##### Table of Contents









SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





Form 10-Q


QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)


OF THE SECURITIES EXCHANGE ACT OF 1934





|                               |  |                       
|------------------------------ |  | ----------------------
|For the quarterly period ended |  | Commission file number
|January 1, 2005                |  | 0-27826               

Party City Corporation


(Exact Name of Registrant as Specified in Its Charter)


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

(Registrants Telephone Number, Including Area Code)


973-983-0888





þ o


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TABLE OF CONTENTS


|                                                                    |  |                                                                                           |    |                                                                                                                                       |    |  |   | 
|------------------------------------------------------------------- |  | ----------------------------------------------------------------------------------------- | -- | ------------------------------------------------------------------------------------------------------------------------------------- | -- |  | - | 
|                                                                    |  |                                                                                           |    | Page No.                                                                                                                              |   
|                                                                    |  |                                                                                           |    |                                                                                                                                       |   
|PART I FINANCIAL INFORMATION                                       
|Item 1.                                                             |  | Financial Statements (Unaudited)                                                          |    |                                                                                                                                       |    | 
|                                                                    |  |                                                                                           |    | Condensed Consolidated Balance Sheets as of
    January 1, 2005, July 3, 2004 and December 27,
    2003                               |    |  | 3 | 
|                                                                    |  |                                                                                           |    | Condensed Consolidated Statements of Income
    for the fiscal quarter and six months ended January 1, 2005
    and December 27, 2003 |    |  | 4 | 
|                                                                    |  |                                                                                           |    | Condensed Consolidated Statements of Cash
    Flows for the six months ended January 1, 2005 and
    December 27, 2003                |    |  | 5 | 
|                                                                    |  |                                                                                           |    | Notes to Condensed Consolidated Financial
    Statements                                                                              |    |  | 6 | 
|Item 2.                                                             |  | Managements Discussion and Analysis
    of Financial Condition and Results of Operations |    |                                                                                                                                       | 15 | 
|Item 3.                                                             |  | Quantitative and Qualitative Disclosures
    About Market Risk                            |    |                                                                                                                                       | 31 | 
|Item 4.                                                             |  | Controls and Procedures                                                                   |    |                                                                                                                                       | 32 | 
|PART II OTHER INFORMATION                                          
|Item 1.                                                             |  | Legal Proceedings                                                                         |    |                                                                                                                                       | 33 | 
|Item 2.                                                             |  | Unregistered Sales of Equity Securities and
    Use of Proceeds                           |    |                                                                                                                                       | 33 | 
|Item 3.                                                             |  | Defaults Upon Senior Securities                                                           |    |                                                                                                                                       | 33 | 
|Item 4.                                                             |  | Submission of Matters to a Vote of Security
    Holders                                   |    |                                                                                                                                       | 33 | 
|Item 5.                                                             |  | Other Information                                                                         |    |                                                                                                                                       | 33 | 
|Item 6.                                                             |  | Exhibits                                                                                  |    |                                                                                                                                       | 34 | 
|                                                                    |  |                                                                                           |    |                                                                                                                                       |    |  |   | 
|Signatures                                                          |  |                                                                                           | 35 |                                                                                                                                      
|                                                                    |  |                                                                                           |    |                                                                                                                                       |    |  |   | 
|Exhibit Index                                                       |  |                                                                                           | 36 |                                                                                                                                      
|EX-10.16: FORM OF EMPLOYEE STOCK OPTION AGREEMENT                  
|EX-10.17: FORM OF NON-EMPLOYEE DIRECTOR STOCK OPTION AGREEMENT     
|EX-10.18: SUMMARY OF FISCAL YEAR 2005 CORPORATE BONUS PLAN         
|EX-10.19: SUMMARY OF COMPENSATION PAYABLE TO NON-EMPLOYEE DIRECTORS
|EX-10.21: FIRST AMENDMENT AGREEMENT OF THE LOAN AGREEMENT          
|EX-10.27: FIRST MODIFICATION OF AGREEMENT OF LEASE                 
|EX-15.1: AWARENESS LETTER                                          
|EX-31.1: CERTIFICATION                                             
|EX-31.2: CERTIFICATION                                             
|EX-32.1: CERTIFICATION                                             
|EX-32.2: CERTIFICATION                                             





 www.partycity.com


http://www.sec.gov.


2



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##### Table of Contents






PART I.


FINANCIAL INFORMATION







|        |                     
|------- | --------------------
|Item 1. | Financial Statements

PARTY CITY CORPORATION AND SUBSIDIARY





CONDENSED CONSOLIDATED BALANCE SHEETS


|                                                  |                                                                                                                                                                                                                                                                                                                                     |                                            |        |        |         |  |        |              |         |  |        |        |         | 
|------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ------ | ------ | ------- |  | ------ | ------------ | ------- |  | ------ | ------ | ------- | 
|                                                  |                                                                                                                                                                                                                                                                                                                                     | January 1,                                 |        |        | July 3, |  |        | December 27, |        
|                                                  |                                                                                                                                                                                                                                                                                                                                     | 2005                                       |        |        | 2004    |  |        | 2003         |        
|                                                  |                                                                                                                                                                                                                                                                                                                                     |                                            |        |        |         |  |        |              |        
|                                                  |                                                                                                                                                                                                                                                                                                                                     | (In thousands, except share information)   |       
|                                                  |                                                                                                                                                                                                                                                                                                                                     | (Unaudited)                                |       
|ASSETS                                           
|Current assets:                                   |                                                                                                                                                                                                                                                                                                                                     |                                            |        |        |         |  |        |              |         |  |        |       
|                                                  | Cash and cash equivalents                                                                                                                                                                                                                                                                                                           |                                            | $      | 49,182 |         |  | $      | 27,845       |         |  | $      | 20,550 |        
|                                                  | Merchandise inventory                                                                                                                                                                                                                                                                                                               |                                            |        | 69,585 |         |  |        | 57,357       |         |  |        | 60,281 |        
|                                                  | Deferred income taxes                                                                                                                                                                                                                                                                                                               |                                            |        | 9,601  |         |  |        | 9,298        |         |  |        | 7,428  |        
|                                                  | Other current assets, net                                                                                                                                                                                                                                                                                                           |                                            |        | 17,089 |         |  |        | 11,371       |         |  |        | 17,835 |        
|                                                  |                                                                                                                                                                                                                                                                                                                                     |                                            |        |        |         |  |        |              |        
|                                                  |                                                                                                                                                                                                                                                                                                                                     | Total current assets                       |        |        | 145,457 |  |        |              | 105,871 |  |        |        | 106,094 | 
|Property and equipment, net                       |                                                                                                                                                                                                                                                                                                                                     |                                            | 45,774 |        |         |  | 48,762 |              |         |  | 48,715 |       
|Goodwill                                          |                                                                                                                                                                                                                                                                                                                                     |                                            | 18,614 |        |         |  | 18,614 |              |         |  | 18,614 |       
|Other assets                                      |                                                                                                                                                                                                                                                                                                                                     |                                            | 4,561  |        |         |  | 4,170  |              |         |  | 5,201  |       
|                                                  |                                                                                                                                                                                                                                                                                                                                     |                                            |        |        |         |  |        |              |        
|                                                  |                                                                                                                                                                                                                                                                                                                                     | Total assets                               |        | $      | 214,406 |  |        | $            | 177,417 |  |        | $      | 178,624 | 
|                                                  |                                                                                                                                                                                                                                                                                                                                     |                                            |        |        |         |  |        |              |        
|                                                 
|LIABILITIES AND STOCKHOLDERS EQUITY             
|Current liabilities:                              |                                                                                                                                                                                                                                                                                                                                     |                                            |        |        |         |  |        |              |         |  |        |       
|                                                  | Accounts payable                                                                                                                                                                                                                                                                                                                    |                                            | $      | 59,257 |         |  | $      | 38,364       |         |  | $      | 34,458 |        
|                                                  | Accrued expenses and other current liabilities                                                                                                                                                                                                                                                                                      |                                            |        | 36,291 |         |  |        | 32,689       |         |  |        | 36,062 |        
|                                                  |                                                                                                                                                                                                                                                                                                                                     |                                            |        |        |         |  |        |              |        
|                                                  |                                                                                                                                                                                                                                                                                                                                     | Total current liabilities                  |        |        | 95,548  |  |        |              | 71,053  |  |        |        | 70,520  | 
|Long-term liabilities:                            |                                                                                                                                                                                                                                                                                                                                     |                                            |        |        |         |  |        |              |         |  |        |       
|                                                  | Deferred rent and other long-term liabilities                                                                                                                                                                                                                                                                                       |                                            |        | 9,477  |         |  |        | 9,526        |         |  |        | 9,905  |        
|Commitments and contingencies (see Notes 7 and 9) |                                                                                                                                                                                                                                                                                                                                     |                                            |        |        |         |  |        |              |         |  |        |       
|Stockholders equity:                             |                                                                                                                                                                                                                                                                                                                                     |                                            |        |        |         |  |        |              |         |  |        |       
|                                                  | Common stock, $0.01 par value; 40,000,000 shares
    authorized; 17,938,479 shares issued and
    17,191,467 shares outstanding at January 1, 2005;
    17,835,778 shares issued and 17,088,766 shares
    outstanding at July 3, 2004; and 17,721,850 shares
    issued and 16,974,838 shares outstanding at
    December 27, 2003 |                                            |        | 179    |         |  |        | 178          |         |  |        | 177    |        
|                                                  | Additional paid-in capital                                                                                                                                                                                                                                                                                                          |                                            |        | 47,606 |         |  |        | 46,683       |         |  |        | 44,611 |        
|                                                  | Retained earnings                                                                                                                                                                                                                                                                                                                   |                                            |        | 67,536 |         |  |        | 55,917       |         |  |        | 59,351 |        
|                                                  | Treasury stock, at cost (747,012 shares)                                                                                                                                                                                                                                                                                            |                                            |        | (5,940 | )       |  |        | (5,940       | )       |  |        | (5,940 | )      
|                                                  |                                                                                                                                                                                                                                                                                                                                     |                                            |        |        |         |  |        |              |        
|                                                  |                                                                                                                                                                                                                                                                                                                                     | Total stockholders equity                 |        |        | 109,381 |  |        |              | 96,838  |  |        |        | 98,199  | 
|                                                  |                                                                                                                                                                                                                                                                                                                                     |                                            |        |        |         |  |        |              |        
|                                                  |                                                                                                                                                                                                                                                                                                                                     | Total liabilities and stockholders equity |        | $      | 214,406 |  |        | $            | 177,417 |  |        | $      | 178,624 | 
|                                                  |                                                                                                                                                                                                                                                                                                                                     |                                            |        |        |         |  |        |              |        



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY





CONDENSED CONSOLIDATED STATEMENTS OF INCOME


|                           |                                                   |                                               |        |         |                  |   |        |            |         |   |              |         |         |   |        |         |         | 
|-------------------------- | ------------------------------------------------- | --------------------------------------------- | ------ | ------- | ---------------- | - | ------ | ---------- | ------- | - | ------------ | ------- | ------- | - | ------ | ------- | ------- | 
|                           |                                                   | Fiscal Quarter Ended                          |        |         | Six Months Ended |  
|                           |                                                   |                                               |        |         |                  |  
|                           |                                                   | January 1,                                    |        |         | December 27,     |   |        | January 1, |         |   | December 27, |        
|                           |                                                   | 2005                                          |        |         | 2003             |   |        | 2005       |         |   | 2003         |        
|                           |                                                   |                                               |        |         |                  |   |        |            |         |   |              |        
|                           |                                                   | (In thousands, except per share amounts)      |       
|                           |                                                   | (Unaudited)                                   |       
|Revenues:                  |                                                   |                                               |        |         |                  |   |        |            |         |   |              |         |         |   |        |        
|                           | Net sales                                         |                                               | $      | 166,779 |                  |   | $      | 175,304    |         |   | $            | 265,381 |         |   | $      | 277,924 |        
|                           | Royalty fees                                      |                                               |        | 7,511   |                  |   |        | 7,216      |         |   |              | 11,338  |         |   |        | 11,123  |        
|                           | Franchise fees                                    |                                               |        |        |                  |   |        | 40         |         |   |              | 120     |         |   |        | 488     |        
|                           |                                                   |                                               |        |         |                  |   |        |            |         |   |              |        
|                           |                                                   | Total revenues                                |        |         | 174,290          |   |        |            | 182,560 |   |              |         | 276,839 |   |        |         | 289,535 | 
|Expenses:                  |                                                   |                                               |        |         |                  |   |        |            |         |   |              |         |         |   |        |        
|                           | Cost of goods sold and occupancy costs            |                                               |        | 100,884 |                  |   |        | 104,705    |         |   |              | 172,741 |         |   |        | 179,033 |        
|                           | Company-owned store operating and selling expense |                                               |        | 36,277  |                  |   |        | 36,290     |         |   |              | 60,536  |         |   |        | 62,169  |        
|                           | Franchise expense                                 |                                               |        | 1,772   |                  |   |        | 1,562      |         |   |              | 3,620   |         |   |        | 3,221   |        
|                           | General and administrative expense                |                                               |        | 10,661  |                  |   |        | 7,498      |         |   |              | 20,383  |         |   |        | 15,657  |        
|                           |                                                   |                                               |        |         |                  |   |        |            |         |   |              |        
|                           |                                                   | Total expenses                                |        |         | 149,594          |   |        |            | 150,055 |   |              |         | 257,280 |   |        |         | 260,080 | 
|                           |                                                   |                                               |        |         |                  |   |        |            |         |   |              |        
|Operating income           |                                                   |                                               | 24,696 |         |                  |   | 32,505 |            |         |   | 19,559       |         |         |   | 29,455 |        
|                           | Interest income                                   |                                               |        | (164    | )                |   |        | (26        | )       |   |              | (219    | )       |   |        | (30     | )      
|                           | Interest expense                                  |                                               |        | 139     |                  |   |        | 138        |         |   |              | 251     |         |   |        | 342     |        
|                           |                                                   |                                               |        |         |                  |   |        |            |         |   |              |        
|                           | Interest (income) expense, net                    |                                               |        | (25     | )                |   |        | 112        |         |   |              | 32      |         |   |        | 312     |        
|                           |                                                   |                                               |        |         |                  |   |        |            |         |   |              |        
|Income before income taxes |                                                   |                                               | 24,721 |         |                  |   | 32,393 |            |         |   | 19,527       |         |         |   | 29,143 |        
|                           | Provision for income taxes                        |                                               |        | 10,011  |                  |   |        | 13,103     |         |   |              | 7,908   |         |   |        | 11,803  |        
|                           |                                                   |                                               |        |         |                  |   |        |            |         |   |              |        
|Net income                 |                                                   | $                                             | 14,710 |         |                  | $ | 19,290 |            |         | $ | 11,619       |         |         | $ | 17,340 |        
|                           |                                                   |                                               |        |         |                  |   |        |            |         |   |              |        
|                           | Basic earnings per share                          |                                               | $      | 0.86    |                  |   | $      | 1.14       |         |   | $            | 0.68    |         |   | $      | 1.03    |        
|                           |                                                   |                                               |        |         |                  |   |        |            |         |   |              |        
|                           |                                                   | Weighted average shares outstanding  basic   |        |         | 17,151           |   |        |            | 16,867  |   |              |         | 17,128  |   |        |         | 16,856  | 
|                           |                                                   |                                               |        |         |                  |   |        |            |         |   |              |        
|                           | Diluted earnings per share                        |                                               | $      | 0.74    |                  |   | $      | 0.98       |         |   | $            | 0.59    |         |   | $      | 0.88    |        
|                           |                                                   |                                               |        |         |                  |   |        |            |         |   |              |        
|                           |                                                   | Weighted average shares outstanding  diluted |        |         | 19,845           |   |        |            | 19,624  |   |              |         | 19,813  |   |        |         | 19,620  | 
|                           |                                                   |                                               |        |         |                  |   |        |            |         |   |              |        



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PARTY CITY CORPORATION AND SUBSIDIARY





CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


|                                                                                      |                                                                                         |                                                |                                                     |        |              |        |        |         |        |         |  
|------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------- | ---------------------------------------------- | --------------------------------------------------- | ------ | ------------ | ------ | ------ | ------- | ------ | ------- | -
|                                                                                      |                                                                                         | Six Months Ended                               |                                                    
|                                                                                      |                                                                                         |                                                |                                                    
|                                                                                      |                                                                                         | January 1,                                     |                                                     |        | December 27, |       
|                                                                                      |                                                                                         | 2005                                           |                                                     |        | 2003         |       
|                                                                                      |                                                                                         |                                                |                                                     |        |              |       
|                                                                                      |                                                                                         | (In thousands)                                 |                                                    
|                                                                                      |                                                                                         | (Unaudited)                                    |                                                    
|Cash flow from operating activities:                                                  |                                                                                         |                                                |                                                     |        |              |        |        |        
|                                                                                      | Net income                                                                              |                                                | $                                                   | 11,619 |              |        | $      | 17,340  |       
|Adjustments to reconcile net income to net cash provided by
    operating activities: |                                                                                         |                                                |                                                     |        |              |        |        |        
|                                                                                      | Depreciation and amortization                                                           |                                                |                                                     | 8,888  |              |        |        | 7,692   |       
|                                                                                      | Amortization of financing costs                                                         |                                                |                                                     | 80     |              |        |        | 80      |       
|                                                                                      | Deferred rent                                                                           |                                                |                                                     | (412   | )            |        |        | (240    | )     
|                                                                                      | Deferred taxes                                                                          |                                                |                                                     | (866   | )            |        |        |        |       
|                                                                                      | Stock-based compensation                                                                |                                                |                                                     | 11     |              |        |        | 148     |       
|                                                                                      | Provision for doubtful accounts                                                         |                                                |                                                     | (49    | )            |        |        | (140    | )     
|                                                                                      | Other                                                                                   |                                                |                                                     | (95    | )            |        |        | 10      |       
|                                                                                      | Tax-effect on non-qualified stock options                                               |                                                |                                                     | 62     |              |        |        |        |       
|                                                                                      | Changes in assets and liabilities:                                                      |                                                |                                                     |        |              |        |        |         |       
|                                                                                      |                                                                                         | Merchandise inventory                          |                                                     |        | (12,228      | )      |        |         | 5,627  |        
|                                                                                      |                                                                                         | Accounts payable                               |                                                     |        | 20,893       |        |        |         | (3,551 | )      
|                                                                                      |                                                                                         | Accrued expenses and other current liabilities |                                                     |        | 3,940        |        |        |         | 11,065 |        
|                                                                                      |                                                                                         | Other long-term liabilities                    |                                                     |        | 58           |        |        |         | (119   | )      
|                                                                                      |                                                                                         | Other current assets and other assets          |                                                     |        | (5,842       | )      |        |         | (3,188 | )      
|                                                                                      |                                                                                         |                                                |                                                     |        |              |       
|                                                                                      |                                                                                         |                                                | Net cash provided by operating activities           |        |              | 26,059 |        |         |        | 34,724  |  
|Cash flow from investing activities:                                                  |                                                                                         |                                                |                                                     |        |              |        |        |        
|                                                                                      | Purchases of property and equipment                                                     |                                                |                                                     | (5,481 | )            |        |        | (3,529  | )     
|                                                                                      | Proceeds from the sale of assets                                                        |                                                |                                                     | 250    |              |        |        |        |       
|                                                                                      |                                                                                         |                                                |                                                     |        |              |       
|                                                                                      |                                                                                         |                                                | Net cash used in investing activities               |        |              | (5,231 | )      |         |        | (3,529  | )
|Cash flow from financing activities:                                                  |                                                                                         |                                                |                                                     |        |              |        |        |        
|                                                                                      | Proceeds from exercise of stock options                                                 |                                                |                                                     | 564    |              |        |        | 1,289   |       
|                                                                                      | Repayment of Capital Lease                                                              |                                                |                                                     | (55    | )            |        |        |        |       
|                                                                                      | Net payments on Loan Agreement                                                          |                                                |                                                     |       |              |        |        | (11,229 | )     
|                                                                                      | Change in cash overdrafts                                                               |                                                |                                                     |       |              |        |        | (4,077  | )     
|                                                                                      |                                                                                         |                                                |                                                     |        |              |       
|                                                                                      |                                                                                         |                                                | Net cash provided by (used in) financing activities |        |              | 509    |        |         |        | (14,017 | )
|                                                                                      |                                                                                         |                                                |                                                     |        |              |       
|Net increase in cash and cash equivalents                                             |                                                                                         |                                                | 21,337                                              |        |              |        | 17,178 |        
|Cash and cash equivalents, beginning of period                                        |                                                                                         |                                                | 27,845                                              |        |              |        | 3,372  |        
|                                                                                      |                                                                                         |                                                |                                                     |        |              |       
|Cash and cash equivalents, end of period                                              |                                                                                         | $                                              | 49,182                                              |        |              | $      | 20,550 |        
|                                                                                      |                                                                                         |                                                |                                                     |        |              |       
|Supplemental disclosure of cash flow information:                                     |                                                                                         |                                                |                                                     |        |              |        |        |        
|                                                                                      | Income taxes paid                                                                       |                                                | $                                                   | 1,296  |              |        | $      | 1,047   |       
|                                                                                      | Interest paid                                                                           |                                                | $                                                   | 172    |              |        | $      | 262     |       
|Supplemental disclosure of non-cash financing activity:                               |                                                                                         |                                                |                                                     |        |              |        |        |        
|                                                                                      | Issuance of shares under employee stock purchase plan                                   |                                                | $                                                   | 236    |              |        | $      | 244     |       
|                                                                                      | Issuance of shares under management stock purchase plan                                 |                                                | $                                                   |       |              |        | $      | 99      |       
|                                                                                      | Capital lease obligation used to purchase fixed assets for the
    logistics initiative |                                                | $                                                   | 566    |              |        | $      |        |       



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS




|   |                      
|-- | ---------------------
|1. | Basis of Presentation











|   |                    
|-- | -------------------
|2. | Accounting Policies







|   |                         
|-- | ------------------------
|3. | Stock-Based Compensation



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)






|                                      |                                                                                                                                         |                                          |        |        |                  |   |        |            |   |   |              |        |   |   |        |        |  
|------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------- | ---------------------------------------- | ------ | ------ | ---------------- | - | ------ | ---------- | - | - | ------------ | ------ | - | - | ------ | ------ | -
|                                      |                                                                                                                                         | Fiscal Quarter Ended                     |        |        | Six Months Ended |  
|                                      |                                                                                                                                         |                                          |        |        |                  |  
|                                      |                                                                                                                                         | January 1,                               |        |        | December 27,     |   |        | January 1, |   |   | December 27, |       
|                                      |                                                                                                                                         | 2005                                     |        |        | 2003             |   |        | 2005       |   |   | 2003         |       
|                                      |                                                                                                                                         |                                          |        |        |                  |   |        |            |   |   |              |       
|                                      |                                                                                                                                         | (In thousands, except per share amounts) |       
|Net income as reported                |                                                                                                                                         | $                                        | 14,710 |        |                  | $ | 19,290 |            |   | $ | 11,619       |        |   | $ | 17,340 |       
|                                      | Add: Stock-based employee compensation expense determined under
    APB 25, net of tax                                                  |                                          |        | 3      |                  |   |        | 14         |   |   |              | 11     |   |   |        | 36     |  
|                                      | Deduct: Total stock-based employee compensation expense
    determined under fair value based method of
    SFAS No. 148, net of tax(1) |                                          |        | (665   | )                |   |        | (521       | ) |   |              | (1,053 | ) |   |        | (662   | )
|                                      |                                                                                                                                         |                                          |        |        |                  |   |        |            |   |   |              |       
|                                      | Pro-forma net income                                                                                                                    |                                          | $      | 14,048 |                  |   | $      | 18,783     |   |   | $            | 10,577 |   |   | $      | 16,714 |  
|                                      |                                                                                                                                         |                                          |        |        |                  |   |        |            |   |   |              |       
|Basic and diluted earnings per share: |                                                                                                                                         |                                          |        |        |                  |   |        |            |   |   |              |        |   |   |        |       
|                                      | Basic earnings per share as reported                                                                                                    |                                          | $      | 0.86   |                  |   | $      | 1.14       |   |   | $            | 0.68   |   |   | $      | 1.03   |  
|                                      | Basic earnings per share pro forma                                                                                                      |                                          | $      | 0.82   |                  |   | $      | 1.11       |   |   | $            | 0.62   |   |   | $      | 0.99   |  
|                                      | Diluted earnings per share as reported                                                                                                  |                                          | $      | 0.74   |                  |   | $      | 0.98       |   |   | $            | 0.59   |   |   | $      | 0.88   |  
|                                      | Diluted earnings per share pro forma                                                                                                    |                                          | $      | 0.71   |                  |   | $      | 0.96       |   |   | $            | 0.53   |   |   | $      | 0.85   |  






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

|                        |  |                    |           |   |              |  |           |  
|----------------------- |  | ------------------ | --------- | - | ------------ |  | --------- | -
|                        |  | Fiscal Quarter and |          
|                        |  | Six Months Ended   |          
|                        |  |                    |          
|                        |  | January 1,         |           |   | December 27, | 
|                        |  | 2005               |           |   | 2003         | 
|                        |  |                    |           |   |              | 
|Expected volatility     |  |                    | 55        | % |              |  | 55        | %
|Expected lives          |  |                    | 4.0 years |   |              |  | 4.0 years |  
|Risk-free interest rate |  |                    | 3.3       | % |              |  | 2.5       | %
|Expected dividend yield |  |                    | 0.0       | % |              |  | 0.0       | %





7



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|   |                   
|-- | ------------------
|4. | Earnings Per Share



|                                                                               |  |                                          |        |  |                  |   |        |            |  |   |              |  |  |   |        | 
|------------------------------------------------------------------------------ |  | ---------------------------------------- | ------ |  | ---------------- | - | ------ | ---------- |  | - | ------------ |  |  | - | ------ | 
|                                                                               |  | Fiscal Quarter Ended                     |        |  | Six Months Ended |  
|                                                                               |  |                                          |        |  |                  |  
|                                                                               |  | January 1,                               |        |  | December 27,     |   |        | January 1, |  |   | December 27, | 
|                                                                               |  | 2005                                     |        |  | 2003             |   |        | 2005       |  |   | 2003         | 
|                                                                               |  |                                          |        |  |                  |   |        |            |  |   |              | 
|                                                                               |  | (In thousands, except per share amounts) |       
|Net income                                                                     |  | $                                        | 14,710 |  |                  | $ | 19,290 |            |  | $ | 11,619       |  |  | $ | 17,340 | 
|Earnings per share  basic                                                     |  | $                                        | 0.86   |  |                  | $ | 1.14   |            |  | $ | 0.68         |  |  | $ | 1.03   | 
|Earnings per share  diluted                                                   |  | $                                        | 0.74   |  |                  | $ | 0.98   |            |  | $ | 0.59         |  |  | $ | 0.88   | 
|Weighted average common shares outstanding                                     |  |                                          | 17,151 |  |                  |   | 16,867 |            |  |   | 17,128       |  |  |   | 16,856 | 
|Dilutive effect of stock options(a)                                            |  |                                          | 380    |  |                  |   | 439    |            |  |   | 375          |  |  |   | 464    | 
|Dilutive effect of warrants                                                    |  |                                          | 2,301  |  |                  |   | 2,301  |            |  |   | 2,297        |  |  |   | 2,278  | 
|Dilutive effect of restricted stock units                                      |  |                                          | 13     |  |                  |   | 17     |            |  |   | 13           |  |  |   | 22     | 
|                                                                               |  |                                          |        |  |                  |   |        |            |  |   |              | 
|Weighted average common and potentially dilutive common shares
    outstanding |  |                                          | 19,845 |  |                  |   | 19,624 |            |  |   | 19,813       |  |  |   | 19,620 | 
|                                                                               |  |                                          |        |  |                  |   |        |            |  |   |              | 






|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(a) | Options to purchase 915,629 and 1,004,973 common shares
    with exercise prices ranging from $13.55 to $30.88 per
    share were outstanding for the fiscal quarter and six months
    ended January 1, 2005, and options to purchase 577,908
    and 703,391 common shares with exercise prices ranging from
    $13.80 to $30.88 per share were outstanding for the fiscal
    quarter and six months ended December 27, 2003, each of
    which were not included in the computation of diluted earnings
    per share for the fiscal quarter and six months ended
    January 1, 2005 and December 27, 2003, respectively,
    because to do so would have been anti-dilutive.



|   |                    
|-- | -------------------
|5. | Financing Agreement





|   |                     
|-- | --------------------
|6. | Stockholders Equity



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



8



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)






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





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





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











9



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)






| |                               
| | ------------------------------
| | Management Stock Purchase Plan





| |                             
| | ----------------------------
| | Employee Stock Purchase Plan





|   |                  
|-- | -----------------
|7. | Legal Proceedings







10



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)






|   |                    
|-- | -------------------
|8. | Segment Information







|                                        |                               |                      |         |         |                  |   |         |            |  |   |              |         |  |   |         |         | 
|--------------------------------------- | ----------------------------- | -------------------- | ------- | ------- | ---------------- | - | ------- | ---------- |  | - | ------------ | ------- |  | - | ------- | ------- | 
|                                        |                               | Fiscal Quarter Ended |         |         | Six Months Ended |  
|                                        |                               |                      |         |         |                  |  
|                                        |                               | January 1,           |         |         | December 27,     |   |         | January 1, |  |   | December 27, |        
|                                        |                               | 2005                 |         |         | 2003             |   |         | 2005       |  |   | 2003         |        
|                                        |                               |                      |         |         |                  |   |         |            |  |   |              |        
|Retail:                                 |                               |                      |         |         |                  |   |         |            |  |   |              |         |  |   |         |        
|Net sales                               |                               | $                    | 166,779 |         |                  | $ | 175,304 |            |  | $ | 265,381      |         |  | $ | 277,924 |        
|Cost of goods sold and occupancy costs  |                               |                      | 100,884 |         |                  |   | 104,705 |            |  |   | 172,741      |         |  |   | 179,033 |        
|                                        |                               |                      |         |         |                  |   |         |            |  |   |              |        
|Gross profit                            |                               |                      | 65,895  |         |                  |   | 70,599  |            |  |   | 92,640       |         |  |   | 98,891  |        
|Store operating and selling expense     |                               |                      | 36,277  |         |                  |   | 36,290  |            |  |   | 60,536       |         |  |   | 62,169  |        
|                                        |                               |                      |         |         |                  |   |         |            |  |   |              |        
|Company-owned store profit contribution |                               |                      | 29,618  |         |                  |   | 34,309  |            |  |   | 32,104       |         |  |   | 36,722  |        
|General and administrative expense      |                               |                      | 10,661  |         |                  |   | 7,498   |            |  |   | 20,383       |         |  |   | 15,657  |        
|                                        |                               |                      |         |         |                  |   |         |            |  |   |              |        
|Retail profit contribution              |                               | $                    | 18,957  |         |                  | $ | 26,811  |            |  | $ | 11,721       |         |  | $ | 21,065  |        
|                                        |                               |                      |         |         |                  |   |         |            |  |   |              |        
|                                        | Identifiable assets           |                      | $       | 210,631 |                  |   | $       | 175,545    |  |   | $            | 210,631 |  |   | $       | 175,545 | 
|                                        | Depreciation and amortization |                      | $       | 4,556   |                  |   | $       | 3,890      |  |   | $            | 8,888   |  |   | $       | 7,692   | 
|                                        | Capital expenditures          |                      | $       | 3,229   |                  |   | $       | 2,081      |  |   | $            | 5,481   |  |   | $       | 3,529   | 
|Franchise:                              |                               |                      |         |         |                  |   |         |            |  |   |              |         |  |   |         |        
|Royalty fees                            |                               | $                    | 7,511   |         |                  | $ | 7,216   |            |  | $ | 11,338       |         |  | $ | 11,123  |        
|Franchise fees                          |                               |                      |        |         |                  |   | 40      |            |  |   | 120          |         |  |   | 488     |        
|                                        |                               |                      |         |         |                  |   |         |            |  |   |              |        
|Total franchise revenue                 |                               |                      | 7,511   |         |                  |   | 7,256   |            |  |   | 11,458       |         |  |   | 11,611  |        
|Total franchise expense                 |                               |                      | 1,772   |         |                  |   | 1,562   |            |  |   | 3,620        |         |  |   | 3,221   |        
|                                        |                               |                      |         |         |                  |   |         |            |  |   |              |        
|Franchise profit contribution           |                               |                      | 5,739   |         |                  |   | 5,694   |            |  |   | 7,838        |         |  |   | 8,390   |        
|                                        |                               |                      |         |         |                  |   |         |            |  |   |              |        
|                                        | Identifiable assets           |                      | $       | 3,775   |                  |   | $       | 3,079      |  |   | $            | 3,775   |  |   | $       | 3,079   | 
|                                        | Depreciation and amortization |                      |         |        |                  |   |         |           |  |   |              |        |  |   |         |        | 
|                                        | Capital expenditures          |                      |         |        |                  |   |         |           |  |   |              |        |  |   |         |        | 

11



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)


|                               |                               |                      |        |         |                  |   |        |            |  |   |              |         |  |   |        |         | 
|------------------------------ | ----------------------------- | -------------------- | ------ | ------- | ---------------- | - | ------ | ---------- |  | - | ------------ | ------- |  | - | ------ | ------- | 
|                               |                               | Fiscal Quarter Ended |        |         | Six Months Ended |  
|                               |                               |                      |        |         |                  |  
|                               |                               | January 1,           |        |         | December 27,     |   |        | January 1, |  |   | December 27, |        
|                               |                               | 2005                 |        |         | 2003             |   |        | 2005       |  |   | 2003         |        
|                               |                               |                      |        |         |                  |   |        |            |  |   |              |        
|Total Company:                 |                               |                      |        |         |                  |   |        |            |  |   |              |         |  |   |        |        
|Operating income               |                               | $                    | 24,696 |         |                  | $ | 32,505 |            |  | $ | 19,559       |         |  | $ | 29,455 |        
|Interest (income) expense, net |                               |                      | (25    | )       |                  |   | 112    |            |  |   | 32           |         |  |   | 312    |        
|                               |                               |                      |        |         |                  |   |        |            |  |   |              |        
|Income before income taxes     |                               |                      | 24,721 |         |                  |   | 32,393 |            |  |   | 19,527       |         |  |   | 29,143 |        
|Provision for income taxes     |                               |                      | 10,011 |         |                  |   | 13,103 |            |  |   | 7,908        |         |  |   | 11,803 |        
|                               |                               |                      |        |         |                  |   |        |            |  |   |              |        
|Net income                     |                               | $                    | 14,710 |         |                  | $ | 19,290 |            |  | $ | 11,619       |         |  | $ | 17,340 |        
|                               |                               |                      |        |         |                  |   |        |            |  |   |              |        
|                               | Identifiable assets           |                      | $      | 214,406 |                  |   | $      | 178,624    |  |   | $            | 214,406 |  |   | $      | 178,624 | 
|                               | Depreciation and amortization |                      | $      | 4,556   |                  |   | $      | 3,890      |  |   | $            | 8,888   |  |   | $      | 7,692   | 
|                               | Capital expenditures          |                      | $      | 3,229   |                  |   | $      | 2,081      |  |   | $            | 5,481   |  |   | $      | 3,529   | 





|   |                                                   
|-- | --------------------------------------------------
|9. | Contractual Obligations and Commercial Commitments



|                       |  |       |         |           |           |   |             |        |  |                      |             |  |  |             |       |  |               |   |     |  |  |   |     | 
|---------------------- |  | ----- | ------- | --------- | --------- | - | ----------- | ------ |  | -------------------- | ----------- |  |  | ----------- | ----- |  | ------------- | - | --- |  |  | - | --- | 
|                       |  |       |         | Operating |           |   | Merchandise |        |  | Logistics Initiative |             |  |  |             |      
|                       |  | Total |         |           | Leases(1) |   |             | Orders |  |                      | Obligations |  |  | Auto Leases |       |  | Capital Lease |  
|                       |  |       |         |           |           |   |             |        |  |                      |             |  |  |             |       |  |               |  
|Fiscal year ending:    |  |       |         |           |           |   |             |        |  |                      |             |  |  |             |       |  |               |   |     |  |  |   |     | 
|2005                   |  | $     | 49,890  |           |           | $ | 23,161      |        |  | $                    | 25,270      |  |  | $           | 1,250 |  |               | $ | 146 |  |  | $ | 63  | 
|2006                   |  |       | 48,525  |           |           |   | 45,719      |        |  |                      |            |  |  |             | 2,500 |  |               |   | 181 |  |  |   | 125 | 
|2007                   |  |       | 45,279  |           |           |   | 42,295      |        |  |                      |            |  |  |             | 2,500 |  |               |   | 129 |  |  |   | 355 | 
|2008                   |  |       | 33,831  |           |           |   | 33,824      |        |  |                      |            |  |  |             |      |  |               |   | 7   |  |  |   |    | 
|2009                   |  |       | 21,250  |           |           |   | 21,250      |        |  |                      |            |  |  |             |      |  |               |   |    |  |  |   |    | 
|Thereafter             |  |       | 48,403  |           |           |   | 48,403      |        |  |                      |            |  |  |             |      |  |               |   |    |  |  |   |    | 
|                       |  |       |         |           |           |   |             |        |  |                      |             |  |  |             |       |  |               |  
|Total minimum payments |  | $     | 247,178 |           |           | $ | 214,652     |        |  | $                    | 25,270      |  |  | $           | 6,250 |  |               | $ | 463 |  |  | $ | 543 | 
|                       |  |       |         |           |           |   |             |        |  |                      |             |  |  |             |       |  |               |  






|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The Company is also obligated for guarantees, subleases or
    assigned lease obligations for 23 of the franchise stores
    through 2011. The majority of the guarantees, subleases and
    assigned lease obligations were given when the Company sold
    stores in 1999 as part of its restructuring. The guarantees,
    subleases and assigned lease obligations continue until the
    applicable leases expire. The maximum amount of the guarantees,
    subleases and assigned lease obligations may vary, but is
    limited to the sum of the total amount due under the leases. As
    of January 1, 2005, the maximum amount of the guarantees,
    subleases and assigned lease obligations was approximately
    $13.9 million, which is not included in this table.



12



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)


















13



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##### Table of Contents



PARTY CITY CORPORATION AND SUBSIDIARY


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|    |                      
|--- | ---------------------
|10. | Non-Compete Agreement



|                           |  |                      |     | 
|-------------------------- |  | -------------------- | --- | 
|Fiscal Year Ending:        |  | Amortization Expense |    
|                           |  |                      |    
|2005                       |  | $                    | 41  | 
|2006                       |  |                      | 82  | 
|2007                       |  |                      | 82  | 
|2008                       |  |                      | 82  | 
|2009                       |  |                      | 20  | 
|Thereafter                 |  |                      | 14  | 
|                           |  |                      |    
|Total amortization expense |  | $                    | 321 | 
|                           |  |                      |    



|    |                                 
|--- | --------------------------------
|11. | Recent Accounting Pronouncements









14



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##### Table of Contents








|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|Item 2. | Managements Discussion and Analysis of Financial
    Condition and Results of Operations

Overview














15



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##### Table of Contents















16



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##### Table of Contents



Key Performance Indicators and Statistics




|                                                                         |  |                      |         |    |                  |   |         |            |  |   |              |    |  |   |         |  
|------------------------------------------------------------------------ |  | -------------------- | ------- | -- | ---------------- | - | ------- | ---------- |  | - | ------------ | -- |  | - | ------- | -
|                                                                         |  | Fiscal Quarter Ended |         |    | Six Months Ended |  
|                                                                         |  |                      |         |    |                  |  
|                                                                         |  | January 1,           |         |    | December 27,     |   |         | January 1, |  |   | December 27, |   
|                                                                         |  | 2005                 |         |    | 2003             |   |         | 2005       |  |   | 2003         |   
|                                                                         |  |                      |         |    |                  |   |         |            |  |   |              |   
|Net sales (in thousands)                                                 |  | $                    | 166,779 |    |                  | $ | 175,304 |            |  | $ | 265,381      |    |  | $ | 277,924 |  
|Total Company-owned store count                                          |  |                      | 248     |    |                  |   | 247     |            |  |   | 248          |    |  |   | 247     |  
|Average same store net sales for Company owned stores (in
    thousands) |  | $                    | 673     |    |                  | $ | 713     |            |  | $ | 1,073        |    |  | $ | 1,135   |  
|Same store average net sale per retail transaction(a)                    |  | $                    | 20.32   |    |                  | $ | 20.24   |            |  | $ | 19.85        |    |  | $ | 19.65   |  
|(Decrease) increase in same store net sales                              |  |                      | (5.6    | )% |                  |   | 3.7     | %          |  |   | (5.4         | )% |  |   | 3.8     | %
|Gross profit as a percent of net sales                                   |  |                      | 39.5    | %  |                  |   | 40.3    | %          |  |   | 34.9         | %  |  |   | 35.6    | %
|Store profit contribution as a percent of net sales                      |  |                      | 17.8    | %  |                  |   | 19.6    | %          |  |   | 12.1         | %  |  |   | 13.2    | %
|Diluted earnings per share                                               |  | $                    | 0.74    |    |                  | $ | 0.98    |            |  | $ | 0.59         |    |  | $ | 0.88    |  
|EBITDA(b) (in thousands)                                                 |  | $                    | 29,252  |    |                  | $ | 36,395  |            |  | $ | 28,447       |    |  | $ | 37,147  |  
|(Decrease) increase in franchise same store sales                        |  |                      | (2.8    | )% |                  |   | 7.0     | %          |  |   | (2.8         | )% |  |   | 5.7     | %






|    |                                                                                                                                                                       
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(a) | Same store net sales divided by same store retail transactions.
    Retail transactions represent each time a customer makes a
    purchase or return at the register.



|    |  |                                  
|--- |  | ---------------------------------
|(b) |  | See EBITDA discussion on page 23.



|                        |                |                                             |                              |  |                  |     |     |            |     |     |              |  |     |     |     |  |     |     |  
|----------------------- | -------------- | ------------------------------------------- | ---------------------------- |  | ---------------- | --- | --- | ---------- | --- | --- | ------------ |  | --- | --- | --- |  | --- | --- | -
|                        |                | Fiscal Quarter Ended                        |                              |  | Six Months Ended |    
|                        |                |                                             |                              |  |                  |    
|                        |                | January 1,                                  |                              |  | December 27,     |     |     | January 1, |     |     | December 27, | 
|                        |                | 2005                                        |                              |  | 2003             |     |     | 2005       |     |     | 2003         | 
|                        |                |                                             |                              |  |                  |     |     |            |     |     |              | 
|Store Data:             |                |                                             |                              |  |                  |     |     |            |     |     |              |  |     |     |     | 
|                        | Company-owned: |                                             |                              |  |                  |     |     |            |     |     |              |  |     |     |     |  |    
|                        |                | Stores open at beginning of period          |                              |  | 249              |     |     |            | 247 |     |              |  | 249 |     |     |  | 242 |    
|                        |                |                                             | Stores opened                |  |                  |    |     |            |     |    |              |  |     | 1   |     |  |     | 6   |  
|                        |                |                                             | Stores closed                |  |                  | (1  | )   |            |     |    |              |  |     | (2  | )   |  |     | (1  | )
|                        |                |                                             |                              |  |                  |     |     |            |     |     |              | 
|                        |                |                                             | Stores open at end of period |  |                  | 248 |     |            |     | 247 |              |  |     | 248 |     |  |     | 247 |  
|                        |                |                                             |                              |  |                  |     |     |            |     |     |              | 
|                        |                | Average Company-owned stores open in period |                              |  | 249              |     |     |            | 247 |     |              |  | 249 |     |     |  | 245 |    
|                        |                |                                             |                              |  |                  |     |     |            |     |     |              | 
|                        | Franchise:     |                                             |                              |  |                  |     |     |            |     |     |              |  |     |     |     |  |    
|                        |                | Stores open at beginning of period          |                              |  | 259              |     |     |            | 253 |     |              |  | 257 |     |     |  | 241 |    
|                        |                |                                             | Stores opened                |  |                  |    |     |            |     | 1   |              |  |     | 3   |     |  |     | 13  |  
|                        |                |                                             | Stores closed                |  |                  |    |     |            |     |    |              |  |     | (1  | )   |  |     |    |  
|                        |                |                                             |                              |  |                  |     |     |            |     |     |              | 
|                        |                |                                             | Stores open at end of period |  |                  | 259 |     |            |     | 254 |              |  |     | 259 |     |  |     | 254 |  
|                        |                |                                             |                              |  |                  |     |     |            |     |     |              | 
|                        |                | Average franchise stores open in period     |                              |  | 259              |     |     |            | 253 |     |              |  | 258 |     |     |  | 251 |    
|                        |                |                                             |                              |  |                  |     |     |            |     |     |              | 
|Total stores chain wide |                |                                             | 507                          |  |                  |     | 501 |            |     |     | 507          |  |     |     | 501 | 
|                        |                |                                             |                              |  |                  |     |     |            |     |     |              | 

Critical Accounting Policies and Estimates




17



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##### Table of Contents









Cash and cash equivalents.


Merchandise inventory.




Finite long-lived assets.


Insurance accruals.


Goodwill.


Sales Returns.


18



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##### Table of Contents



Store Closure Costs.


Income Taxes.


General Definitions for Operating Results


Net Sales


Cost of goods sold and occupancy costs


Gross profit


Store operating and selling expenses


Company-owned store profit contribution


General and administrative expense


Franchising.


Franchise profit contribution


Interest (income) expense, net


19



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##### Table of Contents



Results of Operations




|                                              |                                         |                                                    |        |         |                  |  |        |            |  |  |              |         |  |  |        |         | 
|--------------------------------------------- | --------------------------------------- | -------------------------------------------------- | ------ | ------- | ---------------- |  | ------ | ---------- |  |  | ------------ | ------- |  |  | ------ | ------- | 
|                                              |                                         | Fiscal Quarter Ended                               |        |         | Six Months Ended | 
|                                              |                                         |                                                    |        |         |                  | 
|                                              |                                         | January 1,                                         |        |         | December 27,     |  |        | January 1, |  |  | December 27, |        
|                                              |                                         | 2005                                               |        |         | 2003             |  |        | 2005       |  |  | 2003         |        
|                                              |                                         |                                                    |        |         |                  |  |        |            |  |  |              |        
|                                              |                                         | (In thousands, except share and per share amounts) |       
|Statement of Operations Data:                 |                                         |                                                    |        |         |                  |  |        |            |  |  |              |         |  |  |        |        
|Company-owned stores:                         |                                         |                                                    |        |         |                  |  |        |            |  |  |              |         |  |  |        |        
|                                              | Net sales                               |                                                    | $      | 166,779 |                  |  | $      | 175,304    |  |  | $            | 265,381 |  |  | $      | 277,924 | 
|                                              | Cost of goods sold and occupancy costs  |                                                    |        | 100,884 |                  |  |        | 104,705    |  |  |              | 172,741 |  |  |        | 179,033 | 
|                                              |                                         |                                                    |        |         |                  |  |        |            |  |  |              |        
|                                              | Gross profit                            |                                                    |        | 65,895  |                  |  |        | 70,599     |  |  |              | 92,640  |  |  |        | 98,891  | 
|                                              | Store operating and selling expense     |                                                    |        | 36,277  |                  |  |        | 36,290     |  |  |              | 60,536  |  |  |        | 62,169  | 
|                                              |                                         |                                                    |        |         |                  |  |        |            |  |  |              |        
|                                              | Company-owned store profit contribution |                                                    |        | 29,618  |                  |  |        | 34,309     |  |  |              | 32,104  |  |  |        | 36,722  | 
|                                              | General and administrative expense      |                                                    |        | 10,661  |                  |  |        | 7,498      |  |  |              | 20,383  |  |  |        | 15,657  | 
|                                              |                                         |                                                    |        |         |                  |  |        |            |  |  |              |        
|                                              | Retail profit contribution              |                                                    |        | 18,957  |                  |  |        | 26,811     |  |  |              | 11,721  |  |  |        | 21,065  | 
|Franchise stores:                             |                                         |                                                    |        |         |                  |  |        |            |  |  |              |         |  |  |        |        
|                                              | Royalty fees                            |                                                    |        | 7,511   |                  |  |        | 7,216      |  |  |              | 11,338  |  |  |        | 11,123  | 
|                                              | Franchise fees                          |                                                    |        |        |                  |  |        | 40         |  |  |              | 120     |  |  |        | 488     | 
|                                              |                                         |                                                    |        |         |                  |  |        |            |  |  |              |        
|                                              | Total franchise revenue                 |                                                    |        | 7,511   |                  |  |        | 7,256      |  |  |              | 11,458  |  |  |        | 11,611  | 
|                                              | Total franchise expense                 |                                                    |        | 1,772   |                  |  |        | 1,562      |  |  |              | 3,620   |  |  |        | 3,221   | 
|                                              |                                         |                                                    |        |         |                  |  |        |            |  |  |              |        
|                                              | Franchise profit contribution           |                                                    |        | 5,739   |                  |  |        | 5,694      |  |  |              | 7,838   |  |  |        | 8,390   | 
|                                              |                                         |                                                    |        |         |                  |  |        |            |  |  |              |        
|Total Company:                                |                                         |                                                    |        |         |                  |  |        |            |  |  |              |         |  |  |        |        
|                                              | Operating income                        |                                                    |        | 24,696  |                  |  |        | 32,505     |  |  |              | 19,559  |  |  |        | 29,455  | 
|                                              | Interest (income) expense, net          |                                                    |        | (25     | )                |  |        | 112        |  |  |              | 32      |  |  |        | 312     | 
|                                              |                                         |                                                    |        |         |                  |  |        |            |  |  |              |        
|                                              | Income before income taxes              |                                                    |        | 24,721  |                  |  |        | 32,393     |  |  |              | 19,527  |  |  |        | 29,143  | 
|                                              | Provision for income taxes              |                                                    |        | 10,011  |                  |  |        | 13,103     |  |  |              | 7,908   |  |  |        | 11,803  | 
|                                              |                                         |                                                    |        |         |                  |  |        |            |  |  |              |        
|                                              | Net income                              |                                                    | $      | 14,710  |                  |  | $      | 19,290     |  |  | $            | 11,619  |  |  | $      | 17,340  | 
|                                              |                                         |                                                    |        |         |                  |  |        |            |  |  |              |        
|                                              | Basic earnings per share                |                                                    | $      | 0.86    |                  |  | $      | 1.14       |  |  | $            | 0.68    |  |  | $      | 1.03    | 
|                                              |                                         |                                                    |        |         |                  |  |        |            |  |  |              |        
|Weighted average shares outstanding  basic   |                                         |                                                    | 17,151 |         |                  |  | 16,867 |            |  |  | 17,128       |         |  |  | 16,856 |        
|                                              | Diluted earnings per share              |                                                    | $      | 0.74    |                  |  | $      | 0.98       |  |  | $            | 0.59    |  |  | $      | 0.88    | 
|                                              |                                         |                                                    |        |         |                  |  |        |            |  |  |              |        
|Weighted average shares outstanding  diluted |                                         |                                                    | 19,845 |         |                  |  | 19,624 |            |  |  | 19,813       |         |  |  | 19,620 |        



| |                                                                                            
| | -------------------------------------------------------------------------------------------
| | Fiscal Quarter Ended January 1, 2005 Compared To
    Fiscal Quarter Ended December 27, 2003

Retail.


20



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|                                                   |       |                         |      |      |                                 |                                                                                                                                                                                               | 
|-------------------------------------------------- | ----- | ----------------------- | ---- | ---- | ------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
|                                                   |       | Portion of Total Change |      |      |                                
|Component                                          |       | Increase/(Decrease)     |      |      | Reason for Increase/(Decrease):
|                                                   |       |                         |      |      |                                
|                                                   |       | (In millions)           |      |      |                                
|Net sales impact on merchandise margins            |       | $                       | (3.4 | )    |                                 | Due to lower total sales: same store and new store sales.                                                                                                                                    
|Merchandise margins (including distribution costs) |       |                         | (0.3 | )    |                                 | Due to improved margin in certain product categories offset by
    increased distribution costs because product volume throughput
    has not reached critical mass during our initial phase.
|Occupancy and other costs                          |       |                         | (1.0 | )    |                                 | Due to higher fixed expenses associated with new stores and
    higher depreciation and other occupancy costs.                                                                               
|                                                   |       |                         |      |      |                                
|                                                   | Total |                         | $    | (4.7 | )                               |                                                                                                                                                                                               | 
|                                                   |       |                         |      |      |                                



|                              |       |                         |      |     |                                 |                                                                                                                                    | 
|----------------------------- | ----- | ----------------------- | ---- | --- | ------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------- | 
|                              |       | Portion of Total Change |      |     |                                
|Component                     |       | Increase/(Decrease)     |      |     | Reason for Increase/(Decrease):
|                              |       |                         |      |     |                                
|                              |       | (In millions)           |      |     |                                
|Variable store operating cost |       | $                       | (0.4 | )   |                                 | Declined due to lower total sales: same and new store sales.                                                                      
|Payroll and fringe benefit    |       |                         | (0.4 | )   |                                 | Due primarily to reduced estimates of year-end employee
    compensation, partially offset by higher costs of fringe
    benefits.
|Advertising                   |       |                         | 0.6  |     |                                 | Due primarily to increased advertising during Halloween season.                                                                   
|Other operating costs         |       |                         | 0.2  |     |                                 | Due primarily to increased charge card fees, partially offset by
    a reduction in other store expenses.                         
|                              |       |                         |      |     |                                
|                              | Total |                         | $    | 0.0 |                                 |                                                                                                                                    | 
|                              |       |                         |      |     |                                



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|                            |       |                         |     |     |                                 |                                                                                                                                                                                                                                                                                          | 
|--------------------------- | ----- | ----------------------- | --- | --- | ------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
|                            |       | Portion of Total Change |     |     |                                
|Component                   |       | Increase/(Decrease)     |     |     | Reason for Increase/(Decrease):
|                            |       |                         |     |     |                                
|                            |       | (In millions)           |     |     |                                
|Payroll and fringe benefits |       | $                       | 1.4 |     |                                 | Due to increased corporate staffing and related staffing costs
    to support our product assortment, logistics and information
    systems strategic initiatives, as well as increased fringe
    benefits partially offset by reduced estimates of year-end
    employee compensation.
|Occupancy                   |       |                         | 1.0 |     |                                 | Due to additional temporary corporate office space.                                                                                                                                                                                                                                     
|Professional fees           |       |                         | 0.5 |     |                                 | Due to increased one time expenditures related to our store
    re-set initiative as well as increased miscellaneous
    professional fees.                                                                                                                                             
|Other                       |       |                         | 0.3 |     |                                 | Due to increased other corporate expenses.                                                                                                                                                                                                                                              
|                            |       |                         |     |     |                                
|                            | Total |                         | $   | 3.2 |                                 |                                                                                                                                                                                                                                                                                          | 
|                            |       |                         |     |     |                                

Franchising.






Interest Expense.


Income Taxes.


Net Income.


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| |                                                                                               
| | ----------------------------------------------------------------------------------------------
| | Fiscal Six Months Ended January 1, 2005 Compared To
    Fiscal Quarter Ended December 27, 2003

Retail.




|                                                   |       |                         |      |      |                                 |                                                                                                                                                                                                                                                           | 
|-------------------------------------------------- | ----- | ----------------------- | ---- | ---- | ------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
|                                                   |       | Portion of Total Change |      |      |                                
|Component                                          |       | Increase/(Decrease)     |      |      | Reason for Increase/(Decrease):
|                                                   |       |                         |      |      |                                
|                                                   |       | (In millions)           |      |      |                                
|Net sales impact on merchandise margins            |       | $                       | (4.5 | )    |                                 | Due to lower total sales: same store and new store sales.                                                                                                                                                                                                
|Merchandise margins (including distribution costs) |       |                         | 1.1  |      |                                 | Due to a reduction in promotional markdown activity reflecting a
    shift to less promotional pricing partially offset by increased
    distribution costs because product volume throughput has not
    reached critical mass during our initial phase.
|Occupancy and other costs                          |       |                         | (2.9 | )    |                                 | Due to higher fixed expenses associated with new stores and
    accelerated depreciable life of certain stores internal
    sign and graphics.                                                                                                          
|                                                   |       |                         |      |      |                                
|                                                   | Total |                         | $    | (6.3 | )                               |                                                                                                                                                                                                                                                           | 
|                                                   |       |                         |      |      |                                



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|                                                   |       |                         |      |      |                                 |                                                                                                                                                                                                                                                                                                   | 
|-------------------------------------------------- | ----- | ----------------------- | ---- | ---- | ------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
|                                                   |       | Portion of Total Change |      |      |                                
|Component                                          |       | Increase/(Decrease)     |      |      | Reason for Increase/(Decrease):
|                                                   |       |                         |      |      |                                
|                                                   |       | (In millions)           |      |      |                                
|Net sales impact on variable store operating costs |       |                         | (0.6 | )    |                                 | Due to lower total sales; and new store sales                                                                                                                                                                                                                                                    
|Payroll and fringe benefit                         |       |                         | (1.2 | )    |                                 | Due primarily to reduced labor costs from efficiency
    improvements in customer checkout, product replenishment, store
    receiving and logistics, and inventory management, reduced
    estimates of year-end employee compensation, partially offset by
    higher costs of fringe benefits.
|Other operating costs                              |       |                         | 0.2  |      |                                 | Due primarily to increased advertising and increased charge card
    fees, partially offset by a gain realized on one store closing
    in the first quarter and a reduction in other store expenses.                                                                                            
|                                                   |       |                         |      |      |                                
|                                                   | Total |                         | $    | (1.6 | )                               |                                                                                                                                                                                                                                                                                                   | 
|                                                   |       |                         |      |      |                                





|                            |       |                         |     |     |                                 |                                                                                                                                                                                                                                                              | 
|--------------------------- | ----- | ----------------------- | --- | --- | ------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | 
|                            |       | Portion of Total Change |     |     |                                
|Component                   |       | Increase/(Decrease      |     |     | Reason for Increase/(Decrease):
|                            |       |                         |     |     |                                
|                            |       | (In millions)           |     |     |                                
|Payroll and fringe benefits |       | $                       | 2.4 |     |                                 | Due to increased corporate staffing, fringe benefits and related
    staffing costs to support our product assortment, logistics and
    information systems strategic initiatives, partially offset by
    reduced estimates of year-end incentive payouts.
|Occupancy                   |       |                         | 1.5 |     |                                 | Due to additional temporary corporate office space.                                                                                                                                                                                                         
|Professional fees           |       |                         | 0.3 |     |                                 | Due to increased one-time expenditures related to our store
    re-set initiative as well as increased miscellaneous
    professional fees.                                                                                                                 
|Other                       |       |                         | 0.5 |     |                                 | Due to increased other corporate expenses.                                                                                                                                                                                                                  
|                            |       |                         |     |     |                                
|                            | Total |                         | $   | 4.7 |                                 |                                                                                                                                                                                                                                                              | 
|                            |       |                         |     |     |                                

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##### Table of Contents



Franchising.






Interest Expense.


Income Taxes.


Net Income.


Liquidity and Capital Resources








| |   |                                                                                                                                                                            
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | our logistics initiative, pursuant to which we are outsourcing
    our centralized warehousing and distribution facilities and
    implementing a new distribution network;
|
| |  | revitalizing our brand and retail environment through
    re-merchandising our stores;                                                                                     
|
| |  | transitioning to our new corporate headquarters;                                                                                                                           

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| |   |                                                       
| | - | ------------------------------------------------------
| |  | evaluating our current and future store locations; and
|
| |  | improving customer service at the stores.             





Key Indicators of Liquidity and Capital Resources




|                                  |                               |                        |   |         |                  |  |   |            |        |  |              |         |        |  |   |         |        | 
|--------------------------------- | ----------------------------- | ---------------------- | - | ------- | ---------------- |  | - | ---------- | ------ |  | ------------ | ------- | ------ |  | - | ------- | ------ | 
|                                  |                               | Fiscal Quarter Ended   |   |         | Six Months Ended | 
|                                  |                               |                        |   |         |                  | 
|                                  |                               | January 1,             |   |         | December 27,     |  |   | January 1, |        |  | December 27, |        
|                                  |                               | 2005                   |   |         | 2003             |  |   | 2005       |        |  | 2003         |        
|                                  |                               |                        |   |         |                  |  |   |            |        |  |              |        
|Balance Sheet Data:               |                               |                        |   |         |                  |  |   |            |        |  |              |         |        |  |   |        
|                                  | Cash and cash equivalents     |                        | $ | 49,182  |                  |  | $ | 20,550     |        |  | $            | 49,182  |        |  | $ | 20,550  |       
|                                  | Working capital               |                        |   | 49,909  |                  |  |   | 35,574     |        |  |              | 49,909  |        |  |   | 35,574  |       
|                                  | Total assets                  |                        |   | 214,406 |                  |  |   | 178,624    |        |  |              | 214,406 |        |  |   | 178,624 |       
|                                  | Advance under Loan Agreement  |                        |   |        |                  |  |   |           |        |  |              |        |        |  |   |        |       
|                                  | Stockholders equity          |                        |   | 109,381 |                  |  |   | 98,199     |        |  |              | 109,381 |        |  |   | 98,199  |       
|Other Information:                |                               |                        |   |         |                  |  |   |            |        |  |              |         |        |  |   |        
|                                  | Depreciation and amortization |                        | $ | 4,556   |                  |  | $ | 3,890      |        |  | $            | 8,888   |        |  | $ | 7,692   |       
|Cash Flows (Used In) Provided By: |                               |                        |   |         |                  |  |   |            |        |  |              |         |        |  |   |        
|                                  | Operating activities          |                        | $ | 33,464  |                  |  | $ | 33,929     |        |  | $            | 26,059  |        |  | $ | 34,724  |       
|                                  | Investing activities          |                        |   | (3,229  | )                |  |   | (2,081     | )      |  |              | (5,231  | )      |  |   | (3,529  | )     
|                                  | Financing activities          |                        |   | 334     |                  |  |   | (15,901    | )      |  |              | 509     |        |  |   | (14,017 | )     
|                                  |                               |                        |   |         |                  |  |   |            |        |  |              |        
|                                  |                               | Total cash provided by |   | $       | 30,569           |  |   | $          | 15,947 |  |              | $       | 21,337 |  |   | $       | 17,178 | 
|                                  |                               |                        |   |         |                  |  |   |            |        |  |              |        

Operating Activities.


Investing Activities.


26



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##### Table of Contents



Financing Activities.


Loan Agreement.


Warrants.


EBITDA (Earnings before interest, taxes, depreciation and
amortization)


|                                        |                                             |                      |        |                |                  |   |        |            |  |   |              |        |  |   |        |        | 
|--------------------------------------- | ------------------------------------------- | -------------------- | ------ | -------------- | ---------------- | - | ------ | ---------- |  | - | ------------ | ------ |  | - | ------ | ------ | 
|                                        |                                             | Fiscal Quarter Ended |        |                | Six Months Ended |  
|                                        |                                             |                      |        |                |                  |  
|                                        |                                             | January 1,           |        |                | December 27,     |   |        | January 1, |  |   | December 27, |       
|                                        |                                             | 2005                 |        |                | 2003             |   |        | 2005       |  |   | 2003         |       
|                                        |                                             |                      |        |                |                  |   |        |            |  |   |              |       
|                                        |                                             |                      |        | (In thousands) |                  |   |       
|EBITDA(a)                               |                                             | $                    | 29,252 |                |                  | $ | 36,395 |            |  | $ | 28,447       |        |  | $ | 37,147 |       
|Most directly comparable GAAP measures: |                                             |                      |        |                |                  |   |        |            |  |   |              |        |  |   |        |       
|                                        | Net income                                  |                      |        | 14,710         |                  |   |        | 19,290     |  |   |              | 11,619 |  |   |        | 17,340 | 
|                                        | Cash flows provided by operating activities |                      |        | 33,464         |                  |   |        | 33,929     |  |   |              | 26,059 |  |   |        | 34,724 | 






|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(a) | Our definition of EBITDA is earnings before interest, taxes,
    depreciation and amortization. We use EBITDA to determine a
    portion of our executive compensation, as our incentive
    compensation payments are partially based on our EBITDA
    performance measured against budget, and we believe EBITDA
    provides additional information for determining our ability to
    meet future debt service requirements. EBITDA is also widely
    used by us and others in our industry to evaluate and price
    potential acquisitions. Furthermore, EBITDA is commonly used by
    certain investors and analysts to analyze and compare companies
    on the basis of operating performance and to determine a
    companys ability to service and/or incur debt. EBITDA
    should not be construed as a substitute for net income or net
    cash provided by operating activities (all as determined in
    accordance with generally accepted accounting principles) for
    the purpose of analyzing our operating performance, financial
    position and cash flows as EBITDA is not defined by generally
    accepted accounting principles. Our computation of EBITDA may
    not be comparable to similar titled measures of other companies.

27



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|                               |  |                      |         |   |                  |   |         |            |  |   |              |   |  |   |         |  
|------------------------------ |  | -------------------- | ------- | - | ---------------- | - | ------- | ---------- |  | - | ------------ | - |  | - | ------- | -
|                               |  | Fiscal Quarter Ended |         |   | Six Months Ended |  
|                               |  |                      |         |   |                  |  
|                               |  | January 1,           |         |   | December 27,     |   |         | January 1, |  |   | December 27, |  
|                               |  | 2005                 |         |   | 2003             |   |         | 2005       |  |   | 2003         |  
|                               |  |                      |         |   |                  |   |         |            |  |   |              |  
|                               |  | (In thousands)       |        
|EBITDA(a)                      |  | $                    | 29,252  |   |                  | $ | 36,395  |            |  | $ | 28,447       |   |  | $ | 37,147  |  
|Depreciation and amortization  |  |                      | (4,556  | ) |                  |   | (3,890  | )          |  |   | (8,888       | ) |  |   | (7,692  | )
|Interest income (expense), net |  |                      | 25      |   |                  |   | (112    | )          |  |   | (32          | ) |  |   | (312    | )
|Provision for income taxes     |  |                      | (10,011 | ) |                  |   | (13,103 | )          |  |   | (7,908       | ) |  |   | (11,803 | )
|                               |  |                      |         |   |                  |   |         |            |  |   |              |  
|Net income                     |  | $                    | 14,710  |   |                  | $ | 19,290  |            |  | $ | 11,619       |   |  | $ | 17,340  |  
|                               |  |                      |         |   |                  |   |         |            |  |   |              |  



|                                          |                                                |                                           |         |        |                  |   |         |            |        |   |              |         |        |   |         |        |        | 
|----------------------------------------- | ---------------------------------------------- | ----------------------------------------- | ------- | ------ | ---------------- | - | ------- | ---------- | ------ | - | ------------ | ------- | ------ | - | ------- | ------ | ------ | 
|                                          |                                                | Fiscal Quarter Ended                      |         |        | Six Months Ended |  
|                                          |                                                |                                           |         |        |                  |  
|                                          |                                                | January 1,                                |         |        | December 27,     |   |         | January 1, |        |   | December 27, |        
|                                          |                                                | 2005                                      |         |        | 2003             |   |         | 2005       |        |   | 2003         |        
|                                          |                                                |                                           |         |        |                  |   |         |            |        |   |              |        
|                                          |                                                | (In thousands)                            |        
|EBITDA(a)                                 |                                                | $                                         | 29,252  |        |                  | $ | 36,395  |            |        | $ | 28,447       |         |        | $ | 37,147  |       
|Interest income (expense), net            |                                                |                                           | 25      |        |                  |   | (112    | )          |        |   | (32          | )       |        |   | (312    | )     
|Provision for income taxes                |                                                |                                           | (10,011 | )      |                  |   | (13,103 | )          |        |   | (7,908       | )       |        |   | (11,803 | )     
|Amortization of financing costs           |                                                |                                           | 40      |        |                  |   | 40      |            |        |   | 80           |         |        |   | 80      |       
|Deferred rent                             |                                                |                                           | (285    | )      |                  |   | (117    | )          |        |   | (412         | )       |        |   | (240    | )     
|Deferred taxes                            |                                                |                                           | (866    | )      |                  |   |        |            |        |   | (866         | )       |        |   |        |       
|Stock-based compensation                  |                                                |                                           | 3       |        |                  |   | 24      |            |        |   | 11           |         |        |   | 148     |       
|Provision for doubtful accounts           |                                                |                                           | 21      |        |                  |   | (77     | )          |        |   | (49          | )       |        |   | (140    | )     
|Other                                     |                                                |                                           | 30      |        |                  |   | 6       |            |        |   | (95          | )       |        |   | 10      |       
|Tax effect on non-qualified stock options |                                                |                                           | 62      |        |                  |   |        |            |        |   | 62           |         |        |   |        |       
|Changes in assets and liabilities:        |                                                |                                           |         |        |                  |   |         |            |        |   |              |         |        |   |         |       
|                                          | Merchandise inventory                          |                                           |         | 12,072 |                  |   |         | 32,946     |        |   |              | (12,228 | )      |   |         | 5,627  |       
|                                          | Accounts payable                               |                                           |         | (2,625 | )                |   |         | (27,854    | )      |   |              | 20,893  |        |   |         | (3,551 | )     
|                                          | Accrued expenses and other current liabilities |                                           |         | 9,324  |                  |   |         | 8,662      |        |   |              | 3,940   |        |   |         | 11,065 |       
|                                          | Other long-term liabilities                    |                                           |         | (1     | )                |   |         | (12        | )      |   |              | 58      |        |   |         | (119   | )     
|                                          | Other current assets and other assets          |                                           |         | (3,577 | )                |   |         | (2,869     | )      |   |              | (5,842  | )      |   |         | (3,188 | )     
|                                          |                                                |                                           |         |        |                  |   |         |            |        |   |              |        
|                                          |                                                | Net cash provided by operating activities |         | $      | 33,464           |   |         | $          | 33,929 |   |              | $       | 26,059 |   |         | $      | 34,724 | 
|                                          |                                                |                                           |         |        |                  |   |         |            |        |   |              |        





| |   |                                                                                                                                                  
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------
| |  | EBITDA does not reflect our current or future requirements for
    capital expenditures or contractual commitments;                              
|
| |  | EBITDA does not reflect changes in, or cash requirements for,
    our working capital needs;                                                     
|
| |  | EBITDA does not reflect the interest expense, or the cash
    requirements necessary to service interest or principal
    payments, on our debts;

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| |   |                                                                                                                                                                                                                                               
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Although depreciation and amortization are non-cash charges, the
    assets being depreciated and amortized will often have to be
    replaced in the future, and EBITDA does not reflect any cash
    requirements for such replacements; and
|
| |  | Other companies in our industry may calculate EBITDA differently
    than we do, limiting its usefulness as a comparative measure.                                                                                                            



Contractual Obligations and Commercial Commitments




|                             |  |       |         |           |           |   |             |           |  |            |             |  |  |             |         |  |       |   |     |  |  |   |     | 
|---------------------------- |  | ----- | ------- | --------- | --------- | - | ----------- | --------- |  | ---------- | ----------- |  |  | ----------- | ------- |  | ----- | - | --- |  |  | - | --- | 
|                             |  |       |         |           |           |   |             | Logistics |  |            |             |  | 
|                             |  |       |         | Operating |           |   | Merchandise |           |  | Initiative |             |  |  |             | Capital | 
|                             |  | Total |         |           | Leases(1) |   |             | Orders    |  |            | Obligations |  |  | Auto Leases |         |  | Lease |  
|                             |  |       |         |           |           |   |             |           |  |            |             |  |  |             |         |  |       |  
|Fiscal year ending:          |  |       |         |           |           |   |             |           |  |            |             |  |  |             |         |  |       |   |     |  |  |   |     | 
|2005                         |  | $     | 49,890  |           |           | $ | 23,161      |           |  | $          | 25,270      |  |  | $           | 1,250   |  |       | $ | 146 |  |  | $ | 63  | 
|2006                         |  |       | 48,525  |           |           |   | 45,719      |           |  |            |            |  |  |             | 2,500   |  |       |   | 181 |  |  |   | 125 | 
|2007                         |  |       | 45,279  |           |           |   | 42,295      |           |  |            |            |  |  |             | 2,500   |  |       |   | 129 |  |  |   | 355 | 
|2008                         |  |       | 33,831  |           |           |   | 33,824      |           |  |            |            |  |  |             |        |  |       |   | 7   |  |  |   |    | 
|2009                         |  |       | 21,250  |           |           |   | 21,250      |           |  |            |            |  |  |             |        |  |       |   |    |  |  |   |    | 
|Thereafter                   |  |       | 48,403  |           |           |   | 48,403      |           |  |            |            |  |  |             |        |  |       |   |    |  |  |   |    | 
|                             |  |       |         |           |           |   |             |           |  |            |             |  |  |             |         |  |       |  
|Total minimum lease payments |  | $     | 247,178 |           |           | $ | 214,652     |           |  | $          | 25,270      |  |  | $           | 6,250   |  |       | $ | 463 |  |  | $ | 543 | 
|                             |  |       |         |           |           |   |             |           |  |            |             |  |  |             |         |  |       |  






|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | We are also obligated for guarantees, subleases or assigned
    lease obligations for 23 of the franchise stores through 2011.
    The majority of the guarantees, subleases and assigned lease
    obligations were given when we sold stores in 1999 as part of
    its restructuring. The guarantees, subleases and assigned lease
    obligations continue until the leases expire. The maximum amount
    of the guarantees, subleases and assigned lease obligations may
    vary, but is limited to the sum of the total amount due under
    the lease. As of January 1, 2005, the maximum amount of the
    guarantees, subleases and assigned lease obligations was
    approximately $13.9 million, which is not included in the
    table above.



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Off-Balance Sheet Arrangements




Seasonality






30



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Recent Accounting Pronouncements










Forward-Looking Statements









|        |                                                               
|------- | --------------------------------------------------------------
|Item 3. | Quantitative and Qualitative Disclosures About Market
    Risk



31



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|        |                        
|------- | -----------------------
|Item 4. | Controls and Procedures







32



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PART II.


OTHER INFORMATION







|        |                  
|------- | -----------------
|Item 1. | Legal Proceedings








|        |                                                                
|------- | ---------------------------------------------------------------
|Item 2. | Unregistered Sales of Equity Securities and Use of
    Proceeds








|        |                                
|------- | -------------------------------
|Item 3. | Defaults Upon Senior Securities








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





|                      |  |     |            |  |          |  |           | 
|--------------------- |  | --- | ---------- |  | -------- |  | --------- | 
|Name                  |  | For |            |  | Withheld | 
|                      |  |     |            |  |          | 
|Ralph D. Dillon       |  |     | 10,120,198 |  |          |  | 2,115,131 | 
|L.R. Jalenak, Jr.     |  |     | 10,707,308 |  |          |  | 1,528,021 | 
|Franklin R. Johnson   |  |     | 10,899,190 |  |          |  | 1,336,139 | 
|Howard Levkowitz      |  |     | 10,933,791 |  |          |  | 1,301,538 | 
|Nancy Pedot           |  |     | 10,122,496 |  |          |  | 2,112,833 | 
|Walter J. Salmon      |  |     | 10,700,424 |  |          |  | 1,534,905 | 
|Michael E. Tennenbaum |  |     | 10,977,902 |  |          |  | 1,257,427 | 






|        |                  
|------- | -----------------
|Item 5. | Other Information







33



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##### Table of Contents










|        |         
|------- | --------
|Item 6. | Exhibits



34



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SIGNATURES






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



| |    |                
| | -- | ---------------
| | By | /s/ Nancy Pedot

| |                              
| | -----------------------------
| |                              
| | Nancy Pedot                  
| | Chief Executive Officer      
| | (principal executive officer)



| |    |                     
| | -- | --------------------
| | By | /s/ Gregg A. Melnick

| |                              
| | -----------------------------
| |                              
| | Gregg A. Melnick             
| | Chief Financial Officer      
| | (principal financial officer)



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##### Table of Contents






EXHIBIT INDEX


|        |    |     |  |                                                                                                                                                                                                                                                                                                                                                                          
|------- | -- | --- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |    |     | 
|No.     |    |     | 
|        |    |     | 
|        | 3  | .1  |  | Amended and Restated Certificate of Incorporation of the
    Company, incorporated by reference from the Companys
    Quarterly Report on Form 10-Q as filed with the SEC on
    May 17, 2004 (the S-1).                                                                                                                                                              
|       
|        | 3  | .2  |  | Bylaws of the Company as amended, incorporated by reference from
    the Companys Quarterly Report on Form 10-Q as filed
    with the SEC on November 12, 2003 (the November 2003
    10-Q).                                                                                                                                                                          
|       
|        | 4  | .1  |  | Specimen stock certificate evidencing the Common Stock,
    incorporated by reference from the Companys Registration
    Statement as amended on Form S-1 Number 333-00350 as
    filed with the SEC on January 18, 1996 (the
    S-1).                                                                                                                               
|       
|        | 10 | .1  |  | Form of Unit Franchise Agreement entered into by the Company and
    franchisees, incorporated by reference from the S-1.                                                                                                                                                                                                                                                
|       
|        | 10 | .2  |  | Amended and Restated Investor Rights Agreement, dated as of
    August 18, 2003, by and among the Company and the
    Investors, incorporated by reference from the Companys
    Annual Report on Form 10-K as filed with the SEC on
    September  26, 2003 (the September 2003
    10-K).                                                                           
|       
|        | 10 | .3  |  | Description of oral consulting agreement between the Company and
    Ralph Dillon, incorporated by reference from the Companys
    Quarterly Report on Form  10-Q as filed with the SEC
    on February 13, 2001.                                                                                                                                                       
|       
|        | 10 | .4  |  | Employment Agreement of Steven Skiba, dated as of
    November 29, 2002, by and between the Company and Steven
    Skiba, incorporated by reference from the September 2003 10-K.                                                                                                                                                                                        
|       
|        | 10 | .5  |  | Employment Agreement of Linda Siluk, dated as of
    November 7, 2003, by and between the Company and Linda M.
    Siluk, incorporated by reference from the November 2003 10-Q.                                                                                                                                                                                         
|       
|        | 10 | .6  |  | Employment Agreement of Warren Jeffrey, dated as of
    November 7, 2003, by and between the Company and Warren
    Jeffery, incorporated by reference from the November 2003 10-Q.
    This Employment Agreement was terminated as of
    January  8, 2005, as specified in the Companys
    Current Report on Form 8-K as filed with the SEC on
    December 30, 2004.
|       
|        | 10 | .7  |  | Employment Agreement of Richard H. Griner dated as of
    January 12, 2004, by and between the Company and Richard H.
    Griner, incorporated by reference from the February 2004 10-Q.                                                                                                                                                                                 
|       
|        | 10 | .8  |  | Employment Agreement of Gregg A. Melnick, dated as of
    September 7, 2004, by and between the Company and Gregg A.
    Melnick incorporated by reference from the Companys
    Current Report on Form 8-K as filed on September 9,
    2004.                                                                                                                          
|       
|        | 10 | .9  |  | Separation Agreement of Linda M. Siluk, dated as of
    September 30, 2004, by and between the Company and Linda M.
    Siluk, incorporated by reference from the Companys Current
    Report on Form 8-K as filed with the SEC on October 1,
    2004.                                                                                                                 
|       
|        | 10 | .10 |  | Employment Agreement of Lisa Laube, dated as of April 26,
    2004, by and between the Company and Lisa Laube incorporated by
    reference from the Companys Current Report on
    Form 10-Q as filed with the SEC on November 12, 2004.                                                                                                                               
|       
|        | 10 | .11 |  | Employment Agreement of Nancy Pedot, dated December 23,
    2004, by and between the Company and Nancy Pedot, incorporated
    by reference from the Companys Current Report on
    Form 8-K as filed with the SEC on December 27, 2004.                                                                                                                                
|       
|        | 10 | .12 |  | Management Stock Purchase Plan of the Company, incorporated by
    reference from the Registration of Form S-8 as filed with
    the SEC on July 23, 2001.                                                                                                                                                                                                               
|       
|        | 10 | .13 |  | Employee Stock Purchase Plan of the Company, incorporated by
    reference from the Companys Definitive Proxy Statement for
    the 2001 Annual Meeting of Stockholders, included within
    Form 14-A as filed with the Commission on October 18,
    2001.                                                                                                            
|       
|        | 10 | .14 |  | Amended and Restated 1994 Stock Option Plan, incorporated by
    reference from the Registration of Form S-8 as filed with
    the SEC on January 9, 1997.                                                                                                                                                                                                               

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|        |     |     |  |                                                                                                                                                                                                                                                                                                                                                                                                                       
|------- | --- | --- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |     |     | 
|No.     |     |     | 
|        |     |     | 
|       
|        | 10  | .15 |  | 1999 Stock Incentive Plan (Amended and Restated as of
    October 17, 2003), incorporated by reference from the
    Companys Definitive Proxy Statement for the 2003 Annual
    Meeting of Stockholders included within Form 14-A as filed
    with the SEC on October 20, 2003.                                                                                                                                     
|       
|        | *10 | .16 |  | Form of Employee Stock Option Agreement (1999 Stock Incentive
    Plan).                                                                                                                                                                                                                                                                                                                                              
|       
|        | *10 | .17 |  | Forms of Non-Employee Director Stock Option Agreement (1999
    Stock Incentive Plan).                                                                                                                                                                                                                                                                                                                                
|       
|        | *10 | .18 |  | Summary of Fiscal Year 2005 Corporate Bonus Plan.                                                                                                                                                                                                                                                                                                                                                                     
|       
|        | *10 | .19 |  | Compensation Payable to Non-Employee Directors.                                                                                                                                                                                                                                                                                                                                                                       
|       
|        | 10  | .20 |  | Loan and Security Agreement (the Loan Agreement),
    dated January 9, 2003, by and between the Company and Wells
    Fargo Retail Finance, LLC (WFRF), as the arranger,
    collateral agent and administrative agent, and Fleet Retail
    Finance, Inc., as the documentation agent, incorporated by
    reference from the Companys Current Report on
    Form 8-K as filed with the SEC on January 10, 2003.
|       
|        | *10 | .21 |  | First Amendment to the Loan Agreement (included herein as
    Exhibit 10.20), dated February 10, 2005 by and between
    the Company and Wells Fargo Retail Finance, LLC.                                                                                                                                                                                                                                             
|       
|        | 10  | .22 |  | Stock Pledge Agreement, dated January 9, 2003, by and among
    the Company, Party City Michigan, Inc. (PCMI) and
    WFRF, as the arranger, collateral agent and administrative agent
    for the lender group under the Loan Agreement, incorporated by
    reference from the September 2003 10-K.                                                                                                               
|       
|        | 10  | .23 |  | Trademark Security Agreement, dated January 9, 2003, by and
    between the Company and WFRF, as the arranger, collateral agent
    and administrative agent for the lender group under the Loan
    Agreement, incorporated by reference from the September 2003
    10-K.                                                                                                                                           
|       
|        | 10  | .24 |  | Copyright Security Agreement, dated January 9, 2003, by and
    between the Company and WFRF, as the arranger, collateral agent
    and administrative agent for the lender group under the Loan
    Agreement, incorporated by reference from the September 2003
    10-K.                                                                                                                                           
|       
|        | 10  | .25 |  | Guaranty and Security Agreement, dated January 9, 2003, by
    and between PCMI and WFRF, as the arranger, collateral agent and
    administrative agent for the lender group under the Loan
    Agreement, incorporated by reference from the September 2003
    10-K.                                                                                                                                               
|       
|        | 10  | .26 |  | Agreement of Lease, dated September 16, 2004, by and
    between the Company and North Jersey Green 501, LLC, for the
    Companys new corporate headquarters, incorporated by
    reference from the Companys Current Report on
    Form 8-K as filed with the SEC on September 20, 2004.                                                                                                                          
|       
|        | *10 | .27 |  | First Modification of Agreement of Lease (included herein as
    Exhibit 10.26), dated January 26, 2005 by and between
    the Company and North Jersey Green 501, LLC.                                                                                                                                                                                                                                               
|       
|        | *15 | .1  |  | Awareness Letter of Deloitte & Touche LLP.                                                                                                                                                                                                                                                                                                                                                                            
|       
|        | *31 | .1  |  | Certification of Chief Executive Officer pursuant to
    18 U.S.C. Section 1350, as adopted pursuant to
    Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                            
|       
|        | *31 | .2  |  | Certification of Chief Financial Officer pursuant to
    18 U.S.C. Section 1350, as adopted pursuant to
    Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                            
|       
|        | *32 | .1  |  | Certification of Chief Executive Officer pursuant to
    18 U.S.C. Section 1350, as adopted pursuant to
    Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                            
|        | *32 | .2  |  | Certification of Chief Financial Officer pursuant to
    18 U.S.C. Section 1350, as adopted pursuant to
    Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                            






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

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM


















| |                      
| | ---------------------
| | DELOITTE & TOUCHE LLP





38