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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 26, 2004

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 checkmark whether the registrant is an accelerated filer (as defined in Rule 126-2 of the Exchange Act)    Yes  ¨    No  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

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TULLY’S COFFEE CORPORATION

Form 10-Q

For the Quarterly Period Ended September 26, 2004

Index

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CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

In this report, we refer to Tully’s Coffee Corporation as “we,” “us,” or “Tully’s.” 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 our 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 factors discussed under “Factors That May Affect Our Future Results” in this 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. 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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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. In these condensed consolidated financial statements, references to “we,” “us,” “Tully’s” or the “Company” refer to Tully’s Coffee Corporation.

We end our fiscal year on the Sunday closest to March 31. As a result, we record our revenue and expenses on a 52 or 53 week period, depending on the year. Each of the fiscal years ended March 28, 2004 (“Fiscal 2004”), March 30, 2003 (“Fiscal 2003”), March 31, 2002 (“Fiscal 2002”) and April 1, 2001 (“Fiscal 2001”) included 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 fairly present 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 periods ended September 26, 2004 (“Second Quarter 2005”), the twenty-six week period ended September 26, 2004, the thirteen-week period ended September 28, 2003 (“Second Quarter 2004”), and the twenty-six week period ended September 28, 2003 are not necessarily indicative of future financial results.

Investors should read these interim financial statements in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the financial statements and notes thereto included in our annual report on Form 10-K, SEC File No. 000-26829, for Fiscal 2004.

Stock-based compensation

In December 2002, the Financial Accounting Standards Board 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. We adopted the disclosure-only provisions of SFAS No. 148. We have 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 Tully’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.

Had compensation cost for our 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, as amended by SFAS No. 148, our net loss and loss per share would have been reported as 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.

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2. Liquidity

From our founding through Fiscal 2001, our primary objectives were to establish the Tully’s brand, increase our revenues and expand our retail store base. During this period and through Fiscal 2003, our cash flow from operations was insufficient to cover operating expenses. Since Fiscal 2002, we have shifted our emphasis toward improving our operating performance and placed less emphasis upon expanding our retail store base, reflecting management’s view that Tully’s has sufficiently developed our brand identity and that greater emphasis should be placed on improving corporate productivity and operating performance. During the twenty-six week periods ended September 26, 2004, and September 28, 2003, our operating cash flow was sufficient to cover our cost of goods sold and operating expenses (cash of $28,000 and $913,000 was provided by operations for the twenty-six week periods ended September 26 2004, and September 28, 2003, respectively).

We expect that our operating improvement initiatives and business strategies will result in improved operating results in Fiscal 2005. In June 2004, we reached agreement with the lenders under our credit facilities and our convertible promissory note to extend the maturity dates for those obligations to August 1, 2005, which has reduced the required principal payments under those debt instruments during Fiscal 2005 (See Notes 4 and 5 of the Notes to the Condensed Consolidated Financial Statements). We believe that the operating cash flows, financing cash flows, projected investing cash flows, and the cash and cash equivalents of $863,000 at September 26, 2004, will be sufficient to fund ongoing operations of Tully’s through Fiscal 2005. Accordingly, we do not anticipate that additional equity or long-term debt capital will be required during Fiscal 2005 to sustain current operations and meet our current obligations. However, we do expect to seek additional capital during Fiscal 2005 in order to fund a higher level of growth and to provide increased liquidity reserves.

In Fiscal 2005 we expect to give more attention to growth of the business, including a higher rate of new store openings compared to recent years, while continuing our focus on improving operating results. We expect that additional sources of funding will be required to fund this increased capital investment. Further, if our actual results should differ unfavorably from projections, it could become necessary for us to seek additional capital during Fiscal 2005. Tully’s 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 our long-term obligations and commitments. Such additional sources of funding are expected to include debt or equity financings.

The terms of our credit facilities require that proceeds from sales of new equity first be used for repayment of those obligations. Further, the holders of the credit facility and the guarantors of that facility have a security interest in all of our assets. Accordingly, we expect to first use the proceeds, if any, from new equity or debt financings to repay the borrowings under the credit facilities and our convertible promissory note, and to use any additional proceeds for growth of the business and general corporate purposes. The rights offering (see Note 9 of the Notes to the Condensed Consolidated Financial Statements) may provide some new capital, but that is only a secondary objective of that proposed offering and we are not able to anticipate the extent to which our shareholders will elect to purchase securities in that proposed offering.

If the pricing or terms for any financing do not meet our expectations, we 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 we could be required to substantially reduce operating, marketing, general and administrative costs related to our continuing operations, or reduce or discontinue our investments in store improvements, new customers and new products. In addition, we 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 our capital needs, and the sale of better-performing stores or other income-producing assets could adversely affect our future operating results and cash flows.

At September 26, 2004, we had total liabilities of $26,584,000 and total assets of $20,028,000, so that a deficit of $6,556,000 was reported for our shareholders. Operating with total liabilities in excess of total assets could make it more difficult for us to obtain financing or conclude other business dealings under terms that are satisfactory to us. However, liabilities at September 26, 2004 include deferred revenue in the aggregate amount of $11,286,000. We will liquidate the deferred revenue balance through recognition of non-cash revenues of approximately $1,800,000 annually in future periods, rather than through cash payments by us. The future cash expenses associated with this deferred revenue are expected to be less than $200,000 per year. Accordingly, we expect to liquidate the deferred revenue balance ($11,286,000 at September 26, 2004) for less than $2,000,000 of future cash expenditures.

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As of September 26, 2004 we had cash and cash equivalents of $863,000, and a working capital deficit of $9,958,000. Because we principally operate as a “cash business,” we generally do not require a significant net investment in working capital and historically have operated with current liabilities in excess of our current assets (excluding cash and cash equivalents). Our 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 the Wholesale and Specialty divisions. Subject to the limitations of the Second KCL Line (see Note 4 of the Notes to the Condensed Consolidated Financial Statements), increases in accounts receivable will generally increase our borrowing capacity under the Second KCL Line. Operating with minimal or deficit working capital has reduced our historical requirements for capital, but provides Tully’s with limited immediately available resources to address short-term needs and unanticipated business developments, and increases our dependence upon ongoing financing activities.

3. Inventories

Inventories consist of the following:

As of October 31, 2004, we had approximately $2,200,000 in fixed-price coffee purchase commitments for Fiscal 2005 and $1,500,000 in fixed-price coffee purchase commitments for Fiscal 2006.

4. Credit lines and long term debt

On November 1, 2002, Tully’s entered into a borrowing arrangement with Kent Central LLC (“KCL”) (the “KCL Credit Line”). On March 3, 2003, KCL and Tully’s amended the promissory note for the KCL Credit Line, providing an additional borrowing facility for Tully’s (the “Second KCL Line”). Borrowings under the KCL Credit Line and the Second KCL Line are secured by substantially all of our assets and certain of our directors and shareholders (the “Guarantors”) have, in the aggregate, guaranteed $2,000,000 of the borrowings under these credit lines.

On June 24, 2004, Tully’s and KCL amended the terms of the KCL Credit Line and the Second KCL Line to extend the maturities of the credit lines (the “KCL Third Amendment”). Tully’s is required to make monthly payments of principal for the KCL Credit Line in the amount of $70,000, in addition to any payments required as the result of asset sales or the sale of new equity (these principal payments also reduce the maximum amount which may be borrowed under the KCL Credit Line). Under the KCL Third Amendment, no loan fees are payable during the remainder of the term, and the interest rate for both the KCL Credit Line and the Second KCL line will be 12% per year commencing October 1, 2004. Effective June 24, 2004, maximum borrowings under the Second KCL line may not exceed $750,000. On August 1, 2005, Tully’s is required to repay the remaining obligations under the KCL Credit Line and the Second KCL Line. The guarantors consented to the modification of the KCL facilities in the KCL Third Amendment. At September 26, 2004 the annual interest rate (exclusive of loan fees) for the KCL Credit Line was 4.25% and for the Second KCL Line was 8.75%.

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

5. Convertible promissory note

In December 2000, Tully’s issued a convertible note in the principal amount of $3,000,000 to an affiliate of a then-director of the Company. At any time prior to repayment of the note, the note is convertible into Series A Preferred Stock or common stock in the event that all shares of Series A Preferred Stock have been converted to common stock. The conversion rate is the lesser of $2.50 per share or the price per share of the most recent offering price, public or private, of common stock (the note holder has granted a waiver of this favorable offering price provision with respect to the rights offering described in Note 9).

In June 2004, Tully’s and the note holder agreed to amend the terms of the note as follows: (1) the maturity of the $3,000,000 principal amount was extended to August 1, 2005, (2) interest will be paid in cash on the outstanding balance of the note at the rate of 12% per year commencing January 1, 2005, and (3) no additional warrants will be issued in lieu of cash interest on the note.

6. International licenses and deferred licensing revenues

On August 31, 2003, Tully’s and FOODX Globe Co., Ltd. (“FOODX”), our licensee for Japan, amended the license agreement among the parties. The amendment provided our consent in connection with a 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, we will receive a royalty upon sales of RTD products by FOODX. We received a fee of $500,000 from FOODX in connection with the amendment. Tully’s 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.

During Fiscal 2004 we entered into preliminary discussions with FOODX about the possibility of integrating our business with FOODX. On May 12, 2004, we reported that we had ceased discussions with FOODX. In connection with these discussions and the evaluation of this business integration opportunity, we incurred fees and other expenses of approximately $120,000 during the thirteen week period ended June 27, 2004 (“First Quarter 2005”). No such fees were incurred during the Second Quarter 2005.

7. Commitments and contingencies

President Severance Commitment

In April 2004, Tully’s accepted the resignation of our then-president effective July 11, 2004, and agreed to pay him severance compensation of $424,000 in varying installments over a twenty-four month period starting in July 2004. This obligation was accrued during the First Quarter 2005.

Contingencies

In February 2004, a lawsuit was filed against Tully’s in California state court by two former store managers alleging misclassification of employment position and seeking damages, restitution, reclassification and attorneys’ fees and costs. The plaintiffs also seek class action certification of their lawsuit. We are investigating and intend to vigorously defend this litigation, but cannot predict the financial impact to us of the litigation.

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In April 2004, we were advised by FOODX that the Japanese tax authorities were conducting an examination regarding the withholding taxes collected by FOODX, and that the tax authorities had taken a position that certain amounts paid by FOODX under its supply agreement with us should be subject to Japanese withholding taxes. FOODX has informed us that FOODX has paid taxes, interest and penalties in the aggregate amount of approximately $950,000, for which FOODX has requested indemnification from Tully’s. We are in discussion with the Japanese tax authorities and FOODX regarding this matter, but our investigation is still in its initial stages. We believe that the original withholding tax treatment by FOODX under the supply agreement was appropriate. Further, if this assessment by the Japanese tax authority is determined to have been valid, we believe that FOODX may have compromised its ability to claim indemnification. We intend to further investigate and to vigorously defend our position, but cannot predict the financial impact to us of this matter. No amounts have been accrued for this matter at September 26, 2004.

We are a party to various other legal proceedings arising in the ordinary course of our business, but are not currently a party to any other legal proceeding that we believe could have a material adverse effect on our financial position or results of operations.

8. Stock options and warrants

Options

Tully’s 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 our 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 our board of directors and was $0.30 per share for options granted in Second Quarter 2005.

Option grants to employees and directors and deferred stock compensation for the twenty-six week period ended September 26, 2004 are summarized as follows (dollars in thousands, except share data):

On October 6, 2004, our new president was granted options to purchase shares of common stock as follows:

Warrants

Tully’s had warrants outstanding to purchase 9,594,130 and 8,641,490 shares of common stock as of September 26, 2004 and September 28, 2003, respectively, at exercise prices ranging from $0.01 to $0.33 per share. At September 26, 2004, the weighted average exercise price of the outstanding warrants was $0.24 per share.

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In consideration for guaranteeing Tully’s obligations under the KCL Credit Facilities, Tully’s 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 our borrowings from KCL are $2,000,000 or more during each month of a year, we would issue warrants exercisable for an aggregate of 740,640 shares of common stock for the year. Tully’s is recognizing these non-cash loan guaranty costs as a financing expense based upon the fair value of our common stock at the date of grant of the warrants.

Through October 31, 2004, we had issued warrants to the Guarantors as summarized below:

9. Stockholders’ Equity

Rights Offering

Prior to October 1999, holders of Tully’s capital stock were entitled to preemptive rights pursuant to our Articles of Incorporation and the Washington Business Corporation Act. During this time, we engaged in various offerings. In connection with the evaluation of possible financing and strategic transactions, it has been questioned whether any shareholder(s) might claim that they were not given the opportunity to exercise their preemptive rights.

On May 12, 2004, we filed a registration statement with the SEC relating to a proposed offering of our common stock and investment units (convertible preferred stock and warrants to purchase common stock), through the distribution of subscription rights to eligible shareholders and former shareholders. We filed an amended registration statement on August 4, 2004. Upon the effectiveness of the registration statement, eligible shareholders and former shareholders of Tully’s will receive rights to purchase these securities at the prices at which they were issued by Tully’s between 1994 and 1999. We believe our ability to engage in financing or strategic transactions may be limited by the potential risks regarding the possibility of such future claims, but that such risks could be mitigated by our possible defenses against such possible claims, including the completion of this rights offering. The primary purpose of this rights offering is to provide an opportunity for our shareholders to satisfy any unsatisfied preemptive right which they believe they may have. We believe this rights offering will provide us with an affirmative defense, in addition to other defenses we may have, against any future claims asserting that we issued shares without providing shareholders the opportunity to exercise their preemptive rights. In addition, shareholders of record at the record date will receive under-subscription privileges to purchase any shares of common stock and investment units not purchased through the exercise of the rights. The registration statement has not yet become effective. These securities may not be sold nor may offers to buy be accepted prior to the time the registration statement becomes effective. The provisions of the offering may be revised in an amendment to the registration statement, and the offering may be cancelled at the discretion of our Board of Directors.

The primary rights and under-subscription privileges may be exercised in whole, in part, or not at all. The securities covered by the rights offering are being offered on an “any or all basis,” which means that we may accept payment for securities sold pursuant to any subscription received even if all of the securities offered are not subscribed for in the offering. We have not set a minimum level for the completion of this proposed offering, and we are unable to anticipate the extent to which the rights and under-subscription privileges will be exercised. However, we expect that the subscriptions under the primary rights and under-subscription privileges will be substantially less than the maximum number of shares of common stock and investment units offered in this proposed offering. Completion of the rights offering depends upon shareholder approval of a proposal to amend the articles of incorporation to increase the number of authorized shares of Series A Preferred Stock and a corresponding increase in the total authorized shares of capital stock of Tully’s.

If the rights offering does not prove to be an effective defense to any future claim asserting that we issued shares in violation of the preemptive rights of our shareholders, or if we do not complete the rights offering, we may be required at some point in the future to issue additional shares of our capital stock or otherwise compensate those shareholders whose preemptive rights may not have been satisfied. Any additional issuances of our capital stock could further dilute existing shareholders and any compensatory payment could adversely affect our financial position.

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The securities proposed to be offered in the rights offering are summarized as follows:

As of September 26, 2004, we have incurred approximately $209,000 in rights offering costs, which are included in other assets.

10. Segment Reporting

We are organized into three business units: (1) the Retail division, which includes our domestic store operations, (2) the 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 our mail order and internet sales, and (3) the Specialty division, which sells Tully’s-branded products to our foreign licensees and receives royalties and fees from those licensees, and through which we manage our U.S. franchising and licensing opportunities.

The tables below present information by operating segment:

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11. Net Loss Per Common Share

Basic net loss per share is computed by dividing net loss by the weighted-average number of shares of common stock 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 stock equivalents.

Tully’s 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 September 26, 2004 and September 28, 2003, there were outstanding options and warrants convertible into 36,139,190 and 35,494,871 shares of common stock, respectively. All such instruments were excluded from the computation of diluted loss per share for Second Quarter 2005 and Second Quarter 2004 because the effect of these instruments on the calculation would have been antidilutive.

12. Comprehensive Loss

There were no components of other comprehensive income (loss) other than net loss during the twenty-six week periods ended September 26, 2004 and September 28, 2003, so that net loss equaled comprehensive loss in each of these periods.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis provides information that Tully’s believes is relevant to an assessment and understanding of our results of operations and financial condition for the thirteen-week periods ended September 26, 2004 (“Second Quarter 2005”) and September 28, 2003 (“Second Quarter 2004”) and the twenty-six week periods ended September 26, 2004 (“Six Months Fiscal 2005”), and September 28, 2003 (“Six Months Fiscal 2004”). The following discussion should be read in conjunction with the condensed consolidated financial statements and related notes appearing elsewhere in this report, as well as “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and notes included in Tully’s Fiscal 2004 Annual Report on Form 10-K. We believe that certain statements herein, including statements concerning anticipated store openings, planned capital expenditures, financing plans 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 our business plans, the impact of competition, and other risks summarized more fully below in “Factors that May Affect Our Future Results.”

Overview

We end our fiscal year on the Sunday closest to March 31. As a result, we record our revenue and expenses on a 52 or 53 week period, depending on the year. Each of Fiscal 2004, Fiscal 2003, Fiscal 2002 and Fiscal 2001 included 52 weeks. Fiscal 2005 will include 53 weeks.

We derive our revenues from sales from the:

From our founding through Fiscal 2001, our primary objectives were to establish the Tully’s brand, increase our revenues and expand our retail store base. During this period and through Fiscal 2003, our cash flow from operations was insufficient to cover operating expenses. These losses have been exacerbated by the weak economy in our principal geographic markets since 2001. During Fiscal 2002 through Fiscal 2004, we shifted our emphasis toward improving our operating performance and placed less emphasis upon expanding our retail store base and revenues. This shift in emphasis reflects management’s view that Tully’s has sufficiently developed its brand identity and that greater emphasis should be placed on improving corporate productivity and operating performance, and upon the conservative use of capital. These continuing initiatives toward improved operating performance and cash flow include:

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Our operating results for the Six Months Fiscal 2005 were affected by strategic decisions we made during the period and preceding periods. During the thirteen-week period ended June 27, 2004 (“First Quarter 2005”) we ceased discussions regarding the possible integration of Tully’s and our licensee for Japan, FOODX Globe Co. Ltd (“FOODX”). These discussions affected the Six Months Fiscal 2005 results through $120,000 of costs and through the application of management time. In First Quarter 2005 we accrued $402,000 of severance and other costs in connection with the resignation of our then-president.

The effects of these charges on our operating results are summarized as follows (dollars in thousands):

In the Six Months Fiscal 2005, our Retail division’s contribution decreased compared to the same period ended September 28, 2003. Retail division operating income decreased $220,000 (17.9%) to $1,011,000, and comparable store sales decreased 2.5%. The results of our Retail division’s summer seasonal product offerings and our summer marketing programs did not meet our expectations. Our Wholesale division reported a $712,000 (19.6%) increase in net sales for the Six Months Fiscal 2005 compared to the Six Months Fiscal 2004. Under our strategy to expand the customer base and reach new geographic markets for our Wholesale division in the food service and grocery channels, we are incurring incremental customer sales discounts and operating costs. As a result, Wholesale division operating income for the Six Months Fiscal 2005 decreased by $357,000 (57.3%) compared to the Six Months Fiscal 2004. In the Six Months Fiscal 2005, our Specialty division reported a net increase of 32 licensed international stores and four U.S. franchised and licensed stores. Specialty division net sales increased by $520,000 (30.9%) and Specialty division operating profits increased by $630,000 (43.1%) for the Six Months Fiscal 2005 compared to the Six Months Fiscal 2004.

During the Six Months Fiscal 2005, our operating cash flow covered our cost of goods sold and operating expenses, and $28,000 cash was provided by operations for the Six Months Fiscal 2005. Management expects that the continuing benefits from the improvement initiatives will result in improved operating results in Fiscal 2005 compared to Fiscal 2004, although we expect to incur a net loss (inclusive of financing costs, depreciation and amortization expense) in Fiscal 2005. As described below under “Liquidity and Capital Resources,” we believe that our operating cash flows, financing cash flows, projected investing cash flows, and the cash and cash equivalents of $863,000 at September 26, 2004, will be sufficient to fund our ongoing operations through Fiscal 2005.

The retail stores operated by Tully’s and our licensees and franchisees are summarized as follows:

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Results of Operations

Earnings before Interest, Taxes, Depreciation and Amortization

Earnings before interest, taxes, depreciation and amortization (“EBITDA”) is a financial measurement we use to measure our operating performance, excluding the effects of financing costs, income taxes, and non-cash depreciation and amortization. Management views EBITDA as a key indicator of our operating business performance and EBITDA is the primary determinant in the computation of management incentive compensation.

Regulation S-K (Item 10(e)) under the Securities Exchange Act of 1934 defines and prescribes the conditions for use of certain non-GAAP financial information in quarterly and annual reports filed with the SEC. We believe that our “EBITDA” information, which meets the definition of a non-GAAP financial measure, is important supplemental information to investors.

We use EBITDA for internal managerial purposes and as a means to evaluate period-to-period comparisons. This non-GAAP financial measure is used in addition to and in conjunction with results presented in accordance with generally accepted accounting principles (“GAAP”) and should not be relied upon to the exclusion of GAAP financial measures. EBITDA information reflects an additional way of viewing aspects of our operations that, when viewed with our GAAP results and the accompanying reconciliations to corresponding GAAP financial measures, provide a more complete understanding of factors and trends affecting our business. We strongly encourage investors to review our financial statements and publicly filed reports in their entirety and to not rely on any single financial measure.

Because non-GAAP financial measures are not standardized, it may not be possible to compare these financial measures with other companies’ non-GAAP financial measures having the same or similar names. For information about our financial results as reported in accordance with GAAP, see our condensed consolidated financial statements. For a quantitative reconciliation of our EBITDA information to the most comparable GAAP financial measures, see the table below.

The following table sets forth, for the periods indicated, the computation of EBITDA and reconciliation to the reported amounts for net loss (dollars in thousands):

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Second Quarter 2005 Compared To Second Quarter 2004

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