##### Table of Contents









SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





Form 10-K


ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)


OF THE SECURITIES EXCHANGE ACT OF 1934


For the fiscal year ended July 2, 2005


Commission file number 0-27826





Party City Corporation


(Exact Name of Registrant as Specified in Its Charter)


|                                                                      |  |                                         
|--------------------------------------------------------------------- |  | ----------------------------------------
|Delaware                                                              |  | 22-3033692                              
|(State or Other Jurisdiction of
    Incorporation or Organization)    |  | (I.R.S. Employer
    Identification No.)
|                                                                     
|400 Commons Way, Rockaway, NJ(Address of Principal Executive Offices) |  | 07866(Zip Code)                         

Registrants telephone number, including area code:


(973) 983-0888


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


|                    |  |                                          
|------------------- |  | -----------------------------------------
|Title of Each Class |  | Name of Each Exchange on Which Registered
|                    |  |                                          
|None                |  | None                                     

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


Common Stock, par value $0.01 per share


þ o


þ


þ o


o o






DOCUMENTS INCORPORATED BY REFERENCE


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










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TABLE OF CONTENTS


|                                          |  |                                                                                                                      |  |      |    | 
|----------------------------------------- |  | -------------------------------------------------------------------------------------------------------------------- |  | ---- | -- | 
|                                          |  |                                                                                                                      |  | Page |   
|                                          |  |                                                                                                                      |  |      |   
|PART I                                   
|Item 1                                    |  | Business                                                                                                             |  |      | 3  | 
|Item 2                                    |  | Properties                                                                                                           |  |      | 17 | 
|Item 3                                    |  | Legal Proceedings                                                                                                    |  |      | 17 | 
|Item 4                                    |  | Submission of Matters to a Vote of Security
    Holders                                                              |  |      | 18 | 
|                                         
|PART II                                  
|Item 5                                    |  | Market for Registrants Common Equity,
    Related Stockholder Matters and Issuer Purchases of Equity
    Securities |  |      | 18 | 
|Item 6                                    |  | Selected Financial Data                                                                                              |  |      | 20 | 
|Item 7                                    |  | Managements Discussion and Analysis
    of Financial Condition and Results of Operations                            |  |      | 23 | 
|Item 7A                                   |  | Quantitative and Qualitative Disclosures
    About Market Risk                                                       |  |      | 40 | 
|Item 8                                    |  | Financial Statements and Supplementary
    Data                                                                      |  |      | 40 | 
|Item 9                                    |  | Changes in and Disagreements With
    Accountants on Accounting and Financial Disclosure                             |  |      | 41 | 
|Item 9A                                   |  | Controls and Procedures                                                                                              |  |      | 41 | 
|Item 9B                                   |  | Other Information                                                                                                    |  |      | 45 | 
|                                         
|PART III                                 
|Item 10                                   |  | Directors and Executive Officers of the
    Registrant                                                               |  |      | 45 | 
|Item 11                                   |  | Executive Compensation                                                                                               |  |      | 45 | 
|Item 12                                   |  | Security Ownership of Certain Beneficial
    Owners and Management and Related Stockholder Matters                   |  |      | 45 | 
|Item 13                                   |  | Certain Relationships and Related
    Transactions                                                                   |  |      | 45 | 
|Item 14                                   |  | Principal Accountant Fees and Services                                                                               |  |      | 45 | 
|                                         
|PART IV                                  
|Item 15                                   |  | Exhibits and Financial Statement
    Schedules                                                                       |  |      | 46 | 
|EX-10.26: SECOND AMENDMENT TO THE LOAN   
|EX-23.1: CONSENT OF DELOITTE & TOUCHE LLP
|EX-31.1: CERTIFICATION                   
|EX-31.2: CERTIFICATION                   
|EX-32.1: CERTIFICATION                   
|EX-32.2: CERTIFICATION                   





 www.partycity.com


http://www.sec.gov.


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PART I


Forward-Looking Statements









|        |         
|------- | --------
|Item 1. | Business

Introduction










3



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##### Table of Contents





Business Strategies






| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Offer a Broad Selection of Merchandise. We provide
    customers with convenient one-stop shopping for party supplies,
    and we offer what we believe is one of the most extensive
    selections of party supplies available. The typical Party City
    store offers a broad selection of brand name and private label
    merchandise consisting of more than 15,000 active items. During
    Fiscal 2005, we began and completed a process of introducing new
    products and coordinated assortments within most product
    categories, introducing significant amounts of new seasonal and
    non-seasonal product throughout the past fiscal year.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|
| | Maintain Value Price Position. We use the aggregate
    buying power of approximately 500 Company-owned stores and
    franchise store network, which allows us to offer a broad line
    of high quality merchandise at low prices. We believe we
    reinforce customers expectations of value through our
    advertising and marketing campaigns, which emphasize the byline
    The Discount Party Superstore in our customer
    communications. We recently reinstated a series of key
    equity pricing statements reflecting a commitment to
    offer customers specified percentage savings off the
    manufacturers suggested retail prices. We also maintain a
    lowest price guarantee policy in Company-owned stores, and we
    suggest our franchisees adhere to such a policy. This policy
    guarantees that Party City stores will meet or beat the
    advertised prices of competitors products.                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|
| | Expand Network of Convenient Store Locations. Although we
    believe that our stores typically are destination shopping
    locations, we seek to maximize customer traffic and quickly
    build the visibility of new stores by situating our stores in
    high traffic areas. Site selection criteria include: population
    density, demographics, traffic counts, location of complementary
    retailers, storefront visibility and presence (either in a
    stand-alone building or in dominant power strip shopping
    centers), competition, lease rates and accessible parking. We
    believe there are an extensive number of suitable domestic
    locations available for future stores, and we plan to open
    between 10 and 15 new Company-owned Party City stores and
    approximately five franchise stores during Fiscal 2006. Two of
    the Company-owned new stores are expected to open prior to
    Halloween 2005 (first quarter of Fiscal 2006), while the
    majority of the stores will open in the latter part of Fiscal
    2006. In addition, we are conducting a test program for
    temporary Halloween stores under the Halloween Costume Warehouse
    brand from the beginning of September through early November
    2005, with approximately 10 temporary Company-operated
    stores and five temporary stores to be operated by franchisees.
|
| | Provide Excellent Customer Service. We view the quality
    of our customers shopping experience as critical to our
    continued success, and we are committed to making shopping in
    our stores an enjoyable experience. For example, at Halloween,
    our most important selling season, each store significantly
    increases the number of sales associates. We hire and train
    qualified store managers and other personnel committed to
    serving our customers and compensate them based on performance
    measures in order to enhance the customer-service oriented
    culture in our stores.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|
| | Operate Effective Logistics and Information Systems. We
    believe that an effective logistics and systems infrastructure
    is necessary to operate our business in a cost-efficient manner,
    while enabling us to properly plan, allocate and distribute
    merchandise and enhance in-store selling and customer service by
    centralizing functions that otherwise would have to be performed
    by store personnel. Starting in July 2004, we began shifting
    deliveries of certain products from a direct-to-store model to
    centralized distribution centers operated by third parties with
    the objective of facilitating lower freight costs through
    shipping efficiencies and lower purchase prices. In light of the
    evaluation of strategic alternatives by the Board of Directors,
    we are currently reviewing the timing of the next phase of our
    logistics initiative, but anticipate the full transition from
    direct-to-store delivery to centralized distribution could be
    completed                                                                                                                                                                                                                                                                                                                                                  

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| |                                                                                                                                                                                                                                                                                                                                                                                                                             
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | within the next two to three years. In recent years we also have
    upgraded our point of sale (POS) and other information
    systems, which will allow us to continue to use technology to
    enhance our business practices. In the second quarter of Fiscal
    2006, we will begin to install a software system that will
    further automate the merchandise replenishment, forecasting and
    planning functions.



| |                                     
| | ------------------------------------
| | Strategic Priorities for Fiscal 2006



| |   |                                                                                                                                                                      
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | to return to positive same-store sales comparisons on a
    consistent basis, by increasing both customer traffic and the
    average transaction;                   
|
| |  | to improve margins through sales growth as well as leveraging
    our prior investments in logistics and systems;                                                    
|
| |  | to foster a more direct, in-depth relationship with our
    customers through our marketing efforts; and                                                             
|
| |  | to improve customer service by using our systems and
    distribution infrastructure to further centralize tasks that
    otherwise would be done at the store level.

Store Counts and Locations


Party City Stores.




|                                         |                                  |                                  |     |     |      |   |     |      |     |   |      |     |     |      |     |     |     |      |     |     |     |  
|---------------------------------------- | -------------------------------- | -------------------------------- | --- | --- | ---- | - | --- | ---- | --- | - | ---- | --- | --- | ---- | --- | --- | --- | ---- | --- | --- | --- | -
|                                         |                                  | Fiscal Year                      |    
|                                         |                                  |                                  |    
|                                         |                                  | 2005                             |     |     | 2004 |   |     | 2003 |     |   | 2002 |     |     | 2001 |    
|                                         |                                  |                                  |     |     |      |   |     |      |     |   |      |     |     |      |    
|Company-owned:                           |                                  |                                  |     |     |      |   |     |      |     |   |      |     |     |      |     |     |     |      |     |    
|                                         | Stores open at beginning of year |                                  |     | 249 |      |   |     | 242  |     |   |      | 209 |     |      |     | 193 |     |      |     | 197 |    
|                                         |                                  | Stores opened                    |     |     | 1    |   |     |      | 9   |   |      |     | 22  |      |     |     | 11  |      |     |     |    |  
|                                         |                                  | Stores closed                    |     |     | (3   | ) |     |      | (2  | ) |      |     | (2  | )    |     |     |    |      |     |     | (2  | )
|                                         |                                  | Stores acquired from franchisees |     |     |     |   |     |      |    |   |      |     | 2   |      |     |     | 3   |      |     |     | 1   |  
|                                         |                                  | External acquisitions            |     |     |     |   |     |      |    |   |      |     | 11  |      |     |     | 2   |      |     |     |    |  
|                                         |                                  | Stores sold to franchisees       |     |     |     |   |     |      |    |   |      |     |    |      |     |     |    |      |     |     | (3  | )
|                                         |                                  |                                  |     |     |      |   |     |      |     |   |      |     |     |      |    
|                                         |                                  | Stores open at end of year       |     |     | 247  |   |     |      | 249 |   |      |     | 242 |      |     |     | 209 |      |     |     | 193 |  
|                                         |                                  |                                  |     |     |      |   |     |      |     |   |      |     |     |      |    
|Franchise:                               |                                  |                                  |     |     |      |   |     |      |     |   |      |     |     |      |     |     |     |      |     |    
|                                         | Stores open at beginning of year |                                  |     | 257 |      |   |     | 241  |     |   |      | 242 |     |      |     | 261 |     |      |     | 211 |    
|                                         |                                  | Stores opened                    |     |     | 4    |   |     |      | 18  |   |      |     | 9   |      |     |     | 19  |      |     |     | 51  |  
|                                         |                                  | Stores closed                    |     |     | (6   | ) |     |      | (2  | ) |      |     | (8  | )    |     |     | (35 | )(a) |     |     | (3  | )
|                                         |                                  | Stores purchased by the Company  |     |     |     |   |     |      |    |   |      |     | (2  | )    |     |     | (3  | )    |     |     | (1  | )
|                                         |                                  | Stores purchased by franchisees  |     |     |     |   |     |      |    |   |      |     |    |      |     |     |    |      |     |     | 3   |  
|                                         |                                  |                                  |     |     |      |   |     |      |     |   |      |     |     |      |    
|                                         |                                  | Stores open at end of year       |     |     | 255  |   |     |      | 257 |   |      |     | 241 |      |     |     | 242 |      |     |     | 261 |  
|                                         |                                  |                                  |     |     |      |   |     |      |     |   |      |     |     |      |    
|Total Company-owned and franchise stores |                                  |                                  | 502 |     |      |   | 506 |      |     |   | 483  |     |     |      | 451 |     |     |      | 454 |    
|                                         |                                  |                                  |     |     |      |   |     |      |     |   |      |     |     |      |    






|    |                                                                                                                         
|--- | ------------------------------------------------------------------------------------------------------------------------
|(a) | Our Canadian master franchisee filed for bankruptcy protection
    under Canadian law, closing 28 stores in Fiscal 2002.

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|               |       |               |    |     |           |  |    |            |  |  |    |     | 
|-------------- | ----- | ------------- | -- | --- | --------- |  | -- | ---------- |  |  | -- | --- | 
|State          |       | Company-Owned |    |     | Franchise |  |    | Chain-Wide | 
|               |       |               |    |     |           |  |    |            | 
|Alabama        |       |               |   |     |           |  | 8  |            |  |  | 8  |    
|Arizona        |       |               |   |     |           |  | 9  |            |  |  | 9  |    
|Arkansas       |       |               |   |     |           |  | 3  |            |  |  | 3  |    
|California     |       |               | 52 |     |           |  | 13 |            |  |  | 65 |    
|Colorado       |       |               | 5  |     |           |  |   |            |  |  | 5  |    
|Connecticut    |       |               | 4  |     |           |  | 4  |            |  |  | 8  |    
|Delaware       |       |               |   |     |           |  | 1  |            |  |  | 1  |    
|Florida        |       |               | 13 |     |           |  | 39 |            |  |  | 52 |    
|Georgia        |       |               |   |     |           |  | 27 |            |  |  | 27 |    
|Hawaii         |       |               |   |     |           |  | 1  |            |  |  | 1  |    
|Illinois       |       |               | 22 |     |           |  |   |            |  |  | 22 |    
|Indiana        |       |               | 5  |     |           |  |   |            |  |  | 5  |    
|Kansas         |       |               |   |     |           |  | 4  |            |  |  | 4  |    
|Kentucky       |       |               | 1  |     |           |  |   |            |  |  | 1  |    
|Louisiana      |       |               | 3  |     |           |  | 8  |            |  |  | 11 |    
|Maryland       |       |               | 3  |     |           |  | 10 |            |  |  | 13 |    
|Massachusetts  |       |               | 5  |     |           |  |   |            |  |  | 5  |    
|Michigan       |       |               | 11 |     |           |  |   |            |  |  | 11 |    
|Minnesota      |       |               | 5  |     |           |  |   |            |  |  | 5  |    
|Mississippi    |       |               |   |     |           |  | 3  |            |  |  | 3  |    
|Missouri       |       |               | 4  |     |           |  | 1  |            |  |  | 5  |    
|Nevada         |       |               | 5  |     |           |  |   |            |  |  | 5  |    
|New Jersey     |       |               | 8  |     |           |  | 22 |            |  |  | 30 |    
|New Mexico     |       |               |   |     |           |  | 3  |            |  |  | 3  |    
|New York       |       |               | 32 |     |           |  | 17 |            |  |  | 49 |    
|North Carolina |       |               |   |     |           |  | 18 |            |  |  | 18 |    
|Ohio           |       |               | 10 |     |           |  |   |            |  |  | 10 |    
|Oregon         |       |               |   |     |           |  | 4  |            |  |  | 4  |    
|Pennsylvania   |       |               | 9  |     |           |  | 16 |            |  |  | 25 |    
|Rhode Island   |       |               |   |     |           |  | 2  |            |  |  | 2  |    
|South Carolina |       |               |   |     |           |  | 6  |            |  |  | 6  |    
|Tennessee      |       |               | 1  |     |           |  | 9  |            |  |  | 10 |    
|Texas          |       |               | 26 |     |           |  | 13 |            |  |  | 39 |    
|Utah           |       |               | 2  |     |           |  |   |            |  |  | 2  |    
|Virginia       |       |               | 6  |     |           |  | 8  |            |  |  | 14 |    
|Washington     |       |               | 14 |     |           |  | 1  |            |  |  | 15 |    
|Wisconsin      |       |               | 1  |     |           |  |   |            |  |  | 1  |    
|Puerto Rico    |       |               |   |     |           |  | 5  |            |  |  | 5  |    
|               |       |               |    |     |           |  |    |            | 
|               | Total |               |    | 247 |           |  |    | 255        |  |  |    | 502 | 
|               |       |               |    |     |           |  |    |            | 

Halloween Costume Warehouse Stores.


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Merchandising




| |                                   
| | ----------------------------------
| | Store Layout and Product Selection





An effective franchise program is key to our
success




| |                   
| | ------------------
| | Product Categories





| |         
| | --------
| | Seasonal

Halloween.


Other Seasonal.


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| |             
| | ------------
| | Non-Seasonal

Birthday.


Balloons.


Baby/ Bridal/ Wedding/ Anniversary.


Greeting Cards/ Gift Wrap.


Party Basics/ Catering.


Party Themes.




| |                        
| | -----------------------
| | Suppliers and Inventory



|                         |       |                   |                    |  |             |  |    |             |   |  |             |    |   |  |    |    |  
|------------------------ | ----- | ----------------- | ------------------ |  | ----------- |  | -- | ----------- | - |  | ----------- | -- | - |  | -- | -- | -
|Supplier                 |       | Products Supplied |                    |  | Fiscal 2005 |  |    | Fiscal 2004 |   |  | Fiscal 2003 |   
|                         |       |                   |                    |  |             |  |    |             |   |  |             |   
|Amscan, Inc.             |       |                   | Paper products     |  |             |  | 24 | %           |   |  | 22          | %  |   |  | 23 | % 
|Hallmark Marketing Corp. |       |                   | Paper products     |  |             |  | 6  |             |   |  | 6           |    |   |  | 6  |   
|Unique Industries, Inc.  |       |                   | Paper products     |  |             |  | 6  |             |   |  | 7           |    |   |  | 8  |   
|Rubies Costume Co. Inc.  |       |                   | Halloween costumes |  |             |  | 5  |             |   |  | 7           |    |   |  | 6  |   
|                         |       |                   |                    |  |             |  |    |             |   |  |             |   
|                         | Total |                   |                    |  |             |  |    | 40          | % |  |             | 42 | % |  |    | 43 | %
|                         |       |                   |                    |  |             |  |    |             |   |  |             |   



|      |                                                                                                                                                                              
|----- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note: | The percentages above have been rounded to the nearest whole
    percentage; therefore the sum of exact percentages may differ
    slightly from the rounded totals provided.

If we
lose any of our key vendors or any of our key vendors fail to
supply us with merchandise, we may not be able to meet the
demands of our customers and our sales could decline




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Advertising and Marketing




Logistics




Information Systems




Franchise Operations






9



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Competition






Trademarks




Government Regulation




10



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Employees






Risk Factors






| |                                                                   
| | ------------------------------------------------------------------
| | We may not be able to successfully execute our key
    initiatives



11



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| |                                                         
| | --------------------------------------------------------
| | An effective franchise program is key to our
    success







| |                                                                                                                 
| | ----------------------------------------------------------------------------------------------------------------
| | A downturn in the economy may affect consumer purchases of
    discretionary items, which could reduce our sales





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| |                                                                                                                                                                                                      
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If we are unable to identify and anticipate changes in
    consumer demands and preferences, or we are unable to respond to
    such consumer demands in a timely manner, our sales could
    decline





| |   |                                                                                                                
| | - | ---------------------------------------------------------------------------------------------------------------
| |  | we are unable to identify and respond to emerging trends;                                                      
|
| |  | we miscalculate either the market for the merchandise in our
    stores or our customers purchasing habits; or
|
| |  | consumer demand dramatically shifts away from disposable party
    supplies,                                   





| |                                                                                                                                                                                                
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If we lose any of our key vendors or any of our key
    vendors fail to supply us with merchandise, we may not be able
    to meet the demands of our customers and our sales could
    decline









| |                                                   
| | --------------------------------------------------
| | We face a high level of competition in our markets



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| |                                                                                                                                                                             
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | A Special Committee of our Board is considering various
    strategic alternatives, the consummation of which may have a
    material effect on our business and stock price





| |                                                                   
| | ------------------------------------------------------------------
| | We may need to raise additional capital to fund our
    operations





| |                                                                                                                   
| | ------------------------------------------------------------------------------------------------------------------
| | If we fail to protect our brand name, competitors may
    adopt tradenames that dilute the value of our brand name



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| |                                                                                                                                                                                                              
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our operating results are subject to seasonal and
    quarterly fluctuations, as well as the timing of store openings
    and closings, which could cause the market price of our common
    stock to decline







| |                                                                      
| | ---------------------------------------------------------------------
| | We may be unable to achieve our expansion plans for future
    growth









| |                                                                                                                                                                                                                           
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | In the event we are unable to satisfy regulatory
    requirements relating to internal controls, or if our internal
    controls over financial reporting are not effective, our
    business and stock price could suffer



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| |                                                                                                                                                          
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------
| | We depend on key personnel and may not be able to retain
    these employees or recruit additional qualified personnel, which
    could harm our business



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| |                                                                                                        
| | -------------------------------------------------------------------------------------------------------
| | We rely on third parties to manage our distribution center
    and to deliver merchandise to our stores








|        |           
|------- | ----------
|Item 2. | Properties














|        |                  
|------- | -----------------
|Item 3. | Legal Proceedings



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|        |                                                    
|------- | ---------------------------------------------------
|Item 4. | Submission of Matters to a Vote of Security Holders






PART II







|        |                                                                                                                     
|------- | --------------------------------------------------------------------------------------------------------------------
|Item 5. | Market for Registrants Common Equity, Related
    Stockholder Matters and Issuer Purchases of Equity
    Securities





|                   |  |      |       |  |     |   |       | 
|------------------ |  | ---- | ----- |  | --- | - | ----- | 
|                   |  | High |       |  | Low |  
|                   |  |      |       |  |     |  
|Quarter Ended:     |  |      |       |  |     |   |       | 
|July 2, 2005       |  | $    | 14.67 |  |     | $ | 11.39 | 
|April 2, 2005      |  |      | 16.39 |  |     |   | 11.33 | 
|January 1, 2005    |  |      | 15.63 |  |     |   | 12.15 | 
|October 2, 2004    |  |      | 15.25 |  |     |   | 11.25 | 
|Quarter Ended:     |  |      |       |  |     |   |       | 
|July 3, 2004       |  | $    | 17.32 |  |     | $ | 11.25 | 
|March 28, 2004     |  |      | 15.47 |  |     |   | 11.31 | 
|December 27, 2003  |  |      | 15.00 |  |     |   | 11.83 | 
|September 27, 2003 |  |      | 12.18 |  |     |   | 9.56  | 



Dividends




Issuer Purchases of Equity Securities






18



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Equity Compensation Plan Information




|                                                              |       |                      |           |           |                      |                      |                      |                         |  |  |           |           | 
|------------------------------------------------------------- | ----- | -------------------- | --------- | --------- | -------------------- | -------------------- | -------------------- | ----------------------- |  |  | --------- | --------- | 
|                                                              |       |                      |           |           |                      | Number of Securities |                     
|                                                              |       | Number of Securities |           |           |                      |                      | Available for Future |                        
|                                                              |       | to be Issued Upon    |           |           | Weighted-Average     |                      |                      | Issuance Under Equity   | 
|                                                              |       | Exercise of          |           |           | Exercise Price of    |                      |                      | Compensation Plans      | 
|                                                              |       | Outstanding Options, |           |           | Outstanding Options, |                      |                      | (Excluding Securities   | 
|                                                              |       | Warrants and Rights  |           |           | Warrants and Rights  |                      |                      | Reflected in Column(a)) | 
|Plan Category                                                 |       | (a)                  |           |           | (b)                  |                      |                      | (c)                     | 
|                                                              |       |                      |           |           |                      |                      |                      |                         | 
|Equity compensation plans approved by security holders(2)     |       |                      | 2,901,049 | (3)       |                      | $                    | 11.77                |                         |  |  | 4,551,804 | (4)      
|Equity compensation plans not approved by security holders(5) |       |                      | 13,567    | (6)       |                      | $                    | 11.10                |                         |  |  | 269,763   | (7)      
|                                                              |       |                      |           |           |                      |                      |                      |                         | 
|                                                              | Total |                      |           | 2,914,616 |                      |                      | $                    | 11.76                   |  |  |           | 4,821,567 | 
|                                                              |       |                      |           |           |                      |                      |                      |                         | 






|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | See Note 9 to our consolidated financial statements
    included herein for a description of our equity compensation
    plans.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   
|(2) | Consists of our Amended and Restated 1994 Stock Option Plan (the
    1994 Plan), Amended and Restated 1999 Stock
    Incentive Plan (the 1999 Plan) and Employee Stock
    Purchase Plan (the ESPP).                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   
|(3) | Consists of 292,313 outstanding options for our common stock
    pursuant to the 1994 Plan, 2,590,356 outstanding options for our
    common stock pursuant to the 1999 Plan and 18,380 shares of
    our common stock which will be issued on December 30, 2005
    pursuant to the ESPP. Under the ESPP, our employees have the
    opportunity to purchase shares of our common stock at a discount
    through accumulated payroll deductions. The Companys
    liability to employees in the ESPP is approximately $187,000.
    The shares which will be issued in December 2005 will have a
    purchase price of $10.20 per share.
|   
|(4) | Consists of 4,502,151 options that remain available for issuance
    pursuant to the 1999 Plan and 49,653 shares of our common
    stock that remain available for issuance pursuant to the ESPP.
    Since September 4, 2000, no additional options may be
    issued under the 1994 Plan.                                                                                                                                                                                                                                                                                                                                                
|   
|(5) | Consists of our Management Stock Purchase Plan.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   
|(6) | These shares will be issued in future periods as provided for in
    the Management Stock Purchase Plan.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|   
|(7) | As of July 2, 2005, we have cancelled the Management Stock
    Purchase Plan for future contribution periods after the
    completion of the August 2005 contribution period.                                                                                                                                                                                                                                                                                                                                                                                                                                                              



|      |                                                                                                                                                                                      
|----- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Note: | On August 10, 2005 we granted 264,500 stock options of our
    common stock to our employees at a price of $13.28. These stock
    option grants are not included in the above table.

19



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|        |                        
|------- | -----------------------
|Item 6. | Selected Financial Data



Selected Financial Data


|                              |                                                     |                                          |         |         |         |   |         |          |  |   |          |         |  |          |         |         |  |   |         |         | 
|----------------------------- | --------------------------------------------------- | ---------------------------------------- | ------- | ------- | ------- | - | ------- | -------- |  | - | -------- | ------- |  | -------- | ------- | ------- |  | - | ------- | ------- | 
|                              |                                                     | Year Ended                               |        
|                              |                                                     |                                          |        
|                              |                                                     | July 2,                                  |         |         | July 3, |   |         | June 28, |  |   | June 29, |         |  | June 30, |        
|                              |                                                     | 2005                                     |         |         | 2004    |   |         | 2003     |  |   | 2002     |         |  | 2001     |        
|                              |                                                     |                                          |         |         |         |   |         |          |  |   |          |         |  |          |        
|                              |                                                     | (In thousands, except per share amounts) |        
|Statement of Operations Data: |                                                     |                                          |         |         |         |   |         |          |  |   |          |         |  |          |         |         |  |   |         |        
|Total revenues                |                                                     | $                                        | 503,866 |         |         | $ | 516,267 |          |  | $ | 482,620  |         |  | $        | 423,510 |         |  | $ | 395,900 |        
|Company-owned stores:         |                                                     |                                          |         |         |         |   |         |          |  |   |          |         |  |          |         |         |  |   |         |        
|                              | Net sales                                           |                                          | $       | 467,668 |         |   | $       | 496,138  |  |   | $        | 464,258 |  |          | $       | 405,821 |  |   | $       | 380,671 | 
|                              | Cost of goods sold and occupancy costs              |                                          |         | 316,663 |         |   |         | 332,311  |  |   |          | 311,170 |  |          |         | 263,980 |  |   |         | 252,320 | 
|                              |                                                     |                                          |         |         |         |   |         |          |  |   |          |         |  |          |        
|                              | Gross profit                                        |                                          |         | 151,005 |         |   |         | 163,827  |  |   |          | 153,088 |  |          |         | 141,841 |  |   |         | 128,351 | 
|                              | Store operating and selling expense                 |                                          |         | 110,757 |         |   |         | 113,292  |  |   |          | 108,294 |  |          |         | 91,576  |  |   |         | 88,128  | 
|                              |                                                     |                                          |         |         |         |   |         |          |  |   |          |         |  |          |        
|                              | Company-owned store profit contribution             |                                          |         | 40,248  |         |   |         | 50,535   |  |   |          | 44,794  |  |          |         | 50,265  |  |   |         | 40,223  | 
|                              | General and administrative expense                  |                                          |         | 41,502  |         |   |         | 35,537   |  |   |          | 30,970  |  |          |         | 27,086  |  |   |         | 24,328  | 
|                              | Impairment charges                                  |                                          |         | 2,831   |         |   |         |         |  |   |          | 1,505   |  |          |         |        |  |   |         | 2,275   | 
|                              | Litigation charges                                  |                                          |         |        |         |   |         | 4,100    |  |   |          |        |  |          |         |        |  |   |         |        | 
|                              |                                                     |                                          |         |         |         |   |         |          |  |   |          |         |  |          |        
|                              | Retail (loss) profit contribution                   |                                          |         | (4,085  | )       |   |         | 10,898   |  |   |          | 12,319  |  |          |         | 23,179  |  |   |         | 13,620  | 
|Franchise stores:             |                                                     |                                          |         |         |         |   |         |          |  |   |          |         |  |          |         |         |  |   |         |        
|                              | Royalty fees                                        |                                          |         | 19,666  |         |   |         | 19,521   |  |   |          | 18,007  |  |          |         | 17,048  |  |   |         | 14,604  | 
|                              | Net sales to franchisees                            |                                          |         | 16,372  |         |   |         |         |  |   |          |        |  |          |         |        |  |   |         |        | 
|                              | Franchise fees                                      |                                          |         | 160     |         |   |         | 608      |  |   |          | 355     |  |          |         | 641     |  |   |         | 625     | 
|                              |                                                     |                                          |         |         |         |   |         |          |  |   |          |         |  |          |        
|                              | Total franchise revenues                            |                                          |         | 36,198  |         |   |         | 20,129   |  |   |          | 18,362  |  |          |         | 17,689  |  |   |         | 15,229  | 
|                              | Cost of goods sold to franchisees                   |                                          |         | 14,388  |         |   |         |         |  |   |          |        |  |          |         |        |  |   |         |        | 
|                              | Franchise transportation and other selling expenses |                                          |         | 2,024   |         |   |         |         |  |   |          |        |  |          |         |        |  |   |         |        | 
|                              | Other franchise expense                             |                                          |         | 8,142   |         |   |         | 7,184    |  |   |          | 6,538   |  |          |         | 6,563   |  |   |         | 4,937   | 
|                              |                                                     |                                          |         |         |         |   |         |          |  |   |          |         |  |          |        
|                              | Total franchise expense                             |                                          |         | 24,554  |         |   |         | 7,184    |  |   |          | 6,538   |  |          |         | 6,563   |  |   |         | 4,937   | 
|                              |                                                     |                                          |         |         |         |   |         |          |  |   |          |         |  |          |        
|                              | Franchise profit contribution                       |                                          |         | 11,644  |         |   |         | 12,945   |  |   |          | 11,824  |  |          |         | 11,126  |  |   |         | 10,292  | 
|                              |                                                     |                                          |         |         |         |   |         |          |  |   |          |         |  |          |        
|Operating income              |                                                     |                                          | 7,559   |         |         |   | 23,843  |          |  |   | 24,143   |         |  |          | 34,305  |         |  |   | 23,912  |        
|Interest expense, net         |                                                     |                                          | 49      |         |         |   | 471     |          |  |   | 3,990    |         |  |          | 5,610   |         |  |   | 7,949   |        
|                              |                                                     |                                          |         |         |         |   |         |          |  |   |          |         |  |          |        
|Income before income taxes    |                                                     |                                          | 7,510   |         |         |   | 23,372  |          |  |   | 20,153   |         |  |          | 28,695  |         |  |   | 15,963  |        
|Provision for income taxes    |                                                     |                                          | 3,246   |         |         |   | 9,466   |          |  |   | 8,061    |         |  |          | 11,503  |         |  |   | 6,002   |        
|                              |                                                     |                                          |         |         |         |   |         |          |  |   |          |         |  |          |        
|Net income                    |                                                     | $                                        | 4,264   |         |         | $ | 13,906  |          |  | $ | 12,092   |         |  | $        | 17,192  |         |  | $ | 9,961   |        
|                              |                                                     |                                          |         |         |         |   |         |          |  |   |          |         |  |          |        
|                              | Basic earnings per share                            |                                          | $       | 0.25    |         |   | $       | 0.82     |  |   | $        | 0.73    |  |          | $       | 1.32    |  |   | $       | 0.78    | 
|                              |                                                     |                                          |         |         |         |   |         |          |  |   |          |         |  |          |        
|                              | Weighted average shares outstanding  basic         |                                          |         | 17,184  |         |   |         | 16,880   |  |   |          | 16,602  |  |          |         | 13,068  |  |   |         | 12,723  | 
|                              |                                                     |                                          |         |         |         |   |         |          |  |   |          |         |  |          |        
|                              | Diluted earnings per share                          |                                          | $       | 0.22    |         |   | $       | 0.71     |  |   | $        | 0.62    |  |          | $       | 0.89    |  |   | $       | 0.56    | 
|                              |                                                     |                                          |         |         |         |   |         |          |  |   |          |         |  |          |        
|                              | Weighted average shares outstanding  diluted       |                                          |         | 19,831  |         |   |         | 19,651   |  |   |          | 19,646  |  |          |         | 19,313  |  |   |         | 17,819  | 
|                              |                                                     |                                          |         |         |         |   |         |          |  |   |          |         |  |          |        

20



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|                                        |                                                         |                                              |        |         |         |   |        |          |        |   |          |         |     |          |        |         |        |   |        |         |       | 
|--------------------------------------- | ------------------------------------------------------- | -------------------------------------------- | ------ | ------- | ------- | - | ------ | -------- | ------ | - | -------- | ------- | --- | -------- | ------ | ------- | ------ | - | ------ | ------- | ----- | 
|                                        |                                                         | Year Ended                                   |       
|                                        |                                                         |                                              |       
|                                        |                                                         | July 2,                                      |        |         | July 3, |   |        | June 28, |        |   | June 29, |         |     | June 30, |       
|                                        |                                                         | 2005                                         |        |         | 2004(a) |   |        | 2003     |        |   | 2002     |         |     | 2001     |       
|                                        |                                                         |                                              |        |         |         |   |        |          |        |   |          |         |     |          |       
|                                        |                                                         | (In thousands, except store data)            |       
|Operating Data:                         |                                                         |                                              |        |         |         |   |        |          |        |   |          |         |     |          |        |         |        |   |        |        
|                                        | Number of Company-owned stores (end of year)            |                                              |        | 247     |         |   |        | 249      |        |   |          | 242     |     |          |        | 209     |        |   |        | 193     |      
|                                        |                                                         |                                              |        |         |         |   |        |          |        |   |          |         |     |          |       
|                                        | (Decrease) increase in Company-owned same store sales   |                                              |        | (4.7    | )%      |   |        | 0.6      | %      |   |          | 2.2     | %   |          |        | 4.9     | %      |   |        | 10.3    | %    
|                                        |                                                         |                                              |        |         |         |   |        |          |        |   |          |         |     |          |       
|                                        | Number of franchise owned stores (end of year)          |                                              |        | 255     |         |   |        | 257      |        |   |          | 241     |     |          |        | 242     |        |   |        | 261     |      
|                                        |                                                         |                                              |        |         |         |   |        |          |        |   |          |         |     |          |       
|                                        | (Decrease) increase in franchise-owned same store sales |                                              |        | (3.1    | )%      |   |        | 3.0      | %      |   |          | 3.7     | %   |          |        | 4.5     | %      |   |        | 4.3     | %    
|                                        |                                                         |                                              |        |         |         |   |        |          |        |   |          |         |     |          |       
|                                        | Average net sales per Company-owned store               |                                              | $      | 1,883   |         |   | $      | 2,009    |        |   | $        | 2,090   |     |          | $      | 2,044   |        |   | $      | 1,961   |      
|                                        |                                                         |                                              |        |         |         |   |        |          |        |   |          |         |     |          |       
|Balance Sheet Data:                     |                                                         |                                              |        |         |         |   |        |          |        |   |          |         |     |          |        |         |        |   |        |        
|                                        | Cash and cash equivalents                               |                                              | $      | 11,034  |         |   | $      | 27,845   |        |   | $        | 3,372   |     |          | $      | 3,467   |        |   | $      | 9,842   |      
|                                        |                                                         |                                              |        |         |         |   |        |          |        |   |          |         |     |          |       
|                                        | Working capital                                         |                                              | $      | 46,753  |         |   | $      | 34,818   |        |   | $        | 12,867  |     |          | $      | 14,707  |        |   | $      | 8,784   |      
|                                        |                                                         |                                              |        |         |         |   |        |          |        |   |          |         |     |          |       
|                                        | Total assets                                            |                                              | $      | 183,973 |         |   | $      | 177,417  |        |   | $        | 167,999 |     |          | $      | 149,054 |        |   | $      | 141,342 |      
|                                        |                                                         |                                              |        |         |         |   |        |          |        |   |          |         |     |          |       
|                                        | Long term notes payable(b)                              |                                              | $      |        |         |   | $      |         |        |   | $        |        |     |          | $      | 8,915   |        |   | $      | 16,006  |      
|                                        |                                                         |                                              |        |         |         |   |        |          |        |   |          |         |     |          |       
|                                        | Capital Leases                                          |                                              | $      | 741     |         |   | $      |         |        |   | $        | 32      |     |          | $      | 54      |        |   | $      | 414     |      
|                                        |                                                         |                                              |        |         |         |   |        |          |        |   |          |         |     |          |       
|                                        | Stockholders equity                                    |                                              | $      | 102,927 |         |   | $      | 96,838   |        |   | $        | 79,422  |     |          | $      | 67,599  |        |   | $      | 51,090  |      
|                                        |                                                         |                                              |        |         |         |   |        |          |        |   |          |         |     |          |       
|Other Information:                      |                                                         |                                              |        |         |         |   |        |          |        |   |          |         |     |          |        |         |        |   |        |        
|                                        | Depreciation and amortization                           |                                              | $      | 17,026  |         |   | $      | 17,601   |        |   | $        | 16,229  |     |          | $      | 12,156  |        |   | $      | 10,431  |      
|Cash Flows (Used In) Provided By:       |                                                         |                                              |        |         |         |   |        |          |        |   |          |         |     |          |        |         |        |   |        |        
|                                        | Operating activities                                    |                                              | $      | (5,486  | )       |   | $      | 51,599   |        |   | $        | 23,088  |     |          | $      | 31,042  |        |   | $      | 33,876  |      
|                                        | Investing activities                                    |                                              |        | (12,214 | )       |   |        | (13,484  | )      |   |          | (22,234 | )   |          |        | (20,008 | )      |   |        | (15,664 | )    
|                                        | Financing activities                                    |                                              |        | 889     |         |   |        | (13,642  | )      |   |          | (949    | )   |          |        | (17,409 | )      |   |        | (12,320 | )    
|                                        |                                                         |                                              |        |         |         |   |        |          |        |   |          |         |     |          |       
|                                        |                                                         | Total cash (used in) provided by the Company |        | $       | (16,811 | ) |        | $        | 24,473 |   |          | $       | (95 | )        |        | $       | (6,375 | ) |        | $       | 5,892 | 
|                                        |                                                         |                                              |        |         |         |   |        |          |        |   |          |         |     |          |       
|EBITDA and Adjusted EBITDA:(c)          |                                                         |                                              |        |         |         |   |        |          |        |   |          |         |     |          |        |         |        |   |        |        
|EBITDA                                  |                                                         | $                                            | 24,585 |         |         | $ | 41,444 |          |        | $ | 40,372   |         |     | $        | 46,461 |         |        | $ | 34,343 |        
|Impairment of assets                    |                                                         |                                              | 2,831  |         |         |   |       |          |        |   | 1,505    |         |     |          |       |         |        |   | 2,275  |        
|                                        |                                                         |                                              |        |         |         |   |        |          |        |   |          |         |     |          |       
|                                        | Adjusted EBITDA                                         |                                              | $      | 27,416  |         |   | $      | 41,444   |        |   | $        | 41,877  |     |          | $      | 46,461  |        |   | $      | 36,618  |      
|                                        |                                                         |                                              |        |         |         |   |        |          |        |   |          |         |     |          |       
|Most directly comparable GAAP measures: |                                                         |                                              |        |         |         |   |        |          |        |   |          |         |     |          |        |         |        |   |        |        
|                                        | Net income                                              |                                              | $      | 4,264   |         |   | $      | 13,906   |        |   | $        | 12,092  |     |          | $      | 17,192  |        |   | $      | 9,961   |      
|                                        |                                                         |                                              |        |         |         |   |        |          |        |   |          |         |     |          |       
|                                        | Cash flows (used in) provided by operating activities   |                                              | $      | (5,486  | )       |   | $      | 51,599   |        |   | $        | 23,088  |     |          | $      | 31,042  |        |   | $      | 33,876  |      
|                                        |                                                         |                                              |        |         |         |   |        |          |        |   |          |         |     |          |       






|    |                                                                                        
|--- | ---------------------------------------------------------------------------------------
|(a) | The figures provided for the fiscal year ended July 3, 2004
    reflect a 53-week year.



|    |  |                                                                                                                                                                                                                                                                                
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(b) |  | Long term notes payable balance at June 29, 2002 represent
    long term secured notes of $10.2 million less debt discount
    of $1.3 million, and the balance at June 30, 2001
    represent long term secured notes of $17.9 million less
    debt discount of $1.9 million.

21



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|    |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(c) |  | Our definition of EBITDA is earnings before interest, taxes, and
    depreciation and amortization. Our definition for Adjusted
    EBITDA is EBITDA before non-cash impairments charges relating to
    goodwill and fixed assets. EBITDA and Adjusted EBITDA should not
    be construed as a substitute for net income or net cash (used
    in) provided by operating activities (all as determined in
    accordance with generally accepted accounting principles) for
    the purpose of analyzing our operating performance, financial
    position and cash flows as EBITDA and Adjusted EBITDA are not
    defined by generally accepted accounting principles.                                                                                                                                                                                                                            
|   
|    |  | We have presented EBITDA and Adjusted EBITDA, because we believe
    they are indicative measures of, and are commonly used by
    certain investors and analysts to analyze and compare companies
    on the basis of operating performance and a companys
    ability to service and/or incur debt. Furthermore, our executive
    compensation plans base incentive compensation payments on our
    EBITDA and Adjusted EBITDA performance measured against budget.
    EBITDA and Adjusted EBITDA are also widely used by us and others
    in our industry to evaluate and price potential acquisitions.
    EBITDA and Adjusted EBITDA have limitations as an analytical
    tool, and you should not consider it in isolation or as a
    substitute for analyses of our results as reported under
    Generally Accepted Accounting Principles (GAAP).
    Some of these limitations are:



| |   |                                                                                                                                                                                                                                                             
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | EBITDA and Adjusted EBITDA do not reflect our cash expenditures,
    or future requirements, for capital expenditures or contractual
    commitments;                                                                                                       
|
| |  | EBITDA and Adjusted EBITDA do not reflect changes in, or cash
    requirements for, our working capital needs;                                                                                                                                              
|
| |  | EBITDA and Adjusted EBITDA do not reflect the interest expense,
    or the cash requirements necessary to service interest or
    principal payments, on any debts we may have;                                                                             
|
| |  | Although depreciation and amortization are non-cash charges, the
    assets being depreciated and amortized will often have to be
    replaced in the future, and EBITDA and Adjusted EBITDA do not
    reflect any cash requirements for such replacements;
|
| |  | EBITDA and Adjusted EBITDA do not reflect the impact of earnings
    or charges resulting from matters we consider not to be
    indicative of our ongoing operations; and                                                                                  
|
| |  | Other companies in our industry may calculate EBITDA and
    Adjusted EBITDA differently than we do, limiting their
    usefulness as comparative measures.                                                                                                 



|                              |  |                |         |   |         |   |         |          |  |   |          |   |  |          |         |   |  |   |         |  
|----------------------------- |  | -------------- | ------- | - | ------- | - | ------- | -------- |  | - | -------- | - |  | -------- | ------- | - |  | - | ------- | -
|                              |  | Year Ended     |        
|                              |  |                |        
|                              |  | July 2,        |         |   | July 3, |   |         | June 28, |  |   | June 29, |   |  | June 30, |        
|                              |  | 2005           |         |   | 2004    |   |         | 2003     |  |   | 2002     |   |  | 2001     |        
|                              |  |                |         |   |         |   |         |          |  |   |          |   |  |          |        
|                              |  | (In thousands) |        
|EBITDA                        |  | $              | 24,585  |   |         | $ | 41,444  |          |  | $ | 40,372   |   |  | $        | 46,461  |   |  | $ | 34,343  |  
|Impairment of assets          |  |                | 2,831   |   |         |   |        |          |  |   | 1,505    |   |  |          |        |   |  |   | 2,275   |  
|                              |  |                |         |   |         |   |         |          |  |   |          |   |  |          |        
|Adjusted EBITDA               |  | $              | 27,416  |   |         | $ | 41,444  |          |  | $ | 41,877   |   |  | $        | 46,461  |   |  | $ | 36,618  |  
|Depreciation and amortization |  |                | (17,026 | ) |         |   | (17,601 | )        |  |   | (16,229  | ) |  |          | (12,156 | ) |  |   | (10,431 | )
|Impairment of assets          |  |                | (2,831  | ) |         |   |        |          |  |   | (1,505   | ) |  |          |        |   |  |   | (2,275  | )
|Interest expense, net         |  |                | (49     | ) |         |   | (471    | )        |  |   | (3,990   | ) |  |          | (5,610  | ) |  |   | (7,949  | )
|Provision for income taxes    |  |                | (3,246  | ) |         |   | (9,466  | )        |  |   | (8,061   | ) |  |          | (11,503 | ) |  |   | (6,002  | )
|                              |  |                |         |   |         |   |         |          |  |   |          |   |  |          |        
|Net income                    |  | $              | 4,264   |   |         | $ | 13,906  |          |  | $ | 12,092   |   |  | $        | 17,192  |   |  | $ | 9,961   |  
|                              |  |                |         |   |         |   |         |          |  |   |          |   |  |          |        

22



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|                                   |                                                |                                                     |        |         |         |   |        |          |        |   |          |        |        |          |         |        |        |   |        |        |        | 
|---------------------------------- | ---------------------------------------------- | --------------------------------------------------- | ------ | ------- | ------- | - | ------ | -------- | ------ | - | -------- | ------ | ------ | -------- | ------- | ------ | ------ | - | ------ | ------ | ------ | 
|                                   |                                                | Year Ended                                          |       
|                                   |                                                |                                                     |       
|                                   |                                                | July 2,                                             |        |         | July 3, |   |        | June 28, |        |   | June 29, |        |        | June 30, |        
|                                   |                                                | 2005                                                |        |         | 2004    |   |        | 2003     |        |   | 2002     |        |        | 2001     |        
|                                   |                                                |                                                     |        |         |         |   |        |          |        |   |          |        |        |          |        
|                                   |                                                | (In thousands)                                      |       
|EBITDA                             |                                                | $                                                   | 24,585 |         |         | $ | 41,444 |          |        | $ | 40,372   |        |        | $        | 46,461  |        |        | $ | 34,343 |       
|Impairment of assets               |                                                |                                                     | 2,831  |         |         |   |       |          |        |   | 1,505    |        |        |          |        |        |        |   | 2,275  |       
|                                   |                                                |                                                     |        |         |         |   |        |          |        |   |          |        |        |          |        
|Adjusted EBITDA                    |                                                | $                                                   | 27,416 |         |         | $ | 41,444 |          |        | $ | 41,877   |        |        | $        | 46,461  |        |        | $ | 36,618 |       
|Interest expense, net              |                                                |                                                     | (49    | )       |         |   | (471   | )        |        |   | (3,990   | )      |        |          | (5,610  | )      |        |   | (7,949 | )     
|Provision for income taxes         |                                                |                                                     | (3,246 | )       |         |   | (9,466 | )        |        |   | (8,061   | )      |        |          | (11,503 | )      |        |   | (6,002 | )     
|Amortization of financing costs    |                                                |                                                     | 159    |         |         |   | 163    |          |        |   | 1,624    |        |        |          | 1,395   |        |        |   | 1,815  |       
|Deferred rent                      |                                                |                                                     | 411    |         |         |   | (608   | )        |        |   | 556      |        |        |          | 765     |        |        |   | 1,148  |       
|Deferred taxes                     |                                                |                                                     | 2,311  |         |         |   | (1,051 | )        |        |   | (2,131   | )      |        |          | 819     |        |        |   | 1,543  |       
|Stock-based compensation           |                                                |                                                     | 47     |         |         |   | 102    |          |        |   | 342      |        |        |          | 463     |        |        |   | 264    |       
|Provision for doubtful accounts    |                                                |                                                     | 343    |         |         |   | (141   | )        |        |   | (498     | )      |        |          | (67     | )      |        |   | (65    | )     
|Other                              |                                                |                                                     | 389    |         |         |   | 72     |          |        |   | 162      |        |        |          |        |        |        |   | (131   | )     
|Changes in assets and liabilities: |                                                |                                                     |        |         |         |   |        |          |        |   |          |        |        |          |         |        |        |   |        |       
|                                   | Merchandise inventory                          |                                                     |        | (15,461 | )       |   |        | 8,551    |        |   |          | (9,634 | )      |          |         | (7,310 | )      |   |        | (6,606 | )     
|                                   | Accounts payable                               |                                                     |        | 5,511   |         |   |        | 404      |        |   |          | 5,545  |        |          |         | 4,509  |        |   |        | 1,937  |       
|                                   | Accrued expenses and other current liabilities |                                                     |        | (6,290  | )       |   |        | 9,298    |        |   |          | (1,381 | )      |          |         | 422    |        |   |        | 9,585  |       
|                                   | Other long-term liabilities                    |                                                     |        | (3      | )       |   |        | (41      | )      |   |          | 121    |        |          |         | 833    |        |   |        | (326   | )     
|                                   | Other current assets and other assets          |                                                     |        | (17,024 | )       |   |        | 3,343    |        |   |          | (1,444 | )      |          |         | (135   | )      |   |        | 2,045  |       
|                                   |                                                |                                                     |        |         |         |   |        |          |        |   |          |        |        |          |        
|                                   |                                                | Net cash (used in) provided by operating activities |        | $       | (5,486  | ) |        | $        | 51,599 |   |          | $      | 23,088 |          |         | $      | 31,042 |   |        | $      | 33,876 | 
|                                   |                                                |                                                     |        |         |         |   |        |          |        |   |          |        |        |          |        






|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|Item 7. | Managements Discussion and Analysis of Financial
    Condition and Results of Operations

Overview








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| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Product. We introduced significant amounts of new
    products in Fiscal 2005, focusing primarily on seasonal products
    during the first half of the fiscal year, followed by
    non-seasonal products during the second half of the fiscal year.
    As non-seasonal merchandise historically represented
    approximately two-thirds of a typical stores selling space
    and annual net sales volume (and approximately 80% of total net
    sales volume in the second half of Fiscal 2005), the successful
    introduction of new non-seasonal products is important to our
    strategic plan. The initial customer reaction to the
    availability of significant quantities of new products has been
    positive, as indicated by improved net sales trends in 22 out of
    24 non-seasonal product categories during the fourth quarter of
    Fiscal 2005.
|
| | Store Configuration. We completed the reconfiguration of
    our in-store product layout during the third quarter of Fiscal
    2005. Initiatives included cutting through long aisles to allow
    customers to navigate the stores more easily and repositioning
    merchandise categories to create adjacencies among coordinated
    items. In connection with the reconfiguration, we incurred
    non-recurring store labor expenses of approximately
    $1.0 million.                                                                                                                                                                                                                                                                                                                                                                                                 
|
| | Pricing and Promotion. During the first three quarters of
    Fiscal 2005, we de-emphasized our traditional
    promotional/discount pricing and instead adopted a strategy that
    generally emphasized low prices on a regular basis. Our
    advertising messages also were changed to reflect the new
    pricing approach. We believe that a weak customer response to
    the new pricing and advertising approach may have contributed to
    the decline in same-store net sales during Fiscal 2005 as
    compared to the prior fiscal year. Accordingly, in the fourth
    quarter of Fiscal 2005 we reinstated promotional/discount
    pricing, consistent with our traditional positioning as
    The Discount Party Superstore.                                                                                                                               

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| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Advertising. In the fourth quarter of Fiscal 2005, in
    connection with the return to our traditional discount pricing
    strategy, we adopted a more aggressive promotional stance in our
    advertising messages. Advertising inserts emphasized
    equity pricing statements that offered savings
    compared to manufacturers suggested retail prices,
    promotional offers, and lower priced items.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|
| | While the new product and store configuration initiatives,
    coupled with more aggressive promotional and advertising
    strategies, were not adopted until late in the fiscal year, we
    believe they have begun to contribute to an improvement in net
    sales trends. The decrease in same-store net sales of
    Company-owned stores was 0.8% for the fourth quarter of Fiscal
    2005 compared with the prior year period, which was the lowest
    quarterly decline since the second quarter of Fiscal 2004. This
    improvement reflected an increase of 3% in the average
    transaction for the fourth quarter of Fiscal 2005 as compared to
    the same quarter of the prior year, as well as a reduced decline
    in customer traffic comparing the fourth quarter of Fiscal 2005
    to the first three quarters of the fiscal year.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|
| | Logistics. Since July 2004, we have been receiving and
    distributing certain of our products for our Company-owned
    stores from two distribution centers  one in
    California and one in Pennsylvania. Earlier in Fiscal 2005,
    nearly all of our franchisees agreed to participate in our
    logistics program, and the addition of such franchisees to the
    program was implemented in January 2005 (discussed further
    below). We have outsourced the operations of this distribution
    network to a third party, and we have engaged a separate third
    party to provide management services to schedule and route
    product shipments. Additionally, a Preferred Carrier Program
    that was implemented in Fiscal 2004 has resulted in lower
    negotiated transportation rates, better visibility on deliveries
    to stores and improved service levels.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|
| | In the second half of Fiscal 2005, the volume of merchandise
    processed through our new distribution centers continued to
    increase materially as compared with the first half of Fiscal
    2005. At the end of Fiscal 2005, approximately 30% to 35% of
    corporate unit volume was being shipped through the distribution
    centers. The distribution initiative has resulted in a reduction
    in freight and handling costs per product case shipped as
    compared to our previous direct-to-store model. However, because
    we use the weighted average cost method to account for our
    inventory and cost of goods sold, and therefore our merchandise
    margin reflects a blend of the former and current cost
    structures, these savings have not yet been fully reflected in
    our financial results. Accordingly, the distribution initiative
    generated an incremental cost during Fiscal 2005 of
    approximately $2.9 million. We anticipate continued
    throughput increases during Fiscal 2006, thereby generating
    savings to more than offset operating costs of the distribution
    centers and provide the basis for improved financial
    performance. In light of the evaluation of strategic
    alternatives by the Board of Directors, as noted above, we are
    currently reviewing the timing of our plans for the next phase
    of the distribution initiative, although we believe it could be
    completed within two to three years.
|
| | Information Systems. In recent years we have focused on
    enhancing our store and corporate information systems to improve
    business processes, reduce store labor costs, and provide the
    systemic foundation for our logistics initiative. Continuing
    this process, in the second quarter of Fiscal 2006 we will begin
    to install a software system designed to forecast and project
    merchandise needs, as well as automate the replenishment of a
    large percentage of a stores inventory. This system is
    intended to contribute to our efforts to increase store in-stock
    levels, achieve efficiencies in purchasing, and eliminate
    certain in-store ordering functions to allow store personnel to
    focus on sales and customer service. In subsequent stages of our
    information systems initiative, we plan to install space
    planning and central planning systems.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|
| | Employee Base. During Fiscal 2005, we continued to add
    employees in key departments to support our initiatives in
    merchandising, planning and allocation and logistics. We also
    restructured our corporate and regional offices in an effort to
    streamline operations and reduce corporate expenses, resulting
    in a decrease of approximately 30 staff positions, or
    approximately 10% of corporate and regional headcount. Severance
    expense related to the restructuring was approximately
    $0.7 million in the fourth quarter of Fiscal 2005; however,
    we believe the staff reduction will eliminate more than
    $2.0 million of corporate expense on an annualized basis.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        

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| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Cash Flow and Liquidity. Cash on hand at the end of
    fiscal 2005 decreased by $16.8 million as compared to the
    prior year-end, primarily due to investments in inventory and
    working capital relating to the inclusion of franchise stores in
    the centralized distribution program and a commitment to
    increase in- stock levels in our stores, investments in other
    capital projects, cash payments relating to the settlement of
    California wage and hour litigation and lower net income. We had
    no advances outstanding under our loan agreement at any time
    during fiscal 2005.                                                                                                                                                                                                                        
|
| | Inventory was $72.8 million at the end of Fiscal 2005, as
    compared with $57.4 million a year ago. Approximately
    one-third of the increase relates to inventory necessary to
    support the franchisees program and the balance attributable to
    our efforts to increase our in-stock positions in Company-owned
    stores as well as additional seasonal merchandise that we plan
    to sell in future seasons. It is also important to emphasize
    that inventory on hand at year end was down nearly
    $15 million from the $87 million at the end of the
    third quarter this year. A major part of this reduction was due
    to our aggressive efforts to liquidate discontinued merchandise
    during the fourth quarter. By the end of Fiscal 2005 merchandise
    was in line with historical and year ago levels.
|
| | We believe that our recently completed product and store
    reconfiguration initiatives, the increased promotional and
    advertising activities adopted by the Executive Committee and
    the cost efficiencies to be gained from our self-distribution
    program should provide the basis for improved financial
    performance during Fiscal 2006.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    

Key Performance Indicators and Statistics




|                                                                                        |  |            |         |    |         |   |         |          |  |   |         |  
|--------------------------------------------------------------------------------------- |  | ---------- | ------- | -- | ------- | - | ------- | -------- |  | - | ------- | -
|                                                                                        |  | Year Ended |        
|                                                                                        |  |            |        
|                                                                                        |  | July 2,    |         |    | July 3, |   |         | June 28, | 
|                                                                                        |  | 2005       |         |    | 2004(c) |   |         | 2003     | 
|                                                                                        |  |            |         |    |         |   |         |          | 
|Net sales (in thousands)                                                                |  | $          | 467,668 |    |         | $ | 496,138 |          |  | $ | 464,258 |  
|Total Company-owned store count                                                         |  |            | 247     |    |         |   | 249     |          |  |   | 242     |  
|Average same store net sales for Company-owned
    storescurrent period (in thousands) |  | $          | 1,893   |    |         | $ | 2,034   |          |  | $ | 2,101   |  
|(Decrease) increase in Company-owned same store net sales                               |  |            | (4.7    | )% |         |   | 0.6     | %        |  |   | 2.2     | %
|Same store average net sale per retail transaction(a)                                   |  | $          | 19.16   |    |         | $ | 18.92   |          |  | $ | 18.70   |  
|Gross profit as a percent of net sales                                                  |  |            | 32.3    | %  |         |   | 33.0    | %        |  |   | 33.0    | %
|Store profit contribution as a percent of net sales                                     |  |            | 8.6     | %  |         |   | 10.2    | %        |  |   | 9.6     | %
|Diluted earnings per share                                                              |  | $          | 0.22    |    |         | $ | 0.71    |          |  | $ | 0.62    |  
|EBITDA(b) (in thousands)                                                                |  | $          | 24,585  |    |         | $ | 41,444  |          |  | $ | 40,372  |  
|Adjusted EBITDA(b) (in thousands)                                                       |  | $          | 27,416  |    |         | $ | 41,444  |          |  | $ | 41,877  |  
|(Decrease) increase in franchise same store net sales                                   |  |            | (3.1    | )% |         |   | 3.0     | %        |  |   | 3.7     | %






|    |  |                                                                                                                                                                       
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(a) |  | Same store net sales divided by same store retail transactions.
    Retail transactions represent each time a customer makes a
    purchase or return at the register.
|   
|(b) |  | See Part I, Item 6 Selected Financial Data
    for EBITDA and Adjusted EBITDA discussion and definition.                                                            
|   
|(c) |  | The figures provided for the fiscal year ended July 3, 2004
    reflect a 53-week year.                                                                               

Critical Accounting Policies and Estimates




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Merchandise inventory.








Allowance for doubtful accounts.


Finite long-lived assets.




| |   |                                                                                                     
| | - | ----------------------------------------------------------------------------------------------------
| |  | significant changes in the manner of our use of assets or the
    strategy for our overall business;
|
| |  | significant negative industry or economic trends;                                                   

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| |   |                                 
| | - | --------------------------------
| |  | store closings; or              
|
| |  | underperforming business trends.



Insurance accruals.


Goodwill.




Sales Returns.


Store Closure Costs.


Income Taxes.


28



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General Definitions for Operating Results


Net sales


Cost of goods sold and occupancy costs


Gross profit


Store operating and selling expenses


Company-owned store profit contribution


General and administrative expense


Franchising.


Franchise profit contribution


Interest expense, net


Results of Operations




29



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| |                                      
| | -------------------------------------
| | Fiscal 2005 Compared with Fiscal 2004

Retail.




|                                                   |       |                         |      |       |                                 |                                                                                                                                                                                                                                 | 
|-------------------------------------------------- | ----- | ----------------------- | ---- | ----- | ------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
|                                                   |       | Portion of Total Change |      |       |                                
|Component                                          |       | Increase/(Decrease)     |      |       | Reason for Increase/(Decrease):
|                                                   |       |                         |      |       |                                
|                                                   |       | (In millions)           |      |       |                                
|Net sales impact on merchandise margins            |       | $                       | (9.4 | )     |                                 | Due to lower total net sales including the absence of the 53
    rdweek in Fiscal 2005 (both same store and new store sales).                                                                                                  
|Merchandise margins (including distribution costs) |       |                         | (0.4 | )     |                                 | Due to incremental distribution costs of $2.9 million partially
    offset by a reduction in promotional markdown activity
    reflecting a shift to less promotional pricing as well as
    improved inventory shrink expense.
|Occupancy and other costs                          |       |                         | (3.0 | )     |                                 | Due to higher fixed expenses in proportion to net sales,
    partially offset by improved insurance claim experience.                                                                                                          
|                                                   |       |                         |      |       |                                
|                                                   | Total |                         | $    | (12.8 | )                               |                                                                                                                                                                                                                                 | 
|                                                   |       |                         |      |       |                                

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|                               |       |                         |      |      |                                 |                                                                                                                                                                                                                             | 
|------------------------------ | ----- | ----------------------- | ---- | ---- | ------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
|                               |       | Portion of Total Change |      |      |                                
|Component                      |       | Increase/(Decrease)     |      |      | Reason for Increase/(Decrease):
|                               |       |                         |      |      |                                
|                               |       | (In millions)           |      |      |                                
|Variable store operating costs |       | $                       | (1.6 | )    |                                 | Due to lower total net sales including the absence of the 53
    rdweek
    in Fiscal 2005 (both same store and new store sales).                                                                                          
|Payroll and fringe benefit     |       |                         | 0.4  |      |                                 | Due primarily to incremental store labor hours of $ 1.0 million
    required for the store reset initiative as well as higher costs
    of fringe benefits, partially offset by reduced year-end
    employee compensation.
|Payroll  labor efficiencies   |       |                         | (2.5 | )    |                                 | Due primarily to reduced labor costs from efficiency
    improvements.                                                                                                                                                     
|Other operating costs          |       |                         | 1.2  |      |                                 | Due primarily to increased advertising and charge card fees,
    partially offset by a gain realized on one store closing in the
    first quarter and a reduction in other store expenses.                                
|                               |       |                         |      |      |                                
|                               | Total |                         | $    | (2.5 | )                               |                                                                                                                                                                                                                             | 
|                               |       |                         |      |      |                                



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|                            |       |                         |     |     |                                 |                                                                                                                                                                                                                                                                                                                                                                                                                                        | 
|--------------------------- | ----- | ----------------------- | --- | --- | ------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
|                            |       | Portion of Total Change |     |     |                                
|Component                   |       | Increase/(Decrease)     |     |     | Reason for Increase/(Decrease):
|                            |       |                         |     |     |                                
|                            |       | (In millions)           |     |     |                                
|Payroll and fringe benefits |       | $                       | 4.1 |     |                                 | Due to increased corporate staffing and related staffing costs
    to support the transition of our product assortment, logistics
    and information systems initiatives as well as increased fringe
    benefits and severance for the departed CEO in the third quarter
    of Fiscal 2005 and staff reductions during the fourth quarter of
    Fiscal 2005, partially offset by reductions in year-end employee
    compensation.
|Occupancy                   |       |                         | 1.4 |     |                                 | Due to additional corporate office space.                                                                                                                                                                                                                                                                                                                                                                                             
|Other                       |       |                         | 0.5 |     |                                 | Due to the discontinuation of management fee income related to
    the ad-fund as well as increased sales and use tax expenses
    relating to state audits.                                                                                                                                                                                                                                                                          
|                            |       |                         |     |     |                                
|                            | Total |                         | $   | 6.0 |                                 |                                                                                                                                                                                                                                                                                                                                                                                                                                        | 
|                            |       |                         |     |     |                                





Franchising.








Interest Expense.


32



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Income Taxes.


Net Income.




| |                                      
| | -------------------------------------
| | Fiscal 2004 Compared with Fiscal 2003



Retail.




|                          |       |                         |      |      |                                      |                                                                                                                                                     | 
|------------------------- | ----- | ----------------------- | ---- | ---- | ------------------------------------ | --------------------------------------------------------------------------------------------------------------------------------------------------- | 
|                          |       | Portion of Total Change |      |      |                                     
|Component                 |       | Increase /(Decrease)    |      |      | Impact of Component on Gross Profit:
|                          |       |                         |      |      |                                     
|                          |       | (In millions)           |      |      |                                     
|Net sales                 |       | $                       | 10.5 |      |                                      | Due to increase in total sales.                                                                                                                    
|Merchandise margins       |       |                         | 2.1  |      |                                      | Due to improved product costing and pricing partially offset by
    increased mark down provisions during the year.                                
|Occupancy and other costs |       |                         | (1.9 | )    |                                      | Due to increased common area maintenance and real estate tax
    costs, as well as accelerated depreciation associated with
    in-store fixturing.
|                          |       |                         |      |      |                                     
|                          | Total |                         | $    | 10.7 |                                      |                                                                                                                                                     | 
|                          |       |                         |      |      |                                     



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|                                                 |       |                         |      |     |                                             |                                                                                                | 
|------------------------------------------------ | ----- | ----------------------- | ---- | --- | ------------------------------------------- | ---------------------------------------------------------------------------------------------- | 
|                                                 |       | Portion of Total Change |      |     | Impact of Components on Store Operating and
|Component                                        |       | Increase /(Decrease)    |      |     | Selling Expenses:                          
|                                                 |       |                         |      |     |                                            
|                                                 |       | (In millions)           |      |     |                                            
|Net sales                                        |       | $                       | 7.4  |     |                                             | Due to increase in total sales.                                                               
|Payroll and fringe benefits                      |       |                         | (0.2 | )   |                                             | Due to store labor efficiencies.                                                              
|Advertising                                      |       |                         | (0.4 | )   |                                             | Due to reduced grand opening charges.                                                         
|Credit card, bank fees and other operating costs |       |                         | (1.8 | )   |                                             | Due primarily to reduced inventory levels and corresponding
    physical inventory count fees.
|                                                 |       |                         |      |     |                                            
|                                                 | Total |                         | $    | 5.0 |                                             |                                                                                                | 
|                                                 |       |                         |      |     |                                            





|                               |       |                         |      |     |                                     |                                                                                       | 
|------------------------------ | ----- | ----------------------- | ---- | --- | ----------------------------------- | ------------------------------------------------------------------------------------- | 
|                               |       | Portion of Total Change |      |     | Impact of Components on General and
|Component                      |       | Increase /(Decrease)    |      |     | Administrative Expenses:           
|                               |       |                         |      |     |                                    
|                               |       | (In millions)           |      |     |                                    
|Litigation settlement          |       | $                       | 4.1  |     |                                     | Due to California class action settlement                                            
|Corporate payroll              |       |                         | 2.8  |     |                                     | Due to increased corporate staffing.                                                 
|Professional fees and training |       |                         | 0.9  |     |                                     | Due to information systems, logistics, and Sarbanes-Oxley
    compliance initiatives.
|Other                          |       |                         | 0.9  |     |                                     | Due to store closing expenditures.                                                   
|Impairment                     |       |                         | (1.5 | )   |                                     | Due to asset and goodwill impairment charges in Fiscal 2003.                         
|                               |       |                         |      |     |                                    
|                               | Total |                         | $    | 7.2 |                                     |                                                                                       | 
|                               |       |                         |      |     |                                    

Franchising.


34



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Interest Expense.


Income Taxes.


Net Income.


Liquidity and Capital Resources








| |   |                                                                                                                                                                                                            
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | implementing new merchandising systems;                                                                                                                                                                    
|
| |  | transitioning to our new corporate headquarters;                                                                                                                                                           
|
| |  | investing in our current and future permanent and temporary
    store locations;                                                                                                                           
|
| |  | improving customer service to foster a more direct, in depth
    relationship with our customers through our marketing efforts;                                                                            
|
| |  | our logistics initiative, pursuant to which we have outsourced
    the management of our centralized warehousing and distribution
    facilities and continued to enhance our distribution
    network; and
|
| |  | servicing our franchise owners participating in the distribution
    network.                                                                                                                              



35



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Key Indicators of Liquidity and Capital Resources




|                                  |                               |                                              |   |         |         |   |   |         |        | 
|--------------------------------- | ----------------------------- | -------------------------------------------- | - | ------- | ------- | - | - | ------- | ------ | 
|                                  |                               | Year Ended                                   |  
|                                  |                               |                                              |  
|                                  |                               | July 2,                                      |   |         | July 3, |  
|                                  |                               | 2005                                         |   |         | 2004    |  
|                                  |                               |                                              |   |         |         |  
|                                  |                               | (In thousands)                               |  
|Balance Sheet Data:               |                               |                                              |   |         |         |   |   |        
|                                  | Cash and cash equivalents     |                                              | $ | 11,034  |         |   | $ | 27,845  |       
|                                  | Working capital               |                                              |   | 46,753  |         |   |   | 34,818  |       
|                                  | Total assets                  |                                              |   | 183,973 |         |   |   | 177,417 |       
|                                  | Long term notes payable       |                                              |   |        |         |   |   |        |       
|                                  | Capital leases                |                                              |   | 741     |         |   |   |        |       
|                                  | Stockholders equity          |                                              |   | 102,927 |         |   |   | 96,838  |       
|Other Information:                |                               |                                              |   |         |         |   |   |        
|                                  | Depreciation and amortization |                                              | $ | 17,026  |         |   | $ | 17,601  |       
|Cash Flows (Used In) Provided By: |                               |                                              |   |         |         |   |   |        
|                                  | Operating activities          |                                              | $ | (5,486  | )       |   | $ | 51,599  |       
|                                  | Investing activities          |                                              |   | (12,214 | )       |   |   | (13,484 | )     
|                                  | Financing activities          |                                              |   | 889     |         |   |   | (13,642 | )     
|                                  |                               |                                              |   |         |         |  
|                                  |                               | Total cash (used in) provided by the Company |   | $       | (16,811 | ) |   | $       | 24,473 | 
|                                  |                               |                                              |   |         |         |  

Operating Activities.


Investing Activities.


36



---



##### Table of Contents





Financing Activities.


Loan Agreement.




Warrants.


Contractual Obligations and Commercial Commitments


|                    |  |                |         |           |           |   |             |                |  |            |             |  |      |        |       |  |              |   |     |  |  |   |       | 
|------------------- |  | -------------- | ------- | --------- | --------- | - | ----------- | -------------- |  | ---------- | ----------- |  | ---- | ------ | ----- |  | ------------ | - | --- |  |  | - | ----- | 
|                    |  |                |         |           |           |   |             | Logistics      |  |            |             |  |     
|                    |  |                |         | Operating |           |   | Merchandise |                |  | Initiative |             |  | Auto |        |       | 
|                    |  | Total          |         |           | Leases(1) |   |             | Commitments(2) |  |            | Obligations |  |      | Leases |       |  | Severance(3) |  
|                    |  |                |         |           |           |   |             |                |  |            |             |  |      |        |       |  |              |  
|                    |  | (In thousands) |        
|Fiscal year ending: |  |                |         |           |           |   |             |                |  |            |             |  |      |        |       |  |              |   |     |  |  |   |       | 
|2006                |  | $              | 72,669  |           |           | $ | 47,798      |                |  | $          | 20,744      |  |      | $      | 2,700 |  |              | $ | 265 |  |  | $ | 1,162 | 
|2007                |  |                | 46,912  |           |           |   | 44,002      |                |  |            |            |  |      |        | 2,700 |  |              |   | 210 |  |  |   |      | 
|2008                |  |                | 35,402  |           |           |   | 35,330      |                |  |            |            |  |      |        |      |  |              |   | 72  |  |  |   |      | 
|2009                |  |                | 23,478  |           |           |   | 23,478      |                |  |            |            |  |      |        |      |  |              |   |    |  |  |   |      | 
|2010                |  |                | 15,442  |           |           |   | 15,442      |                |  |            |            |  |      |        |      |  |              |   |    |  |  |   |      | 
|Thereafter          |  |                | 44,838  |           |           |   | 44,838      |                |  |            |            |  |      |        |      |  |              |   |    |  |  |   |      | 
|                    |  |                |         |           |           |   |             |                |  |            |             |  |      |        |       |  |              |  
|                    |  | $              | 238,741 |           |           | $ | 210,888     |                |  | $          | 20,744      |  |      | $      | 5,400 |  |              | $ | 547 |  |  | $ | 1,162 | 
|                    |  |                |         |           |           |   |             |                |  |            |             |  |      |        |       |  |              |  






|    |                                                                                                                                                                                                                                
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | We are also obligated for guarantees, subleases or assigned
    lease obligations for 22 of the franchise stores through 2011.
    The majority of the guarantees, subleases and assigned lease
    obligations were given when

37



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| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | we sold stores in 1999 as part of our restructuring. The
    guarantees, subleases and assigned lease obligations continue
    until the applicable leases expire. The maximum amount of the
    guarantees, subleases and assigned lease obligations may vary,
    but is limited to the sum of the total amount due under the
    lease. As of July 2, 2005, the maximum amount of the
    guarantees, subleases and assigned lease obligations was
    approximately $11.3 million, which is not included in the
    table above.





|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(2) | In Fiscal 2005, we purchased in excess of $400 million of
    merchandise from third party suppliers. We currently have one
    contract, which terminates on December 31, 2005 but may be
    extended until December 31, 2010 at the suppliers
    option, that provides for minimum merchandise commitments equal
    to less than 5% per year of our total merchandise purchased
    from third party suppliers (based on Fiscal 2005 total
    purchases). These potential merchandise commitments are not
    reflected in the table above.
|   
|(3) | We had an aggregate contingent liability of up to
    $1.9 million related to potential severance payments for 17
    employees as of August 30, 2005 and 16 employees as of
    July 2, 2005 pursuant to their respective employment
    agreements. We are not currently aware of any event that would
    trigger any or all of such $1.9 million contingent
    liability. These potential severance payments are not reflected
    in the table above.                                                                                       



Operating Leases.






Merchandise Commitments.


38



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##### Table of Contents





Logistics Initiative Obligations.


Auto Leases.


Severance.


Capital Leases.


Other.


Off-Balance Sheet Arrangements




Recent Accounting Pronouncements






39



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##### Table of Contents









| |                    
| | -------------------
| | Impact of Inflation





| |            
| | -----------
| | Seasonality










|         |                                                               
|-------- | --------------------------------------------------------------
|Item 7A. | Quantitative and Qualitative Disclosures about Market
    Risk








|        |                                            
|------- | -------------------------------------------
|Item 8. | Financial Statements and Supplementary Data



40



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|        |                                                                                         
|------- | ----------------------------------------------------------------------------------------
|Item 9. | Changes in and Disagreements with Accountants on
    Accounting and Financial Disclosure








|         |                        
|-------- | -----------------------
|Item 9A. | Controls and Procedures



| |                                        
| | ---------------------------------------
| | Evaluation of Disclosure and Procedures







| |                                                                     
| | --------------------------------------------------------------------
| | Managements Report on Internal Control Over
    Financial Reporting







41



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##### Table of Contents











| |                                               
| | ----------------------------------------------
| | Remediation Steps to Address Material Weakness





| |                                                         
| | --------------------------------------------------------
| | Changes in Internal Control over Financial
    Reporting



42



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##### Table of Contents



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM


















43



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##### Table of Contents













44



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##### Table of Contents








|         |                  
|-------- | -----------------
|Item 9B. | Other Information






PART III







|         |                                                   
|-------- | --------------------------------------------------
|Item 10. | Directors and Executive Officers of the Registrant



Code of Business Conduct and Ethics









|         |                       
|-------- | ----------------------
|Item 11. | Executive Compensation








|         |                                                                                                   
|-------- | --------------------------------------------------------------------------------------------------
|Item 12. | Security Ownership of Certain Beneficial Owners and
    Management and Related Stockholder Matters








|         |                                               
|-------- | ----------------------------------------------
|Item 13. | Certain Relationships and Related Transactions








|         |                                       
|-------- | --------------------------------------
|Item 14. | Principal Accountant Fees and Services



45



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##### Table of Contents






PART IV







|         |                                                                     
|-------- | --------------------------------------------------------------------
|Item 15. | Exhibits, Financial Statement Schedules, and Reports on
    Form 8-K







| |                                                                                                                          
| | -------------------------------------------------------------------------------------------------------------------------
| | Report of Independent Registered Public Accounting
    Firm  Deloitte & Touche LLP.                                     
|
| | Consolidated Balance Sheets as of July 2, 2005 and
    July 3, 2004.                                                     
|
| | Consolidated Statements of Income for the years ended
    July 2, 2005, July 3, 2004 and June 28, 2003.                  
|
| | Consolidated Statements of Stockholders Equity for the
    years ended July 2, 2005, July 3, 2004 and
    June 28, 2003.
|
| | Consolidated Statements of Cash Flows for the years ended
    July 2, 2005, July 3, 2004 and June 28, 2003.              
|
| | Notes to Consolidated Financial Statements for the years ended
    July 2, 2005, July 3, 2004 and June 28, 2003.         









46



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##### Table of Contents



EXHIBIT INDEX


|        |    |     |  |                                                                                                                                                                                                                                                                                                                                                                         
|------- | -- | --- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |    |    
|No.     |    |    
|        |    |    
|        | 3  | .1  |  | Amended and Restated Certificate of Incorporation of the
    Company, incorporated by reference from the Companys
    Quarterly Report on Form 10-Q as filed with the SEC on
    May 17, 2004 (the S-1).                                                                                                                                                             
|       
|        | 3  | .2  |  | Bylaws of the Company as amended, incorporated by reference from
    the Companys Quarterly Report on Form 10-Q as filed
    with the SEC on November 12, 2003 (the November
    2003 10-Q).                                                                                                                                                                         
|       
|        | 4  | .1  |  | Specimen stock certificate evidencing the Common Stock,
    incorporated by reference from the Companys Registration
    Statement as amended on Form S-1 Number 333-00350 as
    filed with the SEC on January 18, 1996 (the
    S-1).                                                                                                                              
|       
|        | 10 | .1  |  | Form of Unit Franchise Agreement entered into by the Company and
    franchisees, incorporated by reference from the S-1.                                                                                                                                                                                                                                               
|       
|        | 10 | .2  |  | Amended and Restated Investor Rights Agreement, dated as of
    August 18, 2003, by and among the Company and the
    Investors, incorporated by reference from the Companys
    Annual Report on Form 10-K as filed with the SEC on
    September 26, 2003 (the September
    2003 10-K).                                                                           
|       
|        | 10 | .3  |  | Description of oral consulting agreement between the Company and
    Ralph Dillon, incorporated by reference from the Companys
    Quarterly Report on Form 10-Q as filed with the SEC on
    February 13, 2001.                                                                                                                                                       
|       
|        | 10 | .4  |  | Consulting Agreement between the Company and Dillon Associates
    Retail Consultants, dated April 12, 2005, incorporated by
    reference from the Companys Current Report 8-K as
    filed with the SEC on April 18, 2005.                                                                                                                                           
|       
|        | 10 | .5  |  | Employment Agreement of Steven Skiba, dated as of
    November 29, 2002, by and between the Company and Steven
    Skiba, incorporated by reference from the September
    2003 10-K.                                                                                                                                                                                   
|       
|        | 10 | .6  |  | Employment Agreement of Linda Siluk, dated as of
    November 7, 2003, by and between the Company and Linda M.
    Siluk, incorporated by reference from the November
    2003 10-Q.                                                                                                                                                                                    
|       
|        | 10 | .7  |  | Separation Agreement of Linda M. Siluk, dated as of
    September 30, 2004, by and between the Company and Linda M.
    Siluk, incorporated by reference from the Companys Current
    Report on Form 8-K as filed with the SEC on October 1,
    2004.                                                                                                                
|       
|        | 10 | .8  |  | Employment Agreement of Warren Jeffrey, dated as of
    November 7, 2003, by and between the Company and Warren
    Jeffery, incorporated by reference from the November
    2003 10-Q. This Employment Agreement was terminated as of
    January 8, 2005, as specified in the Companys Current
    Report on Form 8-K as filed with the SEC on
    December 30, 2004.
|       
|        | 10 | .9  |  | Employment Agreement of Richard H. Griner dated as of
    January 12, 2004, by and between the Company and Richard H.
    Griner, incorporated by reference from the February
    2004 10-Q.                                                                                                                                                                            
|       
|        | 10 | .10 |  | Employment Agreement of Gregg A. Melnick, dated as of
    September 7, 2004, by and between the Company and Gregg A.
    Melnick incorporated by reference from the Companys
    Current Report on Form 8-K as filed on September 9,
    2004.                                                                                                                         
|       
|        | 10 | .11 |  | Employment Agreement of Lisa Laube, dated as of April 26,
    2004, by and between the Company and Lisa Laube incorporated by
    reference from the Companys Current Report on
    Form 10-Q as filed with the SEC on November 12, 2004.                                                                                                                              
|       
|        | 10 | .12 |  | Employment Agreement of Nancy Pedot, dated December 23,
    2004, by and between the Company and Nancy Pedot, incorporated
    by reference from the Companys Current Report on
    Form 8-K as filed with the SEC on December 27, 2004.                                                                                                                               
|       
|        | 10 | .13 |  | Separation Agreement of Nancy Pedot, dated March 30, 2005,
    by and between the Company and Nancy Pedot, incorporated by
    reference from the Companys Current Report on
    Form 8-K as filed with the SEC on August 1, 2005.                                                                                                                                     
|       
|        | 10 | .14 |  | Form of Indemnification Agreement, dated May 26, 2005, by
    and between the Company and each of its directors, incorporated
    by reference from the Companys Current Report on
    Form 8-K as filed with the SEC on May 26,2005.                                                                                                                                  
|       
|        | 10 | .15 |  | Form of Retention Bonus and Severance Agreements, dated
    June 30, 2005, by and between the Company and certain
    employees of the Company, incorporated by reference from the
    Companys Current Report on Form 8-K as filed with the
    SEC on July 5, 2005.                                                                                                  

47



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|        |     |     |  |                                                                                                                                                                                                                                                                                                                                                                                                                        
|------- | --- | --- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |     |    
|No.     |     |    
|        |     |    
|       
|        | 10  | .16 |  | Management Stock Purchase Plan of the Company, incorporated by
    reference from the Registration of Form S-8 as filed with
    the SEC on July 23, 2001.                                                                                                                                                                                                                                                             
|       
|        | 10  | .17 |  | Employee Stock Purchase Plan of the Company, incorporated by
    reference from the Companys Definitive Proxy Statement for
    the 2001 Annual Meeting of Stockholders, included within Form
    14-A as filed with the Commission on October 18, 2001.                                                                                                                                                              
|       
|        | 10  | .18 |  | Amended and Restated 1994 Stock Option Plan, incorporated by
    reference from the Registration of Form S-8 as filed with
    the SEC on January 9, 1997.                                                                                                                                                                                                                                                             
|       
|        | 10  | .19 |  | 1999 Stock Incentive Plan (Amended and Restated as of
    October 17, 2003), incorporated by reference from the
    Companys Definitive Proxy Statement for the 2003 Annual
    Meeting of Stockholders included within Form 14-A as filed with
    the SEC on October 20, 2003.                                                                                                                                      
|       
|        | 10  | .20 |  | Form of Employee Stock Option Agreement (1999 Stock Incentive
    Plan) incorporated by reference from the Companys
    Quarterly Report on Form 10-Q as filed with the SEC on
    February 10, 2005.                                                                                                                                                                                                                 
|       
|        | 10  | .21 |  | Forms of Non-Employee Director Stock Option Agreement (1999
    Stock Incentive Plan) incorporated by reference from the
    Companys Quarterly Report on Form 10-Q as filed with
    the SEC on February 10, 2005.                                                                                                                                                                                                   
|       
|        | 10  | .22 |  | Summary of Fiscal Year 2005 Corporate Bonus Plan incorporated by
    reference from the Companys Quarterly Report on
    Form 10-Q as filed with the SEC on February 10, 2005.                                                                                                                                                                                                                                        
|       
|        | 10  | .23 |  | Compensation Payable to Non-Employee Directors incorporated by
    reference from the Companys Quarterly Report on
    Form 10-Q as filed with the SEC on February 10, 2005.                                                                                                                                                                                                                                          
|       
|        | 10  | .24 |  | Loan and Security Agreement (the Loan Agreement),
    dated January 9, 2003, by and between the Company and Wells
    Fargo Retail Finance, LLC, (WFRF), as the arranger,
    collateral agent and administrative agent, and Fleet Retail
    Finance, Inc., as the documentation agent, incorporated by
    reference from the Companys Current Report on
    Form 8-K as filed with the SEC on January 10, 2003.
|       
|        | 10  | .25 |  | First Amendment to the Loan, dated February 10, 2005 by and
    between the Company and Wells Fargo Retail Finance, LLC
    incorporated by reference from the Companys Quarterly
    Report on Form 10-Q as filed with the SEC on
    February 10, 2005.                                                                                                                                                             
|       
|        | *10 | .26 |  | Second Amendment to the Loan, dated June 23, 2005 by and
    between the Company and Wells Fargo Retail Finance, LLC.                                                                                                                                                                                                                                                                                                  
|       
|        | 10  | .27 |  | Third Amendment to the Loan, dated July 15, 2005 by and
    between the Company and Wells Fargo Retail Finance, LLC,
    incorporated by reference from the Companys Current Report
    on Form 8-K as filed with the SEC on July 19, 2005.                                                                                                                                                                           
|       
|        | 10  | .28 |  | Stock Pledge Agreement, dated January 9, 2003, by and among
    the Company, Party City Michigan, Inc. (PCMI) and
    WFRF, as the arranger, collateral agent and administrative agent
    for the lender group under the Loan Agreement, incorporated by
    reference from the September 2003 10-K.                                                                                                                
|       
|        | 10  | .29 |  | Trademark Security Agreement, dated January 9, 2003, by and
    between the Company and WFRF, as the arranger, collateral agent
    and administrative agent for the lender group under the Loan
    Agreement, incorporated by reference from the September
    2003 10-K.                                                                                                                                            
|       
|        | 10  | .30 |  | Copyright Security Agreement, dated January 9, 2003, by and
    between the Company and WFRF, as the arranger, collateral agent
    and administrative agent for the lender group under the Loan
    Agreement, incorporated by reference from the September
    2003 10-K.                                                                                                                                            
|       
|        | 10  | .31 |  | Guaranty and Security Agreement, dated January 9, 2003, by
    and between PCMI and WFRF, as the arranger, collateral agent and
    administrative agent for the lender group under the Loan
    Agreement, incorporated by reference from the September
    2003 10-K.                                                                                                                                                
|       
|        | 10  | .32 |  | Agreement of Lease, dated September 16, 2004, by and
    between the Company and North Jersey Green 501, LLC, for the
    Companys new corporate headquarters, incorporated by
    reference from the Companys Current Report on
    Form 8-K as filed with the SEC on September 20, 2004.                                                                                                                           
|       
|        | 10  | .33 |  | First Modification of Agreement of Lease (included herein as
    Exhibit 10.26), dated January 26, 2005 by and between
    the Company and North Jersey Green 501, LLC incorporated by
    reference from the Companys Quarterly Report on
    Form 10-Q as filed with the SEC on February 10, 2005.                                                                                                                  

48



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##### Table of Contents



|        |     |    |  |                                                                                                                                                           
|------- | --- | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |     |   
|No.     |     |   
|        |     |   
|       
|        | *23 | .1 |  | Consent of Deloitte & Touche LLP.                                                                                                                         
|       
|        | *31 | .1 |  | Certification of Chief Executive Officer pursuant to
    18 U.S.C. Section 1350, as adopted pursuant to
    Section 302 of the Sarbanes-Oxley Act of 2002.
|       
|        | *31 | .2 |  | Certification of Chief Financial Officer pursuant to
    18 U.S.C. Section 1350, as adopted pursuant to
    Section 302 of the Sarbanes-Oxley Act of 2002.
|       
|        | *32 | .1 |  | Certification of Chief Executive Officer pursuant to
    18 U.S.C. Section 1350, as adopted pursuant to
    Section 906 of the Sarbanes-Oxley Act of 2002.
|       
|        | *32 | .2 |  | Certification of Chief Financial Officer pursuant to
    18 U.S.C. Section 1350, as adopted pursuant to
    Section 906 of the Sarbanes-Oxley Act of 2002.






|  |                 
|- | ----------------
|* | Included herein.

49



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##### Table of Contents



SIGNATURES






| |                       
| | ----------------------
| | PARTY CITY CORPORATION



| |     |                          
| | --- | -------------------------
| | By: | /s/ MICHAEL E. TENNENBAUM

| |                                    
| | -----------------------------------
| |                                    
| | Michael E. Tennenbaum              
| | Chairman of the Executive Committee



| |     |                     
| | --- | --------------------
| | By: | /s/ GREGG A. MELNICK

| |                        
| | -----------------------
| |                        
| | Gregg A. Melnick       
| | Chief Financial Officer



|     |  |                                                    |  |                                                  |  |                   
|---- |  | -------------------------------------------------- |  | ------------------------------------------------ |  | ------------------
|Name |  | Title                                              |  | Date                                            
|     |  |                                                    |  |                                                 
|    
|By:  |  | /s/ RALPH D. DILLONRalph
    D. Dillon             |  | Non-Executive Chairman of the Board and Director |  | September 15, 2005
|    
|By:  |  | /s/ MICHAEL E. TENNENBAUMMichael
    E. Tennenbaum |  | Vice Chairman and Director                       |  | September 15, 2005
|    
|By:  |  | /s/ L.R. JALENAK, JR.L.R.
    Jalenak, Jr.         |  | Director                                         |  | September 15, 2005
|    
|By:  |  | /s/ FRANKLIN R. JOHNSONFranklin
    R. Johnson     |  | Director                                         |  | September 15, 2005
|    
|By:  |  | /s/ HOWARD LEVKOWITZHoward
    Levkowitz           |  | Director                                         |  | September 15, 2005
|    
|By:  |  | /s/ WALTER SALMONWalter
    Salmon                 |  | Director                                         |  | September 15, 2005

50



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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM






















F-1



---



##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


CONSOLIDATED BALANCE SHEETS


|                                                    |                                                                                                                                                                                                                                     |                                            |        |        |         |  |        |        |         | 
|--------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ------ | ------ | ------- |  | ------ | ------ | ------- | 
|                                                    |                                                                                                                                                                                                                                     | As of                                      |       
|                                                    |                                                                                                                                                                                                                                     |                                            |       
|                                                    |                                                                                                                                                                                                                                     | July 2,                                    |        |        | July 3, | 
|                                                    |                                                                                                                                                                                                                                     | 2005                                       |        |        | 2004    | 
|                                                    |                                                                                                                                                                                                                                     |                                            |        |        |         | 
|                                                    |                                                                                                                                                                                                                                     | (In thousands, except                      |       
|                                                    |                                                                                                                                                                                                                                     | share data)                                |       
|ASSETS                                             
|Current assets:                                     |                                                                                                                                                                                                                                     |                                            |        |        |         |  |        |       
|                                                    | Cash and cash equivalents                                                                                                                                                                                                           |                                            | $      | 11,034 |         |  | $      | 27,845 |        
|                                                    | Merchandise inventory                                                                                                                                                                                                               |                                            |        | 72,818 |         |  |        | 57,357 |        
|                                                    | Other current assets, net                                                                                                                                                                                                           |                                            |        | 33,486 |         |  |        | 20,669 |        
|                                                    |                                                                                                                                                                                                                                     |                                            |        |        |         | 
|                                                    |                                                                                                                                                                                                                                     | Total current assets                       |        |        | 117,338 |  |        |        | 105,871 | 
|                                                    | Property and equipment, net                                                                                                                                                                                                         |                                            |        | 45,269 |         |  |        | 48,762 |        
|                                                    | Goodwill                                                                                                                                                                                                                            |                                            |        | 16,378 |         |  |        | 18,614 |        
|                                                    | Other assets                                                                                                                                                                                                                        |                                            |        | 4,988  |         |  |        | 4,170  |        
|                                                    |                                                                                                                                                                                                                                     |                                            |        |        |         | 
|                                                    |                                                                                                                                                                                                                                     | Total assets                               |        | $      | 183,973 |  |        | $      | 177,417 | 
|                                                    |                                                                                                                                                                                                                                     |                                            |        |        |         | 
|                                                   
|LIABILITIES AND STOCKHOLDERS EQUITY               
|Current liabilities:                                |                                                                                                                                                                                                                                     |                                            |        |        |         |  |        |       
|                                                    | Accounts payable                                                                                                                                                                                                                    |                                            | $      | 43,875 |         |  | $      | 38,364 |        
|                                                    | Accrued expenses and other current liabilities                                                                                                                                                                                      |                                            |        | 26,710 |         |  |        | 32,689 |        
|                                                    |                                                                                                                                                                                                                                     |                                            |        |        |         | 
|                                                    |                                                                                                                                                                                                                                     | Total current liabilities                  |        |        | 70,585  |  |        |        | 71,053  | 
|Long-term liabilities:                              |                                                                                                                                                                                                                                     |                                            |        |        |         |  |        |       
|                                                    | Deferred rent and other long-term liabilities                                                                                                                                                                                       |                                            |        | 10,461 |         |  |        | 9,526  |        
|Commitments and contingencies (See notes 13 and 15) |                                                                                                                                                                                                                                     |                                            |        |        |         |  |        |       
|Stockholders equity:                               |                                                                                                                                                                                                                                     |                                            |        |        |         |  |        |       
|                                                    | Common stock, $0.01 par value; 40,000,000 shares
    authorized; 18,030,360 shares issued and
    17,283,348 shares outstanding at July 2, 2005;
    17,835,778 shares issued and 17,088,766 shares
    outstanding at July 3, 2004 |                                            |        | 180    |         |  |        | 178    |        
|Additional paid-in capital                          |                                                                                                                                                                                                                                     |                                            | 48,506 |        |         |  | 46,683 |       
|Retained earnings                                   |                                                                                                                                                                                                                                     |                                            | 60,181 |        |         |  | 55,917 |       
|Treasury stock, at cost (747,012 shares)            |                                                                                                                                                                                                                                     |                                            | (5,940 | )      |         |  | (5,940 | )     
|                                                    |                                                                                                                                                                                                                                     |                                            |        |        |         | 
|                                                    |                                                                                                                                                                                                                                     | Total stockholders equity                 |        |        | 102,927 |  |        |        | 96,838  | 
|                                                    |                                                                                                                                                                                                                                     |                                            |        |        |         | 
|                                                    |                                                                                                                                                                                                                                     | Total liabilities and stockholders equity |        | $      | 183,973 |  |        | $      | 177,417 | 
|                                                    |                                                                                                                                                                                                                                     |                                            |        |        |         | 



F-2



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


CONSOLIDATED STATEMENTS OF INCOME


|                           |                                                    |                                       |       |         |         |   |        |          |         |   |        |         |         | 
|-------------------------- | -------------------------------------------------- | ------------------------------------- | ----- | ------- | ------- | - | ------ | -------- | ------- | - | ------ | ------- | ------- | 
|                           |                                                    | Year Ended                            |      
|                           |                                                    |                                       |      
|                           |                                                    | July 2,                               |       |         | July 3, |   |        | June 28, |        
|                           |                                                    | 2005                                  |       |         | 2004    |   |        | 2003     |        
|                           |                                                    |                                       |       |         |         |   |        |          |        
|                           |                                                    | (In thousands, except per share data) |      
|Revenues:                  |                                                    |                                       |       |         |         |   |        |          |         |   |        |        
|                           | Net sales (retail)                                 |                                       | $     | 467,668 |         |   | $      | 496,138  |         |   | $      | 464,258 |        
|                           | Royalty fees                                       |                                       |       | 19,666  |         |   |        | 19,521   |         |   |        | 18,007  |        
|                           | Net sales to franchisees                           |                                       |       | 16,372  |         |   |        |         |         |   |        |        |        
|                           | Franchise fees                                     |                                       |       | 160     |         |   |        | 608      |         |   |        | 355     |        
|                           |                                                    |                                       |       |         |         |   |        |          |        
|                           |                                                    | Total revenues                        |       |         | 503,866 |   |        |          | 516,267 |   |        |         | 482,620 | 
|Expenses:                  |                                                    |                                       |       |         |         |   |        |          |         |   |        |        
|                           | Cost of goods sold and occupancy costs (retail)    |                                       |       | 316,663 |         |   |        | 332,311  |         |   |        | 311,170 |        
|                           | Cost of goods sold to franchisees                  |                                       |       | 14,388  |         |   |        |         |         |   |        |        |        
|                           | Company-owned store operating and selling expense  |                                       |       | 110,757 |         |   |        | 113,292  |         |   |        | 108,294 |        
|                           | Franchise transportation and other selling expense |                                       |       | 2,024   |         |   |        |         |         |   |        |        |        
|                           | Other franchise expense                            |                                       |       | 8,142   |         |   |        | 7,184    |         |   |        | 6,538   |        
|                           | General and administrative expense                 |                                       |       | 41,502  |         |   |        | 35,537   |         |   |        | 30,970  |        
|                           | Impairment charges                                 |                                       |       | 2,831   |         |   |        |         |         |   |        | 1,505   |        
|                           | Litigation charges                                 |                                       |       |        |         |   |        | 4,100    |         |   |        |        |        
|                           |                                                    |                                       |       |         |         |   |        |          |        
|                           |                                                    | Total expenses                        |       |         | 496,307 |   |        |          | 492,424 |   |        |         | 458,477 | 
|                           |                                                    |                                       |       |         |         |   |        |          |        
|Operating income           |                                                    |                                       | 7,559 |         |         |   | 23,843 |          |         |   | 24,143 |        
|                           | Interest income                                    |                                       |       | (451    | )       |   |        | (92      | )       |   |        | (175    | )      
|                           | Interest expense                                   |                                       |       | 500     |         |   |        | 563      |         |   |        | 4,165   |        
|                           |                                                    |                                       |       |         |         |   |        |          |        
|                           | Interest expense, net                              |                                       |       | 49      |         |   |        | 471      |         |   |        | 3,990   |        
|                           |                                                    |                                       |       |         |         |   |        |          |        
|Income before income taxes |                                                    |                                       | 7,510 |         |         |   | 23,372 |          |         |   | 20,153 |        
|Provision for income taxes |                                                    |                                       | 3,246 |         |         |   | 9,466  |          |         |   | 8,061  |        
|                           |                                                    |                                       |       |         |         |   |        |          |        
|Net income                 |                                                    | $                                     | 4,264 |         |         | $ | 13,906 |          |         | $ | 12,092 |        
|                           |                                                    |                                       |       |         |         |   |        |          |        
|                           | Basic earnings per share                           |                                       | $     | 0.25    |         |   | $      | 0.82     |         |   | $      | 0.73    |        
|                           |                                                    |                                       |       |         |         |   |        |          |        
|                           | Weighted average shares outstanding  basic        |                                       |       | 17,184  |         |   |        | 16,880   |         |   |        | 16,602  |        
|                           |                                                    |                                       |       |         |         |   |        |          |        
|                           | Diluted earnings per share                         |                                       | $     | 0.22    |         |   | $      | 0.71     |         |   | $      | 0.62    |        
|                           |                                                    |                                       |       |         |         |   |        |          |        
|                           | Weighted average shares outstanding  diluted      |                                       |       | 19,831  |         |   |        | 19,651   |         |   |        | 19,646  |        
|                           |                                                    |                                       |       |         |         |   |        |          |        



F-3



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY


|                                                     |  |                                   |            |  |            |   |     |          |  |          |          |  |  |      |        |  |       |   |        |   |  |   |         |  
|---------------------------------------------------- |  | --------------------------------- | ---------- |  | ---------- | - | --- | -------- |  | -------- | -------- |  |  | ---- | ------ |  | ----- | - | ------ | - |  | - | ------- | -
|                                                     |  | Common Stock                      |            |  | Additional |   |     |          |  | Treasury |          |  | 
|                                                     |  |                                   |            |  | Paid-in-   |   |     | Retained |  |          | Stock at |  |  |     
|                                                     |  | Shares                            |            |  | Amounts    |   |     | Capital  |  |          | Earnings |  |  | Cost |        |  | Total |  
|                                                     |  |                                   |            |  |            |   |     |          |  |          |          |  |  |      |        |  |       |  
|                                                     |  | (In thousands, except share data) |           
|Balance at June 29, 2002                             |  |                                   | 16,239,081 |  |            | $ | 162 |          |  | $        | 39,347   |  |  | $    | 29,919 |  |       | $ | (1,829 | ) |  | $ | 67,599  |  
|Warrant exercise                                     |  |                                   | 672,459    |  |            |   | 7   |          |  |          | 484      |  |  |      |       |  |       |   |       |   |  |   | 491     |  
|Equity compensation                                  |  |                                   |           |  |            |   |    |          |  |          | 342      |  |  |      |       |  |       |   |       |   |  |   | 342     |  
|Tax effect of non-qualified options                  |  |                                   |           |  |            |   |    |          |  |          | 556      |  |  |      |       |  |       |   |       |   |  |   | 556     |  
|Exercise of stock options                            |  |                                   | 213,486    |  |            |   | 2   |          |  |          | 1,130    |  |  |      |       |  |       |   |       |   |  |   | 1,132   |  
|Issuance of shares of Management Stock Purchase Plan |  |                                   | 95,511     |  |            |   | 1   |          |  |          | 707      |  |  |      |       |  |       |   |       |   |  |   | 708     |  
|Issuance of shares of Employee Stock Purchase Plan   |  |                                   | 76,270     |  |            |   | 1   |          |  |          | 612      |  |  |      |       |  |       |   |       |   |  |   | 613     |  
|Repurchase of common shares (463,012 shares)         |  |                                   |           |  |            |   |    |          |  |          |         |  |  |      |       |  |       |   | (4,111 | ) |  |   | (4,111  | )
|Net income                                           |  |                                   |           |  |            |   |    |          |  |          |         |  |  |      | 12,092 |  |       |   |       |   |  |   | 12,092  |  
|                                                     |  |                                   |            |  |            |   |     |          |  |          |          |  |  |      |        |  |       |  
|Balance at June 28, 2003                             |  |                                   | 17,296,807 |  |            |   | 173 |          |  |          | 43,178   |  |  |      | 42,011 |  |       |   | (5,940 | ) |  |   | 79,422  |  
|Equity compensation                                  |  |                                   |           |  |            |   |    |          |  |          | 102      |  |  |      |       |  |       |   |       |   |  |   | 102     |  
|Tax effect on non-qualified options                  |  |                                   |           |  |            |   |    |          |  |          | 1,110    |  |  |      |       |  |       |   |       |   |  |   | 1,110   |  
|Exercise of stock options                            |  |                                   | 471,220    |  |            |   | 4   |          |  |          | 1,709    |  |  |      |       |  |       |   |       |   |  |   | 1,713   |  
|Issuance of shares of Management Stock Purchase Plan |  |                                   | 10,880     |  |            |   |    |          |  |          | 87       |  |  |      |       |  |       |   |       |   |  |   | 87      |  
|Issuance of shares of Employee Stock Purchase Plan   |  |                                   | 56,871     |  |            |   | 1   |          |  |          | 497      |  |  |      |       |  |       |   |       |   |  |   | 498     |  
|Net income                                           |  |                                   |           |  |            |   |    |          |  |          |         |  |  |      | 13,906 |  |       |   |       |   |  |   | 13,906  |  
|                                                     |  |                                   |            |  |            |   |     |          |  |          |          |  |  |      |        |  |       |  
|Balance at July 3, 2004                              |  |                                   | 17,835,778 |  |            |   | 178 |          |  |          | 46,683   |  |  |      | 55,917 |  |       |   | (5,940 | ) |  |   | 96,838  |  
|Equity compensation                                  |  |                                   |           |  |            |   |    |          |  |          | 47       |  |  |      |       |  |       |   |       |   |  |   | 47      |  
|Tax effect on non-qualified options                  |  |                                   |           |  |            |   |    |          |  |          | 176      |  |  |      |       |  |       |   |       |   |  |   | 176     |  
|Exercise of stock options                            |  |                                   | 136,849    |  |            |   | 1   |          |  |          | 1,029    |  |  |      |       |  |       |   |       |   |  |   | 1,030   |  
|Issuance of shares of Management Stock Purchase Plan |  |                                   | 8,895      |  |            |   |    |          |  |          | 52       |  |  |      |       |  |       |   |       |   |  |   | 52      |  
|Issuance of shares of Employee Stock Purchase Plan   |  |                                   | 48,838     |  |            |   | 1   |          |  |          | 519      |  |  |      |       |  |       |   |       |   |  |   | 520     |  
|Net income                                           |  |                                   |           |  |            |   |    |          |  |          |         |  |  |      | 4,264  |  |       |   |       |   |  |   | 4,264   |  
|                                                     |  |                                   |            |  |            |   |     |          |  |          |          |  |  |      |        |  |       |  
|Balance at July 2, 2005                              |  |                                   | 18,030,360 |  |            | $ | 180 |          |  | $        | 48,506   |  |  | $    | 60,181 |  |       | $ | (5,940 | ) |  | $ | 102,927 |  
|                                                     |  |                                   |            |  |            |   |     |          |  |          |          |  |  |      |        |  |       |  



F-4



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


CONSOLIDATED STATEMENTS OF CASH FLOWS


|                                                          |                                                                                                 |                                                |                                                     |          |         |         |        |          |        |         |       |         |        |         |  
|--------------------------------------------------------- | ----------------------------------------------------------------------------------------------- | ---------------------------------------------- | --------------------------------------------------- | -------- | ------- | ------- | ------ | -------- | ------ | ------- | ----- | ------- | ------ | ------- | -
|                                                          |                                                                                                 | Year Ended                                     |                                                    
|                                                          |                                                                                                 |                                                |                                                    
|                                                          |                                                                                                 | July 2,                                        |                                                     |          | July 3, |         |        | June 28, |       
|                                                          |                                                                                                 | 2005                                           |                                                     |          | 2004    |         |        | 2003     |       
|                                                          |                                                                                                 |                                                |                                                     |          |         |         |        |          |       
|                                                          |                                                                                                 | (In thousands)                                 |                                                    
|Cash flow from operating activities:                      |                                                                                                 |                                                |                                                     |          |         |         |        |          |        |         |       |        
|                                                          | Net income                                                                                      |                                                | $                                                   | 4,264    |         |         | $      | 13,906   |        |         | $     | 12,092  |       
|                                                          | Adjustments to reconcile net income to net cash (used in)
    provided by operating activities: |                                                |                                                     |          |         |         |        |          |        |         |       |         |       
|                                                          |                                                                                                 | Depreciation and amortization                  |                                                     |          | 17,026  |         |        |          | 17,601 |         |       |         | 16,229 |        
|                                                          |                                                                                                 | Impairment of assets                           |                                                     |          | 2,831   |         |        |          |       |         |       |         | 1,505  |        
|                                                          |                                                                                                 | Amortization of financing costs                |                                                     |          | 159     |         |        |          | 163    |         |       |         | 1,624  |        
|                                                          |                                                                                                 | Deferred rent                                  |                                                     |          | 411     |         |        |          | (608   | )       |       |         | 556    |        
|                                                          |                                                                                                 | Deferred taxes                                 |                                                     |          | 2,311   |         |        |          | (1,051 | )       |       |         | (2,131 | )      
|                                                          |                                                                                                 | Stock-based compensation                       |                                                     |          | 47      |         |        |          | 102    |         |       |         | 342    |        
|                                                          |                                                                                                 | Provision for doubtful accounts                |                                                     |          | 343     |         |        |          | (141   | )       |       |         | (498   | )      
|                                                          |                                                                                                 | Other                                          |                                                     |          | 389     |         |        |          | 72     |         |       |         | 162    |        
|                                                          | Changes in assets and liabilities:                                                              |                                                |                                                     |          |         |         |        |          |        |         |       |         |       
|                                                          |                                                                                                 | Merchandise inventory                          |                                                     |          | (15,461 | )       |        |          | 8,551  |         |       |         | (9,634 | )      
|                                                          |                                                                                                 | Accounts payable                               |                                                     |          | 5,511   |         |        |          | 404    |         |       |         | 5,545  |        
|                                                          |                                                                                                 | Accrued expenses and other current liabilities |                                                     |          | (6,290  | )       |        |          | 9,298  |         |       |         | (1,381 | )      
|                                                          |                                                                                                 | Other long-term liabilities                    |                                                     |          | (3      | )       |        |          | (41    | )       |       |         | 121    |        
|                                                          |                                                                                                 | Other current assets and other assets          |                                                     |          | (17,024 | )       |        |          | 3,343  |         |       |         | (1,444 | )      
|                                                          |                                                                                                 |                                                |                                                     |          |         |         |        |          |       
|                                                          |                                                                                                 |                                                | Net cash (used in) provided by operating activities |          |         | (5,486  | )      |          |        | 51,599  |       |         |        | 23,088  |  
|                                                          |                                                                                                 |                                                |                                                     |          |         |         |        |          |       
|Cash flow from investing activities:                      |                                                                                                 |                                                |                                                     |          |         |         |        |          |        |         |       |        
|                                                          | Purchase of short-term investments                                                              |                                                |                                                     | (123,125 | )       |         |        |         |        |         |       |        |       
|                                                          | Sale of short-term investments                                                                  |                                                |                                                     | 123,125  |         |         |        |         |        |         |       |        |       
|                                                          | Purchases of property and equipment                                                             |                                                |                                                     | (12,464  | )       |         |        | (13,484  | )      |         |       | (20,476 | )     
|                                                          | Proceeds from the sale of assets                                                                |                                                |                                                     | 250      |         |         |        |         |        |         |       |        |       
|                                                          | Stores acquired                                                                                 |                                                |                                                     |         |         |         |        |         |        |         |       | (1,758  | )     
|                                                          |                                                                                                 |                                                |                                                     |          |         |         |        |          |       
|                                                          |                                                                                                 |                                                | Net cash used in investing activities               |          |         | (12,214 | )      |          |        | (13,484 | )     |         |        | (22,234 | )
|                                                          |                                                                                                 |                                                |                                                     |          |         |         |        |          |       
|Cash flow from financing activities:                      |                                                                                                 |                                                |                                                     |          |         |         |        |          |        |         |       |        
|                                                          | Proceeds from exercise of stock options and warrants                                            |                                                |                                                     | 1,030    |         |         |        | 1,713    |        |         |       | 1,623   |       
|                                                          | Repayment of capital lease                                                                      |                                                |                                                     | (141     | )       |         |        |         |        |         |       |        |       
|                                                          | Net (repayment of) proceeds from Loan Agreement                                                 |                                                |                                                     |         |         |         |        | (11,229  | )      |         |       | 11,229  |       
|                                                          | Change in cash overdrafts                                                                       |                                                |                                                     |         |         |         |        | (4,126   | )      |         |       | 1,041   |       
|                                                          | Payments on senior notes                                                                        |                                                |                                                     |         |         |         |        |         |        |         |       | (10,207 | )     
|                                                          | Purchase of treasury shares                                                                     |                                                |                                                     |         |         |         |        |         |        |         |       | (4,111  | )     
|                                                          | Payment of financing costs                                                                      |                                                |                                                     |         |         |         |        |         |        |         |       | (524    | )     
|                                                          |                                                                                                 |                                                |                                                     |          |         |         |        |          |       
|                                                          |                                                                                                 |                                                | Net cash provided by (used in) financing activities |          |         | 889     |        |          |        | (13,642 | )     |         |        | (949    | )
|                                                          |                                                                                                 |                                                |                                                     |          |         |         |        |          |       
|Net (decrease) increase in cash and cash equivalents      |                                                                                                 |                                                | (16,811                                             | )        |         |         | 24,473 |          |        |         | (95   | )      
|Cash and cash equivalents, beginning of year              |                                                                                                 |                                                | 27,845                                              |          |         |         | 3,372  |          |        |         | 3,467 |        
|                                                          |                                                                                                 |                                                |                                                     |          |         |         |        |          |       
|Cash and cash equivalents, end of year                    |                                                                                                 | $                                              | 11,034                                              |          |         | $       | 27,845 |          |        | $       | 3,372 |        
|                                                          |                                                                                                 |                                                |                                                     |          |         |         |        |          |       
|Supplemental disclosure of cash flow information:         |                                                                                                 |                                                |                                                     |          |         |         |        |          |        |         |       |        
|                                                          | Income taxes paid                                                                               |                                                | $                                                   | 6,493    |         |         | $      | 8,531    |        |         | $     | 9,895   |       
|                                                          | Interest paid                                                                                   |                                                | $                                                   | 340      |         |         | $      | 401      |        |         | $     | 2,978   |       
|                                                          | Tax-effect on non-qualified stock options                                                       |                                                | $                                                   | 176      |         |         | $      | 1,110    |        |         | $     | 556     |       
|Supplemental disclosure of non-cash investing activity:   |                                                                                                 |                                                |                                                     |          |         |         |        |          |        |         |       |        
|                                                          | Accrued purchases of property and equipment                                                     |                                                | $                                                   | 1,374    |         |         | $      |         |        |         | $     |        |       
|Supplemental disclosure of non-cash financing activities: |                                                                                                 |                                                |                                                     |          |         |         |        |          |        |         |       |        
|                                                          | Issuance of shares under employee stock purchase plan                                           |                                                | $                                                   | 520      |         |         | $      | 498      |        |         | $     | 613     |       
|                                                          | Issuance of shares under management stock purchase plan                                         |                                                | $                                                   | 52       |         |         | $      | 87       |        |         | $     | 708     |       
|                                                          | Capital lease obligation used to purchase fixed assets                                          |                                                | $                                                   | 851      |         |         | $      |         |        |         | $     |        |       
|                                                          | Issuance of warrants                                                                            |                                                | $                                                   |         |         |         | $      |         |        |         | $     | 245     |       



F-5



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS




|   |                                           
|-- | ------------------------------------------
|1. | Summary of Significant Accounting Policies



| |                                  
| | ---------------------------------
| | Consolidated Financial Statements







| |                 
| | ----------------
| | Use of Estimates









| |                          
| | -------------------------
| | Cash and Cash Equivalents





| |                       
| | ----------------------
| | Short-Term Investments



F-6



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




| |                                    
| | -----------------------------------
| | Fair Value of Financial Instruments





| |                      
| | ---------------------
| | Merchandise Inventory











| |                                
| | -------------------------------
| | Allowance for Doubtful Accounts





| |                  
| | -----------------
| | Vendor Allowances



F-7



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)










| |           
| | ----------
| | Litigation





| |               
| | --------------
| | Self-Insurance





| |                  
| | -----------------
| | Advertising Costs





| |                 
| | ----------------
| | Advertising Fund





| |                       
| | ----------------------
| | Property and Equipment



F-8



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)








| |                                  
| | ---------------------------------
| | Impairment of Finite-Lived Assets





| |                      
| | ---------------------
| | Non-Compete Agreement



|                           |  |                |     | 
|-------------------------- |  | -------------- | --- | 
|                           |  | Amortization   |    
|                           |  | Expense        |    
|                           |  |                |    
|                           |  | (In thousands) |    
|Fiscal Year Ending:        |  |                |     | 
|2006                       |  | $              | 82  | 
|2007                       |  |                | 82  | 
|2008                       |  |                | 82  | 
|2009                       |  |                | 21  | 
|2010                       |  |                | 1   | 
|Thereafter                 |  |                | 13  | 
|                           |  |                |    
|Total amortization expense |  | $              | 281 | 
|                           |  |                |    

F-9



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




| |         
| | --------
| | Goodwill







| |             
| | ------------
| | Income Taxes





| |                         
| | ------------------------
| | Stock-Based Compensation



|                        |  |            |           |   |         |  |           |          |  |  |           |  
|----------------------- |  | ---------- | --------- | - | ------- |  | --------- | -------- |  |  | --------- | -
|                        |  | Year Ended |          
|                        |  |            |          
|                        |  | July 2,    |           |   | July 3, |  |           | June 28, | 
|                        |  | 2005       |           |   | 2004    |  |           | 2003     | 
|                        |  |            |           |   |         |  |           |          | 
|Expected volatility     |  |            | 52        | % |         |  | 55        | %        |  |  | 55        | %
|Expected lives          |  |            | 4.0 years |   |         |  | 4.0 years |          |  |  | 5.4 years |  
|Risk-free interest rate |  |            | 3.3       | % |         |  | 2.5       | %        |  |  | 2.3       | %
|Expected dividend yield |  |            | 0.0       | % |         |  | 0.0       | %        |  |  | 0.0       | %





F-10



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|                            |                                                                                                                             |                |       |        |         |   |        |          |   |   |        |        |  
|--------------------------- | --------------------------------------------------------------------------------------------------------------------------- | -------------- | ----- | ------ | ------- | - | ------ | -------- | - | - | ------ | ------ | -
|                            |                                                                                                                             | Year Ended     |      
|                            |                                                                                                                             |                |      
|                            |                                                                                                                             | July 2,        |       |        | July 3, |   |        | June 28, |  
|                            |                                                                                                                             | 2005           |       |        | 2004    |   |        | 2003     |  
|                            |                                                                                                                             |                |       |        |         |   |        |          |  
|                            |                                                                                                                             | (In thousands) |      
|Net income as reported      |                                                                                                                             | $              | 4,264 |        |         | $ | 13,906 |          |   | $ | 12,092 |       
|                            | Add: Stock-based employee compensation expense determined under
    APB 25, net of tax                                      |                |       | 28     |         |   |        | 73       |   |   |        | 205    |  
|                            | Deduct: Total stock based employee compensation determined under
    fair value based method of SFAS No. 123, net of tax(1) |                |       | (2,022 | )       |   |        | (1,816   | ) |   |        | (1,247 | )
|                            |                                                                                                                             |                |       |        |         |   |        |          |  
|                            | Pro-Forma net income                                                                                                        |                | $     | 2,270  |         |   | $      | 12,163   |   |   | $      | 11,050 |  
|                            |                                                                                                                             |                |       |        |         |   |        |          |  
|Basic earnings per share:   |                                                                                                                             |                |       |        |         |   |        |          |   |   |        |       
|                            | As reported                                                                                                                 |                | $     | 0.25   |         |   | $      | 0.82     |   |   | $      | 0.73   |  
|                            | Pro-forma                                                                                                                   |                | $     | 0.13   |         |   | $      | 0.72     |   |   | $      | 0.67   |  
|Diluted earnings per share: |                                                                                                                             |                |       |        |         |   |        |          |   |   |        |       
|                            | As reported                                                                                                                 |                | $     | 0.22   |         |   | $      | 0.71     |   |   | $      | 0.62   |  
|                            | Pro-forma                                                                                                                   |                | $     | 0.11   |         |   | $      | 0.62     |   |   | $      | 0.56   |  






|    |                                                                                                                                                                                                                                  
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | In accordance with SFAS No. 123, the fair value of
    each option grant is estimated on the date of grant using the
    Black-Scholes option-pricing model using the above assumptions
    for grants in the respective periods.



| |                   
| | ------------------
| | Earnings Per Share





| |                    
| | -------------------
| | Revenue Recognition





F-11



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)








| |                 
| | ----------------
| | Operating Leases





| |                                
| | -------------------------------
| | Store Opening and Closing Costs





| |                                 
| | --------------------------------
| | Recent Accounting Pronouncements







F-12



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)






| |            
| | -----------
| | Seasonality







| |              
| | -------------
| | Concentration





|          |                   |            |  |      |         |  |  |          |   |  |  |      |  
|--------- | ----------------- | ---------- |  | ---- | ------- |  |  | -------- | - |  |  | ---- | -
|          |                   | Year Ended | 
|          |                   |            | 
|          |                   | July 2,    |  |      | July 3, |  |  | June 28, |  
|          |                   | 2005       |  |      | 2004    |  |  | 2003     |  
|          |                   |            |  |      |         |  |  |          |  
|Seasonal: |                   |            |  |      |         |  |  |          |   |  |  |     
|          | Halloween         |            |  | 20   | %       |  |  | 20       | % |  |  | 19   | %
|          | All other seasons |            |  | 16   | %       |  |  | 16       | % |  |  | 19   | %
|         
|          | Non-seasonal      |            |  | 64   | %       |  |  | 64       | % |  |  | 62   | %
|          |                   |            |  |      |         |  |  |          |  
|          |                   |            |  | 100% |         |  |  | 100%     |   |  |  | 100% |  
|          |                   |            |  |      |         |  |  |          |  



| |                  
| | -----------------
| | Reclassifications



F-13



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|   |         
|-- | --------
|2. | Goodwill



|                                             |                                        |         |        |        |  
|-------------------------------------------- | -------------------------------------- | ------- | ------ | ------ | -
|                                             |                                        | Balance |       
|                                             |                                        |         |       
|Balance as of June 28, 2003 and July 3, 2004 |                                        | $       | 18,614 |       
|                                             | Goodwill impairment during Fiscal 2005 |         |        | (2,236 | )
|                                             |                                        |         |       
|Balance as of July 2, 2005                   |                                        | $       | 16,378 |       
|                                             |                                        |         |       



|   |                     
|-- | --------------------
|3. | Other Current Assets



|                                          |  |         |        |   |         |   |        |  
|----------------------------------------- |  | ------- | ------ | - | ------- | - | ------ | -
|                                          |  | July 2, |        |   | July 3, |  
|                                          |  | 2005    |        |   | 2004    |  
|                                          |  |         |        |   |         |  
|Prepaid expenses and other current assets |  | $       | 11,163 |   |         | $ | 3,984  |  
|Receivables from franchisees              |  |         | 10,340 |   |         |   | 2,354  |  
|Deferred taxes                            |  |         | 6,199  |   |         |   | 9,298  |  
|Prepaid rent                              |  |         | 4,699  |   |         |   | 3,794  |  
|Advance merchandise payments              |  |         | 1,280  |   |         |   | 595    |  
|Advertising Fund Cash                     |  |         | 296    |   |         |   | 792    |  
|                                          |  |         |        |   |         |  
|                                          |  |         | 33,977 |   |         |   | 20,817 |  
|Less: Allowance for doubtful accounts     |  |         | (491   | ) |         |   | (148   | )
|                                          |  |         |        |   |         |  
|                                          |  | $       | 33,486 |   |         | $ | 20,669 |  
|                                          |  |         |        |   |         |  



|   |                       
|-- | ----------------------
|4. | Property and Equipment



|                               |  |         |         |   |         |   |         |  
|------------------------------ |  | ------- | ------- | - | ------- | - | ------- | -
|                               |  | July 2, |         |   | July 3, |  
|                               |  | 2005    |         |   | 2004    |  
|                               |  |         |         |   |         |  
|Equipment                      |  | $       | 55,253  |   |         | $ | 52,998  |  
|Furniture                      |  |         | 38,808  |   |         |   | 36,025  |  
|Leasehold improvements         |  |         | 30,095  |   |         |   | 27,558  |  
|                               |  |         |         |   |         |  
|                               |  |         | 124,156 |   |         |   | 116,581 |  
|Less: accumulated depreciation |  |         | (78,887 | ) |         |   | (67,819 | )
|                               |  |         |         |   |         |  
|                               |  | $       | 45,269  |   |         | $ | 48,762  |  
|                               |  |         |         |   |         |  



F-14



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|   |             
|-- | ------------
|5. | Other Assets



|                               |  |         |       |  |         |   |       | 
|------------------------------ |  | ------- | ----- |  | ------- | - | ----- | 
|                               |  | July 2, |       |  | July 3, |  
|                               |  | 2005    |       |  | 2004    |  
|                               |  |         |       |  |         |  
|Deferred income taxes          |  | $       | 2,749 |  |         | $ | 1,961 | 
|Security deposits              |  |         | 1,825 |  |         |   | 1,556 | 
|Non-compete agreement          |  |         | 282   |  |         |   | 362   | 
|Loan commitment fees and other |  |         | 132   |  |         |   | 291   | 
|                               |  |         |       |  |         |  
|                               |  | $       | 4,988 |  |         | $ | 4,170 | 
|                               |  |         |       |  |         |  



|   |                                               
|-- | ----------------------------------------------
|6. | Accrued Expenses and Other Current Liabilities



|                                        |  |         |        |  |         |   |        | 
|--------------------------------------- |  | ------- | ------ |  | ------- | - | ------ | 
|                                        |  | July 2, |        |  | July 3, |  
|                                        |  | 2005    |        |  | 2004    |  
|                                        |  |         |        |  |         |  
|Accrued compensation                    |  | $       | 6,590  |  |         | $ | 7,812  | 
|Accrued insurance                       |  |         | 4,667  |  |         |   | 4,529  | 
|Sales and use taxes                     |  |         | 1,982  |  |         |   | 1,929  | 
|Accrued legal settlement and legal fees |  |         | 381    |  |         |   | 5,980  | 
|Other                                   |  |         | 13,090 |  |         |   | 12,439 | 
|                                        |  |         |        |  |         |  
|                                        |  | $       | 26,710 |  |         | $ | 32,689 | 
|                                        |  |         |        |  |         |  



|   |                     
|-- | --------------------
|7. | Financing Agreements





F-15



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)












|   |                   
|-- | ------------------
|8. | Earnings Per Share



|                                                                               |  |            |        |  |         |   |        |          |  |   |        | 
|------------------------------------------------------------------------------ |  | ---------- | ------ |  | ------- | - | ------ | -------- |  | - | ------ | 
|                                                                               |  | Year Ended |       
|                                                                               |  |            |       
|                                                                               |  | July 2,    |        |  | July 3, |   |        | June 28, | 
|                                                                               |  | 2005       |        |  | 2004    |   |        | 2003     | 
|                                                                               |  |            |        |  |         |   |        |          | 
|Net income                                                                     |  | $          | 4,264  |  |         | $ | 13,906 |          |  | $ | 12,092 | 
|Earnings per share  basic                                                     |  | $          | 0.25   |  |         | $ | 0.82   |          |  | $ | 0.73   | 
|Earnings per share  diluted                                                   |  | $          | 0.22   |  |         | $ | 0.71   |          |  | $ | 0.62   | 
|Weighted average common shares outstanding                                     |  |            | 17,184 |  |         |   | 16,880 |          |  |   | 16,602 | 
|Dilutive effect of stock options                                               |  |            | 339    |  |         |   | 460    |          |  |   | 637    | 
|Dilutive effect of warrants                                                    |  |            | 2,294  |  |         |   | 2,293  |          |  |   | 2,323  | 
|Restricted stock units                                                         |  |            | 14     |  |         |   | 18     |          |  |   | 84     | 
|                                                                               |  |            |        |  |         |   |        |          | 
|Weighted average common and potentially dilutive common shares
    outstanding |  |            | 19,831 |  |         |   | 19,651 |          |  |   | 19,646 | 
|                                                                               |  |            |        |  |         |   |        |          | 
|Options excluded from dilutive calculation                                     |  |            | 1,046  |  |         |   | 744    |          |  |   | 686    | 
|                                                                               |  |            |        |  |         |   |        |          | 





|   |                                       
|-- | --------------------------------------
|9. | Stockholders Equity and Stock Options



| |                   
| | ------------------
| | Shares Outstanding



F-16



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)






| |                 
| | ----------------
| | Stock Repurchase





| |         
| | --------
| | Warrants





| |              
| | -------------
| | Stock Options









F-17



---



##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)










F-18



---



##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|                         |  |           |           |          |          |   |       | 
|------------------------ |  | --------- | --------- | -------- | -------- | - | ----- | 
|                         |  |           |           | Weighted |         
|                         |  |           |           | Average  |         
|                         |  | Number of |           |          | Exercise |  
|                         |  | Shares    |           |          | Price    |  
|                         |  |           |           |          |          |  
|Balance at June 29, 2002 |  |           | 2,004,876 |          |          | $ | 6.59  | 
|Granted                  |  |           | 638,000   |          |          |   | 14.85 | 
|Exercised                |  |           | (212,486  | )        |          |   | 5.28  | 
|Canceled                 |  |           | (208,901  | )        |          |   | 9.71  | 
|                         |  |           |           |          |          |  
|Balance at June 28, 2003 |  |           | 2,221,489 |          |          |   | 8.78  | 
|Granted                  |  |           | 1,447,217 |          |          |   | 12.90 | 
|Exercised                |  |           | (471,033  | )        |          |   | 3.96  | 
|Canceled                 |  |           | (175,499  | )        |          |   | 11.21 | 
|                         |  |           |           |          |          |  
|Balance at July 3, 2004  |  |           | 3,022,174 |          |          |   | 11.36 | 
|Granted                  |  |           | 552,900   |          |          |   | 13.70 | 
|Exercised                |  |           | (136,849  | )        |          |   | 7.27  | 
|Canceled                 |  |           | (555,556  | )        |          |   | 12.63 | 
|                         |  |           |           |          |          |  
|Balance at July 2, 2005  |  |           | 2,882,669 |          |          | $ | 11.77 | 
|                         |  |           |           |          |          |  
|Options Exercisable at:  |  |           |           |          |          |   |       | 
|June 28, 2003            |  |           | 1,399,241 |          |          | $ | 7.94  | 
|July 3, 2004             |  |           | 1,485,978 |          |          | $ | 10.42 | 
|July 2, 2005             |  |           | 1,875,678 |          |          | $ | 11.06 | 

|                         |  |                     |           |          |                     |  |      |          |  |   |             |  |  |          |           |  |  |   |       | 
|------------------------ |  | ------------------- | --------- | -------- | ------------------- |  | ---- | -------- |  | - | ----------- |  |  | -------- | --------- |  |  | - | ----- | 
|                         |  | Options Outstanding |           |          | Options Exercisable | 
|                         |  |                     |           |          |                     | 
|                         |  |                     |           | Weighted |                     |  |      |          | 
|                         |  | Number              |           |          | Average             |  |      | Weighted |  |   | Number      |  |  | Weighted |          
|                         |  | Outstanding         |           |          | Remaining           |  |      | Average  |  |   | Exercisable |  |  | Average  |          
|                         |  | at July 2,          |           |          | Contractual         |  |      | Exercise |  |   | at July 2,  |  |  | Exercise |          
|Range of Exercise Prices |  | 2005                |           |          | Life                |  |      | Price    |  |   | 2005        |  |  | Price    |          
|                         |  |                     |           |          |                     |  |      |          |  |   |             |  |  |          |          
|$ 1.71 to $ 9.38         |  |                     | 619,877   |          |                     |  | 5.36 |          |  | $ | 4.99        |  |  |          | 561,440   |  |  | $ | 4.74  | 
|$ 9.39 to $12.34         |  |                     | 935,392   |          |                     |  | 7.65 |          |  |   | 11.84       |  |  |          | 641,279   |  |  |   | 11.81 | 
|$12.35 to $14.00         |  |                     | 597,400   |          |                     |  | 8.74 |          |  |   | 13.30       |  |  |          | 194,750   |  |  |   | 13.49 | 
|$14.01 to $17.00         |  |                     | 686,750   |          |                     |  | 7.68 |          |  |   | 15.87       |  |  |          | 434,959   |  |  |   | 16.02 | 
|$17.01 to $30.88         |  |                     | 43,250    |          |                     |  | 2.70 |          |  |   | 21.20       |  |  |          | 43,250    |  |  |   | 21.20 | 
|                         |  |                     |           |          |                     |  |      |          |  |   |             |  |  |          |          
|                         |  |                     | 2,882,669 |          |                     |  | 7.30 |          |  | $ | 11.77       |  |  |          | 1,875,678 |  |  | $ | 11.06 | 
|                         |  |                     |           |          |                     |  |      |          |  |   |             |  |  |          |          



F-19



---



##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|    |             
|--- | ------------
|10. | Income Taxes



|          |         |            |       |       |         |   |        |          |   |   |        |        |  
|--------- | ------- | ---------- | ----- | ----- | ------- | - | ------ | -------- | - | - | ------ | ------ | -
|          |         | Year Ended |      
|          |         |            |      
|          |         | July 2,    |       |       | July 3, |   |        | June 28, |  
|          |         | 2005       |       |       | 2004    |   |        | 2003     |  
|          |         |            |       |       |         |   |        |          |  
|Current:  |         |            |       |       |         |   |        |          |   |   |        |       
|          | Federal |            | $     | 412   |         |   | $      | 8,163    |   |   | $      | 8,036  |  
|          | State   |            |       | 338   |         |   |        | 2,108    |   |   |        | 1,925  |  
|          | Foreign |            |       | 185   |         |   |        | 246      |   |   |        | 231    |  
|          |         |            |       |       |         |   |        |          |  
|          |         |            | 935   |       |         |   | 10,517 |          |   |   | 10,192 |       
|Deferred: |         |            |       |       |         |   |        |          |   |   |        |       
|          | Federal |            |       | 1,876 |         |   |        | (854     | ) |   |        | (1,730 | )
|          | State   |            |       | 435   |         |   |        | (197     | ) |   |        | (401   | )
|          |         |            |       |       |         |   |        |          |  
|          |         |            | 2,311 |       |         |   | (1,051 | )        |   |   | (2,131 | )     
|          |         |            |       |       |         |   |        |          |  
|          |         | $          | 3,246 |       |         | $ | 9,466  |          |   | $ | 8,061  |       
|          |         |            |       |       |         |   |        |          |  





|             |                                  |                                |   |        |         |  |   |        |       | 
|------------ | -------------------------------- | ------------------------------ | - | ------ | ------- |  | - | ------ | ----- | 
|             |                                  | July 2,                        |   |        | July 3, | 
|             |                                  | 2005                           |   |        | 2004    | 
|             |                                  |                                |   |        |         | 
|Current:     |                                  |                                |   |        |         |  |   |       
|             | Inventory                        |                                | $ | 4,349  |         |  | $ | 5,216  |      
|             | Vacation pay accrual             |                                |   | 653    |         |  |   | 810    |      
|             | Reserves not currently available |                                |   | 1,127  |         |  |   | 1,046  |      
|             | Bonus accrual                    |                                |   | 60     |         |  |   | 32     |      
|             | Litigation accrual               |                                |   | 10     |         |  |   | 2,194  |      
|             |                                  |                                |   |        |         | 
|             |                                  | Net current deferred tax asset |   | $      | 6,199   |  |   | $      | 9,298 | 
|             |                                  |                                |   |        |         | 
|Non-current: |                                  |                                |   |        |         |  |   |       
|             | Deferred rent                    |                                | $ | 3,298  |         |  | $ | 3,686  |      
|             | Start-up costs                   |                                |   | (479   | )       |  |   | (303   | )    
|             | Property and equipment           |                                |   | 1,860  |         |  |   | 198    |      
|             | Amortization of goodwill         |                                |   | (2,585 | )       |  |   | (2,287 | )    
|             | Other liabilities                |                                |   | 655    |         |  |   | 667    |      
|             |                                  |                                |   |        |         | 
|             |                                  | Non-current deferred tax asset |   | $      | 2,749   |  |   | $      | 1,961 | 
|             |                                  |                                |   |        |         | 

F-20



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|                                                     |  |            |      |   |         |  |      |          |  |  |      |  
|---------------------------------------------------- |  | ---------- | ---- | - | ------- |  | ---- | -------- |  |  | ---- | -
|                                                     |  | Year Ended |     
|                                                     |  |            |     
|                                                     |  | July 2,    |      |   | July 3, |  |      | June 28, | 
|                                                     |  | 2005       |      |   | 2004    |  |      | 2003     | 
|                                                     |  |            |      |   |         |  |      |          | 
|Federal statutory rate                               |  |            | 35.0 | % |         |  | 35.0 | %        |  |  | 35.0 | %
|State income taxes net of Federal income tax benefit |  |            | 7.6  |   |         |  | 5.3  |          |  |  | 4.9  |  
|Other                                                |  |            | 0.6  |   |         |  | 0.2  |          |  |  | 0.1  |  
|                                                     |  |            |      |   |         |  |      |          | 
|Effective tax rate                                   |  |            | 43.2 | % |         |  | 40.5 | %        |  |  | 40.0 | %
|                                                     |  |            |      |   |         |  |      |          | 







|    |                       
|--- | ----------------------
|11. | Employee Benefit Plans







|    |                           
|--- | --------------------------
|12. | Related Party Transactions





F-21



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)












F-22



---



##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|    |                                              
|--- | ---------------------------------------------
|13. | Lease Commitments and Contractual Obligations



|                       |  |            |        |  |         |   |        |          |  |   |        | 
|---------------------- |  | ---------- | ------ |  | ------- | - | ------ | -------- |  | - | ------ | 
|                       |  | Year Ended |       
|                       |  |            |       
|                       |  | July 2,    |        |  | July 3, |   |        | June 28, | 
|                       |  | 2005       |        |  | 2004    |   |        | 2003     | 
|                       |  |            |        |  |         |   |        |          | 
|Minimum rentals        |  | $          | 45,013 |  |         | $ | 45,577 |          |  | $ | 42,748 | 
|Contingent rentals     |  |            | 19     |  |         |   | 14     |          |  |   | 26     | 
|                       |  |            |        |  |         |   |        |          | 
|                       |  |            | 45,032 |  |         |   | 45,591 |          |  |   | 42,774 | 
|Less: Sublease rentals |  |            | 288    |  |         |   | 295    |          |  |   | 113    | 
|                       |  |            |        |  |         |   |        |          | 
|Net rental expense     |  | $          | 44,744 |  |         | $ | 45,296 |          |  | $ | 42,661 | 
|                       |  |            |        |  |         |   |        |          | 



|                    |  |                |         |           |           |   |             |                |  |            |             |  |      |        |       |  |              |   |     |  |  |   |       | 
|------------------- |  | -------------- | ------- | --------- | --------- | - | ----------- | -------------- |  | ---------- | ----------- |  | ---- | ------ | ----- |  | ------------ | - | --- |  |  | - | ----- | 
|                    |  |                |         |           |           |   |             | Logistics      |  |            |             |  |     
|                    |  |                |         | Operating |           |   | Merchandise |                |  | Initiative |             |  | Auto |        |       | 
|                    |  | Total          |         |           | Leases(1) |   |             | Commitments(2) |  |            | Obligations |  |      | Leases |       |  | Severance(3) |  
|                    |  |                |         |           |           |   |             |                |  |            |             |  |      |        |       |  |              |  
|                    |  | (In thousands) |        
|Fiscal year ending: |  |                |         |           |           |   |             |                |  |            |             |  |      |        |       |  |              |   |     |  |  |   |       | 
|2006                |  | $              | 72,669  |           |           | $ | 47,798      |                |  | $          | 20,744      |  |      | $      | 2,700 |  |              | $ | 265 |  |  | $ | 1,162 | 
|2007                |  |                | 46,912  |           |           |   | 44,002      |                |  |            |            |  |      |        | 2,700 |  |              |   | 210 |  |  |   |      | 
|2008                |  |                | 35,402  |           |           |   | 35,330      |                |  |            |            |  |      |        |      |  |              |   | 72  |  |  |   |      | 
|2009                |  |                | 23,478  |           |           |   | 23,478      |                |  |            |            |  |      |        |      |  |              |   |    |  |  |   |      | 
|2010                |  |                | 15,442  |           |           |   | 15,442      |                |  |            |            |  |      |        |      |  |              |   |    |  |  |   |      | 
|Thereafter          |  |                | 44,838  |           |           |   | 44,838      |                |  |            |            |  |      |        |      |  |              |   |    |  |  |   |      | 
|                    |  |                |         |           |           |   |             |                |  |            |             |  |      |        |       |  |              |  
|                    |  | $              | 238,741 |           |           | $ | 210,888     |                |  | $          | 20,744      |  |      | $      | 5,400 |  |              | $ | 547 |  |  | $ | 1,162 | 
|                    |  |                |         |           |           |   |             |                |  |            |             |  |      |        |       |  |              |  






|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The Company is also obligated for guarantees, subleases or
    assigned lease obligations for 22 of the franchise stores
    through 2011. The majority of the guarantees, subleases and
    assigned lease obligations were given when the Company sold
    stores in 1999 as part of its restructuring. The guarantees,
    subleases and assigned lease obligations continue until the
    applicable leases expire. The maximum amount of the guarantees,
    subleases and assigned lease obligations may vary, but is
    limited to the sum of the total amount due under the lease. As
    of July 2, 2005, the maximum amount of the guarantees,
    subleases and assigned lease obligations was approximately
    $11.3 million, which is not included in the table above.



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



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                    
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(2) | In Fiscal 2005, Party City Corporation purchased in excess of
    $400 million of merchandise from third party suppliers. The
    Company currently has one contract, which terminates on
    December 31, 2005 but may be extended until
    December 31, 2010 at the suppliers option, that
    provides for minimum merchandise commitments equal to less than
    5% per year of the Companys total merchandise
    purchased

F-23



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    | from third party suppliers (based on Fiscal 2005 total
    purchases). These potential merchandise commitments are not
    reflected in the table above.                                                                                                                                                                                                                                                                                                                    
|   
|(3) | The Company had an aggregate contingent liability of up to
    $1.9 million related to potential severance payments for 17
    employees as of August 30, 2005 and 16 employees as of
    July 2, 2005 pursuant to their respective employment
    agreements. The Company is not currently aware of any event that
    would trigger any or all of such $1.9 million contingent
    liability. These potential severance payments are not reflected
    in the table above.



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

Operating Leases.






Merchandise Commitments.


Logistics Initiative Obligations.


F-24



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)


Auto Leases.


Severance.


Capital Leases.


Other.




|    |                                      
|--- | -------------------------------------
|14. | Costs Associated with Exit Activities



|                             |  |           |      |   |              |   |        |  
|---------------------------- |  | --------- | ---- | - | ------------ | - | ------ | -
|                             |  | Severance |      |   | Closed Store |  
|                             |  | Reserve   |      |   | Reserve      |  
|                             |  |           |      |   |              |  
|Balance as of June 29, 2003  |  | $         | 199  |   |              | $ | 1,451  |  
|Accrual made in Fiscal 2004  |  |           | 145  |   |              |   | 1,050  |  
|Payments made in Fiscal 2004 |  |           | (344 | ) |              |   | (1,713 | )
|                             |  |           |      |   |              |  
|Balance as of July 3, 2004   |  |           |     |   |              |   | 788    |  
|Accrual made in Fiscal 2005  |  |           | 540  |   |              |   | 236    |  
|Payments made in Fiscal 2005 |  |           | (3   | ) |              |   | (249   | )
|                             |  |           |      |   |              |  
|Balance as of July 2, 2005   |  | $         | 537  |   |              | $ | 775    |  
|                             |  |           |      |   |              |  



|    |                                    
|--- | -----------------------------------
|15. | Other Commitments and Contingencies



| |                  
| | -----------------
| | Legal Proceedings



F-25



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)








|    |                    
|--- | -------------------
|16. | Segment Information





F-26



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|                              |                                                     |                |         |         |         |   |         |          |  |   |         |         | 
|----------------------------- | --------------------------------------------------- | -------------- | ------- | ------- | ------- | - | ------- | -------- |  | - | ------- | ------- | 
|                              |                                                     | Year Ended     |        
|                              |                                                     |                |        
|                              |                                                     | July 2,        |         |         | July 3, |   |         | June 28, | 
|                              |                                                     | 2005           |         |         | 2004    |   |         | 2003     | 
|                              |                                                     |                |         |         |         |   |         |          | 
|                              |                                                     | (In thousands) |        
|                              |                                                     | (Unaudited)    |        
|Retail:                       |                                                     |                |         |         |         |   |         |          |  |   |         |        
|                              | Net sales                                           |                | $       | 467,668 |         |   | $       | 496,138  |  |   | $       | 464,258 | 
|                              | Cost of goods sold and occupancy costs              |                |         | 316,663 |         |   |         | 332,311  |  |   |         | 311,170 | 
|                              |                                                     |                |         |         |         |   |         |          | 
|                              | Gross profit                                        |                |         | 151,005 |         |   |         | 163,827  |  |   |         | 153,088 | 
|                              | Store operating and selling expense                 |                |         | 110,757 |         |   |         | 113,292  |  |   |         | 108,294 | 
|                              |                                                     |                |         |         |         |   |         |          | 
|                              | Company-owned store profit contribution             |                |         | 40,248  |         |   |         | 50,535   |  |   |         | 44,794  | 
|                              | General and administrative expense                  |                |         | 41,502  |         |   |         | 35,537   |  |   |         | 30,970  | 
|                              | Impairment charges                                  |                |         | 2,831   |         |   |         |         |  |   |         | 1,505   | 
|                              | Litigation charges                                  |                |         |        |         |   |         | 4,100    |  |   |         |        | 
|                              |                                                     |                |         |         |         |   |         |          | 
|                              | Retail (loss) profit contribution                   |                |         | (4,085  | )       |   |         | 10,898   |  |   |         | 12,319  | 
|                              | Identifiable assets                                 |                | $       | 174,124 |         |   | $       | 175,211  |  |   | $       | 165,833 | 
|                              | Depreciation and amortization                       |                | $       | 16,901  |         |   | $       | 17,601   |  |   | $       | 16,229  | 
|                              | Capital expenditures                                |                | $       | 11,362  |         |   | $       | 13,484   |  |   | $       | 22,234  | 
|Franchise:                    |                                                     |                |         |         |         |   |         |          |  |   |         |        
|                              | Royalty fees                                        |                | $       | 19,666  |         |   | $       | 19,521   |  |   | $       | 18,007  | 
|                              | Net sales to franchisees                            |                |         | 16,372  |         |   |         |         |  |   |         |        | 
|                              | Franchise fees                                      |                |         | 160     |         |   |         | 608      |  |   |         | 355     | 
|                              |                                                     |                |         |         |         |   |         |          | 
|                              | Total franchise revenues                            |                |         | 36,198  |         |   |         | 20,129   |  |   |         | 18,362  | 
|                              | Cost of goods sold to franchisees                   |                |         | 14,388  |         |   |         |         |  |   |         |        | 
|                              | Franchise transportation and other selling expenses |                |         | 2,024   |         |   |         |         |  |   |         |        | 
|                              | Other franchise expense                             |                |         | 8,142   |         |   |         | 7,184    |  |   |         | 6,538   | 
|                              |                                                     |                |         |         |         |   |         |          | 
|                              | Total franchise expense                             |                |         | 24,554  |         |   |         | 7,184    |  |   |         | 6,538   | 
|                              |                                                     |                |         |         |         |   |         |          | 
|                              | Franchise profit contribution                       |                |         | 11,644  |         |   |         | 12,945   |  |   |         | 11,824  | 
|                              |                                                     |                |         |         |         |   |         |          | 
|                              | Identifiable assets                                 |                | $       | 9,849   |         |   | $       | 2,206    |  |   | $       | 2,166   | 
|                              | Depreciation and amortization                       |                | $       | 125     |         |   | $       |         |  |   | $       |        | 
|                              | Capital expenditures                                |                | $       | 1,102   |         |   | $       |         |  |   | $       |        | 
|Total Company                 |                                                     |                |         |         |         |   |         |          |  |   |         |        
|Operating income              |                                                     |                | 7,559   |         |         |   | 23,843  |          |  |   | 24,143  |        
|Interest expense, net         |                                                     |                | 49      |         |         |   | 471     |          |  |   | 3,990   |        
|                              |                                                     |                |         |         |         |   |         |          | 
|Income before income taxes    |                                                     |                | 7,510   |         |         |   | 23,372  |          |  |   | 20,153  |        
|Provision for income taxes    |                                                     |                | 3,246   |         |         |   | 9,466   |          |  |   | 8,061   |        
|                              |                                                     |                |         |         |         |   |         |          | 
|Net income                    |                                                     | $              | 4,264   |         |         | $ | 13,906  |          |  | $ | 12,092  |        
|                              |                                                     |                |         |         |         |   |         |          | 
|Identifiable assets           |                                                     | $              | 183,973 |         |         | $ | 177,417 |          |  | $ | 167,999 |        
|Depreciation and amortization |                                                     | $              | 17,026  |         |         | $ | 17,601  |          |  | $ | 16,229  |        
|Capital expenditures          |                                                     | $              | 12,464  |         |         | $ | 13,484  |          |  | $ | 22,234  |        

F-27



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|    |                                                                                     
|--- | ------------------------------------------------------------------------------------
|17. | Selected Quarterly Information (Unaudited) (in thousands,
    except per share data)

|                                       |  |               |         |   |          |   |         |       |  |   |         |   |  |   |         |  
|-------------------------------------- |  | ------------- | ------- | - | -------- | - | ------- | ----- |  | - | ------- | - |  | - | ------- | -
|                                       |  | Quarter Ended |        
|                                       |  |               |        
|                                       |  | September     |         |   | December |   |         | March |  |   | June    |  
|                                       |  |               |         |   |          |   |         |       |  |   |         |  
|Year Ended July 2, 2005                |  |               |         |   |          |   |         |       |  |   |         |   |  |   |         |  
|Total revenues                         |  | $             | 102,549 |   |          | $ | 174,290 |       |  | $ | 101,420 |   |  | $ | 125,607 |  
|Cost of goods sold and occupancy costs |  |               | 71,857  |   |          |   | 100,884 |       |  |   | 75,670  |   |  |   | 82,640  |  
|Net (loss) income                      |  |               | (3,091  | ) |          |   | 14,710  |       |  |   | (7,233  | ) |  |   | (122    | )
|Basic (loss) earnings per share        |  | $             | (0.18   | ) |          | $ | 0.86    |       |  | $ | (0.42   | ) |  | $ | (0.01   | )
|Diluted (loss) earnings per share      |  |               | (0.18   | ) |          |   | 0.74    |       |  |   | (0.42   | ) |  | $ | (0.01   | )
|Year Ended July 3, 2004                |  |               |         |   |          |   |         |       |  |   |         |   |  |   |         |  
|Total revenues                         |  | $             | 106,975 |   |          | $ | 182,559 |       |  | $ | 101,549 |   |  | $ | 125,184 |  
|Cost of goods sold and occupancy costs |  |               | 74,328  |   |          |   | 104,705 |       |  |   | 71,432  |   |  |   | 81,846  |  
|Net (loss) income                      |  |               | (1,950  | ) |          |   | 19,290  |       |  |   | (5,561  | ) |  |   | 2,127   |  
|Basic (loss) earnings per share        |  | $             | (0.12   | ) |          | $ | 1.14    |       |  | $ | (0.33   | ) |  | $ | 0.12    |  
|Diluted (loss) earnings per share      |  |               | (0.12   | ) |          |   | 0.98    |       |  |   | (0.33   | ) |  |   | 0.11    |  





|    |                  
|--- | -----------------
|18. | Subsequent Events

Party City Michigan.




Loan Agreement.


Hurricane Katrina.


F-28



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##### Table of Contents



PARTY CITY CORPORATION


SCHEDULE II


VALUATION AND QUALIFYING ACCOUNTS


|                                 |  |                |     |  |                 |   |        |                       |  |         |         |   |  |   |     | 
|-------------------------------- |  | -------------- | --- |  | --------------- | - | ------ | --------------------- |  | ------- | ------- | - |  | - | --- | 
|                                 |  | Balance        |     |  | Amounts         |   |        |                       |  | Balance |        
|                                 |  | Beginning      |     |  | Charged to Cost |   |        | Write-Offs/Recoveries |  |         | End of  |  
|                                 |  | of Year        |     |  | and Expenses    |   |        | Against Reserve       |  |         | Year    |  
|                                 |  |                |     |  |                 |   |        |                       |  |         |         |  
|                                 |  | (In thousands) |    
|Allowance for Doubtful Accounts: |  |                |     |  |                 |   |        |                       |  |         |         |   |  |   |     | 
|Year Ended July 2, 2005          |  | $              | 148 |  |                 | $ | 284    |                       |  | $       | 59      |   |  | $ | 491 | 
|Year Ended July 3, 2004          |  |                | 287 |  |                 |   | (117   | )                     |  |         | (22     | ) |  |   | 148 | 
|Year Ended June 28, 2003         |  |                | 785 |  |                 |   | 50     |                       |  |         | (548    | ) |  |   | 287 | 
|Reserve for Returns:             |  |                |     |  |                 |   |        |                       |  |         |         |   |  |   |     | 
|Year Ended July 2, 2005          |  | $              | 634 |  |                 | $ | 16,368 |                       |  | $       | (16,730 | ) |  | $ | 272 | 
|Year Ended July 3, 2004          |  |                | 673 |  |                 |   | 17,365 |                       |  |         | (17,404 | ) |  |   | 634 | 
|Year Ended June 28, 2003         |  |                | 547 |  |                 |   | 16,249 |                       |  |         | (16,123 | ) |  |   | 673 | 

F-29