Summary of MEXICAN RESTAURANTS INC

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

Special Note Regarding Forward-Looking Statements

This Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Such factors include, among others, the following: national, regional or local economic and real estate conditions; inflation; increased food, labor and benefit costs; growth strategy; dependence on executive officers; geographic concentration; increasing susceptibility to adverse conditions in the region; changes in consumer tastes and eating and discretionary spending habits; the risk of food-borne illness; demographic trends; inclement weather; traffic patterns; the type, number and location of competing restaurants; the availability of experienced management and hourly employees; seasonality and the timing of new restaurant openings; changes in governmental regulations; dram shop exposure; and other factors not yet experienced by the Company. The use of words such as "believes", "anticipates", "expects", "intends" and similar expressions are intended to identify forward-looking statements, but are not the exclusive means of identifying such statements. Readers are urged to carefully review and consider the various disclosures made by us in this report and in our most recently filed Annual Report and Form 10-K that attempt to advise readers of the risks and factors that may affect our business. We undertake no obligation to update any such statements or publicly announce any updates or revisions to any of the forward-looking statements contained herein, to reflect any change in our expectations with regard thereto or any change in events, conditions, circumstances or assumptions underlying such statements.

General

We operate and franchise Mexican-theme restaurants featuring various elements associated with the casual dining experience under the names Casa Olé, Monterey's Little Mexico, Tortuga Coastal Cantina, Crazy Jose's and Mission Burrito. On April 7, 2009, we sold our La Senorita chain in order to focus our resources on our other store brands. At June 28, 2009 we operated 54 restaurants, franchised 17 restaurants and licensed two restaurants in various communities in Texas, Louisiana and Oklahoma.

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 with respect to our franchised restaurants. 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 operations. Initial franchise fees relating to area franchise sales are recognized ratably in proportion to the 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.

Over the last five years, we have focused our growth and development efforts primarily upon assimilating two significant acquisitions (13 restaurants purchased in 2004 from a franchisee and two Mission Burrito restaurants, and related concept rights, acquired in 2006), developing new prototypes for our Casa Olé, Monterey's and Mission Burrito restaurant concepts and initiating a program whereby we remodel several of our existing restaurants each year.

Results of Operations

Revenues. Our revenues for the second quarter of fiscal year 2009 decreased $636,048 or 3.4% to $18.3 million compared with $19.0 million for the same quarter in fiscal year 2008. Restaurant sales for second quarter 2009 decreased by $609,296 or 3.3% to $18.1 million compared with $18.7 million for the second quarter of 2008. The decrease in restaurant revenues primarily reflects a decrease in same-store sales, partially offset by new restaurants revenues. For the second quarter ended June 28, 2009, Company-owned same-restaurant sales decreased approximately 6.6%, caused by a weakening economy. Franchised-owned same-restaurant sales, as reported by franchisees, decreased approximately 1.2% over the same quarter in fiscal 2008.

On a year-to-date basis, the Company's revenue decreased $16,850 to $37.5 million compared with the same 26-week period in fiscal 2008. Restaurant sales for the 26-week period ended June 28, 2009 increased $6,703 to $37.1 million compared with the same 26-week period in fiscal 2008. The flat sales primarily reflects a decline in same-store sales mostly offset by the re-opening of one restaurant that was closed last year due to fire damage and one new Mission Burrito restaurant. For the 26-week period ended June 28, 2009, Company-owned same-restaurant sales decreased approximately 2.8% and franchised-owned same-restaurant sales, as reported by franchisees, increased approximately 0.2% over the same quarter in fiscal 2008.

Costs and Expenses. Costs of sales, consisting of food, beverage, liquor, supplies and paper costs, was 29.1% as a percentage of restaurant sales for the second quarter of both fiscal years 2009 and 2008. Dairy and cheese costs declined in the 2009 second quarter as a percentage of restaurant sales by 100 basis points, but was offset by higher costs in all other categories.

On a year-to-date basis, costs of sales decreased as a percent of restaurant sales 40 basis points to 28.3% compared with 28.7% for the same 26-week period a year ago. Dairy and cheese declined as a percentage of restaurant sales in this period by 100 basis points; dry goods declined 21 basis points; meat and poultry was even with last year and all other categories were higher than the same period a year ago.

Labor and other related expenses increased as a percentage of restaurant sales 60 basis points to 33.4% as compared with 32.8% in the second quarter of fiscal year 2008. The increase reflects labor cost leverage that is lost when same-store sales decline; for example, both management labor and back of the house labor, which are semi-fixed in nature, increased as a percentage of sales due to the decline in sales.

On a year-to-date basis, labor and other related expenses increased as a percentage of restaurant sales 50 basis points to 32.8% compared with 32.3% for the 26-week period a year ago. Again, the increase primarily reflects labor cost leverage that is lost when same-store sales decline. Further, the 26-week period in fiscal year 2008 included a credit adjustment to group health insurance.

Restaurant operating expenses, which primarily include rent, property taxes, utilities, repair and maintenance, liquor taxes, property insurance, general liability insurance and advertising, increased as a percentage of restaurant sales 130 basis points to 25.0% as compared with 23.7% in the second quarter of fiscal year 2008. On a year-to-date basis, restaurant operating expenses increased 70 basis points to 25.1% compared with 24.4% for the 26-week period in fiscal year 2008. The increase primarily reflects higher coupon expense, repair and maintenance expense and semi-fixed costs, such as occupancy costs and insurance costs, reflecting the loss of leverage from declining same-store sales.

General and administrative expenses consist of expenses associated with corporate and administrative functions that support restaurant operations. As a percentage of total revenue, general and administrative expenses decreased 10 basis points to 8.9% for the second quarter of fiscal year 2009 as compared with 9.0% for the second quarter of fiscal year 2008. On a year-to-date basis, general and administrative expenses decreased 100 basis points to 8.9% compared with the 26-week period of fiscal 2008. In absolute dollars, general and administrative costs decreased $70,240 and $377,574 in the 13-week and 26-week periods of fiscal year 2009, respectively, compared with the same periods of fiscal year 2008. General and administrative expenses as a percentage of total revenues decreased due to the planned reduction in salaries, bonuses and most department expenses.

Depreciation and amortization expenses include the depreciation of fixed assets and the amortization of intangible assets. Depreciation and amortization expense increased as a percentage of total sales 50 basis points to 4.8% for the second quarter of fiscal year 2009 as compared with 4.3% the same quarter in fiscal year 2008. Such expense for the second quarter of fiscal year 2009 was $73,455 higher than the second quarter in fiscal year 2008. The increase reflects additional depreciation expense for remodeled restaurants, new restaurants, and the replacement of equipment and leasehold improvements in various existing restaurants.

On a year-to-date basis, depreciation and amortization expenses increased as a percentage of total sales 40 basis points to 4.7% for the 26-week period of fiscal year 2009 as compared with 4.3% the same 26-week period in fiscal year 2008, or $143,305 higher than the same 26-week period in fiscal year 2008. The increase was due to the reasons discussed above.

During the second quarter ended June 28, 2009, we did not open any new restaurants or incur any pre-opening costs. During the second quarter of fiscal year 2008, we re-opened one restaurant that had been closed for repairs due to a fire, incurring $10,427 in pre-opening costs.

Impairment and Restaurant Closure Costs. In accordance with SFAS No. 144, "Accounting for the Impairments or Disposal of Long-Lived Assets", long-lived assets, such as property 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.

The consolidated statements of operations for the 13-week and 26-week periods ended June 28, 2009, include a separate line item for impairment and restaurant closure costs of $214,778 and $237,231, respectively. The impairments and closure costs were primarily related to rent differential adjustments for two subleased restaurants located in Idaho, and to a lesser extent, two under-performing restaurants operating in the Houston area. The consolidated statements of operations for the 13-week and 26-week periods ended June 29, 2008, include a separate line item for impairment and restaurant closure costs of $22,577 and $54,829, respectively. The impairments and closure costs were primarily related to the same two under-performing restaurants.

Gain on Involuntary Disposals. The consolidated statements of operations for the 13-week and 26-week periods ended June 28, 2009 include a separate line item for a loss of $15,028 and $7,797, respectively. The losses resulted from costs related to our Hurricane Ike insurance claim, partially offset by insurance proceeds received for the replacement of assets. We anticipate finalizing all insurance claims related to the property damage from last year's hurricane during fiscal year 2009. The consolidated statements of operations for the 13-week and 26-week periods ended June 29, 2008 includes a separate line item for a gain of $149,338 and $275,709, respectively, resulting from the write-off of assets damaged by the February 2008 fire at the Company's Casa Olé restaurant located in Vidor, Texas, offset by insurance proceeds for the replacement of assets. The claim related to the Vidor fire has been fully settled with the insurance company.

The consolidated statements of operations for the 13-week and 26-week periods ended June 28, 2009 include a separate line item for revenues for business interruption insurance proceeds of $103,528 related to a partial payment of $75,000 for our Hurricane Ike claim combined with additional proceeds of $28,528 related to the final payment for the claim related to the July 2008 fire at the Company's Casa Olé restaurant located in Pasadena, Texas. The consolidated statements of operations for the 13-week and 26-week periods ended June 29, 2008 include a separate line item for revenues for business interruption insurance proceeds of $121,192 related to the February 2008 fire at the Company's Vidor, Texas Casa Olé restaurant.

Loss on Sale of Other Property and Equipment. The consolidated statements of operations for the 13-week periods ended June 28, 2009 and June 29, 2008 include a separate line item for loss on sale of other property and equipment of $36,934 and $14,663, respectively, primarily related to the routine disposal of restaurant assets. The consolidated statements of operations for the 26-week periods ended June 28, 2009 and June 29, 2008 include a separate line item for loss on sale of other property and equipment of $73,696 and $41,670, respectively, primarily related to the routine disposal of restaurant assets.

Other Income (Expense). Net expense decreased $48,301 to $32,434 in the 13-week period ended June 28, 2009 compared with a net expense of $80,735 in the 13-week period ended June 29, 2008. Interest expense decreased $48,771 to $42,918 in the 13-week period ended June 28, 2009 compared with interest expense of $91,689 in the 13-week period ended June 29, 2008. The decrease in interest expense reflects lower interest rates and lower average debt balances during the second quarter of fiscal year 2009 as compared to the second quarter of fiscal year 2008. Net expense decreased $129,698 to $83,146 in the 26-week period ending June 28, 2009 compared with a net expense of $212,844 in the 26-week period ended June 29, 2008. Interest expense decreased $128,101 to $105,111 in the 26-week period ended June 28, 2009 compared with interest expense of $233,212 in the 26-week period ended June 29, 2008. The decrease in interest expense reflects lower interest rates and lower average debt balances during the first half of fiscal year 2009 as compared to the first half of fiscal year 2008.

Income Taxes. The Company's effective tax rate from continuing operations for the 13-week period ended June 28, 2009 was a benefit of 20.00% as compared to an expense of 22.3% for the 13-week period ended June 29, 2008. The Company's effective tax rate from continuing operations for the 26-week period ended June 28, 2009 was an expense of 12.2% as compared to an expense of 22.8% for the 26-week period ended June 29, 2008. The decrease in the effective rate is attributed primarily to permanent differences related to the sale of our La Senorita chain in Michigan. The Company's effective tax rate from discontinued operations for the 13-week period ended June 28, 2009 was an expense of 87.4% as compared to an expense of 22.3% for the 13-week period ended June 29, 2008. The Company's effective tax rate from discontinued operations for the 26-week period ended June 28, 2009 was an expense of 121.4% as compared to an expense of 22.8% for the 26-week period ended June 29, 2008. The increase in the effective rate is attributed to income tax expense related to the sale of our La Senorita chain in Michigan in addition to a capital loss generated related to the La Senorita sale that has been fully reserved.

Discontinued Operations. On April 7, 2009, we sold substantially all of the operating assets and liabilities of our La Senorita restaurant chain (consisting of five site locations) located in Michigan for $2,557,603 as adjusted under the terms of the purchase agreement. We recorded a gain on this sale of $387,083, net of allocated goodwill, in the second quarter of 2009. Proceeds from the sale were used to pay down long-term debt. On January 24, 2009, we closed one underperforming Mission Burrito restaurant. In accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", the results of operations for the current and prior periods for the La Senorita chain and the closed Mission Burrito restaurant have been reported as discontinued operations. For the 13-week and 26-week periods ended June 28, 2009, we recognized net income from discontinued operations of $347,278 and $231,582, respectively, from the sale of the chain and the closure of the Mission Burrito restaurant. Loss from discontinued operations of $39,436 during the 13-week period ended June 28, 2009 reflects operating losses from the La Senorita restaurants. Income from discontinued operations of $36,021 during the 26-week period ended June 28, 2009 reflects operating income from the La Senorita restaurants, partially offset by operating losses from the closed Mission Burrito restaurant. Restaurant closure costs of $190,941, for the 26-week period ending June 28, 2009, primarily reflect costs associated with the closure of the Mission Burrito restaurant. Gain on sale of assets of $387,083 and $386,502 during the 13-week and 26-week periods ended June 28, 2009 resulted primarily from the sale of La Senorita.

Also in accordance with SFAS No. 144, the assets and liabilities related to the sale of the La Senorita chain that were sold have been classified as held for sale in the consolidated balance sheet as of December 28, 2008. The assets and liabilities of the Mission Burrito restaurant and certain assets and liabilities of La Senorita that were not sold have been classified as related to discontinued operations. We plan to use the furniture and equipment from the closed Mission Burrito restaurant at our new Mission Burrito restaurant that we will open later this year. Current liabilities related to discontinued operations of the closed Mission Burrito restaurant include estimated lease obligations and are included with current portion of liabilities associated with leasing and exit activities.

Liquidity and Capital Resources

We financed our capital expenditure requirements for the 26-week period ended June 28, 2009 primarily from our operating cash flows. In the initial 26-week period of fiscal year 2009, we had cash flows provided by operating activities of $1.6 million, compared with cash flows provided by operating activities of $1.3 million in the comparable 26-week period of fiscal year 2008. The increase in cash flows from operating activities reflects the receipt of insurance receivables related to last year's hurricanes and the Pasadena, Texas restaurant fire. During the 26-week period ended June 28, 2009, we made draws of $600,000 and payments of $3,250,000 on our line of credit. Proceeds from the sale of La Senorita contributed to the amount paid on the line of credit. As of June 28, 2009, we had a working capital deficit of $810,367 compared with a working capital deficit (excluding assets held for sale) of $1,023,766 at December 28, 2008. 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 the 26-week period ended June 28, 2009, total cash used for capital requirements was $1,682,393 with $1,667,143 used in continuing operations and $15,250 used in discontinued operations. Total cash used for capital requirements included $1,340,344 spent for routine capital expenditures, $115,250 for new restaurant development, $83,437 for replacement of damaged assets and $143,362 for remodels. We did not open any new restaurants during the first and second quarters of fiscal year 2009. We started construction on our sixth Mission Burrito restaurant during the second quarter of 2009. We anticipate that we will spend approximately $1.2 million for capital expenditures during the remainder of fiscal year 2009.

We entered into a Credit Agreement with Wells Fargo Bank, N.A. ("Wells Fargo") in June 2007 (the "Wells Fargo Agreement"). Originally, the Wells Fargo Agreement provided for a revolving loan of up to $10 million, but the Wells Fargo Agreement was amended effective December 28, 2008, reducing the revolving loan by the amount of the net proceeds received from the sale of La Senorita, which reduced the revolver availability to approximately $7.3 million on April 7, 2009. Effective June 28, 2009, the Wells Fargo Agreement was further amended primarily to extend the maturity date from June 29, 2010 to June 29, 2012. The June 2009 amendment to the Wells Fargo Agreement also increased the stipulated percentages payable in connection with London Interbank Offered Rate ("LIBOR") loans and letters of credit under the Wells Fargo Agreement, added as a condition precedent to loans made to the Company for growth capital expenditures that the Company's total leverage ratio not exceed certain stated amounts, and amended certain financial covenants.

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, we are 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.

Although the Wells Fargo Agreement permits us to implement a share repurchase program for up to $2.0 million annually under certain conditions, we currently have no repurchase programs 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.

On April 7, 2009, we sold substantially all of the operating assets and liabilities of our La Senorita restaurant chain (consisting of five site locations) located in Michigan for an adjusted price of $2.6 million. Proceeds from the sale were used to pay down long-term debt. We recorded a gain on the sale of La Senorita of $387,083 in the second quarter of 2009.

Our management believes that with its operating cash flows 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 restaurant growth through the next 12 months. Unless we violate a debt covenant, our credit facility with Wells Fargo, as amended, is not subject to triggering events that would cause the credit facility to become due sooner than the maturity date described in the previous paragraphs. As of June 28, 2009, the Company was in compliance with all debt covenants and as of the date hereof expects to be in compliance with its debt covenants during the next 12 months.