FACTORY 2 U STORES INC - 10-K Annual Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended January 31, 2004

Commission File number 1-10089

FACTORY 2-U STORES, INC. (1)
---------------------------
(Exact Name of Registrant as Specified in its Charter)

Delaware 51-0299573
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(State or Other Jurisdiction of (I.R.S. Employer Identification Number)
Incorporation or Organization)

4000 Ruffin Road
San Diego, California 92123
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(Address of Principal Offices) (Zip Code)

Registrant's Telephone Number, Including Area Code: (858) 627-1800
--------------

Securities registered pursuant to Section 12(b) of the Act:

Title of each class Name of each exchange on which registered
------------------- -----------------------------------------
None None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $0.01 par value
-----------------------------
(Title of Class)

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 ___

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K [ X ]

Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). YES X NO ___

At August 2, 2003, the aggregate market value of the voting and non-voting
common equity of the Registrant held by non-affiliates was approximately
$83,739,378.

At April 23, 2004, the Registrant had outstanding 17,921,178 shares of Common
Stock, $0.01 par value per share.

(1)Factory 2-U Stores, Inc. has been operating as a Debtor-in-Possession under
Chapter 11 of the United States Bankruptcy Code since January 13, 2004.

1

PART I

Item 1. Business 4
Item 2. Properties 16
Item 3. Legal Proceedings 17
Item 4. Submission of Matters to a Vote of Security Holders 18

PART II

Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters 18
Item 6. Selected Financial Data 20
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations 22
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 35
Item 8. Financial Statements and Supplementary Data 36
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure 36
Item 9A. Controls and Procedures 36

PART III

Item 10. Directors and Executive Officers of the Registrant 38
Item 11. Executive Compensation 40
Item 12. Security Ownership of Certain Beneficial Owners and Management 51
Item 13. Certain Relationships and Related Transactions 55
Item 14. Principal Accounting Fees and Services 56

PART IV

Item 15. Exhibits, Financial Statement Schedules and Reports
on Form 8-K 57

2

Cautionary Statement for Purposes of "Safe Harbor Provisions" of the Private
Securities Litigation Reform Act of 1995

In December 1995, Congress enacted the Private Securities Litigation Reform Act
of 1995 (the "Act"). The Act contains amendments to the Securities Act of 1933
and the Securities Exchange Act of 1934 which provide protection from liability
in private lawsuits for "forward-looking" statements made by specified persons.
We desire to take advantage of the "safe harbor" provisions of the Act.

Certain statements in this Annual Report on Form 10-K, or in documents
incorporated by reference into this Annual Report on Form 10-K, are
forward-looking statements, which are within the meaning of Section 27A of the
Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.
These forward-looking statements are not based on historical facts, but rather
reflect our current expectation concerning future results and events. These
forward-looking statements generally may be identified by the use of phrases
such as "believe", "expect", "estimate", "anticipate", "intend", "plan",
"foresee", "likely", "will" or other similar words or phrases. Similarly,
statements that describe our objectives, plans or goals are or may be
forward-looking statements. These forward-looking statements involve known and
unknown risks, uncertainties and other factors which may cause our actual
results, performance or achievements to be different from any future results,
performance or achievements expressed or implied by these statements.

The following factors, among others, could affect our future results,
performance or achievements, causing these results to differ materially from
those expressed in any of our forward-looking statements: general economic and
business conditions (both nationally and in regions where we operate); trends in
our business and consumer preferences, especially as may be impacted by economic
weakness on consumer spending; the effect of government regulations and
legislation; litigation and other claims that may be asserted against us; the
effects of intense competition; our ability to successfully implement business
strategies and otherwise execute planned changes in various aspects of the
business; the challenges and costs associated with maintaining and improving
technology; the costs and difficulties of attracting and retaining qualified
personnel; the effects of increasing labor, utility, fuel and other operating
costs; our ability to obtain adequate quantities of suitable merchandise at
favorable prices and on favorable terms and conditions; our ability to maintain
adequate liquidity; the effectiveness of our operating initiatives and
advertising and promotional strategies and other factors described in this
Annual Report on Form 10-K and in our other filings with the Securities and
Exchange Commission.

In addition to the above general factors, the following bankruptcy related
factors, among others, could also affect our future results, performance or
achievements, causing these results to differ materially from those expressed in
any of our forward-looking statements: our ability to continue as a going
concern; our ability to operate pursuant to the terms of our
debtor-in-possession financing facility; our ability to obtain approval from the
United States Bankruptcy Court for the District of Delaware (the "Court") with
respect to motions in the Chapter 11 case (as that term is defined below) from
time to time; our ability to negotiate, confirm and consummate a plan of
reorganization in a timely manner; risks associated with third parties seeking
and obtaining court approval to terminate or shorten the exclusivity period that
we have to propose and confirm one or more plans of reorganization, for the
appointment of a Chapter 11 trustee or to convert the Chapter 11 case to a case
under Chapter 7 of title 11 of the United States Bankruptcy Code (the
"Bankruptcy Code"); our ability to offset the negative effects that the filing
for reorganization under Chapter 11 of the Bankruptcy Code has had on our
business, including the loss in customer traffic, the impairment of vendor
relations and the constraints placed on available capital; our ability to obtain
and maintain normal terms with vendors and service providers; the ability of our
vendors to obtain satisfactory credit terms from factors and other financing
sources; our ability to maintain contracts, including leases, which are critical
to our operations; the potential adverse impact of the Chapter 11 case on our
liquidity or results of operations; our ability to develop a long-term strategy
to revitalize our business and return to profitability; and our ability to fund
and execute our business plan.

3

We do not undertake to publicly update or revise any of our forward-looking
statements, whether as a result of new information, future events and
developments or otherwise, except to the extent that we may be obligated to do
so by applicable law.

Similarly, these and other factors, including the terms of the final plan of
reorganization, if any, ultimately confirmed, can affect the value of our
pre-petition liabilities and common stock. Until a plan of reorganization is
confirmed by the Court, the recoveries of pre-petition claims holders are
subject to change. Accordingly, no assurance can be given as to what values, if
any, will be ascribed in the bankruptcy case to each of these constituencies.

The final plan of reorganization, if any, confirmed by the Court may result in
the cancellation of our existing common stock with holders thereof receiving no
distributions under the plan of reorganization. In light of the foregoing, we
consider the value of our common stock to be highly speculative and caution
equity holders that the stock may ultimately be determined to have no value.
Accordingly, we urge that appropriate caution be exercised with respect to
existing and future investments in our common stock or any claims relating to
pre-petition liabilities.

PART I

Item 1. Business

GENERAL

We operate a chain of off-price retail apparel and housewares stores in Arizona,
California, Nevada, New Mexico, Oregon, Texas and Washington. We sell branded
casual apparel for the family, as well as selected domestic and household
merchandise at prices that generally are significantly lower than other discount
stores.

Our stores average approximately 15,000 square feet and are located mostly in
shopping centers. Our products include a broad range of family apparel, domestic
goods and houseware products. Our typical customers are families with more than
the average number of children and average household income of approximately
$35,000, which generally are profiled as discount store shoppers. Our
merchandising strategy is to offer first quality recognizable national and
discount store brands at a substantial discount, generally 20% to 50% below
prices offered by other discount chains. Our stores are well lit and present the
merchandise primarily on hanging fixtures. We also use strategically placed
in-store signage to emphasize savings and create increased customer awareness.

We define our fiscal year by the calendar year in which most of our business
activity occurs (the fiscal year ended January 31, 2004 is referred to as fiscal
2003).

We were incorporated in Delaware in March 1987 as BMA Life Care Corp., changed
our name later that month to The Longwood Group, Ltd. and changed our name in
May 1992 to DRS Industries, Inc. In December 1992, we acquired an interest in
General Textiles while it was operating under Chapter 11 of the Bankruptcy Code.
General Textiles operated an off-priced apparel retail chain known as Family
Bargain Center. In May 1993, we contributed additional equity to General
Textiles and thereby increased our ownership of General Textiles to 100%, at
which time General Textiles emerged from bankruptcy protection. In January 1994,
we changed our name to Family Bargain Corporation. In November 1995, we acquired
Capin Mercantile Corporation and changed its name to Factory 2-U, Inc. and began
to coordinate the purchasing, warehousing and delivery operations for the Family
Bargain Center and Factory 2-U chains. In July 1998, General Textiles and
Factory 2-U, Inc. were merged into a new corporate entity, General Textiles,
Inc., which was a wholly-owned subsidiary of Family Bargain Corporation. In
November 1998, General Textiles, Inc. was merged into Family Bargain
Corporation, at which time we converted our previous three classes of stock into
a single class of common stock and changed our corporate name from Family
Bargain Corporation to Factory 2-U Stores, Inc.

4

Recent Developments

We experienced a continuation of declining sales volume in fiscal 2003 with a
decrease of 4.4% in comparable store sales for the year. We believe there were a
number of factors that contributed to the lower sales in fiscal 2003: (1) lower
inventory levels for most of our first quarter due to a tightening of credit by
our vendors, (2) war in Iraq, (3) the combined effect of the wildfires and labor
strikes in the southern California region in the third quarter, (4) decrease in
retail price points, and (5) a continuation of a very soft retail environment
impacted by general price deflation and heavy promotion, particularly in
apparel.

As a result of our financial results over the past two fiscal years, bankruptcy
filings by a number of well-known retail chains during calendar year 2002 and
the general weak economic environment, shortly after our fiscal 2002 Christmas
selling season we experienced a tightening of credit extended to us by our
vendors and the credit community for merchandise purchases. The initial impact
of this credit tightening was a disruption of product flow to our stores in
January, February and, to a lesser extent, March of 2003. This credit
environment required us, in many cases, to meet accelerated payment terms in
order to re-establish a consistent flow of product and assure a level of
inventory for Spring 2003 business. The acceleration of payment terms, in turn,
adversely affected our liquidity and, to some extent, further weakened our
existing credit standing. In addition, in response to a very competitive retail
environment, we increased our advertising expenditures above originally planned
levels and equivalent to the prior year. We also increased our in-store
promotional efforts with weekly in-store specials.

In an effort to improve our liquidity, obtain more favorable credit terms and
provide for a consistent flow of merchandise, we initiated a series of financing
transactions and took steps to accelerate the receipt of refunds related to tax
loss carry-back benefits. On March 6, 2003, we completed a private offering of
2,515,379 shares of our common stock for net proceeds of approximately $5.7
million, after deducting the placement fees and other offering expenses. In
addition, during March of 2003, we received an $8.2 million federal tax refund
as a result of utilizing tax loss carry-back benefits. On April 10, 2003, we
completed a $7.5 million debt financing transaction consisting of a $6.5 million
junior term note and a $1.0 million term note. On August 20, 2003, we completed
another private offering of 2,450,000 shares of our common stock for net
proceeds of approximately $11.4 million, after deducting the placement fees and
other offering expenses.

Despite our efforts to improve sales and our liquidity, we were unable to
improve comparable sales growth and operating margin at a rate that could
generate sufficient cash flow to sustain ongoing operations. Accordingly, we
elected to file for bankruptcy protection under Chapter 11 of the Bankruptcy
Code.

PROCEEDINGS UNDER CHAPTER 11 OF THE UNITED STATES BANKRUPTCY CODE

On January 13, 2004 (the "Petition Date"), we filed a voluntary petition to
reorganize under Chapter 11 of the Bankruptcy Code in the Court, which is
currently pending as case number 04-10111(PJW) (the "Chapter 11 filing"). As the
debtor, we remain in possession of our properties, and continue to operate our
business as debtor-in-possession ("DIP") in accordance with the applicable
provisions of the Bankruptcy Code.

We decided to seek judicial reorganization in order to implement a comprehensive
operational and financial restructuring due to the tightening of credit extended
by our vendors and the credit community and a decline in our liquidity caused by
declining sales volume and deteriorating operating margin in a very soft retail
environment. As the debtor, we are authorized to continue to operate as an
ongoing business, but may not engage in transactions outside the ordinary course
of business without the approval of the Court after notice and an opportunity
for a hearing.

5

At hearings held on January 14, 2004 concerning our first day motions, the Court
entered orders granting us authority, among other things, to (1) continue our
centralized cash management system, (2) pay pre-petition wages and continue our
employee benefit plans and other employee programs, (3) continue customer
related practices, (4) pay certain sales, use and other taxes, (5) pay suppliers
and vendors in full for all goods and services provided on or after the Petition
Date and (6) continue ongoing pre-petition "going out of business sales" for
four store locations completed by January 31, 2004. In addition, the Court also
gave interim approval for a $45.0 million DIP financing facility (DIP financing
facility) that was committed by The CIT Group/Business Credit, Inc. and GB
Retail Funding, LLC.

On February 2, 2004, the Court granted final approval of the $45.0 million DIP
financing facility. We intend to utilize this financing, in addition to cash
flow from operations, to fulfill business obligations during the Chapter 11
process. A full description of this DIP financing facility is included in Item 7
Management's Discussion and Analysis of Financial Condition and Results of
Operations.

Additionally, on February 2, 2004, the Court authorized the closure of 44
stores, or approximately 18% of our 239 stores. Stores were selected by
evaluating their market and financial performance. On February 11, 2004, the
Court approved our appointment of the Great American Group ("Great American") as
exclusive agent to conduct store closing sales at these 44 store locations. The
store closing sales started on February 12, 2004. All 44 stores were closed by
March 18, 2004 and as of April 23, 2004, we have terminated or assigned a total
of 13 leases of these stores and rejected the remaining 31 leases.

On February 17, 2004, we filed with the Court our schedules of assets and
liabilities and statements of financial affairs setting forth, among other
things, the assets and liabilities as shown on our books and records as of the
Petition Date, subject to the assumptions contained in certain notes filed in
connection therewith. The schedules of assets and liabilities and statements of
financial affairs remain subject to further amendment or modification. We have
mailed notices to all known creditors that the deadline for filing proofs of
claim with the Court is June 15, 2004. Differences between amounts we have
scheduled and claims by creditors will be investigated and resolved in
connection with our claims resolution process. As we are at an early stage of
the bankruptcy and we do not yet have a plan of reorganization, the ultimate
distribution with respect to allowed claims is not presently ascertainable.

The United States Trustee has appointed an unsecured creditors committee and may
consider the appointment of an equity committee. There can be no assurance that
the unsecured creditors committee or equity committee, if any, will support our
positions in the bankruptcy case or the plan of reorganization once proposed,
and any disagreements could protract the bankruptcy case, negatively impact our
ability to operate during bankruptcy, and/or delay our emergence from
bankruptcy.

Under the Bankruptcy Code, actions to collect pre-petition indebtedness, as well
as most other pending litigation, are stayed and other contractual obligations
against us generally may not be enforced. Absent an order of the Court,
substantially all pre-petition liabilities are subject to compromise under a
plan of reorganization to be voted upon and approved by the Court. Although we
expect to file a reorganization plan that provides for emergence from
bankruptcy, there can be no assurance that a plan of reorganization will be
proposed by us or confirmed by the Court, or that any such plan will be
consummated.

We also may assume or reject executory contracts and unexpired leases, including
our store and distribution center leases, subject to the approval of the Court
and our satisfaction of certain other requirements. In the event we choose to
reject an executory contract or unexpired lease, parties affected by these
rejections may file claims with the Court-appointed claims agent as prescribed
by the Bankruptcy Code and/or orders of the Court. Unless otherwise agreed, the
assumption of an executory contract or unexpired lease will require us to cure
all prior defaults under such executory contract or lease, including all
pre-petition liabilities, some of which may be significant. In addition, in this
regard, we expect that liabilities that will be subject to compromise through
the Chapter 11 process will arise in the future as a result of the rejection of
additional executory contracts and/or unexpired leases, and from the
determination by the Court (or agreement by parties in interest) of allowed
claims for items that we now claim as contingent or disputed. Conversely, we
would expect that the assumption of additional executory contracts may convert
some liabilities shown on our financial statements as subject to compromise to
post-petition liabilities. Due to the uncertain nature of many of the potential
claims, we are unable to project the magnitude of such claims with any degree of
certainty. We have incurred, and will continue to incur, significant costs
associated with the reorganization.

6

Under the priority scheme established by the Bankruptcy Code, certain
post-petition liabilities and pre-petition liabilities need to be satisfied
before shareholders are entitled to receive any distribution. The ultimate
recovery to creditors and shareholders, if any, will not be determined until
confirmation of a plan of reorganization. We can give no assurance as to what
values, if any, will be ascribed in the bankruptcy case to each of these
constituencies.

A plan of reorganization could also result in holders of our common stock
receiving no distribution on account of their interests and cancellation of
their interests. In addition, under certain conditions specified in the
Bankruptcy Code, a plan of reorganization may be confirmed notwithstanding its
rejection by an impaired class of equity holders and notwithstanding the fact
that equity holders do not receive or retain property on account of their equity
interests under the plan. Moreover, as discussed above, there can be no
assurance that a plan of reorganization will be confirmed by the Court. In light
of the foregoing, we consider, as described above, the value of the common stock
to be highly speculative and caution equity holders that the stock may
ultimately be determined to have no value. Accordingly, we urge that appropriate
caution be exercised with respect to existing and future investments in our
common stock or in any claims related to pre-petition liabilities and our other
securities.

At this time, it is not possible to predict the effect of the Chapter 11 filing
on our business, various creditors and shareholders or when we will be able to
exit Chapter 11. Our future results are dependent upon our confirming and
implementing a plan of reorganization.

Our ability to continue as a going concern is predicated upon numerous issues,
including our ability to achieve the following:

- developing and implementing a long-term strategy to revitalize our
business and return to profitability;

- taking appropriate actions to offset the negative impact the Chapter
11 filing has had on our business and the impairment of vendor
relations;

- operating within the framework of our DIP financing facility,
including limitations on capital expenditures and compliance with
financial covenants,

- generating cash flows from operations or seeking other sources of
financing and the availability of projected vendor credit terms;

- attracting, motivating and retaining key executives and associates;
and

- developing, negotiating, and, thereafter, a plan of reorganization
confirmed by the Court.

These challenges are in addition to other operational and competitive challenges
faced by us in connection with our business as an off-price retailer. See the
section below titled "Risk Factors" for a discussion of these items.

A plan of reorganization could materially change the amounts reported in the
financial statements, which do not give effect to all adjustments of the
carrying value of assets or liabilities that might be necessary as a consequence
of a plan of reorganization.

7

The financial statements contained herein have been prepared on a going concern
basis, which assumes continuity of operations and realization of assets and
satisfaction of liabilities in the ordinary course of business, and in
accordance with Statement of Position 90-7 ("SOP 90-7"), "Financial Reporting by
Entities in Reorganization under the Bankruptcy Code." Our ability to continue
as a going concern, as described above, is predicated upon, among other things,
the development and confirmation of a plan of reorganization, compliance with
the provisions of the DIP financing facility and the ability to generate cash
flows from operations and obtain financing sources sufficient to satisfy our
future obligations. See Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations, and Note 2 of the Notes to
Financial Statements in Item 8. Financial Statements and Supplementary Data, for
additional information.

OPERATIONS

Operating Strategy

Our strategy is to be an off-price casual apparel, domestic goods, and
housewares retailer to families with more than the average number of children
and whose average household income is approximately $35,000 in the markets we
serve.

The major element of our operating strategy is to provide value to our customers
by selling merchandise offered by national and discount store chains at savings
of generally 20 to 50% below their prices. We primarily buy excess in-season
inventory of recognized brands at bargain prices and pass along the savings to
our customers. We believe we are positioned to help families dress, decorate
their homes, and entertain their children at a great value.

Buying and Distribution

We purchase merchandise from domestic manufacturers, jobbers, importers, and
other vendors. Historically, our payment terms have typically been net 30 days,
although during the pendency of the Chapter 11 case, many of our vendors have
reduced the amount of time in which we must pay for goods. We do not maintain
any long-term or exclusive purchase commitments or agreements with any vendors.
We believe that there are sufficient sources of supply of first quality,
national and discount store branded merchandise that will meet our inventory
needs.

Unlike traditional department stores and discount retailers (that primarily
purchase merchandise in advance of the selling season, for example,
back-to-school is purchased by March), we primarily purchase our merchandise
in-season (i.e., during the selling season). These in-season purchases generally
represent closeouts of vendors' excess inventories remaining after the
traditional wholesale selling season and are often created by other retailers'
order cancellations. We believe that in-season buying practices are well suited
to our customers, who tend to make purchases on an as-needed basis during the
season. For years, our customers have substantiated this pattern, which has
helped shape the way we do business.

Our in-season buying practice is facilitated by our ability to efficiently
process orders and ship merchandise through our distribution center to our
stores. At our administrative headquarters, we receive daily store sales and
inventory information from point-of-sale equipment located at each of our
stores. This data is reported by stock keeping unit (SKU), permitting us to
tailor purchasing and distribution decisions on an as-needed basis. Our
chain-wide computer network, recently upgraded with a view to enhanced
allocation capabilities, also facilitates communications between store
management with timely pricing and distribution information.

Generally, manufacturers ship goods directly to our distribution center or
freight consolidators who then ship directly to our distribution center. We then
deliver merchandise from our distribution center to our stores within ten to 14
days of receipt utilizing the services of independent trucking companies. We do
not typically store merchandise at our distribution center from season to
season. We believe we are a desirable customer for vendors seeking to liquidate
inventory because we can take immediate delivery of large quantities of
in-season goods. We rarely request markdown concessions, advertising allowances
or special shipping requirements, but insist on the lowest price possible.

8

Merchandising and Marketing

Our merchandise selection, pricing strategies and store formats are designed to
reinforce the concept of value and maximize customer enjoyment of shopping at
our stores. Our stores offer customers a diverse selection of first quality,
in-season merchandise at prices that generally are lower than those of competing
discount stores in their local markets. Our stores generally carry an assortment
of brand name labels, including nationally recognized brands.

We attempt to deliver new merchandise to our stores at least weekly to encourage
frequent shopping trips by our customers and to maximize our inventory turns. As
a result of our purchasing practices and the nature of the off-price retail
industry, store inventory may not always include a full range of colors, sizes
and styles in a particular item. We believe that price, quality and product mix
are more important to our customers than the availability of a specific item at
a given time.

It is important that we emphasize inventory turns in our merchandising and
marketing strategy. Our merchandise presentation, pricing below discounters,
weekly store deliveries, staggered vendor shipments, promotional advertising,
store-tailored distribution and prompt price reductions on slow-moving items are
all designed to increase inventory turns. We believe that the pace of our
inventory turns can lead to increased profits, lower markdowns, and efficient
use of capital and customer urgency to make purchase decisions.

Our stores are characterized by easily accessible merchandise displayed on
hanging fixtures and open shelves in well-lit areas. Our prices are clearly
marked with the comparative retail-selling price often noted on the price tag.

Our major advertising vehicle is the use of full-color advertising circulars
showing photos of our merchandise and emphasizing value to customers. Our print
media is delivered to consumers through both direct mail and newspaper inserts.
We also conduct local promotional activities at various stores throughout our
chain from time to time.

Seasonality

We experience three primary selling seasons: Spring, Back to School and Holiday.
We have historically realized our highest levels of sales during the Holiday
season, which represents approximately 25% of our sales during the fiscal year.
The Back to School season historically has generated our second highest level of
sales for the fiscal year, representing approximately 17% of our sales.

Competition

We operate in a highly competitive marketplace. We compete with large national
and discount store retail chains in most of our markets, such as Wal-Mart,
K-Mart, Target and Mervyn's. In fiscal 2003, we experienced a decrease in market
share due to our store closings and the growth of our major competitors. We
expect that this trend will continue due to the 44 stores we have closed in
fiscal 2004. While these retail chains offer a larger assortment of merchandise
than we do and may provide a higher level of customer service, given our
off-price format, our competitive advantage is that we sell our merchandise at
prices typically 20% to 50% below the prices of these chains. We also carry
national and recognizable brands that may not be carried by these retail chains.
We also compete in most of our markets with other off-price retail chains, such
as TJ Maxx, Ross Stores, Marshall's, and Big Lots. For the most part, these
off-price chains serve the middle and upper-middle income markets offering
apparel that is typically found in department store chains (such as
Robinsons-May, Nordstrom and Dillard's), whereas we serve the lower and
lower-middle income markets and offer apparel that is targeted at a discount
store shopper. These national, discount store and off-price chains may have
substantially greater resources than we do. We also compete with independent or
small chain retailers and flea markets (also known as "swap meets"), which have
a similar price strategy as we do, but generally offer lower service levels. In
the future, new companies may enter the deep-discount retail industry.

9

Over the past few years, the retail industry has experienced price deflation,
primarily due to a soft economy and intense competition. We expect the
competition will continue and increase in the future. In addressing this
competitive environment, we have initiated new merchandise strategies and a
revised print advertising program; all designed to improve store contribution.

Our Stores

Our stores emphasize value and satisfaction to develop customer loyalty and
generate repeat business. Most of our sales are for cash, although we accept
checks, debit and credit cards. We also offer layaway and gift card programs.
Our layaway program is important to our customers, many of whom do not possess
credit cards, because it permits them to pay for purchases over time. In
general, our store business hours are from 9:00 am to 9:00 pm.

On January 22, 2004, we filed a motion with the Court seeking authorization for
closure of 44 stores, or approximately 18% of our 239 stores. Stores were
selected by evaluating their market and financial performance. On February 11,
2004, the Court approved our appointment of Great American as exclusive agent to
conduct store closing sales at these 44 store locations. The store closing sales
started on February 12, 2004. All 44 stores were closed by March 18, 2004 and as
of April 23, 2004, we have terminated or assigned a total of 13 leases of these
stores and rejected the remaining 31 leases.

We continually review store performance and may close additional stores that do
not meet our minimum financial performance criteria. The costs associated with
closing stores consist primarily of inventory liquidation costs, provisions to
write down assets to net realizable value, teardown costs and the estimated cost
with respect to disposition of the lease.

As of April 23, 2004, we operated 195 stores located in Arizona, California,
Nevada, New Mexico, Oregon, Texas and Washington, under various operating leases
with third parties. Our stores are generally located in shopping centers in
densely populated urban areas, lower to moderate income suburban communities and
certain rural locations. Our stores range in size from 6,000 square feet to
35,000 square feet, averaging approximately 15,000 square feet.

We generally lease previously occupied store sites on terms that we believe are
more favorable than those available for newly constructed facilities. We select
store sites based on demographic analysis of the market area, sales potential,
local competition, occupancy costs, operational fit and proximity to existing
store locations.

Our stores typically employ one store manager, two to three assistant store
managers and/or store supervisors, and 15 to 20 sales associates, most of whom
are part-time employees. We train new store managers and assistant store
managers in all aspects of store operations through our management-training
program. Our management training program provides for the training of our store
management candidates over a two to three week period in one of our training
stores. Each of our 20 operating districts has a training store in which the
store manager is responsible to train the store management candidates for that
district. The training program covers operational procedures, merchandising
skills, employee selection and other human resource skills. Our other store
personnel are trained on site. We often promote experienced assistant store
managers to fill open store manager positions.

We maintain customary workers' compensation, commercial liability, fire, theft,
business interruption and other insurance policies for all store, distribution
and corporate office locations.

At January 31, 2004, we operated 239 stores under the name Factory 2-U. The
number of stores we operated in each quarter during fiscal year 2003, 2002 and
2001 were as follows:

10

2003 2002 2001
------ ------ ------

As of the beginning of the first quarter 244 279 243
Opened 1 5 9
Closed (2) (28) (1)
------ ------ ------
As of the end of the first quarter 243 256 251
Opened 1 3 12
Closed (1) (2) -
------ ------ ------
As of the end of the second quarter 243 257 263
Opened - 4 12
Closed - - (2)
------ ------ ------
As of the end of the third quarter 243 261 273
Opened - - 6
Closed (4) (17) -
------ ------ ------
As of the end of the fourth quarter 239 244 279

Subsequent to January 31, 2004, we closed 44 stores in connection with our
reorganization efforts as discussed above.

As of April 23, 2004, our stores were located as follows:

State Strip Center Downtown Power Center Freestanding Mall Total
- ----- ------------ -------- ------------ ------------ ---- -----

Arizona 22 2 2 1 1 28
California 88 7 13 1 2 111
Nevada 6 - 1 - - 7
New Mexico 7 - - - - 7
Oregon 7 - 2 1 - 10
Texas 17 - 2 1 3 23
Washington 6 1 1 - 1 9

------------ --------- ----------- ------------- ------- -------
Total 153 10 21 4 7 195
------------ --------- ----------- ------------- ------- -------

Employees

As of April 23, 2004, we had 3,550 employees (2,020 of whom were part-time
employees). Of that total, 1,301 were store employees and store field
management, 155 were executives and administrative employees and 74 were
warehouse employees. None of our employees are subject to collective bargaining
agreements and we consider relations with our employees to be generally good.

Trademarks

Except for the trade names "Factory 2-U" and "Family Bargain Center", which are
federally registered trademarks, we do not have any material trademarks.

Government Regulation

Our business operations are subject to federal, state and local laws,
regulations and administrative practices. We believe we are in substantial
compliance with all federal, state and local laws and regulations governing our
business operations and we have obtained all material licenses and permits
required to operate our business. We believe that the compliance burdens and
risks relating to these laws and regulations do not have a material adverse
effect on our business.

11

RISK FACTORS

Our High Store Concentration in California Leaves Us Particularly Susceptible to
Risks of Doing Business in California

As of April 23, 2004, we operated 111 stores in California, representing over
half of our total store base. Accordingly, our results of operations and
financial condition are significantly more dependent upon trends and events in
California than are those of our competitors with more geographically balanced
store locations. Operating costs, such as workers' compensation and utilities in
California have been significantly higher than other regions in the country
where we currently operate. If operating costs continue to increase in
California, they could continue to reduce our operating margins.

The costs associated with workers' compensation insurance in the state of
California have increased significantly over the past few years. These cost
increases are related to the average cost per claim and the related state
benefits. In California, the average workers' compensation claim is
significantly higher than other states where we currently operate. With these
continued workers' compensation cost increases, there can be no assurance that
we will be able to obtain workers' compensation insurance at favorable rates.
Additionally, with the uncertain economy, the continued rise in benefits could
reduce our earnings.

Utility costs for electricity and natural gas in California have risen
significantly. These costs may continue to increase due to the actions of
federal and state governments and agencies, as well as other factors beyond our
control. We have attempted to mitigate such increases through energy
conservation measures and other cost cutting steps. However, we can make no
assurances that these measures and other steps taken will be adequate to control
the impact of these utility cost increases in the future. In addition,
increasing utility and gasoline costs, together with high unemployment, may
significantly reduce the disposable income of our target customers. Our sales
could be reduced if our target customers have less disposable income.

In addition, California historically has been vulnerable to certain natural
disasters and other risks, such as earthquakes and fires. At times, these events
have disrupted the local economy. These events could also pose physical risks to
our properties.

We Could Experience Disruptions in Receiving and Distribution

Well-organized and managed receiving and shipping schedules and the avoidance of
interruptions are vital to our success. From time to time, we may face
unexpected demands on our distribution operations that could cause delays in
delivery of merchandise from our distribution center to our stores. A fire,
earthquake or other disaster at our distribution center that disrupts the flow
of merchandise could severely impair our ability to maintain inventory in our
stores and thus reduce sales.

During fiscal 2003, we closed two distribution centers in San Diego, California
and one in Lewisville, Texas and consolidated their operations into a single,
new distribution center in San Diego, California. We may face unexpected or
unforeseen demands, disruptions or costs, which may result from earthquakes or
mechanical breakdowns, that could adversely affect our distribution center
operations and delay or interfere with our ability to deliver merchandise from
our distribution facility to our stores in connection with this consolidation.
Any such delay or interference could lead to a reduction in sales.

We Depend Upon, But Do Not Have Long-Term Agreements With, Our Vendors for the
Supply of Close-Out and Excess In-Season Merchandise

Our success depends in large part on our ability to locate and purchase quality
close-out and excess in-season merchandise at attractive prices from our
vendors. We cannot be certain that such merchandise will continue to be
available in the future. Further, we may not be able to find and purchase
merchandise in quantities necessary to accommodate our needs.

12

We do not have long-term agreements with any vendor. As a result, we must
continuously seek out buying opportunities from our existing suppliers and from
new sources. We compete for these opportunities with other wholesalers and
retailers, discount and deep-discount chains, and mass merchandisers. Although
we do not depend on any single vendor or group of vendors and believe we can
successfully compete in seeking out new vendors, a disruption in the
availability of merchandise at attractive prices could result in reductions in
sales and gross margins.

We Rely on Credit Support From Our Vendors and the Credit Community

Our ability to purchase merchandise depends upon our receiving credit support
from trade vendors or the credit community that extends financing terms to
certain of our vendors. In light of our recent Chapter 11 filing, certain
vendors and factors have significantly reduced our credit support. Any
improvement in our credit terms will be contingent upon, among other things, our
results of operations, liquidity and a plan of reorganization. Any further
withdrawal or reduction of the extension of credit from the credit community and
our vendors may result in our not being able to purchase merchandise at
attractive prices, disrupt product flow, reduce our liquidity and result in a
reduction in sales and profit margins. It may also impair our ability to finance
our operations, pay our debt obligation, and complete our reorganization efforts
over the next twelve months.

Our Sales Fluctuate According to Seasonal Buying Patterns, Which Expose Us to
Excess Inventory Risk

We have historically realized our highest levels of sales and income during the
third and fourth quarters of our fiscal year (the quarters ending in October and
January) as a result of the Back to School and Holiday seasons. Any adverse
events during the third and fourth quarters could therefore reduce sales. In
anticipation of the Back to School and Holiday seasons, we may purchase
substantial amounts of seasonal merchandise. If for any reason, including
periods of sustained inclement weather, our net sales during these seasons were
to fall below seasonal norms and/or our expectations, a seasonal merchandise
inventory imbalance could result. If such an imbalance were to occur, markdowns
are required to clear excess inventory. Our sales, gross margins and net income
could be reduced by higher than expected markdowns.

We Face Intense Competition

We operate in a highly competitive marketplace. We compete with large national
and discount store retail chains, such as Wal-Mart, K-Mart, Target and Mervyn's,
and other off-price chains, such as TJ Maxx, Ross Stores, Marshall's and Big
Lots, some of which have substantially greater resources than ours. We also
compete with independent and small chain retailers and flea markets (also known
as "swap meets"), which serve the same low and low-middle income market. Over
the past few years, the retail industry has experienced price deflation,
primarily due to a weak economy and intense competition. We compete in the
discount retail merchandise business, which is a highly competitive environment
that subjects us to the price competition, the potential for lower net sales and
decreased operating margins. We expect the competition will continue and
increase in the future. In addressing this competitive environment, we have
initiated new merchandise strategies and a revised print advertising program;
all designed to improve store contribution. However, we can make no assurances
that these strategies and other actions taken will be adequate to minimize our
exposure to reduced sales and lower gross margins due to competition.

We Handle Certain Materials that Could Expose Us to Liability Under
Environmental Laws

In the ordinary course of our business, we sometimes handle or dispose of
commonplace household products that are classified as hazardous materials under
various environmental laws and regulations. We have adopted policies regarding
the handling and disposal of these products and we train our employees on how to
handle and dispose of them. We cannot assure that our policies and training will
successfully help us avoid potential violations of these environmental laws and
regulations in the future.

13

Our Anti-Takeover Provisions Could Depress Our Stock Price

In addition to some governing provisions in our Certificate of Incorporation and
Bylaws, we are also subject to certain Delaware laws and regulations which could
delay, discourage and prevent others from initiating a potential merger,
takeover or other change in control, even if such actions would benefit our
shareholders and us.

The Market Price of Our Existing Common Stock is Subject to Substantial
Fluctuation and Ultimately May Have No Value

The market price of our common stock has fluctuated substantially since our
recapitalization occurred in November 1998. In addition, a final plan of
reorganization, if any, confirmed by the Court may result in the cancellation of
our existing common stock with holders thereof receiving no distributions under
the plan of reorganization other than, possibly, for a minor interest in a
creditor litigation trust to be established pursuant to the plan of
reorganization. In light of the foregoing, we consider the value of our common
stock to be highly speculative and caution equity holders that the stock may
ultimately be determined to have no value.

On January 22, 2004, we were delisted from the Nasdaq national market as we were
not in compliance with certain of the Nasdaq National Market continued listing
requirements. Our stock is currently trading in an "over-the-counter" market and
accordingly trading prices for our common stock could fluctuate significantly
due to many factors, including:

o the depth of the market for our common stock;
o changes in expectations of our future financial performance, including
financial estimates by securities analysts and investors;
o our ability to reorganize under Chapter 11;
o variations in our operating results and financial conditions;
o conditions or trends in our industry;
o additions or departures of key personnel; and
o future issuances of our common stock.

We Face Exposure in Lawsuits

On or about April 28, 2003, Lynda Bray and Masis Manougian, two of our former
employees, filed a lawsuit against us entitled Lynda Bray, Masis Manougian,
etc., Plaintiffs v. Factory 2-U Stores, Inc., et al., Defendants, Case No.
RCV071918, in the Superior Court of the State of California for the County of
San Bernardino (the "Bray Lawsuit"). The First Amended Complaint in the Bray
Lawsuit alleges purported claims for: (1) "Failure to Record Hours and or
Illegally Modify Recorded Hours Worked;" (2) "Failure to Pay Wages Under State
Labor Code, Penal Code and IWC Wage Order 7, Injunctive and Monetary Relief;"
(3) "Unfair Business Practice, Bus. & Prof. Code ss.17200 et. seq., Failure to
Pay Wages and Record Hours Worked;" (4) "Equitable Conversion;" and (5) "False
Advertising." The thrust of plaintiffs' claim is that the Company failed to pay
wages and overtime for all hours worked, failed to document all hours worked,
and failed to inform prospective or new employees of unpaid wage claims.
Plaintiffs purport to bring this action on behalf of all persons who were
employed in one of the California stores at anytime after April 25, 2003.
Plaintiffs seek compensatory and exemplary damages, interest, penalties,
attorneys' fees and disgorged profits in an amount which plaintiffs estimated to
be not less than $100,000,000. Plaintiffs also seek injunctive relief requiring
correction of the alleged unlawful practices.

Although at this stage of the litigation it is difficult to predict the outcome
of the case with certainty, we believe that we have meritorious defenses to the
Bray Lawsuit. All proceedings in the Bray Lawsuit are currently stayed pursuant
to the automatic stay provisions of Section 362 of the Bankruptcy Code, subject
to the possible entry of an order by the Court lifting the automatic stay. In
the event the Court enters an order lifting the automatic stay, we will continue
to vigorously defend against the Bray Lawsuit. If the Bray Lawsuit is decided
adversely, the potential exposure could be material to our results of
operations.

14

In November 2003, Virginia Camarena, a current employee in one of our California
stores, filed a lawsuit against us entitled Virginia Camarena, Plaintiff, vs.
Factory 2-U Stores Inc., etc., Defendants, Case No. BC305173 in the Superior
Court of the State of California for the County of Los Angeles - Central
District (the "Camarena Lawsuit"). The plaintiff alleges that we violated the
California Wage Orders, California Labor Code, California Business and
Profession Code and the Federal Fair Labor Standards Act by failing to pay her
wages and overtime for all hours worked, by failing to provide her with
statements showing the proper amount of hours worked, and by wrongfully
converting her property by failing to pay overtime wages owed on the next payday
after they were earned. The plaintiff purports to bring this as an action on
behalf of all persons who were employed in one of our California stores or
outside the state of California. Plaintiffs seek compensatory, punitive and
liquidated damages, restitution, interest, penalties and attorneys' fees. In
December 2003, we filed an answer to the complaint and removed the Camarena
Lawsuit to the United States District Court for the Central District of
California, Case No. CV-03-8880 RGK (SHx), where it is currently pending.

Although at this stage of the litigation it is difficult to predict the outcome
of the case with certainty, we believe that we have meritorious defenses to the
Camarena Lawsuit. All proceedings in the Camarena Lawsuit are currently stayed
pursuant to the automatic stay provisions of Section 362 of the Bankruptcy Code,
subject to the entry of an order by the Court lifting the automatic stay. In the
event the Court enters an order lifting the automatic stay, we will continue to
vigorously defend against the Camarena Lawsuit.

We are periodically subject to legal actions that arise in the ordinary course
of business that could subject us to substantial money damages or injunctive
relief.

Our Customers Might Reduce their Houseware and Apparel Purchases as a Result of
Downturns in the United States and Local Economy

Our typical customers are families with more than the average number of children
and with an average annual household income of approximately $35,000. This
customer base is particularly vulnerable to economic recessions, depressions and
general slowdowns in the overall United States and local economy. During periods
of general economic weakness, our customers may choose to reduce their houseware
and apparel purchases in favor of housing and food expenditures, which could
result in a reduction in our sales.

We Face Uncertainties Relating to Our Bankruptcy Case

At this time, it is not possible to predict the effect of our Chapter 11 filing
on our business, creditors and shareholders or when we will be able to exit
Chapter 11. Our ability to continue as a going concern is predicated upon
numerous issues, including our ability to develop a long-term strategy to
revitalize our business and return to profitability; take appropriate actions to
offset the negative impacts that the Chapter 11 filing has had on our business
and the impairment of vendor relations; operate within the framework of our DIP
financing facility including limitations on capital expenditures and compliance
with financial covenants; generate cash flows from operations or seek other
sources of financing and the availability of projected vendor credit terms;
attract, motivate and retain key executives and associates; and develop,
negotiate, confirm and consummate a plan of reorganization in a timely manner.

AVAILABLE INFORMATION

We make available on our web site, www.factory2-u.com, our filings on Form 10-K,
10-Q, 8-K and amendments thereto, as soon as reasonably practical after we file
or furnish such materials with the Securities and Exchange Commission. All such
materials are available free of charge. Any information that is included on or
linked to our Internet site is not a part of this report or any registration
statement that incorporates this report by reference.

15

Item 2. Properties

As of April 23, 2004, we operated 195 retail stores located in seven states,
under various operating leases with third parties. Our store locations include
shopping centers, downtown business districts, malls and freestanding sites.
Each store lease is separately negotiated. The lease term for our stores is
between five to ten years with renewal options typically in five-year
increments. Approximately 98% of our leases are "triple net leases" under which
we are required to reimburse landlords for insurance, real estate taxes and
common area maintenance costs; however, for many of those leases, we have
negotiated reimbursement limitations on common area costs. As well as the
monthly minimum base rent, some of our store leases require additional rent,
which generally is based on an agreed percentage of sales in excess of a
specified sales level. Our store rent expense for the fiscal year ended January
31, 2004 was approximately $36.1 million.

Subsequent to January 31, 2004, we closed 44 stores in conjunction with our
reorganization efforts. As of April 23, 2004, we have terminated or assigned a
total of 13 leases of these stores and rejected the remaining 31 leases.

During fiscal 2003, we completed the consolidation of our two former San Diego
distribution centers and our Lewisville, Texas distribution center into one
single distribution center, which is located at a new facility in San Diego,
California. As part of our bankruptcy case, we have rejected the lease of our
San Diego distribution center located at 7130 Miramar Road and the lease of our
Lewisville, Texas distribution center at 1875 Waters Ridge Drive.

We continue to lease the space at our headquarters, located in a 208,460
square-foot multi-use facility at 4000 Ruffin Road, San Diego, California. This
facility consists of 58,460 square feet of office space and 150,000 square feet
of distribution space.

The lease of our new distribution facility located at 2020 Piper Ranch Road in
San Diego, California expires in July 2015 and provides for an annual base rent
of approximately $2.6 million.

16

Item 3. Legal Proceedings

On January 13, 2004, we filed a voluntary petition for reorganization under
Chapter 11 of the Bankruptcy Code. We retain control of our assets and are
authorized to operate the business as a debtor-in-possession while being subject
to the jurisdiction of the Court. As of the Petition Date, most pending
litigation is stayed, and absent further order of the Court, substantially all
pre-petition liabilitities are subject to settlement under a plan of
reorganization. At this time, it is not possible to predict the outcome of the
Chapter 11 case or its effect on our business. If it is determined that the
liabilities subject to compromise in the Chapter 11 case exceed the fair value
of the assets, unsecured claims may be satisfied at less than 100% of their fair
value and the equity interests of our shareholders may have no value. See Item
1. Business Proceedings Under Chapter 11 of the Bankruptcy Code.

On or about April 28, 2003, Lynda Bray and Masis Manougian, two of our former
employees, filed a lawsuit against us entitled Lynda Bray, Masis Manougian,
etc., Plaintiffs v. Factory 2-U Stores, Inc., et al., Defendants, Case No.
RCV071918, in the Superior Court of the State of California for the County of
San Bernardino (the "Bray Lawsuit"). The First Amended Complaint in the Bray
Lawsuit alleges purported claims for: (1) "Failure to Record Hours and or
Illegally Modify Recorded Hours Worked;" (2) "Failure to Pay Wages Under State
Labor Code, Penal Code and IWC Wage Order 7, Injunctive and Monetary Relief;"
(3) "Unfair Business Practice, Bus. & Prof. Code ss.17200 et. seq., Failure to
Pay Wages and Record Hours Worked;" (4) "Equitable Conversion;" and (5) "False
Advertising." The thrust of plaintiffs' claim is that the Company failed to pay
wages and overtime for all hours worked, failed to document all hours worked,
and failed to inform prospective or new employees of unpaid wage claims.
Plaintiffs purport to bring this action on behalf of all persons who were
employed in one of the California stores at anytime after April 25, 2003.
Plaintiffs seek compensatory and exemplary damages, interest, penalties,
attorneys' fees and disgorged profits in an amount which plaintiffs estimated to
be not less than $100,000,000. Plaintiffs also seek injunctive relief requiring
correction of the alleged unlawful practices.

Although at this stage of the litigation it is difficult to predict the outcome
of the case with certainty, we believe that we have meritorious defenses to the
Bray Lawsuit. All proceedings in the Bray Lawsuit are currently stayed pursuant
to the automatic stay provisions of Section 362 of the Bankruptcy Code, subject
to the entry of an order by the Court lifting the automatic stay. In the event
the Court enters an order lifting the automatic stay, we will continue to
vigorously defend against the Bray Lawsuit. If the Bray Lawsuit is decided
adversely, the potential exposure could be material to our results of
operations.

In November 2003, Virginia Camarena, a current employee in one of our California
stores, filed a lawsuit against us entitled Virginia Camarena, Plaintiff, vs.
Factory 2-U Stores Inc., etc., Defendants, Case No. BC305173 in the Superior
Court of the State of California for the County of Los Angeles - Central
District (the "Camarena Lawsuit"). The plaintiff alleges that we violated the
California Wage Orders, California Labor Code, California Business and
Profession Code and the Federal Fair Labor Standards Act by failing to pay her
wages and overtime for all hours worked, by failing to provide her with
statements showing the proper amount of hours worked, and by wrongfully
converting her property by failing to pay overtime wages owed on the next payday
after they were earned. The plaintiff purports to bring this as an action on
behalf of all persons who were employed in one of our California stores or
outside the state of California. Plaintiffs seek compensatory, punitive and
liquidated damages, restitution, interest, penalties and attorneys' fees. In
December 2003, we filed an answer to the complaint and removed the Camarena
Lawsuit to the United States District Court for the Central District of
California, Case No. CV-03-8880 RGK (SHx), where it is currently pending.

Although at this stage of the litigation it is difficult to predict the outcome
of the case with certainty, we believe that we have meritorious defenses to the
Camarena Lawsuit. All proceedings in the Camarena Lawsuit are currently stayed
pursuant to the automatic stay provisions of Section 362 of the Bankruptcy Code,
subject to the entry of an order by the Court lifting the automatic stay. In the
event the Court enters an order lifting the automatic stay, we will continue to
vigorously defend against the Camarena Lawsuit.

17

There are numerous other matters filed with the Court in our reorganization
proceedings by creditors, landlords or other third parties related to our
business operations or the conduct of our reorganization activities. Although
none of these individual matters which have been filed to date have had or are
expected to have a material adverse effect on us, our ability to successfully
manage the reorganization process and develop an acceptable reorganization plan
could be negatively impacted by adverse determinations by the Court on certain
of these matters.

We are at all times subject to pending and threatened legal actions that arise
in the normal course of business.

Item 4. Submission of Matters to a Vote of Security Holders

None.

PART II

Item 5. Market for Factory 2-U Stores, Inc. Common Equity and Related
Stockholder Matters

Market Information

On January 22, 2004 our Common Stock was suspended from trading on the NASDAQ
National Market and began trading on the "Over-the-Counter" (OTC) market under
the symbol of "FTUSQ.PK." Prior to January 22, 2004, our Common Stock was traded
on NASDAQ under the symbol of "FTUS."

The following table sets forth the range of high and low trading prices of each
of our fiscal quarters in fiscal 2002 and 2003. For Fiscal 2002 and through the
13 weeks ended November 1, 2003 the prices were based on the NASDAQ National
Market of the Common Stock, as reported by NASDAQ. Prices for the 13 weeks ended
January 31, 2004 were based on prices as reported by NASDAQ and Pinksheets LLC.
Such quotations represent inter-dealer prices without retail markup, markdown or
commission and may not necessarily represent actual transactions.

High Low
------- -------

Fiscal 2002
- -----------
13 weeks ended May 4, 2002 $ 18.31 $ 11.35
13 weeks ended August 3, 2002 $ 16.49 $ 10.61
13 weeks ended November 2, 2002 $ 10.91 $ 1.11
13 weeks ended February 1, 2003 $ 5.64 $ 1.45

Fiscal 2003
- -----------
13 weeks ended May 3, 2003 $ 5.35 $ 1.67
13 weeks ended August 2, 2003 $ 8.55 $ 2.85
13 weeks ended November 1, 2003 $ 7.65 $ 1.84
13 weeks ended January 31, 2004 $ 2.89 $ 0.28

Fiscal 2004 ending January 29, 2005
- -----------------------------------
Through April 23, 2004 $ 1.76 $ 0.86

As of April 23, 2004, we had approximately 230 stockholders of record and
approximately 2,200 beneficial stockholders.

18

Dividend Policy

We have never paid cash dividends on our Common Stock and do not anticipate
paying cash dividends in the foreseeable future. The declaration and payment of
any cash dividends on our Common Stock in the future will be determined by the
Board of Directors in light of conditions then existing, including our earnings,
financial condition, cash requirements and contractual, legal and regulatory
restrictions relating to the payments of dividends and any other factors that
our Board of Directors deems relevant. During the pendency of the Chapter 11
proceedings, any such dividend would be remote and, in any event, subject to the
approval of the Court. We are contractually prohibited from paying cash
dividends on our Common Stock under the terms of our existing DIP financing
facility without the consent of the lenders. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations - Liquidity and
Capital Resources - DIP Financing Facility."

Equity Compensation Plan Information

The following table sets forth information as of January 31, 2004 with respect
to our common stock that may be issued upon the exercise of stock options under
our Amended and Restated 1997 Stock Option Plan, together with information
relating to our common stock that may be issued under plans not approved by
stockholders.

(c)

(a) Number of Securities
Remaining Available for
Number of (b) Future Issuance Under
Securities to be Equity Compensation
Issued Upon Exercise Weighted Average Exercise Plans (Excluding
of Outstanding Price of Outstanding Securities Reflected in
Plan Category Options Options Column (a))
- ------------------------------ ----------------------- -------------------------- -------------------------

Equity Compensation 1,514,380 $8.19 1,643,600
Plans Approved by
Stockholders
- ------------------------------ ----------------------- -------------------------- -------------------------

19

Item 6. Selected Financial Data

The selected financial data set forth below, except for Operating Data, is
derived from our audited financial information and should be read in conjunction
with "Management's Discussion and Analysis of Financial Condition and Results of
Operations" and our Financial Statements, including the Notes, and Supplementary
Data included in this Annual Report on Form 10-K.

Fiscal Year Ended
-----------------
January 31, February 1, February 2, February 3, January 29,
2004(1) 2003 (2) 2002 (3) 2001 (4) 2000 (5)
---------- ---------- ---------- ---------- -----------
(in thousands, except per share and operating data)

Statement of Operations Data
- ----------------------------
Net sales $ 493,297 $ 535,270 $ 580,460 $ 555,670 $ 421,391
Operating income (loss) (26,383) (45,050) (16,786) 31,868 22,753
Reorganization items (31,703) - - - -
Income (loss) from continuing operations
before income taxes and extraordinary
items (61,779) (46,661) (17,746) 30,322 20,481
Net income (loss) applicable to common stock (85,859) (28,509) (10,896) 21,264 12,442
Weighted average shares outstanding
Basic 16,187 12,957 12,807 12,589 12,214
Diluted 16,187 12,957 12,807 13,066 12,864
Income (loss) before extraordinary items and
discontinued operations applicable to
common stock
Basic (5.30) (2.20) (0.85) 1.69 1.02
Diluted (5.30) (2.20) (0.85) 1.63 0.97
Net income (loss) per common stock
Basic (5.30) (2.20) (0.85) 1.69 1.02
Diluted (5.30) (2.20) (0.85) 1.63 0.97

Operating Data
- --------------
Number of stores at fiscal year end 239 244 279 243 187
Total selling square footage at fiscal
year end 2,965,000 3,021,000 3,459,000 2,979,000 2,169,000
Sales per average selling square foot $ 164 $ 167 $ 178 $ 211 $ 209
Comparable store sales increase (decrease)(6) (4.4%) (7.7%) (8.7%) 4.4% 10.3%

Balance Sheet Data
- ------------------
Working capital (deficit) (7) $ 21,521 $ (2,913) $ 14,633 $ 18,896 $ 1 ,241
Total assets 70,708 126,504 155,709 142,265 108,466
Liabilities subject to compromise 63,062 - - - -
Long-term debt and revolving credit
facility, including current portion (7) 128 15,746 10,376 11,218 11,067
Stockholders' equity (deficit) (24,932) 44,319 70,566 79,737 46,430

(1) Includes the following pre-tax items:
(a) $26.3 million adjustment related to the impairment of goodwill
(reorganization items),
(b) $7.8 million inventory valuation allowance, net of a $0.5 million
adjustment for the reserve established at the end of fiscal 2002 for
slow moving and aged items (cost of sales),
(c) $1.5 million adjustment to reduce the reserves for the fiscal 2002 and
2001 restructuring plans (restructuring charge, net),
(d) $2.4 million related to impairment of fixed assets associated with the
44 closing stores, (reorganization items),
(e) $1.7 million related to inventory sold below cost at our 44 closing
stores (reorganization items),
(f) $1.3 million related to professional services and other expenses as
a result of the Chapter 11 filing (reorganization items),
(g) $1.0 million related to separation with former executives (selling and
administrative expenses), and
(h) $0.7 million favorable adjustment to the stock subscription notes
receivable valuation allowance established at the end of fiscal 2002
(selling and administrative expenses).

20

(2) Included the following pre-tax items:
(a) $16.1 million related to clearing slow-moving inventory and an
inventory valuation allowance (cost of sales),
(b) $2.8 million related to a long-term consulting project, which was
terminated in November 2002,
(c) $2.1 million related to a litigation settlement,
(d) $14.4 million related to fiscal 2002 restructuring efforts, partially
offset by a $5.0 million reserve reduction related to the fiscal 2001
restructuring efforts (as a result of favorable experience with lease
termination costs),
(e) $0.8 million related to the separation agreement of our former Chief
Executive Officer, and
(f) $2.2 million write-down of shareholders and trade notes receivable.
(3) Included pre-tax expenses of $21.2 million related to fiscal 2001
restructuring efforts, $0.5 million non-cash stock option charge, and $1.1
million related to the retirement and replacement of our former General
Merchandising Manager.
(4) Fiscal year included 53 weeks. Included pre-tax expenses of $4.8 million
non-cash charge for performance-based stock options, partially offset by a
$1.2 million condemnation award and $2.9 million after-tax reduction to our
tax valuation allowance.
(5) Included a pre-tax $2.1 million non-cash charge related to
performance-based stock options.
(6) We averaged 230, 217, 179, 152 and 151 comparable stores for fiscal years
2003, 2002, 2001, 2000 and 1999, respectively. We define comparable stores
as follows:
o New stores are considered comparable after 18 months from date of
opening.
o When a store relocates within the same market, it is considered
comparable after 6 months of operations.
o Store expansion greater than 25% of the original store size is treated
like a new store and becomes comparable after 18 months of operations.
Store expansion less than 25% of the original store size remains in
the comparable store base.
(7) As of January 31, 2004, working capital and long term debt and revolving
credit facility, including current portion, do not include liabilities
classified as subject to compromise.

21

Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations

The following discussion and analysis should be read in conjunction with the
information set forth under "Selected Financial Data" and "Financial Statements
and Supplementary Data."

General

We operate a chain of off-price retail apparel and houseware stores in Arizona,
California, Nevada, New Mexico, Oregon, Texas and Washington. We sell branded
casual apparel for the family, as well as selected domestic and household
merchandise at prices that generally are significantly lower than other discount
stores.

In fiscal 2002, we continued to experience declining transaction counts,
declining purchase size, increased competition, rising operating costs and a
slow economy. These factors were exacerbated by the lingering effects of the
September 11 terrorist attacks and fear of war in Iraq. In December 2002, we
announced the fiscal 2002 restructuring initiatives needed to improve operating
results. These initiatives included the closure of 23 under-performing stores
and consolidation of our distribution center network and corporate overhead
structure. In connection with the fiscal 2002 restructuring, we recorded a
pre-tax restructuring charge of approximately $14.4 million. We also announced
efforts to liquidate our slow-moving and aged inventory chain-wide. We incurred
a pre-tax charge of $16.1 million related to clearing slow-moving inventory and
an inventory valuation allowance.

We experienced a continuation of declining sales volume in fiscal 2003 with a
decrease of 4.4% in comparable store sales for the year. We believe there were a
number of factors that contributed to the lower sales in fiscal 2003: (1) lower
inventory levels for most of our first quarter due to a tightening of credit by
our vendors, (2) war in Iraq, (3) the combined effect of the wildfires and labor
strikes in the southern California region in the third quarter, (4) decrease in
retail price points, and (5) a continuation of a very soft retail environment
impacted by general price deflation and heavy promotion, particularly in
apparel.

As a result of our financial results in fiscal 2001 and 2002, bankruptcy filings
by a number of well-known retail chains during calendar year 2002 and the
general weak economic environment, shortly after the fiscal 2002 Christmas
selling season we experienced a tightening of credit extended to us by vendors,
factors and others for merchandise purchases. The initial impact of this credit
tightening was a disruption of product flow to our stores in January, February
and to a lesser extent March of 2003. This credit environment required us, in
many cases, to meet accelerated payment terms in order to re-establish a
consistent flow of product and assure a level of inventory for Spring 2003
business. The acceleration of payment terms, in turn, adversely affected our
liquidity and, to some extent, further weakened our existing credit standing.

In an effort to improve our liquidity, obtain more reasonable credit terms and
provide for a consistent flow of merchandise, we initiated a series of financing
transactions and took steps to accelerate the receipt of refunds related to tax
loss carry-back benefits. On March 6, 2003, we completed a private offering of
2,515,379 shares of our common stock for net proceeds of approximately $5.7
million, after deduction the placement fees and other offering expenses. In
addition, during March of 2003, we received an $8.2 million federal tax refund
as a result of utilizing a tax loss carry-back benefit. On April 10, 2003, we
completed a $7.5 million debt financing transaction consisting of a $6.5 million
junior term note secured primarily by inventory and a $1.0 million term note
secured primarily by equipment and other assets. On August 20, 2003, we
completed another private offering of 2,450,000 shares of our common stock for
net proceeds of approximately $11.4 million, after deducting the placement fees
and other offering expenses.

Despite our efforts to improve sales and our liquidity, we were unable to
improve comparable sales growth and operating margin at a rate that could
generate sufficient cash flow to sustain ongoing operations. Accordingly, we
elected to file for bankruptcy protection under Chapter 11 of the Bankruptcy
Code on January 13, 2004.

22

Under Chapter 11, we are operating our business as a debtor-in-possession. As of
the Petition Date, actions to collect pre-petition indebtedness as well as most
other pending litigation, are stayed and other pre-petition contractual
obligations generally may not be enforced against us. In addition, under the
Bankruptcy Code, we may assume or reject executory contracts and unexpired
leases, subject to approval of the Court and our satisfaction of certain other
requirements. Parties affected by these rejections may file claims in accordance
with the reorganization process. Absent an order of the Court, substantially all
pre-petition liabilities are subject to settlement under a plan of
reorganization to be voted upon by creditors and equity holders and approved by
the Court.

At hearings held on January 14, 2004 concerning our first day motions, the Court
entered orders granting us authority, among other things, to (1) continue our
centralized cash management system, (2) pay pre-petition wages and continue our
employee benefit plans and other employee programs, (3) continue customer
related practices, (4) pay certain sales, use and other taxes, (5) pay suppliers
and vendors in full for all goods and services provided on or after the Petition
Date and (6) continue ongoing pre-petition "going out of business sales" for
four store locations completed by January 31, 2004. In addition, the Court also
gave interim approval for a $45.0 million DIP financing facility that was
committed by The CIT Group/Business Credit, Inc. and GB Retail Funding, LLC.

On February 2, 2004, the Court granted final approval of the $45.0 million DIP
financing facility. We intend to utilize this financing, in addition to cash
flow from operations, to fulfill business obligations during the Chapter 11
case.

Additionally, on February 2, 2004, the Court authorized the closure of 44
stores, or approximately 18% of our 239 stores. Stores were selected by
evaluating their market and financial performance. On February 11, 2004, the
Court approved our appointment of Great American as exclusive agent to conduct
store closing sales at these 44 store locations. The store closing sales started
on February 12, 2004. All 44 stores were closed by March 18, 2004 and as of
April 23, 2004, we have terminated or assigned a total of 13 leases of these
stores and rejected the remaining 31 leases.

In connection with our Chapter 11 case, the United States Trustee has appointed
an unsecured creditors committee and may consider the appointment of an equity
committee. These official committees and their legal representatives often take
positions on matters that come before the Court, and are the entities with which
we plan to negotiate the terms of our plan of reorganization. There can be no
assurance that the unsecured creditors committee or equity committee, if any,
will support our positions in the bankruptcy case or the plan of reorganization
once proposed, and any disagreements could protract the bankruptcy case,
negatively impact our ability to operate during bankruptcy, and/or delay our
emergence from bankruptcy.

See additional information regarding the Chapter 11 case in Item 1. Business --
Proceedings Under Chapter 11 of the United States Bankruptcy Code, of this Form
10-K.

Our ability to continue as a going concern is predicated upon numerous issues,
including our ability to achieve the following:

- developing and implementing a long-term strategy to revitalize our
business and return to profitability;

- taking appropriate actions to offset the negative impact the Chapter
11 filing has had on our business and the impairment of vendor
relations;

- operating within the framework of our DIP financing facility,
including limitations on capital expenditures and compliance with
financial covenants;

23

- generating cash flows from operations or seeking other sources of
financing and the availability of projected vendor credit terms;

- attracting, motivating and retaining key executives and associates;
and

- developing, negotiating, and, thereafter, having a plan of
reorganization confirmed by the Court.

These challenges are in addition to those operational and competitive challenges
faced by Factory 2-U in connection with our business as an off-price retailer.
See " Cautionary Statement for Purposes of "Safe Harbor Provisions" of the
Private Securities Litigation Reform Act of 1995" immediately preceding Item 1
of this Form 10-K.

We started fiscal 2004 with numerous issues and tasks that we need to resolve
and achieve. The Chapter 11 filing right before the beginning of our fiscal 2004
provides us an opportunity to improve our business operations, reduce our cost
structure and restructure our financial affairs. Our primary goal for fiscal
2004 is to improve our cash flows. We have started taking steps and continue to
focus on our major management objectives including:

- improving store performance - closing 44 non-core underperforming
stores (all these stores were closed by March 18, 2004);

- improving our gross margin - raising our initial mark up and adjusting
our retail price points;

- reducing advertising spend - reducing the number of advertising
circulars and improving productivity of our advertising circulars; and

- reducing our selling, general and administrative expenses - monitoring
store payroll and reducing costs at the corporate headquarters.

With respect to store openings and closings in fiscal 2004, we have already
closed 44 stores as discussed above and we currently plan to open one new store
for which the lease was signed before our Chapter 11 filing. We continue to
review and monitor our store performance by evaluating each existing store's
market and financial performance and we may close additional stores that do not
meet our minimum financial performance criteria.

Critical Accounting Policies

The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires us to make
estimates, assumptions and judgments that affect the reported amounts of assets
and liabilities and disclosures of contingent assets and liabilities at the date
of the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.

The financial statements have been prepared on a going concern basis, which
assumes continuity of operations and realization of assets and satisfaction of
liabilities in the ordinary course of business. Based on guidance in SOP 90-7,
all pre-petition liabilities subject to compromise have been segregated in the
Balance Sheet and are classified as Liabilities subject to compromise, at the
estimated amount of allowable claims. Liabilities not subject to compromise are
separately classified as current and non-current. Expenses, realized losses, and
provision for losses resulting from the reorganization are reported separately
as reorganization items.

24

We believe the following represents the areas where the most critical estimates
and assumptions are used in the preparation of the financial statements:

o Inventory valuation. Merchandise inventory is stated at the lower of cost
or market determined using the retail inventory method ("RIM") on a
first-in, first-out basis. Under the RIM, the valuation of inventory at
cost and the resulting gross margin are calculated by applying a computed
cost-to-retail ratio to the retail value of inventory. RIM is an averaging
method that has been widely used in the retail industry due to its
practicality. Also, it is recognized that the use of the RIM will result in
valuing inventory at the lower of cost or market if markdowns are currently
taken as a reduction of the retail value of inventory. Inherent in the RIM
calculation are certain significant management judgments and estimates
regarding markdowns and shrinkage, which may from time to time cause
adjustments to the gross margin in the subsequent period. Factors that can
lead to distortion in the calculation of the inventory balance include
applying the RIM to a group of merchandise items that is not fairly uniform
in terms of its cost and selling price relationship and turnover, and
applying RIM to transactions over a period of time that includes different
rates of gross profit, such as those relating to seasonal merchandise
items. To minimize the potential of such distortions in the valuation of
inventory from occurring, we utilize 82 sub-departments in which fairly
homogeneous classes of merchandise items having similar gross margin are
grouped. In addition, failure to take markdowns currently may result in an
overstatement of cost under the lower of cost or market principle. As of
January 31, 2004, we had an inventory valuation allowance of approximately
$9.1 million representing our estimate of the cost in excess of the net
realizable value of all clearance items. In addition, we had an allowance
of approximately $2.2 million representing additional inventory shrink
reserve. We believe that our RIM provides an inventory valuation that
reasonably approximates cost and results in carrying inventory at the lower
of cost or market.

o Valuation of goodwill, intangible and other long-lived assets. We use
certain assumptionsin establishing the carrying value and estimated lives
of our long-lived assets and goodwill. The criteria used for these
evaluations include management's estimate of the asset's continuing ability
to generate income from operations and positive cash flows. If assets are
considered to be impaired, the impairment recognized is measured by the
amount that the carrying value of the assets exceeds the fair value of the
assets. Useful lives and related depreciation or amortization expense are
based on our estimate of the period that the assets will generate revenues
or otherwise be used in operations. Factors that would influence the
likelihood of a material change in our reported results include a
significant decline in our stock price and market capitalization compared
to our net book value, significant changes in an asset's ability to
generate positive cash flows, significant changes in our strategic business
objectives and utilization of the asset. In conjunction with our Chapter 11
filing, we recorded an impairment charge of $26.3 million for our goodwill.
Additionally, as a result of the closure of 44 stores, we recorded an
impairment charge of $2.4 million regarding fixed assets located at these
stores.

o Accrued restructuring costs. We have estimated amounts for the charges and
the related liabilities regarding our fiscal 2002 and fiscal 2001
restructuring initiatives including store closures, realignment of our
field organization and workforce reductions in accordance with the Emerging
Issues Task Force ("EITF") Issue 94-3, "Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring)." Depending on our
ability to dispose of the remaining lease obligations for the store and
distribution center closures, the actual costs to complete the
restructuring initiatives may be different from our estimated costs. As of
January 31, 2004, we evaluated our accrued restructuring costs and recorded
a favorable adjustment of $1.5 million primarily related to the adjustment
of lease termination costs, which is based on the maximum amount allowed by
the Bankruptcy Code.

25

o Litigation reserves. Based in part on the advice of our legal counsel,
estimated amounts for litigation and claims that are probable and can be
reasonably estimated are recorded as liabilities in the balance sheet. The
likelihood of a material change in these estimated reserves would be
dependent on new claims as they may arise and the favorable or unfavorable
outcome of the particular litigation. We continuously evaluate the adequacy
of these reserves and, as new facts come to light, adjust these reserves
when necessary.

o Workers' compensation accrual. At the beginning of fiscal 2001, we
transitioned to a partially self-insured workers' compensation program. The
program for the policy year ended January 31, 2002 had both a specific and
aggregate stop loss amount of $250,000 and $3.2 million, respectively. The
program for the policy years ended January 31, 2004 and January 31, 2003
had a specific stop loss amount of $250,000 with no aggregate stop loss
limit. We utilize internal actuarial methods, as well as an independent
third-party actuary for the purpose of estimating ultimate costs for a
particular policy year. Based on these actuarial methods along with current
available information and insurance industry statistics, the ultimate
expected losses for the policy year ended January 31, 2004, 2003 and 2002
were estimated to be approximately $3.6 million, $4.7 million and $4.3
million ($3.2 million aggregate stop loss), respectively. Our estimate is
based on average claims experience in our industry and our own experience
in terms of frequency and severity of claims, with no explicit provision
for adverse fluctuation from year to year and is subject to inherent
variability. This variability may lead to ultimate payments being either
greater or less than the amounts presented above.

o Valuation of deferred income taxes. Valuation allowances are established,
if deemed necessary, to reduce deferred tax assets to the amount expected
to be realized. The likelihood of a material change in our expected
realization of these assets is dependent on future taxable income, our
ability to use the net operating loss carryforwards, the effectiveness of
our tax planning and strategies among the various tax jurisdictions that we
operate in, and any significant changes in the tax treatment we currently
receive. In light of our significant net operating losses and our Chapter
11 filing, we provided for a 100% valuation allowance on our deferred tax
assets as of January 31, 2004.

Results of Operations

The financial statements contained herein have been prepared on a going concern
basis, which assumes continuity of operations and realization of assets and
satisfaction of liabilities in the ordinary course of business, and in
accordance with SOP 90-7. Upon emergence from bankruptcy, the amounts reported
in subsequent financial statements may materially change, due to the
restructuring of our assets and liabilities as a result of the plan of
reorganization, if any, and the application of "Fresh Start" accounting.

We define our fiscal year by the calendar year in which most of our business
activity occurs (the fiscal year ended January 31, 2004 is referred to as fiscal
2003). The following table sets forth operating data expressed as a percentage
of net sales for the fiscal years indicated. Due to operational and strategic
changes, year-to-year comparisons of financial results may not be meaningful and
the historical results of our operations may not be indicative of our future
results.

26

Fiscal Year
-----------
2003 2002 2001
---- ---- ----
(percentage of net sales)

Net sales 100.0 100.0 100.0
Cost of sales 68.9 69.7 66.4
------ ------ ------
Gross profit 31.1 30.3 33.6

Selling and administrative expenses 36.7 36.6 32.4
Pre-opening and closing expenses 0.1 0.2 0.5
Amortization of intangibles - - 0.3
Restructuring charge, net (0.3) 1.9 3.2
Stock-based compensation expense - - 0.1
------- ------ ------
Operating loss (5.4) (8.4) (2.9)

Interest expense, net 0.7 0.3 0.2
------- ------- ------
Loss before reorganization items and
income taxes (benefit) (6.1) (8.7) (3.1)
Reorganization items 6.4 - -
------- ------- ------
Loss before income taxes (benefit) (12.5) (8.7) (3.1)
Income taxes (benefit) 4.9 (3.4) (1.2)
------- ------- ------
Net loss (17.4) (5.3) (1.9)
------- ------- ------

We operated 239 stores, 244 stores and 279 stores as of January 31, 2004,
February 1, 2003 and February 2, 2002, respectively. The average number of
stores in operation in fiscal 2003 was 243 versus 259 in fiscal 2002 and 252 in
fiscal 2001.

In addition, we averaged 230, 217 and 179 comparable stores for fiscal 2003,
2002 and 2001, respectively. We define comparable stores as follows:

o New stores are considered comparable after 18 months from date of
opening.

o When a store relocates within the same market, it is considered
comparable after 6 months of operations.

o Store expansion greater than 25% of the original store size is treated
like a new store and becomes comparable after 18 months of operations.
Store expansion less than 25% of the original store size remains in
the comparable store base.

Fiscal 2003 Compared to Fiscal 2002

Net sales were $493.3 million for fiscal 2003 compared to $535.3 million for
fiscal 2002, a decrease of $42.0 million or 7.8%. Comparable store sales
decreased 4.4% in fiscal 2003 versus a decrease of 7.7% in fiscal 2002. The
decrease in net sales was due to negative comparable store sales as well as
fewer stores in operation as a result of our fiscal 2002 restructuring.

Gross profit was $153.2 million for fiscal 2003 compared to $162.4 million for
fiscal 2002, a decrease of $9.2 million or 5.6%. As a percentage of net sales,
gross profit was 31.1% in fiscal 2003 compared to 30.3% in fiscal 2002, or an 80
basis-point improvement versus fiscal 2002. Included in fiscal 2003 cost of
sales were a non-cash inventory valuation allowance charge of $7.8 million, net
and a non-cash adjustment of $217,000 to reduce excess reserve for inventory
liquidation cost related to stores closed under the fiscal 2002 and 2001
restructuring plans. Of the $7.8 million, $6.1 million represented a "lower of
cost or market" adjustment related to approximately $19.2 million of aged and
slow-moving items that we decided to liquidate during the first quarter of
fiscal 2004, $2.2 million represented additional shrink reserve based on
unfavorable shrink results we experienced during physical inventory taken at our

27

stores in February 2004, and an adjustment of $523,000 to reduce excess
inventory reserve established at the end of fiscal 2002. As previously reported,
included in fiscal 2002 cost of sales were (1) a non-cash charge of $16.1
million related to clearing slow-moving inventory and an inventory valuation
allowance, (2) a non-cash charge of $1.1 million related to the expected
inventory liquidation cost for store closings identified in the previously
mentioned fiscal 2002 restructuring, and (3) a non-cash adjustment of $1.3
million to reduce excess reserve for inventory liquidation cost related to
stores closed under the fiscal 2001 restructuring plan. The inventory valuation
allowance represented a "lower of cost or market" adjustment related to
approximately $16.3 million of aged and slow-moving items that we decided to
liquidate in the first quarter of fiscal 2003.

Selling and administrative expenses were $180.9 million for fiscal 2003 compared
to $196.4 million for fiscal 2002, a decrease of $15.5 million or 7.9%. Included
in fiscal 2003 selling and administrative expenses were $1.0 million charge in
connection with separation of two former executives and an income of
approximately $708,000 to adjust the valuation allowance established at the end
of fiscal 2002 related to certain of our stock subscription notes receivable.
Included in fiscal 2002 selling and administrative expenses were: (1) consulting
fees of $2.8 million in connection with a consulting agreement, which was
terminated in November 2002; (2) a charge of $2.1 million recorded during the
second quarter in conjunction with the settlement of litigation; (3) a non-cash
charge of $1.2 million to adjust the value of certain shareholders' notes
receivable; and (4) a non-cash valuation allowance of $1.0 million for an
uncollectible note receivable due from one of our vendors. Excluding these
special items in fiscal 2003 and 2002, the selling and administrative expenses
for fiscal 2003 was $180.5 million or 36.6 % of net sales compared to $189.3
million or 35.4% of net sales for fiscal 2002. The decrease of $8.8 million or
4.7% was primarily due to fewer stores in operation. The average number of
stores in operation for fiscal 2003 was 243, 6.2% lower than fiscal 2002. The
increase in selling and administrative expenses as a percentage of net sales was
primarily due to the loss of sales volume.

In fiscal 2003, we recorded pre-opening and closing expenses of $292,000, which
primarily consisted of start-up expenses for our new distribution center. The
decrease of $794,000, or 73.1% from fiscal 2002 was primarily due to the opening
of ten fewer new stores in fiscal 2003. In addition, fiscal 2002's pre-opening
and closing expenses also included a $250,000 lease termination fee for a store
we decided not to open.

Restructuring charge for fiscal 2003 was a favorable adjustment of approximately
$1.5 million to reduce the reserves for the fiscal 2002 and 2001 restructuring
plans. This favorable adjustment was primarily related to the lease termination
reserve adjustment in accordance with the maximum claim for rejected leases as
allowed by the Bankruptcy Code. During the fourth quarter of fiscal 2002, we
recorded a charge of $14.4 million in relation to our fiscal 2002 restructuring
efforts. The charge of $14.4 million included a non-cash inventory liquidation
cost of $1.1 million, which was included in cost of sales. In addition, as a
result of favorable experience related to the costs of closing the 28 stores
included in our fiscal 2001 restructuring plan, we recorded a favorable
adjustment of approximately $5.0 million to reduce the reserve established for
the fiscal 2001 restructuring plan. Included in this reserve reduction was $1.3
million related to inventory liquidation cost, which was reported as part of
cost of sales. As such, the total amount reported as a restructuring charge for
fiscal 2002 was $9.9 million.

Reorganization items for fiscal 2003 were $31.7 million and consisted of: (1) a
non-cash goodwill impairment charge of $26.3 million; (2) a non-cash impairment
charge of $2.4 million for fixed assets associated with the 44 stores closed
subsequent to January 31, 2004 as part of our reorganization efforts; (3) a
non-cash inventory valuation reserve of $1.7 million related to the sale
inventory at the 44 stores below cost; and (4) $1.3 million of professional fees
and other expenses related to the bankruptcy case and reorganization efforts.

Interest expense, net was $3.7 million in fiscal 2003 versus $1.6 million in
fiscal 2002, an increase of $2.1 million or 131.3%. The increase in interest
expense from fiscal 2002 is due to increased borrowings at higher interest rates
and the write-off of remaining unamortized debt issuance costs of approximately
$353,000 as a result of the Chapter 11 filing.

28

Income tax expense increased from a credit for income taxes of $18.2 million in
fiscal 2002 to an expense for income taxes of $24.1 million in fiscal 2003. The
credit for income taxes recorded during fiscal 2002 reflected the recognition of
a tax benefit associated with our net operating losses. Fiscal 2003 results
reflected the establishment of a valuation reserve against certain previously
recorded deferred tax assets. Due to our significant net operating losses and
our Chapter 11 filing, we now beleive that our ability to recover previously
recorded deferred tax assets in the near term has diminished and that it is
appropriate to establish a valuation allowance to fully reserve our previously
recorded deferred tax assets.

Fiscal 2002 Compared to Fiscal 2001

Net sales were $535.3 million for fiscal 2002 compared to $580.5 million for
fiscal 2001, a decrease of $45.2 million or 7.8%. Comparable store sales
decreased 7.7% in fiscal 2002 versus a decrease of 8.7% in fiscal 2001. The
decrease in net sales was due to fewer stores in operation as well as negative
comparable store sales. Comparable store sales decreased primarily as a result
of continuing slow economy, threat of terrorist attacks, threat of war with
Iraq, increased price competition, and to a lesser extent, increased utilities
and fuel costs in California, our largest market. As a result of these factors,
we experienced fewer transactions and a reduced purchase size. Compounding this,
apparel is considered a deferrable purchase for our core customers who have
limited discretionary income. Apparel and houseware purchases may be reduced and
deferred in favor of more current needs such as food, housing, utilities and
transportation.

Gross profit was $162.4 million for fiscal 2002 compared to $195.1 million for
fiscal 2001, a decrease of $32.7 million or 16.8%. As a percentage of net sales,
gross profit was 30.3% in fiscal 2002 compared to 33.6% in fiscal 2001, or a 330
basis-point decline versus fiscal 2001. Included in fiscal 2002 cost of sales
were: (1) a non-cash charge of $16.1 million related to clearing slow-moving
inventory and an inventory valuation allowance; (2) a non-cash charge of $1.1
million related to the expected inventory liquidation cost for store closings
identified in the previously mentioned fiscal 2002 restructuring; and (3) a
non-cash adjustment of $1.3 million to reduce excess reserve for inventory

liquidation cost related to stores closed under the fiscal 2001 restructuring
plan. The inventory valuation allowance represented a "lower of cost or market"
adjustment related to approximately $16.3 million of aged and slow-moving items
that we decided to liquidate by April 2003. As previously reported, the fiscal
2001 gross margin reflected a non-cash charge of $2.9 million related to the
estimated inventory liquidation cost for the closing of 28 under-performing
stores identified in the fiscal 2001 restructuring plan. After giving effect to
restructuring charges in both years, gross profit margin declined primarily due
to higher markdown volume (260 basis points). The higher markdown volume was
related to a very heavy promotional environment and clearance of slow-moving and
aged merchandise.

Selling and administrative expenses were $196.4 million for fiscal 2002 compared
to $188.3 million for fiscal 2001, an increase of $8.1 million or 4.3%. As a
percentage of net sales, selling and administrative expenses were 36.6% for
fiscal 2002 compared to 32.4% for fiscal 2001. The increase in selling and
administrative spending as a percentage of net sales was both spending related
and sales volume related. Included in fiscal 2002 selling and administrative
expenses were: (1) consulting fees of $2.8 million in connection with a
consulting agreement, which was terminated in November 2002; (2) a charge of
$2.1 million recorded during the second quarter in conjunction with the
settlement of litigation; (3) a non-cash charge of $1.2 million to adjust the
value of certain shareholders' notes receivable; and (4) a non-cash valuation
allowance of $1.0 million for an uncollectible note receivable due from one of
our vendors. In addition to these items, we experienced an increase of
approximately $3.5 million in advertising expense. The higher advertising
expense was due to increased advertising circulars in response to a very
competitive promotional environment. Other store selling expenses, which
included store labor and store occupancy, were lower than fiscal 2001 primarily
due to the lower average number of stores in operation.

Pre-opening expenses were $1.1 million for fiscal 2002 compared to $3.1 million
for fiscal 2001, a decrease of $2.0 million, or 64.8%. The decrease in
pre-opening expenses was primarily related to 12 new store openings this year
versus 39 new store openings last year. Current year pre-opening expenses
included a $250,000 lease termination fee for a store we decided not to open.

29

Amortization of intangibles was not recorded for fiscal 2002 compared to $1.7
million for fiscal 2001. The change was due to the elimination of goodwill
amortization in conjunction with the adoption of Statement of Financial
Accounting Standards ("SFAS") No. 142 and cessation of amortization associated
with prior business acquisitions.

During the fourth quarter of this year, we recorded a charge of $14.4 million in
relation to our previously announced fiscal 2002 restructuring efforts. The
charge of $14.4 million included a non-cash inventory liquidation cost of $1.1
million, which was included in cost of sales. In addition, as a result of
favorable experience related to the costs of closing the 28 stores included in
our fiscal 2001 restructuring plan, we recorded a favorable adjustment of
approximately $5.0 million to reduce the reserve established for the fiscal 2001
restructuring plan. Included in this reserve reduction was $1.3 million related
to inventory liquidation cost, which was reported as part of cost of sales. As
such, the total amount reported as a restructuring charge for fiscal 2002 was
$9.9 million versus $18.3 million for fiscal 2001. The restructuring charge of
$18.3 million in fiscal 2001 was part of the $21.2 million charge related to our
restructuring initiatives, as previously discussed. We recorded $2.9 million of
the pre-tax $21.2 million charge as a non-cash inventory liquidation cost which
was included in cost of sales.

We recorded non-cash stock-based compensation expense related to certain
performance-based stock options during fiscal 2001 in the amount of $456,000.
During the second quarter of fiscal 2001, we removed the market price hurdle of
$49.78 for 19,361 stock options held by a former Executive Vice President who
retired in August 2001. As a result of the removal of the market price hurdle,
we incurred a non-cash charge of $456,000. There was no stock-based compensation
expense incurred in fiscal 2002.

Interest expense, net was $1.6 million in fiscal 2002 versus $960,000 in fiscal
2001, an increase of $651,000 or 67.8%. The increase was due to higher average
outstanding borrowings on the revolving credit facility.

We recorded a federal and state income tax benefit of $18.2 million in fiscal
2002 versus $6.9 million in fiscal 2001, an increase of $11.3 million or 165.0%.
The increase was due to an increased pre-tax loss incurred in the current year
compared to the prior year.

Liquidity and Capital Resources

General

We finance our operations through credit provided by vendors and other
suppliers, amounts borrowed under our revolving credit facilities, internally
generated cash flow, and other financing resources. Credit terms provided by
vendors and other suppliers have historically been approximately 30 days net,
although during the pendency of the Chapter 11 case, many of our vendors have
reduced the amount of time in which we must pay for goods. Amounts that may be
borrowed under the DIP financing facility are based on a percentage of eligible
inventory and accounts receivable, as defined.

During fiscal 2003, we completed a series of financing transactions designed to
improve liquidity and strengthen our financial position. On March 6, 2003, we
completed a private offering of 2,515,379 shares of our common stock for net
proceeds of approximately $5.7 million, after deducting the placement fees and
other offering expenses. On April 10, 2003, we completed a $7.5 million debt
financing transaction, which consists of a $6.5 million junior term note and a
$1.0 million term note. On August 20, 2003, we completed another private
offering of 2,450,000 shares of our common stock for net proceeds of
approximately $11.4 million, after deducting the placement fees and other
offering expenses. In addition to these financing transactions, we also received
a federal tax refund of $8.2 million in March 2003.

After the completion of our private equity offerings, debt financing transaction
and receipt of the federal tax refund, the vendor and credit community provided
support and extended credit terms for merchandise shipments. However, despite
our efforts to improve sales and liquidity, we were unable to improve comparable
sales growth and operating margin at a rate that could generate sufficient cash
flow to sustain ongoing operations. Accordingly, we elected to file for
bankruptcy protection under Chapter 11 of the Bankruptcy Code on January 13,
2004.

30

DIP Financing Facility

In conjunction with our Chapter 11 filing, we entered into a financing agreement
with The CIT Group/Business Credit, Inc. (the Tranche A Lender) and GB Retail
Funding, LLC (the Tranche B Lender), (collectively the "Lenders") in which the
Lenders provide us a $45.0 million revolving credit facility for working capital
needs and other general corporate purposes while we operate as a
debtor-in-possession (the "DIP financing facility"). This DIP financing facility
with a maturity date of January 14, 2005 has since been amended twice, the first
amendment on January 30, 2004 and the second amendment on March 10, 2004.

The DIP financing facility has a superpriority claim status in our Chapter 11
case and is collateralized by first liens on substantially all of our assets,
subject to valid and unavoidable pre-petition liens and certain other permitted
liens. Under the terms of the DIP financing facility, we may borrow up to 85% of
our eligible accounts receivable and up to 70% of our eligible inventory, as
defined. However, the DIP financing facility provides for a $5.0 million
availability block against our availability calculation, as defined. The DIP
financing facility also includes a $20.0 million sub-facility for letters of
credit. Interest on the outstanding borrowings under the DIP financing facility
is payable monthly and accrues at the rate equal to, at our option, either the
prime rate (as announced by JP Morgan Chase Bank) plus 1.50% per annum or LIBOR
plus 3.5% per annum. The Tranche B Lender will fully fund $4.0 million within
five business days after demand by the Tranche A Lender when the outstanding
borrowing provided by the Tranche A Lender first equals or exceeds $6.5 million
for three consecutive business days. In the event that there is any outstanding
borrowing provided by the Tranche B Lender, such borrowing bears interest at
14.5% per annum payable monthly. We are also obligated to pay a monthly fee
equal to 0.375% per annum on the unused available line of credit and a fee equal
to 2.5% per annum on the outstanding letters of credit.

Under the terms of the DIP financing facility, capital expenditure for fiscal
2004 is restricted to $2.0 million. In addition, we are required to be in
compliance with financial covenants and other customary covenants. The financial
covenants include average minimum availability, cumulative four-week rolling
average of cash receipts from store sales and cumulative rolling four-week
average of inventory receipts, as defined. The customary covenants include
certain reporting requirements and covenants that restrict our ability to incur
or create liens, indebtedness and guarantees, make dividend payments, sell or
dispose of assets, change the nature of our business and enter into affiliate
transactions, mergers and consolidations. Failure to satisfy these covenants
would (in some cases, after the expiration of a grace period) result in an event
of default that could cause, absent the receipt of appropriate waivers, the
funds necessary to maintain our operations to become unavailable. The DIP
financing facility contains other customary events of default including certain
ERISA events, a change of control and the occurrence of certain specified events
in the Chapter 11 case. In addition, during the period from December 28, 2004
through January 11, 2005, we are not allowed to have any outstanding borrowings
under the revolving credit facility and our outstanding letters of credit cannot
exceed $11.0 million.

As of January 31, 2004, we were in compliance with our covenants and had no
borrowings outstanding under the revolving credit facility and outstanding
letters of credit of $10.1 million under the sub-facility for letters for
credit. As of January 31, 2004, based on our eligible inventory and accounts
receivable, we were eligible to borrow $33.8 million under the revolving credit
facility and had $17.6 million available after giving effect for the
availability block, as defined.

Cash Flows

Net cash provided by operating activities was $225,000 in fiscal 2003 as
compared to $8.1 million used in operating activities in fiscal 2002. Net cash
generated by operating activities in fiscal 2003 was primarily due to our
obligations to pay for liabilities incurred prior to the Petition Date were
suspended in conjunction with the Chapter 11 filing.

31

Net cash used for investing activities was $3.5 million in fiscal 2003 compared
to $11.0 million in fiscal 2002. Fiscal 2003 investing activities were primarily
related to the final stage of capital improvement at our new Otay Mesa
distribution center and the installation of a new information system for our
planning and allocation department. Fiscal 2002's investing activities were
primarily related to capital expenditures for the Otay Mesa distribution center,
new store development, replacement capital for existing stores, information
system hardware upgrades and replacements, and other general corporate purposes.

Net cash provided by financing activities was $9.8 million in fiscal 2003
compared to $5.2 million in fiscal 2002. In fiscal 2003, our financing
activities included $17.1 million of net proceeds from private offerings, offset
by $6.3 million of net payments on our revolving credit facility and $1.1
million of payments of debt issuance costs. In fiscal 2002, our financing
activities included $6.3 million of net borrowings on our revolving credit
facility, $918,000 in proceeds from the exercise of stock options, partially
offset by $2.0 million in repayments of our junior subordinated notes and
capital lease obligations.

Due to the seasonal nature of our business, where merchandise sales and cash
flows from operations are historically higher in the fourth quarter than any
other period, a disproportionate amount of operating income and cash flows from
operations are earned in the fourth quarter. Our results of operations and cash
flows are primarily dependent upon the large sales volume generated during the
fourth quarter of our fiscal year. Fourth quarter sales represented 29.1% of
total net sales in fiscal 2003. As a result, operating performance for the
interim periods is not necessarily indicative of operating performance for the
entire year. To support generally higher seasonal sales volume we experience a
seasonal inventory build in October and November and therefore our usage of
credit facilities is higher during this period of the year. We believe that our
DIP financing facility will be adequate to support our projected seasonal
borrowing needs.

Our cash needs are satisfied through working capital generated by our business
and funds available under our DIP financing facility. The level of cash
generated by our business is dependent, to a great extent, on our level of sales
and the credit extended by our vendors and the factor community. If we
experience a significant disruption of terms with our vendors and factors, the
DIP financing facility for any reason becomes unavailable, or actual results
differ materially from those projected, our compliance with financial covenants
and our cash resources could be adversely affected.

Pre-petition Revolving Credit Facility

Prior to the Petition Date, we had a $50.0 million revolving credit facility
agreement (the "Financing Agreement") with a financial institution expiring in
March 2006. Under this Financing Agreement, we could borrow up to 70% of our
eligible inventory and 85% of our eligible accounts receivable, as defined, up
to $50.0 million. The revolving credit facility provided for a $7.5 million
availability block against our availability calculation, as defined. The
Financing Agreement also included a $15.0 million sub-facility for letters of
credit. Under the terms of the Financing Agreement, the interest rate could
increase or decrease subject to earnings before interest, tax obligations,
depreciation and amortization expense (EBITDA), as defined, on a rolling four
fiscal quarter basis. Accordingly, prime rate borrowings could range from prime
to prime plus 1.00% and LIBOR borrowings from LIBOR plus 1.50% to LIBOR plus
3.00%. We were obligated to pay fees equal to 0.125% per annum on the unused
amount of the revolving credit facility. We were contractually prohibited from
paying cash dividends on our common stock under the terms of the Financing
Agreement without consent of the lender. As amended on April 10, 2003, the
facility was secured by a first lien on all company assets excluding furniture,
fixtures, machinery and equipment.

On February 14, 2003, we obtained the lender's consent to the incurrence by us
of up to $10.0 million in additional indebtedness, which was secured by a junior
lien on the Collateral, as defined.

On April 10, 2003, we amended the terms of our Financing Agreement (the "Amended
and Restated Financing Agreement") to add $7.5 million of term loans, to add
financial covenants, and to amend certain reporting provisions and other terms.
The term loans consisted of a $6.5 million junior term note secured by all
company assets excluding furniture, fixtures, machinery and equipment and a $1.0
million junior term note secured by furniture, fixtures, machinery and
equipment. These notes bore interest at the rate of 14.5% per annum on the then
current outstanding balance and a maturity date of April 10, 2004.

32

On December 22, 2003, we amended the terms of our Amended and Restated Financing
Agreement ("First Amendment") to shorten the period that we were required to
have zero borrowings, or "clean-up", under the revolving credit facility from 15
consecutive days beginning December 22, 2003 to eight consecutive days beginning
December 29, 2003. The First Amendment also required us to pay the full unpaid
balance of $600,000 under the Tranche B Loan II on or before December 23, 2003,
and we paid it accordingly.

On January 12, 2004 we amended the terms of our Amended and Restated Financing
Agreement ("Second Amendment") in which we were required to pay the full unpaid
balance of $6.5 million on or before January 12, 2004, and we paid it
accordingly.

Junior Subordinated Notes

The Junior Subordinated Notes (the "Notes") are non-interest bearing and were
reflected on our balance sheets at the present value using a discount rate of
10%. We are prohibited from paying cash dividends on our common stock under the
terms of the Notes without the consent of the note holders.

As of January 31, 2004, we were in default under the terms of our Notes and have
included the net carrying value of $10.3 million (face value of $11.3 million
net of a related unamortized discount of $1.0 million) in the line Liabilities
subject to compromise. On the Petition Date, we stopped amortizing debt discount
related to the Notes, in accordance with SOP 90-7.

Under the Bankruptcy Code, the claims of holders of the Notes are subject to
disallowance to the extent they represent a claim for unmatured interest, i.e.,
the portion of face value representing unamortized discount. The amount so
disallowed may differ from the unamortized discount maintained on our books and
records.

Capital Expenditure

We anticipate capital expenditure of approximately $1.0 million in fiscal 2004,
which includes necessary costs for replacement capital at existing stores.

Store Closures

As of April 23, 2004, we had closed 20 of the 23 stores identified in our Fiscal
2002 restructuring efforts and completed the consolidation of our distribution
network and corporate overhead structure. The remaining three stores have not
been closed at this time due to lease concessions agreed to by the landlords. We
have completed the consolidation of our two former San Diego distribution
centers and our Lewisville, Distribution center into one distribution center,
which is also located in San Diego, California. In conjunction with our Chapter
11 filing, we have ceased to make cash payments for any remaining obligations
regarding our Fiscal 2002 restructuring plan except the lease obligation of one
of our former San Diego distribution centers (located in the same building as
our corporate headquarters) and certain satellite communication service fee
obligations. We estimate the cash requirement for these obligations for fiscal
2004 will be approximately $1.2 million, which we intend to fund from our
sources of cash, including the DIP financing facility.

With respect to our Fiscal 2001 restructuring efforts, we closed all 28 stores
during fiscal 2002. In conjunction with our Chapter 11 filing, we have ceased to
make cash payments for any remaining obligations regarding our Fiscal 2001
restructuring plan except certain satellite communication service fee
obligations. The cash requirement for such obligations for fiscal 2004 will be
minimal and we intend to fund them from our sources of cash, including the DIP
financing facility.

On February 2, 2004, the Court authorized the closure of 44 stores, or
approximately 18% of our 239 stores open as of January 31, 2004. On February 11,
2004, the Court approved our appointment of Great American as exclusive agent to
conduct store closing sales at the 44 store locations. The store closing sales
started on February 12, 2004. All 44 stores were closed by March 18, 2004 and as
of April 23, 2004, we have terminated or assigned a total of 13 leases of these
stores and rejected the remaining 31 leases.

33

Reorganization Efforts

In connection with our bankruptcy case and reorganization efforts, we project to
incur approximately $5.3 million of professional fees and other related expenses
for fiscal 2004. We believe that our sources of cash, including the DIP
financing facility, should be adequate to fund the cash requirement for our
reorganization efforts.

Contractual Obligations and Commitments

The following table summarizes, as of January 31, 2004, certain of our
contractual obligations, as well as estimated cash requirements related to our
fiscal 2002 and 2001 restructuring initiatives. This table should be read in
conjunction with "Note 4 Fiscal 2002 Restructuring Charge", "Note 5 Fiscal 2001
Restructuring Charge", "Note 10 Long-Term Debt and Revolving Credit Facilities"
and "Note 12 Lease Commitments" in the accompanying financial statements.

Operating Restructuring Notes
Leases Charges Payable Total
----------------- ----------------- ---------- -----------

Fiscal Year:
2004 $ 32,781 $ 1,321 $ 43 $ 34,145
2005 27,079 1,009 43 28,131
2006 20,605 - 43 20,648
2007 15,459 - 14 15,473
2008 12,060 - - 12,060
Thereafter 34,811 - - 34,811
----------------- ----------------- ----------- -----------
Total $ 142,795 $ 2,330 $ 143 $ 145,268
----------------- ----------------- ----------- -----------

Certain amounts included in the above table are related to executory contracts
or lease obligations, which we have neither assumed nor rejected as of January
31, 2004. Under the Bankruptcy Code, we may assume or reject executory
contracts, including lease obligations. Therefore, the commitments shown in the
above table may not reflect actual cash outlays in the future periods.

Reorganization Items

Reorganization items represent amounts we incurred as a result of the Chapter 11
proceedings in accordance with SOP 90-7. The amounts for Reorganization items in
the Statements of Operations include: (1) a $26.3 million impairment of
goodwill; (2) a $2.4 million charge to accelerate depreciation on the remaining
fixed assets associated with the 44 closing stores; (3) a $1.7 million charge
for inventory sold below cost at our 44 closing stores; and (4) $1.3 million of
professional fees related to the bankruptcy case.

Recent Accounting Pronouncements

In January 2003, the Financial Accounting Standards Board (the "FASB") issued
FIN 46 - "Consolidation of Variable Interest Entities." FIN 46 clarifies the
application of Accounting Research Bulletin No. 51 - Consolidated Financial
Statements to those entities defined as "Variable Interest Entities" (more
commonly referred to as special purpose entities) in which equity investors do
not have the characteristics of a "controlling financial interest" or do not
have sufficient equity at risk for the entity to finance its activities without
additional subordinated financial support from other parties. FIN 46 applies
immediately to all Variable Interest Entities created after January 31, 2003,
and by the beginning of the first interim or annual reporting period commencing
after June 15, 2003 for Variable Interest Entities created prior to February 1,
2003. The adoption of this statement did not have a material impact on our
financial position or results of operations.

34

In April 2003, the FASB issued Statement of Financial Accounting Standard (the
"SFAS") No. 149, "Amendment of Statement 133 on Derivative Instruments and
Hedging Activities." This statement provides clarification on the financial
accounting and reporting of derivative instruments and hedging activities and
requires contracts with similar characteristics to be accounted for on a
comparable basis. The adoption of this statement did not have a material impact
on our financial position or results of operations.

In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity." This statement
establishes standards on the classification and measurement of financial
instruments with characteristics of both liabilities and equity and is effective
for financial instruments entered into or modified after May 31, 2003. The
adoption of this statement did not have a material impact on our financial
position or results of operations.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

Currently, our exposure to market risks results primarily from changes in
interest rates, principally with respect to the DIP financing facility, which is
a variable rate financing agreement. We do not use swaps or other interest rate
protection agreements to hedge this risk. As of January 31, 2004, we had no
borrowings outstanding under our DIP financing facility.

35

Item 8. Financial Statements and Supplementary Data

INDEX TO FINANCIAL STATEMENTS

FACTORY 2-U STORES, INC. Page
- ------------------------ ----

Report of Independent Public Accountants F-1

Report of Independent Public Accountants (Arthur Andersen LLP) F-3

Balance Sheets as of January 31, 2004 and
February 1, 2003 F-4

Statements of Operations for Fiscal Years Ended
January 31, 2004, February 1, 2003 and February 2, 2002 F-6

Statements of Stockholders' Equity (Deficit) for Fiscal Years
Ended January 31, 2004, February 1, 2003 and February 2, 2002 F-7

Statements of Cash Flows for Fiscal Years Ended January 31, 2004,
February 1, 2003 and February 2, 2002 F-8

Notes to Financial Statements F-10

Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure

On April 24, 2002, our Board of Directors, on the recommendation of the Audit
Committee, determined not to renew the engagement of its independent public
accountants, Arthur Andersen LLP ("Andersen"), for the fiscal year ended
February 1, 2003.

During our fiscal years ended February 2, 2002 and February 3, 2001, and the
subsequent interim period through April 24, 2002, there were no disagreements
between us and Andersen on any matter of accounting principles or practices,
financial statement disclosures, or auditing scope or procedure, which
disagreements, if not resolved to the satisfaction of Andersen, would have
caused Andersen to make reference to the matter of the disagreement in
connection with their reports. Andersen's reports on our financial statements
for each fiscal year ended February 2, 2002 and February 3, 2001 did not contain
an adverse opinion or disclaimer of opinion, nor were they qualified or modified
as to uncertainty, audit scope or accounting principles.

Andersen's report on our financial statements for the fiscal year ended February
2, 2002, dated February 27, 2002, was issued on an unqualified basis in
conjunction with the filing of our Annual Report on Form 10-K for the fiscal
year ended February 2, 2002 filed on April 19, 2002 with the Securities and
Exchange Commission.

None of the reportable events described under Item 304 (a) (1) (v) of Regulation
S-K occurred within our two most recent fiscal years and subsequent interim
period through April 24, 2002.

Item 9A. Controls and Procedures

Evaluation. We evaluated the effectiveness of the design and operation of our
disclosure controls and procedures as defined under Rule 13a-14 and Rule 15d-14
of the Securities Exchange Act of 1934, as amended, as of the end of the period
covered by this report. This evaluation was done under the supervision and with
the participation of management, including our Chief Executive Officer (CEO) and
Chief Financial Officer (CFO).

36

Conclusions. Based upon our evaluation, our CEO and CFO have concluded that our
disclosure controls and procedures are effective to ensure that material
information relating to the Company is made known to management, including the
CEO and CFO, particularly during the period when our periodic reports are being
prepared.

Changes in Internal Controls. There have not been any significant changes in our
internal controls or in other factors that could significantly affect these
controls subsequent to the date of our last evaluation of such internal
controls, including any corrective actions with regard to significant
deficiencies and material weaknesses.

37

PART III

Item 10. Directors and Executive Officers of the Registrant

Directors

The following table sets forth, as of April 23, 2004, certain information
concerning our directors.

Served on the Expiration of Term
Name Age Position Board Since as Director
---- --- -------- ------------- -------------------

Peter V. Handal 61 Director 1997 2004
Ronald Rashkow 63 Lead Director 1997 2004
Wm. Robert Wright II 36 Director 1998 2004
Willem F.P. de Vogel 53 Director 2000 2006
Norman G. Plotkin 50 Director and Chief
Executive Officer 2004 2005

Peter V. Handal has been a director since February 1997. Mr. Handal is
President and Chief Executive Officer of Dale Carnegie & Associates. Since 1990,
he has been President of COWI International Group (a management consulting
firm). Mr. Handal is also Chief Executive Officer of J4P Associates LP (a real
estate developer). He serves on the Board of Directors of Dale Carnegie &
Associates and Cole National Corporation.

Ronald Rashkow was appointed by the Board of Directors to the position of
Lead Director in November 2002. Mr. Rashkow has been a director since February
1997. He has been a principal of RPMS, Inc., an investment banking firm, since
January 2004. Prior to that, he was a principal of Chapman Partners, L.L.C., an
investment banking firm, from September 1995 to December 2003. For more than
five years prior to that, he served as Chief Executive Officer and Chairman of
the Board of Directors of Handy Andy Home Improvement Centers, Inc. (a building
supply retailer started by his family in 1946).

Wm. Robert Wright II has been a director since November 1998. He has been a
managing partner of Grey Mountain Partners, LLC, a private equity firm that
invests in middle market companies, since its founding in January 2003. Prior to
that, he was employed by Three Cities Research, Inc., a firm engaged in the
investment and management of private capital, from 1992 through 2002, except for
a period from July 1993 to August 1995 when he was in a graduate program at
Harvard University. His last position with Three Cities Research, Inc. was
"managing partner", a title he held from 1999 to 2002.

Willem F.P. de Vogel has been a director since December 2000. Mr. de Vogel
has served as President of Three Cities Research, Inc. since 1982.

Norman G. Plotkin has been a director since March 2004 and has been Chief
Executive Officer since December 2003. Prior to his appointment as Chief
Executive Officer, Mr. Plotkin was our Executive Vice President, Store
Development, Human Resources and General Counsel. He also assumed responsibility
over our Store Operations for a period during 2002. Mr. Plotkin joined us in
July 1998 in the position of Senior Vice President, Store Development and
General Counsel. Prior to joining us, Mr. Plotkin was the President of Normark
Real Estate Services, Ltd., a commercial real estate firm based in Des Plaines,
Illinois. Prior to that, from 1988 until 1996, Mr. Plotkin was the Senior Vice
President of Finance and Administration and General Counsel of Handy Andy Home
Improvement Centers, Inc. Additionally, Mr. Plotkin was engaged in the private
practice of law from 1980 to 1988.

38

Executive Officers

The following table sets forth certain information concerning our executive
officers who are not directors.

Name Age Position Officer Since
---- --- -------- -------------

A.J. Nepa 52 Executive Vice President and 2003
General Merchandise Manager

Norman Dowling 41 Executive Vice President and 2004
Chief Financial Officer

A.J. Nepa is Executive Vice President and General Merchandise Manager. Mr.
Nepa joined us in November 2003. Prior to joining us, Mr. Nepa was the General
Merchandise Manager for Forman Mills, a privately held off-price retail chain
headquartered in Pennsylvania. He previously served as Senior Vice President and
General Merchandise Manager of One Price Clothing Stores from 1998 to 2000 and
General Merchandise Manger for It's Fashion, a division of Cato Stores, from
1992 to 1998.

Norman Dowling is Executive Vice President and Chief Financial Officer. Mr.
Dowling joined us in March 2004. Prior to joining us, Mr. Dowling served as Vice
President, Finance of PETCO Animal Supplies, Inc., from November 1999 to March
2004. Prior to joining PETCO, he served as Chief Financial Officer and Secretary
of CinemaStar Luxury Theaters, Inc. from 1997 to 1999. CinemaStar Luxury
Theaters, Inc. filed a voluntary petition under Chapter 11 of the United States
Bankruptcy Code in January 2001. Previously, Mr. Dowling was Director of Finance
at Advanced Marketing Services, Inc. from 1993 to 1997. From 1990 to 1993, Mr.
Dowling was Controller and then Director of Mergers & Acquisitions at Medical
Imaging Centers of America, Inc.

Section 16(a) Beneficial Ownership Reporting Compliance

Section 16(a) of the Securities Exchange Act of 1934, as amended requires the
Company's directors, executive officers and beneficial owners of more than ten
percent (10%) of the Common Stock to file with the SEC initial reports of
ownership and reports of changes in ownership of Common Stock of the Company.
SEC regulations also require such persons to furnish the Company with copies of
all such reports.

Based solely upon its review of the copies of such reports furnished to it, or
written representations from the reporting persons that no forms were required
to be filed, the Company believes that during the fiscal year ended January 31,
2004 all section 16(a) filing requirements applicable to its executive officers,
directors and greater than ten percent beneficial owners were complied with.

Audit Committee

The Company's Board of Directors has identified Wm. Robert Wright II as its
Audit Committee Financial Expert, as defined by Item 401 of Regulation S-K. Mr.
Wright is an independent Board member, as defined by Item 7(d)(3)(iv) of
Schedule 14A under the Exchange Act.

Code of Ethics

We have adopted the Factory 2-U Stores, Inc. Standards of Business Conduct,
which is applicable to all of our employees, including our chief executive
officer, chief financial officer, controller and all vice presidents. Our
Standards of Business Conduct complies with the requirements of the
Sarbanes-Oxley Act of 2002 and the regulations promulgated by the Securities and
Exchange Commission thereunder. We have filed a copy of our Standards of
Business Conduct as an exhibit to this annual report.

39

Item 11. Executive Compensation

Compensation of Directors

We pay each director who is not a Lead Director or an employee of ours an annual
fee of $12,000 plus $1,250 for attendance at each meeting of the Board of
Directors ($250 for a telephonic meeting). Additionally, prior to our Chapter 11
filing, at the end of each fiscal quarter, we granted each director who was not
an employee 250 shares of common stock and awarded a cash payment equal to the
closing market price of our common stock on such date times 500 shares. Since
the Petition Date, we have discontinued such equity-related grants and awards.

We also reimburse all directors for any out-of-pocket travel expenses incurred
in attending meetings.

Ronald Rashkow Lead Director Agreement

On November 4, 2002, Mr. Rashkow was appointed to the newly created position of
Lead Director by our Board of Directors under the terms of an agreement. We have
neither assumed nor rejected the agreement under the federal bankruptcy laws.
Mr. Rashkow's service as Lead Director will continue at the pleasure of the
Board of Directors for up to three years. Under the terms of his agreement, Mr.
Rashkow receives monthly compensation of $12,500, plus reimbursement of all
reasonable out-of-pocket travel and other expenses related to the performance of
his duties as Lead Director. He is also entitled to receive $3,500 per day, plus
reimbursement of all reasonable out-of-pocket travel and other expenses related
to the performance of his duties as Lead Director, for each day of service in
excess of six days per quarter.

As an inducement to secure his services as Lead Director, Mr. Rashkow also
received options to purchase 50,000 shares of our common stock on November 4,
2002 at an exercise price of $1.61, the fair market value of our common stock on
the date of grant. The options vested immediately and are exercisable for five
years from the date of grant. As a further inducement to secure his services,
Mr. Rashkow also received 25,000 shares of restricted common stock, subject to
his completion of 12 months of service as Lead Director. Mr. Rashkow has a
target grant of 25,000 similar shares of restricted common stock, subject to his
completion of 24 months of service, and another 25,000 shares subject to his
completion of 36 months of service. His receipt of these restricted shares, in
addition to the length of service requirement, will be commensurate with our
Chief Executive Officer's achievement of his performance goals for the
applicable year. If the goals are not attained, the shares will not be granted.

Compensation of Executive Officers

Employment Contracts with Named Executive Officers

The following employment agreements and other arrangements with respect to our
named executive officers are described as in effect as of January 31, 2004. We
have neither assumed nor rejected the employment agreements under the federal
bankruptcy laws.

Norman Plotkin Employment Agreement

Prior to Mr. Plotkin's appointment as Chief Executive Officer on December 10,
2003, we employed Mr. Plotkin as Executive Vice President - Store Development,
Human Resources and General Counsel, pursuant to a one-year employment agreement
dated May 20, 2003 that was entered into prior to the Petition Date. His
employment agreement was automatically extended under its terms for an
additional one-year period, and will continue to be extended on each anniversary
thereafter, unless either Mr. Plotkin or we give notice to the other at least 90
days before an extension is to take effect that either does not desire the
employment term to be extended.

40

Under the employment agreement, Mr. Plotkin's base salary was $285,000 annually.
After his appointment as Chief Executive Officer, his base salary was increased
to $400,000 annually. Mr. Plotkin's target bonus for the fiscal year ended
January 31, 2004 was 50% of his annual base salary for that year. Under the
employment agreement, for each subsequent fiscal year Mr. Plotkin's target bonus
will be based on 50% of his base salary in effect as of the start of that fiscal
year. Also, the employment agreement provides that if the performance objectives
accepted by the Compensation Committee are exceeded in any year, the annual
bonus will be increased by 1% of his base salary for each 1% of excess, up to a
maximum bonus of 100% of his base salary for the achievement of 150% of the
performance objectives. If the performance objectives are not met, Mr. Plotkin
will not be entitled to any bonus.

On May 20 2003, we granted Mr. Plotkin non-qualified options to purchase 50,000
shares of our common stock at an exercise price of $3.26 per share, the fair
market value of our stock on the date of grant. These options vest in tranches
of 3,125 shares on each March, June, September and December 30 during the first
four years of his employment term. The options in each tranche will be
exercisable for a period of five years after the vesting of that tranche.

In addition, on September 17, 2003, we granted Mr. Plotkin 50,000 restricted
shares of our common stock for $500. These restricted shares will vest in
installments as follows: 16,666.7 shares when the closing market price of our
common stock equals or exceeds $10 per share for 20 consecutive trading days in
any three-month period, an additional 16,666.7 shares will vest when the closing
market price of our common stock equals or exceeds $20 per share for 20
consecutive trading days in any three-month period; and 16,666.7 shares will
vest when the closing market price equals or exceeds $30 per share for 20
consecutive trading days in any three-month period. Mr. Plotkin's right to
receive any shares of restricted stock that has not vested prior to April 10,
2008 will terminate and the restricted stock will be returned to us.
Additionally, Mr. Plotkin will not be entitled to sell any vested shares of
restricted stock until the expiration of two years from the effective date of
his employment agreement.

Melvin Redman Employment Agreement

Mr. Redman resigned his position with us as of April 27, 2004. Prior to his
appointment as Executive Vice President and Chief Operating Officer on January
13, 2004, we employed Mr. Redman as Executive Vice President - Store Operations
and Distribution, pursuant to a one-year employment agreement dated January 6,
2003 that was entered into prior to the Petition Date. His employment agreement
was automatically extended under its terms for an additional one-year period,
and would have continued to be extended on each anniversary thereafter.

Under the employment agreement, Mr. Redman's base salary was $500,000 annually.
Mr. Redman received a signing bonus in the amount of $100,000 upon beginning his
employment. Mr. Redman's target bonus for the fiscal year ended January 31, 2004
was 50% of his annual base salary for that year. Under the employment agreement,
for each subsequent fiscal year, Mr. Redman's target bonus would have been based
on 50% of his base salary in effect as of the start of that fiscal year. If the
performance objectives accepted by the Chief Executive Officer had been exceeded
in any year, the annual bonus would have increased by 1% of his base salary for
each 1% of excess, up to a maximum bonus of 100% of his base salary for the
achievement of 150% of the performance objectives. Mr. Redman would have
received no bonus if the performance objectives were not met.

As an inducement necessary to secure his services, on January 6, 2003, we
granted Mr. Redman non-qualified options to purchase 125,000 shares of our
common stock at an exercise price per share of $3.13, the fair market value of
our stock on the date of grant. These options vested in tranches of 7,812.5
shares on each March 30, 2003, June 30, 2003, September 30, 2003 and December
30, 2003, and would have vested in tranches of 7,812.5 shares on the 30th of
each December, March, June and September during the next three years of his
employment term. The non-qualified options in each tranche would have been
exercisable for a period of five years after the vesting of that tranche.

41

As a further inducement necessary to secure his services, we also granted Mr.
Redman on January 6, 2003, 125,000 restricted shares of our common stock for
$1,250. These restricted shares would have vested in installments as follows:
41,666.7 shares when the closing market price of our common stock equals or
exceeds $10 per share for 20 consecutive trading days in any three-month period;
an additional 41,666.7 shares when the closing market price of our common stock
equals or exceeds $20 per share for 20 consecutive trading days in any
three-month period; and 41,666.7 shares would have vested when the closing
market price equals or exceeds $30 per share for 20 consecutive trading days in
any three-month period. Mr. Redman's right to receive any shares of restricted
stock that has not vested terminated as a result of his resignation, and all of
such restricted shares were forfeited.

A.J. Nepa Employment Agreement

We employed A.J. Nepa, Executive Vice President - General Merchandise Manager,
pursuant to a one-year employment agreement dated November 10, 2003 that expires
on November 9, 2004, provided that at the scheduled end of the initial
employment term, and on each anniversary thereafter, his employment term will be
automatically extended for an additional one-year period unless either Mr. Nepa
or we give notice to the other at least 90 days before an extension is to take
effect that either does not desire the employment term to be extended.

Under the employment agreement, Mr. Nepa's base salary is $250,000 annually. Mr.
Nepa's target bonus for the fiscal year ending January 29, 2005 is 50% of his
annual base salary for that year. Under the employment agreement, for each
subsequent fiscal year, Mr. Nepa's target bonus will be based on 50% of his base
salary in effect as of the start of that fiscal year. If the performance
objectives accepted by the Chief Executive Officer are exceeded in any year, the
annual bonus will be increased by 1% of his base salary for each 1% of excess,
up to a maximum bonus of 100% of his base salary for the achievement of 150% of
the performance objectives. If the performance objectives are not met, Mr. Nepa
will not be entitled to any bonus.

As an inducement to secure his services, on November 10, 2003 we granted Mr.
Nepa non-qualified options to purchase 50,000 shares of our common stock at an
exercise price per share of $2.56, the fair market value of our stock on the
date of grant. These options vest in tranches of 3,125 shares on each March,
June, September and December 30 during the first four years of his employment
term. The options in each tranche will be exercisable for a period of five years
after the vesting of that tranche.

As a further inducement to secure his services, we also granted Mr. Nepa on
November 10, 2003, 50,000 restricted shares of our common stock for $500. These
restricted shares will vest in installments as follows: 16,666.7 shares when the
closing market price of our common stock equals or exceeds $10 per share for 20
consecutive trading days in any three-month period, an additional 16,666.7
shares will vest when the closing market price of our common stock equals or
exceeds $20 per share for 20 consecutive trading days in any three-month period;
and 16,666.7 shares will vest when the closing market price equals or exceeds
$30 per share for 20 consecutive trading days in any three-month period. Mr.
Nepa's right to receive any shares of restricted stock that has not vested prior
to November 10, 2008 will terminate and the restricted stock will be returned to
us. Additionally, Mr. Nepa will not be entitled to sell any vested shares of
restricted stock until the expiration of two years from the effective date of
his employment agreement.

Severance Agreements

On December 10, 2003, William R. Fields' employment with us was terminated.
Under the terms of his employment agreement with us, he was entitled to twelve
months of his base salary, all accrued but unpaid compensation, vacation pay and
reimbursable business expenses through his termination date, payable in a lump
sum in the amount of approximately $1.0 million. In addition, he was entitled to
the amounts or benefits owing under benefit plans and policies, exclusive of
cash severance policies and up to three years of COBRA premiums. We have neither
assumed nor rejected Mr. Fields' employment agreement under the federal
bankruptcy laws. As a result of the Chapter 11 filing on January 13, 2004, Mr.
Fields' severance payments have not been made.

42

On January 5, 2004, Douglas C. Felderman's employment with us was terminated.
Under the terms of his employment agreement with us, he was entitled to twelve
months of his base salary in the total amount of $285,000, of which $50,000 was
paid. We have neither assumed nor rejected Mr. Felderman's employment agreement
under the federal bankruptcy laws. As a result of the Chapter 11 filing on
January 13, 2004, no further severance payments have been made to Mr. Felderman.

Compensation Committee Report on Executive Compensation

The discussion below describes our compensation practices and principles for
fiscal 2003 prior to the Petition Date. During the pendency of our bankruptcy
case, our compensation practices and principles are subject to the jurisdiction
of the Court. We have submitted to the Court a proposed key employee retention
plan with respect to which the Court has yet to act.

The Compensation Committee of the Board of Directors is composed entirely of
outside directors. The Compensation Committee is responsible for establishing
and administering the compensation policies applicable to our executive
officers. All decisions by the Compensation Committee are subject to review and
approval by the full Board of Directors.

Our executive compensation philosophy and specific compensation plans tie a
significant portion of executive compensation to our success in meeting specific
profit, growth and performance goals.

Our compensation objectives include attracting and retaining the best possible
executive talent, motivating executive officers to achieve our performance
objectives, rewarding individual performance and contributions, and linking
executives' and stockholders' interests through equity based plans.

Our executive compensation consists of three key components: base salary, annual
incentive compensation and stock options, each of which is intended to
complement the others and, taken together, to satisfy our compensation
objectives. The Compensation Committee's policies with respect to each of the
three components are discussed below.

Base Salary. In the early part of each fiscal year, the Compensation Committee
reviews the base salary of the Chief Executive Officer (subject to requirements
of his employment agreement) and the recommendations of the Chief Executive
Officer with regard to the base salary of all other executive officers, and
approves, with any modifications it deems appropriate, annual base salaries for
each of our executive officers. We base the recommended base salaries of the
executive officers on an evaluation of the individual performance of the
executive officer, including satisfaction of annual objectives. The recommended
base salary of the Chief Executive Officer is based on achievement of our annual
goals relating to financial objectives, including earnings growth and return on
capital employed, and an evaluation of individual performance.

Recommended base salaries of the executive officers are also based in part upon
an evaluation of the salaries of executives who hold comparable positions at
comparable companies.

Annual Incentive Compensation. Our executive officers participate in a
discretionary incentive bonus plan which provides for the payment of annual
bonuses in cash or stock (or both), based on our success in attaining financial
objectives, and subjective factors established from time to time by the
Compensation Committee or the Board of Directors. With the exception of those
executives who have separate employment agreements with us, the Compensation
Committee normally considers aggregate incentive cash and stock bonus payments
to the executive officers, as a group, of up to 50% of their base salaries, and
any bonus payments in excess of 50% of the aggregate base salaries, may be paid
in cash or stock, at the discretion of the Compensation Committee. The
Compensation Committee did not award annual incentive bonus payments to any of
our executive officers for fiscal 2003.

Compensation of the Chief Executive Officer. Mr. Plotkin was appointed Chief
Executive Officer on December 10, 2003 and elected as a director on our Board of
Directors in March 2004. Mr. Plotkin's base salary is $400,000 annually. The
Compensation Committee determined Mr. Plotkin's compensation by considering his
prior experience, expertise and compensation paid to other executives with
similar experience in comparable companies. In determining Mr. Plotkin's
compensation, the Compensation Committee took into account Mr. Plotkin's
extensive prior experience. Mr. Plotkin has been with us since July 1998 and has
held the positions of Executive Vice President of Store Development, Human
Resources and General Counsel and for a period in 2002 he assumed responsibility
over Store Operations. The Compensation Committee concluded that Mr. Plotkin's
compensation was commensurate with the compensation paid to other executives
with similar experience in comparable companies.

43

Compensation of the former Chief Executive Officer. Mr. Fields joined the
Company in November 2002 as Chairman of our Board of Directors and Chief
Executive Officer. Under the terms of his employment agreement, Mr. Fields' base
salary was $750,000 annually. For the first year of his employment term, Mr.
Fields received a guaranteed bonus of $375,000, that was payable in 12 monthly
installments. The Compensation Committee determined Mr. Fields' compensation by
considering his prior experience and expertise, compensation paid to other
executives with similar experience in comparable companies, and what would be
required in order to induce Mr. Fields to join the Company. In determining Mr.
Fields' compensation, the Compensation Committee took into account Mr. Fields'
extensive prior experience, including his 24 years of experience with Wal-Mart,
culminating in his serving as Chief Executive Officer and President of Wal-Mart
Stores Division during 1993 through 1996, as well as his experience as Chairman
and Chief Executive Officer of Blockbuster Entertainment Group during 1996 and
1997 and as Chief Executive Officer and President of Hudson's Bay Company during
1997 though 1999. The Compensation Committee concluded that Mr. Fields'
compensation was required in order to induce him to join the Company and that it
was commensurate with the compensation paid to other executives with similar
experience in comparable companies.

Stock Options. The primary objective of the stock option program is to link our
interests and those of our executive officers and other selected employees to
those of the stockholders through significant grants of stock options. The
Compensation Committee bases the aggregate number of options it recommends on
practices of comparable companies, while grants of stock options to specific
employees reflect their expected long-term contribution to our success. As a
result of the Chapter 11 filing, the Company is not currently granting stock
options to its employees.

Compensation Committee:

Willem F.P. de Vogel, Chairman
Peter V. Handal

Compensation Committee Interlocks and Insider Participation

No member of the Compensation Committee of the Board of Directors was, during
fiscal 2003 or at any other time, one of our officers or employees.

44

Summary of Cash and Other Compensation

The following table contains information about the compensation during fiscal
2003 of our former principal executive officer; current principal executive
officer; our two other most highly paid executive officers who served as
executive officers at the end of fiscal 2003 and received salary and bonus in
excess of $100,000 during fiscal 2003; and two other named executive officers
who were not serving as executive officers at the end of fiscal 2003:

SUMMARY COMPENSATION TABLE

Annual Compensation Long-Term Compensation
------------------- ----------------------
Fiscal All Other
Name and Principal Year Securities Underlying Compensation
Position (1) Salary ($) Bonus ($) Options ($) (2)
-------- --- ---------- --------- --------------------- ------------

William R. Fields (3) 2003 $663,461 $ 312,500 - $326,944
Former Chief Executive 2002 158,754 62,500 250,000 40,328
Officer and Chairman of - - - - -
the Board

Norman G. Plotkin (4) 2003 290,308 - 50,000 2,071
Chief Executive Officer 2002 285,000 112,468 - 2,200
and Director 2001 282,500 - - 15,689

Douglas C. Felderman (5) 2003 270,750 - 50,000 87,102
Former Executive Vice 2002 285,000 94,271 - 987
President and 2001 283,250 - - 66,195
Chief Financial Officer

Melvin C. Redman (6) 2003 480,769 - - 123,694
Former Executive Vice - - - - -
President - Chief - - - - -
Operating Officer

John W. Swygert (7) 2003 146,442 - 25,000 881
Former Senior Vice - - - - -
President - Chief - - - - -
Financial Officer

Larry I. Kelley (8) 2003 216,923 58,333 - 42,242
Former Executive Vice - - - - -
President - Merchandising - - - - -
and Marketing

- ---------------------------------------------------------------------------------------------------------

Note:The aggregate amount of any other annual compensation is less than the
lesser of $50,000 or 10% of such person's total annual salary and bonus.

(1) We refer to a fiscal year by the year in which most of the activity
occurred (for example, we refer to fiscal year ended January 31, 2004 as
fiscal 2003).

(2) "All Other Compensation" for fiscal 2003 includes (i) matching
contributions under our 401(k) Savings Plan of $1,973 for Mr. Felderman,
$2,071 for Mr. Plotkin and $881 for Mr. Swygert; (ii) payment of moving
expenses of $326,944 for Mr. Fields and $123,694 for Mr. Redman; (iii)
final vacation pay of $35,129 for Mr. Felderman and $8,695 for Mr. Wong;
and (iv) severance payments of $50,000 for Mr. Felderman and $41,538 for
Mr. Wong.

(3) Mr. Fields was Chief Executive Officer and Chairman of the Board until his
termination of employment on December 10, 2003. Mr. Fields received
$312,500 during fiscal 2003 and $62,500 during fiscal 2002, of his
guaranteed first year bonus of $375,000 under the terms of his employment
agreement.

45

(4) Mr. Plotkin was appointed Chief Executive Officer effective December 10,
2003 and a member of the Board of Directors effective March 16, 2004.

(5) As of January 5, 2004, Mr. Felderman was no longer an employee.

(6) As of April 27, 2004, Mr. Redman was no longer an employee.

(7) As of February 20, 2004, Mr. Swygert was no longer an employee.

(8) As of August 11, 2003, Mr. Kelley was no longer an employee.

46

Grants of Stock Options

The following table sets forth information concerning the award of stock options
during fiscal 2003. We have never granted stock appreciation rights.

% of Total Potential Realizable
Number of Options Value at Assumed
Securities Granted to Exercise Annual Rates of
Underlying Employees or Base Stock Price Appreciation
Options in Fiscal Price Expiration For Option Term (1)
Granted (#) Year ($/Share) Date
5% ($) 10%($)
Name ---------- --------- -------- ----------- ------ ------
----

William R. Fields (2) - - $ - - $ - $ -
Norman G. Plotkin 50,000 7.54% 3.26 3/30/2012 89,866 221,345
Douglas C. Felderman (3) 50,000 7.54% 3.26 3/30/2012 89,866 221,345
Melvin C. Redman (4) - - - - - -
John W. Swygert (5) 25,000 3.77% 4.26 9/17/2013 66,977 169,734
Larry I. Kelley (6) - - - - - -

(1) Amounts shown represent the potential value of granted options if the
assumed annual rates of stock appreciation are maintained over the terms of
the granted options. The assumed rates of appreciation are established by
regulation and are not intended to be a forecast of our performance or to
represent our expectations with respect to the appreciation, if any, of the
common stock.

Any value of our common stock underlying the options will depend on the
value, if any, ascribed to our common stock in any plan of reorganization
which may be confirmed. As described earlier, we believe that, in light of
the Chapter 11 filing, the value of our common stock is highly speculative.
Accordingly, we are not presently ascribing any value to the above options.
Nevertheless, in order to comply with SEC rules, this column sets forth the
estimated present value of the options granted during fiscal year 2003.

(2) As of December 10, 2003, Mr. Fields was no longer an employee. All such
options expired unexercised 3 months after that date.

(3) As of January 5, 2004, Mr. Felderman was no longer an employee. All such
options expired unexercised 3 months after that date.

(4) As of April 27, 2004, Mr. Redman was no longer an employee.

(5) As of February 20, 2004, Mr. Swygert was no longer an employee. All such
options expired unexercised 60 days after that date.

(6) As of August 11, 2003, Mr. Kelley was no longer an employee. All such
options expired unexercised on that date.

47

Exercise of Stock Options and Holdings

The following table sets forth information concerning exercises of stock options
during fiscal 2003 and the fiscal year-end value of unexercised options. We have
never granted stock appreciation rights.

Aggregated Option Exercises in Fiscal 2003
Fiscal 2003 Year-End Option Values

Shares Number of Securities
Acquired Value Underlying Unexercised Value of Unexercised
On Realized Options at Fiscal Year End (#) In-the-Money Options at
Name Exercise ($) Fiscal Year End ($)
---- -------- ---------
Exercisable Unexercisable Exercisable Unexercisable
----------- ------------- ----------- -------------

William R. Fields (1) - $ - 78,125 171,875 $ - $ -
Norman G. Plotkin - - 72,523 56,131 - -
Douglas C. Felderman (2) - - 89,585 60,415 - -
Melvin C. Redman (3) - - 31,250 93,750 - -
John W. Swygert (4) - - 9,080 35,920 - -
Larry I. Kelley (5) - - - - - -

(1) As of December 10, 2003, Mr. Fields was no longer an employee. All such
options expired unexercised 3 months after that date.

(2) As of January 5, 2004, Mr. Felderman was no longer an employee. All such
options expired unexercised 3 months after that date.

(3) As of April 27, 2004, Mr. Redman was no longer an employee. All such
options will expire 3 months after that date.

(4) As of February 20, 2004, Mr. Swygert was no longer an employee. All such
options expired unexercised 60 days after that date.

(5) As of August 11, 2003, Mr. Kelley was no longer an employee. All such
options expired unexercised on that date.

48

Long-Term Incentive Plans - Awards in Last Fiscal Year

Number of
Shares,
Units or
Other
Name Rights (#) Performance or Other Period Until Maturation or Payout
---- ---------- ------------------------------------------------------

William R. Fields -
Former Chief Executive
Officer and Chairman of
the Board

Norman G. Plotkin 50,000 (1) Restricted stock shares potentially vest in three increments of
Chief Executive Officer 16,666.7 shares each. The first increment vests when the closing
and Director market price of our common stock equals or exceeds $10 for 20
consecutive trading days in any three-month period. The second
increment vests when the closing market price of our common stock
equals or exceeds $20 for 20 consecutive trading days in any
three-month period. The third increment vests when the closing
market price of our common stock equals or exceeds $20 for 20
consecutive trading days in any three-month period.

Douglas C. Felderman (2) 50,000 Restricted stock shares would have vested in three increments of
Former Executive Vice 16,666.7 shares each. The first increment would have vested when
President and the closing market price of our common stock equals or exceeds $10
Chief Financial Officer for 20 consecutive trading days in any three-month period. The
second increment would have vested when the closing market price of
our common stock equals or exceeds $20 for 20 consecutive trading
days in any three-month period. The third increment would have
vested when the closing market price of our common stock equals or
exceeds $20 for 20 consecutive trading days in any three-month
period.
Melvin C. Redman (3) -
Executive Vice President
- - Chief Operating Officer

John W. Swygert (4) -
Former Executive Vice
President - Chief
Financial Officer

Larry I. Kelley (5) -
Former Executive Vice
President -
Merchandising and
Marketing

- ---------------------------------------------------------------------------------------------------------

(1) Mr. Plotkin received a restricted stock grant of 50,000 shares of common
stock on September 17, 2003 when the closing market price of our common
stock was $4.26 per share. Mr. Plotkin's right to receive any shares of
restricted stock that have not vested prior to September 17, 2008 will
terminate and the restricted stock will be returned to us. Additionally,
Mr. Plotkin will not be entitled to sell any vested shares of restricted
stock until the expiration of two years from the date of grant. Mr. Plotkin
is entitled to receive dividends that are paid on common stock and he has
the right to vote his restricted shares.

(2) As of January 5, 2004, Mr. Felderman was no longer an employee. Mr.
Felderman received a restricted stock grant of 50,000 shares of common
stock on September 17, 2003 when the closing market price of our common
stock was $4.26 per share. Mr. Felderman's right to receive any shares of
restricted stock terminated as a result of the termination of his
employment and the restricted stock has been returned to us.

(3) As of April 27, 2004, Mr. Redman was no longer an employee.

(4) As of February 20, 2004, Mr. Swygert was no longer an employee.

(5) As of August 11, 2003, Mr. Kelley was no longer an employee.

49

PERFORMANCE CHART

The following chart compares the five-year cumulative total return (change in
stock price plus reinvested dividends) on our common stock with the total
returns of the Nasdaq Composite Index, a broad market index covering stocks
listed on the Nasdaq National Market, the Dow Jones Retailers Broadline Index
("Industry Index") which currently encompasses 22 companies, and the companies
in the Family Clothing Retail industry (SIC Code 5651), a group currently
encompassing 23 companies (the "SIC Index"). This information is provided
through January 31, 2004, the end of fiscal 2003.

COMPARISON OF FIVE-YEAR CUMULATIVE TOTAL RETURN AMONG
FACTORY 2-U STORES, INC., NASDAQ MARKET INDEX,
INDUSTRY INDEX AND SIC INDEX

50

FISCAL YEAR 2003
(1998 = 100)

Measurement Period Factory 2-U Nasdaq
(Fiscal Year Covered) Stores, Inc. Composite Index Industry Index SIC Index

1998 100.00 100.00 100.00 100.00
1999 198.48 149.59 115.13 91.88
2000 351.57 107.10 117.80 81.28
2001 149.58 75.46 130.15 53.91
2002 22.67 52.09 98.62 49.80
2003 3.67 81.75 121.70 72.59

The composition of the Industry Index is as follows: BJ's Wholesale Club, Inc.,
Bon-Ton Stores, Inc., Coles Myer Ltd., Controladora Comer Mex, Cost-U-Less,
Inc., Costco Wholesale Corp., Daiei Inc ADR, Dillard's, Inc., Dollar General
Corp., Duckwall-Alco Stores, Inc., Family Dollar Stores, Inc., Federated Dept.
Stores, Fred's, Inc., Ltd., J.C. Penney Holding Co., May Department Stores,
Overstock.com Inc., Pricesmart, Inc., Retail Ventures, Inc., Sears, Roebuck &
Co., Shopko Stores Inc., Target Corporation and Wal-Mart Stores, Inc.

The composition of the SIC Index is as follows: Abercrombie & Fitch Co.,
Aeropostale, Inc., American Eagle Outfitter, Big Dog Holdings, Inc., Buckle,
Inc., Burlington Coat Factory Warehouse, Casual Male Retail Group, Chico's FAS,
Inc., Children's Place Retail Stores, Factory 2-U Stores, Inc., Freestar
Technologies, Gadzooks, Inc., Gap, Inc., Goody's Family Clothing, Gymboree
Corp., Harold's Stores, Inc., Nordstrom, Inc., Ross Stores, Inc., Stage Stores,
Inc., Stein Mart, Inc., Syms Corp., Urban Outfitters, Inc., and Wilsons the
Leather Expert.

Source: Media General Financial Services

Item 12. Security Ownership of Certain Beneficial Owners and Management

Principal Stockholders

The following persons are known by us, based solely upon information filed by
such persons with the Securities Exchange Commission, to have owned beneficially
more than 5% of any class of our voting securities as of April 23, 2004:

Name and Address Common Stock
of Beneficial Owner Number Percent of Class
------------------- ------ ----------------

Lonestar Partners, L.P. (1) 1,584,000 8.8%
Gryphon Master Fund, L.P. (2) 1,205,269 6.7%
Couchman Partners, L.P. (3) 1,192,200 6.6%
Conus Partners, Inc. (4) 1,011,450 5.6%
Cannell Capital LLC (5) 900,000 5.0%
- -------------------------------------------------------------------------------

51

(1) Based solely on our review of the Schedule 13G filed by such stockholder
with the SEC: The address of the beneficial owner is One Maritime Plaza,
11th Floor, San Francisco, CA 94111. Lonestar Partners, L.P. ("Lonestar")
filed its 13G with the SEC on January 23, 2004 and claimed beneficial
ownership of 1,584,000 shares, or 8.8% of our common stock. The statement
was filed by Lonestar a Delaware limited partnership, with respect to
Shares owned by it, Lonestar Capital Management LLC, a Delaware limited
liability company ("LCM"), the investment adviser to and general partner of
Lonestar, with respect to the Shares held by Lonestar, and Jerome L. Simon
("Simon"), the manager and sole member of LCM, with respect to Shares held
by Lonestar. The Shares reported hereby for Lonestar are owned directly by
Lonestar. LCM, as general partner and investment adviser to Lonestar, may
be deemed to be the beneficial owner of all such Shares owned by Lonestar.
Simon, as the manager and sole member of LCM, may be deemed to be the
beneficial owner of all such Shares held by Lonestar. Each of LCM and Simon
hereby disclaim any beneficial ownership of any such Shares.

(2) Based solely on our review of the Schedule 13G filed by such stockholder
with the SEC: The address of the beneficial owner is 100 Crescent Court,
Suite 490, Dallas, Texas 75201. Gryphon Master Fund, L.P. ("Master Fund")
filed its 13G with the SEC on January 27, 2004 and claimed beneficial
ownership of 1,205,269 shares, or 6.7% of our common stock. The statement
was filed by Master Fund, Gryphon Partners L.P. ("Gryphon Partners"),
Gryphon Management Partners, L.P. ("GMP"), Gryphon Advisors, LLC ("Gryphon
Advisors"), and E.B. Lyon, IV ("Lyon"). The shares of our common stock are
owned directly by Master Fund. The General Partner of Master Fund is
Gryphon Partners, L.P., which may be deemed to be the beneficial owner of
all such shares of our common stock owned by Master Fund. The General
Partner of Gryphon Partners is GMP, which may be deemed to be the
beneficial owner of all such shares of our common stock owned by Mater
Fund. The General Partner of GMP is Gryphon Advisors, which may be deemed
to be the beneficial owner of all such shares of our common stock owned by
Master Fund. Lyon controls Gryphon Advisors and may be deemed to be the
beneficial owner of all such shares of our common stock owned by Master
Fund. Each of Gryphon Partners, GMP, Gryphon Advisors and Lyon disclaims
any beneficial ownership of any such shares of our common stock owned by
Master Fund.

(3) Based solely on our review of the Schedule 13G filed by such stockholder
with the SEC: The statement filed on March 29, 2004 was jointly filed by
Couchman Partners, L.P. ("CP"), Capital LLC ("CC"), and Jonathan Couchman
(together with CP and CC, the "Reporting Persons"). Because Jonathan
Couchman is the sole member of the Management Board of CC, which in turn is
the partner of CP, the Reporting Persons may be deemed, pursuant to Rule
13d-3 of the Securities Exchange Act of 1934, as amended (the "Act"), to be
the beneficial owners of all shares of our common stock held by CP. The
Reporting Persons are filing this joint statement, as they may be
considered a "group" under Section 13(d)(3) of the Act. However, neither
the fact of this filing nor anything contained herein shall be deemed to be
an admission by the Reporting Persons that such a group exists. The
principal business address of CP is c/o Hedge Fund Services (BVI) Limited,
James Frett Building, PO Box 761, Wickhams Cay 1, Road Town, Tortola,
British Virgin Islands. The principal business of CC and Mr. Couchman is
800 Third Avenue, 31st Floor, New York, New York 10022.

(4) Based solely on our review of the Schedule 13G filed by such stockholder
with the SEC: The address of the beneficial owner is One Rockefeller Plaza,
19th Floor, New York, New York 10020. Conus Partners, Inc. filed its
Schedule 13G with the SEC on January 22, 2004 and claimed beneficial
ownership of 1,011,450 shares, or 5.6% of our common stock.

(5) Based solely on our review of the Schedule 13G filed by such stockholder
with the SEC: The address of the beneficial owner is 150 California Street,
Fifth Floor, San Francisco, CA 94111. Cannell Capital LLC filed its
Schedule 13G with the SEC on November 5, 2003 and claimed beneficial
ownership of 900,000 shares, or 5.0% of our common stock. This statement
was filed by (i) Cannell Capital, LLC, a California limited liability
company and California licensed investment adviser ("IA"), (ii) J. Carlo
Cannell ("Managing Member"), (iii) The Anegada Fund Limited ("Anegada"),
(iv) The Cuttyhunk Fund Limited ("Cuttyhunk"), (v) Tonga Partners, L.P.
("Tonga"), (vi) GS Cannell Portfolio, LLC ("GS Cannell") and (vii) Pleiades
Investment Partners, LP ("Pleiades") (collectively, the Reporting Persons).
Managing Member controls IA by virtue of Managing Member's position as

52

managing member and majority owner of IA. IA's beneficial ownership of the
Common Stock is direct as a result of IA's discretionary authority to buy,
sell, and vote shares of such Common Stock for its investment advisory
clients. Managing Member's ownership of Common Stock is indirect as a
result of Managing Member's ownership and management of IA. The beneficial
ownership of Managing Member is reported solely because Rules 13d-1(a) and
(b) under the Securities Exchange Act of 1934, as amended, require any
person who is "directly or indirectly" the beneficial owner of more than
five percent of any equity security of a specified class to file a Schedule
13G. The answers in blocks 6, 8, 9 and 11 above and the response to item 4
by Managing Member are given on the basis of the "indirect" beneficial
ownership referred to in such Rule, based on the direct beneficial
ownership of Common Stock by IA and the relationship of Managing Member to
IA referred to above.

On April 23, 2004, The Depository Trust Company owned of record 17,003,657
shares of common stock, constituting 94.88% of our outstanding common stock. We
understand these shares were held beneficially for members of the New York Stock
Exchange, some of whom may in turn have been holding shares beneficially for
customers.

Management Stockholders

As of April 23, 2004, our directors and executive officers beneficially owned
the following amounts of our voting securities:

Amount and
Nature of
Beneficial Percent of
Name of Beneficial Owner Ownership (1) Class
- ------------------------ ------------- ----------

Willem F.P. de Vogel 22,847 *
Norman Dowling - -
Peter V. Handal 92,267 *
A.J. Nepa (2) 56,250 *
Norman G. Plotkin (2) 160,791 *
Ronald Rashkow (3) 320,704 1.8%
Melvin C. Redman (2)(4) 164,063 *
Wm. Robert Wright II 13,617 *
Directors and Officers as a Group (8 persons) 830,539 4.6%

- -------------------------------------------------------------------------------

* Less than 1%.

(1) Includes shares which may be acquired within 60 days through the exercise
of stock options or warrants, as follows: Mr. de Vogel, 3,000 shares; Mr.
Handal, 6,500 shares; Mr. Nepa, 6,250 shares; Mr. Plotkin, 86,902 shares;
Mr. Rashkow, 56,500 shares; Mr. Redman, 39,063 shares; and Mr. Wright,
6,500 shares; all officers and directors as a group, 204,715 shares.

(2) Includes shares considered beneficially owned under SEC rules, but that are
subject to restrictions on disposition, as follows: Mr. Nepa, 50,000
shares; Mr. Plotkin, 50,000 shares; and Mr. Redman, 125,000 shares.

(3) Includes 45,525 shares of common stock held by Mr. Rashkow's spouse, 2,340
shares of common stock held by a limited partnership of which Mr. Rashkow
is the general partner and 56,500 shares, which Mr. Rashkow may acquire
within 60 days through the exercise of stock options.

53

(4) As of April 27, 2004, Mr. Redman was no longer an employee. His right to
receive any shares of restricted stock that has not vested terminated, and
all of such restricted shares were forfeited. In addition, his options will
expire 3 months after that date.

54

Item 13. Certain Relationships and Related Transactions

Transactions with Management and Others

In March 1997, we entered into an agreement with Three Cities Research, Inc.
("TCR") engaging TCR to act as financial advisors to us. Under this agreement,
we paid TCR an annual fee of $50,000 and reimbursed TCR all of its out-of-pocket
expenses incurred for services rendered, up to an aggregate of $50,000 annually.
As of January 31, 2004, we no longer engage TCR as our financial advisors. We
reimbursed TCR for out-of-pocket expenses in the amounts of $46,000, $47,000 and
$34,000 during fiscal 2003, 2002 and 2001, respectively. In addition, we paid
legal fees in the amount of $24,000 to TCR in connection with our private equity
placements during fiscal 2003. As of January 31, 2004, TCR did not own any of
our outstanding common stock, however a principal of TCR is still a member of
our Board of Directors.

On March 6, 2003, Three Cities Fund II L.P. purchased 240,793 shares of our
common stock and Three Cities Offshore II C.V. purchased 407,207 shares of our
common stock in a private placement at a purchase price of $2.75 per share (a
price in excess of the closing market price of our common stock on such date),
for an aggregate purchase price of $1,782,000.

Also on March 6, 2003, Mr. Rashkow purchased 72,700 shares of our common stock
in the private placement at a price of $2.75 per share (a price in excess of the
closing market price of our common stock on such date), for an aggregate
purchase price of $199,925.

Indebtedness of Management

During fiscal years 1997 and 1998, we sold to our executive management shares of
our Series B Preferred Stock, which were subsequently converted to common stock.
With the exception of Michael M. Searles, our former Chief Executive Officer,
and Johnathan W. Spatz, our Former Chief Financial Officer, each of the
executives paid for his or her shares by giving us a full-recourse promissory
note secured by the purchased stock. Each note accrues interest at 8% per annum
and requires principal payments equivalent to 16.25% of the annual bonus paid to
the purchaser (if such bonus is actually paid in a given year) and a balloon
payment of the unpaid principal and interest at maturity. Each of the notes
matures five years after the date it was made.

Mr. Searles' promissory note in the principal amount of $1,400,000 was
partial-recourse and was due on April 29, 2003. Mr. Searles was liable for the
payment of principal and accrued but unpaid interest on his note up to $600,000
(including the value of the shares of our stock securing the note) and we had
the right to retain the stock securing his note with respect to the balance of
any principal and accrued interest on his note to the extent such stock had a
value in excess of $600,000 (but not in excess of the outstanding balance of
principal and accrued interest). We had forgiven interest payments aggregating
$157,808 through November 7, 2002, but Mr. Searles' note accrued interest from
November 7, 2002 to April 29, 2003. On April 29, 2003, the principal and accrued
interest due on Mr. Searles' note was $1,458,608 and we foreclosed on the
collateral which had a market value of $1,198,750, resulting in a deficiency of
$259,858, for which Mr. Searles does not have personal liability under the terms
of the note.

Mr. Plotkin's promissory note was outstanding during fiscal 2002, but as of
March 21, 2003, Mr. Plotkin had repaid his promissory note in full in the amount
of $101,008.

On April 29, 2003, the principal and accrued interest on two notes due from Mr.
Spatz, were $688,197 and the collateral's market value on that date was
$376,744, resulting in a deficiency of $311,453, for which Mr. Spatz is
personally liable for $136,614 of the deficiency under the terms of his notes.
Based on Mr. Spatz's current financial condition, we have elected, at this time,
to forbear our collection efforts regarding the amount for which he is
personally liable.

Additionally, on April 29, 2003, the principal and accrued interest on the notes
due from Tracy W. Parks, our former Executive Vice President and Chief Operating
Officer, was $117,042. On that date, we foreclosed on the collateral which had a
market value of $82,197, resulting in a deficiency of $34,845, for which Mr.
Parks was personally liable under the terms of his notes. In August 2003, we
received payment in full from Mr. Parks to repay the outstanding principal
balance of his note plus interest.

55

Item 14. Principal Accounting Fees and Services

The following table shows the aggregate fees billed to us by Ernst & Young LLP
for fiscal years ended January 31, 2004 and February 1, 2003.

Fiscal Year Ended
-----------------------------
January 31, Februaray 1,
2004 2003
-----------------------------
Fees Fees
-----------------------------

Audit Fees(1) $ 50,600 $144,468

Audit-Related Fees (2) 27,396 -

Tax Fees - -

All Other Fees - -
-------- --------
Total Fees $ 77,996 $144,468
======== ========

(1) Includes fees for professional services provided in conjunction with the
audit of our financial statements and review of our quarterly financial
statements;

(2) Includes fees for assurance and related professional services primarily
related to services provided in connection with our registration statements
on Form S-3 filed with respect to the resale of securities sold in the
private offerings in March 2003 and August 2003.

Our Audit Committee's policy is to pre-approve all audit and permissible
audit-related services provided by the independent auditors. Our Audit Committee
considers annually for pre-approval a list of specific services and categories
of services, including audit and audit-related services, for the upcoming or
current fiscal year. All non-audit services are approved by our Audit Committee
in advance on a case-by-case basis. Any service that is not included in the
approved list of services or that does not fit within the definition of a
pre-approved service is required to be presented separately to our Audit
Committee for consideration at its next regular meeting or, if earlier
consideration is required, by other means of communication.

All fees were pre-approved in accordance with our Audit Committee pre-approval
policy. Our Audit Committee considered and concluded that the provision of those
services provided by Ernest & Young LLP was compatible with the maintenance of
the auditor's independence in conducting auditing functions.

56

PART IV

Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K.

(a) 1. Financial Statements.

See Index to Financial Statements contained in Item 8.

2. Financial Statement Schedules.

Schedule II Valuation and Qualifying Accounts contained on page
59.

All other schedules are omitted because of the absence of
conditions under which they are required or because the required
information is set forth in the financial statements and notes
thereto.

3. Exhibits. See Item 15(c).

(b) Reports on Form 8-K.

On December 24, 2003, we filed a report on Form 8-K regarding an
amendment to our Amended and Restated Financing Agreement, announcing
an agreement in principle with holders of our Junior Subordinated
Notes to amend the scheduled payment dates and announcing revised
expectations for sales and operating results for the fourth quarter
ended January 31, 2004. The full text of our press release dated
December 23, 2003 was attached as an exhibit to the Form 8-K.

On January 7, 2004, we filed a report on Form 8-K regarding the
termination of Douglas C. Felderman as Chief Financial Officer
effective January 5, 2004, and the appointment of John Swygert as
Chief Financial Officer on an interim basis. The full text of our
press release dated January 6, 2004 was attached as an exhibit to the
Form 8-K.

On January 16, 2004, we filed a report on Form 8-K regarding the
following: (1) our filing of a voluntary petition to reorganize under
Chapter 11 of the Bankruptcy Code on January 13, 2004, (2) our receipt
of a commitment for a $45 million DIP financing facility from the CIT
Group/Business Credit, Inc. and GB Retail Funding, LLC, (3) our
appointment of Norman G. Plotkin as Chief Executive Officer and John
W. Swygert as Chief Financial Officer, (4) the discontinuation of our
mid-month sales updates and monthly sales press releases, and (5) the
notice from Nasdaq of its determination to delist us and our intention
not to appeal. The full text of the press releases dated January 13,
2004 and January 15, 2004 related to items (1), (2) and (3) above were
furnished and attached as an exhibit to the Form 8-K. The full text of
the press release dated January 16, 2004 related to item (5) above was
furnished and attached as an exhibit to the Form 8-K. In addition, the
full text of our DIP financing facility agreement was filed and
attached as an exhibit to the Form 8-K.

On January 22, 2004, we furnished a report on Form 8-K regarding our
filing of a motion with the Court seeking authorization to close 44
stores. The full text of our press release dated January 22, 2004 was
furnished and attached as an exhibit to the Form 8-K.

On February 3, 2004, we furnished a report on Form 8-K regarding the
decision by the Court to grant final approval for the use of the
entire $45 million debtor-in-possession financing agreement. The full
text of our press release dated February 2, 2004 was furnished and
attached as an exhibit to the Form 8-K.

57

On February 17, 2004, we filed a report on Form 8-K regarding the
resignation of John W. Swygert as Chief Financial Officer, effective
February 20, 2004.

On March 22, 2004, we filed a report on Form 8-K regarding the
appointment of Norman Dowling as Executive Vice President and Chief
Financial Officer effective March 22, 2004 and the election of Norman
G. Plotkin to our Board of Directors effective March16, 2004. The full
text of our press release dated March 22, 2004 was furnished and
attached as an exhibit to the Form 8-K.

(c) Exhibits.

Reference is made to the Index to Exhibits immediately preceding the
exhibits thereto.

58

Schedule II
Factory 2-U Stores, Inc.
Valuation and Qualifying Accounts
Fiscal Year Ended January 31, 2004, February 1, 2003 and February 2, 2002
(in thousands)

Additions
Balance at Charged to Charged to Balance at
Beginning Costs and Other End of
Description of Period Expenses Accounts Deductions Period
----------- ---------- ---------- ---------- ---------- ----------

As of January 31, 2004
Notes Receivable Allowance $ 2,340 $ 60 $ - $ (1,109) $ 1,291
Inventory Valuation Allowance 8,362 10,155 - (7,100) 11,417
FY02 Restructuring Reserve 12,411 (471) - (7,125) 4,815
FY01 Restructuring Reserve 4,774 (1,076) - (2,329) 1,369

As of February 1, 2003
Notes Receivable Allowance $ - $ 2,340 $ - $ - $ 2,340
Inventory Valuation Allowance 1,152 7,210 - - 8,362
FY02 Restructuring Reserve - 14,398 - (1,987) 12,411
FY01 Restructuring Reserve 21,154 (4,969) - (11,411) 4,774

As of February 2, 2002
Inventory Valuation Allowance $ 1,265 $ - $ - $ (113) $ 1,152
FY01 Restructuring reserve - 21,231 - (77) 21,154

59

Index to Exhibits

Exhibit
Number Document
- --------------------------------------------------------------------------------
2.1 (1) Plan and Agreement of Merger dated June 18, 1998 between
Family Bargain Corporation and General Textiles, Inc.
3.1 (2) (i) Restated Certificate of Incorporation
(ii) Bylaws
4.1 (1) Junior Subordinated Note Agreement dated April 30, 1998 among
General Textiles, American Endeavour Fund Limited and London
Pacific Life & Annuity Company
4.2 (1) Form of Warrant dated April 30, 1998
10.1 (3) Factory 2-U Stores, Inc. Employee Stock Purchase Plan
10.2 (4) Amended and Restated Factory 2-U Stores, Inc. 1997 Stock
Option Plan
10.3 (5) Factory 2-U Stores, Inc. Employee Compensation Agreements
10.4 (6) Financing Agreement between The CIT Group/Business Credit,
Inc. (as Agent and a Lender) and Factory 2-U Stores, Inc. (as
Borrower), dated as of March 3, 2000
10.5 (6) First Amendment to the Financing Agreement between The CIT
Group/Business Credit, Inc. (as Agent and a Lender) and
Factory 2-U Stores, Inc. (as Borrower), dated as of March 3,
2000
10.6 (6) Amended Employment Agreement between Factory 2-U Stores, Inc.
and Michael M. Searles
10.7 (7) Second Amendment to the Financing Agreement between The CIT
Group/Business Credit, Inc. (as Agent and a Lender) and
Factory 2-U Stores, Inc. (as Borrower), dated as of April 10,
2001
10.8 (7) Third Amendment to the Financing Agreement between The CIT
Group/Business Credit, Inc. (as Agent and a Lender) and
Factory 2-U Stores, Inc. (as Borrower), dated as of April 9,
2002
10.9 (8) Fourth Amendment to the Financing Agreement between The CIT
Group/Business Credit, Inc. (as Agent and a Lender) and
Factory 2-U Stores, Inc. (as Borrower), dated as of September
16, 2002
10.10 (10) Fifth Amendment to the Financing Agreement between The CIT
Group/Business Credit, Inc. (as Agent and a Lender) and
Factory 2-U Stores, Inc. (as Borrower), dated as of February
14, 2003
10.11 (10) Sixth Amendment to the Financing Agreement by and among The
CIT Group/Business Credit, Inc. (as Agent and a Lender),
Factory 2-U Stores, Inc. (as Borrower), and GB Retail Funding
LLC (a Lender), dated as April 10, 2003
10.12 (9) Employment Agreement, dated as of November 7, 2002, by and
between Factory 2-U Stores, Inc. and William R. Fields
10.13 (9) Letter Agreement, dated as of November 4, 2002, by and between
Factory 2-U Stores, Inc. and Ronald Rashkow
10.14 (10) Employment Agreement, dated as of January 6, 2003, by and
between Factory 2-U Stores, Inc. and Melvin Redman
10.15 (10) Employment Agreement, dated as of January 6, 2003, by and
between Factory 2-U Stores, Inc. and Larry I. Kelley
10.16 (10) Industrial/Commercial Single-Tenant Lease as of March 8, 2002,
by and between Factory 2-U Stores, Inc. (as Tenant) and ORIX
Otay, LLC (as Landlord)
10.17 (11) Employment Agreement, dated as of May 20, 2003, by and between
Factory 2-U Stores, Inc. and Douglas C. Felderman
10.18 (11) Employment Agreement, dated as of May 20, 2003, by and between
Factory 2-U Stores, Inc. and Norman G. Plotkin
10.19 (12) Employment Agreement, dated as of November 10, 2003, by and
between Factory 2-U Stores, Inc. and A.J. Nepa
10.20 (13) First Amendment to Amended and Restated Financing Agreement by
and among The CIT Group/Business Credit, Inc. (as Agent and a
Lender), Factory 2-U Stores, Inc. (as Borrower), and GB Retail
Funding LLC (a Lender), dated December 23, 2003
10.21 (14) Second Amended and Restated Financing Agreement by and among
The CIT Group/Business Credit, Inc. (as Agent and a Lender),
Factory 2-U Stores, Inc. (as Borrower), and GB Retail Funding
LLC (a Lender), dated January 12, 2004
10.22 * Second Amendment to Amended and Restated Financing Agreement
by and among The CIT Group/Business Credit, Inc. (as Agent and
a Lender), Factory 2-U Stores, Inc. (as Borrower), and GB
Retail Funding LLC (a Lender), dated January 12, 2004

60

10.23 * First Amendment to the Second Amended and Restated Financing
Agreement by and among The CIT Group/Business Credit, Inc.
(as Agent and a Lender), Factory 2-U Stores, Inc. (as Borrower)
, and GB Retail Funding LLC (a Lender), dated January 30, 2004
10.24 * Agency Agreement, dated as of February 10, 2004, by and
between The Great American Group and Factory 2-U Stores, Inc.
10.25 * Second Amendment to the Second Amended and Restated Financing
Agreement by and among The CIT Group/Business Credit, Inc.
(as Agent and a Lender), Factory 2-U Stores, Inc. (as Borrower)
, and GB Retail Funding LLC (a Lender), dated March 10, 2004
14.1 * Standards of Business Conduct
23.1 * Consent of Ernst & Young LLP, Independent Auditors
23.2 * Information regarding consent of Arthur Andersen LLP
31.1 * Certification of the Chief Executive Officer filed pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 * Certification of the Chief Financial Officer filed pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 ** Certification furnished pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002 by Norman G. Plotkin, Chief Executive Officer
32.2 ** Certification furnished pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002 by Norman Dowling, Executive Vice President and Chief
Financial Officer

61

(1) Incorporated by reference to Registration Statement on Form S-2, No.
333-58797 filed with the SEC on October 14, 1998.
(2) Incorporated by reference to Registration Statement on Form S-1, No.
33-77448 filed with the SEC on April 7, 1994.
(3) Incorporated by reference to Registration Statement on Form S-8 No.
333-94123 filed with the SEC on January 5, 2000.
(4) Incorporated by reference to Registration Statement on Form S-8 No.
333-40682 filed with the SEC on June 30, 2000.
(5) Incorporated by reference to Registration Statement on Form S-8 No.
333-89267 filed with the SEC on October 19, 1999.
(6) Incorporated by reference to Form 10-K for the fiscal year ended
January 29, 2000 filed with the SEC on April 24, 2000.
(7) Incorporated by reference to Form 10-K for the fiscal year ended
February 2, 2002 filed with the SEC on April 19, 2002.
(8) Incorporated by reference to Form 10-Q for the quarterly period
ended August 3, 2002 filed with the SEC on September 17, 2002.
(9) Incorporated by reference to Form 8-K for report dated November 7,
2002 filed with the SEC on November 19, 2002.
(10) Incorporated by reference to Form 10-K for the fiscal year ended
February 1, 2003 filed with the SEC on May 2, 2003.
(11) Incorporated by reference to Form 10-Q for the quarterly period
ended May 3, 2003 filed with the SEC on June 17, 2003.
(12) Incorporated by reference to Form 10-Q for the quarterly period ended
November 1, 2003 filed with the Sec on December 16, 2003.
(13) Incorporated by reference to Form 8-K for report dated December
22, 2003 filed with the SEC on December 24, 2003.
(14) Incorporated by reference to Form 8-K for report dated January 13,
2004 filed with the SEC on January 16, 2004.

* Filed herewith.

** Furnished herewith.

62

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Company has duly caused this report to be signed on
its behalf by the undersigned, hereunto duly authorized.

FACTORY 2-U STORES, INC.

By:/s/ Norman G. Plotkin
----------------------------
Norman G. Plotkin
Chief Executive Officer

Dated: April 30, 2004

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of this Company
and in the capacities and on the date indicated.

Signature Title Date
--------- ----- ----

/s/ Norman G. Plotkin Director and Chief
--------------------- Executive Officer April 30, 2004
Norman G. Plotkin

/s/ Norman Dowling Executive Vice President, April 30, 2004
--------------------- Chief Financial Officer
Norman Dowling (Principal Financial and
Accounting Officer)

/s/ Ronald Rashkow Lead Director April 30, 2004
------------------
Ronald Rashkow

/S/ Willem de Vogel Director April 30, 2004
--------------------
Willem de Vogel

/s/ Peter V. Handal Director April 30, 2004
-------------------
Peter V. Handal

/s/ Wm. Robert Wright II Director April 30, 2004
------------------------
Wm. Robert Wright II

63

REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

To the Shareholders and the
Board of Directors of Factory 2-U Stores, Inc.

We have audited the accompanying balance sheets of Factory 2-U Stores, Inc. (the
"Company") as of January 31, 2004 and February 1, 2003 and the related
statements of operations, stockholders' equity (deficit) and cash flows for the
years ended January 31, 2004 ("fiscal 2003") and February 1, 2003 ("fiscal
2002'). Our audits also included the financial statement schedule listed in the
Index at Item 15(a). These financial statements and the financial statement
schedule are the responsibility of the Company's management. Our responsibility
is to express an opinion on these financial statements and schedule based on our
audit. The financial statements and financial statement schedule of the Company
for the fiscal year ended February 2, 2002 ("fiscal 2001"), were audited by
other auditors who have ceased operations. Those auditors expressed an
unqualified opinion on those statements in their report dated February 27, 2002.

We conducted our audits in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.

In our opinion, the fiscal 2003 and fiscal 2002 financial statements referred to
above present fairly, in all material respects, the financial position of the
Company as of January 31, 2004 and February 1, 2003 and the results of its
operations and its cash flows for the years ended January 31, 2004 and February
1, 2003 in conformity with accounting principles generally accepted in the
United States. Also, in our opinion, the related fiscal 2003 and fiscal 2002
financial statement schedule, when considered in relation to the basic financial
statements taken as a whole, presents fairly in all material respects the
information set forth therein.

As discussed in Note 8 to the financial statements, the Company changed its
method of accounting for goodwill and other intangible assets in accordance with
Statement of Financial Accounting Standards ("Statement") No.142 during the
first quarter of fiscal 2002.

As discussed above, the financial statements of the Company as of February 2,
2002, and for the year then ended were audited by other auditors who have ceased
operations. As described in Note 8, these financial statements have been updated
to include the transitional disclosures required by Statement No. 142, "Goodwill
and Other Intangible Assets," which was adopted by the Company as of February 3,
2002. Our audit procedures with respect to the disclosures in Note 8 for fiscal
2001 included (i) agreeing the previously reported net income (loss) to the
previously issued financial statements and the adjustments to reported net
income (loss) representing amortization expense (including any related tax
effects) recognized in those periods related to goodwill that are no longer
being amortized to the Company's underlying records obtained from management,
and (ii) testing the mathematical accuracy of the reconciliation of adjusted net
income (loss) to reported net income (loss), and the related net income
(loss)-per-share amounts. In our opinion, the disclosures for fiscal 2001 in
Note 8 related to the transitional disclosures of Statement 142 are appropriate.
However, we were not engaged to audit, review, or apply any procedures to the
Company's financial statements for fiscal 2001 other than with respect to such
disclosures and, accordingly, we do not express an opinion or any other form of
assurance on the Company's fiscal 2001 financial statements taken as a whole.

F-1

The accompanying financial statements have been prepared assuming that Factory
2-U Stores, Inc. will continue as a going concern, which contemplates continuity
of the Company's operations and realization of its assets and payments of its
liabilities in the ordinary course of business. As more fully described in the
notes to the financial statements, on January 13, 2004 Factory 2-U Stores, Inc.
filed a voluntary petition for reorganization under Chapter 11 of the United
States Bankruptcy Code. The uncertainties inherent in the bankruptcy process and
the Company's recurring losses from operations raise substantial doubt about
Factory 2-U Stores, Inc.'s ability to continue as a going concern. The Company
is currently operating its business as a Debtor-in-Possession under the
jurisdiction of the Bankruptcy Court, and continuation of the Company as a going
concern is contingent upon, among other things, the confirmation of a Plan of
Reorganization, the Company's ability to comply with all debt covenants under
the existing debtor-in-possession financing agreement, and the Company's ability
to generate sufficient cash from operations and obtain financing sources to meet
its future obligations. If no reorganization plan is approved, it is possible
that the Company's assets may be liquidated. The financial statements do not
include any adjustments to reflect the possible future effects on the
recoverability and classification of assets or the amount and classification of
liabilities that may result from the outcome of these uncertainties.

/s/ ERNST & YOUNG LLP
San Diego, California

April 19, 2004

F-2

REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

THIS IS A COPY OF THE AUDIT REPORT PREVIOUSLY ISSUED BY ARTHUR ANDERSEN LLP IN
CONNECTION WITH FACTORY 2-U STORES, INC.'S FILING ON FORM 10-K FOR THE YEAR
ENDED FEBRUARY 2, 2002. THIS AUDIT REPORT HAS NOT BEEN REISSUED BY ARTHUR
ANDERSEN LLP IN CONNECTION WITH THIS FILING ON FORM 10-K. SEE EXHIBIT 23.2 FOR
FURTHER DISCUSSION. THE BALANCE SHEET AS OF FEBRUARY 3, 2001, REFERRED TO IN
THIS REPORT HAS NOT BEEN INCLUDED IN THE ACCOMPANYING FINANCIAL STATEMENTS.

To Factory 2-U Stores, Inc.:

We have audited the accompanying balance sheets of Factory 2-U Stores, Inc. (a
Delaware corporation) as of February 2, 2002 and February 3, 2001, and the
related statements of operations, stockholders' equity and cash flows for each
of the three years in the period ended February 2, 2002. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

We conducted our audits in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Factory 2-U Stores, Inc. as of
February 2, 2002 and February 3, 2001 and the results of its operations and its
cash flows for each of the three years in the period ended February 2, 2002 in
conformity with accounting principles generally accepted in the United States.

Our audits were made for the purpose of forming an opinion on the basic
financial statements taken as a whole. The schedule listed in the index to
financial statements and supplementary data is presented for purposes of
complying with the Securities and Exchange Commission's rules and is not a
required part of the basic financial statements. This schedule has been
subjected to the auditing procedures applied in our audits of the basic
financial statements and, in our opinion, is fairly stated in all material
aspects in relation to the basic financial statements taken as a whole.

/s/ ARTHUR ANDERSEN LLP

San Diego, California
February 27, 2002

F-3

FACTORY 2-U STORES, INC.
(Debtor-in-Possession)
Balance Sheets
(in thousands)

January 31, February 1,
2004 2003

---------- -----------

ASSETS

Current assets:
Cash and cash equivalents $ 9,963 $ 3,465
Merchandise inventory 38,168 32,171
Accounts receivable, net 618 884
Income taxes receivable - 8,200
Prepaid expenses 2,740 5,436
Deferred income taxes - 9,732
-------- --------
Total current assets 51,489 59,888

Leasehold improvements and equipment, net 18,186 28,602
Deferred income taxes - 10,750
Other assets 1,033 963
Goodwill - 26,301
-------- --------
$ 70,708 $126,504
======== ========

The accompanying notes are an integral part of these financial statements.

(continued)

F-4

FACTORY 2-U STORES, INC.
(Debtor-in-Possession)
Balance Sheets
(in thousands)

January 31, February 1,
2004 2003
----------- -----------

LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
DIP financing facility $ - $ -
Current maturities of long-term debt 36 3,000
Accounts payable 8,257 27,961
Income tax payable 3,500 -
Sales tax payable 5,615 5,840
Accrued expenses 12,560 27,831
---------- ---------
Total current liabilities 29,968 64,632

Revolving credit facility - 6,300
Long-term debt 92 6,445
Accrued restructuring charges - 1,747
Deferred rent and other liabilities 2,518 3,061
---------- ---------
Total liabilities not subject to compromise 32,578 82,185
---------- ---------

Liabilities subject to compromise 63,062 -

Stockholders' equity (deficit):
Common stock, $0.01 par value; 35,000 shares authorized
and 17,921 shares and 13,476 shares issued and
outstanding, respectively 179 135
Stock subscription notes receivable - (1,116)
Additional paid-in capital 137,964 122,516
Accumulated deficit (163,075) (77,216)
--------- ---------
Total stockholders' equity (deficit) (24,932) 44,319
--------- ---------
$ 70,708 $126,504
========== =========

Commitments and contingencies

The accompanying notes are an integral part of these financial statements.

F-5

FACTORY 2-U STORES, INC.
(Debtor-in-Possession)
Statements of Operations
(in thousands, except per share data)

Fiscal Year Ended
-------------------------------------------------
January 31, February 1, February 2,
2004 2003 2002
-------------------------------------------------

Net sales $ 493,297 $ 535,270 $ 580,460
Cost of sales 340,069 372,885 385,390
---------- ---------- ----------
Gross profit 153,228 162,385 195,070

Selling and administrative expenses
(exclusive of non-cash stock-based
compensation expense shown below) 180,866 196,435 188,272
Pre-opening and closing expenses 292 1,086 3,086
Amortization of intangibles - - 1,682
Restructuring charge, net (1,547) 9,914 18,360
Stock-based compensation expense - - 456
---------- ---------- ----------
Operating loss (26,383) (45,050) (16,786)

Interest expense, net 3,693 1,611 960
---------- ---------- ----------
Loss before reorgranization items and
income taxes (benefit) (30,076) (46,661) (17,746)
Reorganization items 31,703 - -
---------- ---------- ----------
Loss before income taxes (benefit) (61,779) (46,661) (17,746)
Income taxes (benefit) 24,080 (18,152) (6,850)
---------- ---------- ----------
Net loss $ (85,859) $ (28,509) $ (10,896)
========== ========== ==========

Net loss per share, basic and diluted $ (5.30) $ (2.20) $ (0.85)

Weighted average common shares
outstanding, basic and diluted 16,187 12,957 12,807

The accompanying notes are an integral part of these financial statements.

F-6

FACTORY 2-U STORES, INC.
(Debtor-in-Possession)
Statements of Stockholders' Equity (Deficit)
(in thousands, except share data)

Stock
Common Stock Subscription Additional
--------------------- Notes Paid-in Accumulated
Shares Amount Receivable Capital Deficit Total
---------- -------- ------------ ----------- ------------ -----------

Balance at February 3, 2001 12,759,304 $ 127 $ (2,225) $ 119,646 $ (37,811) $ 79,737
---------- ------ ---------- ---------- ------------ -----------

Issuance of common stock for exercise
of stock options 66,456 1 - 522 - 523

Compensation expense related to the
removal of price hurdle for performance-
based stock options - - - 456 - 456

Tax effect related to non-qualified stock options - - - 389 - 389

Issuance of common stock to Board members
as compensation 4,000 - - 106 - 106

Issuance of common stock under
employee stock purchase plan 12,386 - - 251 - 251

Net loss - - - - (10,896) (10,896)
---------- ------ ----------- ---------- ------------- -----------
Balance at February 2, 2002 12,842,146 128 (2,225) 121,370 (48,707) 70,566
---------- ------ ----------- ---------- ------------- -----------
Issuance of common stock for exercise
of stock options 124,764 1 - 917 - 918

Issuance of common stock to Board
Members and management as compensation 478,000 5 - 78 - 83

Issuance of common stock under
employee stock purchase plan 30,795 1 - 151 - 152

Payments of notes receivable - - 76 - - 76

Write-down of stock subscription notes
receivable to fair value - - 1,033 - - 1,033

Net loss - - - - (28,509) (28,509)
---------- ------ ---------- --------- ------------ ----------
Balance at February 1, 2003 13,475,705 135 (1,116) 122,516 (77,216) 44,319
---------- ------ ---------- --------- ------------ ----------

Issuance of common stock in private
placements 4,965,379 50 - 17,019 - 17,069

Issuance of common stock to Board members
and management as compensation 154,250 1 - 14 - 15

Issuance of common stock under
employee stock purchase plan 36,410 - - 63 - 63

Forfeiture of common stock issued to
former management (375,000) (4) - 4 - -

Payments of notes receivable - - 143 - - 143

Forfeiture of common stock in connection
with default on stock subscription notes
receivable (335,566) (3) 973 (1,652) - (682)

Net loss - - - - (85,859) (85,859)
----------- ------ --------- ------------ ----------- -----------
Balance at January 31, 2004 17,921,178 $ 179 $ - $ 137,964 $ (163,075) $ (24,932)
----------- ------ --------- ------------ ----------- -----------

The accompanying notes are an integral part of these financial statements.

F-7

FACTORY 2-U STORES, INC.
(Debtor-in-Possiession)
Statements of Cash Flows
(in thousands)

Fiscal Year Ended
-----------------------------------------
January 31, February 1, February 2,
2004 2003 2002
-----------------------------------------

Cash flows from operating activities
Net loss $ (85,859) $ (28,509) $ (10,896)
Adjustments to reconcile net loss to net cash
provided by (used in) operating activities
Depreciation and amortization 13,602 15,160 14,773
Loss on disposal of equipment 81 76 205
Deferred income tax 20,482 (9,748) (3,240)
Deferred rent (571) (550) 264
Reorganization items 31,164 - -
Restructuring charge, net (1,547) 4,734 4,922
Stock-based compensation expense 15 78 562
Stock subscription notes receivable
valuation adjustment (708) 1,033 -
Vendor note receivable valuation reserve - 1,106 -
Other - 171 -
Changes in operating assets and liabilities
Merchandise inventory (7,519) 22,454 (5,286)
Income taxes - net 11,700 (9,311) (4,347)
Prepaid expenses and other assets 3,141 3,430 (369)
Advances to vendor (51) (3,118) -
Repayments from vendor 116 789 -
Accounts payable 22,030 (8,310) 11,077
Accrued expenses and other liabilities (5,851) 2,432 19,208
------- ------- --------
Net cash provided by (used in) operating activities 225 (8,083) 26,873
------- ------- --------

Cash flows from investing activities
Purchase of leasehold improvements and equipment (3,493) (11,001) (12,694)
------- -------- --------
Net cash used in investing activities (3,493) (11,001) (12,694)
------- -------- --------

(continued)

The accompanying notes are an integral part of these financial statements.

F-8

FACTORY 2-U STORES, INC.
(Debtor-in-Possession)
Statements of Cash Flows
(in thousands)

Fiscal Year Ended
----------------------------------------------------
January 31, February 1, February 2,
2004 2003 2002
----------------------------------------------------

Cash flows from financing activities
Borrowings on revolving credit facility 148,097 94,794 88,044
Payments on revolving credit facility (154,397) (88,494) (88,044)
Payments on long-term debt and capital
lease obligations (7,523) (2,019) (2,171)
Proceeds from debt financing 7,500 - -
Payments of debt issuance costs (1,123) (121) (40)
Proceeds from issuance of common stock, net 17,069 5 160
Proceeds from exercise of stock options - 918 523
Payments of stock subscription notes receivable 143 76 -
--------- --------- --------
Net cash provided by (used in) financing activities 9,766 5,159 (1,528)
--------- --------- --------

Net increase (decrease) in cash and cash equivalents 6,498 (13,925) 12,651
Cash and cash equivalents at the beginning of the period 3,465 17,390 4,739
--------- --------- ---------
Cash and cash equivalents at the end of the period $ 9,963 $ 3,465 $ 17,390
========= ========= =========

Supplemental disclosure of cash flow information
Cash paid during the period for
Interest $ 1,947 $ 613 $ 387
Income taxes $ 94 $ 1,328 $ 5,698

Supplemental disclosures of non-cash investing and
financing activities
Acquisition of equipment under notes payable $ 151 $ - $ -
Foreclosure of collateral on stock subscription
notes receivable $ 1,681 $ - $ -
Tax effect related to non-qualified stock options $ - $ - $ 389

The accompanying notes are an integral part of these financial statements.

F-9

FACTORY 2-U STORES, INC.
(Debtor-in-Possession)
Notes to Financial Statements

1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Description of Our Company and Business

We operate a chain of off-price retail apparel and houseware stores in
Arizona, California, Nevada, New Mexico, Oregon, Texas and Washington.
We sell branded casual apparel for the family, as well as selected
domestics and household merchandise at prices, which generally are
significantly lower than other discount stores.

On January 13, 2004 (the "Petition Date"), we filed a voluntary
petition to reorganize under Chapter 11 of the United States
Bankruptcy Code (the "Bankruptcy Code") in the United States
Bankruptcy Court for the District of Delaware (the "Court"), which is
currently pending as case number 04-10111(PJW) (the "Chapter 11
filing"). We remain in possession of our properties and continue to
operate our business as debtor-in-possession ("DIP") in accordance
with the applicable provisions of the Bankruptcy Code.

At January 31, 2004, we operated 239 stores under the name Factory
2-U. Subsequently, we closed 44 stores located in states listed above
as well as Arkansas, Idaho and Oklahoma.

Fiscal Year

Our fiscal year is based on a 52/53 week year ending on the Saturday
nearest January 31. Fiscal years ended January 31, 2004, February 1,
2003 and February 2, 2002 included 52 weeks. We define our fiscal year
by the calendar year in which most of the activity occurs (e.g. the
fiscal year ended January 31, 2004 is referred to as fiscal 2003).

Basis of Presentation

The accompanying Financial Statements are prepared on a going concern
basis, which assumes continuity of operations and realization of
assets and satisfaction of liabilities in the ordinary course of
business. In accordance with Statement of Position 90-7 "Financial
Reporting by Entities in Reorganization under the Bankruptcy Code"
("SOP 90-7"), all pre-petition liabilities subject to compromise have
been segregated in the Balance Sheet as of January 31, 2004 and
classified as Liabilities subject to compromise, at the estimated
amount of allowable claims. Liabilities not subject to compromise are
separately classified as current and non-current. Expenses, realized
gains and losses, and provisions for losses resulting from the
reorganization are reported separately as Reorganization items in the
Statement of Operations for fiscal year ended January 31, 2004. Cash
used for reorganization items is disclosed separately in the Statement
of Cash Flows for fiscal year ended January 31, 2004.

Our ability to continue as a going concern is predicated upon numerous
issues, including our ability to achieve the following:

- developing and implementing a long-term strategy to revitalize
our business and return to profitability;

- taking appropriate actions to offset the negative impact the
Chapter 11 filing has had on our business and the impairment of
vendor relations;

- operating within the framework of our DIP financing facility,
including limitations on capital expenditures and compliance with
financial covenants,

F-10

- generating cash flows from operations or seeking other sources of
financing and the availability of projected vendor credit terms;

- attracting, motivating and retaining key executives and
associates; and

- developing, negotiating, and, thereafter, having a plan of
reorganization confirmed by the Court.

These challenges are in addition to other operational and competitive
challenges faced by us in connection with our business as an off-price
retailer.

Bankruptcy Accounting

Since the Chapter 11 filing, we have applied the provisions of SOP
90-7, which does not significantly change the application of
accounting principles generally accepted in the United States;
however, it requires the financial statements for periods including
and subsequent to filing Chapter 11 petition distinguish transactions
and events that are directly associated with the reorganization from
the ongoing operations of the business.

Cash Equivalents

We consider all liquid investments with original maturities of three
months or less to be cash equivalents.

Merchandise Inventory

Merchandise inventory is stated at the lower of cost or market
determined using the retail inventory method on a first-in, first-out
basis. In addition, consistent with industry practice, we capitalize
direct buying (primarily salaries and wages of buyers and their
traveling expenses), warehousing, storage and transportation costs.
Such costs are thereafter expensed as cost of sales upon the sale of
the merchandise. At January 31, 2004 and February 1, 2003, such costs
included in inventory were $4.3 million and $3.4 million,
respectively. As of January 31, 2004 and February 1, 2003, we had an
inventory valuation allowance of $11.6 million and $8.4 million,
respectively, which represented our estimate of the cost in excess of
the net realizable value of all clearance and slow-moving items. The
inventory valuation allowance of $11.6 million as of January 31, 2004
also included a $2.2 million shrink reserve and a $1.7 million
allowance related to the sale of inventory at the 44 stores to be
closed.

Leasehold Improvements and Equipment

Leasehold improvements and equipment are stated at original cost less
accumulated depreciation and amortization. Tenant improvement
allowances, offered by landlords from time to time, are recorded as a
reduction to the original cost of leasehold improvements. Equipment
under capital leases is stated at the present value of minimum lease
payments at the date of acquisition. Depreciation expense for the
fiscal year ended January 31, 2004, February 1, 2003 and February 2,
2002 was $11.9 million, $14.0 million and $14.0 million, respectively.
We calculate depreciation and amortization using the straight-line
method over the estimated useful lives as follows:

Leasehold improvements the shorter of the asset's
useful life or thelease
term,generally five years

Furniture, fixtures and other equipment three to five years

F-11

Goodwill

At the beginning of fiscal 2002, we adopted Statement of Financial
Accounting Standards (SFAS) No. 142, "Goodwill and Other Intangible
Assets", which ceases goodwill amortization and instead, requires us
to evaluate goodwill for impairment at least annually using a fair
value test. In conjunction with our Chapter 11 filing on January 13,
2004, our annual impairment test indicated that goodwill was impaired
and we recorded a goodwill impairment charge of $26.3 million.

At February 1, 2003, we concluded that our goodwill was not impaired.
Prior to fiscal 2002, goodwill was amortized on a straight-line basis
over 25 years. Goodwill amortization was $1.6 million for the fiscal
year ended February 2, 2002.

We do not have any other intangible assets recorded in our books as of
January 31, 2004 and February 1, 2003.

Comprehensive Loss

Comprehensive loss for the fiscal years ended January 31, 2004,
February 1, 2003 and February 2, 2002 did not differ from net loss.

Asset Impairment

We assess potential asset impairment in accordance with SFAS No. 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets",
which establishes an accounting model to be used for long-lived assets
to be disposed of by sale or held for use and broadens the
presentation of discontinued operations to include more disposal
transactions. SFAS No. 144 supersedes SFAS No. 121, "Accounting for
the Impairment of Long-Lived Assets and for Long-Lived Assets to Be
Disposed Of" and the accounting and reporting provisions of Accounting
Principles Board ("APB") No. 30, "Reporting the Results of Operations
- Reporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and
Transactions" for the disposal of a segment of a business (as
previously defined in that Opinion). This statement requires that
long-lived assets and certain identifiable intangibles be reviewed for
impairment whenever events or changes in circumstances indicate that
the carrying amount of an asset may not be recoverable. Recoverability
of an asset to be held and used is measured by comparing the carrying
amount of the asset to future net cash flows expected to be generated
by the asset. If such asset is considered to be impaired, the
impairment to be recognized is measured by the amount that the
carrying value of the asset exceeds the fair value of the asset. In
conjunction with our closure of 44 stores soon after January 31, 2004,
we recorded an impairment charge of $2.4 million regarding fixed
assets located at these stores.

Fair Value of Financial Instruments

The carrying amounts of cash and cash equivalents, receivables,
payables and accrued expenses approximate fair value due to the
short-term nature of such instruments. The carrying amount of the DIP
financing facility approximates fair value due to the floating rate on
such instrument. The carrying value of long-term debt with fixed
payment terms approximates fair value.

Self-Insurance

We self-insure or retain a portion of the exposure for losses related
to workers' compensation and general liability costs. The self-insured
policies provide for both specific and aggregate stop-loss limits. The
workers' compensation program for the policy years ended January 31,
2004 and 2003 have a specific stop loss amount of $250,000 with no
aggregate stop loss limit. The program for the policy year ended
January 31, 2002 had both a specific and aggregate stop loss amount of
$250,000 and $3.2 million, respectively. We utilize internal actuarial
methods, as well as an independent third-party actuary for the purpose
of estimating ultimate costs for a particular policy year. Based on
these actuarial methods along with current available information and
insurance industry statistics, the ultimate expected losses for the
policy years ended January 31, 2004, 2003 and 2002 were estimated to
be approximately $3.6 million, $4.7 million and $4.3 million ($3.2
million aggregate stop loss), respectively. Our estimate is based on
average claims experience in our industry and our own experience in
terms of frequency and severity of claims, with no explicit provision
for adverse fluctuation from year to year and is subject to inherent
variability. This variability may lead to ultimate payments being
either greater or less than the amounts presented above.

F-12

For general liability insurance, our program for fiscal 2003 provided
for a specific stop loss of $35,000 per claim with no aggregate stop
loss limit.

Revenue Recognition

We recognize sales revenue at the time the merchandise is sold to the
customer, except for layaway and gift card sale transactions. The
recognition of layaway sales and the related cost of sales are
deferred until the merchandise is fully paid for and delivered to our
customer. Cash received for the layaway transaction in advance is
recorded as a liability, which is included in Accounts payable in the
accompanying Balance Sheets. Cash received for the sale of gift cards
is recorded as a liability, which is included in Accounts payable in
the accompanying Balance Sheets. The related liability is reduced and
revenue is recognized upon delivery of the layaway merchandise to the
customer or upon redemption of the gift card.

As of January 31, 2004 and February 1, 2003, the balances of the
liability recorded in relation to layaway and gift card programs were
approximately $300,000.

Costs of Sales

Costs of sales include merchandise cost, transportation cost,
markdowns, shrink, direct distribution and processing costs, and
inventory capitalization cost.

Selling and Administrative Expenses

Selling and administrative expenses primarily consist of salaries and
wages, workers compensation, employee benefits, advertising costs,
occupancy costs (primarily rent), utilities, professional fees and
other direct and indirect selling expenses.

Advertising Costs

Advertising costs are expensed as incurred. Advertising costs for the
fiscal years ended January 31, 2004, February 1, 2003 and February 2,
2002 were approximately $23.5 million, $24.7 million and $20.9
million, respectively.

Deferred Rent

Rent expense under non-cancelable operating lease agreements is
recorded on a straight-line basis over the life of the respective
leases. The excess rent expense over rent paid is accounted for as
deferred rent.

Store Pre-opening and Closing Costs

Store pre-opening costs (costs of opening new stores, including grand
opening promotions, training and store set-up costs) are expensed as
incurred.

Costs associated with closing stores consist primarily of inventory
liquidation costs which are recognized as incurred, fixed asset
impairments as recognized in accordance with SFAS No. 144, and future
lease obligations subsequent to the cease use date. Closing costs
related to exit or disposal activities initiated prior to December 31,
2002 were recognized as operating expenses at the date of a commitment
to an exit or disposal plan.

F-13

Debt Issuance Costs

Debt issuance costs are amortized to interest expense evenly over the
life of the related debt. For fiscal years ended January 31, 2004,
February 1, 2003 and February 2, 2002, amortization for debt issuance
costs was $833,000, $118,000 and $132,000, respectively. Debt issuance
costs for the fiscal year ended January 31, 2004 included the
write-off of remaining unamortized debt issuance costs of
approximately $353,000 as a result of the Chapter 11 filing.

Income Taxes

Income taxes are accounted for under the asset and liability method
required by SFAS No. 109, "Accounting for Income Taxes." Deferred tax
assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying
amounts of existing assets and liabilities and their respective tax
bases and operating losses and tax credit carryforwards. Deferred tax
assets and liabilities are measured using enacted tax rates expected
to apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. The effect on
deferred tax assets and liabilities of a change in tax rates is
recognized in income in the period that includes the enactment date.

In evaluating exposure associated with various tax filing positions,
we often accrue charges for probable exposures. The Internal Revenue
Service ("IRS") is currently conducting an examination of our
consolidated tax returns for the fiscal years 1998 through 2002. We
expect the IRS examination to be completed within the next two years.
We believe that adjustments, if any, are adequately provided for in
the accrued income taxes account in the accompanying financial
statements. To the extent we prevail in matters for which accruals
have been established or are required to pay amounts in excess of
these accruals, our effective tax rate in a given financial statement
period could be materially affected.

Stock-based Compensation

We have elected under the provisions of SFAS No. 123, "Accounting for
Stock-Based Compensation" to continue using the intrinsic value method
of accounting for employee stock- based compensation in accordance
with APB No. 25, "Accounting for Stock Issued to Employees." Under the
intrinsic value method, compensation expense is recognized only in the
event that the exercise price of options granted is less than the
market price of the underlying stock on the date of grant. The fair
value method generally requires entities to recognize compensation
expense over the vesting period of options based on the estimated fair
value of the options granted. We have disclosed the pro forma effect
of using the fair value based method to account for our stock-based
compensation as required by SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure."

The following table illustrates the effect on net loss and net loss
per common share if we had applied the fair value recognition
provisions of SFAS No. 148.

(in thousands, except per share data)
2003 2002 2001
---------- ---------- ----------

Net loss before stock-based
compensation, as reported $ (85,859) $ (28,509) $ (10,896)

Stock based compensation using
the fair value method, net of tax (1,901) (3,159) (5,877)
---------- ---------- -----------
Pro-forma net loss $ (87,760) $ (31,668) $ (16,773)
========== ========== ===========
Pro-forma net loss per share,
basic and diluted $ (5.42) $ (2.44) $ (1.31)

F-14

The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options that have no vesting
restrictions and are fully transferable. Option valuation models also
require the input of highly subjective assumptions such as expected
option life and expected stock price volatility. Because our employee
stock-based compensation plan has characteristics significantly
different from those of traded options and because changes in the
subjective input assumptions can materially affect the fair value
estimate, we believe that the existing option valuation models do not
necessarily provide a reliable single measure of the fair value of
awards from those plans.

The weighted-average fair value of each option grant is estimated on
the date of grant using the Black-Scholes option-pricing model using
the following weighted-average assumptions:

2003 2002 2001
---- ---- ----

(i) Expected dividend yield 0.00% 0.00% 0.00%
(ii) Expected volatility 107.73% 104.00% 96.86%
(iii) Expected life 7 years 8 years 9 years
(iv) Risk-free interest rate 3.68% 3.55% 5.71%

Loss per Share

We compute loss per share in accordance with SFAS No. 128, "Earnings
Per Share." Under the provisions of SFAS No. 128, basic earnings
(loss) per share is computed based on the weighted average shares
outstanding. Diluted income (loss) per share is computed based on the
weighted average shares outstanding and potentially dilutive common
stock equivalent shares. Common stock equivalent shares totaling
144,616, 127,242 and 147,000 for fiscal years ended January 31, 2004,
February 1, 2003 and February 2, 2002, respectively, are not included
in the computation of diluted loss per share because the effect would
have been anti-dilutive.

Use of Estimates

Our management has made a number of estimates and assumptions relating
to the reporting of assets and liabilities and the disclosure of
contingent assets and liabilities at the date of the Financial
Statements and the reported amounts of revenues and expenses during
the reporting period to prepare these Financial Statements in
conformity with generally accepted accounting principles in the United
States. Actual results could differ from these estimates.

Reclassifications

Certain prior period amounts have been reclassified to conform their
presentation to the fiscal 2003 Financial Statements.

Recent Accounting Pronouncements

In January 2003, the Financial Accounting Standards Board (the "FASB")
issued FIN 46 - "Consolidation of Variable Interest Entities." FIN 46
clarifies the application of Accounting Research Bulletin No. 51 -
Consolidated Financial Statements to those entities defined as
"Variable Interest Entities" (more commonly referred to as special
purpose entities) in which equity investors do not have the
characteristics of a "controlling financial interest" or do not have
sufficient equity at risk for the entity to finance its activities
without additional subordinated financial support from other parties.
FIN 46 applies immediately to all Variable Interest Entities created
after January 31, 2003, and by the beginning of the first interim or
annual reporting period commencing after June 15, 2003 for Variable
Interest Entities created prior to February 1, 2003. The adoption of
this statement did not have a material impact on our financial
position or results of operations.

F-15

In April 2003, the FASB issued Statement of Financial Accounting
Standard (the "SFAS") No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities." This statement
provides clarification on the financial accounting and reporting of
derivative instruments and hedging activities and requires contracts
with similar characteristics to be accounted for on a comparable
basis. The adoption of this statement did not have a material impact
on our financial position or results of operations.

In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and
Equity." This statement establishes standards on the classification
and measurement of financial instruments with characteristics of both
liabilities and equity and is effective for financial instruments
entered into or modified after May 31, 2003. The adoption of this
statement did not have a material impact on our financial position or
results of operations.

2. REORGANIZATION ITEMS

Reorganization items represent amounts we incurred as a result of the
Chapter 11 filing, and are recorded and presented in accordance with
SOP 90-7. Reorganization items for the fiscal year ended January 31,
2004 were $31.7 million and consisted of: (1) a non-cash goodwill
impairment charge of $26.3 million; (2) a non-cash impairment charge
of $2.4 million for fixed assets associated with the 44 stores closed
subsequent to January 31, 2004 as part of our reorganization efforts;
(3) a non-cash inventory valuation reserve of $1.7 million related to
the sale inventory at the 44 stores below cost; and (4) $1.3 million
of professional fees and other expenses incurred in our bankruptcy
case and reorganization efforts.

Cash payments resulting from reorganization through January 31, 2004
was approximately $1.2 million.

3. LIABILITIES SUBJECT TO COMPROMISE

Under the Bankruptcy Code, actions by creditors to collect
indebtedness we owe prior to the Petition Date are stayed and certain
other pre-petition contractual obligations may not be enforced against
us. We have received approval from the Court to pay certain
pre-petition liabilities including employee salaries and wages,
benefits and other employee obligations. Except for secured debt,
employee payroll and benefits, sales, use and other taxes, and capital
lease obligations, all pre-petition liabilities have been classified
as Liabilities subject to compromise in the Balance Sheet as of
January 31, 2004. Adjustments to pre-petition liabilities may result
from negotiations, payments authorized by Court order, additional
rejection of executory contracts including leases, or other events.
Therefore, the amounts below in total may vary significantly from the
stated amounts of proofs of claim that will be filed with the Court.

F-16

The following table summarizes the components of Liabilities subject
to compromise in our Balance Sheet as of January 31, 2004.

(in thousands) January 31, 2004
------------------------------------------------------------------------

Trade and other accounts payable $ 41,734
Junior subordinated notes, net of discount 10,349
Restructuring costs, primarily lease termination claims 6,044
General liability and workers compensation claims 2,283
Severance claims 1,385
Other 1,267
---------
Liabilities subject to compromise $ 63,062
---------

4. FISCAL 2002 RESTRUCTURING CHARGE

In December 2002, we recorded a restructuring charge of $14.4 million
in conjunction with the decision to close 23 stores as well as to
consolidate both our distribution center network and corporate
overhead structure. The purpose of these restructuring initiatives was
to improve store profitability, reduce costs and improve efficiency.

In fiscal 2002, the charge and the related liability were recognized
in accordance with the Emerging Issues Task Force ("EITF") No. 94-3
"Liability Recognition for Certain Employee Termination Benefits and
Other Costs to Exit an Activity (including Certain Costs Incurred in a
Restructuring)." EITF No. 94-3 provides specific requirements as to
the appropriate recognition of costs associated with employee
termination and other exit costs.

As of April 23, 2004, we have closed 20 of these 23 stores and
terminated the lease obligations of 14 of these closed stores. In
conjunction with our Chapter 11 filing, we rejected 6 leases and
recorded a non-cash reduction of $296,000 to adjust the lease
termination reserve to the allowed claim amount under the Bankruptcy
Code. The three remaining stores have not been closed at this time due
to lease concessions agreed to by the landlords.

In addition, we have completed the consolidation of our two former San
Diego distribution centers and our Lewisville, Texas distribution
center into one distribution center, which is located at a new
facility in San Diego, California. As a result of our Chapter 11
filing, we have rejected the lease of one of our former San Diego, CA
distribution centers and the lease of our Lewisville, Texas
distribution center. In conjunction with these two lease rejections,
we recorded a non-cash adjustment of $355,000 to increase the related
lease termination reserve to the allowed claim amount under the
Bankruptcy Code. We continue to pay the rent of the other former San
Diego distribution center, which is also the location of our corporate
headquarters.

F-17

The balance of the liability $4.7 million (included in "Liabilities
subject to compromise" in the accompanying Balance Sheet as of January
31, 2004) related to this fiscal 2002 restructuring charge was as
follows:

Non-cash Balance at
Restructuring Cash Charges and January 31,
(in thousands) Charge Payments Adjustments 2004
------------- -------- ----------- ------------

Lease termination costs* $ 6,513 $ (2,605) $ 555 $ 4,463
Employee termination costs 1,027 (723) (239) 65
Other costs 807 (354) (306) 147
------------- --------- ----------- -----------
$ 8,347 $ (3,682) $ 10 $ 4,675
============= ========= =========== ===========

* The non-cash charge portion consists primarily of the write-off of
deferred rent and adjustment of estimated lease termination costs to
the maximum amount allowed by the Bankruptcy Code.

The balances of non-cash inventory liquidation costs and fixed asset
write-downs related to this fiscal 2002 restructuring charge at
January 31, 2004 were as follows:

Balance at
Restructuring Usage/ January 31,
(in thousands) Charge Adjustments 2004
---------------------------------------------------

Inventory liquidation costs* $ 1,082 $ (942) $ 140
Fixed asset write-downs $ 4,969 $ (4,969) $ -

* The balance of inventory liquidation costs of approximately $140,000
was recorded as a valuation allowance for merchandise inventory for
two stores that were closed subsequent to January 31, 2004.

5. FISCAL 2001 RESTRUCTURING CHARGE

In January 2002, we recorded a restructuring charge of $21.2 million
in conjunction with the decision to close 28 under-performing stores
as well as the realignment of our field organization and workforce
reductions. The purpose of the restructuring was to improve store
profitability, streamline field operations, reduce costs and improve
efficiency. In light of the favorable experience related to the costs
of closing these stores, we recorded a non-cash adjustment to reduce
the reserve for the fiscal 2001 restructuring initiatives by
approximately $5.0 million during the fourth quarter of fiscal 2002.
The adjustment included (1) reduction of reserve for lease termination
costs by $3.8 million, (2) reduction of reserve for inventory
liquidation costs by $1.3 million, offset by (3) an additional reserve
for fixed asset write-downs of $94,000.

We closed all 28 stores during fiscal 2002. As of April 23 2004, we
had terminated the lease obligations of 23 of these stores and
rejected the remaining 5 leases. As a result of rejecting these
leases, we recorded a non-cash adjustment of $161,000 to reduce the
reserve to the allowed claim amount under the Bankruptcy Code. In
addition, we recorded a non-cash adjustment of $832,000 to reduce the
reserve for lease termination costs as a result of favorable
experience related to several lease terminations.

F-18

The balance of liability $1.4 million (included in "Liabilities
subject to compromise" in the accompanying Balance Sheet as of January
31, 2004) related to the fiscal 2001 restructuring charge was as
follows:

Non-cash Balance at
Restructuring Cash Charges and January 31,
(in thousands) Charge Payments Adjustments 2004
------------- -------- ----------- ------------

Lease termination costs $ 13,724 $ (7,986) $ (4,489) $ 1,249
Employee termination costs 1,206 (1,152) (54) -
Other costs 1,379 (1,244) (15) 120
----------- --------- ---------- -----------
$ 16,309 $(10,382) $ (4,558) $ 1,369
============ ========= ========== ===========

*The non-cash charge portion consists primarily of adjustments made
during fiscal 2002 and fiscal 2003 as a result of favorable experience
related to lease termination costs.

As of January 31, 2004, the non-cash inventory liquidation costs and
fixed asset write-downs related to this fiscal 2001 restructuring
charge were zero.

Balance at
Restructuring Usage/ January 31,
(in thousands) Charge Adjustments 2004
---------------------------------------------------

Inventory liquidation costs $ 2,870 $ (2,870) $ -
Fixed asset write-downs $ 2,052 $ (2,052) $ -

6. NOTE RECEIVABLE

In July 2002, we entered into a temporary bridge financing agreement
(the "Agreement") with one of our trade vendors (the "Borrower") in
which we, subject to the terms and conditions of the Agreement, agreed
to provide a $4.0 million revolving line of credit facility to the
Borrower. Advances made to the Borrower under this Agreement are
secured by the Borrower's accounts receivable, inventory, personal
property and other assets including cash. Borrowings under this
facility are also secured by personal guarantees from the principals
of the Borrower. This Agreement expired on October 11, 2002, and we
have not made any direct advances to the Borrower thereafter.

Through May 27, 2003, we made cash advances in the aggregate of
approximately $3.1 million to the Borrower and received cash
repayments in the aggregate of approximately $811,000. We also
received approximately $1.5 million of inventory from the Borrower to
partially offset the advances. On May 27, 2003, we filed a lawsuit
against the Borrower and the two guarantors seeking the remaining
balance plus interest of approximately $1.1 million due under the
agreement. As of January 31, 2004, this amount was fully reserved.

On September 17, 2003, we entered into a settlement agreement with the
Borrower in which the Borrower agreed to make payments in the amount
of $500,000 with interest at the rate of 7.5% per annum as full
payment for the balance due under the Agreement. Under the settlement
agreement, the first payment of $50,000 became due on September 30,
2003. Through January 31, 2004, we have received $50,000 from the
Borrower, however the amount was received through several smaller
payments, the last payment of $9,000 having been received on January
20, 2004. As a result of this default, under the settlement agreement,
we reserve the right to reinstate the original amount due under the
Agreement.

F-19

Subsequent to January 31, 2004, we received $70,000 from the Borrower
for payment under the settlement agreement.

7. LEASEHOLD IMPROVEMENTS AND EQUIPMENT

Leasehold improvements and equipment consist of the following (in
thousands):

January 31, February 1,
2004 2003
---------- ---------

Furniture, fixtures and equipment $ 47,810 $ 55,843
Leasehold improvements 12,687 14,090
Automobiles 965 890
Equipment under capital leases* 1,830 2,549
-------- ---------
63,292 73,372
Less: accumulated depreciation and amortization (45,106) (44,770)
--------- ---------
$ 18,186 $ 28,602
--------- ---------

*All obligations related to capital leases were fully paid prior to
February 1, 2003.

We assess potential asset impairment in accordance with SFAS 144.
Recoverability of an asset to be held and used is measured by
comparing the carrying amount of the asset to future net cash flows
expected to be generated by the asset. If such asset is considered to
be impaired, the impairment to be recognized is measured by the amount
that the carrying value of the asset exceeds the fair value of the
asset. In conjunction with our closure of 44 stores soon after January
31, 2004, we recorded an impairment charge of $2.4 million regarding
fixed assets located at these stores.

As of February 1, 2003, we had asset impairment valuation allowances
related to the fiscal 2002 and 2001 restructuring activities totaling
$3.8 million. These allowances were recorded as direct reductions of
the related assets.

8. GOODWILL

As required, we adopted SFAS 142 on February 3, 2002 and ceased the
amortization of goodwill accordingly and instead evaluate the carrying
value of goodwill for impairment at least annually using a fair value
test. In conjunction with our Chapter 11 filing on January 13, 2004,
our annual impairment test indicated that goodwill was impaired and we
recorded a goodwill impairment charge of $26.3 million.

At February 1, 2003, we concluded that our goodwill was not impaired.

Prior to fiscal 2002, goodwill was amortized on a straight-line basis
over 25 years. Goodwill amortization was $1.6 million for the fiscal
year ended February 2, 2002.

F-20

The following table presents the reconciliation of net income and per
share data to what would have been reported had the new rules been in
effect during the fiscal year ended February 2, 2002 (in thousands,
except per share data):

2001
------------

Reported net loss $ (10,896)
Add back goodwill amortization, net of tax 984
------------
Adjusted net loss $ (9,912)
------------

Basic net loss per common share
Reported net loss $ (0.85)
Goodwill amortization, net of tax 0.08
------------
Adjusted net loss $ (0.77)
------------

We do not have any other intangible assets recorded in our books as of
January 31, 2004 or February 1, 2003.

9. ACCRUED EXPENSES

Accrued expenses consist of the following:

(in thousands)
--------------
January 31, February 1,
2004 2003
----------- -----------

Accrued compensation and related costs $ 2,983 $ 4,070
Accrued occupancy 1,469 693
Accrued restructuring charges - 11,117
Accrued workers compensation 5,132 4,741
Other accrued expenses 2,976 7,210
----------- -----------
$ 12,560 $ 27,831
----------- -----------

10. DIP FINANCING FACILITY, LONG-TERM DEBT AND PRE-PETITON REVOLVING
CREDIT FACILITY

Long-term debt and revolving credit facilities consist of the
following:

(in thousands)
--------------
January 31, February 1,
2004 2003
----------- -----------

Junior subordinated notes, $ 10,349 $ 9,445
non-interest bearing, discounted at
a rate of 10%, principal payments in
annual installments of $3.0 million
and final balloon payment of $5.3
million due May 2005
Less amount subject to compromise (10,349) -
Notes payable 128 -
Less current maturities (36) (3,000)
------------ ----------
Long-term debt, net of current
maturities $ 92 $ 6,445
------------ ----------

Debtor-in-possession financing facility $ - $ -
Pre-petition revolving credit facility $ - $ 6,300

F-21

DIP Financing Facility

In conjunction with our Chapter 11 filing, we entered into a financing
agreement with The CIT Group/Business Credit, Inc. (the Tranche A
Lender) and GB Retail Funding, LLC (the Tranche B Lender),
(collectively the "Lenders") in which the Lenders provide us a $45.0
million revolving credit facility for working capital needs and other
general corporate purposes while we operate as a debtor-in-possession
(the "DIP financing facility"). This DIP financing facility with a
maturity date of January 14, 2005 has since been amended twice, the
first amendment on January 30, 2004 and the second amendment on March
10, 2004.

The DIP financing facility has a superpriority claim status in our
Chapter 11 case and is collateralized by first liens on substantially
all of our assets, subject to valid and unavoidable pre-petition liens
and certain other permitted liens. Under the terms of the DIP
financing facility, we may borrow up to 85% of our eligible accounts
receivable and up to 70% of our eligible inventory, as defined.
However, the DIP financing facility provides for a $5.0 million
availability block against our availability calculation, as defined.
The DIP financing facility also includes a $20.0 million sub-facility
for letters of credit. Interest on the outstanding borrowings under
the DIP financing facility is payable monthly and accrues at the rate
equal to, at our option, either the prime rate (as announced by JP
Morgan Chase Bank) plus 1.50% per annum or LIBOR plus 3.5% per annum.
The Tranche B Lender will fully fund $4.0 million within five business
days after demand by the Tranche A Lender when the outstanding
borrowing provided by the Tranche A Lender first equals or exceeds
$6.5 million for three consecutive business days. In the event that
there is any outstanding borrowing provided by the Tranche B Lender,
such borrowing bears interest at 14.5% per annum payable monthly. We
are also obligated to pay a monthly fee equal to 0.375% per annum on
the unused available line of credit and a fee equal to 2.5% per annum
on the outstanding letters of credit.

Under the terms of the DIP financing facility, capital expenditures
for fiscal 2004 is restricted to $2.0 million. In addition, we are
required to be in compliance with financial covenants and other
customary covenants. The financial covenants include average minimum
availability, cumulative four-week rolling average of cash receipts
from store sales and cumulative rolling four-week average of inventory
receipts, as defined. The customary covenants include certain
reporting requirements and covenants that restrict our ability to
incur or create liens, indebtedness and guarantees, make dividend
payments, sell or dispose of assets, change the nature of our business
and enter into affiliate transactions, mergers and consolidations.
Failure to satisfy these covenants would (in some cases, after the
expiration of a grace period) result in an event of default that could
cause, absent the receipt of appropriate waivers, the funds necessary
to maintain our operations to become unavailable. The DIP financing
facility contains other customary events of default including certain
ERISA events, a change of control and the occurrence of certain
specified events in the Chapter 11 case. In addition, during the
period from December 28, 2004 through January 11, 2005, we are not
allowed to have any outstanding borrowings under the revolving credit
facility and our outstanding letters of credit cannot exceed $11.0
million.

As of January 31, 2004, we were in compliance with our covenants and
had no borrowings outstanding under the revolving credit facility and
outstanding letters of credit of $10.1 million under the sub-facility
for letters for credit. As of January 31, 2004, based on our eligible
inventory and accounts receivable, we were eligible to borrow $33.8
million under the revolving credit facility and had $17.6 million
available after giving effect for the availability block, as defined.

F-22

Pre-petition Revolving Credit Facility

Prior to the Petition Date, we had a $50.0 million revolving credit
facility agreement (the "Financing Agreement") with a financial
institution expiring in March 2006. Under this Financing Agreement, we
could borrow up to 70% of our eligible inventory and 85% of our
eligible accounts receivable, as defined, up to $50.0 million. The
revolving credit facility provided for a $7.5 million availability
block against our availability calculation, as defined. The Financing
Agreement also included a $15.0 million sub-facility for letters of
credit. Under the terms of the Financing Agreement, the interest rate
could increase or decrease subject to earnings before interest, tax
obligations, depreciation and amortization expense (EBITDA), as
defined, on a rolling four fiscal quarter basis. Accordingly, prime
rate borrowings could range from prime to prime plus 1.00% and LIBOR
borrowings from LIBOR plus 1.50% to LIBOR plus 3.00%. We were
obligated to pay fees equal to 0.125% per annum on the unused amount
of the revolving credit facility. We were contractually prohibited
from paying cash dividends on our common stock under the terms of the
Financing Agreement without consent of the lender. As amended on April
10, 2003, the facility was secured by a first lien on all company
assets excluding furniture, fixtures, machinery and equipment.

On February 14, 2003, we obtained the lender's consent to the
incurrence by us of up to $10.0 million in additional indebtedness,
which was secured by a junior lien on the Collateral, as defined.

On April 10, 2003, we amended the terms of our Financing Agreement
(the "Amended and Restated Financing Agreement") to add $7.5 million
of term loans, to add financial covenants, and to amend certain
reporting provisions and other terms. The term loans consisted of a
$6.5 million junior term note secured by all company assets excluding
furniture, fixtures, machinery and equipment and a $1.0 million junior
term note secured by furniture, fixtures, machinery and equipment.
These notes bore interest at the rate of 14.5% per annum on the then
current outstanding balance and a maturity date of April 10, 2004.

On December 22, 2003, we amended the terms of our Amended and Restated
Financing Agreement ("First Amendment") to shorten the period that we
were required to have zero borrowings, or "clean-up", under the
revolving credit facility from 15 consecutive days beginning December
22, 2003 to eight consecutive days beginning December 29, 2003. The
First Amendment also required us to pay the full unpaid balance of
$600,000 under the Tranche B Loan II on or before December 23, 2003,
and we paid it accordingly.

On January 12, 2004, we amended the terms of our Amended and Restated
Financing Agreement ("Second Amendment") in which we were required to
pay the full unpaid balance of $6.5 million on or before January 12,
2004, and we paid it accordingly.

Junior Subordinated Notes

The Junior Subordinated Notes (the "Notes") are non-interest bearing
and were reflected on our balance sheets at the present value using a
discount rate of 10%. We are prohibited from paying cash dividends on
our common stock under the terms of the Notes without the consent of
the note holders.

As of January 31, 2004 we were in default under the terms of our Notes
and have included the net carrying value of $10.3 million (face value
of $11.3 million net of a related unamortized discount of $1.0
million) in the line Liabilities subject to compromise. On the
Petition Date, we stopped amortizing debt discount related to the
Notes, in accordance with SOP 90-7.

Under the Bankruptcy Code, the claims of holders of the Notes are
subject to disallowance to the extent they represent a claim for
unmatured interest, i.e., the portion of face value representing
unamortized discount. The amount so disallowed may differ from the
unamortized discount maintained on our books and records.

F-23

11. INCOME TAXES

Significant components of income tax expense/(benefit) are as follows:

(in thousands)
-----------------------------------------
2003 2002 2001
--------- --------- ----------

Federal income tax expense (benefit)
Current $ 3,298 $ (8,200) $ (3,069)
Deferred 13,696 (8,321) (2,754)
--------- --------- ---------
16,994 (16,521) (5,823)
--------- --------- ---------

State income tax expense (benefit)
Current 300 (204) (541)
Deferred 6,786 (1,427) (486)
--------- --------- ---------
7,086 (1,631) (1,027)
--------- --------- ---------
$ 24,080 $(18,152) $ (6,850)
--------- --------- ---------

The principal temporary differences that give rise to significant
portions of the deferred tax assets and liabilities are presented
below:

(in thousands)
------------------------------
January 31, February 1,
2004 2003
------------- -------------

Deferred tax assets
Net operating loss carryforwards $ 23,438 $ 10,483
Compensated absences and bonuses 3,122 3,002
Deferred rent 1,296 1,325
Closed store accrual - 101
Excess of tax over book inventory 4,738 3,648
Accrued expenses 7,992 12,255
Fixed assets 2,196 490
Other 2,445 1,174
---------- ----------
Total gross deferred tax assets 45,227 32,478
Less: valuation allowance (45,227) (7,647)
---------- ----------
Net deferred tax assets - 24,831
---------- ----------
Deferred tax liabilities
Tax basis difference - 4,349
---------- ----------
Deferred tax liabilities - 4,349
---------- ----------
Net deferred tax asset $ - $ 20,482
---------- ----------

A valuation allowance is provided when it is more likely than not that
some portion or all of the deferred tax assets will not be realized.
Accordingly, a valuation allowance has been recognized to offset
deferred tax assets because management cannot conclude that it is more
likely than not that the deferred tax assets will be realized in the
foreseeable future. A portion of the valuation allowance for deferred
tax assets relates to stock option deductions which, when recognized,
will be allocated directly to additional paid-in-capital.

F-24

In evaluating exposure associated with various tax filing positions,
we often accrue charges for probable exposures. The IRS is currently
conducting an examination of our consolidated tax returns for the
fiscal years 1998 through 2002. We expect the IRS examination to be
completed within the next two years. We believe that adjustments, if
any, are adequately provided for in the accrued income taxes account
in the accompanying financial statements. To the extent we prevail in
matters for which accruals have been established or are required to
pay amounts in excess of these accruals, our effective tax rate in a
given financial statement period could be materially affected.

The difference between the expected income tax expense (benefit)
computed by applying the U.S. federal income tax rate of 35% to net
loss from continuing operations for each of the fiscal years 2003,
2002 and 2001, and the actual tax expense (benefit) is a result of the
following:

(in thousands)
2003 2002 2001
------------- ---------- ---------

Computed "expected" tax benefit $(21,622) $(16,331) $ (6,211)
Impairment/Amortization of goodwill 10,100 - 656
Change in valuation allowance 37,581 - -
Business credits (325) (195) (238)
State income taxes, net of federal income
tax credit (2,101) (1,586) (1,064)
Release of tax contingency reserve 849 - -
Other, net (402) (40) 7
--------- --------- --------
$ 24,080 $(18,152) $ (6,850)
--------- --------- ---------

At January 31, 2004, we had net operating loss carryforwards for
federal income tax purposes of approximately $61.2 million that expire
starting in fiscal 2005. At January 31, 2004, we had general business
credit carryforwards for federal income tax purposes of approximately
$2.1 million that expire starting in fiscal year 2014. At January 31,
2004, we had net operating loss carryforwards for state income tax
purposes of approximately $24.7 million that expire starting in fiscal
2012.

A portion of our federal net operating loss carryforwards are subject
to annual usage limitations under Section 382 of the Internal Revenue
Code, annual use of our net operating loss carry-forwards will be
limited due to prior cumulative ownership changes of more than 50%
within a three-year period.

12. LEASE COMMITMENTS

We operate retail stores, a distribution center and administrative
offices under various operating leases. Total rent expense was
approximately $40.5 million, $42.5 million and $40.7 million,
including contingent rent expense of approximately $95,000, $98,000
and $228,000, for fiscal years ended January 31, 2004, February 1,
2003 and February 2, 2002, respectively.

Rent expense is recorded on a straight-line basis over the life of the
lease. For fiscal 2003 and 2001, rent expense charged to operations
exceeded cash payment requirements by approximately $202,000 and
$264,000, respectively, and resulted in an increase to the deferred
rent liability for the same amount. For fiscal 2002, cash payment
requirements exceeded rent expense by $414,000.

F-25

At January 31, 2004, the future minimum lease payments under operating
leases with remaining non-cancelable terms are as follows:

(in thousands)
--------------

Fiscal year:
2004 $ 32,781
2005 27,079
2006 20,605
2007 15,459
2008 12,060
Thereafter 34,811
--------
Total minimum lease payments $142,795
--------

Amounts included in the above table are related to lease agreements,
which we have neither assumed nor rejected as of January 31, 2004.
Under the Bankruptcy Code, we may assume or reject executory
contracts, including lease obligations. Therefore, the commitments
shown in the above table may not reflect actual cash outlays in the
future periods.

13. STOCKHOLDERS' EQUITY

We have 35,000,000 shares of common stock authorized for issuance at a
par value of $0.01 per share. At January 31, 2004, we have reserved
3,157,980 shares of common stock for issuance in connection with our
stock option plan. We have also reserved 263,102 shares for issuance
under the employee stock purchase plan and 270,190 shares for issuance
related to outstanding warrants.

On March 6, 2003, we completed a private offering of 2,515,379 shares
of our common stock for net proceeds of approximately $5.7 million,
after deducting placement fees and other offering expenses. In
addition to the placement fees, the placement agent received warrants
to purchase 75,000 shares of our common stock at an exercise price of
$3.50 per share, a 30% premium over the closing price of $2.68 on
March 6, 2003. These warrants will expire in March 2006.

On August 20, 2003, we completed another private offering of 2,450,000
shares of our common stock for net proceeds of approximately $11.4
million, after deducting placement fees and other offering expenses.
This transaction also provides for warrants to purchase 490,000 shares
at the same price as the initial shares purchased, which expired on
December 23, 2003. In addition to the placement fees, the placement
agent received warrants to purchase 112,500 shares of our common stock
at an exercise price of $6.00 per share, a 7% premium over the closing
price of $5.62 on August 20, 2003. These warrants will expire in
August 2006.

We used the net proceeds of these two private offerings primarily for
working capital purposes.

In fiscal 2002, we issued a total of 450,000 restricted shares of
common stock to certain of our new senior management members as an
inducement to accept employment at the time they were hired. In fiscal
2003, we issued an additional 150,000 restricted shares of common
stock to existing and new management members. Of these 600,000
restricted shares, 375,000 shares were forfeited in fiscal 2003 as a
result of employment terminations. The remaining 225,000 restricted
shares shall vest in installments; 75,000 shares at such time as the
closing market price of our common stock equals or exceeds $10.00 per
share for 20 consecutive trading days in any three-month period,
75,000 shares at such time as the closing market price of our common
stock equals or exceeds $20.00 per share for 20 consecutive trading
days in any three-month period, and the final 75,000 shares at such
time as the closing market price of our common stock equals or exceeds
$30.00 per share for 20 consecutive trading days in any three-month
period. In the event that the closing market price of our common stock
equals or exceeds $10.00, $20.00 and $30.00 per share for 20
consecutive trading days in any three-month period, at a minimum we
may incur non-cash charges of approximately $750,000, $1.5 million,
and $2.3 million, respectively.

F-26

We have never paid cash dividends on our common stock and do not
anticipate paying cash dividends in the foreseeable future. During the
pendency of the Chapter 11 proceedings, any such dividend would be
remote and, in any event, subject to the approval of the Court. We are
contractually prohibited from paying cash dividends on our common
stock under the terms of our DIP financing facility without the
consent of the lenders.

14. STOCK SUBSCRIPTION NOTES RECEIVABLE

At February 1, 2003, the outstanding stock subscription notes
receivable balance was $1.1 million, net of a valuation allowance. All
outstanding stock subscription notes receivable, which were secured by
the underlying common stock of the Company, at that time were due from
either current or former members of management with a five-year term
and had maturity dates ranging from April 29, 2003 to July 29, 2003
and an interest rate of 8.0% per annum. On March 21, 2003, two stock
subscription notes in the principal amount of $92,642 and $50,000,
respectively, plus accrued interest, were paid in full by current
members of management.

On April 29, 2003, the remaining stock subscription notes matured and
we foreclosed on the shares of our common stock that served as
collateral as of the close of business. The principal and accrued
interest on the note due from Michael M. Searles, our former President
and Chief Executive Officer, was $1,458,608 and the collateral's
market value on April 29, 2003 was $1,198,750, resulting in a
deficiency of $259,858, for which Mr. Searles was not personally
liable under the terms of the note. In addition, the principal and
accrued interest on two notes due from Jonathan W. Spatz, our former
Chief Financial Officer, were $688,197 and the collateral's market
value on April 29, 2003 was $376,744, resulting in a deficiency of
$311,453, for which Mr. Spatz is personally liable for $136,614 of the
deficiency under the terms of his notes. Additionally, on April 29,
2003, the principal and accrued interest on the notes due from Tracy
W. Parks, our former Chief Operating Officer, was $117,042 and the
collateral had a market value of $82,197, resulting in a deficiency of
$34,845, for which he is personally liable under the terms of his
notes.

In conjunction with the foreclosures as discussed above, we recorded
income of approximately $708,000 to adjust the valuation allowance
established as of February 1, 2003 as a result of the increase in the
market value of our common stock on April 29, 2003 as compared to
February 1, 2003.

In August 2003, we received payment in full from Mr. Parks to repay
the outstanding principal balance of his note plus interest. Based on
Mr. Spatz's current financial condition, we have elected, at this
time, to forbear our collection efforts regarding the amount for which
he is personally liable. The outstanding amount of $136,614 plus
accrued interest was fully reserved as of January 31, 2004.

15. WARRANTS AND STOCK OPTIONS

At January 31, 2004, warrants to purchase 270,190 common shares were
outstanding. These warrants have an exercise prices in the range of
$3.50 to $19.91 (weighted average exercise price of $9.56) and expire
on various dates between May 2005 and August 2006.

We have a stock option plan, the Amended and Restated Factory 2-U
Stores, Inc. 1997 Stock Option Plan (the "Plan") that provides for the
granting of incentive or nonqualified stock options. Under the Plan,
we may grant up to 3,157,980 options. The options are issued at fair
market value with exercise prices equal to our stock price on the date
of grant. Options vest over three to five years; are exercisable in
whole or in installments; and expire from five to ten years from the
date of grant.

F-27

Our Board of Directors has granted stock options to members of the
Board and to our management. A summary of our stock option activity
and related information is as follows:

Number of Weighted average
options exercise price
------------- ---------------

Balance at February 3, 2001 1,285,432 $ 15.52
Granted 238,323 20.64
Exercised (66,456) 7.90
Canceled (41,141) 24.38
-------------- --------
Balance at February 2, 2002 1,416,158 16.49
Granted 807,556 5.34
Exercised (124,764) 7.36
Canceled (375,546) 20.09
-------------- ---------
Balance at February 1, 2003 1,723,404 11.14
Granted 662,720 3.76
Exercised - -
Canceled (871,744) 10.64
-------------- ---------
Balance at January 31, 2004 1,514,380 $ 8.19

Exercisable at January 31, 2004 478,319 $ 13.56

The following table summarizes information about the stock options
outstanding at January 31, 2004:

Weighted -
average Weighted- Weighted-
Number of contractual average Number of average
Range of options life exercise options exercise
exercise prices outstanding (Years) price exercisable price
- ---------------------------------------------------------------------------------------

$0.00 - $4.23 725,156 6.9 $ 2.52 184,723 $ 2.11
$4.23 - $8.45 339,670 9.6 4.26 - -
$8.45 - $12.68 79,404 5.1 12.10 62,046 12.10
$12.68 - $16.90 133,410 6.7 14.76 69,432 14.98
$16.90 - $21.13 47,260 7.1 20.62 24,004 20.38
$21.13 - $25.35 56,660 6.3 24.88 33,296 24.84
$25.35 - $29.58 103,887 5.8 26.55 83,459 26.39
$29.58 - $33.80 7,933 6.7 32.43 5,559 32.31
$33.80 - $38.03 14,500 5.5 37.55 10,500 37.55
$38.03 - $42.25 6,500 3.9 40.22 5,300 40.64
------------------------------------------------------------
1,514,380 7.3 $ 8.19 478,319 $ 13.56
-------------------------------------------------------------

In fiscal 2001, we recorded non-cash stock-based compensation expense
of $456,000 as a result of the removal of the market price hurdle of
19,361 stock options held by former Executive Vice President who
retired in August 2001.

In fiscal 2003 and 2002, there was no event related to our stock
options triggered by the market price hurdle; and therefore, we did
not record any non-cash stock-based compensation expense.

F-28

16. EMPLOYEE BENEFITS

We sponsor a defined contribution plan, qualified under Internal
Revenue Code Section 401(k), for the benefit of employees who have
completed twelve months of service and who work a minimum of 1,000
hours during that twelve-month period. We make a matching contribution
equal to 20% of participating employees' voluntary contributions.
Participants may contribute from 1% to 15% of their compensation
annually, subject to IRS limitations. We contributed approximately
$184,000, $238,000 and $232,000 in fiscal 2003, 2002 and 2001,
respectively.

We also sponsor the Factory 2-U Stores, Inc. Employee Stock Purchase
Plan (the "ESPP") which allows eligible employees to acquire shares of
our Common Stock at a discount from market price, at periodic
intervals, paid for with accumulated payroll deductions. The discount
is 15% of the lower of the market price per share as quoted on the
NASDAQ National Market on the first and last day of an offering
period. The ESPP will terminate when all 350,000 shares available for
issuance are sold although the ESPP may be terminated earlier by us at
any time. At December 31, 2003 the ESPP was temporarily suspended. As
of January 31, 2004, eligible employees had purchased 86,898 shares of
our common stock under the ESPP.

17. LEGAL MATTERS, COMMITMENTS AND CONTINGENCIES

On January 13, 2004, we filed a voluntary petition for reorganization
under Chapter 11 of the Bankruptcy Code. We retain control of our
assets and are authorized to operate the business as a
debtor-in-possession while being subject to the jurisdiction of the
Court. As of the Petition Date, most pending litigation is stayed, and
absent further order of the Court, substantially all pre-petition
liabilitities are subject to settlement under a plan of
reorganization. At this time, it is not possible to predict the
outcome of the Chapter 11 case or its effect on our business. If it is
determined that the liabilities subject to compromise in the Chapter
11 case exceed the fair value of the assets, unsecured claims may be
satisfied at less than 100% of their fair value and the equity
interests of our shareholders may have no value. See Item 1. Business
Proceedings Under Chapter 11 of the Bankruptcy Code.

On or about April 28, 2003, Lynda Bray and Masis Manougian, two of our
former employees, filed a lawsuit against us entitled Lynda Bray,
Masis Manougian, etc., Plaintiffs v. Factory 2-U Stores, Inc., et al.,
Defendants, Case No. RCV071918, in the Superior Court of the State of
California for the County of San Bernardino (the "Bray Lawsuit"). The
First Amended Complaint in the Bray Lawsuit alleges purported claims
for: (1) "Failure to Record Hours and or Illegally Modify Recorded
Hours Worked;" (2) "Failure to Pay Wages Under State Labor Code, Penal
Code and IWC Wage Order 7, Injunctive and Monetary Relief;" (3)
"Unfair Business Practice, Bus. & Prof. Code ss.17200 et. seq.,
Failure to Pay Wages and Record Hours Worked;" (4) "Equitable
Conversion;" and (5) "False Advertising." The thrust of plaintiffs'
claim is that the Company failed to pay wages and overtime for all
hours worked, failed to document all hours worked, and failed to
inform prospective or new employees of unpaid wage claims. Plaintiffs
purport to bring this action on behalf of all persons who were
employed in one of the California stores at anytime after April 25,
2003. Plaintiffs seek compensatory and exemplary damages, interest,
penalties, attorneys' fees and disgorged profits in an amount which
plaintiffs estimated to be not less than $100,000,000. Plaintiffs also
seek injunctive relief requiring correction of the alleged unlawful
practices.

Although at this stage of the litigation it is difficult to predict
the outcome of the case with certainty, we believe that we have
meritorious defenses to the Bray Lawsuit. All proceedings in the Bray
Lawsuit are currently stayed pursuant to the automatic stay provisions
of Section 362 of the Bankruptcy Code, subject to the entry of an
order by the Court lifting the automatic stay. In the event the Court
enters an order lifting the automatic stay, we will continue to
vigorously defend against the Bray Lawsuit. If the Bray Lawsuit is
decided adversely, the potential exposure could be material to our
results of operations.

F-29

In November 2003, Virginia Camarena, a current employee in one of our
California stores, filed a lawsuit against us entitled Virginia
Camarena, Plaintiff, vs. Factory 2-U Stores Inc., etc., Defendants,
Case No. BC305173 in the Superior Court of the State of California for
the County of Los Angeles - Central District (the "Camarena Lawsuit").
The plaintiff alleges that we violated the California Wage Orders,
California Labor Code, California Business and Profession Code and the
Federal Fair Labor Standards Act by failing to pay her wages and
overtime for all hours worked, by failing to provide her with
statements showing the proper amount of hours worked, and by
wrongfully converting her property by failing to pay overtime wages
owed on the next payday after they were earned. The plaintiff purports
to bring this as an action on behalf of all persons who were employed
in one of our California stores or outside the state of California.
Plaintiffs seek compensatory, punitive and liquidated damages,
restitution, interest, penalties and attorneys' fees. In December
2003, we filed an answer to the complaint and removed the Camarena
Lawsuit to the United States District Court for the Central District
of California, Case No. CV-03-8880 RGK (SHx), where it is currently
pending.

Although at this stage of the litigation it is difficult to predict
the outcome of the case with certainty, we believe that we have
meritorious defenses to the Camarena Lawsuit. All proceedings in the
Camarena Lawsuit are currently stayed pursuant to the automatic stay
provisions of Section 362 of the Bankruptcy Code, subject to the entry
of an order by the Court lifting the automatic stay. In the event the
Court enters an order lifting the automatic stay, we will continue to
vigorously defend against the Camarena Lawsuit.

There are numerous other matters filed with the Court in our
reorganization proceedings by creditors, landlords or other third
parties related to our business operations or the conduct of our
reorganization activities. Although none of these individual matters
which have been filed to date have had or are expected to have a
material adverse effect on us, our ability to successfully manage the
reorganization process and develop an acceptable reorganization plan
could be negatively impacted by adverse determinations by the Court on
certain of these matters.

We are at all times subject to pending and threatened legal actions
that arise in the normal course of business.

18. RELATED PARTY TRANSACTIONS

In March 1997, we entered into an agreement with Three Cities
Research, Inc. ("TCR") engaging TCR to act as financial advisor to us.
Under this agreement, we paid TCR an annual fee of $50,000 and
reimburse TCR for all of its out-of-pocket expenses incurred for
services rendered, up to an aggregate of $50,000 annually. As of
January 31, 2004, we no longer engage TCR as our financial advisors.
We reimbursed TCR for out-of-pocket expenses in the approximate
amounts of $46,000, $47,000 and $34,000 during fiscal 2003, 2002 and
2001, respectively. In addition, we paid legal fees in the amount of
$24,000 to TCR in connection with our private equity placements during
fiscal 2003. As of January 31, 2004, TCR did not own any of our
outstanding common stock, however a principal of TCR is still a member
of our Board of Directors.

On November 4, 2002, with the approval of the Board of Directors, we
appointed Ronald Rashkow to a newly-created position as the Lead
Director to our Board for three years. In connection with his Lead
Director duties, we granted 50,000 options at an exercise price of
$1.68 per share, the fair market value of our common stock on the date
of grant. These options are fully vested and are exercisable for five
years from the date of grant. We also issued 25,000 shares of
restricted common shares to Mr. Rashkow at a price of $0.01 per share.
These options vested on November 4, 2003, after his completion of 12
months of service as Lead Director. In addition to this equity
compensation, we are also required to pay Mr. Rashkow a monthly fee of
$12,500 plus reimbursement of all reasonable out-of-pocket expenses.

F-30

On March 6, 2003, two individual investment entities controlled by
TCR, Three Cities Offshore II, C.V. and Three Cities Fund II, L.P.,
participated in our private offering transaction and acquired 407,207
shares and 240,793 shares of our common stock, respectively, at a
purchase price of $2.75 per share (a price in excess of the closing
market price of our common stock on such date), for an aggregate
purchase price of $1,782,000. Mr. Rashkow, our Lead Director, also
participated in this private offering transaction and acquired 72,700
shares of our common stock at a price of $2.75 per share (a price in
excess of the closing market price of our common stock on such date),
for an aggregate purchase price of $199,925. Including these 72,700
shares, Mr. Rashkow's total current direct and indirect ownership of
our outstanding common stock is approximately 1.8%.

19. SUBSEQUENT EVENT

On February 2, 2004, the Court authorized the closure of 44 stores. On
February 11, 2004, the Court approved the agreement between the Great
American Group ("Great American") and us in which Great American acts
as an exclusive agent to conduct store closing sales at the 44 stores
location. The store closing sales started on February 12, 2004. All 44
stores were closed by March 18, 2004 and as of April 23, 2004, we have
terminated or assigned a total of 13 leases with these stores and
rejected the remaining 31 leases.

Under the terms of the agreement with Great American, we receive a
percentage of the aggregate retail price of the merchandise at the 44
stores as of February 11, 2004, as defined. In addition, we receive
reimbursement of sale expenses, as defined, incurred during the store
closing sales. Sales proceeds, net of sales tax, received during the
store closing sales goes to Great American. As of April 23, 2004, we
have received $3.4 million as partial payment for the sale of
inventory to Great American. In addition, we have received
approximately $1.5 million sale expenses reimbursement. These amounts
are subject to final agreed upon reconciliation.

20. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)

The results of operations for fiscal 2003 and 2002 were as follows:

(in thousands, except per share data)
-------------------------------------
First Second Third Fourth
Quarter Quarter Quarter Quarter
------------- --------------- ------------- --------------

Fiscal 2003
- -----------
Net sales $ 104,347 $ 123,659 $ 121,925 $ 143,367
Gross profit 37,635 38,569 41,656 35,369
Operating loss (3,758) (7,762) (3,923) (10,940)
Net loss (2,721) (5,390) (3,008) (74,740)

Loss per share basic & diluted $ (0.19) $ (0.35) $ (0.17) $ (4.23)

Fiscal 2002
- -----------
Net sales $ 116,951 $ 128,088 $ 134,506 $ 155,725
Gross profit 41,158 41,029 44,652 35,546
Operating loss (4,977) (9,418) (4,771) (25,884)
Net loss (3,141) (5,837) (3,516) (16,015)

Loss per share basic & diluted $ (0.24) $ (0.45) $ (0.27) $ (1.23)

As a result of rounding differences, total amounts disclosed in the
Statements of Operations may not agree to the sum of the amounts
disclosed above for the four quarters.

F-31