Summary of MEXICAN RESTAURANTS INC

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Certain statements set forth below under this caption constitute "forward-looking statements" within the meaning of the Reform Act. See "Special Note Regarding Forward-Looking Statements" above for additional factors relating to such statements. The following discussion and analysis should be read in conjunction with the other sections of this Annual report on Form 10-K, including the Company's Consolidated Financial Statements and Notes thereto appearing elsewhere in this Report. Additional information concerning factors that could cause results to differ materially from those in any forward-looking statements is contained under "Item 1A. Risk Factors".

General Overview

The Company was organized under the laws of the State of Texas in February 1996. Through our subsidiaries, we operate and franchise Mexican-theme restaurants featuring various elements associated with the casual dining experience under the names Casa Olé, Monterey's Tex-Mex Café, Monterey's Little Mexico, Tortuga Coastal Cantina, Crazy Jose's and La Señorita. We also operate fast casual burrito restaurants under the name Mission Burrito. At December 28, 2008 we operated 61 restaurants, franchised 18 restaurants and licensed one restaurant in various communities in Texas, Louisiana, Oklahoma and Michigan.

Our primary source of revenues is the sale of food and beverages at Company-owned restaurants. We also derive revenues from franchise fees, royalties and other franchise-related activities. Franchise fee revenue from an individual franchise sale is recognized when all services relating to the sale have been performed and the restaurant has commenced operation. Initial franchise fees relating to area franchise sales are recognized ratably in proportion to services that are required to be performed pursuant to the area franchise or development agreements and proportionately as the restaurants within the area are opened.

The consolidated statements of operations and cash flows for fiscal years 2007 and 2006 have been adjusted to remove the operations of closed restaurants, which have been reclassified as discontinued operations. There were no discontinued operations in 2008.

Fiscal Year

We have a 52/53 week fiscal year ending on the Sunday nearest December
31. References in this Report to fiscal 2008, 2007 and 2006 relate to the periods ended December 28, 2008, December 30, 2007, and December 31, 2006, respectively. Fiscal years 2008, 2007 and 2006, presented herein consisted of 52 weeks.

Results of Operations

Fiscal Year 2008 Compared to Fiscal Year 2007 as Adjusted for Discontinued Operations

Revenues. Our revenues for the fiscal year ended December 28, 2008 were down $221,131 or 0.3% to $81.9 million compared with fiscal year 2007. Restaurant sales for fiscal year 2008 decreased $465,227 or 0.6% to $80.9 million compared with fiscal year 2007. We lost approximately $1.15 million in restaurant sales from the impact of Hurricanes Gustav and Ike. Restaurant sales were also impacted by approximately $900,000 due to restaurant fires at two stores. The decrease also reflects the sale of the Stafford, Texas Casa Olé restaurant in July of 2007. An increase in same-store sales partially offset the above mentioned decreases, along with the addition of four Mission Burrito fast casual restaurants. For the 52-week period ended December 28, 2008, excluding the lost sales from the hurricanes and fires from the same-store sales comparison (only stores open in both periods are included in same-store sales amounts), Company-owned same-restaurant sales increased approximately 1.5%. The same-store sales trend prior to the two hurricanes was up 0.3%. Franchised-owned same-restaurant sales, as reported by franchisees, and reflecting the lost hurricane sales, increased approximately 1.2% over the same 52-week period ended December 28, 2008.

Franchise fees, royalties and other for the fiscal year ended December 28, 2008 was down $73,621 or 10.4% to $636,773 compared with fiscal year 2007 because other miscellaneous revenues of a nonrecurring nature were realized in fiscal year 2007.

In fiscal year 2008, we recorded $317,717 of business interruption proceeds related to claims for two restaurant fires and Hurricane Ike store closures.

Costs and Expenses. Costs of sales, consisting of food, beverage, liquor, supplies and paper costs, increased 50 basis points as a percent of restaurant sales to 29.2% compared with 28.7% in fiscal year 2007. The increase primarily reflects higher commodity prices, especially cheese, produce, tortillas, supplies and paper costs, and higher food discounts to customers. In March and again in September of 2008, we raised menu prices at most of the concepts in an effort to offset some of the rise in commodity costs.

Labor and other related expenses increased as a percentage of restaurant sales 20 basis points to 32.7% compared with 32.5% for fiscal year 2007. Higher group health insurance expense impacted restaurant labor 10 basis points. Hourly back-of-house labor and management costs increased 60 basis points, primarily due to lost sales from Hurricanes Gustav and Ike, while hourly front-of-house labor improved 50 basis points during fiscal year 2008.

Restaurant operating expenses, which primarily includes rent, property taxes, utilities, repair and maintenance, liquor taxes, property insurance, general liability insurance and advertising, increased in fiscal year 2008 as a percentage of restaurant sales 10 basis points to 24.8% as compared with 24.7% in fiscal year 2007. The increase primarily reflects a lower level of sales due to Hurricanes Gustav and Ike. Electricity and natural gas costs also increased. Favorable electricity contracts on approximately 60% of our restaurants expired in August of 2008, resulting in higher electric costs per kilowatt hour thereafter. We have signed short-term, three-month contracts until such time management believes that a lower, longer term contract can be obtained. The price of electricity in Texas is primarily tied to the price of natural gas, which has been on a downward trend over the last three months. These increases were partially offset by lower advertising expense, as we pulled commercial advertising immediately after Hurricane Ike and during the 2008 presidential campaign season.

General and administrative expenses consist of expenses associated with corporate and administrative functions that support restaurant operations. General and administrative expenses increased 20 basis points as a percentage of total sales to 9.3% compared with 9.1% for fiscal year 2007. The increase, as a percentage of total revenue, reflects, in part, a lower level of sales due to Hurricanes Gustav and Ike. Actual general and administrative expenses increased $167,908 in fiscal year 2008 compared with fiscal year 2007. The increase primarily reflects higher relocation expense, banking fees, legal expenses, consulting fees related to marketing for Mission Burrito concept development, and consulting fees related to Sarbanes-Oxley compliance, all of which were partially offset by reductions in general and administrative salaries and bonuses, and lower manager-in-training expenses.

Depreciation and amortization expenses include the depreciation of fixed assets and the amortization of other assets. Depreciation and amortization expense increased as a percentage of total revenues 20 basis points to 4.4% in fiscal year 2008 as compared with 4.2% in fiscal year 2007. Actual depreciation and amortization expense increased $150,405 in fiscal year 2008 compared with fiscal year 2007. The increase reflects additional depreciation expense for remodeled restaurants, new restaurants, and the replacement of equipment and leasehold improvements in various existing restaurants.

During fiscal year 2008, we incurred $166,655 in pre-opening expenses related to the opening of four new Mission Burrito restaurants. In fiscal year 2007, we spent $23,947 in pre-opening expenses related to the re-opening of remodeled restaurants.

Goodwill Impairment. Goodwill represents the excess of costs over fair value of assets of businesses acquired. We adopted the provisions of SFAS No. 142, "Goodwill and Other Intangible Assets", as of January 1, 2002. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but instead tested for impairment at least annually in accordance with the provisions of SFAS No.
142. At year end 2008, management determined that the fair value did not exceed the carrying amount of the reporting unit and recorded an impairment of approximately $5.1 million.

Impairment and Restaurant Closure Costs. In accordance with Statement of Financial Accounting Standards No. 144, "Accounting for the Impairments or Disposal of Long-Lived Assets", long-lived assets, such as property, plant and equipment, and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset.

During fiscal year 2008, we expensed $773,789 to impair the assets of one closed restaurant, one under-performing restaurant earmarked for closure once its lease expires in fiscal year 2009 and two other under-performing restaurants, and for broker commissions related to two subleased restaurant sites in Idaho. During fiscal year 2007, we expensed $99,978 to impair the assets of two under-performing restaurants.

Gain on Involuntary Disposals The consolidated statements of operations for the period ended December 28, 2008 includes a separate line item for gain on involuntary disposals which includes a gain of $685,137 resulting primarily from the write-off of assets damaged by two restaurant fires, offset by insurance proceeds for the replacement of assets. The first fire occurred on February 19, 2008 at our Casa Olé restaurant located in Vidor, Texas which re-opened July 7, 2008. The second fire occurred July 28, 2008 at our Casa Olé restaurant located in Pasadena, Texas which re-opened October 25, 2008. The gain on involuntary disposals was partially offset by losses from Hurricanes Gustav and Ike. We recorded net losses of $60,991 resulting primarily from spoiled inventory caused by temporary electricity outages at 35 Company-owned restaurants after Hurricane Ike made landfall on September 13, 2008.

During fiscal year 2008, our insurers have paid $739,969 and we have recorded a receivable of $241,757 related to property damage. We have spent $1,167,418 as of December 28, 2008 for the replacement of assets related to the two fires and the two hurricanes.

The consolidated statements of operations for period ended December 28, 2008 includes a separate line item for revenues for business interruption insurance proceeds as follows: $248,717 related to the two restaurant fires and $69,000 related to the hurricanes.

Loss on Sale of Other Property and Equipment. During fiscal year ended December 28, 2008, we recorded losses of $206,447 primarily related to the disposal of restaurant assets during the conversion of an existing restaurant into a Mission Burrito restaurant.

Other Income (Expense). Net expense decreased $54,950 to $387,851 in fiscal year 2008 compared with a net expense of $442,801 in fiscal year 2007. Interest expense decreased $72,109 to $427,742 in fiscal year 2008 compared with interest expense of $499,851 in fiscal year 2007, reflecting a decrease in interest rates.

Income Tax Expense. Our effective tax rate from continuing operations for fiscal year 2008 was a benefit of 26.89% as compared to 14.8% of expense for fiscal year 2007. In fiscal year 2008, we had a pretax net loss from continuing operations compared to pretax net income in fiscal year 2007. We recorded a receivable of approximately $128,000 in 2008 for an expected income tax refund for carrying back the 2008 net operating loss to an amended 2006 income tax return. The permanent differences in 2008 were approximately $1.5 million higher as compared to the permanent differences in 2007 because of the goodwill impairment. Since the tax deduction for goodwill is limited to its net tax value, the difference between the net tax value and net book value contributed to the decrease in the effective tax rate. Certain other permanent differences result in tax credits. In fiscal year 2008, we were not able to use any of our current year tax credits, but tax credits of $291,383 can be carried forward for a twenty year period to reduce future federal regular income taxes.

Discontinued Operations. During the fiscal year ended December 28, 2008, we recorded closure income of $46,226, all of which is included in discontinued operations. The closure income related to the revision by management of the estimated repair and maintenance costs, utility costs and property taxes associated with restaurants closed in prior years and actual repairs performed in third quarter 2008. No stores were permanently closed in fiscal year 2008.

Fiscal Year 2007 Compared to Fiscal Year 2006 as Adjusted for Discontinued Operations

Revenues. Our revenues for the fiscal year ended December 30, 2007 were up $400,537 or 0.5% to $82.1 million compared with fiscal year 2006. Restaurant sales for fiscal year 2007 increased $574,879 or 0.7% to $81.4 million compared with fiscal year 2006. The increase in restaurant sales reflects the full year impact of one restaurant opened in fiscal year 2006 and the acquisition of Mission Burrito (two restaurants), offset in part by a 1.8% decline in same-restaurant sales.

Franchise fees, royalties and other for the fiscal year ended December 30, 2007 was down $114,721 or 13.9% to $710,394 compared with fiscal year 2006. Fiscal year 2006 included the recognition of $80,000 in royalties due to a correction of understated royalty income over the 16 previous quarters. For the fiscal year 2007, franchised-owned same-store sales, as reported by franchisees, increased approximately 2.97%.

In fiscal year 2006, we recorded $59,621 of business interruption proceeds related to our Hurricane Rita insurance claim.

Costs and Expenses. Costs of sales, consisting of food, beverage, liquor, supplies and paper costs, increased 120 basis points as a percent of restaurant sales to 28.7% compared with 27.5% in fiscal year 2006. The increase primarily reflects higher commodity prices, especially produce, cheese and dry goods. The increase also reflects a one time adjustment of $100,000 to cost of sales to correct for rebates we mistakenly recorded as our own that should have been paid to franchisees.

Labor and other related expenses increased as a percentage of restaurant sales 20 basis points to 32.5% compared with 32.3% for fiscal year 2006. The increase primarily reflects the lingering impact of the first quarter of fiscal year 2007, which had labor cost of 33.7%, reflecting hourly labor that wasn't scheduled in proportion to declining same-restaurant sales. Since the first quarter of 2007, labor cost improved to 32.0% in the second quarter, 32.5% in the third quarter and 31.7% in the fourth quarter. Since the first quarter, labor utilization improvements were approximately the same for all three quarters. The second quarter benefited from a one time adjustment to worker's compensation insurance and unemployment tax adjustments related to a policy audit and a refund due to excess funding from the State of Texas Workforce Commission.

Depreciation and amortization expenses include the depreciation of fixed assets and the amortization of other assets. Depreciation and amortization expense increased as a percentage of total revenues 40 basis points to 4.2% in fiscal year 2007 as compared with 3.8% in fiscal year 2006. Actual depreciation and amortization expense increased $315,720 in fiscal year 2007 compared with fiscal year 2006. The increase reflects additional depreciation expense for remodeled restaurants, new restaurants, and the replacement of equipment and leasehold improvements in various existing restaurants.

During fiscal year 2007, we incurred $23,947 in pre-opening expenses related to the reopening of a remodeled restaurant. In fiscal year 2006, we spent $108,847 in pre-opening expenses related to the opening of two new restaurants.

Impairment costs. In accordance with Statement of Financial Accounting Standards No. 144, "Accounting for the Impairments or Disposal of Long-Lived Assets", long-lived assets, such as property, plant, and equipment, and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset.

During fiscal year 2007, we expensed $99,978 to impair the assets of two under-performing restaurants. During fiscal year 2006, we expensed $447,903 to impair the assets of two under-performing restaurants. We also expensed real estate broker commissions related to the sale of one subleased restaurant and for future broker commissions related to two other subleased restaurants.

Gain on Disposal of Assets - Hurricane Rita. On September 24, 2005, Hurricane Rita hit the Gulf Coast area, affecting a number of our restaurants in that region. We subsequently hired an insurance consulting firm to assist management with the filing of our insurance claim. During the second quarter of 2006, we finalized negotiations with our insurance carrier for the hurricane insurance claim. Also, during fiscal year 2006, we capitalized $511,236 in asset cost expenditures related to damaged property in the consolidated balance sheets, and recognized in the consolidated statement of operations $366,808 as a gain and $59,621 as business interruption revenue from the insurance claim. As of December 31, 2006, we have collected all receivables related to our hurricane insurance claim.

Loss on Sale of Other Property and Equipment. During fiscal year 2007, we recorded a loss on the sale of assets of $207,517, reflecting the loss from two remodeled restaurants and from the sale of one under-performing restaurant to Mr. Forehand, Vice Chairman of the Company, who purchased the assets of our Casa Olé restaurant located in Stafford, Texas for an agreed price of 26,806 shares of our common stock. The stock was valued at $8.14 per share, which was the ten-day weighted average stock price as of June 12, 2007, for a total value of $218,205. The Stafford restaurant operates under our uniform franchise agreement and is subject to a monthly royalty fee. During fiscal year 2006, we recorded a loss of $29,591 due to the disposition of miscellaneous assets.

Other Expense. Net expense increased $139,487 to $442,801 in fiscal year 2007 compared with a net expense of $303,314 in fiscal year 2006. Interest expense increased $109,312 to $499,851 in fiscal year 2007 compared with interest expense of $390,539 in fiscal year 2006, reflecting an increase in outstanding debt.

Income Tax Expense. Our effective tax rate from continuing operations for fiscal year 2007 was 14.8% as compared to 31.3% for fiscal year 2006. In fiscal year 2007, we had significantly lower pretax income from continuing operations compared to fiscal year 2006. In both years, the permanent differences were approximately the same, resulting in the lower effective tax rate in fiscal year 2007. Certain permanent differences result in tax credits. In fiscal year 2007, we were not able to use all of our current year tax credits, but tax credits of $268,386 can be carried forward for an indefinite period to reduce future federal regular income taxes.

Discontinued Operations. In fiscal year 2007, we closed one under-performing restaurant in February, 2007 after its lease expired incurring losses from discontinued operations, net of taxes, of $106,622 pursuant to Statement of Financial Accounting Standards No. 146, "Accounting for Costs Associated with Exit or Disposal Activities". In fiscal year 2006, we closed four underperforming restaurants incurring losses from discontinued operations, net of taxes, of $840,804.

The circumstances and testing leading to an impairment charge were determined in accordance with SFAS No. 144 which requires that property and equipment be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. See "Notes to Consolidated Financial Statements, Footnotes (1) 'Description of Business and Summary of Significant Accounting Policies' and (10) 'Related Party Transactions'."

Liquidity and Capital Resources

We financed our capital expenditure requirements for the fiscal year ended December 28, 2008 primarily by drawing on our revolving line of credit and drawing on our cash reserves. In fiscal year 2008, we had cash flow provided by operating activities of approximately $3.0 million, compared with cash flow provided by operating activities of approximately $3.7 million in fiscal year 2007 and cash flow provided by operating activities of approximately $5.0 million in fiscal year 2006. The decrease in cash flows from operating activities reflects the decrease in operating income, primarily due to the impact of Hurricanes Gustav and Ike during the third quarter of fiscal year 2008. During fiscal year 2008, we made a net draw of $1.1 million on our line of credit, $1 million of which related directly to the impact of Hurricanes Gustav and Ike. During fiscal year 2007, financing activities provided $1.0 million, in which $3.1 million was drawn from our lines of credit with $1.6 million used for the July 2007 purchase of 200,000 shares of our common stock and $0.5 million used for the prepayment of the Beaumont-based franchise restaurant seller note. As of December 28, 2008, we had a working capital deficit of $846,905 compared with a working capital deficit of $911,023 at December 30, 2007 and $1.9 million at December 31, 2006. A working capital deficit is common in the restaurant industry, since restaurant companies do not typically require a significant investment in either accounts receivable or inventory.

Our principal capital requirements are the funding of routine capital expenditures, new restaurant development or acquisitions and remodeling of older units. During fiscal year 2008, total cash used for capital requirements was approximately $5.3 million, which included approximately $1.8 million spent for routine capital expenditures, approximately $2.2 million for new restaurant development, approximately $0.9 million spent to reconstruct two restaurants damaged by fires, approximately $0.3 million to reconstruct from hurricane damage, and approximately $0.1 million spent on remodels. We opened four Mission Burrito restaurants during fiscal year 2008, for a total of six Mission Burrito restaurants. We closed one Mission Burrito restaurant on January 24, 2009 after seven months of operations. We attribute the closure to a poor real estate location. We expect to begin construction on our seventh Mission Burrito restaurant in the second quarter of fiscal year 2009. Due to the recent economic downturn and the impact of Hurricanes Gustav and Ike, we do not expect to enter into any further lease obligations to develop Mission Burrito restaurants for fiscal year 2009. We plan to resume our development of Mission Burrito in fiscal year 2010 and beyond.

In June 2007, the Company entered into a Credit Agreement (the "Wells Fargo Agreement") with Wells Fargo Bank, N.A. ("Wells Fargo") in order to increase the revolving loan amount available to us from $7.5 million under our then-existing credit facility with Bank of America to $10 million. In connection with the execution of the Wells Fargo Agreement, we prepaid and terminated our then-existing credit facility with Bank of America. The Wells Fargo Agreement provides for a revolving loan of up to $10 million, with an option to increase the revolving loan by an additional $5 million, for a total of $15 million. The Wells Fargo Agreement terminates on June 29, 2010. At our option, the revolving loan bears an interest rate equal to the Wells Fargo Base Rate plus a stipulated percentage or LIBOR plus a stipulated percentage. Accordingly, the Company is impacted by changes in the Base Rate and LIBOR. We are subject to a non-use fee of 0.50% on the unused portion of the revolver from the date of the Wells Fargo Agreement. The Wells Fargo Agreement also allows up to $2.0 million in annual stock repurchases. We have pledged the stock of our subsidiaries, our leasehold interests, our patents and trademarks and our furniture, fixtures and equipment as collateral for our credit facility with Wells Fargo. As of December 28, 2008, total debt outstanding under the Wells Fargo Agreement was $7.5 million.

Under the Wells Fargo Agreement, we are required to maintain certain minimum EBITDA levels, leverage ratios and fixed charge coverage ratios. Due to the impact of Hurricanes Gustav and Ike in the third quarter of fiscal year 2008, which resulted in approximately $1.15 million in lost sales, we increased our debt by $1.0 million to $7.5 million. As a result of the lost sales, we failed to satisfy our minimum EBITDA covenant under the Wells Fargo agreement for the twelve month period as of the third quarter of fiscal year 2008. We requested and received from Wells Fargo a waiver to this covenant. We received an amendment to the agreement effective as of December 28, 2008, eliminating the minimum EBITDA requirement and adding limits on our growth capital expenditures.

Although the Wells Fargo Agreement permits us to implement a share repurchase program under certain conditions, we currently have no repurchase program in effect. Shares previously acquired are being held for general corporate purposes, including the offset of the dilutive effect on shareholders from the exercise of stock options.

Our management believes that with our operating cash flow and our revolving line of credit under the Wells Fargo Agreement, funds will be sufficient to meet operating requirements and to finance routine capital expenditures and new . . .