Table ofContents

 

 

** **

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D.C.**

 

**FORM 10-Q**

 

| **x**                                                | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
|                                                 |                                                                                                    |
| **FOR THE  QUARTERLY PERIOD ENDED OCTOBER 31, 2009** |
| ** **                                           |
| **OR**                                               |
| ** **                                           |
| **o**                                                | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**Commission file number 000-51300**

 

**ZUMIEZINC.**

(Exact name of registrant as specified in its charter)

 

| **Washington**                   | ** ** | **91-1040022**                        |
|----------------------------------|------------|---------------------------------------|
| (State  or other jurisdiction of |       | (I.R.S.  Employer Identification No.) |
| incorporation  or organization)  |       |                                  |

 

**6300 Merrill Creek Parkway, Suite B, Everett, WA 98203**

 (Address of principal executiveoffices)  (Zip Code)

 

Registrant’s telephone number, including area code:**  (425)551-1500**

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes x  No o

 

Indicateby check mark whether the registrant has submitted electronically and posted onits corporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T during thepreceding 12 months (or for such shorter period that the registrant wasrequired to submit and post such files). Yes o  No o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer or a smaller reporting company.  See definition of “accelerated filer andlarge accelerated filer in Rule 12b-2 of the Exchange Act).  (Check one):

 

| Large accelerated filer o |   | Accelerated filer x         |
|--------------------------------|--------|----------------------------------|
|                           |   |                             |
| Non-accelerated filer o   |   | Smaller reporting company o |

 

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

 

Numberof shares of Common Stock outstanding as of December 7, 2009 was30,254,949 shares.

 

 

 

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**ZUMIEZ INC.**

**FORM 10-Q**

**TABLE OF CONTENTS**

 
| Part I.      |   | Financial Information |   |                                                                                                                                              |
|-------------------|--------|-----------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------|
|              |   |                  |   |                                                                                                                                              |   |   |
|              |   | Item 1.               |   | Condensed Consolidated  Financial Statements                                                                                                      |   |   |
|              |   |                  |   |                                                                                                                                              |   |   |
|              |   |                  |   | Condensed Consolidated  Balance Sheets at October 31, 2009 (unaudited) and January 31, 2009                                             |   | 3 |
|              |   |                  |   |                                                                                                                                              |   |   |
|              |   |                  |   | Condensed Consolidated  Statements of Operations for the three and nine months ended October 31,  2009 and November 1, 2008 (unaudited) |   | 4 |
|              |   |                  |   |                                                                                                                                              |   |   |
|              |   |                  |   | Condensed Consolidated  Statement of Changes in Shareholders’ Equity for the nine months ended  October 31, 2009 (unaudited)            |   | 5 |
|              |   |                  |   |                                                                                                                                              |   |   |
|              |   |                  |   | Condensed Consolidated  Statements of Cash Flows for the nine months ended October 31, 2009 and  November 1, 2008 (unaudited)           |   | 6 |
|              |   |                  |   |                                                                                                                                              |   |   |
|              |   |                  |   | Notes to  Condensed Consolidated Financial Statements                                                                                             |   | 7 |
|              |   |                  |   |                                                                                                                                              |   |   |
|              |   | Item 2.               |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                       |   | 17 |
|              |   |                  |   |                                                                                                                                              |   |   |
|              |   | Item 3.               |   | Quantitative  and Qualitative Disclosures About Market Risk                                                                                       |   | 34 |
|              |   |                  |   |                                                                                                                                              |   |   |
|              |   | Item 4.               |   | Controls and  Procedures                                                                                                                          |   | 34 |
|              |   |                  |   |                                                                                                                                              |   |   |
| Part II.     |   | Other Information     |   | 34                                                                                                                                                |
|              |   |                  |   |                                                                                                                                              |   |   |
|              |   | Item 1.               |   | Legal Proceedings                                                                                                                                 |   | 34 |
|              |   |                  |   |                                                                                                                                              |   |   |
|              |   | Item 1A.              |   | Risk Factors                                                                                                                                      |   | 34 |
|              |   |                  |   |                                                                                                                                              |   |   |
|              |   | Item 2.               |   | Changes in  Securities; Use of Proceeds and Issuer Purchases of Equity Securities                                                                 |   | 34 |
|              |   |                  |   |                                                                                                                                              |   |   |
|              |   | Item 3.               |   | Defaults Upon  Senior Securities                                                                                                                  |   | 34 |
|              |   |                  |   |                                                                                                                                              |   |   |
|              |   | Item 4.               |   | Submission of  Matters to a Vote of Security Holders                                                                                              |   | 34 |
|              |   |                  |   |                                                                                                                                              |   |   |
|              |   | Item 5.               |   | Other Information                                                                                                                                 |   | 34 |
|              |   |                  |   |                                                                                                                                              |   |   |
|              |   | Item 6.               |   | Exhibits                                                                                                                                          |   | 35 |
|              |   |                  |   |                                                                                                                                              |   |   |
| Signature         |   |                  |   |                                                                                                                                              |   | 36 |
|              |   |                  |   |                                                                                                                                              |   |   |
| Exhibit 31.1 |   |                  |   |                                                                                                                                              |   |   |
|              |   |                  |   |                                                                                                                                              |   |   |
| Exhibit 31.2 |   |                  |   |                                                                                                                                              |   |   |
|              |   |                  |   |                                                                                                                                              |   |   |
| Exhibit 32.1 |   |                  |   |                                                                                                                                              |   |   |

 

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**ZUMIEZ INC.****CONDENSED CONSOLIDATED BALANCE SHEETS**

**(in thousands, except shareamounts)**

 
| ** **                                                                                                                                                                                            | ** ** | **October 31, 2009** | ** ** | **January 31, 2009** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|---------------------------|------------|
| ** **                                                                                                                                                                                            | ** ** | **(Unaudited)**           | ** ** | ** **                | ** ** |
| **Assets**                                                                                                                                                                                            | ** ** | ** **                | ** ** | ** **                | ** ** |
| **Current assets**                                                                                                                                                                                    | ** ** | ** **                | ** ** | ** **                | ** ** |
| Cash and cash equivalents                                                                                                                                                                             |       | $                         | 10,489     |                      | $          | 33,057 |   |
| Marketable securities                                                                                                                                                                                 |       | 71,315                    |       | 45,525                    |       |
| Receivables                                                                                                                                                                                           |       | 7,879                     |       | 4,555                     |       |
| Inventory                                                                                                                                                                                             |       | 76,381                    |       | 51,974                    |       |
| Prepaid expenses and other                                                                                                                                                                            |       | 6,404                     |       | 5,614                     |       |
| Deferred tax assets                                                                                                                                                                                   |       | 2,995                     |       | 2,588                     |       |
| **Total current assets**                                                                                                                                                                              |       | 175,463                   |       | 143,313                   |       |
| ** **                                                                                                                                                                                            | ** ** | ** **                | ** ** | ** **                | ** ** |
| Leasehold improvements and equipment, net                                                                                                                                                             |       | 71,819                    |       | 73,932                    |       |
| Goodwill and other intangibles                                                                                                                                                                        |       | 13,198                    |       | 13,236                    |       |
| Marketable securities - long-term                                                                                                                                                                     |       | 832                       |       | 1,767                     |       |
| Deferred tax assets                                                                                                                                                                                   |       | 4,595                     |       | 1,101                     |       |
| **Total long-term assets**                                                                                                                                                                            |       | 90,444                    |       | 90,036                    |       |
|                                                                                                                                                                                                  |       |                      |       |                      |       |
| **Total assets**                                                                                                                                                                                      |       | $                         | 265,907    |                      | $          | 233,349 |   |
|                                                                                                                                                                                                  |       |                      |       |                      |       |
| **Liabilities  and Shareholders’ Equity**                                                                                                                                                        | ** ** | ** **                | ** ** | ** **                | ** ** |
| **Current liabilities**                                                                                                                                                                               |       |                      |       |                      |       |
| Trade accounts payable                                                                                                                                                                                |       | $                         | 33,748     |                      | $          | 15,909 |   |
| Accrued payroll and payroll taxes                                                                                                                                                                     |       | 6,133                     |       | 4,739                     |       |
| Income taxes payable                                                                                                                                                                                  |       | 2,705                     |       | 238                       |       |
| Current portion of deferred rent and tenant  allowances                                                                                                                                               |       | 3,368                     |       | 2,682                     |       |
| Other accrued liabilities                                                                                                                                                                             |       | 8,315                     |       | 7,653                     |       |
| **Total current liabilities**                                                                                                                                                                         |       | 54,269                    |       | 31,221                    |       |
| ** **                                                                                                                                                                                            | ** ** | ** **                | ** ** | ** **                | ** ** |
| Long-term deferred rent and tenant allowances,  less current portion                                                                                                                                  |       | 27,632                    |       | 24,000                    |       |
| Other long-term liabilities                                                                                                                                                                           |       | 1,310                     |       | 177                       |       |
| **Total long-term liabilities**                                                                                                                                                                       |       | 28,942                    |       | 24,177                    |       |
| ** **                                                                                                                                                                                            | ** ** | ** **                | ** ** | ** **                | ** ** |
| **Total liabilities**                                                                                                                                                                                 |       | 83,211                    |       | 55,398                    |       |
| Commitments and contingencies (Note 3)                                                                                                                                                                |       |                      |       |                      |       |
| ** **                                                                                                                                                                                            | ** ** | ** **                | ** ** | ** **                | ** ** |
| **Shareholders’ equity**                                                                                                                                                                         | ** ** | ** **                | ** ** | ** **                | ** ** |
| Preferred stock, no par value, 20,000,000 shares  authorized; none issued and outstanding                                                                                                             |       | —                    |       | —                    |       |
| Common stock, no par value, 50,000,000 shares  authorized; 30,254,949 shares issued and outstanding at October 31,  2009, 29,533,067 shares issued and outstanding at January 31, 2009 |       | 80,227                    |       | 75,789                    |       |
| Accumulated other comprehensive income                                                                                                                                                                |       | 95                        |       | 117                       |       |
| Retained earnings                                                                                                                                                                                     |       | 102,374                   |       | 102,045                   |       |
| **Total shareholders’ equity**                                                                                                                                                                   |       | 182,696                   |       | 177,951                   |       |
| ** **                                                                                                                                                                                            | ** ** | ** **                | ** ** | ** **                | ** ** |
| **Total liabilities and  shareholders’ equity**                                                                                                                                                  |       | $                         | 265,907    |                      | $          | 233,349 |   |

 

See accompanying notes tocondensed consolidated financial statements

 

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**ZUMIEZ INC.****CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(in thousands, except share andper share amounts)****(Unaudited)**

** **
| ** **                                                          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| ** **                                                          | ** ** | **October 31,**        | ** ** | **November 1,**       | ** ** | **October 31,** | ** ** | **November 1,** | ** ** |
| ** **                                                          | ** ** | **2009**                    | ** ** | **2008**                   | ** ** | **2009** | ** ** | **2008** | ** ** |
| Net sales                                                           |       | $                           | 113,192    |                       | $          | 112,245 |   | $ | 275,169 |   | $ | 283,205 |   |
| Cost of goods sold                                                  |       | 73,093                      |       | 72,982                     |       | 188,527 |   | 189,279 |   |
| **Gross profit**                                                    |       | 40,099                      |       | 39,263                     |       | 86,642 |   | 93,926 |   |
|                                                                |       |                        |       |                       |       |   |   |   |   |
| Selling, general and administrative expenses                        |       | 31,742                      |       | 28,879                     |       | 86,950 |   | 78,004 |   |
| **Operating profit (loss)**                                         |       | 8,357                       |       | 10,384                     |       | (308 | ) | 15,922 |   |
|                                                                |       |                        |       |                       |       |   |   |   |   |
| Interest income, net                                                |       | 161                         |       | 576                        |       | 825 |   | 1,660 |   |
| Other Income                                                        |       | 5                           |       | 36                         |       | 5 |   | 36 |   |
| Earnings before income taxes                                        |       | 8,523                       |       | 10,996                     |       | 522 |   | 17,618 |   |
| Provision for income taxes                                          |       | 3,450                       |       | 4,178                      |       | 193 |   | 6,711 |   |
| **Net income**                                                      |       | $                           | 5,073      |                       | $          | 6,818 |   | $ | 329 |   | $ | 10,907 |   |
|                                                                |       |                        |       |                       |       |   |   |   |   |
| Basic net income per share                                          |       | $                           | 0.17       |                       | $          | 0.23 |   | $ | 0.01 |   | $ | 0.37 |   |
|                                                                |       |                        |       |                       |       |   |   |   |   |
| Diluted net income per share                                        |       | $                           | 0.17       |                       | $          | 0.23 |   | $ | 0.01 |   | $ | 0.37 |   |
|                                                                |       |                        |       |                       |       |   |   |   |   |
| Weighted average shares used in computation of  earnings per share: |       |                        |       |                       |       |   |   |   |   |
| Basic                                                               |       | 29,562,733                  |       | 29,172,869                 |       | 29,457,792 |   | 29,086,196 |   |
|                                                                |       |                        |       |                       |       |   |   |   |   |
| Diluted                                                             |       | 30,243,944                  |       | 29,373,990                 |       | 30,038,982 |   | 29,394,416 |   |

 

See accompanying notes tocondensed consolidated financial statements

 

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**ZUMIEZ INC.****CONDENSED CONSOLIDATED STATEMENT OF CHANGES INSHAREHOLDERS’ EQUITY**

**(in thousands)****(Unaudited)**

 
| ** **                                                                               | ** ** | ** **            | ** ** | ** **        | ** ** | **Accumulated**    | ** ** | ** **   | ** ** | ** ** | ** ** |
|------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------|------------|--------------------|------------|--------------|------------|------------|------------|
| ** **                                                                               | ** ** | ** **            | ** ** | ** **        | ** ** | **Other**          | ** ** | ** **   | ** ** | ** ** | ** ** |
| ** **                                                                               | ** ** | **Common Stock** | ** ** | **Comprehensive** | ** ** | **Retained**       | ** ** | ** **   | ** ** |
| ** **                                                                               | ** ** | **Shares**            | ** ** | **Amount**        | ** ** | **Income  (Loss)** | ** ** | **Earnings** | ** ** | **Total**  | ** ** |
| **Balance at January 31, 2009**                                                     |       | 29,533                |       | $                 | 75,789     |               | $          | 117          |       | $          | 102,045    |   | $ | 177,951 |   |
| Common stock issued through employee stock benefit  plans, including tax benefit of $671 |       | 722                   |       | 1,407             |       | —             |       | —       |       | 1,407      |       |
| Stock-based compensation expense                                                         |       | —                |       | 3,031             |       |               |       |         |       | 3,031      |       |
| Unrealized losses, net of tax benefit of $14                                             |       | —                |       | —            |       | (22                | )          | —       |       | (22        | )          |
| Net income                                                                               |       |                  |       |              |       |               |       | 329          |       | 329        |       |
| **Balance at October 31, 2009**                                                     |       | 30,255                |       | $                 | 80,227     |               | $          | 95           |       | $          | 102,374    |   | $ | 182,696 |   |

 

See accompanying notes tocondensed consolidated financial statements

 

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**ZUMIEZ INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

**(Unaudited)**

 
| ** **                                                                                 | ** ** | **Nine Months Ended**     | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------------------|------------|
| ** **                                                                                 | ** ** | **October 31, 2009** | ** ** | **November 1, 2008** | ** ** |
| **Cash flows from operating  activities:**                                                 |       |                      |       |   |   |
| Net income                                                                                 |       | $                         | 329        |   | $ | 10,907 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities:         |       |                      |       |   |   |
| Depreciation and amortization                                                              |       | 16,255                    |       | 14,168 |   |
| Deferred tax expense                                                                       |       | (3,886                    | )          | (2,634 | ) |
| Stock-based compensation expense                                                           |       | 3,031                     |       | 3,252 |   |
| Loss on disposal of assets                                                                 |       | 143                       |       | 155 |   |
| Gain from sales of marketable securities, net                                              |       | —                    |       | (36 | ) |
| Excess tax benefit from stock options                                                      |       | (671                      | )          | (756 | ) |
| Impairment of long-lived assets                                                            |       | 713                       |       | — |   |
| Changes in operating assets and liabilities:                                               |       |                      |       |   |   |
| Receivables                                                                                |       | (1,068                    | )          | (1,920 | ) |
| Inventory                                                                                  |       | (24,407                   | )          | (33,126 | ) |
| Prepaid expenses and other                                                                 |       | (790                      | )          | (1,495 | ) |
| Trade accounts payable                                                                     |       | 17,839                    |       | 22,240 |   |
| Accrued payroll and payroll taxes                                                          |       | 1,394                     |       | (602 | ) |
| Income taxes payable                                                                       |       | 3,138                     |       | 5,295 |   |
| Other accrued liabilities                                                                  |       | 834                       |       | (2,033 | ) |
| Deferred rent and tenant allowances                                                        |       | 4,318                     |       | 6,412 |   |
| Net cash provided by operating activities                                                  |       | 17,172                    |       | 19,827 |   |
|                                                                                       |       |                      |       |   |   |
| **Cash flows from investing  activities:**                                                 |       |                      |       |   |   |
| Additions to leasehold improvements and equipment                                          |       | (15,238                   | )          | (26,295 | ) |
| Purchases of marketable securities                                                         |       | (61,028                   | )          | (82,607 | ) |
| Sales and maturities of marketable securities                                              |       | 35,119                    |       | 87,948 |   |
| Net cash used in investing activities                                                      |       | (41,147                   | )          | (20,954 | ) |
|                                                                                       |       |                      |       |   |   |
| **Cash flows from financing  activities:**                                                 |       |                      |       |   |   |
| Change in book overdraft                                                                   |       | —                    |       | (3,337 | ) |
| Proceeds from exercise of stock options                                                    |       | 736                       |       | 1,012 |   |
| Excess tax benefit from stock options                                                      |       | 671                       |       | 756 |   |
| Net cash provided by (used in) financing  activities                                       |       | 1,407                     |       | (1,569 | ) |
|                                                                                       |       |                      |       |   |   |
| Net decrease in cash and cash equivalents                                                  |       | (22,568                   | )          | (2,696 | ) |
| Cash and cash equivalents, beginning of period                                             |       | 33,057                    |       | 11,945 |   |
| Cash and cash equivalents, end of period                                                   |       | $                         | 10,489     |   | $ | 9,249 |   |
|                                                                                       |       |                      |       |   |   |
| **Supplemental disclosure on cash  flow information:**                                     |       |                      |       |   |   |
| Cash paid during the period for interest                                                   |       | $                         | 10         |   | $ | 9 |   |
| Cash paid during the period for income taxes                                               |       | 944                       |       | 4,115 |   |
| Non-cash investing activity - refundable use tax  on leasehold improvments and equipment   |       | (2,256                    | )          | — |   |
| Non-cash investing activity - asset retirement  obligations in other long-term liabilities |       | 961                       |       | — |   |

 

See accompanying notes tocondensed consolidated financial statements

 

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**ZUMIEZ INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**(Unaudited)**

 

**1.Nature of Business and Basis of Presentation**

 

**Basisof Presentation—**The accompanying unaudited  condensed consolidated  financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesof America (“GAAP”) for interim financial information and with the instructionsto Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of theinformation and footnotes required by GAAP for complete financial statements.

 

Inthe opinion of management, the unaudited condensed consolidated financialstatements contain all adjustments, consisting of normal recurring adjustments,necessary for a fair presentation of the condensed consolidated balance sheetas of October 31, 2009, the condensed consolidated statements ofoperations for the three and nine months ended October 31, 2009 and November 1,2008, the condensed consolidated statement of changes in shareholders’ equityfor the nine months ended October 31, 2009 and the condensed consolidatedstatements of cash flows for the nine months ended October 31, 2009 and November 1,2008.

 

Thefinancial data at January 31, 2009 is derived from audited financialstatements which are included in the Company’s Annual Report on Form 10-Kfor the year ended January 31, 2009, and should be read in conjunctionwith the audited financial statements and notes thereto.  Interim results are not necessarilyindicative of results for the full year.

 

**Principlesof Consolidation*****—***Theunaudited  condensed consolidatedfinancial statements include the accounts of Zumiez Inc. and its subsidiary,Zumiez Nevada, LLC, (collectively, “the Company”).  All significant inter-company transactionsand balances are eliminated in consolidation.

 

**Use ofEstimates*****—***The preparationof financial statements in conformity with GAAP requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and the disclosure of contingent assets and liabilities at the dateof the financial statements as well as the reported amounts of revenues andexpenses during the reporting period. These estimates can also affect supplemental information disclosed bythe Company, including information about contingencies, risk, and financialcondition.  In preparing the financialstatements, the Company makes routine estimates and judgments in determiningthe net realizable value of accounts receivable, inventory, leaseholdimprovements and equipment, marketable securities, goodwill and otherintangibles and accrued liabilities. Some of the more significant estimates include the allowance for salesreturns, the reserve for inventory valuation estimates, medical and dentalinsurance reserve, the expected useful lives of leasehold improvements andequipment, asset retirement obligations and assumed future cash flowssupporting long-lived assets.  Actualresults could differ from those estimates. The results of operations for the three and nine months ended October 31,2009 are not necessarily indicative of the results that might be expected forfiscal 2009.  For further information,refer to the Company’s financial statements and notes included in the Company’sForm 10-K filed on March 23, 2009.

 

**Natureof Business—**The Company is a leading specialty retailer ofaction sports related apparel, footwear, equipment and accessories operatingunder the Zumiez brand name.  As of October 31,2009, the Company operated 378 stores primarily located in shopping malls,giving the Company a presence in 35 states. The Company’s stores cater to young men and women between the ages of 12and 24 who seek brands representing a lifestyle centered on activities thatinclude skateboarding, surfing, snowboarding, bicycle motocross (or “BMX”) andmotocross.  The Company supports theaction sports lifestyle and promotes its brand through a multi-facetedmarketing approach that is designed to integrate its brand image with itscustomers’ activities and interests.  Inaddition, the Company operates a website that sells merchandise online andprovides content and a community for its target customers.  The Company, based in Everett, Washington,was formed in August 1978 and operates within one reportable segment.

 

**FiscalYear—**The Company uses a fiscal calendar widely used by the retail industrywhich results in a fiscal year consisting of a 52-week or 53-week period endingon the Saturday closest to January 31. Each fiscal year consists of four 13-week quarters, with an extra weekadded to the fourth quarter every five or six years.  “Fiscal 2008” was the 52-week period ended January 31,2009.  The first nine months of fiscal2009 was the 39-week period ended October 31, 2009.  The first nine months of fiscal 2008 was the39-week period ended November 1, 2008. “Fiscal 2009” is the 52-week period ending January 30, 2010.

 

**Reclassificationof Previously Issued Financial Statements**— The Company hasreclassified certain current liabilities on the condensed consolidated balancesheet as of January 31, 2009 related to store equipment from currentportion of deferred rent and tenant allowances to other accrued liabilities inthe amount of $53,000.  The Company alsorevised the classification of the long-term portion of these certainliabilities from long-term deferred rent and tenant allowances to otherlong-term liabilities as of January 31, 2009 in the approximate of$177,000.  There was no impact on totalcurrent liabilities and total long-term liabilities as of January 31,2009.  As a result of thereclassification, the statement of cash flows for the nine months ended November 1,2008 was revised to 

 

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reflect thisreclassification.  The effect of thereclassification decreased the use of operating cash from other accruedliabilities and reduced the operating cash provided by deferred tenantallowances by approximately $211,000 for the nine months ended November 1,2008 on the condensed consolidated statement of cash flows.  There was no impact on the net cash providedby operating activities for the nine months ended November 1, 2008 on thecondensed consolidated statement of cash flows.

 

**2.Summary of Significant Accounting Policies**

 

Informationregarding the Company’s significant accounting policies is contained in Note 2,“Summary of Significant Accounting Policies,” to the consolidated financialstatements in the Company’s Form 10-K filed on March 23, 2009.  Presented below in this note and thefollowing notes is supplemental information that should be read in conjunctionwith “Notes to Consolidated Financial Statements” in that annual report.  We follow accounting standards set by theFinancial Accounting Standards Board, commonly referred to as the “FASB.”  The FASB sets generally accepted accountingprinciples (GAAP) that we follow to ensure we consistently report our financialcondition, results of operations, and cash flows.  References to GAAP issued by the FASB inthese footnotes are to the FASB Accounting Standards Codification, referred toas Codification or “ASC.”  The FASBfinalized the Codification effective for periods ending on or after September 15,2009.  For further discussion of theCodification see “Critical Accounting Policies and Estimates” in Management’sDiscussion and Analysis of Financial Condition and Results of Operationselsewhere in this report.

 

**MarketableSecurities—** The Companyconsiders all liquid investments with original maturity of three months or lesswhen purchased to be cash equivalents.

 

Thefollowing tables summarize the estimated fair value of our cash and marketablesecurities, the gross unrealized holding gains and losses, theother-than-temporarily impaired gross unrealized losses and the length of timeavailable-for-sale securities were in a continuous unrealized loss positions asof October 31, 2009 and January 31, 2009 (in thousands):

 
| ** **                            | ** ** | **October 31, 2009** | ** ** |
|---------------------------------------|------------|----------------------|------------|
| ** **                            | ** ** | **Amortized   Cost** | ** ** | **Gross   Unrealized   Holding   Gains** | ** ** | **Gross   Unrealized   Holding   Losses** | ** ** | **Estimated   Fair Value** | ** ** | **Unrealized   Loss   Position   Less Than Twelve   Months** | ** ** | **Continuous   Unrealized   Loss Position   Greater Than   Twelve Months** | ** ** |
| Cash and cash equivalents:            |       |                 |       |   |   |   |   |   |   |   |   |   |   |
| Cash                                  |       | $                    | 10,489     |   | $ | — |   | $ | — |   | $ | 10,489 |   | $ | — |   | $ | — |   |
| Total cash and cash equivalents       |       | 10,489               |       | — |   | — |   | 10,489 |   | — |   | — |   |
|                                  |       |                 |       |   |   |   |   |   |   |   |   |   |   |
| Short-term investments                |       |                 |       |   |   |   |   |   |   |   |   |   |   |
| State and local government securities |       | 50,065               |       | 262 |   | (6 | ) | 50,321 |   | (6 | ) | — |   |
| Total short-term investments          |       | 50,065               |       | 262 |   | (6 | ) | 50,321 |   | (6 | ) | — |   |
|                                  |       |                 |       |   |   |   |   |   |   |   |   |   |   |
| Long-term investments                 |       |                 |       |   |   |   |   |   |   |   |   |   |   |
| State and local government securities |       | 21,928               |       | 82 |   | (184 | ) | 21,826 |   | (16 | ) | (168 | ) |
| Total long-term investments           |       | 21,928               |       | 82 |   | (184 | ) | 21,826 |   | (16 | ) | (168 | ) |
| Total                                 |       | $                    | 82,482     |   | $ | 344 |   | $ | (190 | ) | $ | 82,636 |   | $ | (22 | ) | $ | (168 | ) |

 

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| ** **                            | ** ** | **January 31, 2009** | ** ** |
|---------------------------------------|------------|---------------------------|------------|
| ** **                            | ** ** | **Amortized   Cost**      | ** ** | **Gross   Unrealized   Holding   Gains** | ** ** | **Gross   Unrealized   Holding   Losses** | ** ** | **Estimated   Fair Value** | ** ** | **Unrealized   Loss   Position   Less Than Twelve   Months** | ** ** | **Continuous   Unrealized   Loss Position   Greater Than   Twelve Months** | ** ** |
| Cash and cash equivalents:            |       |                      |       |   |   |   |   |   |   |   |   |   |   |
| Cash                                  |       | $                         | 33,057     |   | $ | — |   | $ | — |   | $ | 33,057 |   | $ | — |   | $ | — |   |
| Total cash and cash equivalents       |       | 33,057                    |       | — |   | — |   | 33,057 |   | — |   | — |   |
|                                  |       |                      |       |   |   |   |   |   |   |   |   |   |   |
| Short-term investments                |       |                      |       |   |   |   |   |   |   |   |   |   |   |
| Treasury and agency securities        |       | 8,329                     |       | 61 |   | — |   | 8,390 |   | — |   | — |   |
| State and local government securities |       | 21,235                    |       | 149 |   | — |   | 21,384 |   | — |   | — |   |
| Total short-term investments          |       | 29,564                    |       | 210 |   | — |   | 29,774 |   | — |   | — |   |
|                                  |       |                      |       |   |   |   |   |   |   |   |   |   |   |
| Long-term investments                 |       |                      |       |   |   |   |   |   |   |   |   |   |   |
| State and local government securities |       | 17,540                    |       | 253 |   | (275 | ) | 17,518 |   | (275 | ) | — |   |
| Total long-term investments           |       | 17,540                    |       | 253 |   | (275 | ) | 17,518 |   | (275 | ) | — |   |
| Total                                 |       | $                         | 80,161     |   | $ | 463 |   | $ | (275 | ) | $ | 80,349 |   | $ | (275 | ) | $ | — |   |

 

The long-term grossunrealized holding losses on the state and local obligations primarily consistof an unrealized loss on the Company’s sole auction rate security.  The Company has the ability and intent tohold its available-for-sale securities until recovery of fair value, which maybe at maturity, and thus does not currently consider any securities to beother-than-temporarily impaired.  All ofour available-for-sale securities mature in two years or less.

 

The Company did not record arealized loss for other-than-temporary impairments during the three and ninemonths ended October 31, 2009 or for the fiscal year ended January 31,2009.

 

At October 31, 2009,marketable securities, classified as available for sale, were $72.1 million andconsisted primarily of state and local municipal instruments, U.S. treasuryreserves and U.S. agency debt instruments with original maturities over 90days.  As of January 31, 2009, weheld two separate $1.0 million auction rate securities.  In May 2009, one of the auction ratesecurities sold at auction for par.  Asof October 31, 2009, we had $0.8 million invested, net of temporaryimpairment charge of $0.2 million, in an auction rate security that isclassified as long-term, available-for-sale marketable securities on ourcondensed consolidated balance sheet.

 

Auction rate securities aregenerally long-term debt instruments that provide liquidity through a Dutchauction process that resets the applicable interest rate at pre-determinedcalendar intervals.  This mechanismgenerally allows existing investors to rollover their holdings and continue toown their respective securities or liquidate their holdings by selling theirsecurities at par value.  Prior to February 3,2008, we invested in these securities for short periods of time as part of ourcash management program.  However, theuncertainties in the credit markets, that began in early 2008,  have prevented us and other investors fromliquidating holdings of auction rate securities in recent auctions for thesesecurities because the amount of securities submitted for sale has exceeded theamount of purchase orders.  Should theauction continue to fail, we anticipate we have the ability to hold thesecurity until the liquidity in the market improves.  The investment is fully collateralized by theUnited States government.  Although weare uncertain as to when the liquidity issues relating to this investment willimprove, we consider the issue temporary. It is possible that further declines in fair value may occur, and thosedeclines, if any, would be recognized in our condensed consolidated balancesheet as “accumulated other comprehensive income (loss).”  We continue to monitor the market for auctionrate securities and consider its impact, if any, on the fair market value ofthe investment.

 

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**Receivables—** At October 31,2009 and January 31, 2009, receivables included the following (inthousands):

 
| ** **                   | ** ** | **October 31, 2009** | ** ** | **January 31, 2009** | ** ** |
|------------------------------|------------|---------------------------|------------|---------------------------|------------|
| Credit cards receivable      |       | $                         | 2,270      |                      | $          | 1,884 |   |
| Refundable use tax           |       | 2,256                     |       | —                    |       |
| Tenant allowances receivable |       | 1,348                     |       | 901                       |       |
| Interest receivable          |       | 977                       |       | 418                       |       |
| Vendor credits               |       | 474                       |       | 410                       |       |
| Employee receivables         |       | 331                       |       | 483                       |       |
| Other receivables            |       | 223                       |       | 459                       |       |
|                         |       | $                         | 7,879      |                      | $          | 4,555 |   |

 

TheCompany does not extend credit to its customers except through independentthird-party credit cards, which are generally collected within several businessdays.  The refundable use tax amount inthe table above of approximately $2.3 million represents an overpayment of usetax on construction costs to build and remodel stores that is expected to becollected or credited from State jurisdictions.

 

**Merchandise Inventories—**Merchandise inventoriesare valued at the lower of cost or market. The cost of merchandise inventories are based upon an average costmethodology.  Merchandise inventoriesmay include items that have been written down to the Company’s bestestimate of their net realizable value. The Company’s decisions to write-down its merchandise inventories arebased on its current rate of sale, the age of the inventory and otherfactors.  Actual final sales prices tocustomers may be higher or lower than the Company’s estimated sales pricesand could result in a fluctuation in gross profit.  Historically, any write-downs have not been significantto the Company.  We have reserved forinventory as of October 31, 2009 and January 31, 2009 in the amountsof approximately $1.5 million and $3.6 million. The inventory reserve includes inventory whose estimated market value isbelow cost, and an estimate for inventory shrinkage.  These reserve amounts are evaluatedquarterly.  The inventory related tothese reserves is not marked up in subsequent periods.

 

**Leasehold Improvements and Equipment—**Leasehold improvements and equipment are stated at cost lessaccumulated depreciation utilizing the straight-line method over the assets’estimated useful lives.  The useful livesof our major classes of assets are as follows:

 
| Leasehold  improvements                                         |   | Lesser  of 7 years or the term of the lease |   |
|-----------------------------------------------------------------|--------|---------------------------------------------|--------|
| Fixtures                                                        |   | 3  — 7 years                           |   |
| Computer  equipment, software, store equipment & other |   | 3  — 5 years                           |   |

 

Thecost and related accumulated depreciation of assets sold or otherwise disposedof is removed from the accounts and the related gain or loss is reported in thecondensed consolidated statement of operations.

 

**Valuation of Long-Lived Assets—**The Company reviews the carrying value of long-lived assets for impairmentwhenever events or changes in circumstances indicate that the carrying value ofsuch assets may not be recoverable. Measurement of the impairment loss is based on the fair value of theasset or group of assets.  Generally,fair value will be determined using accepted valuation techniques, such as thepresent value of expected future cash flows.

 

Managementperforms a review of the carrying value of long-lived assets conducted inaccordance with GAAP on a quarterly basis. The third quarter 2009 review revealed that six stores were impaired,resulting in a non-cash impairment charge of approximately $0.4 million for thethree months ended October 31, 2009. For the nine month period ended October 31, 2009 a total of sevenstores were determined to be impaired resulting in a non-cash impairment chargeof approximately $0.7 million.  Thenon-cash impairment charge is included in selling, general and administrativeexpenses for the three and nine months ended October 31, 2009.

 

**Fair Value of Financial Instruments—**The Companydiscloses the estimated fair value of certain assets and liabilities asfinancial instruments.  Financialinstruments are generally defined as cash, evidence of ownership interest in anentity, or a contractual obligation that both conveys to one entity a right toreceive cash or other financial instruments from another entity and imposes onthe other entity the obligation to deliver cash or other financial instrumentsto the first entity.  At October 31,2009 and January 31, 2009, the carrying amounts of cash and cashequivalents, receivables, payables and other accrued liabilities approximatedfair value because of the short maturity of these financial instruments.  The carrying value of marketable securities,excluding auction rate securities described below, approximate the fair valuebecause these financial instruments have floating interest rates, which reflectcurrent market conditions.

 

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Generally Accepted Accounting Principles defines fairvalue, establishes a framework for measuring fair value and requiresdisclosures about fair value measurements. The FASB issued additional guidance that provides advice on determiningwhether a market for a financial asset is not active and eliminates theproposed presumption that all transactions are distressed (not orderly) unlessproven otherwise.  Contractual maturitiesof investments underlying our available-for-sale securities at October 31,2009 included $0.8 million in an auction rate security, net of $0.2 milliontemporary impairment.  Based on current market conditions, auctionsrelated to this security may be unsuccessful at the scheduled auction.  Anunsuccessful auction could result in our holding the security beyond the nextscheduled auction reset date if a secondary market does not develop; therefore,limiting the short-term liquidity of the investment.

 

**OtherAccrued Liabilities****—**At October 31, 2009 and January 31, 2009 other accruedliabilities consisted of the following:

 
| ** **                 | ** ** | **October 31, 2009** | ** **  | **January 31, 2009** | ** ** |
|----------------------------|------------|---------------------------|-------------|---------------------------|------------|
| Accrued payables           |       | $                         | 2,589       |                      | $          | 2,564 |   |
| Unredeemed gift cards      |       | 1,970                     |        | 3,061                     |       |
| Accrued sales tax          |       | 1,676                     |        | 1,425                     |       |
| Accrued legal (see note 3) |       | 1,424                     |        | —                    |       |
| Other current liabilities  |       | 656                       |        | 603                       |       |
|                       |       | $                         |  8,315 |                      | $          | 7,653 |   |

 

**Costof Goods Sold—**Cost of goods sold consists of branded merchandisecosts, and our private label merchandise including design, sourcing, importingand inbound freight costs.  Our cost ofsales also includes shrinkage, certain promotional costs, buying, store occupancyand distribution and warehousing costs.  This may notbe comparable to the way in which the Company’s competitors or other retailerscompute their cost of goods sold.

 

Withrespect to the freight component of our ecommerce sales, we arrange and pay thefreight for our customers and bill them for this service, unless our customershave their product shipped to one of our stores in which case we do not billour customers.  Such amounts, if any, arebilled and included in revenue and the related freight cost is charged to costof goods sold.  For the three months ended October 31, 2009 and November 1,2008, the Company incurred shipping costs related to ecommerce sales ofapproximately $0.2 million and $0.2 million.  For the ninemonths ended October 31, 2009 and November 1, 2008, the Companyincurred shipping costs related to ecommerce sales of approximately $0.5million and $0.4 million.

 

**StockCompensation—**The Company maintains a 2005 Equity Incentive Planunder which non-qualified stock options and restricted stock have been grantedto employees and non-employee directors. The Company accounts for stock-based compensation by which the estimatedfair value of share-based awards granted under the 2005 Equity Incentive Planis recognized as compensation expense over the vesting period.

 

Thefair value of stock option grants, excluding options granted under the exchangeoffer, discussed below, are estimated on the date of grant using theBlack-Scholes option pricing method with the following weighted-averageassumptions used for grants issued during the nine month periods ended October 31,2009 and November 1, 2008.

 
| ** **                        | ** ** | **For the Nine Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|-----------------------------------|------------|-------------------------------|------------|-------------------------------|------------|
| ** **                        | ** ** | **October 31, 2009**     | ** ** | **November 1, 2008**     | ** ** |
| Dividend yield                    |       | —                        | %          | —                        | %          |
| Volatility rate                   |       | 66.78                         | %          | 55.35                         | %          |
| Average expected life (in years): |       |                          |       |                          |       |
| Expected lives-Five years         |       | 6.50                          |       | 6.50                          |       |
| Expected lives-Four years         |       | 6.25                          |       | 6.25                          |       |
| Average risk-free interest rate:  |       | 1.67                          | %          | 2.77                          | %          |

 

*StockOption Exchange*

 

OnJuly 21, 2009, the Company completed an offer to exchange certain employeestock options issued under the 2005 Equity Incentive Plan (“ExchangeOffer”).  Certain previously grantedstock options were exchanged for new, lower-priced stock options granted on aone and one half-for-one basis (1.5:1). An aggregate of 460,700 previously granted stock options were exchangedfor an aggregate of 307,138 new stock options granted pursuant to the ExchangeOffer with an exercise price of $8.64 per share.  The new 

stockoption grants will vest annually over a four-year period beginning on the firstanniversary of the date granted.  TheExchange Offer resulted in a nominal increase in stock-based compensationexpense.

 

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Thefollowing table summarizes the Company’s stock option activity for the ninemonths ended October 31, 2009 and November 1, 2008 (in thousandsexcept weighted-average exercise price):

 
|                                     | ** ** | **Nine Months Ended**     | ** ** |
|------------------------------------------|------------|---------------------------|------------|
|                                     | ** ** | **October 31, 2009** | ** ** | **November 1, 2008** | ** ** |
|                                     | ** ** | **Stock    Options**      | ** ** | **Weighted-  Average   Exercise   Price** | ** ** | **Stock    Options** | ** ** | **Weighted-  Average   Exercise   Price** | ** ** |
| Outstanding at beginning of year         |       | 1,793                     |       | $ | 17.13 |   | 1,958 |   | $ | 16.29 |   |
| Granted year to date (1)                 |       | 528                       |       | $ | 8.03 |   | 160 |   | $ | 14.25 |   |
| Exercised year to date                   |       | (250                      | )          | $ | 1.64 |   | (211 | ) | $ | 2.46 |   |
| Forfeited and exchanged year to date (2) |       | (547                      | )          | $ | 30.25 |   | (96 | ) | $ | 27.36 |   |
| Outstanding at the end of the period     |       | 1,524                     |       | $ | 11.83 |   | 1,811 |   | $ | 17.28 |   |
| Exercisable at end of the period         |       | 621                       |       | $ | 12.09 |   | 699 |   | $ | 11.45 |   |

 

----

(1) Includes307,138 stock options issued pursuant to the Exchange Offer.

(2) Includes460,700 stock options exchanged in the Exchange Offer.

 

During the nine months endedOctober 31, 2009, the Company granted approximately 528,000 stock optionsof which approximately 307,000 were issued in conjunction with the stock optionexchange that occurred on July 21, 2009. There were approximately 221,000 stock options granted during the ninemonths ended October 31, 2009, not issued in conjunction with the stockoption exchange, with a Black-Scholes weighted average fair value of$4.44.  There were 160,000 stock optionswith a Black-Scholes weighted average fair value of $7.89 issued during thenine months ended November 1, 2008.

 

The following tablesummarizes the Company’s restricted stock activity for the nine months ended October 31,2009 and November 1, 2008 (in thousands except weighted-average fairvalue):

 
| ** **                       | ** ** | **Nine Months Ended**     | ** ** |
|----------------------------------|------------|---------------------------|------------|
| ** **                       | ** ** | **October 31, 2009** | ** ** | **November 1, 2008** | ** ** |
| ** **                       | ** ** | **Restricted   Stock**    | ** ** | **Grant Date   Weighted   Average   Fair Value** | ** ** | **Intrinsic   Value** | ** ** | **Restricted   Stock** | ** ** | **Grant Date   Weighted   Average   Fair Value** | ** ** | **Intrinsic   Value** | ** ** |
| Outstanding at beginning of year |       | 285                       |       | $ | 15.49 |   | $ | 2,034 |   | 16 |   | $ | 37.19 |   | $ | 321 |   |
| Granted year to date             |       | 445                       |       | $ | 7.10 |   | — |   | 333 |   | $ | 14.52 |   | — |   |
| Vested year to date              |       | (80                       | )          | $ | 15.96 |   | — |   | (4 | ) | $ | 38.19 |   | — |   |
| Forfeited year to date           |       | (15                       | )          | $ | 10.31 |   | — |   | (15 | ) | $ | 14.22 |   | — |   |
| Outstanding at end if period     |       | 635                       |       | $ | 9.67 |   | $ | 8,553 |   | 330 |   | $ | 15.34 |   | $ | 3,221 |   |

 

The intrinsic value ofrestricted stock awards is the market value of the outstanding restricted stockon the last business day of the quarter. The market value per share was $13.47 and $9.76 at October 31, 2009and November 1, 2008.

 

The Company recordedapproximately $1.2 million and $3.0 million of total stock-based compensationexpense for the three and nine months ended October 31, 2009, of whichapproximately $0.1 million and $0.4 million, was attributable to the Board ofDirectors.  The Company recorded approximately$1.0 million and $3.3 million of stock-based compensation for the three andnine months ended November 1, 2008, of which approximately $0.1 millionand $0.4 million was attributable to the Board of Directors.  The stock-based compensation expense iscalculated on an accelerated method for stock options and a straight-line basisfor restricted stock over the vesting periods of the related equity grant.  This charge had no impact on the Company’sreported cash flows.

 

At October 31, 2009 andJanuary 31, 2009, there was approximately $8.2 million and $8.6 million,of total unrecognized compensation cost related to unvested stock options andrestricted stock grants of which approximately $0.2 million and $0.2 million,was attributable to the Board of Directors. This cost is expected to be recognized over a period of approximatelythree to eight years.

 

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**Goodwill****and Other Intangible Assets** — The Companyevaluates the recoverability of goodwill annually based on a two-stepimpairment test.  The first step comparesthe fair value of each reporting unit with its carrying amount, includinggoodwill.  If the carrying amount exceedsfair value, then the second step of the impairment test is performed to measurethe amount of any impairment loss. Additional impairment assessments may be performed on an interim basisif the Company encounters events or changes in circumstances that wouldindicate that, more likely than not, the book value of goodwill has beenimpaired.  The Company, in accordancewith GAAP, does not amortize goodwill derived from purchase businesscombinations.  There was no impairment ofgoodwill for the nine months ended October 31, 2009 and November 1,2008.

 

**Asset Retirement Obligations**— An assetretirement obligation (ARO) represents a legal obligation associated with theretirement of a tangible long-lived asset that is incurred upon theacquisition, construction, development, or normal operation of that long-livedasset.  The Company’s ARO’s are primarilyassociated with leasehold improvements, which, at the end of a lease, we arecontractually obligated to remove in order to comply with certain leaseagreements.  The ARO is recorded inleasehold improvements and equipment and other long-term liabilities in thecondensed consolidated balance sheet as of October 31, 2009 and will besubsequently adjusted for changes in fair value.  The associated estimated asset retirementcosts are capitalized as part of the carrying amount of the long-lived assetand depreciated over its useful life.

 

**Recent accounting pronouncements—** Effective July 2009,the FASB codified accounting literature into a single source of authoritativeaccounting principles, except for certain authoritative rules andinterpretive releases issued by the Securities and Exchange Commission.  Since the codification did not alter existingU.S. GAAP, it did not have an impact on our condensed consolidated financialstatements.  All references topre-codified U.S. GAAP have been removed from this Form 10-Q.

 

In December 2007,  the FASB issued guidance that continues torequire the acquisition method of accounting to be applied to all businesscombinations but significantly changes the accounting for certain aspects ofbusiness combinations.  Acquisition costswill generally be expensed as incurred; non-controlling interests will bevalued at fair value at the acquisition date; in-process research anddevelopment will be recorded at fair value as an indefinite-lived intangibleasset at the acquisition date; restructuring costs associated with a businesscombination will generally be expensed subsequent to the acquisition date; andchanges in deferred tax asset valuation allowances and income tax uncertaintiesafter the acquisition date generally will affect income tax expense. Thisguidance is to be applied prospectively to business combinations for which theacquisition date is on or after the beginning of the first annual periodsubsequent to December 15, 2008.  Weexpect this guidance to have an impact on our accounting for future businesscombinations, if any, but the effect is dependent upon the acquisitions thatare made in the future.

 

In December 2007, theFASB established new accounting and reporting standards for the noncontrollinginterest in a subsidiary and for deconsolidation of a subsidiary.  This guidance clarifies that a noncontrollinginterest in a subsidiary (minority interest) is an ownership interest in theconsolidated entity that should be reported as equity in the ConsolidatedFinancial Statements and separate from the parent company’s equity.  Among other things, this guidance requiresconsolidated net income to be reported at amounts that include the amountsattributable to both the parent and the noncontrolling interest.  It also requires disclosure, on the face ofthe Consolidated Statements of Operations of the amounts of consolidated netincome attributable to the parent and to the noncontrolling interest, ifmaterial.  This guidance was effectivefor us on February 1, 2009 and it did not have a material impact on ourcondensed consolidated financial statements.

 

In April 2008, the FASBissued guidance that amends the factors that should be considered in developingrenewal or extension assumptions used to determine the useful life of arecognized intangible asset.  The intent ofthis guidance is to improve the consistency between the useful life of arecognized intangible asset and the period of expected cash flows used tomeasure the fair value of the asset. This guidance was effective for us for consolidated financial statementsissued for periods ending on or after January 31, 2009.  We do not expect this guidance to have amaterial impact on our accounting for future acquisitions or renewals ofintangible assets, but the potential impact is dependent upon the acquisitions,if any, or renewals of intangible assets in the future.

 

In March 2009, the FASBissued guidance that provides additional advice on determining whether a marketfor a financial asset is not active and eliminates the proposed presumptionthat all transactions are distressed (not orderly) unless provenotherwise.  This guidance is effectivefor us for interim and annual condensed consolidated financial statements forperiods ending on or after August 1, 2009. The Company’s adoption of this guidance does not have a material impacton its condensed consolidated financial statements.

 

In March 2009, the FASBissued guidance that provides additional support for determining whetherimpairment is other-than-temporary to debt securities in the financialstatements.  This guidance requiresother-than-temporary impairments to be separated into the amount representingthe decrease in cash flows expected to be collected from a security (referredto as credit losses) which is recognized in earnings and the amount related toother factors (referred to as noncredit losses) which is recognized in othercomprehensive income.  This guidance iseffective for us for interim and annual periods ending on or after August 1,2009.  The Company does not meet theconditions necessary to recognize other-than-temporary or credit losses of itsauction rate securities in earnings and as such, this guidance does not have amaterial impact on its condensed consolidated financial statements.

 

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In April 2009, the FASBissued guidance requiring us to provide disclosures about fair value offinancial instruments in interim financial information and requires thosedisclosures in summarized financial information at interim reportingperiods.  These disclosures are effectivefor us for interim periods ending on or after August 1, 2009.  The adoption of this guidance does not have amaterial impact on our condensed consolidated financial statements.

 

In May 2009, the FASBissued guidance on subsequent events that establishes general standards ofaccounting for and disclosure of events that occur after the balance sheet datebut prior to the issuance of the financial statements.  The guidance requires disclosure of the datethrough which subsequent events were evaluated and the basis for thatdate.  The guidance sets forth the following:(1) the period after the balance sheet date during which management of a reportingentity should evaluate events or transactions that may occur for potentialrecognition or disclosure in the financial statements; (2) thecircumstances under which an entity should recognize events or transactionsoccurring after the balance sheet date in its financial statements; and (3) thedisclosures that an entity should make about events or transactions thatoccurred after the balance sheet date. This guidance was effective for us for the period ending August 1,2009 and required prospective application. We have evaluated certain events and transactions occurring after October 31,2009 and through December 7, 2009, the date of our Form10-Q filing.

 

**3. Commitments and Contingencies**

 

L**eases**—The Company is committed under operating leases for allof its retail store locations.  Inaddition to minimum future lease payments, all store leases provide foradditional rental payments based on sales, as well as common area maintenancecharges.  A majority of our leasesprovide for ongoing co-tenancy requirements that would further lower rentalrates, or permit lease terminations, or both, in the event that co-tenantscease to operate for specific periods. Total rent expense, base rent and contingent rent for the three and ninemonth periods ended October 31, 2009 and November 1, 2008 (inthousands) is as follows:

 
| ** **                        | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|-----------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                        | ** ** | **October 31, 2009**      | ** ** | **November 1, 2008**     | ** ** | **October 31, 2009** | ** ** | **November 1, 2008** | ** ** |
| Store base rent expense           |       | $                              | 9,014      |                          | $          | 8,437 |   | $ | 25,606 |   | $ | 22,532 |   |
| Other base rent expense           |       | 243                            |       | 243                           |       | 727 |   | 729 |   |
| Total base rent expense           |       | 9,257                          |       | 8,680                         |       | 26,333 |   | 23,261 |   |
| Contingent and other rent expense |       | 5,796                          |       | 5,555                         |       | 16,457 |   | 14,923 |   |
| Total rent expense                |       | $                              | 15,053     |                          | $          | 14,235 |   | $ | 42,790 |   | $ | 38,184 |   |

 

**Litigation—** On December 10,2007, a putative class action complaint was filed in the U.S. District Courtfor the Western District of Washington against the Company and certain of itscurrent and former directors and officers.  The action was purportedto be brought on behalf of a class of purchasers of the Company’s stock duringthe period March 14, 2007 to January 4, 2008 and alleged thatthe defendants violated the federal securities laws during this period oftime by, among other things, having made materially false or misleadingstatements and that the defendants engaged in insider trading.  The defendants moved to dismiss all claims inOctober 2008.  On March 30,2009, the U.S. District Court for the Western District of Washington issued itsruling without oral argument, dismissing the case with prejudice.

 

In addition, on December 20,2007, a shareholder derivative action was filed in the Superior Court of theState of Washington (Snohomish County), allegedly on behalf of and for thebenefit of the Company, against certain of the Company’s current directors andcurrent and former officers.  Following the March 30, 2009 ruling bythe U.S District Court on the putative class action complaint, the relatedshareholder derivative action was voluntarily dismissed.

 

OnMarch 5, 2008, a former employee commenced an action against the Companyin California state court (*Evan Johnson v. Zumiez, Inc.,et al.,*Case No. RG08374968, Alameda County Superior Court,filed March 5, 2008) alleging that the Company failed to pay all overtimewages owing to him and other employees in California, failed to provide mealbreaks as required by California law, failed to provide employees with properitemized wage statements (pay stubs) as required by California law, and failedto pay terminated employees waiting time penalties under California Labor Codesection 203.  On July 16, 2009, theCompany announced that it had reached an agreement to settle.  The claims made settlement agreement wassubmitted to the court for preliminary approval, but the court denied approvalwithout prejudice and encouraged the parties to restructure and resubmit theagreement to the court for approval.  TheCompany is now discussing modifications to the settlement agreement withplaintiff’s counsel.  The Company doesnot believe the final settlement will be materially different than thepreviously disclosed amount of approximately $1.3 million including

 

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settlementawards to class members, an incentive payment to the plaintiff, attorney’s feesand costs, and claims administration costs. This accrued charge was recorded in selling, general and administrativeexpenses in the condensed consolidated statement of operations for the threemonths ended August 1, 2009.

 

Aputative class action, *Chandra Berg v. ZumiezInc.*, was filed against the Company in the Los Angeles SuperiorCourt under case number BC408410 on February 25, 2009.  The action alleges causes of action forfailure to pay overtime wages to present and former store managers inCalifornia, failure to provide meal periods and rest breaks to store managers,failure to reimburse retail employees for clothing required by the Company’sdress code, failure to reimburse retail employees for business expenses,failure to provide store managers with accurate itemized wage statements,failure to pay terminated store managers all wages due at the time oftermination, unfair business practices and declaratory relief.  The Company has filed an answer to theComplaint and discovery is being conducted. No motion requesting certification of the case as a class action hasbeen filed.  At this early stage of thecase, it is not possible to estimate the amount or range of potential loss withany degree of certainty.

 

**InsuranceReserves—**The Company is responsible for medical and dentalinsurance claims up to a specified aggregate amount.  The Company maintains a reserve for estimatedmedical and dental insurance claims based on historical claims experience andother estimated assumptions.

 

**4. FairValue Measurements—** The Company defines fair value, establishes aframework for measuring fair value and expands disclosure about fair valuemeasurements as follows:

 

·                  Level 1**—**Quotedprices in active markets for identical assets or liabilities;

 

·                  Level 2**—**Quoted pricesfor similar assets or liabilities in active markets or inputs that areobservable;

 

·                  Level 3**—**Inputs thatare unobservable.

 

TheCompany follows the guidelines for assessing fair value measurements consistentwith GAAP that requires an assessment of whether certain factors exist toindicate that the market for an instrument is not active at the measurementdate.  If, after evaluating those factors,the evidence indicates the market is not active, a company must determinewhether recent quoted transaction prices are associated with distressedtransactions.

 

Thefollowing table summarizes assets measured at fair value on a recurring basisat October 31, 2009 and January 31, 2009:

 
| **Marketable Securities** | ** ** | **Level 1**        | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
|---------------------------|------------|--------------------|------------|-------------|------------|-------------|------------|
| ** **                | ** ** | **(in thousands)** | ** ** |
| At October 31, 2009  |       | $                  | —     |        | $          | 71,315      |       | $ | 832 |   |
| At January 31, 2009  |       | $                  | —     |        | $          | 45,525      |       | $ | 1,767 |   |

 

The$0.8 million in Level 3 marketable securities represents a $1.0 million parvalue auction rate security net of temporary impairment charge of approximately$0.2 million.  This security failed tosell at its scheduled auction in March 2009.  The interest rate for this security reset toa rate of 1.16%.  The next scheduledauction for this security is in March 2010.  The Company’s valuation method is based onnumerous assumptions including assessments of the underlying structure of thesecurity, expected cash flows, credit ratings, liquidity and other relevant factors.  Accordingly, this security is classified asLevel 3 within the valuation hierarchy. The assumptions, assessments and the interpretations of relevant marketdata are subject to uncertainties and are difficult to predict and requiresignificant judgment.  The use ofdifferent assumptions, applying different judgment to inherently subjectivematters and changes in future market conditions could result in significantlydifferent estimates of fair value.

 

Asa result of the temporary declines in fair value for the Company’s auction ratesecurity, which the Company attributes to recent liquidity issues rather thancredit issues, it has recorded an unrealized loss of approximately $0.2 millionto accumulated other comprehensive loss in the condensed consolidated balancesheet as of October 31, 2009.  TheCompany believes the current illiquid conditions are temporary in nature andthat it has the ability to hold the auction rate security until liquidityreturns to the market.  If it is laterdetermined that the fair value of this security is other-than-temporarilyimpaired, the Company will record a loss in the consolidated statement ofoperations.  Due to the Company’s beliefthat the market for this investment may take in excess of twelve months tofully recover, the Company has classified it as a noncurrent asset on theaccompanying condensed consolidated balance sheets as of October 31, 2009and January 31, 2009.

 

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TheLevel 2 marketable securities includes high quality money market funds, UStreasuries, US government sponsored enterprises, certificates of deposit, andmunicipal bonds traded in the over-the-counter market.  Fair values are based on quoted market pricesfor similar assets or liabilities or determined using inputs that use as theirbasis readily observable market data that are actively quoted and can bevalidated through external sources, including third-party pricing services,brokers, and market transactions.

 

Thefollowing table presents the changes in the Level 3 fair-value category for thenine months ended October 31, 2009. The Company classifies financial instruments in Level 3 of the fair-valuehierarchy when there is reliance on at least one significant unobservable inputto the valuation model.  In addition tothese unobservable inputs, the valuation models for Level 3 financialinstruments may also rely on a number of inputs that are readily observableeither directly or indirectly.

 
|                  |   | **January 31,  2009** | ** ** | **Sale of  Marketable  Securities  (Level 3)** | ** ** | **Total  Unrealized  Income Included  in Accumlated  Other  Comprehensive  Income (Loss)** | ** ** | **October 31,  2009** |   |
|-----------------------|--------|----------------------------|------------|------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|----------------------------|--------|
|                  |   | **(in  thousands)**        |       |
| Marketable securities |   | $                          | 1,767      |                                           | $          | (1,000                                                                                     | )          | $                          | 65     |   | $ | 832 |   |
|                       |        |                            |            |                                                |            |                                                                                            |            |                            |        |  |  |  |  |

 

Thefollowing table represents the fair value hierarchy for assets measured at fairvalue on a nonrecurring basis as of October 31, 2009:

 
| ** **                      | ** ** | **Fair Value Measurements at October 31, 2009** | ** ** |
|---------------------------------|------------|------------------------------------------------------|------------|
| ** **                      | ** ** | **(in thousands)**                                   | ** ** |
| ** **                      | ** ** | **Nine Months  Ended  October 31,  2009**       | ** ** | **Fair Value  Measurements Using  Significant  Unobservable Inputs  (Level 3 Measurements)** | ** ** | **Net Loss** | ** ** |
| Long-lived assets held and used |       | $                                                    | 127        |   | $ | 127 |   | $ | 714 |   |
|                                 |            |                                                      |            |  |  |  |  |  |  |  |

 

During the nine months endedOctober 31, 2009, certain long-lived store assets (primarily leaseholdimprovements and equipment) with a net carrying amount of $0.8 million werewritten down to their fair value of $0.1 million, resulting in a net impairmentcharge of $0.7 million which was included in earnings for the nine months endedOctober 31, 2009.  The fair valuewas determined using a discounted cash flow model at a store level. Storeimpairment expense was recorded net of the remaining tenant allowance.  The estimation of future cash flows fromoperating activities requires significant judgments of factors that includefuture sales, gross profit and operating expenses.  If the Company’s sales, gross profit oroperating expenses are not achieved at or above the forecasted level, thecarrying value of certain store assets may prove unrecoverable and the Companymay incur additional impairment charges in the future.  There were no impairments charges recognizedfor the nine months ended November 1, 2008.

 

**5. Net Income (Loss) Per Share,Basic and Diluted—** Basic net income per share is computed based on theweighted average number of common shares outstanding during the period.  Diluted net income per share is applicableonly in periods of net income and is computed by dividing net income by theweighted average number of common shares outstanding for the period andpotentially dilutive common share equivalents outstanding for the period.

 

Commonshare equivalents included in the computation of diluted net income per sharerepresent shares issuable upon assumed exercise of outstanding stock options,non-vested restricted stock and employee stock purchase plan share equivalents(“ESPP”).  Options to purchaseapproximately 452,000 and 832,000 shares of common stock in the three monthsended October 31, 2009 and November 1, 2008 and 452,000 and 827,000shares of common stock in the nine months ended October 31, 2009 and November 1,2008, were not included in the computation of diluted earnings per sharebecause either the option exercise price or the grant date fair value of thenon-vested share is greater than the market price of the Company’s commonstock.  There were approximately 617,000and 410,000 shares of non-vested restricted shares included in the calculationof diluted earnings per share for the three and nine months ended October 31,2009.  There were 270,000 and 193,000shares of non-vested restricted shares included in the calculation of dilutedearnings per share for the three and nine months ended November 1, 2008.

 

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Thefollowing table sets forth the computation of basic and diluted net income pershare (in thousands, except share and per share amounts):

 
| ** **                                                       | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|------------------------------------------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                                                       | ** ** | **October 31, 2009**      | ** ** | **November 1, 2008**     | ** ** | **October 31, 2009** | ** ** | **November 1, 2008** | ** ** |
| Net income                                                       |       | $                              | 5,073      |                          | $          | 6,818 |   | $ | 329 |   | $ | 10,907 |   |
| Weighted average common shares for basic net  income per share   |       | 29,562,733                     |       | 29,172,869                    |       | 29,457,792 |   | 29,086,196 |   |
| Dilutive effect of stock options and restricted  stock           |       | 681,211                        |       | 201,121                       |       | 581,190 |   | 308,220 |   |
| Weighted average common shares for diluted net  income per share |       | 30,243,944                     |       | 29,373,990                    |       | 30,038,982 |   | 29,394,416 |   |
| Basic net income per share                                       |       | $                              | 0.17       |                          | $          | 0.23 |   | $ | 0.01 |   | $ | 0.37 |   |
| Diluted net income per share                                     |       | $                              | 0.17       |                          | $          | 0.23 |   | $ | 0.01 |   | $ | 0.37 |   |

 

**6.  Subsequent Events—** The Companyhas evaluated subsequent events through the filing date of this Form 10-Qand has determined that there were no subsequent events to recognize or disclosein these financial statements.

 

**Item 2:  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS**

 

*Thefollowing discussion and analysis of our financial condition and results ofoperations should be read in conjunction with our condensed consolidatedfinancial statements and related notes included elsewhere in this quarterlyreport.  This discussion containsforward-looking statements that involve risks and uncertainties.  Our actual results could differ materiallyfrom those anticipated in these forward-looking statements as a result ofvarious factors, including those discussed in the section entitled “RiskFactors” in our Form 10-K filed with the SEC on March 23, 2009 and inthis Form 10-Q.*

 

*Forward-lookingstatements are based on our expectations regarding net sales, gross profit,selling, general and administrative expenses, profitability, financialposition, business strategy, new store openings, and plans and objectives ofmanagement.  The words “believe,” “may,”“will,” “estimate,” “continue,” “anticipate,” “intend,” “expect” and similarexpressions, as they relate to us and our business, industry, markets andconsumers, are intended to identify forward-looking statements.  We have based these forward-looking statementslargely on our current expectations and projections about future events andfinancial trends that we believe may affect our financial condition, results ofoperations, business strategy and financial needs.  These forward-looking statements are subjectto a number of risks, uncertainties and assumptions, including, among others,those described in “Risk Factors” and elsewhere in this quarterly report and inthe Form 10-K referred to in the preceding paragraph.  New riskfactors emerge from time to time and it is not possible for our management topredict all risk factors, nor can we assess the impact of all factors on ourbusiness or the extent to which any factor, or combination of factors, maycause actual results to differ materially from those contained in anyforward-looking statements.  We assume noobligation to update any forward-looking statements as a result of newinformation, future events or developments. References in the following discussion to “we,” “us,” “our,” “theCompany” and similar references mean Zumiez Inc. and its consolidatedsubsidiary, unless otherwise expressly stated or the context otherwiserequires.*

 

**Overview**

 

Weare a mall based specialty retailer of action sports related apparel, footwear,equipment and accessories operating under the Zumiez brand name.  As of October 31, 2009, we operated 378stores primarily located in shopping malls, giving us a presence in 35states.  We also operate an ecommercewebsite that supports our stores and sells similar products as our stores.  Our stores cater to young men and womenbetween the ages of 12 and 24 who seek brands representing a lifestyle centeredon activities that include skateboarding, surfing, snowboarding, BMX, andmotocross.  We support the action sportslifestyle and promote our brand, and a relevant selection of other popularbrands and styles, through a multi-faceted marketing approach that is designedto integrate our brand image with our customers’ activities and interests.  This approach, combined with our unique cultureand integrated marketing based on a passion for the action sports lifestyle,differentiated brand merchandising strategy, store design, comprehensivetraining programs and passionate employees, allows us to provide an experiencefor our customers that we believe is consistent with their attitudes, fashiontastes and identities and is otherwise unavailable in most malls.

 

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**General**

 

Netsales constitute gross sales net of estimated returns.  Net sales include our in-store sales and ourecommerce sales, which includes ecommerce shipping revenue.  Information in this report with respect tocomparable store sales includes ecommerce sales.  Ecommerce sales were 1.7% and 1.2% of totalsales for the nine month periods ended October 31, 2009 and November 1,2008.  Sales with respect to gift cardsare deferred and recognized when gift cards are redeemed.  The amount of the gift card liability isdetermined taking into account our estimate of the portion of gift cards thatwill not be redeemed or recovered (“gift card breakage”).  Gift card breakage is recognized as revenueafter 24 months, at which time the likelihood of redemption is consideredremote based on our historical redemption data.

 

Wereport “comparable store sales” based on net store sales beginning on the firstanniversary of their first day of operation and ecommerce sales.  Changes in our comparable store sales betweentwo periods are based on net sales of stores which were in operation duringboth of the two periods being compared and, if a store is included in thecalculation of comparable store sales for only a portion of one of the twoperiods being compared, then that store is included in the calculation for onlythe comparable portion of the corresponding period.  When additional square footage is added to astore that is included in comparable store sales, the store remains incomparable store sales.  There may bevariations in the way in which some of our competitors and other apparelretailers calculate comparable or same store sales.  As a result, data regarding our comparablestore sales may not be comparable to similar data made available by our competitorsor other retailers.

 

Cost of goods soldconsists of branded merchandise costs, and our private label merchandiseincluding design, sourcing, importing and inbound freight costs.  Our cost of sales also includes shrinkage,certain promotional costs, buying, store occupancy and distribution andwarehousing costs.  This may not be comparable to theway in which the Company’s competitors or other retailers compute their cost ofgoods sold.

 

Selling,general and administrative expenses consist primarily of store personnel wagesand benefits, administrative staff and infrastructure expenses, store supplies,depreciation on leasehold improvements at our home office and stores, facilityexpenses, training, advertising and marketing costs.  Credit card fees, insurance, public companyexpenses, legal expenses and other miscellaneous operating costs are alsoincluded in selling, general and administrative expenses.  This may not be comparable to the way inwhich our competitors or other retailers compute their selling, general andadministrative expenses.  We expect thatour selling, general and administrative expenses will, as described below,increase in future periods due in part to increased expenses associatedwith opening new stores.

 

Oursuccess is largely dependent upon our ability to anticipate, identify andrespond to the fashion tastes of our customers and to provide merchandise thatsatisfies customer demands.  Anyinability to provide appropriate merchandise in sufficient quantities in atimely manner could have a material adverse effect on our business, operatingresults and financial condition.

 

**KeyPerformance Indicators**

 

Ourmanagement evaluates the following items, which we consider key performanceindicators, in assessing our performance:

 

*Comparablestore sales.*  Comparablestore sales provide a measure of sales growth for stores open at least one yearover the comparable prior year period.

 

Ourmanagement considers comparable store sales to be an important indicator of ourcurrent performance.  Comparable storesales results are important to achieve leveraging of our costs, including storepayroll, store supplies and rent. Comparable store sales also have a direct impact on our total net sales,cash and working capital.

 

*Grossprofit*.  Gross profit measures whetherwe are optimizing the price and inventory levels of our merchandise.  Gross profit is the difference between netsales and cost of sales.  Cost of salesconsists of branded merchandise costs, and our private label merchandiseincluding design, sourcing, importing and inbound freight costs.  Our cost of sales also includes markdowns,shrinkage, certain promotional costs, buying, store occupancy and distributionand warehousing costs.  Any inability toobtain acceptable levels of initial markups or any significant increase in ouruse of markdowns could have an adverse effect on our gross profit and resultsof operations.

 

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*Operatingincome.* We viewoperating income as a key indicator of our success.  The key drivers of operating income arecomparable store sales, gross profit, our ability to control selling, generaland administrative expenses, and our level of capital expenditures affectingdepreciation expense.

 

*Storeproductivity.* Storeproductivity, including net sales per average square foot, average unit retailprice, the number of transactions per store, the number of units sold per storeand the number of units per transaction, is evaluated by our management inassessing our operational performance. In addition, we review our stores operating income as a measure of theirprofitability.

 

**CriticalAccounting Policies and Estimates**

 

Ourdiscussion and analysis of our financial condition and results of operationsare based on our financial statements, which have been prepared in conformancewith accounting principles generally accepted in the United States of America(“GAAP”).  These U.S. GAAP standards areset by the Financial Accounting Standards Board “FASB.”  The FASB sets generally accepted accountingprinciples (GAAP) that we follow to ensure we consistently report our financialcondition, results of operations, and cash flows.  Over the years, the FASB and other designatedGAAP-setting bodies have issued standards in the form of FASB Statements,Interpretations, FASB Staff Positions, EITF consensuses and AICPA Statements ofPosition, etc., many of which have been interpreted and amended several timesover the years.

 

TheFASB recognized the complexity of its standard-setting process and embarked ona revised process in 2004 that culminated in the release on July 1, 2009of FASB No. 168 *“Accounting StandardsCodification,”*  referred to asthe Codification or ASC.  TheCodification does not change how the Company accounts for its transactions orthe nature of related disclosures made, rather it better codifies relevant GAAPtopics into one resource.  However, thiscodification does not include GAAP pronouncements issued by the Securities andExchange Commission.  The above changewas made effective by the FASB for periods ending on or after September 15,2009.  All references to pre-codifiedU.S. GAAP have been removed from this Form 10-Q.

 

Inpreparing financial statements in accordance with GAAP, we are required to makeestimates and assumptions that have an impact on the assets, liabilities,revenue and expense amounts reported. These estimates can also affect supplemental information disclosed byus, including information about contingencies, risk, and financialcondition.  We believe, given currentfacts and circumstances that our estimates and assumptions are reasonable,adhere to GAAP, and are consistently applied. Inherent in the nature of an estimate or assumption is the fact thatactual results may differ from estimates and estimates may vary as new factsand circumstances arise.  In preparingthe financial statements, we make routine estimates and judgments indetermining the net realizable value of accounts receivable, inventory,leasehold improvements and equipment, prepaid assets, goodwill and certainliabilities.  We believe our mostcritical accounting estimates and assumptions are in the following areas:

 

*Impairmentof Marketable and Non-Marketable Securities*.  We periodically review our marketablesecurities for impairment.  If weconclude that any of these investments are impaired, we determine whether suchimpairment is “other-than-temporary.” Factors we consider to make such a determination include theduration and severity of the impairment, as well as the reason for the declinein value and the potential recovery period.  If any impairment is considered“other-than-temporary,” we will write down the asset to its fair value and takea corresponding charge to our consolidated statement of operations.

 

*Valuationof merchandise inventories*.  We carry our merchandise inventories at thelower of cost or market.  Merchandiseinventories may include items that have been written down to our best estimateof their net realizable value.  Ourdecisions to write-down our merchandise inventories are based on our currentrate of sale, the age of the inventory and other factors.  Actual final sales prices to our customersmay be higher or lower than our estimated sales prices and could result in afluctuation in gross profit. Historically, any write-downs have not been significant and we do notadjust the historical carrying value of merchandise inventories upwards basedon actual sales experience.

 

Weestimate an inventory shrinkage reserve for anticipated losses.  Shrinkage refers to a reduction in inventorydue to shoplifting, employee theft and paperwork errors.  The estimate for the shrinkage reserve iscalculated based on historical percentages and can be affected by changes inmerchandise mix and changes in actual shrinkage trends.  We do not believe there is a reasonablelikelihood that there will be a material change in the future estimates or assumptionswe use to calculate our inventory shrinkage reserve.  However, if actual physical inventory lossesdiffer significantly from our estimate, our operating results could beadversely affected.

 

*Leaseholdimprovements and equipment*.  We review the carrying value of our leaseholdimprovements and equipment for impairment whenever events or changes incircumstances indicate that the carrying value of such assets may not berecoverable.  Recoverability of assets tobe held and used is determined by a comparison of the net carrying amount of anasset to future undiscounted net cash flows expected to be generated by theasset.  The estimation of future cashflows from operating activities requires significant judgments of factors thatinclude future sales, gross profit and operating expenses.  If such assets are considered impaired, theimpairment recognized is measured by comparing projected individual storediscounted cash flow to the asset carrying values.  Declines in

 

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projectedstore cash flow could result in the impairment of assets.  The actual economic lives of these assets maybe different than our estimated useful lives, thereby resulting in a differentcarrying value.  These evaluations couldresult in a change in the depreciable lives of those assets and therefore ourdepreciation expense in future periods.

 

*Revenuerecognition and sales returns reserve*.  We recognize revenue upon purchase by customersat our retail store locations or upon shipment for orders placed through ourwebsite as both title and risk of loss have transferred.  Revenue is recorded net of estimated andactual sales returns and deductions for coupon redemptions and other promotions.  We offer a return policy of 30 days and theestimated sales return reserve is based on projected merchandise returnsdetermined through the use of historical sales returns results.  We do not believe there is a reasonablelikelihood that there will be a material change in the future estimates orassumptions we use to calculate our sales return reserve.  However, if the actual rate of sales returnsincreases significantly, our operating results could be adversely affected.

 

Revenueis not recorded on purchase of gift cards. A current liability is recorded upon purchase, and revenue is recognizedwhen the gift card is redeemed for merchandise. The amount of the gift card liability is determined taking into accountour estimate of the portion of gift cards that will not be redeemed orrecovered (“gift card breakage”).  Giftcard breakage is recognized as revenue after 24 months, at which time thelikelihood of redemption is considered remote based on our historicalredemption data.

 

*Lease Accounting.*  The Company occupies its retailstores and combined home office and distribution center under operating leasesgenerally with terms of five to ten years. Some of these leases have early cancellation clauses, which permit thelease to be terminated if certain sales levels are not met in specificperiods.  Some leases contain renewaloptions for periods ranging from one to five years under substantially the sameterms and conditions as the original leases. Most of the store leases require payment of a specified minimum rent,plus a contingent rent based on a percentage of the store’s net sales in excessof a specified threshold.  Most of thelease agreements have defined escalating rent provisions, which are straight-linedover the term of the related lease, including any lease renewals deemedprobable.  The Company straight-lines andrecognizes its rent expense over the term of the lease, plus the constructionperiod prior to occupancy of the retail location, using a mid-monthconvention.  For certain locations, theCompany receives cash tenant allowances and has reported these amounts as adeferred liability, which is amortized to rent expense over the term of thelease.

 

*Accountingfor Income Taxes.*  As part of the process of preparing thecondensed consolidated financial statements, income taxes are estimated foreach of the jurisdictions in which we operate. This process involves estimating actual current tax exposure togetherwith assessing temporary differences resulting from differing treatment of itemsfor tax and accounting purposes.  Thesedifferences result in deferred tax assets and liabilities, which are includedwithin the balance sheet.  The likelihoodthat deferred tax assets will be recovered from future taxable income isassessed, recognizing that future taxable income may give rise to new deferredtax assets.  To the extent that futurerecovery is not likely, a valuation allowance would be established.  To the extent that a valuation allowance isestablished or increased, an expense will be included within the tax provisionin the income statement.

 

Significantmanagement judgment is required in determining the provision for income taxes,deferred tax assets and liabilities and any valuation allowance recordedagainst net deferred tax assets.  Basedon our history of operating earnings, no valuation allowance has been recordedas of October 31, 2009.  In theevent that actual results differ from these estimates, or these estimates areadjusted in future periods, a valuation allowance may need to be established,which could impact our financial position and results of operations.  The Company’s policy is to recognizepenalties and interest related to unrecognized tax benefits in income taxexpense.  Provisions for income taxes arebased on numerous factors that are subject to audit by the Internal RevenueService and the tax authorities in the various jurisdictions in which we dobusiness.

 

*Stock-basedcompensation*.  The Companymaintains a 2005 Equity Incentive Plan under which non-qualified stock optionsand restricted stock have been granted to employees and non-employeedirectors.  The Company accounts forstock compensation in accordance with GAAP. Under the provisions of GAAP, the estimated fair value of share-basedawards granted under the 2005 Equity Incentive Plan is recognized ascompensation expense over the vesting period.

 

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** **

**Resultsof Operations**

 

Thefollowing table presents, for the periods indicated, selected items in thestatements of operations as a percent of net sales:

 
| ** **                                   | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|----------------------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                                   | ** ** | **October 31, 2009**      | ** ** | **November 1, 2008**     | ** ** | **October 31, 2009** | ** ** | **November 1, 2008** | ** ** |
| Net sales                                    |       | 100.0                          | %          | 100.0                         | %          | 100.0 | % | 100.0 | % |
| Cost of goods sold                           |       | 64.6                           |       | 65.0                          |       | 68.5 |   | 66.8 |   |
| Gross profit                                 |       | 35.4                           |       | 35.0                          |       | 31.5 |   | 33.2 |   |
| Selling, general and administrative expenses |       | 28.0                           |       | 25.7                          |       | 31.6 |   | 27.5 |   |
| Operating profit (loss)                      |       | 7.4                            |       | 9.3                           |       | (0.1 | ) | 5.7 |   |
| Interest and other income, net               |       | 0.1                            |       | 0.5                           |       | 0.3 |   | 0.6 |   |
| Earnings before income taxes                 |       | 7.5                            |       | 9.8                           |       | 0.2 |   | 6.3 |   |
| Provision for income taxes                   |       | 3.0                            |       | 3.7                           |       | 0.1 |   | 2.4 |   |
| Net Income                                   |       | 4.5                            | %          | 6.1                           | %          | 0.1 | % | 3.9 | % |

 

**ThreeMonths (13 weeks) Ended October 31, 2009 Compared With Three Months (13weeks) Ended November 1, 2008**

 

***Net Sales***

 

Net sales increased to$113.2 million for the three months ended October 31, 2009 from$112.2 million for the three months ended November 1, 2008, anincrease of $1.0 million, or 0.8%.

 

Comparable store net salesdecreased 8.0% for the three months ended October 31, 2009 compared to thethree months ended November 1, 2008. Geographically our stores in the western region of the U.S., whichaccount for approximately 54% of our comparable store sales, declined byapproximately 10%.  Our stores in theSouth, Midwest and Northeast experienced a comparable store sales decline ofapproximately 7%.  The decrease incomparable stores net sales was primarily due to lower net sales in allmerchandise departments except footwear which experienced a nominalincrease.  For information as to how wedefine comparable stores, see “General” above.

 

Theincrease in total net sales was due to an increase in non-comparable storesales of $10.1 million partially offset by a decrease in net sales fromcomparable stores of approximately $9.1 million.  The decrease incomparable store sales was due to fewer transactions, partially offset by anincrease in dollars per transaction.  Theincrease in dollars per transaction was a result of an increase in units pertransaction, somewhat offset by a decrease in average unit retail.  Theincrease in non-comparable store net sales was primarily due to the opening of39 new stores subsequent to November 1, 2008.

 

***Gross Profit***

 

Grossprofit for the three months ended October 31, 2009 was $40.1 millioncompared with $39.3 million for the three months ended November 1, 2008,an increase of approximately $0.8 million, or 2.1%.  As a percentage of net sales, gross profitincreased to 35.4% for the three months ended October 31, 2009 from 35.0%for the three months ended November 1, 2008.  The increase in gross profit as a percent ofnet sales was driven by an increase in gross profit on inventory sold and areduction in inventory shrinkage partially offset by increased store occupancycosts.

 

***Selling, General and Administrative Expenses***

 

Selling,general and administrative (“SG&A”) expenses in the three months ended October 31,2009 were $31.7 million compared with $28.9 million in the three monthsended November 1, 2008, an increase of $2.8 million, or 9.9%.  This increase was primarily the result ofcosts associated with the opening of 39 new stores subsequent to November 1,2008, the timing of incentive compensation accruals, impairment charges on sixstores and infrastructure and administrative investments to support ourgrowth.  As a percentage of net sales,SG&A expenses increased to 28.0% in the three months ended October 31,2009 from 25.7% in the three months ended November 1, 2008.

 

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***Operating Profit***

 

Asa result of the above factors, operating profit was $8.4 million for the threemonths ended October 31, 2009 compared with operating profit $10.4 millionfor the three months ended November 1, 2008, a decrease of $2.0million.  As a percentage of net sales,operating profit was 7.4% for the three months ended October 31, 2009compared with 9.3% for the three months ended November 1, 2008.

 

***Provision for Income Taxes***

 

Provisionfor income taxes was $3.5 million for the three months ended October 31,2009 compared with $4.2 million for the three months ended November 1,2008.  The effective tax rate was 40.5%for the three months ended October 31, 2009 compared with 38.0% for threemonths ended and November 1, 2008. The increased tax rate is due to the unusually low year-to-date incomebefore tax and the impact of permanent items on expected full year taxes.

 

***Net Income***

 

Netincome was $5.1 million for the three months ended October 31, 2009compared to net income of $6.8 million for the three months ended November 1,2008, a decrease of $1.7 million.  As apercentage of net sales, net income was 4.5% for the three months ended October 31,2009 compared to net income of 6.1% for the three months ended November 1,2008.

 

**Nine Months (39 weeks) Ended October 31, 2009Compared With Nine Months (39 weeks) Ended November 1, 2008**

 

***Net Sales***

 

Net sales decreased to $275.2 million for the nine months ended October 31,2009 from $283.2 million for the nine months ended November 1, 2008, adecrease of $8.0 million, or 2.8%. Comparable store net sales decreased by 13.6% for the nine months ended October 31,2009 compared to the nine months ended November 1, 2008.  Geographically our stores in the westernregion of the U.S. and the South, which account for approximately 66% of ourcomparable store sales, declined by approximately 16%.  Our stores in the Midwest and Northeastexperienced a comparable store sales decline of approximately 10%.  The decrease in comparable stores net saleswas primarily due to lower net sales in all merchandise departments exceptfootwear which experienced a nominal increase. For information as to how we define comparable stores, see “General”above.

 

Thedecrease in total net sales was due to a decrease in net sales from comparablestores of approximately $38.9 million partially offset by an increase innon-comparable store sales of $30.9 million. The decrease in comparable store sales was due to fewer transactions,partially offset by an increase in dollars per transaction.  The increase in dollars per transaction was aresult of an increase in units per transaction, somewhat offset by a decreasein average unit retail.  The increase innon-comparable store net sales was primarily due to the opening of 39 newstores subsequent to November 1, 2008.

 

***Gross Profit***

 

Grossprofit for the nine months ended October 31, 2009 was $86.6 millioncompared with $93.9 million for the nine months ended November 1,2008, a decrease of $7.3 million, or 7.8%. As a percentage of net sales, gross profit decreased to 31.5% for thenine months ended October 31, 2009 from 33.2% for the nine months ended November 1,2008.  The reduction in gross margin as apercent of net sales was driven primarily by increased store occupancy costspartially offset by a reduction in inventory shrinkage and an increase in grossprofit on inventory sold.

 

***Selling, General and AdministrativeExpenses***

 

Selling,general and administrative (“SG&A”) expenses for the nine months ended October 31,2009 were $87.0 million compared with $78.0 million in the nine monthsended November 1, 2008, an increase of $9.0 million, or 11.5%.  This increase was primarily the result ofcosts associated with opening new stores, approximately $1.3 million legalsettlement accrual related to the Johnson case outlined in footnote three“Litigation,” $0.7 million in store impairment charges related to seven storesand to a lesser extent increases in infrastructure and administrative staff tosupport our growth.  As a percentage ofnet sales, SG&A expenses increased to 31.6% for the nine months ended October 31,2009 from 27.5% in the nine months ended November 1, 2008.

 

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***Operating Profit or Loss***

 

Asa result, of the above factors, operating loss was $0.3 million for the ninemonths ended October 31, 2009 compared to operating profit of $15.9million for the nine months ended November 1, 2008 a decrease of $16.2million.  As a percentage of net sales,operating loss was 0.1% for the nine months ended October 31, 2009compared to operating profit of 5.7% for the nine months ended November 1,2008.

 

***Provision for Income Taxes***

 

Provisionfor income taxes was $0.2 million for the nine months ended October 31,2009 compared to income tax provision of $6.7 million for the nine months endedNovember 1, 2008.  The effective taxrate was 37.0 % and 38.1% for nine months ended October 31, 2009 and November 1,2008.

 

***Net Income***

 

Netincome was $0.3 million for the nine months ended October 31, 2009compared with net income of $10.9 million for the nine months ended November 1,2008, a decrease of $10.6 million.  As apercentage of net sales, net income was 0.1% for the nine months ended October 31,2009 compared to net income of 3.9% for the nine months ended November 1,2008.

 

**Liquidityand Capital Resources**

 

Ourprimary uses of cash are for capital investments, inventory, store remodeling,store fixtures and ongoing infrastructure improvements, such as technologyenhancements and distribution capabilities. Our main source of liquidity is cash flows from operations.

 

Thesignificant components of our working capital are inventory and liquid assetssuch as cash, marketable securities and receivables, reduced by accountspayable and accrued expenses.  Ourworking capital position benefits from the fact that we generally collect cashfrom sales to customers the same day or within several days of the relatedsale, while we typically have longer payment terms with our vendors.

 

Asof October 31, 2009, we held a $1.0 million par value auction ratesecurity valued at $0.8 million, net of approximately $0.2 millionimpairment charge.  The $1.0 millionsecurity failed to sell at its scheduled auction in March 2009.  The interest rate for the security reset to aprescribed tax-free rate of 1.16%.  Wepreviously had another $1.0 million auction rate security, but in May 2009,this security was redeemed at par.  Wecurrently do not intend to hold the security beyond the next auction date andwill try to sell this security when the auction date comes up in March 2010.  However, the uncertainties in the creditmarkets have prevented us and other investors from liquidating holdings of auctionrate securities in auctions for these securities because the amount ofsecurities submitted for sale has exceeded the amount of purchase orders.  If the March 2010 auction fails, we planto hold the security until the next auction date and the security coupon ratewill reset to a prescribed “failure” rate. An unsuccessful auction could result in our holding the security beyondthe next scheduled auction reset date if a secondary market does not develop;therefore, limiting the short-term liquidity of the investment.  The security has been classified as a “longterm” asset on our condensed consolidated balance sheet as of October 31,2009.

 

Ourcapital requirements include construction and fixture costs related to theopening of new stores and remodeling expenditures for existing stores.  Future capital requirements will depend onmany factors, including the pace of new store openings, the availability ofsuitable locations for new stores, and the nature of arrangements negotiatedwith landlords.  In that regard, our netinvestment to open a new store has varied significantly in the past due to anumber of factors, including the geographic location and size of the new store,and is likely to vary significantly in the future.  During fiscal 2009, we expect to spendapproximately $17.0 to $19.0 million on capital expenditures, a majority ofwhich will relate to leasehold improvements and fixtures for the 36 total newstores we opened in fiscal 2009, and a smaller amount related to equipment,systems and improvements for our distribution center and supportinfrastructure.  However, there can be noassurance that the actual fiscal 2009 capital expenditures will not differ fromthis expected amount.

 

Weexpect cash flows from operations and available borrowings under our revolvingcredit facility will be sufficient to meet our foreseeable cash requirementsfor operations and planned capital expenditures for at least the next twelvemonths.  Beyond this time frame, if thesesources are not sufficient to meet our capital requirements, then we will berequired to obtain additional equity or debt financing in the future.  There can be no assurance that equity or debtfinancing will be available to us when we need it or, if available, that theterms will be satisfactory to us and not dilutive to our then-currentshareholders.

 

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Netcash provided by operating activities for the nine months ended October 31,2009 was approximately $17.2 million primarily related to increased tradeaccounts payable and deferred rent and tenant allowances, partially offset byan increase in inventory.  Net cashprovided by operating activities for the nine months ended November 1,2008 was $19.8 million primarily related to increased trade accounts payable,income taxes and deferred rent, partially offset by an increase in inventory.

 

Netcash used in investing activities was $41.1 million for the nine monthsended October 31, 2009, related primarily to $15.2 million of capitalexpenditures for new store openings, existing store renovations, home officeand distribution center capital projects and by $25.9 million in net purchasesof marketable securities.  Net cash usedin investing activities was $21.0 million for the nine months ended November 1,2008, related to $26.3 million of capital expenditures primarily for new storeopenings and existing store renovations and home office and distribution centercapital projects, partially offset by $5.3 million in net sales of marketablesecurities.

 

Netcash provided by financing activities for the nine months ended October 31,2009 was $1.4 million related to proceeds received from exercise of stockoptions and the related tax benefit.  Netcash used in financing activities for the nine months ended November 1,2008 was $1.6 million related to the payment of book overdrafts somewhat offsetby proceeds received from exercise of stock options and the related taxbenefit.

 

OnJune 10, 2009, we renewed and amended our secured credit agreement withWells Fargo HSBC Trade Bank, N.A., and the prior facility agreement wasterminated.  The credit agreementprovides us with a secured revolving credit facility until September 1,2011 of up to $25.0 million.  Thesecured revolving credit facility provides for the issuance of a standby letterof credit in an amount not to exceed $5.0 million outstanding at any time andwith a term not to exceed 365 days.  Thecommercial line of credit provides for the issuance of a commercial letter ofcredit in an amount not to exceed $10.0 million and with terms not to exceed120 days.  The amount of borrowingsavailable at any time under our secured revolving credit facility is reduced bythe amount of standby and commercial letters of credit outstanding at thattime.  There were no outstandingborrowings under the secured revolving credit facility at October 31, 2009or January 31, 2009.  The Companyhad open commercial letters of credit outstanding under our secured revolvingcredit facility of $1.3 million at October 31, 2009 and approximately $0.3million at January 31, 2009.  Thesecured revolving credit facility bears interest at the Daily One Month LIBORrate plus 1.00%.  The credit agreementcontains a number of restrictions and covenants that generally limit ourability to, among other things, (1) incur additional debt, (2) undergoa change in ownership and (3) enter into certain transactions.  The credit agreement also contains financialcovenants that require us to meet certain specified financial tests and ratios,including, a maximum net loss not to exceed $10.0 million after taxes on atrailing four-quarter basis provided, that, there shall be added to net incomeall charges for impairment of goodwill and store assets not to exceed $5.0million in aggregate, and a minimum quick ratio of 1.25.  The quick ratio is defined as our cash andnear cash equivalents plus certain defined receivables divided by theoutstanding borrowings.  All of ourpersonal property, including, among other things, our inventory, equipment andfixtures, has been pledged to secure our obligations under the creditagreement.  We must also providefinancial information and statements to our lender.  We were in compliance with all such covenantsat October 31, 2009.

 

**ContractualObligations and Commercial Commitments**

 

Therewere no material changes outside the ordinary course of business in ourcontractual obligations during the nine months ended October 31, 2009.  Our operating lease obligations are notrecognized as liabilities in the financial statements.  The following table summarizes the totalamount of future payments (in thousands) due under certain of our contractualobligations at October 31, 2009:

 
| ** **                  | ** ** | ** ** | ** ** | **Less than** | ** ** | ** **     | ** ** | ** **    | ** ** | **More than** | ** ** |
|-----------------------------|------------|------------|------------|---------------|------------|----------------|------------|---------------|------------|---------------|------------|
| **Contractual Obligations** | ** ** | **Total**  | ** ** | **1 Year**    | ** ** | **1- 3 Years** | ** ** | **3-5 Years** | ** ** | **5 Years**   | ** ** |
| Operating Lease Obligations |       | $          | 318,091    |          | $          | 9,967          |       | $             | 81,323     |          | $          | 77,936 |   | $ | 148,865 |   |
| Purchase Obligations        |       | 52,470     |       | 52,470        |       |           |       | —        |       | —        |       |
| Letters of Credit           |       | 1,255      |       | 1,255         |       | —         |       | —        |       | —        |       |
|                        |       | $          | 371,816    |          | $          | 63,692         |       | $             | 81,323     |          | $          | 77,936 |   | $ | 148,865 |   |

 

Weoccupy our retail stores and combined home office and distribution center underoperating leases generally with terms of five to ten years.  Some of our leases have early cancellationclauses, which permit the lease to be terminated by us if certain sales levelsare not met in specific periods.  Someleases contain renewal options for periods ranging from one to five years undersubstantially the same terms and conditions as the original leases.  In addition to future minimum lease payments,substantially all of our store leases provide for additional rental payments(or “percentage rent”) if sales at the respective stores exceed specified levels,as well as the payment of common area maintenance charges and real estatetaxes, unless guaranteed in the lease agreement.  Amounts in the above table do not includepercentage rent, common area maintenance charges or real estate taxes unlessthese costs are fixed and determinable. Most of our lease agreements have defined escalating rent provisions,which we have straight-lined over the term of the lease, including any leaserenewals deemed to be probable.  Forcertain locations, we receive cash tenant allowances and we have

 

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reportedthese amounts as a deferred liability that is amortized to rent expense overthe term of the lease, including any lease renewals deemed probable.  Rent expense, including common areamaintenance and other occupancy costs, was $42.8 million and $38.2 million forthe nine months ended October 31, 2009 and November 1, 2008.

 

AtOctober 31, 2009, we had outstanding purchase orders to acquiremerchandise from vendors of approximately $52.5 million.  We have an option to cancel these commitmentswith no notice prior to shipment except for private label purchase orders.  At October 31, 2009, we hadapproximately $1.3 million of letters of credit outstanding.

 

**Off-BalanceSheet Obligations**

 

Ouronly off-balance sheet contractual obligations and commercial commitments as ofOctober 31, 2009 related to operating lease obligations, open purchaseorders, and letters of credit.  We haveexcluded these items from our balance sheet in accordance with GAAP.  We presently do not have any non-cancelableinventory purchase commitments, except purchase orders for private labelmerchandise and new unopened store build out commitments.  At October 31, 2009, we had outstandingpurchase orders to acquire merchandise from vendors for approximately$52.5 million.  These purchases areexpected to be financed by cash flows from operations.  We have an option to cancel these commitmentswith no notice prior to shipment except for our private label purchaseorders.  At October 31, 2009, we had$1.3 million of letters of credit outstanding under our secured revolvingcredit facility.  At October 31,2009, we were committed to property owners for operation lease obligations in theapproximate amount of $318.1 million. Most of our leases contain cancellation or kick-out clauses in our favorthat relieve us from any future obligation under a lease if specified saleslevels are not achieved by a specific date.

 

**Impactof Inflation**

 

Wedo not believe that inflation has had a material impact on our net sales oroperating results in the recent past. There can be no assurance that our business will not be affected byinflation in the future.

 

**RiskFactors**

 

*Investing in our securities involves a high degree ofrisk.  The following risk factors, issuesand uncertainties should be considered in evaluating our future prospects.  In particular, keep these risk factors inmind when you read “forward-looking” statements elsewhere in this report.  Forward-looking statements relate to ourexpectations for future events and time periods.  Generally, the words “anticipate,” “believe,”“expect,” “intend” and similar expressions identify forward-lookingstatements.  Forward-looking statementsinvolve risks and uncertainties, and future events and circumstances coulddiffer significantly from those anticipated in the forward-lookingstatements.  Any of the following riskscould harm our business, operating results or financial condition and couldresult in a complete loss of your investment. Additional risks and uncertainties that are not yet identified or thatwe currently think are immaterial may also harm our business and financialcondition in the future.*

 

***Our growth strategy depends on our abilityto open and operate a significant number of new stores each year, which couldstrain our resources and cause the performance of our existing stores tosuffer.***

 

Ourgrowth largely depends on our ability to open and operate new storessuccessfully.  However, our ability toopen new stores is subject to a variety of risks and uncertainties includingthe current deterioration of the macroeconomic environment, and we may beunable to open new stores as planned, and any failure to successfully open andoperate new stores would have a material adverse effect on our results ofoperations and on the market price of our common stock.  We intend to continue to open new stores infuture years while remodeling a portion of our existing store baseannually.  In addition, our proposedexpansion will place increased demands on our operational, managerial andadministrative resources.  Theseincreased demands could cause us to operate our business less effectively,which in turn could cause deterioration in the financial performance of ourindividual stores and our overall business. To the extent our new store openings are in markets where we alreadyhave stores, we may experience reduced net sales in existing stores inthose markets.  In addition, successfulexecution of our growth strategy may require that we obtain additionalfinancing, and we cannot assure you that we will be able to obtain thatfinancing on acceptable terms or at all.

 

Unlikeprevious years, the number of anticipated store openings in fiscal 2009 mayincrease or decrease due to market conditions. We have opened or acquired, on average, approximately twenty-fivepercent new stores over the last five years. As we look to fiscal 2009 and beyond, we will likely slow this rate ofgrowth until we see the macroeconomic environment improve.

 

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***If we fail to effectively execute ourexpansion strategy, we may not be able to successfully open new storelocations in a timely manner, if at all, which could have an adverse affect onour net sales and results of operations.***

 

Ourability to open and operate new stores successfully depends on many factors, including,among others, our ability to:

 

·                  identifysuitable store locations, the availability of which is outside of our control;

 

·                  negotiateacceptable lease terms, including desired tenant improvement allowances;

 

·                  sourcesufficient levels of inventory at acceptable costs to meet the needs of newstores;

 

·                  hire, train andretain store personnel;

 

·                  successfullyintegrate new stores into our existing operations; and

 

·                  identify andsatisfy the merchandise preferences of new geographic areas.

 

Inaddition, many of our planned new stores are to be opened in regions of theUnited States in which we currently have few, or no, stores.  The expansion into these marketsmay present competitive, merchandising and distribution challenges thatare different from those currently encountered in our existing markets.  Any of these challenges could adverselyaffect our business and results of operations.

 

***Our business is dependent upon our beingable to anticipate, identify and respond to changing fashion trends, customerpreferences and other fashion-related factors; failure to do so could have amaterial adverse effect on us.***

 

Customertastes and fashion trends in the action sports lifestyle market are volatileand tend to change rapidly.  Our successdepends on our ability to effectively anticipate, identify and respond tochanging fashion tastes and consumer preferences, and to translate markettrends into appropriate, saleable product offerings in a timely manner.  If we are unable to successfully anticipate,identify or respond to changing styles or trends and misjudge the market forour products or any new product lines, our sales may be lower thanpredicted and we may be faced with a substantial amount of unsoldinventory or missed opportunities.  Inresponse to such a situation, we may be forced to rely on markdowns orpromotional sales to dispose of excess or slow-moving inventory, which couldhave a material adverse effect on our results of operations.

 

***Our ability to attract customers to ourstores depends heavily on the success of the shopping malls in which our storesare located; any decrease in customer traffic in those malls could cause oursales to be less than expected.***

 

Inorder to generate customer traffic we depend heavily on locating our stores inprominent locations within successful shopping malls.  Sales at these stores are derived, in part,from the volume of traffic in those malls. Our stores benefit from the ability of a mall’s other tenants togenerate consumer traffic in the vicinity of our stores and the continuingpopularity of malls as shopping destinations. Our sales volume and mall traffic generally may be adverselyaffected by, among other things, economic downturns in a particular area,competition from ecommerce retailers, non-mall retailers and other malls,increases in gasoline prices and the closing or decline in popularity of otherstores in the malls in which we are located. The continuing slowdown in the United States economy or an uncertaineconomic outlook could curtail new shopping mall development, decrease shoppingmall traffic, reduce the number of hours that shopping mall operators keeptheir shopping malls open or force them to cease operations entirely.  A reduction in mall traffic as a result ofthese or any other factors could have a material adverse effect on ourbusiness, results of operations and financial condition.

 

***Our sales and inventory levels fluctuate ona seasonal basis, leaving our operating results particularly susceptible tochanges in back-to-school and holiday shopping patterns.***

 

Oursales are typically disproportionately higher in the third and fourth fiscalquarters of each fiscal year due to increased sales during the back-to-schooland winter holiday shopping seasons. Sales during these periods cannot be used as an accurate indicator ofannual results.  Our sales in the firstand second fiscal quarters are typically lower than in our third and fourthfiscal quarters due, in part, to the traditional retail slowdown immediatelyfollowing the winter holiday season.  As a result ofthis seasonality, any factors negatively affecting us during the last half ofthe year, including unfavorable economic conditions, adverse weather or ourability to acquire seasonal merchandise inventory, could have a materialadverse effect on our financial condition and results of operations for theentire year.  In addition, inorder to prepare for the back-to-school and winter holiday shopping seasons, wemust order and keep in stock significantly more merchandise than we carryduring other times of the year.  Any unanticipateddecrease in demand for our products during these peak shopping seasons couldrequire us to sell excess inventory at a substantial markdown, which could havea material adverse effect on our business, results of operations and financialcondition.

 

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***Our quarterly results of operations arevolatile and may decline.***

 

Ourquarterly results of operations have fluctuated significantly in the past andcan be expected to continue to fluctuate significantly in the future.  As discussed above, our sales and operatingresults are typically lower in the first and second quarters of our fiscal yeardue, in part, to the traditional retail slowdown immediately following thewinter holiday season.  Our quarterlyresults of operations are affected by a variety of other factors, including:

 

·                  the timing of new store openings and therelative proportion of our new stores to mature stores;

 

·                  whether we are able to successfullyintegrate any new stores that we acquire and the presence or absence of anyunanticipated liabilities in connection therewith;

 

·                  fashion trends and changes in consumerpreferences;

 

·                  calendar shifts of holiday or seasonalperiods;

 

·                  changes in our merchandise mix;

 

·                  timing of promotional events;

 

·                  general economic conditions and, inparticular, the retail sales environment;

 

·                  actions by competitors or mall anchortenants;

 

·                  weather conditions;

 

·                  the level of pre-opening expensesassociated with our new stores; and

 

·                  inventory shrinkage beyond our historicalaverage rates.

 

***Failure to successfully integrate any businessesor stores that we acquire could have an adverse impact on our results ofoperations and financial performance.***

 

Wemay from time to time acquire other retail stores, individually or in groups,or businesses.  We may experiencedifficulties in assimilating any stores or businesses we may acquire and anysuch acquisitions may also result in the diversion of our capital and ourmanagement’s attention from other business issues and opportunities.  We may not be able to successfully integrateany stores or businesses that we may acquire, including their facilities,personnel, financial systems, distribution, operations and general operatingprocedures.  If we fail to successfullyintegrate acquisitions or if such acquisitions fail to provide the benefits thatwe expect to receive, we could experience increased costs and other operatinginefficiencies, which could have an adverse effect on our results of operationsand financial performance.

 

***Our business is susceptible to weather conditions that are out of ourcontrol including the potential risks of unpredictable weather patterns,including any weather patterns associated with global warming, and theresultant unseasonable weather could have a negative impact on our results ofoperations.***

 

Ourbusiness is susceptible to unseasonable weather conditions.  For example, extended periods of unseasonablywarm temperatures (including any weather patterns associated with globalwarming) during the winter season or cool weather during the summer seasoncould render a portion of our inventory incompatible with those unseasonableconditions.  These prolonged unseasonableweather conditions, particularly in regions of the United States where we havea concentration of stores, could have a material adverse effect on our businessand results of operations.

 

***We may be unable to compete favorably inthe highly competitive retail industry, and if we lose customers to ourcompetitors, our sales could decrease.***

 

Theteenage and young adult retail apparel, hardgoods and accessories industry ishighly competitive.  We compete withother retailers for vendors, teenage and young adult customers, suitable storelocations, qualified store associates and management personnel.  In the softgoods market, which includesapparel, accessories and footwear, we currently compete with otherteenage-focused retailers.  In addition,in the softgoods market we compete with independent specialty shops, departmentstores, and direct marketers that sell similar lines of merchandise and targetcustomers through catalogs and ecommerce. In the hardgoods market, which includes skateboards, snowboards,bindings, components and other equipment, we compete directly or indirectlywith the following categories of companies: other specialty retailers thatcompete with us across a significant portion of our merchandising categories,such as local snowboard and skate shops; large-format sporting goods stores andchains and ecommerce retailers.

 

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Someof our competitors are larger than we are and have substantially greaterfinancial, marketing and other resources than we do.  Direct competition with these and otherretailers may increase significantly in the future, which could requireus, among other things, to lower our prices and could result in the loss of ourcustomers.  Current and increasedcompetition could have a material adverse effect on our business, results of operationsand financial condition.

 

***If we fail to maintain good relationshipswith vendors or if a vendor is otherwise unable or unwilling to supply us withadequate quantities of their products at acceptable prices, our business andfinancial performance could suffer.***

 

Ourbusiness is dependent on continued good relations with our vendors.  In particular, we believe that we generallyare able to obtain attractive pricing and other terms from vendors because weare perceived as a desirable customer, and deterioration in our relationshipwith our vendors would likely have a material adverse effect on ourbusiness.  We do not have any contractualrelationships with our vendors, other than normal course of business purchaseorders and, accordingly, there can be no assurance that our vendors willprovide us with an adequate supply or quality of products or acceptablepricing.  Our vendors could discontinueselling to us or raise the prices they charge at any time.  There can be no assurance that we will beable to acquire desired merchandise in sufficient quantities on termsacceptable to us in the future.  Also,certain of our vendors’ sell their products directly to the retail market andtherefore compete with us directly and other vendors may decide to do soin the future.  There can be no assurancethat such vendors will not decide to discontinue supplying their products tous, supply us only less popular or lower quality items, raise the prices theycharge us or focus on selling their products directly.  In addition, a number of our vendors aresmaller, less capitalized companies and are more likely to be impacted byunfavorable general economic and market conditions than larger and bettercapitalized companies.  These smallervendors may not have sufficient liquidity during economic downturns to properlyfund their businesses and their ability to supply their products to us could benegatively impacted.  Any inability toacquire suitable merchandise at acceptable prices, or the loss of one or morekey vendors, would have a material adverse effect on our business, results ofoperations and financial condition.

 

***If we lose key management or are unable to attract and retain thetalent required for our business, our financial performance could suffer.***

 

Ourperformance depends largely on the efforts and abilities of our seniormanagement, including our Co-Founder and Chairman, Thomas D. Campion, our ChiefExecutive Officer, Richard M. Brooks, our Chief Financial Officer, Trevor S.Lang, our President and General Merchandising Manager,Lynn K. Kilbourne and our Executive Vice President of Stores, Ford K.Wright.  None of our employees haveemployment agreements with us and we do not plan to obtain key person lifeinsurance covering any of our employees. If we lose the services of one or more of our key executives, wemay not be able to successfully manage our business or achieve our growthobjectives.  As our business grows, wewill need to attract and retain additional qualified management personnel in atimely manner and we may not be able to do so.

 

***Our failure to meet our staffing needscould adversely affect our ability to implement our growth strategy and couldhave a material impact on our results of operations.***

 

Oursuccess depends in part upon our ability to attract, motivate and retain asufficient number of qualified employees, including regional managers, districtmanagers, store managers and store associates, who understand and appreciateour corporate culture based on a passion for the action sports lifestyle andare able to adequately represent this culture to our customers.  Qualified individuals of the requisitecaliber, skills and number needed to fill these positions may be in shortsupply in some areas, and the employee turnover rate in the retail industry ishigh.  Competition for qualifiedemployees could require us to pay higher wages to attract a sufficient numberof suitable employees.  If we are unableto hire and retain store managers and store associates capable of consistentlyproviding a high level of customer service, as demonstrated by their enthusiasmfor our culture and knowledge of our merchandise, our ability to open newstores may be impaired and the performance of our existing and new storescould be materially adversely affected. We are also dependent upon temporary personnel to adequately staff ourstores and distribution center, particularly during busy periods such as theback-to-school and winter holiday seasons. There can be no assurance that we will receive adequate assistance fromour temporary personnel, or that there will be sufficient sources of temporarypersonnel.  Although none of ouremployees is currently covered by collective bargaining agreements, we cannotguarantee that our employees will not elect to be represented by labor unionsin the future, which could increase our labor costs and could subject us to therisk of work stoppages and strikes. Any such failure to meet our staffing needs, any material increases inemployee turnover rates, any increases in labor costs or any work stoppages orinterruptions or strikes could have a material adverse effect on our businessor results of operations.

 

***Our operations, including our soledistribution center, are concentrated in the western United States, which makesus susceptible to adverse conditions in this region.***

 

Ourhome office and sole distribution center are located in a single facility inWashington, and a substantial number of our stores are located in the westernhalf of the United States.  We also havea substantial number of stores in the New York/New Jersey region andTexas.  As a result, our businessmay be more susceptible to regional factors than the operations of moregeographically diversified competitors. These factors include, among others, economic and weather conditions,demographic and population changes and fashion tastes.  In addition, we rely on a single distributioncenter in Everett, Washington to receive, store and distribute the vastmajority of our merchandise to all of our stores and to fulfill our ecommercesales.  As a result, a natural disasteror other catastrophic event, such as an earthquake affecting westernWashington, in particular, or the West Coast, in general, could significantlydisrupt our operations and have a material adverse effect on our business,results of operations and financial condition.

 

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***We are required to make substantial rentalpayments under our operating leases and any failure to make these leasepayments when due would likely have a material adverse effect on our businessand growth plans.***

 

Wedo not own any of our retail stores or our combined home office anddistribution center, but instead we lease all of these facilities underoperating leases.  Payments under theseoperating leases account for a significant portion of our operating expensesand has historically been our third largest expense behind cost of sales andour employee related costs.  For example,total rental expense, including additional rental payments (or “percentagerent”) based on sales of some of the stores, common area maintenance chargesand real estate taxes, under operating leases was $42.8 million and $38.2million for the nine months ended October 31, 2009 and November 1,2008.  As of October 31, 2009, wewere a party to operating leases requiring future minimum lease paymentsaggregating approximately $169.2 million through fiscal year 2014 and approximately$148.9 million thereafter.  In addition,substantially all of our store leases provide for additional rental paymentsbased on sales of the respective stores, as well as common area maintenancecharges, and require that we pay real estate taxes, none of which is includedin the amount of future minimum lease payments. These amounts generally escalate each year.  We expect that any new stores we open willalso be leased by us under operating leases, which will further increase ouroperating lease expenses.

 

Oursubstantial operating lease obligations could have significant negativeconsequences, including:

 

·                  increasing ourvulnerability to general adverse economic and industry conditions;

 

·                  limiting ourability to obtain additional financing;

 

·                  requiring thata substantial portion of our available cash be applied to pay our rentalobligations, thus reducing cash available for other purposes and;

 

·                  limiting ourflexibility in planning for or reacting to changes in our business or in theindustry in which we compete, and placing us at a disadvantage with respect tosome of our competitors.

 

Wedepend on cash flow from operations to pay our lease expenses and to fulfillour other cash needs.  If our businessdoes not generate sufficient cash flow from operating activities, andsufficient funds are not otherwise available to us from borrowings under bankloans or from other sources, we may not be able to service our operatinglease expenses, grow our business, respond to competitive challenges or to fundour other liquidity and capital needs, which would have a material adverseeffect on us.

 

***The terms of our revolving credit facilityimpose operating and financial restrictions on us that may impair ourability to respond to changing business and economic conditions.  This impairment could have a significantadverse impact on our business.***

 

Werenewed and amended our secured credit agreement with Wells Fargo HSBC TradeBank, N.A., on June 10, 2009, and the prior facility agreement wasterminated.  The credit agreementprovides us with a secured revolving credit facility until September 1,2011 of up to $25.0 million.  Thesecured revolving credit facility provides for the issuance of a standby letterof credit in an amount not to exceed $5.0 million outstanding at any time andwith a term not to exceed 365 days.  Thecommercial line of credit provides for the issuance of a commercial letter ofcredit in an amount not to exceed $10.0 million and with terms not to exceed120 days.  The amount of borrowings availableat any time under our secured revolving credit facility is reduced by theamount of standby and commercial letters of credit outstanding at thattime.  There were no outstandingborrowings under the secured revolving credit facility at October 31, 2009or January 31, 2009.  The Companyhad open commercial letters of credit outstanding under our secured revolvingcredit facility of $1.3 million at October 31, 2009 and approximately $0.3million at January 31, 2009.  Thesecured revolving credit facility bears interest at the Daily One Month LIBORrate plus 1.00%.  The credit agreementcontains a number of restrictions and covenants that generally limit ourability to, among other things, (1) incur additional debt, (2) undergoa change in ownership and (3) enter into certain transactions.  The credit agreement also contains financialcovenants that require us to meet certain specified financial tests and ratios,including, a maximum net loss not to exceed $10.0 million after taxes on atrailing four-quarter basis provided, that, there shall be added to net incomeall charges for impairment of goodwill and store assets not to exceed $5.0million in aggregate, and a minimum quick ratio of 1.25.  The quick ratio is defined as our cash andnear cash equivalents plus certain defined receivables divided by theoutstanding borrowings.  All of ourpersonal property, including, among other things, our inventory, equipment andfixtures, has been pledged to secure our obligations under the creditagreement.  We must also providefinancial information and statements to our lender.  We were in compliance with all such covenantsat October 31, 2009.

 

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Abreach of any of these restrictive covenants or our inability to comply withthe required financial tests and ratios could result in a default under thecredit agreement.  If a default occurs,the lender may elect to declare all borrowings outstanding, together withaccrued interest and other fees, to be immediately due and payable.  If we are unable to repay outstandingborrowings when due, whether at their maturity or if declared due and payableby the lender following a default, the lender has the right to proceed againstthe collateral granted to it to secure the indebtedness.  As a result, any breach of these covenants orfailure to comply with these tests and ratios could have a material adverseeffect on us.  There can be no assurancethat we will not breach the covenants or fail to comply with the tests andratios in our credit agreement or any other debt agreements we may enterinto in the future and, if a breach occurs, there can be no assurance that wewill be able to obtain necessary waivers or amendments from the lenders.

 

Therestrictions contained in our credit agreement could: (1) limit ourability to plan for or react to market conditions or meet capital needs orotherwise restrict our activities or business plans; and (2) adverselyaffect our ability to finance our operations, strategic acquisitions,investments or other capital needs or to engage in other business activitiesthat would be in our interest.

 

***Our business could suffer as a result ofsmall parcel delivery services such as United Parcel Service or Federal Expressbeing unable to distribute our merchandise.***

 

Werely upon small parcel delivery services for our product shipments, includingshipments to, from and between our stores. Accordingly, we are subject to risks, including employee strikes andinclement weather, which may affect their ability to meet our shippingneeds.  Among other things, anycircumstances that require us to use other delivery services for all or aportion of our shipments could result in increased costs and delayed deliveriesand could harm our business materially. In addition, although we have contracts with small parcel deliveryservices, we have the right to terminate these contracts upon 30 days writtennotice.  Although the contracts withthese small parcel delivery services provide certain discounts from theshipment rates in effect at the time of shipment, the contracts do not limittheir ability to raise the shipment rates at any time.  Accordingly, we are subject to the risk thatsmall parcel delivery services may increase the rates they charge, thatthey may terminate their contracts with us, that they may decrease therate discounts provided to us when an existing contract is renewed or that wemay be unable to agree on the terms of a new contract with them, any ofwhich could materially adversely affect our operating results.

 

***Our business could suffer if a manufacturerfails to use acceptable labor practices.***

 

Wedo not control our vendors or the manufacturers that produce the products webuy from them, nor do we control the labor practices of our vendors and thesemanufacturers.  The violation of labor orother laws by any of our vendors or these manufacturers, or the divergence ofthe labor practices followed by any of our vendors or these manufacturers fromthose generally accepted as ethical in the United States, could interrupt, orotherwise disrupt, the shipment of finished products to us or damage ourreputation.  Any of these, in turn, couldhave a material adverse effect on our financial condition and results ofoperations.  In that regard, most of theproducts sold in our stores are manufactured overseas, primarily in Asia andCentral America, which may increase the risk that the labor practicesfollowed by the manufacturers of these products may differ from thoseconsidered acceptable in the United States.

 

***Our failure to adequately anticipate acorrect mix of private label merchandise may have a material adverseeffect on our business.***

 

Salesfrom private label merchandise accounted for 15.0% of our net sales in fiscal2008.  We may take steps to increasethe percentage of net sales of private label merchandise in the future,although there can be no assurance that we will be able to achieve increases inprivate label merchandise sales as a percentage of net sales.  Because our private label merchandisegenerally carries higher gross margins than other merchandise, our failure toanticipate, identify and react in a timely manner to fashion trends with ourprivate label merchandise, would likely have a material adverse effect onour comparable store sales, financial condition and results of operations.

 

***Most of our merchandise is produced byforeign manufacturers, therefore the availability and costs of these productsmay be negatively affected by risks associated with international tradeand other international conditions.***

 

Mostof our merchandise is produced by manufacturers around the world.  Some of these facilities are located inregions that may be affected by natural disasters, political instabilityor other conditions that could cause a disruption in trade.  Trade restrictions such as increased tariffsor quotas, or both, could also affect the importation of merchandise generallyand increase the cost and reduce the supply of merchandise available tous.  Any reduction in merchandiseavailable to us or any increase in its cost due to tariffs, quotas or localissues that disrupt trade could have a material adverse effect on our resultsof operations.  Although the pricescharged by vendors for the merchandise we purchase are all denominated inUnited States dollars, a continued decline in the relative value of the UnitedStates dollar to foreign currencies could lead to increased merchandise costs,which could negatively affect our competitive position and our results ofoperation.

 

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***If our information systems hardware orsoftware fails to function effectively or does not scale to keep pace with ourplanned growth, our operations could be disrupted and our financial resultscould be harmed.***

 

Overthe past several years, we have made improvements to our infrastructure andexisting hardware and software systems, as well as implemented newsystems.  If these or any otherinformation systems and software do not work effectively, this could adverselyimpact the promptness and accuracy of our transaction processing, financialaccounting and reporting and our ability to manage our business and properlyforecast operating results and cash requirements.  To manage the anticipated growth of ouroperations and personnel, we may need to continue to improve ouroperational and financial systems, transaction processing, procedures andcontrols, and in doing so could incur substantial additional expenses thatcould impact our financial results.

 

***Our inability or failure to protect ourintellectual property or our infringement of other’s intellectual propertycould have a negative impact on our operating results.***

 

Webelieve that our trademarks and domain names are valuable assets that arecritical to our success.  Theunauthorized use or other misappropriation of our trademarks or domain namescould diminish the value of the Zumiez brand, our store concept, our privatelabel brands or our goodwill and cause a decline in our net sales.  Although we have secured or are in theprocess of securing protection for our trademarks and domain names in a numberof countries outside of the United States, there are certain countries where wedo not currently have or where we do not currently intend to apply forprotection for certain trademarks or at all. Also, the efforts we have taken to protect our trademarks may not besufficient or effective.  Therefore, wemay not be able to prevent other persons from using our trademarks or domainnames outside of the United States, which also could adversely affect ourbusiness.  We are also subject to therisk that we may infringe on the intellectual property rights of thirdparties.  Any infringement or otherintellectual property claim made against us, whether or not it has merit, couldbe time-consuming, result in costly litigation, cause product delays or requireus to pay royalties or license fees.  Asa result, any such claim could have a material adverse effect on our operatingresults.

 

***The effects of war or acts of terrorismcould adversely affect our business.***

 

Substantiallyall of our stores are located in shopping malls.  Any threat of terrorist attacks or actualterrorist events, particularly in public areas, could lead to lower customertraffic in shopping malls.  In addition,local authorities or mall management could close shopping malls in response tosecurity concerns.  Mall closures, aswell as lower customer traffic due to security concerns, would likely result indecreased sales.  Additionally, theescalation of the armed conflicts in the Middle East, or the threat, escalationor commencement of war or other armed conflict elsewhere, could significantlydiminish consumer spending, and result in decreased sales for us.  Decreased sales would have a material adverseeffect on our business, financial condition and results of operations.

 

***The outcome of litigation could have a material adverse effect on ourbusiness and******mayresult in substantial costs and could divert management’s attention.***

 

Weare involved, from time to time, in litigation incidental to our businessincluding complaints filed by investors. This litigation could result in substantial costs, and could divertmanagement’s attention and resources, which could harm our business.  Risks associated with legal liability areoften difficult to assess or quantify, and their existence and magnitude canremain unknown for significant periods of time. While we maintain director and officer insurance for litigationsurrounding investor lawsuits, the amount of insurance coverage may not besufficient to cover a claim and the continued availability of this insurancecannot be assured.  The Company alsomaintains other forms of insurance that have historically been adequate toaddress lawsuits, however, there can be no assurance that the actual outcome ofpending or future litigation will not have a material adverse effect on ourresults of operations or financial condition.

 

***Our operations expose us to the risk of litigation which could lead tosignificant potential liability and costs that could harm our business,financial condition or results of operations.***

 

Weemploy a substantial numberof full-time and part-time employees, a majority of whom are employed at ourstore locations.  As a result, we aresubject to a large number of federal and state laws and regulations relating toemployment.  This creates a risk ofpotential claims that we have violated laws related to discrimination andharassment, health and safety, wage and hour laws, criminal activity, personalinjury and other claims.  We are alsosubject to other types of claims in the ordinary course of our business.  Some or all of these claims may give rise tolitigation, which could be time-consuming for our management team, costly andharmful to our business.

 

Inaddition, we are exposed to the risk of class action litigation.  The costs of defense and the risk of loss inconnection with class action suits are greater than in single-party litigationclaims.  Due to the costs of defendingagainst such litigation, the size of judgments that may be awarded against us,and the loss of significant management time devoted to such litigation, wecannot assure you that such litigation will not disrupt our business or impactour financial results.

 

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***Our ecommerce operations subject us tonumerous risks that could have an adverse effect on our results of operations.***

 

Althoughecommerce sales constitute a small portion of our overall sales, our ecommerceoperations subject us to certain risks that could have an adverse effect on ouroperational results, including:

 

·                  diversion oftraffic and sales from our stores;

 

·                  liability foronline content; and

 

·                  risks relatedto the computer systems that operate our website and related support systems,including computer viruses and electronic break-ins and similar disruptions.

 

Inaddition, risks beyond our control, such as governmental regulation of theecommerce, entry of our vendors in the ecommerce business in competition withus, online security breaches and general economic conditions specific to theecommerce and online commerce could have an adverse effect on our results ofoperations.

 

***We have incurred and will continue to incursignificant expenses as a result of being a public company, which willnegatively impact our financial performance.***

 

Wecompleted our initial public offering in May 2005 and we have incurred andwill continue to incur significant legal, accounting, insurance and otherexpenses as a result of being a public company. The Sarbanes-Oxley Act of 2002, as well as related rules implemented bythe SEC and The NASDAQ Global Select Market, has required changes in corporategovernance practices of public companies. Compliance with these laws, rules and regulations, includingcompliance with Section 404 of the Sarbanes-Oxley Act as discussed in thefollowing risk factor, have caused and will continue to cause us to incursignificant costs and expenses, including legal and accounting costs, and havemade and will continue to make some activities more time-consuming and costly.  These laws, rules and regulations havemade it more expensive for us to obtain director and officer liabilityinsurance, and we have been required to accept reduced policy limits andcoverage.  As a result, it may bemore difficult for us to attract and retain qualified persons to serve on ourboard of directors or as officers.  As aresult of the foregoing, we have incurred and we expect to incur significantlegal, accounting, insurance and certain other expenses on an ongoing basis,which will negatively impact our financial performance and could have amaterial adverse effect on our results of operations and financial condition.

 

***Failure to maintain adequate financial andmanagement processes and controls could lead to errors in our financialreporting and could harm our ability to manage our expenses.***

 

Reportingobligations as a public company and our anticipated growth are likely to placea considerable strain on our financial and management systems, processes andcontrols, as well as on our personnel. In addition, we are required to document and test our internal controlsover financial reporting pursuant to Section 404 of the Sarbanes-Oxley Actof 2002 so that our management can certify as to the effectiveness of ourinternal controls and our independent registered public accounting firm canrender an opinion on the effectiveness of our internal control over financialreporting on an annual basis.  Thisprocess requires us to document our internal controls over financial reportingand to potentially make significant changes thereto, if applicable.  As a result, we have incurred and expect tocontinue to incur substantial expenses to test our financial controls andsystems, and we have been and in the future may be required to improve ourfinancial and managerial controls, reporting systems and procedures, to incursubstantial expenses to make such improvements and to hire additionalpersonnel.  If our management is everunable to certify the effectiveness of our internal controls or if our independentregistered public accounting firm cannot render an opinion on the effectivenessof our internal control over financial reporting, or if material weaknesses inour internal controls are ever identified, we could be subject to regulatoryscrutiny and a loss of public confidence, which could have a material adverseeffect on our business and our stock price. In addition, if we do not maintain adequate financial and managementpersonnel, processes and controls, we may not be able to accurately reportour financial performance on a timely basis, which could cause a decline in ourstock price and adversely affect our ability to raise capital.

 

***The security of our databases that containpersonal information of our retail customers could be breached, which couldsubject us to adverse publicity, litigation, and expenses.  In addition, if we are unable to comply withsecurity standards created by the credit card industry, our operations could beadversely affected.***

 

Databaseprivacy, network security, and identity theft are matters of growing publicconcern.  In an attempt to preventunauthorized access to our network and databases containing confidential,third-party information, we have installed privacy protection systems, devices,and activity monitoring on our network. Nevertheless, if unauthorized parties gain access to our networks ordatabases, they may be able to steal, publish, delete, or modify our privateand sensitive third-party information. In such circumstances, we could be held liable to our customers or otherparties or be subject to regulatory or other actions for breaching privacyrules.  This could result in costlyinvestigations and litigation, civil or criminal penalties, and adversepublicity that could adversely affect our financial 

 

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condition,results of operations, and reputation. Further, if we are unable to comply with the security standards,established by banks and the credit card industry, we may be subject to fines,restrictions, and expulsion from card acceptance programs, which couldadversely affect our retail operations.

 

***The current uncertainty surrounding theUnited States economy coupled with cyclical economic trends in action sportsretailing could have a material adverse effect on our results of operations.***

 

Theaction sports retail industry historically has been subject to substantialcyclicality.  As economic conditions inthe United States change, the trends in discretionary consumer spending becomeunpredictable and discretionary consumer spending could be reduced due touncertainties about the future.  Whendiscretionary consumer spending is reduced, purchases of action sports appareland related products may decline.  Thecurrent recession in the U.S. economy and increased government debt spendingmay result in economic uncertainties that could have a material adverse impacton our results of operations and financial position.

 

***We may fail to meet analyst expectations,which could cause the price of our stock to decline.***

 

Ourcommon stock is traded publicly and various securities analysts follow ourfinancial results and issue reports on us. These reports include information about our historical financial resultsas well as the analysts’ estimates of our future performance.  The analysts’ estimates are based upon theirown opinions and are often different from our estimates or expectations.  If our operating results are below theestimates or expectations of public market analysts and investors, our stockprice could decline.  In December 2007,a securities class action litigation and associated derivative lawsuits wasbrought against us and such actions are frequently brought against othercompanies following a decline in the market price of their securities.  These lawsuits were dismissed with prejudicein March 2009.  If our stock priceis volatile, we may become involved in this type of litigation in thefuture.  Any litigation could result insubstantial costs and a diversion of management’s attention and resources thatare needed to successfully run our business.

 

***The trading price of our investment in marketable securities mayfluctuate***

 

Wehave our excess cash invested in diversified high credit money market accounts,US treasuries, certificates of deposit, municipal bonds and auction ratesecurities.  The investments havehistorically been considered very safe investments with minimal default rates.  However, the uncertainties in the creditmarkets have prevented us and other investors from liquidating holdings ofauction rate securities in recent auctions for these securities because theamount of securities submitted for sale has exceeded the amount of purchaseorders.  As of October 31, 2009, wehad $0.8 million, net of $0.2 million temporary impairment, invested inauction rate securities that are classified as long-term marketable securitieson our consolidated balance sheet.  Forthe nine months ended, October 31, 2009, we incurred a temporary impairmentcharge on these investments of approximately $0.2 million recorded in othercomprehensive income.  If marketliquidity issues continue, we may incur additional impairment charges on theseinvestments.

 

***A decline in the market price of our stock and our performancemay trigger an impairment of the goodwill recorded on our balance sheet***

 

Goodwilland other intangible assets with indefinite lives must be tested for impairmentat least once a year or more frequently if management believes indicators ofimpairment exist.  We evaluate therecoverability of goodwill annually based on a two-step impairment test.  The first step compares the fair value ofeach reporting unit with its carrying amount, including goodwill.  If the carrying amount exceeds fair value, thenthe second step of the impairment test is performed to measure the amount ofany impairment loss.  Any reduction inthe carrying value of our goodwill as a result of our impairment analysis couldresult in a non-cash goodwill impairment charge to our statement ofoperations.  A goodwill impairment chargecould have a significant impact on earnings and potentially result in aviolation of our financial covenants, thereby limiting our ability to secureshort-term financing.

 

***Changes to estimates related to our leasehold improvements  and equipment, or operating results that arelower than our current estimates at certain store locations, may cause us toincur non-cash impairment charges.***

 

Wemake certain estimates and projections in connection with impairment analysesfor certain of our store locations and other property and equipment.  For example, we review for impairment allstores for which current cash flows from operations are either negative ornominal.  Recoverability of store assetsis measured by a comparison of the carrying amount of an asset to estimatedundiscounted future cash flows expected to be generated by the asset.  If the carrying amount is higher, impairmentloss is measured by the amount, if any, by which the carrying amount of the assetsexceeds their fair value based on the present value of estimated expectedfuture cash flows.  These calculationsrequire us to make a number of estimates and projections of future results.  If these estimates or projections change orprove incorrect, we may be and have been, required to record impairment chargeson certain store locations and other property and equipment.  If these impairment charges are significant,our operating results would be adversely affected and our bank covenants may beviolated.

 

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***Our business could suffer if our ability to acquire financing isreduced or eliminated.***

 

Inthe current economic environment, we cannot be assured that our borrowingrelationship with our lender will continue or that our lender will remain ableto support its commitments to us in the future. If our lender fails to do so, then we may not be able to secure alternativefinancing on commercially reasonable terms, or at all.

 

It**em 3:   Quantitative and Qualitative Disclosures AboutMarket Risk**

 

Duringdifferent times of the year, due to the seasonality of our business, we mayborrow under our revolving credit facility. To the extent we borrow under our secured revolving credit facility,which bears interest at the Daily One Month Libor rate plus 1%, we are exposedto market risk related to changes in interest rates.  At October 31, 2009, we had noborrowings outstanding under our secured revolving credit facility.  At October 31, 2009, we had $1.3 millionof letters of credit outstanding under our secured revolving creditfacility.  We are not a party to anyderivative financial instruments.

 

**Item 4:   Controls and Procedures**

 

*Evaluationof Disclosure Controls and Procedures*.  We carried out an evaluation, under thesupervision and with the participation of our management, including our ChiefExecutive Officer (“CEO”) and Chief Financial Officer (“CFO”), of the effectivenessof the design and operation of our disclosure controls and procedures (asdefined in Securities Exchange Act Rule 13a-15(e)).  Based on this evaluation, our CEO and CFOconcluded that, as of October 31, 2009, our disclosure controls andprocedures were effective.

 

Disclosurecontrols and procedures, no matter how well designed and implemented, canprovide only reasonable assurance of achieving an entity’s disclosureobjectives.  The likelihood of achievingsuch objectives is affected by limitations inherent in disclosure controls andprocedures.  These include the fact thathuman judgment in decision-making can be faulty and that breakdowns in internalcontrol can occur because of human failures such as simple errors or mistakesor intentional circumvention of the established process.

 

*Changesin Internal Control Over Financial Reporting*.  There has been no change in our internalcontrol over financial reporting (as defined in Securities Exchange Act Rule 13a-15(f))during the quarter ended October 31, 2009 that has materially affected, oris reasonably likely to materially affect, our internal control over financialreporting.

 

**PART II - OTHER INFORMATION**

 

**Item 1.  Legal Proceedings**

 

We are involved from time totime in litigation incidental to our business. The Company is unable to predict the outcome of litigated cases.  A court determination in any of litigationactions against the Company could result in significant liability and couldhave a material adverse effect on the Company’s business, results of operationsor financial condition.

 

SeeNote 3 to the Notes to Condensed Consolidated Financial Statements found inItem 1 of this Form 10-Q (listed under “Litigation” under Commitments andContingencies).

 

**Item 1A.  Risk Factors**

 

Pleaserefer to the Risk Factors set forth in Item 2 of Part I of this Form 10-Qas well as the risk factors previously disclosed in Item 1A of Part I ofour Annual Report on Form 10-K for the year ended January 31,2009.  There have been no materialchanges in the risk factors set forth in our Annual Report on Form 10-Kfor the year ended January 31, 2009.

 

**Item 2.  Changes in Securities;Use of Proceeds and Issuer Purchases of Equity Securities**

 

None

 

**Item 3.  Defaults Upon SeniorSecurities**

 

None

 

**Item 4.  Submission of Matters toa Vote of Security Holders**

 

None

 

**Item 5.  Other Information**

 

None

 

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**Item 6.  Exhibits**

 
| **Exhibit No.** | ** ** | **Description of Exhibits**                                                                                                                                                                                                                       |
|----------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.15                | ** ** | Zumiez Inc. 2005 Equity  Incentive Plan, as amended and restated effective May 27, 2009  (incorporated by reference from Exhibit 10.15 to the Form 8-K filed  by the Company on June 1, 2009)                                 |
|                 | ** ** |                                                                                                                                                                                                                                              |
| 10.16                | ** ** | Credit Agreement, including  Revolving Line of Credit Note, with Wells Fargo HSBC Trade Bank, N.A. dated  June 10, 2009 (incorporated by reference from Exhibit 10.16 to the  Form 8-K filed by the Company on June 11, 2009) |
|                 |       |                                                                                                                                                                                                                                              |
| 31.1                 |       | Certification of the  Principal Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of  the Securities Exchange Act of 1934, as amended, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                 |
|                 |       |                                                                                                                                                                                                                                              |
| 31.2                 |       | Certification of the  Principal Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of  the Securities Exchange Act of 1934, as amended, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002                  |
|                 |       |                                                                                                                                                                                                                                              |
| 32.1                 |       | Certifications of the  Principal Executive Officer and Principal Financial Officer pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C.  Section 1350                                                                  |

 

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**SIGNATURE**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, as amended, theregistrant has duly caused this report to be signed on its behalf by theundersigned hereunto duly authorized.

 
|                          | ZUMIEZ INC. |
|-------------------------------|-------------|
|                          |        |
| Dated: December 7,  2009 | By:         | /s/ TREVOR S. LANG |
|                          |        | Trevor S. Lang |
|                          |        | Principal Financial  Officer and Secretary  (Principal Accounting Officer) |

 

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