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FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

(Mark One)

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

For the quarterly period ended May 1, 2004

OR

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

For the transition period from ___________________ to _____________________

Commission file number 00019774

365 West Passaic Street, Rochelle Park, New Jersey 07662
(Address of principal executive offices) (Zip Code)

(201) 845-0880
Registrant's telephone number, including area code

_______________________________________________________________

(Former name, former address and former fiscal year, if changed since last report)

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 (the “Exchange Act”) during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

YES ___X___ NO _______

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

YES _______ NO ___X____

APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY

PROCEEDINGS DURING THE PRECEDING FIVE YEARS:

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Exchange Act subsequent to the distribution of securities under a plan confirmed by a court.

YES _______ NO _______

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date.

As of May 1, 2004, 12,937,304 units, each consisting of one share of the registrant’s common stock, $.001 par value per share, and one attached stock purchase right, were outstanding. The units are referred to herein as “shares.”

PART I - FINANCIAL INFORMATION

ITEM I - FINANCIAL STATEMENTS

UNITED RETAIL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(dollars in thousands)

The accompanying notes are an integral part of the Consolidated Financial Statements

UNITED RETAIL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(dollars in thousands, except per share amounts)

The accompanying notes are an integral part of the Consolidated Financial Statements

UNITED RETAIL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)
(Unaudited)

The accompanying notes are an integral part of the Consolidated Financial Statements

UNITED RETAIL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Basis of Presentation

The consolidated financial statements include the accounts of United Retail Group, Inc. and its subsidiaries (the “Company”). All significant intercompany balances and transactions have been eliminated.

The consolidated financial statements as of and for the thirteen weeks ended May 1, 2004 and May 3, 2003 are unaudited and are presented pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, the consolidated financial statements should be read in conjunction with the financial statement disclosures contained in the Company’s 2003 Annual Report and 2003 Form 10-K. In the opinion of management, the accompanying consolidated financial statements reflect all adjustments necessary to present fairly the financial position and results of operations and cash flows for the interim periods, but are not necessarily indicative of the results of operations for a full fiscal year.

Certain prior year balances have been reclassified to conform with the current year presentation.

2. Net Loss Per Share

Basic per share data has been computed based on the weighted average number of shares of common stock outstanding. Diluted per share data has been computed on the basic shares because for the thirteen weeks ended May 1, 2004 and May 3, 2003, the effect of stock options is anti-dilutive.

Options to purchase shares of common stock which were not included in the computation of diluted per share data were as follows:

The Company uses the intrinsic value method to account for stock-based compensation in accordance with Accounting Principles Board Opinion No. 25, “Accounting For Stock Issued To Employees” (Opinion No. 25) and has adopted the disclosure provisions of Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting For Stock-Based Compensation” (SFAS No. 123). Under Opinion No. 25, compensation expense, if any, is measured as the excess of the market price of the stock over the exercise price on the measurement date. In accordance with Opinion No. 25, compensation expense is recorded ratably over the five-year vesting period of the options.

The following table illustrates the effect on net loss and loss per share if the Company had applied the fair value recognition provisions under SFAS No. 123, “Accounting For Stock-Based Compensation” to stock-based employee compensation:

3. Financing Arrangements

In 1993, the Company executed a ten-year $7.0 million note bearing interest at 7.3%. Interest and principal were payable in equal monthly installments beginning November 1993. Final payment on this note was made in October 2003.

In 1994, the Company executed a fifteen-year $8.0 million loan bearing interest at 8.64%. Interest and principal are payable in equal monthly installments beginning May 1994. The loan is collateralized by a mortgage on the national distribution center owned by the Company in Troy, Ohio.

The Company and certain of its subsidiaries, (collectively, the “Companies”) are parties to a Financing Agreement, dated August 15, 1997 (the “Financing Agreement”), with The CIT Group/Business Credit, Inc.(“CIT”). The Financing Agreement was extended and expanded during fiscal 2003. The term was extended three years to August 15, 2008. The line of credit was increased from $40 million to $50 million for the Companies, subject to availability of credit according to a borrowing base computation. The line of credit may be used on a revolving basis by any of the Companies to support trade letters of credit and standby letters of credit and to finance loans.

The Companies are required to maintain unused at all times combined asset availability of at least $5 million. Except for the maintenance of a minimum availability of $5 million and a limit on capital expenditures, the Financing Agreement does not contain any significant financial covenants.

The Financing Agreement also includes certain restrictive covenants that impose limitations (subject to certain exceptions) on the Companies with respect to, among other things, making certain investments, declaring or paying dividends, making loans, engaging in certain transactions with affiliates, or consolidating, merging or making acquisitions outside the ordinary course of business.

In the event a loan is made to one of the Companies, interest is payable monthly based on a 360-day year at the Chase Manhattan Bank prime rate plus incremental percentages ranging from 0.00% to 0.75% or LIBOR rate plus incremental percentages ranging from 1.75% to 2.50% as determined by the average excess availability each month per the Financing Agreement on a per annum basis. The borrower can select either the prime rate or the LIBOR rate as the basis for determining the interest rate.

The line of credit is collateralized by a security interest in i) inventory and its proceeds ii) bank credit card receivables and iii) the balance on deposit from time to time in a bank account that has been pledged to the lenders.

At May 1, 2004, the borrowing capacity of the Companies under the Financing Agreement with CIT, after satisfying the $5 million minimum availability requirement, was $22.4 million, trade letters of credit for the account of the Companies were outstanding in the amount of $22.1 million, standby letters of credit were outstanding in the amount of $5.5 million and no loan from CIT was outstanding. The Company’s cash and cash equivalents of $14.3 million were unrestricted.

In January 2002, the Company executed a five-year $8.2 million sale and lease back agreement for certain fixtures in new and remodeled stores. The lease bears an interest rate of 7.0% per annum. The Company was required to pay sales tax as part of the agreement. The agreement provides for equal monthly rent payments beginning February 2002 and gives the Company the option of buying back the fixtures at the end of the term for a nominal price.

In January 2002 through January 2003, the Company executed a series of three-year capital lease agreements for call center systems at the Company’s national distribution center in Troy, Ohio, bearing interest at rates between 6.09% and 6.64% per annum aggregating approximately $1.4 million. The Company has the option of buying the systems at the end of the term for a nominal price.

4. Income Taxes

Reconciliation of the provision for income taxes from the U.S. Federal statutory rate to the Company’s effective rate is as follows (dollars in thousands):

In November 2003, the Company agreed in principle with the Internal Revenue Service (“IRS”) on a settlement and the closure of its examination of the Company’s tax returns for the years through 1996.

In November 2003, the Company also agreed in principle with the IRS on the settlement of a matter related to tax refund claims the Company had filed for research credits and for deductions attributable to certain bank financing transactions during 1989 to 1992. Although only a preliminary settlement has been reached with the IRS, in April 2004, the Company received payment from the IRS in the amount of $2.5 million (which includes $1.2 million representing interest). The Company has not received final clearance from the IRS. Upon receipt of final clearance, the Company will recognize the benefit of the refund claims, including the related interest thereon. It is anticipated that the $1.3 million refund will be recorded as an increase to stockholders’ equity as it relates to stock warrant deductions and the $1.2 million interest amount will be recorded in the Company’s results of operations. An additional payment estimated to be approximately $0.7 million is also expected in connection with the claim related to research credits and when received, this item would be recorded in the Company’s operating results.

Significant components of the Company’s deferred tax assets and liabilities as of May 1, 2004 are summarized below (dollars in thousands):

The Company recorded a $7.3 million non-cash charge to establish a valuation allowance for its net deferred tax assets and net operating loss carryforwards in the fourth quarter of fiscal 2002. The valuation allowance was calculated in accordance with the provisions of SFAS No. 109, “Accounting for Income Taxes” (SFAS No. 109), which places significant importance on the Company’s cumulative operating results in the most recent three-year period when assessing the need for a valuation allowance. The Company’s cumulative loss in the three-year period ended February 1, 2003, which included the net loss reported in the fourth quarter of fiscal 2002, was sufficient to require a full valuation allowance under the provisions of SFAS No. 109. The Company recorded additional valuation allowances of $12.6 million and $1.3 million in the fiscal year ended January 31, 2004 and quarter ended May 1, 2004, respectively. The Company intends to maintain a valuation allowance for its net deferred tax assets and net operating loss carryforwards until sufficient positive evidence exists to support its reversal.

5. Stock Appreciation Rights Plan

Commencing in May 2000 and annually thereafter, each nonmanagement Director received an award under the Company’s Stock Appreciation Rights Plan that provides for a cash payment by the Company when the Director exercises the stock option granted to him contemporaneously under the Company’s Stock Option Plans. The payment will be an amount equivalent to the after tax equity in the option that is being exercised, that is, the excess of the then current market price of the shares issued over the exercise price of the corresponding option plus any personal income tax withholding on the gain arising from the exercise.

6. Supplemental Cash Flow Information

Net cash flow from operating activities reflects cash payments for interest and income taxes as follows (dollars in thousands):

There were no non-cash investing activities for the thirteen weeks ended May 1, 2004 and May 3, 2003.

7. Contingencies

The Company is involved in legal actions and claims arising in the ordinary course of business. Management believes (based on advice of legal counsel) that such litigation and claims will not have a material adverse effect on the Company’s financial position, annual results of operations or cash flows.

In addition, on May 1, 2003, a suit in California Superior Court, Los Angeles County, styled Erik Stanford vs. United Retail Incorporated was served on the Company by a former store manager in California. On March 3, 2004, an amended complaint was served that added another plaintiff. The suit is purportedly a class action on behalf of certain current and former associates in California in the previous four years.

The plaintiffs in the Stanford case assert state wage and hour claims.

The Company intends to oppose class certification strongly and to defend the Stanford case vigorously on the merits.

Although counsel is unable at this early stage to predict the ultimate outcome of the Stanford case, management does not believe that the case will have a material impact on the Company’s financial position. However, given the uncertainty at this stage, it is possible that if either an adverse judgment for damages is rendered or a negotiated settlement is agreed upon, the amount payable could be material to the Company’s annual results of operations or cash flows.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

EXECUTIVE SUMMARY

Introduction

The Executive Summary section of Management’s Discussion and Analysis of Financial Condition and Results of Operations provides a high level summary of the more detailed information elsewhere in this Report, an overview to put this information in context and a plan to return the Company to long-term profitability. This section is also an introduction to the discussion and analysis that follows. Accordingly, it necessarily omits details that appear elsewhere in this Report. It should not be relied upon separately from the balance of this Report.

Products and Purchasing

The Company is a leading specialty retailer featuring its proprietary AVENUE® brand large size (14 or larger) women’s wearing apparel. It also offers AVENUE BODY® brand large size women’s undergarments and lingerie, CLOUDWALKERS® brand women’s footwear and AVENUE brand large size women’s hosiery, as well as AVENUE® brand accessories and gifts.

Most of the Company’s products are made for the Company by contract manufacturing abroad.

Customer Base

The Company serves the mass market in the United States and targets fashion conscious women between 25 and 55 years of age who wear large size apparel. Management believes that the number of women in this age range who wear large size apparel has increased in recent years.

Merchandising and Marketing

Design is an important aspect of the Company’s products. Many AVENUE® and AVENUE BODY® products are custom designed. The Company emphasizes a contemporary brand image and consistency of merchandise quality and fit.

The Company uses direct mail, credit card statement inserts, in-store signage and e-mail messages in its marketing activities.

Channel of Distribution

The Company’s channel of distribution is retail stores using its AVENUE® trade name. It leases 533 stores in 37 states. The Company also operates a website at www.avenue.com that sells a selection of the merchandise that is also on sale in the stores.

Until March 2003, the Company also mailed catalogs that featured a merchandise selection that included both items in the stores and similar products. (The website and the catalog, while it was in existence, are referred to as the “shop@home” business.)

Increased Competition

The women’s retail apparel and shoe industries are highly competitive. Operating results of businesses in these industries, especially businesses that emphasize fashionable merchandise, can vary materially from year to year. The Company’s competition includes other specialty retailers, mass merchants, department stores, discount stores, mail order companies, television shopping channels and Internet websites. Management believes that total sales of large size women’s apparel from these sources of supply increased in recent years. Among specialty retailers for large size women like the Company, the competition includes large store chains that have announced long-term store growth plans to aggressively expand into additional strip shopping center locations.

Deflationary Price Trend in Apparel Industry

The Consumer Price Index published by the U.S. Dept. of Labor, Bureau of Labor Statistics city average for women’s and girls’ apparel (the “CPI”) declined 5.0% in fiscal 2001, 1.9% in fiscal 2002 and 1.8% in fiscal 2003. There is no assurance that this deflationary trend will not continue.

Company Sales Fluctuations

Sales figures and merchandise margins are central to the Company’s profitability. The Company conducts a weekly interdisciplinary review of sales and merchandise margins and prepares budgets for two six-month seasons each year, the Spring season and the Fall season. Management uses comparable store sales (for stores open at least 12 months at the time) as a management tool. However, there is no industry standard for calculating comparable store sales and the Company’s approach may differ from those of competitors.

Seasonal sales and CPI data follows:

___________
* Excluding shop@home sales
**U.S. Dept. of Labor, U.S. City Average, Women’s and Girls’ Apparel

Operating Results

The declines in sales per average store from fiscal 2001 to fiscal 2003 adversely affected operating results.

The Company had net income of $0.4 million in fiscal 2001 and incurred net losses of $23.1 million in fiscal 2002 and $19.1 million in fiscal 2003. The Company had operating income of $0.6 million in fiscal 2001 and incurred operating losses of $22.8 million in fiscal 2002 and $18.8 million in fiscal 2003. (Excluding a one-time goodwill write-off, the operating loss in fiscal 2002 was $17.2 million.)

In order to return to long-term profitability, it will be necessary for the Company to increase sales per average store with merchandise margins at levels equal to, or better than, fiscal 2001.

Product Repositioning Plan

In the women’s retail specialty apparel industry, sales, especially in businesses that emphasize fashionable merchandise, can vary significantly over time. Sales are volatile because of shifts in consumer spending patterns, consumer preferences and overall economic conditions; the impact of competition and pricing; variations in weather patterns; fluctuations in consumer acceptance of the Company’s products; changes in the ability to develop new merchandise; differences in promotional strategies; and movements in consumer confidence levels. These variables caused the Company’s sales per average store to fluctuate in the past. Thus, recent sales performance is not necessarily indicative of future sales performance. As a result, management believes that long-term sales projections within a defined narrow range are not reliable.

After fiscal 2001, when net income declined to $0.4 million, the Company incurred net losses. The Company has sought to return to long-term profitability through higher sales per average store with merchandise margins at levels equal to, or better than, fiscal 2001. These financial goals were translated into an integrated operational plan early in fiscal 2003. This plan has four principal components: (i) to improve the design of the Company’s merchandise and thereby differentiate it from competitors’ merchandise, (ii) to market more items together as coordinated outfits rather than separately as individual garments, (iii) to put more emphasis on fashionable merchandise and less on basic items, and (iv) to raise the level of merchandise presentation in the store to make shopping easier and to encourage outfit buying. This plan relies primarily on the Company’s intellectual capital. Only small amounts of financial capital are required to execute the plan.

This section constitutes forward-looking information under the Reform Act, which is subject to the uncertainties and other risk factors referred to under the caption “Future Results.”

Fluctuation in Store Count

Store counts averaged 543, 557 and 546, respectively, for fiscal 2001, 2002 and 2003. In 2003, the Company opened five stores and closed 24 stores. In 2004, the Company is planning to open two stores and close approximately 15-25 stores as part of its normal lease maintenance program. Thus, the average number of stores is expected to decline further in fiscal 2004.

The annual capital expenditure budgets after fiscal 2004 will provide for new store construction and other infrastructure development priorities. Prioritization will be based, among other things, on overall profitability and the availability of suitable locations at rents and on terms that fit the Company’s financial model for new store construction.

Liquidity

United Retail Group, Inc. and certain of its subsidiaries (collectively, the “Companies”) are parties to a Financing Agreement, dated August 15, 1997, as amended (the “Financing Agreement”), with The CIT Group/Business Credit, Inc. (“CIT”). The Financing Agreement provides credit on a revolving basis.

The Company’s historical sources of liquidity have been the availability of credit under the Financing Agreement on a revolving basis and short-term trade credit, as well as its cash on hand and net cash provided by operating activities. Management believes that these sources of liquidity will continue to be adequate to meet the Company’s cash requirements for 12 months after the date of this Report. The preceding sentence constitutes forward-looking information under the Reform Act and is subject to the uncertainties and other risk factors referred to under the caption “Future Results.” In the event the Company incurs an operating loss in fiscal 2004 materially higher than in fiscal 2003, additional sources of liquidity might be required.

The Company’s cash requirements include (i) anticipated working capital needs, including seasonal inventory financing, (ii) financing activities, including payments due on its principal contractual obligations and (iii) investing activities, including costs for building the stores that it plans to open, renovating certain other stores and replacing fixtures where appropriate.

DISCUSSION AND ANALYSIS

First Quarter of Fiscal 2004 Versus First Quarter of Fiscal 2003

This section provides details about the material line items in the Company’s statement of operations.

Net sales for the first quarter of fiscal 2004 decreased 4.0% from the first quarter of fiscal 2003, to $97.5 million from $101.5 million. The decrease was principally from fewer units sold per store. Comparable store sales for the first quarter of fiscal 2004 decreased 2.2%. (Comparable store sales are at stores that were open at least 12 months; this measure of sales performance is commonly used by specialty retail industry analysts.) Average number of stores decreased from 550 to 534. See, “Stores.”

Gross profit decreased to $20.9 million in the first quarter of fiscal 2004 from $22.2 million in the first quarter of fiscal 2003 decreasing as a percentage of net sales to 21.4% from 21.8%. Gross profit as a percentage of net sales decreased principally because of lower merchandise margins, partially offset by lower marketing expenses. Gross profit levels in the future will be subject to the uncertainties and other risk factors referred to under the caption “Future Results.”

General, administrative and store operating expenses decreased to $24.0 million in the first quarter of fiscal 2004 from $26.4 million in the first quarter of fiscal 2003, decreasing as a percentage of net sales to 24.6% from 26.0%. The percentage decrease was principally because of lower insurance expense in the current quarter.

The Company incurred operating losses of $3.1 million in the first quarter of fiscal 2004 and $4.2 million in the first quarter of the previous year.

The Company’s effective tax rate was 1.5% for the first quarter of fiscal 2004 and 1.8% for the first quarter of fiscal 2003. The primary factor contributing to this rate in each period was that the Company provides a valuation allowance for its net deferred tax assets. The tax valuation allowance was increased by $1.3 million in the first quarter of fiscal 2004 and by $2.1 million in the first quarter of fiscal 2003.

The provision for income taxes was $49,000 for the first quarter of fiscal 2004 and $82,000 for the first quarter of fiscal 2003.

The Company incurred net losses of $3.4 million in the first quarter of fiscal 2004 and $4.5 million in fiscal 2003.

See, “Critical Accounting Policies” for a discussion of estimates made by management in preparing financial statements in accordance with generally accepted accounting principles.

May Sales Results

Net sales for May 2004 decreased 2.5% from May 2003, to $36.0 million from $36.9 million. Comparable store sales for the month declined 1.2%.

Increased Competition

The women’s retail apparel and shoe industries are highly competitive. Operating results of businesses in these industries, especially businesses that emphasize fashionable merchandise, can vary materially from year to year. The Company’s competition includes other specialty retailers, mass merchants, department stores, discount stores, mail order companies, television shopping channels and Internet websites. Management believes that total sales of large size women’s apparel from these sources of supply increased in recent years. Among specialty retailers for large size women like the Company, the competition includes large store chains that have announced long-term store growth plans to aggressively expand into additional strip shopping center locations.

Product Repositioning Plan

In the women’s retail specialty apparel industry, sales, especially in businesses that emphasize fashionable merchandise, can vary significantly over time. Sales are volatile because of shifts in consumer spending patterns, consumer preferences and overall economic conditions; the impact of competition and pricing; variations in weather patterns; fluctuations in consumer acceptance of the Company’s products; changes in the ability to develop new merchandise; differences in promotional strategies; and movements in consumer confidence levels. These variables caused the Company’s sales per average store to fluctuate in the past. Thus, recent sales performance is not necessarily indicative of future sales performance. As a result, management believes that long-term sales projections that fall within a defined narrow range are not reliable.

After fiscal 2001, when net income declined to $0.4 million, the Company incurred net losses. The Company has sought to return to long-term profitability through higher sales per average store with merchandise margins at levels equal to, or better than, fiscal 2001. These financial goals were translated into an integrated operational plan early in fiscal 2003. This plan has four principal components: (i) to improve the design of the Company’s merchandise and thereby differentiate it from competitors’ merchandise, (ii) to market more items together as coordinated outfits rather than separately as individual garments, (iii) to put more emphasis on fashionable merchandise and less on basic items, and (iv) to raise the level of merchandise presentation in the store to make shopping easier and more enjoyable. This plan relies primarily on the Company’s intellectual capital. Only small amounts of financial capital are required to execute the plan.

This section constitutes forward-looking information under the Reform Act, which is subject to the uncertainties and other risk factors referred to under the caption “Future Results.”

Liquidity and Capital Resources

This section provides details about the Company’s sources of liquidity.

Cash Flow

Net cash provided from operating activities was $1.1 million in the first quarter of fiscal 2004 compared with net cash used in operating activities of $0.1 million in the first quarter of fiscal 2003. This improvement resulted principally from (i) a larger increase in accounts payable and accrued expenses ($9.9 million in the first quarter of fiscal 2004 versus $4.9 million in the first quarter of fiscal 2003) and (ii) a larger improvement in the balance of other assets and liabilities ($2.6 million versus $0.2 million), primarily from receipt in the first quarter of fiscal 2004 of a federal income tax refund and related interest, partially offset by a larger increase in inventory from year end to quarter end ($11.7 million in the first quarter of fiscal 2004 versus $6.3 million in the first quarter of fiscal 2003).

Balance Sheet Sources of Liquidity

The Company’s cash and cash equivalents were $14.3 million at May 1, 2004 compared with $12.1 million at May 3, 2003 and $14.4 million at January 31, 2004.

During the first quarter of fiscal 2004, a planned decrease in inventories was implemented. Inventories were stated at $60.8 million at May 1, 2004 compared with $67.8 million at May 3, 2003, principally as a result of fewer units, and compared with $49.1 million at January 31, 2004. (See, “Critical Accounting Policies – Inventory” for a discussion of estimates made by management in stating inventories in financial statements prepared in accordance with generally accepted accounting principles.)

Property and equipment decreased to $73.7 million at May 1, 2004 from $84.9 million at May 3, 2003, principally from depreciation, compared with $76.7 million at January 31, 2004.

Other Liquidity Sources

Import purchases by the Company are made in U.S. dollars. Imports are generally financed by trade letters of credit. They constituted approximately 53% of total purchases in fiscal 2003.

The Financing Agreement was extended and expanded during fiscal 2003. The term was extended three years to August 15, 2008. The line of credit was increased from $40 million to $50 million for the Companies, subject to availability of credit as described in the following paragraphs. The line of credit may be used on a revolving basis by any of the Companies to support trade letters of credit and standby letters of credit and to finance loans. At May 1, 2004, trade letters of credit for the account of the Companies and supported by CIT were outstanding in the amount of $22.1 million and standby letters of credit were outstanding in the amount of $5.5 million. Standby letters of credit were used principally in connection with insurance policies issued to the Company.

Subject to the following paragraph, the availability of credit (within the aggregate $50 million line of credit) to any of the Companies at any time is the excess of its borrowing base over the sum of (x) the aggregate outstanding amount of its letters of credit and its revolving loans, if any, and (y) at CIT’s option, the sum of (i) unpaid sales taxes, and (ii) up to $500,000 in total liabilities of the Companies under permitted encumbrances (as defined in the Financing Agreement). The borrowing base, as to any of the Companies, is the sum of (x) a percentage of the book value of its eligible inventory (both on hand and unfilled purchase orders financed with letters of credit), ranging from 65% to 75% depending on the time of year, (y) the balance from time to time in an account in its name that has been pledged to the lenders (a “Pledged Account”) and (z) 85% of certain receivables from credit card companies.

The provisions of the preceding paragraph to the contrary notwithstanding, the Companies are required to maintain unused at all times combined availability of at least $5 million. Except for the maintenance of a minimum availability of $5 million and a limit on capital expenditures, the Financing Agreement does not contain any financial covenants.

The combined borrowing capacity of the Companies is cyclical due to the seasonality of the retail industry. At May 1, 2004, the combined borrowing capacity of the Companies, after satisfying the $5 million minimum availability requirement, was $22.4 million; the Pledged Account had a zero balance; the Companies’ cash on hand was unrestricted; and no loan was outstanding.

The line of credit is collateralized by a security interest in (i) inventory and its proceeds, (ii) receivables from credit card companies and (iii) the balance from time to time in the Pledged Account.

The Financing Agreement includes certain restrictive covenants that impose limitations (subject to certain exceptions) on the Companies with respect to making certain investments, declaring or paying dividends, making loans, engaging in certain transactions with affiliates, or consolidating, merging or making acquisitions outside the ordinary course of business.

The Company has drawn on the revolving loan facility under the Financing Agreement from time to time to meet its peak working capital requirements. Interest is payable monthly based on a 360-day year either at the prime rate plus an incremental percentage up to 0.75% per annum or at the LIBOR rate plus an incremental percentage ranging from 1.75% to 2.50% per annum. The borrower can select either the prime rate or the LIBOR rate as the basis for determining the interest rate. In either case, the incremental percentage is determined by the average excess availability.

The Company’s obligation to pay customs duties on merchandise imports was collateralized by an unsecured surety bond for $1.5 million during the first quarter of fiscal 2003. The surety bond is now $2.0 million. The tightening market for surety bonds has made it necessary for the Company to support the surety bond with a standby letter of credit under the Financing Agreement in the amount of $0.5 million.

Short-term trade credit represents a significant source of financing for domestic merchandise purchases. Trade credit arises from the willingness of the Company’s domestic vendors to grant extended payment terms for inventory purchases and is generally financed either by the vendor or a third-party factor. The availability of trade credit depends on the Company’s having other sources of liquidity, as well. In particular, credit authorizations by trade creditors focus on the amount of the Company’s cash and cash equivalents and its borrowing capacity under the Financing Agreement.

In November 2003, the Company also agreed in principle with the IRS on the settlement of a matter related to tax refund claims the Company had filed for research credits and for deductions attributable to certain bank financing transactions during 1989 to 1992. Although only a preliminary settlement has been reached with the IRS, in April 2004, the Company received payment from the IRS in the amount of $2.5 million (which includes $1.2 million representing interest.) The Company has not received final clearance from the IRS. Upon receipt of final clearance, the Company will recognize the benefit of the refund claims, including the related interest thereon. It is anticipated that the $1.3 million refund will be recorded as an increase to stockholders’ equity as it relates to stock warrant deductions and the $1.2 million interest amount will be recorded in the Company’s results of operations. An additional payment estimated to be approximately $0.7 million is also expected in connection with the claim related to research credits and, when received, this item would be recorded in the Company’s operating results.

Capital Expenditures

This section and the one that follows provide details about certain uses of cash by the Company.

Capital expenditures in the first quarter of fiscal 2004 were less than $0.1 million compared with $0.6 million in the first quarter of fiscal 2003.

Capital expenditures are projected to be approximately $3.0 million for fiscal 2004, including implementation of the Company’s product repositioning plan. This paragraph constitutes forward-looking information under the Reform Act and is subject to the uncertainties and other risk factors referred to under the caption “Future Results.”

Principal Contractual Obligations and Certain Other Commercial Commitments

The principal contractual obligations of the Company and certain other commercial commitments at May 1, 2004 (see, also “Critical Accounting Policies – Incurred But Not Reported Claims For Personal Injuries and Medical Benefits”) are