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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

OF THE SECURITIES EXCHANGE ACT OF 1934

SHOE PAVILION, INC.

(Exact name of registrant as specified in its charter)

3200-F Regatta Boulevard

Richmond, California 94804

(Address of principal executive offices) (Zip Code)

Telephone Number: (510) 970-9775

Securities Registered Pursuant to Section 12(b) of the Act:

Securities Registered Pursuant to Section 12(g) of the Act:

Common Stock

(Title of Class)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x  No  ¨

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

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

At March 18, 2003 the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was approximately $2,639,000.

At March 18, 2003 the number of shares outstanding of registrant’s common stock was 6,800,000.

DOCUMENTS INCORPORATED BY REFERENCE

Definitive Proxy Statement for the Company’s 2002 Annual Meeting of Stockholders—Part III of this Form 10-K.

Table of Contents

Shoe Pavilion, Inc.

Index to Annual Report on Form 10-K

For the year ended December 28, 2002

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PART I

Item 1—Business

General

Shoe Pavilion, Inc. is the largest independent off-price footwear retailer on the West Coast that offers a broad selection of women’s, men’s and children’s designer label and name brand merchandise. The Company was among the first footwear retailers on the West Coast to expand the off-price concept into the designer and name brand footwear market. As of December 28, 2002 the Company operated 88 retail stores, including an internet store, in California, Washington and Oregon under the trade name Shoe Pavilion.

In July 1999, the Company entered into a licensing agreement to operate the shoe department of Gordmans, Inc. (formerly Richman Gordman ½ Price Stores, Inc.) department stores located in the Midwest. Pursuant to notification from Gordmans on December 28, 2001 the license agreement was scheduled to expire effective June 29, 2002. On June 14, 2002, the license agreement with Gordmans department stores was terminated (due to Gordmans default) and the Company discontinued operating all 40 of the licensed shoe departments in Gordmans department stores. Certain terms and conditions of the license agreement are the subject of a lawsuit and counterclaim filed by the Company against Gordmans. See “Item 3 Legal Proceedings.”

The Company offers quality designer and name brand footwear such as Dr, Marten, Fila, Ralph Lauren, Rockport, Steve Madden, Vans and Via Spiga, typically at 30% to 70% below regular department store prices. Such price discounts appeal to value-oriented consumers seeking quality brand name footwear not typically found at other off-price retailers or mass merchandisers. The Company is able to offer lower prices by (i) selectively purchasing from manufacturers at significant discounts, large blocks of production over-runs, over-orders, mid- and late-season deliveries and last season’s stock, (ii) sourcing in-season name brand and branded design merchandise directly from factories in Italy, Brazil and China and (iii) negotiating favorable prices with manufacturers by ordering merchandise during off-peak production periods and taking delivery. During 2002, the Company purchased footwear merchandise from over 100 domestic and international vendors, independent resellers and manufacturers that had excess inventory for sale.

The Company’s stores utilize a self-service format that allows inventory to be stored directly under a displayed shoe, thereby eliminating the need for a stockroom and significantly increasing retail floor space. The functionality and simplicity of this format enable flexible store layouts that can be easily reconfigured to accommodate a new mix of merchandise. Moreover, this format allows customers to locate all available sizes of a particular shoe and to try them on for comfort and fit without a salesperson’s assistance, thereby reducing in-store staffing needs and allowing customers to make independent purchasing decisions.

Shoe Pavilion is a standardized concept that offers a bright, clean, low maintenance and functional shopping environment to customers interested in purchasing quality men’s, women’s and children’s value priced footwear. The Company’s stores are strategically located in strip malls, outlet centers and downtown locations, frequently in close proximity to other off-price apparel retailers that attract similar customers. Shoe Pavilion stores average approximately 7,800 square feet. The Company opened, net of closures, 5 retail stores in 2002, 3 in 2001 and 2 in 2000. The Company closed all 40 of its licensed shoe departments in 2002, including 2 it opened in 2002 and opened 2 in 2001 and 3 in 2000. During 2003, the Company intends to open approximately 3 to 5 new stores, primarily in California.

The Company was incorporated in Delaware in November 1997 and is the successor to Shoe Pavilion Corporation (formerly Shoe Inn, Inc.), which was incorporated in Washington in 1983. The Company’s executive offices are located at 3200-F Regatta Boulevard, Richmond, California 94804, and its telephone number is (510) 970-9775.

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Operating Strategy

The Company’s objective is to be the leading off-price retailer of designer label and name brand footwear in each of the markets it serves. The operating strategy is designed to allow the Company to offer its customers quality footwear typically at 30% to 70% below department store prices for the same shoes. The following summarizes key elements of the Company’s operating strategy:

Growth Strategy

Since opening its first store in 1979 in Washington, the Company has expanded to 88 stores, including its internet store. The Company intends to continue to expand by opening new stores and increasing comparable store sales.

Continue New Store Openings.    The Company intends to increase its presence in its current markets and to enter new markets by selectively opening new stores, which can be served by the Company’s business support infrastructure. When entering a new market, the Company prefers to open multiple stores, thereby creating an immediate market presence and enabling television advertising costs to be spread economically across a number of stores. The Company opened 10 stores, including its internet store, and 2 licensed shoe departments in 2002, 6 stores and 2 licensed shoe departments in 2001 and 7 stores and 3 licensed shoe departments in 2000. The Company closed 5 stores and 40 licensed shoe departments in 2002, 3 stores in 2001 and 5 stores in 2000.

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During 2003, the Company intends to open 3 to 5 new stores in California. Management believes that new store openings in the Company’s current markets will further increase name recognition, which, in turn, will facilitate expansion into new markets.

The Company’s ability to execute its operating and growth strategy is subject to numerous risks and uncertainties. Also, certain events, such as local economic downturns or the uncertainties related to the ongoing conflict in the Middle East, are beyond the control of management. Consequently, there can be no assurance that the Company will be successful in implementing its strategy or that its strategy, even if implemented, will result in the achievement of the Company’s objectives.

Merchandising

Unlike deep-discount retailers, Shoe Pavilion offers high quality merchandise and a consistent selection of name brand dress and casual shoes for men, women and children. List prices generally range between $19.99 and $69.99 for women’s shoes, between $39.99 and $99.99 for men’s shoes and between $19.99 and $29.99 for children’s shoes. The principal categories of footwear offered by Shoe Pavilion stores, and selected brands for each, are summarized in the following table:

Site Selection, Opening Costs and Leases

The Company uses an exclusive broker on the West Coast to identify potential retail sites. Before entering a new market, management reviews detailed reports on demographics; spending, traffic and consumption patterns; and other site and market related data. As of December 28, 2002, 44 of the Company’s stores were located in strip malls, 11 were located in outlet centers, 9 were located in free standing stores and 23 were located in other types of facilities. The Company also operates an online store at Shoe Pavilion.com.

Opening costs for stores are typically minimal, excluding the initial stocking of inventory. The Company estimates that its total capital requirements to open a typical new store average $370,000, consisting of approximately $340,000 for inventory and $30,000 for fixtures and equipment, excluding leasehold improvements which are occasionally paid for by the landlord allowances. Costs vary from store to store depending on, among other things, the location, size, property condition, and the tenant improvement package offered by the landlord. The Company does not own any of its real estate.

Sourcing and Purchasing

Vendors.    During 2002, the Company purchased its inventory from over 100 domestic and international vendors and independent resellers. In 2002, the Company’s top ten suppliers accounted for

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approximately 28% of its inventory purchases. No vendor accounted for more than 10% of total inventory purchases in 2002. The Company purchases from its suppliers on an order-by-order basis and has no long-term purchase contracts or other contractual assurances of continued supply or pricing. Since the Company has locations in a number of markets along the West Coast, Shoe Pavilion can accommodate and distribute a wide variety of merchandise that meets the needs of customers in different geographic areas. Management believes that the strength and variety of its supplier network mitigates much of the Company’s exposure to inventory supply risks. See “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Factors Affecting Financial Performance—Inventory and Sourcing Risk.”

Direct Sourcing.    The Company purchases in-season name brand and branded design merchandise directly from factories in Italy, Brazil and China. These purchases include both branded and non-branded goods and provide a consistent source of in-season merchandise. The Company purchases from its manufacturing sources on an order-by-order basis and has no long-term purchase contracts or other contractual assurances of continued supply or pricing. See “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Factors Affecting Financial Performance—International Purchasing.”

Advertising

The Company believes that television advertising benefits all stores in a common viewing market. In 2002 the Company spent 4.1% of its net sales on advertising or $3.5 million. In 2001 the Company spent 3.2% of its net sales on advertising or $2.8 million. In 2000 the amount spent on advertising was 4.7% of net sales, or $4.3 million. The Company believes that advertising costs for a particular market will be more effectively and economically leveraged as the number of stores increases in that market. The Company occasionally uses print advertising, usually at the time of a new store opening; however, it has found print advertising to be less effective than television advertising. Shoe Pavilion’s signage is consistent at all of its locations, with highly visible signage at the front and, when appropriate, rear of the store.

Merchandise Distribution

During the year ended December 29, 2001 the Company’s corporate offices and distribution facility were located in a 92,000 square foot facility in Richmond, California, which the Company occupied under a lease that expired in February 2002. The Company decided not to renew the lease and instead engaged a third party that began providing the warehousing and distribution services for the Company in February 2002. The Company continues to lease its corporate office space in Richmond, California on a month to month basis.

Information Systems

During 1999, the Company completed an upgrade of its information systems on an enterprise-wide basis, including all critical areas of corporate office, network infrastructure and point of sale (POS). This fully integrated upgrade, uses an IBM AS 400 that is reliable and scalable, allowing simple upgrades of processing power as the business grows. In addition, the corporate network infrastructure was upgraded to a Windows NT environment with standardized workstations and a common set of desktop applications that may be used throughout the Company. This upgrade provided a stable networking environment as well as a foundation for future growth.

Competition

The retail footwear market is highly competitive, and the Company expects the level of competition to increase. The Company competes with off-price and discount retailers (e.g., Nordstrom Rack, Payless ShoeSource, Ross Dress for Less and Famous Footwear), branded retail outlets (e.g., Nine West), national retail stores (e.g., DSW Shoe Warehouse, Nordstrom, Marshalls, Macy’s, Sears, J.C. Penney, Loehmann’s, Robinsons-May and Mervyn’s), traditional shoe stores and mass merchants. Many of these competitors have stores in the markets in which the Company now operates and in which it plans to expand. Additionally, many of the competitors are larger and have more resources than the Company.

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Employees

As of December 28, 2002, the Company had approximately 275 full-time employees and 235 part-time employees. The number of part-time employees fluctuates depending upon seasonal needs.

Executive Officers

Certain information regarding the executive officers of the Company is set forth below:

Dmitry Beinus has served as Chairman of the Board, President and Chief Executive Officer of the Company since founding the Company in 1979. From 1976 to 1978, Mr. Beinus was employed in the shoe department of Nordstrom, Inc.

Robert R. Hall has served as Vice President and Chief Operating Officer of the Company since January 1997. Mr. Hall joined the Company as a Regional Manager in 1990, and has held various positions within the Company including Operations Manager and Vice President of Merchandising.

John D. Hellmann has served as Vice President of Finance and Chief Financial Officer of the Company since June 2000. From September 1995 until June 2000, Mr. Hellmann served as Vice President and Chief Financial Officer of The Lamaur Corporation, a manufacturer and wholesaler of hair care products. Mr. Hellmann is a Certified Public Accountant.

The Company’s executive officers serve at the discretion of the Board of Directors. There is no family relationship between any of the Company’s executive officers or between any executive officer and any of the Company’s directors.

Item 2— Properties

As of December 28, 2002 the Company’s corporate offices were located in a 5,600 square foot facility in Richmond, California, which the Company leases on a month to month basis. As of December 28, 2002 the Company’s 87 stores, excluding its internet store, occupied an aggregate of approximately 683,000 square feet of space. The Company leases all of its stores, with leases expiring between 2003 and 2013. The Company has options to renew most of its leases.

Store Locations

As of December 28, 2002, the Company operated 88 retail stores, including its internet store, in the states of California, Washington and Oregon. Pursuant to notification from Gordmans on December 28, 2001 the license agreement was scheduled to expire effective June 29, 2002. On June 14, 2002, the license agreement with Gordmans department was terminated (due to Gordmans default) and the Company discontinued operating all 40 of the licensed shoe departments. The number of stores in each geographic area is set forth below:

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In June 2002 the Company ceased operations at all 40 of its licensed shoe departments.

Item 3— Legal Proceedings

On May 31, 2002 the Company filed a lawsuit against Gordmans department stores in Douglas County, Nebraska. In the suit the Company claims that Gordmans violated the terms of the license agreement the parties entered into in July 1999 by improperly withholding approximately $474,000 due the Company from shoe department sales and by making unauthorized markdowns and discounts of approximately $384,000. The Company is seeking $858,000, which includes the $474,000 withheld by Gordmans.

In a counterclaim against the Company, Gordmans asserts that it is entitled to $546,000 because the Company violated the license agreement by engaging in a liquidation sale, failed to maintain adequate inventory and did not perform required advertising. The violations alleged in the counterclaim apparently form the basis for Gordmans decision to withhold the $474,000 due the Company.

The suit is in its early stages and discovery has begun. Management believes that the ultimate resolution of this matter will not have a material adverse impact on the Company’s financial condition.

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

None.

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PART II

Item 5— Market for the Registrant’s Common Equity and Related Stockholder Matters

The common stock of the Company is traded on the Nasdaq SmallCap Market^® under the symbol SHOE. The following table sets forth, for the periods indicated, the highest and lowest closing sale prices for the common stock, as reported by the Nasdaq Market^®.

After the Company went public its common stock was listed on the Nasdaq National Market. On March 1, 2001 the Company received a Nasdaq Staff Determination indicating that the Company had failed to comply with the Minimum Market Value of Public Float requirement for continued listing and that its shares were subject to delisting from The Nasdaq National Market. On April 6, 2001 the Company participated in a hearing with the Nasdaq Listing Qualifications Panel to appeal the Nasdaq Staff Determination. On April 30, 2001 the Company was notified that the Panel determined to transfer the listing of the Company’s securities to The Nasdaq SmallCap Market. On May 3, 2001 the listing of Company’s securities was transferred from The Nasdaq National Market to The Nasdaq SmallCap Market. The Company’s securities continue to be listed under the symbol SHOE.

As of December 28, 2002, there were 18 holders of record of the Company’s common stock.

From August 1988 through February 1998, the Company made distributions to its sole stockholder primarily to allow the stockholder to pay taxes on earnings of the Company included or includable in the taxable income of the stockholder as a result of the Company’s S corporation status. Upon completion of its initial public offering in February 1998, the Company made an S corporation distribution in the amount of $7.8 million to its previous sole stockholder, which approximately equaled the estimated earned and previously undistributed taxable S corporation income of the Company through the day preceding the termination date of its S corporation status. Except as mentioned in the previous sentences, the Company has not paid any cash dividends in the past. The Company currently intends to retain any earnings for use in its business and does not anticipate paying any cash dividends on its common stock in the foreseeable future. In addition, the Company’s line of credit restricts the Company’s ability to pay dividends. See Note 3 of Notes to Consolidated Financial Statements.

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Item 6—Selected Financial Data

The selected consolidated financial and operating data set forth below should be read in conjunction with “Item 8—Financial Statements and Supplementary Data—Consolidated Financial Statements of the Company and related Notes thereto” and “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations” included herein.

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Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations

The statements contained in this Form 10-K which are not historical facts are forward-looking statements that are subject to risks and uncertainties and actual results could differ materially from those set forth in or implied by forward-looking statements. Factors that could cause or contribute to such differences include those discussed in the Company’s filings with the Securities and Exchange Commission, including, without limitation, the factors discussed in this Form 10-K under the captions—“Factors Affecting Financial Performance” and “Liquidity and Capital Resources,” as well as those discussed elsewhere in this Form 10-K.

Overview

Shoe Pavilion is the largest independent off-price footwear retailer on the West Coast that offers a broad selection of women’s, men’s and children’s designer label and name brand merchandise. The Company operated 88 retail stores, including an internet store, in California, Washington and Oregon under the trade name Shoe Pavilion, as of December 28, 2002. The Company operated 83 retail stores as of December 29, 2001.

In July 1999, the Company entered into a licensing agreement to operate the shoe departments of Gordmans, Inc. (formerly Richman Gordman ½ Price Stores, Inc.) department stores located in the Midwest. Pursuant to notification from Gordmans on December 28, 2001 the license agreement was scheduled to expire effective June 29, 2002. On June 14, 2002, the license agreement with Gordmans department stores was terminated (due to Gordmans default) and the Company discontinued operating all 40 of the licensed shoe departments in Gordmans department stores. The Company operated 38 shoe departments of Gordmans, Inc. at December 29, 2001.

The Company opened, net of closures, 5 retail stores in 2002, 3 in 2001 and 2 in 2000. The Company closed 40 licensed shoe departments in 2002, including 2 it had opened in 2002, and opened 2 in 2001 and 3 in 2000. During 2003, the Company intends to open approximately 3 to 5 new stores, primarily in California.

The Company’s growth in net sales historically has resulted primarily from the opening of new stores. The Company expects that the primary source of future sales growth will continue to be new store openings. Because the Company’s comparable store sales have fluctuated widely, the Company does not expect that comparable store sales will contribute significantly to future growth in net sales. The Company defines comparable stores as those stores that have been open for at least 14 consecutive months. Stores open less than 14 consecutive months are treated as new stores, and stores closed during the period are excluded from comparable store sales. The Company’s comparable store net sales decreased 1.0% in 2002, decreased 5.9% in 2001 and increased 9.4% in 2000. Net sales will be negatively impacted as the Company no longer operates the 40 licensed shoe departments. Net sales generated from the licensed shoe departments were $5.0 million, $14.5 million and $14.8 million for the years ended December 28, 2002, December 29, 2001 and December 30, 2000, respectively. In addition, these stores generated a store operating contribution before overhead, distribution costs, interest and taxes of approximately $.7 million, $2.9 million and $2.3 million for the years ended December 28, 2002, December 29, 2001 and December 30, 2000, respectively. The Company does not allocate overhead, distribution costs, interest or taxes to stores. The majority of the overhead costs, which consist of costs such as merchandising, accounting, information systems, rent and insurance, are shared expenses of the Shoe Pavilion stores and the licensed shoe departments.

The Company seeks to acquire footwear merchandise on favorable financing terms and in quantities large enough to support future growth. This strategy causes an increase in inventory levels at various times throughout the year. As a result, similar to other off-price retailers, the Company’s inventory turnover rates are typically less than full-price retailers.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with generally accepted accounting principles requires the appropriate application of certain accounting policies, many of which require management to make estimates

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and assumptions about future events and their impact on amounts reported in the Company’s financial statements and related notes. Since future events and their impact cannot be determined with certainty, the actual results will inevitably differ from the Company’s estimates. Such differences could be material to the financial statements.

Management believes that the Company’s application of accounting policies, and the estimates inherently required therein, are reasonable. These accounting policies and estimates are constantly reevaluated, and adjustments are made when facts and circumstances dictate a change. Historically, management has found the Company’s application of accounting policies to be appropriate, and actual results have not differed materially from those determined using necessary estimates.

The Company’s accounting policies are more fully described in Note 2 to the financial statements, located elsewhere in this Form 10-K. The Company has identified certain critical accounting policies which are described below.

Allowance for Doubtful Accounts.    The Company maintains an allowance for doubtful accounts on its accounts receivable balances for estimated losses projected to result from its debtors inability to make the required payments. The estimated allowance is based upon specific indentification. If the financial condition of the debtor was to deteriorate additional allowances may be required.

Merchandise inventory.    Merchandise inventory is carried at the lower of average cost or market. The Company makes certain assumptions to adjust inventory based on historical experience and current information in order to assess that inventory is recorded properly at the lower of cost or market. These assumptions can have a significant impact on current and future operating results and financial position.

Fixed assets.    In evaluating the fair value and future benefits of fixed assets, the Company performs an analysis of the anticipated undiscounted future net cash flows of the related fixed assets and reduces their carrying value by the excess, if any, of the result of such calculation. The Company believes at this time that the fixed assets’ carrying values and useful lives continue to be appropriate.

Results of Operations

The following table sets forth, for the periods indicated, the relative percentages that certain income and expense items bear to net sales:

2002 Compared with 2001

Net Sales.    Net sales decreased 4.9% to $83.8 million for 2002 from net sales of $88.1 million for 2001. The decrease in net sales was primarily attributable to the discontinuation of the Gordmans licensed shoe departments in June 2002 and to the 1.0% decrease in comparable store net sales. The decline in net sales was partially offset by the effect of a full year of sales of 3 retail stores opened in 2001 (net of 3 closed) and the net sales generated from 5 retail stores opened in 2002 (net of 5 closed). Net sales from the Company’s retail stores and Gordmans licensed shoe departments were $78.8 million and $5.0 million, respectively, for 2002 compared to $73.6 million and $14.5 million, respectively, for 2001. Future net sales will be impacted as the Company no longer operates the licensed shoe departments.

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Gross Profit.    Cost of sales includes landed merchandise and occupancy costs and the license fee paid to Gordmans for the licensed shoe departments. Gross profit decreased 3.5% to $26.5 million in 2002 from $27.4 million in 2001. Gross profit as a percentage of net sales increased to 31.6% in 2002 from 31.1% in 2001. This increase in gross profit as a percentage of net sales for 2002 was principally attributable to lower merchandise costs partially offset by an increase in occupancy costs as a percentage of sales. The increase in occupancy costs as a percentage of net sales was due in part to a change in the percentage of net sales generated from the retail stores versus the licensed shoe departments. Occupancy costs as a percentage of net sales are higher in the retail stores compared to the licensed shoe departments. In 2002 the retail stores net sales were 94.1% of total net sales compared to 83.5% in 2001. Net sales in the licensed shoe departments were 5.9% of net sales in 2002 compared to 16.5% in 2001.

Selling Expenses.    Selling expenses consist primarily of sales payroll and related costs, advertising, freight to stores and credit card processing fees. Selling expenses increased 4.3% to $18.4 million in 2002 from $17.6 million in 2001 and increased as a percentage of net sales to 21.9% in 2002 from 20.0% in 2001. The increase in selling expenses in 2002 was principally due to increased advertising of approximately $.7 million. Advertising as a percentage of net sales increased to 4.1% in 2002 compared to 3.2% in 2001. The Company spent more on advertising in 2002 in an effort to increase sales.

General and Administrative Expenses.    General and administrative expenses consist primarily of corporate and administrative expenses, including payroll, employee benefits, warehousing costs, legal fees and utilities. General and administrative expenses increased 13.6% to $7.8 million in 2002 from $6.9 million in 2001. This increase was principally due to an increase in legal fees and costs of approximately $500,000 incurred as part of the settlement of a class action suit filed against the Company as well as the increase in utility costs, primarily related to the new stores opened.

Interest Expense.    Interest expense decreased 77.3% to $.2 million in 2002 from $.7 million in 2001. This decrease was primarily attributable to lower average borrowings and a lower average interest rate on the Company’s revolving line of credit. The weighted average interest on the Company’s borrowings in 2002 decreased to 3.2 % from 6.4% in 2001.

Income Taxes.    The effective tax rate in 2002 decreased to 27.3% compared to 38.0% in 2001. The decrease in the effective tax rate in 2002 is primarily due to the utilization of certain state tax credits in 2002.

2001 Compared with 2000

Net Sales.    Net sales decreased 3.2% to $88.1 million for 2001 from net sales of $91.1 million for 2000. The decrease in net sales is principally attributable to the decline in comparable store net sales of 5.9% or $4.6 million. The decline in comparable store net sales was partially offset by net sales generated from five stores opened in 2001 (net of three closed) and the effect of a full year of sales for five stores opened in 2000 (net of five closed). On June 14, 2002, the license agreement with Gordmans department stores was terminated (due to Gordmans default) and the Company discontinued operating the licensed shoe departments in Gordmans department stores. Net sales in 2002 were impacted by the effects of the termination of the license agreement with Gordmans department stores. Net sales for the licensed shoe departments in 2001 were $14.5 million compared to $14.8 million in 2000.

Gross Profit.    Cost of sales includes landed merchandise and occupancy costs and the license fee paid to Gordmans for the licensed shoe departments. Gross profit decreased 6.6% to $27.4 million from $29.4 million in 2000. Gross profit as a percentage of net sales decreased to 31.1% in 2001 from 32.3% in 2000, principally due to the increase in occupancy costs of 1.6% as a percentage of net sales. This increase in occupancy costs as a percentage of net sales was primarily driven by the decrease in comparable store net sales in 2001.

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Selling Expenses.    Selling expenses decreased 8.0% to $17.6 million in 2001 from $19.1 million in 2000 and decreased as a percentage of net sales to 20.0% in 2001 from 21.0% in 2000. The decrease in selling expenses was principally due to a $1.5 million reduction in advertising in 2001 compared to 2000. Advertising costs for 2001 were $2.8 million or 3.2% of net sales compared to $4.3 million or 4.7% of net sales in 2000. This was in part due to a decrease in advertising for the licensed shoe departments of approximately $.8 million.

General and Administrative Expenses.    General and administrative expenses consist primarily of corporate and administrative expenses, including payroll, employee benefits and warehousing costs. General and administrative expenses remained relatively unchanged at $6.9 million or 7.8% of sales compared with $7.0 million or 7.7% for 2000.

Interest Expense.    Interest expense decreased 39.2% to $.7 million in 2001 from $1.1 million in 2000. This decrease was primarily attributable to a lower average interest rate and reduced average borrowings on the Company’s revolving line of credit. The weighted average interest on the Company’s borrowings in 2001 decreased to 6.4% from 8.4% in 2000. The Company was able to reduce its average borrowings primarily through funds generated from the $6.8 million reduction in inventory during 2001.

Income Taxes.    The effective tax rate in 2001 decreased to 38.0% compared to 39.9% in 2000. The decrease in the effective tax rate in 2001 was primarily due to the benefit of certain state tax credits realized in 2001.

Inflation

The Company does not believe that inflation has had a material impact on its results of operations. There can be no assurance, however, that inflation will not have such an effect in future periods.

Liquidity and Capital Resources

Historically, the Company has funded its cash requirements primarily through cash flows from operations and borrowings under its credit facility. Net cash provided (used) by operating activities was ($3.1) million, $10.0 million and ($4.8) million for 2002, 2001 and 2000, respectively. Net cash provided (used) by operating activities historically has been driven primarily by net income before depreciation and fluctuations in inventory and accounts payable. In 2002 the decrease in cash provided from operations was principally due to reduced net income and to the increase in inventory. As of December 28, 2002 inventory increased approximately $2.3 million to $33.7 million compared to $31.4 million at December 29, 2001. The increase in inventory was due in part to new stores opened in 2002 and to lower than planned sales in the fourth quarter of 2002. In addition, the average retail stores inventory increased in part as the Company transferred the balance of the licensed shoe departments inventory to the retail stores. The increase in the cash provided from operating activities in 2001 was principally due to the $6.8 million reduction in inventory for the year ended December 29, 2001. This reduction in inventory was in part a result of the Company’s focus on strengthening its financial condition.

The Company had $27.6 million in working capital as of December 28, 2002 compared to $22.8 million as of December 29, 2001. This $4.8 million increase is principally due to a $2.3 million increase in inventory and a $2.3 million reduction in accounts payable. The Company’s working capital needs are typically higher in the second and third quarters as a result of increased inventory purchases for the spring and fall selling seasons.

Capital expenditures were $1.1 million, $.6 million and $1.3 million in 2002, 2001 and 2000, respectively. Expenditures for 2002 were primarily for the build out of 9 new stores and fixtures for 2 new licensed shoe departments. Expenditures for 2001 were primarily for the build out of 6 new stores and 2 new Gordmans’ shoe departments and the remodeling of 7 stores. Expenditures for 2000 were primarily for the build out of 7 new stores and 3 new Gordmans’ shoe departments and the remodeling of 12 stores. The Company currently expects capital expenditures to be between $400,000 and $600,000 in 2003, net of construction allowances from

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landlords. The actual amount will depend in part upon the number of stores opened in 2003 and the construction allowances received from landlords. The Company expects to open between 3 and 5 stores in 2003. The number of stores ultimately opened is, in part, dependent upon the availability of desirable locations and management’s ability to negotiate acceptable lease terms.

Financing activities provided (used) cash of $3.9 million, ($9.4) million and $6.0 million in 2002, 2001 and 2000, respectively. The cash provided by financing activities in 2002 and 2000 relates to the net increase in borrowings under the Company’s revolving line of credit. The cash used by financing activities in 2001 relates to the pay down on the Company’s revolving line of credit, primarily driven by the $6.8 million reduction in inventory as of December 29, 2001 compared with December 30, 2000.

The Company has an existing credit agreement for a revolving line of credit up to $15.0 million, including a $5.0 million sublimit for the issuance of letters of credit, with a maturity date of August 1, 2004. Borrowings are based upon eligible inventory and are secured by the Company’s accounts receivable, general intangibles, inventory and other rights to payment. The agreement prohibits the declaration and payment of cash or stock dividends. The credit agreement contains various restrictive and financial covenants including those tied to EBITDA as determined on a rolling four quarters basis and minimum net income requirements.

Interest on outstanding borrowings is at the bank’s floating prime rate or LIBOR plus from 1.3% to 3.0%, depending on the Company’s achievement of certain financial ratios. The weighted average interest rate on outstanding borrowings at December 28, 2002 was 2.85%. As of December 28, 2002, outstanding borrowings on the revolving line of credit were $8.5 million and no additional amounts were available for advances under the line of credit.

As of December 28, 2002 the Company was out of compliance with a financial loan covenant. The lender provided the Company with a waiver on this default until April 30, 2003. On March 18, 2003 the Company received a commitment from another lender for a revolving line of credit of up to $20.0 million, including a $5.0 million sublimit for the issuance of letters of credit, for a term of three years. The new facility is subject to loan documentation. The Company anticipates funding will occur in April 2003. Upon funding the Company will use the proceeds to payoff the amount outstanding under its current loan agreement.

The Company expects that anticipated cash flows from operations and available borrowings under the Company’s new committed credit facility will satisfy its cash requirements for at least the next 12 months. The Company’s capital requirements may vary significantly from anticipated needs, depending upon such factors as operating results and the number and timing of new store openings.

The following summarizes the Company's significant cash obligations by fiscal year as of December 28, 2002. ($ in thousands):

Recently Issued Accounting Standards

In August 2001, the FASB issued SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which is effective for fiscal years beginning after December 15, 2001. SFAS 144 supersedes FASB Statement No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of,” and the accounting and reporting provisions relating to the disposal of a segment of a business of Accounting Principles Board Opinion No. 30. SFAS No. 144 requires that long-lived assets to be disposed of by

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sale, including those of discontinued operations, be measured at the lower of carrying amount or fair value less cost to sell, whether reported in continuing operations or in discontinued operations. Liabilities for discontinued operations will no longer include amounts for operating losses that have not yet been incurred. SFAS No. 144 also broadens the reporting of discontinued operations to include all components of an entity with operations that can be distinguished from the rest of the entity and that will be eliminated from the ongoing operations of the entity in a disposal transaction. The Company adopted SFAS 144 in the current year ended December 28, 2002. Adoption of this statement did not have a significant impact on the Company’s financial statements.

In June 2002, the FASB issued SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities”, which addresses accounting for restructuring and similar costs. SFAS 146 supersedes previous accounting guidance, principally Emerging Issues Task Force Issue No. 94-3. SFAS 146 requires that the liability for costs associated with an exit or disposal activity be recognized when the liability is incurred. Under Issue 94-3, a liability for an exit cost was recognized at the date of the company’s commitment to an exit plan. SFAS 146 also establishes that the liability should initially be measured and recorded at fair value. Accordingly, SFAS 146 may affect the timing of recognizing future restructuring costs as well as the amounts recognized. The statement also requires certain financial statement disclosures to be included in the notes to the financial statements that include the period in which an exit or disposal activity is initiated and any subsequent period until the related activity is completed. The Company will adopt the provisions of SFAS No. 146 for any restructuring activities and store closures initiated after December 28, 2002. The Company does not expect adoption to have a significant impact on its financial position or results of operations.

Weather and Seasonality

Historically, net sales and net income have been weakest during the first quarter. The Company’s quarterly results of operations may also fluctuate significantly as a result of a variety of factors, including timing of new store openings, the level of net sales contributed by new stores, merchandise mix, the timing and level of price markdowns, availability of inventory, store closures, advertising costs, competitive pressures and changes in the demand for off-price footwear.

Factors Affecting Financial Performance

In addition to the other information in this Form 10-K, the following factors should be considered carefully in evaluating an investment in the shares of common stock of the Company. The statements contained in this Form 10-K which are not historical facts are forward-looking statements that are subject to risks and uncertainties and actual results could differ materially from those set forth in or implied by forward-looking statements. Factors that could cause or contribute to such differences include those discussed below, as well as those discussed elsewhere in this Form 10-K.

Risks Associated with Expansion

The Company’s continued growth will depend to a significant degree on its ability to expand its operations through the opening of new stores and to operate these stores on a profitable basis. The success of the Company’s planned expansion will be significantly dependent upon the Company’s ability to locate suitable store sites and negotiate acceptable lease terms. In addition, several other factors could affect the Company’s ability to expand, including the adequacy of the Company’s capital resources, the ability to hire, train and integrate employees and the ability to adapt the Company’s operational systems. There can be no assurance that the Company will achieve its planned expansion or that any such expansion will be profitable. In addition, there can be no assurance that the Company’s expansion within its existing markets will not adversely affect the individual financial performance of the Company’s existing stores or its overall operating results, or that new stores will achieve net sales and profitability levels consistent with existing stores. To manage its planned expansion, the Company regularly evaluates the adequacy of its existing systems and procedures, including product distribution facilities, store management, financial controls and management information systems. However, there can be no assurance that

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the Company will anticipate all of the changing demands that expanded operations may impose on such systems. Failure to adapt its internal systems or procedures as required could have a material adverse effect on the Company’s business, financial condition and results of operations.

The Company actively monitors individual store performance and has closed underperforming stores in the past. The Company intends to continue to close underperforming stores in the future, and if it were to close a number of stores, it could incur significant closure costs and reductions in net sales. In certain instances, the Company may be unable to close an underperforming store on a timely basis because of lease terms. A significant increase in closure costs or the inability to close one or more underperforming stores on a timely basis could have a material adverse effect on the Company’s business, financial condition and results of operations.

Termination of License Agreement

In July 1999, the Company entered into a license agreement to operate the shoe departments in Gordmans Inc. department stores located in the Midwest. Pursuant to notification from Gordmans on December 28, 2001 the license agreement was scheduled to expire effective June 29, 2002. On June 14, 2002, the license agreement with Gordmans department stores was terminated (due to Gordmans default) and the Company discontinued operating all 40 of its licensed shoe departments in Gordmans department stores. On May 31, 2002 the Company filed a lawsuit against Gordmans seeking $858,000 for violating certain terms of the license agreement. Gordmans has filed a counterclaim against the Company asserting violations of certain terms of the license agreement. See “Item—3 Legal Proceedings”.

Net sales will be impacted as the Company no longer operates the 40 licensed shoe departments. Net sales generated from the licensed shoe departments were $5.0 million and $14.5 million for the years ended December 28, 2002 and December 29, 2001, respectively. In addition, these stores generated a store operating contribution before overhead, distribution costs, interest and taxes of approximately $.7 million and $2.9 million for the years ended December 28, 2002 and December 29, 2001, respectively. The Company does not allocate overhead, distribution costs, interest or taxes to stores. The majority of the overhead costs which consist of costs such as merchandising, accounting, information systems, rent and insurance are shared expenses of the Shoe Pavilion stores and the licensed shoe departments. During the coming year the Company will continue to focus on replacing the Gordmans business by seeking to improve comparable store sales results and opening new stores in carefully targeted markets. There can be no assurance that the Company will be able to increase comparable store sales or open new stores to an extent sufficient to offset the loss of net sales and operating contribution received under the Gordmans license agreement. Failure to successfully implement these plans could have a material adverse impact on the Company’s results of operations.

Uncertainty of Future Operating Results; Fluctuations in Comparable Store Sales

Although the Company has been profitable, there can be no assurance that the Company will continue to remain profitable. Future operating results will depend upon many factors, including general economic conditions, the level of competition and the ability of the Company to acquire sufficient inventory, achieve its expansion plans and effectively monitor and control costs. There can be no assurance that the Company’s recent gross margin levels will be sustainable in the future.

Although the Company achieved a substantial portion of its 1999 net sales growth through the licensing agreement with Gordmans, historically its growth in net sales has resulted primarily from new store openings. At the present time, the Company expects that the primary source of future sales growth will be from new store openings.

Historically, the Company’s comparable store sales have fluctuated widely. Although the Company is endeavoring to achieve consistent growth in comparable store sales, there can be no assurance that the Company will not continue to experience volatility in comparable store sales. The Company defines comparable stores as

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those stores that have been open for at least 14 consecutive months. Stores open less than 14 consecutive months are treated as new stores, and stores closed during the period are excluded from comparable store sales. The Company’s comparable store sales decreased 1.0% in 2002, 5.9% in 2001 and increased 9.4% in 2000.

Inventory and Sourcing Risk

The Company’s future success will be significantly dependent on its ability to obtain merchandise that consumers want to buy, particularly name brand merchandise with long-term retail appeal, and to acquire such merchandise under favorable terms and conditions. In 2002, the Company’s top ten suppliers accounted for approximately 28% of its inventory purchases. The deterioration of the Company’s relationship with any key vendor or vendors could result in delivery delays, merchandise shortages or less favorable terms than the Company currently enjoys. The Company deals with its suppliers on an order-by-order basis and has no long-term purchase contracts or other contractual assurances of continued supply or pricing. As the Company’s operations expand, its demand for off-price inventory will continue to increase. The Company’s footwear purchases typically involve manufacturing over-runs, over-orders, mid- or late-season deliveries or last season’s stock. The inability of the Company to obtain a sufficient supply of readily salable, high margin inventory, to negotiate favorable discount and payment agreements with its suppliers or to sell large inventory purchases without markdowns could have a material adverse effect on the Company’s business, financial condition and results of operations. See “Item 1—Business—Sourcing and Purchasing.”

Warehousing and Distribution Services

As of December 29, 2001 the Company’s corporate offices and distribution facility were located in a 92,000 square foot facility in Richmond, California, which the Company occupied under a lease that expired in February 2002. The Company decided not to renew the lease and instead engaged a third party that began providing the warehousing and distribution services for the Company in February 2002. The Company did not encounter any major transition difficulties, however, there can be no assurances that future operational difficulties will not occur that could affect the flow of inventory to its stores.

Reliance on Key Personnel

The Company’s future success will be dependent, to a significant extent, on the efforts and abilities of its executive officers. The loss of the services of any one of the Company’s executive officers could have a material adverse effect on the Company’s operating results. In addition, the Company’s continued growth will depend, in part, on its ability to attract, motivate and retain skilled managerial and merchandising personnel. There can be no assurance that the Company will be able to retain a substantial percentage of its existing personnel or attract additional qualified personnel in the future.

Seasonality and Quarterly Fluctuations

The Company has experienced, and expects to continue to experience, seasonal fluctuations in its net sales and net income. Historically, net sales and net income have been weakest during the first quarter. The Company’s quarterly results of operations may also fluctuate significantly as a result of a variety of factors, including timing of new store openings, the level of net sales contributed by new stores, merchandise mix, the timing and level of price markdowns, availability of inventory, store closures, advertising costs, competitive pressures and changes in the demand for off-price footwear.

Dependence on Consumer Spending and Preferences

The success of the Company’s operations depends upon a number of general economic factors relating to consumer spending, including employment levels, business conditions, interest rates, inflation and taxation. There can be no assurance that consumer spending will not decline in response to economic conditions, thereby adversely affecting the Company’s operating results.

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All of the Company’s products are subject to changing consumer preferences. Consumer preferences could shift to types of footwear other than those that the Company currently offers. Any such shift could have a material adverse effect on the Company’s operating results. The Company’s future success will depend, in part, on its ability to anticipate and respond to changes in consumer preferences, and there can be no assurance that the Company will be able to effectively anticipate or respond to such changes on a timely basis or at all. Failure to anticipate and respond to changing consumer preferences could lead to, among other things, lower net sales, excess inventory and lower gross margins, any of which could have a material adverse effect on the Company’s business, financial condition and results of operations.

International Purchasing

The Company purchases in-season name brand and branded-design merchandise directly from factories in Italy, Brazil and China. The Company has no long-term contracts with direct manufacturing sources and competes with other companies for production facilities. All of the manufacturers with which the Company conducts business are located outside of the United States, and the Company is subject to the risks generally associated with an import business, including foreign currency fluctuations, unexpected changes in foreign regulatory requirements, disruptions or delays in shipments and the risks associated with United States import laws and regulations, including quotas, duties, taxes, tariffs and other restrictions. There can be no assurance that the foregoing factors will not disrupt the Company’s supply of directly-sourced goods or otherwise adversely impact the Company’s business, financial condition and results of operations in the future. See “Item  1—Business—Sourcing and Purchasing.”

Inventory Shrinkage

The retail industry is subject to theft by customers and employees. Because the Company uses a self-service format, where shoppers have access to both shoes of a pair, the Company must maintain substantial store security. Although the Company has implemented enhanced security procedures, there can be no assurance that the Company will not suffer from significant inventory shrinkage in the future, which could have a material adverse effect on the Company’s business, financial condition and results of operations.

Competition

The retail footwear market is highly competitive, and the Company expects the level of competition to increase. The Company competes with off-price and discount retailers (e.g., Nordstrom Rack, Payless ShoeSource, Ross, Dress for Less and Famous Footwear), branded retail outlets (e.g., Nine West), national retail stores (e.g., DSW Shoe Warehouse, Nordstrom, Marshalls, Macy’s, Sears, J.C. Penney, Loehmann’s, Robinsons-May and Mervyn’s), traditional shoe stores and mass merchants. Many of these competitors have stores in the markets in which the Company now operates and in which it plans to expand. Many of the Company’s competitors have significantly greater financial, marketing and other resources than the Company. In addition, there can be no assurance that in the future new participants will not enter the off-price segment of the footwear market. Competitive pressures resulting from competitors’ pricing policies could materially adversely affect the Company’s gross margins. There can be no assurance that the Company will not face greater competition from other national, regional or local retailers or that the Company will be able to compete successfully with existing and new competitors. The inability of the Company to respond to such competition could have a material adverse effect on the Company’s business, financial condition and results of operations.

Future Capital Needs

The Company expects that anticipated cash flows from operations and available borrowings under the new committed loan facility will satisfy its cash requirements for at least the next 12 months. To the extent that the foregoing cash resources are insufficient to fund the Company’s activities, including new store openings planned for 2003, additional funds will be required. There can be no assurance that additional financing will be available

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on reasonable terms or at all. Failure to obtain such financing could delay or prevent the Company’s planned expansion, which could adversely affect the Company’s business, financial condition and results of operations.

Substantial Control by Single Stockholder

Dmitry Beinus, the Company’s Chairman of the Board, President and Chief Executive Officer owns approximately 66.2% of the Company’s outstanding Common Stock. As a result, Mr. Beinus is able to decide all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. Concentration of stock ownership could also have the effect of preventing a change in control of the Company.

Possible Volatility of Stock Price

The Company’s common stock is quoted on the Nasdaq SmallCap Market, which has experienced and is likely to experience in the future significant price and volume fluctuations, either of which could adversely affect the market price of the common stock without regard to the operating performance of the Company. In addition, the trading price of the Company’s common stock could be subject to wide fluctuations in response to quarterly variations in operating results, fluctuations in the Company’s comparable store sales, announcements by other footwear retailers, the failure of the Company’s earnings to meet the expectations of investors, as well as other events or factors.

Item 7A— Quantitative and Qualitative Disclosure about Market Risk

The Company is exposed to market risks, which include changes in U.S. interest rates and foreign exchange rates. The Company does not engage in financial transactions for trading or speculative purposes.

Interest Rate Risk.    The interest payable on the Company’s bank line of credit is based on variable interest rates and therefore is affected by changes in market rates. A 1% fluctuation in the interest rate on the Company’s credit facility in 2002 and 2001 would have resulted in a change in interest expense of approximately $48,000 and $105,000, respectively. The Company does not use derivative financial instruments in its investment portfolio and believes that the market risk is insignificant.

Commodity Prices.    The Company is not exposed to fluctuation in market prices for any commodities.

Foreign Currency Risks.    The Company did not have any foreign exchange contracts outstanding at December 28, 2002. As of December 29, 2001, the Company had a foreign exchange contract outstanding to hedge certain purchases in Eurodollars. The purpose of the Company’s foreign currency hedging activities is to protect the Company from the risk that the eventual dollar net cash outflow resulting from inventory purchases will be affected by changes in exchange rates.

As of December 29, 2001 the notional amount and fair value of the Company’s foreign exchange contract in U.S. dollars were $500,000 and $12,535, respectively.

The Company makes minimal purchases outside of the United States that involve foreign currencies and, therefore, has only minimal exposure to foreign currency exchange risks. The Company does not typically hedge against foreign currency risks and believes that foreign currency exchange risk is insignificant.

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Item 8— Financial Statements and Supplementary Data

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

Shoe Pavilion, Inc.

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INDEPENDENT AUDITORS’ REPORT

To the Board of Directors and Stockholders of

Shoe Pavilion, Inc.

We have audited the accompanying consolidated balance sheets of Shoe Pavilion, Inc. and subsidiary (the “Company”) as of December 28, 2002 and December 29, 2001 and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 28, 2002. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

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

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 28, 2002 and December 29, 2001, and the results of its operations and its cash flows for each of the three years in the period ended December 28, 2002 in conformity with accounting principles generally accepted in the United States of America.

/s/ DELOITTE & TOUCHE LLP

San Francisco, California

February 14, 2003 (March 18, 2003 as to Note 3)

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SHOE PAVILION, INC.

CONSOLIDATED BALANCE SHEETS

See notes to consolidated financial statements.

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SHOE PAVILION, INC.

CONSOLIDATED STATEMENTS OF INCOME

See notes to consolidated financial statements.

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SHOE PAVILION, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

See notes to consolidated financial statements.

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SHOE PAVILION, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS