Tableof 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 AUGUST 2, 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 of registrantas 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 ofprincipal executive offices)  (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 by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor 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 andlarge accelerated filer in Rule 12b-2 of the Exchange Act).  (Check one):

 

Large acceleratedfiler   o           Acceleratedfiler   x           Non-acceleratedfiler   o           Smallerreporting 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 August 28, 2008 was 29,399,608 shares.

 

 

 

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**ZUMIEZINC.**

**FORM 10-Q**

**TABLE OFCONTENTS**

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

 

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**ZUMIEZ INC.****CONDENSED CONSOLIDATED BALANCE SHEETS****(in thousands, except share amounts)**

** **
| ** **                                                                                                                                                                                            | ** ** | **August 2, 2008** | ** ** | **February 2, 2008** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                                                                                                            | ** ** | **(Unaudited)**              | ** ** | ** **                     | ** ** |
| **Assets**                                                                                                                                                                                            | ** ** | ** **                   | ** ** | ** **                     | ** ** |
| **Current  assets**                                                                                                                                                                                   | ** ** | ** **                   | ** ** | ** **                     | ** ** |
| Cash and cash  equivalents                                                                                                                                                                            |       | $                            | 8,075      |                           | $          | 11,945 |   |
| Marketable  securities                                                                                                                                                                                |       | 58,516                       |       | 64,587                         |       |
| Receivables                                                                                                                                                                                           |       | 8,276                        |       | 4,775                          |       |
| Inventory                                                                                                                                                                                             |       | 72,080                       |       | 48,721                         |       |
| Prepaid expenses  and other                                                                                                                                                                           |       | 5,655                        |       | 4,440                          |       |
| Deferred tax  assets                                                                                                                                                                                  |       | 3,267                        |       | 1,089                          |       |
| **Total  current assets**                                                                                                                                                                             |       | 155,869                      |       | 135,557                        |       |
| ** **                                                                                                                                                                                            | ** ** | ** **                   | ** ** | ** **                     | ** ** |
| Leasehold  improvements and equipment, net                                                                                                                                                            |       | 75,994                       |       | 65,937                         |       |
| Goodwill                                                                                                                                                                                              |       | 13,154                       |       | 13,154                         |       |
| Marketable  securities - long-term                                                                                                                                                                    |       | 1,847                        |       | —                         |       |
| Deferred tax  assets                                                                                                                                                                                  |       | 1,655                        |       | 1,447                          |       |
| **Total  long-term assets**                                                                                                                                                                           |       | 92,650                       |       | 80,538                         |       |
|                                                                                                                                                                                                  |       |                         |       |                           |       |
| **Total  assets**                                                                                                                                                                                     |       | $                            | 248,519    |                           | $          | 216,095 |   |
| ** **                                                                                                                                                                                            | ** ** | ** **                   | ** ** | ** **                     | ** ** |
| **Liabilities and Shareholders’ Equity**                                                                                                                                                         | ** ** | ** **                   | ** ** | ** **                     | ** ** |
| **Current  liabilities**                                                                                                                                                                              | ** ** | ** **                   | ** ** | ** **                     | ** ** |
| Trade accounts  payable                                                                                                                                                                               |       | $                            | 44,594     |                           | $          | 19,672 |   |
| Book overdraft                                                                                                                                                                                        |       | 2,201                        |       | 7,384                          |       |
| Accrued payroll  and payroll taxes                                                                                                                                                                    |       | 3,495                        |       | 5,097                          |       |
| Income taxes  payable                                                                                                                                                                                 |       | 2,730                        |       | 47                             |       |
| Current portion  of deferred rent and tenant allowances                                                                                                                                               |       | 2,631                        |       | 2,136                          |       |
| Other accrued  liabilities                                                                                                                                                                            |       | 8,673                        |       | 9,060                          |       |
| **Total  current liabilities**                                                                                                                                                                        |       | 64,324                       |       | 43,396                         |       |
| ** **                                                                                                                                                                                            | ** ** | ** **                   | ** ** | ** **                     | ** ** |
| Long-term  deferred rent and tenant allowances, less current portion                                                                                                                                  |       | 22,657                       |       | 18,097                         |       |
| **Total  liabilities**                                                                                                                                                                                |       | 86,981                       |       | 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, 100,000,000 shares authorized; 29,399,608 shares issued and  outstanding at August 2, 2008, 29,002,852 shares issued and outstanding  at February 2, 2008 |       | 72,544                       |       | 69,297                         |       |
| Accumulated  other comprehensive income                                                                                                                                                               |       | 64                           |       | 464                            |       |
| Retained  earnings                                                                                                                                                                                    |       | 88,930                       |       | 84,841                         |       |
| **Total  shareholders’ equity**                                                                                                                                                                  |       | 161,538                      |       | 154,602                        |       |
| ** **                                                                                                                                                                                            | ** ** | ** **                   | ** ** | ** **                     | ** ** |
| **Total  liabilities and shareholders’ equity**                                                                                                                                                  |       | $                            | 248,519    |                           | $          | 216,095 |   |

 

See accompanying notes 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** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                          | ** ** | **August 2, 2008**     | ** ** | **August 4, 2007**   | ** ** | **August 2, 2008** | ** ** | **August 4, 2007** | ** ** |
| Net sales                                                           |       | $                                | 92,258     |                           | $          | 81,974 |   | $ | 170,960 |   | $ | 150,765 |   |
| Cost of goods  sold                                                 |       | 62,155                           |       | 53,783                         |       | 116,297 |   | 100,853 |   |
| **Gross  profit**                                                   |       | 30,103                           |       | 28,191                         |       | 54,663 |   | 49,912 |   |
|                                                                |       |                             |       |                           |       |   |   |   |   |
| Selling, general  and administrative expenses                       |       | 26,191                           |       | 23,489                         |       | 49,125 |   | 43,027 |   |
| **Operating  profit**                                               |       | 3,912                            |       | 4,702                          |       | 5,538 |   | 6,885 |   |
|                                                                |       |                             |       |                           |       |   |   |   |   |
| Interest income,  net                                               |       | 495                              |       | 327                            |       | 1,084 |   | 753 |   |
| Other expense                                                       |       | —                           |       | —                         |       | — |   | (1 | ) |
| **Earnings  before income taxes**                                   |       | 4,407                            |       | 5,029                          |       | 6,622 |   | 7,637 |   |
|                                                                |       |                             |       |                           |       |   |   |   |   |
| Provision for  income taxes                                         |       | 1,680                            |       | 1,911                          |       | 2,533 |   | 2,902 |   |
|                                                                |       |                             |       |                           |       |   |   |   |   |
| **Net  income**                                                     |       | $                                | 2,727      |                           | $          | 3,118 |   | $ | 4,089 |   | $ | 4,735 |   |
|                                                                |       |                             |       |                           |       |   |   |   |   |
| Basic net income  per share                                         |       | $                                | 0.09       |                           | $          | 0.11 |   | $ | 0.14 |   | $ | 0.17 |   |
|                                                                |       |                             |       |                           |       |   |   |   |   |
| Diluted net  income per share                                       |       | $                                | 0.09       |                           | $          | 0.11 |   | $ | 0.14 |   | $ | 0.16 |   |
|                                                                |       |                             |       |                           |       |   |   |   |   |
| Weighted average  shares used in computation of earnings per share: |       |                             |       |                           |       |   |   |   |   |
| Basic                                                               |       | 29,072,536                       |       | 28,540,326                     |       | 29,042,861 |   | 28,478,125 |   |
|                                                                |       |                             |       |                           |       |   |   |   |   |
| Diluted                                                             |       | 29,378,589                       |       | 29,186,270                     |       | 29,374,015 |   | 29,094,234 |   |

 

See accompanyingnotes to condensed consolidated financial statements

 

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**ZUMIEZ INC.****CONDENSED CONSOLIDATED STATEMENT OF CHANGES INSHAREHOLDERS’ EQUITY****(in thousands)****(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 $509 |       | 397                   |       | 1,118             |       | —                 |       | —       |       | 1,118      |       |
| Stock-based  compensation expense                  |       | —                |       | 2,129             |       | —                 |       | —       |       | 2,129      |       |
| Unrealized  losses, net                            |       | —                |       | —            |       | (400                   | )          | —       |       | (400       | )          |
| Net income                                         |       |                  |       |              |       |                   |       | 4,089        |       | 4,089      |       |
| **Balance  at August 2, 2008**                |       | 29,400                |       | $                 | 72,544     |                   | $          | 64           |       | $          | 88,930     |   | $ | 161,538 |   |

 

See accompanyingnotes to condensed consolidated financial statements

 

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** **

**ZUMIEZINC.**

**CONDENSED CONSOLIDATED STATEMENTS OFCASH FLOWS**

**(inthousands)**

**(Unaudited)**

 
| ** **                                                                                   | ** ** | **For the Six Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                   | ** ** | **August 2, 2008**                     | ** ** | **August 4, 2007** | ** ** |
| **Cash  flows from operating activities:**                                                   |       |                                             |       |   |   |
| Net income                                                                                   |       | $                                                | 4,089      |   | $ | 4,735 |   |
| Adjustments to  reconcile net income to net cash provided by (used in) operating activities: |       |                                             |       |   |   |
| Depreciation and  amortization                                                               |       | 9,170                                            |       | 6,764 |   |
| Deferred tax  expense                                                                        |       | (2,424                                           | )          | (1,623 | ) |
| Stock-based  compensation expense                                                            |       | 2,129                                            |       | 2,174 |   |
| Loss on disposal  of assets                                                                  |       | 138                                              |       | 100 |   |
| Excess tax  benefit from stock options                                                       |       | (509                                             | )          | (11,410 | ) |
| Changes in  operating assets and liabilities:                                                |       |                                             |       |   |   |
| Receivables                                                                                  |       | (3,501                                           | )          | (683 | ) |
| Inventory                                                                                    |       | (23,359                                          | )          | (19,646 | ) |
| Prepaid expenses  and other                                                                  |       | (1,215                                           | )          | (864 | ) |
| Trade accounts  payable                                                                      |       | 24,922                                           |       | 14,241 |   |
| Accrued payroll  and payroll taxes                                                           |       | (1,602                                           | )          | (1,466 | ) |
| Income taxes  payable                                                                        |       | 3,192                                            |       | (2,666 | ) |
| Other accrued  liabilities                                                                   |       | (387                                             | )          | (241 | ) |
| Deferred rent  and tenant allowances                                                         |       | 5,055                                            |       | 3,841 |   |
| **Net  cash provided by (used in) operating activities**                                     |       | 15,698                                           |       | (6,744 | ) |
|                                                                                         |       |                                             |       |   |   |
| **Cash  flows from investing activities:**                                                   |       |                                             |       |   |   |
| Additions to  leasehold improvements and equipment                                           |       | (19,006                                          | )          | (19,135 | ) |
| Purchases of  marketable securities                                                          |       | (51,722                                          | )          | (37,854 | ) |
| Sales and  maturities of marketable securities                                               |       | 55,225                                           |       | 54,296 |   |
| **Net  cash used in investing activities**                                                   |       | (15,503                                          | )          | (2,693 | ) |
|                                                                                         |       |                                             |       |   |   |
| **Cash  flows from financing activities:**                                                   |       |                                             |       |   |   |
| Change in book  overdraft                                                                    |       | (5,183                                           | )          | (6,083 | ) |
| Proceeds from  exercise of stock options                                                     |       | 609                                              |       | 2,088 |   |
| Excess tax  benefit from stock options                                                       |       | 509                                              |       | 11,410 |   |
| **Net  cash provided by (used in) financing activities**                                     |       | (4,065                                           | )          | 7,415 |   |
|                                                                                         |       |                                             |       |   |   |
| **Net  decrease in cash and cash equivalents**                                               |       | (3,870                                           | )          | (2,022 | ) |
| **Cash  and cash equivalents, beginning of period**                                          |       | 11,945                                           |       | 8,161 |   |
| **Cash  and cash equivalents, end of period**                                                |       | $                                                | 8,075      |   | $ | 6,139 |   |
|                                                                                         |       |                                             |       |   |   |
| **Supplemental  disclosure on cash flow information:**                                       |       |                                             |       |   |   |
| Cash paid during  the period for interest                                                    |       | $                                                | 9          |   | $ | 1 |   |
| Cash paid during  the period for income taxes                                                |       | 1,768                                            |       | 7,320 |   |
| 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  condensedconsolidated  financial statements havebeen prepared in accordance with accounting principles generally accepted inthe United States of America (“GAAP”) for interim financial information andwith the instructions to Form 10-Q and Article 10 of RegulationS-X.  Accordingly, they do not includeall of the information and footnotes required by GAAP for complete financialstatements.

 

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 of August 2,2008, the condensed consolidated statements of operations for the three and sixmonths ended August 2, 2008 and August 4, 2007, the condensedconsolidated statement of changes in shareholders’ equity for the six monthsended August 2, 2008 and the condensed consolidated statements of cashflows for the six months ended August 2, 2008 and August 4, 2007.

 

The financial data at February 2,2008 is derived from audited financial statements which are included in theCompany’s Annual Report on Form 10-K for the year ended February 2,2008, and should be read in conjunction with the audited financial statementsand notes thereto.  Interim results arenot necessarily indicative of results for the full year.

 

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

 

**Use 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. These estimates can also affect supplemental information disclosed bythe Company, including information about contingencies, risk, and financialcondition.  In preparing the financialstatements, the Company makes routine estimates and judgments in determiningthe net realizable value of accounts receivable, inventory, fixed assets,prepaid assets, goodwill and certain liabilities.  Some of the more significant estimatesinclude the allowance for sales returns, the reserve for inventory valuationestimates and the expected useful lives of fixed assets.  Actual results could differ from thoseestimates.  The results of operations forthe three and six months ended August 2, 2008 are not necessarilyindicative of the results that might be expected for fiscal 2008.  For further information, refer to the Company’sfinancial statements and notes included in the Company’s Form 10-K filedon 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 August 2, 2008, the Companyoperated 324 stores primarily located in shopping malls, giving the Company apresence in 28 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 2007” was the 52-week period ended February 2,2008.  The first six months of fiscal2008 was the 26-week period ended August 2, 2008.  The first six months of fiscal 2007 was the26-week period ended August 4, 2007. “Fiscal 2008” is the 52-week period ending January 31, 2009.

 

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**Revision to Previously IssuedStatements of Cash Flows**— For the six months ended August 4,2007, we have corrected the classification of changes in income tax receivablefrom changes in receivables to changes in income tax payable of $7.5 million toconform with the six months ended August 2, 2008 and fiscal 2007presentations.  There was no impact oncash used in operations for the six months ended August 4, 2007 or on thenet decrease in cash and cash equivalents on the statements of cash flows.  The Company has determined these adjustmentsare not material to the condensed consolidated financial statements.

 

**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—**AtAugust 2, 2008, marketable securities, classified as available for sale,were $60.4 million and consisted primarily of municipal and U.S. agency debtinstruments with original maturities over 90 days.  As of August 2, 2008, we had $1.8million invested, net of impairment charge of $0.2 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.  Historically,we have invested in these securities for short periods of time as part of ourcash management program.  However, therecent uncertainties in the credit markets have prevented us and otherinvestors from liquidating holdings of auction rate securities in recentauctions for these securities because the amount of securities submitted forsale 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 current creditrating is AA.  Although we are uncertainas to when 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 other comprehensive loss.  We continue to monitor the market for auctionrate securities and consider its impact, if any, on the fair market value ofthe investments.

 

**Receivables—** AtAugust 2, 2008 and February 2, 2008 the Company receivables includedthe following:

 
| ** **                    | ** ** | **August 2, 2008** | ** ** | **February 2, 2008** | ** ** |
|-------------------------------|------------|------------------------------|------------|--------------------------------|------------|
| Tenant  allowances receivable |       | $                            | 3,372      |                           | $          | 1,334 |   |
| Credit cards  receivable      |       | 3,459                        |       | 2,108                          |       |
| Interest  receivable          |       | 535                          |       | 557                            |       |
| Vendor credits                |       | 525                          |       | 212                            |       |
| Employee  receivables         |       | 197                          |       | 257                            |       |
| Other  receivables            |       | 188                          |       | 307                            |       |
|                          |       | $                            | 8,276      |                           | $          | 4,775 |   |

 

The Company does notextend credit to its customers except through independent third-party creditcards.

 

**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 of August 2,2008 and February 2, 2008 in the amounts of approximately$2.7 million and $3.0 million, respectively.  The inventory reserve includes inventorywhose estimated market value is below cost, and an estimate for inventoryshrinkage.

 

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These reserve amounts areevaluated quarterly.  The inventoryrelated to these reserves is not marked up in subsequent periods.

 

**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 fair value of certain assets andliabilities as financial instruments. Financial instruments are generally defined by SFAS No. 107 ascash, evidence of ownership interest in an entity, or a contractual obligationthat both conveys to one entity a right to receive cash or other financialinstruments from another entity and imposes on the other entity the obligationto deliver cash or other financial instruments to the first entity.  At August 2, 2008 and February 2,2008, the carrying amounts of cash and cash equivalents, receivables, payablesand other accrued liabilities approximated fair value because of the shortmaturity of these financial instruments. The carrying value of marketable securities, approximate the fair valuebecause these financial instruments have floating interest rates, which reflectcurrent market conditions.  Contractualmaturities of investments underlying our available-for-sale securities at August 2,2008 included $1.8 million in auction rate securities, net of $0.2 millionimpairment.  Based on current market conditions, auctions related to these securitiesmay be unsuccessful at the scheduled auctions in fiscal 2009. Unsuccessful auctions could result in our holding securities beyond their nextscheduled auction reset dates if a secondary market does not develop;therefore, limiting the short-term liquidity of 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 six month period ended August 4, 2007, the Companypreviously reported shipping costs on internet sales in selling, general andadministrative expense.  During the threeand six months ended August 4, 2007, the Company reclassifiedapproximately $94,000 and $176,000, respectively, of this expense to cost ofgoods sold.

 

**Stock Compensation—**EffectiveJanuary 29, 2006, the Company adopted the fair value method of accountingfor stock-based compensation arrangements in accordance with FinancialAccounting Standards Board (“FASB”) Statement No. 123(R), *Share-Based Payment* (“SFAS No. 123(R)”), using the modifiedprospective method of transition.  Underthe provisions of SFAS No. 123(R), the estimated fair value of share-basedawards granted under the 2005 Stock Incentive Plan is recognized ascompensation expense over the vesting period. Using the modified prospective method, compensation expense isrecognized beginning with the effective date of adoption of SFAS No. 123(R) forall share-based payments (i) granted after the effective date of adoptionand (ii) granted prior to the effective date of adoption and after theCompany’s initial public offering on May 5, 2005.  Prior to January 29, 2006, the Companyaccounted for stock-based employee compensation plans using the intrinsic valuemethod of accounting in accordance with Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to Employees (“APB 25”), and its relatedinterpretations.  Under the provisions ofAPB 25, no compensation expense was recognized when stock options were grantedwith exercise prices equal to or greater than market value on the date ofgrant.

 

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 sixmonth periods ended August 2, 2008.

 
| ** **                         | ** ** | **For the Six Months Ended** | ** ** |
|------------------------------------|------------|--------------------------------------------------|------------|
| ** **                         | ** ** | **August 2, 2008**                     | ** ** |
| Dividend yield                     |       | —                                           | %          |
| Volatility rate                    |       | 55.20                                            | %          |
| Average expected  life (in years): |       |                                             |       |
| Expected  lives-Five years         |       | 6.50                                             |       |
| Expected  lives-Four years         |       | 6.25                                             |       |
| Average  risk-free interest rate:  |       | 2.78                                             | %          |

 

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The following table summarizes the Company’s stockoption activity for the six months ended August 2, 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                 |       | 155                    |       | $                                       | 14.17      |   |
| Exercised year  to date               |       | (79                    | )          | $                                       | 3.45       |   |
| Forfeited year  to date               |       | (54                    | )          | $                                       | 32.73      |   |
| Outstanding at  August 2, 2008   |       | 1,980                  |       | $                                       | 18.26      |   |
| Exercisable at  August 2, 2008   |       | 684                    |       | $                                       | 10.33      |   |

 

During the six months ended August 2, 2008, theCompany granted 155,000 stock options with a Black-Scholes weighted averagefair value of $7.83 and an exercise price of $14.17.  In connection with these grants, the Companyrecognized approximately $222,000 of stock-based compensation expense for thesix months ended August 2, 2008.

 

The following table summarizes the Company’s restrictedstock activity for the six months ended August 2, 2008 (in thousandsexcept weighted-average exercise price):

 
| ** **                            | ** ** | **Restricted  Stock** | ** ** | **Grant Date  Weighted  Average  Fair Value** | ** ** |
|---------------------------------------|------------|-----------------------|------------|---------------------------------------------------------|------------|
| Outstanding at  February 2, 2008 |       | 16                    |       | $                                                       | 37.19      |   |
| Granted year to  date                 |       | 285                   |       | $                                                       | 14.33      |   |
| Vested year to  date                  |       | (3                    | )          | $                                                       | 38.19      |   |
| Forfeited year  to date               |       | (3                    | )          | $                                                       | 14.00      |   |
| Outstanding at  August 2, 2008   |       | 295                   |       | $                                                       | 16.37      |   |

 

During the six months ended August 2, 2008, theCompany granted approximately 285,000 shares of restricted stock with a weightedaverage fair market value on the date of grant of $14.33 per share.  In connection with these grants, the Companyrecognized approximately $325,000 in stock-based compensation expense duringthe six months ended August 2, 2008. There were 10,000 shares of performance-based restricted stock includedin the calculation of stock-based compensation expense for the six months endedAugust 2, 2008.

 

During the six months ended August 2, 2008, theCompany issued 40,000 shares of performance-based restricted stock that willvest between 0% and 100% based upon a predetermined earnings milestone.  If performance-based milestones are not met,the restricted stock will not vest, in which case, any compensation expense wehave recognized to date will be reversed.

 

The Company recorded approximately $1.2 million and$2.1 million of total stock-based compensation expense for the three and sixmonths ended August 2, 2008, of which approximately $0.1 million and $0.3million, respectively, was attributable to the Board of Directors.  The Company recorded approximately $1.4million and $2.2 million of stock-based compensation for the three and sixmonths ended August 4, 2007, of which approximately $0.4 million and $0.5million, 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’s reportedcash flows.  For the six months ended August 2,2008 and August 4, 2007, the Company recorded approximately $40,000 and$80,000, respectively, in stock-based compensation expense pursuant to APB25.  At August 2, 2008 and February 2,2008, there was approximately $10.3 million and $9.2 million, respectively, oftotal unrecognized compensation cost related to unvested stock options andrestricted stock grants of

 

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which approximately $0.4 million and $0.5 million,respectively, was attributable to the Board of Directors.  This cost is expected to be recognized over aweighted-average period of approximately three to eight years.  The Company accounts for unvested stock-basedemployee compensation arrangements granted prior to its initial public offeringon the intrinsic value method in accordance with the provisions of APB No. 25,and related amendments and interpretations.

 

**Goodwill** — Inaccordance with Statement of Financial Accounting Standards No. 142, “*Accounting for Goodwill and Other Intangible Assets”* (“SFAS No. 142”),the Company does not amortize goodwill derived from purchase businesscombinations.  The Company evaluates therecoverability of goodwill annually based on a two-step impairment test.  The first step compares the fair value ofeach reporting unit with its carrying amount, including goodwill.  If the carrying amount exceeds fair value,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 six months ended August 2, 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 ValueMeasurements,”*for nonfinancial assets and nonfinancial liabilities,except for items that are recognized or disclosed at fair value in the financialstatements on a recurring basis (at least annually).  Nonfinancial assets and nonfinancialliabilities would include all assets and liabilities other than those meetingthe definition of a financial asset or financial liability as defined inparagraph 6 of SFAS No. 159, “The Fair Value Option for Financial Assetsand Financial Liabilities.”  This FASBStaff Position defers the effective date of Statement 157 to fiscal yearsbeginning after November 15, 2008, and interim periods within those fiscalyears for items within the scope of FSP No. FAS 157-2.  We are currently evaluating the effects, ifany, that FSP No. SFAS 157-2 may have on our condensed consolidatedfinancial statements.

 

In February 2007,the FASB issued SFAS No. 159, *“The Fair Value Option forFinancial Assets and Financial Liabilities”* including an amendmentof FASB Statement No. 115, which provides entities with an option toreport selected financial assets and liabilities at fair value.  SFAS No.159 also establishes presentation anddisclosure requirements designed to facilitate comparisons between entitiesthat choose different measurement attributes for similar types of assets andliabilities.  This statement is effectiveas of the beginning of the first fiscal year that begins after November 15,2007.  At the effective date, an entitymay elect the fair value option for eligible items that exist at thatdate.  The entity shall report the effectof the first re-measurement to fair value as a cumulative-effect adjustment tothe opening balance of retained earnings. The Company has not elected the fair value option for eligible itemsthat existed as of February 3, 2008.

 

In December 2007,the FASB issued SFAS No. 141 (revised 2007), *“BusinessCombinations”* (“SFAS No, 141(R)”), which replaces SFAS No. 141,*“Business Combinations”* (“SFAS No. 141”).  SFAS No. 141(R) retains theunderlying concepts of SFAS No. 141 in that all business combinationsare still required to be accounted for at fair value under the acquisitionmethod of accounting but SFAS No. 141(R) changed the method ofapplying the acquisition method in a number of significant aspects.  Acquisition costs will generally be expensedas incurred; non-controlling interests will be valued at fair value at theacquisition date; in-process research and development will be recorded at fairvalue as an indefinite-lived intangible asset at the acquisition date;restructuring costs associated with a business combination will generally beexpensed subsequent to the acquisition date; and changes in deferred tax assetvaluation allowances and income tax uncertainties after the acquisition dategenerally will affect income tax 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) amendsSFAS No. 109, “Accounting for Income Taxes,” such that adjustments made tovaluation allowances on deferred taxes and acquired tax contingenciesassociated with acquisitions that closed prior to the effective date ofSFAS No. 141(R) would also apply the 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 Financial Statements” and requires (i) classificationof non-controlling interests, commonly referred to as minority interests,within stockholders’ equity, (ii) net income to include the net incomeattributable to the non-controlling interest and (iii) enhanced disclosureof activity related to

 

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non-controllinginterests.  SFAS No. 160 iseffective for fiscal years beginning after December 15, 2008.  We will evaluate the impact, if any, that theadoption of SFAS No. 160 could have on our condensed consolidatedfinancial 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 FASB No. 142,*Goodwill and Other Intangible Assets*.The intent of FSP 142-3 is to improve the consistency between the useful lifeof a recognized intangible asset under SFAS No. 142 and the period ofexpected cash flows used to measure the fair value of the asset under SFAS No. 141(R) andother U.S. generally accepted accounting principles. The Company does notexpect the adoption of FSP 142-3 to have a material effect on its consolidatedfinancial position or results of operations.

 

In May 2008, theFASB issued SFAS No. 162, *“The Hierarchy ofGenerally Accepted Accounting Principles”* (“SFAS 162”).  SFAS162 identifies the sources of accounting principles and the framework forselecting the principles to be used in the preparation of financial statementsof nongovernmental entities that are presented in conformity with generally acceptedaccounting principles.  SFAS 162 iseffective 60 days following the Securities and Exchange Commission’sapproval of the Public Company Accounting Oversight Board Auditing amendmentsto AU Section 411, “The Meaning of**PresentFairly in Conformity with Generally Accepted Accounting Principles.”  Thisstatement will not have an impact on the Company’s condensed consolidatedfinancial statements.

 

**3. Commitments and Contingencies**

 

**Leases**—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 six month periods ended August 2, 2008 and August 4,2007 (in thousands) are as follows:

 
| ** **                         | ** ** | **For the Three Months Ended** | ** ** | **For the Six Months Ended** | ** ** |
|------------------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                         | ** ** | **August 2, 2008**                       | ** ** | **August 4, 2007**                     | ** ** | **August 2, 2008** | ** ** | **August 4, 2007** | ** ** |
| Store base rent  expense           |       | $                                                  | 7,308      |                                             | $          | 5,708 |   | $ | 14,095 |   | $ | 11,169 |   |
| Other base rent  expense           |       | 243                                                |       | 244                                              |       | 486 |   | 487 |   |
| Total base rent  expense           |       | 7,551                                              |       | 5,952                                            |       | 14,581 |   | 11,656 |   |
| Contingent and  other rent expense |       | 4,915                                              |       | 4,231                                            |       | 9,368 |   | 7,851 |   |
| Total rent  expense                |       | $                                                  | 12,466     |                                             | $          | 10,183 |   | $ | 23,949 |   | $ | 19,507 |   |

 

**Litigation—** On December 10,2007, a putative class action complaint was filed in the U.S. District Courtfor the Western District of Washington against the Company and certain of itscurrent and former directors and officers.  The complaint asserts claimsunder Sections 10(b), 20(a), and 20A of the Securities Exchange Actof 1934, as amended, and Rule 10b-5.   A substantially similarcomplaint was filed in the same court on December 14, 2007.  Thesecases, which were subsequently consolidated, purported to be brought on behalfof a class of purchasers of the Company’s stock during the period March 14,2007 to November 7, 2007.  Plaintiffs fileda consolidated amended complaint on May 5, 2008, extending theclass period to January 4, 2008, and alleging that the defendants violatedthe federal securities laws during this period of time by, among other things,making misrepresentations about the Company’s projected financial results inorder to artificially inflate the Company’s stock price.  Plaintiffs areseeking compensatory damages in an unspecified amount, interest, and an awardof attorneys’ fees and costs.

 

On July 21, 2008,defendants filed a motion to dismiss the amended complaint.  Plaintiffs have until September 19, 2008to oppose that motion, and defendants reply is due on or before October 20,2008.

 

In addition, on December 20,2007, a shareholder derivative action was filed in the Superior Court of theState of Washington (Snohomish County), allegedly on behalf of and for thebenefit of the Company, against certain of the Company’s current directors andcurrent and former officers.  The Company was named as a nominaldefendant.  The derivative complaint is based on the same allegations offact as in the securities class action, and claims that the defendant directorsand officers breached fiduciary duties, abused their control, engaged in grossmismanagement, wasted corporate assets, unjustly enriched themselves, andengaged in insider trading.  The complaint seeks unspecified damages,restitution, disgorgement of profits, equitable and injunctive relief,attorneys’ fees, costs, and expenses.  Because the complaint is derivativein nature, it does not seek monetary damages from the Company.  However,the Company may be required throughout the pendency of the action

 

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to advance the legal feesand costs incurred by the defendant directors and officers.  Under theterms of its corporate bylaws and related indemnity agreements, the Company isobligated to indemnify all current and former officers and directors involvedin civil, criminal, or investigative matters, in connection with theirservice.  The Company is also obligatedto advance fees and expenses, but only if the involved officer or directoracted in “good faith.”  There is no limit on the indemnification paymentsthe Company could 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 on June 27,2008.  Before Zumiez was to file itsreply, it agreed with the plaintiff to stay the derivative action pending theoutcome of the motion to dismiss in the federal securities action.  On August 3, 2008 the court overseeingthe 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 insurance claims based on historical claims experienceand 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”), which defines fair value, establishes a framework for measuringfair value, and expands disclosure about fair value measurements under SFAS 157is as follows:

 

·                  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.

 

The following tablesummarizes assets measured at fair value on a recurring basis at August 2,2008, as required by SFAS 157:

 
| ** **             | ** ** | **Level 1**        | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
|------------------------|------------|-------------------------|------------|------------------|------------|------------------|------------|
| ** **             |       | **(in thousands)** | ** ** |
| Marketable  securities |       | $                       | —     |             | $          | 58,516           |       | $ | 1,847 |   |
|                        |            |                         |            |                  |            |                  |            |  |  |  |

 

The $1.8 million in Level3 marketable securities represents two $1.0 million auction rate securities netof impairment charge of $0.2 million. One of these $1.0 million securities failed to sell at its scheduledauction in March 2008.  The interestrate of this 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.

 

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Accordingly, thesesecurities are classified as Level 3 within SFAS 157’s valuation hierarchy since the Company’sinitial adoption of SFAS 157 at February 3, 2008.  These assumptions, assessments and theinterpretations of relevant market data are subject to uncertainties, aredifficult to predict and require significant judgment.  The use of different assumptions, applyingdifferent judgment to inherently subjective matters and changes in futuremarket conditions could result in significantly different estimates of fairvalue.

 

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 $0.2 million toaccumulated other comprehensive loss in the condensed consolidated balancesheet as of August 2, 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 of operations.  Due to the Company’s belief that the marketfor these investments may take in excess of twelve months to fully recover, theCompany has classified them as noncurrent assets on the accompanying condensedconsolidated balance sheet as of August 2, 2008.

 

The $58.5 million inLevel 2 marketable securities includes corporate and municipal bonds traded inthe over-the-counter market.  Fair valuesare based on quoted market prices for similar assets or liabilities ordetermined using inputs that use as their basis readily observable market datathat are actively quoted and can be validated through external sources,including third-party pricing services, brokers, and market transactions.

 

The following table presentsthe changes in the Level 3 fair-value category for the six months ended August 2,2008.  The Company classifies financialinstruments in Level 3 of the fair-value hierarchy when there is reliance on atleast one significant unobservable input to the valuation model.  In addition to these unobservable inputs, thevaluation models for Level 3 financial instruments may also rely on a number ofinputs that are readily observable either directly or indirectly.

 
| ** **             | ** ** | **February 2,**    | ** ** | **Transfers in  and/or (out) of** | ** ** | **Total unrealized  loss included in  Accumlated  Comprehensive** | ** ** | **August 2,** | ** ** |
|------------------------|------------|-------------------------|------------|--------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|--------------------|------------|
| ** **             | ** ** | **2008**                | ** ** | **Level 3**                                 | ** ** | **Loss**                                                                         | ** ** | **2008**           | ** ** |
|                   |       | **(in thousands)** |       |
| Marketable  securities |       | $                       | —     |                                             | $          | 2,000                                                                            |       | $                  | (153       | ) | $ | 1,847 |   |
|                        |            |                         |            |                                                  |            |                                                                                  |            |                    |            |  |  |  |  |

 

**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 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 periodreported.  Total common stock options notincluded in the calculation of diluted earnings per share were 861,712 and5,000 for the three and six months ended August 2, 2008 and August 4,2007, respectively.  There were 251,024and 207,825 of non-vested restricted shares included in the calculation ofdiluted earnings per share for the three and six months ended August 2,2008, respectively.

 

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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 Six Months Ended** | ** ** |
|------------------------------------------------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                       | ** ** | **August 2, 2008**                       | ** ** | **August 4, 2007**                     | ** ** | **August 2, 2008** | ** ** | **August 4, 2007** | ** ** |
| Net income                                                       |       | $                                                  | 2,727      |                                             | $          | 3,118 |   | $ | 4,089 |   | $ | 4,735 |   |
| Weighted average  common shares for basic net income per share   |       | 29,072,536                                         |       | 28,540,326                                       |       | 29,042,861 |   | 28,478,125 |   |
| Dilutive effect  of stock options and restricted stock           |       | 306,053                                            |       | 645,944                                          |       | 331,154 |   | 616,109 |   |
| Weighted average  common shares for diluted net income per share |       | 29,378,589                                         |       | 29,186,270                                       |       | 29,374,015 |   | 29,094,234 |   |
| Basic net income  per share                                      |       | $                                                  | 0.09       |                                             | $          | 0.11 |   | $ | 0.14 |   | $ | 0.17 |   |
| Diluted net  income per share                                    |       | $                                                  | 0.09       |                                             | $          | 0.11 |   | $ | 0.14 |   | $ | 0.16 |   |

 

6**. Goodwill—**In connection with the acquisition of Action Concepts Fast Forward, Ltd., on June 24,2006 the Company recorded goodwill in accordance with SFAS 141 *“Business Combinations.” * During the quarter ended August 2, 2008,the Company released $250,000 of restricted cash held in escrow that waspayable to Action Concepts Fast Forward, Ltd. The Company recorded $13.2 million of goodwill as the excess of thepurchase price of $15.5 million over the fair value of the net amounts assignedto assets acquired and liabilities assumed. In accordance with SFAS 142, *“Goodwill and OtherIntangible Assets,”* the Company will continue to assess, inaccordance with our “goodwill” policy as stated in Note 2, whether goodwill isimpaired.

 

**7. Related Party Transactions—**The Company committedcharitable contributions to Zumiez Foundation in the six months ended August 2,2008 of approximately $43,000.  TheCompany committed charitable contributions to the Zumiez Foundation in the sixmonths ended August 4, 2007 of approximately $210,000.

 

**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-lookingstatements that involve risks and uncertainties.  Our actual results could differ materiallyfrom those anticipated in these forward-looking statements as a result ofvarious factors, including those discussed in the section entitled “RiskFactors” in our Form 10-K filed with the SEC on March 25, 2008 and inthis Form 10-Q.*

 

*Forward-looking statements arebased on our expectations regarding net sales, selling, general andadministrative expenses, profitability, financial position, businessstrategy, new store openings, and plans and objectives of management.  The words “believe,” “may,” “will,” “estimate,”“continue,” “anticipate,” “intend,” “expect” and similar expressions, as theyrelate to us and our business, industry, markets and consumers, are intended toidentify forward-looking statements.  Wehave based these forward-looking statements largely on our current expectationsand projections about future events and financial trends that we believe mayaffect our financial condition, results of operations, business strategy andfinancial needs.  These forward-lookingstatements are subject to a number of risks, uncertainties and assumptions,including, among others, those described in “Risk Factors” and elsewhere inthis quarterly report and in the Form 10-K referred to in the precedingparagraph.  New risk factors emerge from time to time and it is notpossible for our management to predict all risk factors, nor can we assess theimpact of all factors on our business or the extent to which any factor, orcombination of factors, may cause actual results to differ materially fromthose contained in any forward-looking statements.  We assume no obligation to update anyforward-looking statements as a result of new information, future eventsor developments.  References in thefollowing discussion to “we”, “us”, “our”, “the Company” and similar referencesmean Zumiez Inc. and its consolidated subsidiary, unless otherwise expresslystated or the context otherwise requires.*

 

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**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 constitutegross sales net of estimated returns. Net sales include our in-store sales and our internet sales and,accordingly, information in this quarterly report with respect to comparablestore sales includes internet sales.  Ourinternet sales 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, facilityexpenses, training, advertising and marketing costs.  Credit card fees, insurance and other miscellaneousoperating costs are also included in selling, general and administrativeexpenses.  This may not be comparable tothe way in which our competitors or other retailers compute their selling,general and administrative expenses.

 

**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 consistentlyapplied.  Inherent in the nature of anestimate or assumption is the fact that actual results may differ fromestimates and estimates 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 and Non-MarketableSecurities*.  Weperiodically review our marketable securities for impairment.   If we conclude that any of these investmentsare impaired, we determine whether such impairment is “other-than-temporary” asdefined under FSP 115-1.  Factors weconsider to make such a determination include the duration and severity ofthe impairment, as well as the reason for the decline in value andthe potential recovery period.  If anyimpairment is considered “other-than-temporary,” we will write down the assetto its fair value and take a corresponding charge to our consolidated statementof operations.

 

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*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 on the fair value of theasset or group of assets.  Generally,fair value will be determined using valuation techniques, such as the expectedpresent value of future cash flows.  Theactual economic lives of these assets may be different than our estimateduseful lives, thereby resulting in a different carrying value.  These evaluations could result in a change inthe depreciable lives of those assets and therefore our depreciation expense infuture 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 financial statements,income taxes are estimated for each of the jurisdictions in which weoperate.  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.

 

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 of August 2,2008.  In the event that actual resultsdiffer from these estimates, or these estimates are adjusted in future periods,a valuation allowance may need to be established, which could impact ourfinancial position and results of operations. The Company adopted the provisions of FASB Interpretation No. 48, *“Accounting for Uncertainty 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*.  Effective January 29, 2006, we adoptedthe fair value method of accounting for stock-based compensation arrangementsin accordance with FASB Statement No. 123(R), Share-Based Payment (“SFAS No. 123(R)”),using the modified prospective method of transition.  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 vestingperiod.  Using the modified prospectivemethod, compensation expense is recognized beginning with the effective date ofadoption of SFAS No. 123(R) for all share-based issuances (i) grantedafter the effective date of adoption and (ii) granted prior to theeffective date of adoption and after our initial public offering on May 5,2005.  Prior to January 29, 2006, weaccounted for stock-based employee compensation plans using the intrinsic valuemethod of accounting in accordance with Accounting Principles Board Opinion No. 25,*“Accounting for Stock Issued to Employees”*(“APB 25”), and its related 

 

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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 of grant.

 

We account for unvestedstock-based employee compensation arrangements granted prior to our initialpublic offering on the intrinsic value method as allowed by SFAS 123(R).

 

**Resultsof 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 Six Months Ended** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                    | ** ** | **August 2, 2008**                       | ** ** | **August 4, 2007**                     | ** ** | **August 2, 2008** | ** ** | **August 4, 2007** | ** ** |
| Net  sales                                    |       | 100.0                                              | %          | 100.0                                            | %          | 100.0 | % | 100.0 | % |
| Cost  of goods sold                           |       | 67.4                                               |       | 65.6                                             |       | 68.0 |   | 66.9 |   |
| Gross  profit                                 |       | 32.6                                               |       | 34.4                                             |       | 32.0 |   | 33.1 |   |
| Selling,  general and administrative expenses |       | 28.4                                               |       | 28.7                                             |       | 28.7 |   | 28.5 |   |
| Operating  profit                             |       | 4.2                                                |       | 5.7                                              |       | 3.3 |   | 4.6 |   |
| Interest  income, net                         |       | 0.6                                                |       | 0.4                                              |       | 0.6 |   | 0.5 |   |
| Earnings  before income taxes                 |       | 4.8                                                |       | 6.1                                              |       | 3.9 |   | 5.1 |   |
| Provision  for income taxes                   |       | 1.8                                                |       | 2.3                                              |       | 1.5 |   | 2.0 |   |
| Net  Income                                   |       | 3.0                                                | %          | 3.8                                              | %          | 2.4 | % | 3.1 | % |

 

**Three Months (13 weeks) Ended August 2,2008 Compared With Three Months (13 weeks) Ended August 4, 2007**

 

***NetSales***

 

Net sales increased to $92.3 million for thethree months ended August 2, 2008 from $82.0 million for the threemonths ended August 4, 2007, an increase of $10.3 million, or 12.5%.

 

Comparable store net sales decreased 1.7% for thethree months ended August 2, 2008 compared to the three months ended August 4,2007.  The decrease in comparable storenet sales was primarily due to lower net sales of juniors apparel, men’sapparel, and accessories partially offset by higher net sales of footwearand skate hardgoods.  For information asto how we define comparable stores, see “General” above.

 

The increase in total netsales was due to an increase in net sales from non-comparable stores ofapproximately $11.7 million partially offset by a decrease in comparablestore net sales of approximately $1.4 million. The increase in non-comparable store net sales was primarily due to theopening of 58 new stores subsequent to August 4, 2007.

 

***GrossProfit***

 

Gross profit for thethree months ended August 2, 2008 was $30.1 million compared with$28.2 million for the three months ended August 4, 2007, an increase ofapproximately $1.9 million, or 6.8%. As a percentage of net sales, gross profit decreased to 32.6% for thethree months ended August 2, 2008 from 34.4% for the three months ended August 4,2007.  The reduction in gross profit as apercent of net sales was driven by store occupancy costs growing at a fasterrate than sales and to a lesser extent a decline in gross margin on apparelproducts.

 

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

 

Selling, general andadministrative, or “SG&A” expenses in the three months ended August 4,2008 were $26.2 million compared with $23.5 million in the threemonths ended August 4, 2007, an increase of $2.7 million, or11.5%.  This increase was primarily theresult of costs associated with operating new stores and to a lesser extentincreases in infrastructure and administrative staff to support ourgrowth.  As a percentage of net sales,SG&A expenses decreased to 28.4% in the three months ended August 2,2008 from 28.7% in the three months ended August 4, 2007.  The decrease in SG&A expenses as apercentage of net sales was primarily attributable to a decrease in stock-basedcompensation, incentive compensation and 

 

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credit card feespartially offset by increased store payroll and payroll related costs,additional depreciation on new stores and administrative support for new storegrowth.

 

***OperatingProfit***

 

As a result of the abovefactors, operating profit was $3.9 million in the three months ended August 2,2008 compared with $4.7 million in the three months ended August 4, 2007,a decrease of $0.8 million or 16.8%.  Asa percentage of net sales, operating profit was 4.2% in the three months ended August 2,2008 compared with 5.7% in the three months ended August 4, 2007.

 

***Provisionfor Income Taxes***

 

Provision for incometaxes was $1.7 million for the three months ended August 2, 2008compared with $1.9 million for the three months ended August 4, 2007.  Our income tax rate was relatively consistentfor both referenced periods.

 

***NetIncome***

 

Net income was $2.7million in the three months ended August 2, 2008 compared to $3.1 millionin the three months ended August 4, 2007, a decrease of $0.4 million, or12.5%.  As a percentage of net sales, netincome was 3.0% in the three months ended August 2, 2008 compared with3.8% in the three months ended August 4, 2007.

 

**Six Months (26 weeks) Ended August 2, 2008 Compared WithSix Months (26 weeks) Ended August 4, 2007**

 

***Net Sales***

 

Netsales increased to $171.0 million for the six months ended August 2,2008 from $150.8 million for the six months ended August 4, 2007, anincrease of $20.2 million, or 13.4%.

 

Comparablestore net sales decreased by 1.3% for the six months ended August 2, 2008compared to the six months ended August 4, 2007.  The decrease in comparable store net saleswas primarily due to lower net sales of men’s apparel, juniors apparel andaccessories partially offset by higher net sales of footwear and skatehardgoods.  For information as to how wedefine comparable stores, see “General” above.

 

Theincrease in total net sales was due to an increase in non-comparable store netsales of approximately $22.2 million partially offset by a decrease in netsales from comparable stores of approximately $2.0 million.  The increase in non-comparable store netsales was primarily due to the opening of 58 new stores subsequent to August 4,2007.

 

***Gross Profit***

 

Grossprofit for the six months ended August 2, 2008 was $54.7 million comparedwith $49.9 million for the six months ended August 4, 2007, an increase of $4.8million, or 9.5%.  As a percentage of netsales, gross profit decreased to 32.0% for the six months ended August 2,2008 from 33.1% for the six months ended August 4, 2007.  The decline in gross profit as a percent ofnet sales was driven primarily by store occupancy costs growing at a fasterrate than sales.

 

***Selling, General and AdministrativeExpenses***

 

Selling, general andadministrative, “SG&A,” expenses for the six months ended August 2,2008 were $49.1 million compared with $43.0 million in the six monthsended August 4, 2007, an increase of $6.1 million, or 14.2%.  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 compensation and incentive compensationexpenses.  As a percentage of net sales,SG&A expenses increased to 28.7% in the six months ended August 2,2008 from 28.5% in the six months ended August 4, 2007.  The increase in SG&A expenses as apercentage 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.

 

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***OperatingProfit***

 

As aresult of the above factors, operating profit decreased to $5.5 million for thesix months ended August 2, 2008 compared with $6.9 million for the sixmonths ended August 4, 2007 a decrease of $1.3 million, or 19.6%.  As a percentage of net sales, operatingprofit was 3.3% and 4.6% for the six months ended August 2, 2008 and August 4,2007, respectively.

 

***Provision for Income Taxes***

 

Provisionfor income taxes was $2.5 million for the six months ended August 2,2008 compared with $2.9 million for the six months ended August 4, 2007.

 

***Net Income***

 

Netincome decreased to $4.1 million for the six months ended August 2, 2008from net income of $4.7 million for the six months ended August 4, 2007, adecrease of $0.6 million or 13.6%.  As apercentage of net sales, net income was 2.4% and 3.1% for the six months ended August 2,2008 and August 4, 2007, respectively.

 

**Liquidity and Capital Resources**

 

Our primary capitalrequirements are for inventory, store fixtures, store construction andremodeling, capital investments and ongoing infrastructure improvements such astechnology enhancements and distribution capabilities.  Historically, our main sources of liquidityhave been cash flows from operations, borrowings under our revolving creditfacility and proceeds from the sale of our equity 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 August 2,2008, we held two $1.0 million Auction Rate Securities valued at$1.8 million, net of approximately $0.2 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, the recent uncertainties in thecredit markets have prevented us and other investors from liquidating holdingsof auction rate securities in recent auctions for these securities because theamount of securities submitted for sale has exceeded the amount of purchaseorders.  If the March 2009 and May 2009auctions fail, we plan to hold these securities until the next auction date andthe securities coupon rate will reset to a prescribed “failure” rate.  Unsuccessful auctions could result in ourholding securities beyond their next scheduled auction reset dates if asecondary market does not develop; therefore, limiting the short-term liquidityof these investments.  These securitieshave been reclassified from “current” to “long term” assets on our condensedconsolidated balance sheet as of August 2, 2008.

 

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 $33.0 to $35.0 million on capitalexpenditures, a majority of which will relate to leasehold improvements andfixtures for the 57 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 

 

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additional equity or debtfinancing in the future.  There can be noassurance that equity or debt financing will be available to us when we need itor, if available, that the terms will be satisfactory to us and not dilutive toour then-current shareholders.

 

Net cash provided byoperating activities for the six months ended August 2, 2008 wasapproximately $15.7 million primarily related to increased trade accountspayable, taxes payable, depreciation and deferred rent, partially offset by anincrease in inventory and receivables. Net cash used in operating activities for the six months ended August 4,2007 was $6.7 million primarily related to an increase in inventory andreceivables partially offset by an increase in trade accounts payable and anincrease in depreciation.

 

Net cash used ininvesting activities was $15.5 million for the six months ended August 2,2008, related to $19.0 million of capital expenditures for new store openingsand existing store renovations partially offset by the $3.5 million in netsales of marketable securities.  Net cashused in investing activities was $2.7 million for the six months ended August 4,2007, related to capital expenditures for new store openings and existing storerenovations predominately offset by the net sales of marketable securities.

 

Net cash used infinancing activities for the three months ended August 4, 2008 was $4.1million 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 three months ended August 4, 2007 was $7.4 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 securedrevolving credit facility provides for the issuance of standby commercialletters of credit in an amount not to exceed $5.0 million outstanding at anytime and with a term not to exceed 365 days, although the amount of borrowingsavailable at any time under our secured revolving credit facility is reduced bythe amount of standby letters of credit outstanding at that time.  There were no outstanding borrowings underthe secured revolving credit facility at August 2, 2008 or February 2,2008.  The Company had open letters ofcredit outstanding under our secured revolving credit facility of $3.6 millionat August 2, 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(5.00% at August 2, 2008) minus 0.50% or the LIBOR rate (3.26% at August 2,2008), plus 1.00% for advances over $500,000 for a minimum of 30 days anda maximum of 180 days.  The creditagreement contains a number of restrictions and covenants that generally limitour ability to, among other things, (1) incur additional debt, (2) undergoa change in ownership and (3) enter into certain transactions.  The credit agreement also contains financialcovenants that require us to meet certain specified financial tests and ratios,including, minimum net income after taxes, maximum total liabilities divided bytangible net worth and minimum quick asset ratio.  All of our personal property, including,among other things, our inventory, equipment and fixtures, has been pledged tosecure our obligations under the credit agreement.  We must also provide financial informationand statements to our lender.  We were incompliance with all such covenants at August 2, 2008.

 

**Contractual Obligations andCommercial Commitments**

 

There was no materialchanges outside the ordinary course of business in our contractual obligationsduring the three months ended August 2, 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 August 2, 2008:

 
| **Contractual Obligations** | ** ** | **Total** | ** ** | **Less than  1 Year** | ** ** | **1- 3 Years** | ** ** | **3-5 Years** | ** ** | **More than  5 Years** | ** ** |
|----------------------------------|------------|-----------|------------|---------------------------------|------------|--------------------------|------------|--------------------|------------|----------------------------------|------------|
| Operating Lease  Obligations     |       | $         | 265,540    |                            | $          | 16,273                   |       | $                  | 65,255     |                             | $          | 61,264 |   | $ | 122,748 |   |
| Purchase  Obligations            |       | 95,127    |       | 95,127                          |       | —                   |       | —             |       | —                           |       |
| Letters of  Credit               |       | 3,563     |       | 3,563                           |       | —                   |       | —             |       | —                           |       |
|                             |       | $         | 364,230    |                            | $          | 114,963                  |       | $                  | 65,255     |                             | $          | 61,264 |   | $ | 122,748 |   |

 

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, 

 

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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 $23.9 million and $19.5 millionfor the six months ended August 2, 2008 and August 4, 2007,respectively.

 

At August 2, 2008,we had outstanding purchase orders to acquire merchandise from vendors ofapproximately $95.1 million.  Wehave an option to cancel these commitments with no notice prior toshipment.  At August 2, 2008, we hadapproximately $3.6 million of letters of credit outstanding.

 

**Off-Balance Sheet Obligations**

 

Our only off-balancesheet contractual obligations and commercial commitments as of August 2,2008 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 August 2, 2008, we had outstandingpurchase orders to acquire merchandise from vendors for approximately$95.1 million.  These purchases areexpected to be financed by cash flows from operations and borrowings under oursecured revolving credit facility.  Wehave an option to cancel these commitments with no notice prior toshipment.  At August 2, 2008, we had$3.6 million of letters of credit outstanding under our secured revolvingcredit facility.  At August 2, 2008,we were committed to property owners for operation lease obligations in theamount of $265.5 million.  Most of ourleases contain cancellation or kick-out clauses in our favor that relieve usfrom any future obligation under a lease if specified sales levels are notachieved 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 andcould result in a complete loss of your investment.  Additional risks and uncertainties that arenot yet identified or that we currently think are immaterial may also harmour business and financial condition in the future.*

 

***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 baseannually.  In addition, our proposedexpansion will place increased demands on our operational, managerial andadministrative resources.  Theseincreased demands could cause us to operate our business less effectively,which in turn could cause deterioration in the financial performance of ourindividual stores and our overall business. To the extent our new store openings are in markets where we alreadyhave stores, we may experience reduced net sales in existing stores inthose markets.  In addition, successfulexecution of our growth strategy may require that we obtain additionalfinancing, and we cannot assure you that we will be able to obtain that financingon acceptable terms or at all.

 

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***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 newstores;

 

·         hire, trainand retain store personnel;

 

·         successfullyintegrate new stores into our existing operations; and

 

·         identify andsatisfy 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.

 

***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 

 

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year.  Any unanticipated decreasein demand for our products during these peak shopping seasons could require usto sell excess inventory at a substantial markdown, which could have a materialadverse effect on our business, results of operations 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:

 

·         the timingof new store openings and the relative proportion of our new stores to maturestores;

 

·         whether weare 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;

 

·         changes inour merchandise mix;

 

·         timing ofpromotional events;

 

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

 

·         actions bycompetitors or mall anchor tenants;

 

·         weatherconditions;

 

·         the level ofpre-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 in assimilatingany stores or businesses we may acquire, and any such acquisitions may alsoresult in the diversion of our capital and our management’s attention fromother 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 integrateacquisitions or if such acquisitions fail to provide the benefits that weexpect to receive, we could experience increased costs and other operatinginefficiencies, which could have an adverse effect on our results of operationsand financial performance.

 

***Ourbusiness is susceptible to weather conditions that are out of our controlincluding the potential risks of unpredictable weather patterns, includingany weather patterns associated with global warming, and the resultantunseasonable weather 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.

 

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***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, hardgoods and accessories industry is highlycompetitive.  We compete with otherretailers for vendors, teenage and young adult customers, suitable storelocations, qualified store associates and management personnel.  In the softgoods market which includesapparel, accessories and footwear, we currently compete with a large number ofother teenage-focused retailers.  Inaddition, in the softgoods market we compete with independent specialty shops,department stores, and direct marketers that sell similar lines of merchandiseand target customers through catalogs and e-commerce.  In the hardgoods market which includesskateboards, snowboards, bindings, components and other equipment, we competedirectly or indirectly with the following categories of companies: otherspecialty retailers that compete with us across a significant portion of ourmerchandising categories, such as local snowboard and skate shops, large-formatsporting goods stores and chains and internet retailers.

 

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.

 

***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 President and Chief ExecutiveOfficer, Richard M. Brooks, our Chief Financial Officer, Trevor S. Lang, ourExecutive Vice President and General Merchandising Manager,Lynn K. Kilbourne and our Executive Vice President of Stores, Ford K.Wright.  None of our employees, except Mr. Brooks,has an employment agreement with us and we do not plan to obtain key personlife insurance covering any of our employees. If we lose the services of one or more of our key executives, wemay not be able to successfully manage our business or achieve our growthobjectives.  As our business grows, wewill need to attract and retain additional qualified management personnel in atimely manner and we may not be able to do so.

 

***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 in part uponour ability to attract, motivate and retain a sufficient number of qualifiedemployees, including regional managers, district managers, store managers andstore associates, who understand and appreciate our corporate culture based ona passion for the action sports lifestyle and are able to adequately representthis culture to our customers.  Qualifiedindividuals of the requisite caliber, skills and number needed to fill thesepositions may be in short supply in some areas, and the employee turnoverrate in the retail industry is high. Competition for qualified employees could require us to pay higher wagesto attract a sufficient number of suitable employees.  If we are unable to hire and retain storemanagers and store associates capable of consistently providing a high level ofcustomer service, as demonstrated by their enthusiasm for our culture andknowledge of our merchandise, our ability to open new stores may be 

 

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impaired and theperformance of our existing and new stores could be materially adverselyaffected.  We are also dependent upontemporary personnel to adequately staff our stores and distribution center,particularly during busy periods such as the back-to-school and winter holidayseasons.  There can be no assurance thatwe will receive adequate assistance from our temporary personnel, or that therewill be sufficient sources of temporary personnel.  Although our employees are not currentlycovered by collective bargaining agreements, we cannot guarantee that ouremployees will not elect to be represented by labor unions in the future, whichcould increase our labor costs and could subject us to the risk of work stoppages andstrikes.  Any such failure to meet ourstaffing needs, any material increases in employee turnover rates, anyincreases in labor costs or any work stoppages or interruptions or strikescould have a material adverse effect on our business or results of operations.

 

***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 andpopulation changes 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 storesand to fulfill our internet sales.  As aresult, a natural disaster or other catastrophic event, such as an earthquakeaffecting western Washington, in particular, or the West Coast, in general,could significantly disrupt our operations and have a material adverse effecton 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 $23.9 million and $19.5 million for the six months ended August 2,2008 and August 4, 2007, respectively, and $22.2 million,$31.9 million and $43.5 million for fiscal 2005, 2006, and 2007respectively.  As of August 2, 2008,we were a party to operating leases requiring future minimum lease paymentsaggregating approximately $142.8 million through fiscal year 2012 andapproximately $122.7 million thereafter. In addition, substantially all of our store leases provide foradditional rental payments based on sales of the respective stores, as well ascommon area maintenance charges and other costs, and require that we pay realestate taxes, none of which is included in the amount of future minimum leasepayments.  We expect that any new storeswe open will also be leased by us under operating leases, which will furtherincrease our operating lease expenses.

 

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

 

·         increasingour vulnerability to general adverse economic and industry conditions;

 

·         limiting ourability 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;

 

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

 

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.

 

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***Theterms of our revolving credit facility impose operating and financialrestrictions on us that may impair our ability to respond to changingbusiness and economic conditions.  Thisimpairment could 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 certain specifiedfinancial tests and ratios, including minimum net income after taxes, maximumtotal 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 lendermay elect to declare all borrowings outstanding, together with accruedinterest and other fees, to be immediately due and payable.  If we are unable to repay outstandingborrowings when due, whether at their maturity or if declared due and payableby the lender following a default, the lender has the right to proceed againstthe collateral granted to it to secure the indebtedness.  As a result, any breach of these covenants orfailure to comply with these tests or ratios could have a material adverseeffect on us.  There can be no assurancethat we will not breach the covenants or fail to comply with the tests orratios in our credit agreement or any other debt agreements we may enterinto in the future and, if a breach occurs, there can be no assurance that wewill be able to obtain necessary waivers or amendments from the lenders.

 

The restrictions containedin our credit agreement could: (1) limit our ability to plan for or reactto market conditions or meet capital needs or otherwise restrict our activitiesor business plans; and (2) adversely affect our ability to finance ouroperations, strategic acquisitions, investments or other capital needs or toengage 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 delivery servicesmay increase the rates they charge, that they may terminate their contractswith us, that they may decrease the rate discounts provided to us when anexisting contract is renewed or that we may be unable to agree on the terms ofa new contract with them, any of which could materially adversely affect ouroperating results.

 

***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 otherwisedisrupt, 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.

 

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***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 merchandiseavailable to us or any increase in its cost due to tariffs, quotas or localissues that disrupt trade could have a material adverse effect on our resultsof operations.  Although the pricescharged by vendors for the merchandise we purchase are all denominated inUnited States dollars, a continued decline in the relative value of the UnitedStates dollar to foreign currencies could lead to increased merchandise costs,which could negatively affect our competitive position and our results ofoperation.

 

***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.

 

***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.

 

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***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:

 

·         diversion oftraffic 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.

 

***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.  TheSarbanes-Oxley Act of 2002, as well as related rules implemented by theSEC and The Nasdaq Global Market, has required changes in corporate governancepractices of public companies. Compliance with these laws, rules and regulations, includingcompliance with Section 404 of the Sarbanes-Oxley Act as discussed in thefollowing risk factor, have caused and will continue to cause us to incursignificant costs and expenses, including legal and accounting costs, and havemade and will continue to make some activities more time-consuming andcostly.  These laws, rules andregulations have made it more expensive for us to obtain director and officerliability insurance, and we have been required to accept reduced policy limitsand coverage.  As a result, itmay be more difficult for us to attract and retain qualified persons toserve on our board of directors or as officers. As a result of the foregoing, we have incurred and we expect to incursignificant legal, accounting, insurance and certain other expenses on anongoing basis, which will negatively impact our financial performance and couldhave a material adverse effect on our results of operations and financialcondition.

 

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***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, and reputation.  Further, if we are unable to comply with thesecurity standards, established by banks and the credit card industry, we maybe subject to fines, restrictions, and expulsion from card acceptance 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 has beensubject to substantial cyclicality.  Aseconomic conditions in the United States change, the trends in discretionaryconsumer spending become unpredictable and discretionary consumer spendingcould 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.

 

***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 adecline in the market price of their securities.  If our stock price is volatile, we may becomeinvolved in this type of litigation in the future.  Any litigation could result in substantialcosts and a diversion of management’s attention and resources that are neededto successfully run our business.

 

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

 

We invest ourexcess cash in diversified high credit money market accounts, US treasuries,certificates of deposit, municipal bonds and auction rate securities.  The investments have historically beenconsidered very safe investments with very minimal default rates.  However, the recent uncertainties in thecredit markets have prevented us and other investors from liquidating holdingsof auction rate securities in recent auctions for these securities because theamount of securities submitted for sale has exceeded the amount of purchaseorders.  We reduced our holdings ofauction rate securities during 2007 through the auction process.  As of August 2, 2008, we had$1.8 million invested in auction rate securities, which are classified aslong-term marketable securities on our condensed consolidated balancesheet.  In the quarter ended August 2,2008 we incurred an impairment charge on these investments of approximately$0.2 million.  If market liquidity issuescontinue, we may have additional impairment charges on these investments.

 

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 August 2, 2008, we had no borrowingsoutstanding under our secured revolving credit facility.  At August 2, 2008, we had $3.6 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 interestrates, 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.

 

**Item 4:   Controls and Procedures**

 

*Evaluationof Disclosure Controls and Procedures*.  We carried out an evaluation, under thesupervision and with the participation of our management, including our ChiefExecutive Officer (“CEO”) and Chief Financial Officer (“CFO”), of 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 August 2, 2008, our disclosure controls and procedureswere 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.

 

*Changes in Internal Control Over FinancialReporting*.  There hasbeen no change in our internal control over financial reporting (as defined inSecurities Exchange Act Rule 13a-15(f)) during the quarter ended August 2,2008 that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

 

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**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 this Form 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 ended February 2,2008.

 

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

 

None

 

**Item3.  Defaults Upon Senior Securities**

 

None

 

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

 

Atour Annual Meeting of Shareholders held on May 28, 2008, the followingproposals were adopted by the following number of votes:

 

ProposalNumber One:  The election of twodirectors to hold office until the 2011 Annual Meeting of Shareholders.  Each of the following nominees for directorwas elected to serve for a three-year term, by the following margins of votes:

 
| **Nominees**       | ** ** | **For**    | ** ** | **Withheld** | ** ** |
|--------------------|------------|------------|------------|--------------|------------|
| Thomas D.  Campion |       | 27,690,811 |       | 333,195      |       |
| David M.  DeMattei |       | 27,906,147 |       | 117,859      |       |

 

ProposalNumber Two:  Ratification of selection ofMoss Adams LLP, independent registered public accounting firm, reappointed bythe Board of Directors to audit the consolidated financial statements of theCompany for the fiscal year ending January 31, 2009:

 
| **Independent Registered Public Accountants** | ** ** | **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** |
|--------------------------------------------------------------|------------|------------|------------|-------------|------------|-------------|------------|
| Moss Adams LLP                                               |       | 27,991,670 |       | 25,493      |       | 6,842       |       |

 

**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:  August 28, 2008 |        |   |

 

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