SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

Party City Corporation

(Exact Name of Registrant as Specified in Its Charter)

(Registrant’s Telephone Number, Including Area Code)

973-983-0888

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

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

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

      As of April 29, 2005, there were 17,244,592 shares of common stock, $0.01 par value, outstanding.

TABLE OF CONTENTS

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

      Our website — www.partycity.com — provides access, free of charge, to our Securities and Exchange Commission (the “SEC”) reports, as soon as reasonably practicable after we electronically file such reports with, or furnish such reports to, the SEC, including proxy statements, Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to these reports. The reference to Party City’s website address in this Quarterly Report on Form 10-Q is not intended to function as a hyperlink and the information contained on such website is not part of this Quarterly Report on Form 10-Q.

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

Forward-Looking Statements

      This Quarterly Report on Form 10-Q (including the information incorporated herein by reference) contains forward-looking statements within the meaning of The Private Securities Litigation Reform Act of 1995. The statements may be identified by forward-looking terminology such as “estimate,” “project,” “expect,” “believe,” “may,” “will,” “intend” or similar statements or variations of such terms. Forward-

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

PART I.

FINANCIAL INFORMATION

PARTY CITY CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED BALANCE SHEETS

See accompanying notes to condensed consolidated financial statements.

PARTY CITY CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

See accompanying notes to condensed consolidated financial statements.

PARTY CITY CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

See accompanying notes to condensed consolidated financial statements.

PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

      Party City Corporation (together with its wholly-owned subsidiary, the “Company”) is incorporated in the State of Delaware and operates retail party supply stores within the United States and sells franchises on an individual store and area basis throughout the United States and Puerto Rico. The condensed consolidated unaudited financial statements have been prepared in accordance with the rules and regulations established by the Securities and Exchange Commission (the “SEC”). In the opinion of management, the accompanying condensed consolidated unaudited financial statements fairly present, in all material respects, the financial position of the Company as of April 2, 2005 and March 27, 2004 and the results of operations for the quarters and nine months ended April 2, 2005 and March 27, 2004 and cash flows for the nine months ended April 2, 2005 and March 27, 2004. All significant intercompany accounts and transactions have been eliminated. Because of the seasonality of the party goods industry, operating results of the Company on a quarterly basis may not be indicative of operating results for the full fiscal year.

      These condensed consolidated unaudited financial statements should be read in conjunction with the Company’s audited consolidated financial statements for the year ended July 3, 2004, which are included in the Company’s Annual Report on Form 10-K filed with the SEC on September 14, 2004 (the “2004 10-K”). The July 3, 2004 condensed consolidated unaudited balance sheet amounts included herein are derived from the Company’s audited consolidated financial statements.

      The Company’s fiscal year ends the Saturday nearest to June 30. As used herein, the term “Fiscal Year” or “Fiscal” refers to the 52- or 53-week period, as applicable, ending the Saturday nearest to June 30. Fiscal 2005 is a 52-week period ending July 2, 2005, while Fiscal 2004 is a 53-week period that ended July 3, 2004. However, the financial results for the fiscal quarter ended and nine months ended April 2, 2005 and March 27, 2004 are each based on a 13-week period and 39-week period, respectively.

      We have made certain reclassifications to prior period information to conform to the current period presentation. Auction rate securities, which were previously recorded in cash and cash equivalents in our interim fiscal 2004 consolidated financial statements, have been included in short-term investments in the accompanying consolidated financial statements due to their liquidity and pricing reset feature. Prior period quarterly information will be reclassified to conform to the current year presentation. There will be no impact on net income, stockholders’ equity, debt covenants or cash flow from operations as a result of this reclassification.

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

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

      During the third quarter of Fiscal 2005, the Company began providing product and logistics services through its distribution network to all of its franchise operators. Revenues and expenses associated with servicing the franchisees through the distribution network include product sales and fixed and variable distribution center expenses, transportation and other selling expenses, respectively. As defined in the Emerging Issues Task Force (“EITF”) EITF 99-19 “Reporting Revenue Gross as a Principal Versus Net as an Agent”, the Company records revenues and expenses related to servicing its franchisees on a gross basis

PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

because the Company acts as a principal in the transaction, takes title to the products, and holds inventory ownership risk.

      Short-Term Investments. Although the Company did not have a balance of short-term investments as of April 2, 2005, the Company purchased and subsequently sold short-term investments during this fiscal year, which consisted of auction rate debt and preferred stock securities. Auction rate securities are term securities earning income at a rate that is periodically reset, typically within 35 days, to reflect current market conditions through an auction process. These securities are classified as “available-for-sale” securities under the provisions of SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities”. Accordingly, these short-term investments are recorded at fair-value, with any related unrealized gains and losses included as a separate component of stockholders’ equity, net of tax. Realized gains and losses and investment income are included in earnings. Although the Company had no short-term investments at April 2, 2005, as mentioned above, the year to date investment activity on a cumulative basis is presented in the Cash Flows from Investing Activities.

      The Company periodically grants stock options to employees. In December 2004, the Financial Accounting Standards Board (the “FASB”) published Statement of Financial Accounting Standards (“SFAS”) No. 123R, “Share-Based Payment” (“SFAS No. 123R”), an amendment of FASB Statements No. 123 and No. 95. Under SFAS No. 123R, all forms of share-based payment to employees, including employee stock options, would be treated as compensation and recognized in the income statement. SFAS No. 123R is effective beginning the first quarter of Fiscal 2006. The Company is continuing to evaluate the full impact of SFAS No. 123R for its adoption in the first quarter of fiscal 2006. We currently account for stock options under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”).

      Pursuant to APB No. 25, the Company accounts for stock-based employee compensation arrangements using the intrinsic value method. If the options are granted to employees below fair market value, compensation expense is recognized.

      The Company has adopted the disclosure only provisions of SFAS No. 123, “Accounting for Stock Based Compensation” (“SFAS No. 123”), as amended by SFAS No. 148, “Accounting for Stock Based Compensation — Transition and Disclosure, an Amendment of SFAS No. 123” (“SFAS No. 148”). If

PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

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

      The weighted average fair value of options granted during the third quarter of Fiscal 2005 and 2004 were $5.54 and $5.56, respectively.

      The weighted average fair value of options granted during the first nine months of Fiscal 2005 and 2004 were $5.64 and $5.63, respectively.

PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

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

      In January 2003, the Company entered into a $65 million revolving credit facility (the “Loan Agreement”) with Wells Fargo Retail Finance, LLC, as the arranger, collateral agent and administrative

PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

agent, and Fleet Retail Finance, Inc., as the documentation agent. Under the terms of the Loan Agreement, the Company may borrow amounts based on a percentage of its eligible inventory and credit card receivables, subject to certain borrowing conditions and customary sub-limits, reserves and other limitations. The Company has the option, based on its liquidity needs, to borrow at (i) the adjusted Eurodollar rate per annum plus the applicable margin, which is currently at 1.25% (which in the aggregate under the Loan Agreement was 2.87% for a 1 month term at April 2, 2005), or (ii) the prime rate per annum less the applicable margin, which is currently 0.25% (which in the aggregate under the Loan Agreement was 5.5% at April 2, 2005). The Loan Agreement matures on April 30, 2006 and is secured by a lien on substantially all of the Company’s assets. Pursuant to the terms of the Loan Agreement, the Company had a standby letter of credit of $5.7 million and $3.7 million outstanding at April 29, 2005 and April 2, 2005, respectively, relating to general liability and workers compensation insurance, the increase is due to the addition of a new policy year for general liability and workers compensation insurance. At April 29, 2005 and April 2, 2005, the Company had no borrowings outstanding under the Loan Agreement. Based on a percentage of current eligible inventory and credit card receivables, the Company had $29.4 million and $27.2 million available to be borrowed under the Loan Agreement at April 29, 2005 and April 2, 2005, respectively.

6.     Stockholders’ Equity

      The Company’s authorized capital stock consists solely of shares of its common stock, $0.01 par value per share. At April 2, 2005 and March 27, 2004, there were 17,986,354 shares and 17,760,444 shares, respectively, of the Company’s common stock issued. At April 2, 2005 and March 27, 2004, there were 747,012 shares of the Company’s common stock held as treasury stock. At April 2, 2005 and March 27, 2004, there were 17,239,342 shares and 17,013,432 shares, respectively, of the Company’s common stock outstanding.

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

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

      On October 19, 1999, the Company’s Board of Directors adopted the Company’s 1999 Stock Incentive Plan (“1999 Plan”). This adoption was approved by the Company’s stockholders on November 15, 1999. A total of 500,000 shares of the Company’s common stock were reserved for issuance under the 1999 Plan.

      On October 5, 2000, the Board approved an amendment and restatement of the 1999 Plan, increasing the number of shares of common stock reserved for issuance thereunder from 500,000 to 2,000,000. This adoption was approved by the Company’s stockholders on November 15, 2000. On October 17, 2003, the Board approved an amendment and restatement of the 1999 Plan, increasing the number of shares of common stock reserved for issuance under the Plan from 2,000,000 to 7,500,000, and increasing the limit on the number of shares of the Company’s common stock which may be subject to options or stock appreciation rights granted

PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

to a single participant in any given year from 400,000 to 750,000. This adoption was approved by the shareholders on November 12, 2003. A total of 7,500,000 are currently reserved for issuance under the 1999 Plan.

      The purpose of the 1999 Plan is to promote the long-term financial success of the Company by enhancing the ability of the Company to attract, retain and reward individuals who can and do contribute to such success and to further align the interest of the Company’s key personnel with its stockholders. Key employees, directors and consultants of the Company are eligible to receive options under the 1999 Plan.

      The 1999 Plan provides for the grants of options and restricted stock and other stock-based awards as the compensation committee of the Board of Directors may from time to time deem appropriate. Such awards may include stock appreciation rights, phantom stock awards, bargain purchase of stock and stock bonuses. Vesting and other terms of stock options awarded are set out in the agreements between the Company and the individuals receiving such awards. The exercise price of the options is determined by the compensation committee at the time of grant and may not be less than the fair market value of the Company’s common stock on the date of grant. Options granted under the 1999 Plan vest over four to seven years from the date of grant and expire in ten years.

      The Company also maintains the Amended and Restated 1994 Stock Option Plan (“1994 Plan”) pursuant to which options were granted to employees, directors and consultants for the purchase of common stock of the Company. No additional grants of options under the 1994 Plan are permitted. The 1994 Plan, as amended, permitted the Company to grant incentive and non-qualified stock options to purchase a total of up to 1,800,000 shares of the Company’s common stock at an exercise price not less than fair value at date of grant. The original terms of the agreements between the Company and the individuals receiving the grants under the 1994 Plan with respect to vesting, expiration and exercise price remain unchanged.

      In June 2001, the Company established a Management Stock Purchase Plan (“MSPP”). The MSPP provides certain management employees of the Company the opportunity to defer a portion of their incentive compensation to acquire and maintain ownership of the Company’s common stock, with the intent to strengthen their commitment to the welfare of the Company and to promote an identity of interest among Company stockholders and these employees. The amount deferred by the individual is held in restricted stock units. The restricted stock units are converted into the Company’s common stock on a one-to-one basis upon vesting. These restricted stock units are purchased at a discount of 20% or 25%, depending on the amount of the individual deferral, from the average price of Company’s common stock on the determination date. Such discounts vest at the end of three years or seven years, selected by the participant, after the determination date. To date, all participants have selected three-year vesting periods for all deferrals. The amortization of the discount is charged to compensation expense over the deferral period. The compensation expense attributable to the MSPP for the third quarter of Fiscal 2005 and Fiscal 2004 was approximately $4,000 and $3,000, respectively, and during the nine months of Fiscal 2005 and Fiscal 2004 was approximately $10,000 and $19,000, respectively. Based on management participation in the MSPP from June 2002 until the end of the third quarter of Fiscal 2005, the Company was obligated to issue 13,567 shares of common stock, which represents $151,000 of deferred compensation as of the end of the third quarter of Fiscal 2005, upon vesting and conversion. Based on management participation in the MSPP from June 2001 until the end of the third quarter of Fiscal 2004, the Company was obligated to issue 16,012 shares of common stock, which represents $134,000 of deferred compensation as of the end of the third quarter of Fiscal 2004, upon vesting and conversion.

PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

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

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

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

      On September 27, 2004, the Company entered into a final settlement agreement which contained no material changes from the aforementioned agreement-in-principle. As of April 29, 2005, no payments have been made for the settlement payments, attorneys’ fees or the expenses of administering the settlement.

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

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

      SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information”, establishes standards for reporting information about operating segments. This standard requires segmentation based on the Company’s internal organization and reporting of revenue and operating income based upon internal accounting methods. The Company’s segments are designed to allocate resources internally and provide a framework to determine management responsibility. Additionally, the Company’s financial reporting systems present various data by segment for management to run the business, including internal profit and loss statements prepared on a basis consistent with accounting principles generally accepted in the United States of America.

PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

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

PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

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

      As of April 2, 2005, the Company’s contractual obligations and commercial commitments are as follows (in thousands):

The operating leases included in the above table do not include contingent rent based upon sales volume, which represented less than 1% of minimum lease obligations in Fiscal 2004, or other variable costs such as maintenance, insurance and taxes, which represents approximately 5.9% of minimum lease obligations in Fiscal 2004.

PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      The Company closed one store during the third quarter of Fiscal 2005 and three stores for the nine months ended April 2, 2005, as compared to no store closings during the third quarter of Fiscal 2004 and one store closing for the nine months ended March 27, 2004. A reserve of $871,000 has been recorded for future rent, property tax and utility payments for one store closed in Fiscal 2005 and two stores closed in prior fiscal years. The Company does not expect to incur significant additional exit costs relating to these closures.

      On September 16, 2004, the Company entered into a new corporate office lease for 106,000 square feet of office space. The initial term is for 12 years, with two five-year renewal options. The lease contains escalation clauses and obligations for reimbursement of common area maintenance and real estate taxes. The lease for the Company’s current corporate headquarters expired in December 2004, but the Company negotiated an extension of such lease to expire in August 2005. As part of the lease extension, the Company will incur increased rent after August 2005 if it continues to occupy the existing corporate headquarters. The Company intends to relocate to the new corporate headquarters by the end of the first quarter of Fiscal 2006 and intends to vacate its current corporate headquarters thereafter.

      The Company enters into arrangements to purchase merchandise up to eight months in advance of expected delivery. Historically, these purchase commitments did not contain any significant termination payments or other penalties if cancelled. Certain of these purchase commitments may obligate the Company to specified quantities, even if desired quantities change at a later date. As of April 2, 2005, the Company had approximately $19.0 million of proprietary product for which the Company has made purchase arrangements.

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

      At April 2, 2005, the Company operated a fleet of 36 leased motor vehicles, primarily for the district managers and regional management. The terms of these leases generally run for 36 months and expire at various times through December 2007.

      The Company has entered into a capital lease arrangement with a third party provider that involves dedicated assets needed for the Company’s logistics initiative. As of April 2, 2005, the contractual obligation of this capital lease is equal to $795,000, which includes $43,000 of imputed interest. The remaining current and long-term portion of this capital lease liability, excluding imputed interest, is $177,000 and $575,000, respectively.

      Pursuant to the terms of the Loan Agreement, the Company had a standby letter of credit of $5.7 million and $3.7 million outstanding at April 29, 2005 and April 2, 2005, respectively, relating to general liability and workers compensation insurance, which is not reflected in the above table. The increase is due to the addition of a new policy year for general liability and workers compensation insurance.

      The Company prepared a fair value analysis for one reporting unit and as a result recorded a goodwill impairment charge of $115,000 during the third quarter of Fiscal 2005.

PARTY CITY CORPORATION AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      All of the Company’s recorded goodwill is associated with its retail segment. The changes in the carrying amount of goodwill during Fiscal 2005 are as follows (in thousands):

      The Company has two non-compete agreements, one with a franchise owner and the other with Paper Warehouse, Inc. The Company also has trademark license agreements. All of these agreements are included in other assets and are being amortized using the straight-line method over the life of the agreement. Amortization expense for these non-compete agreements and trademark license agreements was approximately $59,000 and $105,000 for the nine months ended April 2, 2005 and March 27, 2004, respectively. The following chart shows the amortization expense of these intangibles by year until they are fully amortized (in thousands):

      In December 2004, the FASB published SFAS No. 123R, pursuant to which all forms of share-based payments to employees, including employee stock options, would be treated as compensation and recognized in the income statement. SFAS No. 123R is effective beginning the first quarter of Fiscal 2006. The Company currently accounts for stock options under APB No. 25. The Company is continuing to evaluate the full impact of SFAS No. 123R for its adoptions in the first quarter of Fiscal 2006.

      In December 2004, the FASB published Statement of Financial Accounting Standards No. 151, “Inventory Costs” (“SFAS No. 151”), an amendment of Accounting Research Bulletin (ARB) No. 43, Chapter 4, which clarifies that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges. In addition, SFAS No. 151 requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The Company has determined that SFAS No. 151 will not have a material impact on its condensed consolidated results of operations, financial position or cash flows.

      In March 2005, the FASB issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143” (“Interpretation No. 47”). Interpretation No. 47 clarifies that the term conditional asset retirement obligation, as used in FASB Statement No. 143, “Accounting for Asset Retirement Obligations”, refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. The obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and/or method of settlement. Accordingly, an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. The Company has determined that FASB Interpretation No. 47 will not have a material impact on its condensed consolidated results of operations, financial position or cash flows.

Overview

      We operate retail party supply stores within the continental United States and we sell franchises on an individual store and area franchise basis throughout the United States and Puerto Rico. As of April 2, 2005, our network consisted of 506 stores, with 247 Company-owned stores and 259 stores owned by franchisees. We report two segments — retail and franchising. The retail segment generates revenue primarily through the sale of third-party branded party goods through Company-owned stores. The franchising segment generates revenue through the imposition of an initial one-time franchise fee, ongoing royalty payments based on retail sales, and sales of product and services through our distribution network.

      Beginning the third quarter of Fiscal 2004, we have undertaken a series of related initiatives to make fundamental improvements in our business, profitability and cash flow. These initiatives have primarily focused on: improving the breadth of assortment and quality of our products and related product pricing; reconfiguring our in-store product layout to better align product categories and facilitate an easier shopping experience for our customers; improving logistics, including financial, distribution and inventory systems; and building our talent base.

      While we consider these initiatives essential to improve customer satisfaction and strengthen our financial performance, we have experienced reduced net sales and earnings during this transitional period. For the nine months ended April 2, 2005, we experienced a decline in total and same store net sales of 5.1% and 5.9%, respectively as compared to the same period last fiscal year. Also, in connection with the implementation of the above initiatives, we have incurred significant initial expenses that are disproportionate to our sales performance.

      During the third quarter of Fiscal 2005, we announced that our Board of Directors had formed a Special Committee consisting of certain of our independent directors to explore strategic alternatives, and that the Company had received inquiries from more than one entity interested in engaging in a strategic combination with Party City. Subsequently, we announced the engagement of Credit Suisse First Boston as our financial advisor to assist the Company in its exploration of strategic alternatives. The Board of Directors has not agreed to accept any proposal or to take any other action with respect to any possible strategic transaction, and investors are cautioned that there can be no assurance that the consideration of strategic alternatives by the Special Committee will lead to any action by Party City, including a definitive proposal or agreement with respect to a strategic combination on terms that the Board of Directors believes will be in the best interests of the shareholders of Party City.

      In addition, we announced the appointment of a new Executive Committee chaired by Michael E. Tennenbaum, Vice-Chairman of the Board of Directors, and including Richard H. Griner, Chief Operating Officer, Lisa G. Laube, Chief Merchandising Officer, Gregg A. Melnick, Chief Financial Officer, and Steven Skiba, Chief Information Officer. This Executive Committee is charged with oversight of the operations of Party City and has implemented changes in certain elements of our business strategies, as described below. Mr. Tennenbaum is serving as Chairman of the Executive Committee at the direction of the Board of Directors and will receive $250 per hour of work in such capacity in accordance with the Board of Directors’ existing policy on non-employee director compensation. Mr. Tennenbaum has agreed to cap his compensation relating to such work at $2,000 per week.

      We further announced that Nancy Pedot has stepped down as the Company’s Chief Executive Officer and as a member of the Board of Directors, effective March 30, 2005. Ms. Pedot’s responsibilities as Chief Executive Officer have been assumed by the Executive Committee.

      Several of the initiatives that we believe will be important to the Company’s future financial performance were completed in the third quarter of Fiscal 2005. Furthermore, beginning in the fourth quarter of Fiscal 2005, our new Executive Committee took steps to change certain of our marketing and promotional strategies in an effort to increase store traffic and average transaction size and, ultimately, net sales and profitability. The

current status of these key initiatives, as well as the changes in marketing and promotional strategies, are described below:

      Product. Building on our introduction of significant amounts of new seasonal products in the first half of Fiscal 2005, we introduced significant amounts of new non-seasonal product into our stores during the end of the third quarter of Fiscal 2005 and continuing to date. As non-seasonal merchandise historically represented approximately two thirds of a typical store’s selling space and annual net sales volume (and represented 80% of net sales volume in the third quarter of Fiscal 2005), the successful introduction of new non-seasonal products is important to our strategic plan. While our efforts in terms of these new non-seasonal products are just now becoming fully evident in the stores, the initial customer reaction since the introduction of the new products has been positive, as indicated by the higher net sales and profits of certain new lines as compared with the products they replaced.

      Store Configuration. We recently completed the reconfiguration of our in-store product layout. In connection with the reconfiguration, we incurred non-recurring store labor expenses of approximately $1.0 million, which was below our expectations due to store labor efficiencies and a lower level of sales volume.

      Although it has only been a few weeks since much of the new product was delivered and the stores were re-set, our early indications are that customers are responding very favorably. We have seen improving trends in several categories that had been experiencing sales declines, as well as sales growth in a number of other areas. Categories where we have seen improvements include: Solids, Baby, Catering, Birthday Accessories, and Decorations.

      Logistics. In the third quarter of Fiscal 2005, the volume of merchandise processed through our new distribution centers increased by more than 70% as compared with the Fiscal 2005 second quarter. Since July 2004, we have been receiving and distributing certain of our products for our Company-owned stores from two distribution centers — one in California and one in Pennsylvania. Earlier in Fiscal 2005, nearly all of our franchisees agreed to participate in our logistics program, and the addition of such franchisees to the program was implemented as of January 2005 (discussed further below). We have outsourced the operations of this distribution network to a third party. Additionally, a Preferred Carrier Program that was implemented in Fiscal 2004 has resulted in lower negotiated transportation rates, better visibility on deliveries to stores and improved service levels. Currently, our capabilities include handling single cartons of individual items from multiple vendors, as well as “cross-dock” merchandise from other vendors (i.e. flow product through the distribution centers to optimize outbound transportation costs to stores), as well as transporting such goods to the stores. This program supports weekly scheduling of store deliveries, further reducing store labor requirements and improving inventory accuracy. To date, however, product volume throughput has not reached critical mass for our initial phase. We anticipate continued throughput increases, thereby generating savings to more than offset operating costs of the distribution centers which will provide the basis for improved financial performance. In light of the evaluation of strategic alternatives by the Board of Directors, as noted above, we are currently reviewing the timing of our plans for the next phase of the logistics initiative.

      The franchise participation in our distribution network provides a low-cost distribution alternative for all stores and ensures consistency of merchandise between franchise and corporate locations. The program is not considered a profit center, but rather a business necessity to maintain brand consistency nationwide. In the second quarter of Fiscal 2005 we began making certain system and inventory investments relating to the transitioning of our franchisees into our logistics program. Through the end of the third quarter, we procured approximately $3.4 million of additional inventory to service the franchisees. Additionally, we have incurred approximately $4.1 million in working capital through the third quarter related to receivables due from franchisees on product shipped to their stores.

      As a result of these initiatives and other factors described below, the inventory level increased approximately $26 million, or 42%, in the third quarter of Fiscal 2005 compared to the same quarter in Fiscal 2004. Of this increase in inventory, approximately $11 million relates to our product and remerchandising initiatives, including the effort to improve in-stock positions, approximately $4 million reflects the inclusion of the franchisees in our distribution network, approximately $3 million is related to the timing of certain

seasonal merchandise sets, and approximately $5 million reflects prior season merchandise that we intend to sell in subsequent seasons.

      We currently have an active effort under way to reduce clearance inventory through the use of markdowns, as well as to reduce the weeks of supply on new merchandise as we gain a better understanding of our current selling patterns. However, we expect to maintain higher inventory levels, compared with prior years, to continue to support the franchisee distribution system, allow for stronger in-stock positions, and sell-down on seasonal merchandise during the upcoming quarters.

      Promotion and Marketing. As noted earlier, the Executive Committee has revised some of our promotional and marketing strategies to address elements of our pricing and marketing initiatives that we believe have not been effective and to improve store traffic and net sales. Toward that end, early in the fourth quarter of Fiscal 2005, we adopted a more aggressive promotional stance in certain product categories in the form of deeper discounts and introduced a “buy-one-get-one free” offer. While it is too early to gauge the impact of such programs, we are generally satisfied with initial customer response.

      Information Systems. We have also focused on enhancing our information systems, completing significant store and corporate system installations. The investment in our store and corporate information systems has improved certain store processes, such as customer check-out, product replenishment, and inventory management, and was a key contributor to the decline in store labor costs during Fiscal 2005. In addition, these investments have provided, and will continue to provide, the systemic foundation for our logistics initiative.

      We plan to implement new merchandise replenishment software in the late summer of 2005 to complement our distribution, planning and allocation initiatives. We will begin implementation gradually, with a select number of items during the September-October 2005 period, which will increase as the program is proven. The system is intended to enhance the store replenishment function by improving in-stocks, leveraging our logistics infrastructure and allowing us to become more effective in our use of store labor.

      Employee Base. Another important initiative is the continuation of key investments in our employee base. During the third quarter of Fiscal 2005, we continued to add employees in key departments to support our initiatives in merchandising, planning and allocation and logistics.

      We believe that our recently completed product and store reconfiguration initiatives, the increased promotional and advertising activities adopted by the Executive Committee, and the cost efficiencies to be gained from our self-distribution program, should provide the basis for improved financial performance.

Key Performance Indicators and Statistics

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

      The following table shows the growth in our network of Company-owned and franchise stores for the quarter and nine months ended April 2, 2005 and March 27, 2004.

Critical Accounting Policies and Estimates

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

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

      Our accounting policies are more fully described in Note 1 of our 2004 10-K.

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

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

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

      Insurance accruals. Our condensed consolidated balance sheets include significant liabilities with respect to self-insured workers’ compensation and general liability claims. We estimated the required liability of such claims as of April 2, 2005, utilizing an actuarial method based upon various assumptions, which include, but are not limited to, our historical loss experience, projected loss development factors, actual payroll and other data. The required liability is also subject to adjustment in the future based upon the changes in claims experience, including changes in the number of incidents (frequency) and changes in the ultimate cost per incident (severity).

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

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

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

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

General Definitions for Operating Results

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

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

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

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

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

      General and administrative expense includes payroll and employee benefits, employment taxes, management information systems, marketing, insurance, legal and other corporate level expenses, less the allocation of corporate expenses to the franchising segment discussed below. Corporate level expenses are primarily attributable to our corporate office in Rockaway, New Jersey, and district and regional offices throughout the country.

      Franchising. Franchising revenue is composed of the initial franchise fees, which are recorded as revenue when a franchise store opens, ongoing royalty fees, generally 4.0% of the store’s net sales, and revenues from the sale of product through the distribution network. Such distribution network revenues include the sale of product, including inbound freight reimbursement; pass-through of variable distribution center expenses (handling costs); subscription fees relating to fixed costs in the distribution centers, and other management fees associated with customer service centers. Franchise expenses include cost of goods relating to product sales, including inbound freight costs, fixed and variable distribution center expenses, order management expenses, transportation costs from distribution centers to stores, and direct and indirect expenses. The direct expenses include salaries, travel and other direct expenses of the franchise operations department in addition to legal fees, bad debt expense, insurance expense and other miscellaneous charges. The indirect expenses include allocations of corporate general and administrative expenses for salaries, including bonuses, occupancy and depreciation, based on time spent on franchise support.

      Franchise profit contribution is franchise revenue minus franchise expenses.

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

Results of Operations

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

PARTY CITY CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

      Retail. Net sales from Company-owned stores decreased 6.8% to $91.0 million for the third quarter of Fiscal 2005 from $97.7 million in the same period last year. The 6.8% decrease in net sales resulted from a same store net sales decrease of 7.1% which was partially offset by net sales from new stores opened during the fiscal year. Same store sales for non-seasonal merchandise decreased 5.4% due to the ongoing transition to new product assortments, and same store sales for seasonal merchandise decreased 13.4%, largely due to the timing of certain holiday selling periods (New Years sales mainly occurred in the second quarter of Fiscal 2005 compared with the third quarter of Fiscal 2004, while Easter sales occurred in the third quarter of Fiscal 2005 compared to the fourth quarter of Fiscal 2004) as well as a decline in sales of Valentine’s Day merchandise compared to last year. The customer count in Company-owned stores, on a same store basis, decreased 6.0% during the quarter ended April 2, 2005, and the same store average net sale per retail transaction decreased 1.2% primarily due to the timing of New Years sales. One store joined the same store sales group during the third quarter of Fiscal 2005. We did not open any new stores and closed one store during the third quarter of Fiscal 2005, and we opened two stores and did not close any stores during the same period last year.

      Gross profit as a percent of net sales was 23.0% for the third quarter of Fiscal 2005 compared with 26.9% for the same period last year. The decrease includes incremental distribution costs of $0.7 million, which represents approximately 80 basis points of merchandise margin. As shown in the table below, gross profit decreased $5.3 million to $20.9 million in the third quarter of Fiscal 2005 from $26.2 million in the same period last year.

      Store operating and selling expenses were 26.8% and 25.3% of net sales for the third quarter of Fiscal 2005 and Fiscal 2004, respectively. As shown in the table below, store operating and selling expenses decreased $0.3 million, or 1.4%, to $24.4 million for the quarter ended April 2, 2005 from $24.8 million in the same period last year. Our spending during the third fiscal quarter reflected increased store labor hours necessary to support our store reset initiative more than offset by continued savings during non -peak holiday selling weeks, reduced labor due to lower sales volumes and timing of certain other costs.

      Company-owned store (loss) profit contribution as a percent of net sales was (3.8%) for the third quarter of Fiscal 2005 compared with 1.5% in the same period last year. Company-owned store profit contribution decreased $5.0 million during the third quarter of Fiscal 2005 to a loss contribution of $3.5 million compared to profit contribution of $1.5 million during the same period last year.

      General and administrative expenses were 11.3% and 8.7% of net sales for the third quarter of Fiscal 2005 and Fiscal 2004, respectively. As shown in the table below, general and administrative expenses increased $1.8 million to $10.3 million for the third quarter of Fiscal 2005 from $8.5 million in the same period last year.

      During the third quarter of Fiscal 2004, we recorded a pre-tax charge of $4.1 million related to the settlement payments, attorneys’ fees and estimated expenses of administering the settlement of the lawsuit

regarding California overtime wage and hour laws. See Note 7 in the condensed consolidated financial statements included herein.

      Franchising. Product sales through the distribution network for the third quarter of Fiscal 2005 were $6.7 million, including $5.5 million relating to product and inbound freight and $1.2 million of service and reimbursable charges. Cost of goods expenses during the third quarter of Fiscal 2005 were $5.6 million, including $4.8 million related to product and inbound freight and $0.8 million of distribution center expenses.

      Franchise transportation and other selling expenses for the third quarter of Fiscal 2005 were $931,000 for the quarter.

      There were no franchise fees recognized in the third quarter of Fiscal 2005, compared with $80,000 recognized on two store opening in the same period last year. Royalty fees decreased 1.1% to $3.76 million in the third quarter of Fiscal 2005 from $3.81 million in the same period last year. This decrease was primarily due to the same store sales decrease of 7.4% for franchise stores for the third quarter of Fiscal 2005 which is partially offset by the increase of five franchise stores since the end of the same period last year as well as 12 franchise stores (acquired from the Company in 1999 as part of its restructuring), that were required to pay royalties in the third quarter of Fiscal 2005 due to the end of a five- year royalty free period for such stores.

      Other franchise expenses increased 15.4% to $2.3 million for the third quarter of Fiscal 2005 from $2.0 million for the third quarter of Fiscal 2004. This increase is primarily due to a larger corporate expense allocation that was allocated to the franchise segment during the fiscal quarter ended April 2, 2005.

      Franchise profit contribution was $1.6 million in third quarter of Fiscal 2005, a decrease of approximately $0.3 million from the same period last year. The decrease in franchise profit contribution is due to an increase in corporate expenses allocated to the franchise segment during the quarter.

      Interest (Income) Expense. We recorded net interest income of $44,000 for the third quarter of Fiscal 2005 as compared with net interest expense of $79,000 during the same period last year. We recorded net interest income mainly due to our higher average cash balance this quarter partially offset by interest expense. We had no advances under our Loan Agreement at any point during the third quarter of Fiscal 2005 and Fiscal 2004.

      Income Taxes. An income tax benefit of $4.9 million, or 40.5% of pre-tax loss, and $3.8 million, or 40.5% of pre-tax loss, was recorded in the third quarter of Fiscal 2005 and Fiscal 2004, respectively.

      Net (Loss) Income. As a result of the above factors, we recorded a net loss of $7.2 million, or $0.42 per diluted share, in the third quarter of Fiscal 2005, as compared with a net loss of $5.6 million, or $0.33 per diluted share, in the third quarter of Fiscal 2004. Weighted average diluted shares outstanding increased to 17.2 million in the third quarter of Fiscal 2005 from 17.0 million in the same period last year due to stock option exercises and participation in the employee and management stock purchase plans since March 27, 2004.

      Retail. Net sales from Company-owned stores decreased 5.1% to $356.4 million for the nine months ended April 2, 2005 from $375.6 million in the same period last year. The 5.1% decrease in net sales resulted from a same store net sales decrease of 5.9% which was partially offset by net sales from new stores. Same store sales for non-seasonal merchandise decreased 6.7% due to the ongoing transition of this merchandise category, and same store sales for seasonal merchandise decreased by 4.7%, largely attributed to a decrease in Halloween and Christmas sales. Although the customer count in Company-owned stores, on a same store basis, decreased 6.3% during the nine months ended April 2, 2005, the same store average net sale per retail transaction increased 0.4% reflecting a lower level of discounting and promotional markdown activity compared with the same time last year. Seven stores joined the same store sales group during the nine months ended April 2, 2005. We opened one new store and closed three stores during the nine-months ended April 2, 2005, and opened eight new stores and closed one store during the same period last year.

      Gross profit as a percent of net sales was 31.9% for the nine months ended April 2, 2005 compared with 33.3% for the same period last year. As shown in the table below, gross profit decreased $11.6 million to $113.6 million during the nine months ended April 2, 2005 from $125.1 million in the same period last year.

      Store operating and selling expenses were 23.8% and 23.1% of net sales for the nine months ended April 2, 2005 and March 27, 2004, respectively. As shown in the table below, store operating and selling expenses decreased $2.0 million, or 2.3%, to $84.9 million for the nine months ended April 2, 2005 from $86.9 million in the same period last year. We incurred pre-opening expenses of $28,000 during the nine months ended April 2, 2005 for one new store opened during such period, while we incurred $474,000 during the same period last year for eight new stores opened during such period and one store that were opened later in Fiscal 2004. Pre-opening expenses include payroll and fringe benefits, as well as other operating costs.

      Company-owned store profit contribution as a percent of net sales was 8.0% for the nine months ended April 2, 2005 compared with 10.2% in the same period last year. Company-owned store profit contribution decreased $9.6 million during the nine months ended April 2, 2005 to $28.6 million from $38.2 million during the same period last year.

      General and administrative expenses were 8.6% and 6.4% of net sales during the nine months ended April 2, 2005 and March 27, 2004, respectively. As shown in the table below, general and administrative expenses increased $6.5 million to $30.7 million for the nine months ended April 2, 2005 from $24.2 million in the same period last year.

      During the third quarter of Fiscal 2004, we recorded a pre-tax charge of $4.1 million related to the settlement payments, attorneys’ fees and estimated expenses of administering the settlement of the lawsuit regarding California overtime wage and hour laws. See Note 7 in the condensed consolidated financial statements included herein.

      Franchising. The product and logistics servicing of franchisees began in the third quarter of Fiscal 2005, and therefore revenues and expenses relating to these services are the same as reported above for the third quarter of Fiscal 2005.

      Franchise fees recognized on three store openings were $120,000 during the nine months ended April 2, 2005, compared with $568,000 recognized on 15 store openings in the same period last year. Royalty fees increased 1.2% to $15.1 million for the nine months ended April 2, 2005 from $14.9 million in the same period last year. This increase was primarily due to eight franchise store openings since the end of the same period last year and 12 franchise stores (acquired from us in 1999 as part of our restructuring) that were required to pay royalties in the third quarter of Fiscal 2005 due to the end of a five-year royalty free period partially offset by the same store sales decrease of 4.0% for the franchise stores during the nine months ended April 2, 2005.

      Other franchise expenses increased 13.5% to $6.0 million for the nine months ended April 2, 2005 from $5.2 million for the same period last year. This increase is primarily due to a larger corporate expense allocation.

      Franchise profit contribution decreased 8.3% to $9.4 million during the nine months ended April 2, 2005 from $10.3 million in the same period last year. The decrease in franchise profit contribution is primarily due

to an increase in corporate expense allocations that were allocated to the franchise segment during the nine months ended April 2, 2005, partially offset by an increase in royalty fees.

      Interest (Income) Expense. We recorded net interest income of $12,000 for the nine months ended April 2, 2005 as compared with net interest expense of $391,000 during the same period last year. This is mainly due to increased interest income from a higher average cash balance as well as overall lower interest expense. We had no advances under our Loan Agreement at any point during the nine months ended April 2, 2005 compared with minimal average borrowings during the same period last year.

      Income Taxes. Income tax expense of $3.0 million, or 40.5% of pre-tax income, and $8.0 million, or 40.5% of pre-tax income, was recorded for the nine months ended April 2, 2005 and March 27, 2004, respectively.

      Net Income. As a result of the above factors, we recorded net income of $4.4 million, or $0.22 per diluted share, for the nine months ended April 2, 2005, as compared with $11.8 million, or $0.60 per diluted share, for the same period last year. Weighted average diluted shares outstanding increased to 19.8 million for the nine months ended April 2, 2005 from 19.6 million in the same period last year due to the stock option exercises and participation in the employee and management stock purchase plans since March 27, 2004.

Liquidity and Capital Resources

      Our cash requirements have historically been for working capital, the opening of new stores, the improvement and expansion of existing facilities and the improvement of information systems. These cash requirements have been met through cash flow from operations and borrowings under our credit facilities. At April 2, 2005, working capital was $42.6 million compared with $29.9 million in the same period last year. Our ending cash and cash equivalents balance at April 2, 2005 was $14.3 million as compared with $15.8 million at March 27, 2004.

      Our current priorities for the use of cash are primarily for investments in working capital and value-added capital projects including, in particular, investments in technology to improve merchandising and distribution, cost reduction initiatives, improve efficiencies and assist each store to better serve its customers. In addition, we anticipate funding the settlement of the $5.5 million California overtime wage class action during the fourth quarter of Fiscal 2005. Key initiatives include:

      We believe that the cash generated by operations and cash and cash equivalents, together with the borrowing availability under the Loan Agreement, will be sufficient to meet our working capital needs for the next twelve months, including investments made and expenses incurred in connection with systems development, the logistics initiative and store improvements. We expect to invest between $12 million and $15 million in capital projects during Fiscal 2005, in aggregate of which $8.9 million has been invested through the third fiscal quarter of Fiscal 2005.

      We currently have no borrowings under our Loan Agreement and have minimal debt, which permits us to consider a wide variety of corporate initiatives intended to improve shareholder value, although there is no assurance that any specific initiative will be pursued or consummated.

Key Indicators of Liquidity and Capital Resources

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