##### Table of Contents









SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549




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Form 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934



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|                               |  |                        |         | 
|------------------------------ |  | ---------------------- | ------- | 
|For the quarterly period ended |  | Commission file number
|October 2, 2004                |  |                        | 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




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Indicate
by check mark whether the registrant: (1) has filed all
reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding
12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been
subject to such filing requirements for the past
90 days.     Yes þ          No: o

Indicate
by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange
Act).     Yes þ          No: o

Indicate the number of shares outstanding of each
of the issuers classes of common stock as of the latest
practicable date:

As of October 22, 2004, there were
17,145,573 shares of Common Stock, $0.01 par value,
outstanding.



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TABLE OF CONTENTS

|                                                  |  |                                                                                                                             |    |          |    | 
|------------------------------------------------- |  | --------------------------------------------------------------------------------------------------------------------------- | -- | -------- | -- | 
|                                                  |  |                                                                                                                             |    | Page No.
|                                                  |  |                                                                                                                             |    |         
|PART I FINANCIAL
    INFORMATION                 
|Item 1.                                           |  | Financial Statements
    (Unaudited)                                                                                        |    |          |    | 
|                                                  |  | Condensed Consolidated
    Balance Sheets as of October 2, 2004, July 3, 2004 and
    September 27, 2003                    |    |          | 2  | 
|                                                  |  | Condensed Consolidated
    Statements of Operations for the fiscal quarter ended
    October 2, 2004 and September 27, 2003 |    |          | 3  | 
|                                                  |  | Condensed Consolidated
    Statements of Cash Flows for the fiscal quarter ended
    October 2, 2004 and September 27, 2003 |    |          | 4  | 
|                                                  |  | Notes to Condensed
    Consolidated Financial Statements                                                                    |    |          | 5  | 
|Item 2.                                           |  | Managements Discussion
    and Analysis of Financial Condition and Results of Operations                                   |    |          | 13 | 
|Item 3.                                           |  | Quantitative and Qualitative
    Disclosures About Market Risk                                                              |    |          | 26 | 
|Item 4.                                           |  | Controls and Procedures                                                                                                     |    |          | 26 | 
|PART II OTHER
    INFORMATION                    
|Item 1.                                           |  | Legal Proceedings                                                                                                           |    |          | 27 | 
|Item 2.                                           |  | Unregistered Sales of Equity
    Securities and Use of Proceeds                                                             |    |          | 27 | 
|Item 3.                                           |  | Defaults Upon Senior
    Securities                                                                                         |    |          | 27 | 
|Item 4.                                           |  | Submission of Matters to a
    Vote of Security Holders                                                                     |    |          | 27 | 
|Item 5.                                           |  | Other Information                                                                                                           |    |          | 27 | 
|Item 6.                                           |  | Exhibits                                                                                                                    |    |          | 27 | 
|Signatures                                        |  |                                                                                                                             | 28 |         
|Exhibit Index                                     |  |                                                                                                                             | 29 |         
|EX-10.12 EMPLOYMENT AGREEMENT FOR LISA LAUBE     
|EX-15.1 AWARENESS LETTER OF DELOITTE & TOUCHE LLP
|EX-31.1 CERTIFICATION                            
|EX-31.2 CERTIFICATION                            
|EX-32.1 CERTIFICATION                            
|EX-32.2 CERTIFICATION                            



References throughout this document to the
Company include Party City Corporation and its wholly-owned
subsidiary. In accordance with the Securities and Exchange
Commissions Plain English guidelines, this
Quarterly Report on Form 10-Q has been written in the first
person. In this document the words we,
our, ours and us refer only
to Party City Corporation and its wholly-owned subsidiary and
not to any other person.

Our website 
www.partycity.com  provides access, free of
charge, to our Securities and Exchange Commission
(SEC) reports, as soon as reasonably practicable
after we electronically file such reports with, or furnish such
reports to, the SEC, including proxy statements, Annual Reports
on Form 10-K, Quarterly Reports on Form 10-Q, Current
Reports on Form 8-K and amendments to these reports.

You may also read and copy any materials we file
with the SEC at the SECs Public Reference Room at
450 Fifth Street, NW, Washington, DC 20549. You may obtain
information on the operations of the Public Reference Room by
calling the SEC at 1-800-SEC-0330. The SEC maintains a website
that contains reports, proxy and information statements and
other information regarding issuers that file electronically
with the SEC, including us, at http://www.sec.gov.

1



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##### Table of Contents






PART I.

FINANCIAL INFORMATION





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

PARTY CITY CORPORATION AND
SUBSIDIARY



CONDENSED CONSOLIDATED BALANCE
SHEETS


(In thousands, except share
information)

(Unaudited)


|                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                            |        |         |         |               |        |        |         |  |        |        |         | 
|----------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ------ | ------- | ------- | ------------- | ------ | ------ | ------- |  | ------ | ------ | ------- | 
|                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                         | October 2,                                 |        | July 3, |         | September 27,
|                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                         | 2004                                       |        | 2004    |         | 2003         
|                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                            |        |         |         |              
|ASSETS                                               
|Current assets:                                       |                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                            |        |         |         |               |        |        |         |  |        |       
|                                                      | Cash and cash equivalents                                                                                                                                                                                                                                                                                                                                                                                                               |                                            | $      | 18,614  |         |               | $      | 27,845 |         |  | $      | 4,603  |        
|                                                      | Merchandise inventory                                                                                                                                                                                                                                                                                                                                                                                                                   |                                            |        | 81,657  |         |               |        | 57,357 |         |  |        | 93,227 |        
|                                                      | Deferred income taxes                                                                                                                                                                                                                                                                                                                                                                                                                   |                                            |        | 9,298   |         |               |        | 9,298  |         |  |        | 7,428  |        
|                                                      | Other current assets, net                                                                                                                                                                                                                                                                                                                                                                                                               |                                            |        | 13,735  |         |               |        | 11,371 |         |  |        | 14,932 |        
|                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                            |        |         |         |               |        |        |         |  |        |       
|                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                         | Total current assets                       |        |         | 123,304 |               |        |        | 105,871 |  |        |        | 120,190 | 
|Property and equipment, net                           |                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                            | 46,563 |         |         |               | 48,762 |        |         |  | 50,495 |       
|Goodwill                                              |                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                            | 18,614 |         |         |               | 18,614 |        |         |  | 18,614 |       
|Other assets                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                            | 4,082  |         |         |               | 4,170  |        |         |  | 5,234  |       
|                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                            |        |         |         |               |        |        |         |  |        |       
|                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                         | Total assets                               |        | $       | 192,563 |               |        | $      | 177,417 |  |        | $      | 194,533 | 
|                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                            |        |         |         |               |        |        |         |  |        |       
|                                                     
|LIABILITIES AND STOCKHOLDERS
    EQUITY             
|Current liabilities:                                  |                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                            |        |         |         |               |        |        |         |  |        |       
|                                                      | Accounts payable                                                                                                                                                                                                                                                                                                                                                                                                                        |                                            | $      | 61,882  |         |               | $      | 38,364 |         |  | $      | 64,841 |        
|                                                      | Accrued expenses and other current liabilities                                                                                                                                                                                                                                                                                                                                                                                          |                                            |        | 27,306  |         |               |        | 32,689 |         |  |        | 24,823 |        
|                                                      | Cash overdraft                                                                                                                                                                                                                                                                                                                                                                                                                          |                                            |        |        |         |               |        |       |         |  |        | 1,548  |        
|                                                      | Advances under Loan Agreement                                                                                                                                                                                                                                                                                                                                                                                                           |                                            |        |        |         |               |        |       |         |  |        | 15,171 |        
|                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                            |        |         |         |               |        |        |         |  |        |       
|                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                         | Total current liabilities                  |        |         | 89,188  |               |        |        | 71,053  |  |        |        | 106,383 | 
|Long-term liabilities:                                |                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                            |        |         |         |               |        |        |         |  |        |       
|                                                      | Deferred rent and other long-term liabilities                                                                                                                                                                                                                                                                                                                                                                                           |                                            |        | 9,393   |         |               |        | 9,526  |         |  |        | 10,034 |        
|Commitments and contingencies (see Notes 7
    and 9) |                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                            |        |         |         |               |        |        |         |  |        |       
|Stockholders equity:                                 |                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                            |        |         |         |               |        |        |         |  |        |       
|                                                      | Common stock, $0.01 par value;
    40,000,000 shares authorized at October 2, 2004 and
    July 3, 2004 and 25,000,000 shares authorized at
    September 27, 2003; 17,871,210 shares issued and
    17,124,198 shares outstanding at October 2, 2004;
    17,835,778 shares issued and 17,088,766 shares
    outstanding at July 3, 2004; and 17,425,070 shares
    issued and 16,678,058 shares outstanding at
    September 27, 2003 |                                            |        | 179     |         |               |        | 178    |         |  |        | 174    |        
|                                                      | Additional paid-in capital                                                                                                                                                                                                                                                                                                                                                                                                              |                                            |        | 46,917  |         |               |        | 46,683 |         |  |        | 43,821 |        
|                                                      | Retained earnings                                                                                                                                                                                                                                                                                                                                                                                                                       |                                            |        | 52,826  |         |               |        | 55,917 |         |  |        | 40,061 |        
|                                                      | Treasury stock, at cost (747,012 shares for
    all periods presented)                                                                                                                                                                                                                                                                                                                                                                  |                                            |        | (5,940  | )       |               |        | (5,940 | )       |  |        | (5,940 | )      
|                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                            |        |         |         |               |        |        |         |  |        |       
|                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                         | Total stockholders equity                 |        |         | 93,982  |               |        |        | 96,838  |  |        |        | 78,116  | 
|                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                            |        |         |         |               |        |        |         |  |        |       
|                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                         | Total liabilities and stockholders equity |        | $       | 192,563 |               |        | $      | 177,417 |  |        | $      | 194,533 | 
|                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                            |        |         |         |               |        |        |         |  |        |       

See accompanying notes to condensed consolidated
financial statements.

2



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##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY



CONDENSED CONSOLIDATED STATEMENTS OF
OPERATIONS


(In thousands, except per share
amounts)

(Unaudited)


|               |                                                             |                      |        |               |         |   |        |         |         | 
|-------------- | ----------------------------------------------------------- | -------------------- | ------ | ------------- | ------- | - | ------ | ------- | ------- | 
|               |                                                             |                     
|               |                                                             | Fiscal Quarter Ended
|               |                                                             |                     
|               |                                                             | October 2,           |        | September 27,
|               |                                                             | 2004                 |        | 2003         
|               |                                                             |                      |        |              
|Revenues:      |                                                             |                      |        |               |         |   |        |        
|               | Net sales                                                   |                      | $      | 98,602        |         |   | $      | 102,620 |        
|               | Royalty fees                                                |                      |        | 3,827         |         |   |        | 3,908   |        
|               | Franchise fees                                              |                      |        | 120           |         |   |        | 447     |        
|               |                                                             |                      |        |               |         |   |        |        
|               |                                                             | Total revenues       |        |               | 102,549 |   |        |         | 106,975 | 
|Expenses:      |                                                             |                      |        |               |         |   |        |        
|               | Cost of goods sold and occupancy costs                      |                      |        | 71,857        |         |   |        | 74,328  |        
|               | Company-owned stores operating and selling expense          |                      |        | 24,259        |         |   |        | 25,879  |        
|               | Franchise expense                                           |                      |        | 1,848         |         |   |        | 1,659   |        
|               | General and administrative expense                          |                      |        | 9,722         |         |   |        | 8,159   |        
|               |                                                             |                      |        |               |         |   |        |        
|               |                                                             | Total expenses       |        |               | 107,686 |   |        |         | 110,025 | 
|               |                                                             |                      |        |               |         |   |        |        
|Operating loss |                                                             |                      | (5,137 | )             |         |   | (3,050 | )      
|               | Interest income                                             |                      |        | (54           | )       |   |        | (4      | )      
|               | Interest expense                                            |                      |        | 111           |         |   |        | 204     |        
|               |                                                             |                      |        |               |         |   |        |        
|               | Interest expense, net                                       |                      |        | 57            |         |   |        | 200     |        
|               |                                                             |                      |        |               |         |   |        |        
|               | Loss before income taxes                                    |                      |        | (5,194        | )       |   |        | (3,250  | )      
|               | Benefit from income taxes                                   |                      |        | (2,103        | )       |   |        | (1,300  | )      
|               |                                                             |                      |        |               |         |   |        |        
|Net loss       |                                                             | $                    | (3,091 | )             |         | $ | (1,950 | )      
|               |                                                             |                      |        |               |         |   |        |        
|               | Basic and diluted loss per share                            |                      | $      | (0.18         | )       |   | $      | (0.12   | )      
|               |                                                             |                      |        |               |         |   |        |        
|               | Weighted average shares outstanding 
    basic and diluted |                      |        | 17,105        |         |   |        | 16,599  |        
|               |                                                             |                      |        |               |         |   |        |        

See accompanying notes to condensed consolidated
financial statements.

3



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##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY



CONDENSED CONSOLIDATED STATEMENTS OF CASH
FLOWS


(In thousands)

(Unaudited)


|                                                                                              |                                                             |                                                |                                                         |               |         |        |       |        |         |        |  
|--------------------------------------------------------------------------------------------- | ----------------------------------------------------------- | ---------------------------------------------- | ------------------------------------------------------- | ------------- | ------- | ------ | ----- | ------ | ------- | ------ | -
|                                                                                              |                                                             |                                               
|                                                                                              |                                                             | Fiscal Quarter Ended                          
|                                                                                              |                                                             |                                               
|                                                                                              |                                                             | October 2,                                     |                                                         | September 27,
|                                                                                              |                                                             | 2004                                           |                                                         | 2003         
|                                                                                              |                                                             |                                                |                                                         |              
|Cash flow from operating activities:                                                          |                                                             |                                                |                                                         |               |         |        |       |       
|                                                                                              | Net loss                                                    |                                                | $                                                       | (3,091        | )       |        | $     | (1,950 | )      
|Adjustments to reconcile net loss to net cash
    (used in) provided by operating activities: |                                                             |                                                |                                                         |               |         |        |       |       
|                                                                                              | Depreciation and amortization                               |                                                |                                                         | 4,332         |         |        |       | 3,802  |        
|                                                                                              | Amortization of financing costs                             |                                                |                                                         | 40            |         |        |       | 40     |        
|                                                                                              | Deferred rent                                               |                                                |                                                         | (127          | )       |        |       | (123   | )      
|                                                                                              | Stock-based compensation                                    |                                                |                                                         | 7             |         |        |       | 37     |        
|                                                                                              | Provision for doubtful accounts                             |                                                |                                                         | (70           | )       |        |       | (63    | )      
|                                                                                              | Other                                                       |                                                |                                                         | (125          | )       |        |       | 4      |        
|                                                                                              | Changes in assets and liabilities:                          |                                                |                                                         |               |         |        |       |        |        
|                                                                                              |                                                             | Merchandise inventory                          |                                                         |               | (24,301 | )      |       |        | (27,319 | )     
|                                                                                              |                                                             | Accounts payable                               |                                                         |               | 23,518  |        |       |        | 24,303  |       
|                                                                                              |                                                             | Accrued expenses and other current liabilities |                                                         |               | (5,383  | )      |       |        | 2,403   |       
|                                                                                              |                                                             | Other long-term liabilities                    |                                                         |               | 60      |        |       |        | (20     | )     
|                                                                                              |                                                             | Other current assets and other assets          |                                                         |               | (2,264  | )      |       |        | (319    | )     
|                                                                                              |                                                             |                                                |                                                         |               |         |        |       |       
|                                                                                              |                                                             |                                                | Net cash (used in) provided by operating
    activities |               |         | (7,404 | )     |        |         | 795    |  
|Cash flow from investing activities:                                                          |                                                             |                                                |                                                         |               |         |        |       |       
|                                                                                              | Purchases of property and equipment                         |                                                |                                                         | (2,252        | )       |        |       | (1,448 | )      
|                                                                                              | Proceeds from the sale of assets                            |                                                |                                                         | 250           |         |        |       |       |        
|                                                                                              |                                                             |                                                |                                                         |               |         |        |       |       
|                                                                                              |                                                             |                                                | Net cash used in investing activities                   |               |         | (2,002 | )     |        |         | (1,448 | )
|Cash flow from financing activities:                                                          |                                                             |                                                |                                                         |               |         |        |       |       
|                                                                                              | Proceeds from exercise of stock options                     |                                                |                                                         | 175           |         |        |       | 520    |        
|                                                                                              | Net proceeds from Loan Agreement                            |                                                |                                                         |              |         |        |       | 3,942  |        
|                                                                                              | Change in cash overdrafts                                   |                                                |                                                         |              |         |        |       | (2,578 | )      
|                                                                                              |                                                             |                                                |                                                         |               |         |        |       |       
|                                                                                              |                                                             |                                                | Net cash provided by financing activities               |               |         | 175    |       |        |         | 1,884  |  
|                                                                                              |                                                             |                                                |                                                         |               |         |        |       |       
|Net (decrease) increase in cash and cash
    equivalents                                      |                                                             |                                                | (9,231                                                  | )             |         |        | 1,231 |       
|Cash and cash equivalents, beginning of period                                                |                                                             |                                                | 27,845                                                  |               |         |        | 3,372 |       
|                                                                                              |                                                             |                                                |                                                         |               |         |        |       |       
|Cash and cash equivalents, end of period                                                      |                                                             | $                                              | 18,614                                                  |               |         | $      | 4,603 |       
|                                                                                              |                                                             |                                                |                                                         |               |         |        |       |       
|Supplemental disclosure of cash flow information:                                             |                                                             |                                                |                                                         |               |         |        |       |       
|                                                                                              | Income taxes paid                                           |                                                | $                                                       | 1,200         |         |        | $     | 788    |        
|                                                                                              | Interest paid                                               |                                                |                                                         | 70            |         |        |       | 165    |        
|Supplemental disclosure of non-cash financing
    activity:                                   |                                                             |                                                |                                                         |               |         |        |       |       
|                                                                                              | Issuance of shares under management stock
    purchase plan |                                                | $                                                       | 53            |         |        | $     | 87     |        

See accompanying notes to condensed consolidated
financial statements.

4



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##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY



NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS




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

Party City Corporation (together with its
wholly-owned subsidiary, the Company) is
incorporated in the State of Delaware and operates retail party
supply stores within the United States and sells franchises on
an individual store and area basis throughout the United States
and Puerto Rico. The condensed consolidated unaudited financial
statements have been prepared in accordance with the rules and
regulations established by the Securities and Exchange
Commission (SEC). In the opinion of management, the
accompanying condensed consolidated financial statements contain
all adjustments (consisting only of normal recurring accruals)
necessary to present fairly the financial position of the
Company as of October 2, 2004 and September 27, 2003
and the results of operations and cash flows for the quarters
ended October 2, 2004 and September 27, 2003. All
significant intercompany accounts and transactions have been
eliminated. Because of the seasonality of the party goods
industry, operating results of the Company on a quarterly basis
may not be indicative of operating results for the full fiscal
year.

These condensed consolidated financial statements
should be read in conjunction with the Companys audited
consolidated financial statements for the year ended
July 3, 2004, which are included in the Companys
Annual Report on Form 10-K with respect to such period
filed with the Securities and Exchange Commission on
September 14, 2004 (the 2004 10-K). The
July 3, 2004 condensed consolidated balance sheet amounts
included herein are derived from the Companys audited
consolidated financial statements.

The Companys fiscal year ends the Saturday
nearest to June 30. As used herein, the term Fiscal
Year or Fiscal refers to the 52- or 53-week
period, as applicable, ending the Saturday nearest to
June 30. Fiscal 2005 is a 52-week period ending
July 2, 2005, while Fiscal 2004 is a 53-week period that
ended July 3, 2004. However, the financial results for the
fiscal quarter ended October 2, 2004 and September 27,
2003 are each based on a 13-week period.

Certain reclassifications have been made to the
condensed consolidated financial statements in prior periods to
conform to the current period presentation.



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

The Companys significant accounting
policies are described in Note 1 to the consolidated
financial statements included in the 2004 10-K.

During the first quarter of Fiscal 2005, the
Company launched its supply chain initiative, which includes
modifying its business operations to vertically integrate
certain logistics and distribution activities, and therefore
adopted new specific accounting policies for the treatment of
the costs associated with the modified distribution network. The
Company has outsourced the operations of its modified
distribution network to a third party. The Companys
distribution costs include the fees and expenses of operating
the distribution centers and the freight expense related to
transporting merchandise to the stores. These distribution costs
are initially capitalized into merchandise inventory and
expensed when the merchandise is sold in the stores.



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

The Company periodically grants stock options to
employees. Pursuant to Accounting Principles Board Opinion
No. 25, Accounting for Stock Issued to
Employees, the Company accounts for stock-based employee
compensation arrangements using the intrinsic value method. If
the options are granted to employees below fair market value,
compensation expense is recognized. The Company has adopted the
disclosure only provisions of Statement of Financial Accounting
Standards (SFAS) No. 123, Accounting for
Stock Based Compensation (SFAS No. 123),
as amended by SFAS No. 148, Accounting for Stock
Based Compensation  Transition and Disclosure, an
Amendment of SFAS No. 123 (SFAS
No. 148). If

5



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##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

compensation cost for the Companys stock
option plans had been determined in accordance with the fair
value method prescribed by SFAS No. 148, the
Companys net loss would have been:

|                                  |                                                                                                                                         |                       |        |               |   |   |        |        |  
|--------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------- | --------------------- | ------ | ------------- | - | - | ------ | ------ | -
|                                  |                                                                                                                                         |                      
|                                  |                                                                                                                                         | Fiscal Quarter Ended 
|                                  |                                                                                                                                         |                      
|                                  |                                                                                                                                         | October 2,            |        | September 27,
|                                  |                                                                                                                                         | 2004                  |        | 2003         
|                                  |                                                                                                                                         |                       |        |              
|                                  |                                                                                                                                         |                      
|                                  |                                                                                                                                         | (In thousands, except
|                                  |                                                                                                                                         | per share amounts)   
|Net loss as reported              |                                                                                                                                         | $                     | (3,091 | )             |   | $ | (1,950 | )     
|                                  | Add: Stock-based employee compensation expense
    determined under APB 25, net of tax                                                  |                       |        | 4             |   |   |        | 22     |  
|                                  | Deduct: Total stock-based employee compensation
    expense determined under fair value based method of
    SFAS No. 148, net of tax(1) |                       |        | (436          | ) |   |        | (136   | )
|                                  |                                                                                                                                         |                       |        |               |   |   |        |       
|                                  | Pro-forma net loss                                                                                                                      |                       | $      | (3,523        | ) |   | $      | (2,064 | )
|                                  |                                                                                                                                         |                       |        |               |   |   |        |       
|Basic and diluted loss per share: |                                                                                                                                         |                       |        |               |   |   |        |       
|                                  | Basic and diluted loss per share as reported                                                                                            |                       | $      | (0.18         | ) |   | $      | (0.12  | )
|                                  | Basic and diluted loss per share pro forma                                                                                              |                       | $      | (0.21         | ) |   | $      | (0.12  | )



---



|    |                                                                                                                                                                                                                                      
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(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 Ended
|                        |  |                     
|                        |  | October 2,           |           | September 27,
|                        |  | 2004                 |           | 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%      | 

The weighted average fair value of options
granted during the first quarter of Fiscal 2005 and 2004 were
$5.53 and $4.50, respectively.

6



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##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|   |               
|-- | --------------
|4. | Loss Per Share

The following table sets forth the computations
of basic and diluted loss per share:

|                                                                               |  |                       |        |               |  |   |        |  
|------------------------------------------------------------------------------ |  | --------------------- | ------ | ------------- |  | - | ------ | -
|                                                                               |  |                      
|                                                                               |  | Fiscal Quarter Ended 
|                                                                               |  |                      
|                                                                               |  | October 2,            |        | September 27,
|                                                                               |  | 2004                  |        | 2003         
|                                                                               |  |                       |        |              
|                                                                               |  |                      
|                                                                               |  | (In thousands, except
|                                                                               |  | per share amounts)   
|Net loss                                                                       |  | $                     | (3,091 | )             |  | $ | (1,950 | )
|Loss per share  basic and diluted(a)                                          |  | $                     | (0.18  | )             |  | $ | (0.12  | )
|Weighted average common shares outstanding                                     |  |                       | 17,105 |               |  |   | 16,599 |  
|Dilutive effect of stock options(a)(b)                                         |  |                       |       |               |  |   |       |  
|Dilutive effect of warrants(a)(c)                                              |  |                       |       |               |  |   |       |  
|Dilutive effect of restricted stock units(a)(d)                                |  |                       |       |               |  |   |       |  
|                                                                               |  |                       |        |               |  |   |        |  
|Weighted average common and potentially dilutive
    common shares outstanding |  |                       | 17,105 |               |  |   | 16,599 |  
|                                                                               |  |                       |        |               |  |   |        |  



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(a) | Stock options and warrants with exercise prices
    below the applicable market price of the Companys common
    stock and all restricted stock units are included in potentially
    dilutive common shares outstanding if the Company reports net
    income for a reporting period. Therefore, if the Company reports
    net income, its earnings per share would be lower on a diluted
    basis. Options to purchase 2,125,999 common shares with exercise
    prices ranging from $1.71 to $13.14 per share at
    October 2, 2004, and options to purchase 1,345,243 common
    shares with exercise prices ranging from $1.71 to
    $11.06 per share at September 27, 2003, would have
    been included in the weighted-average common and potentially
    dilutive common shares outstanding, respectively, if the Company
    was in a net income position.
|   
|    | However, when the Company incurs a net loss for a
    reporting period, the inclusion of any such shares would result
    in a decrease in loss per share, and therefore all stock
    options, warrants and restricted stock units are ignored when
    calculating diluted earnings per share. Therefore, the
    Companys loss per share for the quarter ended
    October 2, 2004 and September 27, 2003 are the same
    amounts on a basic and diluted basis, respectively.                                                                                                                                                                                                                                                                                                                                                                                       
|   
|(b) | Options to purchase 3,171,199 common shares
    with exercise prices ranging from $1.71 to $30.88 per share
    were outstanding at October 2, 2004, and options to
    purchase 2,080,618 common shares with exercise prices
    ranging from $1.71 to $30.88 per share were outstanding at
    September 27, 2003 were not included in the computation of
    diluted loss per share for the fiscal quarter ended
    October 2, 2004 and September 27, 2003, respectively,
    because to do so would have been anti-dilutive.                                                                                                                                                                                                                                                                                                                                        
|   
|(c) | Warrants to purchase 2,496,000 common shares
    with an exercise price of $1.07 per share were outstanding
    at October 2, 2004 and September 27, 2003 but were not
    included in the computation of diluted loss per share for the
    fiscal quarter ended October 2, 2004 and September 27,
    2003, respectively, because to do so would have been
    anti-dilutive.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   
|(d) | Restricted stock units of 13,567 and
    17,396 shares of common stock were outstanding at
    October 2, 2004 and September 27, 2003, respectively,
    related to the Management Stock Purchase Plan and were not
    included in the computation of diluted loss per share for the
    fiscal quarter ended October 2, 2004 and September 27,
    2003, respectively, because to do so would have been
    anti-dilutive.                                                                                                                                                                                                                                                                                                                                                                                                                                             

7



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##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



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

In January 2003, the Company entered into a
$65 million revolving credit facility (the Loan
Agreement) with Wells Fargo Retail Finance, LLC, as the
arranger, collateral agent and administrative agent, and Fleet
Retail Finance, Inc., as the documentation agent. Under the
terms of the Loan Agreement, the Company may borrow amounts
based on a percentage of its eligible inventory and credit card
receivables, subject to certain borrowing conditions and
customary sub-limits, reserves and other limitations. Interest
on each advance is charged, at the Companys option, at
(i) the adjusted Eurodollar rate per annum plus the
applicable margin, which is currently at 1.25%, or (ii) the
prime rate per annum less the applicable margin, which is
currently 0.25% (the Companys effective cost of borrowing
under the Loan Agreement is 4.50% at October 2, 2004). The
Loan Agreement matures on April 30, 2006 and is secured by
a lien on substantially all of the Companys assets.
Pursuant to the terms of the Loan Agreement, the Company had a
standby letter of credit of $3.7 million outstanding at
October 2, 2004. At October 2, 2004 and
October 22, 2004, the Company had no borrowings outstanding
under the Loan Agreement. Based on a percentage of current
eligible inventory and credit card receivables, the Company had
$51.3 million available to be borrowed under the Loan
Agreement at October 22, 2004.



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



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

The Companys authorized capital stock was
increased from 25,000,000 shares to 40,000,000 shares
of its common stock, $0.01 par value per share, at the
annual shareholders meeting on November 12, 2003. At
October 2, 2004 and September 27, 2003, there were
17,871,210 shares and 17,425,070 shares, respectively,
of the Companys common stock issued. At October 2,
2004 and September 27, 2003, there were 747,012 shares
of the Companys common stock held as treasury stock. At
October 2, 2004 and September 27, 2003, there were
17,124,198 shares and 16,678,058 shares, respectively,
of the Companys common stock outstanding.



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

In September 2001, the Board of Directors
authorized the Company to repurchase up to $15 million of
its outstanding common stock at a price not to exceed
$7.00 per share, which was amended on February 7, 2003
to a price not to exceed $10.00 per share. Stock
repurchases are made at the discretion of management. There were
no stock repurchases during Fiscal 2004 or the first quarter of
Fiscal 2005. As of October 2, 2004, the Company had
purchased 747,012 shares for an aggregate amount of
$5.9 million or 39.6% of the total amount to be purchased.



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

There were no warrant exercises in Fiscal 2004 or
the first quarter of Fiscal 2005. As of October 2, 2004,
the Company had 2,496,000 warrants outstanding with an exercise
price of $1.07 per share.



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

In June 2001, the Company established a
Management Stock Purchase Plan (MSPP). The MSPP
provides certain management employees of the Company the
opportunity to defer a portion of their incentive compensation
to acquire and maintain ownership of the Companys common
stock, with the intent to strengthen their commitment to the
welfare of the Company and to promote an identity of interest
among

8



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##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Company stockholders and these employees. The
amount deferred by the individual is held in restricted stock
units. The restricted stock units are converted into the
Companys common stock on a one-to-one basis upon vesting.
These restricted stock units are purchased at a discount of 20%
or 25%, depending on the amount of the individual deferral, from
the average price of Companys common stock on the
determination date. Such discounts vest at the end of three
years or seven years, selected by the participant, after the
determination date. The amortization of the discount is charged
to compensation expense over the deferral period. The
compensation expense attributable to the MSPP for the first
quarter of Fiscal 2005 and Fiscal 2004 was approximately $3,000
and $15,000, respectively, resulting in the obligation to issue
13,567 and 17,396 shares of common stock, respectively,
upon vesting and conversion.



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

In June 2001, the Company established an Employee
Stock Purchase Plan (ESPP). The ESPP provides
employees of the Company with an opportunity to purchase shares
of the Companys common stock at a discount of 15% through
accumulated payroll deductions. This plan qualifies as an
Employee Stock Purchase Plan under Section 423
of the Internal Revenue Code.



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

A lawsuit was filed on September 25, 2001
against Party City Corporation in Los Angeles Superior Court by
an assistant manager in one of the Companys California
stores for himself and on behalf of other members of an alleged
class of Party City store managers (the Class) who
claimed the Company misclassified the Class members as exempt
from California overtime wage and hour laws. The Class members
sought the disgorgement of overtime wages allegedly owed by the
Company to them but not paid and they also sought punitive
damages and statutory penalties.

On March 30, 2004, the parties reached an
agreement-in-principle to settle this lawsuit for
$5.5 million on a claims made basis, which
means that a payout to class members will only occur when claims
are actually made by Class members. Previously, the Company
recorded a pre-tax charge of $1.4 million related to this
lawsuit. In connection with the agreement-in-principle, the
Company recorded an additional pre-tax charge of
$4.1 million during the third quarter of Fiscal 2004 to
fully cover the settlement payments, attorneys fees and
the estimated expenses of administering the settlement.

On September 27, 2004, the Company entered
into a final settlement agreement which contained no material
changes from the aforementioned agreement-in-principle.

In addition to the foregoing, from time to time
the Company is involved in routine litigation incidental to the
conduct of the business. The Company is aware of no other
material existing or threatened litigation to which the Company
is or may be a party.



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

The Company reports two business
segments  retail and franchising. The retail segment
generates revenue primarily through the sale of third-party
branded party goods through Company-owned stores. The
franchising segment generates revenue through the imposition of
an initial one-time franchise fee that is paid upon the grant of
a new franchise and ongoing royalty payments by franchisees
based on retail sales.

SFAS No. 131, Disclosures about
Segments of an Enterprise and Related Information,
establishes standards for reporting information about operating
segments. This standard requires segmentation based on the
Companys internal organization and reporting of revenue
and operating income based upon internal accounting methods. The
Companys segments are designed to allocate resources
internally and provide a framework to determine management
responsibility. Additionally, the Companys financial
reporting systems present various data by segment for management
to run the business, including internal profit and loss

9



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##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

statements prepared on a basis consistent with
accounting principles generally accepted in the United States of
America.

The following table contains key financial
information of the Companys business segments (in
thousands):

|                                        |                           |                      |        |               |  |   |         |         | 
|--------------------------------------- | ------------------------- | -------------------- | ------ | ------------- |  | - | ------- | ------- | 
|                                        |                           |                     
|                                        |                           | Fiscal Quarter Ended
|                                        |                           |                     
|                                        |                           | October 2,           |        | September 27,
|                                        |                           | 2004                 |        | 2003         
|                                        |                           |                      |        |              
|Retail:                                 |                           |                      |        |               |  |   |         |        
|Net sales                               |                           | $                    | 98,602 |               |  | $ | 102,620 |        
|Cost of goods sold and occupancy costs  |                           |                      | 71,857 |               |  |   | 74,328  |        
|                                        |                           |                      |        |               |  |   |         |        
|Gross profit                            |                           |                      | 26,745 |               |  |   | 28,292  |        
|Store operating and selling expense     |                           |                      | 24,259 |               |  |   | 25,879  |        
|                                        |                           |                      |        |               |  |   |         |        
|Company-owned store profit contribution |                           |                      | 2,486  |               |  |   | 2,413   |        
|General and administrative expense      |                           |                      | 9,722  |               |  |   | 8,159   |        
|                                        |                           |                      |        |               |  |   |         |        
|Retail loss contribution                |                           | $                    | (7,236 | )             |  | $ | (5,746  | )      
|                                        |                           |                      |        |               |  |   |         |        
|                                        | Identifiable assets       |                      | $      | 189,966       |  |   | $       | 192,131 | 
|                                        | Depreciation/amortization |                      | $      | 4,332         |  |   | $       | 3,802   | 
|                                        | Capital expenditures      |                      | $      | 2,252         |  |   | $       | 1,448   | 
|Franchise:                              |                           |                      |        |               |  |   |         |        
|Royalty fees                            |                           | $                    | 3,827  |               |  | $ | 3,908   |        
|Franchise fees                          |                           |                      | 120    |               |  |   | 447     |        
|                                        |                           |                      |        |               |  |   |         |        
|Total franchise revenue                 |                           |                      | 3,947  |               |  |   | 4,355   |        
|Total franchise expense                 |                           |                      | 1,848  |               |  |   | 1,659   |        
|                                        |                           |                      |        |               |  |   |         |        
|Franchise profit contribution           |                           | $                    | 2,099  |               |  | $ | 2,696   |        
|                                        |                           |                      |        |               |  |   |         |        
|                                        | Identifiable assets       |                      | $      | 2,597         |  |   | $       | 2,402   | 
|                                        | Depreciation/amortization |                      | $      |              |  |   | $       |        | 
|                                        | Capital expenditures      |                      | $      |              |  |   | $       |        | 
|Total Company:                          |                           |                      |        |               |  |   |         |        
|Operating loss                          |                           | $                    | (5,137 | )             |  | $ | (3,050  | )      
|Interest expense, net                   |                           |                      | 57     |               |  |   | 200     |        
|                                        |                           |                      |        |               |  |   |         |        
|Loss before income taxes                |                           |                      | (5,194 | )             |  |   | (3,250  | )      
|Benefit from income taxes               |                           |                      | (2,103 | )             |  |   | (1,300  | )      
|                                        |                           |                      |        |               |  |   |         |        
|Net loss                                |                           | $                    | (3,091 | )             |  | $ | (1,950  | )      
|                                        |                           |                      |        |               |  |   |         |        
|                                        | Identifiable assets       |                      | $      | 192,563       |  |   | $       | 194,533 | 
|                                        | Depreciation/amortization |                      | $      | 4,332         |  |   | $       | 3,802   | 
|                                        | Capital expenditures      |                      | $      | 2,252         |  |   | $       | 1,448   | 

The Companys accounting policies are
described in Note 2 of the Companys condensed
consolidated financial statements included herein. The Company
has no inter-segment sales. No single customer accounts for 10%
or more of total revenues. All assets of the Company are located
in the United States, including Puerto Rico.

10



---



##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



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

As of October 2, 2004, the Companys
contractual obligations and commercial commitments are as
follows (in thousands);

|                       |  |       |         |           |  |             |         |             |  |             |        |           |  |   |       |  |  |   |     |  |  |   |    | 
|---------------------- |  | ----- | ------- | --------- |  | ----------- | ------- | ----------- |  | ----------- | ------ | --------- |  | - | ----- |  |  | - | --- |  |  | - | -- | 
|                       |  |       |         |           |  |             |         | Logistics   |  |             |        |          
|                       |  |       |         | Operating |  | Merchandise |         | Initiative  |  |             |        |          
|                       |  | Total |         | Leases    |  | Orders      |         | Obligations |  | Auto Leases |        | Severance
|                       |  |       |         |           |  |             |         |             |  |             |        |          
|Fiscal year ending:    |  |       |         |           |  |             |         |             |  |             |        |           |  |   |       |  |  |   |     |  |  |   |    | 
|2005                   |  | $     | 53,878  |           |  | $           | 34,703  |             |  | $           | 17,000 |           |  | $ | 1,875 |  |  | $ | 227 |  |  | $ | 73 | 
|2006                   |  |       | 47,834  |           |  |             | 45,153  |             |  |             |       |           |  |   | 2,500 |  |  |   | 181 |  |  |   |   | 
|2007                   |  |       | 44,236  |           |  |             | 41,611  |             |  |             |       |           |  |   | 2,500 |  |  |   | 125 |  |  |   |   | 
|2008                   |  |       | 33,326  |           |  |             | 33,322  |             |  |             |       |           |  |   |      |  |  |   | 4   |  |  |   |   | 
|2009                   |  |       | 21,243  |           |  |             | 21,243  |             |  |             |       |           |  |   |      |  |  |   |    |  |  |   |   | 
|Thereafter             |  |       | 48,296  |           |  |             | 48,296  |             |  |             |       |           |  |   |      |  |  |   |    |  |  |   |   | 
|                       |  |       |         |           |  |             |         |             |  |             |        |           |  |   |       |  |  |   |     |  |  |   |    | 
|Total minimum payments |  | $     | 248,813 |           |  | $           | 224,328 |             |  | $           | 17,000 |           |  | $ | 6,875 |  |  | $ | 537 |  |  | $ | 73 | 
|                       |  |       |         |           |  |             |         |             |  |             |        |           |  |   |       |  |  |   |     |  |  |   |    | 

The Company leases real estate in connection with
the operation of Company-owned retail stores as well as the
corporate offices. The store leases are for properties ranging
in size from 6,750 to 19,800 square feet. The terms range
from five years to twenty years. Of the leases for the
Company-owned stores, three expire in Fiscal 2005, 21 expire in
Fiscal 2006, 30 expire in Fiscal 2007, 59 expire in Fiscal 2008
and the balance expire in Fiscal 2009 or thereafter. The
Companys operating leases provide for step rent
provisions, renewal options from five years to ten years,
capital improvement funding, obligations for reimbursement of
common area maintenance and real estate taxes and other lease
concessions as applicable in each lease. The minimum lease
payments are recognized on a straight-line basis over the term
of each individual underlying lease. Certain leases contain
contingent rent based upon specified sales volume. The Company
paid $3,000 for contingent rent during the first quarter in each
of Fiscal 2005 and 2004.

On September 16, 2004, the Company entered
into a new corporate office lease for 106,000 square feet
of office space. The initial term is for 12 years, with two
five-year renewal options. The lease contains escalation clauses
and obligations for reimbursement of common area maintenance and
real estate taxes. The lease for the Companys current
corporate headquarters expires in December 2004, but the Company
is currently negotiating an extension of such lease for a period
of months to coincide with its transition to the new corporate
headquarters. The Company intends to relocate to the new
corporate headquarters by June 2005, and intends to vacate its
current corporate headquarters thereafter.

The Company is also obligated for guarantees,
subleases or assigned lease obligations for 23 of the
franchisees 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 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 October 2, 2004, the maximum amount of the guarantees,
subleases and assigned lease obligations was approximately
$15.0 million, which is not included in the table above.

The Company enters into arrangements to purchase
merchandise up to eight months in advance of expected delivery.
Historically, these purchase commitments did not contain any
significant termination payments or other penalties if
cancelled. Since the Company is transitioning toward selling
more proprietary product, certain of these purchase commitments
may obligate the Company to specified quantities, even if
desired quantities change at a later date. As of October 2,
2004, the Company had approximately $17 million of
proprietary product for which the Company has made purchase
arrangements.

11



---



##### Table of Contents



PARTY CITY CORPORATION AND
SUBSIDIARY


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Logistics initiative obligations include a
commitment for the purchase of selected equipment and services
associated with the operation of the distribution centers.

At October 2, 2004, the Company operated a
fleet of thirty-nine leased motor vehicles, primarily for the
district managers and regional management. The terms of these
leases generally run for 36 months and expire at various
times through September 2007.

In addition to the severance obligations
specified in the table above, as of October 2, 2004 and
October 22, 2004, the Company had an aggregate contingent
liability of up to $2.2 million related to potential
severance payments for 14 employees pursuant to their respective
employment agreements. As of October 2, 2004 and
October 22, 2004, the Company had a standby letter of
credit of $3.7 million pursuant to the Loan Agreement
relating to general liability and workers compensation insurance.



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

The Company has two non-compete agreements. One
is with a franchise owner and the other is with Paper Warehouse,
Inc. The Company also has trademark license agreements. All of
these agreements are included in other assets and are being
amortized using the straight-line method over the life of the
agreement. Amortization expense for these non-compete agreements
was $19,000 and $35,000 for the fiscal quarters ended
October 2, 2004 and September 27, 2003, respectively.
The following chart shows the amortization expense of these
intangibles by year until they are fully amortized (in
thousands):

|                           |  |                      |     | 
|-------------------------- |  | -------------------- | --- | 
|Fiscal Year Ending:        |  | Amortization Expense
|                           |  |                     
|2005                       |  | $                    | 82  | 
|2006                       |  |                      | 82  | 
|2007                       |  |                      | 82  | 
|2008                       |  |                      | 82  | 
|2009                       |  |                      | 20  | 
|Thereafter                 |  |                      | 14  | 
|                           |  |                      |     | 
|Total amortization expense |  | $                    | 362 | 
|                           |  |                      |     | 



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

In June 2004, the Financial Accounting Standards
Board (FASB) issued an interpretation of FASB
No. 143, Accounting for Asset Retirement
Obligations (FASB No. 143). This
interpretation clarifies the scope and timing of liability
recognition for conditional asset retirement obligations under
FASB No. 143 and is effective no later than the end of
Fiscal 2005. The Company has determined that this
interpretation, and the adoption of FASB No. 143, will not
have a material impact on the Companys condensed
consolidated results of operations, financial position or cash
flows.

In May 2004, the FASB issued FSP FAS 106-2
to provide guidance on accounting for the effects of the
Medicare Prescription Drug, Improvement and Modernization Act of
2003 (the Act), to employers that sponsor post-retirement health
care plans that provide prescription drug benefits. The Company
continues to sponsor a post-retirement healthcare plan for one
individual, and the Company does not provide such benefits to
any other employee and has no intention to do so in the future.
The Company has determined that FAS 106-2 will not have a
material impact on its consolidated results of operations,
financial position or cash flows.

In March 2004, the FASB published an Exposure
Draft, Share-Based Payment, an amendment of FASB
Statements No. 123 and No. 95. Under this FASB
proposal, all forms of share-based payment to employees,
including employee stock options, would be treated as
compensation and recognized in the income statement. This
proposed statement, if adopted, would be effective beginning in
Fiscal 2006. The Company currently accounts for stock options
under APB No. 25. The pro-forma impact of expensing options
is disclosed in Note 3 to the Companys condensed
consolidated financial statements included herein.

12



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

Overview

We operate retail party supply stores within the
continental United States and we sell franchises on an
individual store and area franchise basis throughout the United
States and Puerto Rico. As of October 2, 2004, our network
consisted of 508 stores, with 249 Company-owned stores and 259
stores owned by franchisees. We report two segments 
retail and franchising. The retail segment generates revenue
primarily through the sale of third-party branded party goods
through Company-owned stores. The franchising segment generates
revenue through the imposition of an initial one-time franchise
fee and ongoing royalty payments based on retail sales.

We continually strive to improve customer
satisfaction and strengthen our financial condition. We have
recently undertaken various initiatives to make fundamental
improvements in our business, profitability and cash flow. These
initiatives have primarily focused on our breadth and quality of
products and product pricing; logistics, including financial,
distribution and inventory systems; and building our talent
base. To date, most of our improvements have involved business
processes and infrastructure. While this effort has been
absolutely essential to support our future product initiatives,
our work is generally not yet visible to the customer and has
not yet positively impacted our net sales results. We believe
that our efforts will be more evident to the customer as we
transition our merchandise presentation and introduce
significant amounts of new non-seasonal product in the latter
part of this fiscal year.

With respect to our products, we are developing
proprietary processes to evaluate and select our product
assortment more efficiently and effectively. We are also
reconfiguring our in-store product layout to better align
product categories and facilitate an easier shopping experience
for our customers.

As discussed more fully in Part I,
Item 1. Business in our 2004 Form 10-K, we
are in the process of transitioning our product base through the
development of new, coordinated assortments within selected
product categories. We initially focused on enhancing our
seasonal merchandise (e.g., Summer Luau, Halloween, and
other seasonal categories) and the preliminary results
demonstrate the customer is responding positively. As a result
of the ongoing transition process in non-seasonal merchandise,
which currently represents approximately two-thirds of a typical
stores selling space and net sales volume, our financial
results for the first quarter of fiscal 2005 were impacted by a
decline in same store sales performance of non-seasonal
merchandise. In the third quarter of Fiscal 2005, we will begin
to remerchandise our stores to enhance our product presentation,
and will introduce significant amounts of new product and
coordinated assortments, which we anticipate to be completed
early in the fourth quarter of Fiscal 2005.

We also continue to benefit from our inventory
reduction initiative during the quarter in the form of store
labor efficiencies across our stores. During the fiscal quarter
ended October 2, 2004, our average inventory per store
declined 13% compared to the same period in Fiscal 2003,
primarily reflecting the disposal of the previous seasons
merchandise that we had traditionally maintained in our stores
at the end of such season. We continue to believe these
strategies will provide us with the flexibility to offer fresh
merchandise choices to our customers and still maintain a
sufficient variety and quantity of products to satisfy customer
needs.

Our initial phase of the logistics initiative was
completed in July 2004. We are now able to receive and
distribute products for our Company-owned stores from two
distribution centers  one in California and one in
Pennsylvania. This program supports weekly scheduling of store
deliveries, further reducing store labor requirements and
improving inventory accuracy. We have outsourced the operations
of our modified distribution network to a third party.
Additionally, a Preferred Carrier Process that was implemented
in Fiscal 2004 is expected to result in lower negotiated
transportation rates, better visibility on deliveries and higher
service levels. Currently, our capabilities include handling
single cartons of individual items from multiple vendors, as
well as cross-dock merchandise from other vendors
and then transport to the stores. Approximately 35% to 40% of
our total annual dollar volume is now being delivered under our
initial phase of the logistics initiatives.

Effective in the first half of calendar year
2005, all of our franchisees have agreed to participate in our
logistics program. This is anticipated to create efficiencies in
product purchasing, as well as cost savings from

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##### Table of Contents



joint deliveries (e.g., distribution
centers can better coordinate deliveries to Company-owned and
franchise stores in the same market). We anticipate making
certain system and inventory investments during the remainder of
Fiscal 2005 in preparation for the inclusion of, and the
transitioning of, our franchisees into our logistics program.


We have also focused on enhancing our information
systems, completing significant store and corporate system
installations. The investment in our store and corporate
information systems has improved certain store processes, such
as customer check-out, product replenishment, and inventory
management, and was a major contributor to the decline in store
labor costs during the past fiscal quarter. In addition, these
investments will provide the systemic foundation for our
logistics initiative. Working with our vendor partners and
third-party logistics providers, we are embarking on
enhancements that will further drive product in-stock positions
and lower our supply-chain network costs.

Another important initiative is the continuation
of making key investments in our employee base. During the first
quarter Fiscal 2005, we hired a new Chief Financial Officer and
Vice President of Marketing, and added employees in key
departments to support our initiatives in Merchandising,
Planning and Allocation and Logistics.

In connection with the implementation of these
initiatives, we have incurred significant initial expenses that
are disproportionate to our sales performance. However, we
anticipate these initial expenses will diminish over time. Most
importantly, these investment initiatives are anticipated to
improve customer experience and solidify brand recognition which
we believe will ultimately result in increased sales, reduced
expenses and, accordingly, greater net income.

Key Performance Indicators and
Statistics

We use a number of key indicators of financial
condition and operating results to evaluate the performance of
our business, including the following:

|                                                                         |  |                      |        |               |  |   |         |  
|------------------------------------------------------------------------ |  | -------------------- | ------ | ------------- |  | - | ------- | -
|                                                                         |  |                     
|                                                                         |  | Fiscal Quarter Ended
|                                                                         |  |                     
|                                                                         |  | October 2,           |        | September 27,
|                                                                         |  | 2004                 |        | 2003         
|                                                                         |  |                      |        |              
|Net sales (in thousands)                                                 |  | $                    | 98,602 |               |  | $ | 102,620 |  
|Total Company-owned store count                                          |  |                      | 249    |               |  |   | 247     |  
|Average same store net sales for Company owned
    stores (in thousands) |  | $                    | 400    |               |  | $ | 429     |  
|Same store average net sale per retail
    transaction(a)                |  | $                    | 19.09  |               |  | $ | 18.73   |  
|(Decrease) increase in same store net sales                              |  |                      | (5.2   | )%            |  |   | 3.9     | %
|Gross profit as a percent of net sales                                   |  |                      | 27.1   | %             |  |   | 27.6    | %
|Store profit contribution as a percent of net
    sales                  |  |                      | 2.5    | %             |  |   | 2.4     | %
|Basic and diluted loss per share                                         |  | $                    | (0.18  | )             |  | $ | (0.12   | )
|EBITDA(b) (in thousands)                                                 |  | $                    | (805   | )             |  | $ | 752     |  
|(Decrease) increase in franchise same store sales                        |  |                      | (2.9   | )%            |  |   | 3.3     | %



---



|    |  |                                                                                                                                                                   
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(a) |  | Same store 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 22.                                                                                                                                 

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##### Table of Contents



The following table shows the growth in our
network of Company-owned and franchise stores for the quarter
ended October 2, 2004 and September 27, 2003.

|                        |                |                                             |                              |               |     |     |     |  |     |     |  
|----------------------- | -------------- | ------------------------------------------- | ---------------------------- | ------------- | --- | --- | --- |  | --- | --- | -
|                        |                |                                            
|                        |                | Fiscal Quarter Ended                       
|                        |                |                                            
|                        |                | October 2,                                  |                              | September 27,
|                        |                | 2004                                        |                              | 2003         
|                        |                |                                             |                              |              
|Store Data:             |                |                                             |                              |               |     |     |     | 
|                        | Company-owned: |                                             |                              |               |     |     |     |  |    
|                        |                | Stores open at beginning of period          |                              |               | 249 |     |     |  | 242 |    
|                        |                |                                             | Stores opened                |               |     | 1   |     |  |     | 6   |  
|                        |                |                                             | Stores closed                |               |     | (1  | )   |  |     | (1  | )
|                        |                |                                             |                              |               |     |     |     | 
|                        |                |                                             | Stores open at end of period |               |     | 249 |     |  |     | 247 |  
|                        |                |                                             |                              |               |     |     |     | 
|                        |                | Average Company-owned stores open in period |                              |               | 249 |     |     |  | 245 |    
|                        |                |                                             |                              |               |     |     |     | 
|                        | Franchise:     |                                             |                              |               |     |     |     |  |    
|                        |                | Stores open at beginning of period          |                              |               | 257 |     |     |  | 241 |    
|                        |                |                                             | Stores opened                |               |     | 3   |     |  |     | 12  |  
|                        |                |                                             | Stores closed                |               |     | (1  | )   |  |     |    |  
|                        |                |                                             |                              |               |     |     |     | 
|                        |                |                                             | Stores open at end of period |               |     | 259 |     |  |     | 253 |  
|                        |                |                                             |                              |               |     |     |     | 
|                        |                | Average franchise stores open in period     |                              |               | 258 |     |     |  | 248 |    
|                        |                |                                             |                              |               |     |     |     | 
|Total stores chain wide |                |                                             | 508                          |               |     |     | 500 | 
|                        |                |                                             |                              |               |     |     |     | 

Critical Accounting Policies and
Estimates

The preparation of financial statements in
conformity with accounting principles generally accepted in the
United States of America requires the appropriate application of
certain accounting policies, many of which require estimates and
assumptions about future events and their impact on amounts
reported in the financial statements and related notes. Since
future events and their impact cannot be determined with
certainty, the actual results will inevitably differ from our
estimates. Such differences could be material to the
consolidated financial statements.

We believe our application of accounting
policies, and the estimates inherently required by the policies,
are reasonable. These accounting policies and estimates are
constantly reevaluated and adjustments are made when facts and
circumstances dictate a change. Historically, we have found the
application of accounting policies to be appropriate, and actual
results generally do not differ materially from those determined
using necessary estimates.

Our accounting policies are more fully described
in Note 1 of our 2004 10-K. We have identified certain
critical accounting policies that are described below.

Merchandise
inventory.Inventory is valued using
the cost method which values inventory at the individual item
level at the lower of the actual cost or market. Cost is
determined using the weighted average method. Market is
determined by the estimated net realizable value, based upon the
merchandise selling price. Inventory levels are reviewed to
identify slow-moving and closeout merchandise that will no
longer be carried. We also estimate amounts of current
inventories that will ultimately become obsolete due to changes
in fashion and style, based on the following factors:
(i) supply on hand, (ii) historical experience and
(iii) our expectations as to future sales.

During the first quarter of Fiscal 2005, we
launched our supply chain initiative, which includes modifying
our business operations to vertically integrate certain
logistics and distribution activities, and we therefore adopted
new specific accounting policies for the treatment of the costs
associated with our modified distribution network. We have
outsourced the operations of our modified distribution network
to a third party.

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Our distribution costs include the fees and
expenses of operating the distribution centers and the freight
expense related to transporting merchandise to our stores. These
distribution costs are initially capitalized into merchandise
inventory and expensed when the merchandise is sold in our
stores.


Finite long-lived
assets.In the evaluation of the fair
value and future benefits of finite long-lived assets, we
perform an analysis by store of the anticipated undiscounted
future net cash flows of the related finite long-lived assets.
If the carrying value of the related asset exceeds the
undiscounted cash flows, the carrying value is reduced to its
fair value. Various factors including future sales growth and
profit margins are included in this analysis. To the extent
these future projections or strategies change, the conclusion
regarding impairment may differ from the current estimates.

Insurance accruals.Our condensed consolidated balance sheets include significant
liabilities with respect to self-insured workers
compensation and general liability claims. We estimated the
required liability of such claims as of October 2, 2004,
utilizing an actuarial method based upon various assumptions,
which include, but are not limited to, our historical loss
experience, projected loss development factors, actual payroll
and other data. The required liability is also subject to
adjustment in the future based upon the changes in claims
experience, including changes in the number of incidents
(frequency) and changes in the ultimate cost per incident
(severity).

Goodwill.All of our
goodwill is associated with our retail segment. We evaluate
goodwill annually or whenever events and changes in
circumstances suggest that the carrying amount may not be
recoverable from its estimated future cash flows. In making this
assessment, management relies on a number of factors including
operating results, business plans, economic projections,
anticipated future cash flows and marketplace data. A change in
these underlying assumptions may cause a change in the results
of the tests and, as such, could cause fair value to be less
than the carrying value. In such event, we would then be
required to record a charge, which would impact earnings.

Sales Returns.We
estimate future sales returns and, when material, record a
provision in the period that the related sales are recorded
based on historical information. Should actual returns differ
from our estimates, we would be required to revise estimated
sales returns.

Store Closure Costs.We record estimated store closure costs, estimated lease
commitment costs net of estimated sublease income and other
miscellaneous store closing costs, when the liability is
incurred. Such estimates, including sublease income, may be
subject to change.

Income Taxes.Temporary differences arising from differing treatment of income
and expense items for tax and financial reporting purposes
result in deferred tax assets and liabilities that are recorded
on the balance sheet. These balances, as well as income tax
expense, are determined through managements estimations,
interpretation of tax law for multiple jurisdictions and tax
planning. If our actual results differ from estimated results
due to changes in tax laws, new store locations or tax planning,
our effective tax rate and tax balances could be affected.

General Definitions for Operating
Results

Net Salesinclude
Company-owned same store net sales and Company-owned new store
net sales. Stores are included in the same store net sales
calculation when in operation for a full fiscal month in both
the current fiscal month and the corresponding fiscal month of
the prior year. All other stores are included in new store net
sales.

Cost of goods sold and occupancy costsinclude the cost of merchandise,
distribution costs and store occupancy costs. Distribution costs
include the costs of operating the out-sourced distribution
centers and freight expense related to transporting merchandise
to our stores. These distribution costs are initially
capitalized into merchandise inventory and expensed when the
merchandise is sold in our stores. Store occupancy costs include
rent, common area maintenance, real estate taxes, repairs and
maintenance, depreciation, insurance and utilities.

Gross profitis net
sales minus cost of goods sold and occupancy costs.

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##### Table of Contents



Store operating and selling expensesconsist of selling and store
management payroll, employee benefits, medical insurance,
employment taxes, advertising, other store level expenses and
pre-opening expenses which are expensed when incurred.

Company-owned store profit contributionis gross profit minus store operating
and selling expenses.

General and administrative expenseincludes payroll and employee
benefits, employment taxes, management information systems,
marketing, insurance, legal and other corporate level expenses.
Corporate level expenses are primarily attributable to our
corporate office in Rockaway, New Jersey, and district and
regional offices throughout the country.

Franchising.Franchising revenue is composed of the initial franchise fees,
which are recorded as revenue when a franchise store opens, and
ongoing royalty fees, generally 4.0% of the stores net
sales. Franchise expenses include direct and indirect expenses.
The direct expenses include salaries, travel and other direct
expenses of the franchise operations department in addition to
legal fees, bad debt expense, insurance expense and other
miscellaneous charges. The indirect expenses include allocations
of corporate expenses for salaries, including bonuses, occupancy
and depreciation, based on time spent on franchise support.

Franchise profit contributionis franchise revenue minus franchise
expenses.

Interest expense, netincludes interest relating to our
credit facility, amortization of financing costs and bank
service charges. Interest expense, net also includes interest
income from other highly liquid investments purchased, with an
original maturity of three months or less, as part of our daily
cash management activities.

Results of Operations

The following table sets forth the results of
operations for the periods indicated:

|                              |                                          |                       |   |               |   |  |   |         |  
|----------------------------- | ---------------------------------------- | --------------------- | - | ------------- | - |  | - | ------- | -
|                              |                                          |                      
|                              |                                          | Fiscal Quarter Ended 
|                              |                                          |                      
|                              |                                          | October 2,            |   | September 27,
|                              |                                          | 2004                  |   | 2003         
|                              |                                          |                       |   |              
|                              |                                          |                      
|                              |                                          | (In thousands, except
|                              |                                          | per share amounts)   
|Statement of Operations Data: |                                          |                       |   |               |   |  |   |        
|Company-owned stores:         |                                          |                       |   |               |   |  |   |        
|                              | Net sales                                |                       | $ | 98,602        |   |  | $ | 102,620 |  
|                              | Cost of goods sold and occupancy costs   |                       |   | 71,857        |   |  |   | 74,328  |  
|                              |                                          |                       |   |               |   |  |   |        
|                              | Gross profit                             |                       |   | 26,745        |   |  |   | 28,292  |  
|                              | Store operating and selling expense      |                       |   | 24,259        |   |  |   | 25,879  |  
|                              |                                          |                       |   |               |   |  |   |        
|                              | Company-owned stores profit contribution |                       |   | 2,486         |   |  |   | 2,413   |  
|                              | General and administrative expense       |                       |   | 9,722         |   |  |   | 8,159   |  
|                              |                                          |                       |   |               |   |  |   |        
|                              | Retail loss contribution                 |                       |   | (7,236        | ) |  |   | (5,746  | )
|                              |                                          |                       |   |               |   |  |   |        
|Franchise stores:             |                                          |                       |   |               |   |  |   |        
|                              | Royalty fees                             |                       |   | 3,827         |   |  |   | 3,908   |  
|                              | Franchise fees                           |                       |   | 120           |   |  |   | 447     |  
|                              |                                          |                       |   |               |   |  |   |        
|                              | Total franchise revenue                  |                       |   | 3,947         |   |  |   | 4,355   |  
|                              | Total franchise expense                  |                       |   | 1,848         |   |  |   | 1,659   |  
|                              |                                          |                       |   |               |   |  |   |        
|                              | Franchise profit contribution            |                       |   | 2,099         |   |  |   | 2,696   |  
|                              |                                          |                       |   |               |   |  |   |        

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|                                                            |                                  |                       |        |               |   |  |        |        |  
|----------------------------------------------------------- | -------------------------------- | --------------------- | ------ | ------------- | - |  | ------ | ------ | -
|                                                            |                                  |                      
|                                                            |                                  | Fiscal Quarter Ended 
|                                                            |                                  |                      
|                                                            |                                  | October 2,            |        | September 27,
|                                                            |                                  | 2004                  |        | 2003         
|                                                            |                                  |                       |        |              
|                                                            |                                  |                      
|                                                            |                                  | (In thousands, except
|                                                            |                                  | per share amounts)   
|Total Company:                                              |                                  |                       |        |               |   |  |        |       
|                                                            | Operating loss                   |                       |        | (5,137        | ) |  |        | (3,050 | )
|                                                            | Interest expense, net            |                       |        | 57            |   |  |        | 200    |  
|                                                            |                                  |                       |        |               |   |  |        |       
|                                                            | Loss before income taxes         |                       |        | (5,194        | ) |  |        | (3,250 | )
|                                                            | Benefit for income taxes         |                       |        | (2,103        | ) |  |        | (1,300 | )
|                                                            |                                  |                       |        |               |   |  |        |       
|                                                            | Net loss                         |                       | $      | (3,091        | ) |  | $      | (1,950 | )
|                                                            |                                  |                       |        |               |   |  |        |       
|                                                            | Basic and diluted loss per share |                       | $      | (0.18         | ) |  | $      | (0.12  | )
|                                                            |                                  |                       |        |               |   |  |        |       
|Weighted average shares outstanding 
    basic and diluted |                                  |                       | 17,105 |               |   |  | 16,599 |       
|                                                            |                                  |                       |        |               |   |  |        |       



| |                                                                                                 
| | ------------------------------------------------------------------------------------------------
| | Fiscal Quarter Ended October 2, 2004
    Compared To Fiscal Quarter Ended September 27,
    2003

Retail.Net sales
from Company-owned stores decreased 3.9% to $98.6 million
for the first quarter of Fiscal 2005 from $102.6 million in
the same period last year. The 3.9% decrease in net sales
resulted from a same store net sales decrease of 5.2% which was
partially offset by net sales from new stores. Same store sales
for non-seasonal merchandise decreased 8.7% due to the ongoing
transition of this merchandise category. This decline was
partially offset by a 5.0% increase in same store sales for
seasonal merchandise, largely aided by five additional days of
Halloween sales included in the first quarter of Fiscal 2005.
Although the customer count in Company-owned stores, on a same
store basis, decreased 7.1% during the quarter ended
October 2, 2004, the same store average net sale per retail
transaction increased 1.9% reflecting a lower level of
discounting and promotional markdown activity compared with the
same time last year. Five stores joined the same store sales
group during the first quarter of Fiscal 2005. We opened one new
store and closed one store during the first quarter of Fiscal
2005 and opened six new stores and closed one store during the
same period last year.

Gross profit as a percent of net sales was 27.1%
for the first quarter of Fiscal 2005 compared with 27.6% for the
same period last year. As shown in the table below, gross profit
decreased $1.6 million to $26.7 million in the first
quarter of Fiscal 2005 from $28.3 million in the same
period last year.

|                          |       |                         |      |                                 |   |                                                                                                                                                                                                                           | 
|------------------------- | ----- | ----------------------- | ---- | ------------------------------- | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
|                          |       | Portion of Total Change |      |                                
|Component                 |       | Increase/(Decrease)     |      | Reason for Increase/(Decrease):
|                          |       |                         |      |                                
|                          |       | (In millions)           |      |                                
|Net sales                 |       | $                       | (1.1 | )                               |   | Due to lower same store and total sales.                                                                                                                                                                                 
|Merchandise margins       |       |                         | 1.4  |                                 |   | Due to a reduction in promotional markdown
    activity reflecting a shift to less promotional pricing.                                                                                                                  
|Occupancy and other costs |       |                         | (1.9 | )                               |   | Due to higher fixed expenses and accelerated
    depreciable life of certain stores internal sign and
    graphics packages that are going to be retired in connection
    with of our brand-revitalization initiatives.
|                          |       |                         |      |                                 |   |                                                                                                                                                                                                                          
|                          | Total |                         | $    | (1.6                            | ) |                                                                                                                                                                                                                           | 
|                          |       |                         |      |                                 |   |                                                                                                                                                                                                                          

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Store operating and selling expenses were 24.6%
and 25.2% of net sales for the first quarter of Fiscal 2005 and
Fiscal 2004, respectively. As shown in the table below, store
operating and selling expenses decreased $1.6 million, or
6.3%, to $24.3 million for the first quarter of Fiscal 2005
from $25.9 million in the same period last year. We
incurred pre-opening expenses of $28,000 in the first quarter of
Fiscal 2005 for the one new store opened during such quarter,
while we incurred $303,000 in the first quarter of Fiscal 2004
for six new stores opened during such quarter and three stores
that were projected to be opened later in such fiscal year.
Pre-opening expenses include payroll and fringe benefits, as
well as other operating costs.

|                                           |       |                         |      |                                 |   |                                                                                                                                        | 
|------------------------------------------ | ----- | ----------------------- | ---- | ------------------------------- | - | -------------------------------------------------------------------------------------------------------------------------------------- | 
|                                           |       | Portion of Total Change |      |                                
|Component                                  |       | Increase/(Decrease)     |      | Reason for Increase/(Decrease):
|                                           |       |                         |      |                                
|                                           |       | (In millions)           |      |                                
|Net sales volume                           |       | $                       | (0.2 | )                               |   | Due to lower same store and total sales                                                                                               
|Fixed payroll and fringe benefit reduction |       |                         | (0.8 | )                               |   | Due to reduced labor costs from efficiency
    improvements in customer check-out, product replenishment and
    inventory management.
|Other operating costs                      |       |                         | (0.6 | )                               |   | Due primarily to a reduction in store supplies as
    well as a gain realized on one store closing.                                   
|                                           |       |                         |      |                                 |   |                                                                                                                                       
|                                           | Total |                         | $    | (1.6                            | ) |                                                                                                                                        | 
|                                           |       |                         |      |                                 |   |                                                                                                                                       

Company-owned store profit contribution as a
percent of net sales was 2.5% for the first quarter of Fiscal
2005 compared with 2.4% in the same period last year.
Company-owned store profit contribution was relatively flat for
the first quarter of Fiscal 2005 at $2.5 million compared
with $2.4 million the same period last year. The store
profit contribution from the 11 Seattle stores that were
acquired in 2002 improved 10% during the first quarter, and
stores open less than two years improved 4%, while stores open
at least two years declined $95,000 during the quarter.

General and administrative expenses were 9.9% and
8.0% of net sales for the first quarter of Fiscal 2005 and
Fiscal 2004, respectively. As shown in the table below, general
and administrative expenses increased $1.6 million to
$9.7 million for the first quarter of Fiscal 2005 from
$8.2 million in the same period last year.

|                            |       |                         |      |                                 |  |                                                                                                                                        | 
|--------------------------- | ----- | ----------------------- | ---- | ------------------------------- |  | -------------------------------------------------------------------------------------------------------------------------------------- | 
|                            |       | Portion of Total Change |      |                                
|Component                   |       | Increase/(Decrease)     |      | Reason for Increase/(Decrease):
|                            |       |                         |      |                                
|                            |       | (In millions)           |      |                                
|Payroll and fringe benefits |       | $                       | 1.1  |                                 |  | Due to increased corporate staffing to support
    our product assortment, logistics and information systems
    strategic initiatives
|Professional fees           |       |                         | (0.1 | )                               |  | Due to lower spending on professional fees.                                                                                           
|Other                       |       |                         | 0.6  |                                 |  | Due to additional temporary corporate office
    space leased prior to the transition to the new corporate office
    location.       
|                            |       |                         |      |                                 |  |                                                                                                                                       
|                            | Total |                         | $    | 1.6                             |  |                                                                                                                                        | 
|                            |       |                         |      |                                 |  |                                                                                                                                       

Franchising.Franchise fees recognized on three store openings was $120,000
in the first quarter of Fiscal 2005 and $447,000 recognized on
twelve store openings in the same period last year. Royalty fees
decreased 2.0% to $3.8 million in the first quarter of
Fiscal 2005 from $3.9 million in the same period last year.
This was primarily due to a same store sales decrease of 2.9%
for the franchise stores in the first quarter of Fiscal 2005.

Expenses attributable to the franchise segment
increased 11.4% to $1.85 million for the first quarter of
Fiscal 2005 from $1.66 million for the first quarter of
Fiscal 2004. As a percentage of franchise revenue, franchise
expenses were 46.8% and 38.1% for the first quarter of Fiscal
2005 and Fiscal 2004, respectively.

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This increase is primarily due to a larger
corporate expense allocation, which is primarily based on
corporate compensation.


Franchise profit contribution decreased 22.1% to
$2.1 million in first quarter of Fiscal 2005 from
$2.7 million in the same period last year. The decrease in
franchise profit contribution is due to a decrease in franchise
fees from nine fewer store openings as well as an increase in
corporate expenses allocated to the franchise segment during the
quarter.

Interest Expense.Net interest expense decreased to $57,000 for the first quarter
of Fiscal 2005 from $200,000 in the same period last year due
mainly to a reduction in interest expense. We had no advances
under our Loan Agreement at any point during the first quarter
of Fiscal 2005 as compared to $15.2 million at the end of
same period last year.

Income Taxes.An
income tax benefit of $2.1 million, or 40.5% of pre-tax
income, and $1.3 million, or 40.0% of pre-tax income, was
recorded in the first quarter of Fiscal 2005 and Fiscal 2004,
respectively. The change in tax rate to 40.5% from 40.0% is due
to an increase in the blended state tax rate.

Net Income.As a
result of the above factors, we recorded a net loss of
$3.1 million, or $0.18 per basic and diluted share, in
the first quarter of Fiscal 2005, as compared to a net loss of
$2.0 million, or $0.12 per basic and diluted share, in
the first quarter of Fiscal 2004. Weighted average basic and
diluted shares outstanding increased to 17.1 million in the
first quarter of Fiscal 2005 from 16.6 million in the same
period last year. This increase is due to the stock option
exercises since September 27, 2003.

Liquidity and Capital Resources

Our cash requirements have historically been for
working capital, the opening of new stores, the improvement and
expansion of existing facilities and the improvement of
information systems. These cash requirements have been met
through cash flow from operations and borrowings under our
credit facilities. At October 2, 2004, working capital was
$34.1 million compared with $13.8 million in the same
period last year.

Our current priorities for the use of cash are
primarily for investments in value-added capital projects
including, in particular, investments in technology to improve
merchandising and distribution, reduce costs, improve
efficiencies and assist each store to better serve its
customers. Key initiatives include:



| |   |                                                                                                                                                                             
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | our logistics initiatives, pursuant to which we
    are outsourcing our centralized warehousing and distribution
    facilities and implementing a new distribution network;
|
| |  | executing our store information systems roll-out;                                                                                                                           
|
| |  | revitalizing our brand and retail environment
    through re-merchandising our stores;                                                                                      
|
| |  | transitioning to our new corporate headquarters;                                                                                                                            
|
| |  | evaluating our current and future store
    locations; and                                                                                                                  
|
| |  | improving customer service at the stores.                                                                                                                                   

We believe that the cash generated by operations,
together with the borrowing availability under the Loan
Agreement, will be sufficient to meet our working capital needs
for the next twelve months, including investments made and
expenses incurred in connection with systems development,
logistic initiatives and store improvements. We expect to invest
between $25 million and $30 million in capital
projects during Fiscal 2005, which will be partially offset by a
maximum reimbursement of $7 million associated with our new
corporate office lease.

We are currently free of debt, which permits us
to consider a wide variety of corporate initiatives intended to
improve shareholder value, although there is no assurance that
any specific initiative will be pursued or consummated.

20



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Key Indicators of Liquidity and Capital
Resources

The following table sets forth key indicators of
our liquidity and capital resources (in thousands):

|                                  |                               |                                  |   |               |        |   |   |         |       | 
|--------------------------------- | ----------------------------- | -------------------------------- | - | ------------- | ------ | - | - | ------- | ----- | 
|                                  |                               |                                 
|                                  |                               | Fiscal Quarter Ended            
|                                  |                               |                                 
|                                  |                               | October 2,                       |   | September 27,
|                                  |                               | 2004                             |   | 2003         
|                                  |                               |                                  |   |              
|Balance Sheet Data:               |                               |                                  |   |               |        |   |   |        
|                                  | Cash and cash equivalents     |                                  | $ | 18,614        |        |   | $ | 4,603   |      
|                                  | Working capital               |                                  |   | 34,116        |        |   |   | 13,807  |      
|                                  | Total assets                  |                                  |   | 192,563       |        |   |   | 194,533 |      
|                                  | Advance under Loan Agreement  |                                  |   |              |        |   |   | 15,171  |      
|                                  | Stockholders equity          |                                  |   | 93,982        |        |   |   | 78,116  |      
|Other Information:                |                               |                                  |   |               |        |   |   |        
|                                  | Depreciation and amortization |                                  | $ | 4,332         |        |   | $ | 3,802   |      
|Cash Flows (Used In) Provided By: |                               |                                  |   |               |        |   |   |        
|                                  | Operating activities          |                                  | $ | (7,404        | )      |   | $ | 795     |      
|                                  | Investing activities          |                                  |   | (2,002        | )      |   | $ | (1,448  | )    
|                                  | Financing activities          |                                  |   | 175           |        |   |   | 1,884   |      
|                                  |                               |                                  |   |               |        |   |   |        
|                                  |                               | Total cash (used in) provided by |   | $             | (9,231 | ) |   | $       | 1,231 | 
|                                  |                               |                                  |   |               |        |   |   |        

Operating
Activities.For the fiscal quarter
ended October 2, 2004, cash used in operating activities
was $7.4 million compared to cash provided by operating
activities of $0.8 million for the same period last year.
The increase in cash used in operating activities was primarily
attributable to a higher net loss, certain advanced payments for
inventory, advertising and taxes as well as higher cash payments
related to management incentives and other current liabilities
as a result of timing. The investment in inventory during this
seasonally high period was fully offset by a corresponding
increase in accounts payables.

Investing
Activities.Cash used in investing
activities for the fiscal quarter ended October 2, 2004 was
$2.0 million compared with $1.4 million in the same
period in last year. The increase in cash used in investing
activities was primarily attributable to new and existing stores
leasehold improvements and furniture and fixtures of
$1.1 million, development costs for our management
information systems of $0.7 million and implementation
costs of our logistics initiatives of $0.4 million,
partially offset by $0.2 million of proceeds from the
closure of one store.

Financing
Activities.Cash provided by financing
activities was $0.2 million for the fiscal quarter ended
October 2, 2004 compared with $1.9 million for the
same period last year. We had no advances under our Loan
Agreement at the end of the first quarter of Fiscal 2005 and the
end of Fiscal 2004 as compared with $15.2 million in
advances at the end of the first quarter of Fiscal 2004.

Loan Agreement.At
October 2, 2004 and October 22, 2004, we had no
balance outstanding under the Loan Agreement. Under the terms of
the Loan Agreement, we may from time to time borrow amounts
based on a percentage of our eligible inventory and credit card
receivables, up to a maximum of $65 million at any time
outstanding, subject to certain borrowing conditions and
customary sub-limits, reserves and other limitations. Interest
on each advance is charged, at our option, at (i) the
adjusted Eurodollar rate plus the applicable margin, which is
currently at 1.25% per annum or (ii) the prime rate
less the applicable margin, which is currently 0.25% per
annum (our effective cost of borrowing under the Loan Agreement
is 4.50% at October 2, 2004). The Loan Agreement matures on
April 30, 2006, and borrowings are secured by a lien on
substantially all of our assets. Based on a percentage of
current eligible inventory and credit card receivables, we had
$51.3 million available to be borrowed under the Loan
Agreement at October 22, 2004.

Warrants.There were
no warrants exercised in Fiscal 2004 or the first quarter of
Fiscal 2005. As of October 2, 2004, we had 2,496,000
warrants outstanding at an exercise price of $1.07 per
share.

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

|                                            |                                                           |                      |      |               |   |   |     |        |  
|------------------------------------------- | --------------------------------------------------------- | -------------------- | ---- | ------------- | - | - | --- | ------ | -
|                                            |                                                           |                     
|                                            |                                                           | Fiscal Quarter Ended
|                                            |                                                           |                     
|                                            |                                                           | October 2,           |      | September 27,
|                                            |                                                           | 2004                 |      | 2003         
|                                            |                                                           |                      |      |              
|                                            |                                                           |                     
|                                            |                                                           | (In thousands)      
|EBITDA(a)                                   |                                                           | $                    | (805 | )             |   | $ | 752 |       
|Most directly comparable GAAP
    measures: |                                                           |                      |      |               |   |   |     |       
|                                            | Net loss                                                  |                      | $    | (3,091        | ) |   | $   | (1,950 | )
|                                            | Cash flows (used in) provided by operating
    activities |                      | $    | (7,404        | ) |   | $   | 795    |  



---



|    |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(a) |  | Our definition of EBITDA is earnings before
    interest, taxes, depreciation and amortization. We believe
    EBITDA provides additional information for determining our
    ability to meet future debt service requirements. 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. We have presented EBITDA,
    however, because it 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. Our computation of EBITDA may not
    be comparable to similar titled measures of other companies.

Because we consider EBITDA useful as an operating
measure, a reconciliation of EBITDA to net loss follows for the
periods indicated:

|                              |  |                      |        |               |  |   |        |  
|----------------------------- |  | -------------------- | ------ | ------------- |  | - | ------ | -
|                              |  |                     
|                              |  | Fiscal Quarter Ended
|                              |  |                     
|                              |  | October 2,           |        | September 27,
|                              |  | 2004                 |        | 2003         
|                              |  |                      |        |              
|                              |  |                     
|                              |  | (In thousands)      
|EBITDA(a)                     |  | $                    | (805   | )             |  | $ | 752    |  
|Depreciation and amortization |  |                      | (4,332 | )             |  |   | (3,802 | )
|Interest expense, net         |  |                      | (57    | )             |  |   | (200   | )
|Benefit from income taxes     |  |                      | 2,103  |               |  |   | 1,300  |  
|                              |  |                      |        |               |  |   |        |  
|Net loss                      |  | $                    | (3,091 | )             |  | $ | (1,950 | )
|                              |  |                      |        |               |  |   |        |  

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Because we also consider EBITDA useful as a
liquidity measure, we present the following reconciliation of
EBITDA to our net cash (used in) provided by operating
activities:

|                                   |                                                |                                                         |       |               |        |   |       |         |     | 
|---------------------------------- | ---------------------------------------------- | ------------------------------------------------------- | ----- | ------------- | ------ | - | ----- | ------- | --- | 
|                                   |                                                |                                                        
|                                   |                                                | Fiscal Quarter Ended                                   
|                                   |                                                |                                                        
|                                   |                                                | October 2,                                              |       | September 27,
|                                   |                                                | 2004                                                    |       | 2003         
|                                   |                                                |                                                         |       |              
|                                   |                                                |                                                        
|                                   |                                                | (In thousands)                                         
|EBITDA(a)                          |                                                | $                                                       | (805  | )             |        | $ | 752   |        
|Interest expense, net              |                                                |                                                         | (57   | )             |        |   | (200  | )      
|Benefit from income taxes          |                                                |                                                         | 2,103 |               |        |   | 1,300 |        
|Non-cash interest                  |                                                |                                                         | 40    |               |        |   | 40    |        
|Deferred rent                      |                                                |                                                         | (127  | )             |        |   | (123  | )      
|Stock-based compensation           |                                                |                                                         | 7     |               |        |   | 37    |        
|Provision for doubtful accounts    |                                                |                                                         | (70   | )             |        |   | (63   | )      
|Other                              |                                                |                                                         | (125  | )             |        |   | 4     |        
|Changes in assets and liabilities: |                                                |                                                         |       |               |        |   |       |        
|                                   | Merchandise inventory                          |                                                         |       | (24,301       | )      |   |       | (27,319 | )  
|                                   | Accounts payable                               |                                                         |       | 23,518        |        |   |       | 24,303  |    
|                                   | Accrued expenses and other current liabilities |                                                         |       | (5,383        | )      |   |       | 2,403   |    
|                                   | Other long-term liabilities                    |                                                         |       | 60            |        |   |       | (20     | )  
|                                   | Other current assets and other assets          |                                                         |       | (2,264        | )      |   |       | (319    | )  
|                                   |                                                |                                                         |       |               |        |   |       |        
|                                   |                                                | Net cash (used in) provided by operating
    activities |       | $             | (7,404 | ) |       | $       | 795 | 
|                                   |                                                |                                                         |       |               |        |   |       |        

We use EBITDA to determine our executive
compensation which bases incentive compensation payments on our
EBITDA performance measured against budget. EBITDA is also
widely used by us and others in our industry to evaluate and
price potential acquisitions.

EBITDA has limitations as an analytical tool, and
you should not consider it in isolation, or as a substitute for
analysis of our results as reported under GAAP. Some of these
limitations are:



| |   |                                                                                                                                                                                                                                               
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | 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;                                                                                             
|
| |  | 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.                                                                                                        

Because of these limitations, EBITDA should not
be considered as a measure of discretionary cash available to us
to invest in the growth of our business. We compensate for these
limitations by relying primarily on our GAAP results and using
EBITDA only supplementally. See the Statements of Cash Flows
included in our financial statements.

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Contractual Obligations and Commercial
Commitments

As of October 3, 2004, our contractual
obligations and commercial commitments are as follows (in
thousands);

|                             |  |       |         |           |  |             |         |             |  |             |        |           |  |   |       |  |  |   |     |  |  |   |    | 
|---------------------------- |  | ----- | ------- | --------- |  | ----------- | ------- | ----------- |  | ----------- | ------ | --------- |  | - | ----- |  |  | - | --- |  |  | - | -- | 
|                             |  |       |         |           |  |             |         | Logistics   |  |             |        |          
|                             |  |       |         | Operating |  | Merchandise |         | Initiative  |  |             |        |          
|                             |  | Total |         | Leases    |  | Orders      |         | Obligations |  | Auto Leases |        | Severance
|                             |  |       |         |           |  |             |         |             |  |             |        |          
|Fiscal year ending:          |  |       |         |           |  |             |         |             |  |             |        |           |  |   |       |  |  |   |     |  |  |   |    | 
|2005                         |  | $     | 53,878  |           |  | $           | 34,703  |             |  | $           | 17,000 |           |  | $ | 1,875 |  |  | $ | 227 |  |  | $ | 73 | 
|2006                         |  |       | 47,834  |           |  |             | 45,153  |             |  |             |       |           |  |   | 2,500 |  |  |   | 181 |  |  |   |   | 
|2007                         |  |       | 44,236  |           |  |             | 41,611  |             |  |             |       |           |  |   | 2,500 |  |  |   | 125 |  |  |   |   | 
|2008                         |  |       | 33,326  |           |  |             | 33,322  |             |  |             |       |           |  |   |      |  |  |   | 4   |  |  |   |   | 
|2009                         |  |       | 21,243  |           |  |             | 21,243  |             |  |             |       |           |  |   |      |  |  |   |    |  |  |   |   | 
|Thereafter                   |  |       | 48,296  |           |  |             | 48,296  |             |  |             |       |           |  |   |      |  |  |   |    |  |  |   |   | 
|                             |  |       |         |           |  |             |         |             |  |             |        |           |  |   |       |  |  |   |     |  |  |   |    | 
|Total minimum lease payments |  | $     | 248,813 |           |  | $           | 224,328 |             |  | $           | 17,000 |           |  | $ | 6,875 |  |  | $ | 537 |  |  | $ | 73 | 
|                             |  |       |         |           |  |             |         |             |  |             |        |           |  |   |       |  |  |   |     |  |  |   |    | 

We lease real estate in connection with the
operation of Company-owned retail stores as well as the
corporate offices. The store leases are for properties ranging
in size from 6,750 to 19,800 square feet. The terms range
from five years to twenty years. Of the leases for the
Company-owned stores, three expire in Fiscal 2005, 21
expire in Fiscal 2006, 30 expire in Fiscal 2007,
59 expire in Fiscal 2008 and the balance expire in
Fiscal 2009 or thereafter. Our operating leases provide for
step rent provisions, renewal options from five years to ten
years, capital improvement funding, obligations for
reimbursement of common area maintenance and real estate taxes
and other lease concessions as applicable in each lease. The
minimum lease payments are recognized on a straight-line basis
over the term of each individual underlying lease. Certain
leases contain contingent rent based upon specified sales
volume. We paid $3,000 for contingent rent during the first
quarter in each of Fiscal 2005 and 2004.

On September 16, 2004, we entered into a new
corporate office lease for 106,000 square feet of office space.
The initial term is for 12 years, with two five-year
renewal options. The lease contains escalation clauses and
obligations for reimbursement of common area maintenance and
real estate taxes. The lease for our current corporate
headquarters expires in December 2004, but we are currently
negotiating an extension of such lease for a period of months to
coincide with our transition to the new corporate headquarters.
We intend to relocate to our new corporate headquarters by June
2005, and intend to vacate our current corporate headquarters
thereafter.

We are also obligated for guarantees, subleases
or assigned lease obligations for 23 of the franchisees 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 October 2, 2004, the
maximum amount of the guarantees, subleases and assigned lease
obligations was approximately $15.0 million, which is not
included in the table above.

We enter into arrangements to purchase
merchandise up to eight months in advance of expected delivery.
Historically, these purchase commitments did not contain any
significant termination payments or other penalties if
cancelled. Since we are transitioning toward selling more
proprietary product, certain of these purchase commitments may
obligate us to specified quantities, even if desired quantities
change at a later date. As of October 2, 2004, we had
approximately $17 million of propriety product for which we
have made purchase arrangements.

Logistics initiative obligations include a
commitment for the purchase of selected equipment and services
associated with the operation of the distribution centers.

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##### Table of Contents



At October 2, 2004, we operated a fleet of
thirty-nine leased motor vehicles, primarily for the district
managers and regional management. The terms of these leases
generally run for 36 months and expire at various times
through September 2007.

In addition to the severance obligations
specified in the table above, as of October 2, 2004 and
October 22, 2004, we had an aggregate contingent liability
of up to $2.2 million related to potential severance
payments for 14 employees pursuant to their respective
employment agreements. As of October 2, 2004 and
October 22, 2004, we had a standby letter of credit of
$3.7 million pursuant to the Loan Agreement relating to
general liability and workers compensation insurance.

Off-Balance Sheet Arrangements

We have not created, and are not party to, any
special-purpose or off-balance sheet entities for the purpose of
raising capital, incurring debt or operating our business. We do
not have any off-balance sheet arrangements or relationships
with entities that are not consolidated into our financial
statements that have or are reasonably likely have a material
current or future effect on our financial condition, changes in
financial condition, revenues, expenses, results of operations,
liquidity, capital expenditures or capital resources.

Seasonality

Our business is subject to substantial seasonal
variations. Historically, we have realized a significant portion
of our net sales, cash flow and net income in the second Fiscal
quarter of the year principally due to the sales in October for
the Halloween season and, to a lesser extent, due to holiday
sales for end of year holidays. We expect that this general
pattern will continue.

Our results of operations and cash flows may also
fluctuate significantly as a result of a variety of other
factors, including the timing of new store openings and store
closings and the timing of the acquisition and disposition of
stores.

Recent Accounting Pronouncements

In June 2004, the Financial Accounting Standards
Board (FASB) issued an interpretation of FASB
No. 143, Accounting for Asset Retirement
Obligations (FASB No. 143). This
interpretation clarifies the scope and timing of liability
recognition for conditional asset retirement obligations under
FASB No. 143 and is effective no later than the end of
Fiscal 2005. We have determined that this interpretation,
and the adoption of FASB No. 143, will not have a material
impact on our condensed consolidated results of operations,
financial position or cash flows.

In May 2004, the FASB issued FSP FAS 106-2
to provide guidance on accounting for the effects of the
Medicare Prescription Drug, Improvement and Modernization Act of
2003 (the Act), to employers that sponsor post-retirement health
care plans that provide prescription drug benefits. We continue
to sponsor a post-retirement healthcare plan for one individual,
and we do not provide such benefits to any other employee and
have no intention to do so in the future. We have determined
that FAS 106-2 will not have a material impact on our
condensed consolidated results of operations, financial position
or cash flows.

In March 2004, the FASB published an Exposure
Draft, Share-Based Payment, an amendment of FASB
Statements No. 123 and No. 95. Under this FASB
proposal, all forms of share-based payment to employees,
including employee stock options, would be treated as
compensation and recognized in the income statement. This
proposed statement, if adopted, would be effective beginning in
Fiscal 2005. We currently account for stock options under
APB No. 25. The pro-forma impact of expensing options is
disclosed in Note 3 to our condensed consolidated financial
statements included herein.

Forward-Looking Statements

This Quarterly Report on Form 10-Q
(including the information incorporated herein by reference)
contains forward-looking statements within the meaning of The
Private Securities Litigation Reform Act of 1995. The statements
may be identified by forward-looking terminology such as
estimate, project,

25



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##### Table of Contents



expect, believe,
may, will, intend or similar
statements or variations of such terms. Forward-looking
statements involve known and unknown risks and uncertainties,
which may cause our actual results in future periods to differ
materially from forecasted results. Those risks and
uncertainties include, among other things, the effect of price
and product competition in the party goods industry in general
and in our specific market areas, our ability to anticipate
customer demand for products and to design and develop products
that will appeal to our customers, our ability to open new
stores successfully and/or to identify, execute and integrate
acquisitions and to realize synergies, the availability and
terms of capital to fund capital improvements, acquisitions and
ongoing operations, our ability to manage successfully our
franchise program, our ability to improve our fundamental
business processes and reduce costs throughout our organization,
our ability to attract and retain qualified personnel, changes
in costs of goods and services and economic conditions in
general. See Part I, Item 1. Business-Risk
Factors in our 2004 10-K for further information on such
risks and uncertainties. Furthermore, additional information
concerning certain risks and uncertainties that could cause our
actual results to differ materially from those projected or
suggested may be identified from time to time in our SEC filings
and our public announcements. You are cautioned not to place
undue reliance on such forward-looking statements, which are
made as of the date of this release, and we have no obligation
or intention to update or revise such forward-looking statements.







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

In the normal course of doing business, we are
exposed to interest rate change and market risk. Our business is
seasonal and our borrowing patterns follow such seasonality.
Debt balances generally go up in the spring and down in the
fall. All of our available borrowings under the Loan Agreement
are at variable rates, equal to, at our option, at (i) the
adjusted Eurodollar rate per annum, plus the applicable margin
which is currently 1.25% or (ii) the prime rate per annum,
less the applicable margin which is currently 0.25% (our
effective cost of borrowing under the Loan Agreement is 4.50% at
October 2, 2004) and , therefore, any sudden material
increase in the Eurodollar rate or prime rate in a peak
borrowing period may negatively impact our short term results.
However, because we pay our outstanding debt down quickly, such
an increase would not affect us unless it were very large. A
hypothetical 1.0% increase or decrease in interest rates in the
associated debts variable rate would not materially affect
our results of operations or cash flows.






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

We maintain disclosure controls and procedures
that are designed to ensure that information required to be
disclosed in our Exchange Act reports is recorded, processed,
summarized and reported within the time periods specified in the
Securities and Exchange Commissions (the SEC)
rules and forms and that such information is accumulated and
communicated to our management, including our Chief Executive
Officer and Chief Financial Officer, as appropriate, to allow
for timely decisions regarding required disclosure. In designing
and evaluating the disclosure controls and procedures,
management recognizes that any controls and procedures, no
matter how well designed and operated, can provide only
reasonable assurance of achieving the desired control
objectives, and management is required to apply its judgment in
evaluating the cost-benefit relationship of possible controls
and procedures.

As required by Rule 13a-15(b) under the
Exchange Act, we conducted an evaluation, under the supervision
and with the participation of our management, including our
Chief Executive Officer and our Chief Financial Officer, of the
effectiveness of the design and operation of our disclosure
controls and procedures as of the end of the period covered by
this report. Based on the foregoing, our management, including
our Chief Executive Officer and Chief Financial Officer,
concluded that our disclosure controls and procedures were
effective at the reasonable assurance level as of the end of the
period covered by this report.

Other than as described above, there has been no
change in our internal control over financial reporting during
the Fiscal quarter ended October 2, 2004 that has
materially affected, or is reasonably likely to materially
affect, our internal control over financial reporting. In
addition, other than as described above, since the most recent
evaluation date, there have been no significant changes in our
internal control structure, policies and procedures or in other
areas that could significantly affect our internal control over
financial reporting.

26



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##### Table of Contents






PART II.

OTHER INFORMATION






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

The information set forth in Note 7 in the
Condensed Consolidated Financial Statements included herein is
hereby incorporated by reference.






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

In September 2001, the Board of Directors
authorized us to repurchase up to $15 million of our
outstanding common stock at a price not to exceed $7.00 per
share, which was amended on February 7, 2003 to a price not
to exceed $10.00 per share. Stock repurchases are made at the
discretion of management. There were no stock repurchases during
the first quarter of Fiscal 2005. As of October 2,
2004, we had purchased 747,012 shares for an aggregate amount of
$5.9 million or 39.6% of the total amount to be purchased.






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

None






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

None






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

None






|        |                                     
|------- | ------------------------------------
|Item 6. | Exhibits and Reports on
    Form 8-K

(a) The exhibits required to be filed as
part of this report on Form 10-Q are listed in the attached
Exhibit Index.

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##### Table of Contents






SIGNATURES

Pursuant to the requirements of the Securities
Exchange Act of 1934, the registrant has duly caused this report
to be signed on its behalf by the undersigned thereunto duly
authorized.



| |                       
| | ----------------------
| | 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)

Date: November 12, 2004

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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 Commission 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 Commission 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 Commission 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 Commission 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 Commission on February 13, 2001.                                                                        
|        | 10.4   |  |  | General Release and Severance Agreement of James
    Shea, dated as of May 28, 2003, by and between the Company
    and James Shea, incorporated by reference from the September
    2003 10-K.                                                                                                 
|        | 10.5   |  |  | Separation Agreement of Andrew Bailen, dated as
    of July 14, 2003, by and between the Company and Andrew
    Bailen, incorporated by reference from the September 2003 10-K.                                                                                                                 
|        | 10.6   |  |  | 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.                                                                                                               
|        | 10.7   |  |  | 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.                                                                                                                
|        | 10.8   |  |  | Employment Agreement of Warren Jeffrey, dated as
    of November 7, 2003, by and between the Company and Warren
    Jeffery, incorporated by reference from the November 2003 10-Q.                                                                                                             
|        | 10.9   |  |  | Employment Agreement of Richard H. Griner dated
    as of January 12, 2004, by and between the Company and Richard
    H. Griner, incorporated by reference from the February 2004 10-Q.                                                                                                        
|        | 10.10  |  |  | Employment Agreement of Gregg A. Melnick, dated
    as of September 7, 2004, by and between the Company and
    Gregg A. Melnick incorporated by reference from the
    Companys Current Report on Form 8-K as filed on
    September 9, 2004.                                                 
|        | 10.11  |  |  | 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 on October 1, 2004.                                                         
|        | *10.12 |  |  | Employment Agreement of Lisa Laube, dated as of
    April 26, 2004, by and between the Company and Lisa Laube.                                                                                                                                                                                  
|        | 10.13  |  |  | Management Stock Purchase Plan of the Company,
    incorporated by reference from the Registration of Form S-8
    as filed with the Commission on July 23, 2001.                                                                                                                               
|        | 10.14  |  |  | 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.                                   
|        | 10.15  |  |  | Amended and Restated 1994 Stock Option Plan,
    incorporated by reference from the Registration of Form S-8
    as filed with the Commission on January 9, 1997.                                                                                                                               
|        | 10.16  |  |  | 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 Commission on October 20, 2003.        

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##### Table of Contents



|        |       |  |  |                                                                                                                                                                                                                                                                                                                                                                                                                                  
|------- | ----- |  |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |       | 
|No.     |       | 
|        |       | 
|        | 10.17 |  |  | 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 Commission on
    January 10, 2003.
|        | 10.18 |  |  | 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.                                                                                                                      
|        | 10.19 |  |  | 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.                                                                                                                                                      
|        | 10.20 |  |  | 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.                                                                                                                                                      
|        | 10.21 |  |  | 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.                                                                                                                                                          
|        | 10.22 |  |  | Agreement of Lease, dated September 16,
    2004, by and between Party City Corporation 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 on September 20,
    2004.                                                                                                                                   
|        | *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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##### Table of Contents



REPORT OF INDEPENDENT REGISTERED PUBLIC
ACCOUNTING FIRM

To the Board of Directors and Stockholders of

Party City Corporation


Rockaway, New Jersey


We have reviewed the accompanying condensed
consolidated balance sheets of Party City Corporation and
subsidiary as of October 2, 2004 and September 27,
2003, and the related condensed consolidated statements of
operations and cash flows for the quarter ended October 2,
2004 and September 27, 2003. These interim financial
statements are the responsibility of the Companys
management. Our responsibility is to express an opinion on these
consolidated financial statements based on our reviews.

We conducted our reviews in accordance with
standards of the Public Company Accounting Oversight Board
(United States). A review of interim financial information
consists principally of applying analytical procedures and
making inquiries of persons responsible for financial and
accounting matters. It is substantially less in scope than an
audit conducted in accordance with auditing standards of the
Public Company Accounting Oversight Board (United States), the
objective of which is the expression of an opinion regarding the
financial statements taken as a whole. Accordingly, we do not
express such an opinion.

Based on our reviews, we are not aware of any
material modifications that should be made to such condensed
consolidated financial statements for them to be in conformity
with accounting principles generally accepted in the United
States of America.

We have previously audited, in accordance with
standards of the Public Company Accounting Oversight Board
(United States), the consolidated balance sheet of Party City
Corporation and subsidiary as of July 3, 2004, and the
related consolidated statements of income, shareholders
equity, and cash flows for the year then ended (not presented
herein); and in our report dated September 7, 2004, we
expressed an unqualified opinion on those consolidated financial
statements. In our opinion, the information set forth in the
accompanying condensed consolidated balance sheet as of
July 3, 2004 is fairly stated, in all material respects, in
relation to the consolidated balance sheet from which it has
been derived.



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

New York, New York

November 3, 2004


31