10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 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 December 12, 2007

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

Irvine, California 92614

(Address of Principal Executive Offices, 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.

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 January 23, 2008, there were 5,468,316 shares of common stock of the registrant outstanding.

TABLE OF CONTENTS

	Page Number
PART I—FINANCIAL INFORMATION	1
Item 1. Financial Statements	1
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	12
Item 3. Quantitative And Qualitative Disclosures About Market Risk	22
Item 4. Controls and Procedures	22
PART II—OTHER INFORMATION	23
Item 1. Legal Proceedings	23
Item 1A. Risk Factors	23
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	23
Item 3. Defaults upon Senior Securities	23
Item 4. Submission of Matters to a Vote of Security Holders	23
Item 5. Other Information	23
Item 6. Exhibits	24
SIGNATURES	25

PART I—FINANCIAL INFORMATION

Item 1. Financial Statements

DIEDRICH COFFEE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

	December 12, 2007			June 27, 2007
	(Unaudited)
Assets
Current assets:
Cash	$	1,963,000		$	6,873,000
Restricted cash and short term investments		623,000			669,000
Accounts receivable, less allowance for doubtful accounts of $424,000 at December 12, 2007 and $163,000 at June 27, 2007		6,600,000			4,069,000
Inventories		4,207,000			4,323,000
Income tax refund receivable		533,000			533,000
Current portion of notes receivable, less allowance of $148,000 at December 12, 2007 and $63,000 at June 27, 2007		1,046,000			1,031,000
Advertising funds, restricted		53,000			339,000
Prepaid expenses		570,000			252,000
Total current assets		15,595,000			18,089,000
Property and equipment, net		6,395,000			4,437,000
Goodwill		6,832,000			6,832,000
Notes receivable, less allowance of $75,000 at December 12, 2007 and June 27, 2007		3,032,000			3,386,000
Cash surrender value of life insurance policy		657,000			430,000
Other assets		153,000			159,000
Total assets	$	32,664,000		$	33,333,000
Liabilities and Stockholders’ Equity
Current liabilities:
Liabilities of discontinued operations	$	126,000		$	125,000
Accounts payable		5,052,000			3,814,000
Accrued compensation		1,622,000			2,052,000
Accrued expenses		1,182,000			1,725,000
Franchisee deposits		692,000			674,000
Deferred franchise fee income		57,000			82,000
Advertising fund liabilities		321,000			339,000
Accrued provision for store closure		868,000			686,000
Total current liabilities		9,920,000			9,497,000
Income tax liabilities		245,000			—
Deferred rent		201,000			216,000
Deferred compensation		715,000			468,000
Total liabilities		11,081,000			10,181,000
Commitments and contingencies (Notes 8 and 9)
Stockholders’ equity:
Common stock, $.01 par value; authorized 8,750,000 shares; issued and outstanding 5,448,000 shares at December 12, 2007 and June 27, 2007		54,000			54,000
Additional paid-in capital		59,776,000			59,671,000
Accumulated deficit		(38,247,000	)		(36,573,000	)
Total stockholders’ equity		21,583,000			23,152,000
Total liabilities and stockholders’ equity	$	32,664,000		$	33,333,000

See accompanying notes to condensed consolidated financial statements.

1

DIEDRICH COFFEE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

	Twelve Weeks Ended December 12, 2007			Twelve Weeks Ended December 13, 2006			Twenty-Four Weeks Ended December 12, 2007			Twenty-Four Weeks Ended December 13, 2006
Net revenue:
Wholesale and other	$	10,370,000		$	7,339,000		$	16,834,000		$	12,459,000
Franchise revenue		803,000			990,000			1,432,000			1,758,000
Retail sales		1,275,000			1,256,000			2,342,000			2,200,000
Total net revenue		12,448,000			9,585,000			20,608,000			16,417,000
Costs and expenses:
Cost of sales and related occupancy costs (exclusive of depreciation shown separately below)		9,362,000			6,195,000			15,334,000			10,472,000
Operating expenses		2,346,000			2,274,000			4,578,000			4,195,000
Depreciation and amortization		280,000			241,000			532,000			500,000
General and administrative expenses		1,694,000			1,730,000			3,149,000			3,402,000
(Gain) loss on asset disposals		(6,000	)		1,000			(7,000	)		(11,000	)
Asset impairment		—			338,000			—			338,000
Total costs and expenses		13,676,000			10,779,000			23,586,000			18,896,000
Operating loss from continuing operations		(1,228,000	)		(1,194,000	)		(2,978,000	)		(2,479,000	)
Interest expense		(12,000	)		(62,000	)		(23,000	)		(88,000	)
Interest and other income, net		81,000			92,000			265,000			183,000
Loss from continuing operations before income tax benefit		(1,159,000	)		(1,164,000	)		(2,736,000	)		(2,384,000	)
Income tax benefit		—			—			540,000			—
Net loss from continuing operations		(1,159,000	)		(1,164,000	)		(2,196,000	)		(2,384,000	)
Discontinued operations:
Loss from discontinued operations, net of tax expense of $0		—			(965,000	)		—			(1,391,000	)
Gain on sale of discontinued operations, net of tax expense of $507,000		—			—			767,000			—
Net loss	$	(1,159,000	)	$	(2,129,000	)	$	(1,429,000	)	$	(3,775,000	)
Basic and diluted net income (loss) per share:
Loss from continuing operations	$	(0.21	)	$	(0.22	)	$	(0.40	)	$	(0.45	)
Income (loss) from discontinued operations, net	$	—		$	(0.18	)	$	0.14		$	(0.26	)
Net loss	$	(0.21	)	$	(0.40	)	$	(0.26	)	$	(0.71	)
Weighted average and equivalent shares outstanding:
Basic and diluted		5,448,000			5,362,000			5,448,000			5,335,000

See accompanying notes to condensed consolidated financial statements.

2

DIEDRICH COFFEE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

	Twenty-four Weeks Ended December 12, 2007			Twenty-four Weeks Ended December 13, 2006
Cash flows from operating activities:
Net loss	$	(1,429,000	)	$	(3,775,000	)
Loss from discontinued operations		—			1,391,000
Gain on sale of discontinued operations, net		(767,000	)		—
Loss from continuing operations:		(2,196,000	)		(2,384,000	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		532,000			500,000
Amortization and write off of loan fees		—			18,000
Provision for bad debt		229,000			25,000
Income tax benefit		(540,000	)		—
Provision for inventory obsolescence		2,000			29,000
Provision for asset impairment and restructuring		—			339,000
Provision for store closure		352,000			455,000
Stock compensation expense		106,000			162,000
Notes receivable issued		(138,000	)		(89,000	)
Gain on disposal of assets		(8,000	)		(10,000	)
Changes in operating assets and liabilities:
Accounts receivable		(2,760,000	)		(2,199,000	)
Inventories		114,000			506,000
Prepaid expenses		(318,000	)		(591,000	)
Notes Receivable		(67,000	)		(168,000	)
Other assets		46,000			(105,000	)
Accounts payable		1,238,000			1,172,000
Accrued compensation		(183,000	)		(73,000	)
Accrued expenses		(509,000	)		281,000
Deferred franchise fee income and franchisee deposits		(7,000	)		(42,000	)
Accrued provision for store closure		(133,000	)		(53,000	)
Deferred rent		(15,000	)		—
Net cash used in continuing operations		(4,255,000	)		(2,227,000	)
Net cash used in discontinued operations		(36,000	)		(614,000	)
Net cash used in operating activities		(4,291,000	)		(2,841,000	)
Cash flows from investing activities:
Capital expenditures for property and equipment		(2,490,000	)		(689,000	)
Proceeds from disposal of property and equipment		7,000			12,000
Payments received on notes receivable		544,000			624,000
Net investment in restricted money market account		46,000			(78,000	)
Net cash used in investing activities of continuing operations		(1,893,000	)		(131,000	)
Net cash used in discontinued operations		—			(16,000	)
Proceeds from sale of discontinued operations, net		1,274,000			—
Net cash used in investing activities		(619,000	)		(147,000	)
Cash flows from financing activities:
Exercise of stock options		—			341,000
Borrowings under credit agreement		—			2,000,000
Payments on long-term debt		—			(139,000	)
Net cash provided by financing activities of continuing operations		—			2,202,000
Net cash used in financing activities of discontinued operations		—			(9,000	)
Net cash provided by financing activities		—			2,193,000
Net decrease in cash		(4,910,000	)		(795,000	)
Cash at beginning of year		6,873,000			2,593,000
Cash at end of period	$	1,963,000		$	1,798,000
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Value of common stock warrants recorded as debt discount	$	—		$	25,000
Interest	$	25,000		$	16,000
Income taxes	$	—		$	58,000
Non-cash transactions:
Issuance of notes receivable	$	138,000		$	89,000

See accompanying notes to condensed consolidated financial statements.

3

DIEDRICH COFFEE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 12, 2007

(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 for the year ended June 27, 2007.

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

During the year ended June 27, 2007, the Company sold leaseholds and related assets of 32 stores to Starbucks Corporation and seven stores to other third parties.

In accordance with Statement of Financial Accounting Standards (“SFAS”) 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”), the financial results of the retail operations that were sold or closed are reported as discontinued operations for all periods presented.

The following accounts are reflected in loss from discontinued operations in the condensed consolidated statements of operations:

• Retail revenues for Diedrich Coffee, Inc. and Coffee People, Inc.

• Cost of sales and related occupancy costs

• Operating expenses

• Depreciation and amortization

• General and administrative expenses

• Interest expense

4

• Provision for taxes paid

• Impairment of assets

• Employee termination costs

• Operating lease termination costs

Liabilities of discontinued operations in the condensed consolidated balance sheets include accrued provision for store closure related to retail stores under the Diedrich Coffee and Coffee People brands.

Recent Accounting Pronouncements

In September 2006, the FASB issued Statement on Financial Accounting Standards No. 157 “Fair Value Measurements” (“SFAS 157”). SFAS 157 clarifies the definition of fair value for financial reporting, establishes a framework for measuring fair value and requires additional disclosures about the use of fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The Company has not yet determined the impact, if any, of adopting SFAS 157 on its consolidated financial statements.

In February 2007, the FASB issued Statement on Financial Accounting Standards No. 159 “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS 159 permits companies to make a one-time election to carry eligible types of financial assets and liabilities at fair value, even if fair value measurement is not required under U.S. GAAP. SFAS 159 is effective for fiscal years beginning after November 15, 2007. The Company has not yet determined the impact, if any, of adopting SFAS 159 on its consolidated financial statements.

Income Taxes

The Company accounts for income taxes under SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”). This statement requires the recognition of deferred tax assets and liabilities for the future consequences of events that have been recognized in the Company’s financial statements or tax returns. The measurement of the deferred items is based on enacted tax laws. 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 requires an evaluation of 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.

In July 2006, the Financial Accounting Standards Board issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—An Interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 prescribes a recognition threshold and measurement methodology to recognize and measure an income tax position taken, or expected to be taken, in a tax return. The evaluation of a tax position is based on a two-step approach. The first step requires an entity to evaluate whether the tax position would “more likely than not” be sustained upon examination by the appropriate taxing authority. The second step requires the tax position be measured at the largest amount of tax benefit that is greater than 50 percent likely of being realized upon ultimate settlement. In addition, previously recognized benefits from tax positions that no longer meet the new criteria would be derecognized. The cumulative effect of applying the provisions of FIN 48 will be reported as an adjustment to the opening balance of retained earnings in the period of adoption. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company adopted FIN 48 on June 28, 2007.

Upon adoption of FIN 48, the Company analyzed its filing positions for all open tax years in all U.S. federal and state jurisdictions where the Company is required to file. At the adoption date of June 28, 2007, the Company had $200,000 of unrecognized tax benefits. The Company recorded a cumulative effect adjustment related to the adoption of FIN 48 of approximately $245,000 including interest and penalties, which was accounted for as an adjustment to the beginning balance of accumulated deficit on the condensed consolidated balance sheet. The $200,000 of unrecognized tax benefits, if ultimately recognized, would reduce the Company’s annual effective tax rate. There were no significant changes in unrecognized tax benefits as of the quarter ended December 12, 2007.

The Company files income tax returns in the U.S. federal jurisdiction and various state jurisdictions. In general, the Company is no longer subject to U.S. federal tax examinations for tax years ended prior to 1999 and for state tax examinations for tax years ended prior to 2003. The Company does not believe there will be any material changes in its unrecognized tax positions over the next 12 months.

The Company’s policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense. As of the date of adoption of FIN 48, the gross amount of interest and penalties included in the $245,000 of unrecognized tax benefits noted above is approximately $45,000. As of December 12, 2007, there was no significant change in accrued interest and penalties related to unrecognized tax benefits.

5

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 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 October 16, 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 alternative 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, “Accounting for Stock-Based Compensation” (“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 assumptions:

	TWELVE WEEKS ENDED				TWENTY-FOUR WEEKS ENDED
	December 12, 2007		December 13, 2006		December 12, 2007	December 13, 2006
Risk free interest rate	4.00	%	4.81	%	4.00% – 4.91%	4.81% –5.29%
Expected life	2 years		2 years		2 years	2 years
Expected volatility	59	%	64	%	59% – 63%	55% – 64%
Expected dividend yield	0	%	0	%	0 %	0 %
Forfeiture rate	9.38	%	6.32	%	5.45% – 9.38%	5.02% – 6.32%

6

A summary of option activity under our stock option plans for the twelve weeks ended December 12, 2007 is as follows:

	Number of options		Weighted average exercise price ($)		Weighted average remaining contractual term (years)	Aggregate intrinsic Value ($)
Options outstanding at June 27, 2007	555,000		$	4.76
Plus options granted	67,000			3.59
Less:
Options canceled or expired	(85,000	)		6.35
Options outstanding at December 12, 2007	537,000			4.36	5.6	$	25,000
Options exercisable at December 12, 2007	424,000		$	4.52	4.5	$	25,000

Stock-based compensation expense included in the statement of operations for the twelve weeks ended December 12, 2007 was approximately $54,000 and for the twenty-four weeks ended December 12, 2007 was approximately $106,000. Stock-based compensation expense included in the statement of operations for the twelve weeks ended December 13, 2006 was approximately $95,000 and for the twenty-four weeks ended December 13, 2006 was approximately $162,000. As of December 12, 2007, there was approximately $137,000 of total unrecognized stock-based compensation cost related to options granted under our plans that will be recognized over a weighted average period of 1.0 years. Approximately 21,000 options vested during the twenty-four weeks ended December 12, 2007.

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 11.

Reclassifications

Certain reclassifications have been made to the previously reported condensed consolidated financial statements to conform to the December 12, 2007 presentation.

2. ACCOUNTS RECEIVABLE

During the twenty-four weeks ended December 12, 2007, the Company provided for $261,000 of additional allowance for doubtful accounts of which $204,000 resulted from charges for franchise rent and related receivables with the balance of $57,000 from wholesale accounts. No amounts were written off during the twenty-four weeks ended December 12, 2007.

The following table details the components of net accounts receivable:

	December 12, 2007			June 27, 2007
Wholesale receivables	$	5,973,000		$	3,591,000
Allowance for wholesale receivables		(136,000	)		(79,000	)
		5,837,000			3,512,000
Franchise and other receivables		1,051,000			641,000
Allowance for franchise and other receivables		(288,000	)		(84,000	)
		763,000			557,000
Total accounts receivable, net	$	6,600,000		$	4,069,000

3. INVENTORIES

Inventories consist of the following:

	December 12, 2007		June 27, 2007
Unroasted coffee	$	2,076,000	$	2,101,000
Roasted coffee		933,000		962,000
Accessory and specialty items		153,000		99,000
Other food, beverage and supplies		1,045,000		1,161,000
Total inventory	$	4,207,000	$	4,323,000

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4. NOTES RECEIVABLE

Notes receivable consist of the following:

	December 12, 2007			June 27, 2007
Notes receivable bearing interest at rates from 0% to 8.0%, payable in monthly installments varying between $115 and $10,000 and due on various dates through August 2016. Notes are secured by the assets sold under the asset purchase and sale agreements or general security agreement. Amounts are net of allowance of $223,000 and $138,000, respectively	$	173,000		$	164,000
Notes receivable from a corporation discounted at an annual rate of 8.0%, payable annually in installments varying between $1,000,000 and $2,000,000, due between January 31, 2008 and January 31, 2011		3,905,000			4,253,000
Less: current portion of notes receivable		(1,046,000	)		(1,031,000	)
Long-term portion of notes receivable	$	3,032,000		$	3,386,000

5. ACCRUED PROVISION FOR STORE CLOSURE

As required by SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”), 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.

The following table details the components of accrued provision for store closure:

	Beginning Balance		Amounts Charged to Expense		Adjustments		Cash Payments			Ending Balance
Fiscal Year ended June 27, 2007	$	401,000	$	1,051,000	$	—	$	(641,000	)	$	811,000
Twenty-four Weeks ended December 12, 2007	$	811,000	$	343,000	$	9,000	$	(169,000	)	$	994,000

Of the $811,000 reserve balance for store closures at June 27, 2007, $686,000 and $125,000 are reserved for continuing operations and discontinued operations, respectively. For the twenty-four weeks ended December 12, 2007, $343,000 was charged to costs of sales and related occupancy costs. Of the $994,000 reserve balance for store closures at December 12, 2007, $868,000 and $126,000 are reserved for continuing operations and discontinued operations, respectively.

6. EARNINGS PER SHARE

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

	Twelve Weeks Ended December 12, 2007			Twelve Weeks Ended December 13, 2006			Twenty-Four Weeks Ended December 12, 2007			Twenty-Four Weeks Ended December 13, 2006
Numerator:
Net loss from continuing operations	$	(1,159,000	)	$	(1,164,000	)	$	(2,196,000	)	$	(2,384,000	)
Denominator:
Basic weighted average shares outstanding		5,448,000			5,362,000			5,448,000			5,335,000
Effect of dilutive securities		—			—			—			—
Diluted adjusted weighted average shares		5,448,000			5,362,000			5,448,000			5,335,000
Basic and diluted net loss per share from continuing operations	$	(0.21	)	$	(0.22	)	$	(0.40	)	$	(0.45	)

For the quarters ended December 12, 2007 and December 13, 2006, employee stock options of approximately 537,000, and 674,000, respectively, and warrants of 500,000 for each year, were excluded from the computation of diluted earnings

8

per share as their impact would have been anti-dilutive. Approximately 1,275,000 stock purchase warrants outstanding at December 12, 2007 and approximately 994,000 stock purchase warrants outstanding at December 13, 2006, pursuant to terms of the Contingent Convertible Note Purchase Agreement (as discussed in Note 9) were excluded from the computation of diluted earnings per share as their impact would have been anti-dilutive.

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

	Twelve Weeks Ended December 12, 2007			Twelve Weeks Ended December 13, 2006			Twenty-Four Weeks Ended December 12, 2007			Twenty-Four Weeks Ended December 13, 2006
Numerator:
Net loss	$	(1,159,000	)	$	(2,129,000	)	$	(1,429,000	)	$	(3,775,000	)
Denominator:
Basic weighted average shares outstanding		5,448,000			5,362,000			5,448,000			5,335,000
Effect of dilutive securities		—			—			—			—
Diluted adjusted weighted average shares		5,448,000			5,362,000			5,448,000			5,335,000
Basic and diluted net loss per share	$	(0.21	)	$	(0.40	)	$	(0.26	)	$	(0.71	)

7. SEGMENT AND RELATED INFORMATION

The Company has three reportable segments: wholesale operations, franchise operations and retail operations. The Company evaluates performance of its operating segments based on income before provision for asset impairment and restructuring costs, income taxes, interest expense, depreciation and amortization, and general and administrative expenses.

Summarized financial information concerning the Company’s reportable segments is shown in the following tables. 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						TWENTY-FOUR WEEKS ENDED
	December 12, 2007			December 13, 2006			December 12, 2007			December 13, 2006
Net revenue:
Wholesale	$	10,370,000		$	7,339,000		$	16,834,000		$	12,459,000
Franchise		803,000			990,000			1,432,000			1,758,000
Retail		1,275,000			1,256,000			2,342,000			2,200,000
Total net revenue	$	12,448,000		$	9,585,000		$	20,608,000		$	16,417,000
Interest expense:
Wholesale	$	—		$	—		$	—		$	—
Franchise		—			—			—			—
Corporate		12,000			62,000			23,000			88,000
Total interest expense	$	12,000		$	62,000		$	23,000		$	88,000
Depreciation and amortization:
Wholesale	$	176,000		$	119,000		$	320,000		$	231,000
Retail		30,000			59,000			59,000			137,000
Corporate		74,000			63,000			153,000			132,000
Total depreciation and amortization	$	280,000		$	241,000		$	532,000		$	500,000
Segment income (loss) from continuing operations before income tax benefit:
Wholesale	$	827,000		$	1,177,000		$	993,000		$	1,773,000
Franchise		(510,000	)		66,000			(900,000	)		(55,000	)
Retail		216,000			(640,000	)		229,000			(674,000	)
Corporate		(1,692,000	)		(1,767,000	)		(3,058,000	)		(3,428,000	)
Total segment loss from continuing operations before income tax provision	$	(1,159,000	)	$	(1,164,000	)	$	(2,736,000	)	$	(2,384,000	)

	December 12, 2007		June 27, 2007
Identifiable assets:
Wholesale	$	14,688,000	$	10,711,000
Franchise		1,318,000		1,300,000
Retail		657,000		418,000
Corporate		9,169,000		14,072,000
Tangible assets		25,832,000		26,501,000
Goodwill – Wholesale		6,311,000		6,311,000
Goodwill – Franchise		521,000		521,000
Total assets	$	32,664,000	$	33,333,000

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8. LEASE CONTINGENCIES

In addition to corporate office, warehouse and store leases, the Company is liable on the master real property leases for 60 franchise locations. Under the Company’s historical franchising business model, the Company executed the master lease for these locations and entered into subleases on the same terms with its franchisees, which typically pay their rent directly to the landlords. Should any of these franchisees default on their subleases, the Company would be responsible for making payments under the master lease. The Company’s maximum theoretical future exposure at December 12, 2007, computed as the sum of all remaining lease payments through the expiration dates of the respective leases, was $15,715,000. 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 and related payables.

9. OUTSTANDING FINANCING ARRANGEMENTS AND RESTRICTED CASH

On May 10, 2004 the Company entered into a $5,000,000 Contingent Convertible Note Purchase Agreement. The agreement provides for the Company to, at its election, issue notes with up to an aggregate principal amount of $5,000,000. The notes are to be amortized on a monthly basis at a rate that will repay 60% of the principal amount of the note by June 30, 2008. The remaining 40% will mature on that date. Interest is payable at three-month LIBOR plus 5.30%, and a facility fee of 1.00% annually is payable on the unused portion of the facility. The agreement contains covenants that limit the amount of indebtedness that the Company may have outstanding in relation to its tangible net worth. As of December 12, 2007, the Company was in compliance with all the covenants in the agreement. Notes are convertible into common stock only upon certain changes of control. For notes issued and repaid, warrants to purchase shares are to be 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 expire on June 30, 2010. The fair value of warrants issued with respect to notes repaid will be recorded as a discount to debt, at the date of issuance, which will then be amortized using the effective interest method. Warrants to purchase common stock of the Company will be issued only upon a change in control of the Company. The lender under this agreement is a limited partnership of which the chairman of the Company’s board of directors serves as the sole general partner. A total of 1,270,738 warrants are issuable upon a change in control for previous debt repayments under this facility. The Company has issued 4,219 warrants as of December 12, 2007. As of December 12, 2007, the Company had no amounts outstanding under the facility and $5,000,000 available for borrowing.

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

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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.

On November 4, 2005, the Company entered into a Credit Agreement with Bank of the West. The agreement provides for a $750,000 letter of credit facility that expires on October 15, 2008. The letter of credit facility is secured by a deposit account at Bank of the West. As of December 12, 2007, this deposit account had a balance of $623,000, which is shown as restricted cash on the condensed consolidated balance sheets. As of December 12, 2007, $472,000 of letters of credit was 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 December 12, 2007, the Company was in compliance with all Bank of the West agreement covenants.

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 default of the Minimum EBITDA Covenant as of March 8, 2006 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) extended the exercise date of all warrants issued or to be issued under the Note Purchase Agreement by one year, to May 10, 2009, which was subsequently extended as discussed below. The maturity date for any notes issued in the future was unaffected by Amendment No. 2. As of December 12, 2007, the Company was in compliance with all agreement covenants as amended by Amendment No 2.

On September 22, 2006, the Company entered into Amendment No. 3 to Contingent Convertible Note Purchase Agreement (“Amendment No. 3”). Amendment No. 3 (i) changes the date specified in the definition of “Maturity Date” from May 10, 2007 to June 30, 2008; (ii) adjusts the calculation of monthly payments to reflect the extended maturity date; (iii) removes a condition precedent to each loan that previously required there to be no material adverse effect or event reasonably likely to result in a material adverse effect before the obligation of the lender to purchase any note arose; (iv) amends the events of default so that an event that has, or is reasonably likely to have, a material adverse effect will not be considered such an event of default; (v) amends the notice requirements so that the Company is not required to give notice to the lender of any event that is reasonably likely to have a material adverse effect; and (vi) extends the exercise date of all warrants issued or to be issued under the Note Purchase Agreement to June 30, 2010.

10. DISCONTINUED OPERATIONS

The Company’s strategic direction is to focus on growing the wholesale business segment and the related distribution channels, including franchise stores.

During the year ended June 27, 2007, the Company sold leaseholds and related assets of 32 stores to Starbucks Corporation and seven stores to other third parties.

As part of the asset purchase agreement with Starbucks Corporation, the Company agreed to a non-compete provision that for three years after the closing of the transaction, restricts the Company’s ability to operate or have any interest in the ownership or operation of any entity operating any retail specialty coffee stores in any city where a Company Store was located at the time that the asset purchase agreement was executed. The non-compete provision applies only to stores opened after the date of the asset purchase agreement and does not apply to (1) any retail stores operated under the “Gloria Jean’s” brand name, (2) wholesale sales to retail businesses that are not operated by the Company, or other non-retail businesses, or (3) the conversion of Company-operated stores existing on the date of the asset purchase agreement to franchise stores. The Company has also agreed that it will not solicit any Starbucks Corporation employee to enter the Company’s employment for three years after the closing of the transaction.

In accordance with SFAS 144, the financial results of the retail operations that were sold or closed are reported as discontinued operations for all periods presented.

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The financial results included in discontinued operations were as follows:

	TWELVE WEEKS ENDED					TWENTY-FOUR WEEKS ENDED
	December 12, 2007		December 13, 2006			December 12, 2007		December 13, 2006
Net revenue	$	—	$	6,470,000		$	—	$	13,043,000
Loss from discontinued operations, net of $0 income taxes	$	—	$	(965,000	)	$	—	$	(1,391,000	)
Gain on sale of discontinued operations, net of tax expense of $507,000		—		—			767,000		—
Income (loss) from discontinued operations, net	$	—	$	(965,000	)	$	767,000	$	(1,391,000	)

11. EMPLOYEE BENEFITS

401(k) Plan

The Company maintains a 401(k) Salary Deferral Plan (the “401(k) Plan”) for eligible employees. Employer matching contributions relating to the 401(k) Plan totaled $11,000 for each of the twelve weeks ended December 12, 2007 and December 13, 2006 and $21,000 and $24,000 for the twenty-four weeks ended December 12, 2007 and December 13, 2006, respectively.

Deferred Compensation Plan

Effective December 15, 2005, the Company amended its non-qualified deferred compensation plan. Under the amended plan, 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 plan participant will be credited to the plan 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 twenty-four weeks ended December 12, 2007 and December 13, 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.

The Company has purchased a COLI contract insuring two 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 December 12, 2007 was $657,000 as shown in the accompanying condensed consolidated balance sheets. Total life insurance policy death benefits payable was $15,099,000 at December 12, 2007.

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

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consider these risks when you review this report, along with the following possible events or factors:

• the financial and operating performance of our wholesale 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 Relating to Diedrich Coffee and Its Business” in our Annual Report on Form 10-K for the fiscal year ended June 27, 2007 and in other reports that we file with the Securities and Exchange Commission. You are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s analysis only as of the date of this quarterly report. Except as required by law, 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.

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. 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 twenty-four weeks ended December 12, 2007 to the results for the twelve and twenty-four weeks ended December 13, 2006, respectively.

• Financial condition, liquidity and capital resources. This section provides an analysis of our cash flows and a discussion of our outstanding debt and commitments, both firm and contingent, that existed as of December 12, 2007. 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 are summarized in Note 1 to the accompanying unaudited condensed consolidated financial statements.

OVERVIEW

Business

We are a specialty coffee roaster, wholesaler and retailer. Our brands include Diedrich Coffee, Gloria Jean’s, and Coffee People. The majority of our revenue is generated from wholesale customers located across the United States. Our wholesale operation sells a wide variety of whole bean and ground coffee as well as single serve coffee products through a network of office coffee service (“OCS”) distributors, chain and independent restaurants, coffeehouses, other hospitality operators and specialty retailers. We operate a large coffee roasting facility in Castroville, California that supplies freshly roasted coffee to all of our wholesale and retail customers.

We also 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. The critical components for each of our retail locations include high quality, fresh roasted coffee and superior customer service by knowledgeable employees. As of December 12, 2007, we owned and operated 5 retail locations and franchised 136 other retail locations under the brands described above, for a total of 141 retail coffee outlets. Although the retail specialty coffee industry is presently dominated by a single company, which operates over ten thousand domestic retail locations, we are one of the nation’s

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largest specialty coffee retailers with annual system-wide revenues in excess of $57 million. System-wide revenues include sales from company operated and franchise locations. Our retail units are located in 30 states.

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 2007 and fiscal 2008 through the twenty-four weeks ended December 12, 2007, is set forth below:

	Units at June 28, 2006	Opened	Closed/ Sold (A)		Net transfers between the Company and Franchise (B)		Units at June 27, 2007	Opened	Closed		Units at December 12, 2007
Gloria Jean’s Brand
Company Operated	5	—	(1	)	2		6	—	(2	)	4
Franchise	139	13	(14	)	(2	)	136	2	(9	)	129
Subtotal Gloria Jean’s	144	13	(15	)	—		142	2	(11	)	133
Diedrich Coffee Brand
Company Operated	26	—	(23	)	—		3	—	(2	)	1
Franchise – Domestic	8	—	(4	)	—		4	—	(1	)	3
Subtotal Diedrich	34	—	(27	)	—		7	—	(3	)	4
Coffee People Brand
Company Operated	21	—	(18	)	(3	)	—	—	—		—
Franchise – Domestic	1	—	—		3		4	—	—		4
Subtotal Coffee People	22	—	(18	)	—		4	—	—		4
Total	200	13	(60	)	—		153	2	(14	)	141

(A) During fiscal 2007, the Company sold 32 retail stores to Starbucks Corporation and seven stores to other third parties.

(B) Two Company operated Gloria Jean’s and three Company operated Coffee People coffeehouses were sold to franchisees during fiscal year 2007.

Seasonality and Quarterly Results

Our business experiences some variations in sales from quarter to quarter due to the holiday season and other factors including, but not limited to, general economic trends, competition, marketing programs and the weather. The fall and winter months are generally the best sales months but our geographic and product line diversity provide for some sales stability in the warmer months when coffee consumption ordinarily decreases. Because of the seasonality of our business, results for any quarter are not necessarily indicative of the results that may be achieved for the full fiscal year.

RESULTS OF OPERATIONS

Twelve weeks ended December 12, 2007 compared with the twelve weeks ended December 13, 2006

Total Revenue. Total revenue for the twelve weeks ended December 12, 2007 increased by $2,863,000, or 29.9%, to $12,448,000 from $9,585,000 for the twelve weeks ended December 13, 2006. This result was the net effect of a 41.3% increase in wholesale revenue, a 1.5% increase in retail sales, offset by a 18.9% decrease in domestic franchise revenue. Each component of total revenue is discussed below.

Wholesale Revenue. Our wholesale sales for the twelve weeks ended December 12, 2007 increased by $3,031,000, or 41.3%, to $10,370,000 from $7,339,000 for the twelve weeks ended December 13, 2006. Wholesale sales to OCS and foodservice customers for the twelve weeks ended December 12, 2007 increased by $3,553,000, or 68.5%, to $8,738,000 from $5,185,000 for the twelve weeks ended December 13, 2006 led by a 79.6%, or $3,474,000, net increase in Keurig “K-cup” sales. Sales of roasted coffee to our franchisees decreased $522,000, or 24.2%, for the twelve weeks ended December 12, 2007 as compared to the twelve weeks ended December 13, 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 $187,000, or 18.9%, to $803,000 for the twelve weeks ended December 12, 2007 from $990,000 for the twelve weeks ended December 13, 2006. Of the decrease in domestic franchise revenue, $146,000 of the decrease resulted from a decrease in royalty income and was due to a net decrease in same stores sales of 8.6% for the Gloria Jean’s brand in the current quarter compared to the prior year same quarter. The

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balance of the decrease of $41,000 was due to fewer new franchise store openings and renewal fees compared to the prior year same quarter.

Retail Sales. Retail sales for the twelve weeks ended December 12, 2007 increased by $19,000, or 1.5%, to $1,275,000 from $1,256,000 for the prior year period. The increase in retail sales during the current quarter was primarily due to an increase in sales from our internet website by $142,000, or 45.1%, to $457,000 for the twelve weeks ended December 12, 2007 from $315,000 for the twelve weeks ended December 13, 2006. The increase in internet website sales was offset by a decrease in sales at our retail stores of $123,000, or 13.1%, which resulted from a decrease in same store sales for Gloria Jean’s company stores of 9.7% partially offset by an increase in same store sales for Diedrich Coffee Company stores of 7.4% compared to the prior year quarter.

Cost of Sales and Related Occupancy Costs. Cost of sales and related occupancy costs for the twelve weeks ended December 12, 2007 increased $3,167,000, or 51.1%, to $9,362,000 from $6,195,000 in the prior year quarter. As a percentage of total revenue, cost of sales and related occupancy increased from 64.6% for the twelve weeks ended December 13, 2006 to 75.2% in the current fiscal quarter. Because none 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 as a percentage of total retail and wholesale sales from 72.1% for the twelve weeks ended December 13, 2006 to 80.4% for the twelve weeks ended December 12, 2007. Retail cost of sales increased from 35.6% to 36.3% in the current fiscal quarter whereas wholesale cost of sales increased from 71.2% to 81.9% of wholesale sales in the current fiscal quarter due to a higher percentage of higher cost Keurig business over the prior year period. Wholesale sales that carry a higher cost of goods sold than retail sales, also slightly increased as a percentage of the retail and wholesale sales mix from 85.4% to 89.1%. Occupancy costs for the twelve weeks ended December 12, 2007 decreased $113,000, to $407,000 from $520,000 in the prior year period primarily due to a decrease retail rent associated with closed stores and offset by an increase in franchise rent expense associated with closed store reserve adjustments associated with the Gloria Jean’s brand.

Operating Expenses. Total operating expenses for the twelve weeks ended December 12, 2007 increased $72,000 and as a percentage of retail and wholesale sales, decreased from 26.5% of retail and wholesale sales to 20.1% for the twelve weeks ended December 12, 2007. The increase in operating costs primarily resulted from an increase in wholesale of $57,000 and franchise of $97,000 which was partially offset by a decrease in retail operating expense of $82,000. The increase in wholesale costs of $57,000 resulted primarily from increases in compensation, equipment costs, travel and other overhead costs of $133,000 and was offset by a decrease in allowances for doubtful accounts of $76,000. The decrease in retail operating costs of $82,000 resulted primarily from a $127,000 net decrease in costs associated with fewer retail stores and was partially offset by an increase of $45,000 in marketing and labor costs associated with our internet business. Of the $97,000 increase in franchise costs, $79,000 related to an increase in allowance for doubtful accounts and $76,000 related to an increase in compensation costs which was partially offset by decreases in legal, consulting, and other of $58,000.

Depreciation and Amortization. Depreciation increased slightly by $39,000 to $280,000 for the twelve weeks ended December 12, 2007 as compared to $241,000 for the twelve weeks ended December 13, 2006.

General and Administrative Expenses. Our general and administrative expenses decreased by $36,000, or 2.1%, to $1,694,000 for the twelve weeks ended December 12, 2007 compared to $1,730,000 for the twelve weeks ended December 13, 2006. As a percentage of total revenue, general and administrative expenses decreased from 18.0% for the twelve weeks ended December 13, 2006 to 13.6% for the twelve weeks ended December 12, 2007 due primarily as a result of a decrease in compensation, benefits, stock option and bonus costs of $258,000 and offset by increases in legal, consulting, outside services and other of $222,000.

Interest Expense and Other, Net. Interest expense, interest income and other income, net was $69,000 in the twelve weeks ended December 12, 2007 compared to $30,000 in the twelve weeks ended December 13, 2006. This change was primarily the result of a decrease in interest expense due to a decrease in outstanding loans compared to the prior year same period.

Income Tax Benefit. We had losses from continuing operations for the twelve weeks ended December 12, 2007 and December 13, 2006. In accordance with SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”), the income tax benefit generated by the loss from continuing operations was $0 for the twelve weeks ended December 12, 2007.

Results of Discontinued Operations—Retail As a result of the sale and closure of certain retail stores during the previous fiscal year, the results from this component of our business are presented as discontinued operations for all periods presented in accordance with SFAS 144. For the twelve weeks ended December 13, 2006, loss on discontinued operations was $965,000, net of $0 in taxes. The tax expense associated with the discontinued retail operations differed from the statutory federal effective tax rate primarily due

15

to changes in the valuation allowance and permanently nondeductible goodwill associated with the discontinued operations.

Twenty-four weeks ended December 12, 2007 compared with the twenty-four weeks ended December 13, 2006

Total Revenue. Total revenue for the twenty-four weeks ended December 12, 2007 increased by $4,191,000, or 25.5%, to $20,608,000 from $16,417,000 for the twenty-four weeks ended December 13, 2006. This result was the net effect of a 35.1% increase in wholesale revenue, a 6.5% increase in retail sales, offset by a 18.5% decrease in domestic franchise revenue. Each component of total revenue is discussed below.

Wholesale Revenue. Our wholesale sales for the twenty-four weeks ended December 12, 2007 increased by $4,375,000, or 35.1%, to $16,834,000 from $12,459,000 for the twenty-four weeks ended December 13, 2006. Wholesale sales to OCS and foodservice customers for the twenty-four weeks ended December 12, 2007 increased by $5,003,000, or 54.1%, to $14,254,000 from $9,251,000 for the twenty-four weeks ended December 13, 2006 led by a 64.3%, or $4,968,000 net increase in Keurig “K-cup” sales. Sales of roasted coffee to our franchisees decreased $628,000, or 19.6%, for the twenty-four weeks ended December 12, 2007 as compared to the twenty-four weeks ended December 13, 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 $326,000, or 18.5%, to $1,432,000 for the twenty-four weeks ended December 12, 2007 from $1,758,000 for the twenty-four weeks ended December 13, 2006. Of the decrease in domestic franchise revenue, $224,000 of the decrease resulted from a decrease in royalty income and was due to a net decrease in same stores sales of 7.5% for the Gloria Jean’s brand for the twenty-four weeks ended December 12, 2007 compared to the twenty-four weeks ended December 13, 2006. The balance of the decrease of $102,000 was due to fewer new franchise store openings and renewal fees compared to the prior year same quarter.

Retail Sales. Retail sales for the twenty-four weeks ended December 12, 2007 increased by $142,000, or 6.5%, to $2,342,000 from $2,200,000 for the prior year period. The increase in retail sales was primarily due to an increase in sales from our internet website by $227,000, or 43.7%, to $746,000 for the twenty-four weeks ended December 12, 2007 from $519,000 for the twenty-four weeks ended December 13, 2006. This increase in internet website sales was offset by a decrease in sales at our retail stores of $86,000, or 5.1%, and resulted from a decrease in same store sales for Gloria Jean’s company stores of 8.8% partially offset by an increase in same store sales for Diedrich Coffee Company stores of 6.6% compared to the prior year quarter same period.

Cost of Sales and Related Occupancy Costs. Cost of sales and related occupancy costs for the twenty-four weeks ended December 12, 2007 increased $4,862,000, or 46.4%, to $15,334,000 from $10,472,000 in the prior year period. As a percentage of total revenue, cost of sales and related occupancy increased from 63.8% for the twenty-four weeks ended December 13, 2006 to 74.4% in the current fiscal quarter. Because none 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 as a percentage of total retail and wholesale sales from 71.4% for the twenty-four weeks ended December 13, 2006 to 80.0% for the twenty-four weeks ended December 12, 2007. Retail cost of sales increased from 35.7% to 36.8% in the current fiscal quarter whereas wholesale cost of sales increased from 72.3% to 81.4% of wholesale sales in the current fiscal quarter due to a higher percentage of higher cost Keurig business over the prior year period. Wholesale sales that carry a higher cost of goods sold than retail sales, also slightly increased as a percentage of the retail and wholesale sales mix from 85.0% to 87.8%. Occupancy costs for the twenty-four weeks ended December 12, 2007 increased $91,000, to $768,000 from $677,000 in the prior year period primarily due to an increase in franchise rent expense associated with closed stores.

Operating Expenses. Total operating expenses for the twenty-four weeks ended December 12, 2007 increased $383,000 and as a percentage of retail and wholesale sales, decreased from 28.6% of retail and wholesale sales to 23.9% for the twenty-four weeks ended December 12, 2007. The increase in operating costs primarily resulted from an increase in wholesale of $375,000 and franchise of $33,000 which was partially offset by a decrease in retail operating expense of $25,000. The increase in wholesale costs of $375,000 resulted primarily from increases in compensation, equipment costs, travel, allowances for doubtful accounts and other overhead costs. The decrease in retail operating costs of $25,000 resulted primarily from a $102,000 net decrease in costs associated with fewer retail stores and was partially offset by an increase of $77,000 in marketing and labor costs associated with our internet business. Franchise operating expense increased by $33,000 and primarily resulted from an increase in allowance for doubtful accounts of $170,000 and salaries and related of $51,000 and was partially offset by a decrease in legal, consulting, and outside services of $139,000 along with decreases marketing and other costs of $49,000.

Depreciation and Amortization. Depreciation remained relatively flat with a slight increase of $32,000 to $532,000 for the twenty-four weeks ended December 12, 2007 as compared to $500,000 for the twenty-four weeks ended December 13, 2006.

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General and Administrative Expenses. Our general and administrative expenses decreased by $253,000, or 7.4%, to $3,149,000 for the twenty-four weeks ended December 12, 2007 compared to $3,402,000 for the twenty-four weeks ended December 13, 2006. As a percentage of total revenue, general and administrative expenses decreased from 20.7% for the twenty-four weeks ended December 13, 2006 to 15.3% for the twenty-four weeks ended December 12, 2007 due primarily as a result of a decrease in compensation, benefits, stock option, and bonus costs of $479,000, which was offset by increases in legal, consulting, outside services and other of $226,000.

Interest Expense and Other, Net. Interest expense, interest income and other income, net was $242,000 in the twenty-four weeks ended December 12, 2007 compared to $95,000 in the twenty-four weeks ended December 13, 2006. This change was the result of a decrease in interest expense along with an increase in interest income due to an increase in invested cash compared to the prior year same period.

Income Tax Benefit. We had losses from continuing operations for the twenty-four weeks ended December 12, 2007 and December 13, 2006. In accordance with SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”), the income tax benefit generated by the loss from continuing operations was $540,000 for the twenty-four weeks ended December 12, 2007. As of December 12, 2007 net operating loss carryforwards of approximately $9,181,000 and $7,806,000 for federal and state income tax purposes, respectively are available to be utilized against future taxable income for years through fiscal 2026, subject to annual limitation pertaining to change in ownership rules under the Internal Revenue Code. Based upon the level of historical taxable income and projections of future taxable income over the periods which the deferred tax assets are deductible, management believes it is more likely than not that the Company will not realize the benefits of these deductible differences, and thus has recorded a valuation allowance against the entire deferred tax asset balance.

Results of Discontinued Operations—Retail As a result of the sale and closure of certain retail stores during the previous fiscal year, the results from this component of our business are presented as discontinued operations for all periods presented in accordance with SFAS 144. During the first fiscal quarter, the Company received proceeds from escrow of $1,274,000 as part of the transaction with Starbucks in fiscal 2007. For the twenty-four weeks ended December 12, 2007, gain on sale of discontinued operations was $767,000, net of $507,000 in taxes. Loss from discontinued operations for the twenty-four weeks ended December 13, 2006, was $1,391,000 net of $0 in taxes. The tax expense associated with the discontinued retail operations differed from the statutory federal effective tax rate primarily due to changes in the valuation allowance and permanently nondeductible goodwill associated with the discontinued operations.

FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES

Current Financial Condition. At December 12, 2007, we had working capital of $5,675,000, long term tax liabilities, deferred rent and deferred compensation of $1,161,000 and $21,583,000 of stockholders’ equity, compared to working capital of $8,592,000, total deferred rent and deferred compensation of $684,000 and $23,152,000 of stockholders’ equity at June 27, 2007. The decrease in working capital of $2,917,000 in the current fiscal quarter resulted primarily from net losses from continuing operations of $2,196,000 for the twenty-four weeks ended December 12, 2007. Available credit under our credit agreements was $5,000,000 as of December 12, 2007 and June 27, 2007.

The accounts receivable balance of $6,600,000 as of December 12, 2007 increased $2,531,000 from the June 27, 2007 balance of $4,069,000. This increase is due primarily to an increase in our wholesale sales receivables with wholesale revenue increasing over 35.0% for the twenty-four weeks ended December 12, 2007 compared to the prior year period. The accounts payable balance of $5,052,000 as of December 12, 2007 increased $1,238,000 from the June 27, 2007 balance of $3,814,000. This increase in accounts payable for the current quarter compared to the balance at June 27, 2007 is primarily attributable to the increase in Keurig royalties and green coffee and raw material purchases resulting from increases in the Company’s wholesale revenue with the second quarter being traditionally higher than other fiscal quarters of the Company’s fiscal year.

Cash Flows. Net cash used in operating activities for the twenty-four weeks ended December 12, 2007 totaled $4,291,000 as compared with $2,841,000 cash used in operating activities for the twenty-four weeks ended December 13, 2006. The Company has incurred losses from continuing operations of $2,196,000, and $2,384,000 for the twenty-four weeks ended December 12, 2007 and December 13, 2006, respectively. Net cash used in continuing operations of $4,255,000 and $2,227,000 for the twenty-four weeks ended December 12, 2007 and December 13, 2006, respectively, resulted primarily from increases in accounts receivable which was attributable to working capital needs from a more than 35.0% and 32.0% increase in wholesale revenue over the prior year same periods.

Net cash used in investing activities for the twenty-four weeks ended December 12, 2007 totaled $619,000 as compared with net cash used of $147,000 for the twenty-four weeks ended December 13, 2006. During the twenty-four weeks ended December 12, 2007, a total of $2,490,000 was used to invest in property and equipment primarily related to our Castroville roasting facility of

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$1,862,000, wholesale of $217,000, retail stores of $198,000, and our home office facility $213,000. These expenditures were offset by $544,000 of payments received on notes receivable and $1,274,000 of proceeds from escrow fund resulting from the sale of retail stores to Starbucks in the prior year. Net cash used in investing activities of $147,000 for the twenty-four weeks ended December 13, 2006 was primarily attributable to $689,000 of investments in property and equipment, investments in restricted cash of $78,000 and primarily offset by payments received on notes receivable of $624,000.

There were no financing activities for the twenty-four weeks ended December 12, 2007 compared to $2,193,000 of cash provided by financing activities for the twenty-four weeks ended December 13, 2006. Cash provided by financing activities during the twenty-four weeks ended December 13, 2006, were primarily attributed to $2,000,000 in borrowings under our contingent convertible note purchase agreement along with $341,000 in proceeds from the exercise of stock options.

Outstanding Debt and Financing Arrangements. On May 10, 2004, we entered into a $5,000,000 Contingent Convertible Note Purchase Agreement. The agreement provides for us to, at our election, issue notes with up to an aggregate principal amount of $5,000,000. The notes are to be amortized on a monthly basis at a rate that will repay 60% of the principal amount of the note by June 30, 2008. The remaining 40% will mature on that date. Interest is payable at three-month LIBOR plus 5.30%, and a facility fee of 1.00% annually is payable on the unused portion of the facility. The agreement contains covenants among others that limit the amount of indebtedness that we may have outstanding in relation to our tangible net worth. As of December 12, 2007, we were in compliance with all the covenants in the agreement. Notes are convertible into our common stock only upon certain changes of control. For notes issued and repaid, warrants to purchase shares are to be 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 expire on June 30, 2010. The fair value of warrants issued with respect to notes repaid will be recorded as a discount to debt, at the date of issuance, which will then be amortized using the effective interest method. Warrants to purchase our common stock will be issued only upon a change in control. The lender under this agreement is a limited partnership of which the chairman of our board of directors serves as the sole general partner. A total of 1,270,738 warrants are issuable upon a change in control for previous debt repayments under this facility. We have issued 4,219 warrants as of December 12, 2007. As of December 12, 2007, the Company had no amounts outstanding under the facility and $5,000,000 available for borrowing.

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.

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, 2008. The letter of credit facility is secured by a deposit account at Bank of the West. As of December 12, 2007, this deposit account had a balance of $623,000, which is shown as restricted cash and short term investments on the consolidated balance sheets. As of December 12, 2007, $472,000 of letters of credit was outstanding under the letter of credit facility. The agreement contains covenants that, among other matters, require us to submit financial statements to the bank within specified time periods. As of December 12, 2007, the Company was in compliance with all Bank of the West agreement covenants.

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 default of the Minimum EBITDA Covenant as of March 8, 2006 and removes the Minimum EBITDA from the Note Purchase Agreement; (ii) clarifies that warrants to purchase our common stock will be issued with respect to repaid principal amounts only upon a change in control; (iii) increases the interest rate applicable to outstanding amounts under the credit facility by 2%, to LIBOR plus 5.30%; and (iv) extended the exercise date of all warrants issued or to be issued under the Note Purchase Agreement by one year, to May 10, 2009 which was subsequently extended as discussed below. The maturity date for any notes issued in the future was unaffected by Amendment No. 2. As of December 12, 2007, the Company was in compliance with all agreement covenants as amended by Amendment No. 2.

On September 22, 2006, we entered into Amendment No. 3 to Contingent Convertible Note Purchase Agreement (“Amendment No. 3”). Amendment No. 3 (i) changes the date specified in the definition of “Maturity Date” from May 10, 2007 to June 30, 2008; (ii) adjusts the calculation of monthly payments to reflect the extended maturity date; (iii) removes a condition precedent to each loan that previously required there to be no material adverse effect or event reasonably likely to result in a material adverse effect before the obligation of the lender to purchase any note arose; (iv) amends the events of default so that an event that has, or is reasonably likely to have, a material adverse effect will not be considered such an event of default; (v) amends the notice requirements so that the Company is not required to give notice to the lender of any event that is reasonably likely to have a material adverse effect; and

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(vi) extends the exercise date of all warrants issued or to be issued under the Note Purchase Agreement to June 30, 2010.

Based on the terms of our credit agreements, as amended, cash received from the sale of Diedrich and Coffee People retail locations, the focus on growing the wholesale and franchise business segments, the status of our balance sheet and the overall business outlook for us and the specialty coffee market, our management believes that current cash balance, cash from ongoing operations, and funds available to us from our current 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 equity financing 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 December 12, 2007:

	Payments Due By Period
	Total		Less than 1 year		1-3 years		3-5 years		More than 5 years
	(In thousands)
Company operated retail locations and other operating leases	$	8,469	$	2,213	$	3,255	$	1,276	$	1,725
Franchise operated retail locations operating leases		15,715		3,103		5,076		3,734		3,802
Green coffee commitments		2,105		2,105		—		—		—
	$	26,289	$	7,421	$	8,331	$	5,010	$	5,527

As of December 12, 2007, there were no employment agreements with 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. In addition, pursuant to an engagement agreement with Stephen V. Coffey, our chief executive officer, a one-time bonus is payable at the end of Mr. Coffey’s engagement, which will be paid in the form of stock (60%) and cash (40%) in an aggregate amount equal to 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, other than a current affiliate, within 12 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 is greater than the market capitalization at the end of the engagement, Mr. Coffey’s management company will receive an additional bonus equal to 5.0% of the difference of the disposition value less the termination market capitalization. Because these amounts are contingent, they have not been included in the table above. As of December 12, 2007, no amounts have been accrued under the agreement with Mr. Coffey since there has been no appreciation in our total market capitalization as defined in this agreement.

As reflected in the table above, we have obligations under non-cancelable operating leases for our coffeehouses, 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 60 franchise locations. Under our historical franchising business model, we executed the master lease for these locations and entered into subleases on the same terms with our franchisees, which typically pay their rent directly to the landlords. Should any of these franchisees default on their subleases, we would be responsible for making payments under the master lease. Our maximum theoretical future exposure at December 12, 2007, computed as the sum of all remaining lease payments through the expiration dates of the respective leases, was $15,715,000. 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 and related payables.

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,

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the valuation allowance for net deferred tax assets and contingencies. We believe that the following represent the critical accounting policies and estimates that we use in the preparation of our unaudited condensed consolidated financial statements. The following discussion, however, does not list all of our accounting policies and estimates.

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

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

The most significant assumptions in our analysis are those used when we estimate a unit’s future cash flows. We generally use the assumptions in our strategic plan and modify them as necessary based on unit specific information. If our assumptions are incorrect, the carrying value of our operating unit assets may be overstated or understated. With the sale or closure of all but five of our Company-owned stores this has become less significant in the current year.

Impairment of Goodwill

At the reporting unit level, goodwill is tested for impairment annually or whenever an event or circumstance indicates that impairment has likely 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.

At fiscal year end 2007, an independent third party analysis of the fair value of the wholesale and franchise operating segments was conducted to determine whether any potential impairment to the goodwill associated with the operating segments was appropriate. The definition of value used in this analysis was fair value, which is defined as the amount at which an asset or assets could be bought or sold in a current transaction between willing parties, that is, other than in a forced sale or liquidation. The determination of fair value of the operating segments was based on financial statements and projections supplied by management in addition to current and future economic, market and competitive conditions, and other relevant factors.

In addition, a sensitivity analysis was completed to determine at what point impairment of the carrying value of the goodwill associated with the wholesale business segment would be appropriate. Using historical trends and the projected growth rates, the sensitivity analysis indicates that an annual 22% decline in cash flow into perpetuity would trigger a potential impairment of the goodwill associated with the wholesale business segment. The wholesale business segment has experienced significant revenue growth over the past two years averaging approximately 31% average annual growth from fiscal year 2005 to fiscal year 2007. This wholesale business segment is not on a declining revenue growth curve, but instead is experiencing significant growth in revenue.

Though the Gloria Jean’s domestic franchise operating segment has experienced declining revenue in recent years, the business segment has relatively few assets other than the associated goodwill. However, the analysis indicates that it would require a significant drop in the franchise store count, approximately 29%, before the Gloria Jean’s franchise operations business segment carrying value exceeded its calculated fair value.

If our assumptions used in performing the impairment test prove inaccurate, the fair value of the segments may ultimately prove to be significantly higher or lower, thereby causing the carrying value to be less than or to exceed the fair value and indicating impairment has or has not 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. No conditions exist at December 12, 2007 indicating that that goodwill is impaired.

Estimated Liability for Closing Stores

We make decisions to close stores based on prospects for estimated future profitability and sometimes we are forced to close stores due to circumstances beyond our control (e.g., a landlord’s refusal to negotiate a new lease). Our management team evaluates each store’s performance every period. When stores continue to perform poorly, we consider the demographics of the location, as

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well as the likelihood of being able to improve the performance of an unprofitable store. Based on the management team’s judgment, we estimate the future net 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. We established the estimated liability on the actual store closure date which is generally the date on which we cease to receive economic benefit from the unit. We also review the net cash flows to determine the need to provide for asset impairment.

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

Estimated Liability for Self-Insurance

We are self-insured for a portion of our losses related to workers’ compensation insurance for policy years ended prior to October 2006. We obtained stop loss insurance for individual workers’ compensation claims with a $250,000 deductible per occurrence and a program maximum for all claims of $750,000. Insurance liabilities and reserves are accounted for based on the present value of actuarial estimates of the amount of incurred and unpaid losses, based approximately on a risk-free interest rate. These estimates rely on actuarial observations of historical claim loss development. Management, 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 a result, if we experience a higher than expected number of claims or the costs of claims are greater than expected, then we may adjust the expected losses upward and our future self-insurance expenses will rise. As of October 2006, we are no longer self-insured.

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, 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

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into restructured franchise agreements may result in reduced franchise royalty rates in the future.

Stock-Based Compensation

As discussed in the notes to the condensed consolidated financial statements, we have various stock-based compensation plans that provide options for certain employees and outside directors to purchase common shares of stock. Prior to June 30, 2005, we elected to account for stock-based compensation in accordance with Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” which utilizes the intrinsic value method of accounting for stock-based compensation. Starting June 30, 2005, we adopted the provisions of SFAS 123R, which 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.

We determine the estimated fair value of stock-based compensation on the date of the grant using the Black-Scholes option-pricing model. The Black-Scholes option-pricing model requires us to apply highly subjective assumptions, including our historical stock price volatility, expected life of the option and the risk-free interest rate. A change in one or more of the assumptions used in the Black-Scholes option-pricing model may result in a material change to the estimated fair value of the stock-based compensation.

Valuation Allowance for Net Deferred Tax Assets

As discussed above, we have recorded a 100% valuation allowance against our net deferred tax assets. If we have been profitable for a number of years and our prospects for the realization of our deferred tax assets are more likely than not, we would then reverse our valuation allowance and credit income tax expense. 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 December 12, 2007, our net deferred tax assets and related valuation allowance totaled approximately $5,663,000.

Item 3. Quantitative And Qualitative Disclosures About Market Risk.

Market Risk Sensitive Items Entered Into for Trading Purposes

None.

Market Risk Sensitive Items Entered Into for Other Than Trading Purposes

Interest Rate Risk. We are exposed to market risk from changes in interest rates on our outstanding debt. At December 12, 2007, we had no amounts outstanding under our $5,000,000 loan facility. Should we incur debt on this facility, we could be affected by changes in short term interest rates. Our borrowing rate on our loan facility is based on a three-month LIBOR plus 5.30% (5.06% at December 12, 2007). During the second fiscal quarter, three month LIBOR rates ranged from 4.86% to 5.25%

Commodity Price Risk. Green coffee, the principal raw material for our products, is subject to significant price fluctuations caused by a number of factors, including weather, political, and economic conditions. To date, we have not used commodity based financial instruments to hedge against fluctuations in the price of coffee. To ensure that we have an adequate supply of coffee, however, we enter into agreements to purchase green coffee in the future that may or may not be fixed as to price. As of December 12, 2007, we had commitments to purchase coffee totaling $2,105,000 for 1,219,000 pounds of green coffee, the majority of which commitments were fixed as to price. The coffee scheduled to be delivered to us over the next twelve months pursuant to these commitments will satisfy approximately 21% of our anticipated green coffee requirements. Most of these commitments are for fiscal year 2008. Assuming we require approximately 4,684,000 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 $47,000 of additional cost. However, because the price we pay for green coffee is negotiated with suppliers independent of the commodities market we believe that the commodity market price for green coffee, in general, would have to increase significantly, by as much as $0.25 per pound, before suppliers would increase the price they charge us.

Item 4. Controls and Procedures.

(a) As of the end of the period covered by this quarterly report, our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)). Based on that

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evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective.

(b) There was no 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. There are no material changes from the legal proceedings disclosure set forth in Part I, Item 3 of our Form 10-K for the fiscal year ended June 27, 2007. Please refer to the Form 10-K for the fiscal year ended June 27, 2007 for disclosure regarding legal proceedings.

Item 1A. Risk Factors.

There are no material changes from the risk factors set forth in Part I, Item 1A of our Form 10-K for the fiscal year ended June 27, 2007. Please refer to the Form 10-K for the fiscal year ended June 27, 2007 for disclosure regarding the risks and uncertainties related to our business.

Item 2. Unregistered sales of Equity Securities and use of Proceeds.

None

Item 3. Defaults upon Senior Securities.

None

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

The Company held its annual stockholder meeting on December 11, 2007 at which time stockholders were asked to vote on the election of directors and the ratification of BDO Seidman, LLP as our independent registered public accounting firm for the fiscal year ending June 25, 2008.

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
Paul C. Heeschen	4,868,602	209,678
Greg D. Palmer	4,904,197	174,083
J. Russell Phillips	4,904,148	174,132
Timothy J. Ryan	4,691,589	386,691

Ratification of Auditors

The stockholders ratified the selection of BDO Seidman, LLP as our independent registered public accounting firm for the fiscal year ending June 25, 2008. The votes were cast as follows:

FOR	AGAINST	ABSTAIN
5,066,549	9,097	2,634

Item 5. Other Information.

None

23

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 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	Severance and Consultant Agreement and General Release dated as of November 21, 2007 by and between Diedrich Coffee, Inc. and Pamela J. Britton * (8)
31.1	Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2	Certification 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 Current Report on Form 8-K/A filed with the Securities and Exchange Commission on December 14, 2007.

24

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.

Dated: January 28, 2008	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)

25

EXHIBIT INDEX

Exhibit No.	Description
31.1	Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2	Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

26

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: January 28, 2008	/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: January 28, 2008	/s/ Sean M. McCarthy
	Sean M. McCarthy
	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 December 12, 2007 (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: January 28, 2008	/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 December 12, 2007 (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: January 28, 2008	/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.