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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

SHOE PAVILION, INC.

(Exact name of registrant as specified in its charter)

1380 Fitzgerald Drive, Pinole, California 94564

(Address of principal executive offices) (Zip Code)

Telephone Number: (510) 222-4405

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

The aggregate market value of the common stock held by non-affiliates of the registrant was approximately $2,363,000 as of June 27, 2003 (the last trading day of the registrant’s most recently completed second fiscal quarter ended June 28, 2003) based upon the closing price of the registrant’s common stock on the Nasdaq SmallCap Market reported for June 27, 2003. Shares of common stock held by each executive officer and director and by each person who, as of such date, may be deemed to have beneficially owned more than 5% of the outstanding voting stock have been excluded in that such persons may be deemed to be affiliates of the registrant under certain circumstances. This determination of affiliate status is not necessarily a conclusive determination of affiliate status for any other purpose.

At March 30, 2004 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 2004 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 January 3, 2004

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PART I

Item 1—Business

General

Shoe Pavilion, Inc. is an 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 January 3, 2004 the Company operated 85 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 expired in June 2002 at which time the Company discontinued operating all 40 of the licensed shoe departments in Gordmans department stores. Certain terms and conditions of the license agreement were 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 Converse, Anne Klein 2, Steve Madden, Reebok, Skechers and Nine West, typically at 20% to 60% 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 2003, 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’s stores are based upon 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 7,900 square feet. In 2003 the Company opened four stores and closed seven stores. In 2002 the Company opened 10 stores and closed five and in 2001 the Company opened six retail stores and closed three stores. The Company closed all 40 of its licensed shoe departments in 2002, including two it had opened in 2002 and two it had opened in 2001. During 2004, the Company intends to open two to four 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 1380 Fitzgerald Drive, Pinole, California 94564, and its telephone number is (510) 222-4405.

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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 20% to 60% 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 85 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.

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.

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Increase Comparable Store Sales.    During the past several years, comparable store sales have declined. Comparable store sales decreased 3.9%, in 2003, 1.0% in 2002 and 5.9% in 2001. In an effort to improve comparable store sales performance, management intends to focus on refining its sales efforts, including merchandise selection, advertising and promotions. In addition in late 2002 the Company expanded its product line to include children’s shoes and handbags. In 2004 the Company plans to expand its product line to include athletic accessories.

The Company plans to improve its operating performance in 2004 compared to 2003 with the goal of returning to profitability. This strategy in part is based upon improvement in comparable store sales, a modest growth in the number of stores, some improvement in gross margin and the reduction in advertising as a percentage of net sales to approximately 5% compared to 6.1% in 2003.

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.

The following table sets forth store openings and closings for the periods indicated:

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 $59.99 for women’s shoes, between $39.99 and $99.99 for men’s shoes and between $19.99 and $34.99 for children’s shoes.

Site Selection, Opening Costs and Leases

The Company uses a broker on the West Coast to identify potential retail sites. Prior to opening a new store, management reviews detailed reports on demographics; spending, traffic and consumption patterns; and other site and market related data. As of January 3, 2004, 43 of the Company’s stores were located in strip malls, 12 were located in outlet centers, 10 were located in regional malls, 9 were located in free standing stores and 10 were located in other types of facilities primarily downtown locations. 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 $350,000, consisting of

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approximately $320,000 for inventory and $30,000 for fixtures and equipment, excluding leasehold improvements which are frequently 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 2003, the Company purchased its inventory from over 100 domestic and international vendors and independent resellers who over bought merchandise. In 2003, the Company’s top ten suppliers accounted for approximately 35% of its inventory purchases. No vendor accounted for more than 10% of total inventory purchases in 2003. 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 provisions. 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 2003 the Company spent 6.1% of its net sales on advertising or $5.1 million. 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. 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

In February 2002 the Company engaged an unrelated third party to provide its warehousing and distribution services.

Information Systems

During 1999, the Company completed the installation 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 system, 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 system provides 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

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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.

Employees

As of January 3, 2004, the Company had approximately 287 full-time employees and 243 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 January 3, 2004 the Company’s corporate offices were located in a 5,000 square foot facility in Pinole, California. As of January 3, 2004 the Company’s 84 stores, excluding its internet store, occupied an aggregate of approximately 661,000 square feet of space. The Company leases all of its stores, with leases expiring between 2004 and 2013. The Company has options to renew most of its leases.

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Store Locations

As of January 3, 2004, the Company operated 84 retail stores, in the states of California, Washington and Oregon. The Company also operates an internet store. Pursuant to notification from Gordmans on December 28, 2001 the license agreement expired in June 2002 at which time the Company discontinued operating all 40 of the licensed shoe departments. The number of stores in each geographic area is set forth below:

Item 3—Legal Proceedings

On March 5, 2002, the Company was sued in Los Angeles County Superior Court by one of its store managers who asserted that he and all other store managers in California were improperly classified as “exempt” employees under California’s wage and hour laws and therefore are entitled to overtime wages. An amended complaint seeking class action status on behalf of all store managers in California was subsequently filed with the court. The Company denied the plaintiff’s claims and filed an answer challenging class certification. In December 2003, the Company entered into a settlement agreement of the lawsuit. Under the terms of the agreement, which must be approved by the court, the Company would pay store managers a stipulated cash settlement based upon the number of weeks worked for the period from April 1, 1998 through December 31, 2003. During the fourth quarter ended January 3, 2004 the Company recorded a reserve of approximately $1.0 million for the estimated costs associated with the lawsuit settlement.

On May 31, 2002 the Company filed a lawsuit against Gordmans department stores in Douglas County, Nebraska. In the suit the Company claimed 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 was seeking $858,000, which included the $474,000 withheld by Gordmans. In a counterclaim against the Company, Gordmans asserted that it was 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 formed the basis for Gordmans decision to

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withhold the $474,000 due the Company. In April 2003 the Company and Gordmans settled the lawsuit and the case was dismissed. The resolution of this matter did not have a material impact on the Company’s financial statements.

The Company is also party to various legal proceedings arising from normal business activities. Management believes that while it is reasonably possible that some of these matters will result in settlements to be paid by the Company, the ultimate resolution of these matters will not have a material adverse impact on the Company’s financial statements.

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, Related Stockholder Matters and Issuer Purchases

of Equity securities

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 Stock 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 January 3, 2004, there were 19 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 approximated the 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” 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 future risks and uncertainties. Consequently, the Company’s 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 an 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 84 retail stores in California, Washington and Oregon under the trade name Shoe Pavilion as of January 3, 2004 and 87 retail stores as of December 28, 2002. The Company operated an internet store as of January 3, 2004 and December 28, 2002.

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 expired in June 2002 at which time the Company discontinued operating all 40 of the licensed shoe departments in Gordmans department stores. At December 29, 2001, the Company operated shoe departments at 38 Gordmans, Inc. stores.

The Company opened four retail stores and closed seven in 2003. In 2002 the Company opened 10 stores and closed five and in 2001 the Company opened six retail stores and closed three. The Company closed 40 licensed shoe departments in 2002, including two it had opened in 2002. The Company opened two licensed shoe departments in 2001 and three in 2000. During 2004, the Company intends to open two to four 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 and to a lesser extent from an improvement in comparable store sales. Although the Company’s comparable store sales have decreased during the past three years, the Company believes that it can achieve an improvement in comparable store sales by focusing on refining its sales efforts, including merchandise selection, advertising and promotions. In addition in late 2002 the Company expanded its product line to include children’s shoes and handbags. In 2004 the Company plans to expand its product line to include athletic accessories. 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 3.9%, in 2003, 1.0% in 2002 and 5.9% in 2001. Net sales in 2003 and 2002 were negatively impacted because as of June 2002 the Company no longer operated 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 previously 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.

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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 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.

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.

Accrued workers’ compensation.    In December 2002, the Company modified its workers’ compensation insurance policy to a high deductible insurance program with an overall program ceiling to minimize exposure. The Company began recording an estimated liability for the self-insured portion of the workers’ compensation claims. The liability as of January 3, 2004 was $227,000 and is determined based on information received from our insurance carrier including claims paid, filed and reserved for, as well as using historical experience. Should a greater amount of claims occur compared to what is estimated or the settlement costs increase beyond what was anticipated, the recorded liability may not be sufficient.

Accrued Litigation.    In 2002, the Company was sued in Los Angeles County Superior Court by one of its store managers who asserted that he and all other store managers were improperly classified as “exempt” employees under California’s wage and hour laws and therefore are entitled to overtime wages. An amended complaint seeking class action status on behalf of all store managers in California was subsequently filed with the court. In December 2003 the Company entered into a settlement agreement of the lawsuit. Under the terms of the agreement, which must be approved by the court, the Company would pay store managers a stipulated cash settlement based upon the number of weeks worked for the period from April 1, 1998 through December 31, 2003. During the fourth quarter ended January 3, 2004 the Company recorded a reserve of approximately $1.0 million for the estimated costs associated with the lawsuit settlement. The liability recorded is an estimate and should a greater amount of claims occur or if the court does not certify the settlement, the recorded liability may not be sufficient.

Income taxes.    A valuation allowance is provided when it is more likely than not that some or a portion or all of the deferred tax asset will not be realized. Based upon its history of earnings the Company believes that the realization of its deferred tax asset is more likely than not and therefore has not provided a valuation allowance for its deferred tax asset.

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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:

2003 Compared with 2002

Net Sales.    Net sales for the 53 weeks ended January 3, 2004 were $83.6 million, relatively unchanged compared to net sales of $83.8 million for the 52 weeks ended December 28, 2002. The year ended January 3, 2004 had one additional week. Sales for the additional week in 2003 were approximately $1.5 million. Excluding the additional week in 2003, sales would have declined approximately $1.7 million or 2.0%. This decline in net sales was principally due to the discontinuation of the licensed shoe departments operations in June 2002 and to the 3.9% decrease in comparable store net sales. The effect of the loss of the Gordman’s sales was partially offset by the effect of a full year of sales of nine retail stores opened in 2002 (net of five closed). Net sales from the Gordman’s licensed shoe departments in 2002 were $5.0 million. The decline in the comparable store sales of $2.8 million was in part due to the impact of the conflict in Iraq primarily in the first and second quarter of 2003, as well as the weak California economy coupled with increased competition.

The Company increased its advertising expenditures in the third quarter of 2003 in an effort to increase sales. The Company’s comparable store net sales increased 4.7% during the third quarter but these increases were below the Company’s expectations. In addition, in an effort to increase comparable store sales the Company also expanded its product line in late 2002 to include children’s shoes and handbags. In 2004 the Company plans to expand its product line to include athletic accessories.

Gross Profit.    Cost of sales includes landed merchandise and occupancy costs and for 2002 the license fee paid to Gordmans for the licensed shoe departments. Gross profit as a percentage of net sales decreased to 28.8% in 2003 from 31.6% in 2002. The decrease in gross profit as a percentage of net sales was primarily due to higher occupancy costs as a percentage of net sales as well as higher merchandise cost as a percentage of net sales.

The increase in occupancy costs as a percentage of net sales is primarily attributable to the higher occupancy costs for stores opened in 2002 and 2003 and from the negative occupancy leverage. The negative occupancy leverage was the result of the decrease in comparable store net sales in 2003. The increase in merchandise cost as a percentage of net sales was due in part to more markdowns taken in 2003 to promote sales.

Selling Expenses.    Selling expenses in 2003 increased by $1.8 million or 9.8% to $20.2 million from $18.4 million in 2002. As a percentage of net sales, selling expenses were 24.1% in 2003 compared to 21.9% in 2002. The increase in selling expenses was primarily attributable to a $1.7 million increase in advertising. Advertising as a percentage of net sales increased to 6.1% in 2003 from 4.1% in 2002. In the third quarter ended September 27, 2003 the Company increased advertising spending in an effort to increase sales. Comparable store net sales did increase 4.7% during the third quarter of 2003, although below the Company’s expectations.

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The Company’s plan for 2004 is to reduce advertising to approximately 5.0% of net sales. This percentage could change based upon the impact that the advertising has on sales, product availability or the conditions in the retail market for footwear.

General and Administrative Expenses.    General and administrative expenses consist primarily of corporate and administrative expenses, including payroll, store utilities, warehousing costs, professional fees and insurance. General and administrative expenses increased by $.4 million or 4.7% to $8.2 million in 2003 from $7.8 million in 2002. The increase in general and administrative expenses in 2003 is primarily attributable to the $1.0 million reserve recorded in 2003 for costs associated with the settlement of a wage and hour lawsuit and an increase in general insurance costs. These increases were partially offset by a reduction in legal fees and costs of approximately $.6 million in 2003. During the second quarter ended June 29, 2002, the Company incurred legal fees and costs of approximately $.5 million as part of a settlement of a class action lawsuit filed against the Company.

Income Tax Benefit.    The effective tax rate benefit for 2003 was 40.2%. In 2002 the Company’s effective tax rate was 27.3%. The effective tax rate was lower in 2002 primarily due to the utilization of certain tax credits in 2002.

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 three retail stores opened in 2001 (net of three closed) and the net sales generated from five retail stores opened in 2002 (net of five 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.

Gross Profit.    Cost of sales included 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 were higher in the retail stores compared to the licensed shoe departments. In 2002 the retail stores net sales represented 94.1% of the Company’s net sales compared to 83.5% in 2001. Net sales in the licensed shoe departments were 5.9% of the Company’s net sales in 2002 compared to 16.5% in 2001.

Selling Expenses.    Selling expenses consisted 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 and legal fees. 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 $.5 million 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.

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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.

Inflation

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

Liquidity and Capital Resources

In 2003 and 2001 the Company satisfied its cash requirements through cash flows generated from operations as compared to 2002 when cash requirements were satisfied by borrowings under the Company’s credit facility. Net cash provided (used) by operating activities was $4.9 million, ($3.1) million and $10.0 million for 2003, 2002 and 2001, respectively. Cash provided from operations in 2003 was primarily generated from a $6.7 million reduction in inventory. During 2001 the Company generated $10.0 million from operating activities primarily due to a reduction in inventory of $6.8 million and net income before depreciation and amortization of $3.0 million. The reduction in inventory in 2003 was in part due to the discontinuation of the 40 licensed shoe departments and the reduction in inventory maintained at the Company’s outside warehouse. The Company reduced inventory in its outside warehouse in order to improve the Company’s liquidity.

Capital expenditures were $1.0 million, $1.1 million and $.6 million, for 2003, 2002 and 2001, respectively. In 2003 capital expenditures of $.3 million were for the remodel of four stores, $.4 million were for leasehold improvements, fixtures and equipment for four new stores and $.2 million were for leasehold improvements for the build out of the new corporate office. Expenditures for 2002 were primarily for the build out of nine new stores and fixtures for two new licensed shoe departments. Expenditures for 2001 were primarily for the build out of six new stores, two new licensed shoe departments and the remodeling of seven stores.

The Company has signed leases to open two new stores and plans to close one. Net capital expenditures for the two new stores are expected to be approximately $70,000. In addition the Company expects its inventory investment for these two stores to be approximately $.6 million. The Company estimates that total net capital expenditures for 2004 will be approximately $.6 million. The actual amount of capital expenditures will depend in part upon the number of stores opened in 2004 and the construction allowances received from landlords. 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.

The Company intends to carry back a portion of its $3.2 million Federal net operating loss (“NOL”) to the preceding two tax years. This NOL carry back will produce a tax refund of approximately $900,000 which the Company expects to receive in the third quarter of 2004.

Financing Activities provided (used) cash of ($3.7) million, $3.9 million and ($9.4) million in 2003, 2002 and 2001, respectively. The cash used by financing activities in 2003 and 2001 relate to the paydown on the Company’s credit facility primarily driven by the reduction of inventory of $6.7 million in 2003 and $6.8 million in 2001 and from net income before depreciation of $3.0 million in 2001. The cash provided by financing activities in 2002 relates to the net increase in borrowings under the Company’s credit facility.

In April 2003, the Company entered into a credit facility agreement with Wells Fargo Retail Finance, LLC. The facility expires on April 18, 2006 and provides financing for up to $20.0 million, including a $5.0 million

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sublimit for the issuance of letters of credit. Borrowings under the new facility are based upon a percentage of eligible inventory less certain reserves. Borrowings are secured by inventory, equipment, general intangibles and other rights to payments. The agreement prohibits the payment of cash dividends and contains various restrictive covenants, including a limitation on the amount of capital expenditures and the number of stores the Company may open and close during any fiscal year.

Interest on borrowings is at prime plus up to .25% or Libor plus 1.75% to 2.25%, depending on the amount the Company has available for advances under the line of credit. The Company paid off the amount outstanding on its previous loan agreement from proceeds provided from its new loan facility. The average interest rate on outstanding borrowings at January 3, 2004 was 2.98%. As of January 3, 2004 approximately $7.0 million was available for advances under the facility. As of January 3, 2004 the Company was in compliance with its loan covenants.

Although the credit facility expires in April 2006 and the Company has the intent and ability to maintain this debt outstanding far more than one year, the Company has classified its borrowings under the facility as a current liability in accordance with the provisions set forth in Emerging Issues Task Force (EITF) 95-22 “Balance Sheet Classifications, Borrowings Outstanding Under Revolving Credit Agreements that include both a Subjective Acceleration Clause and a Lock-Box Arrangement.”

The Company expects that anticipated cash flows from operations and available borrowings under the Company’s 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 contractual cash obligations as of January 3, 2004 ($ in thousands):

Recently Issued Accounting Standards

In June 2002, Financial Accounting Standards Board (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 EITF 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 EITF No. 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 adopted the provisions of SFAS 146 in the year ended January 3, 2004 for any restructuring activities initiated after December 28, 2002. Adoption of this statement did not have a significant impact on the Company’s financial statements.

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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 that could cause actual results to 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 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 expired in June 2002 at which time the Company discontinued operating all 40 of its licensed shoe departments in Gordmans department stores.

Net sales in 2003 and 2002 were negatively impacted because as of June 2002 the Company no longer operated 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,

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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 previously 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

Until 2003, the Company had been profitable. There can be no assurance that the Company will return to profitability. 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.

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 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 3.9% in 2003, 1.0% in 2002 and, 5.9% in 2001.

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 2003, the Company’s top ten suppliers accounted for approximately 35% 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 expects to continue this third party relationship. Although the Company did not encounter any major transition difficulties, 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

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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, the success of advertising campaigns 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.

During the past three years the economies of the three states in which the Company has stores have been subjected to a significant economic downturn that has only recently begun to end. Although, Shoe Pavilion’s footwear prices are very reasonable, customers have been more cautious in spending for discretionary retail items.

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

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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 its credit 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 2004, additional funds will be required. There can be no assurance that additional financing will be available 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 credit facility 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 2003 would have resulted in a change in interest expense of approximately $73,000. The

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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 January 3, 2004 or December 28, 2002. 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. In the past the Company has used foreign exchange contracts 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.

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Item 8—Financial Statements and Supplementary Data

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

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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 January 3, 2004 and December 28, 2002 and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended January 3, 2004. 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 January 3, 2004 and December 28, 2002, and the results of its operations and its cash flows for each of the three years in the period ended January 3, 2004 in conformity with accounting principles generally accepted in the United States of America.

/s/ DELOITTE & TOUCHE LLP

San Francisco, California

March 30, 2004

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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 OPERATIONS

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