Summary of PEETS COFFEE & TEA INC

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

You should read the following discussion and analysis in conjunction with our financial statements and related notes included elsewhere in this report. Except for historical information, the discussion in this report contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. In some cases, you can identify forward-looking statements by terminology, such as "may," "should," "could," "predict," "potential," "continue," "expect," "anticipate," "future," "intend," "plan," "believe," "estimate," "forecast" and similar expressions (or the negative of such expressions). The forward-looking statements in this Form 10-Q include, but are not limited to, statements regarding our expectations for the growth of the specialty coffee industry; our planned geographic expansion of our retail presence; our plans to open new retail stores; our plans to expand into new grocery markets; and our expectations for future revenue, margins, expenses, operating results, inventory levels and capital expenditures; and our anticipated working capital needs and the adequacy of our capital resources. These statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Forward-looking statements reflect our current views with respect to future events, are based on assumptions, and are subject to risks, uncertainties and other important factors. Given these risks, uncertainties and other important factors, you should not place undue reliance on these forward-looking statements. Also, forward-looking statements represent our estimates and assumptions only as of the date of this report. Except as required by law, we assume no obligation to update any forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in any forward-looking statements, even if new information becomes available in the future. Important factors that could cause actual results to differ materially include, but are not limited to, the following:

· The current recession or a worsening of the United States and global economy could materially adversely affect our business. Our revenues and performance depend significantly on consumer confidence and spending, which have recently deteriorated due to the recession and may remain depressed for the foreseeable future. Some of the factors that could influence the levels of consumer confidence and spending include, without limitation, continuing conditions in the residential real estate and mortgage markets, access to credit, labor and healthcare costs, increases in fuel and other energy costs, consumer confidence and other macroeconomic factors affecting consumer spending behavior. These and other economic factors could have a material adverse effect on demand for our products and on our financial condition and operating results.

· Increases in the cost and decreases in availability of high quality Arabica coffee beans could impact our profitability and growth of our business. Although we do not purchase coffee on the commodity markets, price movements in the commodity trading of coffee impact the prices we pay. Coffee is a trade commodity and, in general, its price can fluctuate depending on: weather patterns in coffee-producing countries; economic and political conditions affecting coffee-producing countries; foreign currency fluctuations; the ability of coffee-producing countries to agree to export quotas; and general economic conditions that make commodities more or less attractive investment options. If costs increase and we are unable to pass along increased coffee costs, our margin will decrease and our profitability will decrease accordingly. In addition, if we are not able to purchase sufficient quantities of high quality Arabica beans due to any of the above factors, we may not be able to fulfill the demand for our coffee, our revenue may decrease and our ability to expand our business may be negatively impacted.

· Because we have only one roasting facility, a significant interruption in the operation of our roasting and distribution facility could potentially disrupt our operations. A significant interruption in the operation of our roasting and distribution facility, whether as a result of a natural disaster, pandemic or other causes, could significantly impair our ability to operate our business. Since we only roast our coffee to order, we do not carry inventory of roasted coffee in our roasting plant. Therefore, a disruption in service in our roasting facility would impact our sales in our retail and specialty channels almost immediately. Moreover, our roasting and distribution facility and most of our stores are located near several major earthquake faults. The impact of a major earthquake on our facilities, infrastructure and overall operations is difficult to predict and an earthquake could seriously disrupt our entire business.

· Complaints or claims by current, former or prospective employees or governmental agencies could adversely affect us. We are subject to a variety of laws and regulations which govern such matters as minimum wages, overtime and other working conditions, various family leave mandates and a variety of other laws enacted, or rules and regulations promulgated, by federal, state and local governmental authorities that govern these and other employment matters. We have been, and in the future may be, the subject of complaints or litigation from current, former or prospective employees or governmental agencies. In addition, successful complaints against our competitors may spur similar lawsuits against us. For instance, in 2003, two lawsuits (which have since been settled) were filed against the Company alleging misclassification of employment position and sought damages, restitution, reclassification and attorneys' fees and costs. In addition, on July 14, 2008, a complaint was filed alleging that store managers based in California were not paid overtime wages, were not provided meal or rest periods, were not provided accurate wage statements and were not reimbursed for business expenses. These types of claims and litigation involving current, former or prospective employees could divert our management's time and attention from our business operations and might potentially result in substantial costs of defense, settlement or other disposition, which could have a material adverse effect on our results of operations in one or more fiscal periods.

For a discussion of additional material risks and uncertainties that the Company faces, see the discussion in the 2008 Form 10-K titled "Risk Factors." In addition, we may face additional risks in connection with our pending acquisition of Diedrich Coffee, Inc. For a discussion of the risks in connection with the pending acquisition, see the additional risk factors set forth in Item 1A of this quarterly report on Form 10-Q.

Company Overview and Industry Outlook

Peet's is a specialty coffee roaster and marketer of fresh, deep-roasted whole bean coffee and tea sold through multiple channels of distribution for home and away-from-home enjoyment. Founded in Berkeley, California in 1966, Peet's has established a loyal customer base with strong brand awareness in California. Our growth strategy is based on the sale of whole bean coffee, tea and high-quality beverages in multiple channels of distribution including our own retail stores, grocery, home delivery, and foodservice and office accounts throughout the United States.

As we grow, we expect our operations to continue to be vertically integrated, allowing us to control the quality of our product at all stages. We purchase high quality Arabica coffee beans from countries around the world, and we use our artisan-roasting technique to bring out the distinctive flavor of our coffees. Because roasted coffee is perishable, we are committed to delivering our coffee under the strictest freshness standards. As a result, we do not stock or inventory roasted coffee. We roast to order and ship fresh coffee daily to our stores and customers. Control of purchasing, roasting, packaging and distribution of our coffee allows us to maintain our commitment to freshness, is cost effective, and enhances our margins and profit potential.

We expect the specialty coffee industry to continue to grow. We believe that this growth will be fueled by continued consumer interest in high quality coffee and related products. We believe that by offering high-quality products to consumers throughout the country, we will attract the same loyal customer base that we have attracted in California.

We believe growth opportunities exist in all of our distribution channels. We believe that our specialty sales can expand to geographies where we do not have a retail presence. Our first priority has been to develop primarily in the western U.S. markets where we already have a presence and have higher customer awareness. We expect to continue to open new retail stores in strategic west coast locations that meet our demographic profile and partner with distributors and companies who share our passion for quality and freshness and are willing and able to execute accordingly in the foodservice and office environment. In grocery, we expect to continue to expand into new markets although the full extent of our penetration will depend upon the development of specialty coffee as a category in many markets. In addition to the Peet's brand, we recently entered into a licensing agreement with privately held Godiva® Chocolatier, Inc. to sell and distribute a premium line of Godiva brand coffees in the grocery channel. We began selling Godiva coffee in the last week of the third quarter of 2009.

Coffee commodity costs began to decline in July 2008 after over four years of increases above the prior three to four year range. We expect the commodity market to continue to be volatile as worldwide demand, the strength of the dollar, and weather will continue to cause uncertainty in the market.

Our net revenues depend significantly on consumer confidence and spending, which have recently deteriorated due to the recession and may remain depressed for the foreseeable future. The current recession or a worsening of the United States and global economy could materially adversely affect our business as our revenues depend significantly on consumer confidence and spending. We believe that the current recession negatively impacted our rate of growth in 2008 and the first three quarters of 2009. Despite the recession, we have been able to grow our revenues by opening new retail stores, adding new foodservice accounts, and growing our business in our current grocery customer base. In addition, we were able to increase our net earnings per share by 27% and 31% for the thirteen and thirty-nine week periods ended September 27, 2009, respectively, over the same periods last year primarily by leveraging our infrastructure investments and diligently managing our costs. We plan to open one new store for the remainder of 2009, in addition to the seven new stores we opened in the first three quarters of 2009.

Pending Acquisition of Diedrich

On November 2, 2009, the Company, Acquisition Sub and Diedrich entered into the Merger Agreement that contemplates the acquisition by the Company, through Acquisition Sub, of all of the outstanding common stock of Diedrich for a total purchase price of $214.0 million, including approximately $70.0 million in Peet's common stock and $144.0 million in cash, of which approximately $124.0 million is expected to be funded with debt. The Merger Agreement contemplates a two-step transaction comprised of a combination cash and stock exchange offer for all of the issued and outstanding shares of Diedrich common stock (the "Offer"), followed by a merger of Acquisition Sub with and into Diedrich (the "Merger"). In the Offer, the Company will deliver a combination of $17.33 in cash and a fraction of a share of the Company's common stock having a numerator equal to $8.67 and a denominator equal to the Parent Average Stock Price (as defined in the Merger Agreement), provided that in no event will such fraction of a share exceed 0.315 of a share of the Company's common stock, all of the foregoing cash and stock in exchange for each share of Diedrich common stock validly tendered in the Offer (and not withdrawn), subject to adjustment for stock splits, stock dividends and similar events. In addition, upon the acquisition by Acquisition Sub of shares of Diedrich common stock tendered in the Offer, all outstanding warrants and options to acquire Diedrich common stock will be converted into a combination of cash and shares of the Company's common stock based on formulae set forth in the Merger Agreement, and certain of the options will vest in full as a result of the transactions contemplated by the Merger Agreement. See Note 9 "Subsequent Events" to the Consolidated Financial Statements.