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THE UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended October 30, 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 December 7, 2004 were 34,692,225 and 1,500,000, respectively. There were no shares of Preferred Stock, par value $.01 per share, outstanding at December 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)

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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. On November 9, 2004, the Company signed a securities purchase agreement with S.A.C. Capital Associates, LLC and other investors which, if approved by the shareholders of the Company, would bring substantial additional capital to the Company. For information regarding the securities purchase agreement, refer to Note 11 to the Consolidated Condensed Financial Statements. Should the Company be unable to consummate the transactions contemplated by the securities purchase agreement, the Company may be unable to continue as a going concern. 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 13 weeks and 39 weeks ended October 30, 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 on-line sales, revenue is recognized at the estimated time goods are received by customers. Additionally, shipping and handling fees billed to customers are 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 $89,000 and $66,000 for the 13 week ended October 30, 2004 and November 1, 2003 and $244,000 and $162,000 for the 39 weeks ended October 30, 2004 and November 1, 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 between a 10 and 20 percent discount on all purchases made during the twelve-month program period. The annual membership fee of $20.00 is non-refundable. Based upon historical spending patterns for Wet Seal customers, revenue is recognized over the twelve-month membership period.

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 and then 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 recorded. For the 39 weeks ended October 30, 2004, total markdowns on a cost basis represented 19.0% of sales compared to 13.7% for the 39 weeks of the prior fiscal year ended November 1, 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, 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 expectation for continued operating losses through the end of fiscal 2004 and the Company’s 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, estimating future cash flows over remaining lease terms and determining the 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 noncash 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

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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 disappointing sales results during the back-to-school season and the Company’s 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 has discontinued recognizing 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.” 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

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previously been reported as equity, as a liability (or an asset in some circumstances). The adoption of SFAS 150 did not have a material impact on the Company’s financial statements.

NOTE 2 - 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”.

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 3 - Revolving Credit Arrangement and Long-Term Debt

As of the end of the first quarter of fiscal year 2004, the Company was not in compliance with two covenants as outlined under the $50 million revolving line-of-credit arrangement with Bank of America, N.A. A waiver was obtained from the bank for the non-compliance with these covenants, which related 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

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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 with a $50 million sub-limit for letters of credit with Fleet Retail Group, Inc. (the “Lender”) which matures May 26, 2007. On September 22, 2004, the credit facility was amended to accommodate a new $8 million junior secured term loan (as so amended, the “New Credit Facility”). The term loan is junior in payment to the $50 million revolving line-of-credit under the New Credit Facility. The term loan bears interest at prime plus 7% and matures on May 27, 2007. Monthly payments of interest are payable through the maturity date, and the principal payment of $8 million is due on the maturity date. The average interest rate for the 13 weeks ended October 30, 2004 was 11.75%.

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 are 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.

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 revolving line-of-credit under the New Credit Facility is the prime rate plus a margin based on the average excess availability 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.

At October 30, 2004, the amount outstanding under the New Credit Facility consisted of the $8 million junior secured term loan as well as $14.7 million in open documentary letters of credit related to merchandise purchases and $16.4 million in outstanding standby letters

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of credit, which included $15.0 million for inventory purchases. At October 30, 2004 the Company had $11.4 million available for cash advances and/or for the issuance of additional letters of credit. At October 30, 2004, the Company was in compliance with all covenant requirements related to the New Credit Facility.

NOTE 4: 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.

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):

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NOTE 5 – 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):

NOTE 6 - 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 October 30, 2004, there were 4,328,100 shares remaining that are authorized for repurchase. Presently, there are no plans to repurchase additional shares.

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NOTE 7 - Litigation

Between August 26, 2004 and October 12, 2004, six securities class action lawsuits were filed in the United States District Court for the Central District of California (the “Court”), on behalf of persons who purchased the Company’s common stock between January 7, 2003 and August 19, 2004. The Company and certain present and former executives of the Company were named as defendants. The complaints allege violations of Section 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. On November 17, 2004, the Court consolidated the actions and appointed lead plaintiffs and counsel. Pursuant to stipulations with plaintiffs’ counsel, the lead plaintiffs have until January 18, 2005 to file a consolidated amended complaint that will become the operative pleading in the case. The Company will then have 60 days after receipt of the amended complaint to file a formal response with the Court.

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 October 30, 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.

NOTE 8 - Sale of Common Stock

On June 29, 2004 the Company completed a private placement of equity securities to institutional and other accredited investors totaling $27.2 million in gross proceeds. After transaction costs, the Company raised approximately $25.6 million which was 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.

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

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Securities and Exchange Commission notified the Company that the registration statement was declared effective.

NOTE 9 – Sale of Class B Common Stock

During the 39 weeks ended October 2004, through a series of open market transactions, certain shareholders of the Company sold 3,002,833 shares of Class B common stock. 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 October 30, 2004 there were 1,500,000 Class B shares outstanding.

NOTE 10 – Retention Agreements

On September 27, 2004, the Company and Jennifer Pritchard, President of the Company’s Arden B. division, entered into a retention agreement. Ms. Pritchard’s base salary was increased by $25,000 to an annual rate of $410,000 and her bonus opportunity, which was previously 50% of her salary increased to 75% of her salary, and from a maximum of 100% of her salary to a new maximum of 150% of her salary. She also received an award of 200,000 shares of Class A common stock of the Company, which vests over a 3 year period. In addition, Ms. Pritchard was given a retention cash bonus of $200,000, which would be owed back to the Company if she were to leave voluntarily within 12 months. Ms. Pritchard has the right to exchange the retention cash bonus for an award of an additional 200,000 shares of the Company’s stock and certain severance protections in the event of an involuntary termination by the Company.

On October 28, 2004, the Company entered into retention agreements with each of Allan Haims, the President of the Wet Seal division, Douglas Felderman, Executive Vice President and Chief Financial Officer, and Joseph Deckop, Executive Vice President. Each agreement includes a grant of 155,000 shares of Class A common stock of the Company that vest over a 3-year period. In addition, the agreements with each of Douglas Felderman and Joseph Deckop include certain severance protections in the event of an involuntary termination of employment by the Company and one-time retention payments of $100,000 payable on December 1, 2004, which would be owed back to the Company if the executive were to voluntarily terminate his employment with the Company within 12 months.

During the 13 weeks ended October 30, 2004, the Company entered into retention agreements with certain other (non-executive) employees. The agreements provide for various amounts of cash payments and/or shares of Class A common stock of the Company provided the employee remains with the Company through January 28, 2005. The cash portion for these retention payments totals $883,000 of which $238,000 is included in the results for the 13 weeks ended October 30, 2004. The remaining balance will be recognized in the fourth quarter of fiscal 2004.

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NOTE 11 – Subsequent Events

On November 9, 2004 the Company announced the resignation of Peter D. Whitford as Chief Executive Officer, and as Chairman of the Board of Directors and as a Director of the Company, effective as of November 4, 2004 and Anne K. Zehren as a Director of the Company, effective as of November 8, 2004. Additionally, the Company announced the appointment of Henry Winterstern as Chairman of the Company’s Board of Directors and the appointment of Joseph Deckop as Interim Chief Executive Officer, each effective as of November 8, 2004.

On November 4, 2004, the Company and its former Chief Executive Officer entered into an Agreement and General Release (the “Agreement”) to terminate his employment with the Company. The Agreement provides for certain payments and grant of options from the Company, including: (i) bi-weekly payments of $29,807 to be paid from November 5, 2004 until the earlier of (x) January 31, 2005 and (y) the closing of the financing transaction contemplated by the SPA (as defined below)(the “Payment Date”), (ii) options to purchase 300,000 shares of Class A common stock at an exercise price of $1.75 per share and options to purchase 200,000 shares of Class A common stock at an exercise price of $2.00 per share, exercisable until June 1, 2006, to be granted on or before December 1, 2004, (iii) a payment of $1,585,000 (less the total amount of bi-weekly payments) to be paid on the Payment Date, representing two years of compensation, (iv) a payment of $509,400 to be paid on the Payment Date, representing the cost of three annual contributions to his supplemental executive retirement plan, (v) an amount equal to the cost of his continued healthcare coverage for eighteen months following November 4, 2004, to be paid on or before the Payment Date, and (vi) $50,000 representing the cost of providing outplacement services to be paid on the Payment Date.

On November 9, 2004, the Company signed a Securities Purchase Agreement (“SPA”) with S.A.C. Capital Associates, LLC and other investors (the “investors”). Under the terms of the SPA, the Company will issue and sell to the investors an aggregate of $40,000,000 of the Company’s secured convertible notes having an initial conversion price of $1.50 per share, two series of Additional Investment Right Warrants (“AIRS”) to purchase up to an additional $15,850,000 of secured convertible notes, all of which are convertible into Class A common stock of the Company at initial prices ranging from $1.65 to $1.75 per share of Class A common stock and, subject to satisfaction of certain conditions, as to which the Company has the right to require exercise into additional secured convertible notes which, upon this forced exercise, will have an initial conversion price equal to the lesser of the then market price and $1.65 to $1.75, as the case may be; and, multiple tranches of warrants to purchase up to 13,600,000 shares of Class A common stock of the Company, exercisable for up to five years from the date of issuance at initial exercise prices ranging from $1.75 to $2.75 per share (all of which are “Securities”). Warrants to acquire 2,3000,000 shares of common stock of the aggregate warrants to acquire 13,600,000 shares of common stock, exercisable for up to four years at an initial exercise price of $1.75 per share, were

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issued to the investors in connection with entering into the SPA. The notes and warrants will have full ratchet antidilution protection for any future stock issuances below their exercise of conversion price as the case may be.

Each investor will be prohibited from converting or exercising any Securities into Class A common stock of the Company, if the result would be that the investor (together with its affiliates) would beneficially own at any time more than 9.99% of the outstanding Class A common stock of the Company.

The Company has agreed to file a registration agreement within 30 days after the closing date of the transactions contemplated by the SPA covering resales of the Securities and the shares of Class A common stock underlying the Securities.

The Company is required to obtain shareholder approval of the issuance of the Securities as well as the increase in the number of shares of Class A common stock which the Company is authorized to issue and other related matters.

In connection with the SPA, the investors have provided the Company with a $10 million secured bridge term loan (the “Bridge Loan”) to be used to fund the Company’s working capital obligations through the closing of the transactions contemplated by the SPA. The Bridge Loan bears an interest rate of 25%. The Bridge Loan will become due and payable on the earlier to occur of (i) the closing of the transactions contemplated by the SPA, (ii) the termination of the SPA and (iii) certain dates set forth in the Bridge Loan but not earlier than February 28, 2005. At the closing of the transactions contemplated by the SPA, the outstanding principal amount (together with accrued and unpaid interest) of the Bridge Loan will be applied as partial payment of the aggregate purchase price for the securities.

On November 23, 2004 the Company announced the resignation of Allan Haims, the President of the Wet Seal division.

NOTE 12: Accrued Liabilities

Accrued liabilities consist of the following:

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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 559 retail stores in 47 states, Washington, D.C. and Puerto Rico. Of the 559 stores, 450 are Wet Seal stores, 13 are Contempo Casuals stores and 96 are Arden B. stores. We opened 8 stores and closed 40 stores during the period from November 1, 2003 to October 30, 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.

Current Trends and Outlook

The 13 weeks ended October 30, 2004 was our ninth 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 12.6% for the 13 weeks ended October 30, 2004. Despite our negative comparable store sales trend, our store sales performance at our Arden B. division has been positive and continues to improve over the prior fiscal year. The 13-week 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. These factors were the principal contributors to our net loss of $24.6 million, or $0.68 per share for the 13-week period ending October 30, 2004.

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Due to our operating losses over the past 27 months and diminished liquidity, we have experienced 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. We expect this tight credit environment to continue through the remainder of this fiscal year and may negatively impact our holiday season business, as well as, our initial Spring inventory position. All of these factors will increase demand for working capital. As a result, a number of steps have been taken with the objective of improving the company’s working capital position and future operations. On August 19, 2004, we announced that our board of directors established a special committee to analyze appropriate alternatives to enhance shareholder value and appoint the services of a financial advisor. The special committee appointed Rothschild Inc. as financial advisor on September 16, 2004 for the sole purpose of exploring various strategic alternatives for the Company. On September 28, 2004 we announced the completion of an $8.0 million junior secured term loan (see Note 3 to the Consolidated Condensed Financial Statements, and Management’s Discussion and Analysis – Liquidity and Capital Resources), the proceeds have been used for working capital needs. The work of the special committee and its financial advisor resulted in our announcing on November 9, 2004 a series of agreements with S.A.C. Capital Associates, LLC and other investors (the “SAC Transaction”) to provide a Bridge Loan of $10.0 million, which funded November 10, 2004, and a securities purchase agreement to provide longer term financing of up to $55.8 million, subject to shareholder approval, in the form of secured convertible notes. If the SAC Transaction is completed, the proceeds would be used for working capital and new store development and store closures if necessary.

In conjunction with the SAC Transaction, we have, or intend to, enter into consulting arrangements with certain individuals for the purpose of formulating and executing new plans to return the Company to profitability. We plan to enter into a long-term arrangement with Michael Gold, a retail executive who owns more than 400 retail clothing stores in Canada and the U.S., as a consultant to guide the merchandising initiatives and help streamline operations. We have also entered into a short-term consulting arrangement with RT Management & Consulting Services, LLC, of which Thomas Brosig is president (“RT Management”). RT Management has been engaged to provide an on-site analysis of all non-merchandising departments, information systems, compensation structure and distribution. With the assistance of these consultants and others, we intend to reevaluate our merchandising history, the operating viability of each of our stores, the value of our real estate and leases and the strengths and weaknesses of our general operations.

The purpose of the SAC Transaction and entering into arrangements with Michael Gold and RT Management and other management additions, which may occur, is to implement our strategy to return our Company to profitability. We believe that the SAC Transaction will provide us with the capital needed to effect closures, if necessary, while

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maintaining appropriate inventory levels at stores we intend to keep open as well as to absorb operating losses that may be incurred while we implement our plans. With regard to our merchandise, our merchandising strategy will focus on price, while increasing our sales per square foot by offering fresh inventory reflecting current fashion trends.

As a result of the pending SAC Transaction and to facilitate the execution of a new business plan, a number of management changes have occurred during the month of November 2004. The Company’s Chairman and Chief Executive Officer Peter D. Whitford and the Wet Seal division President Allan D. Haims, resigned. The Wet Seal board of directors named Henry Winterstern, a current Wet Seal board member, Chairman of the Board. Concurrently with the appointment of Mr. Winterstern, the Board accepted the resignation of Anne Zehren as a director. The Board also appointed Joe Deckop as interim Chief Executive Officer. Mr. Deckop has served as Executive Vice President of the Company since April 2004. The Company is taking steps to identify a permanent chief executive officer.

Our ability to execute our business plans, fund our future operations and capital expenditures will most likely depend upon the SAC Transaction being approved by our shareholders. In the event the SAC Transaction is not approved there can be no assurance that additional funding, or another liquidity event, will become available to us, or that an alternative transaction involving the sale of all or part of the company’s assets would occur on a timely basis. In that event, we would be required to consider other 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.

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

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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.

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 $89,000 and $66,000 for the quarters ended October 30, 2004 and November 1, 2003 and $244,000 and $162,000 for the nine months ended October 30, 2004 and November 1, 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

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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 third quarter ending October 30, 2004, total markdowns on a cost basis represented 19.0% of sales compared to 13.7% for the third quarter of the prior fiscal year ended November 1, 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, expectations for continued operating losses and the Company’s historical operating performance, the Company concluded that

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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 noncash 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 likely than not that some portion or the entire net deferred tax asset will not be realized. As a result of disappointing sales results during the back-to-school season and the Company’s 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 has discontinued 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.

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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.

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:

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Thirteen Weeks Ended October 30, 2004 Compared to Thirteen Weeks Ended November 1, 2003

Net Sales

For the 13 weeks ended October 30, 2004, net sales decreased $21.0 million from the same period last year primarily due to fewer stores in operation and a comparable store sales decrease of 12.6%, down from a comparable store sales decrease of 10.1% in the 13 weeks ended November 1, 2003.

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

For the 13 weeks ended October 30, 2004, cost of sales decreased $10.1 million from the same period last year, but increased 570 basis points as a percentage of net sales as a result of the following 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. The general and administrative (“G&A”) expense component includes the cost of corporate overhead functions. As a percent of sales, SG&A expenses increased 880 basis points compared to the prior year third quarter. The major components to the increase as a percent of sales were:

Net Interest Income (Expense)

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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 $22.7 million at the end of October 30, 2004 compared to $69.3 million at November 1, 2003. We also incurred interest expense, including the amortization of costs, related to our Credit Facility (as defined below).

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. This was deemed necessary in light of disappointing sales results and our 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.

The Thirty-Nine Weeks Ended October 30, 2004 Compared to the Thirty-Nine Weeks Ended November 1, 2003

Net Sales