- ---------------------------------------------------------------------------- - ---------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------- 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 October 28, 1998 OR / / 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 (IRS Employer Identification No.) of Incorporation or Organization) 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 December 1, 1998, there were 5,988,764 shares of common stock of the registrant outstanding. - ---------------------------------------------------------------------------- - ---------------------------------------------------------------------------- DIEDRICH COFFEE, INC. INDEX PART I - FINANCIAL INFORMATION PAGE NO. 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 5 Other Information................................... 15 Item 6 Exhibits and Reports on Form 8-K.................... 15 Signatures.......................................... 16 2 PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS DIEDRICH COFFEE, INC. CONDENSED BALANCE SHEETS OCTOBER 28, 1998 JANUARY 28, 1998 ----------------- ----------------- ASSETS (Note 3) Current Assets: Cash $ 863,730 $ 1,408,161 Accounts receivable 289,131 181,628 Inventories (Note 2) 1,334,488 1,375,119 Prepaid expenses 292,459 157,393 Income taxes receivable 17,686 42,528 ----------------- ----------------- Total current assets 2,797,494 3,164,829 Property and equipment, net 9,388,599 10,104,843 Costs in excess of net assets acquired, net 335,897 389,651 Other assets 270,107 289,103 ----------------- ----------------- Total assets $ 12,792,097 $ 13,948,426 ----------------- ----------------- ----------------- ----------------- LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Current installments of obligations under capital lease $ 169,488 $ 168,139 Accounts payable 1,395,798 1,204,366 Accrued compensation 848,774 716,742 Accrued expenses 1,220,318 1,796,869 Provision for store closings and restructuring costs 124,217 237,320 ----------------- ----------------- Total current liabilities 3,758,595 4,123,436 Obligation under capital lease - long term 306,183 317,292 Long term debt (Note 3) 2,500,000 2,500,000 Deferred rent 200,338 172,231 ----------------- ----------------- Total liabilities 6,765,116 7,112,959 ----------------- ----------------- Stockholders' Equity: (Note 4) Common stock 59,478 57,417 Additional paid-in capital 18,254,247 16,928,546 Accumulated deficit (12,286,744) (10,150,496) ------------------ ------------------ Total stockholders' equity 6,026,981 6,835,457 ----------------- ----------------- Commitments and contingencies Total liabilities and stockholders' equity $ 12,792,097 $ 13,948,426 ----------------- ----------------- ----------------- ----------------- See accompanying notes to financial statements. 3 DIEDRICH COFFEE, INC. CONDENSED STATEMENT OF OPERATIONS (UNAUDITED) THIRTEEN WEEKS THIRTEEN WEEKS THIRTY-NINE WEEKS THIRTY-NINE WEEKS ENDED OCTOBER 28, ENDED OCTOBER 29, ENDED OCTOBER 28, ENDED OCTOBER 29, 1998 1997 1998 1997 ---------------- --------------- ---------------- --------------- Net Sales: Retail $ 5,268,622 $ 4,989,024 $ 15,897,471 $ 15,632,429 Wholesale and other 674,630 573,848 1,998,657 1,608,685 Franchise area development fees 100,000 - 100,000 - ---------------- --------------- ---------------- --------------- Total 6,043,252 5,562,872 17,996,128 17,241,114 ---------------- --------------- ---------------- --------------- Cost and Expenses: Cost of sales and related occupancy costs 2,718,436 2,716,323 8,113,504 8,619,031 Store operating expenses 2,187,605 2,029,491 6,744,513 6,536,446 Other operating expenses 165,595 92,896 460,896 232,985 Depreciation and amortization 490,531 426,778 1,434,105 1,313,294 Provision for store closings and restructuring costs - - - 4,550,068 General and administrative expenses 1,002,556 951,683 3,090,934 2,695,562 ---------------- --------------- ---------------- --------------- Total 6,564,723 6,217,171 19,843,952 23,947,386 ---------------- --------------- ---------------- --------------- Operating loss (521,471) (654,299) (1,847,824) (6,706,272) Interest expense (94,640) (79,954) (291,894) (101,605) Interest and other income 7,280 (4,501) 27,686 (9,258) ---------------- ---------------- ---------------- ---------------- Loss before income taxes (608,831) (738,754) (2,112,032) (6,817,135) Income tax provision - - 3,690 2,890 ---------------- --------------- ---------------- --------------- Net loss (608,831) $ (738,754) (2,115,722) $ (6,820,025) ---------------- --------------- ---------------- --------------- ---------------- --------------- ---------------- --------------- Basic net loss per share: $ (0.10) $ (0.14) $ (0.36) $ (1.27) ---------------- --------------- ---------------- --------------- ---------------- --------------- ---------------- --------------- Diluted net loss per share: $ (0.10) $ (0.14) $ (0.36) $ (1.27) ---------------- --------------- ---------------- --------------- ---------------- --------------- ---------------- --------------- Weighted average shares outstanding 5,944,146 5,391,650 5,895,596 5,391,650 ---------------- --------------- ---------------- --------------- ---------------- --------------- ---------------- --------------- See accompanying notes to financial statements. 4 DIEDRICH COFFEE, INC. CONDENSED STATEMENTS OF CASH FLOWS (UNAUDITED) THIRTY-NINE WEEKS THIRTY-NINE WEEKS ENDED OCTOBER 28, ENDED OCTOBER 29, 1998 1997 ----------------- ----------------- Cash flows from operating activities: Net loss $ (2,115,722) $ (6,820,025) Adjustments to reconcile net loss to cash used in operating activities: Depreciation and amortization 1,434,105 1,313,294 Provision for asset impairment and restructuring costs - 3,903,280 Changes in assets and liabilities: Accounts receivable (107,503) (55,522) Inventories 40,631 45,466 Prepaid expenses (135,066) (335,895 Income taxes receivable 24,842 241,744 Other assets (16,947) 5,124 Accounts payable 191,432 (387,820) Accrued compensation 19,117 (115,363) Accrued expenses (47,660) 214,498 Deferred rent 28,107 5,854 ---------------- ---------------- Net cash used in operating activities (684,664) (1,985,365) ----------------- ---------------- Cash flows from investing activities: Capital expenditures for property and equipment (1,103,116) (1,536,263) Property disposition - - ---------------- ---------------- Net cash used in investing activities $ (1,103,116) $ (1,754,268) ---------------- ---------------- ---------------- ---------------- Cash flows from financing activities: Proceeds from issuance of common stock, net fees paid 1,307,236 - Proceeds from long-term debt - 3,000,000 Payment on capital lease obligation (63,887) - ----------------- ---------------- Net cash provided by financing activities $ 1,243,349 $ 3,000,000 ---------------- ---------------- Net increase (decrease) in cash (544,431) (521,628) ----------------- ----------------- Cash at beginning of period 1,408,161 2,071,904 ---------------- ---------------- Cash at end of period 863,730 $ 1,550,276 ---------------- ---------------- ---------------- ---------------- Supplemental disclosure of cash flow information: Cash paid during the period for: Interest $ 205,950 $ 64,729 ---------------- ---------------- ---------------- ---------------- Income taxes $ 3,690 $ 2,890 ---------------- ---------------- ---------------- ---------------- Non-cash transactions Equipment purchased under capital lease $ 54,127 $ 146,819 ---------------- ---------------- ---------------- ---------------- See accompanying notes to financial statements 5 DIEDRICH COFFEE, INC. NOTES TO CONDENSED FINANCIAL STATEMENTS OCTOBER 28, 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 October 28, 1998 and the results of operations and cash flows for both the thirteen and thirty-nine weeks ended October 28, 1998 and October 29, 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 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities." This pronouncement will require the Company to recognize derivatives on its balance sheet at fair value. Changes in the fair values of derivatives that qualify as cash flow hedges will be recognized in comprehensive income until the hedged item is recognized in earnings. The Company expects that this new standard will not have a significant effect on its results of operations. SFAS No. 133 is effective for fiscal years beginning after June 15, 1999. NET LOSS PER COMMON SHARE The computation of basic earnings per share in accordance with Statement of Financial Accounting Standard ("SFAS") No. 128, "Earnings Per Share" is based on the weighted average number of common shares outstanding during the periods presented. All periods presented have been calculated in accordance with SFAS No. 128. 2. INVENTORIES Inventories consist of the following: OCTOBER 28, 1998 JANUARY 28, 1998 ---------------- ---------------- Green coffee (raw materials) $ 449,568 $ 535,885 Roasted coffee (finished goods) 134,909 67,965 Accessory and specialty items 215,153 230,502 Other food, beverage and supplies 534,858 540,767 ---------- ---------- $1,334,488 $1,375,119 ---------- ---------- ---------- ---------- 6 DIEDRICH COFFEE, INC. NOTES TO CONDENSED FINANCIAL STATEMENTS OCTOBER 28, 1998 (UNAUDITED) 3. DEBT Long-term debt consists of the following: OCTOBER 28, 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. 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 Trust loans to pay off and discharge outstanding indebtedness. 7 DIEDRICH COFFEE, INC. NOTES TO CONDENSED FINANCIAL STATEMENTS OCTOBER 28, 1998 (UNAUDITED) 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. On April 14, 1998 the Company announced the commitment of Franchise Mortgage Acceptance Company ("FMAC") to make a secured loan of up to $5 million to the Company. After extensive discussions, the Company determined that the structure required by FMAC was not in the Company's best interest. In anticipation of this possible outcome, the Company engaged an investment banker in November 1998 to seek alternative sources of capital. The Company is currently operating at a net cash deficit and, in addition to working with the investment bankers, is pursuing alternative sources of capital. Management believes that one or more of these sources will be in place by the end of the current fiscal year. 4. STOCKHOLDERS' EQUITY On April 25, 1997, the Company's Board of Directors approved the 1997 Non-Employee Directors 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 ("Martin Option Agreement"). 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. 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 Directors 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. 8 DIEDRICH COFFEE, INC. NOTES TO CONDENSED FINANCIAL STATEMENTS OCTOBER 28, 1998 (UNAUDITED) 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. On September 22, 1998, 6,140 shares of common stock were issued pursuant to the exercise of certain Boston Group warrants. On October 28, 1998 , 18.382 shares of common stock were issued pursuant to the exercise of certain options granted under the Company's 1996 Stock Incentive Plan. Subsequently to the end of the quarter an additional 15,120 shares of common stock were issued pursuant to the exercise of certain Boston Group warrants and 7,472 shares of common stock were issued pursuant to the exercise of options granted under the Company's 1996 Stock Incentive Plan. 9 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 October 28, 1998, the Company operated thirty-six coffeehouses and seven coffee carts located in California, Colorado and Texas. FIRST THREE QUARTERS. In the first thirty-nine weeks of the current fiscal year the Company experienced losses of approximately $2.1 million 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. 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. On September 16, 1998 the Company announced its first franchise area development agreement which calls for the development of 44 coffeehouses and an undisclosed number of carts and kiosks in the state of North Carolina over a five year period. In connection with the signing this agreement the Company recorded area development fee income of $100,000. On November 16, 1998 the Company announced its second franchise area development agreement which provides for the development of 50 coffeehouses and an undisclosed number of carts and kiosks in San Diego, Palm Springs and Temecula, California over the next five years. 10 Although the Company is engaged in discussions with potential additional area developers, there can be no assurances given as to when or at what rate area development agreements are entered into. 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 the commitment of Franchise Mortgage Acceptance Company ("FMAC") to make a secured loan of up to $5 million to the Company. After extensive discussions, the Company determined that the structure required by FMAC was not in the Company's best interest. In anticipation of this possible outcome, the Company engaged an investment banker in November 1998 to seek alternative sources of capital. The Company is currently operating at a net cash deficit and, in addition to working with the investment bankers, is pursuing alternative sources of capital. Management believes that one or more of these sources will be in place by the end of the current fiscal year. 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 and third quarters the Company's cost of green coffee fell below the prior year levels by approximately 8% on a year to date basis. 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. 11 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 its future growth rate. RESULTS OF OPERATIONS THIRTEEN AND THIRTY-NINE WEEKS ENDED OCTOBER 28, 1998 COMPARED WITH THE THIRTEEN AND THIRTY-NINE WEEKS ENDED OCTOBER 29, 1997 NET SALES. Net sales for the thirteen weeks ended October 28, 1998 increased 8.6% to $6,043,000 from $5,563,000 for the thirteen weeks ended October 29, 1997. During this most recent quarter, the Company derived 87.2% of net sales from its retail coffeehouse operations. The Company's wholesale and mail order sales accounted for 11.2% of net sales and franchise area development fees accounted for 1.7% of net sales. Net retail sales for the thirteen weeks ended October 28, 1998 increased 5.6% to $5,269,000 from $4,989,000 in the thirteen weeks October 29, 1997. As of October 28, 1998, the Company operated 36 coffeehouses and seven carts; as of October 29, 1997, the Company operated 36 coffeehouses and one cart. The percentage increase in comparable store sales was 1.3% during the third quarter of fiscal 1999. Wholesale and other sales increased 17.6% to $675,000 in the thirteen weeks ended October 28, 1998 from $574,000 in the thirteen weeks ended October 29, 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 thirty-nine weeks ended October 28, 1998 increased 4.4% to $17,996,000 from $17,241,000 for the thirty-nine weeks ended October 29, 1997. Net retail sales for the thirty-nine weeks ended October 28, 1998 increased 1.7% to $15,897,000 from $15,632,000 in the thirty-nine weeks October 29, 1997. Wholesale and other sales for the thirty-nine weeks ended October 28, 1998 increased 24.2% to $1,999,000 from $1,609,000 for the thirty-nine weeks ended October 29, 1997. The percentage increase in comparable store sales was 1.1% for the thirty-nine weeks ended October 28, 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 October 28, 1998 increased to $2,718,000 from $2,716,000 for the thirteen weeks ended October 29, 1997. As a percentage of net sales, cost of sales and related occupancy costs decreased to 44.9% in the third quarter of fiscal 1999 from 48.8% for the third 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 and the addition of franchise area development revenues. 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 thirty-nine weeks ended October 28, 1998 decreased to $8,114,000 from $8,619,000 for the thirty-nine weeks ended October 29, 1997. As a percentage of net sales, costs of sales and related occupancy costs decreased to 45.1% for the first three quarters in fiscal 1999 from 50.0% for the first three quarters in fiscal 1998. This decrease stems from lower green coffee prices, the closure of low volume locations, and improved controls. 12 STORE OPERATING EXPENSES. Store operating expenses increased to $2,188,000 for the thirteen weeks ended October 28, 1998 from $2,029,000 for the thirteen weeks ended October 29, 1997. As a percentage of retail net sales, store operating expenses increased to 41.5% in the third quarter of fiscal 1999 from 40.7% in the prior fiscal year's third quarter. For the thirty-nine weeks ended October 28, 1998, store operating expenses, as a percentage of retail net sales, increased to 42.4% from 41.8% for the thirty-nine weeks ended October 29, 1997. These increases were due to additional management and related expenses at the coffeehouse level. OTHER OPERATING EXPENSES. Other operating expenses (those associated with wholesale and other sales) increased to $166,000 for the third quarter of fiscal 1999 from $93,000 in the third quarter of fiscal 1998. These expenses, as a percentage of the net sales from the wholesale division, increased to 24.5% from 16.2%. For the thirty-nine weeks ended October 28, 1998, other operating expenses, as a percentage of wholesale net sales, increased to 23.1% from 14.5% for the thirty-nine weeks ended October 29, 1997. These increases reflect the cost of additional management and sales staff recruited to further develop the sales of the wholesale division. As a percentage of net sales these costs should decrease as wholesale sales increase DEPRECIATION AND AMORTIZATION. Depreciation and amortization increased to $491,000 for the thirteen weeks ended October 28, 1998 from $427,000 for the thirteen weeks ended October 29, 1997. As a percentage of net sales, depreciation and amortization increased to 8.1% in comparison to 7.7% in the prior year. Depreciation and amortization increased to $1,434,000 for the thirty-nine weeks ended October 28, 1998 from $1,313,000 for the thirty-nine weeks ended October 29, 1997. GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses increased to $1,003,000 for the third quarter of fiscal 1999 from $952,000 for the third quarter of fiscal 1998. As a percentage of net sales, general and administrative expenses decreased to 16.6% from 17.1%. The Company believes that it will continue to 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. As a percentage of net sales, general and administrative expenses increased to 17.2% for the thirty-nine weeks ended October 28, 1998 from 15.6% for the thirty-nine weeks ended October 29, 1997 due to the ongoing costs associated with the management resources added in the fourth quarter of fiscal 1998 and the first half of fiscal 1999. 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 $87,000 for the thirteen weeks ended October 28, 1998 from $84,000 for the thirteen weeks ended October 29, 1997. For the thirty-nine weeks ended October 28, 1998 interest and other increased to $264,000 from $111,000 for the thirty-nine weeks ended October 29, 1997; this increase resulted from the addition of the $2.5 million in long-term debt and $553,000 in assets under capital leases. LOSS BEFORE TAXES. Loss before taxes for the thirteen weeks ended October 28, 1998 was $609,000 compared to loss before taxes of $739,000 for the thirteen weeks ended October 29, 1997. This decreased loss was primarily due to franchise area development income and improved retail operating margins. Loss before taxes for the thirty-nine weeks ended October 28, 1998 was $2,112,000 compared to a loss before taxes of $6,820,000 for the thirty-nine weeks ended October 29, 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 $(961,000) as of October 28, 1998 compared to working capital deficit of $(959,000) as of January 28, 1998. The current period working capital includes remaining restructuring liabilities of $124,000. Cash used by operating activities for the thirty-nine weeks ended October 28, 1998 totaled $(685,000). 13 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 the commitment of Franchise Mortgage Acceptance Company ("FMAC") to make a secured loan of up to $5 million to the Company. After extensive discussions, the Company determined that the structure required by FMAC was not in the Company's best interest. In anticipation of this possible outcome, the Company engaged an investment banker in November 1998 to seek alternative sources of capital. The Company is currently operating at a net cash deficit and, in addition to working with the investment bankers, is pursuing alternative sources of capital. Management believes that one or more of these sources will be in place by the end of the current fiscal year. The Company believes that cash from operations and the aforementioned financing activities will be sufficient to satisfy the Company's working capital needs through fiscal year 2000. 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 October 28, 1998 these commitments totaled $559,000. 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 October 28, 1998 the prime rate was 8%. The Company does not and has not used derivative financial instruments for any purpose, including hedging or mitigating interest rate risk. 14 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 December 1, 1998, the Company was not a party to any material pending legal proceedings. 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) 10.46 Form of Franchise Agreement 10.47 Form of Area Development Agreement 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. 15 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: December 10, 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) 16