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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

For the quarterly period ended September 22, 2004

OR

For the transition period from              to             

Commission file number: 0-21203

DIEDRICH COFFEE, INC.

(Exact name of registrant as specified in its Charter)

28 EXECUTIVE PARK, SUITE 200

IRVINE, CALIFORNIA 92614

(Address of principal executive offices, including zip code)

(949) 260-1600

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    YES  x    NO  ¨

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

As of November 8, 2004, there were 5,162,620 shares of common stock of the registrant outstanding.

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DIEDRICH COFFEE, INC.

INDEX

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PART I - FINANCIAL INFORMATION

Item 1. Financial Statements.

DIEDRICH COFFEE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

See accompanying notes to condensed consolidated financial statements.

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DIEDRICH COFFEE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

See accompanying notes to condensed consolidated financial statements.

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DIEDRICH COFFEE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

See accompanying notes to condensed consolidated financial statements.

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DIEDRICH COFFEE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 22, 2004

(UNAUDITED)

Basis of Presentation

The unaudited condensed consolidated financial statements of Diedrich Coffee, Inc. and its subsidiaries (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America, as well as the instructions to Form 10-Q and Article 10 of Regulation S-X. These statements should be read in conjunction with the consolidated financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K/A filed on October 12, 2004.

In the opinion of management, all adjustments (consisting of normal, recurring adjustments and accruals) considered necessary for a fair presentation have been included. Operating results for interim periods are not necessarily indicative of the results expected for a full year.

Restatement of Unaudited Condensed Consolidated Financial Statements

The Company has restated its previously issued unaudited condensed consolidated financial statements for the first three quarters of the previous fiscal year. As part of the Company’s accounting activities during its year-end audit, the Company determined that an adjustment was required to recognize $113,000 of additional franchise revenue in the first quarter of fiscal 2004 under an area development agreement that had terminated in that quarter. The Company originally recorded this franchise revenue in the fourth quarter of fiscal 2004. As a consequence, a correction of reported year-to-date income for its second and third quarters of fiscal year 2004 was also required. This adjustment had no effect on reported revenues and earnings for the 2004 fiscal year. The net effect of all of the adjustments was to increase first fiscal quarter 2004 revenue and earnings by $113,000 and to reduce fourth fiscal quarter revenue and earnings by the same amount.

Recent Accounting Pronouncements

On June 30, 2004, the Company completed its adoption of Financial Accounting Standards Board Interpretation No. 46 (revised), “Consolidation of Variable Interest Entities — an interpretation of Accounting Research Bulletin (“ARB”) No. 51” (“FIN 46R”), which was issued in January 2003 and which is effective for all reporting periods ending after March 15, 2004.

FIN 46R addresses the consolidation of entities in which a reporting enterprise has an economic interest, but for which the traditional voting interest approach to consolidation, based on voting rights, is ineffective in identifying where control of the entity lies, or in which the equity investors do not bear the economic risks and rewards of the entity. FIN 46R refers to those entities as variable interest entities (“VIEs”). FIN 46R requires the consolidation of VIEs by the primary beneficiary that absorbs a majority of the economic risks and rewards from the VIEs activities.

The principal entities in which the Company possesses a variable interest are franchisees. The Company does not possess any ownership interests in its franchisees, but it provide financial support to a number of franchisees by serving as the primary obligor on lease obligations for properties in which the franchisees operate their business. There are also some franchised coffeehouses that are VIEs in which the Company holds a significant variable interest, but which the Company does not consolidate because the Company is not the primary beneficiary. The adoption of FIN 46R did not result in the consolidation of any franchise entities.

The Company utilizes a segregated advertising fund to administer contributions received from its franchisees for advertising programs. Upon the adoption of FIN 46R, the Company consolidated the advertising fund. The Company has included $337,000 of advertising fund assets, restricted and advertising fund liabilities in its accompanying consolidated balance sheet as of September 22, 2004. The advertising contributions and disbursements are reported in the consolidated statement of operations on a net basis whereby contributions from franchisees are recorded as offsets to the Company’s reported general and administrative expenses.

Income Taxes

Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and for operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income in the period that includes the enactment date.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could materially differ from those estimates.

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Stock Option Plans

The Company applies the intrinsic value-method of accounting prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations (“APB No. 25”), in accounting for employee stock options. As such, compensation expense would be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” as amended (“SFAS No. 123”), established accounting and disclosure requirements using a fair value-based method of accounting for stock-based employee compensation plans. The Company has adopted the disclosure provisions of SFAS No. 123 and continues to follow APB No. 25 for stock-based employee compensation.

Pro forma net loss and pro forma net loss per share, as if the fair value-based method of SFAS No. 123 had been applied in measuring compensation cost for stock-based awards, is as follows:

The fair values of the options granted were estimated using the Black-Scholes option-pricing model based on the following weighted average assumptions:

Reclassifications

Certain reclassifications have been made to the September 24, 2003 unaudited condensed consolidated financial statements to conform to the September 22, 2004 presentation.

Inventories consist of the following:

Long-term debt consists of the following:

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On May 10, 2004, the Company entered into a $5,000,000 Contingent Convertible Note Purchase Agreement. The agreement provides for the Company, at its election, to issue notes to the lender, Sequoia Enterprises L.P., with up to an aggregate principal amount of $5,000,000. The notes are amortized on a monthly basis at a rate that will repay 60% of the principal amount of the note by May 10, 2007. The remaining 40% will mature on that date. Interest is payable at LIBOR plus 3.30%, and a facility fee of 1.00% annually is payable on the unused portion of the facility. The agreement contains covenants that limit the amount of indebtedness that the Company may have outstanding in relation to its tangible net worth and that require the Company to maintain a specified minimum dollar value of EBITDA for the trailing four fiscal quarters. As of September 22, 2004, the Company was in compliance with all debt covenants. Notes are convertible into the Company’s common stock only upon certain changes of control. In addition, upon the occurrence of the same changes in control that would permit the notes to be converted into common stock, the Company will issue the lender warrants to purchase shares of common stock. The number of warrants that the Company will issue, if any, will directly correlate to the amount of notes issued and repaid. The issued warrants, if any, will expire on May 10, 2008. The lender under this agreement is a limited partnership of which the chairman of the Company’s board of directors serves as the sole general partner. On May 10, 2004, upon entering into the agreement, the Company immediately issued a $1,000,000 note, and used the proceeds of the note and other available cash to repay all outstanding debt with Bank of the West (“BOW”). On September 15, 2004, the Company issued an additional $1,000,000 note under this facility.

On May 10, 2004, the Company also entered into an Amended and Restated Credit Agreement with BOW. The agreement provides for a working capital facility of $250,000 and a letter of credit facility of $750,000. At September 22, 2004, no debt was outstanding under the working capital facility and $426,000 of letters of credit were outstanding under the letter of credit facility. With respect to the working capital facility, the Company may elect to pay interest on amounts outstanding at the BOW reference rate plus 1.00% or LIBOR plus 3.25%. Borrowings and issuance of letters of credit under the BOW facility are secured by substantially all of the Company’s assets. Letters of credit issued under the letter of credit facility are subject to an annual fee of 2.00% of the face amount. The agreement contains covenants that limit the amount of indebtedness that the Company may have outstanding in relation to its tangible net worth and that require the Company to maintain a specified minimum dollar value of EBITDA for the trailing four fiscal quarters. The working capital and letter of credit facilities mature on October 15, 2005.

Maturities of long-term debt for years subsequent to September 22, 2004 are as follows:

Prior to January 1, 2003, the estimated cost associated with closing under-performing stores was accrued in the period in which the store was identified for closure by management under a plan of termination. Effective January 1, 2003, the Company adopted Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” and now records these estimated costs when they are incurred rather than at the date of a commitment to an exit or disposal plan. Such costs primarily consist of the estimated cost to terminate real estate leases.

For the twelve weeks ended September 22, 2004, no expenses were incurred. The Company made cash payments in the amount of $9,000.

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

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All 971,000 options outstanding as of September 22, 2004 were excluded from the calculation of diluted net loss per share for the twelve weeks ended September 22, 2004 because their inclusion would have been anti-dilutive. Further, all 504,000 warrants to purchase shares of common stock outstanding during the twelve weeks ended September 22, 2004 were excluded from the calculation of diluted net loss per share for the twelve weeks ended September 22, 2004 because their inclusion would have been anti-dilutive. All 748,000 options outstanding and all 730,000 warrants to purchase shares of common stock outstanding as of September 24, 2003 were excluded from the calculation of diluted net loss per share for the twelve weeks ended September 24, 2003 because their inclusion would have been anti-dilutive.

The Company has three reportable segments: retail operations, wholesale operations and franchise operations. The Company evaluates performance of its operating segments based on income before income taxes.

Summarized financial information concerning the Company’s reportable segments is shown in the following table. Corporate identifiable assets consist of corporate cash, corporate notes receivable, corporate prepaid expenses, and corporate property and equipment. The corporate component of segment profit (loss) before tax includes corporate general and administrative expenses, depreciation and amortization expense, and interest expense.

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We are liable on the master leases for 98 franchise locations. Under the Company’s historical franchising business model, the Company executed the master leases for these locations and entered into subleases on the same terms with its franchisees, which typically pay their rent directly to the landlords. If any of these franchisees default on their subleases, the Company would be required to make all payments under the master leases. The Company’s maximum theoretical future exposure at September 22, 2004, computed as the sum of all remaining lease payments through the expiration dates of the respective leases, was $14,419,000. This amount does not take into consideration any mitigating measures that the Company could take to reduce this exposure in the event of default, including re-leasing the locations or terminating the master lease by negotiating a lump sum payment to the landlord in an amount that is less than the sum of all remaining future rents.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

A WARNING ABOUT FORWARD LOOKING STATEMENTS.

We make forward-looking statements in this quarterly report that are subject to risks and uncertainties. These forward-looking statements include information about possible or assumed future results of our financial condition, operations, plans, objectives and performance. Additionally, when we use the words “believe,” “expect,” “anticipate,” “estimate” or similar expressions, we are making forward-looking statements. Many possible events or factors could affect our future financial results and performance. This could cause our results or performance to differ materially from those expressed in our forward-looking statements. You should consider these risks when you review this document, along with the following possible events or factors:

Additional risks and uncertainties are described elsewhere in this report and in detail under the caption “Risk Factors and Trends Affecting Diedrich Coffee and Its Business” in our Annual Report on Form 10-K/A for the fiscal year ended June 30, 2004 and in other reports that we file with the Securities and Exchange Commission. We undertake no obligation to publicly release the results of any revision of the forward-looking statements. Unless otherwise indicated, “we,” “us,” “our,” and similar terms refer to Diedrich Coffee, Inc.

INTRODUCTION

Management’s discussion and analysis of financial condition and results of operations is provided as a supplement to the accompanying unaudited condensed consolidated financial statements and footnotes to help provide an understanding of our financial condition, the changes in our financial condition and the results of operations. Our discussion is organized as follows:

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OVERVIEW

Business

We are a specialty coffee roaster, wholesaler and retailer. We sell brewed, espresso based and various blended beverages primarily made from our own fresh roasted premium coffee beans, as well as light food items, whole bean coffee and accessories, through our company operated and franchised retail locations. We also sell whole bean and ground coffees on a wholesale basis in the Office Coffee Service market and to other wholesale customers, including restaurant chains and other retailers. We roast coffee at our coffee roasting facility in central California. It supplies freshly roasted coffee to our company operated and franchised retail locations and to our wholesale accounts.

Our brands include Diedrich Coffee, Gloria Jean’s, and Coffee People. The Diedrich Coffee and Coffee People brands are primarily company store operations and the Gloria Jean’s brand is primarily a franchised store operation. As of September 22, 2004, we owned and operated 56 retail locations and franchised 437 other retail locations under these brands, for a total of 493 retail coffee outlets. Our retail units are located in 33 states and 13 foreign countries. As of September 22, 2004, we had over 460 wholesale accounts with Office Coffee Service distributors, chain and independent restaurants, and others. Although the specialty coffee industry is dominated by a single company with more than 8,000 locations, we are one of the nation’s largest specialty coffee retailers and a significant competitor in the international market.

We believe that our company is differentiated from other specialty coffee companies by the quality of our coffee products, the superior personalized customer service provided to our customers and the warm and friendly ambiance offered by our coffeehouses. We serve our distinctively roasted coffee products in all of our brand locations and an extensive variety of fine quality flavored whole bean coffees are offered in our Gloria Jean’s units. Our roasting recipes take into account the specific variety, origin and physical characteristics of each coffee bean to maximize its unique flavor.

A table summarizing the relative sizes of each of our brands, on a unit count basis, and changes in unit count for each over the first quarter ended September 22, 2004, is set forth below:

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Seasonality and Quarterly Results

Our business is subject to seasonal fluctuations as well as economic trends that affect retailers in general. Historically, our net sales are highest during the second fiscal quarter, which includes the November – December holiday season. Hot weather tends to reduce sales. Quarterly results are affected by the timing of the opening of new stores, which may not occur as anticipated due to events outside our control. As a result of these factors, the financial results for any individual quarter may not be indicative of the results that may be achieved in a full fiscal year.

Key Performance Indicators

We have several key indicators that we use to evaluate the performance of our business. These include same-store sales growth, the number of company operated and franchised stores opened and closed, and the measured relationship of cost of sales and related occupancy costs, operating expenses and general and administrative expenses to sales.

Same-store sales growth, or comparative sales growth, is a primary statistic used in the retail industry to measure core revenues. This measure compares sales for all units open for one year or more to the comparable prior year period. We use this measure to evaluate single coffeehouse, total brand and total company sales performance. Until recently, comparable sales of our company operated stores and domestic franchised stores had declined, primarily as a result of aging stores, a lack of capital to fund store improvements, and no new store openings. New stores typically achieve relatively strong comparative sales growth in their early years. Franchised units that are located in malls have also experienced declining sales due to overall declines in mall traffic.

The number of operating units opened and closed is also a measure of the health of our brands and our business, although it is affected by a number of factors, including the availability of capital to finance growth. In recent years, the number of domestic units has declined because the number of aging units closed exceeded the number of new units opened. International unit growth has been robust in recent years, particularly in Australia. Also, company operated stores have declined and franchised stores have increased. Unlike new company operated stores, new franchised stores do not require our capital. In addition, franchised stores typically make an immediate profit contribution, whereas company stores generally are not profitable in the first year. Domestic franchises generate more profit than international franchises because the domestic royalty fees are higher and because all domestic franchisees are required to purchase their coffee from us.

We use the relationship between cost of sales and related occupancy costs and operating expenses to sales to measure the operating efficiency of our individual coffeehouses and to measure the relationship between general and administrative expenses to sales to monitor and control the level of corporate overhead. Cost of sales and related occupancy costs have declined, and gross margins have improved, in recent years, primarily because wholesale sales, which have higher gross margins than retail sales, have become a higher percentage of our overall sales mix. Operating expenses have increased in the past two years as a result of dedicating more in-store labor and supervision to the retail stores. General and administrative expenses have increased as a percentage of sales due to staffing for accelerated growth and to the effect of continuing declines in sales on a relatively fixed expense base.

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Results of Operations.

Twelve weeks ended September 22, 2004 Compared with the Twelve Weeks Ended September 24, 2003

Total Revenue. Total revenue for the twelve weeks ended September 22, 2004 increased by $836,000, or 7.3%, to $12,260,000 from $11,424,000 for the twelve weeks ended September 24, 2003. Revenue increased in all business segments in the first quarter of fiscal 2005. Each component is discussed below.

Retail sales for the twelve weeks ended September 22, 2004 increased by $256,000, or 3.7%, to $7,129,000 from $6,873,000 for the prior year period. This increase is the net result of a 6.2% increase in same store sales and a $25,000, or 39.6%, increase in e-commerce retail sales partially offset by a decrease of $344,000 due to the sale or closure of six company operated units since the beginning of the prior fiscal year.

Wholesale sales increased $490,000, or 17.0%, to $3,364,000 for the twelve weeks ended September 22, 2004 from $2,874,000 for the prior year period. Wholesale sales to third party customers increased by $422,000 or 24.3%, primarily due to strong performance in the Keurig “K-cup” line that increased sales by $364,000, or 28.8%, in the first fiscal quarter of fiscal 2005. Additionally, wholesale sales of roasted coffee to our franchisees increased $68,000, or 6.0%, primarily due to timing differences of coffee orders, despite a nine-unit decrease in the number of domestic franchise stores when compared to the prior year period.

Franchise revenue increased over the prior year first quarter by $90,000, or 5.4%, to $1,767,000. International fees and royalties increased $197,000, or 38.5%, to $712,000, primarily as a result of a 90-unit increase since the beginning of fiscal 2004. Area development agreement fees decreased $84,000, or 20.0%, due to a $98,000 decline in dissolution settlements of franchise agreements, slightly offset by a $14,000 increase in franchise renewal fees. The first quarter of fiscal 2005 included a $165,000 dissolution settlement of the Thailand agreement, while the first quarter of fiscal 2004 included a $263,000 dissolution settlement of the Malaysian agreement. Domestic franchise royalties and fees declined by $23,000, or 3.1%, to $718,000 as a result of a reduction of 12 domestic franchise units since the beginning of fiscal 2004.

Cost of Sales and Related Occupancy Costs. Cost of sales and related occupancy costs for the twelve weeks ended September 22, 2004 increased $496,000, or 9.7%, to $5,607,000 from $5,111,000 in the prior year period. Because none of these costs relate to franchise revenue, the most relevant benchmark of these costs is their relationship to total retail and wholesale sales. Using that measure, cost of sales and related occupancy costs increased to 53.4% of retail and wholesale sales for the twelve weeks ended September 22, 2004 from 52.4% in the twelve weeks ended September 24, 2003. This unfavorable margin basis point variance was primarily due to cost of sales in the wholesale segment. Wholesale cost of sales, as a percentage of wholesale sales increased by 1.5% in the current year quarter due to higher Keurig sales which carry a higher cost of goods sold. Occupancy costs declined as a percentage of retail and wholesale sales by 1.0% as a result of the closure of five of high occupancy cost company operated stores.

Operating Expenses. Operating expenses for the twelve weeks ended September 22, 2004 increased $206,000, or 5.6%, from the prior year period to $3,906,000. On a margin basis, operating expenses declined slightly in both retail and wholesale segments, from 32.4% of sales in last year’s first fiscal quarter to 31.9% in the current fiscal quarter. This margin basis point improvement was primarily due to the elimination of grocery store operating expenses, as we exited the grocery store channel in the prior year, slightly offset by increases in retail bonus expenses and e-commerce operating expenses.

Depreciation and Amortization. Depreciation and amortization declined by $42,000 to $545,000 for the twelve weeks ended September 22, 2004 from the prior year first fiscal quarter. This decrease is primarily due to a $122,000 decline in other depreciation expense related to accelerated depreciation of our former home office leasehold improvements in the prior year quarter, partially offset by an $80,000 increase in our retail store depreciation expense in the current year quarter, which related to our store remodel project that was commenced during the prior year.

General and Administrative Expenses. General and administrative expenses increased by $490,000, or 22.9%, to $2,634,000 for the twelve weeks ended September 22, 2004 from the prior year fiscal quarter. As a percentage of revenue, general and administrative expenses increased to 21.5% in the first quarter of fiscal 2005 from 18.8% in the prior year quarter. Approximately $275,000 of the increase was in the areas of franchise development, construction, management information systems and recruiting fees, all of which was to provide for the planned acceleration of company operated and franchised store growth. The increase also included a $104,000 increase in the provision for management incentive compensation payable upon achievement of 2005 budgetary and personal achievement goals and $58,000 of expense in the current year fiscal quarter related to the settlement of a lawsuit with one of our previous distributors who filed for bankruptcy in fiscal 2003. Additionally, the increased G&A expenses also included an increase in audit fees of $38,000, or 70.4%, compared to the prior year fiscal quarter. As previously reported, we appointed a new independent auditor on October 28, 2004.

Interest Expense and Other, Net. Interest expense and other, net decreased by $13,000 to $44,000 for the twelve weeks ended September 22, 2004 from the prior year period. This decrease is primarily due to lower interest rates and loan fee amortization, and a reduction in outstanding capital lease obligations and long-term debt from $3,316,000 at September 24, 2003 to $2,447,000 at September 22, 2004. These improvements were slightly offset by a decrease in interest income due to a re-negotiated note receivable contract.

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Income Tax Provision. Net operating losses generated in previous years resulted in no federal income tax liability and only a nominal amount of state income tax expense for the twelve weeks ended September 22, 2004 and the prior year period. Due to the uncertainty of future taxable income, deferred tax assets resulting from these net operating losses have been fully reserved. The slight fluctuation in expense between the twelve weeks ended September 22, 2004 versus the prior year period is due to changes in state income taxes owed in conjunction with the portfolio of company operated Gloria Jean’s units, which are located in a variety of states. As of September 22, 2004, net operating loss carryforwards for federal and state income tax purposes of $31,753,000 and $19,832,000 respectively, are available to be utilized against future taxable income for years through fiscal 2024 for federal and fiscal 2014 for state, subject to possible annual limitations pertaining to change in ownership rules under the Internal Revenue Code. For the twelve weeks ended September 22, 2004, our valuation allowance increased $329,000.

Congress passed the American Jobs Creation Act of 2004 on October 22, 2004 (“the Act”). The Act contains numerous changes to existing tax laws, including both domestic and foreign tax incentives. We have not yet determined what impact, if any, the Act may have on our results of operations and financial condition in the future.

Financial Condition, Liquidity and Capital Resources.

Current Financial Condition. At September 22, 2004, we had working capital of $645,000, as compared to working capital of $524,000 as of September 24, 2003. Total outstanding capital lease obligations and long-term debt decreased from $3,316,000 at September 24, 2003 to $2,447,000 at the end of the current year fiscal quarter, while stockholder’s equity increased slightly from $16,288,000 to $16,415,000.

Cash Flows. Cash used in operating activities for the twelve weeks ended September 22, 2004 totaled $572,000 as compared with $13,000 in net cash used in operating activities for the twelve weeks ended September 24, 2003. The increase in cash used in operations was primarily due to the higher loss in the current year quarter and an increase in accounts receivable and inventories.

Net cash used in investing activities for the twelve weeks ended September 22, 2004 totaled $787,000 as compared with net cash used of $488,000 for the twelve weeks ended September 24, 2003. During the twelve weeks ended September 24, 2004, $798,000 was used to invest in property and equipment in our store remodel project, our Castroville roasting facility and our home office facility. These expenditures were partially offset by $11,000 of payments received on notes receivable.

Net cash provided by financing activities for the twelve weeks ended September 22, 2004 totaled $920,000 as compared to the $361,000 in net cash used in financing activities for the twelve weeks ended September 24, 2003. In the first quarter of fiscal 2005, we borrowed $1,000,000 under our contingent convertible note purchase agreement.

Outstanding Debt and Financing Arrangements. On May 10, 2004, we entered into a $5,000,000 Contingent Convertible Note Purchase Agreement. The agreement provides for us, at our election, to issue notes to the lender, Sequoia Enterprises L.P., up to an aggregate principal amount of $5,000,000. Issued notes are amortized on a monthly basis at a rate that will repay 60% of the principal amount of each note by May 10, 2007. The remaining 40% will mature on that date. Interest is payable at LIBOR plus 3.30%, and a facility fee of 1.00% annually is payable on the unused portion of the facility. The agreement contains covenants that limit the amount of indebtedness that we may have outstanding in relation to our tangible net worth and that require us to maintain a specified minimum dollar value of earnings before interest, tax, depreciation and amortization for the trailing four fiscal quarters. Notes are convertible into our common stock only upon certain changes of control. In addition, upon the occurrence of the same changes in control that would permit the notes to be converted into common stock, we will issue the lender warrants to purchase shares of common stock. The number of warrants we will issue, if any, will directly correlate to the amount of notes issued and repaid. The issued warrants, if any, will expire on May 10, 2008. The lender under this agreement is a limited partnership of which the chairman of our board of directors serves as the sole general partner. On May 10, 2004, upon entering into the agreement, we immediately issued a $1,000,000 note under the facility and used the proceeds from that note and other available cash to repay all outstanding debt with Bank of the West. On September 15, 2004, we issued another $1,000,000 note under the facility. As of September 22, 2004, $1,933,000 was outstanding under the facility.

On May 10, 2004, we also entered into an Amended and Restated Credit Agreement with Bank of the West. The agreement provides for a working capital facility of $250,000 and a letter of credit facility of $750,000. At September 22, 2004, no debt was outstanding under the working capital facility and $426,000 of letters of credit were outstanding under the letter of credit facility.

Based upon the terms of our credit agreements, our recent operating performance and business outlook, and status of our balance sheet, we believe that cash from operations, cash and cash equivalents, and funds available under our credit agreements will be sufficient to satisfy our working capital needs at the anticipated operating levels for at least the next twelve months.

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Other Commitments. The following represents a comprehensive list of our contractual obligations and commitments as of September 22, 2004:

We have obligations under non-cancelable operating leases for our coffee houses, roasting facility and administrative offices. Lease terms are generally for periods of 10 to 20 years with renewal options, and generally require us to pay a proportionate share of real estate taxes, insurance, common area, and other operating costs. Some retail leases provide for contingent rental payments based on sales thresholds. In addition, we are liable on the master leases for 98 franchise locations. Under our historical franchising business model, we executed the master leases for these locations and entered into subleases on the same terms with our franchisees, which typically pay their rent directly to the landlords. If any of these franchisees default on their subleases, we would be required to make all payments under the master leases. Our maximum theoretical future exposure at September 22, 2004, computed as the sum of all remaining lease payments through the expiration dates of the respective leases, was $14,419,000. This amount does not take into consideration any mitigating measures that we could take to reduce this exposure in the event of default, including re-leasing the locations or terminating the master lease by negotiating a lump sum payment to the landlord in an amount that is less than the sum of all remaining future rents.

Critical Accounting Estimates

The preparation of our unaudited condensed consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts. The estimates and assumptions are evaluated on an ongoing basis and are based on historical experience and on various other factors that are believed to be reasonable. Accounts significantly impacted by estimates and assumptions include, but are not limited to, franchise receivables, allowance for bad debt reserves, fixed asset lives, goodwill, intangible assets, income taxes, self-insurance and workers’ compensation reserves, store closure reserves, stock-based compensation, the valuation allowance for net deferred tax assets and contingencies. We believe that the following represent our critical accounting policies and estimates used in the preparation of our unaudited condensed consolidated financial statements. The following discussion, however, does not list all of our accounting policies and estimates.

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

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

The most significant assumptions in our analysis are those used when we estimate a unit’s future cash flows. We generally use the assumptions in our strategic plan and modify them as necessary based on unit specific information. If our assumptions are incorrect, the carrying value of our operating unit assets may be overstated or understated.

Impairment of Goodwill

At the reporting unit level, goodwill is tested for impairment annually or whenever an event or circumstance indicates that it is more likely than not an impairment may have occurred. We consider the reporting unit level to be the segment level since the components within each segment have similar economic characteristics, including products and services, production processes, types or classes of customers and distribution methods. The impairment, if any, is measured based on the estimated fair value of the segment. Fair value can be determined based on discounted cash flows or valuations of similar businesses. Impairment occurs when the carrying amount of goodwill exceeds its estimated fair value.

The most significant assumptions we use in this analysis are those made in estimating future cash flows. In estimating future cash flows, we consider historical results as well as the assumptions utilized in our strategic plan for items such as same-store sales, store count growth rates, and the discount rate we consider to be the market discount rate used for acquisitions of similar businesses.

If our assumptions used in performing the impairment test prove inaccurate, the fair value of the segments may ultimately prove to be significantly lower, thereby causing the carrying value to exceed the fair value and indicating an impairment has occurred. If our assumptions are incorrect, the carrying value of our goodwill may be understated or overstated. Our annual impairment measurement date is our fiscal year-end.

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Estimated Liability for Closing Stores

We make decisions to close stores based on prospects for estimated future profitability and sometimes we are forced to close stores due to circumstances beyond our control (e.g., a landlord’s refusal to negotiate a new lease). Our management team evaluates each store’s performance every period. When stores continue to perform poorly, we consider the demographics of the location, as well as the likelihood of being able to improve the performance of an unprofitable store. Based on the management team’s judgment, we estimate the future cash flows. If we determine that the store will not, within a reasonable period of time, operate at break-even cash flow or be profitable, and we are not contractually obligated to continue operating the store, we may close the store. Additionally, franchisees may close stores for which we are the primary lessee. If the franchisee cannot make payments on the lease, we continue making the lease payments and establish an estimated liability for the closed store if we decide not to operate it as a company operated store. Effective January 1, 2003, we establish the estimated liability on the actual closure date. Prior to the adoption of Statement of Financial Accounting Standards No. 146, Accounting for Costs Associated with Exit or Disposal Activities (“SFAS 146”) on January 1, 2003, we established the estimated liability when we identified a store for closure, which may or may not have been the actual closure date.

The estimated liability for closing stores on properties vacated is generally based on the term of the lease and the lease termination fee we expect to pay, as well as estimated maintenance costs until the lease has been abated. The amount of the estimated liability established is generally the present value of these estimated future payments. The interest rate used to calculate the present value of these liabilities is based on our incremental borrowing rate at the time the liability is established. The related discount is amortized and shown in provision for asset impairment and restructuring costs, net in our unaudited condensed consolidated statements of earnings.

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

Estimated Liability for Self-Insurance

Effective October 1, 2003, we became self-insured for a portion of our current year’s losses related to workers’ compensation insurance. We have obtained stop loss insurance for individual workers’ compensation claims with a $250,000 deductible per occurrence and a program maximum for all claims of $750,000. Insurance liabilities and reserves are accounted for based on the present value of actuarial estimates of the amount of incurred and unpaid losses, based approximately on a risk-free interest rate. These estimates rely on actuarial observations of historical claim loss development. The actuary, in determining the estimated liability, bases the assumptions on the average historical losses on claims we have incurred. The actual loss development may be better or worse than the development we estimated in conjunction with the actuary. In that event, we will modify the reserve. As such, if we experience a higher than expected number of claims or the costs of claims rise more than expected, then we may, in conjunction with the actuary, adjust the expected losses upward and our future self-insurance expenses will rise.

Franchised Operations

We monitor the financial condition of certain franchisees and record provisions for estimated losses on receivables when we believe that our franchisees are unable to make their required payments to us. Each period we perform an analysis to develop estimated bad debts for each franchisee. We then compare the aggregate result of that analysis to the amount recorded in our unaudited condensed consolidated financial statements as the allowance for doubtful accounts and adjust the allowance as appropriate. Over time, our assessment of individual franchisees may change. For instance, we have had some franchisees, who in the past we had determined required an estimated loss equal to the total amount of the receivable, who have paid us in full or established a consistent record of payments (generally one year) such that we determined an allowance was no longer required.

Depending on the facts and circumstances, there are a number of different actions we and/or our franchisees may take to resolve franchise collections issues. These actions may include the purchase of franchise stores by us or by other franchisees, a modification to the franchise agreement which may include a provision to defer certain royalty payments or reduce royalty rates in the future, a restructuring of the franchisee’s business and/or finances (including the restructuring of leases for which we are the primary or secondary obligee) or, if necessary, the termination of the franchise agreement. The allowance established is based on our assessment of the most probable course of action that will occur.

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In accordance with SFAS 146, which we adopted on January 1, 2003, an estimated liability for future lease obligations on stores operated by franchisees for which we are the primary or secondary obligee is established on the date the franchisee closes the store. Also, we record an estimated liability for subsidized lease payments when we sign a sublease agreement committing us to the subsidy.

The amount of the estimated liability is established using the methodology described under the heading “Estimated Liability for Closing Stores” above. Consistent with SFAS 146, we have not established an additional estimated liability for potential losses not yet incurred. If sales trends or economic conditions worsen for our franchisees, their financial health may worsen, our collection rates may decline and we may be required to assume the responsibility for additional lease payments on franchised stores. Entering into restructured franchise agreements may result in reduced franchise royalty rates in the future.

Stock-Based Compensation

As discussed in the Notes to Unaudited Condensed Consolidated Financial Statements, we have various stock-based compensation plans that provide options for certain employees and outside directors to purchase common shares of stock. We have elected to account for stock-based compensation in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” which utilizes the intrinsic value method of accounting for stock-based compensation, as opposed to using the fair-value method prescribed in Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). Because of this election, we are required to make certain disclosures of pro forma net income assuming we had adopted SFAS 123. We determine the estimated fair value of stock-based compensation on the date of the grant using the Black-Scholes option-pricing model. The Black-Scholes option-pricing model requires the input of highly subjective assumptions, including the historical stock price volatility, expected life of the option and the risk-free interest rate. A change in one or more of the assumptions used in the Black-Scholes option-pricing model may result in a material change to the estimated fair value of the stock-based compensation (see Note 1 of Notes to Unaudited Condensed Consolidated Financial Statements for analysis of the effect of certain changes in assumptions used to determine the fair value of stock-based compensation).

Valuation Allowance for Net Deferred Tax Assets

As discussed above, we have recorded a 100% valuation allowance against our net deferred tax assets. If we have been profitable for a number of years and our prospects for the realization of our deferred tax assets are more likely than not, we would then reverse our valuation allowance and credit income tax expense. In assessing the prospects for future profitability, many of the assessments of same-store sales and cash flows discussed above become relevant. When circumstances warrant, we assess the likelihood that our net deferred tax assets will more likely than not be realized from future taxable income. As of September 22, 2004, our net deferred tax assets and related valuation allowance totaled approximately $14,821,000.

Item 3. Quantitative And Qualitative Disclosures About Market Risk.

Market Risk Sensitive Items Entered Into for Trading Purposes.

None.

Market Risk Sensitive Items Entered Into for Other Than Trading Purposes.

Interest Rate Risk. We are exposed to market risk from changes in interest rates on our outstanding bank debt. At September 22, 2004, we had a $5,000,000 loan facility, with an outstanding balance of $1,933,000, and a $250,000 working capital facility, with no outstanding balance, each of which could be affected by changes in short term interest rates. Interest rates ranged from 4.90% to 5.32% during our first fiscal quarter. These rates can be fixed over periods ranging from one to six months, at our discretion. At September 22, 2004, a hypothetical 100 basis point increase in the adjusted rates would result in additional interest expense of $19,330 on an annualized basis. The current loan approximates the fair value.

Commodity Price Risk. Green coffee, the principal raw material for our products, is subject to significant price fluctuations caused by a number of factors, including weather, political, and economic conditions. To date, we have not used commodity based financial instruments to hedge against fluctuations in the price of coffee. To ensure that we have an adequate supply of coffee, however, we enter into agreements to purchase green coffee in the future that may or may not be fixed as to price. At September 22, 2004, we had commitments to purchase coffee through fiscal year 2006 totaling $1,492,000 for 1,430,000 pounds of green coffee, some of which commitments were fixed as to price. The coffee scheduled to be delivered to us in this fiscal year pursuant to these commitments will satisfy approximately 28% of our anticipated green coffee requirements for this fiscal year. Assuming we require approximately 3,000,000 additional pounds of green coffee during 2004 for which no price has yet been fixed, each $0.01 per pound increase in the price of green coffee could result in approximately $30,000 of additional cost. However, because the price we pay for green coffee is negotiated with suppliers, we believe that the commodity market price for green coffee would have to increase significantly, by as much as $0.25 per pound, before suppliers would increase the price they charge us.

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Item 4. Controls and Procedures.

(a) As of the end of the period covered by this quarterly report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective in timely alerting them to material information relating to Diedrich Coffee (including our subsidiaries) required to be included in our periodic SEC filings.

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

PART II - OTHER INFORMATION

Item 1. Legal Proceedings.

In the ordinary course of our business, we may become involved in legal proceedings from time to time. As of and for the twelve week period ending September 22, 2004, we were not a party to any material legal proceedings.

Item 6. Exhibits

Set forth below is a list of the exhibits included as part of this quarterly report.

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