In accordance with SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS No. 133"), and SFAS No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities," the Company recognizes all derivatives on the balance sheet at fair value. Although the swap essentially provides for matched terms to its underlying obligation, and effectively mitigates its variability, it currently does not qualify for hedge accounting under SFAS No. 133.

The interest rate swap will expire February 2, 2009. The net income or expense from the exchange of interest rate payments is included in interest expense. The estimated fair value of the interest rate swap agreement, based on dealer quotes, at August 4, 2007 was a gain of $10,000 and represents the amount the Company would receive if the agreement was terminated as of that date. As of August 4, 2007, the Company reflected a derivative asset in other assets for such amount to recognize the fair value of the interest rate swap. Changes in the fair value of derivatives not designated as qualifying cash flow hedges are reported in interest expense. Accordingly, interest expense for the twenty-six weeks ended August 4, 2007 includes an unfavorable fair value adjustment of $88,000 related to the interest rate swap.

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7. INCOME TAXES

The Company has an unrecognized tax benefit at adoption of FIN 48 of approximately $2.4 million, exclusive of interest, reported in the Condensed Balance Sheets in Deferred Income Taxes and Other Liabilities, which did not change significantly during the six months ended August 4, 2007. Of this amount, the amount that would impact the Company's effective tax rate, if recognized, is $0.2 million. The adoption of FIN 48 effective February 4, 2007 resulted in an immaterial change in retained earnings, after the application of a valuation allowance. The Company estimates that the unrecognized tax benefit will not change significantly within the next twelve months.

The Company's policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense. Total accrued interest included in the FIN 48 liability was $0.3 million at February 4, 2007 and August 4, 2007. No penalties were accrued at February 4, 2007 or August 4, 2007.

The Company files its tax returns as prescribed by the tax laws of the jurisdiction in which it operates. The Company is no longer subject to U.S. federal tax examinations for years before fiscal 2004 while the fiscal 2004 through fiscal 2006 tax years are still subject to examination. For the various state jurisdictions, tax years from fiscal 2002 through fiscal 2006 remain open to examination as well, although the Company believes any potential assessment would not have a material impact on the Company's financial position or results of operations.

Options with an exercise price greater than the average market price of the Company's common stock during the period, or outstanding in a period in which the Company reports a net loss, are excluded from the computation of the weighted average number of shares on a diluted basis, as such options are anti-dilutive.

Weighted average options outstanding of approximately 1,006,800 are excluded from the computation of dilutive shares due to the Company's net loss position in the thirteen weeks ended August 4, 2007. Had the Company reported profit in this period, approximately 30,000 options with exercise prices greater than the average market price of the Company's common stock during the thirteen weeks ended August 4, 2007 would have been excluded from the computation of weighted average number of shares, and the approximate effect of dilutive options would have been 375,300 shares for the thirteen weeks ended August 4, 2007. Approximately 469,800 options with an exercise price greater than the average market price of the Company's common stock have been excluded from the computation of weighted average number of shares for the thirteen weeks ended July 29, 2006.

Weighted average options outstanding of approximately 1,077,700 and 1,005,100 were excluded from the computation of dilutive shares due to the Company's net loss position in the twenty-six weeks ended August 4, 2007 and July 29, 2006, respectively. Had the Company reported profit for these periods, approximately zero and 356,800 options with exercise prices greater than the average market price of the Company's common stock during the twenty-six weeks ended August 4, 2007 and July 29, 2006, respectively, would have been excluded from the computation of weighted average number of shares, and the approximate effect of dilutive options would have been 404,200 and 323,600 shares for the twenty-six weeks ended August 4, 2007 and July 29, 2006, respectively.

On September 19, 2005, the Company became subject to a complaint filed in the Superior Court of California for the County of Santa Cruz alleging violation of California law regarding payment of accrued vacation upon termination of employment. The complaint seeks wage payments for employees who allegedly forfeited accrued vacation, waiting time penalties, interest, injunctive relief and costs. The Company believed settlement of this matter was in its best interests and entered into a memorandum of understanding for class settlement which was approved at a hearing on September 29, 2006. The Company accrued $1.8 million during the fourth quarter of fiscal 2005 for estimated legal fees and settlement costs and an additional $60,000 in the fourth quarter of fiscal 2006. All payments were made in December 2006 and a final accounting for unclaimed payments took place in the second quarter of fiscal 2007. All expense accounting related to this settlement is reflected in the financial statements as of August 4, 2007. The final expense accounting did not have a material adverse effect on the Company's business, financial condition or results of operations.

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The Company is party to other legal proceedings and claims which arise during the ordinary course of business. In the opinion of management, the ultimate outcome of such litigation and claims are not expected to have a material adverse effect on the Company's financial position or results of its operations.

In July 2007, the Company began subleasing a 58,000 square foot building in Elk Grove, California from Safeway Inc. The Company expects to spend approximately $4.0 million on fixtures and leasehold improvements to convert the building to the Gottschalks' format and the store is expected to open early November 2007.

As of August 4, 2007, the Company had issued a total of $1.5 million of standby letters of credit and documentary letters of credit totaling $3.7 million. Management believes that the likelihood of any draws under the standby letters of credit is remote. Documentary letters of credit are issued in the ordinary course of business to facilitate the purchase of merchandise from overseas suppliers. The suppliers draw against the documentary letters of credit upon delivery of the merchandise to the Company's customs broker at a United States port.

The Company closed one underperforming store in the Seattle/Tacoma market during the first quarter of fiscal 2006 and one underperforming store in the Seattle metro-area market during the third quarter of fiscal 2006. These closures are reported as discontinued operations due to the Company's exit from the respective market areas. The loss from operations of discontinued stores includes only revenues generated from, and expenses directly associated with, the operations of such stores and consists of the following:

Gain on store closures of $72,000 in fiscal 2006, which includes a net gain on the sale of the building associated with the store closed during the first quarter of fiscal 2006 of approximately $147,000, was partially offset by store closure costs of approximately $75,000 related to that store and one store closed at the end of fiscal 2005, primarily consisting of severance and other incremental costs associated with the store closing.

In addition, the Company closed one store in Wasilla, Alaska during the first quarter of fiscal 2007. This closure is not reported as discontinued operations due to the shift of revenues to other stores in the market area.

The Company will close one store in Tacoma, Washington during the third quarter of fiscal 2007. This closure will not be reported as discontinued operations due to the expected shift of revenues to another store in the market area.

In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements," (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS 157 applies under other accounting pronouncements that require or permit fair value measurement. SFAS 157 does not require any new fair value measurement and the Company is currently evaluating the impact, if any, of SFAS 157 on its financial position, results of operations and cash flows. SFAS 157 requires prospective application for fiscal years beginning after November 15, 2007.

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In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities," (SFAS 159). This statement permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to reduce fluctuation in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. Most of the provisions of SFAS 159 apply only to entities that elect the fair value option. However, the amendment to FASB Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities," applies to all entities with available-for-sale and trading securities. SFAS 159 is effective for Gottschalks Inc. on February 3, 2008. The Company is currently evaluating the impact, if any, of SFAS 159 on its financial position, results of operations, and cash flows.

The following is management's discussion and analysis of significant factors which have affected the Company's financial position and its results of operations for the periods presented in the accompanying condensed financial statements. The Company's operating results, like those of most retailers, are subject to seasonal influences, with the major portion of sales, gross margin and operating results realized during the fourth quarter of each fiscal year. Accordingly, performance for the thirteen and twenty-six week periods ended August 4, 2007 (hereinafter referred to as the "second quarter" and "first half" of fiscal 2007, respectively), is not necessarily indicative of performance for the remainder of the year.

The Company's financial statements are based on the application of critical accounting policies, many of which require management to make significant estimates and assumptions. Some of these critical accounting policies involve a higher degree of judgment or complexity than its other accounting policies. The Company evaluates its estimates on an ongoing basis, including those related to its revenue recognition policy, the carrying value of its merchandise inventories, and the valuation of its long-lived assets, including goodwill, and its deferred tax assets. The impact and associated risks related to these policies on the Company's business operations are described more fully in the Company's 2006 Annual Report on Form 10-K. The Company believes there have been no changes to the critical accounting policies described therein.

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Results of Operations

The following table sets forth the Company's Statements of Operations as a percent of net sales:

13

Second Quarter of Fiscal 2007 Compared to Second Quarter of Fiscal 2006

The Company operated 59 department stores and 4 specialty stores as of the end of the second quarter of fiscal 2007, as compared to 62 department stores and 6 specialty stores as of the end of the second quarter of fiscal 2006.

Net credit revenues related to the Company's proprietary credit cards increased approximately $0.4 million in the second quarter of fiscal 2007 as compared to the second quarter of fiscal 2006. As a percent of net sales, net credit revenues were 0.8% of net sales in the second quarter of fiscal 2007 and 0.5% in the second quarter of fiscal 2006. This increase is attributable to the new Credit Card Program Agreement with HSBC, effective February 4, 2007, which provides for an enhanced percentage paid to the Company based on net sales.

Leased department sales are presented net of the related costs for financial reporting purposes. Net leased department revenues generated by the Company's various leased departments in the second quarter of fiscal 2007 was $0.1 million lower than the second quarter of fiscal 2006.

Sales generated in the Company's leased departments in the second quarter of fiscal 2007 consisted primarily of sales in the fine jewelry departments and the beauty salons. These leased department sales were $4.4 million in the second quarter of fiscal 2007 and $4.9 million in the second quarter of fiscal 2006.

Cost of sales from continuing operations, which includes costs associated with the purchasing, handling, storage and distribution of merchandise, decreased by approximately $2.2 million to $96.3 million in the second quarter of fiscal 2007 as compared to $98.5 million in the second quarter of fiscal 2006. The 2.2% decrease is attributable to decreased sales. The Company's gross margin percentage was 33.6% in the second quarter of fiscal 2007 and 35.5% in the second quarter of fiscal 2006. The decrease is a result of more net markdowns in the second quarter of fiscal 2007 compared to second quarter of fiscal 2006.

Selling, general and administrative expenses from continuing operations increased by approximately $0.8 million to $50.6 million in the second quarter of fiscal 2007 as compared to $49.8 million in the second quarter of fiscal 2006, an increase of 1.5%. The increase is primarily attributable to increased professional fees related to the Company's strategic initiatives in the second quarter of fiscal 2007 (for further discussion see the Company's 2006 Annual Report on Form 10-K, page 8, "Special Strategic Committee") and to a $0.4 million payment received in the second quarter of fiscal 2006 as a member of a settled lawsuit against Visa U.S.A. Inc. and MasterCard International Incorporated.

As a percent of net sales, selling, general and administrative expenses from continuing operations increased in the second quarter of fiscal 2007 by 2.3% to 34.9% as compared to the second quarter of fiscal 2006.

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Gain on Sale of Aircraft

The Company sold a corporate aircraft on June 30, 2006 for $1,037,000 (net of selling costs) that resulted in a gain of $946,000 ($579,000 after tax). The gain is reflected in operating income as the aircraft was reported as an operating asset.

Depreciation and amortization expense, which includes the amortization (accretion) of intangible assets other than goodwill, was $3.7 million in the second quarter of fiscal 2007 as compared to $3.8 million in the second quarter of fiscal 2006. As a percent of net sales, depreciation and amortization expense increased 0.1% to 2.5% in the second quarter of fiscal 2007 as compared to 2.4% in the second quarter of fiscal 2006.

New store opening costs, which are expensed as incurred, typically include costs such as payroll and fringe benefits for store associates, store rents, temporary storage, utilities, travel, grand opening advertising, credit solicitation and other costs incurred prior to the opening of a store. The Company recognized $15,000 of costs in the second quarter of fiscal 2007 in connection with a new store in Elk Grove, California, which is scheduled to open in the fourth quarter 2007. The Company recognized new store opening costs totaling $52,000 in the second quarter of fiscal 2006 in connection with the opening of a new store in Eugene, Oregon. The store opened August 31, 2006.

Interest expense, which includes the amortization of deferred financing costs, increased by approximately $0.1 million to $2.5 million in the second quarter of fiscal 2007 as compared to $2.4 million in the second quarter of fiscal 2006, an increase of 4.6%. As a percent of net sales, interest expense increased to 1.7% in the second quarter of fiscal 2007 as compared to 1.5% in the second quarter of fiscal 2006. These increases are primarily due to continued increases in interest rates charged on the Company's variable rate debt. The weighted average interest rate applicable to the revolving credit facility was 7.1% in the second quarter of fiscal 2007 (7.1% at August 4, 2007) as compared to 7.0% in the second quarter of fiscal 2006.

Miscellaneous income, which includes the amortization of deferred income and other non-operating income and expense amounts, was $0.3 million in the second quarter of fiscal 2007 and $0.4 million in the second quarter of fiscal 2006.

The Company's interim effective tax rates from continuing operations was 30.2% in the second quarter of fiscal 2007 and 38.8% in the second quarter of fiscal 2006. The decrease in the interim effective tax rate is primarily due to the expiration of certain federal tax credit programs during the first half of fiscal 2006, and the subsequent restoration of such programs in the fourth quarter of 2006 for calendar years 2006 and 2007, along with expected earnings below those of last year.

15

Discontinued Operations

The Company closed one underperforming store in the Seattle metro-area market during the third quarter of fiscal 2006. This closure is being reported as discontinued operations due to the Company's exit from the market area. The loss from operations of discontinued stores includes only revenues generated from, and expenses directly associated with, the operations of such stores and consists of the following:

In addition, the Company closed one store in Wasilla, Alaska during the first quarter of fiscal 2007, and one store each in Danville, California and Moscow, Idaho in the third and fourth quarters of fiscal 2006. These closures are not reported as discontinued operations due to the shift of revenues to other stores in their respective market areas. The Company will close one store in Tacoma, Washington during the third quarter of fiscal 2007. This closure will not be reported as discontinued operations due to the expected shift of revenues to another store in the market area.

As a result of the foregoing, the Company reported a net loss of approximately $4.8 million in the second quarter of fiscal 2007 as compared to net income of $0.5 million in the second quarter of fiscal 2006. On a per share basis, the net loss was $0.35 per share (basic and diluted) in the second quarter of fiscal 2007 as compared to net income of $0.04 per share (basic and diluted) in the second quarter of fiscal 2006.

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First Half of Fiscal 2007 Compared to First Half of Fiscal 2006

Net Sales

Net sales decreased by approximately $8.2 million to $286.8 million in the first half of fiscal 2007 as compared to $294.9 million in the first half of fiscal 2006, a decrease of 2.8%. The best performing merchandise categories in the first half were dresses, special sizes, shoes and children's.  Home merchandise sales were below the same period last year. Comparable store sales for the first half of fiscal 2007, which includes sales for stores open for the full period in both years, were down 2.4% as compared to the first half of fiscal 2006.

The Company operated 59 department stores and 4 specialty stores as of the end of the first half of fiscal 2007, as compared to 62 department stores and 6 specialty stores as of the end of the first half of fiscal 2006.

Net credit revenues related to the Company's proprietary credit cards increased by $0.9 million or 63.9% for the first half of fiscal 2007 as compared to the first half of fiscal 2006. As a percent of net sales, net credit revenues were 0.8% in the first half of fiscal 2007 and 0.5% in the first half of fiscal 2006. This increase is attributable to the new Credit Card Program Agreement with HSBC, effective February 4, 2007, which provides for enhanced percentage paid to the Company based on net sales.

Leased department sales are presented net of the related costs for financial reporting purposes. Net leased department revenues generated by the Company's various leased departments decreased by $0.2 million to $1.3 million in the first half of fiscal 2007 as compared to the first half of fiscal 2006.

Sales generated in the Company's leased departments in the first half of fiscal 2007 consisted primarily of sales in the fine jewelry departments and the beauty salons. These leased department sales were $9.0 million in the first half of fiscal 2007 and $10.2 million in the first half of fiscal 2006.

Cost of sales, which includes costs associated with the buying, handling, storage and distribution of merchandise, decreased by approximately $1.7 million to $191.5 million in the first half of fiscal 2007 as compared to $193.2 million in the first half of fiscal 2006, a decrease of 0.9%. The Company's gross margin percentage decreased to 33.2% in the first half of fiscal 2007 as compared to 34.5% in the first half of fiscal 2006. The decrease is a result of more net markdowns in the first half of fiscal 2007 compared to the first half of fiscal 2006.

Selling, general and administrative expenses increased by approximately $0.6 million to $99.9 million in the first half of fiscal 2007 as compared to $99.3 million in the first half of fiscal 2006, an increase of 0.6%. The increase is primarily due to the $0.4 million received in fiscal 2006 as a member of a class of a settled lawsuit against Visa U.S.A. Inc. and MasterCard International Incorporated and expense reductions in fiscal 2007 related to closed stores partially offset by increase in professional fees related to the Company's strategic initiatives. As a percent of net sales, selling, general and administrative expenses in the first half of fiscal 2007 increased to 34.9% as compared to 33.7% in the first half of fiscal 2006.

The Company sold a corporate aircraft on June 30, 2006 for $1,037,000 (net of selling costs) that resulted in a gain of $946,000 ($579,000 after tax). The gain is reflected in operating income as the aircraft was reported as an operating asset.

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Depreciation and Amortization

Depreciation and amortization expense, which includes the amortization (accretion) of intangible assets other than goodwill, was $7.6 million in the first half of fiscal 2007 as compared to $7.3 million in the first half of fiscal 2006. As a percent of net sales, depreciation and amortization expense increased to 2.6% in the first half of fiscal 2007 as compared to 2.5% in the first half of fiscal 2006. The dollar increase is a result of the depreciation of capital additions related to the Company's Eugene, Oregon store opened in the third quarter of fiscal 2006 and major remodel projects at certain existing stores during the second half of fiscal 2006. The Company also made substantial upgrades to its planning and allocations and point of sale systems which were placed in service at various dates during the second and first half of fiscal 2006 and 2007, respectively.

New store opening costs, which are expensed as incurred, typically include costs such as payroll and fringe benefits for store associates, store rents, temporary storage, utilities, travel, grand opening advertising, credit solicitation and other costs incurred prior to the opening of a store. The Company recognized $15,000 of costs in the first half of fiscal 2007 in connection with a new store in Elk Grove, California, which is scheduled to open in the fourth quarter 2007. The Company recognized new store opening costs totaling $52,000 million in connection with the opening of a new store in Eugene, Oregon in the first half of fiscal 2006. The store opened August 31, 2006.

Interest expense, which includes the amortization of deferred financing costs, increased by approximately $0.5 million to $5.1 million in the first half of fiscal 2007 as compared to $4.7 million in the first half of fiscal 2006, an increase of 9.9%. As a percent of net sales, interest expense increased to 1.8% in the first half of fiscal 2006 as compared to 1.6% in the first half of fiscal 2006. These increases are primarily due to a $0.1 million unfavorable fair value adjustment on the Company's $25 million notional amount interest swap for the first half of fiscal 2007 versus a $0.3 favorable adjustment in the first half of fiscal 2006. The increases are also due to continued interest rate increases in the Company's variable rate debt despite the first half of fiscal 2006 including a one-time charge of $0.2 million related to the early termination of the Company's 9.39% mortgages. The Company anticipates that its interest rate swap will continue to provide protection against these rising interest rates for the near term. The weighted average interest rate applicable to the revolving credit facility was 7.2% in the first half of fiscal 2007 (7.1% at August 4, 2007) as compared to 7.0% in the first half of fiscal 2006.

Miscellaneous income, which includes the amortization of deferred income and other non-operating income and expense amounts, was $0.6 million in the first half of fiscal 2007 and $0.8 million in the first half of fiscal 2006.

The Company's interim effective tax rates from continuing operations of 30.2% in the first half of fiscal 2007 and 38.8% in the first half of fiscal 2006 relate to the net losses incurred in those periods and represent the Company's best estimates of the annual effective tax rates for those fiscal periods. The decrease in the interim effective tax rate is primarily due to the expiration of certain federal tax credit programs during the first half of fiscal 2006, and the subsequent restoration of such programs in the fourth quarter of 2006 for calendar years 2006 and 2007, along with expected earnings below those of last year.

18

Discontinued Operations

The Company closed one underperforming store in the Seattle metro-area during the third quarter of fiscal 2006 and one underperforming store in the Seattle/Tacoma market during the first quarter of fiscal 2006. These closures are reported as discontinued operations due to the Company's exit from the respective market areas. The loss from operations of discontinued stores includes only revenues generated from, and expenses directly associated with, the operations of such stores and consists of the following:

Gain on store closures of $72,000 in fiscal 2006, which includes a net gain on the sale of the building associated with the store closed during the first quarter of fiscal 2006 of approximately $147,000, was partially offset by store closure costs of approximately $75,000 related to that store and one store closed at the end of fiscal 2005, primarily consisting of severance pay and other incremental costs associated with the store closing.

In addition, the Company closed one store in Wasilla, Alaska during the first quarter of fiscal 2007, and one store each in Danville, California and Moscow, Idaho in the third and fourth quarters of fiscal 2006. These closures are not reported as discontinued operations due to the shift of revenues to other stores in their respective market areas. The Company will close one store in Tacoma, Washington during the third quarter of fiscal 2007. This closure will not be reported as discontinued operations due to the expected shift of revenues to another store in the market area.

As a result of the foregoing, the Company reported a net loss of approximately $9.4 million in the first half of fiscal 2007 as compared to net loss of $3.5 million in the first half of fiscal 2006. On a per share basis (basic and diluted), the net loss was $0.69 per share in the first half of fiscal 2007 as compared to $0.26 per share in the first half of fiscal 2006.

As described more fully in the Company's 2006 Annual Report on Form 10-K and Note 5 to the accompanying financial statements, the Company's working capital requirements are currently met through a combination of cash provided by operations, borrowings under its senior revolving credit facility, and by short-term trade and factor credit. The Company's liquidity position, like that of most retailers, is affected by seasonal influences, with the greatest portion of cash from operations generated in the fourth quarter of each fiscal year.

The Company's increase of cash from operations during the first half of fiscal 2007 is primarily the result of decreased inventory and a decrease in receivables after a build-up from the holiday season at the beginning of the year, and a decrease in trade accounts payable and accrued expenses resulting from the payment of December 2006 sales and use tax in January 2007. Since the fiscal year ended February 3, 2007, the payments, due and paid January 31, 2007, were made in fiscal 2006. December 2005 sales and use tax payments were made in fiscal February 2006.

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The Company's use of cash during the first half of fiscal 2006 is primarily the result of the build-up of spring and summer inventory after the winter holiday season and for the opening of the Eugene, Oregon store.

Net cash used in investing activities is the result of capital spending during the first half of fiscal 2007 primarily relating to renovations of the Clovis, California and Hanford, California stores and upgrades to the Company's point of sale systems. Capital spending during the first half of fiscal 2006 relates to renovations of primarily accessory and shoe areas of certain key stores and to upgrades to the Company's planning and allocations and point of sale systems which was offset by proceeds related to the sale of a corporate aircraft and sale of an owned store in the Seattle/Tacoma market.

Net cash used by financing activities during the first half of fiscal 2007 primarily relates to fewer outstanding checks at quarter end due to the timing of a check run as it relates to fiscal quarter end, partially offset by routine borrowings on the revolving credit facility and increased stock option exercises. In fiscal 2006, increases to the Company's revolving line of credit relate to the pay-off of the 9.39% mortgages on four of the Company's owned properties of approximately $16.6 million.

The credit facility, as amended, consists of a revolving credit facility of up to $172 million (including a $20 million letter of credit sub-facility) and a fully funded term loan of $9 million. Borrowings under the revolving credit facility, as amended, are limited to the sum of (a) a specified percentage of eligible credit card receivables, (b) the lesser of specified percentages of (i) the cost of eligible inventory and (ii) the net recovery value of the inventory, as determined by periodic valuation performed by an independent appraiser, and (c) the lesser of (i) up to 60% of the fair market value of the designated properties and (ii) $21.6 million. Such borrowings are further limited by a requirement to maintain a minimum of $5 million of excess availability at all times, and other reserves that are in effect. As of August 4, 2007, outstanding borrowings under the credit facility totaled $86.5 million, and excess borrowing availability under the credit facility, after the deduction of the minimum availability requirement and other reserves, totaled $42.8 million. Substantially all of the Company's assets, including its merchandise inventories, are pledged under the credit facility. The credit facility expires February 2, 2009, and provides for an optional extension through February 2, 2011.

As of August 4, 2007, interest charged on amounts borrowed under the revolving portion of the credit facility are at the prime rate, or at the Company's option, at the applicable LIBOR rate plus 1.25% per annum, and interest charged on the term loan is a fixed rate of 6.6% per annum. In addition, the Company pays an unused commitment fee equal to 0.375% per annum on the average unused daily balance of the revolving portion of the credit facility. The interest rate applicable to the revolving portion of the credit facility is adjusted upwards or downwards on a quarterly basis based on a pricing matrix which is tied to the Company's daily average excess availability for the preceding fiscal quarter (as defined in the agreement). Under the pricing matrix, the applicable interest rate could range from a rate as low as prime or LIBOR plus 1.25%, to as high as prime plus 0.5%, or LIBOR plus 2.5%.

The credit facility, as amended, contains restrictive financial and operating covenants, including the requirement to maintain a fixed charge coverage ratio of 1:1 (as defined in the agreement) if the Company's excess borrowing availability is below $15 million. As of August 4, 2007, management believes the Company was in compliance with all restrictive financial covenants applicable to the credit facility.

The Company signed a Commitment Letter from General Electric Capital Corporation to refinance its existing credit facility on August 29, 2007.

The new credit facility consists of a $200 million senior secured revolving credit facility (including a $20 million letter of credit sub-facility). Borrowings under the revolving credit facility are limited to the sum of (a) a specified percentage of eligible credit card receivables, (b) a specified percentage of the net recovery value of eligible inventory, and (c) 65% of the fair market value of the Company's real estate. Such borrowings are further limited by a requirement to maintain a minimum of $15 million of excess availability at all times, and other reserves.

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Substantially all of the Company's assets, including its merchandise inventories, are pledged under the credit facility.

Interest charges on the new credit facility are consistent with the current credit facility with the exception that the Company will pay a reduced unused commitment fee equal to 0.20% per annum on the average unused daily balance.

The new credit facility contains restrictive financial and operating covenants consistent with the current credit facility. Loan fees related to the new credit facility include a 0.5% origination fee, $1,000,000, and a $37,500 annual administration fee. The agreement has a five year term expiring in September 2012.

Terms of the new credit facility are still under review and subject to the final signed agreement.

The success of the Company's business is partially dependent upon the adequacy of trade credit offered by key factors and vendors, the vendors' ability and willingness to sell its products at favorable prices and terms, and the willingness of vendors to ship merchandise on a timely basis. The Company has been able to purchase adequate levels of merchandise to support its operations and expects the level of trade credit to be sufficient to support its operations in the foreseeable future. Restrictions to the amount of trade credit granted by key factors and vendors can adversely impact the volume of merchandise the Company is able to purchase. Any significant reduction in the volume of merchandise the Company is able to purchase, or a prolonged disruption in the timing of when merchandise is received, could have a material adverse affect on the Company's business, liquidity position, and results of operations.

The Company may consider various other sources of liquidity in the future, including but not limited to the issuance of additional securities that might have a dilutive effect on existing shareholders, or incurring additional indebtedness which would increase the Company's leverage.

The Company's primary uses of liquidity are for working capital, debt service requirements and capital expenditures. Capital expenditures during the first half of fiscal 2007 totaling $7.2 million primarily relate to renovations of the Clovis, California and Hanford, California stores and upgrades to the Company's point of sale systems.

As of August 4, 2007, the Company had issued a total of $1.5 million of standby letters of credit and documentary letters of credit totaling $3.7 million. The standby letters of credit were issued to provide collateral for workers compensation insurance policies. Management believes that the likelihood of any draws under the standby letters of credit is remote. Documentary letters of credit are issued in the ordinary course of business to facilitate the purchase of merchandise from overseas suppliers. The supplier draws against the documentary letter of credit upon delivery of the merchandise.

Subject to the previously described risks and uncertainties relative to the Company's sources of liquidity, management currently believes that the described sources of liquidity, including cash generated by operations, liquidity provided by the revolving credit facility and other financial resources, will be adequate to meet the Company's planned cash requirements for at least the next 12 months. However, the Company's actual results may differ from the expectations set forth in the preceding sentence. The Company's liquidity and capital resources may be affected by a number of factors and risks (many of which are beyond the control of the Company), including but not limited to the availability of adequate borrowing capacity, adequate cash flows generated by operations and the adequacy of factor and trade credit. If the estimates or assumptions relative to any one of these sources of liquidity are not realized, or if these sources of liquidity are significantly reduced or eliminated, the Company's liquidity position, financial condition and results of operations will be materially adversely affected.

21

Value Improvement Program

As discussed more fully in Part II, Item 7 of the Company's 2006 Annual Report on Form 10-K, the Company formed a Special Strategic Committee comprised of Gottschalks' independent directors in the fourth quarter of 2006. The committee conducted a review of various strategic alternatives to maximize shareholder value, including a revised business plan, operating partnerships, joint ventures, strategic alliances, share repurchase, recapitalization, and the sale or merger of the Company. On August 30, 2007, the Company announced that the Committee had concluded its evaluation of strategic alternatives and determined it was in the best interest of Gottschalks' shareholders to aggressively focus on a revised business plan. With this decision, the Strategic Committee has been dissolved.

In connection with the conclusion of the strategic alternatives review process, the Company announced its new Value Improvement Program (V.I.P.). Goals of the V.I.P. include increasing top line performance, improving operating margin, and maximizing shareholder value. The V.I.P., developed with the assistance of Financo Inc., includes an aggressive new store opening schedule, new creative and targeted marketing programs, significant enhancements to information technology systems and a plan to better utilize the Company's owned real estate. The Company also plans to accelerate closings of poor performing stores, including the closing of two stores at their lease expirations in the second quarter of fiscal 2008. Under the V.I.P., the Board of Directors is also evaluating a share repurchase program that would be funded through the Company's cash and credit facility. If approved, the Company may begin repurchasing shares in the third quarter of fiscal 2007.

The V.I.P. will be carried out over the remainder of the year and into fiscal 2008, and will be funded through the refinancing of the Company's credit facility with General Electric Capital Corporation (discussed previously in Sources of Liquidity). The Company anticipates seeing near-term benefits to its top and bottom lines in the second half of fiscal 2008 with results more fully realized in fiscal 2009.

Certain statements contained in this Quarterly Report on Form 10-Q are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 and the Company intends that such forward-looking statements be subject to the safe harbors created thereby. These forward-looking statements include the plans and objectives of management for future operations and the future economic performance of the Company that involve risks and uncertainties. In some instances, such statements may be identified by the use of forward-looking terminology such as "may," "will," "expects," "believes," "intends," "projects," "forecasts," "plans," "estimates," "anticipates," "continues," "targets," or similar terms, variations of such terms or the negative of such terms. Such statements are based on management's current expectations and are subject to a number of factors and uncertainties which could cause actual results to differ materially from those described in the forward-looking statements, including, without limitation, the Company's ability to meet debt obligations and adhere to the restrictions and covenants imposed under its various debt agreements; the timely receipt of merchandise and the Company's ability to obtain adequate trade credit from its key factors and vendors; risks arising from general economic and market conditions (including uncertainties arising from future acts of terrorism or war); the ability to modify operations in order to minimize the adverse impact of rising costs, including but not limited to health care, workers' compensation, property and casualty insurance, unemployment insurance, and utilities costs; the effects of seasonality and weather conditions, changing consumer trends and preferences, competition, consumer credit; the Company's dependence on its key personnel; and general labor conditions, all of which are described in more detail under the caption "Risk Factors" in Item 1A. "Business" in the Company's 2006 Annual Report on Form 10-K and other reports filed by the Company with the Securities and Exchange Commission. THE COMPANY PRESENTLY DOES NOT INTEND TO UPDATE THESE STATEMENTS AND UNDERTAKES NO DUTY TO ANY PERSON TO EFFECT ANY SUCH UPDATE UNDER ANY CIRCUMSTANCES.

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Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

As described more fully in Part II, Item 7A of the Company's 2006 Annual Report on Form 10-K, the Company is exposed to market risks in the normal course of business due to changes in interest rates on short-term borrowings under its revolving line of credit and on certain of its long-term borrowing arrangements. Based on current market conditions, management does not believe there has been a material change in the Company's exposure to interest rate risks as described in that report.

The Company maintains "disclosure controls and procedures," for purposes of Rules 13a-14 and 15d-14 of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), that are designed to ensure that information required to be disclosed in the Company's reports, pursuant to the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and that such information is accumulated and communicated to the Company's management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding the required disclosures. Management necessarily applied its judgment in assessing the costs and benefits of such controls and procedures, which by their nature can provide only reasonable assurance regarding management's control objectives. The Company has carried out an evaluation, under the supervision and with the participation of the Company's management, including the Company's Chief Executive Officer along with the Company's Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(b). Based upon the foregoing, as of August 4, 2007, the Company's Chief Executive Officer along with the Company's Chief Financial Officer, concluded that the Company's disclosure controls and procedures are effective in reaching the level of reasonable assurance regarding management's control objectives.

There has been no change during the Company's second quarter ended August 4, 2007 in the Company's internal control over financial reporting that was identified in connection with the evaluation required by Exchange Act Rule 13a-15(d) which has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting.

Multiple risk factors exist which could have a material effect on the Company's operations, results of operations, profitability, financial position, liquidity and capital resources. These risk factors are more fully presented in the Company's 2006 Annual Report on Form 10-K as filed with the SEC.

There have been no material changes with respect to the risk factors disclosed in our 2006 Annual Report on Form 10-K.

On June 21, 2007, the Company held its 2007 Annual Meeting of Stockholders at which the following matter was submitted to a vote of the Company's shareholders:

1. The stockholders voted for eleven nominees for director, each for a one-year term. Each of the eleven nominees was elected. The results of the vote are as follows:

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