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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

For the fiscal year ended March 30, 2003

OR

For the transition period from            to            

Commission File Number 0-26829

TULLY’S COFFEE CORPORATION

(Exact name of registrant as specified in its charter)

3100 Airport Way South

Seattle, Washington 98134

(Address of principal executive offices) (Zip Code)

Registrant’s telephone number, including area code: (206) 233-2070

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, no par value

Series A Convertible Preferred Stock, no par value

(Title of each class)

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

As of June 11, 2003, the number of shares of the registrant’s Common Stock outstanding was 16,409,187, and the number of shares of the registrant’s Series A Convertible Preferred Stock outstanding was 15,378,264.

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A Warning About Forward-Looking Statements

We make forward-looking statements in this report that are subject to risks and uncertainties. These forward-looking statements include information about possible or assumed future results of the Company’s operations and its financial condition, plans, objectives and performance. Additionally, when we use the words “believe,” “expect,” “anticipate,” “estimate” or similar expressions, we are making forward-looking statements. Many possible events or factors could affect our future financial results and performance. The forward-looking statements are not guarantees of future performance and results or performance may differ materially from those expressed in our forward-looking statements. In addition to the other factors discussed under “Item 1—Business —Risk Factors” in this annual report, the following possible events or factors could cause our actual results to differ materially:

In addition, this document contains forward-looking statements relating to estimates regarding the specialty coffee business. You should not place undue reliance on any of these forward-looking statements. Except to the extent required by the federal securities laws, we do not intend to update or revise the forward-looking statements contained in this report.

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PART I

General

Tully’s Coffee Corporation (“Tully’s” or the “Company”) roasts and sells high quality, premium roasted whole bean coffees. Tully’s Retail division operates specialty coffee stores that offer its premium roasted whole bean coffees and serve a wide selection of hot and cold beverages that feature its coffees, teas and premium softened ice cream (introduced in Fiscal 2003). The stores also sell baked goods, pastries and other food products, and coffee-related supplies, accessories and equipment. As of June 11, 2003, Tully’s operated 99 retail stores, all of which are located in the western United States.

Tully’s complements its retail operations with additional channels for distribution of its branded products: (1) Tully’s Wholesale division sells Tully’s coffees and related products and supplies to domestic customers in the supermarket, food service, restaurant, office coffee service, and institutional channels; and (2) Tully’s International division sells Tully’s coffee and related products and supplies to foreign licensees and manages the relationships with these licensees. The Wholesale division is also responsible for the Company’s mail order and internet sales activities.

The International division has significant relationships with two Japanese companies. Tully’s has a license and supply agreement with FOODX GLOBE Co., Ltd. (“FOODX”) (formerly known as Tully’s Coffee Japan) which, as of June 11, 2003, operated 85 Tully’s retail stores in Japan and had franchised an additional 32 stores that operate under the Tully’s brand in Japan. In addition, Tully’s has licensed Ueshima Coffee Company Ltd. (“UCC”) to operate coffee stores under the Tully’s brand throughout Asia, excluding Japan. During Fiscal 2003 UCC opened its first Tully’s-branded store in Seoul, South Korea.

The Company’s retail store philosophy focuses on providing an upscale atmosphere, with quick, friendly service where customers can relax and enjoy some of the finest hot and cold coffee, espresso, and hand-made ice cream shake drinks available, together with other tasty treats. The Company seeks to make each location a comfortable neighborhood meeting place, with employees who go out of their way to make customers feel special. The Company believes that developing customer loyalty and brand recognition on the foundation of product appeal and customer service is of the utmost importance in its business and growth strategy, and that its retail image builds product and brand credibility for its Wholesale and International divisions.

Fiscal Periods

The Company ends its fiscal year on the Sunday closest to March 31. As a result, the Company records its revenue and expenses on a 52 or 53 week period, depending on the year. Each of the fiscal years ended March 30, 2003 (“Fiscal 2003”), March 31, 2002 (“Fiscal 2002”) and April 1, 2001(“Fiscal 2001”) included 52 weeks. The fiscal year ending March 29, 2004 will include 52 weeks (“Fiscal 2004”).

Company Background

Tully’s was formed in July 1992 after its founder and Chairman of the Board, Tom T. O’Keefe, concluded that an opportunity to develop, own and operate a chain of specialty coffee stores existed in the greater Puget Sound, Washington area. During the early 1990s, Mr. O’Keefe’s real estate company was approached by numerous companies inquiring about locating specialty coffee stores in the properties owned and managed by his company. As a result, Mr. O’Keefe began researching the specialty coffee industry and determined that an opportunity existed for development of a company focused on the sale of high-quality coffee beans, coffee drinks and coffee related products in an upscale atmosphere that emphasized customer service. On September 16, 1992, Tully’s opened its first store in Kent, Washington.

Tully’s Coffee Corporation is a Washington corporation and is headquartered at 3100 Airport Way South, Seattle, Washington 98134. The Company’s telephone number is (206) 233-2070 or 1-800-96Tully.

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Strategy

General

From its founding through Fiscal 2001, the Company’s objective was to establish Tully’s as one of the most respected coffee brands in the world. To achieve this goal, the Company made significant investments in marketing and building its brand. Starting in Fiscal 2002, the Company decided that it had successfully developed its brand identity and that it could modify its strategy to place greater emphasis on improving store and overall corporate operating performance and less emphasis on brand development. The shift in emphasis continued during Fiscal 2003, and the Company has adopted a business plan for Fiscal 2004 (the “2004 Business Plan”) that is focused on improving overall corporate operating performance and on the conservative use of the Company’s capital. Management believes that the Tully’s brand and retail store model have been developed to a point where they can be leveraged for improved operating results, and then replicated to additional locations and markets.

Tully’s strives to develop customer loyalty and brand recognition by providing superior service and offering quality coffee products that are competitively priced. Tully’s seeks to employ people who contribute to the “coffee experience” of its customers. Management believes that the Company’s staff is well trained and knowledgeable about the products offered for sale. It is the Company’s belief that customer service, along with product freshness and consistency, has become its hallmark, and it seeks to sustain these attributes in all three of its operating divisions—Retail, Wholesale, and International.

The Company believes that its customers enjoy the flavor profiles and qualities of its coffee beverages and other products, and often purchase them from more than one channel. For example, customers may patronize Tully’s stores and also may enjoy Tully’s coffee beverages at a favorite restaurant or espresso bar, and may purchase Tully’s whole bean coffee from a supermarket for home consumption. Tully’s also believes that its customers will be receptive to the introduction of other complementary products into its stores and through its Wholesale division. Further, products that are successful in Tully’s domestic stores may have opportunities for export or for license to the stores operated or franchised by Tully’s licensees in Asia. In Fiscal 2003, the Company introduced Tully’s Premium Softened Ice Cream^™ into 63 of its Tully’s stores. The Company considers the launch of its ice cream product line to have been successful, and it added ice cream to another 22 stores in May 2003. This product line is based upon premium soft-serve vanilla ice cream and Tully’s coffee flavor ice cream, and supports an expanded menu including ice cream shakes, cones, and sundaes that complements the Company’s other cold beverages, Spin^™ and Tango^™.

The Company believes that customer interest is increased, and incremental sales will occur, when customers are informed about new Company products and special offers, and about the qualities of the Company’s product offerings. Accordingly, the Company’s strategies include advertising and marketing inside and outside of its stores.

The Company also believes that customers will be receptive to improved value, variety and convenience through broader distribution, and it seeks expanded market share through its Wholesale division in the supermarket, food service, and institutional channels. It is the Company’s belief that expanded product mix and broader distribution help Tully’s reach prospective customers that do not currently buy the Company’s products, and increase the frequency and size of customer purchases.

Another important element of the Company’s strategy is to be an integral part of the local neighborhood served by each retail store. This is accomplished in a variety of ways, such as becoming involved in local fundraising and charitable organizations, participating in primary and secondary school programs and by providing jobs to area high school students. The Company believes that community involvement not only helps the Company by building goodwill, but also strengthens its market position.

Historical Expansion and Future Growth Strategy

Tully’s principal domestic expansion strategy has been to develop new retail stores in the Company’s current geographic markets in the western United States and to introduce its Wholesale division to targeted wholesale segments (supermarket, food service and restaurants, office coffee services and institutional clients) in

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those same markets. Tully’s also has expanded into new markets by purchasing existing retail coffee locations, with the goal of converting these into Tully’s stores. As the Company’s focus has shifted from brand development and revenue growth toward improving overall corporate operating performance, its rate of new store openings has decreased. During Fiscal 2003, Tully’s opened one new store and in Fiscal 2002, the Company opened two new stores. During Fiscal 2001, the Company opened 37 new stores and acquired 14 stores. During Fiscal 2001, Tully’s acquired the assets and real property leases of four Los Angeles-area stores and one Seattle-area store from Coffee Station, Inc. (“Coffee Station”), and the Company entered the Portland, Oregon market by acquiring nine stores from Tri-Brands, Inc., dba Marsee Baking (“Marsee Baking”).

Tully’s regularly evaluates store performance, and periodically closes stores that do not meet the Company’s financial expectations. Tully’s closed five stores in Fiscal 2003, 12 stores in Fiscal 2002 and two stores in Fiscal 2001.

The 2004 Business Plan is focused on improving overall corporate operating performance and upon the conservative use of the Company’s capital. In Fiscal 2004, the Company will seek growth primarily from increased sales at existing stores and from expansion of its Wholesale Division. The Company does not expect to open any new retail stores during Fiscal 2004. In Fiscal 2004, Tully’s intends to focus its Retail division primarily on improving the results of its existing stores through introduction of new products, targeted marketing, merchandising, and advertising initiatives, and operating cost savings. In Fiscal 2004, the Company expects to close at least two stores that do not meet the Company’s financial criteria. Tully’s will continue to investigate and evaluate expansion opportunities that fit strategically into its future growth plans and are consistent with the focus of the 2004 Business Plan

In Fiscal 2004, Tully’s expects to continue developing its Wholesale division, especially in the supermarket and food service channels. During Fiscal 2003, the number of supermarkets selling the Company’s whole bean coffees increased from approximately 80 to approximately 790, with growth concentrated in the Pacific Northwest. The Company expects to add additional supermarkets in Fiscal 2004, with most of the growth coming in western states outside of the Pacific Northwest. Food service channel growth is expected to occur primarily as the result of additional food service distributors selling the Company’s products and through the addition of major-coffee user customers (who may buy directly from the Company or purchase through food service distributors). Growth in the wholesale segment is expected to include the addition of new customers in the Company’s principal market areas, and also programs to expand the volume of products sold through current customers. The growth in the approximate number of grocery stores selling Tully’s coffee during Fiscal 2003 is depicted by the following graph, which also presents the approximate number of such stores as of June 22, 2003.

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The Company’s primary international growth strategy has been to license others to operate or franchise the right to operate Tully’s-branded retail stores and sell Tully’s coffees in the foreign markets. The Company expects continuing growth in its International division in Fiscal 2004, primarily from the expected growth of the FOODX business, and the Company may pursue other international licensing and joint venture opportunities.

Marketing

Retail Stores

Tully’s focus on consistency and quality in its products and customer service has been a key element of its marketing program. Point of sale signage, custom bags, boxes, cups, gift sets, products and literature with the Company’s distinctive name and logo, and community activities in which Tully’s name and logo are featured, are intended to increase name awareness and to reinforce the Company’s image. Sponsorship of two major league baseball teams was a major element in Tully’s marketing strategy through Fiscal 2003, but the Company has decided to shift its focus to other marketing strategies. Accordingly, one sponsorship was terminated in March 2003 and the other sponsorship is scheduled to terminate in October 2003 (See Note 19 of the Notes to the Consolidated Financial Statements). Starting during Fiscal 2003 and continuing into Fiscal 2004, the Company is making increased use of outdoor signage, direct mail and newspaper advertisements, coupons and special offer books, special and seasonal product offerings, and joint promotions with other companies.

In May 2003, the Company refurbished its retail store menu boards to provide a fresh look and to more clearly describe its product offerings. The new menu boards also provide greater flexibility for new products, promotions, and pricing changes.

During November 2002, the Company introduced the Tully’s Coffee Card^™, a stored-value payment card. Customers can use this card like a gift certificate for gift giving, or they can use it as a convenient personal purchase card at Tully’s coffee stores, instead of cash or credit card. This card encourages customer visits to Tully’s stores, and is periodically incorporated into the Company’s promotional activities.

Wholesale

Tully’s Wholesale division provides additional opportunities for coffee consumers to experience the Company’s coffee and reinforces Tully’s branded logo and name. The Wholesale division makes many of the Company’s branded products available through supermarkets, restaurants, espresso bars, office coffee services, mail order, and institutional food service. The Company’s products generally feature branded packaging. Tully’s also provides logo-bearing coffee cups, banners and point of use signage to customers of the Wholesale division. The Company believes that marketing programs that support its brand and its retail stores also benefit its Wholesale division. In the supermarket channel, Tully’s provides marketing support through promotional allowances and discounts in support of special price offerings to the grocers’ customers, and through cooperative advertising and other marketing funds. The Company also makes use of other marketing approaches such as direct mail to support wholesale customers and in-store demonstrations.

International

The International division expands the geographic reach of the Tully’s brand and products to consumers outside the United States. FOODX operates and franchises Tully’s-branded stores in Japan. These stores bring the look and feel of the Tully’s store, and the flavor of Tully’s coffees and beverages, to the Japanese customer. The license with UCC is expected to eventually expand this international presence to other countries in Asia, (beyond the one store currently operated by UCC in South Korea). The Company believes that the tourism, media, and trade ties between the principal domestic markets served by its Retail and Wholesale divisions with other Pacific Rim nations (in particular, Japan) are beneficial to the international expansion of the Tully’s brand. Tully’s views other foreign markets as opportunities for growth through licensing or joint venture, but is not presently focused on developing these other markets.

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Community

Tully’s commitment to the local community is another key element of its marketing strategy. Tully’s supports local and national organizations focusing on children’s educational and health-related issues. Each store supports events within its neighborhood and community. The Company’s employees volunteer service and the Company donates product to local non-profit organizations, including schools, sports teams, food banks, charities and service organizations. The Company also provides product and resource donations to national organizations working to improve the health and development of children.

International

The Company’s International division sells Tully’s whole bean coffees and other proprietary merchandise, and supporting supplies, equipment and materials to its foreign licensees.

In April 2001, the Company entered into an exclusive license agreement (the “UCC License Agreement”) with UCC, a Japanese company that is one of Asia’s largest coffee purveyors. Under the terms of the UCC License Agreement, Tully’s granted UCC an exclusive, perpetual license to use Tully’s business names, trademarks, and other intellectual property rights to develop and operate specialty coffee stores throughout Asia, except for Japan. In April 2001, the parties completed the transaction upon payment by UCC to Tully’s of a $12,000,000 license fee. In further consideration of the license, UCC will pay Tully’s a royalty and service fee, commencing in April 2009, based on the aggregate net revenues of the stores that UCC operates under the Tully’s business name, and all other sales of products or services made under the Tully’s business names and trademarks in Asia. The Company expects that UCC will roast most of its own coffee for its licensed stores in Asia.

Also in April 2001, Tully’s entered into a license agreement and a supply agreement with FOODX that permit FOODX to operate and franchise Tully’s stores in Japan. As of June 11, 2003, FOODX operated 85 retail stores in Japan and had franchised 32 stores in Japan. In October 2001, the Company received total consideration of $5,971,000 from FOODX, consisting of 300 shares of FOODX stock (with a market value of approximately $1,771,000 at October 1, 2001) and $4,200,000 cash, in connection with the amendment of Tully’s license and supply agreements with FOODX. The amendments allow FOODX to be the exclusive wholesaler of Tully’s coffee in Japan, to roast Tully’s coffee in Japan and to acquire other supplies and equipment from sources other than the Company, subject to various product and quality requirements. FOODX has contracted with UCC to roast Tully’s coffee for FOODX, and UCC commenced roasting in May 2002. Under the amended supply agreement, the Company receives a fee from FOODX based upon the amount of coffee roasted in Japan. Although Tully’s expects that FOODX will purchase some coffee and supplies from Tully’s in Fiscal 2004, it expects that most of FOODX’s coffee requirements will be roasted in Japan, and that FOODX will purchase most of its supplies and equipment from Japanese suppliers.

Product sales to licensees located outside the United States accounted for approximately 4.0% of Tully’s net sales in Fiscal 2003, 5.6% of Tully’s net sales in Fiscal 2002 and 3.7% of Tully’s net sales in Fiscal 2001. The Company expects this percentage to decline as its international licensees establish more local sourcing of products and materials and while the levels of royalty and service fee income to the Company increase.

Competition

The specialty coffee market is highly fragmented and very competitive. A number of Tully’s competitors have much greater financial and marketing resources, brand recognition and larger customer bases than Tully’s. Tully’s competes with a number of specialty coffee roasters and retailers, including Starbucks Corporation, which has stores throughout the United States and around the world, and regional companies such as Coffee Bean and Tea Leaf, Diedrich Coffee, Inc., the Seattle Coffee Company (“SBC”), which includes the Seattle’s Best Coffee and Torrefazione Italia Coffee brands, and Peet’s Coffee & Tea.

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Coffee roasters and distributors including Starbucks Corporation, Kraft Foods, Inc., The Proctor & Gamble Company and Nestle, Inc. distribute premium coffee products nationally and internationally in supermarkets and other wholesale channels. Many of these products may be alternatives to Tully’s coffees and coffee drinks. Consumers also may choose non-coffee products and beverages offered by these and other competitors as alternatives to the Company’s products. Tully’s coffee beverages, teas, and other beverages compete directly against all restaurant and beverage outlets that serve coffee, tea and other beverages, and the many single location specialty coffee outlets (espresso stands, carts, kiosks, drive-throughs and stores). Tully’s whole bean and ground coffees and its coffee beverages compete indirectly against all other coffees available in the market.

Premium specialty coffees have grown in popularity in the United States, and are being given additional selling space within supermarkets and increased attention from distributors in the food services channel. Tully’s must compete with other premium coffee roasters and distributors (including those providing branded and private label coffees) for space on the supermarket shelves and for distribution by wholesale food service distributors. Sysco Corporation has been the Company’s largest distributor in the wholesale food service distributor channel, but Sysco and Starbucks Corporation have entered into an exclusive distribution agreement and the Company expects its sales to Sysco to diminish significantly during Fiscal 2004. The Company has expanded its relationships with other wholesale food service distributors in the Company’s market areas, and is seeking to expand its food service distribution through direct sales to major coffee users.

These companies are strong competitors, and may become even more formidable through continued growth and industry consolidation (in April 2003, Starbucks Corporation announced that it would acquire SBC). These companies compete for retail and wholesale sales, for store locations, for employees and for supplies of premium coffee beans. Tully’s believes that there is opportunity for many companies to compete in the growing specialty coffee segment, and that the preferences and needs of consumers, owners of commercial store locations, coffee growers, coffee store employees, wholesale distributors and other constituents of the specialty coffee industry will support continued competition in this segment. Tully’s believes that its customers choose among specialty coffee brands primarily on the basis of product quality, service, convenience, and, to a lesser extent, on price. Tully’s also believes that the flavor profile of its coffee and coffee products, and the variety and quality of other food products provided by Tully’s stores, including Tully’s ice cream shakes and its premium softened ice cream products, serve as a point of differentiation for many customers.

Store Operations and Management / Employees

As of June 11, 2003, Tully’s employed approximately 940 people, approximately 860 of whom were employed in retail stores or regional operations. The balance of the employees work in the Company’s administrative, wholesale, international, roasting and distribution operations. All employees are non-union and management anticipates this will continue to be the case. Most of the Company’s employees work 20 or more hours per week.

Tully’s believes that its employees are an integral part of its business, and has structured its benefit programs accordingly. Full time employees are eligible for vacation, holidays, medical and dental insurance, maternity leave and sick leave. Store managers, district managers, wholesale sales personnel and other managers participate in incentive pay programs tied to financial criteria. To promote product loyalty and enhance expertise, all employees receive discounts on beverages and merchandise items. Tully’s believes that its current relations with employees are excellent.

To maintain Tully’s high standards of quality products and customer service, new store employees complete a training course and receive on-site training while working in a store. Training hours are devoted to orientation, Company philosophy, cash register and paperwork procedures, store equipment use, cash handling, retail product knowledge, sales techniques, customer service and thorough familiarization with Tully’s Employee Handbook. Training also covers coffee history, roasting, tasting of Tully’s proprietary blends, and hands-on beverage preparation. Employees who will serve in the Wholesale and International divisions, and those who serve in administrative support roles, receive much of the same training in order to build their specialty coffee industry expertise.

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Suppliers and Equipment Vendors

Tully’s roasts its own coffees to its own specifications. This enables the Company to develop distinctive coffee beverages and unique ground and whole bean coffees, to modify products to better fit the needs of particular customer segments, and to control more elements of this aspect of its product mix. During Fiscal 2003, the Company acquired new packaging equipment and redesigned its packaging, particularly the coffee packages used for the sale of whole bean and ground coffee within the supermarket channel and at the Company’s stores. The Company believes that these changes have improved the quality of the packaging while increasing the Company’s packaging capacity and reducing packaging costs.

Tully’s premium softened ice cream is produced especially for the Company by two suppliers. The coffee flavored ice cream is flavored with extract from Tully’s coffee. Other materials such as teas, dairy products, juices, and accessories are purchased from various vendors and are generally less specialized, although some materials and products are made to the Company’s proprietary recipes, or packaged to the Company’s proprietary specifications.

Coffee Markets

The Company purchases unroasted, or “green” coffee beans. There are many varieties of green coffee beans and a range of quality grades within each variety. Tully’s purchases only premium grade Arabica coffee beans and believes these beans are the best available from each producing region. Tully’s seeks to purchase the finest qualities and varieties of coffee beans by identifying the unique characteristics and flavors of the varieties available from each region of the world.

Coffee is the world’s second largest agricultural product and is grown commercially in over fifty countries in tropical regions of the world. The price and supply of coffee are subject to significant volatility. While most coffee trades in the commodity market, coffee beans of the quality sought by the Company tend to trade on a negotiated basis at a substantial premium above commodity coffee bean prices, depending upon the supply and demand at the time of purchase. Supply and price can be affected by multiple factors in the producing countries including weather and political and economic conditions. In addition, green coffee bean prices have been affected in the past, and may be affected in the future, by the actions of certain organizations and associations that have historically attempted to influence commodity prices of green coffee beans through agreements establishing export quotas or restricting coffee supplies worldwide. The Company’s ability to raise sales prices in response to rising coffee bean prices may be limited, and the Company’s future operating performance could be adversely affected if coffee bean prices were to rise substantially.

During the buying season, Tully’s often enters into forward commitments for the purchase of green coffee beans that may only be available in small quantities. Rotating the coffee bean selection enables the Company to provide its customers with a wider variety of coffees, as well as certain coffees that are available only on a seasonal basis. Tully’s enters into contracts for future delivery of green coffee beans to help ensure adequacy of supply. As of March 30, 2003, the Company had approximately $2,800,000 in fixed-price purchase commitments for Fiscal 2004, which, together with existing inventory, are expected to provide an adequate supply of green coffee beans through Fiscal 2004. Tully’s believes, based on relationships established with its suppliers, that the risk of non-delivery on such purchase commitments is remote. However, if coffee spot market prices are attractive, or if Company sales volumes increase beyond the levels anticipated for Fiscal 2004, the Company may elect to, or be required to, purchase coffee on the spot market, which might be at prices greater or less than the fixed contract pricing.

Roasting

Tully’s procures and roasts green coffee beans to its exacting specifications at its roasting plant in Seattle. Tully’s employs a roasting process that varies based upon the variety, quality, origin and physical characteristics of the coffee beans being roasted. Each batch is craft roasted to maximize the flavor characteristics.

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The Company’s roasting process produces coffee in small batches. Coffee is roasted daily and sealed in bags. Production and inventory levels are carefully monitored to minimize the time between roasting and delivery to the customer as coffee or a beverage, and coffee date codes are monitored to maintain fresh coffee stocks.

Tully’s has authorized its licensees, FOODX and UCC, to roast coffee under the Tully’s brand for sale in the stores operated or franchised by these licensees in their respective territories. In May 2002, UCC commenced roasting coffee in Japan for FOODX. The Company’s agreements with its licensees require that they roast to Tully’s specifications, recipes and quality standards, which are subject to periodic audit by Tully’s.

Equipment and Store Supplies

Tully’s purchases non-coffee merchandise, and the equipment, fixtures and supplies for its retail store locations from a number of vendors. The materials are purchased through purchase orders on an as-needed basis. Some materials and items are distributed through Tully’s roasting plant and warehouse facility, while the suppliers deliver other items directly to the Company’s retail stores. Shipments to Wholesale division and International division customers are generally distributed from the Company’s roasting plant and warehouse facility. In the past Tully’s has used multiple vendors for the same types of non-coffee merchandise, equipment and supplies. During Fiscal 2002 and 2003, Tully’s standardized and consolidated many of its vendors and suppliers to improve the cost of purchases and simplify operations. Tully’s believes that its relationships with its vendors are currently satisfactory. However, if a particular supplier or vendor is unable to meet Tully’s needs, begins to deliver unsatisfactory materials or is not price competitive, Tully’s believes that there are a number of alternative sources to meet all of its merchandise, equipment, store supplies and other materials needs.

Trademarks

Tully’s has applied for federal trademark registration in the United States and for trademark registration in several foreign countries for Tully’s^™. Some of the foreign trademarks have been granted, while others are still under review. The duration of trademark registrations varies from country to country. However, trademarks are generally valid and may be renewed indefinitely as long as they are in use and/or their registrations are properly maintained, and they have not been found to become generic.

After the Company filed its application for federal trademark registration for Tully’s, an operator of a small chain of restaurants in upstate New York applied to register the mark “Tully’s” in a somewhat different form. This claimant filed an opposition to the issuance of a trademark registration to the Company, claiming use of a Tully’s trademark prior to the Company. On January 31, 2001, the Trademark Trial and Appeal Board of the U.S. Patent and Trademark Office (“TTAB”) sustained the claimant’s opposition to Tully’s trademark registration application and refused registration of the Tully’s mark. In response, Tully’s filed an appeal of the TTAB opinion in U.S. District Court. In May 2003 the parties entered into a settlement agreement that sets forth the rights of each party to use marks containing “Tully’s.” The Company’s marks under the settlement agreement include “Tully’s” and “Tully’s Coffee” and all Company logos (among other marks) and the Company expects to complete its federal trademark registration for these marks during Fiscal 2004.

In addition to registered and pending trademarks, Tully’s considers the overall design and visual language of its trade dress to be a valuable asset. The design of its stores, including but not limited to the use of materials, furniture, signage, layout and overall aesthetics, developed in conjunction with packaged goods and marketing collateral, create a distinctive “look and feel” as well as a unique visual language. This “look and feel” and visual language continues to build its brand exposure and deliver “The Tully’s Experience” through all channels of its business. Although Tully’s considers store design, packaging and marketing collateral to be essential to brand identity, Tully’s has not applied to register these trademarks and trade dress, and thus cannot rely on the legal protections afforded by trademark registration.

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The ability to differentiate the Tully’s brand from its competitors depends, in part, on the strength and enforcement of its trademarks. If a competitor infringes on Tully’s trademark rights, the Company may have to litigate to protect its rights, in which case Tully’s may incur significant expenses and management’s attention may be diverted from the Company’s business operations.

Tully’s does not hold any patents.

Seasonality

The Company’s business is subject to seasonal fluctuations. Greater portions of Tully’s net sales are generally realized during the third quarter of Tully’s fiscal year, which includes the December holiday season. Seasonal patterns are generally applicable to all three divisions, Retail, Wholesale and International. In addition, quarterly results are affected by the timing of the opening of new stores or the closure of stores not meeting Company expectations. Because of the seasonality of Tully’s business, results for any quarter are not necessarily indicative of the results that may be achieved for the full fiscal year.

Risk Factors

In this section, the terms “we,” “us,” and “our” refer to Tully’s Coffee Corporation. The following factors may affect our future results and financial condition and should be considered in evaluating our business, operations and prospects.

Company Risks

Our history of losses may continue in the future and this could have an adverse affect on our ability to grow and the value of your investment in us.

To date, we have incurred losses in every year of operations. As of March 30, 2003, our accumulated deficit was $85.3 million. We expect to continue to incur a net loss in Fiscal 2004 and cannot assure you that we will ever become or remain profitable.

Future growth may make it difficult to effectively allocate our resources and manage our business.

Future growth of our business could strain our management, production, financial and other resources. We cannot assure you that we will be able to manage any future growth effectively. To manage our growth effectively, we must:

Any failure to manage our growth effectively could have an adverse effect on our business, financial condition and results of operations.

Our credit facility restricts our operating flexibility and ability to raise additional capital. If we were to default under the facility, the lender, the guarantors, or both would have a right to seize our assets.

The Company has credit lines with Kent Central LLC (see Note 13 of the Notes to Consolidated Financial Statements). The terms of the credit facility, and a related agreement among the Company and certain directors

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and shareholders who are guarantors of the debt under the credit facility, include provisions that, among other things, restrict our ability to incur additional secured debt or liens and to sell, lease or transfer assets. These agreements also provide the lender and the guarantors with a security interest in substantially all of our assets. Other provisions of these agreements would require accelerated repayment of the borrowed amounts in certain circumstances, including the issuance of new equity, certain mergers and changes in control, certain sales of assets, and upon certain changes or events relating to the guarantors. These provisions could limit our ability to raise additional capital when needed, and a default by the Company under these agreements could result in the lender or guarantors taking actions that might be detrimental to the interests of other creditors and shareholders of the Company.

We may not be able to obtain additional capital when needed.

To date, we have not generated sufficient cash to fully fund operations and typically operate with minimal or deficit working capital. We historically have financed this cash shortfall through the issuance of debt and equity securities, through borrowings, and through cash provided under our international licensing relationships. We will need to raise additional capital in the future to fund growth of the business and repayment of debt and other long-term obligations and commitments. Any equity or debt financing may not be available on favorable terms, if at all. Such a financing might provide lenders with a security interest in our assets or other liens that would be senior in position to current investors and creditors. If financing is unavailable to us or is available only on a limited basis, we may be unable to take advantage of business opportunities or respond to competitive pressures that could have an adverse effect on our business, operating results and financial condition. In such event, we would need to modify or discontinue our growth plans and our investments in store improvements, new customers and new products, and substantially reduce operating, marketing, general and administrative costs related to our continuing operations. We also could be required to sell stores or other assets (such as wholesale territories or international contract interests). Store sales would involve the assignment or sub-lease of the store location (which could require the lessor’s consent) and the sale of the store equipment, leasehold improvements and related assets. We have previously disposed of only underperforming store locations, but might be required to dispose of our better-performing locations in order to obtain a significant amount of sales proceeds. The proceeds received from the sale of stores or other assets might not be in amounts or timing satisfactory to us, and the sale of better performing locations or other income-producing assets could adversely affect our future operating results and cash flows.

Our articles of incorporation provide that its Series A Preferred Stock is senior to the common stock for a stated dollar amount of liquidation preferences, and the Series B Preferred stock is junior to a stated dollar amount of liquidation preference of both the Series A Preferred Stock and the common stock. If we were to sell all or a substantial portion of our assets in order to meet our operating needs and satisfy our obligations, the amounts remaining for distribution to shareholders might be less than the aggregate liquidation preferences of the more senior shareholders, and no amounts might be available for distribution to the more junior shareholders.

Our foreign licensees may not be successful in their operations and growth.

If our foreign licensees experience business difficulties or modify their business strategies, our results of operations could suffer. Because our licensees are located outside of the United States, the factors that contribute to their success may be different than those affecting companies in the United States. This makes it more difficult for us to predict the prospects for continued growth in our revenues and profits from these relationships. The economies of our licensees’ markets, particularly Japan, have been weak for the past few years. Recently, there have also been the adverse impacts on the international travel, hospitality and business community from concerns about exposure to SARS and terrorism.

If we are unable to successfully integrate future acquisitions, our business could be negatively impacted.

We may consider future strategic acquisitions similar to our acquisitions of the Coffee Station and Marsee Baking stores in Fiscal 2001. Integrating newly-acquired businesses is expensive and time consuming. Due to

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capital limitations, we have not yet fully conformed all of the Coffee Station and Marsee Baking stores to the Tully’s brand standards. If we acquire a business, we may not manage these integration efforts successfully, and our business and results of operations could suffer.

We have limited supplier choices providing our bakery category products.

We use local bakeries to supply our stores with a multitude of bakery items. Most of these bakeries are independently owned with limited capital resources to fund growth. If one or more of these suppliers is unable to provide high quality products to meet our requirements, or if our supplier relationships are otherwise interrupted, we may experience interruptions in the product availability and our results of operations could suffer.

If we are required to relocate our offices and roasting plant, our business could be negatively impacted.

We have agreed with the lessor for the building housing our headquarters, roasting plant and distribution facilities that the lessor may, at its option, terminate the lease upon 150 days notice, in which case we would be required to relocate our operations. Although the lessor has listed the property for sale or lease, the Company is not aware of any current intention by the lessor to terminate the lease and the Company expects to continue its tenancy under the terms of the lease. If we were required to relocate, we might experience an interruption to our business, or incur extra costs related to the relocation or to the replacement facility. In the event of such an early lease termination, the recoverability of the Company’s leasehold improvements at the facility would be impaired; such leasehold improvements had a net book value of $1,324,000 at March 30, 2003. (See Note 19 of the Notes to the Consolidated Financial Statements).

Our two largest shareholders have significant influence over matters subject to shareholder vote and may support corporate actions that conflict with other shareholders’ interests.

As of June 11, 2003, Mr. Tom T. O’Keefe, our founder and chairman, beneficially owned approximately 32% of our common stock and the estate of Mr. Keith McCaw, a former director, beneficially owned approximately 23% of our common stock. This ownership position gives each of these parties individually, and on a combined basis if acting in unison, the ability to significantly influence or control the election of our directors and other matters brought before the shareholders for a vote, including any potential sale or merger or a sale of our assets. This voting power could prevent or significantly delay another company from acquiring or merging with us, even if the acquisition or merger was in the best interests of our shareholders.

We cannot be certain that our brand and products will be accepted in new markets. Failure to achieve market acceptance will adversely affect our revenues.

Our brand or products may not be accepted in new markets. Consumer tastes and brand loyalties vary from one location or region of the country to another. Consumers in areas other than the Pacific Northwest, San Francisco, Los Angeles and Japanese markets may not embrace the Tully’s brand if we were to expand our domestic or international operations into new geographic areas.

Our retail store operations, and to a lesser extent, our Wholesale and International divisions, sell ice cream products and various foodstuffs and products other than coffee and coffee beverages. We believe that growth of these complementary product categories is important to the growth of our revenues from existing stores, and for growth in total net revenues and profits. Customers may not embrace these complementary product offerings, or may substitute them for products currently purchased from us.

Industry Risks

We compete with a number of companies for customers. The success of these companies could have an adverse effect on us.

Our Retail division and our Wholesale division operate in highly competitive markets in the Pacific Northwest, San Francisco and Los Angeles. Our specialty coffees compete directly against all restaurant and

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beverage outlets that serve coffee and the large number of independent espresso stands, carts and stores. Companies that compete directly with us in the retail and wholesale channels include, among others, Starbucks Corporation, Coffee Bean and Tea Leaf, Diedrich Coffee, Inc., Peet’s Coffee and Tea, Kraft Foods, Inc., Nestle, Inc., and The Proctor & Gamble Company, in addition to the private-label brands of food service distributors, supermarkets, warehouse clubs and other channels. Some of these companies compete with our International division and we also face competition from companies local to those international markets that may better understand those markets, or be better established in those markets. We must spend significant resources to differentiate our product from the products offered by these companies, but our competitors still may be successful in attracting our Retail, Wholesale and International customers. Our failure to compete successfully against current or future competitors would have an adverse effect on our business, including loss of customers, declining revenues and loss of market share.

Competition for store locations and qualified workers could adversely affect our growth plans.

We face intense competition from both restaurants and other specialty retailers for suitable sites for new stores and for qualified personnel to operate both new and existing stores. We may not be able to continue to secure adequate sites at acceptable rent levels or attract a sufficient number of qualified workers. These factors could impact our plans for expansion and our ability to operate existing stores. Similar factors could impact our Wholesale customers and our International customers, and could adversely affect our plans to increase our revenues from those customers.

A shortage in the supply or an increase in price of coffee beans could adversely affect our revenues.

Our future success depends to a large extent upon the availability of premium quality unroasted, or green, coffee beans at reasonable prices. Natural or political events, or disruption of shipping and port channels could interrupt the supply of these premium beans, or affect the cost. In addition, green coffee bean prices have been affected in the past, and could be affected in the future, by the actions of organizations such as the International Coffee Organization and the Association of Coffee Producing Countries, which have attempted to influence commodity prices of green coffee beans through agreements establishing export quotas or restricting coffee supplies worldwide. Price increases for whole bean coffee could result in increases in the costs of coffee beverages served in our stores. These cost increases may force us to increase the retail and wholesale prices for our coffee products, which could adversely affect our revenues.

Changes in the economy could adversely affect our revenues.

Our business is not diversified. Our revenues are derived predominantly from the sale of coffee, coffee beverages, baked goods and pastries, ice cream products, and coffee-related accessories and equipment. Given that many of these items are discretionary items in our customers’ budgets, our business depends upon a healthy economic climate for the coffee industry as well as the economy generally. We believe that the weak economy has adversely impacted our revenues during Fiscal 2001 through 2003. If the economic climate does not improve, or if it worsens, there could be further adverse impact on our revenues.

Investment Risks

We may need additional capital, which if raised, could dilute your interest in our Company.

If we raise additional funds through the issuance of equity, convertible debt or other securities, current stockholders could experience dilution and the securities issued to the new investors could have rights or preferences senior to those of common stock.

In addition, prior to October 1999, holders of our capital stock were entitled to preemptive rights pursuant to our Articles of Incorporation and the Washington Business Corporation Act. As a result, some of our shareholders may be entitled to purchase shares of our common stock and Series A preferred stock at the

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respective purchase prices at which they were originally offered. At some time the Company may satisfy these preemptive rights (through the sale of shares to these shareholders in exchange for the applicable cash consideration) or seek waivers of these preemptive rights from such shareholders, but it has not yet undertaken any efforts to do so. The Company estimates the maximum number of shares that may be issuable upon exercise of preemptive rights to which certain shareholders may be entitled is as follows:

The willingness of shareholders who may have preemptive rights to either purchase additional shares or waive such rights will depend upon a number of factors, including the difference between the value of the Company’s shares at that time and the purchase price applicable to such shares. Any additional issuances of our capital stock pursuant to the exercise of a shareholder’s preemptive rights could further dilute other existing shareholders.

The lack of a public market for Tully’s capital stock and restrictions on transfer substantially limit the liquidity of an investment in our capital stock.

There is currently no public market for our common stock or our preferred stock, and consequently liquidity of an investment in our capital stock currently is limited. Whether Tully’s would ever “go public” and, if so, the timing and particulars of such a transaction, would be determined by our evaluation of the market conditions, strategic opportunities and other important factors at the time, based on the judgment of our management, board of directors and professional advisors. There can be no assurance that such a public market will ever become available for our common or preferred stock.

As of June 11, 2003, Tully’s operated 99 retail stores in the United States, all of which are located on property leased by the Company.

The Company leases the building that houses the Company’s headquarters, roasting plant and distribution facilities (the “Airport Way Property”) pursuant to a ten-year lease (expiring May 2010) and subject to two five-year options to renew. The lessor, KCL, also has provided credit facilities to the Company (See Note 13 of the Notes to the Consolidated Financial Statements). On November 1, 2002, in connection with the establishment of a credit line with KCL, the parties amended the lease and reduced the monthly rental by approximately $16,000 per month for the remainder of the lease term. In addition, the amended lease provides that the lessor may, at its option, terminate the lease prior to the expiration of its term by giving the Company 150 days written notice of termination. Although the lessor has listed the property for sale, the Company is not aware of any current intention by the lessor to terminate the lease and the Company expects to continue its tenancy under the terms of the amended lease, subject to possible further amendment as described below. However, if the lessor were to terminate the lease prior to the expiration of its term, the recoverability of the Company’s leasehold improvements at the facility would be impaired; such leasehold improvements had a net book value of $1,324,000 at March 30, 2003. Annual rent payments under the lease are approximately $612,000 for fiscal years 2004 and 2005, $696,000 for fiscal year 2006, $703,000 for fiscal years 2007 through 2010 and $117,000 for partial fiscal year 2011.

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In June 2003, KCL and another party (the “Prospective Lessor”) informed the Company of a possible sale of the Airport Way Property from KCL to the Prospective Lessor. The possible sale is subject to resolution of certain contingencies, and the Company cannot predict the likelihood that it will be completed. However, the Company and the Prospective Lessor have entered into a contingent amendment to the lease for the Airport Way Property. The contingent lease amendment provides that, if the sale of the Airport Way Property to the Prospective Lessor is completed (and the Prospective Lessor becomes lessor to the Company under the lease), the lease will be amended to: (1) eliminate the 150 day termination provision, (2) reduce the portion of the Airport Way Property occupied by the Company under the lease (the aggregate building premises are approximately 220,000 square feet in size but the Company is presently using less than 100,000 square feet of the building premises), and (3) reduce the rent and occupancy costs paid by the Company.

The Company is a party to various legal proceedings arising in the ordinary course of its business, but is not currently a party to any legal proceeding which the Company believes will have a material adverse effect on the financial position or results of operations of the Company.

No matters were submitted for a vote of stockholders of the Company during the fourth quarter of Fiscal 2003.

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PART II

Market Information, Holders and Dividends

Currently there is no public market for Tully’s common stock. As of June 11, 2003, there were 4,922 holders of record of Tully’s common stock.

The Company has not paid cash dividends in the past and Tully’s presently does not plan to pay dividends in the foreseeable future. The Company intends to retain and use earnings to finance the growth of its business for an indefinite period. Any determination to pay cash dividends will be at the discretion of the Board of Directors and will be dependent upon the Company’s financial condition, results of operations, capital requirements, restrictions under its borrowing agreements, and such other factors as the Board of Directors deems relevant.

Securities Authorized for Issuance Under Equity Compensation Plans

Equity Compensation Plan Information

(As of March 30, 2003)

For a description of the Company’s equity compensation plans, see Note 20 of the Notes to the Consolidated Financial Statements.

Recent Sales of Unregistered Securities

The Company issued and sold securities in the transactions described below during Fiscal 2003. The offer and sale of these securities were made in reliance on the exemptions from registration provided by Section 4(2) of the Securities Act of 1933, as amended, as offers and sales not involving a public offering, based on the limited number of purchasers and their pre-existing relationship with the Company.

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The following selected financial data have been derived from the consolidated financial statements of the Company. The data set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Company’s consolidated financial statements and notes thereto appearing elsewhere in this Form 10-K.

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The following discussion and analysis provides information that Tully’s believes is relevant to an assessment and understanding of its results of operations and financial condition for the fiscal years ended March 30, 2003, March 31, 2002, and April 1, 2001. The following discussion should be read in conjunction with the consolidated financial statements and related notes appearing elsewhere in this report. The Company believes that certain statements herein, including statements concerning anticipated store openings, planned capital expenditures, and trends in or expectations regarding Tully’s operations, constitute “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. Such statements are based on currently available operating, financial and competitive information, and are subject to risks and uncertainties. Actual future results and trends may differ materially depending on a variety of factors, including, but not limited to, coffee and other raw materials prices and availability, successful execution of the Company’s business plans, the impact of competition, the effect of legal proceedings, and other risks summarized at “Item 1—Business—Risk Factors.”

Overview

Tully’s derives its revenues from sales from its:

From its founding through Fiscal 2001, the Company’s primary objectives were to establish the Tully’s brand, increase its revenues and expand its retail store base. Throughout this period and to date, the Company’s cash flow from operations has been insufficient to cover operating expenses and the Company has not made a profit from operations in any year since inception. These losses have been exacerbated by the weak economy in the Company’s principal geographic markets since 2001. During Fiscal 2002, the Company shifted its emphasis toward improving its operating performance and placed less emphasis upon expanding its retail store base and revenues. In Fiscal 2003, this shift in emphasis continued, reflecting Management’s view that the Company has sufficiently developed its brand identity and that greater emphasis should be placed on improving corporate productivity and operating performance. The Fiscal 2003 initiatives toward improved productivity and operating performance include:

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In the fourth quarter of Fiscal 2003, the Company established its business plan for Fiscal 2004 (the “2004 Business Plan”). This plan defines the Company’s operating, financing, and capital investment strategies for Fiscal 2004. The 2004 Business Plan is focused even more strongly upon improving overall corporate operating performance, and upon the conservative use of capital. Fiscal 2004 initiatives expected to improve operating performance and cash flow include:

Management expects that the continuing benefits from the Fiscal 2003 improvement initiatives and the similar initiatives comprising the 2004 Business Plan will result in improved operating results in Fiscal 2004 compared to Fiscal 2003, although the Company expects to incur a net loss (inclusive of depreciation and amortization expense) in Fiscal 2004. Company Management believes that the extension of the Kent Central credit facilities, as described below under “Liquidity and Capital Resources,” together with the operating cashflows, financing cashflows, and investing cashflows projected in the 2004 Business Plan, and the cash and cash equivalents of $993,000 at March 30, 2003, will be sufficient to fund ongoing operations of the Company through Fiscal 2004.

The number of retail stores operated by the Company are summarized as follows (excludes stores operated or franchised by foreign licensees):

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Results of Operations

The following table sets forth, for the periods indicated, selected statement of operations data expressed as a percentage of net sales:

Fiscal Year Ended March 30, 2003 Compared To Fiscal Year Ended March 31, 2002

Net Sales

The Company’s net sales for Fiscal 2003 decreased $658,000, or 1.3%, to $50,800,000 as compared to net sales of $51,458,000 for Fiscal 2002. The decrease in net sales was comprised as follows:

The Retail division sales decrease represented a 2.8% decrease compared to Fiscal 2002. The factors comprising this sales decrease are summarized as follows:

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During Fiscal 2003 and Fiscal 2002, the Company closed a total of seventeen stores, which resulted in a sales decrease of $1,490,000 from Fiscal 2002 to Fiscal 2003, while three new stores opened during Fiscal 2003 and Fiscal 2002 and produced a net sales increase of $598,000 in Fiscal 2003 compared to Fiscal 2002. Comparable store sales are defined as sales from stores open for the full period in both the current and comparative prior year periods. After experiencing negative comparable store sales in Fiscal 2002, the Company has implemented programs to improve its comparable store sales, which have resulted in improving comparable store sales trends, as shown, during the four quarters of Fiscal 2003 and preliminary information for the first 12 weeks (ended June 22, 2003) of the First Quarter of Fiscal 2004 as depicted by this graph. Overall, comparable store sales for Fiscal 2003 decreased by (0.7%) compared to the previous year.

Graph below: Comparable store sales increase (decrease) for Fiscal 2002, for each of the four quarters of Fiscal 2003, and for the first 12 weeks of the First Quarter of Fiscal 2004, as compared to the corresponding periods in the previous fiscal year.

Management believes that the comparable store sales decreases for the periods reflected above reflect the effects of (i) the weak economy, exacerbated by consumer uncertainty following the events of September 11, 2001, (ii) competition (including the effects of new Tully’s stores opened during these periods), (iii) customers purchasing Tully’s coffee through supermarkets instead of Tully’s retail stores, and (iv) limited product innovation and marketing during Fiscal 2002. The Company believes that these negative factors have been offset by the effects from the closure of stores not meeting Management’s financial criteria, including customers of closed stores shifting their business to other Tully’s stores. The Company believes that favorable customer response to the Company’s product, marketing and service improvement initiatives is responsible for the comparable store increases during the last two quarters of Fiscal 2003 and the first twelve weeks of Fiscal 2004.

Wholesale division net sales increased $662,000, or 12.9%, to $5,778,000 for Fiscal 2003 from $5,116,000 for Fiscal 2002. The increase reflects a $945,000 sales increase due primarily to growth in the number of supermarkets selling Tully’s coffees, partially offset by a $283,000 decline in office coffee service sales. Wholesale division sales accounted for 11.4% of net sales in Fiscal 2003 and 10.0% in Fiscal 2002.

Net sales for the International division decreased by $142,000, or 2.9%, for Fiscal 2003 from $4,857,000 to $4,715,000 for Fiscal 2003. Although FOODX increased the number of its owned and franchised stores from 50 to 112 during Fiscal 2003, FOODX began to purchase coffee, supplies and equipment from Japanese suppliers rather than from the Company during this period. The shift toward more local procurement by FOODX will generally decrease the Company’s sales to FOODX, but will result in greater gross margins for the Company.

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The growth in FOODX’s retail store base and business and the shift in its procurement resulted in a $728,000 increase in license royalties (related to the stores franchised by FOODX) and coffee roasting fees compared to Fiscal 2002, but also resulted in a decrease in sales of coffee and supplies of $870,000. International licensing fees, on an amortized basis, accounted for $130,000 of the increase in license royalties (Fiscal 2002 included only a partial year of such revenues). International division sales accounted for 9.3% and 9.4% of net sales in Fiscal 2003 and Fiscal 2002, respectively.

Operating Expenses

Cost of goods sold and related occupancy costs decreased $2,239,000, or 8.6%, to $23,666,000 in Fiscal 2003 from $25,905,000 in Fiscal 2002. As a percentage of net sales, cost of goods sold and related occupancy costs decreased to 46.6% for Fiscal 2003 compared with 50.3% for Fiscal 2002. These changes resulted primarily from:

Store operating expenses decreased $177,000, or 1.0%, to $17,213,000 in Fiscal 2003 from $17,390,000 in Fiscal 2002. As a percentage of net sales, store operating expenses remained unchanged at 33.9% for Fiscal 2003 compared to 33.8% for Fiscal 2002.

Other operating expenses (expenses associated with all operations other than retail stores) increased $322,000 or 20.4% to $1,903,000 in Fiscal 2003 from $1,581,000 in Fiscal 2002. As a percentage of net sales, other operating expenses increased to 3.7% for Fiscal 2003 compared to 3.1% for Fiscal 2002. This increase was primarily due to growth in selling costs related to the growth in the Wholesale division.

Marketing, general and administrative costs decreased $1,870,000, or 16.8%, to $9,290,000 in Fiscal 2003 from $11,160,000 in Fiscal 2002 reflecting Company efforts to reduce costs to levels appropriate for its revenue base. This decrease includes $175,000 in reduced costs under baseball park sponsorship agreements, a $624,000 decrease in professional fees, and a $178,000 decrease in stock option compensation expense.

Depreciation and amortization expense decreased $706,000, or 15.3%, to $3,894,000 in Fiscal 2003 from $4,600,000 in Fiscal 2002. During Fiscal 2003, the Company adopted the full provisions of SFAS 142 and therefore no amortization of goodwill was recorded in Fiscal 2003, compared to $252,000 recorded in Fiscal 2002. The reduction in depreciation and amortization expense also reflects the lower depreciable asset base caused by asset retirements and asset impairment charges (described below) during Fiscal 2001-2003.

Impairment of Long-Lived Assets

During Fiscal 2003 and Fiscal 2002, the Company performed reviews of its long-lived assets to determine whether such assets were impaired (see Note 10 of the Notes to the Consolidated Financial Statements). These reviews determined that impairments did exist, and a non-cash charge of $1,390,000 was recognized in Fiscal 2003 compared to the non-cash impairment charge of $2,350,000 during Fiscal 2002. These non-cash charges represent the write-off of the goodwill, leasehold improvements and other long-lived assets determined to be impaired.

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Store Closure and Lease Termination Costs

Store closure and lease termination costs were $108,000 for Fiscal 2003 as compared to $1,583,000 in Fiscal 2002. This decrease in the amount of costs associated with closure and disposal of stores (not meeting the Company’s financial criteria) and disposal of undeveloped property under leases is the result of the lower number of store closures and surplus properties to be disposed of in Fiscal 2003. See Note 18 of the Notes to the Consolidated Financial Statements.

Operating Loss

As a result of the factors described above, the Company had an operating loss of $6,664,000 in Fiscal 2003 as compared to the operating loss of $13,111,000 in Fiscal 2002, which is an improvement of $6,447,000 (49.2%) as compared to Fiscal 2002. The improvement includes a $2,435,000 reduction in the amount of charges for impairment of long-lived assets and for store closure and lease termination costs for Fiscal 2003 as compared to Fiscal 2002.

Other Income (Expense)

Interest expense decreased $164,000 or 20.2% compared to $812,000 for Fiscal 2002. The decrease relates to the lower level of average outstanding debt during Fiscal 2003 as compared to during Fiscal 2002 as the result of the repayment of the Company’s bank borrowings in Fiscal 2002 and the repayment of other notes and contracts, and the lower cost recorded for warrants issued in lieu of cash interest for the convertible note during Fiscal 2003. See Notes 13 and 14 of the Notes to the Consolidated Financial Statements.

Gains on sale of investments of $14,000 in Fiscal 2003 and $2,887,000 in Fiscal 2002 are the realized gains from the sale of the Company’s holdings of FOODX stock. The greater gain in Fiscal 2002 is the result of (i) lower cost per share on the shares sold in Fiscal 2002, (ii) higher selling price per share in Fiscal 2002, and (iii) more shares sold in Fiscal 2002.

Miscellaneous income (expense) increased $528,000 to income of $510,000 for Fiscal 2003 from expense of $18,000 for Fiscal 2002. The increase reflects primarily the Fiscal 2003 sale of certain intellectual property in the amount of $500,000 less approximately $40,000 of costs (See Note 15 of the Notes to the Consolidated Financial Statements).

Loan guarantee fee expense decreased $122,000 to $94,000 in Fiscal 2003 from $216,000 for Fiscal 2002 primarily as the result of the lower level of average outstanding debt during Fiscal 2003 that was subject to such fees, as compared to Fiscal 2002. These are non-cash fees paid with options or warrants (see Notes 13 and 17 of the Notes to the Consolidated Financial Statements).

Cumulative Effect of Change in Accounting Principle

During Fiscal 2003, the Company adopted the full provisions of SFAS 142. The Company performed an evaluation of its goodwill as of April 1, 2002 and determined that an impairment charge of $3,018,000 should be recorded related to the Company’s Retail division operations in California and Oregon. As provided in SFAS 142, this impairment charge has been retroactively recorded as the cumulative effect of a change in accounting principle as of the beginning of Fiscal 2003. See Note 9 of the Notes to the Consolidated Financial Statements.

Loss before Cumulative Effect of Change in Accounting Principle and Net Loss

Loss before Cumulative Effect of Change in Accounting Principle decreased $4,266,000 or 38.3% to $6,886,000 in Fiscal 2003 from $11,152,000 for Fiscal 2002. The smaller loss in Fiscal 2003 reflects the $6,447,000 improvement in operating loss during Fiscal 2003, partially offset by the smaller gain on sale of investments during Fiscal 2003 as compared to Fiscal 2002.

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After the $3,018,000 non-cash charge for the write-off of goodwill from the cumulative effect of change in accounting principle, the Company had a net loss of $9,904,000 for Fiscal 2003 as compared to $11,152,000 for Fiscal 2002.

Fiscal Year Ended March 31, 2002 Compared To Fiscal Year Ended April 1, 2001

Net Sales

The Company’s net sales for Fiscal 2002 increased $9,356,000 or 22.2% to $51,458,000 as compared to net sales of $42,102,000 for Fiscal 2001. During the same period, Retail division sales increased 16% to $41,477,000 from $35,759,000. This $5,718,000 increase in Retail division sales resulted from the opening during Fiscal 2002 of two new retail stores ($390,000); and stores opened or acquired during Fiscal 2001 and operating for the full year in Fiscal 2002 contributed $8,178,000. These amounts were partially offset by a comparable store sales decrease of (6.9%) which represented a $1,662,000 decrease, and $1,235,000 of sales declines from twelve stores closed during Fiscal 2002. Management believes that the comparable store sales decrease was caused by (i) the weak economy, exacerbated by consumer uncertainty following the events of September 11, 2001, (ii) cannibalization of, or diversion of customers from, comparable stores by new Tully’s stores opened during Fiscal 2001, (iii) customers purchasing Tully’s ground coffee through supermarkets instead of Tully’s retail stores, and (iv) limited product innovation and marketing during Fiscal 2002. Comparable store sales are defined as sales generated in stores open for at least 12 months in each of the periods. At March 31, 2002, the Company operated 104 retail stores (including the Safeco Field store which operated seasonally).

Wholesale division net sales increased $333,000 or 7.0% to $5,116,000 for Fiscal 2002 from $4,783,000 for Fiscal 2001. The increase was due primarily to new supermarket and food service accounts, partially offset by declines in the office coffee service sales.

Net sales for the International division increased by $3,297,000 or 211.3% for Fiscal 2002 from $1,560,000 for Fiscal 2001. International licensing fees, on an amortized basis, accounted for $1,958,000 of the increase and sales of coffee and supplies to FOODX represented $1,339,000 of the increase.

Operating Expenses

Cost of goods sold and related occupancy costs increased $3,400,000 or 15.1% to $25,905,000 in Fiscal 2002 from $22,505,000 in Fiscal 2001. This increase was largely the result of higher sales volumes and the impact of stores open only part of Fiscal 2001 but open all of Fiscal 2002. As a percentage of net sales, cost of goods sold and related occupancy costs decreased to 50.3% for Fiscal 2002 compared with 53.5% for Fiscal 2001, primarily as a result of (i) the consolidation of the Company’s bakery vendors and improved pricing, (ii) reduced costs of green coffee and improved inventory controls and (iii) awareness of cost savings, including more careful management of perishable inventories and supplies.

Store operating expenses increased $2,154,000 or 14.1% to $17,390,000 in Fiscal 2002 from $15,236,000 in Fiscal 2001. Labor and other expenses from new stores operated during part of Fiscal 2001 but all of Fiscal 2002 generated $1,424,000 of the increase, two new stores opened in Fiscal 2002 represented $175,000 of the increase, and costs associated with stores closed in Fiscal 2002 accounted for $555,000 of the increase. As a percentage of net sales, store operating expenses decreased to 33.8% for Fiscal 2002 from 36.2% for Fiscal 2001. This decrease resulted from the closing of stores that did not meet Company expectations offset by an increase in labor and related costs.

Other operating expenses (expenses associated with all operations other than retail stores) decreased $1,430,000 or 47.5% to $1,581,000 in Fiscal 2002 from $3,011,000 in Fiscal 2001. The expense decrease is primarily due to factors in Fiscal 2001 including the write-down of the Company’s investment in TEB and related trade receivables totaling approximately $1,036,000 and the remaining decrease is due to the reduction in labor and overhead costs.

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Marketing, general and administrative costs (excluding non-cash stock option compensation expense) decreased $1,446,000 or 11.7% to $10,901,000 in Fiscal 2002 from $12,346,000 in Fiscal 2001 reflecting Company efforts to reduce costs to levels appropriate for its revenue base. The decrease reflects reduced spending on community relations and donations ($715,000), a reduction in professional fees and services of approximately $373,000, and reduced bad debt expense by $390,000. As a percentage of net sales, marketing, general and administrative costs decreased to 21.2% in Fiscal 2002 from 29.3% in Fiscal 2001. Non-cash stock option compensation expense decreased $523,000 or 66.9% to $259,000 in Fiscal 2002 from $782,000 in Fiscal 2001. As a percentage of net sales, stock option expense decreased to 0.5% for Fiscal 2002 from 1.9% for Fiscal 2001. Non-cash stock compensation expense is a non-cash charge representing the difference between the exercise price and fair market value of the stock at the date of grant and is recognized as expense over the vesting period.

Depreciation and amortization expense increased $207,000 or 4.7% to $4,600,000 in Fiscal 2002 from $4,393,000 in Fiscal 2001, reflecting a full year of depreciation and amortization on stores added during Fiscal 2001. As a percentage of net sales, depreciation and amortization expense decreased to 8.9% for Fiscal 2002 from 10.4% for Fiscal 2001. Retail sales grew faster than depreciation and amortization (primarily due to a full year of sales in Fiscal 2002 at stores opened during Fiscal 2001) and, to a lesser extent, due to the reduced depreciable value of the assets impaired in Fiscal 2001 (described below).

Impairment of Long-Lived Assets

A non-cash charge of $2,350,000 for the impairment of long-lived assets was recognized during Fiscal 2002 compared to $5,006,000 during Fiscal 2001 under the application of FASB Statement No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of” (“SFAS 121”). See Note 10 of the Notes to the Consolidated Financial Statements. The charge consists of a non-cash write-off of the goodwill, leasehold improvements and other long term assets determined to be impaired. As a result of the Fiscal 2002 impairment charge, depreciation and amortization expense for Fiscal 2003 on these assets will decline by approximately $350,000.

Store Closure and Lease Termination Costs

Store closure and lease termination costs of $1,583,000 for Fiscal 2002 reflect the Company’s estimate of write-offs to be made and costs to be incurred in connection with the closure of twelve retail stores (and the termination of the related leases), the termination of one lease (for an unopened store) and additional costs (in excess of the Fiscal 2001 estimate of costs) related to the termination of four leases identified for termination during Fiscal 2001. During Fiscal 2001, store closure and lease termination costs of $2,620,000 reflected the Company’s estimate of write-offs to be made and costs to be incurred in connection with the closure of the four retail stores (and termination of the related leases) and termination of 18 leases (for unopened stores, including the four leases eventually terminated in Fiscal 2002). Lease termination costs include rent, brokers fees, and other anticipated lease settlement costs, and were determined using management’s best estimate. During Fiscal 2002, the Company reached negotiated settlements for most of the store closures and lease terminations recognized in Fiscal 2002 and Fiscal 2001, however, accrued liabilities at March 31, 2002, include an accrual of approximately $852,000 with respect to those leases for which the Company has not yet reached a negotiated settlement. See Note 18 of the Notes to the Consolidated Financial Statements.

Operating Loss

As a result of the factors described above, the Company had an operating loss of $13,111,000 in Fiscal 2002 as compared to the operating loss of $23,797,000 in Fiscal 2001, which is an improvement of $10,686,000 (44.9%) as compared to Fiscal 2001. The improvement includes a $3,693,000 reduction in the amount of charges for impairment of long-lived assets and for store closure and lease termination costs for Fiscal 2002 as compared to Fiscal 2001.

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Other Income (Expense)

Interest expense was essentially unchanged at $812,000 in Fiscal 2002 compared to $778,000 for Fiscal 2001. During Fiscal 2001 the Company repaid its bank line of credit, but incurred a full year of interest on the convertible promissory note in Fiscal 2002 compared to only a partial year in Fiscal 2001. See Note 14 of the Notes to the Consolidated Financial Statements.

Gain on sale of investments of $2,887,000 in Fiscal 2002 reflects the recognized gain from the sale of the Company’s holdings of FOODX stock.

Miscellaneous income (expense) decreased $157,000 to expense of $18,000 for Fiscal 2002 from income of $139,000 for Fiscal 2001. The decrease is largely due to the following losses that offset other income in Fiscal 2002: (i) the loss on the liquidation of TEB of $46,000 and (ii) the $39,000 loss on the sale of Company equipment.

Loan guarantee fee expense decreased $455,000 or 67.8% to $216,000 in Fiscal 2002 from $671,000 for Fiscal 2001. The bank line of credit was repaid on October 1, 2001. This non-cash expense is for options to purchase common stock of the Company granted to two directors in consideration of their guarantees of the Company’s bank line of credit, with the number of options based on the amount outstanding on the line of credit.

Net Loss

Net loss decreased $13,905,000 or 55.5% to $11,152,000 in Fiscal 2002 from $25,057,000 for Fiscal 2001. The smaller net loss in Fiscal 2002 reflects the $3,693,000 reduction in charges relating to the impairment of long-lived assets and store closure and lease termination costs, and the $2,887,000 recognized gain on the Fiscal 2002 sale of the Company’s FOODX stock. The remaining $7 million improvement in net loss resulted from the increase in net sales (including the international license fee revenue), improved gross margins, cost management efforts, and lower financing costs in Fiscal 2002 as compared to Fiscal 2001. The Company recognized no income tax benefit from its net loss in Fiscal 2002 or Fiscal 2001. Net loss applicable to common stockholders decreased $13,905,000 or 55.5% to $11,152,000 from $25,057,000 for Fiscal 2001. There was no preferred stock dividend/accretion in Fiscal 2002 or Fiscal 2001. Net loss applicable to common stockholders per share decreased by $0.90 or 56.6% to $0.69 per share in Fiscal 2002 from $1.59 per share in Fiscal 2001.

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Liquidity and Capital Resources

The following table sets forth, for the periods indicated, selected statement of cash flows data:.

Cash used in operating activities in Fiscal 2003 was $3,287,000. In Fiscal 2002, operations provided cash of $6,963,000, which includes the cash receipt of $16,200,000 of advance license fees (which did not recur in Fiscal 2003) as discussed in Note 15 of the Notes to Consolidated Financial Statements, and also the Fiscal 2002 use of such proceeds to reduce approximately $4 million of accounts payable and accrued liabilities that had accumulated in Fiscal 2001. Operations used cash of $6,611,000 in Fiscal 2001 (which was reduced by the accumulation of approximately $4 million of accounts payable and accrued liabilities as of the end of Fiscal 2001). The effects of the advance collection of license fees and the accumulation (Fiscal 2001) and payment (Fiscal 2002) of accounts payable and accrued liabilities impacted the amounts of cash provided (used) by operating activities. Also during Fiscal 2001 there was a build-up of inventories of green (unroasted) coffee. Starting in Fiscal 2002, the Company has managed its inventories more closely and the green coffee inventory levels in Fiscal 2002 and Fiscal 2003 were typically $1-$2 million below the levels of Fiscal 2001.

Cash used in operating activities has improved during Fiscal 2002 and Fiscal 2003 as the result of the improvements in operating results discussed above under “Management’s Discussion and Analysis of Financial Condition and Results of Operation” under “Overview” and “Results of Operations.” As discussed therein, the Company’s loss before cumulative effect of change in accounting principle has decreased in both Fiscal 2003 and Fiscal 2002. The improvement in the Company’s loss was due in part to the reductions in the amount of non-cash charges during Fiscal 2003 and Fiscal 2002 (particularly the reductions in the impairment charges and in depreciation and amortization). However, excluding the effects of these non-cash charges, the cash flow from net loss adjusted for non-cash operating statement amounts improved in both Fiscal 2003 and Fiscal 2002 as compared to the preceding year. For Fiscal 2003 compared to Fiscal 2002, the net loss adjusted for non-cash operating statement amounts improved by $3,462,000, from a use of cash of $6,097,000 in Fiscal 2002 to a use of cash of $2,635,000 in Fiscal 2003. For Fiscal 2002 compared to Fiscal 2001, the net loss adjusted for non-cash operating statement amounts improved by $4,403,000, from a use of cash of $10,500,000 in Fiscal 2001 to a use of cash of $6,097,000 in Fiscal 2002.

Investing activities provided cash of $643,000 in Fiscal 2003 but used cash of $11,000 in Fiscal 2002 and used cash of $13,948,000 in Fiscal 2001. During Fiscal 2003 and Fiscal 2002, the Company’s investing activities

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focused on conversion of investments to cash, principally involving the sale of the Company’s holdings of FOODX stock, and received proceeds of approximately $1,829,000 (Fiscal 2003) and $3,025,000 (Fiscal 2002). More FOODX shares were sold in Fiscal 2002 than in Fiscal 2003, and all holdings have been sold. During Fiscal 2001 the investment activities focused on growing the number of stores in operation. Capital expenditures for property and equipment used cash of $11,020,000 in Fiscal 2001 and the purchase of businesses used another $2,745,000 of cash. The number of new stores was greatly reduced in Fiscal 2002 and Fiscal 2003. Cash used for capital expenditures was $1,186,000 in Fiscal 2003 and $3,024,000 in Fiscal 2002. The Company also acquired $723,000 of equipment in Fiscal 2003 through capitalized leases.

Financing activities provided cash of $1,953,000 in Fiscal 2003 and $15,909,000 in Fiscal 2001, but used cash of $5,676,000 in Fiscal 2002. In Fiscal 2003, financing activities consisted primarily of borrowings under the new Kent Central Lines (see Note 13 of the Notes to the Consolidated Financial Statements) and the payment of scheduled maturities of other obligations. In Fiscal 2002, the primary financing activity was the repayment of the bank credit line ($5,500,000), and other obligations, using proceeds from the advance license fees and from the sale of FOODX stock. In Fiscal 2001, financing activities consisted primarily of the raising of capital to fund capital expenditures, business purchases and operating losses, including $12,477,000 from issuance of preferred stock, $3,000,000 from issuance of the convertible note, and $2,500,000 of borrowings under the bank credit line.

Overall, the Company’s operating activities, investing activities, and financing activities used $691,000 of cash in Fiscal 2003 as compared to cash provided of $1,276,000 in Fiscal 2002 and cash used of $4,650,000 in Fiscal 2001.

As of March 30, 2003 the Company had cash and cash equivalents and short-term investments in the aggregate amount of $993,000, and a working capital deficit of $2,505,000. Because the Company principally operates as a “cash business,” it generally does not require a significant net investment in working capital and historically has operated with current liabilities in excess of its current assets (excluding cash and cash equivalents). The Company’s inventory levels typically increase during the spring due to coffee crop seasonality and, to a lesser degree, during the autumn due to holiday season merchandise. Inventories also are subject to short-term fluctuations based upon the timing of coffee deliveries from abroad. Tully’s expects that its investment in accounts receivable will increase in connection with anticipated sales growth in its Wholesale and International divisions. Subject to the limitations of the KCL Credit Line, increases in accounts receivable will generally increase the Company’s borrowing capacity under the Second KCL Line (See Note 13 of the Notes to the Consolidated Financial Statements). Operating with minimal or deficit working capital has reduced the Company’s historical requirements for capital, but provides the Company with limited immediately available resources to address short-term needs and unanticipated business developments, and increases the Company’s dependence upon ongoing financing activities.

Cash requirements for Fiscal 2004, other than normal operating expenses and the commitments described below, are expected to consist primarily of capital expenditures related to the remodeling of retail stores, fixtures and equipment related to the introduction of other products into Tully’s stores, equipment and accounts receivable related to new Wholesale division customers, and roasting plant equipment. Management expects Fiscal 2004 capital expenditures will be approximately $545,000 and approximately $250,000 of additional store and roasting plant fixtures and equipment will be obtained through operating or capital leases.

As discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Overview.” Management expects that the continuing benefits from the Fiscal 2003 improvement initiatives and the similar initiatives comprising the 2004 Business Plan will result in improved operating results in Fiscal 2004. As described in Note 13 of the Notes to the Consolidated Financial Statements, the Company has extended the maturities of its credit lines with Kent Central to October 1, 2004. Company Management believes that the extension of the Kent Central credit facilities, together with the operating cashflows, financing cashflows, and investing cashflows projected in the 2004 Business Plan, and the cash and cash equivalents of $993,000 at March 30, 2003, will be sufficient for the Company to fund ongoing operations of the Company through Fiscal 2004. Accordingly, the 2004 Business Plan does not anticipate that additional equity or long-term debt capital will be required during Fiscal 2004. However, the Company may pursue such funding if satisfactory financing opportunities become available in Fiscal 2004.

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At March 30, 2003 the Company had total liabilities of $27,780,000 and total assets of $24,591,000, so that a deficit of $3,189,000 was reported for the shareholders’ equity of the Company, as compared with shareholders’ equity of $6,417,000 at March 31, 2002. Operating with total liabilities in excess of total assets could make it more difficult for the Company to obtain financing or conclude other business dealings under terms that are satisfactory to the Company. However, liabilities at March 30, 2003 include deferred licensing revenues in the aggregate amount of $14,007,000. The deferred licensing revenues will be liquidated through amortization of non-cash revenues of approximately $1.8 million annually in future operating statements, rather than through cash payments by the Company. The future cash expenses associated with these deferred revenues are expected to be less than $200,000 per year. Accordingly, the Company expects to liquidate this deferred licensing royalty of $14,007,000 for less than $1.4 million of future cash expenditures.

The following table summarizes the Company’s principal financial commitments (other than ordinary trade obligations such as accounts payable and accrued liabilities) as of March 30, 2003:

Notes to Schedule:

As of March 30, 2003, the Company had fixed price inventory purchase commitments for green coffee totaling approximately $2,800,000 for deliveries scheduled at various dates during Fiscal 2004. The Company believes, based on relationships established with its suppliers, that the risk of loss on nondelivery on such purchase commitments is remote.

Since its formation, the Company has funded its capital investments and its losses primarily from the proceeds from common and preferred stock sales and (in Fiscal 2002) with proceeds from international licensing and supply agreements. The Company expects that additional sources of funding would be required fund increased capital investment if the Company were to resume a higher growth strategy. Further, if the Company’s actual results should differ unfavorably from the 2004 Business Plan, it could become necessary for the Company to seek additional capital during Fiscal 2004. The Company expects that additional sources of funding will be required in subsequent periods to fund capital expenditures required for growth of the business, and fund repayment of debt and other long-term obligations and commitments. Such additional sources of funding are expected to include debt or equity financings. If such funding is required, but the pricing or terms are do not meet the Company’s expectations, the Company may be required to choose between completion of the financing on such unfavorable terms or not complete the financing. If these other sources of capital are unavailable, or are available only on a limited basis or under unacceptable terms, then the Company could be required to substantially reduce operating, marketing, general and administrative costs related to its continuing operations, or

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reduce or discontinue its investments in store improvements, new customers and new products. In addition, the Company might be required to sell individual or groups of stores or other assets (such as wholesale distribution territories) and would be unable to take advantage of business opportunities or respond to competitive pressures. Store sales would involve the assignment or sub-lease of the store location (which may require the lessor’s consent) and the sale of the store equipment, leasehold improvements and related assets. The proceeds received from the sale of stores or other assets might not be sufficient to satisfy the Company’s capital needs, and the sale of better-performing stores or other income-producing assets could adversely affect the Company’s future operating results and cash flows.

The Company’s articles of incorporation provide that its Series A Preferred Stock is senior to the common stock for a stated dollar amount of liquidation preference, and the Series B Preferred stock is junior to a stated dollar amount of liquidation preference for each of the Series A Preferred Stock and the holders of the common stock. If the Company were to sell all or a substantial portion of its assets in order to meet its operating needs and satisfy its obligations or were to be liquidated, the amounts available for distribution to shareholders might be less than the aggregate liquidation preferences of the more senior shareholders, and no amounts might be available for distribution to the more junior shareholders.

In late 1999, the Company entered into a ten-year lease for the facility that houses the Company’s headquarters, roasting plant and distribution facilities in Seattle, Washington. During November 2002, the parties amended the lease in connection with the establishment of the new credit facility as described below and in Note 13 of the Notes to the Consolidated Financial Statements. When the Company first occupied this property in Fiscal 2001, the lessor funded $1,000,000 of tenant improvements to the property, and the lease was amended at that time to reimburse the lessor for the improvement allowance through increased lease payments. As a result, in Fiscal 2001 the Company recorded $1,000,000 as a deferred lease cost liability, and has been amortizing this liability as rent was paid. Under the provisions of the new credit facility and the November 2002 lease amendment, the parties agreed to add the unamortized tenant improvement allowance of $890,037 to the borrowed principal amount under the credit facility and to reduce the monthly rental for the remainder of the lease term by approximately $16,000 per month. In addition, the amended lease provides that the lessor may, at its option, terminate the lease prior to the expiration of its term early by giving the Company 150 days written notice of termination. Although the lessor has listed the property for sale or lease, the Company is not aware of any current intention by the lessor to terminate the lease and the Company expects to continue its tenancy under the terms of the amended lease subject to possible further amendment as described below. However, if the lessor were to terminate the lease prior to the expiration of its term, early, the recoverability of the Company’s leasehold improvements at the facility would be impaired; such leasehold improvements had a net book value of $1,324,000 at March 30, 2003. As described in Note 19 of the Notes to Consolidated Financial Statements, the lessor and another party have informed the Company of a possible sale of the property under which the prospective buyer would become lessor to the Company under the lease. The Company and the prospective buyer have negotiated a lease amendment, conditional upon the closing of the sale, which would, among other things, eliminate the 150-day termination provision.

Application of Critical Accounting Policies

We have identified the policies below as critical to our business operations and the understanding of our results of operations. The impact and any associated risks related to these policies on our business operations is discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations where such policies affect our reported and expected financial results. For a detailed discussion on the application of these and other accounting policies, see Note 1 of the Notes to the Consolidated Financial Statements. Note that our preparation of the consolidated financial statements requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our financial statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurance that actual results will not differ from those estimates.

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The Company’s discussion and analysis of its financial condition and results of operations are based upon its consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The Company believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements, and should be read in conjunction with the Consolidated Financial Statements. The Company’s critical accounting policies relate particularly to (1) revenue recognition and (2) evaluation for impairment of long-lived assets, and (3) lease termination reserves.

Revenue recognition

Sales are generally recognized at the time of the sale at retail store locations. Sales for the Wholesale and International divisions are recognized upon shipment of the products. Allowances to Wholesale Division customers for retail distribution positions (“slotting” allowances) are recognized as a reduction in sales, reducing gross profits until fully amortized (typically a period of two to six months). Other Wholesale discounts and allowances are recognized in the period earned by the customer.

Revenues from advance license fees are recognized on the straight-line basis over the expected life of the agreements (ranging from eight to fifteen years). Management’s judgement is involved in determining the applicable amortization periods for these advance license fees. Royalty revenues are recognized in accordance with the license agreements based upon sales at specific licensee store locations. International coffee roasting fees are recognized when coffee is roasted for the licensee that is subject to the fee.

Evaluation of long-lived assets for impairment

We periodically review the carrying value of our long-lived assets for continued appropriateness. This review is based upon our projections of anticipated future cash flows. We record impairment losses on long-lived assets used in operations when events and circumstances indicate that the assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amount of those items. Our cash flow estimates are based on historical results adjusted to reflect our best estimate of future market and operating conditions. While we believe that our estimates of future cash flows are reasonable, different assumptions regarding such cash flows could materially affect our evaluations. The net carrying value of assets not recoverable are reduced to their fair value. Our estimates of fair value represent our best estimate based on either discounted cash flows or appraised values, depending on the nature of the asset.

Recognition and measurement of lease termination reserves

Periodically, the Company will determine that certain leases will be terminated and the store or other operation will be closed. At the time when agreements are reached, the Company accrues for the net future minimum lease payments of the related lease agreements. Amounts accrued as net future minimum losses include the discounted estimated future rental payments and lease termination fees, and estimated sub-lease recoveries.

New Accounting Standards

See Note 1 of the Notes to the Consolidated Financial Statements.

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ITEM 7(a).     QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

License royalty revenues from FOODX are computed based upon the sales of the FOODX franchised stores in Japan, and coffee roasting fees are computed, in part, based upon the cost of the coffee roasted for FOODX in Japan, which are both transacted by FOODX in yen. These amounts are therefore subject to fluctuations in the currency exchange rates. These amounts are paid monthly and represent less than two percent of the Company’s net sales. The Company currently has no foreign currency exchange rate exposure related to its purchasing of coffee beans, because all transactions are denominated in U.S. dollars. At the present time, the Company does not hedge foreign currency risk, but may hedge known transaction exposure in the future.

The supply and price of coffee beans are subject to significant volatility and can be affected by multiple factors in producing countries, including weather, political and economic conditions. In addition, green coffee bean prices have been affected in the past, and may be affected in the future, by the actions of certain organizations and associations that have historically attempted to influence commodity prices of green coffee beans through agreements establishing export quotas or restricting coffee bean supplies worldwide. In order to limit the cost exposure of the main commodity used in the Company’s business, the Company enters into fixed-price purchase commitments. The Company’s practice has been to annually contract for most of its green coffee bean purchases in advance for the next fiscal year. This allows the Company to secure an adequate supply of quality green coffee beans and fix its cost of green coffee beans. As of March 30, 2003, the Company had fixed price inventory purchase commitments for green coffee remaining for delivery in Fiscal 2004 totaling approximately $2,800,000. The Company believes, based on relationships established with its suppliers, that the risk of loss on nondelivery on such purchase commitments is remote.

Under the credit lines described in Note 13 of the Notes to the Consolidated Financial Statements, the Company borrows at interest rates that are based upon the prime borrowing rate. From time to time, the Company has other transactions and agreements that include provisions for interest at a variable rate. Accordingly, the Company expects to be subject to fluctuating interest rates in the normal course of business during Fiscal 2004 and subsequent periods.

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The following consolidated financial statements, and related notes thereto, of Tully’s Coffee Corporation, and the Reports of Independent Accountants, are filed as a part of this report on Form 10-K.

Index to Consolidated Financial Statements

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Report of Independent Accountants

To the Board of Directors and Stockholders of

Tully’s Coffee Corporation

We have audited the accompanying consolidated balance sheet of Tully’s Coffee Corporation as of March 30, 2003, and the related consolidated statements of operations, comprehensive loss, changes in stockholders’ equity (deficit), and cash flows for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Tully’s Coffee Corporation as of March 30, 2003 and the results of its operations and cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.

As discussed in Note 1 to the financial statements, during the year ended March 30, 2003 the Company adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets”.

MOSS ADAMS LLP

Seattle, Washington

June 26, 2003

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Report of Independent Accountants

To the Board of Directors and Stockholders of

Tully’s Coffee Corporation

In our opinion, the consolidated balance sheet as of March 31, 2002 and the related consolidated statements of operations, of comprehensive loss, of changes in stockholders’ equity and of cash flows for each of the two years in the period ended March 31, 2002 present fairly, in all material respects, the financial position, results of operations and cash flows of Tully’s Coffee Corporation at March 31, 2002 and for each of the two years in the period ended March 31, 2002, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. We have not audited the consolidated financial statements for any period subsequent to March 31, 2002.

See Note 2 for discussion of the Company’s recent and prospective liquidity issues.

PRICEWATERHOUSECOOPERS LLP

Seattle, Washington

June 28, 2002

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Tully’s Coffee Corporation

Consolidated Balance Sheets

The accompanying notes are an integral part of these consolidated financial statements.

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Tully’s Coffee Corporation

Consolidated Statements of Operations