**SECURITIES ANDEXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-K**

 

**ANNUAL REPORT PURSUANT TO SECTION13 OR 15(d)**

**OF THE SECURITIES EXCHANGE ACT OF1934**

 

**For the FiscalYear Ended February 1, 2002**

 

**Commission File No. 0-23389**

 

 

 

**PAPERWAREHOUSE, INC.**

(Exact name of registrantas specified in its charter)

 
| **Minnesota**                                                    |   | **41-1612534**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |

 

**7630 Excelsior Boulevard**

**Minneapolis, Minnesota 55426**

(Address of principalexecutive offices) (Zip code)

 

Registrant’stelephone number, including area code:  **(952)936-1000**

Securities registeredpursuant to Section 12(b) of the Act:  **None**

Securities registeredpursuant to Section 12(g) of the Act:

 

**Common Stock, $.03 par value**

 

Indicate by check mark whether the Registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. YES  ý  NO  o

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K is not contained herein, and will not be contained, tothe best of the Registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K.  o

 

As of April 23, 2002, 1,886,192 shares of the Registrant’s Common Stockwere outstanding.  The aggregate marketvalue of the Common Stock held by non-affiliates of the Registrant on suchdate, based upon the last sale price of the Common Stock as reported on theNasdaq SmallCap Market on April 23, 2002, was $1,034,717.  For purposes of this computation, affiliatesof the Registrant are deemed only to be the Registrant’s executive officers,directors and greater than 10% shareholders.

 

**DOCUMENTS INCORPORATED BY REFERENCE:**

 

Part III of this Annual Report on Form 10-K incorporates by referenceinformation (to the extent specific sections are referred to herein) from theRegistrant’s definitive Proxy Statement for its Annual Meeting of Shareholdersto be held on June 13, 2002 (the “2002 Proxy Statement”).

 

 

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**PAPER WAREHOUSE, INC.**

**Form 10-K**

** **

**For the fiscal year ended February1, 2002**

 

**TABLE OF CONTENTS**

** **
|         | **Description**                                                                                          |   |   |
|--------------|----------------------------------------------------------------------------------------------------------|--------|--------|
| **PART I**   |                                                                                                     |   |
| Item 1.      | Business                                                                                                 |   |
| Item 1A.     | Cautionary  Statement Regarding Future Results, Forward-LookingInformation and Certain Important Factors |   |
| Item 2.      | Properties                                                                                               |   |
| Item 3.      | Legal  Proceedings                                                                                       |   |
| Item 4.      | Submission  of Matters to a Vote of Security Holders                                                     |   |
| Item 4A.     | Executive  Officers of the Registrant                                                                    |   |
| **PART II**  |                                                                                                     |   |
| Item 5.      | Market  for Registrant’s Common Equity and RelatedStockholder Matters                               |   |
| Item 6.      | Selected  Financial Data                                                                                 |   |
| Item 7.      | Management’s  Discussion and Analysis of Financial Condition andResults of Operations               |   |
| Item 7A.     | Quantitative  and Qualitative Disclosures About Market Risk                                              |   |
| Item 8.      | Financial  Statements                                                                                    |   |
| Item 9.      | Changes  in and Disagreements with Accountants on Accounting andFinancial Disclosure                     |   |
| **PART III** |                                                                                                     |   |
| Item 10.     | Directors  and Executive Officers of the Registrant                                                      |   |
| Item 11.     | Executive  Compensation                                                                                  |   |
| Item 12.     | Security  Ownership of Certain Beneficial Owners andManagement                                           |   |
| Item 13.     | Certain  Relationships and Related Transactions                                                          |   |
| **PART IV**  |                                                                                                     |   |
| Item 14.     | Exhibits,  Financial Statement Schedules and Reports on Form 8-K                                         |   |

 

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**PART I**

 

**ITEM 1****.  BUSINESS.**

 

*(a) General Development of Business*

Paper Warehouse isa chain of retail stores specializing in party supplies and paper goods.  Our fiscal year ends on the Friday closestto January 31st.  Our fiscalyear is generally 52 weeks; however it periodically consists of 53 weeks.  Our fiscal year ended February 1, 2002(fiscal 2001) consisted of 52 weeks, our fiscal year ended February 2, 2001(fiscal 2000) consisted of 53 weeks, and our fiscal year ended January 28, 2000(fiscal 1999) consisted of 52 weeks.

As of February 1,2002, we had 152 stores, including 100 Company-owned stores and 52 franchisestores.  These stores are convenientlylocated in major retail trade areas to provide customers with easy access.  We operate these stores under the names *PaperWarehouse* and *Party Universe*. * *We also operate awebsite, which can be accessed at *www.PartySmart.com*.  Our website is not intended to be, and isnot, a part of this Annual Report on Form 10-K.  As of February 1, 2002, our stores were located in the followingprincipal markets: 
| •       Denver, CO               |   | •       Des Moines, IA          |   | •       Kansas City, MO and KS |
|---------------------------------------------------------------------|--------|--------------------------------------------------------------------|--------|-------------------------------------------------------------------|
| •       Minneapolis/St. Paul, MN |   | •       Oklahoma City/Tulsa, OK |   | •       Omaha, NE              |
| •       Seattle, WA              |   | •       Tucson, AZ              |   |                                                              |

 

On April 12, 2002,however, we signed a purchase agreement to sell 13 stores located in Seattle,Washington, and on April 23, 2002, we closed on this transaction and exited theSeattle market. 

We offer anextensive selection of party supplies and paper goods, at everyday low prices,for a wide variety of celebratory occasions, everyday uses and seasonal events,including:
| **Celebratory occasions and everyday uses**                                                                                                                                                                                                                           |   | **Seasonal events**                                                                                                                                                                                         |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| •      birthdays•      weddings •      baby showers •     graduations •      other family and religious celebrations |   | •      Valentine’s Day •      Easter •      Fourth of July •      Thanksgiving |   | •      Halloween•      Christmas•      Hanukkah  •      New Year’s |

Through our 8,500 squarefoot store prototype, we offer a comprehensive selection of over 19,000different products, offering customers the convenience of one-stop shopping forall of their party supplies and paper goods needs.  We organize our merchandise by party themes.  The prominent signage, wide aisles,knowledgeable staff and depth of product offerings allow customers tocoordinate various merchandise offerings for all party occasions.  We believe that our extensive productselection and high in-stock positions stimulate customers to purchaseadditional products.

The first PaperWarehouse store opened in Minneapolis, Minnesota in 1983.  We purchased the business, consisting ofthree stores located in the Minneapolis/St. Paul metropolitan area, in 1986,and incorporated it in Minnesota in 1987. In this Annual Report on Form 10-K, “Paper Warehouse,” “Company,” “we,”“our” and “us” refer to Paper Warehouse, Inc. and our subsidiaries, PaperWarehouse Franchising, Inc. and PartySmart.com, Inc.  Our principal executive offices are located at 7630 ExcelsiorBoulevard, Minneapolis, Minnesota 55426. Our telephone number is (952) 936-1000.

*(b)Financial Information about Segments*

Since our inception, our revenues, operating income (loss) and assetshave been attributable to the single industry segment of party supplies andpaper goods.

 

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*(c) Narrative Description ofBusiness*

**Paper Warehouse Stores**

 

*Format.*  We operatestores that range in size from 3,000 square feet to 9,300 square feet of retailspace.  We introduced our current8,500-square foot prototype store in 1994, which was developed based onmanagement’s extensive retail and other industry experience, in addition tocustomer research. Of our 100 Company-owned stores at year end approximately90% were 6,000 square feet or larger.

Our stores are designedto create a customer-friendly environment. We use vibrant colors, theme-oriented merchandise displays and uniqueproducts to create a fun and festive shopping experience.  The focal point of our stores is theseasonal display located at the front of each store, which creates a“store-within-a-store” appearance.  Thisdisplay maximizes the season’s selling opportunity and is continuously updatedto promote a fresh image within the store. To assist customers in coordinating party supplies for occasions, welocate related departments, such as gift-wrap and greeting cards adjacent toone another and display related merchandise such as party hats, plates, cupsand napkins together within a department. Customers are able to easily move about the different departments tofind specific product categories due to prominent, easy-to-read signage, brightlighting and wide aisles.  We believethat our store layout assists customers in finding and coordinating their partysupply needs, and also encourages browsing, impulse purchases and repeatvisits.

In 1998 we introduced our“concept store.”  A concept store has adifferent look and feel than our other stores. These stores have more colorful ceilings, lower shelves in the front ofthe store, carpeting and confetti-tiled floors and new vibrant unclutteredsignage.  In addition, in our conceptstore, we endeavor to stow all extra merchandise out of sight.  These features give the store a very openand organized feel, allow customers to more easily see merchandise throughoutthe store, and provide a more fun and festive shopping atmosphere.  Of our 100 Company-owned stores at year end,36 were concept stores.  NewCompany-owned stores are configured as concept stores and we selectivelyremodel existing stores to concept stores where the revenue potential justifiesthe investment involved.  We believethat our concept stores help facilitate the creation of brand awareness,generate strong sales per square foot and are readily transferable to newmarkets.  During fiscal 2002, wecurrently plan to remodel four existing stores, to incorporate theconcept-store format.

*Party Smart Concept*.  We continueto distinguish our business from our competitors by positioning Paper Warehouseas the party expert.  We believe that wehave the opportunity to create a distinct identity for ourselves, one in whichcustomers equate us with the word *“party”* in every possible way.  During fiscal 1999, we implemented a programin our stores called *Party Smart. *Webelieve strongly in this concept*,* and continue to invest resources, bothfinancial and personnel, towards the success of this program.  We define *Party Smart*as being able toprovide a customer with all the information and resources necessary to have asuccessful party, celebration or gathering. We reinforce this concept through shopping bag inserts, window and aislesigns, buttons for employees, in-store audio messages, radio broadcasting andthe Internet.  Through this program, wecontinue to strive towards:

•                  increasing the average purchase percustomer visit;

•                  increasing the frequency of store visits;and

•                  developing customers’ preference for usover our competitors.

 

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The first phase ofthe *PartySmart* program consisted of the following:

•                  providing helpful and engaging in-storepresentations to add value to the shopping experience;

•                  communicating our expertise by givingcustomers party ideas, decorating tips, referrals and planning advice andintegrating this with our in-depth product knowledge; and

•                  creating a “party planning resourcecenter” in each store that carries different types of brochures for differenttypes of parties and seasonal events such as entertainment and catering ideas,games to play at children’s birthday parties and shopping checklists.

In an effort tostress our commitment to building and enhancing management skills, duringfiscal 2001, we rolled out Phase II of *Party Smart*.  This phase included, among other things, in-depth discussions andworkshops covering a variety of managerial topics, the implementation of a newperformance evaluation tool and the introduction of certain methods, includingbackground checks, to enhance the evaluation of potential employee candidates.

During fiscal2002, we intend to continue promoting and supporting the *Party Smart* philosophy byreinforcing the use of training materials, updating the sales associatesworkbooks and enhancing the performance evaluation tools to reflect thestandards of *Party Smart*.

*Customer Service. *We strive towards providing a high level of customerservice to enhance our customer-friendly store environment.  Store managers and sales associates aretrained to assist customers with party planning and event coordination.  In connection with our *Party Smart* program, allemployees are trained on how to provide nontraditional customer service to ourcustomers.  We want our employees to beable to offer our customers party ideas, decorating tips and referrals, as wellas help customers find and purchase products. In addition, we provide party planning guides and checklists.  Our “no hassles” return policy makes it easyfor customers to return or exchange products, which we believe, encouragescustomers to purchase additional product quantities.  Certain products that require additional sales assistance, suchas balloons, are located near checkout counters where sales associates canreadily assist customers.  Wecontinually monitor our level of customer service by regular store visits andby employing anonymous “mystery shoppers.” Mystery shoppers visit all Company-owned stores at least once perquarter, and evaluate personnel based on our *PartySmart* philosophy*,*includingvarious aspects of customer service, such as responsiveness, quality of productdisplays and store cleanliness.  Thesemystery shopper results are utilized during the evaluation process of our storemanagers.

*Operations and Training.* Each Company-owned store is typically operated by a store manager, oneassistant manager and a varying number of full-time and part-time salesassociates, depending on the store size, sales volume and selling season.  Store managers are responsible for allaspects of a store’s day-to-day operations, including employee hiring andtraining, work scheduling, expense control and customer service.  These managers report to a district oroperations manager, each of whom is responsible for several stores.  Within each geographic market, we usefloating managers to assist in smaller stores that cannot support both a storemanager and an assistant manager.  Inaddition, floating managers support store managers during busy holiday seasons,and substitute for store managers during vacations and other absences, and workwith newly hired store managers to ensure a smooth transition for salespersonnel and customers.

                Beforeopening a new Company-owned store, we train store managers intensely for twoweeks, on average, depending on their prior experience.  During the new store set-up, our districtmanagement team provides additional training to our store managers.  After the store opening, corporateheadquarters personnel spend considerable time overseeing the operations.  We schedule periodic training sessions forstore managers in the central or district offices on various topics, includinghuman resources,

 

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merchandising, loss prevention and employeesupervision.  We cover additionaltraining topics at monthly managers’ meetings and through mailings, such as ourweekly merchandising updates and our monthly Company newsletter.

Paper Warehousestores are typically open:

 
| Monday through Friday |   | 9:00 a.m. to  9:00 p.m. |
|-----------------------|--------|-------------------------|
| Saturday              |   | 9:00 a.m. to 6:00 p.m.  |
| Sunday                |   | 10:00 a.m. to 5:00 p.m. |

 

**SiteSelection and Locations**

 

*Site Selection. *In order to select the optimal locationfor our stores, we use a site selection process that considers variouscriteria, including:

•                  population density;

•                  demographics, including age and income;

•                  parking availability;

•                  storefront visibility and presence;

•                  local competition;

•                  traffic counts; and

•                  lease rates.

We locate ourstores in or near visible high traffic strip mall centers in close proximity toprominent mass merchandisers, discount or grocery store anchors.  Our strategy of clustering stores inmetropolitan markets promotes customer convenience and creates favorableeconomies of scale for marketing and advertising, operations and merchandising.

*Locations.* As of February 1, 2002, we had 100 Company-owned stores in the followingstates:
|                       |   | **Number of Stores**                        |
|----------------------------|--------|---------------------------------------------|
| Arizona                    |   |     4                        |
| Colorado                   |   |   14                                   |
| Iowa                       |   |     5                        |
| Kansas                     |   |     8                        |
| Minnesota                  |   |   29                                   |
| Missouri                   |   |   10                                   |
| Nebraska                   |   |     2                        |
| Oklahoma                   |   |   14                                   |
| Washington                 |   |        13 (1) |
| Wisconsin                  |   |     1                        |
| Total Company-owned Stores |   | 100                                         |

 

(1)  As noted above, on April 23, 2002, we soldthese stores and exited the Seattle market.

 

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**Merchandising**

*Overview.*Through our 8,500 square foot storeprototype, we offer a comprehensive selection of over 19,000 products,providing customers the breadth of product offerings and the convenience ofone-stop shopping for all party supplies and paper goods.  Our merchandise is organized by party themes.  The prominent signage and wide aisles in ourstores allow customers easy access to coordinate the merchandise required forall party occasions.  We also believethat our extensive and readily available merchandise selection stimulatescustomers to purchase additional products.

*Party Supplies. *We offer an extensive selection ofcomplementary and coordinating party supplies in unique and traditionalpatterns, colors and designs.  Examplesof party supplies include:
| •  invitations | •  plates  | •  napkins  | •  party  favors | •  streamers | •  giftware            |
|--------------------------|----------------------|-----------------------|----------------------------|------------------------|----------------------------------|
| •  banners     | •  candles | •  balloons | •  party  snacks | •  candy     | •  seasonal  novelties |

We typicallyoffer, in our 8,500 square foot prototype, over 120 ensembles of everyday andseasonal party goods for many occasions, which include party hats, plates,napkins and cups.  A significant portionof our juvenile party goods ensembles involves the use of movie and televisionfigures, animated characters and celebrity likenesses licensed to themanufacturer of these ensembles.

*Gift Wrapping Products.*  We offer awide assortment of everyday and seasonal gift wrapping products in variouspatterns and colors, including gift-wrap, gift bags, gift boxes, tissue paper,ribbons, bows, shred, gift tags and tape. In addition to holiday selections, we offer distinctive gift packagingproducts for special occasions such as birthdays, graduations, weddings, babyshowers and other family and religious celebrations.

*Greeting Cards.*  We feature awide variety of special occasion, seasonal and everyday greeting cards withtraditional, humorous and contemporary styles under the Ambassador brand ofHallmark.

*Catering Food Service Supplies. *Weoffer food service products such as plates, cups, serving trays and bowls andtable coverings.  In addition tooffering such products to our regular party goods customers, many commercialusers of food service products buy these products from us, including cateringcompanies and non-profit organizations.

*Low Prices*.  We providecustomers with everyday low pricing. Our low price position is reinforced with extensive promotional andseasonal advertised specials.

**Product Sourcing and Inventory Management**

                We purchase oureveryday and seasonal merchandise from approximately 280 suppliers.  During fiscal 2001, our largest supplieraccounted for approximately 21% of our purchases and our 4 largest suppliersrepresented approximately 58% of our purchases.  We have a multi-year supply agreement with Hallmark Cards, Inc.,for Hallmark to be the exclusive supplier of greeting cards for ourCompany-owned and franchise stores.  Asa result of this partnership, we have a remaining contractual obligation forchain-wide purchases of $27.5 million of greeting cards and gift-wrap.  We estimate that these purchase commitmentswill be fulfilled over a four-year period. With the exception of the agreement with Hallmark, we do not have anylong-term purchase commitments or exclusive contracts with any of our othersuppliers.  We believe that alternativesources of product are available at comparable terms and conditions. We considernumerous factors in supplier selection, including price, payment terms, productofferings and product quality.  Wenegotiate pricing with suppliers on behalf of all Company-owned and franchisestores.  We believe that this buyingpower enables us to receive favorable pricing terms and to

 

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more readilyobtain high demand merchandise. Although franchise stores are responsible for purchasing their owninventory, franchisees are able to make purchases on our negotiated pricingterms.  As we add new stores, we believewe will increase the volume of our inventory purchases and benefit further fromincreased discounts, trade allowances and more favorable payment terms from oursuppliers.

Approximately 95% of oureveryday merchandise is shipped directly from the supplier to our stores.  Shipping merchandise directly to our storesprovides us with flexibility in pursuing new markets without the geographicalconstraints and costs associated with a central distribution system.  Deliveries are processed and inventory itemsare inspected, sorted and priced in a segregated receiving area in the back ofthe store (approximately 10% of total gross square feet per store) before beingplaced on the selling floor.  We believethat we realize substantial savings by not maintaining a large centraldistribution system.

Some of our suppliers,such as overseas suppliers, will not ship directly to our stores, but willinstead ship products directly to one store in each of our major metropolitanmarkets.  This store then separates andships the products to our other stores within that market.  This approach allows us to makeopportunistic volume purchases and allows us to carry products not availablefrom domestic suppliers.  We utilizesome of the stores in our markets for the separation and redistribution ofproducts to other stores within that market. We maintain a relatively small cross-dock facility in Minneapolis,Minnesota from which we separate and distribute merchandise system-wide,including to our franchise stores.

**Advertising and Marketing**

We maintain aggressiveadvertising and marketing programs.  Ourstrategy of clustering stores in metropolitan markets enables us to costeffectively employ a variety of media. We primarily advertise through newspaper and direct mail inserts, and toa lesser degree, radio.  We also promoteproducts through the use of direct mail mini-catalogs as well as throughin-store coupon books and party planning aids.

Our advertising effortsare designed to promote the breadth and value of product offerings, educateconsumers about our convenient store locations and stress the customer servicelevels and knowledge of our sales associates. Our advertising consists primarily of full color newspaper and directmail inserts designed around major holidays and seasonal events.  For fiscal 2001, we distributed 12 newspaperand direct mail inserts in all of our markets, and four in limited markets.  We supplement inserts with radio advertisingfor Easter, the spring season, graduation, Halloween and Christmas.  In addition, we typically advertise theopening of new stores in newspaper and direct mail inserts, as well as on theradio.

We have a targeted directmail program for special events. Historically we have mailed mini-catalogs of wedding and graduationparty goods to brides-to-be and families of high school graduates but we haveexpanded this direct mail program to other special occasions, such as a child’sfirst birthday, and to organizations purchasing basic party and paper goods forcommercial or institutional use.  Ourinstitutional customers include a variety of small businesses, caterers, foodservice companies, schools, synagogues, churches, civic groups and otherorganizations.  For certain institutionalcustomers, we offer an organizational discount of 15% off of purchases inexcess of $50.00.

                Forfiscal 2001, we spent approximately 65% of our marketing budget on full colornewspaper and direct mail inserts, approximately 25% for radio advertising andthe remainder on yellow pages advertising, in-store sales promotions and othermiscellaneous advertising expenses.

 

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**Information Systems**

We believe that astrong information systems infrastructure is essential to our currentoperations and is critical towards enhancing our competitive position in ourindustry.  We have investedsignificantly in building this infrastructure. Our current system provides daily sales information and inventory levelsat store, department, class, and product level.  This information allows the corporate office to monitor dailysales, gross profit, repricing and inventory by product across the entire storebase.  Also, our automatic merchandisereplenishment system uses this information to reorder goods for individualstores based on specific product requirements.

During fiscal 2001, wecompleted the roll out of “POS Smart”, which is our back-office computersystem, to the remainder of our store base. “POS Smart” has improved communication among the stores and thecorporate office by enhancing receiving processes, providing timely electroniccommunication among the corporate office and the stores and improving otherback-office processes at the stores. During fiscal 2001, we also implemented electronic data interchange withseveral of our key vendors, which has allowed us to systematically manageinventory processes and improve order accuracy.  In addition, during fiscal 2001 we activated our data warehouse,which has improved our ability to analyze data and report results.  During fiscal 2002, we intend to implementtime and attendance software that will provide better tracking, accuracy andanalysis of store labor hours.

**Internet and e-commerce**

In order to increase oursales and strengthen our name recognition, we developed a website, *PartySmart.com,*to sell party supplies and paper goods over the Internet.  We believe this site is an additionaldistribution channel for consumers who want to purchase party or theme productson-line, and it is an information tool for consumers who want party planningadvice or who want to identify the nearest Paper Warehouse or Party Universelocation.  On this site, we offereveryday party goods for parties and celebrations such as baby showers,birthdays, theme parties and anniversaries. In addition, the site is regularly updated with unique themes andproduct offerings that match the current season, such as Halloween andChristmas.  Our website allows ourcustomers to, among other things:

•                  put together an entire party;

•                  obtain party advice, ideas and tips;

•                  pay for everything at one time at a check-out screen;

•                  check on the status of orders that have already beenplaced;

•                  contact customer service about the products andservices available on our website;

•                  preview our store to learn more about our history,products and services; and

•                  obtain information about us, such as store locations,franchising opportunities, investor relations and career opportunities.

                Lookingforward, we believe that the Internet can be an important information tool anda successful distribution channel for us, and we remain committed to keep thisdistribution and information channel active. However, we will continue to evaluate the website’s contributions toensure that they are aligned with our overall goals and objectives.

 

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**Franchising**

We have offeredfranchises of our Paper Warehouse store concept since October 1987.  As of February 1, 2002, we had 39 franchiseesoperating 52 franchise stores in the following locations:
|                   |   | **Number of Stores** |
|------------------------|--------|----------------------|
| Arizona                |   | 1                    |
| Canada                 |   | 1                    |
| Colorado               |   | 5                    |
| Florida                |   | 1                    |
| Georgia                |   | 1                    |
| Illinois               |   | 1                    |
| Iowa                   |   | 2                    |
| Kansas                 |   | 2                    |
| Kentucky               |   | 1                    |
| Louisiana              |   | 4                    |
| Maryland               |   | 1                    |
| Massachusetts          |   | 1                    |
| Michigan               |   | 1                    |
| Minnesota              |   | 1                    |
| Mississippi            |   | 1                    |
| Missouri               |   | 2                    |
| Montana                |   | 3                    |
| Nebraska               |   | 3                    |
| Nevada                 |   | 2                    |
| North Dakota           |   | 4                    |
| South Dakota           |   | 5                    |
| Texas                  |   | 7                    |
| Wyoming                |   | 2                    |
|                   |   |                 |
| Total Franchise Stores |   | 52                   |

We typicallyestablish franchise stores in markets outside of metropolitan areas withCompany-owned stores.  We believe thatthese markets are not usually served adequately by the party supplies and papergoods industry.  In addition togenerating franchise revenues, franchise stores benefit us through increasedname recognition and increased buying power with our suppliers.

We assist franchisees inopening and operating a Paper Warehouse store. During the pre-opening phase, our support includes:

•                  site evaluation and assistance with leasenegotiations;

•                  store build-out assistance;

•                  fixtures, equipment, supplies andinventory procurement;

•                  opening advertising materials; and

•                  operations training.

 

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We make available to ourfranchisees, services such as business planning, operations and promotional activities.  In addition, we perform the merchandisingprocess for our franchisees.  We makeperiodic inspections of the franchise stores to ensure that the franchisee iscomplying with our various requirements and quality standards.  We may, in the future, enter into multiplestore development agreements with franchisees granting them certain exclusiverights to develop stores in specified markets, so long as the franchisee meetsa stated development schedule and complies with other provisions of the developmentagreement and the franchise agreement.

Our franchise revenuesare comprised of initial franchise fees and continuing royalty payments.  Our current initial franchise fee istypically $35,000 for new franchisees. We may offer a discounted franchise fee for developers opening multiplestores.  If a franchisee enters into asecond or third franchise agreement they will receive a discount on the initialfee associated with the second or third store. Franchisees are also required to pay us a continuing royalty equal to apercentage of their weekly gross sales. Historically, this percentage has varied from 3% to 5%.  Currently, new franchises pay us acontinuing royalty of 5% of their gross sales.

The franchisee’s initialinvestment depends primarily upon store size. This investment includes the initial franchise fee, real estate andleasehold improvements, fixtures and equipment, signs, point of sale systems,deposits and business licenses, initial inventory, opening promotional expensesand working capital.  We reserve theright to require franchisees to pay a weekly advertising fee not to exceed 1%of gross sales, although to date we have not charged this fee.  Each franchisee is granted a license from usfor the right to use certain of our intellectual property rights, including themark *PaperWarehouse* or *Party Universe* and related designs.  Our franchise agreements are for a ten-yearterm and contain conditional renewal options.

**Competition**

The party suppliesand paper goods retailing business is highly competitive.  In order to compete successfully againstother party supplies and paper goods retailers, we believe we must maintainconvenient locations, broad merchandise selections, competitive pricing andstrong customer service.  Our storescompete with a variety of smaller and larger retailers, including:

•                  specialty party supply retailers;

•                  other party superstores such as Party City and FactoryCard Outlet;

•                  card shops;

•                  designated departments in mass merchandisers, discountretailers, toy stores, drug stores, supermarkets and department stores; and

•                  other Internet retailers.

We believe the followingfactors distinguish our business from other party superstores:

•                  we have grown our number of stores in a morecontrolled manner;

•                  our clustering growth strategy creates a critical massof stores in our principal markets, which allows us to promote customerconvenience and create favorable economies of scale for marketing, advertisingand operations; and

•                  we have a strong dedicated senior management team andboard of directors with significant retail experience.

 

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**Trademarks and Service Marks**

We use the marks *PaperWarehouse, Party Universe* and *Party Smart,*all of which are federallyregistered.  We are aware of the commonlaw usage of the name *Paper Warehouse* by several companies invarious parts of the United States, which may prevent us from using that namein certain regional markets.  In marketswhere we cannot use *Paper Warehouse,*we intend to use the name*PartyUniverse*.  Because of ourregional approach to advertising and store clustering, we believe that the useof a single trademark within each market is more important to our growth andbusiness strategy than the use of one mark nationally.

**Seasonality**

Generally ourresults of operations have fluctuated from quarter to quarter because ofvariations in revenues and operating expenses. We generate a significant portion of our operating income in our secondand fourth fiscal quarters because of seasonal events.  Any factor that negatively affects ourrevenues or increases our operating expenses during the second and fourthfiscal quarters could negatively affect our annual results of operations.  As a result of the seasonality of ourrevenues, we expect to incur a loss in the first quarter of each year for theforeseeable future.  Although wetypically realize strong sales during the third quarter, due to increasedpromotional activities, we have historically experienced reduced operatingincome for this quarter.

Our results of operationsalso fluctuate from quarter to quarter as a result of the following:

•      thetiming of new store openings, remodels or relocations;

•      costsassociated with new store openings, remodels or relocations; and 

•      expensesincurred to support any expansion strategy.

** **

**Government Regulation**

As a franchisor,we comply with rules and regulations adopted by the Federal Trade Commissionand with state laws that regulate the offer and sale of franchises.  We also comply with a number of state lawsthat regulate certain substantive aspects of the franchisor-franchiseerelationship.  These laws regulate thefranchise relationship, for example, by requiring the franchisor to deal withfranchisees in good faith, by prohibiting interference with the right of freeassociation among franchisees and by regulating illegal discrimination amongfranchises with regard to charges, royalties or fees.  To date, those laws have not kept us from seeking franchisees inany given area and have not affected our operations.

All of our stores complywith regulations adopted by federal agencies and with licensing and otherregulations enforced by state and local health, sanitation, safety, fire andother departments.  More stringent and variedrequirements of local governmental bodies with respect to zoning, land use andenvironmental factors and difficulties or failures in obtaining the requiredlicenses or approvals can delay and sometimes prevent the opening of a newstore.  In addition, we comply with theFair Labor Standard Act and various state laws governing matters such asminimum wage, overtime and other working conditions.  We also comply with the provisions of the Americans withDisabilities Act of 1990, which generally requires that employers providereasonable accommodation for employees with disabilities and that stores beaccessible to customers with disabilities.

**Employees**

As of February 1,2002, we employed approximately 370 full-time and approximately 770 part-timeemployees.  We consider our relationshipswith our employees to be good.  None ofour employees are covered by a collective bargaining agreement.

 

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*(d) Financial Information About Geographic Areas*

Since inception, with theexception of continuing franchise fees earned on our Canadian franchise’sretail sales equal to approximately $9,000 for fiscal 2001, all of our revenueshave been derived from within the United States.  In addition, since inception, all of our assets have been locatedin the United States.

**Item 1A****.**                                                  **CAUTIONARY STATEMENT REGARDING FUTURE RESULTS,FORWARD-LOOKING INFORMATION AND CERTAIN IMPORTANT FACTORS.**

                Paper Warehouse makes writtenand oral statements from time to time regarding its business and prospects,such as projections of future performance, statements of management’s plans andobjectives, forecasts of market trends, and other matters that areforward-looking statements within the meaning of Sections 27A of the SecuritiesAct of 1933 and Section 21E of the Securities Act of 1934.  Statements containing the words or phrases“will likely result,” “are expected to,” “will continue,” “is anticipated,”“estimates,” “projects,” “believes,” “expects,” “anticipates,” “intends,”“target,” “goal,” “plans,” “objective,” “should” or similar expressionsidentify forward-looking statements, which may appear in documents, reports,filings with the Securities and Exchange Commission, news releases, written ororal presentations made by our officers or other representatives to analysts,shareholders, investors, news organizations and others, and discussions withour management and other Company representatives.  For such statements, we claim the protection of the safe harborfor forward-looking statements contained in the Private Securities LitigationReform Act of 1995.

Our futureresults, including results related to forward-looking statements, involve anumber of risks and uncertainties.  Noassurance can be given that the results reflected in any forward-lookingstatements will be achieved.  Anyforward-looking statements made by us or on our behalf speak only as of thedate on which such statement is made. Our forward-looking statements are based upon assumptions that aresometimes based upon estimates, data, communications and other information fromsuppliers, government agencies and other sources that may be subject torevision.  We do not undertake anyobligation to update or keep current either (i) any forward-looking statementto reflect events or circumstances arising after the date of such statement, or(ii) the important factors that could cause our future results to differmaterially from historical results or trends, results anticipated or planned byus, or which are reflected from time to time in any forward-looking statementwhich may be made by us or on our behalf.

                In addition to other mattersidentified or described by us from time to time in filings with the SEC, thereare several important factors that could cause our future results to differmaterially from historical results or trends, results anticipated or planned byus, or results that are reflected from time to time in any forward-lookingstatement that may be made by us or on our behalf.  Some of these important factors, but not necessarily all of theimportant factors, include the following:

**We Have Experienced Losses and May Not be Profitable**

                Weincurred a net loss of $9.8 million for fiscal 2001.  This net loss reflects our decision to record a full valuationallowance against our deferred tax asset, equal to approximately $6.1 million,as prescribed by authoritative accounting guidance.  We incurred net losses of $434,000 and $4.4 million for fiscal2000 and fiscal 1999, respectively.  Wecannot assure you that we will generate sufficient revenues, or controloperating expenses, to achieve or sustain profitability in future years, or toreverse the valuation allowance established in fiscal 2001 against our deferredtax asset.

 

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**Ifthe Amount Outstanding Under Our Debentures or Revolving Line of Credit Were tobe Accelerated, We May Not Have Sufficient Cash Readily Available to SatisfySuch Obligations**

                We are currently in breach of a covenant under theindenture governing our outstanding subordinated debentures, which could resultin an "Event of Default" under such indenture and a cross-defaultunder our revolving credit agreement if not waived by the debenture holdersprior to June 16, 2002.  Such events of default could possibly cause the payment amounts outstanding underour subordinated debentures and revolving line of credit to be accelerated, inwhich case we may not have sufficient cash readily available to satisfy suchobligations.  In addition, if such accelerationwere to occur, at that time, we would evaluate our options to attempt to remedysuch acceleration.

**WeMay Need to Raise Additional Capital to Fund Our Operations**

                Ifwe are unable to generate sufficient cash from operations, we will be requiredto adopt one or more alternatives to raise cash such as refinancing orrestructuring our outstanding indebtedness, selling our assets or seeking toraise additional debt or equity capital. Our losses, coupled with the financial difficulties of other party goodcompetitors, could affect our ability to obtain such additional financing.  In addition, such financing may beunavailable or may be unavailable on favorable terms.  If adequate funds are unavailable or are unavailable onacceptable terms, we may be unable to develop or enhance our operations,products and services, take advantage of future opportunities or respond tocompetitive pressures.

**OurIndebtedness Could Negatively Affect Our Financial Position**

As of February 1, 2002,we had approximately $14.9 million of borrowings outstanding, which includeamounts outstanding under our revolving line of credit, our subordinated debt,our mortgage, our note payable to an unrelated business partner, capital leasesand other debt.  We are considerablymore leveraged than some of our competitors, which might place us at acompetitive disadvantage.  Thesubstantial level of our indebtedness could:

•                  impair our ability to obtain additionalfinancing for operations, capital expenditures or general corporate purposes;

•                  cause a substantial portion of our cashflow from operations to be spent on principal and interest payments;

•                  affect our ability to fund our operations;

•                  make us more vulnerable to economic orindustry downturns and competitive pressures;

•                  prevent us from making interest and principal paymentson our debt obligations;

•                  hinder our ability to adjust to changingmarket conditions; and

•                  prevent us from meeting certain financial testscontained in our debt obligations, which could lead to a default on thoseobligations.

 

**Our Plans to Remodel and RelocateStores May Reduce Profitability**

In fiscal 2002, we plan to remodel and relocate four stores.  Any remodeling or relocating plan is subjectto several risks, including the loss of sales during the remodeling orrelocation period, cost overruns of the remodeling or relocation and failure toachieve increased sales after the remodeling or relocation.

 

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**Our Annual Results Are SignificantlyDependent on the Results of Second and Fourth Quarters**

We typically generate asignificant portion of our operating income in our second and fourth fiscalquarters because of the seasonality of our revenues and promotionalexpenses.  Any factor that negativelyaffects our revenues or increases our operating expenses during our second andfourth fiscal quarters could negatively affect our annual results ofoperations.  As a result of theseasonality of our revenues, we expect to incur a loss in the first quarter offiscal 2002 and for the first quarter of each fiscal year in the foreseeablefuture.  Although we typically realizestrong sales during the third quarter, due to increased promotional activities,we have generally experienced a lower level of operating income for thisquarter.

**CompetitionMay Reduce Our Revenues and Operating Income**

Increased competition byexisting or future competitors may reduce our sales and cause us to incur aloss.  As a result of competition fromother specialty party supplies and paper goods retailers, as well as mass merchants,we have experienced reduced sales growth in our existing stores and incurredadditional marketing and promotional expenses. Many of our competitors have substantially greater financial resourcesthan we do.  Some of our competitorshave been, or may be, funded by certain members of the vendor community.  We may also encounter additional competitionfrom new entrants in the future in our existing markets.

**OurBusiness Depends on Continued Good Relations with Our Suppliers**

Our failure to maintaingood relationships with our principal suppliers or the loss of our principalsuppliers could hurt our business.  Manyof our principal suppliers currently provide us with incentives such as volumepurchasing allowances and trade discounts. If our suppliers were to reduce or discontinue these incentives, pricesfrom our suppliers could increase, which could negatively impact ourrevenues.  Any supplier coulddiscontinue selling to us at any time.

**We May Move to the NASDAQ Bulletin Board**

OnFebruary 14, 2002, the Nasdaq Stock Market notified us that we were not incompliance with two of its SmallCap market maintenance requirements, onerequiring that we maintain a minimum market value of $1,000,000 public float,and one requiring that we maintain a minimum bid price of $1.00 per share.  We have until May 15, 2002 to comply withthe minimum value of public float requirement, and we have until August 13,2002 to comply with the minimum bid price requirement.  In order to comply with the minimum marketvalue of public float requirement, our common stock must trade above $1.11 forat least 10 consecutive trading days prior to May 15, 2002.  If we do not trade at this level for therequired time period, Nasdaq could delist our stock as early as the opening ofbusiness on May 16, 2002.  Meeting theminimum value of public float requirement would also put us in compliance withthe minimum bid price standard of $1.00 per share.  If we do not satisfy the maintenance requirements, our commonstock would trade on the Nasdaq Bulletin Board, or any other organized marketon which our shares may be eligible for trading, unless we successfully appealthe decision by Nasdaq to delist our common stock.  Any move of our common stock from the Nasdaq SmallCap Marketcould cause the market price of our common stock to decline and could make itmore difficult to buy and sell our common stock.  There can be no assurance that we will be able to satisfy theNasdaq SmallCap Market’s maintenance requirements, or if we do so satisfy them,that we can continue to satisfy them in the future.

 

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**A Failure in Executing Our FranchiseProgram May Negatively Impact our Revenue**

 

Our growth and successdepends in part upon our ability to attract, contract with and retain qualifiedfranchisees.  It also depends upon theability of those franchisees to successfully operate their stores and promoteand develop the Paper Warehouse and Party Universe store concept.  Although we have established criteria toevaluate prospective franchisees, and our franchise agreements include certainoperating standards, each franchisee operates his/her store independently.  Various laws limit our ability to influencethe day-to-day operations of our franchise stores.  We cannot assure you that franchisees will be able tosuccessfully operate Paper Warehouse stores in a manner consistent with ourconcepts and standards.  As a result,our franchisees may operate their stores in a manner that reduces the grossrevenues of these stores, and therefore reduces our franchise revenues.

**A Changein Consumer Preferences Could Negatively Affect Our Business**

If consumer demandfor single-use, disposable party goods were to diminish, our revenues would benegatively affected.  For example, ifcost increases in raw materials such as paper, plastic, cardboard or petroleumwere to cause our prices to increase significantly, consumers might decide toforgo the convenience associated with single-use, disposable products and usestandard dinnerware and flatware. Similarly, changes in consumer preferences away from disposable productsin favor of reusable products for environmental or other reasons could reducethe demand for our products.

**RegionalRisks May Affect Our Business**

Because our operationsare located principally in less than ten metropolitan areas, we are subject tocertain regional risks, such as the economy, weather conditions, naturaldisasters and government regulations. If any region in which we operate stores were to suffer an economic downturnor other adverse regional risks were to occur, our sales could decline.

**WeAre Unlikely to Recoup Our Original Investment in Our Internet Strategy**

Although we have scaled-back the extent of, and minimized our financialexposure to, our e-commerce venture, operation of our website still requiresmanagement’s ongoing attention and the dedication of our merchandising,accounting and information systems departments.  In addition, although we have made attempts to minimize thefinancial impact of our web store, there are still incremental costs to operatethe site.  Our website is unlikely togenerate any profits and we are unlikely to recapture the money originallyinvested in our Internet strategy of approximately $2.5 million.

 

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**We Needto Anticipate and Respond to Merchandising Trends**

Our success depends inpart on our ability to anticipate and respond in a timely manner to changingmerchandise trends and consumer demands. We make merchandising decisions well in advance of the seasons duringwhich we will sell the merchandise.  Asa result, if we fail to identify and respond quickly to emerging trends,consumer acceptance of the merchandise in our stores could diminish, and we mayexperience a reduction in revenues.  Wesell certain licensed products that are in great demand for short time periods,making it difficult to project our inventory needs for these products.  Significantly greater or less-than-projectedproduct demand, could lead to one or more of the following:

•                  lost sales due to insufficient inventory;

•                  higher carrying costs associated with slower turninginventory;

•                  higher levels of carryover merchandise; and

•                  reduced or eliminated margins due to mark downs onexcess or slow moving inventory.

**ITEM 2****.  PROPERTIES.**

                Weown a 23,000 square foot building in a suburb of Minneapolis, Minnesota, inwhich our headquarters is located.  Aterm note, equal to $1.0 million at February 1, 2002, is payable in monthlyinstallments of $8,612, including interest at 7.125%, through May 2009, and issecured by a first mortgage on our office headquarters.

We lease a 23,600 squarefoot building in a suburb of Minneapolis, Minnesota for warehouse space.  We lease all the locations for ourCompany-owned stores.  We anticipatethat any new Company-owned stores will have ten-year leases with at least onefive-year renewal option.

We believe thatthe space provided by these properties is suitable and adequate to meet ouroperations for the foreseeable future.

**ITEM 3****.  LEGAL PROCEEDINGS.**

We are not a partyto any material litigation nor are we aware of any threatened litigation thatwould have a material adverse effect on our business.

**ITEM 4****.  SUBMISSION OF MATTERSTO A VOTE OF SECURITY HOLDERS.**

No matters weresubmitted to a vote of our security holders during the fourth quarter of thefiscal year ended February 1, 2002.

 

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**ITEM 4A****.               EXECUTIVEOFFICERS OF THE REGISTRANT.**

**ExecutiveOfficers and Other Key Personnel**

The following tablecontains certain information about our executive officers as of March 1, 2002:
| **Name**           |   | **Age** |   | **Position**                                                  |
|--------------------|--------|---------|--------|---------------------------------------------------------------|
| Yale T. Dolginow   |   | 59      |   | President, Chief Executive Officer and Chairman of  the Board |
| Steven R. Anderson |   | 55      |   | Vice President and Chief Information Officer                  |
| Steven P. Durst    |   | 33      |   | Vice President of Merchandising                               |
| Cheryl W. Newell   |   | 48      |   | Vice President and Chief Financial Officer                    |

The followingtable contains certain information about our other key personnel as of March 1,2002:
| **Name**            |   | **Age** |   | **Position**                                             |
|---------------------|--------|---------|--------|----------------------------------------------------------|
| Michael A. Anderson |   | 41      |   | Vice President of Franchising                            |
| Kristen Lenn        |   | 34      |   | Vice President of Human Resources                        |
| Willard V. Lewis    |   | 65      |   | Vice President of Store Development                      |
| Carol A. Nelson     |   | 51      |   | Vice President of Stores                                 |
| Diana G. Purcel     |   | 35      |   | Vice President, Controller and Chief Accounting  Officer |

 

*YaleT. Dolginow* hasbeen our President, Chief Executive Officer, and one of our directors since1986.  From 1982 to 1986, Mr. Dolginowserved as President and Chief Executive Officer of Carlson Catalog Showrooms,Inc., which was a chain of 59 catalog showrooms located throughout theMidwest.  From 1981 to 1982, Mr.Dolginow served as Assistant to the President of Dayton Hudson Corporation(k/n/a Target Corporation).  From 1978to 1980, Mr. Dolginow served as President of Modern Merchandising, Inc., a70-store retail chain operating in several markets, and as Executive VicePresident from 1977 to 1978.  From 1968until 1976, Mr. Dolginow was the Chief Executive Officer and President of Dolgin’s,Inc., a chain of catalog showroom stores that operated in the Kansas City andSt. Louis metropolitan markets.  Mr.Dolginow is a member of the advisory board of University of Kansas School ofBusiness and a director of Bet Shalom Congregation, both not-for-profitorganizations.  Mr. Dolginow and DianeC. Dolginow, one of our directors, are husband and wife.

 

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*Steven R. Anderson* has served as our Vice President and ChiefInformation Officer since December 1998. From May 1997 until June 1998, Mr. Anderson was Senior Vice Presidentand Chief Information Officer for County Seat, a publicly held specialty softgoods retailer.  From 1986 to 1997, Mr.Anderson held a number of information systems positions, including Senior VicePresident and Chief Information Officer at Best Buy Co., a publicly heldspecialty retailer.

*Steven P. Durst* has served as Vice President of Merchandising since1998.  Mr. Durst joined us in 1995 asDirector of Information Systems, and became Vice President of InformationSystems in 1997.  From 1990 to 1995, Mr.Durst was employed by Exxon Corporation where he performed various engineeringand business planning functions.  Mr.Durst is the son-in-law of Mr. and Mrs. Dolginow, two of our directors.

*Cheryl W. Newell* has served as our Vice President and Chief FinancialOfficer since August 1997.  From 1991 toAugust 1997, Ms. Newell was a Vice President with the Corporate Banking Groupat U.S. Bancorp, a bank holding company, responsible for management of desktoptechnology, disaster recovery and training and development. From 1986 to 1991,Ms. Newell was a Vice President with Citicorp (k/n/a Citigroup), a bank holdingcompany.  From 1976 to 1986, Ms. Newellwas a Vice President at Norwest Bank (k/n/a Wells Fargo Corporation).

*Michael A. Anderson* has served as our Vice President of Franchising since1999.  From 1991 to 1999 Mr. Andersonserved as our Controller.  From 1987 to1991, Mr. Anderson was an accountant at Luri, Eiger, Besikof & Company, aMinneapolis public accounting firm. From 1982 to 1986, Mr. Anderson was a staff accountant with Marvin O.Anderson, LPA, a public accounting firm located in Minnesota.

*Kristen Lenn*has served as our Vice President of Human Resources since August 1997.  From 1994 to 1997, Ms. Lenn was a SeniorConsultant with McGladrey & Pullen LLP (k/n/a RSM McGladrey, Inc.), apublic accounting and consulting firm, and provided a wide range of humanresources services to clients.  From1989 to 1994, Ms. Lenn held a number of positions for mid-size companiesimplementing human resources strategies.

*Willard V. Lewis*has served as our Vice President of Store Developmentsince 1997.  Mr. Lewis served as ourDirector of Development from 1992 to 1997. From 1990 to 1992, Mr. Lewis served as Vice President of NetworkFacilities Professionals, Inc., a Minnesota-based computer software firm.

*Carol A. Nelson*has served as our Vice President of Stores since1997.  Ms. Nelson joined us as Directorof Stores from 1994 to 1997.  From 1992to 1994, Ms. Nelson was Director of Stores of CBR, Inc., a privately ownedretailer, specializing in airport retail. From 1976 to 1992, Ms. Nelson served as a District Manager, managing 17stores in a five-state area, for Best Products, Inc.

*DianaG. Purcel* hasserved as our Controller and Chief Accounting Officer since 1999 and as one ofour Vice Presidents since 2000.  She isa certified public accountant.  From1998 to 1999, Ms. Purcel was Divisional Controller for Corporate Planning andReporting for Damark International, Inc. (k/n/a Provell, Inc).  From 1994 to 1998, Ms. Purcel was a SeniorAnalyst with Dayton Hudson Corporation (k/n/a Target Corporation).  Prior to joining Dayton Hudson Corporationand since 1988, Ms. Purcel was a senior auditor with Arthur Andersen LLP.

 

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**PART II**

 

**ITEM 5****.****                                                    ****MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDERMATTERS.**

 

**               ***(a) Market Information*

Since August 4, 2001, ourcommon stock has traded on the NASDAQ SmallCap Market under the symbol“PWHS”.  Prior to August 4, 2001, andsince November 25, 1997, our common stock traded on the NASDAQ National Marketunder the same symbol.  The followingtable summarizes the high and low closing sale prices per share of our commonstock for the periods indicated, as reported on the NASDAQ SmallCap andNational Markets.  These prices reflectthe retroactive application of our one-for-three reverse stock split, as if thereverse stock split had occurred on January 28, 2000.  These prices do not include commissions, mark-ups ormarkdowns.  
| **Fiscal  Year 2001** |   |   | **High** |   | **Low** |       |
|-----------------------|--------|--------|----------|--------|---------|------------|
| First Quarter         |   | $      | 1.94     |   | $       | 0.55       |   |
| Second Quarter        |   | 2.00   |     | 1.25   |    |
| Third Quarter         |   | 1.36   |     | 0.47   |    |
| Fourth Quarter        |   | 0.91   |     | 0.56   |    |
|                  |   |   |     |   |    |
| **Fiscal Year 2000**  |   |   | **High** |   | **Low** | ** ** |
| First Quarter         |   | $      | 5.25     |   | $       | 2.64       |   |
| Second Quarter        |   | 4.68   |     | 1.89   |    |
| Third Quarter         |   | 5.07   |     | 3.00   |    |
| Fourth Quarter        |   | 4.32   |     | 2.16   |    |

*(b) Holders*

As of April 25, 2002, wehad approximately 150 shareholders of record and an estimated 800 beneficialshareholders.

*(c) Dividends*

We have never declared orpaid any cash or stock dividends with respect to our common stock, as it is ourpolicy, and the policy of our Board of Directors, to retain any earnings toprovide for our growth and development. In addition, the declaration and payment of dividends is prohibitedunder our revolving line of credit agreement as well as the trust indenture forour subordinated debt.

*(d) Recent Sale of Unregistered Securities*

We did not engagein any unregistered sales of equity securities during our fiscal year endedFebruary 1, 2002.

 

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**ITEM 6****.  SELECTED FINANCIALDATA.**

The SelectedFinancial Data presented below should be read in conjunction with theConsolidated Financial Statements and notes thereto included elsewhere in thisForm 10-K, and in conjunction with “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” included elsewhere in this Form10-K.  The Selected Financial Data as ofand for the fiscal years ended February 1, 2002, February 2, 2001 and January28, 2000 (fiscal years 2001, 2000 and 1999) have been derived from ourConsolidated Financial Statements as audited by Grant Thornton LLP, independentcertified public accountants.  TheSelected Financial Data as of and for the two years ended January 29, 1999(fiscal years 1998 and 1997) have been derived from our Consolidated FinancialStatements as audited by KPMG LLP, independent certified public accountants.

**Summaryof Financial and Operating Data**

**(Dollars in thousands, except pershare data)**

 
|                                                      |   | **Fiscal Year** |   |
|-----------------------------------------------------------|--------|-----------------|--------|
| **Statement of Operations Data:**                         |   | **2001**        |   | **2000** |   | **1999** |   | **1998** |   | **1997** |   |
| Revenues                                                  |   | $               | 86,809 |   | $ | 90,246 |   | $ | 82,371 |   | $ | 63,491 |   | $ | 52,949 |   |
| Repositioning  and store closing (credits) provision, net |   | (121            | )      | (970 | ) | 3,962 |   | — |   | — |   |
| Operating (loss)  income                                  |   | (4,768          | )      | 605 |   | (6,496 | ) | (667 | ) | 889 |   |
| Income tax  (provision) benefit (1)                       |   | (3,733          | )      | 295 |   | 2,970 |   | 324 |   | (6 | ) |
| Net loss                                                  |   | (9,801          | )      | (434 | ) | (4,449 | ) | (521 | ) | (191 | ) |
| Basic and  diluted net loss per share (2)                 |   | (5.20           | )      | (0.27 | ) | (2.88 | ) | (0.34 | ) | — |   |
| Pro forma net  loss (3)                                   |   | —          |   | — |   | — |   | — |   | (207 | ) |
| Pro forma  diluted net loss per share (2) (3)             |   | —          |   | — |   | — |   | — |   | (0.24 | ) |
|                                                      |   |            |   |   |   |   |   |   |   |   |   |
| **Other  Data:**                                          |   |            |   |   |   |   |   |   |   |   |   |
| Number of stores  open at year end:                       |   |            |   |   |   |   |   |   |   |   |   |
| Company-owned  stores                                     |   | 100             |   | 98 |   | 102 |   | 97 |   | 73 |   |
| Franchise stores                                          |   | 52              |   | 49 |   | 47 |   | 46 |   | 51 |   |
|                                                      |   |            |   |   |   |   |   |   |   |   |   |
| Comparable store  sales (decrease) increase (4) (5)       |   | (2.6%           | )      | 5.8 | % | 9.5 | % | 2.9 | % | 9.7 | % |
|                                                      |   |            |   |   |   |   |   |   |   |   |   |
| **Balance  Sheet Data:**                                  |   |            |   |   |   |   |   |   |   |   |   |
| Working capital                                           |   | $               | (4,662 | ) | $ | 4,910 |   | $ | 4,701 |   | $ | 5,369 |   | $ | 9,383 |   |
| Total assets                                              |   | 27,772          |   | 34,400 |   | 37,389 |   | 30,453 |   | 21,017 |   |
| Long-term debt  less current maturities (6)               |   | 1,462           |   | 5,946 |   | 6,448 |   | 1,497 |   | 1,267 |   |
| Total  stockholders’ equity                          |   | 593             |   | 10,412 |   | 9,641 |   | 14,090 |   | 14,594 |   |

 

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(1)                                  We recordeda valuation allowance against our deferred tax asset equal to approximately$6.1 million in fiscal year 2001.

(2)                                  Reflects theretroactive application of our April 2001 one-for-three reverse stock split, asif the reverse stock split had occurred on February 1, 1997.

(3)                                  For theperiod from February 1, 1993 through November 28, 1997, we were anS-Corporation.  We have reflected a proforma provision for income taxes for this period as if we were subject tocorporate income taxes.

(4)                                  Company-owned stores enter the comparablestore sales base at the beginning of their 13th month of operation.

(5)                                  For purposes of computing the increase incomparable store sales, this computation assumes fiscal 2000 was a 52-weekyear.

(6)                                  Long-term debt consists of total debt,including capital lease obligations, less current maturities.

 

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**ITEM 7****.****                                                    ****MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONAND RESULTS OF OPERATIONS.**

 

Certainstatements contained in this Annual Report on Form 10-K include“forward-looking statements” within the meaning of the Private SecuritiesLitigation Reform Act of 1995.  Allforward-looking statements in this Annual Report on Form 10-K are based oninformation currently available to us as of the date of this Annual Report onForm 10-K, and we assume no obligation to update any forward-lookingstatements.  Forward-looking statementsinvolve known and unknown risks, uncertainties and other factors that may causethe actual results to differ materially from any future results, performance orachievements expressed or implied by such forward-looking statements.  Such factors may include, among others,those factors listed in Item 1A of this Annual Report on Form 10-K and elsewherein this Annual Report on Form 10-K, and our other filings with the Securitiesand Exchange Commission.  The followingdiscussion should be read in conjunction with “Selected Financial Data” above(Item 6 of this Annual Report on Form 10-K) and our financial statements andrelated notes appearing elsewhere in this Annual Report on Form 10-K.

**Overview**

 

We are a chain of retailstores specializing in party supplies and paper goods.  As of February 1, 2002, we operated 100stores in ten states throughout the central and western regions of the UnitedStates under the names *Paper Warehouse* and *Party Universe,* and awebsite which can be accessed at *www.PartySmart.com*.  Additionally, we sell Paper Warehousefranchises through our wholly owned subsidiary, Paper Warehouse Franchising,Inc.  We purchased the business,consisting of three stores located in the Minneapolis/St. Paul metropolitanarea, in 1986, and incorporated it in Minnesota in 1987.  In growing the number of Company-ownedstores, we employed a strategy of clustering stores in our principal marketsto:

•             provide our customers with convenient store locations;

•             expand our total market share; and

•             achieve favorable economies of scale.

***Fiscal year***

Our fiscal year ends on the Friday closest to January 31st.  Our fiscal year is generally 52 weeks;however it periodically consists of 53 weeks. Our fiscal year ended February 1, 2002 (fiscal 2001) consisted of 52weeks, our fiscal year ended February 2, 2001 (fiscal 2000) consisted of 53weeks, and our fiscal year ended January 28, 2000 (fiscal 1999) consisted of 52weeks.

 

***Basis of Presentation***

The financial results presented and discussed herein, reflect theresults of the Company and its wholly owned subsidiaries.  All intercompany balances and transactionshave been eliminated in consolidation.

 

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***Revenues***

Total revenuesconsist of retail sales from our Company-owned stores and e-commerce website,and franchise related fees.  Franchiserelated fees include royalties we receive on sales, generally 4-5% of thestore’s sales, and initial franchise fees, recognized at the time thefranchisee signs a lease for a store, and at which time we have substantiallyperformed all of our services. Company-owned stores enter the comparable store sales base at thebeginning of their thirteenth month of operation.

***Costs and Expenses***

Costsof products sold and occupancy costs include the direct cost of merchandise,plus handling and distribution, and certain occupancy costs.

Storeoperating expenses include all costs incurred at the store level, includingstore payroll and related benefits, advertising and credit card processingfees.

Generaland administrative expenses include corporate administrative expenses forCompany-owned stores, district store staff, expenses relating to franchising,such as payroll, legal, travel and advertising, and non-capitalizable costsassociated with our Internet subsidiary.

**Results of Operations**

The followingtable sets forth for the periods indicated, certain costs and expenses as apercentage of total revenues and retail sales:
|                                         |   | **Fiscal  Year Ended** |   |
|----------------------------------------------|--------|------------------------|--------|
|                                         |   | **February  1,  2002** |   | **February  2,  2001** |   | **January  28,  2000** |   |
| Costs of  products sold and occupancy costs: |   |                   |   |   |   |   |   |
| as % of total  revenues                      |   | 67.1                   | %      | 65.2 | % | 67.2 | % |
| as % of retail  sales                        |   | 68.3                   | %      | 66.3 | % | 68.2 | % |
|                                         |   |                   |   |   |   |   |   |
| Store operating  expenses:                   |   |                   |   |   |   |   |   |
| as % of total  revenues                      |   | 26.4                   | %      | 24.4 | % | 23.7 | % |
| as % of retail  sales                        |   | 26.8                   | %      | 24.8 | % | 24.0 | % |
|                                         |   |                   |   |   |   |   |   |
| General and  administrative expenses:        |   |                   |   |   |   |   |   |
| as % of total  revenues                      |   | 12.1                   | %      | 10.8 | % | 12.2 | % |
| as % of retail  sales                        |   | 12.3                   | %      | 11.0 | % | 12.4 | % |
|                                         |   |                   |   |   |   |   |   |
| Number of Company-owned stores               |   | 100                    |   | 98 |   | 102 |   |

 

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***Fiscal Year Ended February 1, 2002 (Fiscal 2001 — 52 weeks)Compared to Fiscal Year Ended February 2, 2001 (Fiscal 2000 — 53 weeks)***

***Revenues***

*Retail Sales. *Retail sales of $85.3 million for fiscal 2001decreased $3.5 million, or 3.9%, from retail sales of $88.8 million for fiscal2000.  Fiscal 2001 contained 52 weeks comparedto 53 weeks for fiscal 2000.  Excludingthe 53rd week for fiscal 2000, equal to approximately $1.2 millionof sales, retail sales declined 2.6% year-over-year.  Our fiscal 2001 sales were negatively impacted by the weakenedeconomy, which was compounded by the September 11, 2001 tragedy, and resultingeffect on consumer confidence.  Althoughour seasonal category sales consistently performed well during fiscal 2001, oureveryday product categories performed at below prior year levels.  Sales from our Internet website were notsignificant during fiscal 2001, although the website’s results reflectedsubstantial improvement since it’s relaunch in the third quarter of fiscal2000.  During fiscal 2001, we opened twoCompany-owned stores, bringing the total to100 as of February 1, 2002, compared to 98 at the end of fiscal 2000.  Comparable store sales for fiscal 2001decreased 2.6% from the prior year comparable period, and were calculatedassuming fiscal 2000 was a 52-week year. This growth rate compares to a comparable store sales increase of 5.8%for fiscal 2000.  Looking forward, weanticipate comparable-store increases to result from increased advertising,selected price increases and additional in-store promotional activity.

*Franchise Related Fees. *Fiscal 2001 franchise related fees of $1.5 millionincreased $56,000, or 3.9%, over fees for fiscal 2000.  Theyear-over-year increase reflects increased royalties from increased franchisestore sales and higher initial franchise fees. For both fiscal 2001 and 2000, royalty payments averaged 4% offranchise store sales.  During fiscal 2001, seven franchise stores openedand four franchise stores closed, bringing the total franchise stores to 52 asof February 1, 2002, compared to 49 at the end of fiscal 2000.

***Costs and Expenses***

*Cost of Products Sold and Occupancy Costs.* Cost of products sold and occupancy costs totaled $58.3 million, or68.3% of retail sales, for fiscal 2001, as compared to $58.9 million, or 66.3%of retail sales, for fiscal 2000.  Werealized a significant decrease in our product margins during fiscal 2001 ascompared to the prior year.  The lowermargin reflects the implementation, during the second half of the year, of anaggressive markdown program in which we elected to take faster and deepermarkdowns than we had previously done. This strategy enabled us to reduce carryover and remove slower movingitems from our merchandise assortment. This strategy has also allowed us to purchase fresher and trendiermerchandise for fiscal 2002.  We reflectour inventories at the lower of cost (as determined on a first-in, first-outbasis) or market.  Occupancy costs wereslightly higher year-over-year primarily due to the opening of two new stores.  Looking forward, we expect to realizeimproved gross margins as compared to fiscal 2001, resulting from the clean-upand removal of slower-moving items from our merchandise assortment.

*StoreOperating Expenses.*  Store operating expenses for fiscal 2001were $22.9 million, or 26.8% of retail sales, as compared to $22.0 million, or24.8% of retail sales, for the comparable period in the prior year.  More than half the increase in thepercentage year-over-year is due to an increase in fixed labor costs.  Although somewhat dissipated, we continue torealize higher wage rate pressure due to the tightness of certain labormarkets.  Our labor needs, particularlyfor seasonal events, are projected based on an expected sales volume, whichdidn’t materialize in fiscal 2001.  Wealso realized higher net advertising costs year-over-year due to our investmentin two additional flyers in the second and third quarters of fiscal 2001 in aneffort to bring additional customers into our stores.  Looking forward to fiscal 2002, we expect store operating expensedollars to increase over fiscal 2001, primarily due to our goal for maintainingappropriate staffing levels, and to a lesser degree, due to rate increases.

 

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*Generaland Administrative Expenses.*  General andadministrative expenses were $10.5 million, or 12.1% of total revenues, forfiscal 2001, compared to $9.7 million, or 10.8% of total revenues, for fiscal2000.  Excluding the 53rdweek of sales reflected in fiscal 2000’s results of approximately $1.2 million,fiscal 2000 general and administrative expenses as a percentage of totalrevenue were 11.1%.  The year-over yearincrease reflects costs associated with the leasing and maintenance on ourback-office computer systems for our Company-owned stores, which were installedduring fiscal 2001.  The increase alsoreflects higher health insurance costs, as we absorbed a larger percentage ofthe health insurance coverage during fiscal 2001.  In addition, during fiscal 2001 we incurred higher marketingcosts for our franchise operations to gain additional exposure in order toimprove franchise sales.  Lookingforward, we expect general and administrative expenses to remain relativelyflat to 2001 levels, or decrease as we vigilantly strive to maintain or reducecosts.

*RepositioningCredits/Provision. *In the event we plan to close a storebefore its lease has expired, we provide for any remaining lease obligation,net of expected sublease recovery, in the period we adopt the plan to close thestore.  During fiscal 2001, we subletone store location and reversed $230,000 of our repositioning reserve that wasrecorded during fiscal 1999.  Inaddition, during fiscal 2001, we recorded a provision of $108,000 equal to theremaining lease obligations on a store that was subsequently relocated.

We reviewlong-lived assets for impairment annually, and whenever events or changes incircumstances indicate that the carrying amount may not be recoverable.  We recognize a loss for the difference ifthe fair value is less than the carrying amount of the asset.  No impairment loss was recognized in eitherfiscal 2001 or fiscal 2000.

*Interest Expense.* For fiscal 2001, interest expense of $1.4 million, or 1.7% of totalrevenues, decreased 14%, or $237,000 from interest expense of $1.7 million forfiscal 2000.  The decrease from prioryear reflects a lower level of borrowings on our revolving credit facilitythroughout the year, stemming from our ability to defer approximately $3.0million in trade payments with some of our largest vendors, as well assubstantial reductions throughout the year in the prime rate.  The interest favorability was partiallyoffset by the write-off of approximately $75,000 in deferred financing costsassociated with our previous line of credit. We expect interest expense for fiscal 2002 to be slightly lower thanfiscal 2001 levels, reflecting a full year’s impact of the lower prime rate,partially offset by a higher level of borrowings on our revolving line ofcredit.

*Net Loss.* As a result of the factors discussed above, we realized a net loss of$9.8 million, or $5.20 per diluted share, in fiscal 2001.  For fiscal 2000, we realized a net loss of$434,000, or $0.27 per diluted share.

*Income Tax Benefit and ValuationAllowance. *Our fiscal 2001 results reflect ourdecision to record a full valuation allowance against our deferred tax assetequal to approximately $6.1 million, as prescribed by authoritative accountingguidance.  Realization of the netoperating loss carryforwards and other deferred tax timing differences iscontingent on future taxable earnings. The recording of this allowance does not have any impact on, orcorrelation to, our ability to operate as a continuing enterprise.

Ourdeferred tax asset was reviewed for expected utilization using a “more likely thannot” approach as required by Statement of Financial Accounting Standards No.109, *Accountingfor Income Taxes,* by assessing the available positive and negativeevidence surrounding the recoverability of the deferred tax asset.  We continue to assess and evaluatestrategies that will enable the deferred tax asset, or portion thereof, to beutilized, and will reduce the valuation allowance appropriately at such timewhen it is determined that the “more likely than not” approach is satisfied.

 

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***Fiscal Year Ended February 2, 2001 (Fiscal 2000 — 53 weeks)Compared to Fiscal Year Ended January 28, 2000 (Fiscal 1999 — 52 weeks)***

***Revenues***

*Retail Sales. *Retail sales of $88.8 million for fiscal 2000increased $7.7 million, or 9.4%, over retail sales of $81.1 million for fiscal1999.  Fiscal 2000 contained 53 weekscompared to 52 weeks for fiscal 1999. The increase reflected the continued maturation of our store base, asapproximately $4.5 million of the increase was attributable to an increase incomparable store sales.  Theyear-over-year increase also reflected sales of approximately $1.2 million forthe additional week in fiscal 2000. Sales from our Internet website, which became operational in the thirdquarter of fiscal 1999, were not significant during fiscal 2000, as our sitewas under construction through the first half of the year and was relaunched inthe third quarter.  During fiscal 2000,we opened one and closed five Company-owned stores, bringing the total to 98 as of February 2, 2001, compared to 102 atthe end of fiscal 1999. Comparable store sales for fiscal 2000 increased 5.8% over the prioryear comparable period, and were calculated assuming fiscal 2000 was a 52-weekyear.  This growth rate compared to acomparable store sales increase of 9.5% for fiscal 1999.  The reduction in comparable sales wasattributable to a disappointing fourth quarter in which we realized acomparable sales decline of 3%.  Incomparison, for the first nine months of fiscal 2000, we reported a comparablesales increase of over 9%.

*Franchise Related Fees. *Fiscal 2000 franchise related fees of $1.5 millionincreased 17.2% over fees of $1.2 million for fiscal 1999.  Theyear-over-year increase reflected increased royalties from increased franchisestore sales and higher initial franchise fees. For both fiscal 2000 and 1999, royalty payments averaged 4% offranchise store sales.  During fiscal 2000, three franchise stores openedand one franchise store closed, bringing the total franchise stores to 49 as ofFebruary 2, 2001, compared to 47 at the end of fiscal 1999.

***Costs and Expenses***

*Cost of Products Sold and Occupancy Costs.* Cost of products sold and occupancy costs totaled $58.9 million, or66.3% of retail sales, for fiscal 2000, as compared to $55.3 million, or 68.2%of retail sales, for fiscal 1999.  Werealized an increase in our product margins as compared to the prior year.  The higher margin reflected selected priceincreases that were implemented early in fiscal 2000 in addition to a stronggraduation season, in which higher graduation sales were augmented by increasedsales for solid color merchandise, which typically carry higher margins.  Increased purchasing allowances asnegotiated with our vendors additionally contributed to the gross marginfavorability for fiscal 2000 versus fiscal 1999. We realized increased salesacross the majority of our product categories year-over-year.  However, we also experienced margin pressurein the juvenile birthday category due to increased sales of licensed products,which typically has a lower margin.  Theyear-over-year favorability also reflected payments applied against the storeclosing reserve in fiscal 2000 for rent, common area maintenance and realestate taxes on the stores that were reserved for during fiscal 1999.

*StoreOperating Expenses.*  Store operating expenses for fiscal 2000were $22.0 million, or 24.8% of retail sales, as compared to $19.5 million, or24.0% of retail sales, for the comparable period in the prior year.  The increase in the percentage primarilyreflected a 17% increase in fixed labor costs for the fourth quarter against arelatively flat sales base.  Our fourthquarter labor needs were projected based on an expected sales volume, whichdidn’t materialize in fiscal 2000.  Inaddition, we continued to realize higher wage rate pressure due to thetightness of certain labor markets. Through the third quarter of fiscal 2000, store operating expenses as apercentage of retail sales were favorable to prior year store operatingexpenses as a percentage of retail sales.

 

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*Generaland Administrative Expenses.*  General andadministrative expenses were $9.7 million, or 10.8% of total revenues, forfiscal 2000 compared to $10.1 million, or 12.2% of total revenues, for fiscal1999.  The year-over year favorabilityreflected a concerted attempt during fiscal 2000 to reduce overall general andadministrative expenses.

*Repositioning Credits. *During fiscal 2000, we sublet three store locationsand terminated the lease on one store location.  We reversed $970,000 of our repositioning reserve that wasrecorded during fiscal 1999.

*Interest Expense.* For fiscal 2000, interest expense of $1.7 million, or 1.9% of total revenues,increased $487,000 over interest expense for fiscal 1999.  The increase over fiscal 1999 reflected anincreased level of borrowing from our revolving credit facility necessary tofund working capital requirements, in addition to a full year of interestpayments related to our convertible subordinated debentures, which were issuedduring the second quarter of fiscal 1999. Interest expense also increased due to the amortization of the deferredfinancing costs related to our financing activities and increases in the primerate.

*Other Income, net. *Other income, net of other expense, of $335,000 forfiscal 2000 primarily reflected the receipt of $200,000 as consideration forterminating the lease on our warehouse facility.  Other income of $368,000 for fiscal 1999 included the receipt ofapproximately $250,000 from a landlord as consideration for terminating thelease on a store.

*Net Loss.*  As a resultof the factors discussed above, we realized a net loss of $434,000, or $0.27per diluted share, in fiscal 2000 as compared to a net loss of $4.4 million, or$2.88 per diluted share, for fiscal 1999. The per share data has been adjusted to reflect our one-for threereverse stock split.

**Seasonality**

Generally, our results ofoperations have fluctuated from quarter to quarter because of variations inrevenues and operating expenses.  Wegenerate a significant portion of our operating income in our second and fourthfiscal quarters because of seasonal events. Any factor that negatively affects our revenues or increases ouroperating expenses during the second and fourth fiscal quarters couldnegatively affect our annual results of operations.  As a result of the seasonality of our revenues, we expect toincur a loss in the first quarter of each year for the foreseeable future.  Although we typically realize strong salesduring the third quarter, due to increased promotional activities, we havehistorically experienced reduced operating income for this quarter.

Our results of operationsalso fluctuate from quarter to quarter as a result of the following:

•                  the timing of new store openings, remodels or relocations;

•                  costs associated with new store openings, remodels or relocations; and 

•                  expenses incurred to support our expansion strategy.

 

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**Liquidity and Capital Resources**

Our liquidity needs varythroughout the year as a result of the seasonal nature of our business.  Our cash availability also fluctuates as aresult of:

•                  the level of our inventory, which primarily determines ourline-of-credit borrowing capacity;

 

•                  quarterly fluctuations in revenues and operating income;

 

•                  timing of seasonal purchases;

 

•                  timing of new store openings, remodels and/or relocations;

 

•                  intra-month cash needs for payment of rent, payroll and otheroperational payables; and

 

•                  our revolving line of credit covenants.

 

Our primary cash requirementsare for ongoing operations, consisting primarily of investments in ourinventory, costs associated with payroll, and payments on our store leasesconsisting of rent, common area maintenance and real estate taxes.

Our primary sources ofcash have been:

•                  borrowings under our revolving line of credit;

•                  extended payment terms negotiated with several of ourlargest vendors and with certain of our landlords;

•                  proceeds from financings such as our shareholderrights offering, our public sale of convertible subordinated debt, therefinancing of our mortgage and our initial public offering;

•                  everyday payment terms from venders; and

•                  lease financings.

In order to provide uswith the liquidity needed during the first quarter of fiscal 2002, we entered intoa short-term loan of $1,000,000 with an unrelated business partner, due May 1,2002.  In addition, we recently sold our13 stores in the Seattle market for approximately $4.5 million.  The proceeds from the sale will provide uswith the additional liquidity necessary to meet our short-term working capitalneeds.

During the first quarter of fiscal 2000, our Chairman and ChiefExecutive Officer issued a $1.2 million standby letter of credit that resultedin the lender on our revolving line of credit providing an additional $1.2million advance over our existing revolving line of credit.  During the first quarter of fiscal 2001, inorder to provide us with the liquidity we needed to fund our operations intothe second quarter, we negotiated extended payment terms with several of ourlargest vendors.  The arrangements withour vendors resulted in the extended dating of approximately $3.0 million oftrade payments which were repaid in full during fiscal 2001 as agreed upon.  In addition, we were able to extendapproximately $500,000 of rent payments into the second half of fiscal 2001 orbeyond.

 

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Our working capital wasapproximately ($4.7 million) at February 1, 2002 compared to $4.9 million atFebruary 2, 2001.  Our current ratio was0.80 to 1.00 at February 1, 2002 compared to 1.31 to 1.00 at February 2,2001.  The year-over-year change in ourworking capital and current ratio calculations reflects the reclassification ofour subordinated covertible debt due in 2005 as current as a result of a breachof one covenant under our indenture as of February 1, 2002 and a reduction of$1.1 million in merchandise inventory levels. The change also reflects a higher 2001 end of year balance on ourrevolving line of credit and accounts payable, as well as the current yearaddition of a $1.0 million note payable to an unrelated business partner.

Net cash used foroperations for each of the last three fiscal years was approximately $490,000in fiscal 2001, $175,000 in fiscal 2000 and $999,000 in fiscal 1999.  The cash used in fiscal 2001 reflects thecurrent year loss, net of depreciation and amortization, partially offset by a$1.1 million reduction in inventory and a $1.8 million increase in accountspayable.  The reduction in inventorylevels reflects our decision during fiscal 2001 to aggressively remove slowermoving merchandise from our assortment. The increase in accounts payable reflects the consolidation of certainsegments of our business to some of our larger vendors who offer more extendedterms than some of our smaller vendors. The cash used in fiscal 2000 primarily reflects a planned reduction inmerchandise inventory levels and a reduction in accounts payable.  Wecontinue to strive, when possible, to take advantage of cash discounts andother favorable terms that are offered by our vendors.  The cash used in fiscal 1999 primarilyreflects increases in merchandise levels, partially offset by increases inaccounts payable.

Net cash used forinvesting activities was approximately $776,000 for fiscal 2001, $987,000 forfiscal 2000 and $3.2 million for fiscal 1999. The use of cash in fiscal 2001 and fiscal 2000 consisted almost entirelyof capital expenditures related to upgrading our information systems and remodelingour Company-owned stores.  Capitalexpenditures during fiscal 1999 primarily represented expenditures necessary todevelop and launch our website and expenditures related to the opening of newstores.  We have invested and willcontinue to evaluate our needs for additional investment in informationtechnology and infrastructure capabilities in order to gain operationalefficiencies.  We anticipate that wewill spend an aggregate $1.1 million on capital expenditures during fiscal 2002for four store relocations, four remodels of existing stores, and continuinginvestments in information systems.  Weseek to lease sites, of approximately 8,500 square feet, for our Company-ownedstores rather than own real estate.  Ifthe number of stores we plan to open, relocate or remodel increases ordecreases, this estimate may change accordingly.  Our plans may also vary based upon the availability of suitablelocations and the availability of acceptable terms.  It is our intention to finance new store fixtures and equipmentwith long-term leases, assuming availability and reasonable terms.  We may additionally seek to acquire existingstores from franchisees.  At present, wehave no agreement to acquire any franchise store.

                Netcash provided by financing activities was $1.1 million for fiscal 2001 andfiscal 2000, and $3.6 million for fiscal 1999. The generation of cash in fiscal2001 reflects the proceeds received from a $1.0 million note from an unrelatedbusiness partner in addition to increases in our revolving line of credit,partially offset by required payments on our long-term debt.  The generation of cash in fiscal 2000primarily reflects the net proceeds received from our shareholder rightsoffering.  Cash provided by financingactivities in 1999 reflects our subordinated debt offering, the refinancing ofour mortgage and the financing of our capital leases.

 

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During fiscal 1999, we issued convertible subordinated debentures in anaggregate principal amount of $4.0 million, which mature in 2005, and areconvertible at $9.00 into approximately 444,000 shares of our commonstock.  We received net proceeds ofapproximately $3.2 million from the issuance of these debentures, which wereused to develop and implement our Internet website, to repay indebtedness andfor other general corporate purposes. The indenture under which these debentures were issued containscovenants that require us to satisfy certain financial tests and imposerestrictions on our ability to pay dividends. Until September 15, 2000, the debentures bore interest at an annual rateof 9.0% that was payable quarterly.  Asa result of our fiscal 1999 financial results, we were in breach of a covenantthat required a minimum consolidated tangible net worth.  However, we were current on all requiredpayments under the indenture.  Duringfiscal 2000, we received a waiver of this breach and approval of an amendmentto the indenture from our debenture holders. In consideration for the waiver and amendment of certain covenants, weincreased the interest rate to an annual rate of 10.5%, effective as ofSeptember 15, 2000.

As of February 1,2002, we were in breach of a covenant under the indenture that requires aminimum consolidated net worth of $7.0 million.  We are current, however, on all required payments under theindenture.  Under the indenture, if thisbreach continues until June 16, 2002, it will become an “Event of Default.”  An “Event of Default” would permit eitherthe indenture trustee or the holders owning at least 25% in principal amount ofthe outstanding debentures to declare all of the $4.0 million of outstandingdebentures to be immediately due and payable. An “Event of Default” under our indenture would also cross-default ourrevolving credit agreement and would provide our secured lender with the rightto prevent us from paying future principal or interest payments to the holdersof our subordinated debentures until such “Event of Default” is cured, waivedor ceases to exist, if such lender exercised such right.  We will ask our debenture holders, prior toJune 16, 2002, to waive this breach and to approve amendments to our indentureto eliminate the covenants that require us to satisfy certain financialtests.  In the future, we may alsoconsider a program to repurchase our outstanding debentures, provided that wehave the funds available for such program and that our secured lender hasapproved such a program.  Due to ourbreach, the $4.0 million convertible subordinated debentures are reflected ascurrent debt in our consolidated balance sheet at February 1, 2002.

We have a $15.0 millionmulti-year revolving line of credit facility with a bank for general workingcapital purposes that expires in September 2004.  Borrowings outstanding under this line of credit bear interest ata variable rate and are secured by substantially all of our assets.  Advances under this credit line are limitedto a fixed percentage of certain assets, primarily inventory.  As a result of the limitations on the fixedpercentage and on inventory levels, we often maximize the availability underour line during intra-month peaks and at certain times during the year.  At February 1, 2002 and February 2, 2001, wehad borrowings outstanding of approximately $7.7 million and $6.9 million,respectively, under our revolving line of credit facilities.  Capacity under our revolving line of creditis largely contingent on our inventory levels as well as an advance rate onthose inventory levels.  The advancerate is determined based on a third party valuation of our inventory that takesinto consideration among other factors, the quality of our inventory, inaddition to the expected rate of sale and the estimated costs should aliquidation of the inventory be required. A significant decline in the valuation of our inventory as a result ofany of the factors above could have a significant impact on our borrowingcapacity and on our ability to meet short-term obligations.

 

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                The creditagreement also contains covenants, that require us to satisfy certain financialtests and impose restrictions on our ability to pay dividends.  We were in compliance with, or obtained awaiver for, all of our financial covenants as required by the credit facilityat February 1, 2002.  If an “Event ofDefault” occurs under our trust indenture, however it will cross-default ourrevolving credit agreement.

During fiscal 1999, werefinanced our corporate office building. The term note, equal to $1.0 million at February 1, 2002, is payable inmonthly installments of $8,612, including interest through May 2009, and issecured by a first mortgage on our office headquarters.

We lease all ofour retail stores under noncancelable operating leases that have variousexpiration dates.  Some of our operatingleases provide for scheduled increases in base rentals over their terms.  For these leases, we recognize the totalrental amounts due over the lease terms on a straight-line basis, and weestablish corresponding deferred rent credits for the differences between theamounts recognized and the amounts paid.

It is ourintention to finance new store fixtures and equipment with long-term leases,provided that financing options are available, and on reasonable terms.

In addition tocommitments we have related to our lease obligations, we also have requiredpayments to be made on our debt outstanding.

The following is aschedule summarizing some of our contractual obligations at February 1, 2002:
|                               |   | **Payments due by period** |       |
|------------------------------------|--------|----------------------------|------------|
| **Contractual**

**Obligations:**  |   | **Total**                  |       | **Less than  1 year** |   | **1-2 years** |   | **3-4 years** |   | **After  4 years** |   |
| Debt obligations (1) (2) (3)       |   | $                          | 5,128,675  |   | $ | 4,093,520 |   | $ | 108,845 |   | $ | 80,019 |   | $ | 846,291 |   |
| Capital lease obligations (2)      |   | 1,012,429                  |       | 560,635 |   | 451,794 |   | — |   | — |   |
| Operating leases                   |   | 60,055,637                 |       | 10,993,108 |   | 19,511,957 |   | 14,811,262 |   | 14,739,310 |   |
| Total contractual cash obligations |   | $                          | 66,196,741 |   | $ | 15,647,263 |   | $ | 20,072,596 |   | $ | 14,891,281 |   | $ | 15,585,601 |   |

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(1)           Debt obligationsreflect required principal payments on debt existing at February 1, 2002,excluding a $1.0 million note payable due in full on June 1, 2002 and $100,000of subordinated notes payable on demand. In addition, the debt obligations disclosure above does not reflect our$15.0 million revolving line-of-credit facility that had a balance outstandingof approximately $7.7 million at February 1, 2002.

(2)           We define currentmaturities of long-term debt and capital lease obligations as being due withina twelve-month period from February 1, 2002.

(3)           The $4.0 millionconvertible subordinated debentures are reflected as current debt in ourconsolidated balance sheet at February 1, 2002 as a result of the breach of onecovenant under our indenture.

In addition to the contractual obligations above, we have a multi-yearpartnership with a vendor to be the exclusive supplier for greeting cards forour Company-owned and franchise stores. As of February 1, 2002, we have a remaining contractual obligation ofapproximately $27.5 million for chain-wide purchases of greeting cards andgift-wrap.  We estimate that thesepurchase commitments will be fulfilled over a four-year period.

 

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As discussed above, withthe passage of time, unless it is cured, we will be in default of a financialcovenant in the indenture under which our subordinated debentures were issued,which will also cause a default under our revolving line of creditfacility.  Although we intend to obtain fromour debenture holders a waiver of this default, we may not be successful.  In the event repayment of the amountsoutstanding under either our outstanding debentures or the revolving creditline were to be accelerated, we may not have the funds readily available tosatisfy such obligations or meet other operating cash needs of ourbusiness.  In addition, if suchacceleration were to occur, at that time, we would evaluate our options toattempt to remedy such acceleration.  Ingeneral, our highly-leveraged financial condition, as well as the possiblereactions of customers, employees, suppliers and franchisees to publicityregarding our continuing losses, make it extremely difficult to predict ouractual liquidity needs. The assumptions underlying our projections as to suchneeds, therefore, may not be realized.

Provided our subordinateddebt and revolving credit line are not accelerated as a result of an “Event ofDefault” under our trust indenture or our credit facility, we believe that theliquidity sources described above, together with the net proceeds from the saleof our 13 stores in the Seattle market and funds expected to be generated fromoperations, will be adequate to meet our cash needs through the remainder offiscal 2002.

**Inflation**

We do not believe thatinflation has had a material impact upon our historical operating results, andwe do not expect it to have a material impact in the future.  There can be no assurances, however, thatour business will not be affected by inflation in the future.  We could be negatively impacted by substantialcost increases for raw materials such as paper, petroleum and cardboard, assignificant cost increases in these areas could have a material impact on ourcosts of products in future periods.

**ITEM7A****.****                                           ****QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.**

We have used acombination of fixed rate and floating rate debt to fund our operations,capital expenditures and the growth in our Company-owned stores and ourInternet business.  As a result of ourfloating rate debt, we are exposed to market risk from changes in interestrates.  There have been recent changesin the prime rate.  We do not considerthis exposure to be material to our consolidated financial position, results ofoperations or cash flows.  We do not useany derivative financial instruments or engage in any other hedging activities.

**ITEM 8****.****                                                    ****FINANCIAL STATEMENTS.**

The Company’sConsolidated Financial Statements and the reports of its independent certifiedpublic accountants are included elsewhere in this Annual Report on Form10-K.   The index to these financial statements is included in Item 14 (a)(1) of this Annual Report.

**ITEM 9****.****                                                    ****CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTINGAND FINANCIAL DISCLOSURE.**

Not applicable.

 

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**PART III**

 

**ITEM 10****.               DIRECTORS AND EXECUTIVE OFFICERSOF THE REGISTRANT.**

*(a)Directors of the Registrant*

The information under thecaptions “Election of Directors—Information About Nominees” and “Election ofDirectors—Other Information About Nominees” in our 2002 Proxy Statement isincorporated herein by reference.

*(b) Executive Officers of the Registrant*

Information concerningour Executive Officers is included in this Annual Report on Form 10-K underItem 4A, “Executive Officers of the Registrant.”

*(c) Compliance with Section 16 (a) of the Exchange Act*

The informationunder the caption “Section 16(a) Beneficial Ownership Reporting Compliance” inour 2002 Proxy Statement is incorporated herein by reference.

**ITEM 11****.               EXECUTIVECOMPENSATION.**

The information underthe captions “Election of Directors—Directors’ Fees and Compensation CommitteeInterlocks” and “Executive Compensation and Other Benefits” in our 2002 ProxyStatement is incorporated herein by reference.

**ITEM 12****.****                                             ****SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS ANDMANAGEMENT.**

The informationunder the caption “Principal Shareholders and Beneficial Ownership ofManagement” in our 2002 Proxy Statement is incorporated herein by reference.

**ITEM 13****.               CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS.**

The informationunder the caption “Certain Relationships and Related Transactions” in our 2002Proxy Statement is incorporated herein by reference.

 

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**PART IV**

 

**ITEM 14**.                                              EXHIBITS, FINANCIAL STATEMENT SCHEDULESAND REPORTS ON FORM 8-K.

 

*(a)**                              **Documents Filed as Part of this Report*

 

(1)                      Consolidated Financial Statements:

 

The following Consolidated Financial Statements areincluded in this Annual Report on Form 10-K:

 
| Report  of Independent Certified Public Accountants   |   |
|-------------------------------------------------------|--------|
|                                                  |   |
| Financial Statements:                                 |   |
| Consolidated Balance Sheets                           |   |
| Consolidated  Statements of Operations                |   |
| Consolidated  Statements of Stockholders’ Equity |   |
| Consolidated  Statements of Cash Flows                |   |
| Notes to  Consolidated Financial Statements           |   |

 

(2)                    Financial Statement Schedules:

 

ScheduleII - Valuation and Qualifying Accounts:

 
| **Reserve  for Store  Closings**   |   | **Balance at  beginning  of year** |      | **Provision** |   | **Charges/  Write-offs** |   | **Credits** |    | **Balance at  end  of year** |   |
|------------------------------------|--------|------------------------------------|-----------|---------------|--------|--------------------------|--------|-------------|---------|------------------------------|--------|
| Fiscal year ended February 1, 2002 |   | $                                  | 1,315,000 |          | $      | 108,000                  |   | $           | 498,000 |                         | $      | 230,000 |   | $ | 695,000 |   |
|                               |   |                               |      |          |   |                     |   |        |    |                         |   |
| Fiscal year ended February 2, 2001 |   | $                                  | 3,000,000 |          | $      | —                   |   | $           | 715,000 |                         | $      | 970,000 |   | $ | 1,315,000 |   |
|                               |   |                               |      |          |   |                     |   |        |    |                         |   |
| Fiscal year ended January 28, 2000 |   | $                                  | —    |          | $      | 3,000,000                |   | $           | —  |                         | $      | — |   | $ | 3,000,000 |   |

 

The reserve for storeclosings at the end of fiscal 2001 reflects a provision of $108,000 for theremaining lease obligations on a store that was subsequently relocated duringthe first quarter of fiscal 2002.  Inaddition, the reserve for store closings also reflects reductions related toongoing payments of rent, common area maintenance, real estate taxes and othermiscellaneous expenses on the stores that were closed during fiscal 1999, aswell as beneficial adjustments of $230,000 resulting from the subleasing of onestore location.

All other schedules havebeen omitted since they are not required, not applicable or the information hasbeen included in the financial statements or the notes thereto.

 

32

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(3)                      Exhibits:

 

                The exhibits to this Annual Report on Form 10-K arelisted in the Exhibit Index attached hereto.

 

                A copy of any ofthe exhibits listed in the Exhibit Index or referred to below will be furnishedat a reasonable cost to any person who was a shareholder of the Company onApril 25, 2002, upon receipt from any such person of a written request for anysuch exhibit.  Such request should besent to Paper Warehouse, Inc., 7630 Excelsior Boulevard, Minneapolis, Minnesota55426; Attn: Shareholder Relations.

 

The following is a list of each management contract orcompensatory plan or arrangement required to be filed as an exhibit to thisAnnual Report on Form 10-K pursuant to Item 14(c):

1.                                       1997 Stock Option and CompensationPlan  (incorporated by reference to ourRegistration Statement on Form S-1 File No. 333-36911).

2.                                       Directors’ Stock Option Plan(incorporated by reference to our Registration Statement on Form S-1 File No.333-36911).

3.                                       1998 Employee Stock Purchase Plan(incorporated by reference to our Form 10-K for fiscal year ended January 29,1999 File No. 000-23389).

4.                                       Amendments to 1997 Stock Option andCompensation Plan  (incorporated byreference to our Annual Report on Form 10-K for fiscal year ended January 28,2000 and to our Quarterly Report on Form 10Q for the quarter ended April 28,2000, File No. 0-23389).

*(b)          Reports on Form 8-K.*

                Wedid not file any Current Reports on Form 8-K during the fourth quarter offiscal 2001.

 

33

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**Report of Independent Certified Public Accountants**

 

The Board of Directorsand Stockholders

Paper Warehouse, Inc.:

 

We have audited the accompanying consolidated balancesheets of Paper Warehouse, Inc. and subsidiaries as of February 1, 2002 andFebruary 2, 2001, and the related consolidated statements of operations,stockholders’ equity, and cash flows for each of the three years in the periodended February 1, 2002.  Theseconsolidated financial statements are the responsibility of the Company’smanagement.  Our responsibility is toexpress an opinion on these consolidated financial statements based on ouraudits.

 

We conducted ouraudits in accordance with auditing standards generally accepted in the UnitedStates of America.  Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the consolidated financial statements are free of materialmisstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe consolidated financial statements. An audit also includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation.  We believe ouraudits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of Paper Warehouse, Inc. and subsidiaries as of February 1, 2002 andFebruary 2, 2001 and the results of their operations and their cash flows foreach of the three years in the period ended February 1, 2002, in conformitywith accounting principles generally accepted in the United States of America.

 

The accompanying financial statements have beenprepared assuming that the Company will continue as a going concern.  The Company was in breach of a financialcovenant under its subordinated convertible debt agreement on February 1, 2002and a waiver of the breach has not yet been obtained.  If a waiver of the breach is not obtained, payments on thesubordinated convertible debentures and the revolving line of credit could beaccelerated.  This factor raisessubstantial doubt about the Company's ability to continue as a going concernand satisfy all current obligations as they become due.  Management's plan in regard to this matteris described in Note 2.  The financialstatements do not include any adjustments that might result from the outcome ofthis uncertainty.

 

We have also audited Schedule II of Paper Warehouse,Inc. and subsidiaries for each of the three years in the period ended February1, 2002.  In our opinion, this schedule,when considered in relation to the basic financial statements taken as a whole,presents fairly, in all material respects, the information therein.

 

/s/ Grant Thornton LLP

 

 

Minneapolis, Minnesota

March 12, 2002 (exceptfor Note 17 as to which the date is April 23, 2002)

 

 

F-1

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**PAPERWAREHOUSE, INC. and SUBSIDIARIES**

**ConsolidatedBalance Sheets**

**February 1, 2002 and February 2, 2001**

 
|                                                                                                                      |   | **February  1,  2002** |       | **February  2,  2001** |   |
|---------------------------------------------------------------------------------------------------------------------------|--------|------------------------|------------|------------------------|--------|
| **ASSETS**                                                                                                           |   |                   |       |                   |   |
|                                                                                                                      |   |                   |       |                   |   |
| Current assets:                                                                                                           |   |                   |       |                   |   |
| Cash and cash  equivalents                                                                                                |   | $                      | 264,067    |                   | $      | 427,878 |   |
| Merchandise  inventories                                                                                                  |   | 17,018,472             |       | 18,150,433             |   |
| Accounts  receivable                                                                                                      |   | 1,179,939              |       | 1,168,209              |   |
| Prepaid expenses  and other current assets                                                                                |   | 521,686                |       | 862,957                |   |
| Total current  assets                                                                                                     |   | 18,984,164             |       | 20,609,477             |   |
|                                                                                                                      |   |                   |       |                   |   |
| Property and  equipment, net                                                                                              |   | 7,172,452              |       | 8,698,745              |   |
| Deferred tax  asset (Note 12)                                                                                             |   | —                 |       | 3,483,468              |   |
| Other assets,  net                                                                                                        |   | 1,615,235              |       | 1,608,056              |   |
| Total assets                                                                                                              |   | $                      | 27,771,851 |                   | $      | 34,399,746 |   |
|                                                                                                                      |   |                   |       |                   |   |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                            |   |                   |       |                   |   |
|                                                                                                                      |   |                   |       |                   |   |
| Current  liabilities:                                                                                                     |   |                   |       |                   |   |
| Notes payable —  line of credit                                                                                      |   | $                      | 7,731,966  |                   | $      | 6,867,583 |   |
| Notes payable —  other                                                                                               |   | 1,000,000              |       | —                 |   |
| Convertible  subordinated debt                                                                                            |   | 4,000,000              |       | —                 |   |
| Current  maturities of long-term debt                                                                                     |   | 685,733                |       | 601,943                |   |
| Accounts payable                                                                                                          |   | 8,087,854              |       | 6,324,741              |   |
| Accrued  liabilities                                                                                                      |   | 1,829,542              |       | 1,468,129              |   |
| Current portion  — reserve for store closings                                                                        |   | 311,383                |       | 437,565                |   |
| Total current  liabilities                                                                                                |   | 23,646,478             |       | 15,699,961             |   |
|                                                                                                                      |   |                   |       |                   |   |
| Convertible  subordinated debt                                                                                            |   | —                 |       | 4,000,000              |   |
| Other long-term  debt, less current maturities                                                                            |   | 1,461,940              |       | 1,945,909              |   |
| Reserve for  store closings, less current portion                                                                         |   | 383,908                |       | 877,601                |   |
| Deferred rent  credits                                                                                                    |   | 1,686,381              |       | 1,464,477              |   |
| Total  liabilities                                                                                                        |   | 27,178,707             |       | 23,987,948             |   |
|                                                                                                                      |   |                   |       |                   |   |
| Commitments                                                                                                               |   | —                 |       | —                 |   |
|                                                                                                                      |   |                   |       |                   |   |
| Stockholders’  equity:                                                                                               |   |                   |       |                   |   |
| Serial preferred  stock, $.03 par value; 3,333,333 shares authorized; none issued or  outstanding                         |   | —                 |       | —                 |   |
| Common stock,  $.03 par value;  13,333,333 shares  authorized; 1,886,192 and 1,882,593 shares issued and outstanding |   | 56,585                 |       | 56,477                 |   |
| Additional  paid-in capital                                                                                               |   | 15,010,548             |       | 15,027,827             |   |
| Accumulated  deficit                                                                                                      |   | (14,473,989            | )          | (4,672,506             | )      |
| Total  stockholders’ equity                                                                                          |   | 593,144                |       | 10,411,798             |   |
|                                                                                                                      |   |                   |       |                   |   |
| Total liabilities  and stockholders’ equity                                                                          |   | $                      | 27,771,851 |                   | $      | 34,399,746 |   |

** **

See accompanying notes to consolidatedfinancial statements.

 

F-2

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**PAPER WAREHOUSE, INC. andSUBSIDIARIES**

**Consolidated Statements of Operations**

**Years ended February 1, 2002, February 2, 2001 and January 28, 2000**

** **
|                                                                                        |   | **February  1,  2002** |       | **February  2,  2001** |   | **January  28,  2000** |   |
|---------------------------------------------------------------------------------------------|--------|------------------------|------------|------------------------|--------|------------------------|--------|
| Revenues:                                                                                   |   |                   |       |                   |   |                   |   |
| Retail sales                                                                                |   | $                      | 85,296,609 |                   | $      | 88,789,995             |   | $ | 81,128,437 |   |
| Franchise  related fees                                                                     |   | 1,512,665              |       | 1,456,376              |   | 1,242,330              |   |
| Total revenues                                                                              |   | 86,809,274             |       | 90,246,371             |   | 82,370,767             |   |
|                                                                                        |   |                   |       |                   |   |                   |   |
| Costs and expenses:                                                                         |   |                   |       |                   |   |                   |   |
| Costs of products sold  and occupancy costs                                                 |   | 58,276,275             |       | 58,871,216             |   | 55,332,014             |   |
| Store operating  expenses                                                                   |   | 22,890,037             |       | 22,001,011             |   | 19,488,775             |   |
| General and  administrative expenses                                                        |   | 10,532,069             |       | 9,738,851              |   | 10,083,556             |   |
| Repositioning and store  closing (credits) provision, net                                   |   | (121,450               | )          | (970,000               | )      | 3,962,454              |   |
| Total costs and  expenses                                                                   |   | 91,576,931             |       | 89,641,078             |   | 88,866,799             |   |
|                                                                                        |   |                   |       |                   |   |                   |   |
| Operating (loss)  income                                                                    |   | (4,767,657             | )          | 605,293                |   | (6,496,032             | )      |
|                                                                                        |   |                   |       |                   |   |                   |   |
| Interest expense                                                                            |   | (1,432,884             | )          | (1,669,744             | )      | (1,182,349             | )      |
| Other income,  net                                                                          |   | 132,326                |       | 335,229                |   | 368,008                |   |
|                                                                                        |   |                   |       |                   |   |                   |   |
| Loss before  income taxes and cumulative effect of accounting change                        |   | (6,068,215             | )          | (729,222               | )      | (7,310,373             | )      |
|                                                                                        |   |                   |       |                   |   |                   |   |
| Income tax  (provision) benefit (Note 12)                                                   |   | (3,733,268             | )          | 295,000                |   | 2,970,332              |   |
|                                                                                        |   |                   |       |                   |   |                   |   |
| Net loss before  cumulative effect of accounting change                                     |   | (9,801,483             | )          | (434,222               | )      | (4,340,041             | )      |
|                                                                                        |   |                   |       |                   |   |                   |   |
| Cumulative effect  of accounting change, net                                                |   | —                 |       | —                 |   | (108,506               | )      |
|                                                                                        |   |                   |       |                   |   |                   |   |
| Net loss                                                                                    |   | $                      | (9,801,483 | )                      | $      | (434,222               | )      | $ | (4,448,547 | ) |
|                                                                                        |   |                   |       |                   |   |                   |   |
| Net loss per common share:                                                                  |   |                   |       |                   |   |                   |   |
|                                                                                        |   |                   |       |                   |   |                   |   |
| Basic and diluted net loss per common share before  cumulative  effect of accounting change |   | $                      | (5.20      | )                      | $      | (0.27                  | )      | $ | (2.81 | ) |
|                                                                                        |   |                   |       |                   |   |                   |   |
| Cumulative effect of accounting change, net                                                 |   | —                 |       | —                 |   | (0.07                  | )      |
|                                                                                        |   |                   |       |                   |   |                   |   |
| Basic and diluted net loss per common share                                                 |   | $                      | (5.20      | )                      | $      | (0.27                  | )      | $ | (2.88 | ) |
|                                                                                        |   |                   |       |                   |   |                   |   |
| Weighted average shares outstanding                                                         |   | 1,884,470              |       | 1,627,311              |   | 1,542,645              |   |

 

See accompanying notes to consolidatedfinancial statements.

 

F-3

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**PAPERWAREHOUSE, INC. and SUBSIDIARIES**

**Consolidated Statements ofStockholders’ Equity**

**YearsEnded February 1, 2002, February 2, 2001 and January 28, 2000**

 
|                                                                                                    |   | **Serial  Preferred Stock** |   | **Number of  Common Shares** |   | **Common  Stock** |   | **Additional  Paid-In Capital** |   | **Accumulated  Earnings / (Deficit)** |   | **Total  Stockholders’ Equity** |        |
|---------------------------------------------------------------------------------------------------------|--------|-----------------------------|--------|------------------------------|--------|-------------------|--------|---------------------------------|--------|---------------------------------------|--------|--------------------------------------|-------------|
| Balance, January 29, 1999                                                                               |   | —                      |   | 1,542,645                    |   | $                 | 46,279 |                            | $      | 13,833,442                            |   | $                                    | 210,263     |   | $ | 14,089,984 |   |
| Net loss                                                                                                |   | —                      |   | —                       |   | —            |   | —                          |   | (4,448,547                            | )      | (4,448,547                           | )           |
| Balance, January 28, 2000                                                                               |   | —                      |   | 1,542,645                    |   | 46,279            |   | 13,833,442                      |   | (4,238,284                            | )      | 9,641,437                            |        |
| Net loss                                                                                                |   | —                      |   | —                       |   | —            |   | —                          |   | (434,222                              | )      | (434,222                             | )           |
| Issuance of common stock pursuant to shareholder rights offering (net  of offering expenses of $67,100) |   | —                      |   | 331,571                      |   | 9,947             |   | 1,166,322                       |   | —                                |   | 1,176,269                            |        |
| Employee purchases of stock                                                                             |   | —                      |   | 8,377                        |   | 251               |   | 28,063                          |   | —                                |   | 28,314                               |        |
| Balance, February 2, 2001                                                                               |   | —                      |   | 1,882,593                    |   | 56,477            |   | 15,027,827                      |   | (4,672,506                            | )      | 10,411,798                           |        |
| Net loss                                                                                                |   | —                      |   | —                       |   | —            |   | —                          |   | (9,801,483                            | )      | (9,801,483                           | )           |
| Employee purchases of stock                                                                             |   | —                      |   | 3,528                        |   | 106               |   | 3,793                           |   | —                                |   | 3,899                                |        |
| Other                                                                                                   |   | —                      |   | 71                           |   | 2                 |   | (21,072                         | )      | —                                |   | (21,070                              | )           |
| Balance, February 1, 2002                                                                               |   | —                      |   | 1,886,192                    |   | $                 | 56,585 |                            | $      | 15,010,548                            |   | $                                    | (14,473,989 | ) | $ | 593,144 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

F-4

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**PAPER WAREHOUSE, INC. andSUBSIDIARIES**

**Consolidated Statements of Cash Flows**

**Years Ended February 1, 2002,February 2, 2001 and January 28, 2000**

 
|                                                                 |   | **February  1,**

**2002** |       | **February  2,  2001** |   | **January  28,  2000** |   |
|----------------------------------------------------------------------|--------|----------------------------|------------|------------------------|--------|------------------------|--------|
| **OPERATING ACTIVITIES:**                                            |   |                       |       |                   |   |                   |   |
| Net loss                                                             |   | $                          | (9,801,483 | )                      | $      | (434,222               | )      | $ | (4,448,547 | ) |
| Adjustments to  reconcile net loss to net cash used for operations:  |   |                       |       |                   |   |                   |   |
| Depreciation and  amortization                                       |   | 2,357,515                  |       | 2,345,028              |   | 2,222,025              |   |
| Repositioning  and store closing (credits) provision, net            |   | (121,450                   | )          | (970,000               | )      | 3,962,454              |   |
| Deferred taxes                                                       |   | 3,733,268                  |       | (295,000               | )      | (3,042,669             | )      |
| Deferred rent  credits                                               |   | 340,914                    |       | 202,746                |   | 226,915                |   |
| Other noncash  items affecting earnings                              |   | 282,614                    |       | 67,925                 |   | 342,872                |   |
| Changes in  operating assets and liabilities:                        |   |                       |       |                   |   |                   |   |
| Merchandise  inventories                                             |   | 1,131,961                  |       | 2,056,418              |   | (3,904,781             | )      |
| Accounts  receivable                                                 |   | (11,730                    | )          | (338,056               | )      | 275,109                |   |
| Prepaid expenses  and other current assets                           |   | 91,471                     |       | 131,001                |   | (130,574               | )      |
| Accounts payable                                                     |   | 1,763,113                  |       | (1,902,252             | )      | 2,912,400              |   |
| Accrued  liabilities                                                 |   | 242,403                    |       | (323,337               | )      | 585,895                |   |
| Reserve for  store closing                                           |   | (498,425                   | )          | (714,834               | )      | —                 |   |
| Net cash used  for operations                                        |   | (489,829                   | )          | (174,583               | )      | (998,901               | )      |
|                                                                 |   |                       |       |                   |   |                   |   |
| **INVESTING ACTIVITIES:**                                            |   |                       |       |                   |   |                   |   |
| Purchases of  property and equipment, net                            |   | (775,686                   | )          | (980,128               | )      | (3,117,032             | )      |
| Other                                                                |   | (635                       | )          | (6,600                 | )      | (43,196                | )      |
| Net cash used  for investing activities                              |   | (776,321                   | )          | (986,728               | )      | (3,160,228             | )      |
|                                                                 |   |                       |       |                   |   |                   |   |
| **FINANCING ACTIVITIES:**                                            |   |                       |       |                   |   |                   |   |
| Net proceeds  from (payments on) notes payable — line of credit |   | 864,383                    |       | 563,935                |   | (546,352               | )      |
| Proceeds from  note payable — other                             |   | 1,000,000                  |       | —                 |   | —                 |   |
| Proceeds from  convertible subordinated debentures                   |   | —                     |       | —                 |   | 4,000,000              |   |
| Net proceeds  from shareholder rights offering                       |   | —                     |       | 1,176,269              |   | —                 |   |
| Proceeds from  refinancing of mortgage                               |   | —                     |       | —                 |   | 1,100,000              |   |
| Net payments on  other long-term debt                                |   | (29,043                    | )          | (27,052                | )      | (930,816               | )      |
| Payment of debt  issuance costs                                      |   | (240,970                   | )          | (33,580                | )      | (1,019,105             | )      |
| Net (payments  on) proceeds from financing of property and equipment |   | (472,899                   | )          | (588,465               | )      | 1,036,595              |   |
| Other                                                                |   | (19,132                    | )          | 28,314                 |   | —                 |   |
|                                                                 |   |                       |       |                   |   |                   |   |
| Net cash  provided by financing activities                           |   | 1,102,339                  |       | 1,119,421              |   | 3,640,322              |   |
|                                                                 |   |                       |       |                   |   |                   |   |
| Net decrease in  cash and cash equivalents                           |   | (163,811                   | )          | (41,890                | )      | (518,807               | )      |
|                                                                 |   |                       |       |                   |   |                   |   |
| Cash and cash  equivalents, beginning of year                        |   | 427,878                    |       | 469,768                |   | 988,575                |   |
|                                                                 |   |                       |       |                   |   |                   |   |
| Cash and cash  equivalents, end of year                              |   | $                          | 264,067    |                   | $      | 427,878                |   | $ | 469,768 |   |
|                                                                 |   |                       |       |                   |   |                   |   |
| **SUPPLEMENTAL CASH FLOW INFORMATION:**                              |   |                       |       |                   |   |                   |   |
| Interest paid  during the year                                       |   | $                          | 1,095,146  |                   | $      | 1,459,294              |   | $ | 930,065 |   |
| Income taxes  paid during the year                                   |   | 5,125                      |       | 10,758                 |   | —                 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

F-5

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**PAPER WAREHOUSE, INC. andSUBSIDIARIES**

**Notes to Consolidated Financial Statements**

 

**(1)           Summary ofSignificant Accounting Policies**

*** ***

***                Descriptionof Business***

We (“PaperWarehouse, Inc.” or the “Company”) are a chain of retail stores, specializingin party supplies and paper goods.  Asof February 1, 2002, we operated 100 Company-owned stores in ten statesthroughout the central and western regions of the United States under the names“Paper Warehouse” and “Party Universe,” and a web site under the name“PartySmart.com.”  In addition, we sellPaper Warehouse franchises through our wholly owned subsidiary, Paper WarehouseFranchising, Inc.

**                *Basis ofPresentation***

The accompanying consolidated financial statementsinclude the accounts of the Company and its wholly owned subsidiaries.  We have eliminated all intercompany balancesand transactions between the entities in consolidation.  All share and per share data have beenrestated to give effect to the retroactive application of our one-for-threereverse stock split, that became effective after the close of market on April16, 2001 (See Note 13).

***                FiscalYear***

Our fiscal yearends on the Friday closest to January 31st.  Our fiscal year is generally 52 weeks;however it periodically consists of 53 weeks. Our fiscal year ended February 1, 2002 (fiscal 2001) consisted of 52weeks, our fiscal year ended February 2, 2001 (fiscal 2000) consisted of 53weeks, and our fiscal year ended January 28, 2000 (fiscal 1999) consisted of 52weeks.  Unless otherwise stated,references to years in this report relate to fiscal years rather than tocalendar years.

**                *AccountingEstimates***

The preparation ofconsolidated financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires us to makeestimates and assumptions that affect the reported amounts of assets andliabilities, and disclosure of contingent assets and liabilities, at the dateof the financial statements, and the reported amounts of revenues and expensesduring the reporting period.  Actualresults could differ from those estimates.

***                CashEquivalents***

We consider allhighly liquid instruments with original maturities of three months or less tobe cash equivalents.  Checks written,but not yet cleared totaling approximately $2.1 million, are included inaccounts payable as of February 1, 2002.

***                FairValues of Financial Instruments***

Due to theirshort-term nature, the carrying value of our current financial assets andliabilities approximates their fair value. The fair value of our borrowings, if recalculated based on currentinterest rates, would not significantly differ from the recorded amounts.

 

F-6

----

 

***                MerchandiseInventories***

Inventories arestated at the lower of cost (as determined on a first-in, first-out basis) ormarket. We review slow moving merchandise and take appropriate markdowns andwrite-downs, as necessary.

** **

**                *Long-LivedAssets***

We reviewlong-lived assets for impairment annually, and whenever events or changes incircumstances indicate that the carrying amount may not be recoverable.  We recognize a loss for the difference ifthe fair value is less than the carrying amount of the asset.

*** ***

***                Propertyand Equipment***

Property andequipment are recorded at cost. Depreciation is computed on a straight-line basis over the estimateduseful lives of 3 years for computers and internally developed software costs,5-7 years for fixtures and equipment and 40 years for building and landimprovements.

** **

**                *Other Assets***

Other assetsconsist of debt issuance costs, goodwill and security deposits.

Debt issuancecosts are amortized to interest expense over the term of the related financingon a straight-line basis.

Goodwillrepresents the excess of purchase price over net assets acquired.  At February 1, 2002, we had unamortizedgoodwill of approximately $477,000. From the time of acquisition through February 1, 2002, goodwill had beenamortized over 15 years on a straight-line basis.  In accordance with the adoption of Statement of FinancialAccounting Standards (SFAS) No. 142, *Goodwill and Intangible Assets,* effectiveFebruary 2, 2002*,*(See Note 3)**we reviewed our recorded goodwill anddetermined it to have an indefinite life. Accordingly, goodwill is no longer subject to amortization effectiveFebruary 2, 2002.

*** ***

***                DeferredRent Credits***

Certain of ouroperating leases provide for scheduled increases in base rentals over theirterms.  For these leases, we recognizethe total rental amounts due over the lease terms on a straight-linebasis.  We have establishedcorresponding deferred rent credits for the differences between the amountsrecognized and the amounts paid.

*** ***

***                StoreOpening and Closing Costs***

Expendituresincurred in connection with the opening of new stores or the remodeling ofexisting stores are expensed as incurred.

In the event thata store is planned to close before its lease has expired, any remaining leaseobligation, net of expected sublease recovery, is provided for in the period weadopt the plan to close the store.  Inaddition, the remaining investment in fixed assets, net of the expectedrecovery value, is also expensed.

 

F-7

----

 

***                Leases***

Leases that meetthe accounting criteria for capital lease treatment are recorded as propertyand equipment and the related capital lease obligations are included indebt.  All other leases are accountedfor as operating leases.

*** ***

***                AdvertisingCosts***

Advertising costsfor our stores are included in store operating expenses and are expensed asincurred.  These advertising costs, netof advertising reimbursements, were approximately $3.3 million, $3.2 millionand $2.9 million for fiscal years 2001, 2000 and 1999, respectively.

*** ***

***                NetLoss Per Common Share***

Basic net loss percommon share (“EPS”) equals net loss divided by the weighted average number ofcommon shares outstanding during the periods.

Diluted EPS equalsnet loss divided by the weighted average number of common shares outstandingduring the period, increased to include assumed conversions of potentiallydilutive shares outstanding into common shares, when dilutive.  Our potentially dilutive shares of commonstock include stock options, our outstanding convertible subordinateddebentures and a warrant granted to the underwriter as part of our convertibledebenture offering.

We had $4.0million of convertible subordinated debentures outstanding at the end of fiscalyear 2001 and fiscal year 2000 that were not included in either computation ofdiluted EPS, as their inclusion would have been antidilutive.  In addition, options to purchase260,068,  259,452 and 173,516 shares ofcommon stock were outstanding at the end of fiscal years 2001, 2000 and 1999,respectively, but were excluded from the computation of common shareequivalents because they were antidilutive. Had we not incurred losses in these periods, we would have assumedconversions of convertible subordinated debentures into approximately 444,000common shares for the years ended February 1, 2002 and February 2, 2001, andinto approximately 243,000 common shares for the year ended January 28,2000.  We would not have assumed anyconversions of stock options for fiscal year 2001.  We would have assumed conversions of stock options intoapproximately 19,000 and 100 common shares for fiscal years 2000 and 1999,respectively.

*** ***

***                Stock-BasedCompensation***

We use theintrinsic value method to value our stock options issued to employees.  Had the fair value method been applied, ourcompensation expense would have been different.  (See Note 14.)

 

F-8

----

 

**(2)           DebtCovenants**

** **

**               **Theaccompanying financial statements have been prepared in conformity withaccounting principles generally accepted in the United States of America, whichcontemplates our continuation as a going concern.  At year-end, we were in breach of a financial covenant under oursubordinated convertible debt agreement. If this breach continues until June 16, 2002, it would become an"Event of Default" as defined by the agreement.  An "Event of Default" would permiteither the indenture trustee or the holders owning at least 25% of the outstandingdebentures to declare all of the $4.0 million of the outstanding debentures tobe due and payable, although we are seeking to obtain a waiver of this breachand amendments to the indenture from the debenture holders prior to it becomingan "Event of Default."  Inaddition, if the waiver is not obtained by June 16, 2002, a cross defaultprovision would occur and cause us to be in default of our bank line ofcredit.  We believe we will obtain therequired waiver.  If we are unable toobtain the waiver and if the indenture trustee or the holders owning at least25% of the outstanding debentures declare all of the $4.0 million of theoutstanding debentures to be due and payable, we currently have no availablesource of additional funds.

 

                In view of the matters describedin the preceding paragraph, recoverability of a major portion of the recordedasset amounts shown in the accompanying balance sheet is dependent upon ourcontinued operations, which in turn is dependent upon our ability to obtain thewaiver in a timely fashion.  Thefinancial statements do not include any adjustments relating to therecoverability and classification of recorded asset amounts or amounts andclassification of liabilities that might be necessary should we be unable tocontinue as a going concern.

 

                We have sought assistance tohelp obtain the waiver and have developed a detailed plan approved by our boardof directors.  We believe theseprocedures will be sufficient to obtain the waiver and the amendments andcontinue as a going concern.

** **

**(3)           RecentlyIssued Accounting Pronouncements**

Recently, theFinancial Accounting Standards Board (FASB) issued SFAS No. 141, *BusinessCombinations,* SFAS No. 142, *Goodwill and Intangible Assets* and SFASNo. 144, *Accountingfor the Impairment or Disposal of Long-lived*Assets.  SFAS No. 141 is effective for all businesscombinations completed after June 30, 2001. SFAS No. 142 and SFAS No. 144 are effective for fiscal years beginningafter December 15, 2001.

We adopted thesestatements effective February 2, 2002. We will review goodwill for impairment, as assigned to reporting units,annually, at the end of the fourth quarter. We have no other intangible assets.

As disclosed in Note 17, subsequent toour fiscal 2001 yearend, on April 23, 2002 we closed on the sale of our 13stores in the Seattle market.  Thistransaction will be recorded and reported in accordance with SFAS No. 144.

** **

**(4)           AccountingChange — Fiscal Year 1999**

We adoptedStatement of Position (SOP) No. 98-5, “*Reporting on the Costs of Start-Up Activities*”during fiscal 1999.  This Statement requiredthat costs of start-up activities and organization costs be expensed asincurred.  Prior to the adoption of thisStatement, our policy was to capitalize lease acquisition fees and amortizethem over the related lease term using the straight-line method.  The impact of the change of approximately$109,000, net of taxes of approximately $72,000, is shown as a cumulativeeffect of accounting change in the Consolidated Statement of Operations for theyear ended January 28, 2000.

 

**(5)           InternetSubsidiary**

During fiscal1999, we incorporated PartySmart.com, Inc. as a wholly owned subsidiary to sellparty supplies and paper goods over the Internet in the third quarter of fiscal1999.  In fiscal 1999, we incurreddevelopment costs of approximately $2.5 million related to the Internetventure, $1.1 million of which was originally capitalized.  In recording these expenses, we followed theguidance prescribed by SOP No. 98-1, “*Accounting for the Costs of Computer SoftwareDeveloped for Internal Use*,” and the guidance prescribed by SOP98-5.

During the fourthquarter of fiscal 1999, we performed a review of the long-lived assetsassociated with PartySmart.com, for impairment.  As a result of this review, we concluded that the asset value ofour Internet website, consisting primarily of capitalized internally developedsoftware costs, was not fully recoverable and we hired an outside firm toperform an appraisal.  As a result ofthis appraisal, and in accordance with SFAS No. 121, “*Accounting for the Impairment of Long-LivedAssets and for Long-Lived Assets to be Disposed Of*”, we recorded apre-tax impairment charge of approximately $800,000 to reflect the relatedassets of PartySmart.com at their fair market value.

 

F-9

----

 

**(6)           Repositioning(Credits) Provision and Store Closing Reserve**

During the fourthquarter of fiscal 1999, we adopted a plan to close four under-performingstores, and recorded a pre-tax charge of approximately $1.7 million.  This amount consisted primarily of reservesfor lease obligations for these four stores, net of expected subleasepayments.  Additionally, we recorded animpairment charge of approximately $200,000 related to furniture and fixtures and goodwill associated withthese stores to be closed.  These fourstores were subsequently closed during the first half of fiscal 2000.  We also reserved approximately $600,000 infiscal 1999 for the remaining lease obligations for one store that wassubsequently relocated during the first quarter of fiscal 2000.  Additionally included in the fiscal 1999repositioning charge was a reserve for a change in the estimate of theremaining lease obligations, net of expected sublease payments, for four storesthat were previously closed of approximately $700,000.

The reserve forstore closings at the end of fiscal 2001 and 2000 reflects reductions relatedto ongoing payments of rent, common area maintenance, real estate taxes andother miscellaneous expenses on stores that were closed, in addition tobeneficial adjustments resulting from the subleasing of store locations. Priorto our original estimate of time to sublease store locations, we closed onagreements to sublease three store locations, and terminated the leases on twolocations.  Accordingly, we recovered$230,000 of the store closing reserve during fiscal 2001 and we recovered$970,000 of the store closing reserve during fiscal 2000.

During the fourthquarter of fiscal 2001, we recorded a pre-tax charge of approximately $108,000for the remaining lease obligations on a store that was subsequently relocated.

** **

**(7)           Propertyand Equipment, net**

Property andequipment, net, consisted of the following at:

 
|                                       |   | **February 1,  2002** |       | **February 2,  2001** |   |
|--------------------------------------------|--------|-----------------------|------------|-----------------------|--------|
| Fixtures and equipment                     |   | $                     | 16,040,113 |                  | $      | 15,445,831 |   |
| Building                                   |   | 1,273,088             |       | 1,273,088             |   |
| Internally developed  software costs       |   | 741,597               |       | 615,905               |   |
| Land and improvements                      |   | 319,733               |       | 319,733               |   |
| Accumulated  depreciation and amortization |   | (11,202,079           | )          | (8,955,812            | )      |
|                                       |   |                  |       |                  |   |
| Total property and  equipment, net         |   | $                     | 7,172,452  |                  | $      | 8,698,745 |   |

 

Depreciation and amortization expense on property and equipment wasapproximately $2.3 million for fiscal years 2001 and 2000, and $2.2 million forfiscal year 1999.

 

F-10

----

 

**(8)           NotesPayable — Line of Credit**

We have a $15.0million multi-year revolving line of credit facility with a bank for generalworking capital purposes that expires in September 2004.  Borrowings outstanding under this line ofcredit bear interest at the prime rate (4.75% at February 1, 2002 and 8.50% atFebruary 2, 2001) and are secured by substantially all of our assets.  Advances under this credit line are limitedto a fixed percentage of certain assets, primarily inventory.  As a result of the borrowing limitation,primarily resulting from the levels of inventory and a financial covenant atmonth end, we often maximize the availability under this line duringintra-month peaks and at certain times during the year.  At February 1, 2002, we had availability of$10.5 million, of which approximately $7.7 million was outstanding.  At February 2, 2001, we had availability of$8.1 million, of which approximately $6.9 million was outstanding.

The creditagreement contains covenants, which require us to maintain certain financialcovenants and a certain level of availability, and imposes restrictions on ourability to pay dividends.  We were incompliance with, or obtained a waiver for, all of our financial covenants asrequired by the credit facility at February 1, 2002.  If an “Event of Default” occurs under our trust indenture,however it will cross-default our revolving credit agreement.  (See Note 11.)

The creditagreement also requires the use of all cash receipts to pay down indebtednessand includes various covenants, which, if violated, could accelerate thematurity of the debt.  Accordingly, wehave classified borrowings outstanding under the revolving credit facility as acurrent liability in our Consolidated Balance Sheets.

** **

**(9)           NotesPayable — Other**

As of February 1,2002, we had a $1.0 million unsecured note payable to an unrelated businesspartner, due in full on June 1, 2002. This note bears interest at a rate equal to $12,500 per month.  In consideration for the $1.0 millionproceeds, we granted this business partner an option to purchase 3,750 sharesof our common stock at an exercise price equal to the stock’s fair market valueat the date of grant.  This option has aten-year term and vests ratably over three years from the date of the grant.

** **

**(10)         Leases**

Our assets undercapital leases consist of agreements for equipment and fixtures and anagreement for software.  At February 1,2002, assets under capital leases were approximately $918,000, net ofaccumulated depreciation of approximately $1.8 million.  At February 2, 2001, assets under capitalleases were approximately $1.5 million, net of accumulated depreciation ofapproximately $1.2 million.

We lease all ofour retail stores under noncancelable operating leases that have variousexpiration dates.  In addition to baserents, some leases require us to pay our share of common area maintenance andreal estate taxes, and include provisions for contingent rentals based uponsales.  Some of the leases containrenewal options under which we may extend the term three to five years.  Total rent expense was approximately $10.3million, $10.2 million and $9.7 million for fiscal years 2001, 2000 and 1999,respectively.

 

F-11

----

 

Future minimum lease payments required under noncancelable leaseagreements existing at February 1, 2002 were:

 
| **Fiscal  Year:**                       |   |       | **Operating  Leases** |    | **Capital**

**Leases** |          |
|-----------------------------------------|--------|------------|-----------------------|---------|-------------------------|---------------|
| 2002                                    |   | $          | 10,993,108            |    | $                       |  560,635 |   |
| 2003                                    |   | 10,224,269 |                  | 410,656 |                    |
| 2004                                    |   | 9,287,688  |                  | 41,138  |                    |
| 2005                                    |   | 8,129,362  |                  | —  |                    |
| 2006                                    |   | 6,681,900  |                  | —  |                    |
| Thereafter                              |   | 14,739,310 |                  | —  |                    |
|                                    |   |       |                  |    |                    |
| Total future  minimum lease commitments |   | $          | 60,055,637            |    | 1,012,429               |          |
| Less:  Interest at 9.4% - 15.3%    |   |       |                  | 93,431  |                    |
| Total capital  lease obligations        |   |       |                  | $       |  918,998           |          |

 

**(11)         Long-TermDebt**

 

***                SubordinatedConvertible Debt***

During fiscal1999, we issued convertible subordinated debentures in an aggregate principalamount of $4.0 million, which mature in 2005, and are convertible at $9.00 intoapproximately 444,000 shares of our common stock.  We received net proceeds of approximately $3.2 million from theissuance of these debentures, which were used to develop and implement ourInternet website, to repay indebtedness and for other general corporatepurposes.  The indenture under whichthese debentures were issued contains covenants that require us to satisfycertain financial tests and impose restrictions on our ability to paydividends.  Until September 15, 2000,the debentures bore interest at an annual rate of 9.0% that was payablequarterly.  As a result of our fiscal1999 financial results, we were in breach of a covenant that required a minimumconsolidated tangible net worth. However, we were current on all required payments under theindenture.  During fiscal 2000, wereceived a waiver of this breach and approval of an amendment to the indenturefrom our debenture holders.  Inconsideration for the waiver and amendment of certain covenants, we increasedthe interest rate to an annual rate of 10.5%, effective as of September 15,2000.

As of February 1,2002, we were in breach of a covenant under the indenture that requires aminimum consolidated net worth of $7.0 million.  We are current, however, on all required payments under theindenture.  Under the indenture, if thisbreach continues until June 16, 2002, it will become an “Event ofDefault.”  An “Event of Default” wouldpermit either the indenture trustee or the holders owning at least 25% inprincipal amount of the outstanding debentures to declare all of the $4.0million of outstanding debentures to be immediately due and payable.  An “Event of Default” under our indenturewould also cross-default our revolving credit agreement and would provide oursecured lender with the right to prevent us from paying future principal orinterest payments to the holders of our subordinated debentures until such“Event of Default” is cured, waived or ceases to exist, if such lenderexercised such right.  We will ask ourdebenture holders, prior to June 16, 2002, to waive this breach and to approveamendments to our indenture to eliminate the covenants that require us tosatisfy certain financial tests.  In thefuture, we may also consider a program to repurchase our outstandingdebentures, provided that we have the funds available for such program and thatour secured lender has approved such a program.  Due to our breach, the $4.0 million convertible subordinateddebentures are reflected as current debt in our consolidated balance sheet atFebruary 1, 2002.

 

F-12

----

 

Long-term debt consisted of the following at:

 
|                                                                                                                                                                             |   | **February  1,  2002** |      | **February  2,  2001** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------|-----------|------------------------|--------|
| Convertible  subordinated debentures due 2005                                                                                                                                    |   | $                      | —    |                   | $      | 4,000,000 |   |
| Term note  payable in monthly installments of $8,612, including interest at 7.125%  through May 2009.  The note is secured  by a first mortgage on our office headquarters. |   | 1,026,912              |      | 1,055,955              |   |
| Note payable in  monthly installments of $5,827, including interest at 10.29% through August  2003.                                                                              |   | 101,763                |      | —                 |   |
| Subordinated  notes payable to private placement holders called and payable upon presentment                                                                                     |   | 100,000                |      | 100,000                |   |
| Sub-total  long-term debt                                                                                                                                                        |   | 1,228,675              |      | 5,155,955              |   |
| Capital lease  obligations                                                                                                                                                       |   | 918,998                |      | 1,391,897              |   |
| Less: current  maturities                                                                                                                                                        |   | 685,733                |      | 601,943                |   |
| Long-term debt                                                                                                                                                                   |   | $                      | 1,461,940 |                   | $      | 5,945,909 |   |

 

Required principal payments on long-term debt over the next five years,excluding capital lease obligations and $100,000 of subordinated notes payableon demand, are:

 
| **Fiscal  Year:**                  |   |    |      |   |
|------------------------------------|--------|---------|-----------|--------|
| 2002                               |   | $       | 93,520    |   |
| 2003                               |   | 72,903  |      |
| 2004                               |   | 35,942  |      |
| 2005                               |   | 38,589  |      |
| 2006                               |   | 41,430  |      |
| Thereafter                         |   | 846,291 |      |
|                               |   |    |      |
| Total required  principal payments |   | $       | 1,128,675 |   |

 

F-13

----

 

**(12)         IncomeTaxes**

 

As prescribed by SFAS No. 109,*Accounting for Income Taxes,*we did notrecord a tax benefit on our fiscal 2001 loss. The actual income tax rate differed from the amounts computed by theU.S. federal income tax rate of 34% to pretax net loss as a result of thefollowing for the fiscal years ending:

 
|                                                                                                                                       |   | **February 1,  2002** |       | **February 2,  2001** |   | **January 28,  2000** |   |
|--------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------|------------|-----------------------|--------|-----------------------|--------|
| Computed  “expected” tax benefit on losses, including tax benefit associated with  change in accounting principle in fiscal 1999 |   | $                     | (2,063,193 | )                     | $      | (247,935              | )      | $ | (2,547,013 | ) |
|                                                                                                                                       |   |                  |       |                  |   |                  |   |
| Reduction in  income taxes resulting from state and local income taxes, net of federal income  tax benefit                                 |   | (293,142              | )          | (25,850               | )      | (514,840              | )      |
| Change in valuation allowance                                                                                                              |   | 6,088,500             |       | —                |   | —                |   |
| Other permanent  differences                                                                                                               |   | 1,103                 |       | (21,215               | )      | 19,184                |   |
| Total income tax  provision (benefit)                                                                                                      |   | $                     | 3,733,268  |                  | $      | (295,000              | )      | $ | (3,042,669 | ) |
|                                                                                                                                       |   |                  |       |                  |   |                  |   |
| Effective tax  rate                                                                                                                        |   | 61.5                  | %          | (40.5                 | )%     | (40.6                 | )%     |

 

The components of the income tax expense (benefit) were as follows forthe fiscal years ending:

 
|                                |   | **February 1,**

**2002** |      | **February 2,  2001** |   | **January 28,  2000** |   |
|-------------------------------------|--------|---------------------------|-----------|-----------------------|--------|-----------------------|--------|
| Deferred:                           |   |                      |      |                  |   |                  |   |   |   |   |
| Federal                             |   | $                         | 3,270,987 |                  | $      | (269,150              | )      | $ | (2,527,829 | ) |
| State                               |   | 462,281                   |      | (25,850               | )      | (514,840              | )      |
| Total income tax  expense (benefit) |   | $                         | 3,733,268 |                  | $      | (295,000              | )      | $ | (3,042,669 | ) |

 

F-14

----

 

Deferred taxes, detailed below, recognize the impact of temporary differencesbetween the amounts of assets and liabilities recorded for financial statementpurposes and such amounts measured in accordance with tax laws.  Realization of the net operating losscarryforwards and other deferred tax temporary differences are contingent onfuture taxable earnings.  Our deferredtax asset was reviewed for expected utilization using a “more likely than not”approach as required by SFAS No. 109 by assessing the available positive andnegative evidence surrounding its recoverability.  Accordingly, we recorded a valuation allowance of approximately$6.1 million on the deferred tax asset.

 

We continue to assess and evaluate strategies that will enable thedeferred tax asset, or portion thereof, to be utilized, and will reduce thevaluation allowance appropriately at such time when it is determined that the“more likely than not” approach is satisfied.

 

The tax effects of temporary differences that give rise to significantportions of the deferred tax assets and deferred tax liabilities were asfollows at:

 
|                                                                                           |   | **February 1,  2002** |    | **February 2,  2001** |   |
|------------------------------------------------------------------------------------------------|--------|-----------------------|---------|-----------------------|--------|
| Deferred tax  asset/(liability):                                                               |   |                  |    |                  |   |
|                                                                                           |   |                  |    |                  |   |
| Short-term  deferred income taxes:                                                             |   |                  |    |                  |   |
| Inventories,  principally due to additional costs inventoried for tax purposes                 |   | $                     | 192,000 |                  | $      | 249,800 |   |
|                                                                                           |   |                  |    |                  |   |
| Long-term  deferred income taxes:                                                              |   |                  |    |                  |   |
| Net operating  loss carryforwards                                                              |   | 5,590,480             |    | 3,274,350             |   |
| Reserve for  store closings                                                                    |   | 278,116               |    | 526,066               |   |
| Difference in  timing of lease deductions                                                      |   | 763,141               |    | 626,775               |   |
| Cumulative  effect of accounting change                                                        |   | 39,160                |    | 46,552                |   |
| Plant and  equipment, principally due to differences in depreciation and capitalized  interest |   | (761,078              | )       | (897,454              | )      |
| Software  development expense                                                                  |   | (42,622               | )       | (92,821               | )      |
| Other                                                                                          |   | 29,303                |    | —                |   |
| Net long-term  deferred tax assets                                                             |   | 5,896,500             |    | 3,483,468             |   |
|                                                                                           |   |                  |    |                  |   |
| Total deferred  tax assets                                                                     |   | 6,088,500             |    | 3,733,268             |   |
|                                                                                           |   |                  |    |                  |   |
| Valuation  allowance                                                                           |   | (6,088,500            | )       | —                |   |
|                                                                                           |   |                  |    |                  |   |
| Total net  deferred tax assets                                                                 |   | $                     | —  |                  | $      | 3,733,268 |   |

 

At February 1, 2002, we had a net operating loss carryforward for federaland state income tax purposes of approximately $25.6 million, available tooffset future taxable income, if any, through fiscal 2021.

 

F-15

----

 

**(13)         EquityTransactions**

 

On April 4, 2001, our Board of Directors approved a one-for-threereverse stock split of our $.01 par value common and preferred stock forstockholders of record on April 16, 2001. The reverse stock split reduced the number of shares of common stockpreviously issued and outstanding at February 2, 2001 from 5,647,779 to1,882,593, subsequently increased to eliminate fractional interests.  No fractional shares of common stock wereissued in connection with the reverse stock split.  The par value of our common and preferred stock correspondinglyincreased to $.03 per share.  Thereverse stock split was effective as of the close of market on April 16,2001.  All share and per share data ispresented to give effect to the reverse stock split as if it occurred onJanuary 29, 1999.

 

During fiscal 2000, we distributed, to shareholders of record onSeptember 15, 2000, 0.108 rights for each share of common stock held onSeptember 15, 2000.  Each whole rightentitled its holder to purchase one-third share of our $.03 par value commonstock at a subscription price of $3.75. No fractional rights were issued and the rights were nottransferable.  As a result of thisoffering, we sold approximately 332,000 shares of $.03 par value common stockand raised approximately $1.2 million of net proceeds, to be used for generalworking capital and corporate purposes.

** **

**(14)         StockOptions**

 

We have a stock option plan (“the Plan”) pursuant to which we grantstock option awards in order to attract and retain eligible participants and topreserve cash resources.  Under thisplan, 341,667 shares are available for issuance and 256,734 were outstanding asof February 1, 2002.  We also have aseparate director stock option plan (“the Director Plan”) which permits up to38,214 shares to be issued, of which 3,334 were outstanding as of February 1,2002.  Under both plans, stock optionsare granted with an exercise price equal to the stock’s fair market value atthe date of grant.  All stock options haveten-year terms and vest ratably over three years from the date of grant.

 

During fiscal 2000, the Compensation Committee of the Board ofDirectors approved the repricing to $6.00 per common share of 141,433 options,all of which were originally granted in excess of $6.00 per common share.  The repricing of these options creates insubstance a modification.  Accordingly,these options are treated as variable awards, and we reflect changes in theirvalue in the general and administrative expense line until the options areexercised or expire.  All exerciseprices as disclosed in the footnotes have been restated to reflect therepricing of these options.

 

During fiscal 1999, our shareholders approved an amendment to the Planto increase the number of shares available for issuance from 175,000 to341,667, to add non-employee directors, consultants and independent contractorsto the class of persons eligible to receive awards under the Plan and to amendthe provisions regarding the Board’s ability to amend the Plan withoutshareholder approval in certain circumstances.

 

F-16

----

 

Details of the status of stock options as of February 1, 2002 arereflected in the tables below:

 
|                                    |   | **Options**            |   |
|-----------------------------------------|--------|------------------------|--------|
|                                    |   | **Total  Outstanding** |   | **Exercisable** |   |
|                                    |   | **Number of  Shares**  |   | **Weighted-  Average  Exercise  Price** |   | **Number of   Shares** |   | **Weighted-  Average  Exercise  Price** |   |
| Options  outstanding   January 29, 1999 |   | 137,435                |   | $ | 6.00 |   | 137,435 |   | $ | 6.00 |   |
| Options granted                         |   | 37,448                 |   | 5.94 |   | 24,965 |   | 5.94 |   |
| Options  forfeited/canceled             |   | (1,367                 | )      | 6.00 |   | (911 | ) | 6.00 |   |
|                                    |   |                   |   |   |   |   |   |   |   |
| Options  outstanding   January 28, 2000 |   | 173,516                |   | 5.99 |   | 161,489 |   | 5.99 |   |
| Options granted                         |   | 94,312                 |   | 2.75 |   | 31,437 |   | 2.75 |   |
| Options  forfeited/canceled             |   | (8,376                 | )      | 5.62 |   | (2,792 | ) | 5.62 |   |
|                                    |   |                   |   |   |   |   |   |   |   |
| Options  outstanding   February 2, 2001 |   | 259,452                |   | 4.82 |   | 190,134 |   | 5.46 |   |
| Options granted                         |   | 4,384                  |   | 0.99 |   | — |   | — |   |
| Options  forfeited/canceled             |   | (3,768                 | )      | 6.00 |   | — |   | — |   |
|                                    |   |                   |   |   |   |   |   |   |   |
| Options  outstanding   February 1, 2002 |   | 260,068                |   | $ | 4.74 |   | 190,134 |   | $ | 5.46 |   |

 

Options exercisable at February 2, 2001 and January 28, 2000 were 124,119and 65,829, respectively.

 
|                          |   | **Options**            |   |
|-------------------------------|--------|------------------------|--------|
|                          |   | **Total  Outstanding** |   | **Exercisable** |   |
| **Range of  exercise  price** |   | **Number of  shares**  |   | **Weighted-  average  remaining  contractual  life in years** |   | **Weighted-  average  exercise  price** |   | **Number of  shares** |   | **Weighted-  average  remaining  contractual  life in years** |   | **Weighted-  average  exercise  price** |   |
| $0.71                         |   | 3,750                  |   | 10.0 |   | $ | 0.71 |   | — |   | — |   | $ | — |   |
| $2.63-$3.93                   |   | 94,312                 |   | 8.2 |   | 2.73 |   | 31,226 |   | 8.2 |   | 2.74 |   |
| $4.31-$6.00                   |   | 162,006                |   | 6.6 |   | 6.00 |   | 158,908 |   | 6.5 |   | 6.00 |   |
|                          |   | 260,068                |   | 7.2 |   | 4.74 |   | 190,134 |   | 6.8 |   | 5.46 |   |
|                               |        |                        |        |  |  |  |  |  |  |  |  |  |  |  |  |

 

F-17

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The per share weighted-average fair value of options granted each yearusing the Black-Scholes option-pricing model was $0.44 at February 1, 2002,$1.14 at February 2, 2001 and $2.13 at January 28, 2000, using the followingweighted-average assumptions for fiscal years:

 
|                      |   | **2001** |   | **2000** |   | **1999** |   |
|---------------------------|--------|----------|--------|----------|--------|----------|--------|
| Volatility                |   | 60       | %      | 60       | %      | 60       | %      |
| Expected divided yield    |   | 0.0      | %      | 0.0      | %      | 0.0      | %      |
| Risk free rate            |   | 5.0      | %      | 5.0      | %      | 6.0      | %      |
| Expected life  (in years) |   | 5.0      |   | 5.0      |   | 5.0      |   |

 

If we had elected to recognize compensation cost based on the fairvalue of the options at the date of grant as prescribed by SFAS No. 123, ournet loss would have increased to the pro forma amounts indicated below for thefiscal years ending:

 
|                                                            |   | **February  1,  2002** |       | **February  2,**

**2001** |   | **January  28,  2000** |   |
|-----------------------------------------------------------------|--------|------------------------|------------|----------------------------|--------|------------------------|--------|
| Net loss — as  reported                                    |   | $                      | (9,801,483 | )                          | $      | (434,222               | )      | $ | (4,448,547 | ) |
| Net loss — pro  forma                                      |   | (9,931,967             | )          | (673,222                   | )      | (4,621,547             | )      |
|                                                            |   |                   |       |                       |   |                   |   |
| Basic and  diluted net loss per common share — as reported |   | (5.20                  | )          | (0.27                      | )      | (2.88                  | )      |
| Basic and  diluted net loss per common share — pro forma   |   | (5.27                  | )          | (0.41                      | )      | (3.00                  | )      |
|                                                                 |        |                        |            |                            |        |                        |        |  |  |  |

 

**(15)         EmployeeBenefits**

 

We have a retirement savings plan that includes a 401(k) feature.  The plan covers substantially all employeeswho are 21 years of age and have completed one year of service.  Employees become fully vested in the plan ona graduated scale over a six-year period. The 401(k) feature allows for employees to elect salary deferrals for upto 15% of their compensation, but not in excess of certain limitations.  We match 25% of the first 4% of employeecontributions to the plan.  Ourcontributions were approximately $52,000, $54,000 and $44,000 for fiscal years2001, 2000 and 1999, respectively. We reserve the right to make a discretionarycontribution each plan year, however we did not make any discretionarycontributions in fiscal years 2001, 2000 or 1999.

 

Due to a low level of participation, during fiscal 2001, we suspendedour Employee Stock Purchase Plan, which was introduced in fiscal 1999.  The plan allows eligible employees topurchase our stock at below-market prices through elected payroll deductionsequal to between 2% and 15% of their compensation.  The plan also allows participants to purchase shares of our stockon each offering date at the lower of 85% of the fair market value of one shareof common stock on the offering date or on the termination date of the offeringperiod.  Pursuant to this plan, duringfiscal 2001 and fiscal 2000, employees purchased approximately 3,500 and 8,400shares of our common stock, respectively. No stock had been purchased by employees under this plan prior to fiscal2000.

 

F-18

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**(16)         Commitments**

 

We have a multi-year partnership with a vendor to be the exclusivesupplier for greeting cards for our Company-owned and franchise stores.  As of February 1, 2002, we have a remainingcontractual obligation for chain-wide purchases of $27.5 million of greetingcards and gift-wrap for our Company-owned and franchise stores.  We estimate that these purchase commitmentswill be fulfilled over a four- year period. Total chain-wide purchases under this agreement since inception wereapproximately $7.6 million and $3.2 million for fiscal 2001 and 2000, respectively.

** **

**(17)         SubsequentEvent**

 

On April 23, 2002, we closed on the sale of our 13 stores in theSeattle market for approximately $4.5 million, and exited this market.  We expect to record a fiscal 2002 firstquarter gain of approximately $1.3 million. This expected gain reflects the proceeds and expenses associated withthe sale.

 

The following unaudited pro forma results related to this transactionassume that the sale occurred on February 2, 2001. For fiscal 2001, we wouldhave reported revenues of $75.9 million, net loss and diluted net loss pershare of $8.6 million and $4.58, respectively, and total assets of $24.6million.

 

F-19

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**(18)         SupplementaryFinancial Information (Unaudited)**

 

The following represents unaudited selected quarterly financialinformation for fiscal years 2001 and 2000:

*($’s in000’s, except per share data)*
|                         |   | **First  Quarter** |   | **Second  Quarter** |   | **Third  Quarter** |   | **Fourth  Quarter** |   |
|------------------------------|--------|--------------------|--------|---------------------|--------|--------------------|--------|---------------------|--------|
|                         |   | **2001**           |   | **2000**            |   | **2001**           |   | **2000**            |   | **2001** |   | **2000** |   | **2001** |   | **2000** |   |
| Retail Sales(1)              |   | $                  | 19,969 |                | $      | 19,423             |   | $                   | 21,780 |   | $ | 23,221 |   | $ | 22,796 |   | $ | 22,367 |   | $ | 20,757 |   | $ | 23,779 |   |
|                         |   |               |   |                |   |               |   |                |   |   |   |   |   |   |   |   |   |
| Gross Profit (2)             |   | 6,719              |   | 5,986               |   | 7,420              |   | 8,266               |   | 7,395 |   | 7,617 |   | 5,491 |   | 8,049 |   |
|                         |   |               |   |                |   |               |   |                |   |   |   |   |   |   |   |   |   |
| Net (loss)  Earnings (3) (4) |   | (426               | )      | (985                | )      | (263               | )      | 879                 |   | (769 | ) | 2 |   | (8,344 | ) | (330 | ) |
|                         |   |               |   |                |   |               |   |                |   |   |   |   |   |   |   |   |   |
| Basic EPS (5)                |   | $                  | (0.23  | )                   | $      | (0.64              | )      | $                   | (0.14  | ) | $ | 0.57 |   | $ | (0.41 | ) | $ | 0.00 |   | $ | (4.42 | ) | $ | (0.18 | ) |
|                         |   |               |   |                |   |               |   |                |   |   |   |   |   |   |   |   |   |
| Diluted EPS (5)              |   | (0.23              | )      | (0.64               | )      | (0.14              | )      | 0.47                |   | (0.41 | ) | 0.00 |   | (4.42 | ) | (0.18 | ) |

----

(1)          The fourth quarter of fiscal 2001 included four weekswhile the fourth quarter of fiscal 2000 included five weeks.

(2)          Gross profit is retail sales less cost of productssold and occupancy costs.

(3)          First quarter 2001 net loss includes $230,000 ($0.07per basic and diluted share, net of tax) related to the recovery of storeclosing reserves.  Fourth quarter 2001loss includes approximately $108,000 ($0.06 per basic and diluted share) relatedto a charge to the store closing reserves for the remaining lease obligation ona store that was subsequently relocated. Fourth quarter 2001 loss also reflects the recording of a valuationallowance of approximately $6.1 million ($3.23 per basic and diluted share) onour deferred tax asset.

(4)          Second, third and fourth quarter 2000 net earnings(loss) include $530,000 ($0.21 per basic and $0.16 per diluted share, net oftax), $160,000 ($0.06 per basic and diluted share, net of tax) and $280,000($0.09 per basic and diluted share, net of tax), respectively, related to therecovery of store closing reserves.

(5)          Basic and Diluted EPS reflect the retroactiverestatement of our one-for-three reverse stock split, effective April 16, 2001.

 

F-20

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.

 
|                      | PAPER WAREHOUSE, INC.                           |
|---------------------------|-------------------------------------------------|
|                      |                                            |
| Dated:   May 2, 2002 |                                            |
|                      |                                            |
|                      | By: /s/ Yale T.  Dolginow                       |
|                      | Yale T. Dolginow                                |
|                      | Chairman, President and Chief Executive Officer |

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, this report has been signed below on May 2, 2002 by thefollowing persons on behalf of the registrant and in the capacities indicated.

 
|   | SIGNATURE                 |                                                                                        |
|--------|---------------------------|---------------------------------------------------------------------------------------------|
|   |                      |                                                                                        |
| /s/    | Yale T. Dolginow          | Chairman of the Board,  President and Chief Executive Officer (principal executive officer) |
|   | Yale T. Dolginow          |
|   |                      |                                                                                        |
| /s/    | Diane C. Dolginow         | Secretary and Director                                                                      |
|   | Diane C. Dolginow         |                                                                                        |
|   |                      |                                                                                        |
| /s/    | Marvin W. Goldstein       | Director                                                                                    |
|   | Marvin W. Goldstein       |                                                                                        |
|   |                      |                                                                                        |
| /s/    | Jeffery S. Halpern        | Director                                                                                    |
|   |  Jeffery S.  Halpern |                                                                                        |
|   |                      |                                                                                        |
| /s/    | Martin A. Mayer           | Director                                                                                    |
|   | Martin A. Mayer           |                                                                                        |
|   |                      |                                                                                        |
| /s/    | Richard W. Perkins        | Director                                                                                    |
|   | Richard W. Perkins        |                                                                                        |
|   |                      |                                                                                        |
| /s/    | Cheryl W. Newell          | Vice President and  Chief Financial Officer (principal financial officer)                   |
|   | Cheryl W. Newell          |
|   |                      |                                                                                        |
| /s/    | Diana  G. Purcel          | Vice  President and Controller (principal accounting officer)                               |
|   | Diana  G. Purcel          |

 

F-21

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PAPER WAREHOUSE, INC. and SUBSIDIARIES

 

EXHIBIT INDEX TO ANNUALREPORT ON FORM 10-K

For the fiscalyear ended February 1, 2002

 
| **Item No.** |   | **Description  of Item**                                                                                                                  |   | **Method of  Filing**                                                                                                  |
|--------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------------------------|
| 3.1          |   | Amended and Restated Articles of Incorporation                                                                                            |   | Incorporated by reference to the Company’s  Registration Statement on Form S-1 (File No. 333-36911)               |
| 3.2          |   | Amended and Restated By-laws                                                                                                              |   | Incorporated by reference to the Company’s  Registration Statement on Form S-1 (File No. 333-36911)               |
| 4.1          |   | Indenture, dated July 20, 1999, between the Company  and Norwest Bank Minnesota, N.A. relating to 9% Convertible Subordinated  Debentures |   | Incorporated by reference to the Company’s  Registration Statement on Form S-1 (File No. 333-79161)               |
| 4.2          |   | Form of 9% Subordinated Debentures due September 15,  2005                                                                                |   | Incorporated by reference to the Company’s  Registration Statement on Form S-1 (File No. 333-79161)               |
| 10.1         |   | 1997 Stock Option and Compensation Plan                                                                                                   |   | Incorporated by reference to the Company’s  Registration Statement on Form S-1 (File No. 333-36911)               |
| 10.2         |   | Directors’ Stock Option Plan                                                                                                         |   | Incorporated by reference to the Company’s  Registration Statement on Form S-1 (File No. 333-36911)               |
| 10.3         |   | 1998 Employee Stock Option Plan                                                                                                           |   | Incorporated by reference to the Company’s Form 10-K  for fiscal year ended January 29, 1999 (File No. 000-23389) |
| 10.4         |   | First Amendment to 1997 Stock Option and  Compensation Plan                                                                               |   | Incorporated by reference to the Company’s Form 10-K  for fiscal year ended January 28, 2000 (File No. 000-23389) |
| 10.5         |   | Mortgage note dated April 8, 1999 between the  Company and Fortis Insurance Company                                                       |   | Incorporated by reference to the Company’s  Registration Statement on Form S-1 (File No. 333-79161)               |
| 10.6         |   | Mortgage and Security Agreement between the Company  and Fortis Insurance Company dated April 8, 1999                                     |   | Incorporated by reference to the Company’s  Registration Statement on Form S-1 (File No. 333-79161)               |
| 10.7         |   | Loan and Security Agreement between BankBoston  Retail Finance, Inc. and the Company dated June 7, 1999                                   |   | Incorporated by reference to the Company’s  Registration Statement on Form S-1 (File No. 333-79161)               |

 

 

E-1

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| 10.8  |   | First Amendment to Loan and Security Agreement  between BankBoston Retail Finance, Inc. and the Company dated December 10,  1999 |   | Incorporated by reference to the Company’s Form 10-Q  for quarter ended October 29, 1999 (File No. 000-23389)     |
|-------|--------|----------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------------------------|
| 10.9  |   | Second Amendment to Loan and Security Agreement  between BankBoston Retail Finance, Inc. and the Company dated March 17, 2000    |   | Incorporated by reference to the Company’s Form 10-K  for fiscal year ended January 28, 2000 (File No. 000-23389) |
| 10.10 |   | Third Amendment to Loan and Security Agreement  between BankBoston Retail Finance, Inc. and the Company dated December 6,  2000  |   | Incorporated by reference to the Company’s Form 10-K  for fiscal year ended February 2, 2001 (File No. 000-23389) |
| 10.11 |   | Fourth Amendment to Loan and Security Agreement  between Fleet Retail Finance, Inc. and the Company dated April 17, 2001         |   | Incorporated by reference to the Company’s Form 10-K  for fiscal year ended February 2, 2001 (File No. 000-23389) |
| 10.12 |   | Indemnification Agreement between Yale T. Dolginow  and the Company dated March 21, 2000                                         |   | Incorporated by reference to the Company’s Form 10-K  for fiscal year ended January 28, 2000 (File No. 000-23389) |
| 10.13 |   | First Supplemental Indenture between the Company and  Norwest Bank, N.A. as trustee                                              |   | Incorporated by reference to the Company’s Form 10-Q  for quarter ended April 28, 2000 (File No. 000-23389)       |
| 10.14 |   | Amendment to 1998 Employee Stock Purchase Plan                                                                                   |   | Incorporated by reference to the Company’s Form 10-Q  for quarter ended April 28, 2000 (File No. 000-23389)       |

 

E-2

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| 10.15 |   | Second Amendment to 1997 Stock Option and  Compensation Plan                                                                    |   | Incorporated by reference to the Company’s Form 10-Q  for quarter ended August 3, 2001 (File No. 000-23389)       |
|-------|--------|---------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------------------------|
| 10.16 |   | Loan and Security Agreement Between Wells Fargo  Retail Finance LLC and the Company dated September 7, 2001                     |   | Incorporated by reference to the Company’s Form 8-K  dated October 2, 2001 (File No. 000-23389)                   |
| 10.17 |   | First Amendment to Loan and Security Agreement  Between Wells Fargo Retail Finance LLC and the Company dated December 12,  2001 |   | Filed with this Annual Report on Form 10-K                                                                             |
| 12    |   | Computation of Ratio of Earnings to Fixed Charges                                                                               |   | Filed with this Annual Report on Form 10-K                                                                             |
| 21    |   | Subsidiaries of Company                                                                                                         |   | Incorporated by reference to the Company’s Form 10-K  for fiscal year ended January 28, 2000 (File No. 000-23389) |
| 23.1  |   | Consent of Grant Thornton LLP                                                                                                   |   | Filed with this Annual Report on Form 10-K                                                                             |

 

E-3

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