Table of Contents

** **

 

** **

**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 NOVEMBER 1, 2008** |
|--------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |       |                                                                                                                                                    |
| **OR** |
|   |       |                                                                                                                                                    |
| **o**  | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                 |

 

**Commissionfile number 000-51300**

 

**ZUMIEZINC.**

(Exact name ofregistrant as specified in its charter)

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

 

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

 (Address of principal executiveoffices)  (Zip Code)

 

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

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes  x   No   o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer or a smaller reporting company.  See definition of “accelerated filer, largeaccelerated filer and smaller reporting company” in Rule 12b-2 of theExchange Act).  (Check one):

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

 

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

 

Number of shares ofCommon Stock outstanding as of December 1, 2008 was 29,578,967 shares.

** **

 

** **

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Table of Contents

 

**ZUMIEZINC.**

**FORM 10-Q**

**TABLE OFCONTENTS**

 
|                   |                             |                                                                                                                                              |
|-------------------|----------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------|
| Part I.      | Financial  Information           |                                                                                                                                              |
|              |                             |                                                                                                                                              |   |
|              | Item 1.                          | Condensed  Consolidated Financial Statements                                                                                                      |   |
|              |                             |                                                                                                                                              |   |
|              |                             | Condensed  Consolidated Balance Sheets at November 1, 2008 (unaudited) and  February 2, 2008                                            | 3 |
|              |                             |                                                                                                                                              |   |
|              |                             | Condensed  Consolidated Statements of Operations for the three and nine months ended  November 1, 2008 and November 3, 2007 (unaudited) | 4 |
|              |                             |                                                                                                                                              |   |
|              |                             | Condensed  Consolidated Statement of Changes in Shareholders’ Equity for the nine months  ended November 1, 2008 (unaudited)            | 5 |
|              |                             |                                                                                                                                              |   |
|              |                             | Condensed  Consolidated Statements of Cash Flows for the nine months ended  November 1, 2008 and November 3, 2007 (unaudited)           | 6 |
|              |                             |                                                                                                                                              |   |
|              |                             | Notes to  Condensed Consolidated Financial Statements                                                                                             | 7 |
|              |                             |                                                                                                                                              |   |
|              | Item 2.                          | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                       | 16 |
|              |                             |                                                                                                                                              |   |
|              | Item 3.                          | Quantitative  and Qualitative Disclosures About Market Risk                                                                                       | 31 |
|              |                             |                                                                                                                                              |   |
|              | Item 4.                          | Controls and  Procedures                                                                                                                          | 32 |
|              |                             |                                                                                                                                              |   |
| Part II.     | Other Information                | 32                                                                                                                                                |
|              |                             |                                                                                                                                              |   |
|              | Item 1.                          | Legal Proceedings                                                                                                                                 | 32 |
|              |                             |                                                                                                                                              |   |
|              | Item 1A.     | Risk Factors                                                                                                                                      | 32 |
|              |                             |                                                                                                                                              |   |
|              | Item 2.                          | Changes in  Securities; Use of Proceeds and Issuer Purchases of Equity Securities                                                                 | 32 |
|              |                             |                                                                                                                                              |   |
|              | Item 3.                          | Defaults  Upon Senior Securities                                                                                                                  | 32 |
|              |                             |                                                                                                                                              |   |
|              | Item 4.                          | Submission  of Matters to a Vote of Security Holders                                                                                              | 32 |
|              |                             |                                                                                                                                              |   |
|              | Item 5.                          | Other Information                                                                                                                                 | 32 |
|              |                             |                                                                                                                                              |   |
|              | Item 6.                          | Exhibits                                                                                                                                          | 32 |
|              |                             |                                                                                                                                              |   |
| Signatures        |                             |                                                                                                                                              | 33 |
|              |                             |                                                                                                                                              |   |
| Exhibit 31.1 |                             |                                                                                                                                              |   |
|              |                             |                                                                                                                                              |   |
| Exhibit 31.2 |                             |                                                                                                                                              |   |
|              |                             |                                                                                                                                              |   |
| Exhibit 32.1 |                             |                                                                                                                                              |   |

 

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** **

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

**(inthousands, except share amounts)**

** **
| ** **                                                                                                                                                                                             | ** ** | **November 1, 2008** | ** ** | **February 2, 2008** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                                                                                                             | ** ** | **(Unaudited)**                | ** ** | ** **                     | ** ** |
| ** **                                                                                                                                                                                             | ** ** | ** **                     | ** ** | ** **                     | ** ** |
| **Assets**                                                                                                                                                                                             | ** ** | ** **                     | ** ** | ** **                     | ** ** |
| **Current assets**                                                                                                                                                                                     | ** ** | ** **                     | ** ** | ** **                     | ** ** |
| Cash  and cash equivalents                                                                                                                                                                             |       | $                              | 9,249      |                           | $          | 11,945 |   |
| Marketable  securities                                                                                                                                                                                 |       | 56,348                         |       | 64,587                         |       |
| Receivables                                                                                                                                                                                            |       | 6,695                          |       | 4,775                          |       |
| Inventory                                                                                                                                                                                              |       | 81,847                         |       | 48,721                         |       |
| Prepaid  expenses and other                                                                                                                                                                            |       | 5,935                          |       | 4,440                          |       |
| Deferred  tax assets                                                                                                                                                                                   |       | 3,390                          |       | 1,089                          |       |
| **Total current assets**                                                                                                                                                                               |       | 163,464                        |       | 135,557                        |       |
| ** **                                                                                                                                                                                             | ** ** | ** **                     | ** ** | ** **                     | ** ** |
| Leasehold  improvements and equipment, net                                                                                                                                                             |       | 78,331                         |       | 65,937                         |       |
| Goodwill  and other intangibles                                                                                                                                                                        |       | 13,248                         |       | 13,154                         |       |
| Marketable  securities - long-term                                                                                                                                                                     |       | 1,694                          |       | —                         |       |
| Deferred  tax assets                                                                                                                                                                                   |       | 1,881                          |       | 1,447                          |       |
| **Total long-term assets**                                                                                                                                                                             |       | 95,154                         |       | 80,538                         |       |
|                                                                                                                                                                                                   |       |                           |       |                           |       |
| **Total assets**                                                                                                                                                                                       |       | $                              | 258,618    |                           | $          | 216,095 |   |
|                                                                                                                                                                                                   |       |                           |       |                           |       |
| **Liabilities  and Shareholders’ Equity**                                                                                                                                                         | ** ** | ** **                     | ** ** | ** **                     | ** ** |
| **Current liabilities**                                                                                                                                                                                |       |                           |       |                           |       |
| Trade  accounts payable                                                                                                                                                                                |       | $                              | 41,912     |                           | $          | 19,672 |   |
| Book  overdraft                                                                                                                                                                                        |       | 4,047                          |       | 7,384                          |       |
| Accrued  payroll and payroll taxes                                                                                                                                                                     |       | 4,578                          |       | 5,097                          |       |
| Income  taxes payable                                                                                                                                                                                  |       | 4,586                          |       | 47                             |       |
| Current  portion of deferred rent and tenant allowances                                                                                                                                                |       | 2,735                          |       | 2,136                          |       |
| Other  accrued liabilities                                                                                                                                                                             |       | 6,816                          |       | 9,060                          |       |
| **Total current liabilities**                                                                                                                                                                          |       | 64,674                         |       | 43,396                         |       |
| ** **                                                                                                                                                                                             | ** ** | ** **                     | ** ** | ** **                     | ** ** |
| Long-term  deferred rent and tenant allowances, less current portion                                                                                                                                   |       | 24,121                         |       | 18,097                         |       |
| **Total liabilities**                                                                                                                                                                                  |       | 88,795                         |       | 61,493                         |       |
| Commitments  and contingencies (Note 3)                                                                                                                                                                |       |                           |       |                           |       |
| ** **                                                                                                                                                                                             | ** ** | ** **                     | ** ** | ** **                     | ** ** |
| **Shareholders’ equity**                                                                                                                                                                          | ** ** | ** **                     | ** ** | ** **                     | ** ** |
| Preferred  stock, no par value, 40,000,000 shares authorized; none issued and  outstanding                                                                                                             |       | —                         |       | —                         |       |
| Common  stock, no par value, 50,000,000 shares authorized; 29,578,967 shares  issued and outstanding at November 1, 2008, 29,002,852 shares issued and  outstanding at February 2, 2008 |       | 74,234                         |       | 69,297                         |       |
| Accumulated  other comprehensive (loss) income                                                                                                                                                         |       | (159                           | )          | 464                            |       |
| Retained  earnings                                                                                                                                                                                     |       | 95,748                         |       | 84,841                         |       |
| **Total shareholders’ equity**                                                                                                                                                                    |       | 169,823                        |       | 154,602                        |       |
| ** **                                                                                                                                                                                             | ** ** | ** **                     | ** ** | ** **                     | ** ** |
| **Total liabilities and shareholders’ equity**                                                                                                                                                    |       | $                              | 258,618    |                           | $          | 216,095 |   |

 

See accompanyingnotes to condensed consolidated financial statements

 

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

**(in thousands,except share and per share amounts)**

**(Unaudited)**

** **
| ** **                                                          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                          | ** ** | **November 1,**             | ** ** | **November 3,**            | ** ** | **November 1,** | ** ** | **November 3,** | ** ** |
| ** **                                                          | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| Net sales                                                           |       | $                                | 112,245    |                            | $          | 104,045 |   | $ | 283,205 |   | $ | 254,810 |   |
| Cost of goods  sold                                                 |       | 72,982                           |       | 65,537                          |       | 189,279 |   | 166,390 |   |
| **Gross  profit**                                                   |       | 39,263                           |       | 38,508                          |       | 93,926 |   | 88,420 |   |
|                                                                |       |                             |       |                            |       |   |   |   |   |
| Selling, general  and administrative expenses                       |       | 28,879                           |       | 25,786                          |       | 78,004 |   | 68,813 |   |
| **Operating  profit**                                               |       | 10,384                           |       | 12,722                          |       | 15,922 |   | 19,607 |   |
|                                                                |       |                             |       |                            |       |   |   |   |   |
| Interest income,  net                                               |       | 576                              |       | 420                             |       | 1,660 |   | 1,173 |   |
| Other income                                                        |       | 36                               |       | 2                               |       | 36 |   | 1 |   |
| **Earnings  before income taxes**                                   |       | 10,996                           |       | 13,144                          |       | 17,618 |   | 20,781 |   |
|                                                                |       |                             |       |                            |       |   |   |   |   |
| Provision for  income taxes                                         |       | 4,178                            |       | 4,995                           |       | 6,711 |   | 7,897 |   |
|                                                                |       |                             |       |                            |       |   |   |   |   |
| **Net income**                                                      |       | $                                | 6,818      |                            | $          | 8,149 |   | $ | 10,907 |   | $ | 12,884 |   |
|                                                                |       |                             |       |                            |       |   |   |   |   |
| Basic net income  per share                                         |       | $                                | 0.23       |                            | $          | 0.28 |   | $ | 0.37 |   | $ | 0.45 |   |
|                                                                |       |                             |       |                            |       |   |   |   |   |
| Diluted net  income per share                                       |       | $                                | 0.23       |                            | $          | 0.28 |   | $ | 0.37 |   | $ | 0.44 |   |
|                                                                |       |                             |       |                            |       |   |   |   |   |
| Weighted average  shares used in computation of earnings per share: |       |                             |       |                            |       |   |   |   |   |
| Basic                                                               |       | 29,172,869                       |       | 28,862,951                      |       | 29,086,196 |   | 28,477,471 |   |
|                                                                |       |                             |       |                            |       |   |   |   |   |
| Diluted                                                             |       | 29,373,990                       |       | 29,554,774                      |       | 29,394,416 |   | 29,386,951 |   |

 

See accompanyingnotes to condensed consolidated financial statements

 

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** **

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

**(inthousands)**

**(Unaudited)**

** **
| ** **                                         | ** ** | ** **            | ** ** | ** **        | ** ** | **Accumulated**        | ** ** | ** **   | ** ** | ** ** | ** ** |
|----------------------------------------------------|------------|-----------------------|------------|-------------------|------------|------------------------|------------|--------------|------------|------------|------------|
| ** **                                         | ** ** | **Common Stock** | ** ** | **Comprehensive** | ** ** | **Retained**           | ** ** | ** **   | ** ** |
| ** **                                         | ** ** | **Shares**            | ** ** | **Amount**        | ** ** | **Income (Loss)** | ** ** | **Earnings** | ** ** | **Total**  | ** ** |
| **Balance  at February 2, 2008**              |       | 29,003                |       | $                 | 69,297     |                   | $          | 464          |       | $          | 84,841     |   | $ | 154,602 |   |
| Common stock  issued including tax benefit of $756 |       | 576                   |       | 1,768             |       | —                 |       | —       |       | 1,768      |       |
| Stock-based  compensation expense                  |       | —                |       | 3,169             |       | —                 |       | —       |       | 3,169      |       |
| Unrealized  losses, net                            |       | —                |       | —            |       | (623                   | )          | —       |       | (623       | )          |
| Net income                                         |       |                  |       |              |       |                   |       | 10,907       |       | 10,907     |       |
| **Balance  at November 1, 2008**              |       | 29,579                |       | $                 | 74,234     |                   | $          | (159         | )          | $          | 95,748     |   | $ | 169,823 |   |

 

See accompanying notesto condensed consolidated financial statements

 

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**ZUMIEZ INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

**(Unaudited)**

 
| ** **                                                                                   | ** ** | **For the Nine Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                   | ** ** | **November 1,**                              | ** ** | **November 3,** | ** ** |
| ** **                                                                                   | ** ** | **2008**                                          | ** ** | **2007** | ** ** |
| **Cash  flows from operating activities:**                                                   |       |                                              |       |   |   |
| Net income                                                                                   |       | $                                                 | 10,907     |   | $ | 12,884 |   |
| Adjustments to  reconcile net income to net cash provided by (used in) operating activities: |       |                                              |       |   |   |
| Depreciation and  amortization                                                               |       | 14,168                                            |       | 10,567 |   |
| Deferred tax  expense                                                                        |       | (2,634                                            | )          | (1,516 | ) |
| Stock-based  compensation expense                                                            |       | 3,252                                             |       | 3,322 |   |
| Loss on disposal  of assets                                                                  |       | 155                                               |       | 110 |   |
| Gain from sales  of marketable securities, net                                               |       | (36                                               | )          | (2 | ) |
| Excess tax  benefit from stock options                                                       |       | (756                                              | )          | (16,672 | ) |
| Changes in  operating assets and liabilities:                                                |       |                                              |       |   |   |
| Receivables                                                                                  |       | (1,920                                            | )          | (227 | ) |
| Inventory                                                                                    |       | (33,126                                           | )          | (25,714 | ) |
| Prepaid expenses  and other                                                                  |       | (1,495                                            | )          | (1,224 | ) |
| Trade accounts  payable                                                                      |       | 22,240                                            |       | 10,388 |   |
| Accrued payroll  and payroll taxes                                                           |       | (602                                              | )          | (352 | ) |
| Income taxes  payable                                                                        |       | 5,295                                             |       | 2,218 |   |
| Other accrued  liabilities                                                                   |       | (2,244                                            | )          | (683 | ) |
| Deferred rent  and tenant allowances                                                         |       | 6,623                                             |       | 6,282 |   |
| Net cash  provided by (used by) operating activities                                         |       | 19,827                                            |       | (619 | ) |
|                                                                                         |       |                                              |       |   |   |
| Cash flows from  investing activities:                                                       |       |                                              |       |   |   |
| Additions to  leasehold improvements and equipment                                           |       | (26,295                                           | )          | (27,245 | ) |
| Purchases of  marketable securities                                                          |       | (82,607                                           | )          | (73,375 | ) |
| Sales and  maturities of marketable securities                                               |       | 87,948                                            |       | 86,519 |   |
| Net cash used in  investing activities                                                       |       | (20,954                                           | )          | (14,101 | ) |
|                                                                                         |       |                                              |       |   |   |
| Cash flows from  financing activities:                                                       |       |                                              |       |   |   |
| Change in book  overdraft                                                                    |       | (3,337                                            | )          | (6,083 | ) |
| Proceeds from  exercise of stock options                                                     |       | 1,012                                             |       | 2,890 |   |
| Excess tax  benefit from stock options                                                       |       | 756                                               |       | 16,672 |   |
| Net cash (used  in) provided by financing activities                                         |       | (1,569                                            | )          | 13,479 |   |
|                                                                                         |       |                                              |       |   |   |
| Net decrease in  cash and cash equivalents                                                   |       | (2,696                                            | )          | (1,241 | ) |
| Cash and cash  equivalents, beginning of period                                              |       | 11,945                                            |       | 8,161 |   |
| Cash and cash  equivalents, end of period                                                    |       | $                                                 | 9,249      |   | $ | 6,920 |   |
|                                                                                         |       |                                              |       |   |   |
| Supplemental  disclosure on cash flow information:                                           |       |                                              |       |   |   |
| Cash paid during  the period for interest                                                    |       | $                                                 | 9          |   | $ | 1 |   |
| Cash paid during  the period for income taxes                                                |       | 4,115                                             |       | 7,324 |   |
| Non-cash  investing activities - acquisition costs in other accrued liabilities              |       | —                                            |       | 250 |   |

 

See accompanyingnotes to condensed consolidated financial statements

 

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** **

**ZUMIEZINC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**(Unaudited)**

 

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

 

**Basis of Presentation—**Theaccompanying unaudited condensed consolidated financial statements have beenprepared in accordance with accounting principles generally accepted in theUnited States of America (“GAAP”) for interim financial information and withthe instructions to 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.

 

In the opinion ofmanagement, the unaudited condensed consolidated financial statements containall adjustments, consisting of normal recurring adjustments, necessary for afair presentation of the condensed consolidated balance sheet as ofNovember 1, 2008, the condensed consolidated statements of operations forthe three and nine months ended November 1, 2008 and November 3,2007, the condensed consolidated statement of changes in shareholders’ equityfor the nine months ended November 1, 2008 and the condensed consolidatedstatements of cash flows for the nine months ended November 1, 2008 andNovember 3, 2007.

 

The financial data atFebruary 2, 2008 is derived from audited financial statements which areincluded in the Company’s Annual Report on Form 10-K for the year endedFebruary 2, 2008, and should be read in conjunction with the audited financialstatements and notes thereto.  Interimresults are not necessarily indicative of results for the full year.

 

**Principles of Consolidation*****—***The unauditedcondensed consolidated financial 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 of Estimates*****—***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.  Theseestimates can also affect supplemental information disclosed by the Company,including information about contingencies, risk, and financial condition.  In preparing the financial statements, theCompany makes routine estimates and judgments in determining the net realizablevalue of accounts receivable, marketable securities, inventory, fixed assets,prepaid assets, goodwill and certain liabilities.  Some of the more significant estimatesinclude the allowance for sales returns, the reserve for inventory valuationestimates, the reserve for level three marketable securities and the expecteduseful lives of fixed assets.  Inaddition, the Company uses a number of estimates when calculating stock-basedcompensation.  Actual results coulddiffer from those estimates.  The resultsof operations for the three and nine months ended November 1, 2008 are notnecessarily indicative of the results that might be expected for fiscal2008.  For further information, refer tothe Company’s financial statements and notes included in the Company’sForm 10-K filed on March 25, 2008.

 

**Nature of Business—**TheCompany is a leading specialty retailer of action sports related apparel,footwear, equipment and accessories operating under the Zumiez brand name.  As of November 1, 2008, the Companyoperated 340 stores primarily located in shopping malls, giving the Company apresence in 31 states.  The Company’sstores cater to young men and women between the ages of 12 and 24 who seekbrands representing a lifestyle centered on activities that includeskateboarding, 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, WA, was formedin August 1978 and operates within one reportable segment.

 

**Fiscal Year—**TheCompany uses a fiscal calendar widely used by the retail industry which resultsin a fiscal year consisting of a 52-week or 53-week period ending on theSaturday 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” is the52-week period ending January 31, 2009. The first nine months of fiscal 2008 was the 39-week period endedNovember 1, 2008.  “Fiscal 2007” wasthe 52-week period ended February 2, 2008. The first nine months of fiscal 2007 was the 39-week period endedNovember 3, 2007.

 

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**2. Summary of SignificantAccounting Policies**

 

Information regarding theCompany’s significant accounting policies is contained in Note 2, “Summary ofSignificant Accounting Policies,” to the consolidated financial statements inthe Company’s Form 10-K filed on March 25, 2008.  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.

 

**Marketable Securities—**AtNovember 1, 2008, marketable securities, classified as available for sale,were $58.0 million and consisted primarily of municipal and U.S. agency debtinstruments with original maturities over 90 days.  As of November 1, 2008, we had $1.7million invested, net of impairment charge of $0.3 million, in auction ratesecurities, which are classified as long-term, available-for-sale marketablesecurities on our condensed consolidated balance sheet.  We reduced our holdings of auction ratesecurities during 2007 through the auction process.

 

Auction rate securitiesare generally 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 toFebruary 3, 2008, we invested in these securities for short periods oftime as part of our cash management program. However, uncertainties in the credit markets, that began in early 2008,have prevented us and other investors from liquidating holdings of auction ratesecurities in recent auctions for these securities because the amount ofsecurities submitted for sale has exceeded the amount of purchase orders.  Should the auctions continue to fail, weanticipate we have the ability to hold these securities until the liquidity inthe market improves.  These investmentsare fully collateralized by the United States government and are insuredagainst loss of principal and interest by a bond insurer whose credit rating isBaa1.  Although we are uncertain as towhen the liquidity issues relating to these investments will improve, weconsider these issues to be only temporary. It is possible that further declines in fair value may occur, and thosedeclines, if any, would be recognized in our condensed consolidated balance sheetas “accumulated other comprehensive loss.” If we deem these losses to be other than temporary we will realize theselosses in our statement of operations. We continue to monitor the market for auction rate securities andconsider its impact, if any, on the fair market value of the investments.

 

**Receivables—**AtNovember 1, 2008 and February 2, 2008 the Company receivablesincluded the following:

 
| ** **                    | ** ** | **November 1, 2008** | ** ** | **February 2, 2008** | ** ** |
|-------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
| Tenant  allowances receivable |       | $                              | 3,148      |                           | $          | 1,334 |   |
| Credit cards  receivable      |       | 2,089                          |       | 2,108                          |       |
| Interest receivable           |       | 784                            |       | 557                            |       |
| Vendor credits                |       | 227                            |       | 212                            |       |
| Employee  receivables         |       | 185                            |       | 257                            |       |
| Other  receivables            |       | 262                            |       | 307                            |       |
|                          |       | $                              | 6,695      |                           | $          | 4,775 |   |

 

The Company does notextend credit to its customers except through independent third-party creditcards which are generally collected in several business days.

 

**MerchandiseInventories—**Merchandiseinventories are valued at the lower of cost or market.  The cost of merchandise inventories are basedupon an average cost methodology. Merchandise inventories may include items that have been writtendown to the Company’s best estimate of their net realizable value.  The Company’s decisions to write-down itsmerchandise inventories are based on its current rate of sale, the age of theinventory and other factors.  Actualfinal sales prices to customers may be higher or lower than the Company’sestimated net realizable value and could result in a fluctuation in grossprofit.  Historically, any additionalwrite-downs have not been significant to the Company.  We have reserved for inventory as ofNovember 1, 2008 and February 2, 2008 in the amounts of approximately$1.7 million and $3.0 million, respectively.  The inventory reserve includes inventorywhose estimated market value is below cost, and an estimate for inventoryshrinkage.  The inventory related tothese reserves is not marked up in subsequent periods.

 

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**FairValue of Financial Instruments—**Statement of Financial Accounting Standards No. 107 *“Disclosures about Fair Value of Financial Instruments”*(“SFAS No. 107”), requires management to disclose the estimated fairvalue of certain assets and liabilities as financial instruments.  Financial instruments are generally definedby SFAS No. 107 as cash, evidence of ownership interest in an entity,or a contractual obligation that both conveys to one entity a right to receivecash or other financial instruments from another entity and imposes on theother entity the obligation to deliver cash or other financial instruments tothe first entity.  At November 1,2008 and February 2, 2008, 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 fair valuebecause these financial instruments have floating interest rates, which reflectcurrent market conditions.

 

Statementof Financial Accounting Standards No. 157 “*Fair ValueMeasurements*.” defines fair value, establishes framework formeasuring fair value in accordance with generally accepted accounting principlesand expands disclosures about fair value measurements.  In October 2008, the FASB, issued FSPNo. SFAS 157-3 (“FSP 157-3”), *“Determining the FairValue of a Financial Asset When the Market for That Asset Is Not Active.  “*FSP 157-3 clarifies the applicationof SFAS No. 157, *“Fair Value Measurements,”*in a market that is not active and provides an example to illustratekey considerations in determining the fair value of a financial asset when themarket for that financial asset is not active. Contractual maturities of investments underlying our available-for-salesecurities at November 1, 2008 included $1.7 million in auction ratesecurities, net of $0.3 million impairment. Based on current marketconditions, auctions related to these securities may be unsuccessful at thescheduled auctions in fiscal 2009.  Unsuccessful auctions could result inour holding securities beyond their next scheduled auction reset dates if asecondary market does not develop; therefore, limiting the short-term liquidityof these investments.

 

**Cost of Goods Sold—**Cost ofgoods sold consists of the cost of merchandise sold to customers, inboundshipping costs, internet shipping costs, distribution costs, depreciation onleasehold improvements at the distribution center, buying and merchandisingcosts and store occupancy costs.  Thismay not be comparable to the way in which the Company’s competitors or otherretailers compute their cost of goods sold. In the nine month period ended November 3, 2007, the Companypreviously reported shipping costs on internet sales in selling, general andadministrative expense.  During the threeand nine months ended November 3, 2007, the Company reclassifiedapproximately $71,000 and $247,000 respectively, of this expense to cost ofgoods sold.

 

**Stock Compensation—**TheCompany maintains several stock incentive plans under which non-qualified stockoptions, incentive stock options and restricted stock have been granted toemployees and non-employee directors. The Company accounts for stock-based compensation in accordance withFinancial Accounting Standards Board (“FASB”) Statement No. 123(R), *Share-Based Payment* (“SFAS No. 123(R)”).  Under the provisions of SFAS No. 123(R),the estimated fair value of share-based awards granted under the 2005 Stock IncentivePlan is recognized as compensation expense over the vesting period.

 

The fair value of stock option grants are estimated onthe date of grant using the Black-Scholes option pricing method with thefollowing weighted-average assumptions used for grants issued during the ninemonth periods ended November 1, 2008 and November 3, 2007.

 
| ** **                         | ** ** | **For the Nine Months Ended  November 1, 2008** | ** ** | **For the Nine Months Ended  November 3, 2007** | ** ** |
|------------------------------------|------------|-------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|
| Dividend yield                     |       | —                                                                        | %          | —                                                                        | %          |
| Volatility rate                    |       | 55.35                                                                         | %          | 53.38                                                                         | %          |
| Average expected  life (in years): |       |                                                                          |       |                                                                          |       |
| Expected  lives-Eight years        |       | 7.25                                                                          |       | 6.38                                                                          |       |
| Expected  lives-Five years         |       | 6.50                                                                          |       | 6.00                                                                          |       |
| Expected  lives-Four years         |       | 6.25                                                                          |       | —                                                                        |       |
| Expected  live-Three years         |       | 6.00                                                                          |       | —                                                                        |       |
| Average  risk-free interest rate:  |       | 2.77                                                                          | %          | 4.55                                                                          | %          |

 

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The following table summarizes the Company’s stockoption activity for the nine months ended November 1, 2008 (in thousandsexcept weighted-average exercise price):

 
| ** **                            | ** ** | **Stock Options** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
|---------------------------------------|------------|------------------------|------------|-----------------------------------------|------------|
| Outstanding at  February 2, 2008 |       | 1,958                  |       | $                                       | 16.29      |   |
| Granted year to  date                 |       | 160                    |       | $                                       | 14.25      |   |
| Exercised year  to date               |       | (211                   | )          | $                                       | 2.46       |   |
| Forfeited year  to date               |       | (96                    | )          | $                                       | 27.36      |   |
| Outstanding at  November 1, 2008 |       | 1,811                  |       | $                                       | 17.28      |   |
| Exercisable at  November 1, 2008 |       | 699                    |       | $                                       | 11.45      |   |

 

During the nine months ended November 1, 2008,the Company granted 160,000 stock options with a Black-Scholes weighted averagefair value of $7.89 and an exercise price of $14.25.  In connection with these grants, the Companyrecognized approximately $143,000 and $364,000 of stock-based compensationexpense for the three and nine months ended November 1, 2008.

 

The following table summarizes the Company’srestricted stock activity for the nine months ended November 1, 2008 (inthousands except weighted-average exercise price):

 
| ** **                            | ** ** | **Restricted  Stock** | ** ** | **Grant Date  Weighted  Average  Fair Value** | ** ** |
|---------------------------------------|------------|-----------------------|------------|----------------------------------------------------|------------|
| Outstanding at  February 2, 2008 |       | 16                    |       | $                                                  | 37.19      |   |
| Granted year to  date                 |       | 333                   |       | $                                                  | 14.52      |   |
| Vested year to  date                  |       | (4                    | )          | $                                                  | 38.19      |   |
| Forfeited year  to date               |       | (15                   | )          | $                                                  | 14.22      |   |
| Outstanding at  November 1, 2008 |       | 330                   |       | $                                                  | 15.34      |   |

 

During the nine months ended November 1, 2008,the Company granted approximately 333,000 shares of restricted stock with aweighted average fair market value on the date of grant of $14.52 pershare.  In connection with these grants,the Company recognized approximately $251,000 and $560,000 in stock-basedcompensation expense during the three and nine months ended November 1,2008.

 

During the nine months ended November 1, 2008,the Company issued 40,000 shares of performance-based restricted stock thatwill vest between 0% and 100% based upon a predetermined earningsmilestone.  If performance-basedmilestones are not met, the restricted stock will not vest, in which case, anycompensation expense we have recognized to date will be reversed.  The Company has made the assessment that theperformance-based milestones will not be met and is therefore not recordingstock-based compensation expense on these performance-based restricted stocksgrants.

 

The Company recorded approximately $1.0 million and$3.3 million of total stock-based compensation expense for the three and ninemonths ended November 1, 2008, of which approximately $0.1 million and$0.4 million, respectively, was attributable to the Board of Directors.  The Company recorded approximately $1.1million and $3.3 million of stock-based compensation for the three and ninemonths ended November 3, 2007, of which approximately $0.2 million and$0.7 million, respectively, 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.  Prior toJanuary 29, 2006, the Company accounted for stock-based employeecompensation plans using the intrinsic value method of accounting in accordancewith Accounting Principles Board Opinion No. 25, Accounting for StockIssued to Employees (“APB 25”), and its related interpretations.  Under the provisions of APB 25, nocompensation expense was recognized when stock options were granted withexercise prices equal to or greater than market value on the date ofgrant.  For the nine months endedNovember 1, 2008 and November 3, 2007, the Company recordedapproximately $0.1 million, respectively, in stock-based compensation expensepursuant to APB 25.  At November 1,2008 and February 2, 2008, there was approximately $9.6 million and $9.2million, respectively, of total unrecognized compensation cost related tounvested stock options and restricted stock grants of which approximately $0.3million and $0.5 million, respectively, was attributable to the Board ofDirectors.  This cost is expected to berecognized over a weighted-average period of approximately three to eightyears.

 

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**Goodwill****and Other Intangible Assets**— In accordance with Statement ofFinancial Accounting Standards No. 142, “*Accountingfor Goodwill and Other Intangible Assets”* (“SFAS No. 142”), theCompany does not amortize goodwill derived from purchase businesscombinations.  The Company evaluates therecoverability of goodwill 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,then the second step of the impairment test is performed to measure the amountof any impairment loss.  Additionalimpairment assessments may be performed on an interim basis if the Companyencounters events or changes in circumstances that would indicate that, morelikely than not, the book value of goodwill has been impaired.  There was no impairment of goodwill in the2007 fiscal year or for the nine months ended November 1, 2008.

 

**Recent accounting pronouncements—**

 

In February 2008,the Financial Accounting Standards Board (“FASB”) issued FSP No. SFAS157-2, which delays the effective date of SFAS No. 157, *“Fair Value Measurements,”*for nonfinancial assets andnonfinancial liabilities, except for items that are recognized or disclosed atfair value in the financial statements on a recurring basis (at leastannually).  Nonfinancial assets andnonfinancial liabilities would include all assets and liabilities other thanthose meeting the definition of a financial asset or financial liability asdefined in paragraph 6 of SFAS No. 159, “The Fair Value Option forFinancial Assets and Financial Liabilities.” This FASB Staff Position defers the effective date of Statement 157 tofiscal years beginning after November 15, 2008, and interim periods withinthose fiscal years for items within the scope of FSP No. SFAS 157-2.  We are currently evaluating the effects, ifany, that FSP No. SFAS 157-2 may have on our condensed consolidatedfinancial statements.

 

In December 2007,the FASB issued SFAS No. 141 (revised 2007), *“BusinessCombinations*” (“SFAS No, 141(R)”), which replaces SFASNo. 141, *“Business Combinations”*(“SFAS No. 141”). SFAS No. 141(R) retains the underlying concepts ofSFAS No. 141 in that all business combinations are still required tobe accounted for at fair value under the acquisition method of accounting butSFAS No. 141(R) changed the method of applying the acquisitionmethod in a number of significant aspects. Acquisition costs will generally be expensed as incurred;non-controlling interests will be valued at fair value at the acquisition date;in-process research and development will be recorded at fair value as anindefinite-lived intangible asset at the acquisition date; restructuring costsassociated with a business combination will generally be expensed subsequent tothe acquisition date; and changes in deferred tax asset valuation allowancesand income tax uncertainties after the acquisition date generally will affect incometax expense. SFAS No. 141(R) is effective on a prospective basis forall business combinations for which the acquisition date is on or after thebeginning of the first annual period subsequent to December 15, 2008, withthe exception of the accounting for valuation allowances on deferred taxes andacquired tax contingencies. SFAS No. 141(R) amends SFAS No. 109, “Accounting forIncome Taxes,” such that adjustments made to valuation allowances on deferredtaxes and acquired tax contingencies associated with acquisitions that closedprior to the effective date of SFAS No. 141(R) would also applythe provisions of SFAS No. 141(R). Early adoption is not permitted. The Company does not expect the adoption ofSFAS No. 141(R) to have a material effect on its consolidatedfinancial position or results of operations.

 

In December 2007,the FASB issued SFAS No. 160, “*Non-controlling Interestsin Consolidated Financial Statements.*”  SFAS No. 160 amends Accounting ResearchBulletin No. 51, *“Consolidated FinancialStatements”* and requires (i) classification of non-controllinginterests, commonly referred to as minority interests, within stockholders’equity, (ii) net income to include the net income attributable to thenon-controlling interest and (iii) enhanced disclosure of activity relatedto non-controlling interests.  SFASNo. 160 is effective for fiscal years beginning after December 15,2008.  We will evaluate the impact, ifany, that the adoption of SFAS No. 160 could have on our condensedconsolidated financial statements.

 

In April 2008, the FASB issued FASB StaffPosition 142-3, *Determination of the UsefulLives of Intangible Assets*(“FSP 142-3”), which amends the factorsthat should be considered in developing renewal or extension assumptions usedto determine the useful life of a recognized intangible asset under FASBNo. 142, *Goodwill and Other IntangibleAssets*.  The intent of FSP142-3 is to improve the consistency between the useful life of a recognizedintangible asset under SFAS No. 142 and the period of expected cash flowsused to measure the fair value of the asset under SFAS No. 141(R) andother U.S. generally accepted accounting principles.  The Company does not expect the adoption ofFSP 142-3 to have a material effect on its consolidated financial position orresults of operations.

 

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In May 2008, theFASB issued SFAS No. 162,*“The Hierarchy ofGenerally Accepted Accounting Principles”* (“SFAS162”).  SFAS 162 identifies the sources of accounting principles andthe framework for selecting the principles to be used in the preparation offinancial statements of nongovernmental entities that are presented in conformitywith generally accepted accounting principles.  SFAS 162 is effective60 days following the Securities and Exchange Commission’s approval of thePublic Company Accounting Oversight Board Auditing amendments to AUSection 411, “The Meaning of**PresentFairly in Conformity with Generally Accepted AccountingPrinciples.”  This statement will not have an impact on the Company’scondensed consolidated financial statements.

 

In October 2008, the FASB, issued FSPNo. SFAS 157-3 (“FSP 157-3”), *“Determining the FairValue of a Financial Asset When the Market for That Asset Is Not Active.” *FSP 157-3 clarifies theapplication of SFAS No. 157, *“Fair Value Measurements,”*in a market that is not active and provides an example to illustratekey considerations in determining the fair value of a financial asset when themarket for that financial asset is not active. FSP157-3 is effective immediately, including prior periods for whichfinancial statements have not been issued. The Company has adopted FSP 157-3 effective with the financialstatements ended November 1, 2008. The adoption of FSP 157-3 had no impact on the Company’s condensedconsolidated financial statements.

 

**3. Commitments and Contingencies**

** **

L**eases**—TheCompany is committed under operating leases for all of its retail storelocations.  In addition to minimum futurelease payments, all store leases provide for additional rental payments basedon sales, as well as common area maintenance charges.  Total rent expense, base rent and contingentrent for the three and nine months ended November 1, 2008 andNovember 3, 2007 (in thousands) are as follows:

 
| ** **                         | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                         | ** ** | **November 1, 2008**                     | ** ** | **November 3, 2007**                    | ** ** | **November 1, 2008** | ** ** | **November 3, 2007** | ** ** |
| Store base rent  expense           |       | $                                                  | 8,437      |                                              | $          | 6,421 |   | $ | 22,532 |   | $ | 17,589 |   |
| Other base rent  expense           |       | 243                                                |       | 243                                               |       | 729 |   | 730 |   |
| Total base rent  expense           |       | 8,680                                              |       | 6,664                                             |       | 23,261 |   | 18,319 |   |
| Contingent and  other rent expense |       | 5,555                                              |       | 4,931                                             |       | 14,923 |   | 12,783 |   |
| Total rent  expense                |       | $                                                  | 14,235     |                                              | $          | 11,595 |   | $ | 38,184 |   | $ | 31,102 |   |

 

**Litigation—** OnDecember 10, 2007, a putative class action complaint was filed in the U.S.District Court for the Western District of Washington against the Company andcertain of its current and former directors and officers.  The complaintasserts claims under Sections 10(b), 20(a), and 20A of the SecuritiesExchange Act of 1934, as amended, and Rule 10b-5.  A substantially similar complaint was filed in the same court onDecember 14, 2007.  These cases, which were subsequentlyconsolidated, purported to be brought on behalf of a class of purchasers of theCompany’s stock during the period March 14, 2007 to November 7,2007.  Plaintiffs filed a consolidated amended complaint onMay 5, 2008, extending the class period to January 4, 2008, andalleging that the defendants violated the federal securities lawsduring this period of time by, among other things, makingmisrepresentations about the Company’s projected financial results in order toartificially inflate the Company’s stock price.  Plaintiffs are seekingcompensatory damages in an unspecified amount, interest, and an award ofattorneys’ fees and costs.

 

On July 21, 2008,defendants filed a motion to dismiss the amended complaint.  Plaintiffs opposed that motion on September 19,2008 and defendants filed their reply on October 20, 2008.  The motion is fully briefed and oral argumenthas been requested but not scheduled.

 

In addition, onDecember 20, 2007, a shareholder derivative action was filed in theSuperior Court of the State of Washington (Snohomish County), allegedly onbehalf of and for the benefit of the Company, against certain of the Company’scurrent directors and current and former officers.  The Company was namedas a nominal defendant.  The derivative complaint is based on the sameallegations of fact as in the securities class action, and claims that thedefendant directors and officers breached fiduciary duties, abused theircontrol, engaged in gross mismanagement, wasted corporate assets, unjustly enrichedthemselves, and engaged in insider trading.  The complaint seeksunspecified damages, restitution, disgorgement of profits, equitable andinjunctive relief, attorneys’ fees, costs, and expenses.  Because thecomplaint is derivative in nature, it does not 

 

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seek monetary damagesfrom the Company.  However, the Company may be required throughout thependency of the action to advance the legal fees and costs incurred by thedefendant directors and officers.  Under the terms of its corporate bylawsand related indemnity agreements, the Company is obligated to indemnify allcurrent and former officers and directors involved in civil, criminal, orinvestigative matters, in connection with their service.  The Company is also obligated to advance feesand expenses, but only if the involved officer or director acted in “goodfaith.”  There is no limit on the indemnification payments the Companycould be required to make under these provisions.  At this time, the Company does not believethat any potential fees or expense arising from officer and directorindemnification will be material.

 

On April 28, 2008,Zumiez moved to dismiss the derivative complaint for failure to make a demandon Zumiez’s Board of Directors.  Plaintiff filed his response onJune 27, 2008.  Before Zumiez was tofile its reply, it agreed with the plaintiff to stay the derivative actionpending the outcome of the motion to dismiss in the federal securitiesaction.  On August 3, 2008 the courtoverseeing the derivative litigation approved the stay.

 

The Company is unable topredict the outcome of these cases.  A court determination in any of theseactions against the Company could result in significant liability and couldhave a material adverse effect on the Company’s business, results of operationsor financial condition.

 

On March 5, 2008, aformer employee commenced an action against the Company in California statecourt (Evan Johnson v. Zumiez, Inc., et al., Case No. RG08374968,Alameda County Superior Court) alleging that the Company failed to pay allovertime wages owing to him and other employees, failed to provide meal breaksas required by California law, failed to provide employees with proper itemizedwage statements (pay stubs) as required by California law, and failed to payterminated employees waiting time penalties under California Labor Code section203.  On April 28, 2008, plaintiff filed a first amended complaintwhich adds an additional claim that employees under age 18 worked more hoursthan permitted by the Labor Code; the first amended complaint also seeks torecover penalties under the Private Attorney General Act for alleged violationof various Labor Code sections.  The company filed an answer to the firstamended complaint on May 20, 2008, denying the allegations of thecomplaint and asserting affirmative defenses. The parties are engaged in discovery. The suit was filed as a putative class action, but no motion requestingcertification of the case as a class action has been filed.  No trial datehas been set.  At this early stage of the case, it is not possible toestimate the amount or range of potential loss with any degree of certainty.

 

**Insurance Reserves—**TheCompany is responsible for medical insurance claims up to a specified aggregateamount.  The Company maintains a reservefor estimated medical and dental insurance claims based on historical claimsexperience and other estimated assumptions.

 

**4. Fair Value Measurements—**EffectiveFebruary 3, 2008 (the first day of our 2008 fiscal year), the Companyadopted SFAS No. 157, *“Fair Value Measurements”*(“SFAS 157”), as clarified by FSP FAS 157-3 *“Determining the FairValue of a Financial Asset When the Market for That Asset Is Not Active,”*for financial assets and financial liabilities. SFAS No. 157 defines fair value, establishes a framework formeasuring fair value and expands disclosure about fair value measurements asfollows:

 

·                  Level 1**—**Quoted prices in active markets for identical assets orliabilities;

 

·                  Level 2**—**Quoted prices for similar assets or liabilities in activemarkets or inputs that are observable;

 

·                  Level 3**—**Inputs that are unobservable.

 

In October 2008, the FASB issued Staff Position No. 157-3, “*Determining the Fair Value of a Financial Asset Whenthe Market for That Asset is Not Active”*(“FSP 157-3”). FSP 157-3clarifies the application of SFAS No. 157 to financial assets for which anactive market does not exist. Specifically, FSP 157-3 addresses the followingSFAS No. 157 application issues:

 

·                  How the reporting entity’s ownassumptions (that is, expected cash flows and appropriately risk-adjusteddiscount rates) should be considered when measuring fair value when relevantobservable inputs do not exist.

 

·                  How availableobservable inputs in a market that is not active should be considered whenmeasuring fair value.

 

·                  How the use ofmarket quotes (for example, broker quotes or pricing services for the same orsimilar financial assets) should be considered when assessing the relevance ofobservable and unobservable inputs available to measure fair value.

 

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The following tablesummarizes assets measured at fair value on a recurring basis atNovember 1, 2008, as required by SFAS 157:

 
| ** **             | ** ** | **Level 1**    | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
|------------------------|------------|---------------------|------------|------------------|------------|------------------|------------|
| ** **             | ** ** | **(in  thousands)** | ** ** |
| Marketable  securities |       | $                   | —     |             | $          | 56,348           |       | $ | 1,694 |   |
|                        |            |                     |            |                  |            |                  |            |  |  |  |

 

The $1.7 million in Level3 marketable securities represents two $1.0 million auction rate securities netof impairment charge of $0.3 million. One of these $1.0 million securities failed to sell at its scheduled auctionin March 2008.  The interest rate ofthis security reset to a tax-free rate of 6.55%.  In May 2008, the remaining $1.0 millionsecurity failed to sell at its scheduled auction.  The interest rate of this security was resetto a tax-free rate of 3.20%.  The nextscheduled auction for these securities is in fiscal 2009.  Based on market conditions, the Companychanged its valuation methodology for auction rate securities to a valuationmethod based on numerous assumptions including assessments of the underlyingstructure of each security, expected cash flows, credit ratings, liquidity andother relevant factors during the first quarter of fiscal 2008.  Accordingly, these securities are classifiedas Level 3 withinSFAS 157’s valuation hierarchy since the Company’s initial adoption of SFAS 157at February 3, 2008.  Theseassumptions, assessments and the interpretations of relevant market data aresubject to uncertainties, are difficult to predict and require significantjudgment.  The use of differentassumptions, applying different judgment to inherently subjective matters andchanges in future market conditions could result in significantly differentestimates of fair value.

 

As a result of thetemporary declines in fair value for the Company’s auction rate securities,which the Company attributes to current liquidity issues rather than creditissues, it has recorded an unrealized loss of approximately $0.3 million toaccumulated other comprehensive loss in the condensed consolidated balancesheet as of November 1, 2008.  TheCompany believes the current illiquid conditions are temporary in nature andthat it has the ability to hold the auction rate securities until liquidityreturns to the market.  If it is laterdetermined that the fair value of these securities is other than temporarilyimpaired, the Company will record a loss in the consolidated statement ofoperations.  Due to the Company’s beliefthat the market for these investments may take in excess of twelve months tofully recover, the Company has classified them as noncurrent assets on theaccompanying condensed consolidated balance sheet as of November 1, 2008.

 

The $56.3 million inLevel 2 marketable securities includes high credit money market accounts, UStreasuries, US government agency securities, 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.

 

The following tablepresents the changes in the Level 3 fair-value category for the nine monthsended November 1, 2008.  The Companyclassifies financial instruments in Level 3 of the fair-value hierarchy whenthere is reliance on at least one significant unobservable input to thevaluation model.  In addition to theseunobservable inputs, the valuation models for Level 3 financial instruments mayalso rely on a number of inputs that are readily observable either directly orindirectly.

 
| ** **             | ** ** | **February 2,  2008** | ** ** | **Transfers in  and/or out of  Level 3** | ** ** | **Total unrealized  loss included in  Accumlated  Comprehensive  Loss** | ** ** | **November 1,  2008** | ** ** |
|------------------------|------------|----------------------------|------------|--------------------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **             | ** ** | **(in thousands)**    | ** ** |
| Marketable  securities |       | $                          | —     |                                                         | $          | 2,000                                                                                  |       | $                          | (306       | ) | $ | 1,694 |   |
|                        |            |                            |            |                                                              |            |                                                                                        |            |                            |            |  |  |  |  |

 

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**5. Net Income Per Share, Basicand Diluted—** Basic net income per share is based on theweighted average number of common shares outstanding during the period.  Diluted net income per share is based on theweighted average number of common shares and common share equivalentsoutstanding during the period.  Commonshare equivalents included in the computation represent shares issuable uponassumed exercise of outstanding stock options and non-vested restricted stockand employee stock purchase plan (“ESPP”) share equivalents.  Potentially anti-dilutive securities notincluded in the calculation of diluted earnings per share include options topurchase common stock where the option exercise price is greater than theaverage market price of the Company’s common stock during the period reported.  Total common stock options not included inthe calculation of diluted earnings per share were 831,762 and 826,762 for thethree and nine months ended November 1, 2008 and 0 and 15,000 for the forthe three and nine months ended November 3, 2007, respectively.  There were 269,690 and 193,317 of non-vestedrestricted shares included in the calculation of diluted earnings per share forthe three and nine months ended November 1, 2008, respectively.

 

The following table setsforth the computation of basic and diluted net income per share (in thousands,except share and per share amounts):

 
| ** **                                                       | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|------------------------------------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                       | ** ** | **November 1, 2008**                     | ** ** | **November 3, 2007**                    | ** ** | **November 1, 2008** | ** ** | **November 3, 2007** | ** ** |
| Net income                                                       |       | $                                                  | 6,818      |                                              | $          | 8,149 |   | $ | 10,907 |   | $ | 12,884 |   |
| Weighted average  common shares for basic net income per share   |       | 29,172,869                                         |       | 28,862,951                                        |       | 29,086,196 |   | 28,477,471 |   |
| Dilutive effect  of stock options, restricted stock and ESPP     |       | 201,121                                            |       | 691,823                                           |       | 308,220 |   | 909,480 |   |
| Weighted average  common shares for diluted net income per share |       | 29,373,990                                         |       | 29,554,774                                        |       | 29,394,416 |   | 29,386,951 |   |
| Basic net income  per share                                      |       | $                                                  | 0.23       |                                              | $          | 0.28 |   | $ | 0.37 |   | $ | 0.45 |   |
| Diluted net  income per share                                    |       | $                                                  | 0.23       |                                              | $          | 0.28 |   | $ | 0.37 |   | $ | 0.44 |   |

 

6. **Goodwill andOther Intangible Assets—** In connection with the acquisition ofAction Concepts Fast Forward, Ltd., on June 24, 2006 the Company recordedgoodwill in accordance with SFAS 141 *“BusinessCombinations.” * During the nine months ended November 1,2008, the Company paid $250,000 of restricted cash included in goodwill andheld in escrow that was payable to Action Concepts Fast Forward, Ltd.  The Company recorded $13.2 million ofgoodwill as the excess of the purchase price of $15.5 million over the fairvalue of the net amounts assigned to assets acquired and liabilitiesassumed.  In accordance with SFAS 142, *“Goodwill and Other Intangible Assets,”* the Company willcontinue to assess, in accordance with our “goodwill” policy as stated in Note2, whether goodwill is impaired.

** **

OnSeptember 16, 2008 the Company acquired the assets of an Island Snow storefrom Kodama Incorporated located in Honolulu, Hawaii.  In connection with the purchase, the Companyentered into a noncompetition agreement for which the Company paid $100,000,and recorded an intangible asset in accordance with SFAS 141 *“Business Combinations.”* Under this agreement, Kodama Incorporated agreed not to compete withZumiez for a period of two years.  TheCompany will amortize the non-compete agreement over the term of the agreement.

 

**7. Related Party Transactions—**The Company incurredcharitable contributions expense to Zumiez Foundation of approximately $159,000and $164,000 in the three and nine months ended November 1, 2008.  The Company incurred charitable contributionsexpense to Zumiez Foundation of approximately $0 and $210,000 in the three andnine months ended November 3, 2007.

 

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** **

**Item2:  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS**

 

*The following discussion andanalysis of our financial condition and results of operations should be read inconjunction with our condensed consolidated financial statements and relatednotes included elsewhere in this quarterly report.  This discussion contains forward-looking statementsthat involve risks and uncertainties. Our actual results could differ materially from those anticipated inthese forward-looking statements as a result of various factors, includingthose discussed in the section entitled “Risk Factors” in ourForm 10-K filed with the SEC on March 25, 2008 and in thisForm 10-Q.*

 

*Forward-looking statements arebased on our expectations regarding net sales, selling, general andadministrative expenses, profitability, financial position, business strategy,new store openings, and plans and objectives of management.  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-lookingstatements largely on our current expectations and projections about futureevents and financial trends that we believe may affect our financial condition,results of operations, 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**

** **

We are a mall basedspecialty retailer of action sports related apparel, footwear, equipment andaccessories operating under the Zumiez brand name.  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 through a multi-faceted marketing approach thatis designed to integrate our brand image with our customers’ activities andinterests.

 

**General**

 

Net sales constitute grosssales net of estimated returns.  Netsales include our in-store sales and our internet sales and, accordingly,information in this quarterly report with respect to comparable store salesincludes internet sales.  Our internetsales are and have historically been approximately 1% of total sales.  Sales with respect to gift cards are deferredand recognized when gift cards are redeemed.

 

We report “comparablestore sales” based on net sales, and stores are included in our comparablestore sales beginning on the first anniversary of their first day ofoperation.  Changes in our comparablestore sales between two periods are based on net sales of stores which were inoperation during both of the two periods being compared and, if a store isincluded in the calculation of comparable store sales for only a portion of oneof the two periods being compared, then that store is included in thecalculation for only the comparable portion of the other 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 ourcompetitors or other retailers.

 

Cost of goods soldconsists of the cost of merchandise sold to customers, inbound shipping costs,internet shipping costs, distribution costs, depreciation on leaseholdimprovements at our distribution center, buying and merchandising costs andstore occupancy costs.  This may not becomparable to the way in which our competitors or other retailers compute theircost of goods sold.

 

Selling, general andadministrative expenses consist primarily of store personnel wages andbenefits, administrative staff and infrastructure expenses, store supplies,depreciation on leasehold improvements at our home office and stores, facility expenses,training, advertising and marketing costs. Credit card fees, insurance and other miscellaneous operating costs arealso included 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.

 

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**Critical Accounting Policies andEstimates**

 

Our discussion andanalysis of our financial condition and results of operations are based on ourfinancial statements, which have been prepared in conformance with accountingprinciples generally accepted in the United States of America (“GAAP”).  In preparing financial statements inaccordance with GAAP, we are required to make estimates and assumptions thathave an impact on the assets, liabilities, revenue and expense amountsreported.  These estimates can alsoaffect supplemental information disclosed by us, including information aboutcontingencies, risk, and financial condition. We believe, given current facts and circumstances, that our estimatesand assumptions are reasonable, adhere to GAAP, and are consistently applied.  Inherent in the nature of an estimate orassumption is the fact that actual results may differ from estimates andestimates may vary as new facts and circumstances arise.  In preparing the financial statements, wemake routine estimates and judgments in determining the net realizable value ofaccounts receivable, inventory, fixed assets, prepaid assets, goodwill andcertain liabilities.  We believe our mostcritical accounting estimates and assumptions are in the following areas:

 

*Impairment of Marketable andNon-Marketable Securities*. We periodically review our marketable securities for impairment.   If we conclude that any of these investmentsare impaired, we determine whether such impairment is“other-than-temporary” as defined under FSP 115-1.  Factors we consider to make such a determinationinclude the duration and severity of the impairment, as well as the reasonfor the decline in 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.

 

*Valuation of merchandiseinventories*.  We carryour merchandise inventories at the lower of cost or market.  Merchandise inventories may include itemsthat have been written down to our best estimate of their net realizablevalue.  Our decisions to write-down ourmerchandise inventories are based on our current rate of sale, the age of theinventory and other factors.  Actualfinal sales prices to our customers may be higher or lower than our estimatedsales prices and could result in a fluctuation in gross margin.  Historically, any additional write-downs havenot been significant and we do not adjust the historical carrying value ofmerchandise inventories upwards based on actual sales experience.

 

*Leasehold improvements andequipment*.  We reviewthe carrying value of our leasehold improvements and equipment 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 onthe fair value of the asset or group of assets. Generally, fair value will be determined using valuation techniques,such as the expected present value of future cash flows.  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.

 

*Revenue recognition and salesreturns reserve*.  Werecognize revenue upon purchase by customers at our retail store locations orupon shipment for orders placed through our website as both title and risk ofloss have transferred.  We offer a returnpolicy of generally 30 days and we accrue for estimated sales returns based onour historical sales returns results. The amounts of these sales returns reserves vary during the year due tothe seasonality of our business.  Actualsales returns could be higher or lower than our estimated sales returns due tocustomer buying patterns that could differ from historical trends.

 

*Impairment of Long-Lived Assets.*  We review long-lived assets for impairmentwhenever events or changes in circumstances indicate that the carrying amountof an asset may not be recoverable. Recoverability of assets to be held and used is determined by acomparison of the carrying amount of an asset to future undiscounted net cashflows expected to be generated by the asset. If such assets are considered impaired, the impairment recognized ismeasured by comparing projected individual store discounted cash flow to theasset carrying values.  Declines inprojected store cash flow could result in the impairment of assets.

 

*Accountingfor Income Taxes.* As part of the process of preparing the condensed consolidated financialstatements, income taxes are estimated for each of the jurisdictions in whichwe operate.  This process involvesestimating actual current tax exposure together with assessing temporarydifferences resulting from differing treatment of items for tax and accountingpurposes.  These differences result indeferred tax assets and liabilities, which are included within the balancesheet.  The likelihood that deferred taxassets will be recovered from future taxable income is assessed, recognizingthat future taxable income may give rise to new deferred tax assets.  To the extent that future recovery is notlikely, 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.

 

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Significant managementjudgment is required in determining the provision for income taxes, deferredtax assets and liabilities and any valuation allowance recorded against netdeferred tax assets.  Based on our historyof operating earnings, no valuation allowance has been recorded as ofNovember 1, 2008.  In the event thatactual results differ from these estimates, or these estimates are adjusted infuture periods, a valuation allowance may need to be established, which couldimpact our financial position and results of operations.  The Company adopted the provisions of FASBInterpretation No. 48, *“Accounting forUncertainty in Income Taxes”* (“FIN 48”), on January 1,2007.  The Company’s policy is torecognize penalties and interest related to unrecognized tax benefits in incometax expense.  Provisions for income taxesare based 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 Company maintains several equity awardplans under which non-qualified stock options and restricted stock have beengranted to employees and non-employee directors.  The Company accounts for stock in accordancewith Financial Accounting Standards Board (“FASB”) Statement No. 123(R), *Share-Based Payment* (“SFAS No. 123(R)”).  Under the provisions of SFAS No. 123(R),the estimated fair value of share-based awards granted under the 2005 StockIncentive Plan is recognized as compensation expense over the vesting period.

 

 **Results of Operations**

 

The following tablepresents, for the periods indicated, selected items in the statements ofoperations as a percent of net sales:

 
| ** **                                    | ** ** | **For the Three Months Ended** | ** ** | **For the Nine Months Ended** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                    | ** ** | **November 1, 2008**                     | ** ** | **November 3, 2007**                    | ** ** | **November 1, 2008** | ** ** | **November 3, 2007** | ** ** |
| Net sales                                     |       | 100.0                                              | %          | 100.0                                             | %          | 100.0 | % | 100.0 | % |
| Cost of goods  sold                           |       | 65.0                                               |       | 63.0                                              |       | 66.8 |   | 65.3 |   |
| Gross profit                                  |       | 35.0                                               |       | 37.0                                              |       | 33.2 |   | 34.7 |   |
| Selling, general  and administrative expenses |       | 25.7                                               |       | 24.8                                              |       | 27.5 |   | 27.0 |   |
| Operating profit                              |       | 9.3                                                |       | 12.2                                              |       | 5.7 |   | 7.7 |   |
| Interest income,  net                         |       | 0.5                                                |       | 0.4                                               |       | 0.6 |   | 0.5 |   |
| Earnings before  income taxes                 |       | 9.8                                                |       | 12.6                                              |       | 6.3 |   | 8.2 |   |
| Provision for  income taxes                   |       | 3.7                                                |       | 4.8                                               |       | 2.4 |   | 3.1 |   |
| Net Income                                    |       | 6.1                                                | %          | 7.8                                               | %          | 3.9 | % | 5.1 | % |

 

**Three Months (13 weeks) EndedNovember 1, 2008 Compared With Three Months (13 weeks) EndedNovember 3, 2007**

 

***NetSales***

 

Net sales increased to $112.2 million for thethree months ended November 1, 2008 from $104.0 million for the threemonths ended November 3, 2007, an increase of $8.2 million, or 7.9%.

 

Comparable store net sales decreased 5.8% for thethree months ended November 1, 2008 compared to the three months endedNovember 3, 2007.  The decrease incomparable store net sales was primarily due to lower net sales of men’sapparel, junior’s apparel, hard goods and accessories partially offset byhigher net sales of footwear.  Forinformation as to how we define comparable stores, see “General” above.

 

The increase in total netsales was due to an increase in net sales from non-comparable or new stores ofapproximately $14.3 million partially offset by a decrease in comparablestore net sales of approximately $6.1 million. The increase in non-comparable store net sales was primarily due to theopening of 57 new stores subsequent to November 3, 2007.

 

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***GrossProfit***

*** ***

Gross profit for thethree months ended November 1, 2008 was $39.3 million compared with$38.5 million for the three months ended November 3, 2007, an increase ofapproximately $0.8 million, or 2.0%. As a percentage of net sales, gross profit decreased to 35.0% for thethree months ended November 1, 2008 from 37.0% for the three months endedNovember 3, 2007.  The reduction ingross profit as a percent of net sales was driven by store occupancy costsgrowing at a faster rate than sales and to a lesser extent a decline in grossmargin on apparel products.

 

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

 

Selling, general andadministrative, or “SG&A” expenses in the three months endedNovember 1, 2008 were $28.9 million compared with $25.8 millionin the three months ended November 3, 2007, an increase of $3.1 million,or 12.0%.  This increase was primarilythe result of costs associated with operating new stores.  As a percentage of net sales, SG&Aexpenses increased to 25.7% in the three months ended November 1, 2008from 24.8% in the three months ended November 3, 2007.  The increase in SG&A expenses as apercentage of net sales was primarily attributable to an increase in storepayroll and payroll related costs, additional depreciation on new storespartially offset by a decrease in stock-based compensation and incentivecompensation.

 

***OperatingProfit***

 

As a result of the abovefactors, operating profit was $10.4 million in the three months endedNovember 1, 2008 compared with $12.7 million in the three months endedNovember 3, 2007, a decrease of $2.3 million or 18.4%.  As a percentage of net sales, operatingprofit was 9.3% in the three months ended November 1, 2008 compared with12.2% in the three months ended November 3, 2007.

 

***Provisionfor Income Taxes***

 

Provision for incometaxes was $4.2 million for the three months ended November 1, 2008compared with $5.0 million for the three months ended November 3,2007.  Our income tax rate was consistentfor both referenced periods.

 

***NetIncome***

 

Net income was $6.8million in the three months ended November 1, 2008 compared to $8.1million in the three months ended November 3, 2007, a decrease of $1.3million, or 16.3%.  As a percentage ofnet sales, net income was 6.1% in the three months ended November 1, 2008compared with 7.8% in the three months ended November 3, 2007.

 

**Nine Months (39 weeks) Ended November 1, 2008 ComparedWith Nine Months (39 weeks) Ended November 3, 2007**

 

***Net Sales***

 

Netsales increased to $283.2 million for the nine months endedNovember 1, 2008 from $254.8 million for the nine months ended November 3,2007, an increase of $28.4 million, or 11.1%.

 

Comparablestore net sales decreased by 3.2% for the nine months ended November 1,2008 compared to the nine months ended November 3, 2007.  The decrease in comparable store net saleswas primarily due to lower net sales of men’s apparel, junior’s apparel,snow hard goods and accessories partially offset by higher net sales offootwear and skate hard goods.  Forinformation as to how we define comparable stores, see “General” above.

 

Theincrease in total net sales was due to an increase in non-comparable store netsales of approximately $36.4 million partially offset by a decrease in netsales from comparable stores of approximately $8.0 million.  The increase in non-comparable store netsales was primarily due to the opening of 57 new stores subsequent toNovember 3, 2007.

 

***Gross Profit***

 

Grossprofit for the nine months ended November 1, 2008 was $93.9millioncompared with $88.4 million for the nine months ended November 3,2007, an increase of $5.5 million, or 6.2%.  As a percentage of net sales, gross profitdecreased to 33.2% for the nine months ended November 1, 2008 from 34.7%for the nine months ended November 3, 2007.  The decline in gross profit as a percent ofnet sales was driven primarily by store occupancy costs growing at a fasterrate than sales and lower gross margin on apparel sales.

 

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***Selling, General and AdministrativeExpenses***

 

Selling, general andadministrative, “SG&A,” expenses for the nine months ended November 1,2008 were $78.0 million compared with $68.8 million in the nine monthsended November 3, 2007, an increase of $9.2 million, or 13.4%.  This increase was primarily the result ofcosts associated with operating new stores as well as increases ininfrastructure and administrative staff to support our growth partially offsetby a decrease in stock-based and incentive compensation expenses, and shippingcosts to stores.  As a percentage of netsales, SG&A expenses increased to 27.5% in the nine months endedNovember 1, 2008 from 27.0% in the nine months ended November 3,2007.  The increase in SG&A expensesas a percentage of net sales was primarily attributable to additional new storedepreciation and store wages and benefits relative to the growth in net salessomewhat offset by a decrease in stock-based compensation and incentivecompensation expenses.

 

***OperatingProfit***

*** ***

As aresult of the above factors, operating profit decreased to $15.9 million forthe nine months ended November 1, 2008 compared with $19.6 million for thenine months ended November 3, 2007 a decrease of $3.7 million, or 18.8%.  As a percentage of net sales, operatingprofit was 5.7% and 7.7% for the nine months ended November 1, 2008 andNovember 3, 2007, respectively.

 

***Provision for Income Taxes***

 

Provisionfor income taxes was $6.7 million for the nine months endedNovember 1, 2008 compared with $7.9 million for the nine months endedNovember 3, 2007.

 

***Net Income***

 

Netincome decreased to $10.9 million for the nine months ended November 1,2008 from net income of $12.9 million for the nine months endedNovember 3, 2007, a decrease of $2.0 million or 15.3%.  As a percentage of net sales, net income was3.9% and 5.1% for the nine months ended November 1, 2008 andNovember 3, 2007, respectively.

 

**Liquidity and Capital Resources**

 

Our primary capitalrequirements are for inventory, store fixtures, store construction and remodeling,capital investments and ongoing infrastructure improvements such as technologyenhancements and distribution capabilities. Historically, our main sources of liquidity have been cash flows fromoperations, borrowings under our revolving credit facility and proceeds fromthe sale of our marketable securities.

 

The significantcomponents of our working capital are inventory and liquid assets such as cash,marketable securities and receivables, specifically tenant allowances andcredit card receivables, reduced by short-term debt, accounts payable andaccrued expenses.  Our working capitalposition benefits from the fact that we generally collect cash from sales tocustomers the same day or within several days of the related sale, while wetypically have extended payment terms with our vendors.

 

As of November 1,2008, we held two $1.0 million Auction Rate Securities valued at$1.7 million, net of approximately $0.3 million impairment charge.  One of these $1.0 million securities failedto sell at its scheduled auction in March 2008.  In May 2008, the remaining $1.0 millionsecurity failed to sell at its scheduled auction.  The interest rates for these securities resetto a prescribed “failure” tax-free rate of 6.55% and 3.20%, respectively.  We currently do not intend to hold thesesecurities beyond their next auction date and will try to sell these securitieswhen their auction dates come up in March 2009 and May 2009.  However, uncertainties in the credit marketsthis fiscal year have prevented us and other investors from liquidatingholdings of auction rate securities in recent auctions for these securitiesbecause the amount of securities submitted for sale has exceeded the amount ofpurchase orders.  If the March 2009and May 2009 auctions fail, we plan to hold these securities until thenext auction date and the securities coupon rate will reset to a prescribed“failure” rate.  Unsuccessful auctionscould result in our holding securities beyond their next scheduled auctionreset dates if a secondary market does not develop; therefore, limiting theshort-term liquidity of these investments. These securities have been reclassified from “current” to “long term”assets on our condensed consolidated balance sheet as of November 1, 2008.

 

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Our capital requirementsinclude construction and fixture costs related to the opening of new stores andremodeling expenditures for existing stores. Future capital requirements will depend on many factors, including thepace of new store openings, the availability of suitable locations for newstores, and the nature of arrangements negotiated with landlords.  In that regard, our net investment to open anew store has varied significantly in the past due to a number of factors,including the geographic location and size of the new store, and is likely tovary significantly in the future.  Duringfiscal 2008, we expect to spend approximately $29.0 to $31.0 million on capitalexpenditures, a majority of which will relate to leasehold improvements andfixtures for the 58 total new stores we plan to open in fiscal 2008, and asmaller amount will relate to equipment, systems and improvements for ourdistribution center and support infrastructure. However, there can be no assurance that the number of stores that weactually open in fiscal 2008 will not be different from the number of stores weplan to open, or that actual fiscal 2008 capital expenditures will not differfrom this expected amount.

 

We expect cash flows fromoperations and available borrowings under our revolving credit facility will besufficient to meet our foreseeable cash requirements for operations and plannedcapital expenditures for at least the next twelve months.  Beyond this time frame, if these sources arenot sufficient to meet our capital requirements, then we will be required toobtain 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.

 

Net cash provided byoperating activities for the nine months ended November 1, 2008 wasapproximately $19.8 million primarily related to increased trade accountspayable, income taxes and deferred rent, partially offset by an increase ininventory and receivables.  Net cash usedin operating activities for the nine months ended November 3, 2007 was$0.6 million primarily related to an increase in inventory and payment ofincome taxes predominately offset by an increase in results from operations andan increase in trade accounts payable.

 

Net cash used ininvesting activities was $21.0 million for the nine months endedNovember 1, 2008, related to $26.3 million of capital expendituresprimarily for new store openings and existing store renovations partiallyoffset by the $5.3 million in net sales of marketable securities.  Net cash used in investing activities was$14.1 million for the nine months ended November 3, 2007, primarilyrelated to capital expenditures for new store openings and existing storerenovations partially offset by the net sales of marketable securities.

 

Net cash used infinancing activities for the nine months ended November 1, 2008 was $1.6million related to the payment of book overdrafts somewhat offset by proceedsreceived from exercise of stock options and the related tax benefit.  Net cash provided by financing activities forthe nine months ended November 3, 2007 was $13.5 million related toproceeds received from exercise of stock options and the related tax benefitpartially offset by the payment of book overdrafts.

 

We have a creditagreement with Wells Fargo HSBC Trade Bank, N.A.  The credit agreement provides us with asecured revolving credit facility until August 30, 2009 of up to$25.0 million.  The secured revolvingcredit facility provides for the issuance of standby commercial letters of creditin an amount not to exceed $5.0 million outstanding at any time and with a termnot to exceed 365 days, although the amount of borrowings available at any timeunder our secured revolving credit facility is reduced by the amount of standbyletters of credit outstanding at that time. There were no outstanding borrowings under the secured revolving creditfacility at November 1, 2008 or February 2, 2008.  The Company had open letters of creditoutstanding under our secured revolving credit facility of $2.5 million atNovember 1, 2008 and approximately $0.5 million at February 2,2008.  The secured revolving creditfacility bears interest at floating rates based on the lower of the prime rate(4.00% at November 1, 2008) minus 0.50% or the LIBOR rate (3.17% atNovember 1, 2008), plus 1.00% for advances over $500,000 for a minimum of30 days and a maximum of 180 days. The credit agreement contains a number of restrictions and covenantsthat generally limit our ability to, among other things, (1) incur additionaldebt, (2) undergo a change in ownership and (3) enter into certaintransactions.  The credit agreement alsocontains financial covenants that require us to meet certain specifiedfinancial tests and ratios, including, minimum net income after taxes, maximumtotal liabilities divided by tangible net worth and minimum quick assetratio.  All of our personal property,including, among other things, our inventory, equipment and fixtures, has beenpledged to secure our obligations under the credit agreement.  We must also provide financial informationand statements to our lender.  We were incompliance with all such covenants at November 1, 2008.

 

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**Contractual Obligations andCommercial Commitments**

 

There was no materialchanges outside the ordinary course of business in our contractual obligationsduring the three months ended November 1, 2008.  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 November 1, 2008:

 
| ** **                       | ** ** | ** ** | ** ** | **Less than** | ** ** | ** **               | ** ** | ** **         | ** ** | **More than** | ** ** |
|----------------------------------|------------|------------|------------|--------------------|------------|--------------------------|------------|--------------------|------------|--------------------|------------|
| **Contractual Obligations** | ** ** | **Total**  | ** ** | **1 Year**    | ** ** | **1- 3 Years** | ** ** | **3-5 Years** | ** ** | **5 Years**   | ** ** |
| Operating Lease  Obligations     |       | $          | 280,624    |               | $          | 8,668                    |       | $                  | 69,979     |               | $          | 65,881 |   | $ | 136,096 |   |
| Purchase  Obligations            |       | 61,815     |       | 28,046             |       | 33,769                   |       | —             |       | —             |       |
| Letters of  Credit               |       | 2,516      |       | 2,516              |       | —                   |       | —             |       | —             |       |
|                             |       | $          | 344,955    |               | $          | 39,230                   |       | $                  | 103,748    |               | $          | 65,881 |   | $ | 136,096 |   |

 

We occupy our retailstores and combined home office and distribution center under operating leasesgenerally with terms of five to ten years. Some of our leases have early cancellation clauses, which permit thelease to be terminated by us 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. In addition to future minimum lease payments, substantially all of ourstore leases provide for additional rental payments (or “percentage rent”) ifsales at the respective stores exceed specified levels, as well as the paymentof common area maintenance charges and real estate taxes, unless guaranteed inthe lease agreement.  Amounts in theabove table do not include percentage rent, common area maintenance charges orreal estate taxes.  Most of our leaseagreements have defined escalating rent provisions, which we havestraight-lined over the term of the lease, including any lease renewals deemedto be probable.  For certain locations,we receive cash tenant allowances and we have reported these amounts as adeferred liability that is amortized to rent expense over the term of thelease, including any lease renewals deemed to be probable.  Rent expense, including common areamaintenance and other occupancy costs, was $38.2 million and $31.1 millionfor the nine months ended November 1, 2008 and November 3, 2007,respectively.

 

At November 1, 2008,we had outstanding purchase orders to acquire merchandise from vendors ofapproximately $61.8 million.  We have anoption to cancel these commitments with no notice prior to shipment.  At November 1, 2008, we had approximately$2.5 million of letters of credit outstanding.

 

**Off-Balance Sheet Obligations**

 

Our only off-balancesheet contractual obligations and commercial commitments as of November 1,2008 related to operating lease obligations, open purchase orders, and lettersof credit.  We have excluded these itemsfrom our balance sheet in accordance with GAAP. We presently do not have any non-cancelable purchase commitments.  At November 1, 2008, we had outstandingpurchase orders to acquire merchandise from vendors for approximately$61.8 million.  These purchases areexpected to be paid for by cash flows from operations.  We have an option to cancel these commitmentswith no notice prior to shipment.  AtNovember 1, 2008, we had $2.5 million of letters of credit outstandingunder our secured revolving credit facility. At November 1, 2008, we were committed to property owners foroperation lease obligations in the amount of $280.6 million.  Most of our leases contain cancellation orkick-out clauses in our favor that relieve us from any future obligation undera lease if specified sales levels are not achieved by a specific date.

 

**Impact of Inflation**

 

We do not believe thatinflation has had a material impact on our net sales or operating results inthe recent past.  There can be noassurance that our business will not be affected by inflation in the future.

 

**Risk Factors**

 

*Investingin our securities involves a high degree of risk.  The following risk factors, issues anduncertainties 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.*

 

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***Ourgrowth strategy depends on our ability to open and operate a significant numberof new stores each year, which could strain our resources and cause theperformance of our existing stores to suffer.***

 

Our growth largelydepends on our ability to open and operate new stores successfully.  However, our ability to open new stores issubject to a variety of risks and uncertainties, and we may be unable toopen new stores as planned, and any failure to successfully open and operatenew stores would have a material adverse effect on our results of operationsand on the market price of our common stock. We intend to continue to open a significant number of new stores infuture years while remodeling a portion of our existing store base annually.  In addition, our proposed expansion willplace increased demands on our operational, managerial and administrativeresources.  These increased demands couldcause us to operate our business less effectively, which in turn could causedeterioration in the financial performance of our individual stores and ouroverall business.  To the extent, our newstore openings are in markets where we already have stores, wemay experience reduced net sales in existing stores in those markets.  In addition, successful execution of ourgrowth strategy may require that we obtain additional financing, and wecannot assure you that we will be able to obtain that financing on acceptableterms or at all.

 

***If wefail to effectively execute our expansion strategy, we may not be able tosuccessfully open new store locations in a timely manner, if at all, whichcould have an adverse affect on our net sales and results of operations.***

 

Our ability to open and operate new storessuccessfully 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 new stores;

 

·         hire,train and retain store personnel;

 

·         successfullyintegrate new stores into our existing operations; and

 

·         identifyand satisfy the merchandise preferences of new geographic areas.

 

In addition, many of ourplanned new stores are to be opened in regions of the United States in which wecurrently have few, or no, stores.  Theexpansion into these markets may present competitive, merchandising anddistribution challenges that are different from those currently encountered inour existing markets.  Any of thesechallenges could adversely affect our business and results of operations.

 

***Ourbusiness is dependent upon our being able to anticipate, identify and respondto changing fashion trends, customer preferences and other fashion-relatedfactors; failure to do so could have a material adverse effect on us.***

 

Customer tastes andfashion trends in the action sports lifestyle market are volatile and tend tochange rapidly.  Our success depends onour ability to effectively anticipate, identify and respond to changing fashiontastes and consumer preferences, and to translate market trends intoappropriate, 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.

 

***Ourability to attract customers to our stores depends heavily on the success ofthe shopping malls in which our stores are located; any decrease in customertraffic in those malls could cause our sales to be less than expected.***

 

In order to generatecustomer traffic we depend heavily on locating our stores in prominentlocations within successful shopping malls. Sales at these stores are derived, in part, from the volume of trafficin those malls.  Our stores benefit fromthe ability of a mall’s other tenants to generate consumer traffic in thevicinity of our stores and the continuing popularity of malls as shoppingdestinations.  Our sales volume and malltraffic generally may be adversely affected by, among other things,economic downturns in a particular area, competition from internet retailers,non-mall retailers and other malls, increases in gasoline prices and theclosing or decline in popularity of other stores in the malls in which we arelocated.  A reduction in mall traffic asa result of these or any other factors could have a material adverse effect onour business, results of operations and financial condition.

 

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***Oursales and inventory levels fluctuate on a seasonal basis, leaving our operatingresults particularly susceptible to changes in back-to-school and holidayshopping patterns.***

 

Our sales are typicallydisproportionately higher in the third and fourth fiscal quarters of eachfiscal year due to increased sales during the back-to-school and winter holidayshopping seasons.  Sales during theseperiods cannot be used as an accurate indicator of annual results.  Our sales in the first and second fiscalquarters are typically lower than in our third and fourth fiscal quarters due,in part, to the traditional retail slowdown immediately following the winterholiday season.  Any significant decreasein sales during the back-to-school and winter holiday seasons would have amaterial adverse effect on our financial condition and results ofoperations.  In addition, in order toprepare for the back-to-school and winter holiday shopping seasons, we mustorder and keep in stock significantly more merchandise than we carry duringother parts of the year.  Anyunanticipated decrease in demand for our products during these peak shoppingseasons could require us to sell excess inventory at a substantial markdown,which could have a material adverse effect on our business, results ofoperations and financial condition.

 

***Ourquarterly results of operations are volatile and may decline.***

 

Our quarterly results ofoperations have fluctuated significantly in the past and can be expected tocontinue 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:

 

·         thetiming of new store openings and the relative proportion of our new stores tomature stores;

 

·         whetherwe are able to successfully integrate any new stores that we acquire and thepresence or absence of any unanticipated liabilities in connection therewith;

 

·         fashiontrends and changes in consumer preferences;

 

·         calendarshifts of holiday or seasonal periods;

 

·         changesin our merchandise mix;

 

·         timingof promotional events;

 

·         generaleconomic conditions and, in particular, the retail sales environment;

 

·         actionsby competitors or mall anchor tenants;

 

·         weatherconditions;

 

·         thelevel of pre-opening expenses associated with our new stores; and

 

·         inventoryshrinkage beyond our historical average rates.

 

***Failureto successfully integrate any businesses or stores that we acquire could havean adverse impact on our results of operations and financial performance.***

 

We may from time to timeacquire other retail stores, individually or in groups, or businesses.  We may experience difficulties inassimilating any stores or businesses we may acquire, and any such acquisitionsmay also result in the diversion of our capital and our management’s attentionfrom other business issues and opportunities. We may not be able to successfully integrate any stores or businessesthat we may acquire, including their facilities, personnel, financial systems, distribution,operations and general operating procedures. If we fail to successfully integrate acquisitions or if suchacquisitions fail to provide the benefits that we expect to receive, we couldexperience increased costs and other operating inefficiencies, which could havean adverse effect on our results of operations and financial performance.

 

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***Ourbusiness is susceptible to weather conditions that are out of our controlincluding the potential risks of unpredictable weather patterns, including anyweather patterns associated with global warming, and the resultant unseasonableweather could have a negative impact on our results of operations.***

 

Our business issusceptible to unseasonable weather conditions. For example, extended periods of unseasonably warm temperatures(including any weather patterns associated with global warming) during thewinter season or cool weather during the summer season could render a portionof our inventory incompatible with those unseasonable conditions.  These prolonged unseasonable weatherconditions, particularly in regions of the United States where we have aconcentration of stores, could have a material adverse effect on our businessand results of operations.

 

***Wemay be unable to compete favorably in the highly competitive retail industry,and if we lose customers to our competitors, our sales could decrease.***

 

The teenage and youngadult retail apparel, hard goods and accessories industry is highlycompetitive.  We compete with otherretailers for vendors, teenage and young adult customers, suitable store locations,qualified store associates and management personnel.  In the soft goods market which includes apparel, accessories and footwear, wecurrently compete with a large number of other teenage-focused retailers.  In addition, in the soft goods market we competewith independent specialty shops, department stores, and direct marketers thatsell similar lines of merchandise and target customers through catalogs ande-commerce.  In the hard goods marketwhich includes skateboards, snowboards, bindings, components and otherequipment, we compete directly or indirectly with the following categories ofcompanies: other specialty retailers that compete with us across a significantportion of our merchandising categories, such as local snowboard and skateshops, large-format sporting goods stores, mass merchant chains and internetretailers.

 

Some of our competitorsare larger than we are and have substantially greater financial, marketing andother resources than we do.  Directcompetition with these and other retailers may increase significantly inthe future, which could require us, among other things, to lower our prices andcould result in the loss of our customers. Current and increased competition could have a material adverse effecton our business, results of operations and financial condition.

 

***If wefail to maintain good relationships with vendors or if a vendor is otherwiseunable or unwilling to supply us with adequate quantities of their products atacceptable prices, our business and financial performance could suffer.***

 

Our business is dependenton continued good relations with our vendors. In particular, we believe that we generally are able to obtainattractive pricing and other terms from vendors because we are perceived as adesirable customer, and deterioration in our relationship with our vendorswould likely have a material adverse effect on our business.  We do not have any contractual relationshipswith our vendors and, accordingly, there can be no assurance that our vendorswill provide 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 lesser quality items, raise the prices theycharge us or focus on selling their products directly.  Any inability to acquire suitable merchandiseat acceptable prices, or the loss of one or more key vendors, would have amaterial adverse effect on our business, results of operations and financialcondition.  In addition, the recenteconomic environment has caused constraints in the credit and equity markets.  If our vendors are not able to obtainadequate financing for their capital needs they may not be able to continueoperations.

 

***If welose key management or are unable to attract and retain the talent required forour business, our financial performance could suffer.***

 

Our performance dependslargely on the efforts and abilities of our senior management, including ourCo-Founder and Chairman, Thomas D. Campion, our Chief Executive Officer,Richard M. Brooks, our Chief Financial Officer, Trevor S. Lang, our Presidentand General Merchandising Manager, Lynn K. Kilbourne and ourExecutive Vice President of Stores, Ford K. Wright.  None of our employees, exceptMr. Brooks, has an employment agreement with us and we do not plan to obtainkey person life insurance covering any of our employees.  If we lose the services of one or more of ourkey executives, we may not be able to successfully manage our business orachieve our growth objectives.  As ourbusiness grows, we will need to attract and retain additional qualifiedmanagement personnel in a timely manner and we may not be able to do so.

 

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***Ourfailure to meet our staffing needs could adversely affect our ability toimplement our growth strategy and could have a material impact on our resultsof operations.***

 

Our success depends inpart upon our ability to attract, motivate and retain a sufficient numberof qualified employees, including regional managers, district managers, storemanagers and store associates, who understand and appreciate our corporateculture based on a passion for the action sports lifestyle and are able toadequately 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 our employees arenot currently covered by collective bargaining agreements, we cannot guaranteethat our employees will not elect to be represented by labor unions in the future,which could increase our labor costs and could subject us to the risk of workstoppages and strikes.  Any suchfailure to meet our staffing needs, any material increases in employee turnoverrates, any increases in labor costs or any work stoppages or interruptionsor strikes could have a material adverse effect on our business or results ofoperations.

 

***Ouroperations, including our sole distribution center, are concentrated in certainregions in the United States, which makes us susceptible to adverse conditionsin these regions.***

 

Our home office and soledistribution center are located in a single facility in Washington, and asubstantial number of our stores are located in Washington and the western halfof the United States.  We also have asubstantial number of stores in the New York/New Jersey region and Texas.  As a result, our business may be moresusceptible to regional factors than the operations of more geographicallydiversified competitors.  These factorsinclude, among others, economic and weather conditions, demographic and populationchanges and fashion tastes.  In addition,we rely on a single distribution center in Everett, Washington to receive,store and distribute merchandise to all of our stores and to fulfill ourinternet sales.  As a result, a naturaldisaster or 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.

 

***Weare required to make substantial rental payments under our operating leases andany failure to make these lease payments when due would likely have a materialadverse effect on our business and growth plans.***

 

We do not own any of ourretail stores or our combined home office and distribution center, but insteadwe lease all of these facilities under operating leases.  Payments under these operating leases accountfor a significant portion of our operating expenses.  For example, total rental expense, includingadditional rental payments (or “percentage rent”) based on sales of some of thestores, common area maintenance charges and real estate taxes, under operatingleases was $38.2 million and $31.1 million for the nine months endedNovember 1, 2008 and November 3, 2007, respectively,and $22.2 million, $31.9 million and $43.5 million for fiscal2005, 2006, and 2007 respectively.  As ofNovember 1, 2008, we were a party to operating leases requiring futureminimum lease payments aggregating approximately $144.5 million throughfiscal year 2012 and approximately $136.1 million thereafter.  In addition, substantially all of our storeleases provide for additional rental payments based on sales of the respectivestores, as well as common area maintenance charges and other costs, and requirethat we pay real estate taxes, none of which is included in the amount offuture minimum lease payments.  We expectthat any new stores we open will also be leased by us under operating leases,which will further increase our operating lease expenses.

 

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Our substantial operatinglease obligations could have significant negative consequences, including:

 

·         increasingour vulnerability to general adverse economic and industry conditions;

 

·         limitingour ability to obtain additional financing;

 

·         requiringthat a substantial portion of our available cash be applied to pay our rentalobligations, thus reducing cash available for other purposes;

 

·         limitingour flexibility in planning for or reacting to changes in our business or inthe industry in which we compete; and placing us at a disadvantage with respectto some of our competitors.

 

We depend on cash flowfrom operations to pay our lease expenses and to fulfill our other cashneeds.  If our business does not generatesufficient cash flow from operating activities, and sufficient funds are nototherwise available to us from borrowings under bank loans or from othersources, we may not be able to service our operating lease expenses, growour business, respond to competitive challenges or to fund our other liquidityand capital needs, which would have a material adverse effect on us.

 

***Theterms of our revolving credit facility impose operating and financial restrictionson us that may impair our ability to respond to changing business andeconomic conditions.  This impairmentcould have a significant adverse impact on our business.***

 

We have a $25 millioncredit agreement with Wells Fargo HSBC Trade Bank, N.A., which we use forinventory financing and other general corporate purposes, that contains anumber of restrictions and covenants that generally limit our ability to, amongother things, (1) incur additional indebtedness, (2) undergo a changein ownership and (3) enter into certain transactions.  In addition, all of our personal property,including our inventory, equipment and fixtures, secure our obligations underthe credit agreement.  Our creditagreement also contains financial covenants that require us to meet certainspecified financial tests and ratios, including minimum net income after taxes,maximum total liabilities divided by tangible net worth and minimum quick assetratio.  Our ability to comply with theseratios may be affected by events beyond our control.

 

A breach of any of theserestrictive covenants or our inability to comply with the required financialtests or ratios could result in a default under the credit agreement.  If a default occurs, the lender may electto declare all borrowings outstanding, together with accrued interest and otherfees, to be immediately due and payable. If we are unable to repay outstanding borrowings when due, whether attheir maturity or if declared due and payable by the lender following adefault, the lender has the right to proceed against the collateral granted toit to secure the indebtedness.  As aresult, any breach of these covenants or failure to comply with these tests orratios could have a material adverse effect on us.  There can be no assurance that we will notbreach the covenants or fail to comply with the tests or ratios in our creditagreement or any other debt agreements we may enter into in the futureand, if a breach occurs, there can be no assurance that we will be able toobtain necessary waivers or amendments from the lenders.

 

The restrictionscontained in our credit agreement could: (1) limit our ability to plan foror react to market conditions or meet capital needs or otherwise restrict ouractivities or business plans; and (2) adversely affect our ability tofinance our operations, strategic acquisitions, investments or other capitalneeds or to engage in other business activities that would be in our interest.

 

***Our business could suffer as a result of small parceldelivery services such as United Parcel Service or Federal Express being unableto distribute our merchandise.***

*** ***

We rely upon small parceldelivery services for our product shipments, including shipments to, from andbetween our stores.  Accordingly, we aresubject to risks, including employee strikes and inclement weather, which mayaffect their ability to meet our shipping needs.  Among other things, any circumstances thatrequire us to use other delivery services for all or a portion of our shipmentscould result in increased costs and delayed deliveries and could harm ourbusiness materially.  In addition,although we have contracts with small parcel delivery services, we have theright to terminate these contracts upon 30 days written notice.  Although the contracts with these smallparcel delivery services provide certain discounts from the shipment rates ineffect at the time of shipment, the contracts do not limit their ability toraise the shipment rates at any time. Accordingly, we are subject to the risk that small parcel deliveryservices may increase the rates they charge, that they may terminate theircontracts with us, that they may decrease the rate discounts provided to uswhen an existing contract is renewed or that we may be unable to agree on theterms of a new contract with them, any of which could materially adverselyaffect our operating results.

 

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***Ourbusiness could suffer if a manufacturer fails to use acceptable laborpractices.***

 

We do not control ourvendors or the manufacturers that produce the products we buy from them, nor dowe control the labor practices of our vendors and these manufacturers.  The violation of labor or other laws by anyof our vendors or these manufacturers, or the divergence of the labor practicesfollowed by any of our vendors or these manufacturers from those generallyaccepted as ethical in the United States, could interrupt, or otherwise disrupt,the shipment of finished products to us or damage our reputation.  Any of these, in turn, could have a materialadverse effect on our financial condition and results of operations.  In that regard, most of the products sold inour stores are manufactured overseas, primarily in Asia and Central America,which may increase the risk that the labor practices followed by themanufacturers of these products may differ from those consideredacceptable in the United States.

*** ***

***Ourfailure to adequately anticipate a correct mix of private label merchandisemay have a material adverse effect on our business.***

 

Sales from private labelmerchandise accounted for 15.4% of our net sales in fiscal year 2007.  We may take steps to increase thepercentage of net sales of private label merchandise in the future, althoughthere can be no assurance that we will be able to achieve increases in privatelabel 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.

 

***Mostof our merchandise is produced by foreign manufactures therefore, theavailability and costs of these products may be negatively affected byrisks associated with international trade and other international conditions.***

 

Manufacturers outside ofthe United States produce most of our merchandise.  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 generally,and increase the cost, and reduce the supply of merchandise available tous.  Any reduction in merchandise availableto us or any increase in its cost due to tariffs, quotas or local issues thatdisrupt trade could have a material adverse effect on our results ofoperations.  Although the prices chargedby vendors for the merchandise we purchase are all denominated in United Statesdollars, a continued decline in the relative value of the United States dollarto foreign currencies could lead to increased merchandise costs, which couldnegatively affect our competitive position and our results of operation.

 

***Ifour information systems hardware or software fails to function effectively ordoes not scale to keep pace with our planned growth, our operations could bedisrupted and our financial results could be harmed.***

 

Over the past severalyears, we have made improvements to our existing hardware and software systems,as well as implemented new systems.  Ifthese or any other information systems and software do not work effectively,this could adversely impact the promptness and accuracy of our transactionprocessing, financial accounting and reporting and our ability to manage ourbusiness and properly forecast 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.

 

***Ourinability or failure to protect our intellectual property or our infringementof other’s intellectual property could have a negative impact on our operatingresults.***

 

We believe that ourtrademarks and domain names are valuable assets that are critical to oursuccess.  The unauthorized use or othermisappropriation of our trademarks or domain names could diminish the value ofthe Zumiez brand, our store concept, our private label brands or our goodwilland cause a decline in our net sales. Although we have secured or are in the process of securing protectionfor our trademarks and domain names in a number of countries outside of theUnited States, there are certain countries where we do not currently have orwhere we do not currently intend to apply for protection for certain trademarksor at all.  Also, the efforts we havetaken to protect our trademarks may not be sufficient or effective.  Therefore, we may not be able to preventother persons from using our trademarks or domain names outside of the UnitedStates, which also could adversely affect our business.  We are also subject to the risk that wemay infringe on the intellectual property rights of third parties.  Any infringement or other intellectualproperty claim made against us, whether or not it has merit, could betime-consuming, result in costly litigation, cause product delays or require usto pay royalties or license fees.  As aresult, any such claim could have a material adverse effect on our operatingresults.

 

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***Theeffects of war or acts of terrorism could adversely affect our business.***

 

Substantially all of ourstores are located in shopping malls. Any threat of terrorist attacks or actual terrorist events, particularlyin public areas, could lead to lower customer traffic in shopping malls.  In addition, local authorities or mallmanagement could close shopping malls in response to security concerns.  Mall closures, as well as lower customertraffic due to security concerns, would likely result in decreased sales.  Additionally, the escalation of the armedconflicts in the Middle East, or the threat, escalation or commencement of waror other armed conflict elsewhere, could significantly diminish consumerspending, and result in decreased sales for us. Decreased sales would have a material adverse effect on our business,financial condition and results of operations.

 

***Theoutcome of litigation could have a material adverse effect on our business and may result insubstantial costs and could divert management’s attention.***

 

We are involved, fromtime to time, in litigation incidental to our business including complaintsfiled by investors.  This litigationcould result in substantial costs, and could divert management’s attention andresources, which could harm our business. Risks associated with legal liability are often difficult to assess orquantify, and their existence and magnitude can remain unknown for significantperiods of time.  While we maintaindirector and officer insurance, the amount of insurance coverage may not besufficient to cover a claim and the continued availability of this insurancecannot be assured.  As a result, therecan be no assurance that the actual outcome of pending or future litigationwill not have a material adverse effect on our results of operations orfinancial condition.

 

***Our operations expose us to the risk of litigation whichcould lead to significant potential liability and costs that could harm ourbusiness, financial condition or results of operations.***

*** ***

We employ asubstantial number of full-time and part-time employees, a majority of whom areemployed at our store locations.  As aresult, we are subject to a large number of federal and state laws andregulations relating to employment.  Thiscreates a risk of potential claims that we have violated laws related todiscrimination and harassment, health and safety, wage and hour laws, criminalactivity, personal injury and other claims. We are also subject to other types of claims in the ordinary course ofour business.  Some or all of theseclaims may give rise to litigation, which could be time-consuming for ourmanagement team, costly and harmful to our business.

 

In addition, we areexposed to the risk of class action litigation. The costs of defense and the risk of loss in connection with classaction suits are greater than in single-party litigation claims.  Due to the costs of defending against suchlitigation, the size of judgments that may be awarded against us, and the lossof significant management time devoted to such litigation, we cannot assure youthat such litigation will not disrupt our business or impact our financialresults.

 

***Ourinternet operations subject us to numerous risks that could have an adverseeffect on our results of operations.***

 

Although internet salesconstitute a small portion of our overall sales, our internet operationssubject us to certain risks that could have an adverse effect on ouroperational results, including:

 

·         diversionof traffic and sales from our stores;

 

·         liabilityfor online content; and

 

·         risksrelated to the computer systems that operate our website and related supportsystems, including computer viruses and electronic break-ins and similardisruptions.

 

In addition, risks beyondour control such as governmental regulation of the internet, entry of ourvendors in the internet business in competition with us, online securitybreaches and general economic conditions specific to the internet and onlinecommerce could have an adverse effect on our results of operations.

 

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***Wehave incurred and will continue to incur significant expenses as a result ofbeing a public company, which will negatively impact our financial performance.***

 

We completed our initialpublic offering in May 2005 and we have incurred and will continue toincur significant legal, accounting, insurance and other expenses as a resultof being a public company.  The Sarbanes-OxleyAct of 2002, as well as related rules implemented by the SEC and TheNasdaq Global Market, has required changes in corporate governance practices ofpublic companies.  Compliance with theselaws, rules and regulations, including compliance with Section 404 ofthe Sarbanes-Oxley Act as discussed in the following risk factor, have causedand will continue to cause us to incur significant costs and expenses,including legal and accounting costs, and have made and will continue to makesome activities more time-consuming and costly. These laws, rules and regulations have made it more expensive forus to obtain director and officer liability insurance, and we have beenrequired to accept reduced policy limits and coverage.  As a result, it may be more difficultfor us to attract and retain qualified persons to serve on our board ofdirectors or as officers.  As a result ofthe foregoing, we have incurred and we expect to incur significant legal,accounting, insurance and certain other expenses on an ongoing basis, whichwill negatively impact our financial performance and could have a materialadverse effect on our results of operations and financial condition.

 

***Failureto maintain adequate financial and management processes and controls could leadto errors in our financial reporting and could harm our ability to manage ourexpenses.***

 

Reporting obligations asa public company and our anticipated growth are likely to place a considerablestrain on our financial and management systems, processes and controls, as wellas on our personnel.  In addition, we arerequired to document and test our internal controls over financial reportingpursuant to Section 404 of the Sarbanes-Oxley Act of 2002 so that ourmanagement can certify as to the effectiveness of our internal controls and ourindependent registered public accounting firm can render an opinion on theeffectiveness of our internal control over financial reporting on an annualbasis.  This process requires us todocument our internal controls over financial reporting and to potentially makesignificant changes thereto, if applicable. As a result, we have incurred and expect to continue to incursubstantial expenses to test our financial controls and systems, and we havebeen and in the future may be required to improve our financial andmanagerial controls, reporting systems and procedures, to incur substantialexpenses to make such improvements and to hire additional personnel.  If our management is ever unable to certifythe effectiveness of our internal controls or if our independent registeredpublic accounting firm cannot render an opinion on the effectiveness of ourinternal control over financial reporting, or if material weaknesses in ourinternal 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 contain personalinformation of our retail customers could be breached, which could subject usto adverse publicity, litigation, and expenses. In addition, if we are unable to comply with security standards createdby the credit card industry, our operations could be adversely affected.***

 

Database privacy, networksecurity, and identity theft are matters of growing public concern.  In an attempt to prevent unauthorized accessto our network and databases containing confidential, third-party information,we have installed privacy protection systems, devices, and activity monitoringon our network.  Nevertheless, ifunauthorized parties gain access to our networks or databases, they may be ableto steal, publish, delete, or modify our private and sensitive third-partyinformation.  In such circumstances, wecould be held liable to our customers or other parties or be subject toregulatory or other actions for breaching privacy rules.  This could result in costly investigationsand litigation, civil or criminal penalties, and adverse publicity that couldadversely affect our financial condition, results of operations, andreputation.  Further, if we are unable tocomply with the security standards, established by banks and the credit cardindustry, we may be subject to fines, restrictions, and expulsion from cardacceptance programs, which could adversely affect our retail operations.

 

***The current uncertainty surrounding the United Stateseconomy coupled with cyclical economic trends in action sports retailing couldhave a material adverse effect on our results of operations.***

 

The action sports retail industry historically hasbeen subject to substantial cyclicality. As economic conditions in the United States change, the trends indiscretionary consumer spending become unpredictable and discretionary consumerspending could be reduced due to uncertainties about the future.  When discretionary consumer spending isreduced, purchases of action sports apparel and related products maydecline.  A recession in the generaleconomy or continued uncertainties regarding future economic prospects couldhave a material adverse effect on our results of operations.

 

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

*** ***

Our common stock is traded publicly and varioussecurities analysts follow our financial results and issue reports on us.  These reports include information about ourhistorical financial results as well as the analysts’ estimates of our futureperformance.  The analysts’ estimates arebased upon their own opinions and are often different from our estimates orexpectations.  If our operating resultsare below the estimates or expectations of public market analysts andinvestors, our stock price could decline. Recently, a securities class action litigation was brought against usand such actions are frequently brought against other companies following a declinein the market price of their securities. If our stock price is volatile, we may become involved in this type oflitigation in the future.  Any litigationcould result in substantial costs and a diversion of management’s attention andresources that are needed to successfully run our business.

 

***The trading price of our investment in marketable securitiesmay fluctuate***

*** ***

We invest ourexcess cash in diversified high credit money market accounts, US treasuries, USgovernment agency securities, certificates of deposit, municipal bonds and auctionrate securities.  The investments havehistorically been considered very safe investments with very minimal defaultrates.  However, the recent uncertaintiesin the credit markets have prevented us and other investors from liquidatingholdings of auction rate securities in recent auctions for these securitiesbecause the amount of securities submitted for sale has exceeded the amount ofpurchase orders.  We reduced our holdingsof auction rate securities during 2007 through the auction process.  As of November 1, 2008, we had$1.7 million invested in auction rate securities, which are classified aslong-term marketable securities on our condensed consolidated balancesheet.  In the nine months ended November 1,2008, we incurred an impairment charge on these investments of approximately$0.3 million.  If market liquidity issuescontinue, we may incur additional impairment charges on these investments.

 

***Adecline in the market price of our stock and performance of our Company maytrigger an impairment of the goodwill recorded on our balance sheet***

*** ***

Goodwill and otherintangible assets with indefinite lives must be tested for impairment at leastonce a year or more frequently if management believes indicators of impairmentexist.  Carrying values are compared withfair values, and when the carrying value exceeds the fair value, the carryingvalue of the impaired asset is reduced to its fair value.  Any reduction in the estimated fair value ofour goodwill as a result of our impairment analysis could result in a non-cashgoodwill impairment charge to our statement of operations.  A goodwill impairment charge could have asignificant impact on earnings and potentially result in a violation of ourfinancial covenants, thereby limiting our ability to secure short termfinancing.

 

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

 

*CreditFacility Risk*.  Duringdifferent times of the year, due to the seasonality of our business, we haveborrowed under our revolving credit facility. To the extent we borrow under our secured revolving credit facility,which bears interests at floating rates based on either the prime rate orLIBOR, we are exposed to market risk related to changes in interest rates.  At November 1, 2008, we had noborrowings outstanding under our secured revolving credit facility.  At November 1, 2008, we had $2.5 millionof letters of credit outstanding under our secured revolving creditfacility.  We are not a party to anyderivative financial instruments.

 

*InterestRate Risk*.  We investin a variety of securities, consisting primarily of investments ininterest-bearing demand deposit accounts with financial institutions,tax-exempt money market funds and debt securities of corporations andmunicipalities.  By policy, we limit theamount of credit exposure to any one issuer.

 

Investments in both fixedrate and floating rate interest earning products carry a degree of interestrate risk.  Fixed rate securities mayhave their fair market value adversely impacted due to a rise in interest rates,while floating rate securities may produce less income than predicted ifinterest rates fall.  Due in part tothese factors, our income from investments may decrease in the future.

 

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**Item4:   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 theeffectiveness of the design and operation of our disclosure controls andprocedures (as defined in Securities Exchange Act Rule 13a-15(e)).  Based on this evaluation, our CEO and CFOconcluded that, as of  November 1,2008, our disclosure controls and procedures were effective.

 

Disclosure controls andprocedures, no matter how well designed and implemented, can provide onlyreasonable assurance of achieving an entity’s disclosure objectives.  The likelihood of achieving such objectivesis affected by limitations inherent in disclosure controls and procedures.  These include the fact that human judgment indecision-making can be faulty and that breakdowns in internal control can occurbecause of human failures such as simple errors or mistakes or intentionalcircumvention 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 ActRule 13a-15(f)) during the quarter ended November 1, 2008 that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

**PART II - OTHER INFORMATION**

 

**Item1.  Legal Proceedings**

 

We are involved from timeto time in litigation incidental to our business.  The Company is unable to predict the outcomeof litigated cases.  A courtdetermination in any of litigation actions against the Company could result insignificant liability and could have a material adverse effect on the Company’sbusiness, results of operations or financial condition.

 

See Note 3 to the Notesto Condensed Consolidated Financial Statements found in Item 1 of thisForm 10-Q (listed under “Litigation” under Commitments and Contingencies).

 

**Item1A.  Risk Factors**

 

Please refer to the RiskFactors set forth in Item 2 of Part I of this Form 10-Q as well asthe risk factors previously disclosed in Item 1A of Part I of our AnnualReport on Form 10-K for the year ended February 2, 2008.  There have been no material changes in therisk factors set forth in our Annual Report on From 10-K for the year endedFebruary 2, 2008.

 

**Item2.  Changes in Securities; Use ofProceeds and Issuer Purchases of Equity Securities**

 

None

 

**Item3.  Defaults Upon Senior Securities**

 

None

 

**Item4.  Submission of Matters to a Vote ofSecurity Holders**

** **

None

** **

**Item 5. Other Information**

 

None

 

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**Item6.  Exhibits**

** **

Exhibits

 
| Exhibit No. | ** ** | **Description of Exhibits**                                                                                                                                                                                              |
|------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 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                                                   |

 

**SIGNATURE**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, as amended, the registranthas duly caused this report to be signed on its behalf by the undersignedhereunto duly authorized.

 
|                               | ZUMIEZ INC. |
|-------------------------------|-------------|
|                          |        |
|                          | By:         | /s/ TREVOR S.  LANG |
|                          |        | Trevor S. Lang |
|                          |        | Chief Financial  Officer |
|                          |        |
| Dated: December 1,  2008 |        |

 

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