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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED DECEMBER 28, 2003

or

FOR THE TRANSITION PERIOD FROM                      to                     

Commission file number 000-26829

Tully’s Coffee Corporation

(Exact Name of Registrant as Specified in its Charter)

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

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 and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

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

As of January 31, 2004, 16,469,187 shares of common stock, no par value, were outstanding.

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TULLY’S COFFEE CORPORATION

Form 10-Q

For the Quarterly Period Ended December 28, 2003

Index

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Unless the context requires otherwise, as used in this report “Tully’s,” “Company,” “we,” “our” and “us” means Tully’s Coffee Corporation.

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 our operations and 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. Information regarding factors that could cause our actual results to differ materially from our expectations is included in this report under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Factors That May Affect Our Future Results.”

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. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

TULLY’S COFFEE CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

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

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TULLY’S COFFEE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(dollars in thousands, except per share data)

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

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TULLY’S COFFEE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(dollars in thousands)

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

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TULLY’S COFFEE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Basis of presentation

The condensed consolidated financial statements include the accounts of Tully’s Coffee Corporation (“Tully’s” or the “Company”) and its wholly owned subsidiary, Spinelli Coffee Company, after elimination of all significant intercompany items and transactions.

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 (“Fiscal 2004”) will also include 52 weeks. The fiscal year ending April 3, 2005 (“Fiscal 2005”) will include 53 weeks.

The accompanying unaudited condensed consolidated financial statements include all adjustments, consisting only of normal recurring adjustments that, in the opinion of management, are necessary to present fairly the financial information set forth therein. Certain information and note disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). Results of operations for the thirteen week period ended December 28, 2003 (“Third Quarter 2004”), the thirty-nine week period ended December 28, 2003, the thirteen week period ended December 29, 2002 (“Third Quarter 2003”), and the thirty-nine week period ended December 29, 2002 are not necessarily indicative of future financial results.

Investors should read these interim statements in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the financial statements and notes thereto for Fiscal 2003 included in our annual report on Form 10-K, SEC File No. 000-26829, for the fiscal year ended March 30, 2003.

Stock-based compensation

In December 2002, the Financial Accounting Standards Board (“FASB”) issued Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure” (“SFAS No. 148”), an amendment to Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”). SFAS No. 148 provides alternative methods of transition for voluntary change to the fair value method of accounting for stock-based compensation. In addition, SFAS No. 148 requires more prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company adopted the disclosure-only provisions of SFAS No. 148. The Company has chosen to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, compensation cost for stock options is measured as the excess, if any, of the fair value of the Company’s stock at the date of grant over the amount an employee must pay to acquire the stock. Compensation cost is amortized on a straight-line basis, over the vesting period of the individual options.

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Had compensation cost for the Company’s stock option plans been determined based on the fair value at the grant date of the awards, consistent with the provisions of SFAS No. 123 and SFAS No. 148, the Company’s net loss and loss per share would have been increased to the pro forma amounts indicated below (in thousands, except per share data):

Reclassifications

Reclassifications of prior year balances have been made to conform to the current year classifications and have no impact on net loss or financial position.

2. Liquidity

From its inception through Fiscal 2001, the Company was focused primarily upon development of its brand and growth of its retail store base and revenues. The Company funded its capital investments and its losses during this period primarily from the proceeds from common and preferred stock sales and proceeds from international licensing and supply agreements.

During Fiscal 2002, the Company started to emphasize improvements in operating performance and place less emphasis upon growth of its retail store base and revenues, in response to the more difficult economy of 2001. In Fiscal 2003, this shift in emphasis continued, reflecting management’s view that the Company had sufficiently developed its brand identity and that greater emphasis should be placed on overall corporate operating performance. The initiatives toward improved operating performance and productivity include (1) improvement in the performance of stores through introduction of new products, marketing support, and improved product purchasing, (2) closure of non-performing stores, (3) growth of the Wholesale and International divisions, (4) reductions in marketing, general and administrative costs, and (5) reduced cash usage for purchases of property and equipment.

The Company’s 2004 business plan is focused even more strongly upon improving overall corporate operating performance and upon the conservative use of capital. 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. Management believes that funds available under its credit facilities (described in Note 5), together with the operating cash flows, financing cash flows, and investing cash flows reflected in the 2004 business plan and the cash of $1,474,000 at December 28, 2003 will be sufficient to fund ongoing operations of the Company through Fiscal 2004. Accordingly, the Company 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 attractive financing opportunities become available in Fiscal 2004.

The Company expects that additional sources of funding would be required to 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 those projected in the 2004 business plan, it could become necessary for the Company to seek additional capital during Fiscal 2004. The terms of the Company’s primary credit facilities require repayment of substantially all amounts borrowed from its lender by October 1, 2004 (see Note 5) and the terms of the Company’s outstanding convertible promissory note require repayment of $3 million on January 2, 2005, unless converted to stock by the holder. Accordingly, the Company expects that it will be required during Fiscal 2005 to negotiate extensions of the maturities under the credit facilities and the convertible promissory note, or to repay these obligations with proceeds from other sources of funding. 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 other long-term obligations and commitments. Such additional sources of funding are expected to include debt or equity financings. If the pricing or terms for new financing or the extension of the current financing (the credit facilities

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and convertible promissory note) 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 completing 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 reduce or discontinue its investments in store improvements, new customers and new products. In addition, the Company could be required to sell individual or groups of stores or other assets (such as wholesale distribution territories) and could 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.

At December 28, 2003, the Company had total liabilities of $26,876,000 and total assets of $22,503,000, so that a deficit of $4,373,000 was reported for the shareholders of the Company. 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 December 28, 2003 include deferred licensing revenues in the aggregate amount of $12,986,000. These deferred licensing revenues will be liquidated through recognition of non-cash revenues of approximately $1,800,000 annually in future periods, 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 liability of $12,986,000 for less than $2,000,000 of future cash expenditures.

As of December 28, 2003 the Company had cash of $1,474,000, and a working capital deficit of $5,072,000. 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 are also 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. Increases in accounts receivable generally will increase the Company’s borrowing capacity under the Second KCL Line (see Note 5). 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.

3. Inventories

Inventories consist of the following:

As of December 28, 2003, the Company had approximately $700,000 of fixed-price purchase commitments for green coffee.

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4. Goodwill and other intangible assets

During Fiscal 2003, the Company adopted the full provisions of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). Tully’s performed an evaluation of its goodwill, and determined that an impairment of $3,018,000 should be recorded as of April 1, 2002 related to the Company’s Retail division operations in California and Oregon. As provided in SFAS 142, this impairment charge was retroactively recorded as the cumulative effect of a change in accounting principle as of the beginning of Fiscal 2003.

Under SFAS 142, goodwill is no longer amortized. In accordance with SFAS 142, the effect of this accounting change is reflected prospectively, and Tully’s ceased amortization of goodwill in Fiscal 2003. Supplemental comparative disclosure follows:

Under SFAS 142, goodwill is to be periodically reevaluated and the carrying amount for goodwill is required to be reduced if impairment is identified. The Company has determined that this analysis will be performed annually during the fourth quarter of each fiscal year. During fourth quarter of Fiscal 2003 an impairment of $31,000 was recorded.

Other intangible assets consist of the following:

Amortization expense for other intangible assets for the thirty-nine week periods ended December 28, 2003 and December 29, 2002 was $58,000 and $80,000, respectively.

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5. Credit lines and long term debt

On November 1, 2002, the Company entered into a credit facility with Kent Central LLC (“KCL”). This facility (the “KCL Credit Line”), which is secured by substantially all of the Company’s assets, was in the principal amount of $2,000,000, plus $890,037 in unamortized tenant improvement allowance. Borrowings under the KCL Credit Line bear interest at the prime rate less ½%, and a 3% loan fee is paid annually. Certain directors and shareholders of the Company (the “Guarantors”) have, in the aggregate, guaranteed $2,000,000 of the borrowings under the KCL Credit Line.

The terms of the KCL Credit Line and a related agreement among the Company and the Guarantors include provisions that, among other things, restrict the Company’s ability to incur additional secured debt or liens and to sell, lease or transfer 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. The Company’s agreement with the Guarantors requires the Guarantors’ consent to any material change in the Company’s license and supply agreements with its international licensees if the Company would receive additional amounts from the licensees or acceleration of licensee payments as consideration for amending the license and supply agreements. The Company has agreed to indemnify the Guarantors in connection with the guaranties and has granted each of them a security interest in substantially all of the Company’s assets (subordinated to the security interest of KCL). In consideration for providing the guaranties, the Company is required to issue warrants to the Guarantors (see Note 7). The Company has repaid approximately $186,000 through December 28, 2003, with the allowable borrowing under the KCL Credit line reduced commensurately.

On March 3, 2003, KCL and the Company entered into an amendment to the promissory note for the KCL Credit Line, providing an additional borrowing facility for the Company (the “Second KCL Line”). Borrowings under the Second KCL Line are secured by substantially all of the Company’s assets and bear interest at prime plus 4%, and a 1.5% loan fee is paid annually on the line amount (including any unused line). Borrowings under the Second KCL Line are limited to the lesser of $1,000,000 or 100% of eligible accounts receivable. The Second KCL Line is not guaranteed by the Guarantors, however KCL and the Guarantors have agreed that KCL’s security interest under the Second KCL Line is senior to the security interests of the Guarantors under their guaranties of the KCL Credit Line.

On June 26, 2003, the Company and KCL amended the terms of the KCL Credit Line and the Second KCL Line. Under the terms of the amendment, all borrowings under the Second KCL Line must be repaid in full by October 1, 2004 and all borrowings under the KCL Credit Line must be repaid in full by October 1, 2004, except for $890,037, which must be repaid in full by April 29, 2005. Further, the amended note requires the Company to make payments of principal on the KCL Credit Line as follows (these principal payments will reduce both the outstanding obligation and the amount which may be borrowed under the KCL Credit Line):

At December 28, 2003 the annual interest rate (exclusive of the loan fees) for the KCL Credit Line was 3.5% and for the Second KCL Line was 8.0%.

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Obligations under the KCL credit facilities, and other long-term debt consist of the following:

6. International licenses and deferred licensing revenues

On August 31, 2003, the Company and FOODX Globe Co., Ltd. (“FOODX”), the Company’s licensee for Japan, amended the license agreement among the parties. The amendment provided the Company’s consent in connection with a proposed tender offer for the stock of FOODX by its management and other investors, and licenses FOODX to develop and market Tully’s brand ready-to-drink coffee beverages (“RTD products”) in Japan. Commencing November 2004, the Company will receive a royalty upon RTD product sales of FOODX. The Company received a fee of $500,000 from FOODX in connection with the amendment. The Company recorded the fee as deferred income and is amortizing the fee over the fourteen-month period from the execution of the amendment through October 2004.

In Second Quarter 2003, the Company assigned its intellectual property rights outside of the United States relating to its Spinelli brand, including the trademarks and related goodwill, to Spinelli Pte. Ltd. (“SPL”). Under the agreement, SPL paid $500,000 to the Company. The Company retains certain rights with respect to the use of the Spinelli brand and related intellectual property in the United States and Japan. The $500,000 purchase price, less approximately $40,000 of costs, was reported as “other-miscellaneous income” in Second Quarter 2003.

7. Stock options and warrants

Options

The Company records deferred compensation under the intrinsic value method of accounting for the difference between the exercise price for the options and the market price for its common stock at the time of grant as established by the Company’s board of directors, and is amortizing the deferred stock compensation over the vesting period of the options. For purposes of these computations, the estimated market price per common share at the time of grant has been established by the Company’s board of directors and was $0.30 per share for options granted through the thirty-nine week period ended December 28, 2003 and $0.31 per share for options granted during the thirty-nine week period ended December 29, 2002.

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Stock option activity under the Company’s 1994 Stock Option Incentive Plan (excluding options under the Founder’s Plan, which would not affect the outstanding shares or provide cash proceeds to the Company if exercised):

Deferred stock compensation for the thirty-nine week period ended December 28, 2003 is summarized as follows (dollars in thousands, except share data):

Warrants

The Company had warrants outstanding to purchase 8,826,650 and 8,334,476 shares of common stock as of December 28, 2003 and March 30, 2003, respectively, at exercise prices ranging from $0.01 to $0.33 per share. The weighted average exercise price of these warrants is $0.25 per share.

In consideration for providing the guaranties of the KCL Credit Line (see Note 5), the Company is required to issue warrants to the Guarantors to purchase 30.86 shares of common stock, at an exercise price of $0.05 per share, for each $1,000 of debt guaranteed during a month. Thus, if the Company’s borrowings under the KCL Credit Line are $2,000,000 or more during each month of a year, the Company would issue warrants exercisable for an aggregate of 740,640 shares of common stock for the year. The Company is recognizing these non-cash loan guaranty costs as a financing expense based upon the fair value at the date of grant of the warrants.

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Through January 31, 2004, the Company has issued warrants to the Guarantors as summarized below:

8. Segment reporting

The Company is organized into three business units: (1) its Retail division, which includes its domestic store operations, (2) its Wholesale division, which sells Tully’s-branded products to domestic customers in the supermarket, food service, office coffee service, restaurant and institutional channels, and which also handles the Company’s mail order and internet sales, and (3) its International division, which sells Tully’s-branded products to the Company’s foreign licensees and manages the international licensing of the Tully’s brand and the related royalty and fee programs.

The tables below present information by operating segment:

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9. Net loss per common share

Basic net loss per share is computed by dividing net loss by the weighted-average number of common shares outstanding during the period. Diluted net loss per share is computed by dividing net loss by the sum of the weighted average number of common shares and the effect of dilutive common share equivalents.

The Company has granted options and warrants to purchase common stock, and issued preferred stock and debt convertible into common stock. These instruments may have a dilutive effect on the calculation of earnings or loss per share. As of December 28, 2003 and December 29, 2002, there were outstanding options and warrants and convertible securities representing and aggregate 34,291,898 and 33,069,608 shares of common stock, respectively. All such instruments were excluded from the computation of diluted loss per share for Third Quarter 2004 and Third Quarter 2003 because the effect of these instruments on the calculation would have been antidilutive.

10. Comprehensive loss

Other comprehensive loss consists of the unrealized gains and losses, net of applicable taxes, on available-for-sale securities. Because of the Company’s net operating losses, no tax expense (benefit) has been allocated to other comprehensive loss. The amounts are as follows: