SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended July 2, 2005

Commission file number 0-27826

Party City Corporation

(Exact Name of Registrant as Specified in Its Charter)

Registrant’s telephone number, including area code:

(973) 983-0888

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

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

Common Stock, par value $0.01 per share

      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 þ          No o

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

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

      Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     Yes o          No o

      The aggregate market value of the registrant’s voting and non-voting common stock, $0.01 par value, held by non-affiliates of the registrant on December 31, 2004, based on the closing sale price on such date, was approximately $178,853,096.

      The number of outstanding shares of the registrant’s common stock as of August 30, 2005 was 18,051,357.

DOCUMENTS INCORPORATED BY REFERENCE

      Portions of the registrant’s Proxy Statement for the 2005 Annual Meeting of Stockholders for the fiscal year ended July 2, 2005 are incorporated by reference into Part III.

TABLE OF CONTENTS

      References throughout this document to the “Company” include Party City Corporation and its wholly owned subsidiary. In accordance with the Securities and Exchange Commission’s “Plain English” guidelines, this Annual Report on Form 10-K has been written in the first person. In this document the words “we,” “our,” “ours” and “us” refer only to Party City Corporation and its wholly owned subsidiary and not to any other person.

      Our website — www.partycity.com — provides access, free of charge, to our Securities and Exchange Commission (“SEC”) reports as soon as reasonably practicable after we electronically file such reports with, or furnish such reports to, the SEC, including Proxy Statements, Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to these reports. The reference to our website address in this Annual Report on Form 10-K is not intended to function as a hyperlink and the information contained on such website is not part of this Annual Report on Form 10-K.

      You may also read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. You may obtain information on the operations of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains a website that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC, including us, at http://www.sec.gov.

PART I

Forward-Looking Statements

      This Annual Report on Form 10-K (including the information incorporated herein by reference) contains forward-looking statements within the meaning of The Private Securities Litigation Reform Act of 1995. The forward-looking statements may be identified by forward-looking terminology such as “estimate,” “project,” “expect,” “believe,” “may,” “will,” “intend” or similar statements or variations of such terms. Forward-looking statements involve known and unknown risks and uncertainties which may cause our actual results in future periods to differ materially from forecasted results. Those risks and uncertainties include, among other things, the effect of price and product competition in the party goods industry in general and in our specific market areas, our ability to anticipate customer demand for products and to design and develop products that will appeal to our customers, our ability to open new stores successfully, our ability to continue to successfully implement our distribution system and to implement our merchandise replenishment and other software systems, the availability and terms of capital to fund capital improvements, acquisitions and ongoing operations, our ability to manage successfully our franchise program, our ability to improve our fundamental business processes, including, but not limited to inventory sourcing, to reduce costs throughout our organization, our ability to attract and retain qualified personnel, changes in costs of goods and services and economic conditions in general and/or to identify, execute and integrate acquisitions and to realize synergies. See Part I, Item 1. “Business-Risk Factors” beginning on page 10 for further information on such risks and uncertainties. Furthermore, additional information concerning certain risks and uncertainties that could cause our actual results to differ materially from those projected or suggested may be identified from time to time in our SEC filings and our public announcements. You are cautioned not to place undue reliance on such forward-looking statements, which are made as of the date of this release, and we have no obligation or intention to update or revise such forward-looking statements.

Introduction

      Party City Corporation operates specialty retail party supply stores in the United States. We operate corporate-owned stores and we sell franchises on an individual store and franchise area basis throughout the United States and Puerto Rico. We believe that we are the nation’s largest retail party goods chain. Our focus is on providing our customers with broad assortments, deep in-stock positions and a compelling price-value proposition. We authorized our first franchise store in 1989 and opened our first Company-owned store in January 1994.

      As of July 2, 2005, our network consisted of 502 stores, with 247 Company-owned stores and 255 stores owned by franchisees. Our stores typically range in size from 10,000 to 12,000 square feet. The stores offer a broad selection of brand name and private label merchandise for a wide variety of seasonal and non-seasonal occasions, including Halloween, Christmas, New Year’s Eve, the Super Bowl, St. Patrick’s Day, Summer Luau, birthdays, graduations, weddings and baby showers. Non-seasonal merchandise generally accounts for approximately two-thirds of annual retail net sales, with birthdays being the largest non-seasonal theme and Halloween representing the largest seasonal occasion.

      We report two segments — retail and franchising. The retail segment generates revenue primarily through the sale of third-party branded party goods through Company-owned stores. The franchising segment generates revenue through the assessment of an initial one-time franchise fee, ongoing royalty payments based on retail sales, and sales of product and services through our distribution network. See Note 16 to our consolidated financial statements included herein for key financial information relating to our business segments.

      Our fiscal year ends the Saturday nearest to June 30. As used herein, the term “Fiscal Year” or “Fiscal” refers to the 52- or 53-week period, as applicable, ending the Saturday nearest to June 30. Unless otherwise stated, the financial results presented for the year ended July 2, 2005, July 3, 2004 and June 28, 2003 are based

on a 52-week period, 53-week period and 52-week period, respectively. Party City Corporation was incorporated in the State of Delaware in 1996 and is headquartered in Rockaway, New Jersey.

Business Strategies

      Our objective is to maintain and expand our position as a leading national chain of party supply stores, while internally improving our operating efficiencies, profitability and cash flows and, therefore, shareholder value. Key components of our business strategy include the following:

Store Counts and Locations

      Party City Stores. There were 502 and 494 Party City stores open in the United States and Puerto Rico as of July 2, 2005 and August 30, 2005, respectively. Of these, 247 were Company-owned as of July 2, 2005 and August 30, 2005, and 255 and 247 were operated by our franchisees as of July 2, 2005 and August 30, 2005, respectively. Seven stores were closed as a result of Hurricane Katrina. We plan to open 10-15 new Company-owned stores and approximately five franchise stores in Fiscal 2006.

      The following table shows the change in Party City’s network of stores for the Fiscal Years 2001 through 2005.

      As of July 2, 2005, Party City stores were located in the following states and Puerto Rico:

      Halloween Costume Warehouse Stores. We are conducting a test program for temporary Halloween stores under the Halloween Costume Warehouse brand from early September through early November, with approximately 10 temporary stores to be Company-operated and five temporary stores to be operated by

franchisees. The Company-owned stores will be located in California, Colorado, Michigan and Nevada, while the franchise-operated stores will located in Connecticut, Missouri, Pennsylvania and Tennessee.

Merchandising

      Our stores are designed to be fun and engaging and to create a compelling shopping experience for our customers. Our stores range in size from 6,750 to 19,800 square feet with a typical store size between 10,000 and 12,000 square feet. The stores are divided into various sections based upon product categories (see below) displayed to emphasize the breadth of merchandise available at a good value. In-store signage is used to emphasize our price-value position and make our stores easy to shop.

      During Fiscal 2005, we upgraded the presentation in the majority of our Company-owned stores, including cutting through long aisles where appropriate to allow customers to navigate the stores more easily and to provide increased exposure for featured products. We also repositioned merchandise categories to create adjacencies among items that are related by event or theme, thereby making it easier for customers to locate and purchase coordinated items.

      To maintain consistency throughout our store network, we maintain a list of approved items that are permitted to be sold in our stores. Franchise stores are required to follow these guidelines according to the terms of their franchise agreements. We maintain a standard store merchandise layout and presentation format to be followed by Company-owned and franchise stores. Any layout or format changes developed by us are communicated to the managers of stores on a periodic basis. See Part I, Item 1. “Business — Risk Factors — An effective franchise program is key to our success” for limitations on our ability to control our franchisees’ in-store standards.

      Although product assortment is continually refreshed and updated, our product categories remain consistent with our historical selection. The typical Party City store offers a broad selection of brand name and private label merchandise consisting of more than 15,000 active items. Non-seasonal merchandise historically represents two-thirds of a typical store’s selling space and annual net retail sales, while seasonal merchandise historically represents the remaining portion. We have over 40 product categories, each of which can be characterized into eight general themes:

      Halloween. This is our largest seasonal product category/theme. As a key component of our sales strategy, our stores provide an extensive selection of Halloween products. The stores also carry a broad array of related decorations and accessories for the Halloween season. Our Halloween merchandise is prominently displayed to provide an exciting and fun shopping experience for customers. As a key component of our sales strategy, our stores provide an extensive selection of Halloween products. The stores display Halloween-related merchandise throughout the year to position us as the customer’s Halloween shopping resource. For the past three fiscal years, our Halloween business represented between 19% and 20% of annual retail net sales.

      Other Seasonal. Customer purchases for other seasonal holidays and events compose a significant part of our business. This grouping of product categories includes Christmas, Hanukkah, New Year’s Eve, the Super Bowl, Valentine’s Day, St. Patrick’s Day, Thanksgiving, Passover, Easter, First Communion, Fourth of July and Summer Luau. In total, we support more than 17 holidays or seasons per year. Some of the major items within these categories are tableware, decorations, cutouts, lights, candy, toys and games and balloons tailored to a particular event.

      Birthday. We have many product categories that generally relate to birthdays, making this theme the largest non-seasonal occasion in terms of net sales. Each birthday product category includes a wide assortment of merchandise to fulfill customer needs for celebrating birthdays, including invitations, thank you cards, tableware, hats, horns, banners, cascades, balloons, novelty gifts, piñatas, favors and candy.

      Balloons. The balloon grouping of product categories includes a wide selection of basic and decorative latex balloons in various sizes, colors and package sizes, as well as Mylar balloons in numerous sizes, shapes and designs relating to birthday, seasonal, anniversary and other themes.

      Baby/ Bridal/ Wedding/ Anniversary. This theme includes tableware, favors, accessories, and decorations for baby showers, bridal showers, anniversary celebrations and weddings. Stores also carry personalized invitation books containing numerous samples of customizable invitations from the leading invitation suppliers for sale at discount prices.

      Greeting Cards/ Gift Wrap. This grouping of product categories includes greeting cards from quality national card vendors and a wide assortment of gift bags, bows, tissue paper, ribbons, printed bags and wrapping paper, as well as customizable invitations.

      Party Basics/ Catering. Our stores carry a wide range of basic party supplies including brand name and private label paper and plastic plates, cups, napkins, cutlery and tablecovers. We also offer a broad assortment of catering supplies for individual use as well as institutional use.

      Party Themes. This grouping of product categories includes themes for party occasions that may occur at any time of the year, such as Sports, Rock “n’ Roll, Fiesta or Western. The grouping of product categories also includes general decorations and crepe paper.

      The following represents suppliers from whom we purchased at least 5% of our merchandise:

      The loss of any of these suppliers could materially adversely affect our business, results of operations, financial condition and cash flow. We consider numerous factors in supplier selection, including, but not limited to, price, credit terms, product offerings and quality. As is customary in our industry, we generally do not have long-term contracts with any supplier and any supplier may discontinue selling to us at any time. See “Business — Risk Factors — If we lose any of our key vendors or any of our key vendors fail to supply us with merchandise, we may not be able to meet the demands of our customers and our sales could decline” for risks and uncertainties related to our suppliers.

      We strive to maintain sufficient inventory to enable us to provide a high level of service to our customers. Inventory, accounts receivable and accounts payable levels, payment terms and return policies are in accordance with the general practices of the retail party supply industry and standard business procedures. We negotiate pricing with suppliers on behalf of all stores in our network (Company-owned and franchise). We believe that our buying power enables us to receive favorable pricing terms and enhances our ability to obtain high demand merchandise.

Advertising and Marketing

      Our advertising focuses on promoting specific seasonal occasions as well as general themes, with a strong emphasis on our price-value positioning. Historically, we have advertised primarily via the use of free-standing inserts in newspapers throughout our market areas. Beginning in Fiscal 2006, we will be introducing additional marketing techniques to supplement the inserts, including outdoor, direct mail, newspaper and television advertising in selected markets, with the goal of increasing customer traffic and building our brand. We also will be placing particular emphasis on highly targeted relationship marketing efforts. For example, we have begun to offer a Birthday Club program. In conjunction with our marketing efforts, we have launched an upgraded Party City website that will better communicate products, party ideas and promotional offers, although it will not have e-commerce functionality initially.

Logistics

      Historically, all merchandise was shipped to our stores directly from our vendors. While avoiding the need for distribution centers, this can lead to inefficiencies in merchandise purchasing and delivery, while also creating congestion in stores as a result of inventory storage, requiring store personnel to devote significant time to product ordering and inventory management, and preventing optimization of freight costs from vendors. In July 2004, we began shifting our distribution model from direct-to-store delivery by vendors to a centralized distribution network operated by a third party. We lease two distribution centers, one in California and one in Pennsylvania. The distribution centers began serving Company-owned stores in July 2004 and began serving franchise stores in January 2005. Currently, our capabilities include handling single cartons of individual items from multiple vendors, as well as “cross-dock” merchandise from other vendors (i.e. flow product through the distribution centers to optimize outbound transportation costs to stores), as well as transporting such goods to the stores. This program supports weekly scheduling of store deliveries, further reducing store labor requirements and improving inventory accuracy. While product volume shipped through the distribution centers increased significantly at the end of the third quarter of Fiscal 2005, the economic benefits have not yet been reflected in our financial results. Because we use the weighted average cost method to account for inventory and cost of goods sold, our merchandise margin reflects a blend of the former and current cost structures. We anticipate that continued sell down of inventory acquired under the former cost structure, as well as continued throughput, will generate savings to more than offset operating costs of the centralized distribution system beginning in Fiscal 2006.

Information Systems

      We continually evaluate and upgrade our information systems to enhance the quantity, quality and timeliness of information available to management and to improve service at the store level. During Fiscal 2004 and 2005, we completed significant store and corporate system installations. The investment in our store and corporate information systems has improved certain store processes, such as customer check-out, product receiving, and inventory management, and contributed to a decline in store labor costs during Fiscal 2005. In addition, these investments have provided, and will continue to provide, the systemic foundation for our logistics initiative. We plan to implement new merchandise replenishment software beginning in the second quarter of fiscal 2006 to complement our distribution, planning and allocation initiatives. The system is intended to enhance the store replenishment function by improving in-stocks, leveraging our logistics infrastructure and allowing us to become more effective in our use of store labor.

Franchise Operations

      As of August 30, 2005, we had 247 franchise stores throughout the United States and Puerto Rico. Party City stores run by franchisees utilize our format, design specifications, methods, standards, operating procedures, systems and trademarks.

      We receive revenue from our franchisees, consisting of an initial one-time fee and ongoing royalty fees, and, beginning in the third quarter of Fiscal 2005, we commenced sales of product and services to the franchise stores in connection with our distribution initiatives. In addition, each franchisee has a mandated

advertising budget, which consists of a minimum initial store opening promotion and ongoing local advertising and promotions. Further, the franchisee must pay an additional 1% of net sales to a Party City group advertising fund to cover common advertising materials related to the Party City store concept. Historically, to cover the expenses of fund administration, the Company has charged the advertising fund a management fee equal to 5% of the contributions. In Fiscal 2005, we discontinued the practice of charging the advertising fund a management fee. We do not offer financing to our franchisees for one-time fees and ongoing royalty fees; however, we do offer payment terms as it relates to product sales.

      Current franchise agreements provide for an assigned area or territory that typically equals a three-mile radius from the franchisee’s store location and the right to use the Party City logo and trademark “The Discount Party Super Store®.” In most stores, the franchisee or the majority owner of a corporate franchisee devotes full time to the management, operation and on-premises supervision of the stores or groups of stores.

      Although franchise locations are generally obtained and secured by the franchisee, pursuant to the franchise agreement we must approve all site locations. As franchisor, we also supply valuable and proprietary information pertaining to the operation of the Party City store business, as well as advice regarding location, improvements and promotion. We also supply consultation in the areas of purchasing, inventory control, pricing, marketing, merchandising, hiring, training, improvements and new developments in the franchisee’s business operations, and we provide assistance in opening and initially promoting the store.

      We continually focus on the management of our franchise operations, looking for ways to improve the collaborative relationship in such areas as merchandising, advertising and information systems.

      As of August 30, 2005, we had 13 territory agreements with certain franchisees. These agreements grant the holder of the territory the right to open one or more stores within a stated time period.

Competition

      We operate in highly competitive markets. Our stores compete with a variety of smaller and larger retailers, including, but not limited to, single owner-operated party supply stores, specialty party supply and paper goods retailers (including superstores), warehouse/merchandise clubs, designated departments in drug stores, general mass merchandisers, supermarkets and department stores of local, regional and national chains and catalog and Internet merchandisers. Major chain competitors in our market for specialty party supply and paper goods retailers include iParty Corp., Factory Card and Party Outlet Corp. and Party America, Inc. In addition, other stores or Internet merchandisers may enter the market and become significant competitors in the future. Our stores compete, among other things, on the basis of location and store layout, product mix, customer convenience and price. Some of our competitors in our markets have greater financial resources than we do.

      Management believes that Party City stores maintain a leading position in the party supply business by offering a wider breadth of merchandise than most competitors, greater selection within merchandise classes and low prices on most items in our stores. We believe that our significant buying power, which results from the size of our Party City store network, is an integral advantage.

Trademarks

      We own and permit our franchisees to use a number of trademarks and service marks registered with the United States Patent and Trademark Office, including Party City®, The Discount Party Super Store® and Halloween Costume Warehouse®.

Government Regulation

      As a franchisor, we must comply with regulations adopted by the Federal Trade Commission, such as the Trade Regulation Rule on Franchising, which requires us, among other things, to furnish prospective franchisees with a franchise offering circular. We also must comply with a number of state laws that regulate the offer and sale of our franchises and certain substantive aspects of franchisor-franchisee relationships. These laws vary in their application and in their regulatory requirements. State laws that regulate the offer and

sale of franchises typically require us to, among other things, register before the offer and sale of a franchise can be made in that state and to provide a franchise offering circular to prospective franchises.

      State laws that regulate the franchisor-franchisee relationship presently exist in a substantial number of states. Those laws regulate the franchise relationship, for example, by restricting a franchisor’s rights with regard to the termination, transfer and renewal of a franchise agreement (for example, by requiring “good cause” to exist as a basis for the termination and the franchisor’s decision to refuse to permit the franchisee to exercise its transfer or renewal rights), by requiring the franchisor to give advance notice to the franchisee of the termination and give the franchisee an opportunity to cure most defaults. To date, those laws have not precluded us from seeking franchisees in any given area and have not had a material adverse effect on our operations.

      Each of our stores must also comply with applicable regulations adopted by federal agencies and with licensing and other regulations enforced by state and local health, sanitation, safety, fire and other departments. Difficulties or failures in obtaining the required licenses or approvals can delay and sometimes prevent the opening of a new store or shut down an existing store.

      Our stores must comply with applicable federal and state environmental regulations, although the cost of complying with these regulations to date has not been material. More stringent and varied requirements of local governmental bodies with respect to zoning, land use, and environmental factors can delay, and sometimes prevent, development of new stores in particular locations.

      Our stores must comply with the Fair Labor Standards Act and various state laws governing various matters such as minimum wages, overtime and other working conditions. Our stores must also comply with the provisions of the Americans with Disabilities Act, which requires that employers provide reasonable accommodation for employees with disabilities and that stores must be accessible to customers with disabilities.

Employees

      As of July 2, 2005, we employed approximately 1,600 full-time and 2,500 part-time employees. We consider our relationships with our employees to be good. None of our employees are covered by a collective bargaining agreement.

      During Fiscal 2005, we continued to add people in key departments that had been understaffed, including merchandising, planning and allocation and logistics. We also restructured our corporate and regional offices and in the process eliminated approximately 30 staff positions or approximately 10% of corporate and regional headcount, as part of an effort to streamline operations and reduce corporate expenses where possible.

Risk Factors

      In addition to other matters identified or described by us in this Annual Report on Form 10-K and from time to time in other filings with the Securities and Exchange Commission, there are several important factors that could cause our future results to differ materially from historical results or trends, results anticipated or planned by us, or results that are reflected from time to time in any forward-looking statement that may be made by us or on our behalf. Certain, but not all, of these important factors, are described below.

      Beginning in the third quarter of Fiscal 2004, we have undertaken a series of related initiatives to make fundamental improvements in our business, profitability and cash flow. These initiatives have primarily focused on: improving the breadth of assortment and quality of our products and related product pricing; reconfiguring our in-store product layout to better align product categories and facilitate an easier shopping experience for our customers; improving logistics, including financial, distribution and inventory systems; and building our talent base.

      In connection with the implementation of these initiatives, we have generated significant initial investment expenses that are disproportionate to our sales performance. However, we anticipate these expenses will normalize over time. Most importantly, these initiatives are anticipated to improve customer experience and solidify brand recognition. We believe these initiatives along with increased promotional and advertising activity should provide the basis for improved financial performance during Fiscal 2006. Should our customers respond less favorably to our merchandise offerings, it could have a material adverse impact on our revenues and operating income.

      Our growth and success depends in part upon our ability to contract with and retain qualified franchisees, as well as the ability of those franchisees to operate their stores and promote and develop our store concept. Although we have established criteria to evaluate prospective franchisees and our franchise agreements include certain operating standards, each franchisee operates independently. Applicable franchise laws may delay or prevent us from terminating a franchise or withholding consent to renew or transfer a franchise. As a franchisor, we are subject to federal and state laws regulating the offer and sale of franchises. These laws impose registration and extensive disclosure requirements on the offer and sale of franchises. We cannot assure you that our franchisees will operate stores in a manner consistent with our concept and standards, which could reduce the gross revenues of these stores and therefore reduce our franchise revenue. The closing of unprofitable stores or the failure of franchisees to comply with our policies could adversely affect our reputation and could reduce the amount of our franchise revenues. These factors could have a material adverse effect on our revenues and operating income.

      If we are unable to attract new franchisees or to convince existing franchisees to open additional stores, any growth in royalties from franchised stores will depend solely upon increases in revenues at existing franchised stores, which could be minimal. In addition, our ability to open additional franchise locations is limited by the territorial restrictions in our existing franchise agreements as well as our ability to identify additional markets in the United States that are not currently saturated with the products we offer. If we are unable to open additional franchise locations, we will have to sustain additional growth through acquisitions, opening new Company-owned stores and by attracting new and repeat customers to our existing locations. If we are unable to do so, our revenues and operating income may decline significantly.

      In general, our sales represent discretionary spending by our customers. Discretionary spending is affected by many factors, including, among others, general business conditions, interest rates, the availability of consumer credit, taxation, weather and consumer confidence in future economic conditions. Our customers’ purchases of discretionary items, including our products, could decline during periods when disposable income is lower or during periods of actual or perceived unfavorable economic conditions. If this occurs, our revenues and profitability will decline. In addition, our sales could be adversely affected by a downturn in the economic conditions in the markets in which we operate.

      On August 28, 2005, Hurricane Katrina stormed through the southeastern section of the United States, severely impacting lives and businesses in the Gulf Coast area. One of our franchisees operates 18 stores in Louisiana, Alabama, Mississippi, and Florida. No corporate stores are operated in the affected areas. Seven stores are either damaged or destroyed, with all other stores having reopened. It is unknown at this time how long, if at all, it will take for these seven stores to recover, and for that reason these stores have been removed from our store count as of August 30, 2005. At this time we do not expect this occurrence to have a material impact on our consolidated results of operations, financial position or cash flows.

      Our products appeal to a broad range of consumers whose preferences cannot be predicted with certainty and are subject to rapid change. Our success depends on our ability to identify product trends as well as to anticipate and respond to changing merchandise trends and consumer demand in a timely manner. We cannot assure you that we will be able to continue to offer assortments of products that appeal to our customers or that we will satisfy changing consumer demands in the future. In addition, if consumer demand for single-use, disposable party goods were to diminish, the party supply and paper goods industry and our revenues would be negatively affected. For example, if cost increases in raw materials such as paper, plastic, cardboard or petroleum were to cause our prices to increase significantly, consumers might decide to forgo the convenience associated with single-use, disposable products. Similarly, changes in consumer preferences away from disposable products and in favor of reusable products for environmental or other reasons could reduce the demand for our products. We also sell certain licensed products that are in great demand for short time periods, making it difficult to project our inventory needs for these products. Accordingly, if:

our business, results of operations, financial condition and cash flow could be materially adversely affected. In addition, we may be faced with significant excess inventory of some products and missed opportunities for other products, which would decrease our profitability.

      Our business is dependent to a significant degree upon strong relationships with vendors and our ability to purchase brand name and private label merchandise at competitive prices. As is customary in our industry, we generally do not have long-term contracts with any supplier and any supplier may discontinue selling to us at any time. During Fiscal 2005, we purchased approximately 40% of the aggregate amount of our merchandise from four vendors. The loss of any of these key vendors could have a material adverse effect on our business, results of operations, financial condition and cash flow. We cannot guarantee that we will be able to acquire such merchandise at competitive prices or on competitive terms in the future. In this regard, certain merchandise that is in high demand may be allocated by vendors based upon the vendors’ internal criteria that are beyond our control, and consequently we may receive less product than we anticipated.

      Many of our vendors currently provide us with incentives like volume purchasing allowances and trade discounts. If our vendors were to reduce or discontinue these incentives, prices from our vendors could increase and our profitability would be reduced. As is customary in our industry, we generally do not have long-term contracts with any vendor and any vendor may discontinue selling to us at any time.

      In addition, we believe many of our vendors source their products from China, Mexico and other foreign countries. A vendor may discontinue selling products manufactured in foreign countries at any time for reasons that may or may not be in our control, including foreign government regulations, political unrest, war, disruption or delays in shipments, changes in local economic conditions and trade issues. If we are unable to replace a vendor promptly who is unwilling or unable to satisfy our requirements with a vendor providing equally appealing products, it could have a material adverse effect on our business, revenues and operating income.

      We operate in highly competitive markets. Our stores compete with a variety of smaller and larger retailers, including, but not limited to, single owner-operated party supply stores, specialty party supplies and

paper goods retailers (including superstores), warehouse/merchandise clubs, designated departments in drug stores, general mass merchandisers, supermarkets and department stores of local, regional and national chains and catalog and Internet merchandisers. Major chain competitors in our market for specialty party supply and paper goods retailers include iParty Corp., Factory Card and Party Outlet Corp. and Party America, Inc. In addition, other stores or Internet merchandisers may enter the market and become significant competitors in the future. Our stores compete, among other things, on the basis of location and store layout, product mix, customer convenience and price. Some of our competitors in our markets have greater financial resources than we do.

      As a result of this competition, we may need to spend more on advertising and promotion than we anticipate. We cannot guarantee that we will continue to be able to compete successfully against existing or future competitors. Expansion into markets served by our competitors and entry of new competitors or expansion of existing competitors into our markets could materially adversely affect our business, results of operations, cash flows and financial condition.

      During the third quarter of Fiscal 2005, we announced that our Board of Directors had formed a Special Committee consisting of certain of our independent directors to explore strategic alternatives, and that the Company had received inquiries from more than one entity interested in engaging in a strategic combination with Party City. Subsequently, we announced the engagement of Credit Suisse First Boston as our financial advisor to assist the Company in its exploration of strategic alternatives. Investors are cautioned that there can be no assurance that the consideration of strategic alternatives by the Special Committee will lead to any action by Party City, including a definitive proposal or agreement with respect to a strategic combination on terms that the Board of Directors believes will be in the best interests of the shareholders of Party City. If the Board of Directors approves any strategic alternative and such strategic alternative is consummated, it could have a material effect on our business and stock price.

      Our management currently believes that the cash generated by operations, together with the borrowing availability under the Loan Agreement, will be sufficient to meet our working capital needs for the next twelve months, including investments made and expenses incurred in connection with technology to improve merchandising and distribution systems, support cost reduction initiatives, and improved efficiencies. However, if we are unable to generate sufficient cash from operations, we may be required to adopt one or more alternatives to raise cash, such as incur indebtedness, selling our assets, seeking to raise additional debt or equity capital or restructuring. If adequate financing is unavailable or is unavailable on acceptable terms, we may be unable to maintain, develop or enhance our operations, products and services, take advantage of future opportunities or respond to competitive pressures.

      We have invested significant resources in our Party City brand name in order to obtain the public recognition that we currently have. However, we may be unable or unwilling to strictly enforce our trademarks in each jurisdiction in which we do business. Also, we may not always be able to successfully enforce our trademarks against competitors, or against challenges by others. Our failure to successfully protect our trademarks could diminish the value and efficacy of our past and future marketing efforts, and could cause customer confusion, which could, in turn, adversely affect our revenues and profitability.

      Our business is subject to substantial seasonal variations. Historically, we have realized a significant portion of our net sales, net income and cash flow in the second fiscal quarter of the year, principally due to the sales in October for the Halloween season and, to a lesser extent, due to sales for end of year holidays. We believe this general pattern will continue in the future. An economic downturn during this period could adversely affect us to a greater extent than if such downturn occurred at other times of the year. Our results of operations and cash flows may also fluctuate significantly as a result of a variety of other factors, including the timing of new store openings, store closings and timing of the potential disposition and acquisition of stores.

      We opened one new Company-owned store and closed three Company-owned stores in Fiscal 2005. In Fiscal 2006, we currently plan to open 10 temporary Halloween stores and as many as 10 to 15 conventional Company-owned stores, and we also expect some store closings and relocations. Our results of operations and cash flows may vary significantly as a result of the timing of new store openings, the amount and timing of net sales contributed by new stores, the level of pre-opening expenses associated with new stores and the relative proportion of new stores to mature stores. Any significant decline in our results of operations and cash flows as a result of these variations could adversely affect our stock price.

      Our continued growth will depend, in significant part, upon our ability to open new stores, such as those noted above, in a timely manner and to operate them profitably. Our expansion is also dependent on the effective continuation and management of our franchise program. Furthermore, successful expansion is subject to various contingencies, many of which are beyond our control. These contingencies include, among others, our ability and our franchisees’ ability to (i) identify and secure suitable store sites on a timely basis, negotiate advantageous lease terms and complete any necessary construction or refurbishment of these sites; (ii) adapt to different local and regional preferences and customs and compete against local businesses which are unfamiliar to us; and (iii) integrate successfully new stores into existing operations.

      As our business grows, we will need to attract and retain additional qualified personnel in a timely manner and develop, train and manage an increasing number of management level and other employees. We cannot assure you that we will be able to attract and retain personnel as needed in the future. Additionally, if we are not able to hire capable store managers and other store level personnel, we will not be able to open new stores as planned and our revenue growth and operating results will suffer.

      We cannot give any assurances that we will be able to continue our expansion plans successfully, that we will be able to achieve results similar to those achieved with prior locations, or that we will be able to continue to manage our growth effectively. Our failure to achieve our expansion plans could have a materially adverse impact on our business, results of operations and financial condition. In addition, we expect our operating margins will be impacted by new store openings because of the addition of pre-opening expenses and the lower sales volume characteristic of new stores. Furthermore, the opening of additional stores in existing markets may attract some of our customers away from our other stores already in operation and diminish their sales.

      Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, we were required during Fiscal 2005 to perform an evaluation of our internal controls over financial reporting and have our auditor publicly attest to such evaluation. Compliance with these requirements has been expensive and time-consuming. In designing and evaluating our internal controls over financial reporting, we recognize that any internal control or procedure, no matter how well designed and operated, can provide only reasonable assurance of achieving desired control objectives. For example, a company’s operations may change over time as the result of new or discontinued lines of business and management must periodically modify a company’s internal controls and procedures to timely match these changes in its business. In addition, management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures and company

personnel are required to use judgment in their application. No system of internal controls can be designed to provide absolute assurance of effectiveness.

      A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. During the audit of our consolidated financial statements for Fiscal 2005, Deloitte & Touche LLP, our independent registered public accounting firm, and management notified our audit committee that we had identified a material weakness in our internal control over financial reporting. A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. In particular, during the financial closing and reporting process in connection with the audit, errors were identified that resulted from a weakness in our financial closing and reporting process, specifically, review, monitoring and analysis of selected account balances and technical interpretation of GAAP. These deficiencies resulted in adjustments to the consolidated financial statements as of July 2, 2005 of which two were material errors: (i) we incorrectly calculated goodwill impairment in accordance with SFAS No. 142, and we were required to record an additional $1.6 million of goodwill impairment; and (ii) we incorrectly classified $1.4 million relating to accrued property and equipment in investing activities in our consolidated statement of cash flows. Based on these facts, and because of the significance of the financial closing and reporting process, our management, including our chairman of the executive committee and CFO, has concluded that these inadequacies in our internal control over financial reporting constitute a material weakness as of July 2, 2005.

      Due to the foregoing assessment, management has concluded that our internal control over financial reporting was not effective as of the end of the fiscal year to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external reporting purposes in accordance with GAAP. We reviewed the results of management’s assessment with our audit committee.

      We are currently reviewing our resources for evaluating and resolving non-routine and/or complex accounting transactions to determine the proper remediation for the material weakness identified. While we believe the primary reason for the material weakness was due to an atypical overload of our accounting and financial staff relating to our compliance with Section 404 of the Sarbanes-Oxley Act of 2002 for the first time, we may conclude to take one or more of the following actions: (a) hire additional qualified employees in our finance and accounting departments that have experience with complex accounting transactions; (b) enhance training relating to GAAP in respect of non-routine and/or complex accounting transactions; (c) adopt more rigorous policies and procedures with respect to goodwill impairment testing and classification of cash flows, and (d) engage a third party specialist to assist the Company’s personnel conducting comprehensive and detailed reviews of non-routine and/or complex accounting transactions. While we intend to take all necessary actions to remediate the material weakness, there remains a risk that the transitional procedures which we may take will not be sufficient.

      A material failure of internal controls over financial reporting could materially impact our reported financial results and the market price of our stock could significantly decline. Additionally, adverse publicity related to a material failure of internal controls over financial reporting would have a negative impact on our reputation and business. Similarly, in future fiscal periods, if we fail to timely complete this evaluation, or if our auditors cannot timely attest to our evaluation, we could be subject to regulatory scrutiny, a loss of public confidence in our financial statements and a negative impact on our business reputation, all of which could have a materially adverse effect our stock price.

      Our success depends to a large extent on the continued service of our executive management team. Departures by our executive officers could have a negative impact on our business, as we may not be able to find suitable management personnel to replace departing executives on a timely basis. We do not maintain key executive life insurance on any of our executive officers.

      As our business expands, we believe that our future success will depend greatly on our continued ability to attract and retain highly skilled and qualified personnel. Although we generally have been able to meet our staffing requirements in the past, our ability to meet our labor needs while controlling costs is subject to external factors, such as unemployment levels, minimum wage legislation and changing demographics. Our inability to meet our staffing requirements in the future at costs that are favorable to us, or at all, could impair our ability to increase revenue, and our customers could experience lower levels of customer care.

      The efficient operation of our stores is dependent on our ability to distribute, in a timely manner, merchandise to our store locations throughout the United States. An independent third party operates our distribution centers. We depend on this third party to receive, sort and distribute a substantial and growing portion of our merchandise. This third party employs personnel represented by a labor union. Although there have been no work stoppages or disruptions since the inception of our relationship with this third party, there can be no assurance that work stoppages or disruptions will not occur in the future. We also use a separate third party transportation company to deliver our merchandise from our distribution centers to our stores. Any failure by either of these third parties to respond adequately to our distribution and transportation needs would disrupt our operations and could have a material adverse effect on our business, results of operations, financial conditions and cash flow.

      As of August 30, 2005, there were 494 Party City stores open in the United States and Puerto Rico. Of these stores, 247 were Company-owned and 247 were operated by our franchisees. See Part I, Item 1. “Business-Store Counts and Locations” for additional information on the growth in Party City’s network of stores for Fiscal 2001 through 2005 and the location of our stores as of July 2, 2005. As of August 30, 2005, we leased the property for all of our 247 Company-owned stores. Our stores range in size from 6,750 to 19,800 square feet, with a typical store size between 10,000 and 12,000 square feet. We do not believe that any individual store property is material to our financial condition or results of operation. Of the leases for the Company-owned stores, 11 expire in Fiscal 2006, 35 expire in Fiscal 2007, 60 expire in Fiscal 2008, 68 expire in Fiscal 2009 and the balance expire in Fiscal 2010 or thereafter. We have options to extend most of these leases for a minimum of five years.

      As of August 30, 2005, we entered into 10 temporary store leases for which we are going to do business as “Halloween Costume Warehouse” for the 2005 Halloween season. These temporary stores are being leased for approximately four months of the year during the Halloween season.

      On September 16, 2004, we entered into a new corporate office lease for 106,000 square feet of office space. The initial term is for 12 years, with two five-year renewal options. The lease contains escalation clauses and obligations for reimbursement of common area maintenance and real estate taxes. The lease for our current corporate headquarters expired in December 2004, but we negotiated an extension of such lease to expire on December 31, 2005. We intend to relocate to our new corporate headquarters by the end of the second quarter of Fiscal 2006 and intend to vacate our current corporate headquarters thereafter.

      We believe that all of our current facilities are in good condition and are suitable and adequate for the purposes for which they are used.

      A lawsuit was filed on September 25, 2001 against us in Los Angeles Superior Court by an assistant manager in one of our California stores for himself and on behalf of other members of an alleged class of Party City store managers (the “Class”) who claim we misclassified the Class members as exempt from California overtime wage and hour laws. The Class members sought the disgorgement of overtime wages allegedly owed by us to them but not paid and they also sought punitive damages and statutory penalties. The parties agreed to a settlement for $5.5 million, on a claims made basis, which was approved by the Los Angeles Superior Court on May 2, 2005. We previously recorded the $5.5 million settlement as pre-tax charges in prior fiscal

periods. During the fourth quarter of Fiscal 2005, we paid $5.1 million in respect of all claims properly filed and approved in conformity to the settlement agreement, and no more claims will be administered. There was an excess accrual of $438,000 related to this lawsuit, which was reversed back to income during Fiscal 2005.

      In addition to the foregoing, from time to time we are involved in routine litigation incidental to the conduct of the business, which is not, individually or in the aggregate, material to us.

      No matters were submitted to a vote of security holders during the fourth quarter of Fiscal 2005.

PART II

      Our common stock has traded on the Nasdaq National Market under the symbol “PCTY” since its re-listing in July 2001. From July 1999 until its re-listing on the Nasdaq National Market, our common stock was traded on the OTC Bulletin Board, an electronic quotation service for NASD Market Makers. From March 1996 until July 1999 our common stock was traded on the Nasdaq National Market.

      The following table sets forth the high and low trading prices of our common stock for each quarter of the latest two fiscal years:

      At August 30, 2005, the number of holders of record of our common stock was 379.

Dividends

      We have never paid cash dividends on our capital stock and do not intend to pay cash dividends in the foreseeable future. We expect that earnings will be retained for the continued growth and development of our business. Future dividends, if any, will depend upon our earnings, financial condition, working capital requirements, compliance with covenants in agreements to which we are or may be subject, future prospects and any other factors deemed relevant by our Board of Directors. Under various agreements to which we are a party, principally under the Loan Agreement with Wells Fargo, there are restrictions on paying out dividends. See Part II, Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources.”

Issuer Purchases of Equity Securities

      We purchased no shares of our common stock during Fiscal 2005 or Fiscal 2004.

      In September 2001, the Board of Directors authorized us to repurchase up to $15 million of our outstanding common stock at a price not to exceed $7.00 per share, which was amended on February 7, 2003

to a price not to exceed $10.00 per share. The stock repurchases are made at the discretion of management. During Fiscal 2003, we repurchased 463,012 shares for an aggregate amount of $4.1 million, or 27.4% of total amount authorized to be purchased. As of July 2, 2005, we have purchased a total of 747,012 shares for an aggregate amount of $5.9 million, or 39.6% of the total amount authorized to be purchased.

Equity Compensation Plan Information

      The following table sets forth certain information as of July 2, 2005 concerning our equity compensation plans (1):

      We have derived the selected financial data presented below from our audited consolidated financial statements for the Fiscal Years ended July 2, 2005, July 3, 2004, June 28, 2003, June 29, 2002 and June 30, 2001. Financial results for Fiscal 2004 are based on a 53-week period, while financial results for all other periods are based on a 52-week period. The selected financial information presented below should be read in conjunction with such consolidated financial statements and notes included herein.

Selected Financial Data

      Because we consider EBITDA and Adjusted EBITDA useful as operating measures, a reconciliation of EBITDA and Adjusted EBITDA to net income follows for the periods indicated:

      Because we also consider EBITDA and Adjusted EBITDA useful as liquidity measures, we present the following reconciliation of EBITDA and Adjusted EBITDA to our net cash (used in) provided by operating activities:

Overview

      We operate retail party supply stores within the continental United States and we sell franchises on an individual store and franchise area basis throughout the United States and Puerto Rico. As of July 2, 2005, our network consisted of 502 stores, with 247 Company-owned stores and 255 stores owned by franchisees. We report two segments — retail and franchising. The retail segment generates revenue primarily through the sale of third-party branded party goods through Company-owned stores. The franchising segment generates revenue through the imposition of an initial one-time franchise fee, ongoing royalty payments based on retail sales, and sales of product and services through our distribution network.

      Beginning in the third quarter of Fiscal 2004, we have undertaken a series of related initiatives to make fundamental improvements in our business, profitability and cash flow. These initiatives have primarily focused on: improving the breadth of assortment and quality of our products; offering coordinated assortments; modifying product pricing; reconfiguring our in-store product layout to better align product categories and facilitate an easier shopping experience for our customers; improving logistics, including financial, distribution and inventory systems; and strengthening the talent of our employee base.

      While we consider these initiatives essential to improve customer traffic and strengthen our financial performance, we experienced reduced net sales and earnings during the past fiscal year, in part related to the transition process resulting from the various initiatives. For Fiscal 2005, we experienced a decline in same store net sales for Company-owned stores of 4.7%, and a decrease in net income to $4.3 million from $13.9 million, as compared to the same period last fiscal year. Also, in connection with the implementation of the above initiatives, we have incurred significant initial expenses that are disproportionate to our sales performance.

      During the third quarter of Fiscal 2005, we announced that our Board of Directors had formed a Special Committee consisting of certain of our independent directors to explore strategic alternatives, and that the Company had received inquiries from more than one entity interested in engaging in a strategic combination with Party City. Subsequently, we announced the engagement of Credit Suisse First Boston as our financial advisor to assist the Company in its exploration of strategic alternatives. Investors are cautioned that there can be no assurance that the consideration of strategic alternatives by the Special Committee will lead to any action by Party City, including a definitive proposal or agreement with respect to a strategic combination on terms that the Board of Directors believes will be in the best interests of the shareholders of Party City. If the Board of Directors approves any strategic alternative and such strategic alternative is consummated, it could have a material effect on our business and stock price.

      In addition, we announced the appointment of a new Executive Committee (“the Executive Committee”) chaired by Michael E. Tennenbaum, Vice-Chairman of the Board of Directors, and including Richard H. Griner, Chief Operating Officer, Lisa G. Laube, Chief Merchandising Officer, Gregg A. Melnick, Chief Financial Officer, and Steven Skiba, Chief Information Officer. This Executive Committee is charged with oversight of the operations of Party City and has implemented changes in certain elements of our business strategies, as described below. Mr. Tennenbaum is serving as Chairman of the Executive Committee at the direction of the Board of Directors. We further announced that Nancy Pedot has stepped down as the Company’s Chief Executive Officer and as a member of the Board of Directors, effective March 30, 2005. Ms. Pedot’s responsibilities as Chief Executive Officer have been assumed by the Executive Committee.

      Under the direction of the Executive Committee, we have made certain revisions to our business strategies. Specifically, we have combined Party City’s traditional price-value positioning and aggressive promotional activities with such recent initiatives as new products and coordinated assortments, an improved store configuration, a commitment to increased in-stock levels in our stores and centralized distribution. The objective of these revised strategies is to restore positive same-store net sales comparisons on a consistent basis by increasing customer traffic and average transaction, while also achieving improved margins through sales growth and efficiencies from the logistics initiative.

      Several of our key initiatives, and their affect on our operational and financial performance during Fiscal 2005, are described below:

Key Performance Indicators and Statistics

      We use a number of key indicators of financial condition and operating results to evaluate the performance of our business, including the following:

Critical Accounting Policies and Estimates

      The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires the appropriate application of certain accounting policies, many of which require estimates and assumptions about future events and their impact on amounts reported in the

financial statements and related notes. Since future events and their impact cannot be determined with certainty, the actual results will inevitably differ from our estimates. Such differences could be material to the consolidated financial statements included herein.

      We believe our application of accounting policies, and the estimates inherently required by the policies, are reasonable. These accounting policies and estimates are constantly reevaluated and adjustments are made when facts and circumstances dictate a change. Historically, we have found the application of accounting policies to be reasonable, and actual results generally do not differ materially from those determined using necessary estimates.

      Merchandise inventory. Inventory is valued using the cost method which values inventory at the individual item level at the lower of the actual cost or market cost. Cost is determined using the weighted average method. Market cost is determined by the estimated net realizable value, i.e. the expected merchandise selling price. Inventory levels are reviewed to identify slow-moving and closeout merchandise that will no longer be carried. We also estimate amounts of current inventories that will ultimately become obsolete due to changes in fashion and style, based on the following factors: (i) supply on hand, (ii) historical experience and (iii) our expectations as to future sales. (Credits)/charges to earnings resulting from changes in valuation trends have been ($57,000), ($3.3) million and $3.3 million, for the years ended July 2, 2005, July 3, 2004 and June 28, 2003, respectively. Further, we do not anticipate any significant change in slow moving and close out merchandise that would cause a significant change in our earnings.

      During the first quarter of Fiscal 2005, we launched our logistics initiative, which includes modifying our business operations to vertically integrate certain logistics and distribution activities, and we therefore adopted new specific accounting policies for the treatment of the costs associated with our distribution network. We have outsourced the operations of our distribution network to a third party. Distribution costs include the third-party fees and expenses of operating the distribution centers and the freight expense related to transporting merchandise to our stores. These distribution costs are initially capitalized into merchandise inventory and expensed when the merchandise is sold in our stores.

      During the third quarter of Fiscal 2005, we began providing product and logistics services through its distribution network to all of our franchise operators. Revenues and expenses associated with servicing the franchisees through the distribution network include product sales and fixed and variable distribution center expenses, transportation and other selling expenses, respectively. As defined in Emerging Issues Task Force (“EITF”) Issue No. 99-19 “Reporting Revenue Gross as a Principal Versus Net as an Agent”, we record revenues and expenses related to servicing its franchisees on a gross basis because we act as a principal in the transaction, take title to the products, and hold inventory ownership risk.

      We estimate inventory shortage for the period from the last inventory date to the end of the reporting period on a store-by-store basis. Our inventory shortage estimate can be affected by changes in merchandise mix and changes in actual shortage trends. The shrinkage rate from the most recent physical inventory, in combination with historical experience, is the basis for estimating shrinkage.

      Allowance for doubtful accounts. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our franchisees to make required payments. Judgment is required in assessing the ultimate realization of these receivables, including consideration of our history of receivable write-offs, the level of past due accounts and the economic status of our franchisees. If the financial condition of our franchisees were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances would be required.

      Finite long-lived assets. The Company’s judgment regarding the existence of impairment indicators is based on market and operational performance. We assess the impairment of long-lived assets, primarily fixed assets, whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following:

      In the evaluation of the fair value and future benefits of finite long-lived assets, we perform an analysis by store of the anticipated undiscounted future net cash flows of the related finite long-lived assets. If the carrying value of the related asset exceeds the undiscounted cash flows, the carrying value is reduced to its fair value. Various factors including future sales growth and profit margins are included in this analysis. To the extent these future projections or strategies change, the conclusion regarding impairment may differ from the current estimates. A charge of $0.6 million related to fixed asset impairment was taken during the fourth quarter of Fiscal 2005. No impairment charges were incurred in Fiscal 2004.

      Insurance accruals. Our consolidated balance sheets include significant liabilities with respect to self-insured workers’ compensation and general liability claims. We estimated the required liability of such claims as of July 2, 2005, utilizing an actuarial method based upon various assumptions, which include, but are not limited to, our historical loss experience, projected loss development factors, actual payroll and other data. The required liability is also subject to adjustment in the future based upon the changes in claims experience, including changes in the number of incidents (frequency) and changes in the ultimate cost per incident (severity). Adjustments to earnings resulting from changes in historical loss trends have been insignificant for Fiscal 2005, 2004 and 2003. Further, we do not anticipate any significant change in loss trends, settlements or other costs that would cause a significant change in our earnings.

      Goodwill. We evaluate goodwill annually or whenever events and changes in circumstances suggest that the carrying amount may not be recoverable from its estimated future cash flows. In making this evaluation, management relies on a number of factors including operating results, business plans, economic projections, anticipated future cash flows and marketplace data. A change in these underlying assumptions may cause a change in the results of the tests and, as such, could cause fair value to be less than the carrying value. In such event, we would then be required to record a charge, which would impact net income.

      In the fourth quarter of Fiscal 2005, in accordance with our annual review of goodwill under SFAS No. 142, we determined that the goodwill associated with certain underperforming stores principally located in the Seattle market was impaired and a charge for $2.2 million was recorded. In measuring fair value we used the discounted cash flow method, and estimated the fair value of the equity based on anticipated cash flows over five years plus a terminal value at the end of five years and discounted these items to their present value using an a rate of return of 13%. We then allocated the fair value to all of the assets and liabilities of the company (including any unrecognized intangible assets) as if the company had been acquired in a business combination and the fair value of the company was the price paid to acquire the company. As such we determined that goodwill was impaired under the fair value test.

      Sales Returns. We estimate future sales returns and, when material, record a provision in the period that the related sales are recorded based on historical information. Should actual returns differ from our estimates, we would be required to revise estimated sales returns. Charges or credits to earnings resulting from revisions to estimates on our sales return provision were approximately ($362,000),($39,000) and $126,000 for Fiscal 2005, 2004 and 2003, respectively.

      Store Closure Costs. We record estimated store closure costs, estimated lease commitment costs net of estimated sublease income and other miscellaneous store closing costs when the liability is incurred. Such estimates, including sublease income, may be subject to change. Charges to earnings resulting from store closing costs were $0.8 million, $0.8 million and $1.5 million for Fiscal 2005, 2004 and 2003.

      Income Taxes. Temporary differences arising from differing treatment of income and expense items for tax and financial reporting purposes result in deferred tax assets and liabilities that are recorded on the balance sheet. These balances, as well as income tax expense, are determined through management’s estimations, interpretation of tax law for multiple jurisdictions and tax planning. If our actual results differ from estimated results due to changes in tax laws, new store locations or tax planning, our effective tax rate and tax balances could be affected. As such these estimates may require adjustment in the future as additional facts become known or as circumstances change.

      The Company’s income tax returns are periodically audited by various state and local jurisdictions. Additionally, the Internal Revenue Service audits the Company’s federal income tax return annually. The Company reserves for tax contingencies when it is probable that a liability has been incurred and the contingent amount is reasonably estimable. These reserves are based upon the Company’s best estimation of the potential exposures associated with the timing and amount of deductions as well as various tax filing positions. Due to the complexity of these examination issues, $1 million has been accrued to date.

General Definitions for Operating Results

      Net sales include Company-owned same store net sales and Company-owned new store net sales. Stores are included in the same store net sales calculation when in operation for a full month in a current fiscal period and the corresponding full month in the prior fiscal year. All other stores are included in new store net sales.

      Cost of goods sold and occupancy costs include merchandise, distribution and store occupancy costs. Distribution costs include the costs of operating the out-sourced distribution centers and freight expense related to transporting merchandise to our stores. These distribution costs are initially capitalized into merchandise inventory and expensed when the merchandise is sold in our stores. Store occupancy costs include rent, common area maintenance, real estate taxes, repairs and maintenance, depreciation, insurance and utilities.

      Gross profit is net sales minus cost of goods sold and occupancy costs.

      Store operating and selling expenses consist of selling and store management payroll, employee benefits, medical insurance, employment taxes, advertising, other store level expenses and pre-opening expenses which are expensed when incurred.

      Company-owned store profit contribution is gross profit minus store operating and selling expenses.

      General and administrative expense includes employee compensation, benefits, and taxes, management information systems, marketing, insurance, legal, occupancy, depreciation and other corporate level expenses, less the allocation of corporate expenses to the franchising segment discussed below. Corporate level expenses are primarily attributable to our corporate office in Rockaway, New Jersey, and district and regional offices throughout the country.

      Franchising. Franchising revenue is composed of the initial franchise fees, which are recorded as revenue when a franchise store opens, ongoing royalty fees, generally 4.0% of the store’s net sales, and revenues from the sale of product and services through the distribution network. Such distribution network revenues include the sale of product, including inbound freight reimbursement, pass-through of variable distribution center expenses (handling costs), subscription fees relating to fixed costs in the distribution centers, and other management fees associated with customer service centers. Franchise expenses include cost of goods relating to product sales, including inbound freight costs, fixed and variable distribution center expenses, order management expenses, transportation costs from distribution centers to stores and other direct and indirect expenses. The direct expenses include salaries, travel and other direct expenses of the franchise operations department in addition to legal fees, bad debt expense, insurance expense and other miscellaneous charges. The indirect expenses include allocations of corporate general and administrative expenses for employee compensation, benefits and taxes, occupancy and depreciation, based on time spent on franchise support.

      Franchise profit contribution is franchise revenue minus franchise expenses.

      Interest expense, net includes interest relating to our credit facility, amortization of financing costs and bank service charges. Interest expense, net also includes interest income from other highly liquid investments purchased, with an original maturity of three months or less, as part of our daily cash management activities.

Results of Operations

      Our revenues and earnings are generated primarily from our two business segments — retail and franchising. See Part I, Item 6. “Selected Financial Data” — for a summary of our financial performance.

Unless otherwise stated, the financial results presented for Fiscal 2005 and Fiscal 2003 are based on a 52-week period, and on a 53-week period for Fiscal 2004.

      Retail. Net sales from Company-owned stores decreased 5.7% to $467.7 million for Fiscal 2005 from $496.1 million in the same period last year. The 5.7% decrease in net sales resulted partially from the additional week of sales in Fiscal 2004 of $8.2 million, as well as a same store net sales decrease of 4.7% which was partially offset by net sales from new stores. Same store net sales results reported here are based on the first 52 weeks in both Fiscal 2005 and 2004 periods for comparison purposes. Same store net sales for non-seasonal merchandise decreased 5.6% due to the ongoing transition of this merchandise category, and same store net sales for seasonal merchandise decreased by 2.9%, largely attributed to a decrease in Halloween and Christmas sales. Although the customer count in Company-owned stores, on a same store basis, decreased 5.7% during Fiscal 2005, the same store average net sale per retail transaction increased 1.1% reflecting a lower level of discounting and promotional markdown activity compared with the same time last year. Six stores joined the same store net sales group during Fiscal 2005. We opened one new store and closed three stores during Fiscal 2005, and opened nine new stores and closed two stores during the same period last year.

      Gross profit as a percent of net sales was 32.3% for Fiscal 2005 compared with 33.0% for the same period last year. As shown in the table below, gross profit decreased $12.8 million to $151.0 million during Fiscal 2005 from $163.8 million in the same period last year.

      Store operating and selling expenses were 23.7% and 22.8% of net sales for Fiscal 2005 and Fiscal 2004, respectively. As shown in the table below, store operating and selling expenses decreased $2.5 million, or 2.2%, to $110.8 million for Fiscal 2005 from $113.3 million in the same period last year. We incurred pre-opening expenses of $28,000 during Fiscal 2005 for one new store opened during such period, while we incurred $552,000 during the same period last year for nine new stores opened during such period. Pre-opening expenses include payroll and fringe benefits, as well as other operating costs.

      Company-owned store profit contribution as a percent of net sales was 8.6% for Fiscal 2005 compared with 10.2% in the same period last year. Company-owned store profit contribution decreased $10.3 million during Fiscal 2005 to $40.2 million from $50.5 million during the same period last year.

      General and administrative expenses were 8.9% and 7.2% of net sales during Fiscal 2005 and Fiscal 2004, respectively. As shown in the table below, general and administrative expenses increased $6.0 million to $41.5 million for Fiscal 2005 from $35.5 million in the same period last year.

      We recorded a pre-tax litigation charge of $4.1 million during Fiscal 2004 relating to the settlement payments, attorneys’ fees and estimated expenses of administering the settlement of the lawsuit regarding California overtime wage and hour laws. There was an excess accrual of $438,000 related to this lawsuit, which was reversed back to income during Fiscal 2005.

      A non-cash impairment charge of approximately $2.2 million was recorded in Fiscal 2005 for certain underperforming stores principally located in the Seattle market. Also, a charge of approximately $0.6 million was recorded relating to the write-off of fixed assets of seven underperforming stores.

      Franchising. We began providing product and logistics services to franchisees in the third quarter of Fiscal 2005. During Fiscal 2005, these services resulted in a net loss of approximately $40,000.

      Franchise fees recognized on four store openings were $160,000 during Fiscal 2005, compared with $608,000 recognized on 18 store openings in the same period last year. Royalty fees increased 0.7% to $19.7 million for the Fiscal 2005 from $19.5 million in the same period last year. This increase was primarily due to four franchise store openings since the end of the same period last year and 12 franchise stores (acquired from us in 1999 as part of our restructuring) that were required to start paying royalties during Fiscal 2005 due to the end of a five-year royalty free period, partially offset by the same store net sales decrease of 3.1% for the franchise stores during Fiscal 2005.

      Other franchise expenses increased 13.3% to $8.1 million for Fiscal 2005 from $7.2 million for the same period last year. This increase is primarily due to a larger corporate expense allocation.

      Accordingly, franchise profit contribution decreased 10.1% to $11.6 million during Fiscal 2005 from $12.9 million in the same period last year.

      Interest Expense. We recorded net interest expense of $49,000 for Fiscal 2005 as compared with $471,000 during the same period last year. This decrease is mainly due to increased interest income from higher average cash balances throughout the year as well as overall lower financing expenses during Fiscal

2005. We had no advances under our Loan Agreement at any point during Fiscal 2005 compared with minimal average borrowings during the same period last year.

      Income Taxes. Income tax expense of $3.2 million, or 43.2% of pre-tax income, and $9.5 million, or 40.5% of pre-tax income, was recorded in Fiscal 2005 and Fiscal 2004, respectively. The increase in tax rate for Fiscal 2005 relates to a provision of approximately $0.2 million for the proposed settlement of state tax audits. The tax rate for Fiscal 2006 is expected to be 40.5%.

      Net Income. As a result of the above factors, we recorded net income of $4.3 million, or $0.22 per diluted share, for Fiscal 2005, as compared with $13.9 million, or $0.71 per diluted share, for the same period last year. Weighted average diluted shares outstanding increased to 19.8 million for Fiscal 2005 from 19.7 million in the same period last year due to the stock option exercises and participation in the employee and management stock purchase plans in Fiscal 2005.

      Unless otherwise stated, the financial results presented for “Fiscal 2004 Compared with Fiscal 2003” are based on a 53-week period for the year ended July 3, 2004, and on a 52-week period for the year ended June 28, 2003.

      Retail. Net sales from Company-owned stores increased 6.9% to $496.1 million for Fiscal 2004 from $464.3 million for the same period last year. The 6.9% increase in net sales resulted from an increase of 6.3% related to stores that have not been open for one year and an increase in same store net sales of 0.6%. For purposes of understanding the effect of the additional week in fiscal 2004, our net sales for the last week of Fiscal 2004 were approximately $8.2 million. The customer count in Company-owned stores, on a same store basis, decreased 1.5%, and the average net sale increased 2.1%. We opened nine new stores and closed two store during Fiscal 2004 and opened 35 stores (including an acquisition of eleven stores from a third party and two stores from a franchisee) and closed two store during the same period last year.

      Gross profit increased 7.0% to $163.8 million in Fiscal 2004 from $153.1 million in the same period last year. The increase was primarily due to increased sales volume. Gross margin as a percent of net sales was 33.0% for Fiscal 2004, relatively flat with last fiscal year. The chart below shows the components of the $10.7 million increase in gross profit:

      Store operating and selling expenses increased 4.6% to $113.3 million for Fiscal 2004 from $108.3 million in the same period last year. The increase in store operating and selling expenses is attributable to increased expenses related to the new stores opened in Fiscal 2004. Pre-opening expenses incurred in Fiscal 2004, which included payroll and fringe benefits and other operating costs, for the stores opened in Fiscal 2004 and stores to be opened in Fiscal 2005 amounted to $552,000 compared with $1.6 million incurred in Fiscal 2003 For stores opened in Fiscal 2003 and stores to be opened in Fiscal 2004. Store operating and selling expenses were 22.8% and 23.3% of sales for Fiscal 2004 and Fiscal 2003, respectively. The decrease as a percent of net sales is

due mainly to a decrease in physical inventory fees as a result of lower inventory and a decrease in advertising expenses. The chart below shows the components of the $5.0 million increase in store operating and selling expenses:

      Company-owned store profit contribution was $50.5 million for Fiscal 2004 compared with $44.8 million for the same period last year. The improvement from Fiscal 2003 is primarily the result of the increase in same store net sales and the number of stores. New store contribution made up 61% of the increase over last year. New stores include locations opened during Fiscal 2004 and 2003 before they are considered same stores. Store profit contribution as a percent of net sales was 10.2% for Fiscal 2004 compared with 9.6% of net sales in the same period last year due to the increase in gross margin and the decrease in store operating and selling expenses as described above.

      General and administrative expenses increased 22.1% to $39.6 million in Fiscal 2004 from $32.5 million in the same period last year. General and administrative expenses were 8.0% and 7.0% of net sales for Fiscal 2004 and Fiscal 2003, respectively. This 22.1% increase is primarily due to a charge taken in connection with the settlement in principle of the employment class action in California, as well as increased corporate staffing, and our information systems, logistics and Sarbanes-Oxley compliance initiatives, partially offset by the $1.5 million decrease in impairment charges. During the third quarter of Fiscal 2004, we recorded a pre-tax charge of $4.1 million related to the settlement payments, attorneys’ fees and estimated expenses of administering the settlement in principle. See Note 15 in the consolidated financial statements included herein for a further description of the class action. The chart below shows the components of the $7.2 million increase in general and administrative expenses:

      Franchising. Franchise fees recognized on 18 store openings were $608,000 for Fiscal 2004 as compared with $355,000 for nine store openings in the same period last year. Royalty fees increased 8.4% to $19.5 million in Fiscal 2004 from $18.0 million in the same period last year. This was primarily due to an

increased franchise store base and a same store net sales increase of 3.0% for the franchise stores in Fiscal 2004.

      Expenses attributable to the franchise segment for Fiscal 2004 increased 9.9% to $7.2 million from $6.5 million for the same period last year. As a percentage of franchise revenue, franchise expenses were 35.7% in Fiscal 2004 as compared with 35.6% for Fiscal 2003. This increase is primarily due to a larger corporate expense allocation, which is primarily based on corporate salaries.

      Franchise profit contribution increased 9.5% to $12.9 million for Fiscal 2004 from $11.8 million in the same period last year. The increase in franchise profit contribution is due to the increase in royalty and franchise fees, partially offset by an increase in franchise expenses.

      Interest Expense. Net interest expense decreased to $471,000 for Fiscal 2004 from $4.0 million in the same period last year. This decrease in interest expense is due to the repurchase of all of the outstanding senior notes during the first six months of Fiscal 2003. The repurchase of these notes was completed using working capital and borrowings under our asset-based revolving credit agreement.

      Income Taxes. An income tax expense of $9.5 million, or 40.5% of pre-tax income, and $8.1 million, or 40.0% of pre-tax income, was recorded in Fiscal 2004 and Fiscal 2003, respectively. The change in tax rate from 40.0% to 40.5% is due to an increase in the overall state tax rate.

      Net Income. As a result of the above factors, net income increased to $13.9 million, or $0.71 per diluted share, for Fiscal 2004 as compared with $12.1 million, or $0.62 per diluted share, in the same period last year. Weighted average diluted shares outstanding remained flat at 19.65 million shares for Fiscal 2004 when compared to last year.

Liquidity and Capital Resources

      Our cash requirements have historically been for working capital, the opening of new stores, the improvement and expansion of existing facilities and the improvement of information systems. These cash requirements have been met through cash flow from operations and borrowings under our Loan Agreement. At July 2, 2005, working capital was $46.8 million compared with $34.8 million in the same period last year, reflecting our investments in inventory to increase our in-stock positions in our stores and working capital for the franchise distribution program. Additionally, in the fourth quarter of Fiscal 2005, we paid a settlement of $5.1 million relating to the California overtime wage and hour class action. The foregoing, along with lower net income, were the major factors affecting our ending cash and cash equivalents balance at July 2, 2005, which was $11.0 million as compared with $27.8 million at July 3, 2004.

      Our current priorities for the use of cash are primarily for investments in working capital and value-added capital projects including, in particular, investments in technology to improve merchandising and distribution systems, support cost reduction initiatives and improve efficiencies and assist each store to better serve its customers. Key initiatives include:

      We believe that the cash generated by operations and cash and cash equivalents, together with the borrowing availability under the Loan Agreement, will be sufficient to meet our working capital needs for the next twelve months, including investments made and expenses incurred in connection with systems develop-

ment, the logistics initiative and store improvements. We expect to invest approximately $25 million in capital projects during Fiscal 2006.

      Our Loan Agreement permits us to consider a wide variety of corporate initiatives intended to improve shareholder value, although there is no assurance that any specific initiative will be pursued or consummated.

Key Indicators of Liquidity and Capital Resources

      The following table sets forth key indicators of our liquidity and capital resources:

      Operating Activities. For Fiscal 2005, net cash used in operating activities was $5.5 million compared to net cash provided by operating activities of $51.6 million for the same period last year. The net cash used in operating activities was primarily due to investments in inventory as we introduced new products, enhanced inventory levels to increase in-stock positions in our stores and service franchisees through our distribution network (resulting in higher franchisee receivables). Also contributing to the decrease was the class action settlement payment, as well as a decrease in net income of $9.6 million. For Fiscal 2004, the amount of cash provided by operating activities was primarily attributable to a decrease in inventory from Fiscal 2003, due to a reduction of discontinued merchandise, as well as higher accrued expenses and other current liabilities as a result of timing, partially offset by a slight increase in accounts payable due to the purchase of new merchandise.

      Investing Activities. Net cash used in investing activities for Fiscal 2005 was $12.2 million compared with $13.5 million for the same period last year. Net cash used in investing activities for Fiscal 2005 was primarily attributable to leasehold improvements and furniture and fixtures of $5.3 million after new and existing stores and $1.3 million for the corporate headquarters, development costs for our management information systems of $3.7 million and implementation costs of our logistics and franchise distribution initiatives of $2.1 million, partially offset by $250,000 of proceeds from the closure of one store. Net cash used in investing activities in Fiscal 2004 was primarily attributable to leasehold improvements and furniture and fixtures of $5.3 million for the corporate headquarters and new and existing stores and development costs for our management information systems of $8.2 million. During Fiscal 2005, we used cash to purchase investments in auction rate securities in the aggregate of $123.1 million, while we also had corresponding cash receipts for the sales of these auction rate securities in the aggregate of $123.1 million. As of the end of Fiscal 2005, 2004 and 2003, we had no investments in auction rate securities. For Fiscal 2004, cash used in investing activities was primarily attributable to the opening of nine Company-owned stores this year compared with the

opening of 35 Company-owned stores (including an acquisition of eleven stores from a third party and two stores from a franchisee) during Fiscal 2003 as well as investments in the information systems and logistics initiatives.

      Financing Activities. Net cash provided by financing activities was $889,000 for Fiscal 2005 compared with cash used in financing activities of $13.6 million for the same period last year. We had no advances under our Loan Agreement during Fiscal 2005. The net cash provided by financing activities was primarily from proceeds received for exercises of company stock options. The net cash used in financing activities during Fiscal 2004 was primarily from the payment of $11.2 million under the Loan Agreement as well as cash overdrafts of $4.1 million, partially offset by proceeds received from the exercise of company stock options.

      Loan Agreement. At July 2, 2005 and August 30, 2005, we had no balance outstanding under the Loan Agreement. Under the terms of the Loan Agreement, we may from time to time borrow amounts based on a percentage of our eligible inventory and credit card receivables, up to a maximum of $65 million at any time outstanding, subject to certain borrowing conditions and customary sub-limits, reserves and other limitations. We have the option, based on our liquidity needs, to borrow at (i) the adjusted Eurodollar rate per annum, plus the applicable margin which is currently at 1.25% (which in the aggregate under the Loan Agreement was 3.34% for a 1 month term at July 2, 2005), or (ii) the prime rate per annum, less the applicable margin which is currently 0.25% (which in the aggregate under the Loan Agreement was 6.00% at July 2, 2005). Borrowings under the Loan Agreement are secured by a lien on substantially all of our assets. Based on a percentage of current eligible inventory and credit card receivables, we had $38.3 million and $25.2 million available to be borrowed under the Loan Agreement at August 30, 2005 and July 2, 2005, respectively.

      On July 15, 2005, we entered into a third amendment (the “Third Amendment”) to our Loan Agreement, dated January 2003, as amended, by and between us and Wells Fargo Retail Finance, LLC, as arranger, collateral agent and administrative agent, and Fleet Retail Finance, Inc. as documentation agent. The purposes of the Third Amendment were to: (i) reduce the LIBOR margin payable by the us for our borrowings; (ii) reduce the fee structure applicable to unused or outstanding borrowings; (iii) recalculate the borrowing base applicable to borrowings including the reduction in the availability block from $10 million to $5 million; (iv) permit us to elect to increase the maximum revolver amount and revolver commitments to an aggregate amount not to exceed $80 million; and (v) extend the maturity date of the Loan Agreement until June 30, 2009. Certain other definitions and provisions of the Loan Agreement were also amended.

      Warrants. There were no warrants to purchase our common stock exercised in Fiscal 2005 or Fiscal 2004. As of July 2, 2005, we had 2,496,000 warrants to purchase our common stock outstanding, all of which are currently exercisable, at an exercise price of $1.07 per share.

Contractual Obligations and Commercial Commitments

      The operating leases included in the above table also do not include contingent rent based upon sales volume, which represented less than 1% of our minimum lease obligations in Fiscal 2005, or other variable costs such as maintenance, insurance and taxes, which represented approximately 5.9% of minimum lease obligations in Fiscal 2005.

      In addition, on June 30, 2005, we entered into Retention Bonus and Severance Agreements (the “RBS Agreements”) with each of the our named executive officers, except Michael E. Tennenbaum, and other employees of ours. The RBS Agreements provide that each such employee will be paid a one-time, lump sum retention payment of a specified amount if (a) there is a Change in Control or Change in CEO (each as defined therein and each a “Qualifying Event”) within three years of the effective date and (b) such employee remains employed by us or the surviving entity for six months after the Qualifying Event. In addition, the RBS Agreements provide that each such employee will be paid a lump sum severance payment of a specified amount if (a) there is a Qualifying Event and (b) the employee is terminated by us without cause or resigns for good reason (“Termination”) after the Qualifying Event and before the second anniversary of the closing date of the Qualifying Event. We will also pay the employer portion of any COBRA continuation coverage timely elected by such employee and will provide such employee with outplacement assistance for three months by a vendor of the our choice (up to a reasonable cost to be established by us). Based on the RBS Agreements, we had an aggregate contingent liability in the amounts of $1.8 million for retention bonus payments and $6.9 million related to potential severance for 31 employees as of August 30, 2005 and July 2, 2005, none of which is reflected in the table above.

      Operating Leases. We closed three stores in Fiscal 2005, as compared to two store closings during Fiscal 2004. A reserve of $775,000 has been recorded for future rent, property tax and utility payments for one store closed in Fiscal 2005 and three stores closed in prior fiscal years. We do not expect to incur significant additional exit costs relating to these closures.

      As of August 30, 2005, we entered into 10 temporary store leases for which we are going to do business as “Halloween Costume Warehouse” for the 2005 Halloween season. These temporary stores are only being leased for the Fiscal 2006 Halloween season and are being leased for approximately four months.

      On September 16, 2004, we entered into a new corporate office lease for 106,000 square feet of office space. The initial term is for 12 years, with two five-year renewal options. The lease contains escalation clauses and obligations for reimbursement of common area maintenance and real estate taxes. The lease for our current corporate headquarters expired in December 2004, but we negotiated an extension of such lease to expire, at our option, on December 31, 2005. We intend to relocate to our new corporate headquarters by the end of the second quarter of Fiscal 2006 and intend to vacate our current corporate headquarters thereafter.

      Merchandise Commitments. We enter into arrangements to purchase merchandise up to eight months in advance of expected delivery. Historically, these purchase commitments did not contain any significant termination payments or other penalties if cancelled. Certain of these purchase commitments may obligate us

to specified quantities, even if desired quantities change at a later date. As of July 2, 2005, we had approximately $20.7 million of propriety product for which we have made purchase arrangements.

      Logistics Initiative Obligations. Logistics initiative obligations include a commitment for the purchase of selected equipment and services associated with the operation of the distribution centers.

      Auto Leases. At July 2, 2005, we operated a fleet of 37 leased motor vehicles, primarily for the district managers and regional management. The terms of these leases generally run for 36 months and expire at various times through June 2008.

      Severance. The severance obligations relate to our former Chief Executive Officer, as well as the elimination of a number of positions throughout the Company. Based on these eliminations, we incurred severance obligations payable throughout Fiscal 2006 according to our normal payroll policy.

      Capital Leases. We have entered into a capital lease arrangement for a period of two years with a third party provider that involves dedicated assets needed for our logistics initiative. As of July 2, 2005, the contractual obligation of this capital lease is equal to $741,000, which includes $31,000 of imputed interest. The remaining current and long-term portion of this capital lease liability recorded, excluding imputed interest of $22,000 and $9,000 respectively, is $181,000 and $529,000, respectively. The capital lease is not reflected in the above table.

      Other. Pursuant to the terms of the Loan Agreement, we had a standby letter of credit of $5.7 million outstanding at August 30, 2005 and July 2, 2005, respectively, relating to general liability and workers compensation insurance which is not reflected in the above table.

Off-Balance Sheet Arrangements

      We have not created, and are not party to, any special-purpose or off-balance sheet entities for the purpose of raising capital, incurring debt or operating our business. We do not have any off-balance sheet arrangements or relationships with entities that are not consolidated into our financial statements that have or are reasonably likely have a material current or future effect on our financial condition, changes in financial condition, revenues, expenses, results of operations, liquidity, capital expenditures or capital resources.

Recent Accounting Pronouncements

      In December 2004, the Financial Accounting Standards Board (“FASB”) published Statement of Financial Accounting Standards (“SFAS”) SFAS No. 123R, “Share-Based Payment” (“SFAS No. 123R”), an amendment of FASB Statements No. 123 and No. 148. Under SFAS No. 123R, all forms of share-based payment to employees, including employee stock options, would be treated as compensation and recognized in the income statement. SFAS No. 123R is effective beginning in the first quarter of Fiscal 2006. We currently account for stock options under Accounting Principles Bulletin (“APB”) No. 25 using the intrinsic value method in accounting for its employee stock options. No stock-based compensation costs were reflected in net income relating to options under those plans because all options were granted at an exercise price greater than or at market value of the underlying common stock on the date of grant. Under the adoption of SFAS No. 123R, the Company will be required to expense stock options over the vesting period in its statement of income. In addition, the Company will need to recognize expense over the remaining vesting period associated with unvested options outstanding as of July 2, 2005. The pro forma impact of expensing options is disclosed in Note 1. The Company expects the adoption of SFAS No. 123R to have a similar effect as currently disclosed by the pro forma disclosures under SFAS No. 123.

      In December 2004, the FASB published SFAS No. 151, “Inventory Costs” (“SFAS No. 151”), an amendment of Accounting Research Bulletin (ARB) No. 43, Chapter 4, which clarifies that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges. In addition, SFAS No. 151 requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. We have determined that SFAS No. 151 will not have a material impact on our condensed consolidated results of operations, financial position or cash flows.