UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the Quarterly Period Ended April 30, 2005

OR

Claire’s Stores, Inc.

Registrant’s telephone number, including area code: (954) 433-3900

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

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

     The number of shares of the registrant’s Common Stock and Class A Common Stock outstanding as of May 27, 2005 was 94,068,740 and 5,122,245, respectively.

CLAIRE’S STORES, INC. AND SUBSIDIARIES
INDEX

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PART I. FINANCIAL INFORMATION

CLAIRE’S STORES, INC. AND SUBSIDIARIES

See accompanying notes to unaudited condensed consolidated financial statements.

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CLAIRE’S STORES, INC. AND SUBSIDIARIES

See accompanying notes to unaudited condensed consolidated financial statements.

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CLAIRE’S STORES, INC. AND SUBSIDIARIES

See accompanying notes to unaudited condensed consolidated financial statements.

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CLAIRE’S STORES, INC. AND SUBSIDIARIES

1. Basis of Presentation and Significant Accounting Policies

2. Earnings Per Share

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3. Stock-Based Compensation

4. New Accounting Pronouncements

5. Segment Information

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6. Income Taxes

7. Statements of Cash Flows

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Management’s Discussion and Analysis is designed to provide the reader of the financial statements with a narrative on our results of operations, financial position and liquidity, risk management activities, significant accounting policies and critical estimates, and the future impact of accounting standards that have been issued but are not yet effective. Management’s Discussion and Analysis is presented in the following sections: Overview, Critical Accounting Policies and Estimates, Results of Operations and Analysis of Consolidated Financial Condition. It is useful to read Management’s Discussion and Analysis in conjunction with the unaudited condensed consolidated financial statements and related notes thereto contained elsewhere in this document.

Annually, our fiscal years end on the Saturday closest to January 31. As a result, both our current and prior fiscal years consist of four 13-week quarters. We refer to the prior fiscal year ended January 29, 2005 as Fiscal 2005, and the current fiscal year ending January 28, 2006 as Fiscal 2006. All references to earnings per share relate to diluted earnings per share from net income.

We include a store in the calculation of comparable store sales once it has been in operation sixty weeks after its initial opening. If a store is closed during a fiscal period, the store’s sales will be included in the computation of comparable store sales for that fiscal month, quarter and year to date period only for the days in which it was operating as compared to those same days in the comparable period. Relocated, remodeled and expanded square footage stores are classified the same as the original store and are not considered new stores upon relocation, remodeling or completion of their expansion.

Overview

We are a leading specialty retailer of value-priced fashion accessories and jewelry for pre-teens and teenagers as well as young adults. We are organized based on our geographic markets, which include our North American operations and our International operations. As of April 30, 2005, we operated a total of 2,852 stores in all 50 states of the United States, Puerto Rico, Canada, the Virgin Islands, the United Kingdom, Switzerland, Austria, Germany (the latter three collectively referred to as “S.A.G.”), France and Ireland. The stores are operated mainly under the trade names “Claire’s Boutiques”, “Claire’s Accessories”, “Icing by Claire’s”, “Afterthoughts” and “The Icing”. We are in the process of transitioning our “Afterthoughts” stores to “Icing by Claire’s” stores to capitalize on the Claire’s brand name. We also operate 161 stores in Japan

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through a 50:50 joint venture with AEON Co. Ltd. (“Claire’s Nippon”). We account for the results of operations of Claire’s Nippon under the equity method and include these results within “Interest and other income” in our Statement of Operations within our North American division. In addition, we license 65 stores in the Middle East under a licensing and merchandising agreement with Al Shaya Co. Ltd. and 5 stores in South Africa under similar agreements with the House of Busby Limited. We account for the goods we sell under the merchandising agreements within “Gross profit” in our North American division and the license fees we charge within “Interest and other income” within our International division in our Statement of Operations.

We have two store concepts: Claire’s Accessories, which caters to fashion-conscious girls and teens in the 7 to 17 age range, and Icing by Claire’s, which caters to fashion-conscious teens and young women in the 17 to 27 age range. Our merchandise typically ranges in price between $2 and $20, with the average product sold at approximately $4. Our stores share a similar format and our different store concepts and trade-names allow us to have multiple store locations in a single mall. Although we face competition from a number of small specialty store chains and others selling fashion accessories, we believe that our stores comprise one of the largest chains of specialty retail stores in the world devoted to the sale of value-priced fashion accessories for pre-teen, teenage and young adult females.

Fundamentally, our business model is to offer the customer a compelling price/value relationship and a wide array of products to choose from. We seek to deliver a high level of profitability and cash flow by:

While our financial results have grown steadily and record sales performance was achieved during the first quarter of Fiscal 2006, the retail environment remains very competitive. Management’s plan for future growth is dependent on:

Our ability to achieve these objectives will be dependent on various factors, including those outlined in “Cautionary Note Regarding Forward-Looking Statements and Risk Factors.”

Critical Accounting Policies and Estimates

Our condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. Preparation of these statements requires management to make judgments and estimates. Some accounting policies have a significant impact on amounts reported in these financial statements. A summary of significant accounting policies and a description of accounting policies that are considered critical may be found in our Fiscal 2005 Annual Report on Form 10-K, filed on April 13, 2005, in the Notes to the Consolidated Financial Statements, Note 1, and the Critical Accounting Policies and Estimates section therein.

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Results of Operations

Consolidated Operations

A summary of our consolidated results of operations is as follows (dollars in thousands, except per share data):

⁽¹⁾Number of stores excludes Claire’s Nippon and stores operated under license agreements

Net sales for the three months ended April 30, 2005 increased by $21.1 million, or 7.5% from the three months ended May 1, 2004. The increase in Net sales was primarily attributable to comparable store sales increases of 5%, or approximately $13.3 million, during the three months ended April 30, 2005, and approximately $3.9 million resulting from the weak US Dollar when translating our foreign operations at higher exchange rates.

During the first quarter of Fiscal 2006, the positive comparable sales were primarily driven by an increase in the average retail price per transaction, which was the result of both an increase in the average unit retail price and the average number of units sold per transaction.

The following table compares our percentage of sales of each product category for each of the periods presented:

In calculating Gross profit and Gross profit percentages, we exclude the costs related to our distribution center. These costs are included instead in Selling, general and administrative expenses. Other retail companies may include these costs in cost of sales, so our gross profit percentages may not be comparable to those retailers.

Gross profit percentages decreased by 120 basis points during the three months ended April 30, 2005 as compared to the three months ended May 1, 2004. The decrease was caused primarily by a drop in our merchandise margins due to an increase in inventory markdowns taken during the period in North America.

Selling, general and administrative expenses increased $6.2 million or 6.0% for the three months ended April 30, 2005 as compared to the three months ended May 1, 2004. The increase was primarily attributable to increases in store payroll including benefits and increases in professional fees associated with litigation matters and Sarbanes-Oxley compliance. As a percentage of Net sales, Selling, general and administrative expenses declined by 50 basis points for the three months ended April 30, 2005 as compared to the three months ended May 1, 2004.

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Our effective income tax rate during the first three months of Fiscal 2006 was 31.1%, as compared to 34.6% during the comparable period of Fiscal 2005. Our lower effective income tax rate for the three month period ended April 30, 2005 was the result of a change in the mix of earnings between U.S. and foreign operations and tax planning. We currently expect our effective income tax rate for Fiscal 2006 to be approximately 33.1%. Our effective income tax rate in future periods will depend on several variables, including the mix of earnings between U.S. and foreign operations and our overall level of earnings. This is primarily due to the fact that our combined effective income tax rate for our foreign operations is generally lower than our effective income tax rate for U.S. operations. Our effective income tax rate could also be affected by the resolution of tax contingencies for amounts different from our current estimates.

Net income increased by approximately $2.0 million during the three months ended April 30, 2005, as compared to the three months ended May 1, 2004. These increases were made possible primarily by the incremental gross profit from additional sales generated during the period and from a lower effective tax rate.

Segment Operations

We are organized into two business segments – North America and International. Following is a discussion of results of operations by business segment.

North America

Key statistics and results of operations for our North American division are as follows (dollars in thousands):

Net sales in North America during the three months ended April 30, 2005 increased by $8.1 million, or 3.9%, from the three months ended May 1, 2004. The increase in Net sales was primarily attributable to comparable store sales increases of 3% during the three months ended April 30, 2005.

The positive comparable sales experienced in North America were primarily attributed to an increase in the average retail price per transaction, which was the result of both an increase in the average unit retail and the average number of units sold per transaction.

Gross profit percentages decreased by 250 basis points during the three months ended April 30, 2005 as compared to the three months ended May 1, 2004. The decrease was caused primarily by a drop in our merchandise margins due to an increase in inventory markdowns taken during the period.

The following table compares our percentage of Net sales of each product category for each of the periods presented:

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International

Key statistics and results of operations for our International division are as follows (dollars in thousands):

Our objective is to increase sales in the International division primarily through store growth and comparable store sales increases. We also continue to explore adding operations in countries in which we do not currently operate.

Net sales in our International division during the three months ended April 30, 2005 increased by approximately $13.0 million, or 17.7%, from the three months ended May 1, 2004. The increase in Net sales for the three months ended April 30, 2005 was primarily attributable to comparable store sales increases of 9% or approximately $6.5 million, the effects of the weak US dollar when translating our foreign operations at higher exchange rates of approximately $3.9 million, and by new store revenue, net of store closures, of approximately $2.5 million during the period. The comparable store increases for the three month period were primarily attributed to an increase in the average retail price per transaction, which was the result of both an increase in the average unit retail price and the average number of units sold per transaction.

We actively employed strategic initiatives within our International division over the past year in an attempt to reverse the negative comparable store sales trend in our International division. These initiatives included sharing best practices for merchandise selection, store operations and attentive customer service. In addition, we are investing in operational systems infrastructure in order to facilitate the greater level of complexity and precision now required of the business.

Gross profit percentages improved by 270 basis points for the first quarter of Fiscal 2006 as compared to the first quarter of Fiscal 2005. The improvement is due to a number of reasons. First, we took fewer markdowns than in the prior year’s quarter. In addition, the ability of our International division to source a significant portion of goods at a lower cost due to those goods being purchased from our vendors in US Dollars. The lower cost was achieved due to the relative weakness in the US Dollar. Also, comparable store sales increased at a faster rate than occupancy costs, which are primarily fixed by nature, and created positive leverage on those costs. Finally, the shift of sales from accessories to jewelry during the three months ended April 30, 2005 as compared to the three months ended May 1, 2004 has had the result of improved gross profit percentages due to the higher initial markup realized on jewelry. The following table compares our percentage of Net sales of each product category for each of the periods presented:

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Analysis of Consolidated Financial Condition

A summary of cash flows from operating, investing and financing activities is outlined in the table below (dollars in thousands):

We have consistently satisfied operating liquidity needs and planned capital expenditure programs through our normal conversion of sales to cash. At April 30, 2005, we had approximately $316.1 million in cash and cash equivalents and short-term investments, a decrease of $9.5 million from January 29, 2005. We ended the first quarter of Fiscal 2006 with no borrowed debt outstanding. The net increase in cash and cash equivalents during the period was due to cash generated from operations and the sale of short-term investments, offset by capital expenditures and the payment of dividends.

Our major source of cash from operations is store sales, nearly all of which are generated on a cash or credit card basis. Our primary outflows of cash from operations are the purchase of inventory, net of accounts payable, operational costs, the payment of current taxes, capital expenditures and the payment of dividends. Cash flows provided by operating activities in the first three months of Fiscal 2006 reflect higher net income as compared to the first three months of Fiscal 2005, reduced investment in inventories offset by the decrease in accrued expenses and increased dividend payments.

Our working capital at April 30, 2005 was $342.0 million compared to $326.4 million at January 29, 2005. Changes in working capital primarily reflect higher inventory levels and prepaid expenses.

Our $17.0 million of capital expenditures were made primarily to remodel existing stores and to open new stores. We generally experience a noticeable increase in sales in locations where a store has been recently remodeled. We also invested approximately $2.4 million in intangible assets primarily within our International division representing acquired lease rights on new store locations in certain countries. We expect to fund approximately $81.0 million of capital expenditures and $10.0 million to $15.0 million of purchased lease rights in Fiscal 2006 in an effort to continue to remodel and expand our store base.

We also paid dividends of $9.7 million during the three months ended April 30, 2005, an increase of approximately $3.9 million from the three months ended May 1, 2004. We expect to pay at least $38.6 million in dividends in Fiscal 2006.

Liquidity and Capital Resources

Our credit facility is a revolving line of credit of up to $60.0 million, is secured by inventory in the United States and is due to expire March 31, 2009. The borrowings under this facility are limited based on certain calculations of availability, based primarily on the amount of inventory on hand in the United States. At April 30, 2005, the entire amount of $60.0 million would have been available for borrowing by us, subject to reduction for $3.4 million of outstanding letters of credit. The credit facility is cancelable by us without penalty and bears interest at an initial margin of 75 basis points over the London Interbank Borrowing Rate (LIBOR). The margin is then adjusted periodically based on certain liquidity measurements. The credit facility also contains a covenant which restricts, among other things, our ability to make dividend distributions if we are in default or if our excess liquidity is less than $20 million during certain periods. Excess liquidity is specifically defined in our debt agreement as the sum of our available credit lines and certain cash and cash equivalent amounts.

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Our non-US subsidiaries have available credit facilities totaling approximately $837,000 with banks. The facilities are used for working capital requirements and letters of credit. These credit facilities have been arranged in accordance with customary lending practices in their respective countries of operation. At April 30, 2005, there were no borrowings under these credit facilities.

Management believes that our present ability to borrow is greater than our established credit lines. However, if market conditions change and sales were to dramatically decline or we could not control operating costs or other expenses, our cash flows and liquidity could be reduced, and we could experience an increase in borrowing costs, or even a reduction in or elimination of our access to debt and/or equity markets.

Cautionary Note Regarding Forward-Looking Statements and Risk Factors

We and our representatives may from time to time make written or verbal forward-looking statements, including statements contained in this and other filings with the Securities and Exchange Commission and in our press releases and reports to shareholders. All statements which address operating performance, events or developments that we expect or anticipate will occur in the future, including statements relating to our future financial performance, business strategy, planned capital expenditures and new store openings for Fiscal 2006, are forward-looking statements. The forward-looking statements are and will be based on management’s then current views and assumptions regarding future events and operating performance and we assume no obligation to update any forward-looking statement. Forward-looking statements involve known or unknown risks, uncertainties and other factors, including changes in estimates and judgments discussed under “Critical Accounting Policies and Estimates” which may cause our actual results, performance or achievements, or industry results to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Some of these risks, uncertainties and other factors are as follows: changes in consumer preferences and consumer spending; competition; general economic, political and social conditions, such as war, political unrest and terrorism or natural disasters; currency fluctuations and exchange rate adjustments; changes in laws, including employment laws relating to overtime pay, tax laws and import laws; uncertainties generally associated with the specialty retailing business; disruptions in our supply of inventory; inability to increase comparable store sales at recent historical rates; inability to design and implement new information systems; and delays in anticipated store openings or renovations. In addition, we typically earn a disproportionate share of our operating income in the fourth quarter due to seasonal buying patterns, which are difficult to forecast with certainty. Additional discussion of these and other risks and uncertainties is contained elsewhere in this Item 2, in Item 3, “Quantitative and Qualitative Disclosures About Market Risk” and in our Form 10-K for Fiscal 2005 under “Cautionary Note Regarding Forward-Looking Statements and Risk Factors.”

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Foreign Currency

We are exposed to market risk from foreign currency exchange rate fluctuations on the US Dollar value of foreign currency denominated transactions and our investment in foreign subsidiaries. We manage this exposure to market risk through our regular operating and financing activities, and from time to time, the use of foreign currency options. Exposure to market risk for changes in foreign exchange rates relates primarily to foreign operations’ buying, selling and financing in currencies other than local currencies and to the carrying value of net investments in foreign subsidiaries. We may manage our exposure to foreign exchange rate risk related to our foreign operations’ buying, selling and financing in currencies other than local currencies by using foreign currency options from time to time to hedge foreign currency transactional exposure. At April 30, 2005, we had not entered into foreign currency options. We do not generally hedge the translation exposure related to our net investment in foreign subsidiaries, since we generally have no near term intent to repatriate funds from such subsidiaries. During the three months ended April 30, 2005, included in comprehensive income and stockholders’ equity is $1.7 million reflecting a foreign currency translation loss. Based on our average net currency positions in Fiscal 2006, the potential gain or loss due to a 10% adverse change on foreign currency exchange rates could be significant to our operations.

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Certain of our subsidiaries make significant US Dollar purchases from Asian suppliers, particularly in China. There continues to be speculation that China may elect to adjust the exchange rate of the Chinese Yuan against the US Dollar. Currently, the Chinese Yuan has a fixed exchange rate against the US Dollar. If China adjusts the exchange rate or allows the value to float, we could experience increases in our cost of merchandise imported from China.

The results of operations of foreign subsidiaries, when translated into US Dollars, reflect the average rates of exchange for the periods presented. As a result, similar results in local currency can vary significantly upon translation into US Dollars if exchange rates fluctuate significantly from one period to the next.

Interest Rates

Our exposure to market risk for changes in interest rates is limited to our cash, cash equivalents and debt. Based on our average invested cash balances and outstanding debt during the first three months of Fiscal 2006, a 10% increase in the average effective interest rate in the remainder of Fiscal 2006 would not have materially impacted our annual interest income or expense.

Item 4. Controls and Procedures

We carried out an evaluation, under the supervision and with the participation of our management, including our Co-Chief Executive Officers and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report. Based upon that evaluation, our Co-Chief Executive Officers and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this Quarterly Report to ensure that information required to be disclosed in this Quarterly Report is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission’s rules and forms.

There was no change in our internal control over financial reporting during our last fiscal quarter identified in connection with the evaluation referred to above that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

We are, from time to time, involved in routine litigation incidental to the conduct of our business, including litigation instituted by persons injured upon premises under our control, litigation regarding the merchandise that we sell, including product and safety concerns regarding metal content in our merchandise, litigation with respect to various employment matters, including litigation with present and former employees, and litigation to protect our trademark rights. Although litigation is routine and incidental to the conduct of our business, like any business of our size and employing a significant number of employees, such litigation can result in large monetary awards when judges, juries or other finders of facts do not agree with management’s evaluation of possible liability or outcome of litigation. Accordingly, the consequences of these matters cannot be finally determined by management. However, in the opinion of management, we believe that current pending litigation will not have a material adverse effect on our financial position, earnings or cash flows.

In April 2005, we closed under the settlement agreement previously approved by the United States Bankruptcy Court for the Central District of California in connection with the litigation filed against us in January 2003 by the Official Committee of Unsecured Creditors of Lux Corporation. Under the terms of the settlement agreement, we paid $5 million ($3.1 million net of income taxes) to settle the case, and exchanged mutual general releases. The settlement was previously recorded, net of tax, in our Fiscal 2005 financial statements as “Net loss from discontinued operations.”

Item 6. Exhibits

Items 2, 3, 4 and 5 are not applicable and have been omitted.

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SIGNATURE

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

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INDEX TO EXHIBITS

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