Overview

We are a leading fast-casual restaurant chain, specializing in high-quality foods for breakfast and lunch in a café atmosphere with a neighborhood emphasis. As of January 2, 2007, we own and operate, franchise or license 598 restaurants in 36 states and the District of Columbia, primarily under the Einstein Bros., Noah's and Manhattan brands. Einstein Bros. is a national fast-casual restaurant chain. Noah's is a regional fast-casual restaurant chain operated exclusively on the West Coast and Manhattan is a regional fast casual chain operated predominantly in the Northeast. Our product offerings include fresh bagels and other goods baked on-site, made-to-order sandwiches on a variety of bagels and breads, gourmet soups and salads, decadent desserts, premium coffees and other café beverages. Our manufacturing and commissary operations prepare and assemble consistent, high-quality ingredients and we deliver them to our restaurants quickly and efficiently through our network of independent distributors. These operations support our main business focus, restaurant operations, by exposing our brands to new product channels as well as enabling sales of our products to third parties.

We commenced operations as an operator and franchisor of coffee cafes in 1993. Substantial growth in our restaurant counts occurred through a series of acquisitions. In 1998, we acquired the stock of Manhattan Bagel Company. In 1999, we acquired the assets of Chesapeake Bagel Bakery. Our largest acquisition was in 2001 when we acquired substantially all the assets of Einstein/Noah Bagel Corp. in an auction conducted by the bankruptcy court. To consummate this acquisition, we engaged in several rounds of financing that included the issuance of $165 million of debt and $65 million of mandatorily redeemable preferred stock. In mid-2003, we recapitalized our balance sheets with the issuance of $160 million of indentures and the issuance of $57 million of mandatorily redeemable preferred stock. In late 2003, we replaced several members of the former senior management team with our current management team. This team focused on our core business, the operation of company-owned restaurants and the improvements necessary to generate positive operating income and cash flow. In early 2006, based on our improved financial condition and favorable market conditions, we redeemed the $160 million indenture and replaced it with our current debt structure.

Current Restaurant Base

As of January 2, 2007, we own and operate, franchise or license 598 locations. Our current base of company-owned restaurants includes 341 Einstein Bros. locations and 73 Noah's locations. Also, we franchise 80 Manhattan locations and franchise/license 93 Einstein Bros. locations and 3 Noah's locations.

Our company-owned restaurants vary in their unit volume, profitability and recent comparable store sales performance. As of January 2, 2007, we have 153 restaurants that generate an AUV in excess of $900,000. These restaurants have an AUV of approximately $1.1 million and an average gross profit of $0.3 million. In the aggregate, these restaurants contribute approximately 44.8% of total restaurant sales and 61.4% of total gross profit. Since 2003, as part of our efforts to improve financial performance, we completed a thorough evaluation of our restaurant base. At the end of 2003, we had 736 restaurants across 33 states and the District of Columbia. Since that time, we have closed 51 company-owned restaurants and 140 franchised and licensed restaurants. Most of our closed company-owned restaurants were either located in inferior real estate locations, had an AUV below $600,000 or were unprofitable or marginally profitable. Substantially all of the franchises that closed either:

º •
º Involved the failure of the franchisee to conform with the requirements of the franchise agreement;

º •
º Were geographically located outside Manhattan's core market; or

º •
º Were restaurants operating under our non-core brands, Chesapeake Bagel Bakery and New World Coffee.

                                 Fiscal 2006                          Fiscal 2005                          Fiscal 2004
                      ----------------------------------   ----------------------------------   ----------------------------------
                       Number of       Net       Gross      Number of       Net       Gross      Number of       Net       Gross
Sales Level:          Restaurants    Revenue     Profit    Restaurants    Revenue     Profit    Restaurants    Revenue     Profit
-------------------   -----------   ---------   --------   -----------   ---------   --------   -----------   ---------   --------
greater than $1,000            97   $ 116,000   $ 33,500            81   $  96,700   $ 27,000            60   $  70,000   $ 18,700
$1,000-$900                    58   $  55,000   $ 12,700            53   $  50,100   $ 11,200            35   $  33,300   $  7,900
$900-$800                      74   $  62,700   $ 12,400            78   $  66,300   $ 12,600            68   $  57,700   $ 11,500
$800-$700                      73   $  55,200   $  9,300            83   $  62,400   $  9,700            89   $  66,900   $ 11,100
$700-$600                      70   $  45,400   $  5,800            82   $  52,700   $  5,900            98   $  63,800   $  7,800
less than $600                 37   $  19,900   $  1,000            54   $  28,100   $    800            95   $  49,600   $  2,600
                      -----------   ---------   --------   -----------   ---------   --------   -----------   ---------   --------
Totals                        409   $ 354,200   $ 74,700           431   $ 356,300   $ 67,200           445   $ 341,300   $ 59,600
                      -----------   ---------   --------   -----------   ---------   --------   -----------   ---------   --------

As of January 2, 2007, we have identified approximately 25 company-owned restaurants that we anticipate closing over the next three years as their leases expire. Generally, these restaurants have an AUV of approximately $550,000 or less and contribute negligible cash flow.

We have recently implemented a number of brand enhancement initiatives in an effort to drive sales and improve profitability. Elements of this plan include quality service checklists at all restaurants, secret shopper inspections, improved ordering systems and enhanced training programs. The implementation of these initiatives has led to our returning to a trend of positive comparable stores sales over the past nine quarters, which reversed a two-year negative trend. In addition, we have started to rollout our remodel program at restaurants where we have the opportunity to improve sales. The remodel program is intended to enhance our guests' experience and increase the speed of service while maintaining the neighborhood feel of the restaurants. We are remodeling our Einstein Bros. restaurants based on sales volume, demographic traits and the related cost of the remodel. Only those restaurants that offer the potential for a superior return on investment are considered for the remodel program. During 2006, we remodeled 23 restaurants at a total cost of $1.6 million.

New Restaurant Openings

Using the knowledge gained from our remodel program, we plan to pursue a measured approach to new company-owned restaurant openings. During 2004, 2005 and 2006, we opened 4, 4 and 5 new company-owned restaurants, respectively. Our ability to open new restaurants during those years was limited by the capital expenditure restrictions of the debt agreements in place at that time. Our current plan is to open new company-owned restaurants in existing markets where we have an established brand name and where existing restaurants are producing average AUVs of $900,000 or greater. Within each market, we consider several factors including: traffic patterns, demographic and psychographic characteristics within a five minute drive time, competition in the trade area and projected growth around the proposed site.

In 2007, we plan to open a total of 10 to 15 new company-owned restaurants in markets where we believe sales at these restaurants will exceed our current AUV. For Einstein Bros., we have targeted the Atlanta, Chicago, Las Vegas, Phoenix, and various cities in Florida for development. For Noah's, we intend to focus our development efforts on Portland, Seattle and various cities in California. We are also in the process of identifying new restaurant sites for 2008 to ensure that we achieve our development goals.

Our Sources of Revenue

The components of our revenue are restaurant sales, manufacturing and commissary revenue and franchise and license revenue.

Company-Owned Restaurant Sales

Over 93% of our revenue is generated by restaurant sales at our Einstein Bros. and Noah's company-owned restaurants. Restaurant sales also include catering sales where the food is prepared at the restaurant and either delivered to or held for pick-up by the guest. The principal factors that affect our restaurant sales in the aggregate are:

º •
º the number of restaurants in operation for the period,

º •
º the AUV of the restaurants, and

º •
º the change in comparable store sales.

In addition to AUV, we measure the change in comparable store sales on a weekly basis. The majority of our growth in comparable store sales has been through an increase in our average check. This increase has been achieved through a combination of multiple initiatives including: system-wide price increases, regional price increases in markets with a higher cost of living and suggestive selling by our restaurant personnel to add-on higher priced items.

Manufacturing and Commissary Revenue

Approximately 5% of our 2006 total revenue was generated by our manufacturing and commissary operations. Our manufacturing revenue is primarily derived from the sale of frozen bagel dough to our franchisees, licensees and third party accounts. Our commissaries generate revenue from the sale of sliced meats (turkey, ham and beef), dairy products (cheese), and pre-portioned salad kits to our licensees. Additionally, our commissaries sell bagels, cream cheese, salad toppers and salads through various supplier relationships, typically with conventional grocery stores as the end user. These products are sold either through a private label program or under the Einstein Bros. or Noah's brand.

The principal factors affecting manufacturing and commissary revenue are:

º •
º the number of franchised and licensed restaurants that purchase frozen bagel dough and commissary products from us,

º •
º sales of our products in existing franchised and licensed restaurants, and

º •
º sales to third parties, including conventional grocery chains and warehouse clubs.

Franchise and License Revenue

Franchise and license revenue consists of a license or franchise fee at the inception of the agreement and ongoing royalty payments based on a percentage of the restaurant's sales. For 2006, we generated approximately 2% of our total revenue from these fees. The principal factors affecting franchise and license revenue are the number of franchised and licensed restaurants as well as the level of sales at those restaurants.

Our Primary Expenses

Company-Owned Restaurant Expenses

Food, Beverage and Packaging Costs

Food, beverage and packaging costs represent one of the largest expense elements at our company-owned restaurants. The most important factor that affects the cost of these products is the underlying cost of the agricultural commodities such as flour, cheese, coffee, turkey and other products. In order to mitigate the impact of rising commodity costs, our suppliers enter into agreements to fix the cost of these products for a specified period of time that is generally one year or less. We do not engage in the practice of buying futures contracts and therefore we do not have derivative accounting. Packaging and distribution costs are primarily affected by the cost of oil because petroleum-based material is often used to package products for distribution. Although we have generally been able to increase our retail prices at our company-owned restaurants to offset the increased costs of these items, we may not be able to do this in the future.

Compared to 2006, we expect most of our food costs that are commodity based to remain relatively stable or increase slightly during 2007. Flour represents the most significant raw ingredient we purchase and we believe several factors related to wheat and corn production appear to be improving for 2007. During 2006 when the cost of oil was significant, the demand for ethanol (a corn-based product) increased, effectively driving demand and placing upward pressure on corn prices. As a result, many farmers rotated to corn crops rather than soy. This has the potential effect of driving prices for corn down and trends in the wheat market generally follow. In addition, demand for the international export of wheat has lessened. Currently, analysts are projecting strong winter wheat crops, which will help to lessen price pressures. However, there can be no assurance that all of the aforementioned factors will occur or that we will even benefit from a decline in the cost of commodity based products we purchase.

Most of the fresh produce that we purchase, such as lettuce and tomatoes, is subject to normal market fluctuations. We purchase predominantly all of our orange juice from a single supplier, which has production in two regions, Arizona and Florida. During 2006 when citrus orchards in California experienced adverse weather conditions, our supplier mitigated risk with their dual sourcing of production. Accordingly, while the cost of oranges and orange-related products is generally increasing by approximately 30%, we expect that our cost for orange juice will remain relatively flat compared to 2006.

In late 2006, we negotiated contract terms with two new distribution partners. In early 2007, these new partners began delivering products to our company-owned, franchise and license restaurants in the respective geographic regions. We believe the new partners will provide a higher level of services at a lower cost for our company-owned restaurants. However, there is no assurance that the new distributor will perform as we expect, or that their cost structure will provide for the cost savings that we anticipate.

Compensation Costs

Compensation costs reflect the hourly wages, salary, bonus, taxes and insurance that we pay our associates at each restaurant. Compensation costs tend to vary by geographic region based upon the labor market, local minimum wages, and the supply and demand of workers. Also, compensation costs tend to be semi-variable in nature and increase or decrease somewhat based upon the volume of products sold.

There is significant competition for personnel and limited availability in the labor pool. In most of the states in which we operate, we are aware of increases in state minimum hourly wage rates that became effective January 1, 2007. Accordingly, we anticipate increases in hourly wages during 2007. We continue to make improvements in labor efficiencies that may help to offset a portion of the increases in labor costs.

Other Operating Costs

Other operating costs consist of utilities, restaurant and other supplies, repairs and maintenance, laundry and uniforms, bank charges and other costs related to the operation of company-owned restaurants. Certain of these costs generally tend to be fixed in nature and are only modestly impacted by changes in the volume of products sold. Utilities, distribution costs and other expenses impacted by fuel price fluctuations are not fixed and are contingent upon contract rates negotiated by third parties outside of our control. Many of our contracts are re-priced quarterly based on the prior quarter's market fluctuations resulting in a delayed effect upon on operating costs. During 2005 and part of 2006, we experienced increases in the cost for oil and accordingly, our distribution partners and common freight carriers passed on fuel surcharges to us. Currently, the cost of a barrel of oil has decreased as compared to the average cost in 2006. During periods of uncertainty and significant market fluctuations, we cannot be certain of the impact on our future operating results. If we are unable to leverage cost increases with operating efficiencies or price increases, it may negatively impact our operating results. Conversely, decreases in fuel prices will positively impact our utilities, distribution costs and other related expenses.

Other operating costs also include rent, common area costs, property taxes and insurance, liability insurance, delivery fees and allocated marketing expenses. We exclude depreciation and amortization expense from company-owned restaurant expenses. Changes in these costs are generally the result of changes in our rent and other related facility costs. Accordingly, these costs are predominantly fixed in nature and are modestly impacted by changes in the volume of products sold.

Certain states and local governments have increased both the rate and nature of taxes on businesses in their regions. These increased taxes include real estate and property taxes, state and local income taxes, and various employment taxes.

Manufacturing and Commissary Costs

Manufacturing costs are comprised of raw materials such as flour, dairy products and meats, compensation costs and the related taxes and employee benefits, rents, supplies and repairs and maintenance. These costs are directly related to the manufacturing revenue they produce. Some of the raw materials used are commodity based products and are subject to the same market fluctuations previously mentioned. Operating results from our manufacturing operations represents third-party sales and can be significantly impacted by fixed overhead costs such as rent, utilities, property taxes and manager salaries and fluctuating commodity costs.

General and Administrative Expenses

General and administrative expenses include corporate and administrative functions that support our company-owned restaurants as well as our manufacturing and franchise and license operations. These costs include employee wages, taxes and related benefits, travel costs, information systems, recruiting and training costs, corporate rent, and general insurance costs.

Depreciation and Amortization

Depreciation and amortization are periodic non-cash charges that represent the reduction in usefulness and value of our tangible and intangible assets. The majority of our depreciation and amortization relates to equipment and leasehold improvements located in our company-owned restaurants. Based on our current purchases of capital assets, our existing base of assets, and our projections for new purchases of fixed assets, we believe our annual rate of depreciation expense will approximate $12 million to $15 million during 2007.

           Results of Operations for Fiscal Years 2006, 2005 and 2004

                            For the years ended:              % Increase /               For the years ended:
                          (in thousands of dollars)            (Decrease)             (percent of total revenue)
                      ---------------------------------   ---------------------    --------------------------------
                                                                          2005
                        2006        2005        2004         2006          vs.       2006        2005        2004
                      (52 wks)    (53 wks)    (52 wks)     vs. 2005       2004     (52 wks)    (53 wks)    (52 wks)
                      ---------   ---------   ---------   -----------     -----    --------    --------    --------
Revenues:
  Restaurant sales      363,699     363,044     347,786           0.2 %     4.4 %      93.3 %      93.3 %      93.0 %
  Manufacturing
  revenues               20,299      20,118      20,122           0.9 %    (0.0 )%      5.2 %       5.2 %       5.4 %
  Franchise and
  license related
  revenues                5,964       5,931       5,952           0.6 %    (0.4 )%      1.5 %       1.5 %       1.6 %
                      ---------   ---------   ---------   -----------     -----    --------    --------    --------
Total revenues          389,962     389,093     373,860           0.2 %     4.1 %     100.0 %     100.0 %     100.0 %
Cost of sales
(percentage of
corresponding
revenue stream):
  Restaurant costs      290,176     296,610     288,736          (2.2 )%    2.7 %      79.8 %      81.7 %      83.0 %
  Manufacturing
  costs                  21,154      18,781      17,925          12.6 %     4.8 %     104.2 %      93.4 %      89.1 %
                      ---------   ---------   ---------   -----------     -----    --------    --------    --------
Total cost of sales     311,330     315,391     306,661          (1.3 )%    2.8 %      79.8 %      81.1 %      82.0 %
Gross profit
(percentage of
corresponding
revenue stream):
  Restaurant             73,523      66,434      59,050          10.7 %    12.5 %      20.2 %      18.3 %      17.0 %
  Manufacturing            (855 )     1,337       2,197        (163.9 )%  (39.1 )%     (4.2 )%      6.6 %      10.9 %
  Franchise and
  license                 5,964       5,931       5,952           0.6 %    (0.4 )%    100.0 %     100.0 %     100.0 %
                      ---------   ---------   ---------   -----------     -----    --------    --------    --------
Total gross profit       78,632      73,702      67,199           6.7 %     9.7 %      20.2 %      18.9 %      18.0 %
General and
administrative
expenses                 37,484      36,096      32,755           3.8 %    10.2 %       9.6 %       9.3 %       8.8 %
Depreciation and
amortization             16,949      26,316      27,848         (35.6 )%   (5.5 )%      4.3 %       6.8 %       7.4 %
Loss on sale,
disposal or
abandonment of
assets, net                 493         314       1,557          57.0 %   (79.8 )%      0.1 %       0.1 %       0.4 %
Charges
(adjustments) of
integration and
reorganization cost           -           5        (869 )           *         *         0.0 %       0.0 %      (0.2 )%
Impairment charges
and other related
costs                     2,268       1,603         450             *         *         0.6 %       0.4 %       0.1 %
                      ---------   ---------   ---------   -----------     -----    --------    --------    --------
Income from
operations               21,438       9,368       5,458         128.8 %    71.6 %       5.5 %       2.4 %       1.5 %
Other expense
(income):
  Interest expense,
  net                    19,555      23,698      23,196         (17.5 )%    2.2 %       5.0 %       6.1 %       6.2 %
  Prepayment
  penalty upon
  redemption of
  $160 Million
  Notes                   4,800           -           -             *         *         1.2 %       0.0 %       0.0 %
  Write-off of debt
  issuance costs
  upon redemption
  of $160 Million
  Notes                   3,956           -           -             *         *         1.0 %       0.0 %       0.0 %
  Other                      (5 )      (312 )      (284 )       (98.4 )%    9.9 %      (0.0 )%     (0.1 )%     (0.1 )%
                      ---------   ---------   ---------   -----------     -----    --------    --------    --------
Loss before income
taxes                    (6,868 )   (14,018 )   (17,454 )       (51.0 )%  (19.7 )%     (1.8 )%     (3.6 )%     (4.7 )%
Benefit for state
income taxes                  -           -         (49 )           *         *         0.0 %       0.0 %      (0.0 )%
                      ---------   ---------   ---------   -----------     -----    --------    --------    --------
Net loss              $  (6,868 ) $ (14,018 ) $ (17,405 )       (51.0 )%  (19.5 )%     (1.8 )%     (3.6 )%     (4.7 )%
                      ---------   ---------   ---------   -----------     -----    --------    --------    --------


--------------------------------------------------------------------------------
   º *
   º not meaningful

Restaurant Operations

We have a 52/53-week fiscal year ending on the Tuesday closest to December 31. Fiscal years 2006 and 2004, which ended on January 2, 2007 and December 28, 2004, respectively, contained 52 weeks, while fiscal year 2005, which ended on January 3, 2006, contained 53 weeks.

While our comparable store sales for 2006 were slightly better than the overall industry, our restaurant sales were below our expectations. Restaurant sales for 2006 improved 0.2% when compared to 2005. Our 2006 restaurant sales increased 1.9% when calculated on a comparative 52-week basis for both fiscal 2006 and 2005. Our 2006 comparable store sales increase of 4.5% consisted of a 6.9% increase in average check partially offset by a 2.2% reduction in transactions. The increase in average check was related to a system-wide price increase, a slight shift in product mix to higher priced items, and suggestive selling techniques for our Bros. Blenders™, "Sweeten the Deal" bundling offer and our "Hate to Wait" promotion (a pre-packaged baker's dozen of bagels with cream cheese). We continue to see growth in markets in which we offer catering by our company-owned restaurants. Our catering business contributed 0.9% of the increase to our comparable store sales.

Comparable store sales represent sales at restaurants open for one full year that have not been relocated or closed during the current year. Comparable store sales include company-owned restaurants only and represent the change in period-over-period sales for the comparable restaurant base. A restaurant becomes comparable in its 12th full month of operation. Comparable store sales are also referred to as "same-store" sales or as "comp sales" within the restaurant industry.

Comparable store sales for each quarter in fiscal 2006, 2005 and 2004 are as follows:

                               Fiscal 2006   Fiscal 2005   Fiscal 2004
                               -----------   -----------   -----------
              First Quarter            6.2 %         4.6 %        (4.8 )%
              Second Quarter           3.6 %         6.3 %        (3.7 )%
              Third Quarter            3.2 %         6.0 %        (1.6 )%
              Fourth Quarter           4.7 %         3.9 %         2.6 %

Our restaurant gross profit increased $7.1 million, or 10.7%, in 2006 compared to the 2005 period, which included an extra week of revenue and costs. Our restaurant margins are impacted by various restaurant-level operating and non-operating expenses such as the cost of products sold, salaries and benefits, insurance, supplies, repair and maintenance expenses, advertising, rent, utilities and property taxes. Because certain elements of cost of sales such as rent, utilities, property taxes and manager salaries are fixed in nature, incremental sales positively impact gross profit. Depreciation, amortization and income taxes do not impact our restaurant contribution margins.

. . .