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THE UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended July 31, 2004

OR

Commission file number 0-18632

THE WET SEAL, INC.

(Exact name of registrant as specified in its charter)

(949) 583-9029

(Registrant’s telephone number, including area code)

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

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

The number of shares outstanding of the registrant’s Class A Common Stock and Class B Common Stock, par value $.10 per share, at September 7, 2004 were 34,657,824 and 1,502,833, respectively. There were no shares of Preferred Stock, par value $.01 per share, outstanding at September 7, 2004.

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THE WET SEAL, INC.

FORM 10-Q

Index

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THE WET SEAL, INC.

CONSOLIDATED CONDENSED BALANCE SHEETS

(Unaudited)

(In thousands)

See accompanying notes to unaudited consolidated condensed financial statements.

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THE WET SEAL, INC.

CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands, except share data)

See accompanying notes to unaudited consolidated condensed financial statements.

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THE WET SEAL, INC.

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands)

See accompanying notes to unaudited consolidated condensed financial statements.

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THE WET SEAL, INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1 - Basis of Presentation, Significant Accounting Policies and New Accounting Pronouncements:

Basis of Presentation

The information set forth in these consolidated condensed financial statements is unaudited. These statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information, the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.

The unaudited financial statements, accompanying this report, have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company has experienced recurring losses from operations and has an accumulated deficit. Management’s plan, to continue as a going concern, consists of continued review of overhead and operating expenses at the store and corporate level, potential closure of certain unprofitable stores and completion of a junior secured term loan of between $7.0 million and $9.0 million. Additionally, our Board of Directors has established and empowered a special committee of three independent directors to analyze appropriate alternatives to enhance shareholder value. The Board of Directors has authorized that committee, among other things, to engage the services of a financial advisor to analyze a number of strategic and financial alternatives. However, there is no assurance that financing will be available in the future, and if available, at terms and conditions agreeable to the Company. Should the Company be unable to execute their plans and obtain additional financing, the Company may be unable to continue as a going concern for a reasonable period of time. The accompanying unaudited financial statements do not include any adjustments that might result from the outcome of these uncertainties.

In the opinion of management, all adjustments, consisting only of normal recurring accruals, necessary for a fair presentation have been included. The results of operations for the quarter and six months ended July 31, 2004 are not necessarily indicative of the results that may be expected for the year ending January 29, 2005. For further information, refer to the consolidated financial statements and notes thereto included in the Annual Report of The Wet Seal, Inc. (the Company) for the year ended January 31, 2004.

Certain prior period amounts have been reclassified to conform to the fiscal 2004 presentation.

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Significant Accounting Policies

Revenue recognition

Sales are recognized upon purchase by customers at the Company’s retail store locations or through the Company’s web-site. For online sales, revenue is recognized at the estimated time goods are received by customers. Additionally, shipping and handling fees billed to customers is classified as revenue. Customers typically receive goods within 5-7 days of being shipped. The Company has recorded reserves to estimate sales returns by customers based on historical sales return results. A customer may return regular or promotionally priced merchandise within 30 days of the original purchase date. Actual return rates have historically been within management’s expectation and the reserves established. Shipping and handling fees billed to customers are included in net sales and approximated $85 and $59 for the quarters ended July 31, 2004 and August 2, 2003 and $155 and $97 for the six months ended July 31, 2004 and August 2, 2003, respectively.

The Company recognizes the sales from gift cards and the issuance of store credits as they are redeemed.

The Company, through its Wet Seal division, has a Frequent Buyer Card program that entitles the customer to receive a 10 percent discount on all purchases made during the twelve-month program period. The annual membership fee of $20.00 is non-refundable. Revenue is recognized over the twelve-month membership period based upon historical spending patterns for Wet Seal customers.

Inventory valuation

Merchandise inventories are stated at the lower of cost (first in, first out) or market. Cost is determined using the retail inventory method. Under the retail inventory method, inventory is stated at its current retail selling value. Inventory retail values are converted to a cost basis by applying a specific average cost factor that represents the average cost-to-retail ratio based on beginning inventory and the fiscal year purchase activity. The retail inventory method inherently requires management judgments and estimates, such as the amount and timing of permanent markdowns to clear unproductive or slow-moving inventory, which may impact the ending inventory valuation as well as gross margins.

Markdowns for clearance activity are recorded when the utility of the inventory has diminished. Factors considered in the determination of permanent markdowns include current and anticipated demand, customer preferences, and age of the merchandise and fashion trends. When a decision is made to permanently mark down merchandise, the resulting gross profit reduction is recognized in the period the markdown is

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recorded. For the second quarter ending July 31, 2004, total markdowns on a cost basis represented 21.3% of sales compared to 19.0% for the second quarter of the prior fiscal year ended August 2, 2003.

To the extent that management’s estimates differ from actual results, additional markdowns may be required that could reduce the Company’s gross margin, operating income and the carrying value of inventories. The Company’s success is largely dependent upon its ability to anticipate the changing fashion tastes of its customers and to respond to those changing tastes in a timely manner. If the Company fails to anticipate, identify or react appropriately to changing styles, trends or brand preferences of its customers, it may experience lower sales, excess inventories and more frequent and extensive markdowns, which would adversely affect its operating results.

Long-lived assets

The Company evaluates the carrying value of long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Factors that are considered important that could trigger an impairment review include a current-period operating or cash flow loss combined with a history of operating or cash flow losses and a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset or asset group. Other factors include a significant change in the manner of the use of the asset or a significant negative industry or economic trend. This evaluation is performed based on estimated undiscounted future cash flows from operating activities compared with the carrying value of the related assets. If the undiscounted future cash flows are less than the carrying value, an impairment loss is recognized, measured by the difference between the carrying value and the estimated fair value of the assets, with such estimated fair values determined using the best information available generally based on prices for similar assets for stores recently opened. In light of disappointing sales results during the back-to-school period, the current expectation for continued operating losses through the end of fiscal 2004 and the Company’s most recent historical operating performance, the Company concluded that an indication of impairment existed as of July 31, 2004. Accordingly, the Company conducted an impairment evaluation in accordance with Statement of Financial Accounting Standards No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS”) as of July 31, 2004. This analysis included reviewing the stores’ historical cash flows, estimated future cash flows over remaining lease terms and recoverability of each store’s long-lived assets. Based on the results of this analysis the Company wrote down the carrying value of these impaired long-lived assets as of July 31, 2004 by $36.7 million, a non cash charge to the consolidated statement of operations.

Deferred income taxes

The Company accounts for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes,” which requires that deferred tax

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assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. SFAS No. 109 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the net deferred tax asset will not be realized. As a result of recent disappointing sales results during the back-to-school season and the Company’s most recent historical operating performance, the Company concluded that it is more likely than not that the Company will not realize its net deferred tax assets. As a result of this conclusion, the Company reduced its deferred tax assets by establishing a tax valuation allowance of $38.8 million as of July 31, 2004. In addition, the Company will discontinue recording income tax benefits in the consolidated condensed income statements of operations until it is determined that it is more likely than not that the Company will generate sufficient taxable income to realize the deferred income tax assets.

Self-insurance coverage

The Company is partially self-insured for its worker’s compensation and group health plans. Under the workers’ compensation insurance program, the Company is liable for a deductible of $250,000 for each individual claim and an aggregate annual liability of $1,600,000. Under the Company’s group health plan, the Company is liable for a deductible of $100,000 for each claim and an aggregate monthly liability of $500,000. The monthly aggregate liability is subject to the number of participants in the plan each month. For both of the insurance plans, the Company records a liability for the costs associated with reported claims and a projected estimate for unreported claims due to historical experience and industry standards. The Company will continue to adjust the estimates as the actual experience dictates. A significant change in the number or dollar amount of claims could cause the Company to revise its estimate of potential losses and affect its reported results.

New accounting pronouncements

In January 2003, the Financial Accounting Standards Board issued FIN No. 46, “Consolidation of Variable Interest Entities” and in December 2003, issued Interpretation No. 46 (R) (revised in December 2003) “Consolidation of Variable Interest Entities – An Interpretation of Accounting Principles Bulletin (“APB”) No. 51.” In general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN No. 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN No. 46 (R) clarifies the application of APB No. 51, “Consolidated Financial

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Statements,” to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without subordinated financial support from other parties. The consolidation requirements of FIN No. 46 applies immediately to variable interest entities created after January 31, 2003. The consolidation requirements apply to older entities in the first fiscal year or interim period beginning after June 15, 2003. Certain of the disclosure requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. FIN No. 46 (R) applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies no later than the first reporting period ending after March 15, 2004 to variable interest entities in which an enterprise holds a variable interest (other than special purpose) that it acquired before February 1, 2004. FIN No. 46 (R) applies to public enterprises as of the beginning of the applicable interim or annual period. The adoption of FIN No. 46 and FIN No. 46 (R) did not have a material impact on the Company’s financial position or results of operation because the Company has no variable interest entities.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Instruments with Characteristics of Both Liabilities and Equity,” (“SFAS 150”) which establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS 150 requires that an issuer classify a financial instrument that is within its scope, which may have previously been reported as equity, as a liability (or an asset in some circumstances). This statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003 for public companies. In October 2003, the FASB deferred implementation of paragraphs 9 and 10 of SFAS 150 regarding parent company treatment of minority interest for certain limited life entities. This deferral is for an indefinite period. The adoption of SFAS 150 did not have a material impact on the Company’s financial statements.

NOTE 2: Discontinued Operations

On January 6, 2004, the Board of Directors authorized the Company to proceed with their strategic decision to close all Zutopia stores by the end of the first quarter or early in the second quarter of fiscal year 2004, due to their poor financial results and perceived limited ability to become profitable in the future.

As of the end of the second quarter of fiscal year 2004, all 31 Zutopia stores were closed. The Company closed 27 Zutopia stores in the first quarter and 4 Zutopia stores within the first two weeks of the second quarter.

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The financial losses generated by this chain and the applicable reserve for lease termination costs have been identified as discontinued operations in the first and second quarters of fiscal 2004.

The operating results of the discontinued Zutopia division included in the accompanying consolidated statements of operations were as follows (in thousands):

NOTE 3 - Revolving Credit Arrangement:

As of the end of the first quarter of fiscal year 2004, we were not in compliance with two covenants as outlined under our $50 million revolving line-of-credit arrangement with Bank of America, N.A. We received a waiver from the bank for the non-compliance with these covenants, which relate to cash and net worth requirements. In connection with obtaining the waiver, the agreement was amended on May 3, 2004 reflecting a reduction of the line-of-credit from $50 million to $40 million and restricting the Company from allowing cash advances, issuing standby letters of credit, shipside bonds or air releases from April 30, 2004 until July 1, 2004.

On May 26, 2004, the Company replaced the existing amended revolving line-of-credit arrangement with a $50 million senior revolving credit facility (the “New Credit Facility”), including a $50 million sub-limit for letters of credit with Fleet Retail Group, Inc. (the “Lender”) which matures May 26, 2007. The New Credit Facility will be used for working capital needs and the issuance of letters of credit. The Company’s obligations under the New Credit Facility is secured by all presently owned and hereafter acquired assets of the Company and its wholly-owned subsidiaries, The Wet Seal Retail, Inc. and Wet Seal Catalog, Inc., each of which may be a borrower under the New Credit Facility. The obligations of the Company and the subsidiary borrowers under the New Credit Facility are guaranteed by another wholly owned subsidiary of the Company, Wet Seal GC, Inc.

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Under the terms of the New Credit Facility, the Company and the subsidiary borrowers are subject to borrowing base limitations on the amount that can be borrowed and certain customary covenants, including covenants restricting their ability to incur additional indebtedness, make investments and acquisitions, grant liens, pay dividends, close stores and dispose of their assets, subject to certain exceptions, or without the Lender’s consent. The ability of the Company and its subsidiary borrowers to borrow and request the issuance of letters of credit also is subject to the requirement that the Company and its subsidiary borrowers maintain an excess of the borrowing base over the outstanding credit extensions of not less than the greater of 15% of such borrowing base or $7.5 million.

The interest rate on the New Credit Facility is the prime rate or, if elected, LIBOR plus a margin ranging from 1.25% to 2.00%. The applicable LIBOR margin is based on the level of “Excess Availability” as defined under the New Credit Facility at the time of election. The average prime interest rate for the three-month period ending July 31, 2004 was 4.09%.

At July 31, 2004, there were no outstanding borrowings under the New Credit Facility. There were $19.7 million in open letters of credit related to merchandise purchases and $19.2 million in outstanding standby letters of credit, which included $15.0 million for inventory purchases. At July 31, 2004 the company had $11.1 million available for cash advances and/or for the issuance of additional letters of credit. At August 28, 2004, $12.0 million was available for cash advances and/or letters of credit. At July 31, 2004, the Company was in compliance with all covenant requirements related to the New Credit Facility.

NOTE 4 - Net Loss Per Share:

A reconciliation of the numerators and denominators used in basic and diluted net loss per share is as follows (in thousands, except for share data):

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NOTE 5 - Treasury Stock:

On October 1, 2002, the Company’s Board of Directors authorized the repurchase of up to 5,400,000 of the outstanding common stock of the Company’s Class A Common shares. This amount includes the remaining shares previously authorized for repurchase by the Company’s Board of Directors. All shares repurchased under this plan will be retired as authorized by the Company’s Board of Directors. During fiscal year 2002, the Company repurchased 947,400 shares for $8.2 million and immediately retired these shares. An additional 124,500 shares were repurchased for $0.9 million in the first quarter of fiscal year 2003 and these shares were immediately retired. As of July 31, 2004, there were 4,328,100 shares remaining that are authorized for repurchase. Presently, there are no plans to repurchase additional shares.

NOTE 6 - Litigation:

From time to time, the Company is involved in litigation relating to claims arising out of our operations in the normal course of business. The Company’s management believes that, in the event of a settlement or an adverse judgment of any of the pending litigations, the Company is adequately covered by insurance. As of July 31, 2004, the Company was not engaged in any legal proceedings that are expected, individually or in the aggregate, to have a material adverse effect on the Company. (See “Subsequent Event” in Note 10 to the Notes to Consolidated Condensed Financial Statements).

NOTE 7 - Sale of Common Stock

On June 29, 2004 the Company completed a private placement of equity securities to institutional and other credited investors totaling $27.2 million in gross proceeds. After transaction costs, the Company raised approximately $25.6 million to be used for working capital and general corporate purposes.

In connection with the private placement, the Company issued 6,026,500 shares of its Class A common stock at $4.51 per share and warrants to acquire 2,109,275 additional shares of Class A common stock at an exercise price of $5.41 per share, subject to adjustment from time to time for stock splits, stock dividends, distributions and similar transactions. The warrants become exercisable beginning on December 30, 2004 and expire on December 29, 2009.

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Additionally, the Company agreed to file a registration statement covering the resale of the Class A common stock purchased in the private placement, as well as the shares of Class A common stock underlying the warrants. On August 24, 2004 the Company filed the registration statement for the resale of the above shares with the Securities and Exchange Commission and on August 25, 2004 the Securities and Exchange Commission notified the Company that the registration statement was effective.

NOTE 8 - Stock-based Compensation

The Company accounts for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board No. 25, “Accounting for Stock Issued to Employees” as amended by SFAS No.148 “Accounting for Stock-Based Compensation”.

Accordingly, no compensation expense has been recognized in the consolidated financial statements for employee incentive stock options or nonqualified stock options.

SFAS No. 123, “Accounting for Stock-Based Compensation,” requires the disclosure of pro forma net income and earnings per share had the Company adopted the fair value method as of the beginning of fiscal 1995. Under SFAS No. 123, the fair value of stock-based awards to employees is calculated through the use of option-pricing models, even though such models were developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which significantly differ from the Company’s stock-option awards. These models also require subjective assumptions, including future stock price volatility and expected time to exercise, which greatly affect the calculated values.

The Company’s calculations were made using the Black-Scholes option-pricing model with the following weighted average assumptions:

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The Company’s calculations are based on a valuation approach and forfeitures are recognized as they occur. If the computed fair values of the stock option awards had been amortized to expense over the vesting period of the awards, net loss (in thousands) and loss per share would have been reduced to the pro forma amounts indicated below:

NOTE 9 - Sale of Class B Common Stock

During July 2004, through a series of open market transactions, a shareholder of Wet Seal, Inc. Class B common stock sold 3,000,000 shares. Under the provisions of the Class B shares, such shares convert to Class A shares upon their transfer or sale. Class B common stock has two votes per share while the Class A common stock has one vote per share. At July 31, 2004 there were 1,502,833 Class B shares outstanding.

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NOTE 10 - Subsequent Event

Several securities class action lawsuits were reportedly filed in the United States District Court for the Central District of California, purportedly on behalf of all persons who purchased the Company’s common stock from January 7, 2004 through August 19, 2004. The Company has not been served with any of the complaints relating to these lawsuits. Based on one complaint which is publicly available, the lawsuit names as defendants the Company, the Company’s Chairman of the Board, Chief Executive Officer and Director, Peter D. Whitford, the Company’s Executive Vice President, Joseph E. Deckop, and the Company’s Director and former Chairman of the Board, Irving Teitelbaum. The publicly available complaint alleges violations of Sections 10(b) and 20(a) of the Exchange Act, and Rule 10b-5 of the Exchange Act, on the grounds that, among other things, the Company failed to disclose and misrepresented material adverse facts which were known to the defendants or disregarded by them.

Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operations

Introduction

Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our consolidated condensed financial statements and the notes thereto.

Executive Overview

We are one of the largest national mall-based specialty retailers focusing primarily on young women’s apparel and accessories. We currently operate 561 retail stores in 47 states, Washington, D.C. and Puerto Rico. Of the 561 stores, 452 are Wet Seal stores, 13 are Contempo Casuals stores and 96 are Arden B. stores. We opened 12 stores and closed 40 stores during the period from August 2, 2003 to July 31, 2004 related to our continuing operations.

Our growth has been internal and by acquisition. In 1990, we completed an initial public offering. In 1995, we acquired 237 Contempo Casuals stores from the Neiman Marcus Group. In November 1998, we introduced Arden B. as a retail concept for young women aged 20 to 35. In August 1999, we launched e-commerce sites www.wetseal.com and www.contempocasuals.com. In late 2002, we launched www.ardenb.com. Although these websites provide information about the Company, the Company does not intend the information available through these websites to be incorporated into this report.

We operated a chain, Zutopia, which was not successful in generating profits. We made the determination to discontinue this chain of 31 stores at the end of fiscal year 2003.

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Current Trends and Outlook

The second quarter of fiscal year 2004 was our eighth consecutive quarter reflecting negative comparable store sales and operating losses. This operating performance is due to negative sales trends at our Wet Seal division. We believe the comparable store sales decline is due to a number of factors, including missed fashion trends by the Wet Seal division, our attempt at re-establishing Wet Seal’s presence in the junior market and a more competitive environment for the Wet Seal target customer. Overall, we experienced a comparable store sales decline of 10.9% for the second quarter of fiscal year 2004. Despite our negative comparative store sales trend, our store sales performance at our Arden B division have been positive and continues to improve over the prior fiscal year. The second quarter sales decline resulted primarily from a decrease in the number of sales transactions associated with the Wet Seal division. The continued sales decline has eroded operating margins, primarily as a result of the de-leveraging of the Company’s cost structure. In addition, in light of disappointing sales results during the back-to-school period, the current expectation for continued operating losses through the end of fiscal 2004 and the Company’s most recent historical operating performance, the Company wrote down the carrying value of certain impaired long-lived assets and established a tax valuation allowance related to deferred tax assets at July 31, 2004 by $36.7 million and $38.8 million, respectively, non cash charges included in the consolidated statement of operations. These factors resulted in a loss of $3.20 per share for the three-month period ending July 31, 2004.

Our outlook for the third quarter ending October 30, 2004 reflects a continuing decline in comparable store sales and operating performance. We currently anticipate comparable store sales for the third quarter to be in the range of negative 14% to 16% and a net operating loss of $0.69 per share. We expect to use approximately $26.0 million of cash for operations and capital expenditures for the third quarter ending October 30, 2004.

Management has responded to the operating declines over the past twelve months by exiting from our unprofitable Zutopia chain, restructuring its management team, including the hiring of a new creative director for the Wet Seal division, initiating a new marketing campaign for the Wet Seal division, reviewing overhead and operating expenses at the store and corporate level, replacing the Company’s $50.0 million working capital facility with a new $50.0 million senior secured credit facility and raising $25.6 million of net proceeds from the sale of approximately 6.0 million shares of Wet Seal, Inc. Class A common stock and warrants to acquire an additional 2.1 million shares of Wet Seal, Inc. Class A common stock in a private placement transaction. However, these initiatives overall have not provided the anticipated results to date. Our marketing and design efforts for our Wet Seal division were planned around our fiscal 2004 “Back-To-School” season. Our comparable store sales for the four week period ended August 28, 2004 declined 14.8% and reflected an acceleration of our

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negative comparable store sales trend from our second quarter which was a negative 10.9%. In August, our creative director for the Wet Seal division resigned. In addition, for the six months ended July 31, 2004, we used $48.8 million of cash to fund operations and capital expenditures and have significantly reduced our cash and investment balances despite our capital raising efforts.

Due to our financial results over the past 24 months, we have begun to experience a tightening of credit extended to us by vendors, factors, and others for merchandise and services. The impact of this credit tightening has required us to issue letters of credit outside of the ordinary course of business, or, in some instances, shorten vendor credit terms. As a result of our “Back-To-School” comparable sales through August 28, 2004 and our expectations the remainder of fiscal 2004, the credit tightening from factors, vendors and others has increased and placed additional demand on the Company’s liquidity in order to maintain the flow of new merchandise into our stores. Continued credit tightening and increased merchandise delays could jeopardize our holiday season business and as a result, our cash flow position.

As a result of recent operating performance and other events, we have begun taking other steps in an effort to improve operating results. These steps include filling the vacant creative director’s position for the Wet Seal division, creating promotional events within the Wet Seal division in an effort to increase traffic counts, evaluating the potential closure of certain unprofitable stores in an effort to improve cash flow and operating results, executing further cost cutting initiatives and seeking additional financing. Currently, we are in the process of completing a junior secured term loan of between $7.0 million and $9.0 million.

Our ability to fund our future operations and capital expenditures will depend upon our ability in the near term to access the capital markets and our near term financial and operating performance, which will be affected by prevailing economic conditions and financial, business and other factors, many of which are beyond our control. There can be no assurance (i) that additional funding will become available to us on either a short-term or long-term basis, (ii) that the terms of any additional funding would not be materially adverse to us including higher interest rates, the imposition of restrictive covenants, the pledging of assets, the sale of assets, the dilution of existing stockholders’ interest or otherwise, or (iii) that we will not be required to consider reductions in capital and other expenditures, the sale of assets or other strategic alternatives, including a reorganization under Chapter 11 of the U.S. bankruptcy code (see “Risk Factors” set forth elsewhere in this report).

Code of Conduct

We recently introduced a Code of Conduct for Vendors and Suppliers for our domestic and foreign suppliers which provides guidelines for their employment practices such as wage and benefits, health and safety, working age, environmental conditions and related employment matters.

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Appointment of Special Committee

In light of the uncertainty of our ability to fund our future operations and capital expenditures, our Board of Directors has established and empowered a special committee of three independent directors to analyze appropriate alternatives to enhance shareholder value. In connection therewith, the Board of Directors has authorized that committee, among other things, to engage the services of a financial advisor. The special committee is completing the process of engaging an investment banker as its financial and strategic advisor and is analyzing financial alternatives within its mandate.

Critical Accounting Policies and Estimates

Our consolidated condensed financial statements were prepared in conformity with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.

The preparation of financial statements in conformity with generally accepted accounting principles requires the appropriate application of certain accounting policies, some of which require us to make estimates and assumptions about future events and their impact on amounts reported in our financial statements. Since future events and their impact cannot be determined with absolute certainty, the actual results will inevitably differ from our estimates.

We believe the application of our accounting policies, and the estimates inherently required therein, are reasonable. Our accounting policies and estimates are reevaluated on an ongoing basis, and adjustments are made when facts and circumstances dictate a change. Our accounting policies are more fully described in Note 1 to the consolidated condensed financial statements and in Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the fiscal year ended January 31, 2004.

Our accounting policies include certain policies that require more significant management judgments and estimates. These include revenue recognition, inventory and long-lived asset valuations, recovery of deferred income taxes, and insurance coverage.

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Revenue Recognition

Sales are recognized upon purchase by customers at the Company’s retail store locations or through the Company’s web-site. For online sales, revenue is recognized at the estimated time goods are received by customers. Additionally, shipping and handling fees billed to customers is classified as revenue. Customers typically receive goods within 5-7 days of being shipped. The Company has recorded reserves to estimate sales returns by customers based on historical sales return results. A customer may return regular or promotionally priced merchandise within 30 days of the original purchase date. Actual return rates have historically been within management’s expectation and the reserves established. Shipping and handling fees billed to customers are included in net sales and approximated $85 and $59 for the quarters ended July 31, 2004 and August 2, 2003 and $155 and $97 for the six months ended July 31, 2004 and August 2, 2003, respectively.

The Company recognizes the sales from gift cards and the issuance of store credits as they are redeemed.

The Company, through its Wet Seal division, has a Frequent Buyer Card program that entitles the customer to receive a 10 percent discount on all purchases made during the twelve-month program period. The annual membership fee of $20.00 is non-refundable. Revenue is recognized over the twelve-month membership period based upon historical spending patterns for Wet Seal customers.

Inventory Valuation

Merchandise inventories are stated at the lower of cost (first in, first out) or market. Cost is determined using the retail inventory method. Under the retail inventory method, inventory is stated at its current retail selling value. Inventory retail values are converted to a cost basis by applying a specific average cost factor that represents the average cost-to-retail ratio based on beginning inventory and the fiscal year purchase activity. The retail inventory method inherently requires management judgments and estimates, such as the amount and timing of permanent markdowns to clear unproductive or slow-moving inventory, which may impact the ending inventory valuation as well as gross margins.

Markdowns for clearance activities are recorded when the utility of the inventory has diminished. Factors considered in the determination of permanent markdowns include current and anticipated demand, customer preferences, and age of the merchandise and fashion trends. When a decision is made to permanently mark down merchandise, the resulting gross profit reduction is recognized in the period the markdown is recorded. For the second quarter ending July 31, 2004, total markdowns on a cost basis represented 21.3% of sales compared to 19.0% for the second quarter of the prior fiscal year ended August 2, 2003.

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To the extent that management’s estimates differ from actual results, additional markdowns may be required that could reduce the Company’s gross margin, operating income and the carrying value of inventories.

The Company’s success is largely dependent upon its ability to anticipate the changing fashion tastes of its customers and to respond to those changing tastes in a timely manner. If the Company fails to anticipate, identify or react appropriately to changing styles, trends or brand preferences of its customers, they may experience lower sales, excess inventories and more frequent and extensive markdowns, which would adversely affect its operating results.

Long-Lived Assets

The Company evaluates the carrying value of long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Factors that are considered important that could trigger an impairment review include a current-period operating or cash flow loss combined with a history of operating or cash flow losses and a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset or asset group. Other factors include a significant change in the manner of the use of the asset or a significant negative industry or economic trend. This evaluation is performed based on estimated undiscounted future cash flows from operating activities compared with the carrying value of the related assets. If the undiscounted future cash flows are less than the carrying value, an impairment loss is recognized, measured by the difference between the carrying value and the estimated fair value of the assets, with such estimated fair values determined using the best information available generally based on prices for similar assets for stores recently opened. In light of disappointing sales results during the back-to-school period, the current expectation for continued operating losses and the Company’s most recent historical operating performance, the Company concluded that an indication of impairment existed as of July 31, 2004. Accordingly, the Company conducted an impairment evaluation in accordance with Statement of Financial Accounting Standards No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”) as of July 31, 2004. This analysis included reviewing the stores’ historical cash flows, estimated future cash flows over remaining lease terms and recoverability of each store’s long-lived assets. Based on the results of this analysis the Company wrote down the carrying value of these impaired long-lived assets as of July 31, 2004 by $36.7 million, a non cash charge to the consolidated statement of operations.

Deferred Income Taxes

The Company accounts for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes,” which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. SFAS No. 109 also requires that deferred tax assets be reduced by a valuation allowance if it is more

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likely than not that some portion or all of the net deferred tax asset will not be realized. As a result of recent disappointing sales results during the back-to-school season and the Company’s most recent historical operating performance, the Company concluded that it is more likely than not that the Company will not realize its net deferred tax assets. As a result of this conclusion, the Company reduced its deferred tax assets by establishing a tax valuation allowance of $38.8 million as of July 31, 2004. In addition, the Company will discontinue recording income tax benefits in our consolidated condensed income statements of operations until we determine that it is more likely than not that we will generate sufficient taxable income to realize our deferred income tax assets.

Insurance Coverage

The Company is partially self-insured for its worker’s compensation and group health plans. Under the workers’ compensation insurance program, the Company is liable for a deductible of $250,000 for each individual claim and an aggregate annual liability of $1,600,000. Under the Company’s group health plan, the Company is liable for a deductible of $100,000 for each claim and an aggregate monthly liability of $500,000. The monthly aggregate liability is subject to the number of participants in the plan each month. For both of the insurance plans, the Company records a liability for the costs associated with reported claims and a projected estimate for unreported claims due to historical experience and industry standards. The Company will continue to adjust the estimates as the actual experience dictates. A significant change in the number or dollar amount of claims could cause the Company to revise its estimate of potential losses and affect its reported results.

New Accounting Pronouncements

Information regarding new accounting pronouncements is contained in Item 1, Note 1 to the Consolidated Condensed Financial Statements.

Results of operations

Except as otherwise noted, the following discussion of our financial position and results of operations excludes our discontinued Zutopia division, which was closed by the second week of the second quarter of fiscal year 2004.

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The following table sets forth selected income statement data as a percentage of net sales for the fiscal periods indicated. The discussion that follows should be read in conjunction with the table below:

Second Quarter Fiscal 2004 Compared to Second Quarter Fiscal 2003

Net Sales

The decrease in sales in the second quarter of fiscal year 2004 was primarily due to the comparable store sales decline of 10.9% compared to a comparable store sales decrease of 20.0% in the second quarter of fiscal 2003.

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Cost of Sales (including buying, merchandise planning, distribution and occupancy)

Our cost of sales, in addition to direct merchandise cost, includes our buying, merchandise planning, distribution and occupancy costs. The dollar amount of cost of sales decreased as a result of fewer stores and lower sales per store for existing stores. The increase as a percentage of sales for the second quarter of fiscal year 2004 compared to the same quarter last year was the result of several key factors:

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Selling, General and Administrative Expenses

Our selling, general and administrative (SG&A) expenses are comprised of two components. The selling expense component includes store and field support costs including supervisory personnel, advertising, and merchandise delivery costs as well as internet/catalog processing costs. The general and administrative (G&A) expense component includes the cost of corporate overhead functions such as legal, accounting, information systems, human resources, real estate, and other centralized services. As a percent of sales, SG&A expenses increased 500 basis points compared to the prior year second quarter. The major components to the increase as a percent of sales was:

Asset Impairment

We recorded a non-cash impairment charge of $36.7 million related to certain long-lived assets at July 31, 2004 including store related assets such as leasehold improvements, furniture, fixtures and equipment. We recorded the impairment charge on certain long-lived assets as a result of disappointing sales results for our “Back-To-School”

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season, our expectations for operating results for the third quarter and recent historical results. We determined the impairment charge in accordance with SFAS 144. Our evaluation and determination of the impairment charge was the result of a store-by-store analysis, their respective historical operating performance over the past three years as well as their future operating performance over the remaining lease term.

Net Interest Income (expense)

The decrease in net interest income was primarily due to a decrease in invested cash balances compared to the same period a year ago. Total cash and investments were $36.4 million at the end of July 31, 2004 compared to $89.9 million at August 2, 2003.

Income Taxes Provision (benefit)

The change in income taxes from the same quarter a year ago was a result of establishing a tax valuation allowance of $38.8 million against all of our deferred tax assets. This was deemed necessary in light of recent disappointing sales results, our expectation for third quarter operating results and our most recent historical operating performance. We established this tax valuation allowance in accordance with SFAS 109 “Accounting for Income Taxes”, which requires deferred tax assets be reduced by a valuation allowance if it is more likely than not that some or all of the deferred tax assets will not be realized in the foreseeable future.

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The Six Months Ended July 31, 2004 Compared to the Six Months Ended August 2, 2003

Net Sales

The decrease in sales for the six months ended July 31,2004 was primarily due to the comparable store sales decline of 14.0% compared to a comparable store sales decrease of 22.9% for the prior year six months ended August 2, 2003.

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Cost of Sales (including buying, merchandise planning, distribution and occupancy)