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SECURITIES AND EXCHANGE COMMISSION  Washington, D.C. 20549
    Form 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934   For the quarterly period ended
March 27, 2004
    
    Commission file number
0-27826
 Party City Corporation (Exact name of registrant as specified in its charter)
 Delaware
    
    22-3033692(State or other jurisdiction of
incorporation or organization)
    
    (I.R.S. Employer
Identification No.)400 Commons WayRockaway, New Jersey
    
    07866(Address of Principal Executive Offices)
    
    (Zip Code)
 973-983-0888(Registrants telephone number, including area code)    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 [x] No: [   ] Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [x] No: [   ] Indicate the number of shares outstanding of each of the issuers classes
of common stock as of the latest practicable date: As
of May 3, 2004, there were 17,046,757 shares of Common Stock, $0.01 par
value, outstanding.




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TABLE OF CONTENTS PARTY CITY CORPORATION AND SUBSIDIARY Page No.Part I Financial InformationItem 1. Financial StatementsCondensed Consolidated Balance Sheets (Unaudited) March 27, 2004, March 29, 2003 and June 28, 2003
    
    
    3Condensed Consolidated Statements of Operations (Unaudited) for the quarters and nine months ended March 27, 2004 and March 29, 2003
    
    
    4Condensed
Consolidated Statements of Cash Flows (Unaudited) for the nine months
ended March 27, 2004 and March 29, 2003 (as Restated 
See Note 12)
    
    
    5Notes to Condensed Consolidated (Unaudited) Financial Statements
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    13Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    25Item 4. Controls and Procedures
    
    
    26Part II Other InformationItem 1. Legal Proceedings
    
    
    27Item 2. Changes in Securities, Use of Proceeds, and Issuer Purchases of Equity Securities
    
    
    27Item 3. Defaults Upon Senior Securities
    
    
    27Item 4. Submission of Matters to a Vote of Security Holders
    
    
    27Item 5. Other Information
    
    
    27Item 6. Exhibits and Reports on Form 8-K
    
    
    27Exhibit Index
    
    
    27Signatures
    
    
    27AMENDED & RESTATED CERTIFICATE OF INCORPORATIONCERTIFICATIONCERTIFICATIONCERTIFICATIONCERTIFICATION
 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. The Companys website  www.partycity.com provides access, free of charge, to
the Companys SEC reports, including 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. 2




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PART I. FINANCIAL INFORMATION 
 Item 1.Financial Statements PARTY CITY CORPORATION AND SUBSIDIARY 
 CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands, except share information)
(unaudited)
 March 27,
    
    March 29,
    
    June 28,2004
    
    2003
    
    2003(1)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    15,773
    
    
    $
    3,036
    
    
    $
    3,372Merchandise inventory
    
    
    61,104
    
    
    
    76,156
    
    
    
    65,908Other current assets, net
    
    
    19,570
    
    
    
    20,819
    
    
    
    21,900Total current assets
    
    
    96,447
    
    
    
    100,011
    
    
    
    91,180Property and equipment, net
    
    
    49,242
    
    
    
    53,432
    
    
    
    52,819Goodwill
    
    
    18,614
    
    
    
    19,172
    
    
    
    18,614Other assets
    
    
    5,117
    
    
    
    4,152
    
    
    
    5,386Total assets
    
    $
    169,420
    
    
    $
    176,767
    
    
    $
    167,999LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    35,796
    
    
    $
    46,272
    
    
    $
    37,960Accrued expenses and other current liabilities
    
    
    30,599
    
    
    
    21,139
    
    
    
    24,998Cash overdraft
    
    
    106
    
    
    
    2,641
    
    
    
    4,126Advances under Loan Agreement
    
    
    
    
    
    
    18,637
    
    
    
    11,229Total current liabilities
    
    
    66,501
    
    
    
    88,689
    
    
    
    78,313Long-term liabilities:Deferred rent and other long-term liabilities
    
    
    9,818
    
    
    
    10,759
    
    
    
    10,264Commitments and contingenciesStockholders equity:Common stock, $0.01 par value, 40,000,000 shares authorized;
17,760,444 shares issued and 17,013,432 shares outstanding at
March 27, 2004; 17,177,151 shares issued and 16,430,139 shares
outstanding at March 29, 2003; and 17,296,807 shares issued and
16,549,795 shares outstanding at June 28, 2003
    
    
    178
    
    
    
    172
    
    
    
    173Additional paid-in capital
    
    
    45,073
    
    
    
    41,662
    
    
    
    43,178Retained earnings
    
    
    53,790
    
    
    
    41,425
    
    
    
    42,011Treasury stock, at cost (747,012 shares for all periods presented)
    
    
    (5,940
    )
    
    
    (5,940
    )
    
    
    (5,940
    )Total stockholders equity
    
    
    93,101
    
    
    
    77,319
    
    
    
    79,422Total liabilities and stockholders equity
    
    $
    169,420
    
    
    $
    176,767
    
    
    $
    167,999
  (1)
    
    The June 28, 2003 condensed consolidated balance sheet was derived from
the Companys audited consolidated financial statements. See accompanying notes to condensed consolidated financial statements. 3




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PARTY CITY CORPORATION AND SUBSIDIARY 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share amounts)
(Unaudited)
 Quarter Ended
    
    Nine Months EndedMarch 27,
    
    March 29,
    
    March 27,
    
    March 29,2004
    
    2003
    
    2004
    
    2003Revenues:Net sales
    
    $
    97,662
    
    
    $
    95,846
    
    
    $
    375,586
    
    
    $
    348,618Royalty fees
    
    
    3,806
    
    
    
    3,607
    
    
    
    14,929
    
    
    
    13,757Franchise fees
    
    
    80
    
    
    
    80
    
    
    
    568
    
    
    
    355Total revenues
    
    
    101,548
    
    
    
    99,533
    
    
    
    391,083
    
    
    
    362,730Expenses:Cost of goods sold and occupancy costs
    
    
    71,432
    
    
    
    70,164
    
    
    
    250,465
    
    
    
    230,563Company-owned stores operating and selling
expense
    
    
    24,754
    
    
    
    23,196
    
    
    
    86,923
    
    
    
    81,182Franchise expense
    
    
    2,024
    
    
    
    1,755
    
    
    
    5,245
    
    
    
    4,963General and administrative expense
    
    
    8,506
    
    
    
    7,223
    
    
    
    24,163
    
    
    
    22,928Litigation charge
    
    
    4,100
    
    
    
    
    
    
    
    4,100
    
    
    
    Total expenses
    
    
    110,816
    
    
    
    102,338
    
    
    
    370,896
    
    
    
    339,636Operating (loss) income
    
    
    (9,268
    )
    
    
    (2,805
    )
    
    
    20,187
    
    
    
    23,094Interest income
    
    
    (29
    )
    
    
    (5
    )
    
    
    (59
    )
    
    
    (29
    )Interest expense
    
    
    108
    
    
    
    213
    
    
    
    450
    
    
    
    3,946Interest expense, net
    
    
    79
    
    
    
    208
    
    
    
    391
    
    
    
    3,917(Loss) income before income taxes
    
    
    (9,347
    )
    
    
    (3,013
    )
    
    
    19,796
    
    
    
    19,177(Benefit) provision for income taxes
    
    
    (3,786
    )
    
    
    (1,205
    )
    
    
    8,017
    
    
    
    7,671Net (loss) income
    
    $
    (5,561
    )
    
    $
    (1,808
    )
    
    $
    11,779
    
    
    $
    11,506Basic (loss) earnings per share
    
    $
    (0.33
    )
    
    $
    (0.11
    )
    
    $
    0.70
    
    
    $
    0.69Weighted average shares outstanding  basic
    
    
    16,992
    
    
    
    16,653
    
    
    
    16,871
    
    
    
    16,617Diluted (loss) earnings per share
    
    $
    (0.33
    )
    
    $
    (0.11
    )
    
    $
    0.60
    
    
    $
    0.58Weighted average shares outstanding  diluted
    
    
    16,992
    
    
    
    16,653
    
    
    
    19,630
    
    
    
    19,757
 See accompanying notes to condensed consolidated financial statements. 4




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PARTY CITY CORPORATION AND SUBSIDIARY 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)
(Unaudited)
 Nine Months EndedMarch 27,
    
    March 29,2004
    
    2003(As
RestatedSee Note 12)Cash flow from operating activities:Net income
    
    $
    11,779
    
    
    $
    11,506Adjustments to reconcile net income to net cash provided
by operating activities:Depreciation and amortization
    
    
    12,306
    
    
    
    11,092Non-cash interest and financing costs
    
    
    120
    
    
    
    1,584Deferred rent
    
    
    (326
    )
    
    
    558Stock-based compensation
    
    
    418
    
    
    
    799Provision for doubtful accounts
    
    
    (82
    )
    
    
    (460
    )Other
    
    
    13
    
    
    
    Changes in assets and liabilities:Merchandise inventory
    
    
    4,804
    
    
    
    (19,882
    )Accounts payable, accrued expenses and other current
liabilities
    
    
    3,438
    
    
    
    8,253Other long-term liabilities
    
    
    (119
    )
    
    
    (95
    )Other current assets and other assets
    
    
    2,456
    
    
    
    (2,026
    )Net cash provided by operating activities
    
    
    34,807
    
    
    
    11,329Cash flow from investing activities:Purchases of property and equipment
    
    
    (8,638
    )
    
    
    (15,023
    )Stores acquired
    
    
    
    
    
    
    (1,758
    )Proceeds from disposals of property and equipment
    
    
    
    
    
    
    144Net cash used in investing activities
    
    
    (8,638
    )
    
    
    (16,637
    )Cash flow from financing activities:Net (payments on) proceeds from Loan Agreement
    
    
    (11,229
    )
    
    
    18,637Cash overdrafts
    
    
    (4,021
    )
    
    
    (443
    )Proceeds from exercise of stock options and warrants
    
    
    1,482
    
    
    
    1,525Payments of senior notes
    
    
    
    
    
    
    (10,207
    )Payments of financing costs
    
    
    
    
    
    
    (524
    )Purchase of treasury stock
    
    
    
    
    
    
    (4,111
    )Net cash (used in) provided by financing activities
    
    
    (13,768
    )
    
    
    4,877Net increase (decrease) in cash and cash equivalents
    
    
    12,401
    
    
    
    (431
    )Cash and cash equivalents, beginning of period
    
    
    3,372
    
    
    
    3,467Cash and cash equivalents, end of period
    
    $
    15,773
    
    
    $
    3,036Supplemental disclosure of cash flow information:Income taxes paid
    
    $
    7,707
    
    
    $
    9,476Interest paid
    
    
    330
    
    
    
    2,758Supplemental disclosure of non-cash financing activity:Issuance of shares under employment stock plan
    
    $
    244
    
    
    $
    265Issuance of shares under management stock plan
    
    
    99
    
    
    
    288Issuance of warrants
    
    
    
    
    
    
    245
 See accompanying notes to condensed consolidated financial statements. 5




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PARTY CITY CORPORATION AND SUBSIDIARY 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. Basis of Presentation The condensed consolidated financial statements are unaudited. 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 Party City
Corporation and its consolidated subsidiary (the Company) as of March 27,
2004 and March 29, 2003 and the results of operations for the quarters and nine
months ended March 27, 2004 and March 29, 2003 and cash flows for the nine
months ended March 27, 2004 and March 29, 2003. Because of the seasonality of
the party goods industry, operating results of the Company on a quarterly or
nine-month 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 June 28, 2003, 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 26, 2003. All significant intercompany accounts and
transactions have been eliminated. The June 28, 2003 condensed consolidated
balance sheet amounts included herein are derived from the Companys audited
consolidated financial statements. Our Fiscal Year (Fiscal Year) refers to the 52 or 53 weeks, as
applicable, ending the Saturday nearest to June 30. The year ended July 3, 2004
(Fiscal 2004) is a 53 week year as compared to the years ended June 28, 2003
(Fiscal 2003) and June 29, 2002 (Fiscal 2002), which were each 52 week
years. 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 the
footnotes to the financial statements in its Annual Report on Form 10-K.
Additional policies are presented below: Vendor allowances.The Company and certain vendors have arrangements
whereby the vendors provide merchandise allowances based on purchases.
Generally, these arrangements provide for a fixed percentage discount to be
provided to the Company. Because the arrangements provide for concessions to be
based on the level of purchases from the vendor, we account for the allowances
from the vendor as a reduction of inventory cost. The Company also receives vendor allowances as reimbursement for
advertising. Advertising allowances are recorded as reductions to advertising
expense as they do not affect inventory or gross margin. These allowances
represent reimbursements of specific, incremental, identifiable costs incurred
by the Company in selling the vendors product and therefore are characterized
as a reduction of that cost when recognized in the income statement. Operating leases.The Companys rent expense under operating leases
provides for step rent provisions, escalation clauses, capital improvement
funding 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. Advertising.Advertising costs, including print and other media
advertising, are expensed as incurred. 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, as amended by SFAS No. 148, Accounting for Stock Based
Compensation  Transition and Disclosure, an Amendment of SFAS No. 123. If
compensation cost for the Companys stock option plans had been determined in
accordance with the fair value method prescribed by SFAS No. 123, the
Companys net income (loss) would have been (in thousands, except per share
data): 6




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Quarter Ended
    
    Nine Months EndedMarch 27,
    
    March 29,
    
    March 27,
    
    March 29,2004
    
    2003
    
    2004
    
    2003Net (loss) income as reported
    
    $
    (5,561

    )
    
    $
    (1,808
    )
    
    $
    11,779
    
    
    $
    11,506Add: Stock-based employee compensation expense determined
under APB 25, net of tax
    
    
    161
    
    
    
    28
    
    
    
    249
    
    
    
    479Deduct: Total stock-based employee
compensation expense determined under fair
value based method, net of tax
    
    
    (533
    )
    
    
    (255
    )
    
    
    (1,526
    )
    
    
    (1,410
    )Pro-forma net (loss) income
    
    $
    (5,933
    )
    
    $
    (2,035
    )
    
    $
    10,502
    
    
    $
    10,575Basic and diluted earnings per share:Basic (loss) earnings per share as reported
    
    $
    (0.33
    )
    
    $
    (0.11
    )
    
    $
    0.70
    
    
    $
    0.69Basic (loss) earnings per share pro forma
    
    $
    (0.35
    )
    
    $
    (0.12
    )
    
    $
    0.62
    
    
    $
    0.64Diluted (loss) earnings per share as reported
    
    $
    (0.33
    )
    
    $
    (0.11
    )
    
    $
    0.60
    
    
    $
    0.58Diluted (loss) earnings per share pro forma
    
    $
    (0.35
    )
    
    $
    (0.12
    )
    
    $
    0.53
    
    
    $
    0.54
 The weighted average fair value of options granted during the third
quarter of Fiscal 2004 and 2003 was $5.56 and $6.95, respectively. The weighted average fair value of options granted during the nine months
ended Fiscal 2004 and 2003 was $5.55 and $7.41, respectively. 4. Earnings Per Share The following table sets forth the computations of basic and diluted
earnings per share (in thousands, except per share amounts): Quarter Ended
    
    Nine Months EndedMarch 27,
    
    March 29,
    
    March 27,
    
    March 29,2004
    
    2003
    
    2004
    
    2003Net (loss) income
    
    $
    (5,561
    )
    
    $
    (1,808
    )
    
    $
    11,779
    
    
    $
    11,506Earnings per share  basic
    
    $
    (0.33
    )
    
    $
    (0.11
    )
    
    $
    0.70
    
    
    $
    0.69Earnings per share  diluted
    
    $
    (0.33
    )
    
    $
    (0.11
    )
    
    $
    0.60
    
    
    $
    0.58Weighted average common shares outstanding
    
    
    16,992
    
    
    
    16,653
    
    
    
    16,871
    
    
    
    16,617Dilutive effect of stock options
    
    
    
    (a)
    
    
    
    (b)
    
    
    454
    (c)
    
    
    692
    (c)Dilutive effect of warrants
    
    
    
    (a)
    
    
    
    (b)
    
    
    2,286
    
    
    
    2,359Restricted stock units
    
    
    
    (d)
    
    
    
    (d)
    
    
    19
    
    
    
    89Weighted average common and potentially dilutive common
shares outstanding
    
    
    16,992
    
    
    
    16,653
    
    
    
    19,630
    
    
    
    19,757
  (a)
    
    Options to purchase 2,958,123 common shares at prices ranging from $1.71
to $30.88 per share and warrants to purchase 2,496,000 common shares at
$1.07 per share were outstanding at March 27, 2004 but were not included
in the computation of diluted loss per share for the quarter ended March
27, 2004 because to do so would have been anti-dilutive.(b)
    
    Options to purchase 1,652,825 common shares at prices ranging from $2.00
to $32.50 per share and warrants to purchase 2,496,000 common shares at
$1.07 per share were outstanding at March 29, 2003 but were not included
in the computation of diluted loss per share for the quarter ended March
29, 2003 because to do so would have been anti-dilutive.(c)
    
    Options to purchase 719,637 common shares at prices ranging from $12.91
to $32.50 and options to purchase 649,879 common shares at prices ranging
from $12.53 to $32.50 were outstanding at March 27, 2004 and March 29,
2003, respectively, but were not included in the computation of diluted
earnings per share for the nine months ended March 27, 2004 and March 29,
2003, respectively, because to do so would have been anti-dilutive.(d)
    
    Restricted stock units of 16,012 and 84,052 shares of common stock were
outstanding at March 27, 2004 and March 29, 2003, respectively, related to
the Management Stock Purchase Plan and were not included in the
computation because to do so would have been anti-dilutive. 7




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5. Financing Agreement In January 2003, the Company entered into a $65 million revolving credit
facility (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, (i) at the adjusted Eurodollar rate plus the
applicable margin, which was set initially at 1.50%, and is currently at 1.25%,
per annum or (ii) at the prime rate less the applicable margin, which was
initially set at and is currently 0.25% per annum (totaling 3.75% at March 27,
2004). The term of the Loan Agreement is through 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 March 27, 2004. At March 27, 2004 and May 3, 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 $23.4 million available to be borrowed under the Loan Agreement at
May 3, 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 March 27, 2004 and
March 29, 2003, there were 17,760,444 shares and 17,177,151 shares,
respectively, of the Companys common stock issued. At
March 27, 2004 and March 29, 2003, there were 747,012
shares of the Companys common stock held as treasury stock. At
March 27, 2004 and March 29, 2003, there were 17,013,432
shares and 16,430,139 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. Stock repurchases
are made at the discretion of management. There was no stock repurchase
activity during the first nine months of Fiscal 2004. During the first nine
months of Fiscal 2003, the Company purchased 463,012 shares for an aggregate
amount of $4.1 million. As of March 27, 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 the first nine months of Fiscal 2004.
In the first nine months of Fiscal 2003, 688,000 warrants to purchase the
Companys common stock were exercised. This included a cash exercise of 458,667
warrants pursuant to which the Company received proceeds of $490,774 and a
cashless exercise of the remaining 229,333 warrants pursuant to which the
warrant holders surrendered 15,541 shares and received 213,792 shares of the
Companys common stock. The 15,541 shares of the Companys common stock
surrendered had a market value of $245,386 at the time of surrender. Management Stock Purchase Plan In June 2001, the Company established a Management Stock Purchase Plan
(MSPP). The MSPP is designed to provide a means by which the Company may
attract highly qualified persons to enter into and remain in the employment of
the Company. The MSPP provides certain management employees of the Company the
opportunity to defer a portion of their 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
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
nine months ended Fiscal 2004 and Fiscal 2003 was $19,000 and $114,000,
respectively, resulting in the obligation to issue 16,012 and 84,052 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 8




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##### Table of Contents



deductions. This plan qualifies as an Employee Stock Purchase Plan under
Section 423 of the Internal Revenue Code. Contributions to the plan during the
first nine months of Fiscal 2004 and 2003 were approximately $254,000 and
$349,000, resulting in the obligation to issue 29,072 and 34,447 shares of
common stock, respectively. 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 claim 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. The settlement
provided for pursuant to the agreement-in-principle is subject to certain
conditions, including the negotiation and execution of a definitive settlement
agreement and the approval of the terms of the definitive settlement agreement
by the Superior Court after notice to the members of the class who have the
right to object. There can be no assurance that all of these conditions will
be satisfied. If a final settlement is not consummated and the lawsuit is
continued, a class is certified, liability is found and a judgment is entered,
such judgment may adversely affect the Company. In addition to the foregoing, from time to time the Company is involved in
routine litigation incidental to the conduct of the business, which is not,
individually or in the aggregate, material to the Company. 9




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##### Table of Contents



8. Segment Information The Company owns, operates and franchises party supplies stores in the
United States. The Companys management reporting system evaluates performance
based on a number of factors; however, the primary measure of performance is
the pre-tax operating profit of each segment. Accordingly, the Company reports
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 which is paid upon the grant of
a new franchise and ongoing royalty payments by franchisees based on retail
sales. The accounting policies are described in the general accounting policies
section included in the Companys 10-K for the year ended June 28, 2003 and in
Note 2 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. The following table contains key financial
information of the Companys business segments (in thousands): Quarter Ended
    
    Nine Months EndedMarch 27,
    
    March 29,
    
    March 27,
    
    March 29,2004
    
    2003
    
    2004
    
    2003Retail:Net sales
    
    $
    97,662
    
    
    $
    95,846
    
    
    $
    375,586
    
    
    $
    348,618Cost of goods sold and occupancy costs
    
    
    71,432
    
    
    
    70,164
    
    
    
    250,465
    
    
    
    230,563Gross profit
    
    
    26,230
    
    
    
    25,682
    
    
    
    125,121
    
    
    
    118,055Store operating and selling expense
    
    
    24,754
    
    
    
    23,196
    
    
    
    86,923
    
    
    
    81,182Company-owned stores profit contribution
    
    
    1,476
    
    
    
    2,486
    
    
    
    38,198
    
    
    
    36,873General and administrative expense
    
    
    8,506
    
    
    
    7,223
    
    
    
    24,163
    
    
    
    22,928Litigation charge
    
    
    4,100
    
    
    
    
    
    
    
    4,100
    
    
    
    Company-owned (loss) profit
    
    $
    (11,130
    )
    
    $
    (4,737
    )
    
    $
    9,935
    
    
    $
    13,945Identifiable assets
    
    $
    167,283
    
    
    $
    175,092
    
    
    $
    167,283
    
    
    $
    175,092Depreciation/amortization
    
    
    4,614
    
    
    
    3,959
    
    
    
    12,306
    
    
    
    11,092Capital expenditures
    
    
    5,109
    
    
    
    1,579
    
    
    
    8,638
    
    
    
    16,781Franchise:Royalty fees
    
    $
    3,806
    
    
    $
    3,607
    
    
    $
    14,929
    
    
    $
    13,757Franchise fees
    
    
    80
    
    
    
    80
    
    
    
    568
    
    
    
    355Total franchise revenue
    
    
    3,886
    
    
    
    3,687
    
    
    
    15,497
    
    
    
    14,112Total franchise expense
    
    
    2,024
    
    
    
    1,755
    
    
    
    5,245
    
    
    
    4,963Franchise profit contribution
    
    $
    1,862
    
    
    $
    1,932
    
    
    $
    10,252
    
    
    $
    9,149Identifiable assets
    
    $
    2,137
    
    
    $
    1,675
    
    
    $
    2,137
    
    
    $
    1,675Depreciation/amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Capital expenditures
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total Company:Total revenues
    
    $
    101,548
    
    
    $
    99,533
    
    
    $
    391,083
    
    
    $
    362,730Operating (loss) income
    
    $
    (9,268
    )
    
    $
    (2,805
    )
    
    $
    20,187
    
    
    $
    23,094Interest expense, net
    
    
    79
    
    
    
    208
    
    
    
    391
    
    
    
    3,917(Loss) income before income taxes
    
    
    (9,347
    )
    
    
    (3,013
    )
    
    
    19,796
    
    
    
    19,177(Benefit) provision for income taxes
    
    
    (3,786
    )
    
    
    (1,205
    )
    
    
    8,017
    
    
    
    7,671Net (loss) income
    
    $
    (5,561
    )
    
    $
    (1,808
    )
    
    $
    11,779
    
    
    $
    11,506Identifiable assets
    
    $
    169,420
    
    
    $
    176,767
    
    
    $
    169,420
    
    
    $
    176,767Depreciation/amortization
    
    
    4,614
    
    
    
    3,959
    
    
    
    12,306
    
    
    
    11,092Capital expenditures
    
    
    5,109
    
    
    
    1,579
    
    
    
    8,638
    
    
    
    16,781
 10




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##### Table of Contents



9. Acquisitions and Dispositions of Stores During Fiscal 2003, the Company acquired two stores from a franchisee. The
aggregate consideration paid in connection with this acquisition was
$1,603,000. The consolidated balance sheets include allocations of the purchase
price related to this transaction of approximately $1,002,000 in goodwill,
$195,000 in fixed assets and $406,000 in inventory. In Fiscal 2002, the Company completed the acquisition of thirteen stores
in the Seattle, Washington market from Paper Warehouse, Inc. The conversion of
these locations to the Party City store format was completed and all stores
were opened by the first quarter of Fiscal 2003. Additional goodwill of
$155,000 was recorded in Fiscal 2003 related to the completion of the
conversion of these locations. The acquisitions have been accounted for under the purchase method of
accounting. The results of operations of the acquired stores are included in
the financial statements from the date the stores were opened. The favorable
real estate locations and market share obtained in the aforementioned
transactions resulted in goodwill premiums paid. Such items continue to
provide sufficient return on the premium invested. The purchase price of these acquisitions was determined by applying a
multiple to the acquired companys proforma earnings before depreciation,
amortization, and taxes. The multiple the Company uses has generally resulted
in an acceptable return on our investment compared to the opening of a new site
as the customer and sales base is established. There were no changes in the carrying amount of goodwill of $18.6 million
(all within our retail segment) for the nine months ended March 27, 2004. Assuming the stores acquired during the nine months ended March 29, 2003
were acquired on June 30, 2002, the beginning of Fiscal 2003, the pro forma
results would have been as follows (in thousands, except per share amounts): Quarter Ended
    
    Nine Months EndedMarch 27,
    
    March 29,
    
    March 27,
    
    March 29,2004
    
    2003
    
    2004
    
    2003Net sales
    
    $
    97,662
    
    
    $
    95,846
    
    
    $
    375,586
    
    
    $
    350,067Net (loss) income
    
    
    (5,561
    )
    
    
    (1,808
    )
    
    
    11,779
    
    
    
    11,583(Loss) earnings per share  basic
    
    $
    (0.33
    )
    
    $
    (0.11
    )
    
    $
    0.70
    
    
    $
    0.70(Loss) earnings per share  diluted
    
    
    (0.33
    )
    
    
    (0.11
    )
    
    
    0.60
    
    
    
    0.59
 10. Guarantees In November 2002, the Financial Accounting Standards Board (FASB) issued
FASB Interpretation No. 45, Guarantors Accounting and Disclosure Requirements
for Guarantees, Including Indirect Guarantees of Indebtedness of Others. The
Interpretation elaborates on the existing disclosure requirements for most
guarantees, including loan guarantees such as standby letters of credit. It
also clarifies that at the time a company issues a guarantee, the company must
recognize an initial liability for the fair value, or market value, of the
obligations it assumes under the guarantee and must disclose that information
in its interim and annual financial statements. The provisions related to
recognizing a liability at inception of the guarantee for the fair value of the
guarantors obligations do not apply to product warranties or to guarantees
accounted for as derivatives. The initial recognition and initial measurement
provisions apply on a prospective basis to guarantees issued or modified after
December 31, 2002. The Company has unconditionally guaranteed the lease payments of 24 leases
associated with franchise stores and the payment of sublease rentals by
subleasees under four subleases where the Company is the sublessor. The
majority of the guarantees were given when the Company sold stores in 1999 as
part of its restructuring. The guarantees continue until the expiration date of
the leases, which range from 2004 through 2011. The maximum amount of the guarantees
may vary, but is limited to the sum of the total amount due under the lease. As of March 27,
2004, the maximum aggregate amount of the guarantees was approximately $17.2
million. 11




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##### Table of Contents



11. Recent Accounting Standards FASB Interpretation No. 46, Consolidation of Variable Interest Entities,
an Interpretation of APB No. 50 (FIN 46), was issued in January 2003, as
amended by FIN 46-R. FIN 46 requires certain variable interest entities to be
consolidated by the primary beneficiary of the entity if the equity investors
in the entity do not have the characteristics of a controlling financial
interest or do not have sufficient equity at risk for the entity to finance its
activities without additional subordinated financial support. The provisions of FIN 46 must be applied
no later than the first reporting period ending after March 15, 2004. The Company does not currently participate in any variable interest entities. 12. Restatement of
Statement of Cash Flows Subsequent
to the issuance of the condensed consolidated financial statements
for the period ended March 29, 2003 the Company determined that
the cash flow related to the Companys cash overdraft should
have been classified as a financing activity rather than an operating
activity. As a result, the condensed consolidated statement of cash
flows for the nine months ended March 29, 2003 has been restated
to reflect the cash flows related to the Companys cash overdraft as a financing activity rather than an operating activity. A summary of the effect of the restatement on cash flows provided by operating and financing activities is as follows (in thousands): As PreviouslyNine months ended March 29, 2003
    
    Reported
    
    As RestatedOperating Activities:
  
  $
  10,886
  
  
  $
  11,329Financing Activities
  
  $
  5,320
  
  
  $
  4,877 12




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##### Table of Contents



Item 2.Managements Discussion and Analysis of Financial Condition and Results
of Operations Introduction We operate retail party supplies 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. At March 27, 2004, our network
consisted of 503 stores, with 249 stores owned by us and 254 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. Traditionally, the retail party supplies business has been fragmented,
with consumers purchasing party-related products from single owner-operated
party supplies stores and designated departments in drug stores, general mass
merchandisers, supermarkets and department stores of local, regional and
national chains. We seek to offer customers a one-stop party store that
provides a wide selection of merchandise at a compelling value and in
sufficient quantities to satisfy customer needs for parties of virtually all
sizes and types. 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 flows. These
initiatives have primarily focused on our: breadth and quality of products;
product pricing; financial, distribution and inventory systems; and employee
base. With respect to our products, we are developing proprietary processes to
evaluate and select our product assortments more efficiently and effectively.
We are also reconfiguring our in-store product layout to better align product
themes and facilitate an easier shopping experience for our customers. Additionally, we continue to make advances in our inventory reduction
initiative. Our SKU reduction, vendor rationalization and product allocation
strategies have facilitated an average per store inventory reduction of 22%
over the prior year and are the principal reason for the increase in our cash
and cash equivalents from $3.0 million at March 29, 2003 to $15.8 million at
March 27, 2004. This inventory reduction has also resulted in an increase of
inventory turnover. We believe these strategies will continue to provide us
with the flexibility needed to provide fresh merchandise choices to our
customers and still maintain a sufficient variety and quantity of products to
satisfy customer needs. We have also focused on enhancing our enterprise systems, with the upgrade
of our store and corporate systems on target to be fully implemented by July
2004. The investment in our enterprise systems has improved certain store
processes, and 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. Underlying these and other important initiatives are key investments we
have made in our employee base, including the implementation of training
programs related to customer service. Over the last several weeks, we have
appointed a chief merchant, a position that remained open for eight months.
Further, to develop the staffing infrastructure needed to support our key
initiatives regarding product and product flow, we have hired several buying
and merchandise managers and two logistics managers. Since the implementation of these initiatives, we have generated
significant upfront investment expenses that are disproportionate to our sales
performance. However, we anticipate these expenses will normalize 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. Should our customers respond less favorably to our merchandise
offerings, we may need to respond by taking markdowns. If we have to reduce
our prices, margins will correspondingly decrease, thus reducing our net
income. 13




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##### Table of Contents



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: Quarter Ended
    
    Nine Months EndedMarch 27,
    
    March 29,
    
    March 27,
    
    March 29,2004
    
    2003
    
    2004
    
    2003Net sales (in thousands)
    
    $
    97,662
    
    
    $
    95,846
    
    
    $
    375,586
    
    
    $
    348,618Total
Company-owned store count
    
    
    249
    
    
    
    241
    
    
    
    249
    
    
    
    241Average net sales per same store  current period
(in thousands)
    
    $
    398
    
    
    $
    426
    
    
    $
    1,544
    
    
    $
    1,583Same store retail transactions (a) (in thousands)
    
    
    5,373
    
    
    
    5,486
    
    
    
    18,554
    
    
    
    18,479Same store average net sale per retail transaction
    
    $
    17.58
    
    
    $
    17.37
    
    
    $
    19.06
    
    
    $
    18.66Same store net sales growth
    
    
    (0.9
    %)
    
    
    (2.4
    %)
    
    
    2.5
    %
    
    
    1.1
    %Gross profit as a percent of net sales
    
    
    26.9
    %
    
    
    26.8
    %
    
    
    33.3
    %
    
    
    33.9
    %Store profit contribution as a percent of net sales
    
    
    1.5
    %
    
    
    2.6
    %
    
    
    10.2
    %
    
    
    10.6
    %Diluted (loss) earnings per share
    
    $
    (0.33
    )
    
    $
    (0.11
    )
    
    $
    0.60
    
    
    $
    0.58EBITDA(b) (in thousands)
    
    $
    (4,654
    )
    
    $
    1,154
    
    
    $
    32,493
    
    
    $
    34,186
   (a)
    
    Retail transactions represent each time a customer makes a purchase
at the register.  (b)
    
    see EBITDA discussion on page 23. For
further discussion of these key indicators, see  Results of Operations
beginning on page 17. The following table shows the growth in our network of Company owned and
franchise stores for the third quarter and nine months ended March 27, 2004 and
March 29, 2003 : Quarter Ended
    
    Nine Months EndedMarch 27,
    
    March 29,
    
    March 27,
    
    March 29,2004
    
    2003
    
    2004
    
    2003Store Data:Company-owned:Stores open at beginning of period
    
    
    247
    
    
    
    239
    
    
    
    242
    
    
    
    209Stores opened
    
    
    2
    
    
    
    3
    
    
    
    8
    
    
    
    31Stores closed
    
    
    
    
    
    
    (1
    )
    
    
    (1
    )
    
    
    (1
    )Stores acquired from franchisees
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2Stores open at end of period
    
    
    249
    
    
    
    241
    
    
    
    249
    
    
    
    241Average Company-owned stores open in period
    
    
    248
    
    
    
    240
    
    
    
    247
    
    
    
    233(Decrease) increase in Company-owned same
store sales
    
    
    (0.9
    %)
    
    
    (2.4
    %)
    
    
    2.5
    %
    
    
    1.1
    %Franchise:Stores open at beginning of period
    
    
    254
    
    
    
    240
    
    
    
    241
    
    
    
    242Stores opened
    
    
    2
    
    
    
    1
    
    
    
    15
    
    
    
    9Stores closed
    
    
    (2
    )
    
    
    
    
    
    
    (2
    )
    
    
    (8
    )Stores sold to Company
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2
    )Stores open at end of period
    
    
    254
    
    
    
    241
    
    
    
    254
    
    
    
    241Average franchise stores open in period
    
    
    253
    
    
    
    240
    
    
    
    251
    
    
    
    244Total
stores chain wide
    
    
    503
    
    
    
    482
    
    
    
    503
    
    
    
    482Increase in franchise same store sales
    
    
    1.3
    %
    
    
    1.7
    %
    
    
    4.5
    %
    
    
    3.3
    %
 14




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##### Table of Contents



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 our 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 to the
consolidated financial statements contained in our Annual Report on Form 10-K
filed with the Securities and Exchange Commission (SEC) on September 26,
2003. 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 lower of the actual cost or market, at the individual
item level. Cost is determined using the weighted average method. Inventory
levels are reviewed to identify slow-moving and closeout merchandise that will
no longer be carried. Market is determined by the estimated net realizable
value, based upon the merchandise selling price. Finite long-lived assets.In the evaluation of the fair value and future
benefits of finite long-lived assets, we perform an analysis of the anticipated
undiscounted future net cash flows of the related finite long-lived assets.
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 consolidated balance sheets include liabilities
with respect to self-insured workers compensation and general liability
claims. We estimate the required liability of such claims 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 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, such as
estimated lease commitment costs net of estimated sublease income and other
miscellaneous store closing costs, when the liability is incurred. Such
estimates may be subject to change should actual costs differ. 15




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##### Table of Contents



General Definitions for Operating Results Net Sales.Net sales include same store net sales and new store net sales.
Same store net sales include net sales for those stores that were in operation
for a full period in both the current month and the corresponding month for the
prior year. New store net sales include net sales in the current fiscal year
from stores opened during the previous fiscal year before they are considered
same stores, and new stores opened in the current fiscal year. Cost of goods sold and occupancy costs.Cost of goods sold and occupancy
costs includes the cost of merchandise, freight to the stores and store
occupancy costs. Store occupancy costs include rent, common area maintenance,
real estate taxes, repairs and maintenance, depreciation, insurance and
utilities. Gross profit. Gross profit is net sales minus cost of goods sold and
occupancy costs. Store operating and selling expenses.Store operating and selling expenses
consist 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 contribution. Company-owned store profit
contribution is gross profit minus store operating and selling expenses. General and administrative expenses.General and administrative expenses
include 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, plus ongoing
royalty fees, which are 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 pro-rata allocations
of corporate expenses for salaries, including bonuses, occupancy and
depreciation, based on time spent on franchise support. Franchise profit contribution. Franchise profit contribution is franchise
revenue minus franchise expenses. Interest expense.Interest expense includes interest relating to our
senior notes and credit facility. Interest also includes amortization of
financing intangibles, bank service charges and interest on capital lease
obligations. 16




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##### Table of Contents



Results of Operations The following table sets forth the results of operations, and also
expresses the results of operations as a percentage of segment revenues and
total revenues, for the periods indicated (in thousands, except per share
amounts): Quarter EndedMarch 27,
    
    March 29,2004
    
    2003Statement of Operations Data:Company-owned stores:Net sales
    
    $
    97,662
    
    
    
    100.0
    %
    
    $
    95,846
    
    
    
    100.0
    %Cost of goods sold and occupancy costs
    
    
    71,432
    
    
    
    73.1
    
    
    
    70,164
    
    
    
    73.2Gross profit
    
    
    26,230
    
    
    
    26.9
    
    
    
    25,682
    
    
    
    26.8Store operating and selling expense
    
    
    24,754
    
    
    
    25.3
    
    
    
    23,196
    
    
    
    24.2Company-owned stores profit contribution
    
    
    1,476
    
    
    
    1.5
    
    
    
    2,486
    
    
    
    2.6General and administrative expense
    
    
    8,506
    
    
    
    8.7
    
    
    
    7,223
    
    
    
    7.5Litigation charge
    
    
    4,100
    
    
    
    4.2
    
    
    
    
    
    
    
    0.0Company-owned loss
    
    
    (11,130
    )
    
    
    (11.4
    )
    
    
    (4,737
    )
    
    
    (4.9
    )Franchise stores:Royalty fees
    
    
    3,806
    
    
    
    97.9
    
    
    
    3,607
    
    
    
    97.8Franchise fees
    
    
    80
    
    
    
    2.1
    
    
    
    80
    
    
    
    2.2Total franchise revenues
    
    
    3,886
    
    
    
    100.0
    
    
    
    3,687
    
    
    
    100.0Total franchise expense
    
    
    2,024
    
    
    
    52.1
    
    
    
    1,755
    
    
    
    47.6Franchise profit contribution
    
    
    1,862
    
    
    
    47.9
    
    
    
    1,932
    
    
    
    52.4Operating loss
    
    
    (9,268
    )
    
    
    (9.1
    )
    
    
    (2,805
    )
    
    
    (2.8
    )Interest expense, net
    
    
    79
    
    
    
    0.1
    
    
    
    208
    
    
    
    0.2Loss before income taxes
    
    
    (9,347
    )
    
    
    (9.2
    )
    
    
    (3,013
    )
    
    
    (3.0
    )Benefit for income taxes
    
    
    (3,786
    )
    
    
    (3.7
    )
    
    
    (1,205
    )
    
    
    (1.2
    )Net loss
    
    $
    (5,561
    )
    
    
    (5.5
    %)
    
    $
    (1,808
    )
    
    
    (1.8
    %)Basic loss per share
    
    $
    (0.33
    )
    
    
    
    
    
    $
    (0.11
    )Diluted loss per share
    
    $
    (0.33
    )
    
    
    
    
    
    $
    (0.11
    )Weighted average shares outstanding  basic
    
    
    16,992
    
    
    
    
    
    
    
    16,653Weighted average shares outstanding  diluted
    
    
    16,992
    
    
    
    
    
    
    
    16,653
 Nine Months EndedMarch 27,
    
    March 29,2004
    
    2003Statement of Operations Data:Company-owned stores:Net sales
    
    $
    375,586
    
    
    
    100.0
    %
    
    $
    348,618
    
    
    
    100.0
    %Cost of goods sold and occupancy costs
    
    
    250,465
    
    
    
    66.7
    
    
    
    230,563
    
    
    
    66.1Gross profit
    
    
    125,121
    
    
    
    33.3
    
    
    
    118,055
    
    
    
    33.9Store operating and selling expense
    
    
    86,923
    
    
    
    23.1
    
    
    
    81,182
    
    
    
    23.3Company-owned stores profit contribution
    
    
    38,198
    
    
    
    10.2
    
    
    
    36,873
    
    
    
    10.6General and administrative expense
    
    
    24,163
    
    
    
    6.4
    
    
    
    22,928
    
    
    
    6.6Litigation charge
    
    
    4,100
    
    
    
    1.2
    
    
    
    
    
    
    
    0.0Company-owned profit
    
    
    9,935
    
    
    
    2.6
    
    
    
    13,945
    
    
    
    4.0Franchise stores:Royalty fees
    
    
    14,929
    
    
    
    96.3
    
    
    
    13,757
    
    
    
    97.5Franchise fees
    
    
    568
    
    
    
    3.7
    
    
    
    355
    
    
    
    2.5Total franchise revenues
    
    
    15,497
    
    
    
    100.0
    
    
    
    14,112
    
    
    
    100.0Total franchise expense
    
    
    5,245
    
    
    
    33.8
    
    
    
    4,963
    
    
    
    35.2Franchise profit contribution
    
    
    10,252
    
    
    
    66.2
    
    
    
    9,149
    
    
    
    64.8Operating income
    
    
    20,187
    
    
    
    5.2
    
    
    
    23,094
    
    
    
    6.4Interest expense, net
    
    
    391
    
    
    
    0.1
    
    
    
    3,917
    
    
    
    1.1Income before income taxes
    
    
    19,796
    
    
    
    5.1
    
    
    
    19,177
    
    
    
    5.3Provision for income taxes
    
    
    8,017
    
    
    
    2.1
    
    
    
    7,671
    
    
    
    2.1Net income
    
    $
    11,779
    
    
    
    3.0
    %
    
    $
    11,506
    
    
    
    3.2
    %Basic earnings per share
    
    $
    0.70
    
    
    
    
    
    
    $
    0.69Diluted earnings per share
    
    $
    0.60
    
    
    
    
    
    
    $
    0.58Weighted average shares outstanding  basic
    
    
    16,871
    
    
    
    
    
    
    
    16,617Weighted average shares outstanding  diluted
    
    
    19,630
    
    
    
    
    
    
    
    19,757
 17




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##### Table of Contents



Quarter Ended March 27, 2004 Compared to Quarter Ended March 29, 2003 Retail.Net sales from Company-owned stores increased 1.9% to $97.7
million for the third quarter of Fiscal 2004 from $95.8 million for the third
quarter of the prior fiscal year. The 1.9% increase in net sales resulted from
an increase of 2.8% related to the stores that have not been open for one year,
partially offset by a decrease of 0.9% from same-store net sales. The customer
count in Company-owned stores, on a same store basis, decreased 2.1%, and the
average net sale increased 1.2%. With six stores joining the same store sales
group during the third quarter of Fiscal 2004, same store net sales increased
0.8% in the western region, 0.3% in the eastern region and decreased 3.4% in
the central region. Same store net sales for Company-owned stores decreased
2.4% for the third quarter of Fiscal 2003. We opened two new stores and closed
no stores during the third quarter of Fiscal 2004 and opened three new stores
and closed one store in the same period last year. Gross profit increased 2.1% to $26.2 million in the third quarter of
Fiscal 2004 from $25.7 million in the same period last year. The increase was
primarily due to increased net sales and reduced markdown activity, partially
offset by increased occupancy and other costs. Gross margin as a percent of net
sales was 26.9% for the third quarter of Fiscal 2004 compared with 26.8% for
the same period last year. The chart below shows the components of
the $0.5 million
increase in gross profit (in millions): Component
    
    Portion of total change
 increase (decrease)Net sales
    
    $
    0.5Merchandise
    
    
    0.9Occupancy and other costs
    
    
    (0.9
    )Total
    
    $
    0.5
 Store operating and selling expenses increased 6.7% to $24.8 million for
the third quarter of Fiscal 2004 from $23.2 million in the same period last
year. The increase in store operating and selling expenses is attributable to
increased expenses related to the additional stores opened since the same
period last year. The pre-opening expenses incurred in the third quarter of
Fiscal 2004 for the new stores opened in this fiscal quarter and stores to be
opened later in the fiscal year amounted to $151,000 compared with $57,000
incurred during the same period last year. Store operating and selling
expenses were 25.3% and 24.2% of net sales for the third quarter of Fiscal 2004
and Fiscal 2003, respectively. The increase as a percent of net sales is due
mainly to increases in payroll, advertising and other operating expenses
relative to the increase in the number of stores and disproportionate sales
growth. The chart below shows the components of the $1.6 million increase in store
operating and selling expenses (in millions): Component
    
    Portion of total change  increase (decrease)Net sales
    
    $
    0.4Payroll and fringe benefits
    
    
    0.3Advertising
    
    
    0.5Credit card,
bank fees and other operating costs
    
    
    0.4Total
    
    $
    1.6
 Company-owned store profit contribution was $1.5 million for the third
quarter of Fiscal 2004 compared with $2.5 million for the same period last
year. The decrease from the prior year is primarily the result of lower same
store net sales and increased occupancy and store operating and selling
expenses. Store profit contribution as a percent of net sales was 1.5% for the
third quarter of Fiscal 2004 compared with 2.6% in the same period last year. General and administrative expenses increased 17.8% to $8.5 million for
the third quarter of Fiscal 2004 from $7.2 million in the same period last
year. General and administrative expenses were 8.7% and 7.5% of net sales for
the third quarter of Fiscal 2004 and Fiscal 2003, respectively. This increase
is primarily due to increased corporate staffing to support our strategic
initiatives, professional fees and training related to the implementation of
our new information system, and professional fees for our logistics and
Sarbanes-Oxley compliance initiatives. The chart below shows the components of
the $1.3 million increase in general and administrative expenses (in
millions): 18




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##### Table of Contents



Portion of total change  increaseComponent
    
    (decrease)Corporate payroll
    
    $
    0.5Professional fees and training
    
    
    0.6Occupancy and other costs
    
    
    0.2Total
    
    $
    1.3
 During this quarter, we recorded a pre-tax charge of $4.1 million related
to the settlement payments, attorneys fees and estimated expenses of
administering the settlement of the lawsuit regarding California overtime wage
and hour laws. See Note 7 in the condensed consolidated financial statements
included herein. Franchising.Franchise fees recognized on two store openings was $80,000
in the third quarter of Fiscal 2004 and $80,000 for two store openings in the
same period last year. Royalty fees increased 5.5% to $3.8 million in the third
quarter of Fiscal 2004 from $3.6 million in the same period last year. This was
primarily due to an increased franchise store base of 13 stores and a same
store sales increase of 1.3% for the franchise stores in the third quarter of
Fiscal 2004. Expenses attributable to the franchise segment increased 15.3% to $2.0
million for the third quarter of Fiscal 2004 from $1.8 million for the third
quarter of Fiscal 2003. As a percentage of franchise revenue, franchise
expenses were 52.1% and 47.6% for the third quarter of Fiscal 2004 and Fiscal
2003, respectively. This increase is due to increased staffing, corporate
allocation and other franchise expenses resulting from new initiative costs, as
previously discussed. Franchise profit contribution decreased 3.6% to $1.86 million in third
quarter of Fiscal 2004 from $1.93 million in the same period last year. The
decrease in franchise profit contribution is due to an increase in franchise
expenses, partially offset by the increase in royalty fees due to the increase
franchise store base and same store net sales increase. Interest
Expense. Interest expense, net decreased to $79,000 for the third
quarter of Fiscal 2004 from $208,000 in the same period last year. This
decrease in interest expense is due to lower average borrowings during the
quarter compared with the same time last year. Income Taxes.An income tax benefit of $3.8 million, or 40.5% of pre-tax
income, and $1.2 million, or 40.0% of pre-tax income, was recorded in the third
quarter of Fiscal 2004 and Fiscal 2003, respectively. The change in tax rate
from 40.0% to 40.5% is due to an increase in the overall state tax rate. Net Income. As a result of the above factors, we recorded a net loss of
$5.6 million, or $0.33 per basic and diluted share, in the third quarter of
Fiscal 2004, as compared to a net loss of $1.8 million, or $0.11 per basic and
diluted share, in the third quarter of Fiscal 2003. Weighted average diluted
shares outstanding increased to 17.0 million in the third quarter of Fiscal
2004 from 16.7 million in the same period last year. This increase is mainly
due to the warrant and stock option exercises during the twelve
months ended
March 27, 2004. Nine Months Ended March 27, 2004 Compared with Nine Months Ended March 29, 2003 Retail.Net sales from Company-owned stores increased 7.7% to $375.6
million for the nine-months ended March 27, 2004 from $348.6 million for the
same period last year. The 7.7% increase in net sales resulted from an increase
of 5.2% related to the stores that have not been open for one year and an
increase in same store net sales of 2.5%. The customer count in Company-owned
stores, on a same store basis, increased 0.4%, and the average net sale
increased 2.1%. With 37 stores joining the same store sales group during the
nine months ended March 27, 2004, same store net sales increased 3.5% in the
western region, 3.2% in the eastern region and 1.2% in the central region. Same
store net sales for Company-owned stores increased 1.1% for the same period
last year. We opened eight new stores and closed one store during the
nine-months ended March 27, 2004 and opened 31 stores, acquired two stores from
franchises and closed one store during the same period last year. Gross profit increased 6.0% to $125.1 million in the nine-months ended
March 27, 2004 from $118.1 million in the same period last year. The increase
was primarily due to increased sales volume. Gross margin as a percent of sales
was 33.3% for the nine-months ended March 27, 2004 compared with 33.9% for the
same period last year. The decrease in gross profit as a percent of sales was
related to a high level of promotional activity in July and August, the
continued emphasis on the clearance of discontinued merchandise as part of the
our strategic focus, and increased occupancy and other costs. The chart below
shows the components of the $7.0 million increase in gross profit (in
millions): 19




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##### Table of Contents



Component
    
    Portion of total change  increase (decrease)Net sales
    
    $
    9.2Merchandise
    
    
    (1.3
    )Occupancy and other costs
    
    
    (0.9
    )Total
    
    $
    7.0
 Store operating and selling expenses increased 7.1% to $86.9 million for
the nine-months ended March 27, 2004 from $81.2 million in the same period last
year. The increase in store operating and selling expenses is attributable to
increased expenses related to the additional stores opened since the same
period last year. The pre-opening expenses incurred in the nine-months ended
March 27, 2004 for the new stores and stores to be opened later in the fiscal
year amounted to $474,000 compared with $853,000 incurred during the same time
period last year. Store operating and selling expenses were 23.1% and 23.3% of
sales for the nine-months ended March 27, 2004 and March 29, 2003,
respectively. The decrease as a percent of sales is due mainly to a decrease in
advertising and other operating expenses. The chart below shows the components
of the $5.7 million increase in store operating and selling expenses (in
millions): Component
    
    Portion of total change  increase (decrease)Net sales
    
    $
    6.3Payroll and fringe benefits
    
    
    0.6Advertising
    
    
    (0.2
    )Credit card,
bank fees and other operating costs
    
    
    (1.0
    )Total
    
    $
    5.7
 Company-owned store profit contribution was $38.2 million for the
nine-months ended March 27, 2004 compared with $36.9 million for the same
period last year. The improvement over the prior year is primarily the result
of the increase in same store net sales and the number of stores. Store profit
contribution as a percent of sales was 10.2% for the nine-months ended March
27, 2004 compared with 10.6% of sales in the same period last year due to the
decrease in gross margin as described above. General and administrative expenses increased 5.4% to $24.2 million in the
nine-months ended March 27, 2004 from $22.9 million in the same period last
year. General and administrative expenses were 6.4% and 6.6% of sales for the
nine-months ended March 27, 2004 and March 29, 2003, respectively. This 5.4%
increase is primarily due to increased corporate staffing, and our information
systems, logistics and Sarbanes-Oxley compliance initiatives. The chart below
shows the components of the $1.3 million increase in general and administrative
expenses (in millions): Portion of total change  increaseComponent
    
    (decrease)Corporate payroll
    
    $
    1.1Professional fees and training
    
    
    0.2Total
    
    $
    1.3
 During the third quarter of Fiscal 2004, we recorded a pre-tax charge of
$4.1 million related to the settlement payments, attorneys fees and estimated
expenses of administering the settlement of the lawsuit regarding California
overtime wage and hour laws. See Note 7 in the condensed consolidated
financial statements included herein. Franchising.Franchising fees recognized on 15 store openings was $568,000
in the nine-months ended March 27, 2004 as compared with $355,000 recognized
for nine store openings in the same period last year. Royalty fees increased
8.5% to $14.9 million in the nine-months ended March 27, 2004 from $13.8
million in the same period last year. This was primarily due to an increased
franchise store base and a same store sales increase of 4.5% for the franchise
stores in the nine-months ended March 27, 2004. Expenses attributable to the franchise segment for the nine-months ended
March 27, 2004 increased 5.7% to $5.2 million from $5.0 million for the same
period last year. As a percentage of franchise revenue, franchise expenses
were 33.8% and 35.2% for the nine-months ended March 27, 2004 and March 29,
2003, respectively. 20




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##### Table of Contents



Franchise profit contribution increased 12.1% to $10.3 million for the
nine months ended March 27, 2004 from $9.1 million in the same period last
year. The increase in franchise profit contribution is due to the increase in
royalty and franchise fees partially offset by a slight increase in franchise
expenses. Interest
Expense. Interest expense, net decreased to $391,000 for the
nine-months ended March 27, 2004 from $3.9 million in the same period last
year. This decrease in interest expense is due to the repurchase of outstanding
senior notes during the first six months of Fiscal 2003. The repurchase of
these notes was completed using working capital and borrowings under our
asset-based revolving credit agreement. Income Taxes.An income tax expense of $8.0 million, or 40.5% of pre-tax
income, and $7.7 million, or 40.0% of pre-tax income, was recorded in the
nine-months ended March 27, 2004 and March 29, 2003, respectively.The change
in tax rate from 40.0% to 40.5% is due to an increase in the overall state tax
rate. Net Income. As a result of the above factors, net income increased to
$11.8 million, or $0.60 per diluted share in the nine-months ended March 27,
2004, as compared to net income of $11.5 million, or $0.58 per diluted share in
the same period last year. Weighted average diluted shares outstanding
decreased to 19.6 million in the nine-months ended March 27, 2004 from 19.8
million in the same period last year. This decrease is mainly due to a slight
decrease in average stock price for the nine months ended March 27, 2004. Liquidity and Capital Resources Our cash requirements are primarily for working capital, the opening of
new stores, the improvement and expansion of existing facilities and the
improvement of information systems. Historically, these cash requirements have
been met through cash flow from operations and borrowings under our credit
facilities. At March 27, 2004, working capital was $29.9 million compared to
$11.3 million in the same period last year. Our current priorities for the use of cash are primarily for investments
in high-return capital projects, 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:  
    
    implementing centralized warehousing and distribution facilities;
    
    executing our store information systems roll-out;
    
    revitalizing our brand and retail environment;
    
    evaluating our current and future store locations;
    
    improving customer service at the stores; and
    
    enhancing franchise growth. Our management currently believes 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 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. 21




---



##### Table of Contents



Key Indicators of Liquidity and Capital Resources The following table sets forth key indicators of our liquidity and capital
resources (in thousands): Quarter Ended
    
    Nine Months EndedMarch 27,
    
    March 29,
    
    March 27,
    
    March 29,2004
    
    2003
    
    2004
    
    2003Balance Sheet Data:Cash and cash equivalents
    
    $
    15,773
    
    
    $
    3,036
    
    
    $
    15,773
    
    
    $
    3,036Working capital
    
    
    29,946
    
    
    
    11,322
    
    
    
    29,946
    
    
    
    11,322Total assets
    
    
    169,420
    
    
    
    176,767
    
    
    
    169,420
    
    
    
    176,767Borrowings
    
    
    
    
    
    
    18,637
    
    
    
    
    
    
    
    18,637Stockholders equity
    
    
    93,101
    
    
    
    77,319
    
    
    
    93,101
    
    
    
    77,319Other Information:Depreciation and amortization
    
    $
    4,614
    
    
    $
    3,959
    
    
    $
    12,306
    
    
    $
    11,092Cash flows (used in) provided by:Operating
activities
    
    $
    4,160
    
    
    $
    (4,973
    )
    
    $
    34,807
    
    
    $
    11,329Investing activities
    
    
    (5,109
    )
    
    
    (1,480
    )
    
    
    (8,638
    )
    
    
    (16,637
    )Financing
activities
    
    
    (3,828
    )
    
    
    6,215
    
    
    
    (13,768
    )
    
    
    4,877Total cash (used in) provided by
    
    $
    (4,777
    )
    
    $
    (238
    )
    
    $
    12,401
    
    
    $
    (431
    )
 Operating Activities.For the nine months ended March 27, 2004, cash
provided by operating activities was $34.8 million, compared to $11.3 million
for the same period last year. The increase in cash provided by operating
activities was primarily attributable to a decrease in inventory. The decrease
in average inventory level per store of 22.0% from the same period last year,
due to managements inventory reduction initiatives, enabled us to focus on
product assortment, merchandise presentation and identify and discontinue
slower moving items. The increase was also a result of higher net income and
lower accounts payable and other current liabilities. Investing
Activities.Cash used in investing activities for the nine
months ended March 27, 2004 was $8.6 million compared to $16.6 million in the
same period in the last fiscal year. The decrease in cash used in investing
activities was primarily attributable to the opening of eight Company-owned
stores this year as compared with 31 new store openings and the acquisition of
two stores from a franchisee during the same period last year. Financing Activities.Cash used in financing activities was $13.8 million
for the nine months ended March 27, 2004 compared with cash provided by
financing activities of $4.9 million for the same period last year. Cash
generated from operating activities during Fiscal 2004 was used to pay down our revolving
credit facility. We also received proceeds of $1.5 million from the exercise
of stock options and warrants in Fiscal 2004 and $1.5 million in Fiscal 2003. Loan Agreement.At March 27, 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, (i) at
the adjusted Eurodollar rate plus the applicable margin, which was set
initially at 1.50%, and is currently at 1.25%, per annum or (ii) at the prime
rate less the applicable margin, which was initially set at and is currently
0.25% per annum, (totaling 3.75% at March 27, 2004). The term of the Loan
Agreement is through April 30, 2006, and borrowings are secured by a lien on substantially
all of our assets. At March 27, 2004 and May 3, 2004, we had no borrowings
outstanding under the Loan Agreement. Based on a percentage of current eligible
inventory and credit card receivables, we had $23.4 million available to be
borrowed under the Loan Agreement at May 3, 2004. Stock Repurchase.In September 2001, the Board of Directors authorized us
to repurchase up to $15 million of our outstanding common stock. Stock
repurchases are made at the discretion of management. There was no stock
repurchase activity during the first nine months of Fiscal 2004. During the
first nine months of Fiscal 2003, we purchased approximately 463,000 shares for
an aggregate amount of $4.1 million. As of March 27, 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. 22




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##### Table of Contents



Warrants.There were no warrant exercises in the first nine months of
Fiscal 2004. In the first nine months of Fiscal 2003, 688,000 warrants to
purchase our common stock were exercised. This included an exercise of 458,667
warrants for which proceeds of
$490,774 were received and a cashless exercise of the remaining 229,333
warrants for which the warrant holders received 213,792 shares of common stock.
The remaining 15,541 shares were surrendered in connection with this exercise.
These 15,541 shares of our common stock had a market value of $245,386 at the
time of surrender. EBITDA (Earnings before interest, taxes, depreciation and amortization) Quarter Ended
    
    Nine Months EndedMarch 27,
    
    March 29,
    
    March 27,
    
    March 29,2004
    
    2003
    
    2004
    
    2003EBITDA (a)
    
    $
    (4,654
    )
    
    $
    1,154
    
    
    $
    32,493
    
    
    $
    34,186Most directly comparable GAAP measures:Net (loss) income
    
    $
    (5,561
    )
    
    $
    (1,808
    )
    
    $
    11,779
    
    
    $
    11,506Cash flows provided by (used in)
operating activities
    
    
    4,160
    
    
    
    (4,973
    )
    
    
    34,807
    
    
    
    11,329
  (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) income follows for the periods
indicated: Quarter Ended
    
    Nine Months EndedMarch 27,
    
    March 29,
    
    March 27,
    
    March 29,2004
    
    2003
    
    2004
    
    2003EBITDA(a)
    
    $
    (4,654
    )
    
    $
    1,154
    
    
    $
    32,493
    
    
    $
    34,186Depreciation and amortization
    
    
    (4,614
    )
    
    
    (3,959
    )
    
    
    (12,306
    )
    
    
    (11,092
    )Interest expense, net
    
    
    (79
    )
    
    
    (208
    )
    
    
    (391
    )
    
    
    (3,917
    )Benefit (provision) for income taxes
    
    
    3,786
    
    
    
    1,205
    
    
    
    (8,017
    )
    
    
    (7,671
    )Net (loss) income
    
    $
    (5,561
    )
    
    $
    (1,808
    )
    
    $
    11,779
    
    
    $
    11,506
 23




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##### Table of Contents



Because we also consider EBITDA useful as a liquidity measure, we present
the following reconciliation of EBITDA to our net cash provided by (used in)
operating activities: Quarter Ended
    
    Nine Months EndedMarch 27,
    
    March 29,
    
    March 27,
    
    March 29,2004
    
    2003
    
    2004
    
    2003EBITDA(a)
    
    $
    (4,654
    )
    
    $
    1,154
    
    
    $
    32,493
    
    
    $
    34,186Interest expense, net
    
    
    (79
    )
    
    
    (208
    )
    
    
    (391
    )
    
    
    (3,917
    )Benefit (provision) for income taxes
    
    
    3,786
    
    
    
    1,205
    
    
    
    (8,017
    )
    
    
    (7,671
    )Non-cash interest
    
    
    40
    
    
    
    30
    
    
    
    120
    
    
    
    1,584Deferred rent
    
    
    (86
    )
    
    
    31
    
    
    
    (326
    )
    
    
    558Stock-based compensation
    
    
    270
    
    
    
    47
    
    
    
    418
    
    
    
    799Provision for doubtful accounts
    
    
    58
    
    
    
    142
    
    
    
    (82
    )
    
    
    (460
    )Other
    
    
    3
    
    
    
    
    
    
    
    13
    
    
    
    Changes in assets and liabilities:Accounts payable, accrued expenses and
other current liabilities
    
    
    1
    
    
    
    (6,134
    )
    
    
    3,438
    
    
    
    8,253Merchandise inventory
    
    
    (823
    )
    
    
    (6,967
    )
    
    
    4,804
    
    
    
    (19,882
    )Other long-term liabilities
    
    
    
    
    
    
    45
    
    
    
    (119
    )
    
    
    (95
    )Other current assets and other assets
    
    
    5,644
    
    
    
    5,682
    
    
    
    2,456
    
    
    
    (2,026
    )Net cash provided by (used in)
operating activities
    
    $
    4,160
    
    
    $
    (4,973
    )
    
    $
    34,807
    
    
    $
    11,329
 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. Restatement of the Consolidated Statement of Cash Flows: As
discussed in Note 12 to the condensed consolidated financial
statements, we restated our condensed consolidated statement of cash
flows for nine month period ended March 29, 2003 to reflect the
cash flows related to our
cash overdraft as a financing activity rather than an operating
activity. The
consolidated statements of cash flows
for the six months ended December 27, 2003 and December 28, 2002,
three months ended September 27, 2003 and September 28, 2002 and for the fiscal
years ended June 28, 2003, June 29, 2002 and June 30,
2001 will also be restated to correct the classification of these cash
flows. We
anticipate amending our Form 10-Q for the periods ended December 27, 2003 and
September 27, 2003 and
our Form 10-K for the year ended June 28, 2003 in the near
future. A summary of the effect of the restatement on cash flows
provided by (used in) operating and our financing activities in these
statements of cash flows is as follows (in thousands): As Previously
    
    AsReported
    
    RestatedSix months ended December 27, 2003Operating Activities:
    
    $
    30,647
    
    
    $
    34,724Financing Activities:
    
    
    (9,940
    )
    
    
    (14,017
    )Six months ended December 28, 2002Operating Activities:
    
    
    19,915
    
    
    
    16,346Financing Activities:
    
    
    (4,907
    )
    
    
    (1,338
    )Three months ended September 27, 2003Operating Activities:
    
    
    (1,783
    )
    
    
    795Financing Activities:
    
    
    4,462
    
    
    
    1,884Three months ended September 28, 2002Operating Activities:
    
    
    (4,814
    )
    
    
    (5,120
    )Financing Activities:
    
    
    16,973
    
    
    
    17,279Year ended June 28, 2003Operating Activities:
    
    
    24,129
    
    
    
    23,088Financing Activities:
    
    
    (1,990
    )
    
    
    (949
    )Year ended June 29, 2002Operating Activities:
    
    
    34,127
    
    
    
    31,042Financing Activities:
    
    
    (20,494
    )
    
    
    (17,409
    )Year ended June 30, 2001Operating Activities:
    
    
    29,655
    
    
    
    33,876Financing Activities:
    
    
    (8,099
    )
    
    
    (12,320
    )
 24




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##### Table of Contents



Contractual Obligations and Commercial Commitments To facilitate an understanding of our contractual obligations and
commercial commitments, the following data is provided as of March 27, 2004: Payments Due By Period (in thousands)Total
    
    1 Year
    
    2-3 Years
    
    4-5 Years
    
    After 5 yearsContractual obligations:Operating leases
    
    $
    233,745
    
    
    $
    46,159
    
    
    $
    84,868
    
    
    $
    64,365
    
    
    $
    38,353Other contractual obligations
    
    
    1,000
    
    
    
    1,000
    
    
    
    
    
    
    
    
    
    
    
    Total contractual obligations
    
    $
    234,745
    
    
    $
    47,159
    
    
    $
    84,868
    
    
    $
    64,365
    
    
    $
    38,353
 Our rent expense under operating leases provides for step rent provisions,
escalation clauses, capital improvement funding 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. Other
contractual obligations include a commitment for selected equipment
and services associated with our logistics initiative. We
enter into arrangements to purchase merchandise up to
eight months in
advance of expected delivery. These purchase orders do not contain any
significant termination payments or other penalties if cancelled. As of March 27, 2004 and May 5, 2004, we had a contingent liability
related to severance payments for 14 and 15 employees, respectively. The total
contingent liability ranges from zero to approximately $2.1 million. As of
March 27, 2004 and May 5, 2004, we had a standby letter of credit of $3.7
million pursuant to the Loan Agreement. 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. Recent Accounting
Pronouncements FASB
Interpretation No. 46, Consolidation of Variable Interest
Entities, an Interpretation of APB No. 50
(FIN 46), was issued in January 2003, as amended by
FIN 46-R. FIN 46 requires certain variable interest
entities to be consolidated by the primary beneficiary of the entity
if the equity investors in the entity do not have the characteristics
of a controlling financial interest or do not have sufficient equity
at risk for the entity to finance its activities without additional
subordinated financial support. The provisions of FIN 46 must be
applied no later than the first reporting period ending after
March 15, 2004. The Company does not currently participate in
any variable interest entities. 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 are made a
number of times throughout the document and may be identified by
forward-looking terminology as estimate, project, expect, believe,
may, will, intend or similar statements or variations of such terms. Such
forward-looking statements are based on many assumptions that are subject to
certain risks and uncertainties, and include among others, the following:
levels of sales, store traffic, acceptance of product offerings, competitive
pressures from other party supplies retailers and other retailers, availability
of qualified personnel, availability of suitable future store locations,
schedules of store expansion plans and other factors beyond our control. As a
result of the foregoing risks and uncertainties, actual results and performance
may differ materially from those projected or suggested herein. 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 Securities and Exchange Commission filings
and our public announcements. 
 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. We generally borrow only during certain times of the
year as our borrowing patterns are cyclical. Therefore, a sudden increase in
interest rates (which under the Loan 25




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##### Table of Contents





Agreement is dependent on, at our option, (i) at the adjusted Eurodollar
rate plus the applicable margin, which was set initially at 1.50% per annum,
and is currently at 1.25% per annum , or (ii) at the prime rate less the
applicable margin, which was set initially at and is 0.25% per annum (totaling
3.75% at March 27, 2004)) may, during peak borrowing, have a negative impact on
short-term results. We believe that our interest rate risk is minimal as 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 SEC Rule 13a-15(b), we carried out 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 Chief
Executive Officer and Chief Financial Officer concluded that our disclosure
controls and procedures were effective at the reasonable assurance level. In
connection with the SEC's review of our 10-K for the year ended June 28,
2003, we concluded that there is a reportable condition (as defined under
standards established by the American Institute of Certified Public
Accountants) relating to our internal controls over our financial reporting
relating to the classification of a financing activity on the cash flow
statement. This reportable condition has been thoroughly discussed among
management, the audit committee and our independent auditors. Previously, the
change in the cash overdraft from year to year was classified in net cash
provided by operating activities rather than net cash provided by
financing activities. For purposes of this Quarterly Report on Form 10-Q, we have
restated our condensed consolidated statements of cash flows for the nine
months ended March 29, 2003 to reflect the cash flow related to
our cash overdraft in the condensed consolidated statements
of cash flows as a financing activity rather
than an operating activity. We
have enhanced our internal control over financial reporting, including
expanding our review
of policies and procedures, which we expect will rectify this condition. Other than as described above, there has been no change in our internal
control over financial reporting during our most recent fiscal quarter that
has materially affected, or is reasonably likely to materially 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.Changes in Securities, Use of Proceeds and Issuer Purchases of Equity
Securities None 
 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.(b)
    
    Reports on Form 8-K: We furnished a Current Report on Form 8-K dated January 8, 2004 under Item 12
in reference to a press release dated January 8, 2004 reporting certain
information regarding our sales results for the second quarter ended December
27, 2003. We furnished a Current Report on Form 8-K dated January 12, 2004 under Items 5
and 7 in reference to a press release dated January 12, 2004 reporting that
Nancy Pedot was named Chief Executive Officer on a permanent basis and that she
would remain on the Board of Directors, and that Rick Griner assumed the newly
created position of Chief Operating Officer and has resigned from the Board. We furnished a Current Report on Form 8-K dated February 6, 2004 under Item 12
in reference to a press release dated February 6, 2004 reporting certain
information regarding our operating results for the second quarter ended
December 27, 2003. 27




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##### Table of Contents



EXHIBIT INDEX Exhibit No.*
    
    
    3.1
    
    
    Amended and Restated Certificate of Incorporation of the Company.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).4.2
    
    
    Form of Amended and Restated Warrant, incorporated by
reference from the Companys Current Report on Form 8-K as
filed with the Commission on January 19, 2000 (the January
2000 8-K).4.3
    
    
    Form of Securities Purchase Agreement, dated as of August 16,
1999, by and between the Company and each of the Investors,
incorporated by reference from the Companys Current Report on
Form 8-K as filed with the Commission on August 25, 1999 (the
August 1999 8-K).4.4
    
    
    First Amendment to Securities Purchase Agreement, dated as of
January 14, 2000, by and between the Company and each of the
Investors, incorporated by reference from the January 2000
8-K.4.5
    
    
    Third Amendment to Securities Purchase Agreement, dated as of
April 1, 2001, by and among the Company and each of the
Investors, incorporated by reference from the Companys
Quarterly Report on Form 10-Q as filed with the Commission on
May 15, 2001 (the May 2001 10-Q).10.1
    
    
    Form of Unit Franchise Agreement entered into by the Company
and franchisees, incorporated by reference from the S-1.10.2
    
    
    Option Agreement, dated as of June 8, 1999, between Steven
Mandell and Jack Futterman, incorporated by reference from
Amendment No. 1 to Schedule 13D as filed by Jack Futterman
with the Commission on June 17, 1999 (Futtermans 13D).10.3
    
    
    Stock Pledge Agreement, dated as of June 8, 1999, between
Steven Mandell and Jack Futterman, incorporated by reference
from Futtermans 13D.10.4
    
    
    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).10.5
    
    
    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, 2001.10.6
    
    
    General Release and Severance Agreement of James Shea, dated
 28




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##### Table of Contents



Exhibit No.as of May 28, 2003, by and between the Company and James Shea,
incorporated by reference from the September 2003 10-K.10.7
    
    
    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.10.8
    
    
    Separation Agreement of Thomas Larson, dated as of August 26,
2002, by and between the Company and Thomas Larson,
incorporated by reference from the September 2003 10-K.10.9
    
    
    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.10.10
    
    
    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.10.11
    
    
    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.10.12
    
    
    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.10.13
    
    
    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, 2003.10.17
    
    
    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
 29




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##### Table of Contents



Exhibit No.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.21.1
    
    
    Subsidiaries, incorporated by reference from the September 2003 10-K.*
    
    
    31.1
    
    
    Certification of Chief Executive Officer pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.*
    
    
    31.2
    
    
    Certification of Chief Financial Officer 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 30




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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 CORPORATIONBy
    
    /s/ NANCY PEDOT(Nancy Pedot)Chief Executive Officer(principal executive officer)By
    
    /s/ LINDA M. SILUK(Linda M. Siluk)Chief Financial Officer(principal financial andaccounting officer)Date: May 17, 2004
 31




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##### Table of Contents



INDEPENDENT ACCOUNTANTS REPORT 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 March 27, 2004 and March 29, 2003,
and the related condensed consolidated statements of operations for the
quarter and nine month periods ended March 27, 2004 and
March 29, 2003 and of cash flows
for the nine month periods ended March 27, 2004 and March 29, 2003. These interim
financial statements are the responsibility of the Companys management. We conducted our reviews in accordance with standards established by the
American Institute of Certified Public Accountants. 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 generally accepted in the United States
of America, 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 auditing standards generally
accepted in the United States of America, the consolidated balance sheet of
Party City Corporation and Subsidiary as of June 28, 2003, 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 August 21,
2003, we expressed an unqualified opinion (and included an
explanatory paragraph relating to the adoption of new accounting
standard) on those consolidated financial
statements. In our opinion, the information set forth in the accompanying
condensed consolidated balance sheet as of June 28, 2003 is fairly stated, in
all material respects, in relation to the consolidated balance sheet from which
it has been derived. As
discussed in Note 12, the condensed consolidated statement of
cash flows
for the nine month period ended March 29, 2003 has been restated. DELOITTE & TOUCHE LLP New York, New York
May 17, 2004 32