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SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Party City Corporation

(Registrant’s telephone number, including area code)

          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 þ          No: o

          Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).     Yes þ          No: o

      Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date:

      As of October 22, 2004, there were 17,145,573 shares of Common Stock, $0.01 par value, outstanding.

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      References throughout this document to the Company include Party City Corporation and its wholly-owned subsidiary. In accordance with the Securities and Exchange Commission’s “Plain English” guidelines, this Quarterly Report on Form 10-Q has been written in the first person. In this document the words “we,” “our,” “ours” and “us” refer only to Party City Corporation and its wholly-owned subsidiary and not to any other person.

      Our website — www.partycity.com — provides access, free of charge, to our Securities and Exchange Commission (“SEC”) reports, as soon as reasonably practicable after we electronically file such reports with, or furnish such reports to, the SEC, including proxy statements, Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to these reports.

      You may also read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. You may obtain information on the operations of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains a website that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC, including us, at http://www.sec.gov.

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PART I.

FINANCIAL INFORMATION

PARTY CITY CORPORATION AND SUBSIDIARY

(In thousands, except share information)

See accompanying notes to condensed consolidated financial statements.

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PARTY CITY CORPORATION AND SUBSIDIARY

(In thousands, except per share amounts)

See accompanying notes to condensed consolidated financial statements.

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PARTY CITY CORPORATION AND SUBSIDIARY

(In thousands)

See accompanying notes to condensed consolidated financial statements.

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PARTY CITY CORPORATION AND SUBSIDIARY

      Party City Corporation (together with its wholly-owned subsidiary, the “Company”) is incorporated in the State of Delaware and operates retail party supply stores within the United States and sells franchises on an individual store and area basis throughout the United States and Puerto Rico. The condensed consolidated unaudited financial statements have been prepared in accordance with the rules and regulations established by the Securities and Exchange Commission (“SEC”). In the opinion of management, the accompanying condensed consolidated financial statements contain all adjustments (consisting only of normal recurring accruals) necessary to present fairly the financial position of the Company as of October 2, 2004 and September 27, 2003 and the results of operations and cash flows for the quarters ended October 2, 2004 and September 27, 2003. All significant intercompany accounts and transactions have been eliminated. Because of the seasonality of the party goods industry, operating results of the Company on a quarterly basis may not be indicative of operating results for the full fiscal year.

      These condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements for the year ended July 3, 2004, which are included in the Company’s Annual Report on Form 10-K with respect to such period filed with the Securities and Exchange Commission on September 14, 2004 (the “2004 10-K”). The July 3, 2004 condensed consolidated balance sheet amounts included herein are derived from the Company’s audited consolidated financial statements.

      The Company’s fiscal year ends the Saturday nearest to June 30. As used herein, the term “Fiscal Year” or “Fiscal” refers to the 52- or 53-week period, as applicable, ending the Saturday nearest to June 30. Fiscal 2005 is a 52-week period ending July 2, 2005, while Fiscal 2004 is a 53-week period that ended July 3, 2004. However, the financial results for the fiscal quarter ended October 2, 2004 and September 27, 2003 are each based on a 13-week period.

      Certain reclassifications have been made to the condensed consolidated financial statements in prior periods to conform to the current period presentation.

      The Company’s significant accounting policies are described in Note 1 to the consolidated financial statements included in the 2004 10-K.

      During the first quarter of Fiscal 2005, the Company launched its supply chain initiative, which includes modifying its business operations to vertically integrate certain logistics and distribution activities, and therefore adopted new specific accounting policies for the treatment of the costs associated with the modified distribution network. The Company has outsourced the operations of its modified distribution network to a third party. The Company’s distribution costs include the fees and expenses of operating the distribution centers and the freight expense related to transporting merchandise to the stores. These distribution costs are initially capitalized into merchandise inventory and expensed when the merchandise is sold in the stores.

      The Company periodically grants stock options to employees. Pursuant to Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”, the Company accounts for stock-based employee compensation arrangements using the intrinsic value method. If the options are granted to employees below fair market value, compensation expense is recognized. The Company has adopted the disclosure only provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock Based Compensation” (“SFAS No. 123”), as amended by SFAS No. 148, “Accounting for Stock Based Compensation — Transition and Disclosure, an Amendment of SFAS No. 123” (“SFAS No. 148”). If

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

compensation cost for the Company’s stock option plans had been determined in accordance with the fair value method prescribed by SFAS No. 148, the Company’s net loss would have been:

(1)	In accordance with SFAS No. 123, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model using the following assumptions for grants in the respective periods:

      The weighted average fair value of options granted during the first quarter of Fiscal 2005 and 2004 were $5.53 and $4.50, respectively.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      The following table sets forth the computations of basic and diluted loss per share:

(a)	Stock options and warrants with exercise prices below the applicable market price of the Company’s common stock and all restricted stock units are included in potentially dilutive common shares outstanding if the Company reports net income for a reporting period. Therefore, if the Company reports net income, its earnings per share would be lower on a diluted basis. Options to purchase 2,125,999 common shares with exercise prices ranging from $1.71 to $13.14 per share at October 2, 2004, and options to purchase 1,345,243 common shares with exercise prices ranging from $1.71 to $11.06 per share at September 27, 2003, would have been included in the weighted-average common and potentially dilutive common shares outstanding, respectively, if the Company was in a net income position.
	However, when the Company incurs a net loss for a reporting period, the inclusion of any such shares would result in a decrease in loss per share, and therefore all stock options, warrants and restricted stock units are ignored when calculating diluted earnings per share. Therefore, the Company’s loss per share for the quarter ended October 2, 2004 and September 27, 2003 are the same amounts on a basic and diluted basis, respectively.
(b)	Options to purchase 3,171,199 common shares with exercise prices ranging from $1.71 to $30.88 per share were outstanding at October 2, 2004, and options to purchase 2,080,618 common shares with exercise prices ranging from $1.71 to $30.88 per share were outstanding at September 27, 2003 were not included in the computation of diluted loss per share for the fiscal quarter ended October 2, 2004 and September 27, 2003, respectively, because to do so would have been anti-dilutive.
(c)	Warrants to purchase 2,496,000 common shares with an exercise price of $1.07 per share were outstanding at October 2, 2004 and September 27, 2003 but were not included in the computation of diluted loss per share for the fiscal quarter ended October 2, 2004 and September 27, 2003, respectively, because to do so would have been anti-dilutive.
(d)	Restricted stock units of 13,567 and 17,396 shares of common stock were outstanding at October 2, 2004 and September 27, 2003, respectively, related to the Management Stock Purchase Plan and were not included in the computation of diluted loss per share for the fiscal quarter ended October 2, 2004 and September 27, 2003, respectively, because to do so would have been anti-dilutive.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      In January 2003, the Company entered into a $65 million revolving credit facility (the “Loan Agreement”) with Wells Fargo Retail Finance, LLC, as the arranger, collateral agent and administrative agent, and Fleet Retail Finance, Inc., as the documentation agent. Under the terms of the Loan Agreement, the Company may borrow amounts based on a percentage of its eligible inventory and credit card receivables, subject to certain borrowing conditions and customary sub-limits, reserves and other limitations. Interest on each advance is charged, at the Company’s option, at (i) the adjusted Eurodollar rate per annum plus the applicable margin, which is currently at 1.25%, or (ii) the prime rate per annum less the applicable margin, which is currently 0.25% (the Company’s effective cost of borrowing under the Loan Agreement is 4.50% at October 2, 2004). The Loan Agreement matures on April 30, 2006 and is secured by a lien on substantially all of the Company’s assets. Pursuant to the terms of the Loan Agreement, the Company had a standby letter of credit of $3.7 million outstanding at October 2, 2004. At October 2, 2004 and October 22, 2004, the Company had no borrowings outstanding under the Loan Agreement. Based on a percentage of current eligible inventory and credit card receivables, the Company had $51.3 million available to be borrowed under the Loan Agreement at October 22, 2004.

      The Company’s authorized capital stock was increased from 25,000,000 shares to 40,000,000 shares of its common stock, $0.01 par value per share, at the annual shareholders’ meeting on November 12, 2003. At October 2, 2004 and September 27, 2003, there were 17,871,210 shares and 17,425,070 shares, respectively, of the Company’s common stock issued. At October 2, 2004 and September 27, 2003, there were 747,012 shares of the Company’s common stock held as treasury stock. At October 2, 2004 and September 27, 2003, there were 17,124,198 shares and 16,678,058 shares, respectively, of the Company’s common stock outstanding.

      In September 2001, the Board of Directors authorized the Company to repurchase up to $15 million of its outstanding common stock at a price not to exceed $7.00 per share, which was amended on February 7, 2003 to a price not to exceed $10.00 per share. Stock repurchases are made at the discretion of management. There were no stock repurchases during Fiscal 2004 or the first quarter of Fiscal 2005. As of October 2, 2004, the Company had purchased 747,012 shares for an aggregate amount of $5.9 million or 39.6% of the total amount to be purchased.

      There were no warrant exercises in Fiscal 2004 or the first quarter of Fiscal 2005. As of October 2, 2004, the Company had 2,496,000 warrants outstanding with an exercise price of $1.07 per share.

      In June 2001, the Company established a Management Stock Purchase Plan (“MSPP”). The MSPP provides certain management employees of the Company the opportunity to defer a portion of their incentive compensation to acquire and maintain ownership of the Company’s common stock, with the intent to strengthen their commitment to the welfare of the Company and to promote an identity of interest among

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Company stockholders and these employees. The amount deferred by the individual is held in restricted stock units. The restricted stock units are converted into the Company’s common stock on a one-to-one basis upon vesting. These restricted stock units are purchased at a discount of 20% or 25%, depending on the amount of the individual deferral, from the average price of Company’s common stock on the determination date. Such discounts vest at the end of three years or seven years, selected by the participant, after the determination date. The amortization of the discount is charged to compensation expense over the deferral period. The compensation expense attributable to the MSPP for the first quarter of Fiscal 2005 and Fiscal 2004 was approximately $3,000 and $15,000, respectively, resulting in the obligation to issue 13,567 and 17,396 shares of common stock, respectively, upon vesting and conversion.

      In June 2001, the Company established an Employee Stock Purchase Plan (“ESPP”). The ESPP provides employees of the Company with an opportunity to purchase shares of the Company’s common stock at a discount of 15% through accumulated payroll deductions. This plan qualifies as an “Employee Stock Purchase Plan” under Section 423 of the Internal Revenue Code.

      A lawsuit was filed on September 25, 2001 against Party City Corporation in Los Angeles Superior Court by an assistant manager in one of the Company’s California stores for himself and on behalf of other members of an alleged class of Party City store managers (the “Class”) who claimed the Company misclassified the Class members as exempt from California overtime wage and hour laws. The Class members sought the disgorgement of overtime wages allegedly owed by the Company to them but not paid and they also sought punitive damages and statutory penalties.

      On March 30, 2004, the parties reached an agreement-in-principle to settle this lawsuit for $5.5 million on a “claims made” basis, which means that a payout to class members will only occur when claims are actually made by Class members. Previously, the Company recorded a pre-tax charge of $1.4 million related to this lawsuit. In connection with the agreement-in-principle, the Company recorded an additional pre-tax charge of $4.1 million during the third quarter of Fiscal 2004 to fully cover the settlement payments, attorneys’ fees and the estimated expenses of administering the settlement.

      On September 27, 2004, the Company entered into a final settlement agreement which contained no material changes from the aforementioned agreement-in-principle.

      In addition to the foregoing, from time to time the Company is involved in routine litigation incidental to the conduct of the business. The Company is aware of no other material existing or threatened litigation to which the Company is or may be a party.

      The Company reports two business segments — retail and franchising. The retail segment generates revenue primarily through the sale of third-party branded party goods through Company-owned stores. The franchising segment generates revenue through the imposition of an initial one-time franchise fee that is paid upon the grant of a new franchise and ongoing royalty payments by franchisees based on retail sales.

      SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information”, establishes standards for reporting information about operating segments. This standard requires segmentation based on the Company’s internal organization and reporting of revenue and operating income based upon internal accounting methods. The Company’s segments are designed to allocate resources internally and provide a framework to determine management responsibility. Additionally, the Company’s financial reporting systems present various data by segment for management to run the business, including internal profit and loss

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

statements prepared on a basis consistent with accounting principles generally accepted in the United States of America.

      The following table contains key financial information of the Company’s business segments (in thousands):

      The Company’s accounting policies are described in Note 2 of the Company’s condensed consolidated financial statements included herein. The Company has no inter-segment sales. No single customer accounts for 10% or more of total revenues. All assets of the Company are located in the United States, including Puerto Rico.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      As of October 2, 2004, the Company’s contractual obligations and commercial commitments are as follows (in thousands);

      The Company leases real estate in connection with the operation of Company-owned retail stores as well as the corporate offices. The store leases are for properties ranging in size from 6,750 to 19,800 square feet. The terms range from five years to twenty years. Of the leases for the Company-owned stores, three expire in Fiscal 2005, 21 expire in Fiscal 2006, 30 expire in Fiscal 2007, 59 expire in Fiscal 2008 and the balance expire in Fiscal 2009 or thereafter. The Company’s operating leases provide for step rent provisions, renewal options from five years to ten years, capital improvement funding, obligations for reimbursement of common area maintenance and real estate taxes and other lease concessions as applicable in each lease. The minimum lease payments are recognized on a straight-line basis over the term of each individual underlying lease. Certain leases contain contingent rent based upon specified sales volume. The Company paid $3,000 for contingent rent during the first quarter in each of Fiscal 2005 and 2004.

      On September 16, 2004, the Company entered into a new corporate office lease for 106,000 square feet of office space. The initial term is for 12 years, with two five-year renewal options. The lease contains escalation clauses and obligations for reimbursement of common area maintenance and real estate taxes. The lease for the Company’s current corporate headquarters expires in December 2004, but the Company is currently negotiating an extension of such lease for a period of months to coincide with its transition to the new corporate headquarters. The Company intends to relocate to the new corporate headquarters by June 2005, and intends to vacate its current corporate headquarters thereafter.

      The Company is also obligated for guarantees, subleases or assigned lease obligations for 23 of the franchisees through 2011. The majority of the guarantees, subleases and assigned lease obligations were given when the Company sold stores in 1999 as part of its restructuring. The guarantees, subleases and assigned lease obligations continue until the leases expire. The maximum amount of the guarantees, subleases and assigned lease obligations may vary, but is limited to the sum of the total amount due under the lease. As of October 2, 2004, the maximum amount of the guarantees, subleases and assigned lease obligations was approximately $15.0 million, which is not included in the table above.

      The Company enters into arrangements to purchase merchandise up to eight months in advance of expected delivery. Historically, these purchase commitments did not contain any significant termination payments or other penalties if cancelled. Since the Company is transitioning toward selling more proprietary product, certain of these purchase commitments may obligate the Company to specified quantities, even if desired quantities change at a later date. As of October 2, 2004, the Company had approximately $17 million of proprietary product for which the Company has made purchase arrangements.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      Logistics initiative obligations include a commitment for the purchase of selected equipment and services associated with the operation of the distribution centers.

      At October 2, 2004, the Company operated a fleet of thirty-nine leased motor vehicles, primarily for the district managers and regional management. The terms of these leases generally run for 36 months and expire at various times through September 2007.

      In addition to the severance obligations specified in the table above, as of October 2, 2004 and October 22, 2004, the Company had an aggregate contingent liability of up to $2.2 million related to potential severance payments for 14 employees pursuant to their respective employment agreements. As of October 2, 2004 and October 22, 2004, the Company had a standby letter of credit of $3.7 million pursuant to the Loan Agreement relating to general liability and workers compensation insurance.

      The Company has two non-compete agreements. One is with a franchise owner and the other is with Paper Warehouse, Inc. The Company also has trademark license agreements. All of these agreements are included in other assets and are being amortized using the straight-line method over the life of the agreement. Amortization expense for these non-compete agreements was $19,000 and $35,000 for the fiscal quarters ended October 2, 2004 and September 27, 2003, respectively. The following chart shows the amortization expense of these intangibles by year until they are fully amortized (in thousands):

      In June 2004, the Financial Accounting Standards Board (“FASB”) issued an interpretation of FASB No. 143, “Accounting for Asset Retirement Obligations” (“FASB No. 143”). This interpretation clarifies the scope and timing of liability recognition for conditional asset retirement obligations under FASB No. 143 and is effective no later than the end of Fiscal 2005. The Company has determined that this interpretation, and the adoption of FASB No. 143, will not have a material impact on the Company’s condensed consolidated results of operations, financial position or cash flows.

      In May 2004, the FASB issued FSP FAS 106-2 to provide guidance on accounting for the effects of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the Act), to employers that sponsor post-retirement health care plans that provide prescription drug benefits. The Company continues to sponsor a post-retirement healthcare plan for one individual, and the Company does not provide such benefits to any other employee and has no intention to do so in the future. The Company has determined that FAS 106-2 will not have a material impact on its consolidated results of operations, financial position or cash flows.

      In March 2004, the FASB published an Exposure Draft, “Share-Based Payment”, an amendment of FASB Statements No. 123 and No. 95. Under this FASB proposal, all forms of share-based payment to employees, including employee stock options, would be treated as compensation and recognized in the income statement. This proposed statement, if adopted, would be effective beginning in Fiscal 2006. The Company currently accounts for stock options under APB No. 25. The pro-forma impact of expensing options is disclosed in Note 3 to the Company’s condensed consolidated financial statements included herein.

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Overview

      We operate retail party supply stores within the continental United States and we sell franchises on an individual store and area franchise basis throughout the United States and Puerto Rico. As of October 2, 2004, our network consisted of 508 stores, with 249 Company-owned stores and 259 stores owned by franchisees. We report two segments — retail and franchising. The retail segment generates revenue primarily through the sale of third-party branded party goods through Company-owned stores. The franchising segment generates revenue through the imposition of an initial one-time franchise fee and ongoing royalty payments based on retail sales.

      We continually strive to improve customer satisfaction and strengthen our financial condition. We have recently undertaken various initiatives to make fundamental improvements in our business, profitability and cash flow. These initiatives have primarily focused on our breadth and quality of products and product pricing; logistics, including financial, distribution and inventory systems; and building our talent base. To date, most of our improvements have involved business processes and infrastructure. While this effort has been absolutely essential to support our future product initiatives, our work is generally not yet visible to the customer and has not yet positively impacted our net sales results. We believe that our efforts will be more evident to the customer as we transition our merchandise presentation and introduce significant amounts of new non-seasonal product in the latter part of this fiscal year.

      With respect to our products, we are developing proprietary processes to evaluate and select our product assortment more efficiently and effectively. We are also reconfiguring our in-store product layout to better align product categories and facilitate an easier shopping experience for our customers.

      As discussed more fully in Part I, Item 1. “Business” in our 2004 Form 10-K, we are in the process of transitioning our product base through the development of new, coordinated assortments within selected product categories. We initially focused on enhancing our seasonal merchandise (e.g., Summer Luau, Halloween, and other seasonal categories) and the preliminary results demonstrate the customer is responding positively. As a result of the ongoing transition process in non-seasonal merchandise, which currently represents approximately two-thirds of a typical store’s selling space and net sales volume, our financial results for the first quarter of fiscal 2005 were impacted by a decline in same store sales performance of non-seasonal merchandise. In the third quarter of Fiscal 2005, we will begin to remerchandise our stores to enhance our product presentation, and will introduce significant amounts of new product and coordinated assortments, which we anticipate to be completed early in the fourth quarter of Fiscal 2005.

      We also continue to benefit from our inventory reduction initiative during the quarter in the form of store labor efficiencies across our stores. During the fiscal quarter ended October 2, 2004, our average inventory per store declined 13% compared to the same period in Fiscal 2003, primarily reflecting the disposal of the previous season’s merchandise that we had traditionally maintained in our stores at the end of such season. We continue to believe these strategies will provide us with the flexibility to offer fresh merchandise choices to our customers and still maintain a sufficient variety and quantity of products to satisfy customer needs.

      Our initial phase of the logistics initiative was completed in July 2004. We are now able to receive and distribute products for our Company-owned stores from two distribution centers — one in California and one in Pennsylvania. This program supports weekly scheduling of store deliveries, further reducing store labor requirements and improving inventory accuracy. We have outsourced the operations of our modified distribution network to a third party. Additionally, a Preferred Carrier Process that was implemented in Fiscal 2004 is expected to result in lower negotiated transportation rates, better visibility on deliveries and higher service levels. Currently, our capabilities include handling single cartons of individual items from multiple vendors, as well as “cross-dock” merchandise from other vendors and then transport to the stores. Approximately 35% to 40% of our total annual dollar volume is now being delivered under our initial phase of the logistics initiatives.

      Effective in the first half of calendar year 2005, all of our franchisees have agreed to participate in our logistics program. This is anticipated to create efficiencies in product purchasing, as well as cost savings from

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      We have also focused on enhancing our information systems, completing significant store and corporate system installations. The investment in our store and corporate information systems has improved certain store processes, such as customer check-out, product replenishment, and inventory management, and was a major contributor to the decline in store labor costs during the past fiscal quarter. In addition, these investments will provide the systemic foundation for our logistics initiative. Working with our vendor partners and third-party logistics providers, we are embarking on enhancements that will further drive product in-stock positions and lower our supply-chain network costs.

      Another important initiative is the continuation of making key investments in our employee base. During the first quarter Fiscal 2005, we hired a new Chief Financial Officer and Vice President of Marketing, and added employees in key departments to support our initiatives in Merchandising, Planning and Allocation and Logistics.

      In connection with the implementation of these initiatives, we have incurred significant initial expenses that are disproportionate to our sales performance. However, we anticipate these initial expenses will diminish over time. Most importantly, these investment initiatives are anticipated to improve customer experience and solidify brand recognition which we believe will ultimately result in increased sales, reduced expenses and, accordingly, greater net income.

Key Performance Indicators and Statistics

      We use a number of key indicators of financial condition and operating results to evaluate the performance of our business, including the following:

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      The following table shows the growth in our network of Company-owned and franchise stores for the quarter ended October 2, 2004 and September 27, 2003.

Critical Accounting Policies and Estimates

      The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires the appropriate application of certain accounting policies, many of which require estimates and assumptions about future events and their impact on amounts reported in the financial statements and related notes. Since future events and their impact cannot be determined with certainty, the actual results will inevitably differ from our estimates. Such differences could be material to the consolidated financial statements.

      We believe our application of accounting policies, and the estimates inherently required by the policies, are reasonable. These accounting policies and estimates are constantly reevaluated and adjustments are made when facts and circumstances dictate a change. Historically, we have found the application of accounting policies to be appropriate, and actual results generally do not differ materially from those determined using necessary estimates.

      Our accounting policies are more fully described in Note 1 of our 2004 10-K. We have identified certain critical accounting policies that are described below.

      Merchandise inventory. Inventory is valued using the cost method which values inventory at the individual item level at the lower of the actual cost or market. Cost is determined using the weighted average method. Market is determined by the estimated net realizable value, based upon the merchandise selling price. Inventory levels are reviewed to identify slow-moving and closeout merchandise that will no longer be carried. We also estimate amounts of current inventories that will ultimately become obsolete due to changes in fashion and style, based on the following factors: (i) supply on hand, (ii) historical experience and (iii) our expectations as to future sales.

      During the first quarter of Fiscal 2005, we launched our supply chain initiative, which includes modifying our business operations to vertically integrate certain logistics and distribution activities, and we therefore adopted new specific accounting policies for the treatment of the costs associated with our modified distribution network. We have outsourced the operations of our modified distribution network to a third party.

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      Finite long-lived assets. In the evaluation of the fair value and future benefits of finite long-lived assets, we perform an analysis by store of the anticipated undiscounted future net cash flows of the related finite long-lived assets. If the carrying value of the related asset exceeds the undiscounted cash flows, the carrying value is reduced to its fair value. Various factors including future sales growth and profit margins are included in this analysis. To the extent these future projections or strategies change, the conclusion regarding impairment may differ from the current estimates.

      Insurance accruals. Our condensed consolidated balance sheets include significant liabilities with respect to self-insured workers’ compensation and general liability claims. We estimated the required liability of such claims as of October 2, 2004, utilizing an actuarial method based upon various assumptions, which include, but are not limited to, our historical loss experience, projected loss development factors, actual payroll and other data. The required liability is also subject to adjustment in the future based upon the changes in claims experience, including changes in the number of incidents (frequency) and changes in the ultimate cost per incident (severity).

      Goodwill. All of our goodwill is associated with our retail segment. We evaluate goodwill annually or whenever events and changes in circumstances suggest that the carrying amount may not be recoverable from its estimated future cash flows. In making this assessment, management relies on a number of factors including operating results, business plans, economic projections, anticipated future cash flows and marketplace data. A change in these underlying assumptions may cause a change in the results of the tests and, as such, could cause fair value to be less than the carrying value. In such event, we would then be required to record a charge, which would impact earnings.

      Sales Returns. We estimate future sales returns and, when material, record a provision in the period that the related sales are recorded based on historical information. Should actual returns differ from our estimates, we would be required to revise estimated sales returns.

      Store Closure Costs. We record estimated store closure costs, estimated lease commitment costs net of estimated sublease income and other miscellaneous store closing costs, when the liability is incurred. Such estimates, including sublease income, may be subject to change.

      Income Taxes. Temporary differences arising from differing treatment of income and expense items for tax and financial reporting purposes result in deferred tax assets and liabilities that are recorded on the balance sheet. These balances, as well as income tax expense, are determined through management’s estimations, interpretation of tax law for multiple jurisdictions and tax planning. If our actual results differ from estimated results due to changes in tax laws, new store locations or tax planning, our effective tax rate and tax balances could be affected.

General Definitions for Operating Results

      Net Sales include Company-owned same store net sales and Company-owned new store net sales. Stores are included in the same store net sales calculation when in operation for a full fiscal month in both the current fiscal month and the corresponding fiscal month of the prior year. All other stores are included in new store net sales.

      Cost of goods sold and occupancy costs include the cost of merchandise, distribution costs and store occupancy costs. Distribution costs include the costs of operating the out-sourced distribution centers and freight expense related to transporting merchandise to our stores. These distribution costs are initially capitalized into merchandise inventory and expensed when the merchandise is sold in our stores. Store occupancy costs include rent, common area maintenance, real estate taxes, repairs and maintenance, depreciation, insurance and utilities.

      Gross profit is net sales minus cost of goods sold and occupancy costs.

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      Store operating and selling expenses consist of selling and store management payroll, employee benefits, medical insurance, employment taxes, advertising, other store level expenses and pre-opening expenses which are expensed when incurred.

      Company-owned store profit contribution is gross profit minus store operating and selling expenses.

      General and administrative expense includes payroll and employee benefits, employment taxes, management information systems, marketing, insurance, legal and other corporate level expenses. Corporate level expenses are primarily attributable to our corporate office in Rockaway, New Jersey, and district and regional offices throughout the country.

      Franchising. Franchising revenue is composed of the initial franchise fees, which are recorded as revenue when a franchise store opens, and ongoing royalty fees, generally 4.0% of the store’s net sales. Franchise expenses include direct and indirect expenses. The direct expenses include salaries, travel and other direct expenses of the franchise operations department in addition to legal fees, bad debt expense, insurance expense and other miscellaneous charges. The indirect expenses include allocations of corporate expenses for salaries, including bonuses, occupancy and depreciation, based on time spent on franchise support.

      Franchise profit contribution is franchise revenue minus franchise expenses.

      Interest expense, net includes interest relating to our credit facility, amortization of financing costs and bank service charges. Interest expense, net also includes interest income from other highly liquid investments purchased, with an original maturity of three months or less, as part of our daily cash management activities.

Results of Operations

      The following table sets forth the results of operations for the periods indicated:

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      Retail. Net sales from Company-owned stores decreased 3.9% to $98.6 million for the first quarter of Fiscal 2005 from $102.6 million in the same period last year. The 3.9% decrease in net sales resulted from a same store net sales decrease of 5.2% which was partially offset by net sales from new stores. Same store sales for non-seasonal merchandise decreased 8.7% due to the ongoing transition of this merchandise category. This decline was partially offset by a 5.0% increase in same store sales for seasonal merchandise, largely aided by five additional days of Halloween sales included in the first quarter of Fiscal 2005. Although the customer count in Company-owned stores, on a same store basis, decreased 7.1% during the quarter ended October 2, 2004, the same store average net sale per retail transaction increased 1.9% reflecting a lower level of discounting and promotional markdown activity compared with the same time last year. Five stores joined the same store sales group during the first quarter of Fiscal 2005. We opened one new store and closed one store during the first quarter of Fiscal 2005 and opened six new stores and closed one store during the same period last year.

      Gross profit as a percent of net sales was 27.1% for the first quarter of Fiscal 2005 compared with 27.6% for the same period last year. As shown in the table below, gross profit decreased $1.6 million to $26.7 million in the first quarter of Fiscal 2005 from $28.3 million in the same period last year.