SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

Party City Corporation

(Exact Name of Registrant as Specified in Its Charter)

(Registrant’s Telephone Number, Including Area Code)

973-983-0888

      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 January 27, 2005, there were 17,232,217 shares of common stock, $0.01 par value, outstanding.

TABLE OF CONTENTS

      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 (the “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.

PART I.

FINANCIAL INFORMATION

PARTY CITY CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED BALANCE SHEETS

See accompanying notes to condensed consolidated financial statements.

PARTY CITY CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

See accompanying notes to condensed consolidated financial statements.

PARTY CITY CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

See accompanying notes to condensed consolidated financial statements.

PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

      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 (the “SEC”). In the opinion of management, the accompanying condensed consolidated unaudited financial statements fairly present, in all material respects, the financial position of the Company as of January 1, 2005 and December 27, 2003 and the results of operations for the quarters and six months ended January 1, 2005 and December 27, 2003 and cash flows for the six months ended January 1, 2005 and December 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 unaudited 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 filed with the SEC on September 14, 2004 (the “2004 10-K”). The July 3, 2004 condensed consolidated unaudited 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 and six months ended January 1, 2005 and December 27, 2003 are each based on a 13-week period and 26-week period, respectively.

      Certain reclassifications have been made to the condensed consolidated unaudited 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 logistics initiative, which includes modifying its business operations to vertically integrate certain logistics and distribution activities, and therefore adopted a new specific accounting policy 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. Distribution costs include the third party 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. In December 2004, the Financial Accounting Standards Board (the “FASB”) published Statement of Financial Accounting Standards (“SFAS”) No. 123R, “Share-Based Payment” (“SFAS No. 123R”), an amendment of FASB Statements No. 123 and No. 95. Under SFAS No. 123R, all forms of share-based payment to employees, including employee stock options, would be treated as compensation and recognized in the income statement. SFAS No. 123R is effective beginning the first quarter of Fiscal 2006. The Company is continuing to evaluate the full impact of SFAS No. 123R for its adoption in the first quarter of fiscal 2006. We currently account for stock options under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”.

PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      Pursuant to APB No. 25, 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 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 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 income would have been:

      The weighted average fair value of options granted during the second quarter of Fiscal 2005 and 2004 were $5.71 and $6.48, respectively.

      The weighted average fair value of options granted during the first six months of Fiscal 2005 and 2004 were $5.65 and $5.61, respectively.

PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

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

      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. The Company has the option, based on its liquidity needs, to borrow at (i) the adjusted Eurodollar rate per annum plus the applicable margin, which is currently at 1.25% (which in the aggregate under the Loan Agreement was 3.65% for a 1 month term at January 1, 2005), or (ii) the prime rate per annum less the applicable margin, which is currently 0.25% (which in the aggregate under the Loan Agreement was 5.0% at January 1, 2005). 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 January 1, 2005. At January 1, 2005 and January 27, 2005, 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 $23.3 million and $24.9 million available to be borrowed under the Loan Agreement at January 1, 2005 and January 27, 2005, respectively.

      The Company’s authorized capital stock consists solely of shares of its common stock, $0.01 par value per share. The authorized common stock was increased from 25,000,000 shares to 40,000,000 shares at the annual shareholders’ meeting on November 12, 2003. At January 1, 2005 and December 27, 2003, there were

PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

17,938,479 shares and 17,721,850 shares, respectively, of the Company’s common stock issued. At January 1, 2005 and December 27, 2003, there were 747,012 shares of the Company’s common stock held as treasury stock. At January 1, 2005 and December 27, 2003, there were 17,191,467 shares and 16,974,838 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 during the first six months of Fiscal 2005. As of January 1, 2005, 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 during the first six months of Fiscal 2005. As of January 1, 2005, the Company had 2,496,000 warrants outstanding with an exercise price of $1.07 per share.

      On October 19, 1999, the Company’s Board of Directors adopted the Company’s 1999 Stock Incentive Plan (“1999 Plan”). This adoption was approved by the Company’s stockholders on November 15, 1999. A total of 500,000 shares of the Company’s common stock were reserved for issuance under the 1999 Plan.

      On October 5, 2000, the Board approved an amendment and restatement of the 1999 Plan, increasing the number of shares of common stock reserved for issuance thereunder from 500,000 to 2,000,000. This adoption was approved by the Company’s stockholders on November 15, 2000. On October 17, 2003, the Board approved an amendment and restatement of the 1999 Plan, increasing the number of shares of common stock reserved for issuance under the Plan from 2,000,000 to 7,500,000, and increasing the limit on the number of shares of the Company’s common stock which may be subject to options or stock appreciation rights granted to a single participant in any given year from 400,000 to 750,000. This adoption was approved by the shareholders on November 12, 2003. A total of 7,500,000 are currently reserved for issuance under the 1999 Plan.

      The purpose of the 1999 Plan is to promote the long-term financial success of the Company by enhancing the ability of the Company to attract, retain and reward individuals who can and do contribute to such success and to further align the interest of the Company’s key personnel with its stockholders. Key employees, directors and consultants of the Company are eligible to receive options under the 1999 Plan.

      The 1999 Plan provides for the grants of options and restricted stock and other stock-based awards as the compensation committee of the Board of Directors may from time to time deem appropriate. Such awards may include stock appreciation rights, phantom stock awards, bargain purchase of stock and stock bonuses. Vesting and other terms of stock options awarded are set out in the agreements between the Company and the individuals receiving such awards. The exercise price of the options is determined by the compensation committee at the time of grant and may not be less than the fair market value of the Company’s common stock on the date of grant. Options granted under the 1999 Plan vest over four to seven years from date of grant, and expire in ten years.

      The Company also maintains the Amended and Restated 1994 Stock Option Plan (“1994 Plan”) pursuant to which options were granted to employees, directors and consultants for the purchase of common stock of the Company. The 1994 Plan, as amended, permitted the Company to grant incentive and non-qualified stock options to purchase a total of up to 1,800,000 shares of the Company’s common stock at an

PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

exercise price not less than fair value at date of grant. No additional grants of options under the 1994 Plan are permitted. The original terms of the agreements between the Company and the individuals receiving the grants under the 1994 Plan with respect to vesting, expiration and exercise price remain unchanged.

      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 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. To date, all participants have selected three-year vesting periods for all deferrals. The amortization of the discount is charged to compensation expense over the deferral period. The compensation expense attributable to the MSPP for the second quarter of Fiscal 2005 and Fiscal 2004 was approximately $3,000 and $1,000, respectively, and during the six months of Fiscal 2005 and Fiscal 2004 was approximately $6,000 and $16,000, respectively. Based on management participation in the MSPP from June 2002 until the end of the second quarter of Fiscal 2005, the Company was obligated to issue 13,567 shares of common stock, which represents $151,000 of deferred compensation as of the end of the second quarter of Fiscal 2005, upon vesting and conversion. Based on management participation in the MSPP from June 2001 until the end of the second quarter of Fiscal 2004, the Company was obligated to issue 16,012 shares of common stock, which represents $134,000 of deferred compensation as of the end of the second quarter of Fiscal 2004, 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.

PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      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 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):

PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      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 and Puerto Rico.

      As of January 1, 2005, 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, two expire in Fiscal 2005, 16 expire in Fiscal 2006, 34 expire in Fiscal 2007, 59 expire in Fiscal 2008 and the balance expire in Fiscal 2009 or thereafter. The Company’s operating leases generally 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. The minimum lease payments are

PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

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 incurred approximately $8,000 of contingent rent during the first six months 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 expired in December 2004, but the Company negotiated an extension of such lease to expire in August 2005, which coincides with its transition to the new corporate headquarters. The Company intends to relocate to the new corporate headquarters by August 2005, and intends to vacate its current corporate headquarters thereafter.

      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 January 1, 2005, the Company had approximately $25.3 million of proprietary product for which the Company has made purchase arrangements.

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

      At January 1, 2005, 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 December 2007.

      As of January 1, 2005 and January 27, 2005, the Company had an aggregate contingent liability of up to $2.4 million related to potential severance payments for 17 employees pursuant to their respective employment agreements.

      As of January 1, 2005 and January 27, 2005, 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 entered into a capital lease arrangement with a third party provider that involves dedicated assets needed for the Company’s logistics initiative. As of January 1, 2005, the contractual obligation of this capital lease is equal to $543,000, which includes $32,000 of imputed interest. The remaining current and long-term portion of this capital lease liability, excluding imputed interest, is $124,000 and $387,000, respectively.

PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      The Company has two non-compete agreements, one with a franchise owner and the other 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 approximately $39,000 and $70,000 for the six months ended January 1, 2005 and December 27, 2003, respectively. The following chart shows the amortization expense of these intangibles by year until they are fully amortized (in thousands):

      In December 2004, the FASB published SFAS No. 123R, pursuant to which all forms of share-based payments to employees, including employee stock options, would be treated as compensation and recognized in the income statement. SFAS No. 123R is effective beginning the first quarter of Fiscal 2006. The Company currently accounts for stock options under APB No. 25. The Company is continuing to evaluate the full impact of SFAS No. 123R for its adoptions in the first quarter of Fiscal 2006.

      In December 2004, the FASB published Statement of Financial Accounting Standards No. 151, “Inventory Costs” (“SFAS No. 151”), an amendment of Accounting Research Bulletin (ARB) No. 43, Chapter 4, which clarifies that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges. In addition, SFAS No. 151 requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The Company has determined that SFAS No. 151 will not have a material impact on its condensed consolidated results of operations, financial position or cash flows.

      In June 2004, the FASB issued an interpretation of SFAS No. 143, “Accounting for Asset Retirement Obligations” (“SFAS No. 143”). This interpretation clarifies the scope and timing of liability recognition for conditional asset retirement obligations under SFAS No. 143 and is effective no later than the end of Fiscal 2005. The Company has determined that this interpretation, and the adoption of SFAS 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 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.

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 January 1, 2005, our network consisted of 507 stores, with 248 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. During the third quarter of 2004, we began to undertake a series of related 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. While this effort has been absolutely essential to support our future product initiatives, our work is generally not yet adequately visible to the customer and has not yet positively impacted our net sales and net income. 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. Non-seasonal merchandise currently represents approximately two-thirds of a typical store’s selling space and annual net sales volume.

      With respect to our products, we are developing processes to evaluate and select our product assortment more efficiently and effectively. We have also begun to reconfigure 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 Annual Report on Form 10-K for Fiscal 2004 (the “2004 10K”), 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 and more recently, to a lesser extent, on enhancing our non-seasonal merchandise. While the improved merchandise categories do not yet represent a significant portion of our total product offerings, the increased net sales trends in these categories indicate that the customer is responding positively to most. Primarily as a result of the ongoing transition process in non-seasonal merchandise, coupled with softness in some Halloween and Christmas categories, we experienced a decline in same store net sales for the first half of Fiscal 2005. Our net sales performance during the Halloween season was affected by two separate factors: (i) a shift in advertising and promotional activity, which adversely impacted net sales primarily in the first few weeks of September and (ii) out of stock positions in portions of our costume assortment during the final selling days of the Halloween season. We did see improvement in merchandise margins in certain seasonal departments during the second quarter of Fiscal 2005.

      In the third quarter of Fiscal 2005, we will begin to re-merchandise our stores by enhancing our product presentation and introducing significant amounts of new product and coordinated assortments, which we anticipate to be completed early in the fourth quarter of Fiscal 2005. We anticipate this re-merchandising will result in an increase in store labor of $1.7 million (mostly in the third quarter of Fiscal 2005) which will not recur once this re-merchandising initiative is complete, an increase in inventory levels (discussed in further detail below) and additional markdowns mostly in the third quarter of Fiscal 2005 to clear out older merchandise in order to make room for our new products.

      Our initial phase of our logistics initiative was completed in July 2004. Since that time, we have been receiving and distributing certain of our 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 Program that was implemented in Fiscal 2004 has lower negotiated transportation rates, better visibility on deliveries to stores and improved service levels. Currently, our capabilities include handling single cartons of individual

items from multiple vendors, as well as “cross-dock” merchandise from other vendors (i.e. flow product through the distribution centers to optimize outbound transportation costs to stores), as well as transporting such goods to the stores. Product volumes processed by the distribution centers continue to increase. To date, however, product volume throughput has not reached critical mass for our initial phase. We anticipate continued throughput increases, thereby generating savings to more than offset operating costs of the distribution centers towards the end of Fiscal 2005.

      Earlier in Fiscal 2005, nearly all of our franchisees agreed to participate in our logistics program. As of January 2005, these franchisees have been added to our logistics program. This provides a low-cost distribution alternative for all stores and ensures consistency of merchandise between franchise and corporate locations. The program is not considered a profit center, but rather a business necessity to maintain brand consistency nationwide. We anticipate making certain system and inventory investments during the remainder of Fiscal 2005 relating to the transitioning of our franchisees into our logistics program. Through the end of the second quarter, the Company procured approximately $2.5 million of additional inventory in anticipation of servicing the franchisees. We continue to plan for the second phase of our logistics initiative, which will allow for a more sophisticated distribution network (including the ability to break pack many items), which is not expected to be implemented until the 2006 calendar year.

      As a result of the aforementioned re-merchandising effort and franchise logistics program, coupled with efforts to improve in-stock levels, Company inventory levels increased 15.4% in the second quarter of Fiscal 2005, primarily in our distribution centers, compared to the same quarter in Fiscal 2004. We believe we will need to maintain higher average inventories per store over the balance of the year as we complete the product transitions, and seek to minimize out of stock positions.

      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 key contributor to the decline in store labor costs during the first six months of Fiscal 2005. In addition, these investments have provided, and will continue to provide, the systemic foundation for our logistics initiative. We have begun evaluating merchandising system vendors that can provide additional software to enhance our merchandise replenishment, planning and allocation initiatives.

      Another important initiative is the continuation of key investments in our employee base. During the second quarter Fiscal 2005, we hired a new Vice President of Product Development, 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, relative to net sales, will diminish over time. Most importantly, these investment initiatives are anticipated to improve our infrastructure and customer shopping experience, solidify brand recognition and maintain our leading position in the party supplies business. We ultimately believe this will 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:

      The following table shows the growth in our network of Company-owned and franchise stores for the quarter and six months ended January 1, 2005 and December 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 condensed consolidated financial statements included herein.

      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 reasonable, 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.

      Cash and cash equivalents. We consider our highly liquid investments purchased (an investment held for less than three months) as part of daily cash management activities to be cash equivalents.

      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 logistics 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. Distribution costs include the third-party fees and expenses of operating the distribution centers and the 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.

      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 January 1, 2005, 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 evaluation, 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 net income.

      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 month in a current fiscal period and the corresponding full month in the prior fiscal year. All other stores are included in new store net sales.

      Cost of goods sold and occupancy costs include merchandise, distribution 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.

      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, less the allocation of corporate expenses to the franchising segment discussed below. 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 general and administrative 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 (income) 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:

      Retail. Net sales from Company-owned stores decreased 4.9% to $166.8 million for the second quarter of Fiscal 2005 from $175.3 million in the same period last year. The 4.9% decrease in net sales resulted from a same store net sales decrease of 5.6% which was partially offset by net sales from new stores. Same store sales for non-seasonal merchandise decreased 6.2% due to the ongoing transition of this merchandise category, and same store sales for seasonal merchandise decreased 5.2%, largely due to a decrease in Halloween sales and a softness in some Christmas categories due to a shift in promotional strategies. Our net sales performance during the Halloween season was affected by two separate factors: (i) a shift in advertising and promotional activity, which adversely impacted net sales primarily in the first few weeks of September and (ii) out of stock positions in portions of our costume assortment during the final selling days of the Halloween season. Although the customer count in Company-owned stores, on a same store basis, decreased 6.0% during the quarter ended January 1, 2005, the same store average net sale per retail transaction increased 0.4%. Two

stores joined the same store sales group during the second quarter of Fiscal 2005. We did not open any new stores and closed one store during the second quarter of Fiscal 2005, and did not open any new stores or close any stores during the same period last year.

      Gross profit as a percent of net sales was 39.5% for the second quarter of Fiscal 2005 compared with 40.3% for the same period last year. Merchandise margin decreased approximately 20 basis points. The decrease includes incremental distribution costs of $0.7 million, which represents approximately 40 basis points of merchandise margin. As shown in the table below, gross profit decreased $4.7 million to $65.9 million in the second quarter of Fiscal 2005 from $70.6 million in the same period last year.

      Store operating and selling expenses were 21.8% and 20.7% of net sales for the second quarter of Fiscal 2005 and Fiscal 2004, respectively. As shown in the table below, store operating and selling expenses were relatively flat at $36.3 million in the second quarter of Fiscal 2005, a decrease of approximately $13,000 from the same period last year. Our spending during the second fiscal quarter reflected a higher concentration of advertising activities and increased levels of store labor during certain weeks to support the Halloween and New Years selling season., which was partially offset by continued savings during non -peak holiday selling weeks.

      Company-owned store profit contribution as a percent of net sales was 17.8% for the second quarter of Fiscal 2005 compared with 19.6% in the same period last year. Company-owned store profit contribution decreased $4.7 million during the second quarter of Fiscal 2005 at $29.6 million compared with $34.3 million during the same period last year.

      General and administrative expenses were 6.4% and 4.3% of net sales for the second quarter of Fiscal 2005 and Fiscal 2004, respectively. As shown in the table below, general and administrative expenses increased $3.2 million to $10.7 million for the second quarter of Fiscal 2005 from $7.5 million in the same period last year.

      Franchising. There were no franchise fees recognized in the second quarter of Fiscal 2005, compared with $40,000 recognized on one store opening in the same period last year. Royalty fees increased 4.1% to $7.5 million in the second quarter of Fiscal 2005 from $7.2 million in the same period last year. This increase was primarily due to eight franchise store openings since the end of the same period last year and 12 franchise stores that were required to pay royalties in the second quarter of Fiscal 2005 due to the end of a five- year royalty free period for such stores (such stores were acquired from the Company in 1999 as part of its restructuring). This increase was partially offset by the same store sales decrease of 2.8% for franchise stores in the second quarter of Fiscal 2005.

      Expenses attributable to the franchise segment increased 13.5% to $1.8 million for the second quarter of Fiscal 2005 from $1.6 million for the second quarter of Fiscal 2004. As a percentage of franchise revenue, franchise expenses were 23.6% and 21.5% for the second quarter of Fiscal 2005 and Fiscal 2004, respectively. This increase is primarily due to a larger corporate expense allocation that were allocated to the franchise segment during the fiscal quarter ended January 1, 2005.

      Franchise profit contribution was relatively flat at $5.7 million in second quarter of Fiscal 2005, an increase of approximately $45,000 from the same period last year. The increase in franchise profit contribution is due to an increase in royalty fees partially offset by an increase in corporate expenses allocated to the franchise segment during the quarter.

      Interest Expense. We recorded net interest income of $25,000 for the second quarter of Fiscal 2005 as compared with net interest expense of $112,000 during the same period last year. We recorded net interest income mainly due to our higher average cash balance this quarter partially offset by higher interest expense. We had no advances under our Loan Agreement at any point during the second quarter of Fiscal 2005 and Fiscal 2004.

      Income Taxes. Income tax expense of $10.0 million, or 40.5% of pre-tax income, and $13.1 million, or 40.5% of pre-tax income, was recorded in the second quarter of Fiscal 2005 and Fiscal 2004, respectively.

      Net Income. As a result of the above factors, we recorded net income of $14.7 million, or $0.74 per diluted share, in the second quarter of Fiscal 2005, as compared with $19.3 million, or $0.98 per diluted share,

in the second quarter of Fiscal 2004. Weighted average diluted shares outstanding increased to 19.8 million in the second quarter of Fiscal 2005 from 19.6 million in the same period last year. This increase is due to stock option exercises and participation in the employee and management stock purchase plans since December 27, 2003.

      Retail. Net sales from Company-owned stores decreased 4.5% to $265.4 million for the six months ended January 1, 2005 from $277.9 million in the same period last year. The 4.5% decrease in net sales resulted from a same store net sales decrease of 5.4% which was partially offset by net sales from new stores. Same store sales for non-seasonal merchandise decreased 7.3% due to the ongoing transition of this merchandise category, and a 3.3% decrease in same store sales for seasonal merchandise, largely attributed to a decrease in Halloween and Christmas sales. Although the customer count in Company-owned stores, on a same store basis, decreased 6.4% during the six months ended January 1, 2005, the same store average net sale per retail transaction increased 1.0% reflecting a lower level of discounting and promotional markdown activity compared with the same time last year. Seven stores joined the same store sales group during the six months ended January 1, 2005. We opened one new store and closed two stores during the six-month s ended January 1, 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 34.9% for the six months ended January 1, 2005 compared with 35.6% for the same period last year. As shown in the table below, gross profit decreased $6.3 million to $92.6 million during the six months ended January 1, 2005 from $98.9 million in the same period last year.

      Store operating and selling expenses were 22.8% and 22.4% of net sales for the six months ended January 1, 2005 and December 27, 2003, respectively. As shown in the table below, store operating and selling expenses decreased $1.6 million, or 2.6%, to $60.5 million for the six months ended January 1, 2005 from $62.2 million in the same period last year. We incurred pre-opening expenses of $28,000 during the six months ended January 1, 2005 for one new store opened during such period, while we incurred $323,000 during the

same period last year for six new stores opened during such period and three stores that were opened later in Fiscal 2004. Pre-opening expenses include payroll and fringe benefits, as well as other operating costs.

      Company-owned store profit contribution as a percent of net sales was 12.1% for the six months ended January 1, 2005 compared with 13.2% in the same period last year. Company-owned store profit contribution decreased $4.6 million during the six months ended January 1, 2005 at $32.1 million compared with $36.7 million during the same period last year.

      General and administrative expenses were 7.7% and 5.6% of net sales during the six months ended January 1, 2005 and December 27, 2003, respectively. As shown in the table below, general and administrative expenses increased $4.7 million to $20.4 million for the six months ended January 1, 2005 from $15.7 million in the same period last year.

      Franchising. Franchise fees recognized on three store openings were $120,000 during the six months ended January 1, 2005, compared with $488,000 recognized on 13 store opening in the same period last year. Royalty fees increased 1.9% to $11.3 million for the six months ended January 1, 2005 from $11.1 million in the same period last year. This increase was primarily due to eight franchise store openings since the end of the same period last year and 12 stores that were required to pay royalties in the second quarter of Fiscal 2005 due to the end of a five year royalty free period (such stores were acquired from the Company in 1999 as part of its restructuring). This increase was partially offset by the same store sales decrease of 2.8% for the franchise stores during the six months ended January 1, 2005.

      Expenses attributable to the franchise segment increased 12.4% to $3.6 million for the six months ended January 1, 2005 from $3.2 million for the same period last year. As a percentage of franchise revenue, franchise expenses were 31.6% and 27.7% for the six months ended January 1, 2005 and December 27, 2003, respectively. This increase is primarily due to a larger corporate expense allocation.

      Franchise profit contribution decreased 6.6% to $7.8 million during the six months ended January 1, 2005 from $8.4 million in the same period last year. The decrease in franchise profit contribution is due to a decrease in franchise fees from 10 fewer store openings as well as an increase in corporate expense allocations that were allocated to the franchise segment during the six months ended January 1, 2005, partially offset by an increase in royalty fees.

      Interest Expense. Net interest expense decreased to $32,000 for the six months ended January 1, 2005 from $312,000 during the same period last year. This is mainly due to increased interest income from a higher average cash balance as well as overall lower interest expense. We had no advances under our Loan Agreement at any point during the six months ended January 1, 2005 compared with minimal average borrowings during the same period last year.

      Income Taxes. Income tax expense of $7.9 million, or 40.5% of pre-tax income, and $11.8 million, or 40.5% of pre-tax income, was recorded for the six months ended January 1, 2005 and December 27, 2003, respectively.

      Net Income. As a result of the above factors, we recorded net income of $11.6 million, or $0.59 per diluted share, for the six months ended January 1, 2005, as compared with $17.3 million, or $0.88 per diluted share, for the same period last year. Weighted average diluted shares outstanding increased to 19.8 million for the six months ended January 1, 2005 from 19.6 million in the same period last year due to the stock option exercises and participation in the employee and management stock purchase plans since December 27, 2003.

Liquidity and Capital Resources

      Our cash requirements have historically been for working capital, the opening of new stores, the improvement and expansion of existing facilities and the improvement of information systems. These cash requirements have been met through cash flow from operations and borrowings under our credit facilities. At January 1, 2005, working capital was $49.9 million compared with $35.6 million in the same period last year. Our ending cash and cash equivalents balance at January 1, 2005 was $49.2 million as compared with $20.6 million at December 27, 2003. A portion of our increased cash position resulted from a higher accounts payable balance relating to the timing of certain merchandise payments.

      Our current priorities for the use of cash are primarily for investments in value-added capital projects including, in particular, investments in technology to improve merchandising and distribution, cost reduction initiatives, improve efficiencies and assist each store to better serve its customers. Key initiatives include:

      We believe that the cash generated by operations and cash and cash equivalents, together with the borrowing availability under the Loan Agreement, will be sufficient to meet our working capital needs for the next twelve months, including investments made and expenses incurred in connection with systems development, the logistics initiative and store improvements. We expect to invest between $20 million and $25 million in capital projects during Fiscal 2005, in aggregate.

      We currently have no borrowings under our Loan Agreement and have minimal debt, which permits us to consider a wide variety of corporate initiatives intended to improve shareholder value, although there is no assurance that any specific initiative will be pursued or consummated.

Key Indicators of Liquidity and Capital Resources

      The following table sets forth key indicators of our liquidity and capital resources (in thousands):

      Operating Activities. For the six months ended January 1, 2005, cash provided by operating activities was $26.1 million compared with $34.7 million for the same period last year. The decrease in cash provided by operating activities was primarily attributable to lower net income, lower provision for income taxes, and cash payments and accruals related to management compensation and other current liabilities. The investment in inventory during this period was less than the corresponding increase in accounts payables, as our merchandise mix shifted to vendors with more favorable payment terms as well as the timing of certain merchandise payments at the end of the fiscal quarter.

      Investing Activities. Cash used in investing activities for the six months ended January 1, 2005 was $5.2 million compared with $3.5 million in the same period in last year. Cash used in investing activities for the six months ended January 1, 2005 was primarily attributable to leasehold improvements and furniture and fixtures of $2.6 million for the corporate headquarters and new and existing stores, development costs for our management information systems of $1.6 million and implementation costs of our logistics and franchise order management initiatives of $1.3 million, partially offset by $250,000 of proceeds from the closure of one store. Cash used in investing activities for the six months ended December 27, 2003 was primarily attributable to leasehold improvements and furniture and fixtures of $1.0 million for the corporate headquarters and new and existing stores and development costs for our management information systems of $2.5 million.

      Financing Activities. Cash provided by financing activities was $509,000 for the six months ended January 1, 2005 compared with cash used in financing activities of $14.0 million for the same period last year. We had no advances under our Loan Agreement at the end of the second quarter of Fiscal 2005. The increase in cash provided by financing activities is primarily due to a net payment of $11.2 million under the Loan Agreement during the six months ended December 27, 2003.

      Loan Agreement. At January 1, 2005 and January 27, 2005, we had no balance outstanding under the Loan Agreement. Under the terms of the Loan Agreement, we may from time to time borrow amounts based on a percentage of our eligible inventory and credit card receivables, up to a maximum of $65 million at any time outstanding, subject to certain borrowing conditions and customary sub-limits, reserves and other limitations. We have the option, based on our liquidity needs, to borrow at (i) the adjusted Eurodollar rate per annum plus the applicable margin, which is currently at 1.25% (which in the aggregate under the Loan Agreement was 3.65% for a 1 month term at January 1, 2005), or (ii) the prime rate per annum less the applicable margin, which is currently 0.25% (which in the aggregate under the Loan Agreement was 5.0% at January 1, 2005). The Loan Agreement matures on April 30, 2006, and borrowings are secured by a lien on substantially all of our assets. Based on a percentage of current eligible inventory and credit card receivables, we had $24.9 million available to be borrowed under the Loan Agreement at January 27, 2005.

      Warrants. There were no warrants exercised in Fiscal 2004 or during the first six months of Fiscal 2005. As of January 1, 2005, we had 2,496,000 warrants outstanding at an exercise price of $1.07 per share.

EBITDA (Earnings before interest, taxes, depreciation and amortization)

      Because we consider EBITDA useful as an operating measure, a reconciliation of EBITDA to net income follows for the periods indicated:

      Because we also consider EBITDA useful as a liquidity measure, we present the following reconciliation of EBITDA to our net cash provided by operating activities: