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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED DECEMBER 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 December 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 and its wholly-owned subsidiary. 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 and the fiscal year ending April 2, 2006 (“Fiscal 2006”) will include 52 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 December 26, 2004 (“Third Quarter 2005”), the thirty-nine week period ended December 26, 2004, the thirteen week period ended December 28, 2003 (“Third Quarter 2004”), and the thirty-nine week period ended December 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, which have not been amended for the restatement for lease accounting adjustments described in Note 2.

Lease Accounting Restatement

Certain financial statement information for periods prior to Third Quarter 2005 has been restated to reflect a correction to the accounting for operating leases as described in Note 2.

Stock-based compensation

In December 2002, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (“SFAS”) 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.

In December 2004, the FASB reissued SFAS No. 123 as SFAS No. 123R, “Share Based Compensation.” Under SFAS No. 123R, public entities will be required to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award and recognize the cost over the period during which an employee is required to render services in exchange for the award. Additionally, SFAS No. 123R will require entities to record compensation expense for employee stock purchase plans that may not have previously been considered compensatory under the existing rules. SFAS No. 123R will be effective for interim or annual reporting periods beginning on or after June 15, 2005. The Company has not yet determined the impact that adopting SFAS No. 123R will have on its results of operations.

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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.

2. Lease Accounting Restatement

In response to recently announced financial statement restatements by a number of public companies, the American Institute of Certified Public Accountants (“AICPA”) requested that the Office of the Chief Accountant of the SEC clarify the interpretation of certain accounting issues and their application under generally accepted accounting principles relating to operating leases. On February 7, 2005, the staff of the Office of the Chief Accountant of the SEC provided its views to the AICPA. In its letter to the AICPA, the SEC staff stated, among other things, that leasehold improvements in an operating lease should be amortized by the lessee over the shorter of the economic life of the improvements or the lease term (which should include lease renewal periods only when they are “reasonably assured” as that term is contemplated by Statement of Financial Accounting Standards No. 13), and that the SEC staff believes its views are based upon existing accounting literature (as opposed to a new interpretation of generally accounting accepted principles).

As a consequence of these developments, we have reevaluated our accounting with respect to operating leases. Generally, our leases have a primary lease term of ten years and one or more renewal options, but some properties have shorter lease terms and/or no lease renewal options. The estimated economic life for leasehold improvements is generally ten years, and our amortization policy is to amortize leasehold improvements over the shorter of the estimated economic life or the lease term (as determined for accounting purposes). In our February 2005 lease accounting analysis, we reevaluated each lease to determine, under generally accepted accounting principles, whether its lease term should include or exclude any lease renewal option(s). In some instances, the lease renewal option involved an economic penalty for nonrenewal, with the result that the option period should be included in the lease term for accounting purposes. For most of our leases, it was determined that the lease term should not include the renewal option(s). After the appropriate lease term for accounting purposes was determined for each leasehold, Tully’s recomputed the amounts of leasehold amortization expense for each leasehold for the historical periods after the leases commenced. We incorporated any identified corrections, where applicable, in the financial statements for Third Quarter 2005 and for the thirty-nine week period ended December 26, 2004. Also, where applicable the financial statement data for periods prior to Third Quarter 2005 included in these condensed financial statements has been restated for the effects of these adjustments (the “Restatement”).

These corrections had the general effect of increasing the amount of depreciation and amortization expense and reducing the corresponding net book value of the leasehold improvement asset. The adjustments and restated financial statement information are subject to possible revision after our independent registered public accountants have reviewed the information.

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The following is a summary of the impact of the Restatement upon the condensed consolidated financial statements (dollars in thousands, except per share data)

In the thirty-nine week period ended December 26, 2004, $93,000 of additional depreciation and amortization expense was recorded in connection with the correction of the results for the twenty-six week period ended September 26, 2004. In addition, certain amounts in Notes 1, 3, and 11 have been restated to reflect the Restatement adjustments described above.

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3. 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 thirty-nine week periods ended December 26, 2004, and December 28, 2003, our operating cash flow was sufficient to cover our cost of goods sold and operating expenses (cash of $171,000 and $940,000 was provided by operations for the thirty-nine week periods ended December 26, 2004, and December 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 5 and 6). We believe that the operating cash flows, financing cash flows, projected investing cash flows, and the cash and cash equivalents of $422,000 at December 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. The terms of our credit facilities (under which $2.5 million was borrowed as of February 1, 2005) require repayment by August 1, 2005 (see Note 5) and the terms of our convertible promissory note require repayment of $3.0 million on August 1, 2005, unless converted to stock by the holder (see Note 6). Accordingly, we expect that prior to August 1, 2005 it will be necessary to negotiate extensions of the maturities under the credit facilities and the convertible promissory note (if not converted), or to repay these obligations with proceeds from other sources of funding. We do expect to seek additional capital during Fiscal 2005 or Fiscal 2006 in order to fund a higher level of growth, to repay or refinance the debt obligations maturing in Fiscal 2006, and to provide increased liquidity reserves.

In the remainder of Fiscal 2005 and in Fiscal 2006 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. Tully’s expects that additional sources of funding will be required to fund capital expenditures required for growth of the business and fund repayment of our long-term obligations and commitments. Further, if our actual results should differ unfavorably from projections, it could become necessary for us to seek additional capital during Fiscal 2005 or Fiscal 2006. 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 10) expired on February 8, 2005. We received approximately $900,000 from subscriptions under that offering. All subscriptions must be evaluated under the requirements of the Rights Offering. As a result, we have not yet determined the securities that will be issued under that offering, or the portions of the proceeds to be retained by Tully’s or refunded to subscribers.

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 December 26, 2004, we had total liabilities of $26,240,000 and total assets of $18,449,000, so that a deficit of $7,791,000 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 December 26, 2004 include deferred revenue in the aggregate amount of $10,791,000. 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 ($10,791,000 at December 26, 2004) for less than $2,000,000 of future cash expenditures.

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As of December 26, 2004 we had cash and cash equivalents of $422,000, and a working capital deficit of $10,071,000. 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 5), 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.

4. Inventories

Inventories consist of the following:

As of January 31, 2005, we had approximately $1,900,000 in fixed-price coffee purchase commitments for Fiscal 2005 and $1,600,000 in fixed-price coffee purchase commitments for Fiscal 2006.

5. 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 annual interest rate for both the KCL Credit Line and the Second KCL line became 12% effective 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.

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

6. 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 at the note holder’s option 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 10).

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.

7. 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 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 amortized the fee over the fourteen-month period 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 $125,000 during the thirty-nine week period ended December 26, 2004.

8. 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 of Fiscal 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. 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 December 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.

9. 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 Third Quarter 2005.

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

Warrants

Tully’s had warrants outstanding to purchase 9,704,290 and 8,826,650 shares of common stock as of December 26, 2004 and December 28, 2003, respectively, at exercise prices ranging from $0.01 to $0.33 per share. At December 26, 2004, the weighted average exercise price of the outstanding warrants was $0.23 per share.

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.

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Through January 31, 2005, we had issued warrants to the Guarantors as summarized below:

10. 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 (the “Rights Offering”). The registration statement was subsequently amended and was declared effective on January 11, 2005. Eligible shareholders and former shareholders of Tully’s received 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 the Rights Offering. The primary purpose of the Rights Offering is to provide an opportunity for our shareholders to satisfy any unsatisfied preemptive right that they believe they may have. We believe the 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 January 6, 2005 received under-subscription privileges to purchase any shares of common stock and investment units not purchased through the exercise of the rights.

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, 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.

The Rights Offering expired on February 8, 2005. We received approximately $900,000 from subscriptions under the Rights Offering. All subscriptions must be reviewed under the requirements of the Rights Offering. As a result, we have not yet determined the number of shares of common stock and Series A Convertible Preferred Stock or the number of common stock warrants to be issued under the Rights Offering subscriptions or the portion of the proceeds to be retained by Tully’s or refunded to subscribers. We have incurred approximately $400,000 in costs for the Rights Offering, which will reduce the net proceeds from the Rights Offering.

11. 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 (which includes restaurant and institutional customers), and office coffee service 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.

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The tables below present information by operating segment:

12. 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 December 26, 2004 and December 28, 2003, there were outstanding options and warrants convertible into 37,327,486 and 34,291,898 shares of common stock, respectively. All such instruments were excluded from the computation of diluted loss per share for Third Quarter 2005 and Third Quarter 2004 because the effect of these instruments on the calculation would have been antidilutive.

13. Comprehensive Loss

There were no components of other comprehensive income (loss) other than net loss during the thirty-nine week periods ended December 26, 2004 and December 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 December 26, 2004 (“Third Quarter 2005”) and December 28, 2003 (“Third Quarter 2004”) and the thirty-nine week periods ended December 26, 2004 (the “Nine Months Fiscal 2005”), and December 28, 2003 (the “Nine Months Fiscal 2004”). All applicable disclosures in the following discussion consider the effects of the Restatement, as described below. 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 (which have not yet been amended for the Restatement). 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.”

The Restatement

In response to recently announced financial statement restatements by a number of public companies, the American Institute of Certified Public Accountants (“AICPA”) requested that the Office of the Chief Accountant of the SEC clarify the interpretation of certain accounting issues and their application under generally accepted accounting principles relating to operating leases. On February 7, 2005, the staff of the Office of the Chief Accountant of the SEC provided its views to the AICPA. In its letter to the AICPA, the SEC staff stated, among other things, that leasehold improvements in an operating lease should be amortized by the lessee over the shorter of the economic life of the improvements or the lease term (which should include lease renewal periods only when they are “reasonably assured” as that term is contemplated by Statement of Financial Accounting Standards No. 13), and that the SEC staff believes its views are based upon existing accounting literature (as opposed to a new interpretation of generally accounting accepted principles).

As a consequence of these developments, we have reevaluated reanalyzed our accounting with respect to operating leases. Generally, our leases have a primary lease term of ten years and one or more renewal options, but some properties have shorter lease terms and/or no lease renewal options. The estimated economic life for leasehold improvements is generally ten years, and our amortization policy is to amortize leasehold improvements over the shorter of the estimated economic life or the lease term (as determined for accounting purposes). In our February 2005 lease accounting analysis, we reevaluated each lease to determine, under generally accepted accounting principles, whether its lease term should include or exclude any lease renewal option(s). In some instances, the lease renewal option involved an economic penalty for nonrenewal, with the result that the option period should be included in the lease term for accounting purposes. For most of our leases, it was determined that the lease term should not include the renewal option(s). After the appropriate lease term for accounting purposes was determined for each leasehold, Tully’s recomputed the amounts of leasehold amortization expense for each leasehold for the historical periods after the leases commenced and compared these to the amounts recorded for leasehold expense in our historical financial statements. Based upon this analysis, we determined the effect on our historical financial statements as summarized in Note 2 of the Notes to the Condensed Consolidated Financial Statements, and have reflected these corrections in the condensed consolidated financial statements for the quarterly period ended December 26, 2004 included in this Quarterly Report on Form 10-Q. As described in that note, we have also restated certain information for periods prior to the quarterly period ended December 26, 2004.

These corrections had the general effect of increasing the amount of depreciation and amortization expense and reducing the corresponding net book value of the leasehold improvement asset. The adjustments and restated financial statement information are subject to possible revision after our independent registered public accountants have completed their audit procedures with respect to the information.

We intend to amend our Annual Report on Form 10-K for the fiscal year ended March 28, 2004 to restate the financial statement data for Fiscal 2002, Fiscal 2003, and Fiscal 2004, and our Quarterly Reports on Form 10-Q for the quarterly periods ended June 27, 2004 and September 26, 2004 to reflect the adjustments determined through our lease review, after our independent registered public accountants have completed their audit procedures with respect to this information.

The cumulative effect of the Restatement as of March 28, 2004 was to reduce the net book value of the leasehold improvement asset by $648,000 and to increase shareholders’ deficit by $648,000. As the result of the correction to depreciation and amortization, net loss for the Nine Months 2005 increased by $138,000. The Restatement did not have any impact on our cash flows, sales, or our earnings before interest, taxes, depreciation and amortization. The impact of these adjustments on the condensed consolidated statements of operations, the condensed consolidated balance sheet and condensed consolidated statements of cashflows are provided in Note 2 of the Notes to the Condensed Consolidated Financial Statements.

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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:

The relative percentage of net sales from each division for Third Quarter 2004, Third Quarter 2005, the Nine Months Fiscal 2004 and the Nine Months Fiscal 2005 are depicted by these graphs:

Divisional Sales Mix

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. This was exacerbated by the weak economy in our principal geographic markets since 2001. Since Fiscal 2002,

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we have 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:

Our operating results for the Nine 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 Nine Months Fiscal 2005 results through $125,000 of costs. 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):