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                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549
 
                               ----------------
 
                                   FORM 10-K
   FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 OR 15(d) OF THE
                        SECURITIES EXCHANGE ACT OF 1934
 
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
   ACT OF 1934
  For the fiscal year ended January 2, 1999
 
                                      OR
 
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
   EXCHANGE ACT OF 1934
  For the transition period from      to
 
                        Commission file number 0-21499
 
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                            SPECIALTY CATALOG CORP.
            (Exact Name of Registrant as Specified in Its Charter)
 
              DELAWARE                                 04-3253301
   (State or other jurisdiction of        (I.R.S. Employer Identification No.)
   incorporation or organization)
 
          21 BRISTOL DRIVE                                02375
     SOUTH EASTON, MASSACHUSETTS                       (Zip Code)
   (Address of principal executive
              offices)
 
                                (508) 238-0199
             (Registrant's telephone number, including area code)
 
          Securities registered pursuant to Section 12(b) of the Act:
                                     None
 
          Securities registered pursuant to Section 12(g) of the Act:
                         Common Stock, $0.01 par value
                               (title of class)
 
  Indicate by check mark whether the Registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding twelve months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [_]
 
  Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of the Registrant's knowledge, if definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.
 
  Aggregate market value of voting stock held by non-affiliates of the
Registrant as of March 26, 1999 (based on the closing sale price of the Common
Stock on the NASDAQ National Market on such date) was $6,007,982.
 
  Number of shares of the Registrant's Common Stock outstanding as of March
26, 1999: 4,418,586
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
  Portions of the Registrant's Definitive Proxy Statement for the Annual
Meeting of Shareholders to be held on May 25, 1999 are incorporated by
reference into Part III of this Annual Report on Form 10-K.
 
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                   NOTE REGARDING FORWARD-LOOKING STATEMENTS
 
  Except for the historical information contained herein, this Annual Report
on Form 10-K for Specialty Catalog Corp. (the "Company") may contain "forward-
looking statements" within the meaning of Section 27A of the Securities Act of
1933 and Section 21E of the Securities Exchange Act of 1934, including, but
not limited to, the Company's expected future revenues, operations and
expenditures, estimates of the potential markets for the Company's products,
assessments of competitors and potential competitors and projected timetables
for the market introduction of the Company's products. Investors are cautioned
that forward-looking statements are inherently uncertain. Actual performance
and results of operations may differ materially from those projected or
suggested in the forward-looking statements due to certain risks and
uncertainties, including, but not limited to, the following risks and
uncertainties: (i) the Company's indebtedness and future capital requirements,
(ii) increasing postal rates, paper prices and media costs, (iii) limited
sources of fiber used to make the Company's products, (iv) the limited number
of suppliers of the Company's products, (v) the Company's dependence upon
foreign suppliers, especially in China, Korea and Indonesia, (vi) the
customary risks of doing business abroad, including fluctuations in the value
of currencies, (vii) the potential development of a cure for hair loss and
cancer treatment improvements, (viii) the effectiveness of the Company's
catalogs and advertising programs, (ix) the Company's competition, (x) the
impact of acquisitions on the Company's prospects and (xi) contingencies and
risks associated with the Year 2000 problem. Additional information concerning
certain risks and uncertainties that could cause actual results to differ
materially from those projected or suggested in the forward-looking statements
is contained under the caption "Risk Factors" under Item 7. Management's
Discussion and Analysis of Financial Condition and Results of Operations. The
forward-looking statements contained herein represent the Company's judgment
as of the date of this Annual Report on Form 10-K, and the Company cautions
readers not to place undue reliance on such statements.
 
                                    PART I
 
ITEM 1. BUSINESS
 
General
 
  The Company targets niche consumer product categories, primarily via direct
marketing. SC Direct, its principal operating subsidiary in the United States
("SC Direct"), is the US's leading retailer of women's wigs and hairpieces.
Daxbourne International Limited, a subsidiary of SC Direct ("Daxbourne"), is a
leading United Kingdom retailer and wholesaler of women's wigs and hairpieces.
SC Publishing, another subsidiary of SC Direct ("SC Publishing"), sells
continuing education courses to nurses and CPAs.
 
 SC Direct
 
  SC Direct sells wigs and hairpieces, primarily to women over the age of 50,
using three distinct catalogs: Paula Young(R), Christine Jordan(R) and
Especially Yours(R). In addition, SC Direct sells apparel, hats and other
fashion accessories to women through its Paula's Hatbox(R) and Especially
Yours(R) catalogs. SC Direct generated net sales of $40.1 million, $38.3
million and $32.2 million for the fiscal years ended 1998, 1997 and 1996,
respectively. For the fiscal years ended 1998, 1997 and 1996, respectively, SC
Direct mailed approximately 25 million, 21 million and 19 million catalogs.
Each catalog includes detailed product descriptions and specifications, full
color photographs and pricing information. Each catalog is published several
times a year, and often variations of each catalog are distributed.
 
  Paula Young(R) is SC Direct's flagship catalog featuring Paula Young(R)
brand wigs. Paula Young(R) wigs are value priced and have "shake and wear"
styling as well as quality construction. The Paula Young(R) catalog also
offers accessories such as turbans, shampoos, combs and styling heads. In
addition, each Paula Young(R) catalog offers a selection of Christine
Jordan(R) wigs, as well as Touch of Class(TM) brand products which include
wiglets, add-ons and extensions. In addition to its own proprietary brands, SC
Direct also offers a selection of
 
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other branded wigs including Eva Gabor(R) and NJ Creations(R). In March 1999,
the Company introduced Raquel Welch(TM) wigs in the Paula Young(R) catalog.
 
  Christine Jordan(R) brand wigs are SC Direct's premium brand, offering the
Company's highest quality wigs. Christine Jordan(R) wigs have a unique fiber
blend and come in their own distinctive colors. In addition, the wigs have a
comfort construction with a natural hairline and are the only brand in the
industry to carry five sizes in most of its styles. Historically, Christine
Jordan(R) brand wigs were offered in their own Christine Jordan(R) catalog, in
addition to the Paula Young(R) catalog. In early 1999, the Company determined
that it would be more cost efficient to eliminate the Christine Jordan(R)
catalog, while continuing to offer Christine Jordan(R) brand wigs in the Paula
Young(R) catalog.
 
  The Especially Yours(R) catalog features Especially Yours(R) brand wigs and
hairpieces with a variety of features specially designed for African-American
women, including natural hairline crimping and fiber texture that reflect the
natural hair of African-Americans. SC Direct has also begun to offer women's
apparel, hats and accessories in the Especially Yours(R) catalog. In 1999, SC
Direct entered into a license agreement with Star Jones, co-host of ABC's TV
show, "The View", to develop the Star Jones(TM) line of wigs and hairpieces.
SC Direct began offering this line of wigs and hairpieces in the first mailing
of the Especially Yours(R) catalog in 1999. In early 1998, the Company became
the exclusive licensee for the Diahann Carroll(TM) line of wigs, which are
also featured in the Especially Yours(R) catalog. A selection of Especially
Yours(R) brand wigs and hairpieces are also offered in selected Paula Young(R)
catalogs.
 
  In 1998, the Paula's Hatbox(R) catalog was repositioned to offer a selection
of women's fashion apparel, including suits, dresses and casual wear, in
addition to the wide variety of hats that have been historically offered. The
Company's strategy is to carve out a share of the women's apparel and
accessories market, using stylish hats as the platform for offering an
attractive selection of quality apparel and accessories at affordable prices.
 
 Daxbourne International Limited
 
  Daxbourne International Limited is a leading retailer and wholesaler of
women's wigs, hairpieces and related products in the United Kingdom. Daxbourne
distributes wigs and hairpieces under its Jacqueline Collection(R) and Natural
Image(R) brands, and has established a strong presence in the UK through
catalog, retail and wholesale distribution channels. Net sales of Daxbourne
for 1998 were $5.1 million, while net sales for the period from October 3,
1997 through January 3, 1998 were approximately $1.2 million.
 
  Daxbourne's direct marketing business offers through its Jacqueline
Collection(R) catalog an extensive selection of women's wigs, hairpieces and
accessories under its Jacqueline Collection(R) brand name. The Jacqueline
Collection(R) catalog also offers accessories such as turbans, shampoos, combs
and styling heads.
 
  Daxbourne also operates two stand-alone retail outlets and eleven retail
concessions within department stores. These locations offer customers the
ability to try on various wig styles and are staffed with experienced sales
associates who can assist the customers in their selections. A portion of this
business consists of supplying customers who have been referred by the
National Health Service Trusts ("NHS").
 
  The wholesale business operates under the Natural Image(R) brand and sells
to shops, agents and other distributors, including agents and retail outlets
that supply wigs to the NHS. The wholesale business also exports a small
amount of wigs to customers in other European countries. Towards the end of
1998, Daxbourne began testing a new fashion range of wigs and hairpieces. A
concession has been established in a leading London department store and
trades under the brand name Hot Hair(TM).
 
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 SC Publishing
 
  SC Publishing distributes catalogs under its Western Schools(R) brand and
specializes in providing continuing education courses ("CE") to nurses and
CPAs. SC Publishing's strategy is to build its business by offering quality
education at value prices. SC Publishing generated net sales of $3.7 million,
$4.0 million and $4.0 million for the fiscal years ended 1998, 1997 and 1996,
respectively. For the fiscal years ended 1998, 1997 and 1996, respectively, SC
Publishing mailed approximately 5 million, 5 million and 6 million catalogs.
SC Publishing sold its real estate division in June 1997.
 
Industry and Markets
 
 Wigs
 
  Based on US Census Bureau import data, approximately 5.8 million wigs are
sold annually in the United States, which the Company estimates to be
approximately $340 million in retail sales. The wig market is comprised of
fashion wig wearers and need-based wig wearers. Need-based wig wearers
purchase wigs as a necessity, due to a physical condition such as naturally
thinning hair or total hair loss, as well as hair loss due to medical
procedures and conditions (e.g., alopecia and cancer treatments). Many
everyday wig wearers replace their wigs every three to four months, and have a
wig "wardrobe," consisting of several wigs, either of the same style and color
or of different styles and colors.
 
  In the 1960s, wigs and hairpieces were broadly viewed as a fashion
accessory. However, as styles and tastes changed, the fashion-driven demand
for wigs decreased. Due to this trend, during the 1970s and 1980s, the number
of specialty wig boutiques declined and department stores reduced their
selling space allocated to inventories of wigs. The Company's catalog business
was started to serve the need-based wig customers who were not being
adequately serviced by other retail alternatives. The Company believes that
only approximately 5.4 million women, or 27%, of the estimated 20 million
American women with thinning hair, currently wear wigs, and that, accordingly,
there is substantial opportunity for future growth of the Company's business.
 
  The Caucasian retail wig market, which the Company estimates to be an
approximately $202 million market with approximately 2.7 million units sold
annually, is serviced by direct mail catalogers and retail outlets, including
beauty salons, wig shops and department stores. The Company estimates that
catalog sales represent 43% of the units sold and 23% of the sales dollars
annually in the Caucasian market and believes that catalogs offer the benefits
of privacy, convenience, lower prices and broader product selection. Retail
stores provide customers with more personalized service and allow customers to
try on the product; however, they generally charge higher prices and offer
less convenience, privacy and selection than catalog retailers.
 
  The African-American wig market, unlike the Caucasian market, has yet to
undergo any significant transition to direct marketing from retail outlets.
Although African-American women comprise approximately 13% of the US female
population, they purchase approximately 53% of the wig units sold annually.
The Company estimates that annual sales to the African-American wig market are
approximately $138 million and 3.1 million units. Only about 5% of African-
American wigs are sold through catalogs, with the balance sold primarily in
beauty salons and wig shops. The Company believes that its Especially Yours(R)
catalog, which targets African-American women, already has the highest sales
volume of any catalog offering wigs designed for African-American women.
 
  The Company estimates that the international wig and hairpiece market is at
least as large as the US market. By identifying opportunities through
acquisitions and licensing programs, the Company has the ability to facilitate
international expansion. The Company currently has license agreements to sell
its products in Germany, Austria and the UK.
 
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 Women's Apparel and Hats
 
  Women's apparel is a multi-billion dollar market. In 1998, the Company began
to position Paula's Hatbox(R) to appeal to the middle aged woman who wants
fashionable, coordinated merchandise at affordable prices. To attract as much
of this segment as possible, many of the fashion items are offered in misses,
as well as regular sizing. The merchandise selection in the Especially
Yours(R) catalog was also expanded to include a greater selection of women's
apparel and hats than were previously offered.
 
  The Company believes that the fashion hat market, like the wig market, has
not been well serviced by existing retail channels of distribution, with no
major retailer offering a broad selection of quality hats. The women's fashion
hat market is fragmented among department stores, small boutiques, resort
stores and other general merchants and catalog retailers who offer a limited
number of styles as a complement to their principal product lines. Although
the women's fashion hat market is estimated to be in excess of a $800 million
market, no dominant hat retailer has emerged.
 
 Continuing Education
 
  Nursing, accounting and other industries require their professionals to meet
continuing education ("CE") requirements on an ongoing basis. Required CE
frequency and the number of required hours vary from profession to profession
and from state to state depending on state laws and association regulations.
The CE industry has many small providers, including local universities, but
few large providers. In addition, some hospitals and accounting firms educate
their own employees through in-house programs and by subsidizing outside
programs. Because CE is a required product, people may not be enthusiastic
buyers. Accordingly, SC Publishing competes aggressively on price, course
content and selection, and customer service.
 
  Nursing CE represented approximately 86% of SC Publishing's CE sales in
1998. Approximately 45% of the states in the US currently require nurses to
have some form of CE. SC Publishing is exploring the expansion of its share of
this market by experimenting with new formats, such as newsletters and
crossfolds, that are more cost effective to produce than the current catalogs
or may create additional revenue opportunities. SC Publishing also sells CE to
CPAs, who generally are required to obtain minimum levels of CE every year. SC
Publishing seeks to compete in this market by offering current CE topics in a
convenient manner at competitive prices. Approximately 14% of SC Publishing's
net sales were represented by the accounting market.
 
  SC Publishing develops its products by first identifying topics pertinent to
its target audiences of nurses and CPAs. For the nursing market, SC Publishing
then contracts with qualified authors to develop course textbooks and exam
materials. Due to the fact that regulations rapidly change in the accounting
market and the economics of writing courses, SC Publishing buys existing
textbooks and contracts with authors or industry experts to create
introductory materials and exams that enhance and test the learning of the
materials presented in the textbooks. All courses and exams are subject to
peer review by industry experts before publishing.
 
Products
 
 Wigs & Hairpieces
 
  The Company sells a wide range of wigs and hairpieces in the United States,
Canada, United Kingdom and through its international licensing agreements. The
Company offers over 100 different wig styles and 10 different hairpieces in
more than 30 colors, including browns, blondes, grays and reds. Most wigs are
available in one or two sizes, except for wigs in the Christine Jordan(R)
brand, most of which are offered in five sizes. Wigs provide full coverage,
and are lighter in weight and more natural looking compared to wigs from the
1960s. Hairpieces include wiglets, add-ons and extensions. Wiglets are small
wigs generally worn on the top of the head to add style or cover thinning hair
on the top or crown area. Add-ons or extensions are usually added for style
reasons, generally to the back of the head.
 
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  Virtually all of the wigs sold by the Company are made from a special
synthetic fiber, the market for which is dominated by two Japanese firms,
Kaneka Corporation and Toyo Chemical Corporation. This synthetic fiber is not
a proprietary material, and other manufacturers in the past have produced this
material. Should there be a permanent or long-term disruption in the supply of
fiber, the Company believes that the time required to obtain an alternate
source and the attendant delay in new production, as well as a possible
significant increase in the price of fiber, may have a material adverse effect
on the Company's wig and hairpiece sales and profit margins.
 
  In early 1999, the Company introduced 100% human hair and human hair blend
wigs to its line of products. Human hair wigs have versatile styling that
allows customers to wear their wigs any way they prefer. The human hair blends
allow the customer to enjoy the shape-retaining endurance and ease of care of
our synthetic style wigs with the versatile look and feel of our human hair
styles.
 
  The Company expects that most of its wigs and hairpieces, including its new
human hair and human hair blend wigs, will continue to be manufactured in Asia
in the future. Accordingly, the Company's operations are subject to the
customary risks of doing business abroad, including fluctuations in the value
of currencies, such as the recent financial instabilities in the Asian
markets, export duties, work stoppages and, in certain parts of the world,
political instability and possible governmental intervention. As such, the
availability and cost of wigs may be favorably or adversely affected by any of
these items. Although to date such risks have not had a significant effect on
the Company's business operations, no assurance can be given that such risks
will not have a material adverse effect on the Company's business operations
in the future.
 
  During 1998, the Company purchased approximately 89% of its wigs and
hairpieces directly from eight foreign manufacturers and the balance from one
US importer. Each of the Company's five largest manufacturers represented
between 8% and 21% of its overall wig purchases in 1998. The Company maintains
close relationships with many of the leading wig manufacturers. Through these
relationships, the Company is able to obtain better control over purchasing,
styles, quality and cost.
 
 Apparel and Hats
 
  The Company offers a variety of fashion apparel in both its Paula's
Hatbox(R) and Especially Yours(R) catalogs. The merchandise in the Paula's
Hatbox(R) catalog includes both dressy as well as casual items and includes a
variety of hats that are specifically offered because of the coordinated look
they allow a woman to put together. The Paula's Hatbox(R) catalog also offers
a selection of shoes and handbags. The Especially Yours(R) catalog offers a
selection of apparel and hats targeted to African-American women.
 
  The majority of the Company's hats are manufactured domestically and
purchased from domestic vendors, including top designers. The Company's
apparel is purchased from designers, who may produce or contract to produce
the merchandise overseas or domestically. With the exception of a few items,
all merchandise is replaced at the beginning of each season (i.e., Spring and
Fall) to offer seasonally appropriate products with additional offerings added
throughout each season to maintain the freshness of the products offered in
and the appearance of the catalog.
 
Marketing
 
  The Company markets its wigs, apparel, hats, fashion accessories and
continuing education courses primarily through catalogs. Also, in 1999, the
Company began to sell its products via the Internet, which is discussed
further in the "New Opportunities" section below. Wig customers are obtained
predominantly by way of a two-step marketing program. Step one involves
obtaining prospective customers by soliciting customer interest through
targeted advertising. The Company uses a variety of advertising media,
including magazines, newspapers, tabloids, co-op mailers, package insert
programs and television. The Company places advertising based on demographics,
cost and historical experience. Historical experience is measured by cost per
inquiry, cost per customer and lifetime value of a customer. Based on this
information, the Company determines which media are effective and where future
marketing dollars should be spent.
 
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  Step two, which commences when a prospective customer responds favorably to
an advertisement placed by the Company, involves sending the prospective
customer a series of catalogs designed to elicit an initial sale. By pre-
qualifying prospects in this manner, the Company has been able to convert up
to approximately 18% of its Paula Young(R) inquirers and up to approximately
12% of its Especially Yours(R) inquirers into customers within one year of
their catalog requests. If a sale is made, the customer is put on an active
list and additional catalogs designed to create a repeat buyer are mailed.
Inactive inquirers and customers are periodically sent a program of targeted
mailings designed to reactivate them.
 
  The Company believes that it differentiates itself from both traditional
storefront retailers and other direct marketers by offering a broad and deep
selection of the core wig products it offers. Also, by virtue of its large
order volume and direct purchasing from wig manufacturers, the Company is able
to offer wigs and hairpieces at prices significantly lower than most hair
salons and wig shops.
 
  Beginning in 1998, customers for the Paula's Hatbox(R) catalog were obtained
using the more traditional one-step approach. In a one-step approach, names
are rented from another catalog company or outside list providers based on
certain criteria, such as buying habits and nature of the products purchased.
 
  The Company markets its CE courses using a one-step marketing program
targeted directly at nursing and accounting professionals whose licenses will
expire if they do not obtain further continuing education credits. The Company
has also begun to put a selection of its courses and catalog titles on the
Internet. The first courses became available on the Internet in January 1999.
 
  The Company continually refines its marketing programs and processes for the
purpose of increasing its conversion rate and the rate of repeat purchases.
The Company employs a variety of research methods, including demographic
analysis, database modeling, customer surveys, test mailings and advertising,
focus groups and outside research sources. The Company's research efforts have
assisted the Company in pursuing its strategic goals by identifying new niche
markets, such as the market for its products among African-American women.
 
New Opportunities
 
  The Company intends to continue to build its business in its existing
markets as well as to enter new markets, both by internal expansion and
through acquisitions. In executing its plans, the Company will pursue the
following:
 
 E-Commerce
 
  In early 1999, the Company redesigned its Internet web-sites
www.paulayoung.com and www.especiallyyours.com to provide information on the
latest selection of wigs and hairpieces, and also added secure, on-line
ordering capabilities. These web-sites also include links to a sister web-
site, www.paulashatbox.com, which will be available later in 1999. These sites
provide information on products and styling, and answers to frequently asked
questions. The wig sites will provide links to additional sites of interest to
wig customers, such as sites that deal with alopecia, cancer, religion and
alternative lifestyles.
 
  In March 1999, the Company purchased the domain name www.wig.com and has
reserved other generic domain Internet sites in order to increase the amount
of online traffic to the Company web-sites. Also, the Company will continue to
look for other Internet related opportunities, such as the use of search
engines to promote the Company's businesses.
 
 Acquisitions
 
  The Company intends to be aggressive with respect to its acquisition
strategy in wigs and hairpieces, which is focused on building market share
through further consolidation of the wig and hairpiece market, both in the
United States and internationally. The Company will also continue to explore
acquisition candidates, aside from
 
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wig and hairpiece companies, such as those offering products targeted to
senior women or those offering products complementary to wigs and hairpieces.
 
 Licensing Agreements
 
  The Company believes there are opportunities to expand into other countries
through licensing agreements. The Company's standard license agreement, in
general, grants each licensee an exclusive right to use the Company's
trademarks to sell wigs in the licensee's territory. Under the terms of the
license agreement, the Company supplies the licensee the inventory for which
the Company is paid its cost for the inventory plus an administrative fee for
its shipping and handling costs. The Company also provides marketing advice
and catalog development assistance. In general, the licensees are required to
pay royalties on their net sales and expend a specified minimum amount of
advertising each year. The Company currently has active license agreements in
the UK, Germany and Austria.
 
 Business to Business
 
  The Company has been testing business to business opportunities in the
United States during the last few years. Since a certain percentage of women
will prefer shopping for wigs in retail outlets, the Company, through a
business to business catalog, seeks to distribute its products to existing
retail channels, such as wig shops and beauty salons. The Company already
sells wigs and hairpieces via the business to business concept in the UK
through Daxbourne.
 
  During 1998, the Company entered into an agreement with CyberImaging
Systems, Inc. to offer the Company's products to salons and other retailers
through a computer based hairstyle imaging system, incorporating the Company's
wig and hairpiece products and brand names. The Company regularly monitors
other technological advances to determine if any may have applicability to its
businesses.
 
 New Products
 
  The Company seeks to leverage its customer relationships by adding new
product lines to its catalogs. By developing and offering new products which
customers desire, the Company creates additional sales opportunities and
reinforces customer loyalty to the Company's catalogs. For example, fashion
apparel began to be offered in the Paula's Hatbox(R) catalog in 1998, human
hair and human hair blend wigs were introduced in the Company's wig catalogs
in January 1999, the Star Jones(TM) line of wigs and hairpieces was introduced
in the first mailing of the Especially Yours(R) catalog in January 1999, and
the Raquel Welch(TM) line of wigs was introduced in the Paula Young(R) catalog
in March 1999.
 
Databases
 
  The Company has developed proprietary databases for its wig, apparel, hat,
African-American and continuing education businesses consisting of customers
and inquirers. The Company markets mailing lists derived from its databases to
non-competing businesses to provide additional sources of income, after
confirming that security measures are in place to protect this proprietary
data. The Company has undertaken limited exchanges of lists of inactive
customers with wig competitors. Due to the fact that wig wearers are difficult
to find, the Company believes that its wig database is unique and would be
very expensive to replicate and, as such, poses a substantial barrier to entry
for any potential competitor in the wig industry.
 
Operations
 
 Order Entry and Customer Service
 
  The Company has structured its telemarketing operation and the training for
its telemarketing representatives to simplify catalog shopping by emphasizing
prompt, courteous and knowledgeable service.
 
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Customers may call toll free telephone numbers 24 hours a day, seven days a
week, to place orders or to request a catalog. Approximately 57% of the
Company's orders are placed by telephone, with calls lasting three to four
minutes. The balance of orders is received by mail. The Company has contracted
with an outside telemarketing provider to handle calls in the event call
volume exceeds the Company's capacity during peak business hours, as well as
to answer the Company's phones during off-peak hours. Overflow situations also
occur due to holidays and operational disruptions, such as poor weather.
 
  Telemarketing representatives process orders directly into the Company's
computer system, which provides customer history, product availability,
product specifications, expected ship date and order number. The telemarketing
representatives use a scripted catalog sales system, are knowledgeable in key
product specifications and features, and are trained to cross-sell accessories
and related products. In keeping with the Company's efforts to maximize
operating efficiency, representatives are trained to handle a range of
products and customer service calls, allowing the Company to shift
representatives among catalogs as call volume requires.
 
  By emphasizing the training of telemarketing representatives, the Company
seeks to maintain high levels of customer satisfaction. The Company seeks to
provide prompt, courteous and knowledgeable service to its customers in order
to build customer loyalty and demonstrate to the customer the convenience and
reliability of catalog shopping.
 
  In November 1997, the Company renegotiated its contract for long distance
service with AT&T for three years at rates approximately 35% lower than rates
under the previous contract. The Company uses Lucent Technology equipment with
a 500-line capacity and presently uses about 300 lines in 90 stations. The
Company's telephone system permits flexibility in routing calls to maximize
tele-service representative efficiency.
 
 Fulfillment
 
  The Company's fulfillment goal is the prompt delivery of ordered
merchandise. Orders received are usually shipped by the next day, primarily
via third class or priority mail. For an additional charge, the Company will
ship by overnight or second day courier. Merchandise not in stock on the date
of order, is shipped within 24 hours of its receipt by the Company.
 
  The Company uses an integrated computer picking, packing and shipping
system. The system monitors the in-stock status of each item ordered,
processes the order and generates all related packing and shipping materials,
taking into account the location of items within the distribution center.
During fiscal 1998, the Company shipped an average of approximately 4,400
packages per business day.
 
 Returns
 
  The Company's return policy allows customers to return products for prompt
refund or exchange. The Company believes that its return levels are normal for
mail order products of this nature. Return experience is closely monitored at
the individual product level to identify trends in product offerings, product
defects and quality issues in an attempt to assess future purchases, enhance
customer satisfaction and reduce overall returns.
 
 Inventory Management
 
  The Company's inventory management goal is to balance a high initial
fulfillment rate with reasonable levels of inventory investment and low
overstocks. To achieve this goal, the Company seeks to schedule merchandise
deliveries and inventory amounts to conform closely to sales levels. Initial
orders for wigs, apparel and hats are placed two to four months before a
catalog mailing. Initial deliveries are scheduled to occur one or two weeks
before the first mailing. Initial purchase quantities are based on a variety
of factors, including past experience with the same or similar products,
future availability, shipping time, and, with respect to apparel, hat and
accessory vendors, the Company's ability to negotiate a reorder commitment
from the vendor. The Company continuously analyzes sales and returns for each
item in a catalog. Using this information, the Company projects
 
                                       9
<PAGE>
 
gross demand and returns for such items and, based on these projections and
inventory on hand and on order, makes decisions regarding additional
purchases. The Company sells overstocks and discontinued items through
targeted mailings and sale pages bound into its full-price catalogs.
 
 Catalog Production
 
  The Company's catalogs are designed in-house by the Company's graphic arts
staff of designers and production artists using a computer desktop publishing
system. The Company's in-house design of catalogs provides the Company with
greater control, flexibility and creativity in catalog production and product
selection, and results in significant cost savings. For the fiscal years ended
1998, 1997 and 1996, respectively, SC Direct mailed approximately 25 million,
21 million and 19 million catalogs. For the fiscal years ended 1998, 1997 and
1996, respectively, SC Publishing mailed approximately 5 million, 5 million
and 6 million catalogs.
 
Competition
 
  The mail order catalog business is highly competitive. The Company believes
that it competes on the basis of quality, value, service, product offerings,
advertising effectiveness, catalog design, convenience and efficiency. The
Company's wig, apparel and hat catalogs compete with other mail order
catalogs, both specialty and general, retail stores, including hair salons and
wig shops, department stores, specialty stores and discount stores and
Internet web-sites. The Company believes it has advantages over its two
principal mail order wig competitors, General Wig Company, which markets wigs
through the Beauty Trends catalog, and Vincent James Company, which markets
wigs through the TWC Catalog. The Company believes that these advantages
include economies of scale, the size of its customer list, and its extensive
advertising programs.
 
  The Company's CE catalogs compete with other mail order catalogs, in-house
CE, professional associations, and seminar providers. The CE industry has many
small providers, including local universities, but few large providers.
Potential competition may emerge from new distribution channels such as the
Internet and interactive television. Accordingly, SC Publishing competes
aggressively on price, course content and selection and customer service. SC
Publishing also plans to compete on the Internet.
 
Employees
 
  As of January 2, 1999, SC Direct and SC Publishing combined employed a total
of 282 employees, consisting of 66 salaried full-time employees, 2 salaried
part-time employees, 153 full-time hourly employees, and 61 part-time hourly
employees. Daxbourne International Limited employed 61 employees, consisting
of 52 salaried full-time employees and 9 full-time hourly employees. None of
the Company's employees are covered by a collective bargaining agreement. The
Company believes that its relations with its employees are good.
 
Trademarks, Patents and Trade Names
 
  The Company has 13 trademarks registered in the United States, two
registered trademarks in the United Kingdom, three trademark applications and
one patent with the US Patent and Trademark Office. The Company also has four
trademarks registered under California state law. In the course of normal
business, the Company often utilizes new trade names. When appropriate, the
Company seeks to register these names.
 
Government Regulations
 
  In 1994, the United States Supreme Court reaffirmed an earlier decision that
allowed direct marketers to make sales into states where they do not have a
physical presence without collecting sales taxes, but noted that Congress has
the power to change this law. The imposition of an obligation to collect sales
taxes may have a negative effect on the Company's response rates and may
require the Company to incur administrative costs in collecting and remitting
sales taxes. The Company believes that Massachusetts is the only jurisdiction
where it is currently required to collect sales taxes.
 
                                      10
<PAGE>
 
ITEM 1A. EXECUTIVE OFFICERS OF THE REGISTRANT
 
  The executive officers of the Company are as follows:
 
<TABLE>
<CAPTION>
          Name           Age                           Position
          ----           ---                           --------
<S>                      <C> <C>
Steven L. Bock..........  45 Chairman of the Board, President and Chief Executive Officer
J. William Heise........  50 Senior Vice President and Chief Financial Officer
</TABLE>
 
  Steven L. Bock has been Chairman of the Board and Chief Executive Officer of
the Company (or its predecessor company) since December 1990 and has been
President of the Company since August 1998. He has been a director of SC
Direct and SC Publishing (including the years when these companies were under
bankruptcy protection of the courts) since March 1989. SC Direct was formed by
RSG Partners, a private investment and management firm founded by Mr. Bock and
two partners in 1988. Mr. Bock was a partner in RSG Partners from 1988 to
1990. From October 1986 to October 1988, Mr. Bock was a Vice President of TSG
Holdings, Inc., the investment advisor to Transcontinental Services Group, a
UK listed investment holding company, where he was responsible for initiating,
financing and managing business investments. Mr. Bock has been a director of
the Juvenile Diabetes Foundation, Bay State Chapter, since January, 1998. Mr.
Bock is also a member of the Young Presidents Organization. He graduated
(summa cum laude) with a B.A. degree from SUNY at Albany and received his J.D.
degree (cum laude) from Harvard Law School.
 
  J. William Heise has been Senior Vice President and Chief Financial Officer
of the Company since August 1996 and was Acting Chief Financial Officer from
March 1996 to August 1996. From November 1994 to November 1995, Mr. Heise was
Vice President/Chief Financial Officer at Sun Television and Appliances, Inc.,
a retailer of consumer electronics and appliances. From October 1983 to March
1994, Mr. Heise served in a variety of positions with Victoria's Secret
Catalogue, Inc., including Executive Vice President/Chief Financial Officer
from 1989 to 1992 and Executive Vice President/Operations from 1992 to 1994.
Mr. Heise holds a B.A. degree from Ohio University.
 
ITEM 2. PROPERTIES
 
  The Company occupies a 43,000 square foot office building in South Easton,
Massachusetts, and a 50,000 square foot warehouse facility in a town adjacent
to South Easton. In November 1997, the Company renewed the lease on its South
Easton facility for a three year and four month term with two one-year renewal
options following the initial term. The Company began a five year and five
month lease on April 1, 1997 for its warehouse facility.
 
  The Company owns a 6,000 square foot building in London, England, which is
used by Daxbourne for office and warehouse operations.
 
ITEM 3. LEGAL PROCEEDINGS
 
  The Company is, from time to time, a party to routine litigation arising in
the normal course of its business. At the present time, the Company is not
involved in any litigation, nor is the Company aware of any potential
litigation.
 
  The Company currently has several registered trademarks and may seek
additional legal protection for its products and trade names. The Company has
invested substantial resources in developing several distinctive catalog
trademarks as well as branded products and product lines. There can be no
assurance that the steps taken by the Company to protect its rights will be
sufficient to deter misappropriation. Failure to protect these intellectual
property assets could have a material adverse effect on the Company's business
operations. Moreover, although the Company does not currently know of any
lawsuit alleging the Company's infringement of intellectual property rights
that could have a material adverse effect on the Company's business, there can
be no assurance that any such lawsuit will not be filed against the Company in
the future or, if such a lawsuit is filed, that the Company would ultimately
prevail.
 
                                      11
<PAGE>
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
  No matter was submitted to a vote of security holders of the Company during
the fourth quarter of the fiscal year covered by this report.
 
                                    PART II
 
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
        MATTERS
 
  The common stock of the Company began trading in October 1996 (subsequent to
the public offering) on the NASDAQ National Market under the symbol "CTLG".
The following table sets forth the high and low quotations from NASDAQ. Prior
to the offering in October 1996, no established public trading market existed.
 
<TABLE>
<CAPTION>
                                                                   High   Low
                                                                  ------ ------
   <S>                                                            <C>    <C>
   1996
     Fourth Quarter (commencing October 17, 1996)................ $7.375 $6.500
   1997
     First Quarter............................................... $7.375 $6.875
     Second Quarter.............................................. $7.125 $6.250
     Third Quarter............................................... $6.969 $6.625
     Fourth Quarter.............................................. $7.000 $6.375
   1998
     First Quarter............................................... $6.625 $5.625
     Second Quarter.............................................. $6.500 $5.000
     Third Quarter............................................... $5.625 $3.875
     Fourth Quarter.............................................. $5.000 $2.500
</TABLE>
 
  The number of holders of record of the Company's common stock as of March
26, 1999 was 23.
 
  The Company has not paid a dividend with respect to its common stock nor
does the Company anticipate paying dividends in the foreseeable future. Under
the terms of the Company's existing debt agreements, the Company is not
permitted to pay dividends.
 
                                      12
<PAGE>
 
ITEM 6. SELECTED FINANCIAL DATA
 
<TABLE>
<CAPTION>
                                              Historical
                           ---------------------------------------------------
                                           Fiscal Year Ended
                           ---------------------------------------------------
                            Jan. 2,    Jan. 3,  Dec. 28,  Dec. 30,   Dec. 31,
                             1999     1998 (4)    1996      1995       1994
                           ---------  --------- --------- ---------  ---------
                                (In thousands, except per-share amounts
                                     and weighted average shares)
<S>                        <C>        <C>       <C>       <C>        <C>
Statement of Operations
 Data:
Net sales................. $  48,884  $  43,492 $  36,272 $  42,568  $  38,179
Cost of sales.............    17,918     14,968    12,811    16,423     15,648
                           ---------  --------- --------- ---------  ---------
Gross profit..............    30,966     28,524    23,461    26,145     22,531
Selling, general and
 administrative...........    26,968     23,431    20,186    22,835     17,772
Restructuring charges.....       470        --        --        513        --
                           ---------  --------- --------- ---------  ---------
Income from operations....     3,528      5,093     3,275     2,797      4,759
Interest expense, net.....       861        821     1,658     1,918        661
Reorganization items......       --         --        --        --       2,890
                           ---------  --------- --------- ---------  ---------
Income before income
 taxes, cumulative effect
 of change in accounting
 principle and
 extraordinary items......     2,667      4,272     1,617       879      1,208
Income taxes..............     1,096      1,793       644       357        498
                           ---------  --------- --------- ---------  ---------
Income before cumulative
 effect of change in
 accounting principle and
 extraordinary items......     1,571      2,479       973       522        710
                           ---------  --------- --------- ---------  ---------
Net income(1)............. $   1,571  $   2,260 $     973 $     522  $  12,789
                           ---------  --------- --------- ---------  ---------
Preferred stock
 dividends................       --         --        --        292         31
                           ---------  --------- --------- ---------  ---------
Net income available to
 common shareholders...... $   1,571  $   2,260 $     973 $     230  $  12,758
                           =========  ========= ========= =========  =========
Earnings per Share--Basic
 EPS(2)
Income before cumulative
 effect of change in
 accounting principle and
 extraordinary items...... $    0.31  $    0.51 $    0.31 $    0.08  $    0.24
Net income available to
 common shareholders...... $    0.31  $    0.46 $    0.31 $    0.08  $    4.51
Weighted average shares
 outstanding.............. 5,033,800  4,905,667 3,180,091 2,826,666  2,826,666
Earnings per Share--
 Diluted EPS(2)
Income before cumulative
 effect of change in
 accounting principle and
 extraordinary items...... $    0.29  $    0.45 $    0.25 $    0.08  $    0.23
Net income available to
 common shareholders...... $    0.29  $    0.41 $    0.25 $    0.08  $    4.23
Weighted average shares
 outstanding.............. 5,495,014  5,527,701 3,946,211 3,015,078  3,015,078
<CAPTION>
                                              Historical
                           ---------------------------------------------------
                                                 As Of
                           ---------------------------------------------------
                            Jan. 2,    Jan. 3,  Dec. 28,  Dec. 30,   Dec. 31,
                             1999     1998 (4)    1996      1995       1994
                           ---------  --------- --------- ---------  ---------
                                            (In thousands)
<S>                        <C>        <C>       <C>       <C>        <C>
Balance Sheet Data:
Working capital........... $     (70) $   1,083 $   5,619 $     649  $   2,114
Total assets..............    22,399     23,293    18,405    18,170     17,364
Long-term debt............     3,671      5,012     8,147    12,876     15,180
Preferred stock...........       --         --        --      2,249      2,249
Stockholders' equity
 (deficit)(3).............     7,436      7,866     4,801    (4,416)    (4,654)
</TABLE>
--------
(1) For the fiscal year ended December 31, 1994, net income reflects a gain
    from an extraordinary item of $12,078,489, net of income taxes, resulting
    from the forgiveness of debt upon the Company's emergence
 
                                       13
<PAGE>
 
   from bankruptcy. In 1997, net income reflects a $218,699 extraordinary loss
   on the early retirement of debt (net of an income tax benefit of $149,083).
(2) In February 1997, the Financial Accounting Standards Board issued
    Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings
    Per Share", which was effective for financial statements issued for
    periods ending after December 15, 1997. This statement required the
    adoption of new calculation methodologies and enhanced disclosures of
    basic and diluted earnings per share computations. As required, the
    Company has adopted SFAS No. 128 in the fourth quarter of 1997 and has
    restated prior year earnings per share presentations to conform to SFAS
    No. 128. See the consolidated financial statements and notes thereto.
(3) In December 1998, the Company repurchased 700,000 shares of its common
    stock from funds affiliated with Dickstein Partners Inc., a large
    stockholder of the Company, in a private transaction at a price of $3.125
    per share. The shares that were repurchased represented approximately 14%
    of the Company's outstanding shares, and are now held in the Company's
    treasury. The repurchase was financed through existing bank lines with
    BankBoston, N.A. The Company also received 57,788 shares of stock from a
    former employee of the Company in lieu of cash to cover withholding taxes
    related to gains on stock options exercised in December 1998.
(4) The fiscal year ended January 3, 1998 includes three months of activity of
    the Company's subsidiary, Daxbourne International Limited, which was
    acquired by the Company on October 3, 1997. For the three months ended
    January 3, 1998, Daxbourne had net sales of $1,172,376, gross profit of
    $844,171 and net income of $80,375. The fiscal year ended January 3, 1998
    contains 53 weeks compared to the 52-week fiscal year for all other years
    presented.
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
       RESULTS OF OPERATIONS
 
  Unless otherwise indicated, "1998" means the Company's fiscal year ended
January 2, 1999, "1997" means the Company's fiscal year ended January 3, 1998,
and "1996" means the Company's fiscal year ended December 28, 1996. The
discussion and analysis below should be read in conjunction with the Financial
Statements of the Company and the notes to the financial statements. In
addition to historical information, the following Management's Discussion and
Analysis of Financial Condition and Results of Operations contains forward-
looking statements that involve risks and uncertainties. The Company's actual
results could differ significantly from those anticipated in these forward-
looking statements.
 
Introduction
 
  The Company targets niche consumer product categories, primarily via direct
marketing. SC Direct, its principal operating subsidiary in the United States
("SC Direct"), is the US leading retailer of women's wigs and hairpieces.
Daxbourne International Limited ("Daxbourne"), a subsidiary of SC Direct,
which was acquired in October 1997 and accounted for under the purchase method
of accounting, is a leading United Kingdom retailer and wholesaler of women's
wigs and hairpieces. SC Publishing, another subsidiary of SC Direct ("SC
Publishing"), sells continuing education courses to nurses and CPAs.
 
  The Company is on a 52/53-week fiscal year, ending on the Saturday closest
to December 31. The fiscal years ended January 2, 1999, January 3, 1998 and
December 28, 1996 consisted of 52, 53 and 52 weeks, respectively.
 
Results of Operations
 
 1998 Compared to 1997
 
  Net sales increased $5.4 million, or 12.4%, from $43.5 million in 1997 to
$48.9 million in 1998. This increase was due to (i) the addition of $3.9
million in net sales from Daxbourne, which went from $1.2 million
 
                                      14
<PAGE>
 
in fiscal 1997 to $5.1 million in fiscal 1998 and (ii) the continued success
of the Company's Especially Yours(R) and Paula's Hatbox(R) catalogs, which
together increased net sales by $2.9 million in 1998 compared to 1997. The
increase in net sales was offset by a decrease in net sales from the Company's
Paula Young(R) catalogs of approximately $1.4 million due to lower response
rates and smaller average order sizes. Also, the Company's 1998 fiscal year
consisted of 52 weeks compared to the 53-week fiscal year in 1997.
 
  Gross margin dollars increased $2.5 million, or 8.8%, from $28.5 million in
1997 to $31.0 million in 1998. The gross margin percentage decreased from
65.6% in 1997 to 63.4% in 1998. The decrease in gross margin percentage
related primarily to (i) expanded promotional pricing on several of the
Company's wig and hairpiece products, which resulted in a decrease in the
average order size in 1998 compared to 1997, (ii) increased sales of apparel,
hats and accessories which have lower margins than wigs and hairpieces, (iii)
increased sales of wigs in the Especially Yours(R) catalog which tend to have
lower price points than in Paula Young(R), (iv) an increase in freight charges
as a result of an increase in the amount of merchandise air freighted from
suppliers in 1998 compared to 1997 and (v) an increase in inventory reserves
for excess Paula's Hatbox(R) inventory.
 
  Selling, general and administrative expenses ("SG&A") increased $3.6
million, or 15.4%, from $23.4 million in 1997 to $27.0 million in 1998. The
increase in SG&A related primarily to (i) the addition of $1.9 million of
expenses from Daxbourne from approximately $543,000 in fiscal 1997 to $2.4
million in fiscal 1998, (ii) additional catalog production and mailing
expenses of $2.1 million in 1998 compared to 1997, due primarily to an
increase in the number of catalogs mailed as well as increased page counts in
the Company's Paula's Hatbox(R) and Especially Yours(R) catalogs, (iii)
expenses of approximately $160,000 for legal and investment banker services in
connection with the Company's efforts to explore various strategic
alternatives to maximize shareholder value, (iv) increased depreciation and
amortization expense of approximately $366,000 and (v) additional photography
expense due to the write-off of approximately $119,000 of photographs that
will not be used in the 1999 catalogs. The increase in SG&A in 1998 compared
to 1997 was offset by (i) a decrease in advertising expense of approximately
$579,000 primarily related to the elimination of unprofitable media testing,
(ii) an increase in shipping and handling income of approximately $385,000 and
(iii) fewer expenses related to the Company's 52-week fiscal year ended 1998
compared to 1997's 53-week fiscal year.
 
  In August 1998, the Company announced a reorganization of certain management
positions. In connection with this reorganization, the Company recorded in the
third quarter of 1998 a pre-tax charge of $469,558, consisting of severance
and other severance related benefits for five former employees of the Company.
The Company will pay out the severance and severance related benefits through
July 1999. Included in accrued expenses at January 2, 1999 are accrued
restructuring charges of $99,301.
 
  Net interest expense increased approximately $40,000, or 4.9%, from
approximately $821,000 in 1997 to approximately $861,000 in 1998, reflecting
higher principal amounts outstanding on the Company's bank facility, due to
additional borrowing to acquire Daxbourne during the fourth quarter of 1997,
which were offset by lower interest rates in 1998 compared to 1997.
 
 1997 Compared to 1996
 
  Net sales increased $7.2 million, or 19.8%, from $36.3 million in 1996 to
$43.5 million in 1997. The sales increase resulted from (i) higher customer
response rates driven by expanded promotional pricing on the Company's
products, (ii) an increase in the number of catalogs mailed in 1997 compared
to 1996, principally due to additional mailings of two of the Company's newer
catalogs, Paula's Hatbox(R) and Especially Yours(R), (iii) the addition of
Daxbourne net sales, which added $1.2 million in sales for 1997 and (iv) one
additional week of sales related to the Company having a 53-week fiscal year
in 1997 compared to a 52-week fiscal year in 1996.
 
  Gross margin dollars increased $5.0 million, or 21.3%, from $23.5 million in
1996 to $28.5 million in 1997. The gross margin percentage increased from
64.7% in 1996 to 65.6% in 1997. This percentage increase resulted from (i) a
larger percentage of the Company's products being purchased at lower prices
directly from overseas
 
                                      15
<PAGE>
 
factories and (ii) a reduction in the cost of shipping packages weighing less
than one pound to customers. The overall increase in gross margin percentage
was, however, reduced by promotional pricing strategies on many of the
Company's wig and hairpiece products which resulted in a decrease in the
average order size in 1997 compared to 1996, as well as a shift in the mix of
products sold from higher margin to lower margin products, such as hats.
 
  SG&A expenses increased $3.2 million, or 15.8%, from $20.2 million in 1996
to $23.4 million in 1997. This increase was primarily due to (i) an increase
in catalog production costs of approximately $900,000 for 1997 compared to
1996, due primarily to an increase in the number of catalogs mailed in 1997
compared to 1996, (ii) the addition of Daxbourne activity for 1997, which
added approximately $550,000 of SG&A in 1997, (iii) additional expenses
related to the Company's 53-week fiscal year ended 1997 compared to 1996's 52-
week fiscal year and (iv) additional variable costs due to increased sales
activity, additional headcount, increased rent expense and increased
administrative expenses relating to being a public company.
 
  On June 27, 1997, the Company's subsidiary, SC Publishing, sold its business
of continuing education for California real estate professionals. The Company
believed that, because this was a single state business, it was no longer a
strategic fit with the broader focus of the nurse and CPA markets. The sales
price of $212,250 included a license to use the trade name Western Schools(R)
for real estate courses, all related inventory for existing courses, and title
and rights to its real estate courses, both existing and under development.
The Company recognized a pre-tax gain of $121,980, included in SG&A, on the
sale of these assets.
 
  Net interest expense for the Company decreased approximately $836,000, or
51.7%, from $1.7 million in 1996 to approximately $821,000 in 1997, reflecting
(i) lower average principal amounts outstanding for the year on the Company's
debt and (ii) lower interest rates. This decrease was offset by added interest
expense as a result of additional borrowing for the Daxbourne acquisition in
October 1997.
 
Liquidity and Capital Resources
 
  Cash flows provided by operating activities was $3.8 million in 1998. The
cash flows provided by operating activities were offset by $2.0 million used
in financing activities and $1.7 million used in investing activities. The
$2.0 million in cash used in financing activities was primarily due to (i) the
Company's repurchase of $2.4 million in stock in December 1998 and (ii) the
repayment of long term debt of approximately $970,000. These financing cash
uses were offset by increased cash sources from the Company's line of credit
of $1.3 million. The $1.7 million in cash used in investing activities was
primarily due to (i) the Company's continued installation of the new catalog
information system which amounted to approximately $465,000, (ii) the
renovation for the new call center which amounted to approximately $300,000,
(iii) the repayment of approximately $500,000 in notes payable relating to the
Daxbourne acquisition and (iv) the purchase of approximately $260,000 of
computer equipment upgrades to handle the hardware and software components of
the new catalog information system.
 
  In October 1996, the Company successfully completed an initial public
offering ("IPO") for 1.5 million shares of its common stock priced at $6.50
per share. Net proceeds to the Company were $7.8 million. The proceeds from
the IPO were used to pay down $5.9 million of bank debt, to bring accounts
payable into a current position and to provide additional working capital. The
reduction of the bank debt reduced future scheduled payments by approximately
one-third and gave the Company full availability of its $2 million revolving
credit line.
 
  In March 1997, the Company entered into an $11 million credit facility with
BankBoston, N.A. (the "BKB Agreement") for the purpose of refinancing its
existing senior and subordinated debt and to provide for the capital
expenditures and working capital needs of the Company. The BKB Agreement
provided for a $5 million term loan (the "Term Loan") and a $6 million
revolving line of credit (the "Line of Credit"). The Term Loan and the Line of
Credit bear interest rates based on either a base rate, as defined in the BKB
agreement, or a LIBOR contract rate. As of January 2, 1999, the Term Loan was
under a LIBOR contract rate of 7.1563% for
 
                                      16
<PAGE>
 
$3.5 million and 6.8603% for $500,000. As of January 2, 1999, $2.3 million of
the Line of Credit was under LIBOR contract rates ranging from 6.9036% to
7.00% and the remainder of the Line of Credit was at the base rate of 8.00%.
The Company is required to pay a commitment fee varying from 0.375% to 0.50%
per annum on the unused portion of the commitment. At January 2, 1999,
$2,827,351 was available under this Line of Credit.
 
  On October 3, 1997, the Company amended the existing BKB Agreement (the
"Amended BKB Agreement") and entered into an additional $4.0 million credit
agreement with BankBoston, N.A., acting through its London Branch (the "BKB UK
Agreement"), in connection with the Company's acquisition of The Daxbourne
Group. The Amended BKB Agreement extended the maturity date of borrowings from
March 2001 to October 2001.
 
  The BKB UK Agreement provides for an approximate $1.8 million term loan (the
"UK Term Loan") and for an approximate $2.2 million revolving line of credit
(the "UK Line of Credit"). The UK Term Loan and the UK Line of Credit bear
interest rates based on either a Sterling base rate, as defined by the BKB UK
Agreement, or a LIBOR contract rate. The BKB UK Agreement matures in October
2001, with the UK Term Loan having a four year repayment schedule with
remaining payments of approximately $463,000 due in 1999, approximately
$515,000 due in 2000, and approximately $656,000 due in 2001. As of January 2,
1999, a portion of both the UK Term Loan and UK Line of Credit were under a
LIBOR contract rate of 9.16%. The Company is required to pay a commitment fee
varying from 0.375% to 0.50% per annum on the unused portion of the
commitment. At January 2, 1999, $275,582 was available under the UK Line of
Credit.
 
  On September 30, 1998, the Amended BKB Agreement was further amended by the
Company and BankBoston, N.A. to exclude from debt covenant computations
certain capital expenditures associated with the Company's purchase and
installation of a new comprehensive catalog information system. Then, on
December 21, 1998, the Amended BKB Agreement was further amended to allow the
Company to defer its January 1, 1999 payment on the Term Loan in connection
with the Company's repurchase of $2.4 million of its common stock in December
1998. The Amended BKB Agreement matures in October 2001 and has repayments of
$1.5 million in 1999 and 2000 and $1.0 million in 2001.
 
  The Amended BKB Agreement and the BKB UK Agreement (collectively the
"Consolidated Credit Facility") are cross-collateralized by a first perfected
security interest in all tangible and intangible assets of the Company. The
Consolidated Credit Facility is subject to certain consolidated covenants,
including but not limited to leverage and debt service coverage ratios,
minimum earnings requirements, and a restriction on the payment of cash
dividends on the Company's common stock.
 
  The Company is in the process of installing a new catalog information system
purchased from an outside vendor. The system is currently undergoing
modification by the Company's internal staff. The system is scheduled to be
implemented for SC Direct, a subsidiary of the Company, in mid-1999. Following
the implementation by SC Direct, it is anticipated that the system will be
modified to deal with the special processing needs of SC Publishing, another
subsidiary of the Company. It is anticipated that these modifications will
take between three and six months to complete, with full implementation being
completed by the end of 1999. The entire cost of the new system, including new
hardware and internal payroll and payroll related costs, is estimated to be
$1.3 million. As of January 2, 1999, $1.1 million of these costs have been
capitalized, of which approximately $465,000 was added during the year ended
January 2, 1999.
 
  During March 1998, the Company completed the renovation of its former
warehouse space in its South Easton facility to allow for further office
expansion. Costs of the renovation and for the purchase of new furniture and
fixtures amounted to approximately $300,000 in the first quarter of 1998.
 
  In December 1998, the Company entered into a private transaction to
repurchase 700,000 shares of its common stock at $3.125 per share from funds
affiliated with Dickstein Partners, Inc., a large stockholder of the Company.
The shares that were repurchased represented approximately 14% of the
Company's outstanding shares, and are now held in the Company's treasury. The
repurchase was financed through existing bank lines
 
                                      17
<PAGE>
 
with BankBoston, N.A. The Company also received 57,788 shares of stock from a
former employee of the Company in lieu of cash to cover withholding taxes
related to gains on stock options exercised in December 1998. In addition, the
Board of Directors authorized the Company to repurchase up to an additional $1
million of common stock during 1999. Through March 26, 1999, the Company has
repurchased 63,400 shares at an average price of $3.50 per share.
 
  The Company's cash flow from operations and available credit facilities are
considered adequate to fund planned business operations and both the short-
term and long-term capital needs of the Company. However, certain events, such
as additional significant acquisitions, could require new external financing.
 
Year 2000 Readiness
 
  The Company's current information and computer systems will be affected by
the Year 2000 ("Y2K") issue, which refers to the inability of computerized
systems to process dates beyond December 31, 1999. The Company is formulating
a Y2K Plan to address the Company's Y2K issues. Based on its current
assessments from the Y2K Plan, the Company does not expect at present that it
will experience a disruption of its operations as a result of the change to
the new millennium.
 
  The Company is in the process of installing a new comprehensive catalog
information system purchased from an outside vendor, who has represented that
the software addresses the Y2K issue. If the Company's new computer system
fails with respect to the Y2K issue, there could be a material adverse impact
on the business operations or financial performance of the Company, including
its ability to take customer orders, ship products, invoice customers and
collect payments. It is anticipated that the installation will be completed in
mid 1999. The Company estimates that the entire cost of the new system,
including new hardware and internal payroll and payroll related costs, will be
$1.3 million. As of January 2, 1999, $1.1 million of these costs have been
capitalized, of which approximately $465,000 was added during the year ended
January 2, 1999. If the new catalog information system cannot be effectively
installed, then the Company has scheduled the current computer vendor to
provide a free upgrade in June 1999 that will make the current computer
operating system Y2K ready. Also, in January 1998, the Company successfully
converted its financial and accounting systems to a new software package that
has been represented by the vendor to be Y2K ready.
 
  The foregoing timetable and assessment of costs to become Y2K compliant
reflect management's current best estimates. These estimates are based on many
assumptions, including assumptions about the cost, availability and ability of
resources to locate, remediate and modify affected systems, equipment and
facilities. Based upon its activities to date, the Company does not currently
believe that these factors will cause results to differ significantly from
those estimated. However, the Company cannot reasonably estimate the potential
impact on its financial condition and operations if key third parties
including, among others, suppliers, contractors, financial institutions, non-
retail customers and governments do not become Y2K compliant on a timely
basis.
 
  The Company is assessing the state of readiness of its major suppliers and
customers through written inquiry and evaluation of responses. The Company
intends to follow up with those suppliers or customers that indicate material
problems. Alternate suppliers or service providers will be identified for
those whose responses indicate an unusually high risk of a Y2K problem. The
Company's evaluation of business processes that are not related to information
systems, and the development of contingency plans where such evaluation
identifies a high risk of a Y2K problem should be completed by the third
quarter of 1999. The main risks associated with the Y2K problem are the
uncertainties as to whether the Company's suppliers can continue to perform
their services for the Company uninterrupted by the Y2K event, and whether the
Company's non-retail customers can continue to operate their business
uninterrupted by the Y2K event. The Company's suppliers, if they are unable to
remediate their Y2K problems, may be unable to produce or deliver goods
ordered by the Company. The Company depends significantly upon telephone
orders; should the Company's telephone service be adversely affected, the
Company will be unable to receive a high percentage of its retail orders. The
Company also depends in large measure on delivery services such as the United
States Post Office, Federal Express and UPS to deliver goods to retail
 
                                      18
<PAGE>
 
customers; accordingly should one or more of these delivery services prove
unable to make deliveries as a result of Y2K problems, the Company's cash flow
and business would be severely and adversely affected. Although the state of
readiness of the Company's suppliers, delivery services and non-retail
customers will be monitored and evaluated, and contingency plans will be
developed, no assurances can be given as to the eventual state of readiness of
the Company's suppliers and/or customers. Nor can any assurances be given as
to eventual effectiveness of the Company's contingency plans.
 
  The preceding discussion contains forward-looking information within the
meaning of Section 21E of the Exchange Act. This disclosure is also subject to
protection under the Year 2000 Information and Readiness Disclosure Act of
1998, Public Law 105-271, as a "Year 2000 Statement" and "Year 2000 Readiness
Disclosure" as defined therein. Actual results may differ materially from such
projected information due to changes in the underlying assumptions.
 
Recently Issued Accounting Pronouncements
 
  In January 1998, the Company adopted Statement of Financial Accounting
Standards ("SFAS") No. 130, "Reporting Comprehensive Income." SFAS No. 130
required that a company (a) classify items of other comprehensive income by
their nature in a financial statement and (b) display the accumulated balance
of other comprehensive income separately from retained earnings and additional
paid-in-capital in the equity section of the balance sheet. Reclassification
of financial statements for earlier periods provided for comparative purposes
is required. Comprehensive income consisted solely of accumulated foreign
currency translation adjustments in connection with the Company's United
Kingdom subsidiary in 1998. During the year ended January 2, 1999, the Company
has recognized other comprehensive income of $12,431.
 
  The Company has also adopted SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information" in the fourth quarter of 1998. SFAS No.
131 established standards for the way public companies report selected
information about operating segments in annual financial statements and
required those companies to report selected information about segments in
interim financial reports issued to shareholders. It also established
standards for related disclosures about products and services, geographic
areas, and major customers. Required disclosures have been made in the
footnotes to the financial statements.
 
  In March 1998, the American Institute of Certified Public Accountants
("AICPA") issued Statement of Position ("SOP") 98-1, "Accounting for the Costs
of Computer Software Developed or Obtained for Internal Use". SOP 98-1
required that costs incurred in the development of internal use software be
capitalized and amortized over a period of time. The Company adopted SOP 98-1
in the first quarter of 1998. During the year ended January 2, 1999, the
Company has capitalized approximately $465,000 of costs associated with a new
comprehensive catalog information system, of which approximately $230,000 were
internal payroll and payroll related costs.
 
  In April 1998, the Company adopted SOP 98-5, "Reporting on the Costs of
Start-Up Activities". SOP 98-5 required costs of start-up activities and
organization costs to be expensed as incurred. SOP 98-5 had no impact on the
Company's financial condition or results of operations for the year ended
January 2, 1999.
 
  In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities." This statement
is effective for all fiscal quarters of all fiscal years beginning after June
15, 1999. The Company has not yet determined the effect, if any, of adopting
SFAS No. 133 on the consolidated financial statements.
 
Risk Factors
 
  Postal Rates, Paper Prices and Media Costs. Postage, shipping and paper
costs are significant expenses in the operation of the Company's business. The
Company mails its catalogs and generally ships its products to customers
through the U.S. Postal Service and, at the customer's request and expense,
ships its products by
 
                                      19
<PAGE>
 
overnight and second day delivery services. The Company passes on the costs of
mailing its products directly to customers as separate shipping and handling
charges, but does not directly pass on paper costs and the costs of mailing
its catalogs. Any future increases in postal or shipping rates or paper costs
will have an adverse effect on the Company's operating results if the Company
is unable to pass on these increases to its customers. In addition, a rise in
media costs could have a material adverse effect on the Company's ability to
generate new customers.
 
  Limited Sources of Fiber. The majority of the Company's revenue is derived
from the sale of wigs. Virtually all of the wigs sold by the Company are made
from special synthetic fiber manufactured by only two Japanese companies,
Kaneka Corporation and Toyo Chemical Corporation. The wig manufacturers from
whom the Company purchases its inventory purchase the fiber from these two
fiber manufacturers. Should there be a permanent or long-term disruption in
the supply of fiber, the Company believes that the time required to obtain an
alternate source and the attendant delay in new production, as well as a
possible significant increase in the price of fiber, may have a material
adverse effect on the Company's wig and hairpiece sales and profit margins.
 
  Limited Number of Wig Manufacturers. The wigs sold by the Company are
produced by a limited number of manufacturers. Each of the Company's five
largest manufacturers supplied between 8% and 21% of the Company's overall wig
purchases in 1998. The loss of one or more of these manufacturers could
materially disrupt the Company's wig operations. Although the Company believes
that in such an event it could purchase its wig requirements from the
remaining manufacturers and from additional manufacturers, there can be no
assurance that such sources of supply could meet the Company's wig
requirements without considerable disruption to the Company's purchasing
cycles, inventory levels and profit margins. The Company does not currently
have, and does not anticipate entering into in the foreseeable future, long-
term supply contracts with its manufacturers.
 
  Dependence Upon Foreign Suppliers; Exchange Rates; and Currency
Fluctuations. The Company expects that most of its wigs and hairpieces will
continue to be manufactured in Asia in the future. Accordingly, the Company's
operations are subject to the customary risks of doing business abroad,
including fluctuations in the value of currencies, such as the recent
financial instabilities in the Asian markets, export duties, work stoppages
and, in certain parts of the world, political instability and possible
governmental intervention. As such, the availability and cost of wigs may be
favorably or adversely affected by any of these items. Although to date such
risks have not had a significant effect on the Company's business operations,
no assurance can be given that such risks will not have a material adverse
effect on the Company's business operations in the future.
 
  Risk of a Cure for Hair Loss; Cancer Treatment Improvement. Millions of
American women suffer varying degrees of hair loss, including those suffering
hair loss as a side effect of cancer treatments. Women suffering from hair
loss comprise a substantial percentage of the Company's customer base for its
wigs and hairpieces. Ongoing research is conducted by numerous groups, both
public and private, seeking remedies for hair loss. One drug, Minoxidil
(marketed under the name Rogaine(R) as well as other names), is now available
over-the-counter and is sold to men and women as a measure against hair loss.
There can be no assurance that another new drug will not be developed that
could prevent hair loss among women. Such an event may have a material adverse
effect on the Company's core wig business. In addition, the development of any
therapies, such as new cancer treatments, that would eliminate hair loss as a
side effect, may have a material adverse effect on the Company's business.
 
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
  The Company's primary exposures to market risks include fluctuations in
interest rates on its short-term and long-term debt of approximately $10.7
million as of January 2, 1999 and in foreign currency exchange rates. The
Company does not use derivative financial instruments. The Company is subject
to interest rate risk on its short-term borrowings under its credit
facilities. Historically, the Company has not experienced material gains or
losses due to interest rate changes. Management does not believe that the risk
inherent in the variable-rate nature
 
                                      20
<PAGE>
 
of these instruments will have a material effect on the Company's consolidated
financial statements. However, no assurance can be given that such a risk will
not have a material adverse effect on the Company's financial statements in
the future.
 
  The Company's Term Loan and Line of Credit bear interest rates based on
either a base rate or a LIBOR contract rate. The Company's UK Term Loan and
the UK Line of Credit bear interest rates based on either a Sterling base rate
or a LIBOR contract rate. See Liquidity and Capital Resources. As of January
2, 1999, the Term Loan was under a LIBOR contract rate of 7.1563% for $3.5
million and 6.8603% for $500,000. As of January 2, 1999, $2.3 million of the
Line of Credit was under LIBOR contract rates ranging from 6.9036% to 7.00%
and the remainder of the Line of Credit was at the base rate of 8.00%. As of
January 2, 1999, a portion of both the UK Term Loan and UK Line of Credit were
under a LIBOR contract rate of 9.16%.
 
  As of January 2, 1999, the outstanding balance on all of the Company's
credit facilities was $10,731,553. Based on this balance, an immediate change
of one percent in the interest rate would cause a change in interest expense
of approximately $100,000 on an annual basis. The Company's objective in
maintaining these variable rate borrowings is the flexibility obtained
regarding early repayment without penalties and lower overall cost as compared
with fixed-rate borrowings.
 
  The foreign currencies to which the Company has the most significant
exchange rate exposure are the British Pound, Chinese Yuan and Indonesian
Rupiah. The Company expects that most of its wigs and hairpieces will continue
to be manufactured in China and Indonesia in the future. Accordingly, the
Company's operations are subject to fluctuations in the value of these
countries' currencies. Although to date such exchange rate exposures have not
had a significant effect on the Company's business operations, no assurance
can be given that such exchange rate exposures will not have a material
adverse effect on the Company's business operations in the future. Also, the
implementation of the Euro currency in 1999 is not expected to materially
affect the Company's operations, or its risk profile.
 
  Based on a hypothetical ten percent adverse movement in interest rates and
foreign currency exchange rates, the potential losses in future earnings, fair
value of risk-sensitive financial instruments, and cash flows are immaterial,
although the actual effects may differ materially from the hypothetical
analysis.
 
                                      21
<PAGE>
 
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
<TABLE>
<CAPTION>
                                                                           Page
                                                                           -----
<S>                                                                        <C>
Independent Auditors' Report.............................................     23
Financial Statements and Supplementary Schedule as of January 2, 1999 and
 January 3, 1998 and for the Three Fiscal Years Ended January 2, 1999,
 January 3, 1998 and December 28, 1996...................................
  Consolidated Balance Sheets............................................     24
  Consolidated Statements of Operations..................................     25
  Consolidated Statements of Stockholders' Equity........................     26
  Consolidated Statements of Cash Flows..................................  27-28
  Notes to Consolidated Financial Statements.............................  29-43
  Schedule II--Valuation and Qualifying Accounts.........................     44
</TABLE>
 
  All other schedules for which provision is made in the applicable
regulations of the Securities and Exchange Commission have been omitted
because the information is disclosed in the Consolidated Financial Statements
or because such schedules are not required or are not applicable.
 
                                      22
<PAGE>
 
                         INDEPENDENT AUDITORS' REPORT
 
To the Board of Directors of
 Specialty Catalog Corp.
 
  We have audited the accompanying consolidated balance sheets of Specialty
Catalog Corp. and subsidiaries (the "Company") as of January 2, 1999 and
January 3, 1998 and the related consolidated statements of operations and
consolidated statements of stockholders' equity and cash flows for the three
years ended January 2, 1999, January 3, 1998 and December 28, 1996. Our audits
also included the consolidated financial statement schedule listed in the
Index at Item 8. These financial statements and financial statement schedule
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements and financial statement
schedule based on our audits.
 
  We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
 
  In our opinion, such consolidated financial statements present fairly, in
all material respects, the financial position of the Company as of January 2,
1999 and January 3, 1998 and the results of its operations and its cash flows
for the three years ended January 2, 1999, January 3, 1998 and December 28,
1996, in conformity with generally accepted accounting principles. Also, in
our opinion, such consolidated financial statement schedule when considered in
relation to the basic consolidated financial statements taken as a whole,
presents fairly, in all material respects the information set forth therein.
 
/s/ Deloitte & Touche LLP
 
Boston, Massachusetts
March 8, 1999
 
                                      23
<PAGE>
 
                            SPECIALTY CATALOG CORP.
 
                          CONSOLIDATED BALANCE SHEETS
 
<TABLE>
<CAPTION>
                                                      January 2,   January 3,
                                                         1999         1998
                                                      -----------  -----------
<S>                                                   <C>          <C>
                       Assets
Current assets:
  Cash and cash equivalents.......................... $   721,949  $   603,840
  Accounts receivable, less allowance for doubtful
   accounts of $65,621 and $79,500 at January 2, 1999
   and January 3, 1998, respectively.................   1,220,741    1,123,176
  Inventories........................................   5,388,395    6,258,928
  Prepaid expenses...................................   3,738,846    3,344,675
                                                      -----------  -----------
    Total current assets.............................  11,069,931   11,330,619
                                                      -----------  -----------
Property, plant and equipment:
  Property, plant and equipment......................   6,935,399    5,769,098
  Less accumulated depreciation and amortization.....  (3,989,287)  (3,606,295)
                                                      -----------  -----------
    Total property, plant and equipment--net.........   2,946,112    2,162,803
                                                      -----------  -----------
Intangible assets--net...............................   3,678,158    3,942,547
Deferred income taxes................................   4,521,988    5,560,050
Other assets.........................................     183,193      297,086
                                                      -----------  -----------
    Total assets..................................... $22,399,382  $23,293,105
                                                      ===========  ===========
        Liabilities and Stockholders' Equity
Current liabilities:
  Accounts payable and accrued expenses.............. $ 3,403,414  $ 3,123,100
  Liabilities to customers...........................     676,447      996,943
  Line of credit.....................................   5,097,067    3,784,952
  Income taxes.......................................         --       282,329
  Current portion of long-term debt..................   1,963,319    1,567,666
  Notes payable......................................         --       492,510
                                                      -----------  -----------
    Total current liabilities........................  11,140,247   10,247,500
                                                      -----------  -----------
Long-term debt.......................................   3,671,167    5,012,092
Other long-term liabilities..........................     151,619      167,755
Commitments and contingencies
Stockholders' equity:
  Preferred stock, $1.00 par value: 1,000,000 shares
   authorized; no shares issued and outstanding......         --           --
  Common stock, $.01 par value: 10,000,000 shares
   authorized; 4,481,986 and 5,022,001 shares issued
   and outstanding at January 2, 1999 and January 3,
   1998, respectively................................      52,397       50,220
  Additional paid-in capital.........................  16,159,570   15,838,826
  Deferred compensation..............................     (48,363)     (65,862)
  Accumulated other comprehensive income.............      15,926        3,495
  Accumulated deficit................................  (6,389,540)  (7,960,921)
                                                      -----------  -----------
                                                        9,789,990    7,865,758
  Less treasury stock, at cost, 757,788 shares at
   January 2, 1999...................................  (2,353,641)         --
                                                      -----------  -----------
    Total stockholders' equity.......................   7,436,349    7,865,758
                                                      -----------  -----------
      Total liabilities and stockholders' equity..... $22,399,382  $23,293,105
                                                      ===========  ===========
</TABLE>
 
                See notes to consolidated financial statements.
 
                                       24
<PAGE>
 
                            SPECIALTY CATALOG CORP.
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
 
<TABLE>
<CAPTION>
                                                    Fiscal Year Ended
                                           ------------------------------------
                                           January 2,  January 3,  December 28,
                                              1999        1998         1996
                                           ----------- ----------- ------------
<S>                                        <C>         <C>         <C>
Net sales................................  $48,883,552 $43,492,459 $36,271,663
Cost of sales (including buying,
 occupancy and order fulfillment costs)..   17,917,572  14,967,880  12,810,921
                                           ----------- ----------- -----------
Gross profit.............................   30,965,980  28,524,579  23,460,742
                                           ----------- ----------- -----------
Operating expenses:
  Selling, general and administrative
   expenses..............................   26,968,408  23,431,242  20,185,965
  Restructuring charges..................      469,558         --          --
                                           ----------- ----------- -----------
    Total operating expenses.............   27,437,966  23,431,242  20,185,965
                                           ----------- ----------- -----------
Income from operations...................    3,528,014   5,093,337   3,274,777
                                           ----------- ----------- -----------
Interest expense--net....................      860,639     821,105   1,657,471
                                           ----------- ----------- -----------
Income before income taxes and
 extraordinary items.....................    2,667,375   4,272,232   1,617,306
Income taxes.............................    1,095,994   1,792,865     644,047
                                           ----------- ----------- -----------
Income before extraordinary items........    1,571,381   2,479,367     973,259
Extraordinary items--loss on early
 extinguishment of debt (net of an income
 tax benefit of $149,083 for the year
 ended January 3, 1998)..................          --      218,699         --
                                           ----------- ----------- -----------
Net income...............................  $ 1,571,381 $ 2,260,668 $   973,259
                                           ----------- ----------- -----------
Other comprehensive income...............       12,431       3,495         --
                                           ----------- ----------- -----------
Comprehensive income.....................  $ 1,583,812 $ 2,264,163 $   973,259
                                           =========== =========== ===========
Earnings per share--Basic EPS:
  Income before extraordinary items......  $      0.31 $      0.51 $      0.31
  Loss on extraordinary items............  $       --  $      0.05 $       --
                                           ----------- ----------- -----------
  Net income per share...................  $      0.31 $      0.46 $      0.31
                                           =========== =========== ===========
  Weighted average shares outstanding....    5,033,800   4,905,667   3,180,091
                                           =========== =========== ===========
Earnings per share--Diluted EPS:
  Income before extraordinary items......  $      0.29 $      0.45 $      0.25
  Loss on extraordinary items............  $       --  $      0.04 $       --
                                           ----------- ----------- -----------
  Net income per share...................  $      0.29 $      0.41 $      0.25
                                           =========== =========== ===========
  Weighted average shares outstanding....    5,495,014   5,527,701   3,946,211
                                           =========== =========== ===========
</TABLE>
 
                See notes to consolidated financial statements.
 
                                       25
<PAGE>
 
                            SPECIALTY CATALOG CORP.
 
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
 
<TABLE>
<CAPTION>
                                                                                                              Accumulated
                      Common Stock     Classes A, B and C    13% Preferred Stock                                 Other
                   ------------------- --------------------  --------------------   Treasury      Deferred   Comprehensive
                    Shares     Amount    Shares     Amount   Shares     Amount        Stock     Compensation    Income
                   ---------  -------- ----------  --------  -------  -----------  -----------  ------------ -------------
<S>                <C>        <C>      <C>         <C>       <C>      <C>          <C>          <C>          <C>
Balance, December
30, 1995.........        --   $     --  2,826,666  $ 28,267   22,491  $ 2,249,100  $       --    $     --      $    --
 Issuance of
 common stock in
 connection with
 initial public
 offering........  1,500,000    15,000        --        --       --           --           --          --           --
 Exchange of
 Class A, Class
 B, and Class C
 shares for
 common stock....  2,826,666    28,267 (2,826,666)  (28,267)     --           --           --          --           --
 Conversion of
 preferred stock
 into common
 stock...........    375,000     3,750        --        --   (22,491)  (2,249,100)         --          --           --
 Net income......        --        --         --        --       --           --           --          --           --
 Redeemable
 preferred stock
 dividends.......        --        --         --        --       --           --           --          --           --
 Forgiveness of
 preferred stock
 dividends and
 related accrued
 interest........        --        --         --        --       --           --           --          --           --
 Deferred
 compensation....        --        --         --        --       --           --           --      (87,750)         --
 Amortization of
 deferred
 compensation....        --        --         --        --       --           --           --        4,387          --
 Issuance of
 warrants........        --        --         --        --       --           --           --          --           --
 Other
 comprehensive
 income..........        --        --         --        --       --           --           --          --           --
                   ---------  -------- ----------  --------  -------  -----------  -----------   ---------     --------
Balance, December
28, 1996.........  4,701,666    47,017        --        --       --           --           --      (83,363)         --
                   ---------  -------- ----------  --------  -------  -----------  -----------   ---------     --------
 Net income......        --        --         --        --       --           --           --          --           --
 Exercise of
 stock options...     55,000       550        --        --       --           --           --          --           --
 Exercise of
 warrants........    265,335     2,653        --        --       --           --           --          --           --
 Amortization of
 deferred
 compensation....        --        --         --        --       --           --           --       17,501          --
 Other
 comprehensive
 income..........        --        --         --        --       --           --           --          --         3,495
                   ---------  -------- ----------  --------  -------  -----------  -----------   ---------     --------
Balance, January
3, 1998..........  5,022,001    50,220        --        --       --           --           --      (65,862)       3,495
                   ---------  -------- ----------  --------  -------  -----------  -----------   ---------     --------
 Net income......        --        --         --        --       --           --           --          --           --
 Exercise of
 stock options...    217,773     2,177        --        --       --           --           --          --           --
 Treasury stock
 repurchase......   (757,788)      --         --        --       --           --   $(2,353,641)        --           --
 Amortization of
 deferred
 compensation....        --        --         --        --       --           --           --       17,499          --
 Other
 comprehensive
 income..........        --        --         --        --       --           --           --          --        12,431
                   ---------  -------- ----------  --------  -------  -----------  -----------   ---------     --------
Balance, January
2, 1999..........  4,481,986  $ 52,397        --   $    --       --   $       --   $(2,353,641)  $ (48,363)    $ 15,926
                   =========  ======== ==========  ========  =======  ===========  ===========   =========     ========
<CAPTION>
                   Additional
                     Paid-in    Accumulated
                     Capital      Deficit
                   ------------ -------------
<S>                <C>          <C>
Balance, December
30, 1995.........  $ 4,641,774  $(11,194,848)
 Issuance of
 common stock in
 connection with
 initial public
 offering........    7,739,760           --
 Exchange of
 Class A, Class
 B, and Class C
 shares for
 common stock....          --            --
 Conversion of
 preferred stock
 into common
 stock...........    2,245,350           --
 Net income......          --        973,259
 Redeemable
 preferred stock
 dividends.......     (146,188)          --
 Forgiveness of
 preferred stock
 dividends and
 related accrued
 interest........      511,542           --
 Deferred
 compensation....       87,750           --
 Amortization of
 deferred
 compensation....          --            --
 Issuance of
 warrants........      119,062           --
 Other
 comprehensive
 income..........          --            --
                   ------------ -------------
Balance, December
28, 1996.........   15,199,050   (10,221,589)
                   ------------ -------------
 Net income......          --      2,260,668
 Exercise of
 stock options...      142,429           --
 Exercise of
 warrants........      497,347           --
 Amortization of
 deferred
 compensation....          --            --
 Other
 comprehensive
 income..........          --            --
                   ------------ -------------
Balance, January
3, 1998..........   15,838,826    (7,960,921)
                   ------------ -------------
 Net income......          --      1,571,381
 Exercise of
 stock options...      320,744           --
 Treasury stock
 repurchase......          --            --
 Amortization of
 deferred
 compensation....          --            --
 Other
 comprehensive
 income..........          --            --
                   ------------ -------------
Balance, January
2, 1999..........  $16,159,570  $ (6,389,540)
                   ============ =============
</TABLE>
 
                See notes to consolidated financial statements.
 
                                       26
<PAGE>
 
                            SPECIALTY CATALOG CORP.
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
 
<TABLE>
<CAPTION>
                                                  Fiscal Year Ended
                                         --------------------------------------
                                         January 2,   January 3,   December 28,
                                            1999         1998          1996
                                         -----------  -----------  ------------
<S>                                      <C>          <C>          <C>
Cash flows from operating activities:
Net income.............................  $ 1,571,381  $ 2,260,668  $   973,259
Adjustments to reconcile net income to
 net cash provided by operating
 activities:
  Extraordinary loss due to early
   extinguishment of debt..............          --        98,504          --
  Interest paid through issuance of
   debt................................          --           --       237,216
  Provision for bad debts..............       17,000       45,360       22,000
  Depreciation and amortization........      745,931      392,950      276,407
  Deferred income taxes................    1,038,062      610,052      609,254
  Amortization of deferred
   compensation........................       17,499       17,501        4,387
  Changes in operating assets and
   liabilities, net of impact of
   acquisitions:
    Accounts receivable................     (113,676)     (40,664)     525,853
    Inventories........................      878,092     (754,929)      87,450
    Prepaid expenses...................     (393,639)     532,858     (414,715)
    Other assets.......................       94,472       85,614       87,285
    Accounts payable and accrued
     expenses..........................      330,725      (98,832)  (2,028,204)
    Liabilities to customers...........     (320,496)     305,566      (64,525)
    Income taxes.......................      (27,815)     301,997       25,074
    Other long-term liabilities........        4,167        8,334      (18,315)
                                         -----------  -----------  -----------
Net cash provided by operating
 activities............................  $ 3,841,703  $ 3,764,979  $   322,426
                                         -----------  -----------  -----------
Cash flows from investing activities:
  Purchases of property, plant and
   equipment...........................   (1,188,905)  (1,051,755)    (148,206)
  Acquisition, net of cash acquired and
   liabilities assumed.................     (505,140)  (4,187,325)         --
                                         -----------  -----------  -----------
Net cash used in investing activities..  $(1,694,045) $(5,239,080) $  (148,206)
                                         -----------  -----------  -----------
Cash flows from financing activities:
  Issuance of common stock.............       10,752       16,896    7,754,760
  Advances (repayments) on line of
   credit--net.........................    1,289,559    3,752,364   (1,050,000)
  Issuance of long-term debt...........          --     6,797,771          --
  Issuance of junior subordinated debt
   and warrants........................          --           --       500,000
  Repayment of subordinated debt.......          --    (4,224,683)         --
  Repurchase of treasury stock.........   (2,353,641)         --           --
  Repayments of long-term debt.........     (969,011)  (5,650,000)  (6,100,000)
  Repayment of capital lease
   obligations.........................      (20,303)         --           --
                                         -----------  -----------  -----------
Net cash provided by (used in)
 financing activities..................  $(2,042,644) $   692,348  $ 1,104,760
                                         -----------  -----------  -----------
Effect of exchange rate changes on cash
 and cash equivalents..................  $    13,095  $    (6,751) $       --
                                         -----------  -----------  -----------
Increase (decrease) in cash and cash
 equivalents...........................      118,109     (788,504)   1,278,980
Cash and cash equivalents, beginning of
 year..................................      603,840    1,392,344      113,364
                                         -----------  -----------  -----------
Cash and cash equivalents, end of
 year..................................  $   721,949  $   603,840  $ 1,392,344
                                         ===========  ===========  ===========
Supplemental disclosures of cash flow
 information:
  Cash paid during the year for:
    Interest...........................  $   812,845  $ 1,076,949  $ 1,102,460
                                         ===========  ===========  ===========
    Income taxes.......................  $   725,000  $   734,958  $    66,158
                                         ===========  ===========  ===========
</TABLE>
 
                See notes to consolidated financial statements.
 
                                       27
<PAGE>
 
                            SPECIALTY CATALOG CORP.
 
              CONSOLIDATED STATEMENTS OF CASH FLOWS--(continued)
 
Summary of Non-cash Transactions:
 
  During the year ended January 2, 1999, a former employee of the Company
exercised 182,773 stock options for which the Company recorded a deduction in
its income tax payable and an increase in additional paid-in capital of
$188,997. In addition, the former employee used $56,148 of his unpaid
severance that was recorded in accrued restructuring charges as payment for
the cost of the stock options exercised.
 
  During the year ended January 2, 1999, an officer of the Company exercised
35,000 stock options for which the Company recorded a deduction in its income
tax payable and an increase in additional paid in capital of $67,024.
 
  During the year ended January 3, 1998, the Company offset $131,146 of note
receivable from a stockholder against the portion of the subordinated notes
owed to that stockholder.
 
  During the year ended January 3, 1998, the Company converted $495,000 of
junior subordinated debt and $5,000 of accrued interest into $2,653 of common
stock and $497,347 of additional paid-in capital as a result of several
shareholders' election to apply amounts owed to them under the junior
subordinated note as consideration in the exercise of warrants held by them.
 
  During the year ended January 3, 1998, the Company recorded capital lease
obligations of $159,421 related to the acquisition of data processing
equipment.
 
  During the year ended January 3, 1998, the Company recorded a note payable
with the seller for $492,510 in connection with the acquisition of The
Daxbourne Group (see footnote 9).
 
  During the year ended January 3, 1998, an officer of the Company exercised
55,000 stock options for which the Company recorded a deduction in its income
tax payable and an increase in additional paid in capital of $126,087.
 
  During the year ended December 28, 1996, the Company issued $237,216 of
subordinated debt in lieu of payment of interest.
 
  During the year ended December 28, 1996, the Company declared dividends on
preferred stock of $146,188. In conjunction with the Company's initial public
offering, all shares of preferred stock were converted into common stock and
all accumulated dividends, and accrued interest on those dividends, through
the date of the offering were irrevocably waived by the holders of the
preferred stock as of August 13, 1996.
 
                See notes to consolidated financial statements.
 
                                      28
<PAGE>
 
                            SPECIALTY CATALOG CORP.
 
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
   Fiscal Years Ended January 2, 1999, January 3, 1998 and December 28, 1996
 
1. Summary of Significant Accounting Policies
 
  Nature of Business--Specialty Catalog Corp. (the "Company") targets niche
consumer product categories, primarily via direct marketing. SC Corporation,
the Company's principal operating subsidiary doing business under the name SC
Direct ("SC Direct"), is the leading US retailer of women's wigs and
hairpieces. Daxbourne International Limited ("Daxbourne"), a subsidiary of SC
Direct, is a leading UK retailer and wholesaler of women's wigs and
hairpieces. SC Publishing ("SC Publishing"), another subsidiary of SC Direct,
sells continuing education courses to nurses and CPAs.
 
  Principles of Consolidation--The accompanying consolidated financial
statements include the accounts of the Company and its wholly owned
subsidiaries. All material inter-company balances and transactions have been
eliminated in consolidation.
 
  Translation of Foreign Currencies--The financial statements of the Company's
foreign subsidiary are translated from the local currency into US dollars
using the current exchange rate at the balance sheet date for assets and
liabilities and the average exchange rate prevailing during the period for
revenues and expenses. The local currency of its foreign subsidiary is
considered to be the functional currency. Exchange gains and losses on inter-
company balances of a long-term investment nature are recorded as a component
of other comprehensive income in stockholders' equity, while other transaction
gains and losses are recorded directly to the consolidated statements of
operations.
 
  Cash and Cash Equivalents--Cash and cash equivalents consist of cash and
temporary investments with maturities of three months or less when purchased.
 
  Inventories--Inventories are stated at the lower of cost or market. Cost is
determined using the weighted average cost method. A reserve for obsolete
inventory is recorded based on the expected realizable value of merchandise.
The cost of inventory includes the cost of merchandise, freight, duty,
brokerage fees and marine insurance.
 
  Prepaid Expenses--The costs incurred to develop, print and place direct
response advertisements to obtain names of potential customers are recorded as
prepaid expenses until the time the advertisement is published, mailed or
otherwise made available to potential customers. Direct response advertising
for selling purposes is capitalized and amortized over the expected period of
future benefit, generally two to four months. For the years ended January 2,
1999, January 3, 1998 and December 28, 1996, advertising expense was $15.0
million, $13.7 million and $13.4 million, respectively.
 
  Property, Plant and Equipment--Property, plant and equipment are stated at
cost, less accumulated depreciation and amortization. Depreciation is computed
using the straight-line method over the estimated useful lives of the
respective assets. Amortization is computed on the straight-line method over
the lesser of the estimated useful lives of the related assets or the lease
terms.
 
  Intangibles--Intangible assets consisting of goodwill, covenants not to
compete, customer lists, trademarks, and tradenames are amortized using the
straight-line method over useful lives of five to thirty years. Management's
policy regarding intangible assets is to evaluate the recoverability of its
intangible assets when the facts and circumstances suggest that these assets
may be impaired. This policy is consistent with those policies set forth in
Statement of Financial Accounting Standards ("SFAS") No. 121, "Accounting for
the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed."
Evaluations consider factors including operating results, business and
strategic plans, economic projections, and market emphasis. Evaluations
compare expected cumulative, undiscounted operating incomes or cash flows with
net book values of related
 
                                      29
<PAGE>
 
                            SPECIALTY CATALOG CORP.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
intangible assets. Unrealizable intangible asset values are charged to
operations. There were no impairment charges during the fiscal years
presented.
 
  Other Assets--Other assets consist primarily of deferred financing costs.
Deferred financing costs which were incurred by the Company in connection with
the BankBoston, N.A. agreements in the US and the UK (see footnote 7) are
amortized over the life of the underlying indebtedness using the straight-line
method. At January 2, 1999 and January 3, 1998, deferred financing costs were
$128,193 and $180,190, respectively. Deferred financing costs which were
incurred by the Company in connection with the Banque Nationale de Paris
("BNP") note were charged as an extraordinary loss in 1997 as part of the
refinancing agreement with BankBoston, N.A. In 1997, the Company recorded an
extraordinary charge of $161,567, net of an income tax benefit of $107,711.
 
  Income Taxes--The Company uses the asset and liability method of accounting
for deferred income taxes. The provision for income taxes includes income
taxes currently payable and those deferred because of temporary differences
between the financial statement and tax bases of assets and liabilities.
 
  Revenue--The Company recognizes sales and the related costs of sales at the
time the merchandise is shipped to customers. The Company allows for
merchandise returns at the customer's discretion within the period stated in
the Company's sales policy. An allowance is provided for returns based on
historical return rates applied to recent shipments.
 
  Fair Value of Financial Instruments--SFAS No. 107, "Disclosures About Fair
Value of Financial Instruments," required disclosure of the fair value of
financial instruments, relating to both those assets and liabilities
recognized and those not recognized in the consolidated balance sheets of the
Company, for which it is practicable to estimate fair value. The estimated
fair value of financial instruments which are presented herein have been
determined by the Company using available market information and appropriate
valuation methodologies. However, considerable judgment is required in
interpreting market data to develop estimates of fair value. Accordingly, the
estimates presented herein are not necessarily indicative of amounts the
Company could realize in a current market exchange.
 
  The fair value of the Company's cash and cash equivalents, accounts
receivable, accounts payable, and line of credit approximate their carrying
values at January 2, 1999 and January 3, 1998, due to the short-term
maturities of these investments. The carrying value and fair value of the
Company's long-term debt at January 2, 1999 was $5,634,486.
 
  Stock-Based Compensation--SFAS No. 123 required expanded disclosures of
stock-based compensation arrangements with employees and encouraged (but did
not require) compensation cost to be measured based on fair value of the
equity instruments awarded. Companies are permitted, however, to continue to
apply Accounting Principles Board ("APB") Opinion No. 25, which recognized
compensation cost based on the intrinsic value of the equity instrument
awarded. The Company will continue to apply APB Opinion No. 25 to its stock-
based compensation awards to employees and has disclosed the required pro
forma effect on net income and basic and diluted earnings per share (see
footnote 11).
 
  Earnings Per Share--In 1997, the Company adopted SFAS No. 128, "Earnings Per
Share." This statement required the adoption of new calculation methodologies
and enhanced disclosures of basic and diluted earnings per share computations.
As required, the Company has restated prior year earnings per share
presentations to conform to SFAS No. 128.
 
  Newly Issued Accounting Pronouncements--In January 1998, the Company adopted
SFAS No. 130, "Reporting Comprehensive Income." SFAS No. 130 required that a
company (a) classify items of other comprehensive income by their nature in a
financial statement and (b) display the accumulated balance of other
 
                                      30
<PAGE>
 
                            SPECIALTY CATALOG CORP.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
comprehensive income separately from retained earnings and additional paid-in-
capital in the equity section of the balance sheet. Reclassification of
financial statements for earlier periods provided for comparative purposes is
required. Comprehensive income consisted solely of accumulated foreign
currency translation adjustments in connection with the Company's United
Kingdom subsidiary in 1998.
 
  The Company has also adopted SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information" in the fourth quarter of 1998. SFAS No.
131 established standards for the way public companies report selected
information about operating segments in annual financial statements and
required those companies to report selected information about segments in
interim financial reports issued to shareholders. It also established
standards for related disclosures about products and services, geographic
areas, and major customers.
 
  In March 1998, the American Institute of Certified Public Accountants
("AICPA") issued Statement of Position ("SOP") 98-1, "Accounting for the Costs
of Computer Software Developed or Obtained for Internal Use". SOP 98-1
required that costs incurred in the development of internal use software be
capitalized and amortized over a period of time. The Company adopted SOP 98-1
in the first quarter of 1998. During the year ended January 2, 1999, the
Company has capitalized approximately $465,000 of costs associated with a new
comprehensive catalog information system, of which approximately $230,000 were
internal payroll and payroll related costs.
 
  In April 1998, the Company adopted SOP 98-5, "Reporting on the Costs of
Start-Up Activities". SOP 98-5 required costs of start-up activities and
organization costs to be expensed as incurred. SOP 98-5 had no impact on the
Company's financial condition or results of operations for the year ended
January 2, 1999.
 
  In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities." This statement
is effective for all fiscal quarters of all fiscal years beginning after June
15, 1999. The Company has not yet determined the effect, if any, of adopting
SFAS No. 133 on the consolidated financial statements.
 
  Fiscal Year--The Company is on a 52/53-week fiscal year, ending on the
Saturday closest to December 31. The fiscal years ended January 2, 1999,
January 3, 1998 and December 28, 1996 consisted of 52/53/52 weeks,
respectively. Unless otherwise indicated, "1998" means the Company's fiscal
year ended January 2, 1999, "1997" means the Company's fiscal year ended
January 3, 1998, and "1996" means the Company's fiscal year ended December 28,
1996.
 
  Accounting Estimates--The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
Management bases its estimates on historical experiences and on various
assumptions which are believed to be reasonable under the circumstances. The
primary estimates underlying the Company's financial statements include
allowances for doubtful accounts, allowances for returns, and inventory
valuation.
 
  Reclassifications--Certain amounts in the 1996 and 1997 financial statements
have been reclassified to conform to the 1998 presentation.
 
                                      31
<PAGE>
 
                            SPECIALTY CATALOG CORP.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
2. Prepaid Expenses
 
  Prepaid expenses at January 2, 1999 and January 3, 1998 consist of the
following:
 
<TABLE>
<CAPTION>
                                                            1998       1997
                                                         ---------- ----------
   <S>                                                   <C>        <C>
   Deferred catalog costs............................... $2,130,662 $1,990,877
   Prepaid advertising..................................    323,661    716,503
   Prepaid income taxes.................................    375,000        --
   Other................................................    909,523    637,295
                                                         ---------- ----------
                                                         $3,738,846 $3,344,675
                                                         ========== ==========
</TABLE>
 
3. Property, Plant and Equipment
 
  Property, plant and equipment consist of the following at January 2, 1999 and
January 3, 1998:
 
<TABLE>
<CAPTION>
                                            Useful
                                             Life       1998         1997
                                           --------  -----------  -----------
   <S>                                     <C>       <C>          <C>
   Furniture and equipment................  7 years  $ 1,725,385  $ 1,511,502
   Building............................... 40 years      332,560      328,340
   Data processing equipment..............  5 years    4,387,015    3,666,508
   Automobiles............................  3 years       95,484      110,907
   Leasehold improvements.................       (i)     394,955      151,841
                                                     -----------  -----------
                                                       6,935,399    5,769,098
   Less accumulated depreciation and
    amortization..........................            (3,989,287)  (3,606,295)
                                                     -----------  -----------
                                                     $ 2,946,112  $ 2,162,803
                                                     ===========  ===========
</TABLE>
--------
(i) Lesser of the estimated useful lives of the related assets or the lease
    term.
 
  Depreciation and amortization expense was $412,279, $308,326 and $275,062 for
the years ended January 2, 1999, January 3, 1998 and December 28, 1996,
respectively.
 
4. Intangible Assets
 
  Intangible assets consist of the following at January 2, 1999 and January 3,
1998:
 
<TABLE>
<CAPTION>
                                                 Useful
                                                  Life      1998        1997
                                                -------- ----------  ----------
   <S>                                          <C>      <C>         <C>
   Goodwill.................................... 30 years $1,816,008  $1,792,964
   Tradenames.................................. 30 years  1,179,772   1,162,562
   Covenant-not-to-compete.....................  5 years    831,400     820,850
   Customer list...............................  5 years    257,719     254,449
                                                         ----------  ----------
                                                          4,084,899   4,030,825
   Less accumulated amortization...............            (406,741)    (88,278)
                                                         ----------  ----------
                                                         $3,678,158  $3,942,547
                                                         ==========  ==========
</TABLE>
 
  Amortization expense was $333,852, $84,624 and $1,345 for the years ended
January 2, 1999, January 3, 1998 and December 28, 1996, respectively.
 
                                       32
<PAGE>
 
                            SPECIALTY CATALOG CORP.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
5. Accounts Payable and Accrued Expenses
 
  Accounts payable and accrued expenses at January 2, 1999 and January 3, 1998
consist of the following:
 
<TABLE>
<CAPTION>
                                                             1998       1997
                                                          ---------- ----------
   <S>                                                    <C>        <C>
   Accounts payable...................................... $2,497,793 $1,986,641
   Accrued compensation..................................    288,167    340,084
   Other accrued expenses................................    617,454    796,375
                                                          ---------- ----------
                                                          $3,403,414 $3,123,100
                                                          ========== ==========
</TABLE>
 
6. Liabilities to Customers
 
  Liabilities to customers at January 2, 1999 and January 3, 1998 consist of
the following:
 
<TABLE>
<CAPTION>
                                                                 1998     1997
                                                               -------- --------
   <S>                                                         <C>      <C>
   Deferred revenue........................................... $223,812 $265,985
   Reserve for returns........................................  452,635  730,958
                                                               -------- --------
                                                               $676,447 $996,943
                                                               ======== ========
</TABLE>
 
  Deferred revenue reflects cash received from customers for ordered items
that have not yet been shipped. The reserve for returns represents estimated
merchandise to be returned for refunds in the future based on historical
return rates applied to recent shipments.
 
7. Long-Term Debt
 
  Long-term debt consists of the following at January 2, 1999 and January 3,
1998:
 
<TABLE>
<CAPTION>
                                                           1998        1997
                                                        ----------- -----------
   <S>                                                  <C>         <C>
   BankBoston, N.A. (Term Loan), due 2001.............. $ 4,000,000 $ 4,750,000
   BankBoston, N.A. (UK Term Loan), due 2001...........   1,634,486   1,829,758
                                                        ----------- -----------
                                                          5,634,486   6,579,758
   Less current portion................................   1,963,319   1,567,666
                                                        ----------- -----------
                                                        $ 3,671,167 $ 5,012,092
                                                        =========== ===========
</TABLE>
 
  In March 1997, the Company entered into an $11 million credit facility with
BankBoston, N.A. (the "BKB Agreement") for the purpose of refinancing its
existing senior and subordinated debt and to provide for the capital
expenditures and working capital needs of the Company. The BKB Agreement
provided for a $5 million term loan (the "Term Loan") and a $6 million
revolving line of credit (the "Line of Credit"). The Term Loan and the Line of
Credit bear interest rates based on either a base rate, as defined in the BKB
agreement, or a LIBOR contract rate. As of January 2, 1999, the Term Loan was
under a LIBOR contract rate of 7.1563% for $3.5 million and 6.8603% for
$500,000. As of January 2, 1999, $2.3 million of the Line of Credit was under
LIBOR contract rates ranging from 6.9036% to 7.00% and the remainder of the
Line of Credit was at the base rate of 8.00%. The Company is required to pay a
commitment fee varying from 0.375% to 0.50% per annum on the unused portion of
the commitment. At January 2, 1999, $2,827,351 was available under this Line
of Credit.
 
  In March 1997, the Company used the proceeds from the Term Loan and $500,000
under the Line of Credit to pay off its remaining indebtedness to BNP. In
conjunction with this repayment, the Company recorded a
 
                                      33
<PAGE>
 
                            SPECIALTY CATALOG CORP.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
$161,567 extraordinary loss on the early retirement of debt (net of an income
tax benefit of $107,711). Also in March 1997, the Company repaid $1,896,913 of
principal and accrued interest on the Company's subordinated debt, with
$1,765,767 repaid from proceeds from the Line of Credit and $131,146 repaid by
offsetting a note receivable from a stockholder. In April 1997, the Company
used proceeds from the Line of Credit to repay its remaining senior
subordinated debt in the amount of $2,901,496 of principal and accrued
interest.
 
  Due to its working capital constraints, on June 1, 1996, the Company entered
into an agreement with Martin E. Franklin, a director of the Company, and two
associates of Mr. Franklin, pursuant to which Mr. Franklin and such associates
loaned the Company $495,000. In connection with such loan, Mr. Franklin and
his associates purchased for $5,000 a warrant to acquire an aggregate of
265,335 shares of the Company's Common Stock at an aggregate exercise price of
$500,000. In April 1997, the holders of these warrants elected to apply
amounts owed to them under the junior subordinated note as consideration to be
paid for 265,335 shares of the Company's Common Stock. In conjunction with
this transaction, the Company recorded a $57,132 extraordinary loss on the
early retirement of debt (net of an income tax benefit of $41,372).
 
  On October 3, 1997, the Company amended the existing BKB Agreement (the
"Amended BKB Agreement") and entered into an additional $4.0 million credit
agreement with BankBoston, N.A., acting through its London Branch (the "BKB UK
Agreement"), in connection with the Company's acquisition of The Daxbourne
Group. The Amended BKB Agreement extended the maturity date of borrowings from
March 2001 to October 2001.
 
  The BKB UK Agreement provides for an approximate $1.8 million term loan (the
"UK Term Loan") and for an approximate $2.2 million revolving line of credit
(the "UK Line of Credit"). The UK Term Loan and the UK Line of Credit bear
interest rates based on either a Sterling base rate, as defined by the BKB UK
Agreement, or a LIBOR contract rate. The BKB UK Agreement matures in October
2001, with the UK Term Loan having a four year repayment schedule with
remaining payments of approximately $463,000 due in 1999, approximately
$515,000 due in 2000, and approximately $656,000 due in 2001. As of January 2,
1999, a portion of both the UK Term Loan and UK Line of Credit were under a
LIBOR contract rate of 9.16%. The Company is required to pay a commitment fee
varying from 0.375% to 0.50% per annum on the unused portion of the
commitment. At January 2, 1999, $275,582 was available under the UK Line of
Credit.
 
  On September 30, 1998, the Amended BKB Agreement was further amended by the
Company and BankBoston, N.A. to exclude from debt covenant computations
certain capital expenditures associated with the Company's purchase and
installation of a new comprehensive catalog information system. Then, on
December 21, 1998, the Amended BKB Agreement was further amended to allow the
Company to defer its January 1, 1999 payment on the Term Loan in connection
with the Company's repurchase of $2.4 million of its common stock in December
1998. The Amended BKB Agreement matures in October 2001 and has repayments of
$1.5 million in 1999 and 2000 and $1.0 million in 2001.
 
                                      34
<PAGE>
 
                            SPECIALTY CATALOG CORP.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
  The Amended BKB Agreement and the BKB UK Agreement (collectively the
"Consolidated Credit Facility") are cross-collateralized by a first perfected
security interest in all tangible and intangible assets of the Company. The
Consolidated Credit Facility is subject to certain consolidated covenants,
including but not limited to leverage and debt service coverage ratios,
minimum earnings requirements, and a restriction on the payment of cash
dividends on the Company's common stock. The aggregate maturities of long-term
debt after January 2, 1999 are as follows:
 
<TABLE>
<CAPTION>
   Fiscal Year                                                          Amount
   -----------                                                        ----------
   <S>                                                                <C>
   1999.............................................................. $1,963,319
   2000..............................................................  2,014,799
   2001..............................................................  1,656,368
                                                                      ----------
                                                                      $5,634,486
                                                                      ==========
</TABLE>
 
8. Sale of Assets
 
  On June 27, 1997, the Company's subsidiary, SC Publishing, sold its business
of continuing education for California real estate professionals. The sales
price of $212,250 included a license to use the trade name Western Schools(R)
for real estate courses, all related inventory for existing courses, and title
and rights to its real estate courses, both existing and under development.
The Company recognized a pre-tax gain, included in selling, general, and
administrative expenses, on the sale of these assets of $121,980.
 
9. Daxbourne Acquisition
 
  In October 1997, the Company, through its new subsidiary, Daxbourne
International Limited, acquired substantially all of the assets of Daxbourne
Limited and its wholly owned subsidiaries, which consisted of Postinstant
Limited and MC Hairways Limited (collectively, the "Sellers" or "The Daxbourne
Group").
 
  As part of this transaction, the Company acquired substantially all of the
assets of The Daxbourne Group including inventory, real property, physical
plant and equipment, intangible assets and other assets used in connection
with the Sellers' business. As aggregate consideration for this acquisition,
the Company paid $3,629,000 at the closing of the transaction (the "Closing"),
incurred acquisition costs of approximately $762,000, agreed to assume certain
trade liabilities of the Sellers totaling $387,000, and agreed to pay
approximately $493,000, without interest, to the Sellers on the one year
anniversary of the Closing. The excess of consideration paid, including
deferred consideration over the fair value of net assets acquired, recorded as
goodwill in the accompanying balance sheet, totaled $1,792,964. The Company
financed this acquisition primarily through its BKB UK Agreement with $1.8
million of proceeds from the UK Term Loan and $1.8 million of proceeds from
the UK Line of Credit.
 
10. Preferred Stock
 
  On November 30, 1994, the Company issued 22,491 shares of 13% Preferred
Stock. Coincidental with the Company's initial public offering on October 17,
1996, all outstanding shares of preferred stock were converted into 375,000
shares of common stock. All accumulated dividends, and accrued interest on
those dividends through the date of the offering, were irrevocably waived by
the holders of the preferred stock as of August 13, 1996.
 
11. Stockholders' Equity
 
  Common Stock--On October 17, 1996, the Company completed an initial public
offering of 1.5 million shares of its common stock at an initial offering
price of $6.50 per share. Net proceeds to the Company after
 
                                      35
<PAGE>
 
                            SPECIALTY CATALOG CORP.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
offering expenses were $7,754,760. Coincidental with the offering, the Company
increased the number of authorized common shares from 6,510,200 to 10 million,
converted on a one-for-one basis the outstanding shares of Class A, Class B
and Class C shares into common stock, and effected a 325.51-for-one split of
outstanding common stock. All numbers of common shares and per share data in
the accompanying consolidated financial statements for the year ended December
28, 1996 have been adjusted for the stock split.
 
  Treasury Stock--In December 1998, the Company entered into a private
transaction to repurchase 700,000 shares of its common stock at $3.125 per
share from funds affiliated with Dickstein Partners, Inc., a large stockholder
of the Company. The shares that were repurchased represented approximately 14%
of the Company's outstanding shares, and are now held in the Company's
treasury. The repurchase was financed through existing bank lines with
BankBoston, N.A. The Company also received 57,788 shares of stock from a
former employee of the Company in lieu of cash to cover withholding taxes on
gains related to stock options exercised in December 1998. In addition, the
Board of Directors authorized the Company to repurchase up to an additional $1
million of common stock during 1999. Through March 26, 1999, the Company has
repurchased 63,400 shares at an average price of $3.50 per share.
 
  Stock Compensation Plan--On October 17, 1996, the Company adopted the 1996
Stock Incentive Plan (the "Plan") which authorized the issuance of up to
500,000 shares of Common Stock through the grant of stock options and awards
of restricted stock. Each option has a maximum term of ten years from the date
of grant, subject to early termination. The per share exercise price for
options granted under the plan will (i) not be less than the fair market value
of a share of the Company's common stock on the date of the grant and (ii) not
be less than the initial public offering price of $6.50 per share. The Plan
was amended in May 1998 to increase the number of shares of Common Stock
authorized for issuance under the Plan from 500,000 to 750,000.
 
  Stock option activity is summarized below:
 
<TABLE>
<CAPTION>
                                                                        Weighted
                                                             Exercise   Average
                                                             Price Per  Exercise
                                                  Shares       Share     Price
                                                 ---------  ----------- --------
   <S>                                           <C>        <C>         <C>
   Outstanding December 30, 1995................   582,999  $      0.31  $0.31
   Granted......................................   476,650  $5.33-$7.15  $6.52
   Exercised....................................       --           --     --
   Forfeited or expired.........................    (2,500) $      6.50  $6.50
                                                 ---------  -----------  -----
   Outstanding December 28, 1996................ 1,057,149  $0.31-$7.15  $3.09
   Granted......................................   174,735  $6.50-$6.88  $6.55
   Exercised....................................   (55,000) $      0.31  $0.31
   Forfeited or expired.........................   (20,150) $      6.50  $6.50
                                                 ---------  -----------  -----
   Outstanding January 3, 1998.................. 1,156,734  $0.31-$7.15  $3.69
   Granted......................................    25,000  $      6.50  $6.50
   Exercised....................................  (217,773) $      0.31  $0.31
   Forfeited or expired.........................   (53,800) $      6.50  $6.50
                                                 ---------  -----------  -----
   Outstanding January 2, 1999..................   910,161  $0.31-$7.15  $4.40
                                                 =========  ===========  =====
</TABLE>
 
  The 910,161 of stock options outstanding as of January 2, 1999 consisted of
310,226 of $0.31 options issued in November 1994 to an employee of the
Company, 75,000 of $5.33 options issued in October 1996 to an employee of the
Company, 150,000 of $7.15 options issued in October 1996 to the Company's
underwriters in connection with the Company's initial public offering, and
374,935 of options ranging in exercise prices from $6.50 to $6.875 issued
under the Plan to employees and directors of the Company.
 
                                      36
<PAGE>
 
                            SPECIALTY CATALOG CORP.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
  Options exercisable at January 2, 1999, January 3, 1998 and December 28,
1996 were 524,633, 635,299 and 592,999, respectively. The options outstanding
as of January 2, 1999 have weighted average remaining contractual lives of 5.9
years for the $0.31 options issued in 1994, 7.8 years for the $5.33-$7.15
options granted in 1996, 8.9 years for the $6.50-$6.88 options granted in 1997
and 9.4 years for $6.50 options granted in 1998.
 
  The Company applies APB Opinion No. 25 and related interpretations in
accounting for the Plan and therefore no compensation cost has been recognized
for options granted under the Plan provisions. Had compensation cost been
determined based on the fair value at the grant dates for options granted with
the method prescribed by Statement of Financial Accounting Standards No. 123
"Accounting for Stock-based Compensation", the Company's net income and basic
and diluted earnings per share would have been changed to the pro forma
amounts indicated below:
 
<TABLE>
<CAPTION>
                                                    1998       1997      1996
                                                 ---------- ---------- --------
   <S>                                           <C>        <C>        <C>
   Net income:
     As reported................................ $1,571,381 $2,260,668 $973,259
                                                 ========== ========== ========
     Pro-forma.................................. $1,385,609 $2,105,590 $925,385
                                                 ========== ========== ========
   Basic earnings per share:
     As reported................................ $     0.31 $     0.46 $   0.31
                                                 ========== ========== ========
     Pro-forma.................................. $     0.28 $     0.43 $   0.29
                                                 ========== ========== ========
   Diluted earnings per share:
     As reported................................ $     0.29 $     0.41 $   0.25
                                                 ========== ========== ========
     Pro-forma.................................. $     0.25 $     0.38 $   0.23
                                                 ========== ========== ========
</TABLE>
 
  The fair value of each option grant used to compute pro-forma net income and
basic and diluted earnings per share disclosures is the estimated present
value on the date of grant using the Black-Scholes option-pricing model with
the following weighted average assumptions for 1998, 1997 and 1996
respectively: expected volatility of 27.59%, 8.23% and 60.14%, a risk free
interest rate of 5.63%, 5.65% and 6.38% and an expected holding period of 6
years.
 
  Stock Warrants--In connection with the issuance of 11.5% junior subordinated
notes on August 12, 1996, the Company issued warrants to purchase 265,335
shares of common stock for an aggregate exercise price of $500,000 ($1.8844
per share). As discussed in Note 7, these warrants were exercised in 1997.
 
                                      37
<PAGE>
 
                            SPECIALTY CATALOG CORP.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
12. Reconciliation of Basic and Diluted Earnings per Share
 
  The following data shows the amounts used in computing basic and diluted
earnings per share for income before extraordinary items and the effects of
potentially dilutive securities on the weighted average number of shares
outstanding.
 
<TABLE>
<CAPTION>
                                                 For the fiscal years ended
                                             ----------------------------------
                                             January 2, January 3, December 28,
                                                1999       1998        1996
                                             ---------- ---------- ------------
   <S>                                       <C>        <C>        <C>
   Income before extraordinary items
    available to common shareholders plus
    assumed conversions..................... $1,571,381 $2,479,367  $ 973,259
                                             ---------- ----------  ---------
   Basic EPS................................ $     0.31 $     0.51  $    0.31
                                             ---------- ----------  ---------
   Basic weighted average shares
    outstanding.............................  5,033,800  4,905,667  3,180,091
                                             ========== ==========  =========
   Effect of Dilutive Securities
   Stock options............................    461,214    568,455    574,124
   Warrants.................................        --      53,579    191,996
   Income before extraordinary items
    available to common shareholders plus
    assumed conversions..................... $1,571,381 $2,479,367  $ 973,259
                                             ========== ==========  =========
   Diluted EPS.............................. $     0.29 $     0.45  $    0.25
                                             ---------- ----------  ---------
   Diluted weighted average shares
    outstanding.............................  5,495,014  5,527,701  3,946,211
                                             ========== ==========  =========
</TABLE>
 
  Options to purchase 599,935 shares of common stock ranging from $5.33 to
$7.15 per share were not included in computing diluted EPS for the year ended
January 2, 1999 because their effects were antidilutive. Options to purchase
152,500 shares of common stock ranging from $6.88 to $7.15 per share were not
included in computing diluted EPS for the year ended January 3, 1998 because
their effects were antidilutive. Options to purchase 150,000 shares of common
stock at $7.15 per share were not included in computing diluted EPS for the
year ended December 28, 1996 because their effects were antidilutive.
 
13. Restructuring Charges
 
  In August 1998, the Company announced a reorganization of certain management
positions. In connection with this reorganization, the Company recorded in the
third quarter of 1998 a pre-tax charge of $469,558, consisting of severance
and other severance related benefits for five former employees of the Company.
The Company will pay out the severance and severance related benefits through
July 1999. Included in accrued expenses at January 2, 1999 are accrued
restructuring charges of $99,301.
 
                                      38
<PAGE>
 
                            SPECIALTY CATALOG CORP.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
14. Income Taxes
 
  The provision for income taxes consists of the following at January 2, 1999,
January 3, 1998 and December 28, 1996:
 
<TABLE>
<CAPTION>
                                                    1998       1997       1996
                                                 ---------- ----------  --------
   <S>                                           <C>        <C>         <C>
   Current:
     Federal.................................... $      --  $  788,683  $ 30,696
     State......................................        --     340,441     4,097
     Foreign....................................     57,932     53,689       --
                                                 ---------- ----------  --------
                                                     57,932  1,182,813    34,793
                                                 ========== ==========  ========
   Deferred:
     Federal....................................    606,533    593,128   517,866
     State......................................    209,800     21,602    91,388
     Foreign....................................    221,729     (4,678)      --
                                                 ---------- ----------  --------
                                                  1,038,062    610,052   609,254
                                                 ---------- ----------  --------
       Total.................................... $1,095,994 $1,792,865  $644,047
                                                 ========== ==========  ========
</TABLE>
 
  Deferred income tax assets and liabilities consist of the following at
January 2, 1999 and January 3, 1998:
 
<TABLE>
<CAPTION>
                                                             1998       1997
                                                          ---------- ----------
   <S>                                                    <C>        <C>
   Deferred income tax assets:
     Net operating loss carryforwards and credits........ $4,414,298 $5,168,319
     Operating reserves..................................    219,042    251,071
     Inventory...........................................    424,230    383,820
     Property, plant and intangibles.....................    280,804    519,014
                                                          ---------- ----------
                                                           5,338,374  6,322,224
   Deferred income tax liabilities:
     Deferred catalog costs..............................    816,386    762,174
                                                          ---------- ----------
   Net deferred income tax asset......................... $4,521,988 $5,560,050
                                                          ========== ==========
</TABLE>
 
  Reconciliation of the statutory Federal income tax rate and the effective
rate of the provision for income taxes for the years ended January 2, 1999,
January 3, 1998 and December 28, 1996 is as follows:
 
<TABLE>
<CAPTION>
                                                               1998  1997  1996
                                                               ----  ----  ----
   <S>                                                         <C>   <C>   <C>
   Statutory Federal income tax rate.......................... 34.0% 34.0% 34.0%
   State taxes, net of Federal income tax benefits............  6.1   6.1   5.8
   Other......................................................  1.0   1.9   --
                                                               ----  ----  ----
                                                               41.1% 42.0% 39.8%
                                                               ====  ====  ====
</TABLE>
 
  The Company has recorded a deferred tax asset of $4,521,988 primarily
reflecting the benefit of $12,558,146 of net operating loss carryforwards
which expire in varying amounts between 1999 and 2010. Realization is
dependent on generating sufficient taxable income prior to expiration of the
loss carryforwards. The use of the net operating losses is subject to an
annual limitation of $1,555,125 due to a change in control of the Company
pursuant to Section 382. Although realization is not assured, management
believes it is more likely than not that all of the deferred tax asset will be
realized.
 
                                      39
<PAGE>
 
                            SPECIALTY CATALOG CORP.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
15. Commitments and Contingencies
 
  Lease Commitments--Certain non-cancelable leases are classified as capital
leases, and the leased assets are included as part of "Property, plant and
equipment." The obligations of the Company under such leases are
collateralized by the leased equipment. Other leases are classified as
operating leases and are not capitalized. Future minimum lease payments under
capital leases are included in other long-term liabilities and are as follows:
 
<TABLE>
<CAPTION>
   Year                                                                 Amount
   ----                                                                --------
   <S>                                                                 <C>
   1999............................................................... $ 59,158
   2000...............................................................   54,231
                                                                       --------
   Total minimum lease payments.......................................  113,389
     Less--amounts representing interest..............................   11,774
                                                                       --------
   Present value of minimum lease payments............................ $101,615
                                                                       ========
</TABLE>
 
  Operating Leases--The Company leases certain administrative, warehousing and
other facilities and equipment under operating leases. The following is a
schedule of future minimum rental payments under non-cancelable operating
leases as of January 2, 1999:
 
<TABLE>
<CAPTION>
   Year                                                                 Amount
   ----                                                               ----------
   <S>                                                                <C>
   1999.............................................................. $  542,517
   2000..............................................................    568,515
   2001..............................................................    260,179
   2002..............................................................    140,878
                                                                      ----------
                                                                      $1,512,089
                                                                      ==========
</TABLE>
 
  Management expects that, in the normal course of business, expiring leases
will be renewed or replaced by other leases. Rent expense under operating
leases for the years ended January 2, 1999, January 3, 1998 and December 28,
1996 was $594,752, $490,292 and $362,676, respectively.
 
  Employment and Bonus Agreements--The Company has an employment and bonus
agreement with one executive officer through December 31, 1999. The Company's
salary commitment under this agreement aggregates $310,000 at January 2, 1999.
 
  In addition, this executive officer, along with all other salaried
employees, may earn certain other bonuses based on the Company's achievement
of certain operating targets.
 
16. Employee Benefit Plan
 
  The Company maintains a qualified defined contribution plan, under the
provisions of Section 401(k) of the Internal Revenue Code, covering
substantially all United States employees. Under the terms of the plan,
eligible employees may make contributions up to 15% of pay, subject to
statutory limitations. Contributions not exceeding 5% of an employee's pay are
matched 40% by the Company. The Company may, at its discretion, make an
additional year-end contribution. Employee contributions are always fully
vested. Company contributions vest 20% for each completed year of service,
becoming fully vested after five years of service. Matching contributions by
the Company under the plan were $86,535, $85,678 and $71,176 in 1998, 1997 and
1996, respectively. No discretionary contributions have been made to the plan.
 
                                      40
<PAGE>
 
                            SPECIALTY CATALOG CORP.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
17. Business Segments and Financial Information by Geographic Location
 
  Specialty Catalog Corp. has three reportable segments: SC Direct, SC
Publishing and Daxbourne International Limited. The SC Direct segment sells
women's wigs and hairpieces using three distinct catalogs: Paula Young(R),
Christine Jordan(R) and Especially Yours(R). In addition, SC Direct sells
apparel, hats and other fashion accessories through its Paula's Hatbox(R)
catalog. SC Publishing distributes catalogs under its Western Schools(R) brand
and specializes in providing continuing education courses to nurses and CPAs.
Daxbourne International Limited is a retailer and wholesaler of women's wigs,
hairpieces and related products in the United Kingdom.
 
  The accounting policies of the reportable segments are the same as those
described in Note 1. The Company's reportable segments are strategic business
units that offer either different products or operate in different geographic
locations. The Company markets its products in two major geographic areas, the
United States and the United Kingdom. SC Direct and SC Publishing market their
products and maintain their assets in the United States. Daxbourne
International Limited markets its products and maintains its assets in the
United Kingdom.
 
                                      41
<PAGE>
 
                            SPECIALTY CATALOG CORP.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
  A summary of information about the Company's operations by segment for the
years ended January 2, 1999, January 3, 1998 and December 28, 1996 follows
(intersegment eliminations are inter-company receivables and investments in
subsidiaries):
 
<TABLE>
<CAPTION>
                                         SC                 Intersegment
                          SC Direct  Publishing  Daxbourne  Eliminations    Total
                         ----------- ----------  ---------- ------------ -----------
<S>                      <C>         <C>         <C>        <C>          <C>
1998
  Net sales............. $40,052,521 $3,711,181  $5,119,850         --   $48,883,552
  Gross profit..........  24,730,142  2,612,521   3,623,317         --    30,965,980
  Selling, general and
   administrative.......  21,523,346  2,280,102   2,419,029         --    26,222,477
  Restructuring charge..     469,558        --          --          --       469,558
  Depreciation and
   amortization.........     323,749     27,504     394,678         --       745,931
  Operating profit......   2,413,489    304,915     809,610         --     3,528,014
  Interest expense......     530,001        --      330,638         --       860,639
  Income taxes..........     772,528    125,013     198,453         --     1,095,994
  Segment assets........  17,278,666  3,625,152   5,075,838  (3,580,274)  22,399,382
  Capital expenditures..   1,119,713     21,122      48,070         --     1,188,905
1997
  Net sales............. $38,341,868 $3,978,215  $1,172,376         --   $43,492,459
  Gross profit..........  24,993,024  2,687,384     844,171         --    28,524,579
  Selling, general and
   administrative.......  19,894,882  2,613,309     542,682         --    23,050,873
  Depreciation and
   amortization.........     281,142     15,948      83,279         --       380,369
  Operating profit......   4,817,000     58,127     218,210         --     5,093,337
  Interest expense......     736,959        --       84,146         --       821,105
  Extraordinary item--
   loss on early
   extinguishment of
   debt,
   net of tax...........     218,699        --          --          --       218,699
  Income taxes..........   1,714,219     24,957      53,689         --     1,792,865
  Segment assets........  17,318,797  3,532,774   5,510,414  (3,068,880)  23,293,105
  Capital expenditures..     936,209     15,747      99,799         --     1,051,755
1996
  Net sales............. $32,222,560 $4,049,103         --          --   $36,271,663
  Gross profit..........  20,642,914  2,817,828         --          --    23,460,742
  Selling, general and
   administrative.......  17,030,022  2,879,536         --          --    19,909,558
  Depreciation and
   amortization.........     257,668     18,739         --          --       276,407
  Operating profit......   3,355,224    (80,447)        --          --     3,274,777
  Interest expense......   1,657,471        --          --          --     1,657,471
  Income taxes..........     677,020    (32,973)        --          --       644,047
  Segment assets........  16,779,287  3,100,211         --   (1,474,302)  18,405,196
  Capital expenditures..     140,509      7,697         --          --       148,206
</TABLE>
 
                                      42
<PAGE>
 
                            SPECIALTY CATALOG CORP.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
 
 
18. Selected Quarterly Financial Data (unaudited):
 
<TABLE>
<CAPTION>
1998                          1st Quarter  2nd Quarter 3rd Quarter 4th Quarter
----                          -----------  ----------- ----------- -----------
<S>                           <C>          <C>         <C>         <C>
Net sales.................... $13,308,564  $13,263,194 $11,011,492 $11,300,302
Gross profit.................   8,475,311    8,517,431   7,058,565   6,914,673
Net income (loss)............    (375,053)   1,134,911     319,544     491,979
Earnings (loss) per share--
 Basic EPS
  Net income (loss).......... $     (0.07) $      0.22 $      0.06 $      0.10
  Weighted average shares
   outstanding...............   5,042,386    5,057,001   5,057,001   4,979,282
Earnings (loss) per share--
 Diluted EPS
  Net income (loss).......... $     (0.07) $      0.21 $      0.06 $      0.09
  Weighted average shares
   outstanding...............   5,042,386    5,529,354   5,517,927   5,409,539
<CAPTION>
1997                          1st Quarter  2nd Quarter 3rd Quarter 4th Quarter
----                          -----------  ----------- ----------- -----------
<S>                           <C>          <C>         <C>         <C>
Net sales.................... $10,973,253  $11,273,442 $ 9,285,242 $11,960,522
Gross profit.................   7,186,806    7,615,786   6,028,257   7,693,730
Income (loss) before
 extraordinary items.........    (555,937)   1,088,094     842,162   1,105,048
Net income (loss)............    (717,504)   1,030,962     842,162   1,105,048
Earnings (loss) per share--
 Basic EPS
  Income (loss) before
   extraordinary items(1).... $     (0.12) $      0.22 $      0.17 $      0.22
  Net income (loss).......... $     (0.15) $      0.21 $      0.17 $      0.22
  Weighted average shares
   outstanding...............   4,701,666    4,929,096   4,967,001   5,016,389
Earnings (loss) per share--
 Diluted EPS
  Income (loss) before
   extraordinary items(1).... $     (0.12) $      0.20 $      0.15 $      0.20
  Net income (loss).......... $     (0.15) $      0.19 $      0.15 $      0.20
  Weighted average shares
   outstanding...............   4,701,666    5,534,395   5,543,028   5,540,784
<CAPTION>
1996                          1st Quarter  2nd Quarter 3rd Quarter 4th Quarter
----                          -----------  ----------- ----------- -----------
<S>                           <C>          <C>         <C>         <C>
Net sales.................... $ 9,277,568  $ 9,477,173 $ 8,209,754 $ 9,307,168
Gross profit.................   5,774,313    5,977,187   5,516,524   6,192,718
Net income (loss) available
 to common shareholders(2)...    (175,816)     178,929     343,848     480,110
Earnings (loss) per share--
 Basic EPS
  Net income (loss) available
   to common shareholders.... $     (0.06) $      0.06 $      0.12 $      0.11
  Weighted average shares
   outstanding...............   2,826,666    2,826,666   2,826,666   4,244,248
Earnings (loss) per share--
 Diluted EPS
  Net income (loss) available
   to common shareholders.... $     (0.06) $      0.05 $      0.10 $      0.09
  Weighted average shares
   outstanding...............   2,826,666    3,570,523   3,570,523   5,090,925
</TABLE>
--------
(1) In 1997, the Company recorded a $218,699 extraordinary loss on the early
    retirement of debt (net of an income tax benefit of $149,083) (see
    footnote 7).
(2) During the six month period ended June 29, 1996, the Company declared
    preferred stock dividends of $146,188. In conjunction with the Company's
    initial public offering, all shares of preferred stock were converted into
    common stock and all accumulated dividends through the date of the
    offering were irrevocably waived by the holders of the preferred stock as
    of August 13, 1996.
 
 
                                      43
<PAGE>
 
                            SPECIALTY CATALOG CORP.
 
                SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
 
<TABLE>
<CAPTION>
                           Column A   Column B   Column C   Column D  Column E
                          ---------- ---------- ---------- ---------- ---------
                                           Additions
                                     ---------------------
                          Balance at Charged to  Charged               Balance
                          beginning  costs and   to other              at end
       Description        of period   expenses   accounts  Deductions of period
       -----------        ---------- ---------- ---------- ---------- ---------
<S>                       <C>        <C>        <C>        <C>        <C>
Year ended January 2,
 1999:
  Allowance for doubtful
   accounts..............  $ 79,500   $ 17,000         --  $   30,879 $ 65,621
  Accrued restructuring
   charge................  $     --   $469,558         --  $  370,257 $ 99,301
  Reserve for returns....  $730,958        --   $7,625,322 $7,903,645 $452,635
Year ended January 3,
 1998:
  Allowance for doubtful
   accounts..............  $ 72,197   $ 45,360         --  $   38,057 $ 79,500
  Reserve for returns....  $515,597        --   $8,311,507 $8,096,146 $730,958
Year ended December 28,
 1996:
  Allowance for doubtful
   accounts..............  $160,000   $ 22,000         --  $  109,803 $ 72,197
  Reserve for returns....  $641,266        --   $7,574,181 $7,699,850 $515,597
</TABLE>
 
                                       44
<PAGE>
 
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURE
 
  None.
 
                                   PART III
 
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
  The response to this item is contained in part under the caption "Executive
Officers of the Registrant" in Part I, Item 1A hereof and the remainder is
incorporated herein by reference from the discussion responsive thereto under
the caption "Election of Directors" in the Company's Proxy Statement relating
to the 1999 Annual Meeting of Shareholders.
 
ITEM 11. EXECUTIVE COMPENSATION
 
  The response to this item is incorporated by reference from the discussion
responsive thereto under the following captions in the Company's Proxy
Statement relating to the 1999 Annual Meeting of Shareholders:
 
  "Election of Directors" and "Executive Compensation"
 
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
  The response to this item is incorporated by reference from the discussion
responsive thereto under the caption "Principal Shareholders" in the Company's
Proxy Statement relating to the 1999 Annual Meeting of Shareholders.
 
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
  The response to this item is incorporated by reference from the discussion
responsive thereto under the caption "Certain Transactions" in the Company's
Proxy Statement relating to the 1999 Annual Meeting of Shareholders.
 
                                    PART IV
 
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
 
  (a) 1. FINANCIAL STATEMENTS
 
    The financial statements are listed under Part II, Item 8 of this
    Report
 
    2. FINANCIAL STATEMENT SCHEDULE
 
    The financial statement schedule is listed under Part II, Item 8 of
    this Report
 
    3. EXHIBITS
 
    The exhibits are listed below under Part IV, Item 14(C) of this Report.
 
  (b) REPORTS ON FORM 8-K
 
  No reports on Form 8-K have been filed during the last quarter of the period
covered by this report.
 
                                      45
<PAGE>
 
  (c) EXHIBITS
 
<TABLE>
<CAPTION>
 Exhibit
   No.                                 Description
 -------                               -----------
 <C>     <S>
  3.1    Certificate of Incorporation of the Registrant, as amended. Filed as
         Exhibit 3.01 to Specialty Catalog Corp.'s Form S-1, File No. 333-
         10793.
 
  3.2    By Laws of the Registrant, as amended. Filed as Exhibit 3.02 to
         Specialty Catalog Corp.'s Form S-1, File No. 333-10793.
 
  4.1    Specimen Certificate representing the Common Stock, par value $0.01
         per share. Filed as Exhibit 4.01 to Specialty Catalog Corp.'s Form S-
         1, File No. 333-10793.
 
 10.1    1996 Stock Option Plan. Filed as Exhibit 10.01 to Specialty Catalog
         Corp.'s Form S-1, File No. 333-10793.
 
 10.2    Employment Agreement dated as of October 4, 1996 between the
         Registrant and Steven L. Bock. Filed as Exhibit 10.02 to Specialty
         Catalog Corp.'s Form S-1, File No. 333-10793.
 
 10.3    Agreement dated June 1, 1996 between SC Direct, Inc., the Registrant
         and Martin E. Franklin. Filed as Exhibit 10.14 to Specialty Catalog
         Corp.'s Form S-1, File No. 333-10793.
 
 10.4    Lease dated July 10, 1985 between Simon D. Young, Trustee of the
         Sandpy Realty Trust, ("Trustee"), and Wigs for premises located at 21
         Bristol Drive, South Easton, MA. Filed as Exhibit 10.18 to Specialty
         Catalog Corp.'s Form S-1, File No. 333-10793.
 
 10.5    First Amendment of Lease, dated March 15, 1986, between the Trustee
         and Wigs. Filed as Exhibit 10.19 to Specialty Catalog Corp.'s Form S-
         1, File No. 333-10793.
 
 10.6    Second Amendment to Lease, dated March 1, 1989, between the Trustee
         and Wigs. Filed as Exhibit 10.20 to Specialty Catalog Corp.'s Form S-
         1, File No. 333-10793.
 
 10.7    Third Amendment to Lease, dated October 22, 1993 between the Trustee
         and Wigs. Filed as Exhibit 10.21 to Specialty Catalog Corp.'s Form S-
         1, File No. 333-10793.
 
 10.8    Printing Agreement, dated January 1, 1995 between Quebecor Printing
         (USA) Corp. and the Registrant, as amended. Filed as Exhibit 10.24 to
         Specialty Catalog Corp.'s Form S-1, File No. 333-10793.
 
 10.9    Amended and Restated Registration Rights Agreement, dated October 3,
         1996 between the Registrant and certain of the Registrant's
         stockholders, as amended. Filed as Exhibit 10.25 to Specialty Catalog
         Corp.'s Form S-1, File No. 333-10793.
 
 10.10   First Amended and Restated Joint Plan of Reorganization of SC
         Corporation, Western Schools, Inc. and Wigs by Paula dated September
         21, 1994. Filed as Exhibit 10.26 to Specialty Catalog Corp.'s Form S-
         1, File No. 333-10793.
 
 10.11   Amendment No. 1 to Shareholder's Agreement. Filed as Exhibit 10.29 to
         Specialty Catalog Corp.'s Form S-1, File No. 333-10793.
 
 10.12   Supplemental Defined Contribution Plan. Filed as Exhibit 10.31 to
         Specialty Catalog Corp.'s Form S-1, File No. 333-10793.
 
 10.13   Form of Indemnification Agreement of Directors. Filed as Exhibit 10.32
         to Specialty Catalog Corp.'s Form S-1, File No. 333-10793.
 
 10.14   Net Building Lease dated March 7, 1997 between Campanelli Investment
         Properties and the Registrant for premises located at 525 Campanelli
         Industrial Drive, Brockton, MA. Filed as Exhibit 10.36 to Specialty
         Catalog Corp.'s Form 10-K, dated March 27, 1997, File No. 0-21499.
 
 10.15   Credit Agreement dated March 12, 1997 between The First National Bank
         of Boston and the Registrant. Filed as Exhibit 10.37 to Specialty
         Catalog Corp.'s Form 10-K, dated March 27, 1997, File No. 0-21499.
 
</TABLE>
 
                                       46
<PAGE>
 
<TABLE>
<CAPTION>
 Exhibit
   No.                                 Description
 -------                               -----------
 <C>     <S>
 10.16   Amendment No. 2 to Printing Agreement, dated January 1, 1995 between
         Quebecor Printing (USA) Corp. and the Registrant, as amended, dated
         December 31, 1996. Filed as Exhibit 10.38 to Specialty Catalog Corp.'s
         Form 10-K, dated March 27, 1997, File No. 0-21499.
 
 10.17   First Amendment to Credit Agreement dated as of October 3, 1997
         between BankBoston, N.A. and the Registrant, Filed as Exhibit 10.4 to
         Specialty Catalog Corp.'s Form 10-Q, dated November 6, 1997, File No.
         0-21499.
 
 10.18   Credit Agreement dated as of October 3, 1997 between BankBoston, N.A.
         (acting through its London Branch) and Daxbourne International
         Limited, a subsidiary of the Registrant, Filed as Exhibit 10.5 to
         Specialty Catalog Corp.'s Form 10-Q, dated November 6, 1997, File No.
         0-21499.
 
 10.19   Fourth Amendment to Lease, dated November 26, 1997 between the Trustee
         and SC Corporation, Filed as Exhibit 10.41 to Specialty Catalog
         Corp.'s Form 10-K, dated March 26, 1998, File No. 0-21499.
 
 10.20   Third Amendment to the Credit and Guaranty Agreement and Second
         Amendment to the Credit Agreement, Dated as of September 30, 1998
         between Specialty Catalog Corp., SC Corporation, d/b/a SC Direct, SC
         Publishing, Inc., Daxbourne International Limited and BankBoston,
         N.A., Filed as Exhibit 10.02 to Specialty Catalog Corp.'s Form 10-Q,
         dated November 16, 1998, File No. 0-21499.
 
 10.21   Fourth Amendment to the Credit and Guaranty Agreement and Third
         Amendment to the Credit Agreement, Dated as of December 21, 1998
         between Specialty Catalog Corp., SC Corporation, d/b/a SC Direct, SC
         Publishing, Inc., Daxbourne International Limited and BankBoston,
         N.A., Filed herewith.
 
 21.1    Subsidiaries of the Registrant, Filed herewith.
 
 23.1    Consent of Deloitte & Touche LLP, Filed herewith.
 
 27.1    Financial Data Schedule (for EDGAR filing purposes only), Filed
         herewith.
</TABLE>
 
                                       47
<PAGE>
 
                                  SIGNATURES
 
  Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of
1934, the Registrant has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized.
 
                                          Specialty Catalog Corp.
 
                                                   /s/ Steven L. Bock
                                          By: _________________________________
                                                       Steven L. Bock
                                               Chairman, President and Chief
                                                     Executive Officer
 
                                                  /s/ J. William Heise
                                          By: _________________________________
                                                      J. William Heise
                                              Senior Vice President and Chief
                                                     Financial Officer
 
  Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons in the capacities and on
the date indicated. By so signing, each of the undersigned, in his or her
capacity as a director or officer, or both, as the case may be, of the
Registrant, does hereby appoint Steven L. Bock and J. William Heise, and each
of them severally and jointly, his or her true and lawful attorneys or
attorney to execute in his or her name, place and stead, in his or her
capacity as a director or officer or both, as the case may be, of the
Registrant, this report on Form 10-K and any and all amendments to said report
and all instruments necessary or incidental in connection therewith, and to
file the same with Securities and Exchange Commission. Each of said attorneys
shall have full power and authority to do and perform in the name and on
behalf of each of the undersigned, in any and all capacities, every act
whatsoever requisite or necessary to be done in the premises as fully and to
all intents and purposes as each of the undersigned might or could do in
person, hereby ratifying and approving the acts of said attorneys and each of
them.
 
<TABLE>
<CAPTION>
              Signature                          Title                   Date
              ---------                          -----                   ----
 
<S>                                    <C>                        <C>
        /s/ Steven L. Bock             Chairman of the Board,       March 29, 1999
______________________________________  President and Chief
            Steven L. Bock              Executive Officer
                                        (Principal Executive
                                        Officer)
 
       /s/ J. William Heise            Senior Vice President and    March 29, 1999
______________________________________  Chief Financial Officer
           J. William Heise             (Principal Financial and
                                        Accounting Officer)
 
        /s/ Alan S. Cooper             Director                     March 29, 1999
______________________________________
            Alan S. Cooper
 
      /s/ Martin E. Franklin           Director                     March 29, 1999
______________________________________
          Martin E. Franklin
 
        /s/ Samuel L. Katz             Director                     March 29, 1999
______________________________________
            Samuel L. Katz
 
   /s/ Andrea Pomerantz Lustig         Director                     March 29, 1999
______________________________________
       Andrea Pomerantz Lustig
 
          /s/ Guy Naggar               Director                     March 29, 1999
______________________________________
              Guy Naggar
</TABLE>
 
                                      48