SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

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

For The Quarterly Period Ended October 30, 2004

Commission File Number 1-14770

PAYLESS SHOESOURCE, INC.

(785) 233-5171
(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 and (2) has been subject to such filing requirements for the past 90 days.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).

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

Common Stock, $.01 par value
68,093,770 shares as of December 6, 2004

Table of Contents

PART I — FINANCIAL INFORMATION

ITEM 1 — FINANCIAL STATEMENTS

PAYLESS SHOESOURCE, INC. AND SUBSIDIARIES

See Notes to Condensed Consolidated Financial Statements.

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PAYLESS SHOESOURCE, INC. AND SUBSIDIARIES

See Notes to Condensed Consolidated Financial Statements.

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PAYLESS SHOESOURCE, INC. AND SUBSIDIARIES

See Notes to Condensed Consolidated Financial Statements.

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PAYLESS SHOESOURCE, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

NOTE 1. INTERIM RESULTS. These unaudited Condensed Consolidated Financial Statements of Payless ShoeSource, Inc., a Delaware corporation, and subsidiaries (the “Company”) have been prepared in accordance with the instructions to Form 10-Q of the United States Securities and Exchange Commission and should be read in conjunction with the Notes to the Consolidated Financial Statements (pages 30-52) in the Company’s 2003 Annual Report on Form 10-K. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, the unaudited Condensed Consolidated Financial Statements are fairly presented and all adjustments (consisting only of normal recurring adjustments) necessary for a fair statement of the results for the interim periods have been included; however, certain items are included in these statements based upon estimates for the entire year. During 2003, the Company changed the reporting period for its operations in the Central American and South American Regions to use a December 31 year-end. The Central American Region is composed of operations in Costa Rica, the Dominican Republic, El Salvador, Guatemala, Honduras, Nicaragua, Panama and Trinidad & Tobago. The South American Region is composed of operations in Chile, Ecuador and Peru. The Company also has a 60-percent ownership interest in a Japanese joint venture. Japanese operations are reported on a one-month lag using a December 31 year-end. The effect of this one-month lag on the Company’s financial position and results of operations is not significant. The results for the three-month period and nine-month period ended October 30, 2004, are not necessarily indicative of the results that may be expected for the entire fiscal year ending January 29, 2005.

NOTE 2. STOCK-BASED COMPENSATION. The Company follows the disclosure provisions of Statement of Financial Accounting Standards (“SFAS”) No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure, an amendment of FASB Statement No. 123.” The Statement requires prominent disclosures in both annual and interim financial statements regarding the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company accounts for stock compensation awards under the intrinsic value method of Accounting Principles Board (“APB”) Opinion No. 25. APB Opinion No. 25 requires compensation cost to be recognized based on the excess, if any, between the quoted market price of the stock at the date of grant and the amount an employee must pay to acquire the stock. All options awarded under all of the Company’s plans are granted with an exercise price equal to the fair market value on the date of the grant.

SFAS 123, “Accounting for Stock-Based Compensation,” provides an alternative method of accounting for stock-based compensation, which establishes a fair value based method of accounting for employee stock options or similar equity instruments. The Company uses the Black-Scholes option pricing model to estimate the grant date fair value of its 1996 and later option grants. The fair value is recognized over the option vesting period. The following table presents the effect on net earnings (loss) and earnings (loss) per share had the Company adopted the fair value based method of accounting for stock-based compensation under SFAS No. 123, “Accounting for Stock-Based Compensation.”

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NOTE 3. INVENTORIES. Merchandise inventories in our stores are valued by the retail method and are stated at the lower of cost, determined using the first-in, first-out (FIFO) basis, or market. Prior to shipment to a specific store, inventories are valued at the lower of cost using the FIFO basis, or market. Raw materials of $8.3 million, $15.6 million and $19.5 million are included in inventories in the condensed consolidated balance sheet at October 30, 2004, November 1, 2003, and January 31, 2004, respectively.

NOTE 4. INTANGIBLES. The Company follows SFAS No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 142 requires that an intangible asset that is acquired other than by business combination shall be initially recognized and measured based on its fair value. This Statement also provides that goodwill and indefinitely-lived intangible assets should not be amortized, but shall be tested for impairment annually, or more frequently if circumstances indicate potential impairment, through a comparison of fair value to its carrying amount. Intangible assets with finite lives will continue to be amortized over their useful lives. No impairment loss was recorded during the first nine months of 2004 related to goodwill; however, as part of the $36.8 million restructuring charges discussed in Footnote 10, the Company reduced the carrying value of the favorable leases associated with the Payless stores to be closed by $1.9 million during the quarter ended July 31, 2004.

Favorable leases subject to amortization pursuant to SFAS 142 are as follows:

Amortization expense on favorable leases was as follows:

The Company expects annual amortization expense for favorable leases for the next five years to be as follows (dollars in millions):

NOTE 5. LONG-TERM DEBT AND LINE OF CREDIT. In January 2004, the Company replaced its $150 million senior secured revolving credit facility (the “Old Facility”) with a new $200 million senior secured revolving credit facility (the “New Facility”). Funds borrowed under the New Facility are secured by domestic merchandise inventory and receivables. The Company may borrow up to $200 million through the New Facility, subject to a sufficient borrowing base. The New Facility bears interest at the London Inter-bank Offered Rate (“LIBOR”), plus a variable margin of 1.25 percent to 2.0 percent, or the base rate as defined in the agreement governing the New Facility. The margin on the New Facility varies based upon certain borrowing levels specified in the agreement governing the New Facility. The variable interest rate including the applicable variable margin at October 30, 2004, was 3.4 percent. A monthly commitment fee of 0.30 percent per annum is payable on the unborrowed balance. The New Facility is scheduled to expire in January 2008, with a one-year extension to January 2009 at the Company’s option. No amounts were drawn on the New Facility as of October 30, 2004. Based on its borrowing base, the Company may borrow up to $200.0 million under its New Facility, less $17.4 million in outstanding letters of credit as of October 30, 2004.

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In July 2003, the Company sold $200.0 million of 8.25% Senior Subordinated Notes (the “Notes”) for $196.7 million, due 2013. The discount of $3.3 million is being amortized to interest expense over the life of the Notes. The Notes are guaranteed by all of the Company’s domestic subsidiaries. Interest on the Notes is payable semi-annually, beginning February 1, 2004. The Notes contain various covenants including those that may limit the Company’s ability to pay dividends, repurchase stock, accelerate the retirement of other subordinated debt or make certain investments. As of October 30, 2004, the Company was in compliance with all covenants. The proceeds of the Notes and additional general funds were used to repay the entire $200.0 million term loan portion of the Company’s Old Facility. As of October 30, 2004, the fair value of the Notes was $195.0 million based on recent trading activity of the Notes. On or after August 1, 2008, the Company may, on any one or more occasions, redeem all or a part of the Notes at the redemption prices set forth below, plus accrued and unpaid interest, if any, on the Notes redeemed, to the applicable redemption date:

NOTE 6. PENSION PLAN. The Company has a nonqualified, supplementary defined benefit plan for certain management employees. The plan is an unfunded, noncontributory plan and provides for benefits based upon years of service and cash compensation during employment.

Pension expense is based on information provided to an outside actuarial firm that uses assumptions to estimate the total benefits ultimately payable to management employees and allocates this cost to service periods. The actuarial assumptions used to calculate pension expense are reviewed annually for reasonableness.

The components of net periodic benefit costs for the plan were:

NOTE 7. INCOME TAXES. The Company’s effective income tax rate was 28.4 percent in the third quarter and 25.3 percent for the first nine months of 2004. The effective income tax rate of 28.4 percent for the third quarter includes an adjustment to reflect an effective tax rate of 25.3 percent for the first nine months of the year. The Company anticipates a tax benefit at the rate of 25.3 percent for the full fiscal year 2004. The Company’s effective income tax rate was 36.5 percent in the third quarter and first nine months of 2003.

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NOTE 8. COMPREHENSIVE INCOME (LOSS). The following table shows the computation of comprehensive income (loss):

The changes in the Company’s cumulative foreign currency translation adjustment were not adjusted for income taxes, as they relate to specific indefinite investments in foreign subsidiaries.

NOTE 9. EARNINGS PER SHARE. Basic earnings per share are computed by dividing net earnings by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share include the effect of exercise of stock options.

NOTE 10. RESTRUCTURING CHARGES. During the second quarter of 2004, the Company initiated a restructuring plan to build long-term shareowner value. Components of the restructuring plan include:

•		Exiting all 181 Parade stores, and related operations;
•		Exiting all 32 Payless ShoeSource stores in Chile and Peru;
•		The closing of approximately 260 Payless ShoeSource stores. These store closings differ from closings in the normal course of business in that they have longer remaining lease terms;
•		The reduction of wholesale businesses that provide no significant growth opportunity, and;
•		A comprehensive review of the Company’s expense structure and appropriate reductions to improve profitability.

As part of the restructuring, during the second quarter of 2004 the Company recorded a non-cash impairment charge of $36.7 million related to a reassessment of the carrying value of the long-lived assets associated with the 32 stores in Chile and Peru, the 181 Parade stores and the approximately 260 Payless stores to be closed. The impairment charge includes a $1.9 million reduction in the carrying value of favorable leases.

During the third quarter of 2004, the Company recorded $7.3 million in restructuring charges primarily related to severance costs, contract termination costs and the reduction in carrying value of assets. The Company eliminated approximately 200 management and administrative positions, closed 65 stores and began to liquidate inventory in its Payless and Parade stores identified for closing. In conjunction with the liquidation, the Company recorded $0.4 million in inventory markdowns to reflect inventory at lower of cost or market. Such markdowns are reflected in cost of sales in the condensed consolidated statement of earnings (loss). Third-party liquidation sales are recognized at the time the sale is made to the customer, are calculated based upon contractually guaranteed amounts pursuant to our agreements with liquidators and are net of associated fees. On October 27, 2004, the Company entered into an agreement to transfer ownership of its Peruvian entity and related operations and liabilities to Orion Investment Capital Inc. (“Orion”), an entity comprised of some owners of the Company’s South American joint venture partner, effective November 15, 2004, in consideration of Orion assuming the liabilities of the entity. In conjunction with this transaction, the Company recorded approximately $1 million of reductions in the carrying value of assets during the third quarter.

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The Company estimates that the total charge related to the restructuring will be in the range of $77 to $90 million, consisting of contract termination costs of $31 to $44 million, asset impairments and net disposal losses of approximately $36 million, employee severance costs of approximately $9 million and other costs of approximately $1 million. The cash component of the total expected charge of $77 to $90 million is expected to be approximately $40 to $53 million, not including the related tax benefit. The Company is in the process of negotiating contract terminations, and the ultimate cost related to these terminations will depend upon the results of the negotiations. The Company expects to incur substantially all such charges in 2004.

The significant components of the restructuring charge incurred to date are summarized as follows:

The status of the restructuring-related liabilities, which are included in accrued expenses in the condensed consolidated balances sheets, are summarized below:

In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the fair value of the long-lived assets evaluated for recoverability was determined using the present value of estimated future cash flows. In accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” employee severance, contract termination and other exit costs are recorded at their fair value when they are incurred.

The Payless and Parade stores located in Chile, Peru, Puerto Rico and Canada are components of the Payless International segment. The Parade and Payless stores located in the United States are components of the Payless Domestic segment. The Company estimates the total restructuring charge related to the Payless Domestic segment to be between $64 and $73 million, and the total restructuring charge related to the Payless International segment to be between $13 million and $17 million. A summary of the restructuring charge by segment is as follows:

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NOTE 11. SEGMENT REPORTING. The Company and its subsidiaries are principally engaged in the operation of retail locations offering family footwear and accessories. The Company operates its business in two reportable business segments: Payless Domestic and Payless International. These segments have been determined based on internal management reporting and management responsibilities. The Payless Domestic segment includes retail operations in the United States, Guam and Saipan and sourcing operations. The Payless International segment includes retail operations in Canada, the South American Region, the Central American Region, Puerto Rico, the U.S. Virgin Islands and operations in Japan. The Company’s operations in its Central American Region, its South American Region and Japan are operated as joint ventures in which the Company maintains a 60-percent ownership interest. Minority interest represents the Company’s joint venture partners’ share of net earnings or losses on applicable international operations. Certain management costs for services performed by Payless Domestic and certain royalty fees and sourcing fees charged by Payless Domestic are allocated to the Payless International segment. These total costs and fees amounted to $5.9 million during the third quarter of 2004 and $4.3 million during the same period in 2003. For the first nine months of 2004, these total costs and fees amounted to $15.4 million, compared with $13.3 million for the first nine months of 2003. The Company’s reporting period for its operations in the South American Region, the Central American Region and Japan is a December 31 year-end. The effect of this one-month lag on the Company’s financial position and results of operations is not significant. Information on the segments is as follows:

Total assets for the Payless Domestic segment include $5.9 million in goodwill as of October 30, 2004, and November 1, 2003.

NOTE 12. RECLASSIFICATIONS. Certain reclassifications have been made to prior years’ balances to conform to the current year presentation.

NOTE 13. FOREIGN CURRENCY TRANSLATION. Local currencies are the functional currencies for all subsidiaries. Accordingly, assets and liabilities of foreign subsidiaries are translated at the rate of exchange at the balance sheet date. Adjustments from the translation process are accumulated as part of other comprehensive income (loss) and are included as a separate component of shareowners’ equity. The changes in foreign currency translation adjustments were not adjusted for income taxes since they relate to indefinite term investments in non-United States subsidiaries. Income and expense items of these subsidiaries are translated at average rates of exchange.

NOTE 14. CONTINGENCIES. On or about December 20, 2001, a First Amended Complaint was filed against the Company in the U.S. District Court for the District of Oregon, captioned Adidas America, Inc. and Adidas-Salomon AG v. Payless ShoeSource, Inc. The First Amended Complaint seeks injunctive relief and unspecified monetary damages for trademark and trade dress infringement, unfair competition, deceptive trade practices and breach of contract. The Company believes it has meritorious defenses to claims asserted in the lawsuit and has filed an answer and a motion for summary judgment which the court granted in part. An estimate of the possible loss, if any, or the range of loss cannot be made.

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On or about January 20, 2000, a complaint was filed against the Company in the U.S. District Court for the District of New Hampshire, captioned Howard J. Dananberg, D.P.M. v. Payless ShoeSource, Inc. The Complaint seeks injunctive relief, unspecified treble monetary damages, attorneys’ fees, interest and costs for patent infringement. The Company believes it has meritorious defenses to claims asserted in the lawsuit. An estimate of the possible loss, if any, or the range of loss cannot be made.

NOTE 15. IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS. In December 2003, the FASB issued FASB Interpretation No. 46R, “Consolidation of Variable Interest Entities and Interpretation of ARB No. 51.” This interpretation, which replaces FASB Interpretation No. 46, “Consolidation of Variable Interest Entities,” clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support. This interpretation is required in financial statements for periods ending after March 15, 2004, for those companies that have yet to adopt the provisions of FIN 46. The application of FASB Interpretation No. 46R did not have a material impact on the Company’s condensed consolidated financial statements.

In January 2003, the FASB issued SFAS 132 (revised 2003), “Employers’ Disclosures about Pensions and Other Postretirement Benefits,” which retains all of the disclosures that are required by SFAS 132 and includes several additional disclosures. It also amends APB Opinion 28, “Interim Financial Reporting,” to require certain disclosures about pension and other postretirement benefit plans in interim financial statements. The provisions of SFAS 132 (revised 2003) are effective for fiscal years ending after June 15, 2004. The interim disclosure provisions are effective for interim periods beginning after December 15, 2003. The Company adopted the provisions of SFAS 132 (revised 2003) in the first quarter of fiscal year 2004.

NOTE 16. SUBSIDIARY GUARANTORS OF SENIOR NOTES — CONDENSED CONSOLIDATING FINANCIAL INFORMATION. The Company has issued Notes guaranteed by all of its domestic subsidiaries (the “Guarantor Subsidiaries”). The Guarantor Subsidiaries are direct or indirect wholly owned domestic subsidiaries of the Company. The guarantees are full and unconditional, to the extent allowed by law, and joint and several.

The following supplemental financial information sets forth, on a consolidating basis, the condensed statements of earnings (loss) and cash flows for Payless ShoeSource, Inc., a Delaware corporation (the “Parent Company”), for the Guarantor Subsidiaries and for the Company’s non-guarantor subsidiaries (the “Non-guarantor Subsidiaries”) and the Company for the thirteen-week and thirty-nine-week periods ended October 30, 2004, and November 1, 2003, and the related condensed consolidating balanced sheets as of October 30, 2004, November 1, 2003, and January 31, 2004. The intercompany investment for each subsidiary is recorded by its parent in Other Assets.

The Non-guarantor Subsidiaries are made up of the Company’s retail operations in the Central American and South American Regions, Canada, Saipan, and Puerto Rico, operations in Japan and the Company’s sourcing organization in Hong Kong, Taiwan, China, Indonesia and Brazil. During 2003, the Company changed the reporting period for its operations in the Central American and South American Regions to use a December 31 year-end. Operations in the Central American Region, the South American Region and Japan are included in our results on a one-month lag relative to results from other regions. The effect of this one-month lag on our financial position and results of operations is not significant.

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CONDENSED CONSOLIDATING BALANCE SHEET
(UNAUDITED)
As of October 30, 2004

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CONDENSED CONSOLIDATING BALANCE SHEET
(UNAUDITED)
As of November 1, 2003

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CONDENSED CONSOLIDATING BALANCE SHEET
(UNAUDITED)
As of January 31, 2004

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CONDENSED CONSOLIDATING STATEMENT OF EARNINGS (LOSS)
(UNAUDITED)
For the Thirteen Weeks Ended October 30, 2004

CONDENSED CONSOLIDATING STATEMENT OF EARNINGS (LOSS)
(UNAUDITED)
For the Thirteen Weeks Ended November 1, 2003

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CONDENSED CONSOLIDATING STATEMENT OF EARNINGS (LOSS)
(UNAUDITED)
For the Thirty-nine Weeks Ended October 30, 2004