Dmitry Beinus - Mr. Beinus has served as our Chairman of the Board, President and Chief Executive Officer since founding Shoe Pavilion in 1979. From 1976 to 1978, Mr. Beinus was employed in the shoe department of Nordstrom, Inc.

Robert R. Hall - Mr. Hall has served as our Vice President and Chief Operating Officer since January 1997. Mr. Hall joined Shoe Pavilion as a Regional Manager in 1990 and has held various positions within the Company including Operations Manager and Vice President of Merchandising.

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Bruce L. Ross - Mr. Ross has served as our Executive Vice President and Chief Financial Officer since July 2006. Prior thereto, from 1994 until February 2006, Mr. Ross served as Executive Vice President and Chief Financial Officer of Guitar Center, Inc.

The Company's executive officers serve at the discretion of the Board of Directors.

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Item 1A.   Risk Factors

A significant element of our growth strategy involves the expansion and improvement of our store base. We intend to open 20 to 25 new stores by the end of fiscal year 2007. The success of our planned expansion will depend significantly on the adequacy of our capital resources as well as our ability to locate suitable store sites and negotiate acceptable lease terms. In addition, there are a number of other factors that could affect our expansion plans, including the ability to:

• build out new store sites on a timely and cost-effective basis;

• hire, train and retain employees; and

• expand and adapt our operational systems to serve a larger number of stores in an expanded geographic region.

There can be no assurance that we will achieve our planned expansion or that any such expansion will be profitable. In addition, there can be no assurance that our expansion within our existing markets will not adversely affect the financial performance of our existing stores or our overall operating results, or that new stores will achieve net sales and profitability levels consistent with existing stores. Because our future revenue growth depends on new store openings, any postponement or reduction in the number of store openings could have a material adverse effect on our growth prospects. In addition, there can be no assurance that the recent shift to larger format stores will produce results in line with our expectations.

If we are unable to successfully implement our growth strategy or manage our growing business, future operating results could be negatively impacted.

No assurance can be given that we will be successful in maintaining or increasing our sales in the future. Any future growth in sales will require additional working capital and may place a significant strain on management, information systems, inventory management and distribution facilities. Any failure to timely enhance our operating systems, or unexpected difficulties in implementing such enhancements, could have a material adverse effect on our results of operations.

Historically, our comparable store sales have fluctuated widely, and we expect them to continue to do so in the future. We define comparable store sales as those stores that have been open for at least 13 consecutive months. For fiscal year 2006, our comparable store sales increased 3.9% from fiscal year 2005. For fiscal year 2005, our comparable store sales increased 6.9% from fiscal year 2004. Because of the wide fluctuations in comparable store sales, investors may have difficulty consistently assessing our growth potential. In addition, fluctuations in our comparable store sales, including any decrease in 2007 comparable stores sales, could adversely impact our revenues, net income and the price of our stock.

We have experienced, and expect to continue to experience, seasonal fluctuations in our net sales and net income. Historically, net sales and net income have been weakest during the first quarter following the holiday season. Our quarterly results of operations may also fluctuate significantly as a result of a variety of factors, including the timing of new store openings, the level of net sales contributed by new stores, merchandise mix, the timing and level of price markdowns, availability of inventory, store closures, advertising costs, the success of advertising campaigns, competitive pressures and changes in the demand for off-price footwear. For example, sales in the first half of 2005 benefited from significant rainfall in Southern California and the introduction of new

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merchandise categories (children's shoes and accessories) in selected store locations. Sales in the first half of 2006 did not benefit from the same factors.

Because our stores are concentrated in the western part of the United States, we are subject to regional risks.

Currently, 75 of our stores are located in California and the balance are located in Washington, Oregon, Arizona, Nevada, Texas and New Mexico. Accordingly, we are subject to regional risks, such as the economy, weather conditions, natural disasters and government regulations. When a region suffers an economic downturn or when other adverse events occur, historically there has been an adverse effect on our sales and profitability and this could also affect our ability to implement our planned growth. In addition, many of our vendors rely on the Ports of Los Angeles and Long Beach as the ports of entry for the merchandise we sell in our stores. Any disruption or congestion at these ports could impair our ability to adequately stock the stores. Several of our competitors operate stores across the United States and, thus, are not as vulnerable to such regional risks.

Consumer spending habits, including spending for the footwear and related accessories that we sell, are affected by, among other things, prevailing economic conditions, levels of employment, salaries and wage rates, prevailing interest rates, income taxes and policies, consumer confidence and consumer perception of economic conditions. In addition, consumer purchasing patterns are influenced by consumers' disposable income. As a result, economic developments that potentially reduce consumers' disposable income, such as recent increases in gasoline and energy prices and the rate of inflation, could impact consumer spending habits.

Consumer confidence is also affected by the domestic and international political landscape. The outbreak or escalation of war, or the occurrence of terrorist acts or other hostilities in or affecting the United States, could lead to a decrease in spending by consumers. If consumers reduce spending, we could experience lower net sales than expected on a quarterly or annual basis and be forced to delay or slow our expansion plans.

Terrorist attacks or acts of war may seriously harm our business.

Terrorist attacks may cause damage or disruption to our employees, facilities, information systems, vendors and customers, which could significantly impact our net sales, costs and expenses and financial condition. The potential for future terrorist attacks, the national and international responses to terrorist attacks, and other acts of war or hostility may cause greater uncertainty and cause our business to suffer in ways that we currently cannot predict. Such terrorist attacks could cause ports to or through which we or our vendors receive shipments, such as the Ports of Los Angeles and Long Beach, to be shut down, thereby preventing the delivery of products to our stores. Our geographical focus in the Western and Southwestern United States may make us more vulnerable to such uncertainties than other comparable retailers who may not have similar geographical concentration.

Our merchandising strategy is based on identifying each region's customer base and having the proper mix of products in each store to attract our target customers in that region. This requires us to anticipate and respond to numerous and fluctuating variables in fashion trends and other conditions in the markets in which our stores are situated. A variety of factors will affect our ability to maintain the proper mix of products in each store, including:

• variations in local economic conditions, which could affect our customers' discretionary spending;

• unanticipated fashion trends;

• our success in developing and maintaining vendor relationships that provide us with access to in-season merchandise at attractive prices;

• our success in distributing merchandise to our stores in a timely and efficient manner; and

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• change in weather patterns, which in turn affect consumer preferences and needs.

If we are unable to anticipate and fulfill the merchandise needs of each region, we may experience decreases in our net sales and may be forced to increase markdowns to slow-moving merchandise, either of which could have an adverse effect on our business, financial condition and results of operations. Our planned expansion into new geographic regions may heighten this risk.

We actively monitor individual store performance and close underperforming stores at the conclusion of the lease term. In certain instances, we may be unable to close an underperforming store on a timely basis because of lease terms. The inability to close one or more underperforming stores on a timely basis could result in operating losses, which could have a material adverse effect on our results of operations.

Our current expansion plan anticipates funding new store openings in 2007 from cash flow, tenant improvement allowances and from borrowings under our revolving credit facility.

We maintain a revolving credit facility with Wells Fargo Retail Finance, LLC that provides for a credit facility of up to $30.0 million, including a $5.0 million sublimit for the issuance of letters of credit. The amount of borrowings under the revolving credit facility may be increased at our option up to a maximum of $50.0 million. Under the terms of this revolving credit facility, we are subject to an annual capital expenditures limit of $10.0 million. In each remaining year of the revolving credit facility, Wells Fargo has indicated that it will adjust our capital expenditure limit based upon our business plan. Inasmuch as Wells Fargo has no obligation to cooperate with us in this regard, there is no assurance that we will be permitted to use the revolving credit facility to make the capital expenditures necessary to fully implement our expansion plans.

Our future success will be significantly dependent on our ability to obtain merchandise that consumers want to buy, particularly designer label and branded merchandise with long-term retail appeal, and to acquire such merchandise under favorable terms and conditions. In fiscal year 2006, our largest ten suppliers accounted for approximately 43% of our inventory purchases. The deterioration of our relationship with any key vendor or vendors could result in delivery delays, merchandise shortages or less favorable terms than we currently enjoy. We deal with our suppliers on an order-by-order basis and have no long-term purchase contracts or other contractual assurances of continued supply or pricing. Our footwear purchases typically involve manufacturing make-ups (shoes made exclusively for our channel) and opportunistic purchases. As our operations expand, our need for off-price inventory will continue to increase. Our inability to obtain a sufficient supply of high margin inventory, to negotiate favorable discount and payment agreements with our suppliers or to make opportunistic purchases could have a material adverse effect on our business, financial condition and results of operations.

Our future success will be dependent, to a significant extent, on the efforts and abilities of our executive officers. Dmitry Beinus, the founder, Chairman of the Board, Chief Executive Officer and President of our company, has primary responsibility for all major business decisions, including expansion into new states and regions, advertising, promotion and marketing activities. The loss of the services of any one of our executive officers, and Mr. Beinus in particular, could have a material adverse effect on our operating results. In addition, our continued growth will depend, in part, on our ability to attract, motivate and retain skilled managerial and

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merchandising personnel. There can be no assurance that we will be able to retain a substantial percentage of our existing personnel or attract additional qualified personnel in the future.

Most of the inventory we purchase is shipped directly from vendors to a single centralized distribution center maintained by a third-party operator in Chino, California, where the inventory is then processed, sorted and shipped to our stores. Because a substantial portion of the inventory first goes through the Chino distribution center, any disruption at this site could negatively impact our receiving and distribution process. Our business interruption insurance may not be invoked or be sufficient to mitigate the financial losses caused by a disruption of this center.

Our corporate information technology infrastructure is essential to our distribution process. If our information technology systems were shut down for any reason, such as a natural disaster, power outage or terrorist attack, or if our information technology systems do not operate effectively, we could incur significantly higher costs and longer lead times associated with distributing our products to our stores. Our insurance coverage may not be invoked or be sufficient to mitigate the financial losses resulting from a disruption in our information technology systems.

Many of the vendors with which we conduct business source their products from outside of the United States, particularly China, Brazil and Italy. As a result, we are subject to the risks generally associated with purchasing from foreign suppliers, such as:

• economic and political instability in countries where these suppliers are located;

• international hostilities or acts of war or terrorism affecting the United States or foreign countries from which our merchandise is sourced;

• increases in shipping costs;

• transportation delays and interruptions, including as a result of increased inspections of import shipments by domestic authorities;

• work stoppages;

• adverse fluctuations in currency exchange rates;

• U.S. laws affecting the importation of goods, including duties, tariffs and quotas and other non-tariff barriers;

• expropriation or nationalization;

• changes in local government administration and governmental policies;

• changes in import duties or quotas;

• compliance with trade and foreign tax laws; and

• local business practices, including compliance with local laws and with domestic and international labor standards.

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There can be no assurance that the foregoing factors will not disrupt our supply of directly-sourced goods or otherwise adversely impact our business, financial condition and results of operations in the future.

The retail industry is subject to theft by customers and employees. Because we use a self-service format, where shoppers have access to both shoes of a pair, we must maintain substantial store security. There can be no assurance that we will not suffer from significant inventory shrinkage in the future, which could have a material adverse effect on our business, financial condition and results of operations.

The retail footwear market is highly competitive, and we expect the level of competition to increase. We compete with off-price and discount retailers (e.g., Nordstrom Rack, Payless Shoe Source, Ross Dress for Less and Famous Footwear), branded retail outlets (e.g., Nine West, Reebok and adidas), national and regional retail stores (e.g., DSW Shoe Warehouse, Nordstrom, Marshalls, Macy's, Sears, J.C. Penney, Loehmann's and Mervyn's), traditional shoe stores and mass merchants. Many of these competitors have stores in the markets in which we now operate and in which we plan to expand. Many of our competitors have significantly greater financial, marketing and other resources than we have. In addition, new participants may enter the off-price segment of the footwear market in the future. Competitive pressures resulting from competitors' pricing policies could have a material adverse affect on our gross margins. As a result, we may face greater competition from other national, regional or local retailers and we may not be able to compete successfully with existing and new competitors. Our inability to effectively respond to such competition could have a material adverse effect on our business, financial condition and results of operations.

We are in the process of documenting and testing our internal control procedures in order to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act, which requires annual management assessments of the effectiveness of the design and operation of our internal controls over financial reporting. During the course of our testing we may identify deficiencies which we may not be able to remediate in time to meet the deadline imposed by the Sarbanes-Oxley Act for compliance with the requirements of Section 404. In addition, if we fail to maintain the adequacy of our internal controls, as such standards are modified, supplemented or amended from time to time, we may not be able to ensure that we can conclude on an ongoing basis that we have effective design and operation of internal controls over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act. Failure to achieve and maintain an effective internal control environment could have a material adverse effect on our business and stock price.

Our common stock is thinly traded making it difficult to sell large amounts. The market price of our common stock is likely to be volatile and could be subject to significant fluctuations in response to factors such as quarterly variations in operating results, operating results which vary from the expectations of securities analysts and investors, changes in financial estimates, changes in market valuations of competitors, announcements by us or our competitors of a material nature, additions or departures of key personnel, future sales of common stock and stock volume fluctuations. Also, general political and economic conditions such as a recession or interest rate fluctuations may adversely affect the market price of our common stock.

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Item 1B.  Unresolved Staff Comments

None.

As of December 30, 2006, we operated a total of 108 retail stores in Washington, Oregon, California, Arizona, Nevada, Texas and New Mexico. Our 108 stores occupied an aggregate of approximately 1,350,000 square feet of space. The average store size is approximately 12,500 square feet. We lease all of our stores, with leases expiring between 2007 and 2017, with the exception of one lease expiring in 2021. We have the option to renew most of our leases. Our corporate offices are located in a 9,100 square foot facility in Sherman Oaks, California.

We are the defendant in a patent infringement action brought by DSW Inc. and DSW Shoe Warehouse, Inc. (collectively "DSW") in the U.S. District Court in Los Angeles, California in October 2006. DSW alleges that we used an original, and now use a redesigned shoe display/storage fixture that infringes its U.S. Patents. We have counterclaimed that the patents are either invalid or not infringed. Initially, DSW moved for a preliminary injunction seeking to halt our use of the redesigned displays until the case was ultimately decided. In late November 2006, the Court denied DSW's request. The Court agreed preliminarily that the redesigned display did not infringe and held that DSW was not likely to prevail on its claims because the patent claims were likely invalid and/or not infringed. We believe that the Court's preliminary ruling is correct and that ultimately we will prevail on the merits. In the unlikely event that we do not ultimately prevail, we believe that damages, if any, will not be significant. In light of the Court's findings in its order denying preliminary injunctive relief, we intend to vigorously defend against DSW's claims and prosecute our counterclaim for declaratory relief.

We are a defendant in two class action lawsuits, one filed on January 22, 2007, and the other filed on February 9, 2007, both in the United States District Court, Central District of California. Both lawsuits have been filed by individuals alleging that we continue to print more than the last five digits and expiration date on credit card receipts in violation of the Fair and Accurate Credit Transaction Act. The first complaint was served on us on January 26, 2007. We have not been served in the second matter as of March 6, 2007. Accordingly, it is premature to address the risk of loss presented by these cases, or the amount or range of potential loss.

From time to time we are party to various routine legal proceedings incidental to normal business activities. We believe that while it is reasonably possible that some of these matters will result in settlements to be paid by us, the ultimate resolution of these matters will not have a material adverse impact on our business, financial condition or results of operations, either due to the nature of the claims, or because we believe that such claims should not exceed the limits of our insurance coverage.

No matters were submitted to our stockholders during the fourth quarter of fiscal year 2006.

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PART II

On February 8, 2006, our common stock began trading on the Nasdaq National Market^®, now known as the Nasdaq Global Market^®, under the symbol SHOE. Prior thereto, our common stock was traded on the Nasdaq Capital Market^® under the same symbol. The following table summarizes the range of the highest and lowest sale prices of our common stock for the periods indicated as reported by the Nasdaq:

As of March 6, 2007, there were 21 stockholders of record of our common stock.

We currently intend to retain earnings for use in the operation and potential expansion of our business and, therefore, do not anticipate declaring or paying any cash dividends on our common stock in the foreseeable future. The declaration and payment of any such dividends in the future will depend upon our earnings, financial condition, capital needs and other factors deemed relevant by the Board of Directors. In addition, our revolving credit facility restricts our ability to pay dividends.

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Item 6.    Selected Financial Data

The following tables set forth selected consolidated financial and operating data for the last five fiscal years. This data should be read in conjunction with the financial statements and related notes thereto and other financial information included herein.

1. Our fiscal year end is based upon a fifty-two or fifty-three week year ending on the Saturday nearest to December 31^st. All references to fiscal years 2006, 2005, 2004, 2003 and 2002 refer to the fiscal years ended December 30, 2006, December 31, 2005, January 1, 2005, January 3, 2004 and December 28, 2002, respectively. Fiscal year 2004, ended January 3, 2004, was a fifty-three week year. All other fiscal years consisted of a fifty-two week year.
2. Fiscal year 2002 includes two licensed shoe departments operated pursuant to a license agreement with Gordmans, Inc.
3. In June of fiscal year 2002, the license agreement with Gordmans, Inc. was terminated, and we closed all 40 licensed shoe departments.
4. We define comparable stores as those stores that have been open for at least 13 consecutive months.

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Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

Shoe Pavilion is an independent off-price footwear retailer with locations in the Western and Southwestern United States. As of December 30, 2006, we operated 108 stores in Washington, Oregon, California, Arizona, Nevada, Texas and New Mexico. We were among the first footwear retailers on the West Coast to expand the off-price concept into the branded footwear market. We offer a broad selection of quality designer label and branded footwear, typically at 20% to 60% below regular department store prices, in a convenient self-service store format.

We are positioned in the retail market between discount and department stores. Unlike discount stores, we offer designer label and branded footwear that, in our opinion, has long-term customer appeal. As a result, we appeal to quality, style and designer label- oriented customers with relatively higher spending power. Unlike department stores, our prices are designed to appeal to value- oriented consumers seeking quality branded footwear typically found at department stores or branded retail outlets at higher everyday prices.

Our stores are strategically located in strip malls, outlet centers, large format retail centers and downtown locations, frequently in close proximity to other off-price apparel retailers that attract similar customers. Our stores averaged approximately 12,500 square feet in 2006. On average, over 20,000 pairs of shoes from over 100 brands are displayed on the selling floor at most of our stores, compared to a significantly smaller product offering at typical department stores. Over the last several years, we have focused on closing smaller stores as the leases expire and replacing them with larger stores in more attractive locations.  Our goal is to become a leading retailer of value-priced branded footwear in the United States.

The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires the appropriate application of certain accounting policies, many of which require us to make estimates and assumptions about future events which affect the results of our operations and the reported value of assets and liabilities. Since future events and their impact cannot be determined with certainty, the actual results

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may differ from our estimates.

We believe that our application of accounting policies, and the estimates inherently required therein, are reasonable. We constantly reevaluate these accounting policies and estimates, and adjustments are made when facts and circumstances dictate a change. Historically, we have found our application of accounting policies to be appropriate, and our actual results have not differed materially from those determined by using necessary estimates. Our significant accounting policies are described in Item 8 - Financial Statements and Supplementary Data in Note 2 to the accompanying consolidated financial statements. We believe that the following summarizes critical accounting policies which require significant estimates and assumptions in the preparation of our consolidated financial statements.

Revenue Recognition. We recognize revenue at the time the products are received by our customers in accordance with the provisions of Staff Accounting Bulletin ("SAB") No. 101, "Revenue Recognition in Financial Statements" as amended by SAB No. 104, "Revenue Recognition". Revenue is recognized for store sales at the point at which the customer receives and pays for the merchandise at the register with either cash or credit card.

Discounts offered to customers consist primarily of point of sale markdowns and are recorded at the time of the related sale as a reduction of revenue. Gift certificates are carried as a liability when sold and revenue is recognized when the gift certificate is redeemed or when the likelihood of redemption becomes remote. Similarly, customers may receive a store credit in exchange for returned goods. Store credits are carried as a liability until redeemed or when the likelihood of redemption becomes remote.

We record a reserve for estimated product returns based on historical return trends. Returns are recorded as a reduction of revenue. At December 30, 2006 and December 31, 2005 the reserve was $175,000 and $118,000, respectively. If actual returns are greater than those projected, additional sales returns reserves may be recorded in the future.

Inventory Valuation. Merchandise inventories are stated at the lower of average cost or market. We adjust inventory based on historical experience and current information in order to assure that inventory is recorded properly at the lower of average cost or market. The factors we consider include current sell through, seasonality and length of time held in inventory. The amount ultimately realized from the sale of our inventory could differ materially from our estimates.

Long-lived Assets. We review long-lived assets for impairment whenever events or changes in circumstances indicate that their carrying value may not be recoverable. We evaluate the carrying value of assets associated with stores which have been open at least 14 consecutive months. We record an impairment charge to write down the assets to their estimated fair value if the carrying values of such assets exceed their related expected undiscounted future cash flows. The impairment charge is recorded in general and administrative expenses. Our estimates and assumptions used in the projections are subject to a high degree of judgment and if actual results differ, additional losses may be recorded.

Self-insurance. We record an estimated liability for the self-insured portion of workers' compensation claims based on our historical experience and an evaluation of outstanding claims. On December 1, 2006, we changed to premium based insurance.

Cost of Sales. Cost of sales includes product costs, inbound freight, inventory shrinkage and store occupancy costs. It does not include purchasing, warehousing, distribution costs and inter-store freight transportation, which are included in selling, general and administrative expenses. Our gross margin may not be comparable to other retailers as some of these entities include purchasing, warehousing, distribution and inter-store freight transportation expenses in cost of sales.

Income Taxes. Income taxes are accounted for under the asset and liability method in accordance with Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." Deferred income taxes result primarily from deferred rent, fixed asset basis differences and differences between inventory valuation for tax purposes and the amount recorded under generally accepted accounting principles ("GAAP").

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We provide a valuation allowance when it is more likely than not that some or a portion or the entire deferred tax asset will not be realized. Based upon our history of earnings, we believe that the realization of our deferred tax asset is more likely than not and therefore we have not provided a valuation allowance for our deferred tax asset.

Share-Based Compensation. Effective January 1, 2006, we adopted the Financial Accounting Standards Board ("FASB") Statement No. 123(R), "Share-Based Payment" ("SFAS 123R"). The fair value of stock options granted is estimated at the date of grant using the Black-Scholes-Merton ("BSM") option valuation model. We record stock based compensation as an expense over the vesting period of the stock option.

 The following table sets forth statement of operations data determined in accordance with GAAP, and the relative percentages of net sales, the percentage increase or decrease, and the dollar increase or decrease for fiscal years 2006 and 2005.

Net Sales - Sales increased $28.8 million, or 28.1%, from $102.5 million for fiscal year 2005 to $131.3 million for fiscal year 2006. The sales growth is the result of increased sales of $18.3 million generated from 24 new stores opened in fiscal year 2006 and a comparable store sales increase of 3.9%, partially offset by a sales reduction of $2.9 million from closed stores. We opened eight new stores in the first half of fiscal year 2006 compared to sixteen new stores opened in the second half of fiscal year 2006. Comparable store sales are based upon stores open at least 13 consecutive months.

Gross Profit - Cost of sales includes landed merchandise and occupancy costs. Gross profit increased $8.1 million, or 22.6%, primarily as a result of increased sales. As a percent of sales, gross profit decreased from 35.0% for fiscal year 2005 to 33.5% for fiscal year 2006. The 1.5% decrease as a percent of sales resulted from higher occupancy expenses of 2.0%, primarily related to our new stores, offset by improved selling margins of 0.5%.

Selling Expenses - Selling expenses increased $6.2 million, or 27.8%, from $22.4 million for fiscal year 2005 to $28.6 million for fiscal year 2006, primarily because of expenses related to additional new stores. The $6.2 million increase in selling expenses is primarily due to increases of $3.3 million in store salaries, $1.1 million in advertising costs, $0.6 million in freight expenses, $0.3 million in payroll taxes and $0.3 million in credit card fees. As a percent of sales, selling expenses were unchanged at 21.8% for fiscal year 2005 and fiscal year 2006. As a percent of sales, advertising costs decreased from 4.7% for fiscal year 2005 to 4.5% for fiscal year 2006.

General and Administrative Expenses - General and administrative expenses increased $2.7 million, or 30.7%, from $8.7 million for fiscal year 2005 to $11.4 million for fiscal year 2006, primarily from expenses related

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to additional new stores. The $2.7 million increase in general and administrative expenses is primarily due to increases of $0.9 million in utilities costs, $0.6 million in legal and accounting fees, $0.5 million in administrative salaries and $0.3 million in warehouse fees. As a percent of sales, general and administrative expenses increased from 8.5% for fiscal year 2005 to 8.7% for fiscal year 2006. The 0.2% increase as a percent of sales is primarily due to an increase of 0.4% in utilities costs, partially offset by savings of 0.2% in miscellaneous expenses.

Interest Expense - Interest expense increased $0.4 million, or 72.6%, from $0.5 million for fiscal year 2005 to $0.9 million for fiscal year 2006 due to a higher average interest rate and increased borrowings under our revolving credit facility.

Income Tax Expense - The effective income tax rate increased from 39.1% for fiscal year 2005 to 41.6% for fiscal year 2006, primarily as a result of state provision adjustments reconciling the estimated effective rate utilized in the state and federal tax blend.

 The following table sets forth statement of operations data determined in accordance with GAAP, and the relative percentages of net sales, the percentage increase or decrease, and the dollar increase or decrease for fiscal years 2005 and 2004.

Net Sales - Net sales for 2005 increased 19.5 percent to $102.5 million compared to $85.8 million for 2004. This increase in net sales in 2005 is primarily due to a 6.9% increase in comparable store sales, increased sales of $13.3 million generated from new stores opened in 2005 and increased sales of $0.7 million due to relocating existing stores. These increases were partially offset by a reduction of $2.7 million related to the closing of underperforming stores.

The increase in comparable store sales was primarily driven by the increase in the women's and men's categories and to a lesser degree from the children's category and other accessories category, which were added to the product line in 2004.

Gross Profit - Cost of sales includes landed merchandise and occupancy costs. Gross profit for 2005 increased 20.0% to $35.9 million from $29.9 million in 2004. Gross profit as a percentage of net sales for 2005 increased to 35.0% compared to 34.9% for 2004. Despite absorbing $0.2 million of pre-opening costs in the fourth quarter related to our new stores in Dallas, Texas, as a percentage of net sales, occupancy costs decreased by 2.5 percentage points, which was partially offset by an increase in landed merchandise costs of 0.8% of revenues.

Selling Expenses - Selling expenses in 2005 increased $3.1 million, or 16.1%, to $22.4 million from $19.3 million in 2004. As a percentage of net sales, selling expenses were 21.8% of net sales in 2005, compared with 22.5% in 2004. The increased amount spent for selling expenses is primarily attributable to increases in labor costs

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of $1.9 million, advertising expenses of $0.5 million, freight expenses of $0.4 million and merchant fees for credit card sales of $0.2 million. Advertising decreased to 4.7% of net sales in 2005 compared to 5.0% in 2004, primarily due to a higher sales level in 2005.

General and Administrative Expenses - General and administrative expenses consist primarily of corporate and administrative expenses, including payroll, store utilities, warehousing costs, professional fees and insurance. General and administrative expenses increased $1.8 million to $8.7 million in 2005 from $6.9 million in 2004. The increase in 2005 was partially due to the relocation of our corporate offices to Southern California. We incurred moving expenses of $0.3 million and increased rent expense of $0.1 million. The remaining increase in general and administrative expenses in 2005 was primarily due to increased utilities expenses of $0.3 million due to higher energy costs, increased legal and accounting expenses of $0.2 million and an increase in other miscellaneous expenses of $0.6 million due to a higher level of overall business activity in 2005.

Interest Expense - Interest expense increased $0.2 million in 2005 due to higher average borrowings under our credit agreement and an increase in interest rates of 2.0% during the year.

Income Tax Expense - Income tax expense increased $0.4 million from $1.3 million in 2004 to $1.7 million in 2005, representing a change in the effective income tax rate from 39.3% to 39.1%. The increase in the income tax expense was primarily due to the increase in pre-tax income for 2005.

Our primary capital requirements are for inventory, store expansion, relocation and remodeling. Historically, cash flows from operations and available borrowings under our revolving credit facility have met our liquidity needs. Additionally, in March 2006, we sold 2,000,000 shares of our common stock in a public offering at $7.20 per share and received $12.8 million in net proceeds from the offering, of which $0.3 million was from warrants issued to one of the underwriters. We believe that these sources will be sufficient to fund currently anticipated cash requirements for the foreseeable future.

Net cash used in operating activities for fiscal years 2006, 2005 and 2004 was $16.0 million, $0.1 million and $0.4 million, respectively. The net cash used in operating activities in fiscal year 2006 was primarily the result of net income of $1.9 million, adjusted for depreciation and amortization of $1.9 million, increase in accounts payable of $2.1 million, increases in accrued expenses and deferred rent of $4.0 million, offset by an increase in inventory of $21.5 million. The increase in inventory as of December 30, 2006 was primarily attributable to the opening of 24 stores in fiscal year 2006.

Working capital at December 30, 2006 increased to $34.1 million from $23.3 million as of December 31, 2005. The increase was primarily due to using our net income and additional borrowings under our revolving credit facility to open 24 new stores. By opening these stores, we increased our inventories and tenant improvement allowances receivable.

Capital expenditures for fiscal years 2006, 2005 and 2004 were $10.0 million, $3.8 million and $1.0 million, respectively. Expenditures for fiscal year 2006 was primarily related to leasehold improvements and fixtures and equipment for the 24 new stores of approximately $8.0 million. Expenditures for fiscal year 2005 was primarily related to leasehold improvements and fixtures and equipment for the ten new stores of approximately $2.6 million, the remodel and upgrade of stores of approximately $0.6 million and the costs related to the relocation of two stores of approximately $0.6 million. Expenditures for fiscal year 2004 was primarily related to leasehold improvements and fixtures for the six new stores we opened.

We estimate that capital expenditures for fiscal year 2007 will be approximately $10 - $12 million, net of lease incentives. The actual amount of capital expenditures will depend in part upon the number of stores we open in fiscal year 2007 and the lease incentives received from landlords. The number of stores ultimately opened is in

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part dependent upon the availability of desirable locations and management's ability to negotiate acceptable lease terms. We plan on opening 20-25 new stores in fiscal year 2007.

We believe that our current operating cash flow, working capital, cash on hand and borrowings available under our revolving credit facility will be sufficient to meet our obligations in the ordinary course of business over the next 12 months, including capital expenditures and new store openings. Traditionally, we have experienced the largest use of cash from operating activities in the latter part of the third quarter and in the fourth quarter due to the build up of inventory to support the holiday season, resulting in additional borrowings under our revolving credit facility.

Cash provided by financing activities for fiscal years 2006, 2005 and 2004 was $26.2 million, $4.0 million and $1.5 million, respectively. The cash provided by financing activities in fiscal year 2006 primarily relates to the net increase in borrowings under our revolving credit facility and the net proceeds of $12.8 million from a public offering of 2 million shares of our common stock in March 2006. The cash provided by financing activities in fiscal year 2005 primarily relates to the net increase in borrowings under our revolving credit facility, the proceeds from the sale of convertible preferred stock and common stock warrants and the exercise of stock options. The cash provided by financing activities in fiscal year 2004 relates to the net increase in borrowings under our revolving credit facility.

We maintain a revolving credit facility with Wells Fargo Retail Finance, LLC that provides for borrowings of up to $30.0 million, including a $5.0 million sublimit for the issuance of letters of credit. The amount of borrowings under the revolving credit facility may be increased at our option up to a maximum of $50.0 million, so long as no event of default has occurred and upon payment of a fee of 0.25% of the amount by which we request that the credit facility be increased. Under the terms of the revolving credit facility, we are subject to an annual capital expenditures limit of $10.0 million. In each remaining year of the revolving credit facility, Wells Fargo has indicated that it will adjust our capital expenditure limit based upon our business plan. Borrowings under the revolving credit facility are based upon a percentage of eligible inventory less certain reserves. The minimum available reserve that we must maintain under the revolving credit facility is 7.5% times the maximum borrowing amount then in effect. Borrowings are secured by inventory, equipment, general intangibles and other rights to payments.

The revolving credit facility contains various restrictive covenants, including a limitation on capital expenditures. The revolving credit facility does not contain any restrictions on disposal of assets or closure of stores other than a restriction prohibiting us from taking action to convey, sell, lease, license, assign, transfer or otherwise dispose of, in one transaction or a series of transactions, all or substantially all of our assets. The revolving credit facility restricts us from incurring additional indebtedness, except to the extent provided in the revolving credit facility, from consigning any of our inventories to third parties under a bill and hold, sale or return, sale on approval or other conditional terms of sales and from making any distribution, declaration or payment of any dividend (in cash or other property, other than common stock).

Borrowings under our revolving credit facility bear interest at the prime rate or London Interbank Offered Rate (LIBOR) plus 1.25% to 1.75%, depending on our average excess availability. The average interest rate on outstanding borrowings at December 30, 2006 was 7.1%. As of December 30, 2006, approximately $5.6 million was available for advances under the revolving credit facility. As of December 30, 2006, we were in compliance with the financial covenants of our revolving credit facility.

The revolving credit facility expires in April 2011 and we have the ability to maintain this debt outstanding for more than one year. However, we have classified our borrowings under the revolving credit facility as a current liability as we are required by the terms of the loan agreement to maintain depository sweep accounts that are used to pay down the revolving credit facility on a daily basis.

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Stock Offerings

In March 2006, we sold 2,000,000 shares of our common stock in a public offering at $7.20 per share. In addition to the common stock sold by us, 1,450,000 shares of common stock held by our Chief Executive Officer (the "Selling Stockholder") were sold in the offering. In connection with the offering, we also issued to one of our underwriters warrants to purchase up to 150,000 shares of our common stock at an exercise price of $8.64 per share.

We used the net proceeds received from the offering of $12.8 million to open new stores, purchase inventory and for working capital. We did not receive any proceeds from the sale of 1,450,000 common stock shares by the Selling Stockholder.

On October 3, 2005, we entered into a Securities Purchase Agreement under which we issued and sold to an investor in a private placement 3,000 shares of our Series A Convertible Preferred Stock (the "Preferred Stock") and warrants to purchase up to 25% of the number of shares of our common stock issuable upon conversion of the Preferred Stock, for a purchase price of $3.0 million. The shares of Preferred Stock were converted by the investor into an aggregate of 571,428 shares of common stock at a conversion price of $5.25 per share in January 2006. The warrants entitle the investor to purchase up to 142,857 shares of common stock. Of this total, 71,429 warrants are exercisable at $8.00 per share and 71,428 warrants are exercisable at $11.00 per share. The warrants expire on October 3, 2008. The funds received from this transaction are being used for general working capital purposes.

The following table summarizes our significant contractual obligations as of December 30, 2006:

1. As part of our store operating leases, we are responsible for other costs including: insurance, taxes, promotional costs and common area and maintenance costs. These costs have not been included in the total obligations under operating leases. As a percentage of net sales, these costs were 3.9%, 3.3% and 3.7% for fiscal years 2006, 2005 and 2004, respectively.
2. Includes imputed interest of 5.9%.

We currently expect that anticipated cash flows from operations and available borrowings under our revolving credit facility will satisfy our cash requirements for at least the next 12 months. Our capital requirements may vary significantly from anticipated needs, depending upon such factors as operating results and the number and timing of new store openings.

If our expenses or capital requirements increase materially or if our cash flows from operations are materially lower than expected, we may need to seek additional financing, which may not be available on attractive terms or at

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all. See Item 1A. "Risk Factors" for a description of certain factors that may impact our expenses, capital requirements and cash flows from operations.

In February 2007, the Financial Accounting Standards Board ("FASB") issued Statements of Financial Accounting Standards ("SFAS") No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115". SFAS No. 159 permits entities to choose to measure eligible items at fair value at specified election dates and report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. Management is currently evaluating the effect that adoption of this statement will have on the Company's consolidated financial position and results of operations.

In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements". This statement clarifies the definition of fair value, establishes a framework for measuring fair value, and expands the disclosures on fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. We have not determined the effect, if any, the adoption of this statement will have on our results of operations or financial position.

In July 2006, the FASB issued FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109" ("FIN 48"). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in a company's financial statements in accordance with SFAS 109, "Accounting for Income Taxes". FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. We adopted FIN 48 on January 1, 2007. We estimate the impact of adopting FIN 48 on our consolidated financial statements to be an adjustment to retained earnings of approximately $0.2 million to $0.3 million.

Our exposure to market risks includes changes in U.S. interest rates and foreign exchange rates. We do not engage in financial transactions for trading or speculative purposes.

Interest Rate Risk - The interest payable on our revolving credit facility is based on variable interest rates and therefore is affected by changes in market rates. The impact on earnings or cash flow during the next fiscal year from a change of 100 basis points in the interest rate would not be significant. We do not use derivative financial instruments in our investment portfolio and believe that our market risk is insignificant.

Foreign Currency Risks - We did not have any foreign exchange contracts outstanding at December 30, 2006. We make minimal purchases outside of the United States that involve foreign currencies and, therefore, have only minimal exposure to foreign currency exchange risks. We do not typically hedge against foreign currency risks and believe that foreign currency exchange risk is insignificant.

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Item 8.    Financial Statements and Supplementary Data

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Report of Independent Registered Public Accounting Firm

To the Board of Directors and Stockholders of Shoe Pavilion, Inc.

We have audited the accompanying consolidated balance sheets of Shoe Pavilion, Inc. and subsidiary (the "Company") as of December 30, 2006 and December 31, 2005, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 30, 2006. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 30, 2006 and December 31, 2005, and the results of its operations and its cash flows for each of the three years in the period ended December 30, 2006 in conformity with accounting principles generally accepted in the United States of America.

As discussed in Note 2 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 123(R), "Share-Based Payment", effective January 1, 2006.

As discussed in Note 12, the accompanying 2005 and 2004 consolidated statements of cash flows have been restated.

/s/ DELOITTE & TOUCHE LLP

Los Angeles, California
March 7, 2007

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Shoe Pavilion, Inc.

Consolidated Balance Sheets
(In thousands, except share data)