incurred $287,000 of compensation expense for the thirty-six weeks ended March 8, 2006 due to the adoption of SFAS 123R in the first quarter of the fiscal 2006 and a net $512,000 increase in legal fees. We also incurred $335,000 in outside services primarily resulting from $237,000 of audit and tax fees expensed in the current fiscal year, but related to the 2005 fiscal year end audit and tax returns. In addition, advertising costs for our Diedrich Coffee brand were up by $249,000 resulting from cable advertising and production costs. These expenses were offset by a $225,000 decrease for the Gloria Jean’s brand resulting from a change in the classification for coordination fees previously reflected in franchise income.

Interest Expense and Other, Net. Interest expense, interest income and other income, net which was a net expense of $90,000 for the thirty-six weeks ended March 9, 2005 and was a net income of $321,000 in the thirty-six weeks ended March 8, 2006. This change was due to interest income on the proceeds from the sale of our international Gloria Jean’s franchise operations and a reduction of interest expense.

Income Tax Benefit. We had losses from continuing operations and income from discontinued operations for the thirty-six weeks ended March 9, 2005. In accordance with SFAS 109, Accounting for Income Taxes, the income tax benefit generated by the loss from continuing operations was $973,000 for the thirty-six weeks ended March 9, 2005. For the thirty-six weeks ended March 8, 2006, a tax benefit of $384,000 was generated primarily due to net operating loss carry-backs to offset taxable income reported for the year ended June 29, 2005. As of March 8, 2006, net operating loss carry-forwards for federal and state income tax purposes of approximately $7,400,000 and $4,174,000, respectively, are available to be utilized against future taxable income for years through fiscal 2025 for federal taxes and 2015 for state taxes, subject to annual limitation pertaining to change in ownership rules under the Internal Revenue Code. Due to the uncertainty of future taxable income, deferred tax assets resulting from the net operating loss carry-forwards have been fully reserved.

Results of Discontinued Operations. As a result of the sale of the international Gloria Jean’s franchise operations on February 10, 2005, the results from this component of our business are presented as discontinued operations for the fiscal thirty-six weeks ended March 9, 2005 in accordance with SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets. For the thirty-six weeks ended March 9, 2005, income from discontinued operations was $1,656,000, net of $985,000 in taxes.

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FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES

Current Financial Condition. At March 8, 2006, we had cash of $4,286,000 as compared to $10,493,000 at June 29, 2005, and we had working capital of $5,811,000 as compared to working capital of $11,203,000 at June 29, 2005. Total outstanding capital lease obligations decreased to $333,000 at March 8, 2006 from $413,000 at June 29, 2005. No long-term debt was outstanding at March 8, 2006 or June 29, 2005. From June 29, 2005 to March 8, 2006, stockholder’s equity decreased from $31,522,000 to $27,269,000.

The accounts receivable balance of $3,527,000 as of March 8, 2006 is an increase of $1,324,000 from the June 29, 2005 balance of $2,203,000. This increase is related to the seasonality of our business and to an increase in wholesale sales to third parties. The accounts payable balance of $3,613,000 as of March 8, 2006 is an increase of $971,000 from the June 29, 2005 balance of $2,642,000. This increase is attributable to an increase in capital spending.

Cash Flows. Cash used in operating activities for the thirty-six weeks ended March 8, 2006 totaled $2,891,000 as compared with $1,846,000 cash used in operating activities for the thirty-six weeks ended March 9, 2005. This increase is the net result of many factors more fully enumerated in the Unaudited Condensed Consolidated Statement of Cash Flows in the accompanying financial statements.

Net cash used in investing activities for the thirty-six weeks ended March 8, 2006 totaled $3,373,000 as compared with net cash provided of $14,039,000 for the thirty-six weeks ended March 9, 2005. During the thirty-six weeks ended March 8, 2006, a total of $3,876,000 was used to invest in property and equipment in our store remodel project (approximately $340,000), new stores (approximately $2,616,000), our Castroville roasting facility (approximately $470,000) and our home office facility (approximately $450,000). These expenditures were partially offset by $1,038,000 of payments received on notes receivable and $43,000 of proceeds received from sales of property and equipment. Our investment in a restricted money market account was $578,000 at March 8, 2006.

Net cash provided by financing activities for the thirty-six weeks ended March 8, 2006 totaled $57,000 as compared to $994,000 for the thirty-six weeks ended March 9, 2005. The decrease is primarily attributed to $1,000,000 in borrowings under our contingent convertible note purchase agreement during the thirty-six weeks ended March 9, 2005 with no comparable activity in the current period.

Outstanding Debt and Financing Arrangements. On May 10, 2004, we entered into a $5,000,000 Contingent Convertible Note Purchase Agreement (the “Note Purchase Agreement”). The agreement provides for us to, at our election, 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 was initially payable at LIBOR plus 3.30%, and a facility fee of 1.00% annually is payable on the unused portion of the facility. The Note Purchase Agreement contains covenants that, among other matters, limit the amount of indebtedness that we may have outstanding in relation to our tangible net worth and that originally required us to maintain a specified minimum dollar value of earnings before interest, tax, depreciation and amortization for the trailing four fiscal quarters (the “Minimum EBITDA Covenant”). The notes are convertible into our common stock only upon certain changes of control. For notes issued and repaid, warrants to purchase shares are issued with the same rights and restrictions for exercise as existed for convertibility of the notes at the time of their issuance. Warrants are exercisable only in the event of a change of control and were to expire on May 10, 2008. The lender under this agreement is our largest single stockholder and the chairman of our board of directors serves as the sole general partner of this limited partnership.

On May 10, 2004, upon entering into the Note Purchase 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 a second note for $1,000,000 under this facility. The price of our common stock on May 10, 2004, the date that the first $1,000,000 note was issued, was $3.95 per share. The price of our common stock on September 15, 2004, the date the second $1,000,000 note was issued, was $4.95 per share. Both the notes were fully repaid in fiscal year 2005, and thus a total of 455,184 warrants are issuable upon a change in control. We have issued 4,219 warrants as of March 8, 2006. As of March 8, 2006, we had no borrowings outstanding under the facility.

On June 30, 2004, we entered into Amendment No. 1 to Contingent Convertible Note Purchase Agreement (“Amendment No. 1”) which revised the definition of “Availability” to mean, on any date, the loan amount less the sum of the principal amounts then outstanding under the Note Purchase Agreement. Under the original Note Purchase Agreement, availability was calculated using a formula that reduced availability over time.

As a result of our cumulative losses over the last three quarters, we were not in compliance with all agreement covenants for the current quarter. On March 31, 2006, we entered into Amendment No. 2 to Contingent Convertible Note Purchase Agreement (“Amendment No. 2”). Amendment No. 2: (i) contains a waiver with respect to the existing default of the Minimum EBITDA Covenant and removes the Minimum EBITDA from the Note Purchase Agreement; (ii) clarifies that warrants to purchase common stock of the Company will be issued with respect to repaid principal amounts only upon a change in control of the Company; (iii) increases the interest rate applicable to outstanding amounts under the credit facility by 2%, to LIBOR plus 5.30%; and

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(iv) extends the exercise date of all warrants issued or to be issued under the Note Purchase Agreement by one year, to May 10, 2009. The maturity date for any notes issued in the future was unaffected by Amendment No. 2. We are in compliance with all agreement covenants as amended by Amendment No 2 for the quarter ended March 8, 2006.

On October 15, 2005, the Amended and Restated Credit Agreement with Bank of the West expired. On November 4, 2005, we entered into a new Credit Agreement with Bank of the West. The agreement provides for a $750,000 letter of credit facility that expires on October 15, 2006. The letter of credit facility is secured by a deposit account at Bank of the West. As of March 8, 2006, this deposit account has a balance of $578,000, which is shown as restricted cash on the consolidated balance sheets. As of March 8, 2006, $651,000 of letters of credit were outstanding under the letter of credit facility. The agreement contains covenants that, among other matters, require us to submit our financial statements to the bank within specified time periods. As of March 8, 2006, we were in compliance with all Bank of the West agreement covenants.

Based upon the terms of our credit agreements, our recent operating performance and business outlook, and the status of our balance sheet, we believe that cash from operations, cash and cash equivalents, and funds available under our credit agreements will be sufficient to satisfy our working capital needs at the anticipated operating levels for at least the next twelve months. Our future capital requirements will depend on many factors, including the extent and timing of the rate at which our business grows, if at all, with corresponding demands for working capital. We may be required to seek additional funding through either debt financing, or public or equity, or a combination of funding methods to meet our capital requirements and sustain our operations. However, additional funds may not be available on terms acceptable to us or at all.

Other Commitments. The following represents a comprehensive list of our contractual obligations and commitments as of March 8, 2006:

	Payments Due by Year
	Total		1 year		2 years		3 years		4 years		5 years		Thereafter
	(In thousands)
Capital leases	$	333	$	19	$	20	$	22	$	22	$	25	$	225
Company operated retail locations and other operating leases		27,010		3,934		3,579		3,364		3,017		2,541		10,575
Gloria Jean’s franchise operated retail locations operating leases		19,608		4,231		3,424		2,567		2,238		1,812		5,336
Green coffee commitments		2,627		2,259		292		76		—		—		—
	$	49,578	$	10,443	$	7,315	$	6,029	$	5,277	$	4,378	$	16,136

As of March 8, 2006, there were employment agreements with three of our officers that provide for severance payments in the event that these individuals are terminated by us without cause or they terminate their employment as a result of a constructive termination. These severance payments range from six months to one year’s salary. Our maximum theoretical liability for severance under the contracts is currently $587,000. Additionally, we have an agreement with Coffee Management Company (“CMC”) under which our Chief Executive Officer provides services to us. If this engagement is terminated before June 14, 2006, then CMC will receive an engagement severance payment equal to $60,000. Because these amounts are contingent, they have not been included in the table above.

The agreement with CMC also provides for a one-time bonus that is payable at the end of the engagement. The bonus will be paid in the form of stock (60%) and cash (40%) and will be in an amount that is equal to the sum of 5.0% of the appreciation of our total market capitalization during the term of the engagement (as measured by the increase in our stock price). In addition, if we are acquired by any person or entity, other than a current affiliate, within twelve months of the termination date of the engagement, and the per share consideration paid in connection with the acquisition multiplied by the then outstanding shares of capital stock (the “Disposition Value”) is greater than the market capitalization at the end of the engagement (the “Termination Market Capitalization”), CMC will receive an additional bonus equal to 5.0% of the difference of the Disposition Value less the Termination Market Capitalization; provided, however, that the additional bonus will not be paid if the engagement is terminated by either party prior to June 14, 2006. Since there was no appreciation in our market capitalization as of March 8, 2006, no liability for bonus was recorded as of that date.

As reflected in the table above, 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 real property leases for 78 Gloria Jean’s franchise locations. Under our franchising business model, from time to time we execute the master lease for a location and enter 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 lease. Our maximum theoretical future exposure at March 8, 2006, computed as the sum of all remaining lease payments through the expiration dates of the respective leases, was $19,608,000. 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 location or terminating the master lease by negotiating a lump sum payment to the landlord in an amount that is less than the sum of all remaining future rents.

CRITICAL ACCOUNTING ESTIMATES

The preparation of our 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

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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.

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 the provision for asset impairment and restructuring costs, net in our unaudited condensed consolidated statements of earnings.

A significant assumption used in determining the amount of the estimated liability for closing stores is the amount of the estimated liability for future lease payments on vacant stores, which we determine based on our assessment of our ability to successfully negotiate early terminations of our lease agreements with the lessors or 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

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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 actuarial estimates of the amount of incurred and unpaid losses. 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 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 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.

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 become profitable for a number of years and our prospects for the realization of our deferred tax assets are more likely than not, we would expect to reverse our valuation allowance and credit income tax expense. In analyzing 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 8, 2006, our net deferred tax assets were fully reserved with a related valuation allowance that totaled approximately $4,267,000.

Item 3. Quantitative And Qualitative Disclosures About Market Risk.

Market Risk Sensitive Items Entered Into for Trading Purposes

None.

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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 8, 2006, we had a $5,000,000 loan facility, with no outstanding balance that could be affected by changes in short term interest rates.

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 8, 2006, we had commitments to purchase coffee through fiscal year 2009 totaling $2,627,000 for 1,705,000 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 2,736,000 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 $27,000 of additional cost.

In addition to coffee, the cost, availability and quality of non-coffee raw ingredients such as fluid milk products, for our products are subject to a number of factors. In particular, the supply and price of fluid milk has been subject to significant volatility, in recent years. Our ability to raise sales prices in response to increases in raw ingredient prices may be limited, and our profitability could be adversely affected if the prices of these ingredients 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 the design and operation of our disclosure controls and procedures. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective.

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

PART II - OTHER INFORMATION

Item 1. Legal Proceedings.

In the ordinary course of our business, we may become involved in legal proceedings from time to time. As of and for the thirty-six week period ending March 8, 2006, we were not a party to any material legal proceedings.

Item 4. Submission of Matters to a Vote of Security Holders.

The annual meeting of stockholders was held on March 2, 2006. At the meeting, Peter Churm, Lawrence Goelman, Paul Heeschen, Timothy Ryan and Richard Spencer were elected to the board of directors to serve until the next annual meeting. Set forth below is a brief description of each matter voted upon at the annual meeting, together with the votes cast on each matter.

Election of Directors

The stockholders elected all of the director nominees named in the proxy statement. The votes cast for each nominee and the votes withheld with respect to each nominee are set forth below:

Director Nominee	Votes For	Votes Withheld
Peter Churm	5,057,517	37,818
Lawrence Goelman	4,952,933	142,402
Paul Heeschen	4,891,722	203,613
Timothy Ryan	4,395,076	700,259
Richard Spencer	4,955,294	140,041

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Ratification of the Appointment of Independent Registered Public Accounting Firm

The stockholders ratified the appointment of BDO Seidman, LLP as our independent registered public accounting firm for our fiscal year ending June 28, 2006. The votes cast on the proposal are set forth below:

For	5,088,084
Against	1,816
Abstain	5,435

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	Credit Agreement with Bank of the West, dated November 4, 2005
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)*
10.18	Employment Letter regarding the employment of Pamela Britton, dated February 6, 2001 (12)*
10.21	Form of Separation Agreement and Release with Martin Diedrich, effective October 28, 2004 (20)*

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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	Amendment No. 1 to Note Purchase Agreement dated June 30, 2004
10.26	Amendment No. 2 to Note Purchase Agreement dated March 31, 2006 (23)
10.27	Asset Purchase Agreement, dated December 5, 2004, by and among, among others, Diedrich Coffee, Inc. and Jireh International Pty. Ltd. (17)
10.28	Mutual Release Agreement by and between Diedrich Coffee, Inc. and Roger M. Laverty, dated December 13, 2005 (19)*
10.29	Engagement Agreement by and between Diedrich Coffee, Inc. and Stephen V. Coffey, dated December 14, 2005 (19)*
10.30	Letter Agreement with Sean M. McCarthy, effective January 1, 2006 (22)*
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’s Definitive Proxy Statement, filed with the Securities and Exchange Commission on April 12, 2001.

(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 December 17, 2003, 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.

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(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 Current Report on Form 8-K, filed with the Securities and Exchange Commission on December 16, 2005.

(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 Current Report on Form 8-K, filed with the Securities and Exchange Commission on January 5, 2006.

(23) Previously filed as an exhibit to Diedrich Coffee’s Current Report on Form 8-K, filed with the Securities and Exchange Commission on March 31, 2006.

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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: April 21, 2006	DIEDRICH COFFEE, INC.
	/s/ Stephen V. Coffey
	Stephen V. Coffey Chief Executive Officer (On behalf of the registrant)
	/s/ Sean M. McCarthy
	Sean M. McCarthy Vice President and Chief Financial Officer (Principal financial officer)

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EXHIBIT INDEX

Exhibit No.	Description
10.9	Credit Agreement with Bank of the West, dated November 4, 2005
10.25	Amendment No. 1 to Note Purchase Agreement, dated June 30, 2004
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

EX-10.9

Exhibit 10.9

CREDIT AGREEMENT

(LETTER OF CREDIT)

This Agreement (the “Agreement”) is made and entered into as of November 4, 2005, by and between BANK OF THE WEST (the “Bank”) and DIEDRICH COFFEE, INC. (the “Borrower”), on the terms and conditions that follow:

SECTION 1

DEFINITIONS

1.1 Certain Defined Terms: Unless elsewhere defined in this Agreement, the following terms shall have the following meanings (such meanings to be generally applicable to the singular and plural forms of the terms defined):

1.1.1  “Business Day”: shall mean a day, other than a Saturday or Sunday, on which commercial banks are open for business in California.

1.1.2   “Collateral”: shall mean the property described in Section 3, together with any other personal or real property in which the Bank may be granted a lien or security interest to secure payment of the Obligations.

1.1.3  “Environmental Claims”: shall mean all claims, however asserted, by any governmental authority or other person alleging potential liability or responsibility for violation of any Environmental Law or for Discharge or injury to the environment or threat to public health, personal injury (including sickness, disease or death), property damage, natural resources damage, or otherwise alleging liability or responsibility for damages (punitive or otherwise), cleanup, removal, remedial or response costs, restitution, civil or criminal penalties, injunctive relief, or other type of relief, resulting from or based upon (a) the presence, placement, discharge, emission or release (including intentional and unintentional, negligent and non-negligent, sudden or non-sudden, accidental or non-accidental placement, spills, leaks, Discharges, emissions or releases) of any Hazardous Material at, in, or from property, whether or not owned by the Borrower, or (b) any other circumstances forming the basis of any violation, or alleged violation, of any Environmental Law.

1.1.4   “Environmental Laws”: shall mean all federal, state or local laws, statutes, common law duties, rules, regulations, ordinances and codes, together with all administrative orders, directed duties, requests, licenses, authorizations and permits of, and agreements with, any governmental authorities, in each case relating to environmental, health, safety and land use matters; including the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (“CERCLA”), the Clean Air Act, the Federal Water Pollution Control Act of 1972, the Solid Waste Disposal Act, the Federal Resource Conservation and Recovery Act, the Toxic Substances Control Act, the Emergency Planning and Community Right-to-Know Act, the California Hazardous Waste Control Law, the California Solid Waste Management, Resource, Recovery and Recycling Act, the California Water Code and the California Health and Safety Code.

1.1.5   “Environmental Permits”: shall have the meaning provided in Section 5.11 hereof.

1.1.6   “ERISA”: shall mean the Employee Retirement income Security Act of 1974, as amended from time to time, including (unless the context otherwise requires) any rules or regulations promulgated thereunder.

1.1.7  “Event of Default”: shall have the meaning set forth in Section 7.

1.1.8  “Expiration Date”: shall mean October 15, 2006, or the date of termination of the Bank’s commitment to lend under this Agreement pursuant to Section 8, whichever shall occur first.

1.1.9  “Hazardous Materials”: shall mean all those substances which are regulated by, or which may form the basis of liability under, any Environmental Law, including all substances identified under any Environmental Law as a pollutant, contaminant, hazardous waste, hazardous constituent, special waste, hazardous substance, hazardous material, or toxic substance, or petroleum or petroleum derived substance or waste.

1.1.10  “Letter of Credit Facility”: shall mean the credit facility described as such in Section 2.

1.1.11  “Obligations”: shall mean all amounts owing by the Borrower to the Bank pursuant to this Agreement including, but not limited to, the unpaid principal amount of any loans or advances.

1.1.12  “Ordinary Course of Business”: shall mean, with respect to any transaction involving the Borrower or any of its subsidiaries or affiliates, the ordinary course of the Borrower’s business, as conducted by the Borrower in accordance with past practice and undertaken by the Borrower in good faith and not for the purpose of evading any covenant or restriction in this Agreement or in any other document, instrument or agreement executed in connection herewith.

1.2 Other Terms: Other terms not otherwise defined shall have the meanings attributed to such terms in the Uniform Commercial Code as in effect on July 1, 2001 and from time to time thereafter.

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SECTION 2

CREDIT FACILITIES

2.1 LETTER OF CREDIT FACILITY

2.1.1  Letter of Credit Facility: The Bank agrees to issue standby letters of credit (each a “Letter of Credit”) on behalf of the Borrower of Up to $750,000.00.

For the purposes hereof, any Letters of Credit issued and outstanding for the account of the Borrower as of the date hereof shall be deemed to be issued hereunder.

(i) Upon the Bank’s request, the Borrower shall promptly pay to the Bank issuance fees and such other fees, commissions, costs and any out-of-pocket expenses charged or incurred by the Bank with respect to any Letter of Credit

(ii) The commitment by the Bank to issue Letters of Credit shall, unless earlier terminated in accordance with the terms of the Agreement, automatically terminate on the Expiration Date of the Letter of Credit Facility and no Letter of Credit shall expire on a date which is more than 90 days after the Expiration Date.

(iii) Each Letter of Credit shall be in form and substance satisfactory to the Bank and in favor of beneficiaries satisfactory to the Bank, provided that the Bank may refuse to issue a Letter of Credit due to the nature of the transaction or its terms or in connection with any transaction where the Bank, due to the beneficiary or the nationality or residence of the beneficiary, would be prohibited by any applicable law, regulation or order from issuing such Letter of Credit.

(iv) Prior to the issuance of each Letter of Credit, but in no event later than 10:00 a.m. (California time) on the day such Letter of Credit is to be issued (which shall be a Business Day), the Borrower shall deliver to the Bank a duly executed form of the Bank’s standard form of application for issuance of a Letter of Credit with proper insertions.

(v) The Borrower shall, upon the Bank’s request, promptly pay to and reimburse the Bank for all costs incurred and payments made by the Bank by reason of any future assessment, reserve, deposit or similar requirement or any surcharge, tax or fee imposed upon the Bank or as a result of the Bank’s compliance with any directive or requirement of any regulatory authority pertaining or relating to any Letter of Credit

2.2 Late Payment: In addition to any other rights the Bank may have hereunder, if any payment of principal or interest or any portion thereof, under this Agreement is not paid within 15 days of when due, a late payment charge equal to five percent (5%) of such past due payment may be assessed and shall be immediately payable.

SECTION 3

COLLATERAL

3.1 The Collateral: To secure payment and performance of all the Borrower’s Obligations under this Agreement and all other liabilities, loans, guarantees, covenants and duties owed by the Borrower to the Bank, whether or not evidenced by this or by any other agreement, absolute or contingent, due or to become due, now existing or hereafter and howsoever created, the Borrower hereby grants the Bank a security interest in and to all of the following property (“Collateral”):

(i) Deposit Accounts. Account No(s). maintained with BANK OF THE WEST and all substitutions thereof, together with all interest accruing thereunder and therefrom.

The Bank’s security interest in the Collateral shall be a continuing lien and shall include the proceeds and products of the Collateral including, but not limited to, the proceeds of any insurance thereon.

Borrower hereby consents to and instructs Bank to file financing statements in all locations deemed appropriate by the Bank from time to time.

The security interest granted to Bank in the Collateral shall not secure or be deemed to secure any indebtedness of the Borrower to the Bank which is, at the time of its creation, subject to the provisions of any state or federal consumer credit or truth-in-lending disclosure statutes.

SECTION 4

CONDITIONS PRECEDENT

4.1 Conditions Precedent: The obligation of the Bank to make the first extension of credit to or on account of the Borrower hereunder is subject to the conditions precedent that the Bank shall have received before the date of such first extension of credit all of the following, in form and substance satisfactory to the Bank:

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(i) Authority to Borrow. Evidence that the execution, delivery and performance by the Borrower of this Agreement and any document, instrument or agreement required hereunder have been duly authorized.

(ii) Miscellaneous. Such other evidence as the Bank may request to establish the consummation of the transaction contemplated hereunder and compliance with the conditions of this Agreement.

4.2 Conditions Precedent to All Extensions of Credit: The obligation of the Bank to make each advance or each other extension of credit, as the case may be, to or on account of the Borrower (including the initial advance or the first extension of credit) shall be subject to the further conditions precedent that, on the date of each advance or each extension of credit and after the making of such advance or extension of credit:

(i) Reporting Requirements. The Bank shall have received the documents set forth in Section 6.1.

(ii) Subsequent Approvals. The Bank shall have received such supplemental approvals, opinions or documents as the Bank may reasonably request.

(iii) Representations and Warranties. The representations contained in Section 5 and in any other document, instrument or certificate delivered to the Bank hereunder are true, correct and complete.

(iv) Event of Default. No event has occurred and is continuing which constitutes, or with the lapse of time or giving of notice or both, would constitute an Event of Default.

(v) Collateral. The security interest in the Collateral has been duly authorized, created and perfected with first priority and is in full force and effect.

The Borrower’s acceptance of the proceeds of any loan, advance or extension of credit or the Borrower’s execution of any document or instrument evidencing or creating any Obligation hereunder shall be deemed to constitute the Borrower’s representation and warranty that all of the above statements are true and correct.

SECTION 5

REPRESENTATIONS AND WARRANTIES

The Borrower hereby makes the following representations and warranties to the Bank, which representations and warranties are continuing:

5.1 Status: The Borrower’s correct legal name is as stated in this Agreement and the Borrower is a corporation duly organized and validly existing under the laws of the state of Delaware and with its chief executive office in the state of California and is properly licensed and is qualified to do business and in good standing in, and, where necessary to maintain the Borrower’s rights and privileges, has complied with the fictitious name statute of every jurisdiction in which the Borrower is doing business.

5.2 Authority: The execution, delivery and performance by the Borrower of this Agreement and any instrument, document or agreement required hereunder have been duly authorized and do not and will not: (i) violate any provision of any law, rule, regulation, order, writ, judgment, injunction, decree, determination or award presently in effect having application to the Borrower; (ii) result in a breach of or constitute a default under any material indenture or loan or credit agreement or other material agreement, lease or instrument to which the Borrower is a party or by which it or its properties may be bound or affected; or (iii) require any consent or approval of its stockholders or violate any provision of its articles of incorporation or by-laws.

5.3 Legal Effect: This Agreement constitutes, and any instrument, document or agreement required hereunder when delivered hereunder will constitute, legal, valid and binding obligations of the Borrower enforceable against the Borrower in accordance with their respective terms.

5.4 Fictitious Trade Styles: There are no fictitious trade styles, fictitious trade names, assumed business names or trade names (defined herein as “Trade Name”) used by the Borrower in connection with its business operations. The Borrower shall notify the Bank not less than 30 days prior to effecting any change in the matters described herein or prior to using any other Trade Name at any future date, indicating the Trade Name and State(s) of its use.

5.5 Financial Statements: All financial statements, information and other data which may have been or which may hereafter be submitted by the Borrower to the Bank are true, accurate and correct, consistently applied and accurately represent the financial condition or, as applicable, the other information disclosed therein. Since the most recent submission of such financial information or data to the Bank, the Borrower represents and warrants that no material adverse change in the Borrower’s financial condition or operations has occurred which has not been fully disclosed to the Bank in writing.

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5.6 Litigation: Except as have been disclosed to the Bank in writing, there are no actions, suits or proceedings pending or, to the knowledge of the Borrower, threatened against or affecting the Borrower or the Borrower’s properties before any court or administrative agency which, if determined adversely to the Borrower, would have a material adverse effect on the Borrower’s financial condition or operations or on the Collateral.

5.7 Title to Assets: The Borrower has good and marketable title to all of its assets (including, but not limited to, the Collateral) and the same are not subject to any security interest, encumbrance, lien or claim of any third person.

5.8 ERISA: If the Borrower has a pension, profit sharing or retirement plan subject to ERISA, such plan has been and will continue to be funded in accordance with its terms and otherwise complies with and continues to comply with the requirements of ERISA.

5.9 Taxes: The Borrower has filed all tax returns required to be filed and paid all taxes shown thereon to be due, including interest and penalties, other than such taxes which are currently payable without penalty or interest or those which are being duly contested in good faith.

5.10 Margin Stock. The proceeds of any loan or advance hereunder will not be used to purchase or carry margin stock as such term is defined under Regulation U of the Board of Governors of the Federal Reserve System.

5.11 Environmental Compliance. The operations of the Borrower comply, and during the term of this Agreement will at all times comply, in all respects with all Environmental Laws; the Borrower has obtained all licenses, permits, authorizations and registrations required under any Environmental Law (“Environmental Permits”) and necessary for its ordinary course operations, all such Environmental Permits are in good standing, and the Borrower is in compliance with all material terms and conditions of such Environmental Permits; neither the Borrower nor any of its present property or operations is subject to any outstanding written order from or agreement with any governmental authority nor subject to any judicial or docketed administrative proceeding, respecting any Environmental Law, Environmental Claim or Hazardous Material; there are no Hazardous Materials or other conditions or circumstances existing, or arising from operations prior to the date of this Agreement, with respect to any property of the Borrower that would reasonably be expected to give rise to Environmental Claims; provided, however, that with respect to property leased from an unrelated third party, the foregoing representation is made to the best knowledge of the Borrower. In addition, (i) the Borrower does not have any underground storage tanks that are not properly registered or permitted under applicable Environmental Laws, or that are leaking or disposing of Hazardous Materials off-site, and (ii) the Borrower has notified all of their employees of the existence, if any, of any health hazard arising from the conditions of their employment and have met all notification requirements under Title III of CERCLA and all other Environmental Laws.

SECTION 6

COVENANTS

The Borrower covenants and agrees that, during the term of this Agreement, and so long thereafter as the Borrower is indebted to the Bank under this Agreement, the Borrower will, unless the Bank shall otherwise consent in writing:

6.1 Reporting and Certification Requirements: Deliver or cause to be delivered to the Bank in form and detail satisfactory to the Bank:

(i) Not later than 120 days after the end of each fiscal year of the Borrower, a copy of the Borrower’s 10-K for such year.

(ii) Not later than 60 days after the end of each fiscal quarter, a copy of the Borrower’s 10-Q for such quarter.

(iii) Promptly upon the Bank’s request, such other information pertaining to the Borrower, the Collateral or any guarantor hereunder as the Bank may reasonably request.

6.2 Preservation of Existence; Compliance with Applicable Laws: Maintain and preserve its existence and all rights and privileges now enjoyed; and conduct its business and operations in accordance with all applicable laws, rules and regulations.

6.3 Maintenance of Insurance: Keep and maintain the Collateral insured for not less than its full replacement value against all risks of loss and damage and maintain insurance in such amounts and covering such risks as is usually carried by companies engaged in similar businesses and owning similar properties in the same general areas in which the Borrower operates and maintains such other insurance and coverages as may be required by the Bank. All such insurance shall be in form and amount and with companies satisfactory to the Bank.

With respect to insurance covering properties in which the Bank maintains a security interest or lien, such insurance shall name the Bank as loss payee pursuant to a loss payable endorsement satisfactory to the Bank and shall not be altered or canceled except upon 10 days’ prior written notice to the Bank. Upon the Bank’s request, the Borrower shall furnish the Bank with the original policy or binder of all such insurance.

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6.4 Payment of Obligations and Taxes: Make timely payment of all assessments and taxes and all of its liabilities and obligations including, but not limited to, trade payables, unless the same are being contested in good faith by appropriate proceedings with the appropriate court or regulatory agency. For purposes hereof, the Borrower’s issuance of a check, draft or similar instrument without delivery to the intended payee shall not constitute payment.

6.5 Depository Relationships: Maintain its primary business depository relationship with Bank, including general, operating and administrative deposit accounts and cash management services.

6.6 Inspection Rights and Accounting Records: The Borrower will maintain adequate books and records in accordance with generally accepted accounting principles consistently applied and in a manner otherwise acceptable to Bank, and, at any reasonable time and from time to time, permit the Bank or any representative thereof to examine and make copies of the records and visit the properties of the Borrower and discuss the business and operations of the Borrower with any employee or representative thereof. If the Borrower shall maintain any records (including, but not limited to, computer generated records or computer programs for the generation of such records) in the possession of a third party, the Borrower hereby agrees to notify such third party to permit the Bank free access to such records at all reasonable times and to provide the Bank with copies of any records which it may request, all at the Borrower’s expense, the amount of which shall be payable immediately upon demand.

6.7 Change in Nature of Business: Not make any material change in its financial structure or the nature of its business as existing or conducted as of the date hereof.

6.8 Maintenance of Jurisdiction: Borrower shall maintain the jurisdiction of its organization and chief executive office, or if applicable, principal residence, as set forth herein and not change such jurisdiction name or form of organization without 30 days prior written notice to Bank.

6.9 Compensation of Employees: Compensate its employees for services rendered at an hourly rate at least equal to the minimum hourly rate prescribed by any applicable federal or state law or regulation.

6.10 Notice: Give the Bank prompt written, notice of any and all (i) Events of Default; (ii) litigation, arbitration or administrative proceedings to which the Borrower is a party or which affects the Collateral; (iii) other matters which have resulted in, or might result in a material adverse change in the Collateral or the financial condition or business operations of the Borrower, and (iv) any enforcement, cleanup, removal or other governmental or regulatory actions instituted, completed or threatened against the Borrower or any of its properties.

6.11 Environmental Compliance: The Borrower shall conduct its operations and keep and maintain all of its property in compliance with all Environmental Laws and, upon the written request of the Bank, the Borrower shall submit to the Bank, at the Borrower’s sole cost and expense, at reasonable intervals, a report providing the status of any environmental, health or safety compliance, hazard or liability.

SECTION 7

EVENTS OF DEFAULT

Any one or more of the following described events shall constitute an event of default (an “Event of Default”) under this Agreement:

7.1 Non-Payment: Any Borrower shall fail to pay the principal amount of any Obligations when due or interest on the Obligations within 5 days of when due.

7.2 Performance Under This Agreement: The Borrower shall fail in any material respect to perform or observe any term, covenant or agreement contained in this Agreement or in any document, instrument or agreement relating to this Agreement or any other document or agreement executed by the Borrower with or in favor of Bank and any such failure shall continue unremedied for more than 30 days after the occurrence thereof.

7.3 Representations and Warranties; Financial Statements: Any representation or warranty made by the Borrower under or in connection with this Agreement or any financial statement given by the Borrower or any guarantor shall prove to have been incorrect in any material respect when made or given or when deemed to have been made or given.

7.4 Other Agreements: lf there is a default under any agreement to which Borrower is a party with Bank or with a third party or parties resulting in a right by the Bank or by such third party or parties, whether or not exercised, to accelerate the maturity of any indebtedness.

7.5 Insolvency: The Borrower or any guarantor shall: (i) become insolvent or be unable to pay its debts as they mature; (ii) make an assignment for the benefit of creditors or to an agent authorized to liquidate any substantial amount of its properties and assets; (iii) file a voluntary petition in bankruptcy or seeking reorganization or to effect a plan or other arrangement with creditors; (iv) file an answer admitting the material allegations of an involuntary petition relating to bankruptcy or reorganization or join in any such petition; (v) become or be adjudicated a bankrupt; (vi) apply for or consent to the appointment of, or consent that an

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order be made, appointing any receiver, custodian or trustee, for itself or any of its properties, assets or businesses; or (vii) in an involuntary proceeding, any receiver, custodian or trustee shall have been appointed for all or substantial part of the Borrower’s or guarantor’s properties, assets or businesses and shall not be discharged within 30 days after the date of such appointment.

7.6 Execution: Any writ of execution or attachment or any judgment lien shall be issued against any property of the Borrower and shall not be discharged or bonded against or released within 30 days after the issuance or attachment of such writ or lien.

7.7 Suspension: The Borrower shall voluntarily suspend the transaction of business or allow to be suspended, terminated, revoked or expired any permit, license or approval of any governmental body necessary to conduct the Borrower’s business as now conducted.

7.8 Material Adverse Change: If there occurs a material adverse change in the Borrower’s business or financial condition, or if there is a material impairment of the prospect of repayment of any portion of the Obligations or there is a material impairment of the value or priority of the Bank’s security interest in the Collateral, or if a Borrower who is a natural person shall die.

7.9 Impairment of Collateral. There shall occur any injury or damage to all or any part of the Collateral or all or any part of the Collateral shall be lost, stolen or destroyed.

SECTION 8

REMEDIES ON DEFAULT

Upon the occurrence of any Event of Default, the Bank may, at its sole and absolute election, without demand and only upon such notice as may be required by law:

8.1 Acceleration: Declare any or all of the Borrower’s indebtedness owing to the Bank, whether under this Agreement or any other document, instrument or agreement, immediately due and payable, whether or not otherwise due and payable.

8.2 Cease Extending Credit: Cease extending credit to or for the account of the Borrower under this Agreement or under any other agreement now existing or hereafter entered into between the Borrower and the Bank.

8.3 Termination: Terminate this Agreement as to any future obligation of the Bank without affecting the Borrower’s obligations to the Bank or the Bank’s rights and remedies under this Agreement or under any other document, instrument or agreement

8.4 Letters of Credit: Require the Borrower to pay immediately to the Bank, for application against drawings under any outstanding Letters of Credit, the outstanding principal amount of any such Letters of Credit which have not expired. Any portion of the amount so paid to the Bank which is not applied to satisfy draws under any such Letters of Credit or any other obligations of the Borrower to the Bank shall be repaid to the Borrower without interest.

8.5 Protection of Security Interest: Make such payments and do such acts as the Bank, in its sole judgment, considers necessary and reasonable to protect its security interest or lien in the Collateral. The Borrower hereby irrevocably authorizes the Bank to pay, purchase, contest or compromise any encumbrance, lien or claim which the Bank, in its sole judgment, deems to be prior or superior to its security interest. Further, the Borrower hereby agrees to pay to the Bank, upon demand therefor, all expenses and expenditures (including attorneys’ fees) incurred in connection with the foregoing.

8.6 Foreclosure: Enforce any security interest or lien given or provided for under this Agreement or under any security agreement, mortgage, deed of trust or other document, in such manner and such order, as to all or any part of the properties subject to such security interest or lien, as the Bank, in its sole judgment, deems to be necessary or appropriate and the Borrower hereby waives any and all rights, obligations or defenses now or hereafter established by law relating to the foregoing. In the enforcement of its security interest or lien, the Bank is authorized to enter upon the premises where any Collateral is located and take possession of the Collateral or any part thereof, together with the Borrower’s records pertaining thereto, or the Bank may require the Borrower to assemble the Collateral and records pertaining thereto and make such Collateral and records available to the Bank at a place designated by the Bank. The Bank may sell the Collateral or any portions thereof, together with all additions, accessions and accessories thereto, giving only such notices and following only such procedures as are required by law, at either a public or private sale, or both, with or without having the Collateral present at the time of the sale, which sale shall be on such terms and conditions and conducted in such manner as the Bank determines in its sole judgment to be commercially reasonable. The Collateral may be disposed of in its then condition without any preparation or processing. In connection with any disposition of the Collateral, the Bank may disclaim any warranty relating to title, possession or quiet enjoyment. Any deficiency which exists after the disposition or liquidation of the Collateral shall be a continuing liability of the Borrower to the Bank and shall be immediately paid by the Borrower to the Bank.

8.7 Non-Exclusivity of Remedies: Exercise one or more of the Bank’s rights set forth herein or seek such other rights or pursue such other remedies as may be provided by law, in equity or in any other agreement now existing or hereafter entered into between the Borrower and the Bank, or otherwise.

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8.8 Application of Proceeds: All amounts received by the Bank as proceeds from the disposition or liquidation of the Collateral shall be applied to the Borrower’s indebtedness to the Bank as follows: first, to the costs and expenses of collection, enforcement, protection and preservation of the Bank’s lien in the Collateral, including court costs and reasonable attorneys’ fees, whether or not suit is commenced by the Bank; next, to those costs and expenses incurred by the Bank in protecting, preserving, enforcing, collecting, liquidating, selling or disposing of the Collateral; next, to the payment of accrued and unpaid interest on all of the Obligations; next, to the payment of the outstanding principal balance of the Obligations; and last, to the payment of any other indebtedness owed by the Borrower to the Bank. Any excess Collateral or excess proceeds existing after the disposition or liquidation of the Collateral will be returned or paid by the Bank to the Borrower.

If any non-cash proceeds are received in connection with any sale of Collateral, the Bank shall not apply such non-cash proceeds to the Obligations unless and until such proceeds are converted to such; provided, however, that if such non-cash proceeds are not expected on the date of receipt thereof to be converted to cash within one year after such date, the Bank shall use commercially reasonable efforts to convert such non-cash proceeds to cash within such one year period.

SECTION 9

MISCELLANEOUS

9.1 Default interest Rate: If an Event of Default, or an event which, with notice or passage of time could become an Event of Default, has occurred or is continuing, the Borrower shall pay to the Bank interest on any Obligations payable under this Agreement at a rate which is 5% in excess of a variable rate per annum equivalent to an index for a variable interest rate which is quoted, published or announced from time to time by the Bank as its Prime Rate and as to which loans may be made by the Bank at, below or above such Prime Rate (the “Prime Rate”). Interest shall be adjusted concurrently with any change in the Prime Rate.

9.2 Reliance and Further Assurances: Each warranty, representation, covenant, obligation and agreement contained in this Agreement shall be conclusively presumed to have been relied upon by the Bank regardless of any investigation made or information possessed by the Bank and shall be cumulative and in addition to any other warranties, representations, covenants and agreements which the Borrower now or hereafter shall give, or cause to be given, to the Bank. Borrower agrees to execute all documents and instruments and to perform such acts as the Bank may reasonably deem necessary to confirm and secure to the Bank all rights and remedies conferred upon the Bank by this agreement and all other documents related thereto.

9.3 Attorneys’ Fees: Borrower shall pay to the Bank all costs and expenses, including but not limited to reasonable attorneys’ fees, incurred by Bank in connection with the administration, enforcement, including any bankruptcy, appeal or the enforcement of any judgment or any refinancing or restructuring of this Agreement or any document, instrument or agreement executed with respect to, evidencing or securing the indebtedness hereunder.

9.4 Notices: All notices, payments, requests, information and demands which either party hereto may desire, or may be required to give or make to the other party hereto, shall be given or made to such party by hand delivery or through deposit in the United States mail, postage prepaid, or by facsimile delivery, or to such other address as may be specified from time to time in writing by either party to the other.

To the Borrower:	To the Bank:
DIEDRICH COFFEE, INC.	BANK OF THE WEST
28 Executive Park, Suite 200	Newport Beach Office (CBC)
Irvine, CA 92614	4400 MacArthur Boulevard, Suite 150
Attn: Roger M. Laverty ·	Newport Beach, CA 92660
CEO	Attn: Bruce Young
M.A. Lynch, EVP/CFO	Vice President
	FAX: (949) 797-1959

9.5 Waiver: Neither the failure nor delay by the Bank in exercising any right hereunder or under any document, instrument or agreement mentioned herein shall operate as a waiver thereof, nor shall any single or partial exercise of any right hereunder or under any other document, instrument or agreement mentioned herein preclude other or further exercise thereof or the exercise of any other right; nor shall any waiver of any right or default hereunder, or under any other document, instrument or agreement mentioned herein, constitute a waiver of any other right or default or constitute a waiver of any other default of the same or any other term or provision.

9.6 Conflicting Provisions: To the extent the provisions contained in this Agreement are inconsistent with those contained in any other document, instrument or agreement executed pursuant hereto, the terms and provisions contained herein shall control. Otherwise, such provisions shall be considered cumulative.

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9.7 Binding Effect; Assignment: This Agreement shall be binding upon and inure to the benefit of the Borrower and the Bank and their respective successors and assigns, except that the Borrower shall not have the right to assign its rights hereunder or any interest herein without the prior written consent of the Bank. The Bank may sell, assign or grant participation in all or any portion of its rights and benefits hereunder. The Borrower agrees that, in connection with any such sale, grant or assignment, the Bank may deliver to the prospective buyer, participant or assignee financial statements and other relevant information relating to the Borrower and any guarantor.

9.8 Jurisdiction: This Agreement, any notes issued hereunder, the rights of the parties hereunder to and concerning the Collateral, and any documents, instruments or agreements mentioned or referred to herein shall be governed by and construed according to the laws of the State of California without regard to conflict of law principles, to the jurisdiction of whose courts the parties hereby submit.

9.9 Counterparts: This Agreement may be executed in any number of counterparts and all such counterparts taken together shall be deemed to constitute one and the same instrument.

9.10 Headings: The headings herein set forth are solely for the purpose of identification and have no legal significance.

9.11 Entire Agreement and Amendments: This Agreement and all documents, instruments and agreements mentioned herein constitute the entire and complete understanding of the parties with respect to the transactions contemplated hereunder. All previous conversations, memoranda and writings between the parties pertaining to the transactions contemplated hereunder not incorporated or referenced in this Agreement or in such documents, instruments and agreements are superseded hereby. This Agreement may be amended only by an instrument in writing signed by the Borrower and the Bank.

IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be executed as of the date first hereinabove written.

BANK:		BORROWER:
BANK OF THE WEST		DIEDRICH COFFEE, INC.
BY:	/s/ Bruce Young	BY:	/s/ Roger M. Laverty
NAME: Bruce Young, Vice President		NAME: Roger M. Laverty, CEO
		BY:	/s/ Martin A. Lynch
		NAME: M.A. Lynch, EVP/CFO

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EX-10.25

Exhibit 10.25

AMENDMENT NO. 1

TO

CONTINGENT CONVERTIBLE NOTE PURCHASE AGREEMENT

This Amendment No. 1 to Contingent Convertible Note Purchase Agreement (this “Amendment”) is made and entered into as of this 30th day of June, 2004 by and between Diedrich Coffee, Inc., a Delaware corporation (the “Company”), and Sequoia Enterprises, L.P., a California limited partnership (“Lender”).

RECITALS

A. On May 10, 2004, Company and Lender entered into that certain Contingent Convertible Note Purchase Agreement (the “Note Purchase Agreement”) pursuant to which Lender agreed to loan to the Company an aggregate principal amount of up to $5,000,000 on the terms and conditions set forth in the Note Purchase Agreement.

B. The parties desire to revise the definition of “Availability” set forth in the Note Purchase Agreement and therefore amend the Note Purchase Agreement on the terms and as provided in this Amendment.

AGREEMENT

In consideration of the foregoing recitals, the parties agree as follows:

1. Definitions. Capitalized terms not otherwise defined in this Amendment shall have the meanings given to them in the Note Purchase Agreement.

2. Revised Definition of Availability. The definition of “Availability” set forth in Section 1.1 of the Note Purchase Agreement shall be deleted in its entirety and replaced with the following:

“Availability” means, on any date, the Loan Amount, less the sum of the principal amount of all Notes outstanding under this Agreement.

3. Express Changes Only. The parties hereto intend to amend the Note Purchase Agreement only as set forth herein, and the parties hereto agree that, except as expressly amended hereby, all other terms and conditions of the Note Purchase Agreement are hereby ratified and confirmed and shall remain in full force and effect.

4. Authority. Each of the parties hereto represents and warrants that it has the authority to enter into this Amendment. This Amendment has been carefully read by, the contents hereof are known and understood by, and it is signed freely by, each person executing this Amendment.

5. Independent Legal Advice. Each of the parties hereto has received independent legal advice from attorneys of its or his own choice, with respect to the advisability of entering into this Amendment. Each party, together with its attorneys, has made such investigation of the facts pertaining to the matters set forth herein and this Amendment, and of all the matters pertaining thereto, as it deems necessary.

6. Governing Law. This Amendment shall be governed by, and construed, interpreted and enforced in accordance with, the laws of the State of California without regard to conflict of laws principles.

7. Counterparts. This Amendment may be executed in any number of counterparts, each of which will be deemed an original, but all of which together will constitute one instrument. Signatures transmitted electronically or by facsimile will be deemed original signatures; provided that the party delivering such electronic or facsimile signature shall deliver to the other an original signature page as soon thereafter as practicable.

IN WITNESS WHEREOF, the parties have executed and delivered this Amendment as of the date first written above.

COMPANY:
DIEDRICH COFFEE, INC.
By:	/s/ Roger M. Laverty
	Roger M. Laverty Chief Executive Officer
By:	/s/ Martin A. Lynch
	Martin A. Lynch Chief Financial Officer
LENDER:
SEQUOIA ENTERPRISES, L.P.
By:	/s/ Paul Heeschen
	Paul Heeschen General Partner

EX-31.1

EXHIBIT 31.1

Section 302 Certification

I, Stephen V. Coffey, certify that:

1. I have reviewed this Quarterly Report on Form 10-Q of Diedrich Coffee, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

a. Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b. Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

c. Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

a. All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b. Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Dated: April 21, 2006	/s/ Stephen V. Coffey
	Stephen V. Coffey Chief Executive Officer

EX-31.2

EXHIBIT 31.2

Section 302 Certification

I, Sean M. McCarthy, certify that:

1. I have reviewed this Quarterly Report on Form 10-Q of Diedrich Coffee, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

a. Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b. Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

c. Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

a. All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b. Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Dated: April 21, 2006	/s/ Sean M. McCarthy
	Sean M. McCarthy Vice President and Chief Financial Officer

EX-32.1

EXHIBIT 32.1

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

The undersigned hereby certifies, in his capacity as an officer of Diedrich Coffee, Inc. (the “Company”), for purposes of 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to the best of his knowledge:

• the Quarterly Report on Form 10-Q for the period ended March 8, 2006 (the “Report”) fully complies with the requirements of Section 13(a) or Section 15(d) of the Securities Exchange Act of 1934, as amended; and

• the information contained in the Report fairly presents, in all material respects, the financial condition and results of operation of the Company.

Dated: April 21, 2006	/s/ Stephen V. Coffey
	Stephen V. Coffey Chief Executive Officer

Note: A signed original of this written statement required by Section 906 has been provided to Diedrich Coffee, Inc. and will be retained by Diedrich Coffee, Inc. and furnished to the Securities and Exchange Commission or its staff upon request.

EX-32.2

EXHIBIT 32.2

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

The undersigned hereby certifies, in his capacity as an officer of Diedrich Coffee, Inc. (the “Company”), for purposes of 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to the best of his knowledge:

• the Quarterly Report on Form 10-Q for the period ended March 8, 2006 (the “Report”) fully complies with the requirements of Section 13(a) or Section 15(d) of the Securities Exchange Act of 1934, as amended; and

• the information contained in the Report fairly presents, in all material respects, the financial condition and results of operation of the Company.

Dated: April 21, 2006	/s/ Sean M. McCarthy
	Sean M. McCarthy Vice President and Chief Financial Officer

Note: A signed original of this written statement required by Section 906 has been provided to Diedrich Coffee, Inc. and will be retained by Diedrich Coffee, Inc. and furnished to the Securities and Exchange Commission or its staff upon request.