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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

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FORM 10-Q

|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the quarterly period ended July 29, 1998

|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the transition period from ___________ to ____________

COMMISSION FILE NUMBER 0-21203

DIEDRICH COFFEE, INC.
(Exact name of registrant as specified in its charter)

DELAWARE 33-0086628
(State or Other Jurisdiction of (IRS Employer
Incorporation or Organization) Identification No.)

2144 MICHELSON DRIVE
IRVINE, CALIFORNIA 92612
(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 |_|

As of September 9, 1998, there were 5,941,650 shares of common stock of
the registrant outstanding.

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DIEDRICH COFFEE, INC.

INDEX

PAGE NO.
--------

PART I - FINANCIAL INFORMATION

Item 1 Financial Statements

Condensed Balance Sheets......................................... 3

Condensed Statements of Operations............................... 4

Condensed Statements of Cash Flows............................... 5

Notes to Condensed Financial Statements.......................... 6

Item 2 Management's Discussion and Analysis of Financial Condition and
Results of Operations............................................ 10

Liquidity and Capital Resources.................................. 13

Item 3 Quantitative and Qualitative Disclosures About Market Risk....... 14

PART II- OTHER INFORMATION

Item 1 Legal Proceedings................................................ 15

Item 4 Submission of Matters to a Vote of Security Holders.............. 15

Item 5 Other Information................................................ 15

Item 6 Exhibits and Reports on Form 8-K................................. 16

Signatures....................................................... 16

PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS

DIEDRICH COFFEE, INC.
CONDENSED BALANCE SHEETS

JULY 29, 1998 JANUARY 28, 1998
-------------- ----------------

ASSETS (Note 3)
Current Assets:
Cash $ 1,001,625 $ 1,408,161
Accounts receivable 332,140 181,628
Inventories (Note 2) 1,263,933 1,375,119
Prepaid expenses 235,634 157,393
Income taxes receivable 19,363 42,528
-------------- -------------
Total current assets 2,852,695 3,164,829

Property and equipment, net 9,581,398 10,104,843
Costs in excess of net assets acquired, net 342,706 389,651
Other assets 248,995 289,103
-------------- -------------
Total assets $ 13,025,794 $ 13,948,426
============== =============

LIABILITIES AND STOCKHOLDERS' EQUITY

Current Liabilities:
Current installments of obligations under capital
lease $ 169,488 $ 168,139
Accounts payable 952,707 1,204,366
Accrued compensation 942,306 716,742
Accrued expenses 1,199,276 1,796,869
Provision for store closings and restructuring costs 138,379 237,320
-------------- -------------
Total current liabilities 3,402,156 4,123,436

Obligation under capital lease - long term 328,319 317,292
Long term debt (Note 3) 2,500,000 2,500,000
Deferred rent 191,743 172,231
-------------- -------------
Total liabilities 6,422,218 7,112,959
-------------- -------------

Stockholders' Equity: (Note 4)
Common stock 59,417 57,417
Additional paid-in capital 18,213,094 16,928,546
Accumulated deficit (11,668,935) (10,150,496)
--------------- --------------
Total stockholders' equity 6,603,576 6,835,457
-------------- -------------
Commitments and contingencies
Total liabilities and stockholders' equity $ 13,025,794 $ 13,948,426
============== =============

See accompanying notes to financial statements.

DIEDRICH COFFEE, INC.
CONDENSED STATEMENT OF OPERATIONS
(UNAUDITED)

THIRTEEN WEEKS THIRTEEN WEEKS TWENTY-SIX WEEKS TWENTY-SIX WEEKS
ENDED ENDED ENDED ENDED
JULY 29, 1998 JULY 30, 1997 JULY 29, 1998 JULY 30, 1997
-------------- -------------- ---------------- ----------------

Net Sales:
Retail $ 5,343,789 $ 5,258,780 $ 10,628,849 $ 10,643,405
Wholesale and other 685,726 551,742 1,324,027 1,034,837
------------ ------------ ------------- ------------
Total 6,029,515 5,810,522 11,952,876 11,678,242
------------ ------------ ------------- ------------

Cost and Expenses:
Cost of sales and related
occupancy costs 2,712,403 2,860,893 5,395,068 5,902,708
Store operating expenses 2,273,005 2,126,728 4,556,908 4,506,955
Other operating expenses 146,516 75,764 295,301 140,089
Depreciation and amortization 461,352 439,077 943,574 886,516
Provision for store closings
and restructuring costs - - - 4,550,068
General and administrative 1,113,530 969,554 2,088,378 1,743,879
------------ ------------ ------------- ------------
expenses
Total 6,706,806 6,472,016 13,279,229 17,730,215
------------ ------------ ------------- ------------

Operating loss (677,291) (661,494) (1,326,353) (6,051,973)

Interest expense (99,981) (21,651) (197,254) (21,651)

Interest and other income 18,896 (12,417) 20,406 (4,757)
------------ ------------ ------------- ------------

Loss before income taxes (758,376) (695,562) (1,503,201) (6,078,381)

Income tax provision 2,890 2,890 3,690 2,890
------------ ------------ ------------- ------------

Net loss $ (761,266) $ (698,452) $ (1,506,891) $ (6,081,271)
============ ============ ============= ============

Basic net loss per share: $ (0.13) $ (0.13) $ (0.26) $ (1.13)
============ ============ ============= ============
Diluted net loss per share: $ (0.13) $ (0.13) $ (0.26) $ (1.13)
============ ============ ============= ============
Weighted average shares
outstanding 5,941,650 5,391,650 5,871,320 5,391,650
============ ============ ============= ============

See accompanying notes to financial statements.

DIEDRICH COFFEE, INC.
CONDENSED STATEMENTS OF CASH FLOWS
(UNAUDITED)

TWENTY-SIX WEEKS TWENTY-SIX WEEKS
ENDED JULY 29, ENDED JULY 30,
1998 1997
----------------- ---------------

Cash flows from operating activities:
Net loss $(1,506,891) $(6,081,271)
Adjustments to reconcile net loss to cash used
in operating activities:
Depreciation and amortization 943,574 886,516
Provision for Asset Impairment and
restructuring costs -- 4,550,068
Changes in assets and liabilities:
Accounts receivable (150,512) 32,107
Inventories 111,186 (27,043)
Prepaid expenses (78,241) (155,132)
Income taxes receivable 23,165 82,653
Other assets 8,053 (6,428)
Accounts payable (251,659) (301,935)
Accrued compensation 112,649 (96,183)
Accrued expenses (59,079) 114,910
Deferred rent 19,512 5,854
----------- -----------
Net cash used in operating activities (828,243) (995,884)
----------- -----------

Cash flows from investing activities:
Capital expenditures for property and equipment (811,542) (1,150,095)
Property disposition -- (604,173)
----------- -----------
Net cash used in investing activities $ (811,542) $(1,754,268)
=========== ===========

Cash flows from financing activities:
Proceeds from issuance of common stock,
net fees paid 1,275,000 --
Proceeds from long-term debt -- 1,250,000
Payment on capital lease obligation (41,751) --
----------- -----------
Net cash provided by financing activities $ 1,233,249 $ 1,250,000
----------- -----------
Net increase (decrease) in cash (406,536) (1,500,152)
----------- -----------
Cash at beginning of period 1,408,161 2,071,904
----------- -----------
Cash at end of period 1,001,625 $ 571,752
=========== ===========

Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest $ 150,000 $ --
=========== ===========
Income taxes $ 3,690 $ 2,890
=========== ===========

Non-cash transactions
Equipment purchased under capital lease $ 54,127 $ --
=========== ===========

See accompanying notes to financial statements

DIEDRICH COFFEE, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
JULY 29, 1998
(UNAUDITED)

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The unaudited condensed financial statements of Diedrich Coffee, Inc.
(the "Company") have been prepared in accordance with generally accepted
accounting principles for interim financial information. In the opinion of
management, all adjustments (consisting of normal, recurring adjustments and
accruals) considered necessary for a fair presentation of the Company's
financial position at July 29, 1998 and the results of operations and cash flows
for both the thirteen and twenty-six weeks ended July 29, 1998 and July 30, 1997
have been included. Results for the interim periods are not necessarily
indicative of the results for an entire year. This information should be read in
conjunction with the financial statements and the notes thereto included in the
Company's Annual Report on Form 10-K for the year ended January 28, 1998.

In June 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting
Comprehensive Income," which establishes standards for reporting and display of
comprehensive income and its components (revenues, expenses, gains and losses)
in a full set of general-purpose financial statements. SFAS No. 130 is effective
for financial statements issued for periods beginning after December 15, 1997.
The Company has determined that the impact of SFAS No. 130 on its consolidated
financial statements is not material.

In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments
of an Enterprise and Related Information." SFAS No. 131 establishes standards
for the way that public business enterprises report information about operating
segments in annual financial statements and requires that those enterprises
report selected information about operating segments in interim financial
reports issued to shareholders. SFAS No. 131 is effective for financial
statements issued for periods beginning after December 15, 1997. The Company has
not determined the impact of SFAS No. 131 on its consolidated financial
statements. SFAS No. 131 will be applied in the preparation of the Company's
annual financial statements for the year ending January 27, 1999.

In April 1998, the American Institute of Certified Public Accountants
("AICPA") issued Statement of Position ("SOP") 98-5, "Reporting on the Costs of
Start-up Activities". This SOP requires that costs incurred during start-up
activities, including organization costs, be expensed as incurred. SOP 98-5 is
effective for financial statements for fiscal years beginning after December 15,
1998. Initial application of the SOP should be as of the beginning of the fiscal
year in which the SOP is first adopted and should be reported as a cumulative
effect of a change in accounting principle. The Company has adopted SOP 98-5
which had an impact of $22,000 in the thirteen weeks ended April 29, 1998.

Net Loss Per Common Share

In February 1997, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings Per
Share." SFAS No. 128 specifies new standards designed to improve the earnings
per share ("EPS") information provided in financial statements by simplifying
the existing computational guidelines, revising the disclosure requirements and
increasing the comparability of EPS data on an international basis. Some of the
changes made to simplify the EPS computations include: (a) eliminating the
presentation of primary EPS and replacing it with basic EPS, with the principal
difference being that the common stock equivalents are not considered in
computing basic EPS, (b) eliminating the modified treasury stock method and the
three percent materiality provision and (c) revising the contingent share
provisions and the supplemental EPS data requirements. SFAS No. 128 also makes a
number of changes to existing disclosure requirements. SFAS No. 128 is effective
for financial statements issued for periods ending after December 15, 1997,
including interim periods. Basic earnings per share are presented for the
thirteen and twenty-six weeks ended July 29, 1998 and July 30, 1997; diluted
earnings per share are not presented as losses were incurred in those periods.

DIEDRICH COFFEE, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
JULY 29, 1998
(UNAUDITED)

2. INVENTORIES

Inventories consist of the following:

JULY 29, 1998 JANUARY 28, 1998
------------- ----------------

Green coffee (raw materials) $ 443,138 $ 535,885
Roasted coffee (finished goods 100,581 67,965
Accessory and specialty items 190,170 230,502
Other food, beverage and supplies 530,044 540,767
---------- ----------
$1,263,933 $1,375,119
========== ==========

3. DEBT

Long-term debt consists of the following:

JULY 29, 1998 JANUARY 28, 1998
------------- ----------------

NUVRTY, INC.
Note payable bearing interest at
prime rate plus 3 1/2%, interest
payable monthly. Note is secured
by the assets of the Company.
Due September 30, 2002 $1,000,000 $1,000,000

GRANDVIEW TRUST
Note payable bearing interest at
prime rate plus 3 1/2%, interest
payable monthly. Note is secured
by the assets of the Company.
Due October 15, 2002 750,000 750,000

OCEAN TRUST
Note payable bearing interest at
prime rate plus 3 1/2%, interest
payable monthly. Note is secured
by the assets of the Company.
Due October 16, 2002 $ 750,000 $ 750,000
---------- ----------
$2,500,000 $2,500,000
========== ==========

On September 30, 1997 the Company entered into a promissory note, term
loan agreement and security agreement with Nuvrty, Inc., a Colorado corporation
controlled by Amre Youness, a former director of the Company (the "Nuvrty Loan
Documents"). All outstanding principal and accrued interest is due and payable
on September 30, 2002. The loan is secured by the assets of the Company and
provides for borrowings up to $1,000,000 with interest accruing and paid monthly
at the prime rate plus 3 1/2%. The Company borrowed the full amount under the
loan.

In connection with the Nuvrty Loan Documents, the Company issued a
warrant to Nuvrty to purchase up to 170,000 shares of the Company's common stock
if the Loan was repaid in full within 120 days of closing and up to 340,000
shares of the Company's common stock if the loan was not repaid within 120 days,
all at a price of $2.25 per share. The warrants are exercisable immediately and
expire on the later of September 30, 2003 or one year following payment in full
of the loan.

DIEDRICH COFFEE, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
JULY 29, 1998
(UNAUDITED)

On October 16, 1997 the Company entered into parallel promissory notes,
term loan agreements and security agreements with the Ocean and Grandview Trusts
on terms identical to those entered into with Nuvrty, Inc. (the "Ocean Trust
Loan Documents" and the "Grandview Trust Loan Documents", respectively). The
Ocean Trust Loan Documents and the Grandview Trust Loan Documents provide for
borrowing up to $750,000 from each Trust. Each loan is secured by the assets of
the Company. Interest on advances is accrued and payable monthly at the prime
rate plus 3 1/2%. The Company borrowed $750,000 under each facility. All
outstanding principal and accrued interest is due and payable to each of the
Ocean and Grandview Trusts on October 16, 2002.

In connection with the Ocean Trust Loan Documents and the Grandview
Trust Loan Documents the Company issued warrants to each Trust respectively to
purchase up to 127,500 shares each of the Company's common stock if the loans
were repaid in full within 120 days of closing, or up to 255,000 shares
respectively of the Company's common stock if the loans were not repaid in full
within 120 days of closing, all at a price of $2.25 per share. The warrants are
exercisable immediately and expire on the later of October 16, 2003 or one year
following payment in full of the respective loans. The Company used the proceeds
from the Ocean Trust and Grandview Trusts Loans to pay off and discharge
outstanding indebtedness.

On April 14, 1998 the Company announced the commitment of Franchise
Mortgage Acceptance Company ("FMAC") , subject to approval of final
documentation by the Boards of Directors of both companies, to make a secured
loan of up to $5 million to the Company. The loan was expected to be closed in
the second quarter, however, the transaction was not completed. The Company
expects it to be approved by the Board of Directors and FMAC by the third
quarter.

The warrants associated with all the above debt were accounted for in
accordance with the provisions of APB 14, "Accounting for Convertible Debt and
Debt Issued Stock Purchase Warrants." Due to the relative immateriality of the
fair value of the warrants, none of the proceeds from issuance of the debt were
allocated to the warrants. The determination of fair value was calculated using
both a Cost of Replacement Model and the Monte Carlo simulation of possible
warrant exercise.

4. STOCKHOLDERS' EQUITY

On April 25, 1997, the Company's Board of Directors approved the 1997
Non-Employee Director's Stock Option Plan under which options for 10,000 shares
each were granted to two non-employee directors. These options have an exercise
price of $2.75, became vested on April 25, 1998 and expire on April 25, 2007.

On November 18, 1997, Mr. John E. Martin joined the Company's Board of
Directors as Chairman, replacing Lawrence Goelman. On November 17, 1997, Mr.
Martin entered into a letter agreement with the Company appointing him Chairman
of the Board of the Company. The Company and Mr. Martin also entered into an
agreement under which Mr. Martin would be granted the option to purchase up to
850,000 shares of the common stock of the Company subject to stockholder
approval. Mr. Martin and the Company also agreed to terms under which Mr. Martin
would purchase 333,333 shares of the Company's common stock at $3.00 per share,
following stockholder approval of the Martin Option Agreement.

On November 18, 1997, Mr. Timothy J. Ryan joined the Company as Diedrich
Coffee's President and Chief Executive Officer to replace Lawrence Goelman,
Interim Chief Executive Officer. Subject to stockholder approval, the Company
entered into a performance based Stock Option Plan and Agreement under which Mr.
Ryan would be granted the option to purchase up to 600,000 shares of the common
stock of the Company and Mr. Ryan would purchase 16,667 shares at $3.00 per
share in the Company pursuant to a private sale of restricted stock.

DIEDRICH COFFEE, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
JULY 29, 1998
(UNAUDITED)

On January 22, 1998 the stockholders of the Company approved the stock
option plans and agreements with John Martin and Timothy Ryan. On January 28,
1998 Messrs. Martin and Ryan completed their respective private purchases of
Company stock of $1,000,000 and $50,000, respectively.

On March 30, 1998 the Company agreed to a private placement of 200,000
shares of the Company's common stock to Franchise Mortgage Acceptance Company
("FMAC") at a price of $6.375 (the stock's closing sale price for that day on
the Nasdaq National Stock Market). In addition, FMAC also received an option to
purchase 100,000 additional shares of the Company's common stock; this option
may be exercised in increments of 25,000 shares or more and expires on April 3,
2000. The exercise prices of this option are as follows: 50,000 shares are
exercisable at $10.00 per share and $12.50 per share, respectively. The fair
value of this option is estimated to be $72,042. The estimated fair value of the
option has been charged to equity and will be amortized ratably over the two
year life of the option. Amortization for the period ended July 29, 1998 totaled
$11,548. This transaction was completed on April 3, 1998.

The Company's registration statements on Form S-8 for the 1997
Non-employee Director's Stock Option Plan, the John E. Martin Option Plan and
Agreement and the Tim J. Ryan Option Plan and Agreement were filed on August 12,
1998.

The Company filed a registration statement on Form S-3 which was
declared effective on August 24, 1998 registering the following shares: 79,183
shares of common stock are issuable upon exercise of options granted to Steven
Lupinacci (former President and Chief Executive Officer of the Company), 160,000
shares of Common Stock are issuable to The Boston Group (underwriters of the
Company's initial public offering) and certain of its officers and affiliates
upon exercise of warrants to purchase common stock, 25,000 shares of common
stock are issuable upon exercise of options granted to Gregg Rondinelli
(financial consultant to the Company), 85,000 shares of common stock are
issuable to Virginia R. Cirica Trust upon exercise of a warrants, 340,000 shares
of common stock issuable to Nuvurty, Inc. upon the exercise of warrants, 255,000
shares of common stock issuable to Ocean Trust upon exercise of warrants,
255,000 shares of common stock issuable to Grandview Trust upon exercise of
warrants, 200,000 shares of common stock were issued pursuant to the Common
Stock and Option Purchase Agreement with FMAC, and 100,000 shares issuable upon
exercise of options to purchase common stock pursuant to the FMAC agreement.

PART I - FINANCIAL INFORMATION

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

FORWARD LOOKING STATEMENTS

From time to time, in both written reports and oral statements, the
Company makes "forward-looking statements" within the meaning of Federal and
state securities laws. Disclosures that use words such as the Company
"believes," "anticipates," "expects," "may" or "plans" and similar expressions
are intended to identify forward-looking statements. These forward-looking
statements reflect the Company's current expectations and are based upon data
available at the time of the statements. Such statements are subject to certain
risks and uncertainties that could cause actual results to differ materially
from expectations. Any such forward-looking statements, whether made in this
report or elsewhere, should be considered in context with the various
disclosures made by the Company about its business, including the factors
discussed below. These projections or forward looking statements fall under the
safe harbors of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended. Foreseeable
risks and uncertainties are described elsewhere in this report and in detail
under "Risk Factors and Trends Affecting Diedrich Coffee and Its Business" in
the Company's annual report on Form 10-K for the fiscal year ended January 28,
1998 and in reports filed by the Company with the Securities and Exchange
Commission.

GENERAL

The Company commenced operations in 1972 as a private company and
completed its initial public offering in September 1996. The Company, a custom
roaster of specialty coffee, sells coffee and a broad range of espresso drinks
through its own coffeehouses. The Company's objective is to be the leading
national chain of neighborhood coffeehouses serving the best coffee possible. To
complement its beverage sales, the Company sells light food items and whole bean
coffee through its coffeehouses. The Company also sells roasted coffee as well
as coffee brewing and espresso equipment through its wholesale division. As of
July 29, 1998, the Company operated thirty-six coffeehouses and seven coffee
carts located in California, Colorado and Texas.

First Two Quarters. In the first twenty-six weeks of the current fiscal
year the Company experienced losses of approximately $1,507,000 principally
related to an increase in interest expense and general and administrative
expense. The level of general and administrative expense is directly related to
management's commitment to grow the Company through retail coffeehouse
development, new wholesale channels, and franchise area development. Achieving
this goal depends upon, among other things, obtaining and maintaining sufficient
working capital, aggressive growth in the wholesale division, execution of new
store management systems, successful negotiation of franchise area development
agreements and improved store management and customer satisfaction. Pursuant to
the Company's strategic plan, the roasting facility in Denver, Colorado was
closed in the first quarter and the roasting was consolidated in Southern
California. The Company also closed an under-performing store in San Diego and
one in Denver, Colorado. Four coffee cart locations at premium Irvine Office
Company locations were opened in the first quarter. Additional coffee cart
locations are under consideration and in discussion with the Irvine Office
Company and similar commercial property managers, but no assurances can be given
as to when or how many more coffee carts may be installed.

New Executives. On May 20, 1998 the Company announced that Dolf Berle,
former Senior Director of Operations for Tricon Restaurants International had
joined Diedrich Coffee as Vice President of Franchise Development. Mr. Berle
will lead franchise sales for the Company in order to expand Diedrich Coffee
with area developers across the country in accordance with the Company's
business plan. He will oversee all areas of training and development for
franchisees as area development agreements are completed. Mr. Berle will direct
operations and create and implement area developer expansion programs. On July
30, 1998 the Company announced that Catherine Saar, former Vice President of
California-based eyeglass retailer, Frame-n-Lens, had joined Diedrich Coffee as
Vice President, Marketing and Wholesale Sales. Ms. Saar has over 10 years of
retail marketing experience which includes service with Taco Bell International.
With the Company's planned franchise expansion into new markets across the
country Ms. Saar will manage the introduction of the Diedirch Coffee brand in
both the retail and wholesale channels.

Area Development. Management's franchise area development goals are to
enter into fifteen to seventeen franchise area development agreements covering
most major U. S. markets by the end of fiscal year 2000. As of July 29, 1998,
the Company had filed a Uniform Franchise Offering Circular in 32 states which
describes the expected terms of the offered franchises. Although the Company is
engaged in preliminary discussions with potential area developers, there can be
no assurances given as to when or at what rate area development agreements are
entered into. The Company does not anticipate entering into any franchise area
development agreements before the latter half of the fiscal year. Area
development agreements commit the area developer to build and open coffeehouses
in the agreed-upon territory according to an agreed-upon schedule covering
several years. No assurances can be given as to the rate of new coffeehouse
construction, much less related franchise revenues. Successful area development
depends significantly upon the expertise, staff and capital of the area
developer as well as all of the contingencies and uncertainties to which the
Company and its business are subject.

Management plans to continue to develop, over the next five years,
Company-owned coffee houses, kiosks and mobile carts in Orange County,
California and in two to four other major U. S. markets. Outside of Orange
County, Company-owned store development will depend upon franchise area
development revenues and continued growth and improvements in Company operations
and coffee house-level execution.

On April 14, 1998 the Company announced a strategic relationship with
the Franchise Mortgage Acceptance Company ("FMAC") located in Los Angeles. FMAC
stated its willingness to finance, through secured lending, franchise area
developers selected by the Company. FMAC is a leading company in multi-unit
restaurant franchise financing. The Company believes that this relationship will
facilitate the Company's planned program of franchise area development, but no
assurances can be given as to actual financing commitments or the effects of any
such commitment.

Green Coffee Prices. Worldwide coffee commodity prices have moderated
from the record levels reached in the second and third quarters of fiscal 1998.
In the first quarter of fiscal year 1999, however, the Company's cost of green
coffee exceeded prior year levels by approximately 7%, while in the second
quarter the Company cost of green coffee fell below the prior year levels by
approximately 3%. The Company usually pays a premium over the commodity price
for the select grade coffee beans that it purchases. As worldwide demand for
coffee of all types remains strong, the Company expects the prices that it pays
to remain comparatively high into the foreseeable future.

Green Coffee Availability. The Company believes that it has adequate
sources of supply of high quality, green arabica coffee to meet its projected
needs for the foreseeable future. While the Company seeks to carefully
anticipate its green coffee needs, there can be no assurance that supplies and
prices will not be affected by political and social events, the weather in the
coffee growing regions of the world, unexpected demand or other market forces.
Green coffee is an international agricultural commodity product subject to
considerable price fluctuations.

Year 2000 As a component of the Company's comprehensive enterprise
information systems architecture review the Year 2000 problem is being addressed
on a system by system basis. To date the Company has upgraded its general
accounting and fixed assets systems to current releases which are Year 2000
compliant. The general accounting system upgrade was planned prior to the
emergence of the Year 2000 problem as a specific project; the cost of this
upgrade was approximately $30,000. The fixed asset system upgrade was
implemented earlier than originally planned in order to address the Year 2000
problem; the cost of this upgrade was approximately $3,500. The Company is
continuing to review its information technology ("IT") hardware and software for
Year 2000 compliance issues and has identified selected additional required
upgrades that in aggregate are expected to cost less that $20,000; the Company
has not completed its review at this time. The Company has not begun its review
of non-IT systems but expects to do this before the end of the current fiscal
year. The Company believes that the most significant risks associated with Year
2000 compliance exist in its general accounting system (which includes invoicing
and accounts receivable for its wholesale business) and within the systems of
the five banks with whom it maintains depository accounts as well as the credit
card processing services. The Company has not confirmed that these organizations
have Year 2000 compliant systems. The Company has no formal contingency plan at
this time. The Company has not yet determined the extent to which it will
develop a formal contingency plan.

Seasonality and Quarterly Results. The Company's business is subject to
seasonal fluctuations as well as economic trends that affect retailers in
general. Historically, the Company's net sales have not been realized
proportionately in each quarter, with net sales being the highest during the
last fiscal quarter which includes the 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
the Company's control. As a result of these factors, and of the other
contingencies and risk factors described elsewhere in this report, the financial
results for any individual quarter may not be indicative of the results that may
be achieved in a full fiscal year. Due to all of the foregoing and variables,
the Company's future earnings and the market price of the Company's securities
are subject to change. There can be no assurance of when the Company will return
to profitability nor of future growth rate.

RESULTS OF OPERATIONS

Thirteen and Twenty-Six Weeks Ended July 29; 1998 Compared with the Thirteen and
Twenty-Six Weeks Ended July 30, 1997

Net Sales. Net sales for the thirteen weeks ended July 29, 1998
increased 3.8% to $6,030,000 from $5,811,000 for the thirteen weeks ended July
30, 1997. During this most recent quarter, the Company derived 88.6% of net
sales from its retail coffeehouse operations. The Company's wholesale and mail
order sales accounted for the remainder of net sales. Net retail sales for the
thirteen weeks ended July 29, 1998 increased 1.6% to $5,344,000 from $5,259,000
in the thirteen weeks July 30, 1997. As of July 29, 1998, the Company operated
36 coffeehouses and seven carts; as of July 30, 1997, the Company operated 39
coffeehouses and one cart. The percentage decrease in comparable store sales was
(0.1%) during the second quarter of fiscal 1999.

Wholesale and other sales increased 24.3% to $686,000 in the thirteen
weeks ended July 29, 1998 from $552,000 in the thirteen weeks ended July 30,
1997. The increase reflects increasing demand for the Company's wholesale coffee
products and increased sales efforts. Although the Company anticipates continued
improvement in wholesale sales, this depends upon successful marketing of
products produced using the new packaging equipment which the Company acquired
and installed in the second quarter. There can be no assurances that the
anticipated wholesale sales gains will happen.

Net sales for the twenty-six weeks ended July 29, 1998 increased 2.4%
to $11,953,000 from $11,678,000 for the twenty-six weeks ended July 30, 1997.
Net retail sales for the twenty-six weeks ended July 29, 1998 decreased 0.1% to
$10,629,000 from $10,643,000 in the twenty-six weeks July 30, 1997. Wholesale
and other sales for the twenty-six weeks ended July 29, 1998 increased 27.9% to
$1,324,000 from $1,035,000 for the twenty-six weeks ended July 30, 1997. The
percentage increase in comparable store sales was 1.1% for the twenty-six weeks
ended July 29, 1998.

Cost of Sales and Related Occupancy Costs. Cost of roasted coffee,
dairy, food, paper and bar supplies, accessories and clothing (cost of sales)
and rent (related occupancy costs) for the thirteen weeks ended July 29, 1998
decreased to $2,712,000 from $2,861,000 for the thirteen weeks ended July 30,
1997. As a percentage of net sales, cost of sales and related occupancy costs
decreased to 45.0% in the second quarter of fiscal 1999 from 49.2% for the
second quarter of fiscal 1998. This decreased percentage was the result of
average unit volume efficiencies resulting from the closure of low volume
locations, lower green coffee prices as well as purchasing efficiencies. These
more than offset the impact of increased occupancy costs, and an increase in the
percentage of total revenues contributed by wholesale sales.

Cost of sales and related occupancy costs for the twenty-six weeks ended
July 29, 1998 decreased to $5,395,000 from $5,903,000 for the twenty-six weeks
ended July 30, 1997. As a percentage of net sales, costs of sales and related
occupancy costs decreased to 45.1% for the first two quarters in fiscal 1999
from 50.5% for the first two quarters in fiscal 1998. This decrease stems from
lower green coffee prices, the closure of low volume locations, and improved
controls.

Store Operating Expenses. Store operating expenses increased to
$2,273,000 for the thirteen weeks ended July 29, 1998 from $2,127,000 for the
thirteen weeks ended July 30, 1997. As a percentage of retail net sales, store
operating expenses increased to 42.5% in the second quarter of fiscal 1999 from
40.4% in the prior fiscal year's second quarter. For the twenty-six weeks ended
July 29, 1998, store operating expenses, as a percentage of retail net sales,
increased to 42.9% from 42.3% for the twenty-six weeks ended July 30, 1997.
These increases were due to additional management at the coffeehouse level.

Other Operating Expenses. Other operating expenses (those associated
with wholesale and other sales) increased to $147,000 for the second quarter of
fiscal 1999 from $76,000 in the second quarter of fiscal 1998. These expenses,
as a percentage of the net sales from the wholesale division, increased to 21.4%
from 13.7%. As a percentage of net sales these costs should decrease as
wholesale sales increase. For the twenty-six weeks ended July 29, 1998, other
operating expenses, as a percentage of wholesale net sales, increased to 22.3%
from 13.5% for the twenty-six weeks ended July 30, 1998. These increases reflect
the cost of additional management and sales staff recruited to further develop
the sales of the wholesale division.

Depreciation and Amortization. Depreciation and amortization increased
to $461,000 for the thirteen weeks ended July 29, 1998 from $439,000 for the
thirteen weeks ended July 30, 1997. As a percentage of net sales, depreciation
and amortization increased to 7.7% in comparison to 7.6% in the prior year.
Depreciation and amortization increased to $944,000 for the twenty-six weeks
ended July 29, 1998 from $887,000 for the twenty-six weeks ended July 30, 1997.

General and Administrative Expenses. General and administrative expenses
increased to $1,114,000 for the second quarter of fiscal 1999 from $970,000 for
the second quarter of fiscal 1998. As a percentage of net sales, general and
administrative expenses increased to 18.5% from 16.7% due to the addition of
selected resources and personnel in order to implement the Company's business
plan. The Company believes that it will see a reduction in general and
administrative expenses relative to sales over the next several quarters as
revenue flows increase - assuming successful execution of the new business plan.
Similarly, as a percentage of net sales, general and administrative expenses
increased to 17.5% for the twenty-six weeks ended July 29, 1998 from 14.9% for
the twenty-six weeks ended July 30, 1997.

Provision for Store Closings and Restructuring Costs. The restructuring
charge recorded in fiscal 1998 included primarily lease termination and other
costs associated with store closures as well as a provision for the impairment
of long-lived assets in accordance with SFAS No. 121.

Interest Expense. Interest expense increased to $100,000 for the
thirteen weeks ended July 29, 1998 from $22,000 for the thirteen weeks ended
July 30, 1997 reflecting the addition of the $2.5 million in long-term debt and
$500,000 in assets under capital leases.

Loss Before Taxes. Loss before taxes for the thirteen weeks ended July
29, 1998 was $758,000 compared to loss before taxes of $696,000 for the thirteen
weeks ended July 30, 1997. This increased loss was primarily due to increases in
general and administrative costs. Loss before taxes for the twenty-six weeks
ended July 29, 1998 was $1,503,000 compared to a loss before taxes of $6,078,000
for the twenty-six weeks ended July 30, 1997. This change was principally the
result of the restructuring charge taken in the first quarter of fiscal 1998.

LIQUIDITY AND CAPITAL RESOURCES

The Company had working capital deficit of $(549,000) as of July 29,
1998 compared to working capital deficit of $(959,000) as of January 28, 1998.
The current period working capital includes remaining restructuring liabilities
of $138,000. Cash used by operating activities for the twenty-six weeks ended
July 29, 1998 totaled $(828,000).

On April 3, 1998, the Company closed a private placement with Franchise
Mortgage Acceptance Company of Los Angeles, California ("FMAC") of 200,000
shares of Company restricted common stock at a price of $6.375 per share, or
approximately a $1,275,000 equity investment in the Company. In addition to the
private purchase, FMAC also acquired options to purchase restricted shares of
the Company's common stock, 50,000 shares at $10.00 and 50,000 shares at $12.50.
John Martin, Chairman of the Board of the Company, serves as a member of the
Board of Directors of FMAC.

On April 14, 1998 the Company announced FMAC's commitment, subject to
approval of final documentation by the Boards of Directors of both companies, to
make a secured loan of up to $5 million to the Company. When closed in the third
quarter, the proceeds from this transaction will be used to repay the Company's
existing $2.5 million in long-term debt, as well as provide additional working
capital.

The Company believes that cash from operations and the aforementioned
financing activities will be sufficient to satisfy the Company's working capital
needs for the remainder of the fiscal year.

ITEM 3. QUANTITATIVE AND QUALITATIVE
DISCLOSURES ABOUT MARKET RISK

Derivative Instruments. The Company did not invest in market risk
sensitive instruments in fiscal 1998, nor in the first two quarters of 1999.
From time to time, the Company enters into agreements to purchase green coffee
in the future at prices to be determined within two to twelve months of the time
of actual purchase. At July 29, 1998 these commitments totaled $1,491,000. These
agreements are tied to specific market prices (defined by both the origin of the
coffee and the month of delivery) but the Company has significant flexibility in
selecting the date of the market price to be used in each contract. The Company
does not use commodity based financial instruments to hedge coffee or any other
commodity as the Company believes there will continue to be a high probability
of maintaining a strong correlation between increases in green coffee prices and
the final selling prices of the Company's products.

Market Risk. The Company's market risk exposure with regard to financial
instruments is to changes in the "prime rate" in the United States. The Company
borrowed $2,500,000 at the prime rate plus 3 1/2%. At July 29, 1998, a
hypothetical 100 basis point increase in the prime rate would result in
additional interest expense of $25,278 on an annualized basis. At July 29, 1998
the prime rate was 8 1/2%.

The Company does not and has not used derivative financial instruments
for any purpose, including hedging or mitigating interest rate risk.

PART II- OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

In the ordinary course of its business, the Company may become involved
in legal proceedings from time to time. As of September 9, 1998, the Company was
not a party to any material pending legal proceedings.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

The Company's Annual Meeting of Stockholders was held on June 23, 1998
at the Disneyland Hotel in Anaheim, California. John Martin, Tim Ryan, Lawrence
Goelman, Martin Diedrich, Paul Heeschen, and Peter Churm were elected to the
Board of Directors to serve until the next Annual Meeting. In addition to the
election of directors, the stockholders voted upon the following proposition:

Voting was as follows, as recorded and reported by the inspector of
elections:

For the Board of Directors

NAME FOR ABSTAIN OR WITHHELD BROKER NON-VOTES
---- --- ------------------- ----------------

Peter Churm 5,144,202 9,690 ---
Martin R. Diedrich 5,144,202 9,690 ---
Lawrence Goelman 5,144,202 9,690 ---
Paul C. Heeschen 5,143,702 10,190 ---
John E. Martin 5,144,202 9,690 ---
Timothy J. Ryan 5,144,202 9,690 ---

Ratification of the Selection of KPMG Peat Marwick LLP as independent
accountants for the company for the fiscal year ending January 27, 1999.

FOR AGAINST OR WITHHELD ABSTAIN BROKER NON-VOTES
--------- ------------------- ------- ----------------

5,110,602 18,440 24,850 ---

ITEM 5. OTHER INFORMATION

Minimum Advance Notice of Stockholder Proposals. Stockholders of the
Company are advised that the Company must be notified at least 45 days prior to
the month and day of mailing the prior year's proxy statement of any proposal or
solicitation that any stockholder intends to present at the next annual meeting
of stockholders and which the stockholder has not sought to have included in the
Company's Proxy Statement for the meeting in accordance with Rule 14a-8 under
the Securities Exchange Act. If a proponent fails to notify the Company before
the required deadline, management proxies will be allowed to use their
discretionary voting authority when the proposal is raised at the annual
meeting, without any discussion of the matter in the Company's Proxy Statement.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.

(A) EXHIBITS

Set forth below is a list of the exhibits included as part of this
Quarterly Report.

EXHIBIT NO. DESCRIPTION
----------- -----------
3.1 Certificate of Incorporation of the Company (1)
3.2 Bylaws of the Company (1)
10.42 Employment Agreement - Dolf Berle
10.43 Indemnification Agreement - Dolf Berle
10.44 Employment Agreement - Catherine Saar
10.45 Indemnification Agreement - Catherine Saar
27 Financial data schedule

- -------------------
(1) Incorporated by reference to the exhibit of the same number to
the Company's Registration Statement on Form S-1 ( No.
333-08633), as amended, as declared effective by the Securities
and Exchange Commission on September 11, 1996.

(B) REPORTS ON FORM 8-K

None.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.

Dated: September 9, 1998 DIEDRICH COFFEE, INC.

/s/ Timothy J. Ryan
-------------------------------------
Timothy J. Ryan,
President and Chief Executive Officer
(Principal Executive Officer)

/s/ Ann Wride
-------------------------------------
Ann Wride
Vice President and Chief Financial
Officer (Principal Financial and
Accounting Officer)