Annual Report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

(Mark One)

x	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended February 3, 2007

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

Commission file number 0-18632

THE WET SEAL, INC.

(Exact name of registrant as specified in its charter)


Delaware		33-0415940
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

26972 Burbank, Foothill Ranch, CA		92610
(Address of principal executive offices)		(Zip Code)

(949) 699-3900

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:


Title of Each Class		Name of Each Exchange on Which Registered
Class A Common Stock, $0.10 par value per share		NASDAQ Global Market

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No þ

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No þ

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act:

Large accelerated filer: ¨ Accelerated filer: þ Non-accelerated filer: ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No þ

The aggregate market value of voting stock held by non-affiliates of the registrant as of July 29, 2006, was approximately $361,666,000 based on the closing sale price of $4.61 per share as reported on the NASDAQ Global Market on July 28, 2006.

The number of shares outstanding of the registrant’s Class A Common Stock, par value $0.10 per share, at April 16, 2007, was 97,448,226. There were no shares outstanding of the registrant’s Class B Common Stock, par value $0.10 per share, at April 16, 2007.

DOCUMENTS INCORPORATED BY REFERENCE

PART III of this Annual Report incorporates information by reference from the registrant’s definitive Proxy Statement for its Annual Meeting of Stockholders to be filed with the SEC within 120 days of February 3, 2007.

THE WET SEAL, INC.

Annual Report on Form 10-K

For the Fiscal Year Ended February 3, 2007

TABLE OF CONTENTS


		Page

	Part I

Item 1.	Business	2

Item 1A.	Risk Factors	9

Item 1B.	Unresolved Staff Comments	16

Item 2.	Properties	17

Item 3.	Legal Proceedings	17

Item 4.	Submission of Matters to a Vote of Security Holders	18

	Part II

Item 5.	Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	19

Item 6.	Selected Financial Data	22

Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	23

Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	44

Item 8.	Financial Statements and Supplementary Data	45

Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	45

Item 9A.	Controls and Procedures	45

Item 9B.	Other Information	47

	Part III

Item 10.	Directors and Executive Officers of the Registrant	48

Item 11.	Executive Compensation	48

Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	48

Item 13.	Certain Relationships and Related Transactions, and Director Independence	48

Item 14.	Principal Accounting Fees and Services	48

	Part IV

Item 15.	Exhibits and Financial Statement Schedules	49

Signatures		50

PART I

Item 1.

Business

Statement Regarding Forward Looking Disclosure and Risk Factors

Certain sections of this Annual Report on Form 10-K, including “Item 1. Business” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contain various forward-looking statements within the meaning of Section 27A of the Securities Act, as amended, and Section 21E of the Exchange Act, which represent our expectations or beliefs concerning future events.

Forward-looking statements include statements that are predictive in nature, which depend upon or refer to future events or conditions, and/or which include words such as “believes,” “plans,” “anticipates,” “estimates,” “expects” or similar expressions. In addition, any statements concerning future financial performance, ongoing concept strategies or prospects, and possible future actions, which may be provided by our management, are also forward-looking statements. Forward-looking statements are based on current expectations and projections about future events and are subject to risks, uncertainties, and assumptions about our company, economic and market factors and the industry in which we do business, among other things. These statements are not guarantees of future performance and we undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise.

Actual events and results may differ materially from those expressed or forecasted in forward-looking statements due to a number of factors. Factors that could cause our actual performance, future results and actions to differ materially from any forward-looking statements include, but are not limited to, those discussed in “Risk Factors” below and discussed elsewhere in this Annual Report.

General

We are a national specialty retailer operating stores selling fashionable and contemporary apparel and accessory items designed for female customers aged 15 to 45. We operate two nationwide, primarily mall-based, chains of retail stores under the names “Wet Seal” and “Arden B.” As of February 3, 2007, we operated 430 retail stores in 46 states, Puerto Rico and Washington D.C. Our products can also be purchased online.

All references to “we,” “our,” “us,” and “our company” in this Annual Report mean The Wet Seal, Inc. and its wholly owned subsidiaries. All references in this Annual Report to “fiscal 2007,” “fiscal 2006,” “fiscal 2005” and “fiscal 2004” mean the fiscal year ending February 2, 2008 and the fiscal years ended February 3, 2007, January 28, 2006, and January 29, 2005, respectively. Our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and all amendments to those reports and the proxy statement for our annual meeting of stockholders are made available, free of charge, on our corporate web site, www.wetsealinc.com , as soon as reasonably practicable after such reports have been filed with or furnished to the Securities and Exchange Commission (“SEC”.) Our Business Ethics Policy and Code of Conduct is also located within the Corporate Information section of our corporate website. These documents are also available in print to any stockholder who requests a copy from our Investor Relations department. The public may also read and copy any materials that we have filed with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. In addition, these materials may be obtained at the website maintained by the SEC at sec.gov . The content of our websites ( www.wetsealinc.com , www.wetseal.com , and www.ardenb.com ) is not intended to be incorporated by reference in this Annual Report.

The names “Wet Seal” and “Arden B” (which are registered in the retail store services class and pending in others) are trademarks and servicemarks of our company. Each trademark, tradename, or servicemark of any other company appearing in this annual report belongs to its respective owner.

Store Formats

Wet Seal . Wet Seal is the junior apparel brand for teenage girls that seek fashion-first clothing with a target customer age of 15 to 19 years old. Wet Seal provides its customer base with a balance of affordably priced fashionable brand name and company-developed apparel and accessories. Wet Seal stores average approximately 4,000 square feet in size and in fiscal 2006 had average sales per square foot of $321. As of February 3, 2007, we operated 338 Wet Seal stores.

Arden B. Arden B is the fashion brand for the sophisticated feminine contemporary woman with sex appeal. Arden B targets customers aged 25 to 45 and delivers contemporary collections of branded fashion separates and accessories for various aspects of the customers’ lifestyles. Arden B stores average approximately 3,200 square feet in size and in fiscal 2006 had average sales per square foot of $459. As of February 3, 2007, we operated 92 Arden B stores.

Internet Operations . In 1999, we established Wet Seal online, a web-based store located at www.wetseal.com , offering Wet Seal merchandise to customers over the Internet. In August 2002, we expanded our online operations with the launch of www.ardenb.com , offering Arden B apparel and accessories comparable to those carried in the stores. Our online stores are designed to serve as an extension of the in-store experience, and offer a wide selection of merchandise, which helps expand in-store sales. In fiscal 2006, we experienced rapid growth in our online sales and we will continue to develop our Wet Seal and Arden B websites to increase their effectiveness in marketing our brands.

Our Stores

In December 2004, we announced the closing of approximately 150 Wet Seal stores as part of our turnaround strategy. We completed our inventory liquidation sales and the closing of 153 Wet Seal stores in March 2005.

During fiscal 2005, we scaled back plans to open new stores in an effort to limit capital expenditures and concentrate our efforts on restoring the core business.

During fiscal 2006, we opened 34 Wet Seal and four Arden B stores and closed four Wet Seal and four Arden B stores. We believe future closures for at least the next 12 months following the date of this Annual Report will primarily result from lease expirations where we decide not to extend, or are unable to extend, a store lease.

Our ability to increase the number of Wet Seal and Arden B stores in the future will depend, in part, on satisfactory cash flows from existing operations, the demand for our merchandise, our ability to find suitable mall or other locations with acceptable sites and satisfactory terms, and general business conditions. Our management does not believe there are significant geographic constraints on the locations of future stores. For fiscal 2007, we intend to open 58 to 62 new Wet Seal and/or Arden B stores, net of store closures at lease expiration. We have approximately 50 existing store leases scheduled to expire in fiscal 2007. We expect to negotiate new leases that will allow us to remain in a substantial majority of these locations.

Competitive Strengths

Strong Brand Positions in Our Wet Seal and Arden B Divisions. In contrast with diversified apparel retailers, we focus on satisfying the fashion needs of two distinct customers, teenage girls age 15 to 19, and women age 25 to 45, through our Wet Seal and Arden B brands. Through these two brands, we are able to closely identify with our customers and implement merchandising practices that more effectively reflect their changing fashion needs. Both of our divisions deliver fashionable, trend-right apparel and accessories at competitive prices for a wide variety of occasions.

Key Management Team is Now in Place. With the appointments of Dyan Jozwick, Gregory Gemette, Gary White and John Luttrell, our senior management team is now in place. We believe that we now have people who have the requisite experience and who are committed to contributing to our company’s turnaround and driving our company into the next phase of its growth cycle.

Dyan Jozwick, our Chief Merchandise Officer, Wet Seal division, joined us in May 2006 from Robinsons-May with 28 years of retail industry experience. Ms. Jozwick’s prior history in the juniors market will help us to strengthen the Wet Seal business. Gregory Gemette, our President of Merchandise, Arden B, joined us in March 2006 with 27 years of retail industry experience. Mr. Gemette’s merchandising background at The Limited and American Eagle will assist us in developing and building the Arden B business. In addition to Mr. Gemette and Ms. Jozwick, we have added depth in our merchandising organizations at both Wet Seal and Arden B. Gary White, our Chief Operating Officer, joined us in July 2004 as Senior Vice President of Sales and Operations and was promoted in April 2006 to Chief Operating Officer. With over 30 years of retail industry experience, Mr. White brings experience in store operations, construction and development, real estate and purchasing. John Luttrell, our Chief Financial Officer, joined us in December 2005 from Cost Plus, Inc. with over ten years of retail industry experience. Mr. Luttrell’s public accounting background and experience with rapid-growth, large, multi-store companies, will help us execute our near-term and long-term strategies. We believe we have retained a full complement of top quality merchants, designers, planners and procurement specialists and have filled our senior merchant ranks at both divisions.

Merchandising Model at Wet Seal Focused on Fast Fashion at Affordable Prices. At Wet Seal, we have developed considerable expertise in identifying, stocking and selling a broad assortment of fresh, fashionable apparel and accessories at competitive prices. Our buyers work closely with senior management to determine the optimal product selection, promotion and pricing strategy. A significant portion of our merchandise is sourced domestically. This sourcing strategy enables us to ship new merchandise to the stores with high frequency. We also take regular markdowns to effect the rapid sale of slow-moving inventory.

Improved Financial Condition. Since the completion of a recapitalization of our company in May 2005, our financial condition has improved materially. During fiscal 2005 and fiscal 2006, we realized seven out of eight consecutive quarters of positive comparable store sales growth and had positive cash flow from operations in each of those fiscal years.

Due to the strength of our financial performance since the end of fiscal 2004, we have been able to reduce our outstanding indebtedness. Through fiscal 2006, $47.9 million in principal amount of our convertible notes had been converted into shares of our Class A Common Stock. We used the proceeds from a May 2005 financing transaction to repay a bridge loan that we received from investors in a January 2005 recapitalization of our company. In addition, in March 2006, we repaid the $8.0 million outstanding balance of a junior secured term loan under our then existing credit facility.

As of February 3, 2007, our total debt, net of discount, is $2.7 million, stockholders’ equity is $116.8 million and cash and cash equivalents is $105.3 million.

This improvement in our financial condition allows us to invest in opening new Wet Seal and Arden B stores.

Growth Strategy

We believe we have significant growth potential. The key elements of our growth strategy are to:

Expand Our Retail Store Base. Our two retail store divisions have broad national appeal, presenting substantial new store expansion opportunities. We believe we took a conservative approach to expansion in fiscal 2006 to allow for the rebuilding of our store development team. If current business trends continue, we expect to accelerate the number of store openings beginning in fiscal 2007.

Take Advantage of Compelling New Store Economics. In relation to many of our competitors, we currently have a modest number of stores supporting our operations. Therefore, we believe that we have significant opportunity for growth and leverage in store operations, distribution, buying and merchandising. Currently, new stores we open generally require us to make a capital investment of $350,000 to $450,000 per store. In addition, in some cases, we receive tenant improvement allowances from landlords to defray certain costs of a new store build out. These allowances, when granted, will reduce the estimated capital requirements noted above.

Continue Our Positive Comparable Store Sales Trend. Since we initiated our turnaround strategy in November 2004, we experienced seven out of eight quarters of positive comparable store sales results versus the negative comparable store sales trends of fiscal 2004. These improvements resulted primarily from increased transaction counts and the number of items purchased per customer, partially offset by a decrease in average retail price per item sold due to a change in pricing strategy.

LOGO

Note: The numbers in the foregoing charts do not include sales from discontinued operations.

For fiscal 2006, we experienced moderate growth in comparable store sales results versus the dramatically improved results we began to see in fiscal 2005. In the second fiscal quarter of 2006, we experienced a 2.2% decline in comparable store sales principally due to a merchandising misstep and delays in inventory receipts, which caused our Wet Seal stores to lack fashion tops and dresses in May and June 2006. Our merchandising team identified the issue and adjusted purchasing levels, thus restoring our positive comparable store sales momentum in each month from July through the end of fiscal 2006. The Wet Seal’s fast-fashion, value-driven strategy resulted in a reduction in average unit retail selling prices, an increase in transactions generated and an increase in average number of units per customer for fiscal 2006. With a more value-oriented pricing strategy, we believe we have been able to increase the number of customers and their purchases and the number of units purchased per transaction.

Revive Arden B. Since the arrival of Gregory Gemette at Arden B in March 2006, we have focused on redefining the “Arden B woman” and brand positioning. We are adjusting our assortments at Arden B to be fashion-right, focused and cohesive. Arden B is a unique division that we believe has yet to achieve its full potential with its core customer. Through a new approach to merchandising and improvements in advertising, we intend to create a feminine, sophisticated brand for the modern woman who wants to project an appropriate level of sex appeal. We aim to drive sales and profitability at Arden B through distinctive, quality merchandise, unified apparel and accessory assortments and an improved in-store customer experience.

Expand our Online Business. We plan to grow our Internet business through several initiatives, including a focus on integrated branding, targeted marketing programs utilizing our customer database and our customer loyalty programs. Although our Internet sales are modest, we are experiencing substantial growth. A combination of several changes contributed to the improvement, including hiring the right staff with Internet marketing experience, changing processes to make them scalable, aligning the online sites to the look of the stores and implementing appropriate targeted marketing. We are optimizing inventory allocated to the Internet business to better meet demand and we have strengthened our buying and planning staff to meet the anticipated sales growth in this area.

Design, Buying and Product Development

Our design and buying teams are responsible for identifying evolving fashion trends and developing themes to guide our merchandising strategy. Each retail concept has a separate buying team. The merchandising team for each retail concept develops fashion themes and strategies through assessing customer responses to current trends, shopping the European market and the appropriate domestic vendor base and through the use of fashion services and gathering references from industry publications. After selecting fashion themes, the design and buying teams work closely with vendors to use colors, materials and designs that create images consistent with the themes for our product offerings.

Since fiscal 2004, we have decreased our dependency on internally-designed merchandise in our Wet Seal division. This allows us more flexibility to respond to the changing fashion trends of the junior customer, to buy in smaller lots and to reduce product development lead times. See also “Allocation and Distribution” below.

Marketing, Advertising and Promotion

We believe that our brands are among our most important assets. Our ability to successfully increase brand awareness is dependent upon our ability to address the changing needs and priorities of each brand’s target customers. We continue to invest in the development of our brands through customer research, print advertising, in-store marketing and the maintenance of our Internet presence.

During fiscal 2006, 2005, and 2004, we spent 1.1%, 0.8%, and 1.9%, respectively, of net sales on advertising. In fiscal 2006, our primary marketing focus was on in-store promotion programs for the Wet Seal stores and print media for the Arden B stores, which included publications in Vogue ^® throughout the year.

As discussed further in Note 1 of Notes to Consolidated Financial Statements contained elsewhere within this Annual Report, we offer a frequent buyer program in our Wet Seal stores in order to build loyalty to the brand, increase the frequency of visits, promote multiple item purchases and gain direct access to the customer. As part of this program we send e-mails to participants to notify them of special in-store promotions. Our Arden B concept also offers a loyalty program, “B Rewarded,” designed for the same purposes as those of our Wet Seal concept.

Sourcing and Vendor Relationships

We purchase our merchandise from both domestic and foreign vendors. For fiscal 2006, approximately 17% of our retail receipts were directly imported from vendors. Although in fiscal 2006 no single vendor provided more than 10% of our merchandise, management believes we are the largest customer of many of our smaller vendors. Quality control is monitored at the distribution points of our largest vendors and manufacturers, and merchandise is inspected upon arrival at our Foothill Ranch, California distribution center.

We do not maintain any long-term or exclusive commitments or arrangements to purchase merchandise from any single supplier, and there are many vendors who could supply our merchandise.

Allocation and Distribution

Our merchandising effort primarily focuses on maintaining a regular flow of fresh, fashionable merchandise into our stores. Successful execution depends in large part on our integrated planning, allocation and distribution functions. By working closely with store operations management and merchandise buyers, our teams of planners and allocators manage inventory levels and coordinate the allocation of merchandise to each of our stores based on sales volume and store size, demographics, climate and other factors that may influence an individual store’s product mix.

All merchandise for retail stores is received from vendors at our Foothill Ranch, California distribution center, where items are inspected and prepared for shipping to our stores. We ship all of our merchandise to our stores by common carrier. Consistent with our goal of maintaining the freshness of our product offerings, we frequently ship new merchandise to stores, and markdowns are taken regularly to effect the rapid sale of slow-moving inventory. Marked-down merchandise that remains unsold is either sent to a clearance center for deep discounting and rapid movement, sold to an outside clearance company or given to charity. The fulfillment process and distribution of merchandise for our online business is performed at our Foothill Ranch distribution center.

Information and Control Systems

Our merchandise, financial and store computer systems are integrated and operate using primarily Oracle ^{^®} technology. We have invested in a large data warehouse that provides management, buyers and planners comprehensive data that helps them identify emerging trends and manage inventories. The core merchandise system is provided by a leading retail enterprise resource planning, or “ERP,” software provider, and is frequently upgraded and enhanced to support strategic business initiatives.

All of our stores have a point-of-sale system operating on software provided by a leading provider of specialty retailing point-of-sale systems. This system facilitates bar-coded ticket scanning, automatic price look-ups and centralized credit authorizations. All stores are networked to the corporate office via a centrally managed virtual private network. We utilize a store portal that is integrated with the corporate merchandise ERP system to provide the stores and corporate staff with current information regarding sales, promotions, inventory and shipments, and enables more efficient communications with the corporate office. In fiscal 2006, we installed in-store radio frequency systems to manage inventory, upgraded direct marketing and customer loyalty systems, began implementing a revision to our merchandise allocation system, upgraded our company-wide payroll system and upgraded our online business order fulfillment system. In fiscal 2007, we anticipate launching a new website platform for the online business, implementing a new time and attendance labor system and upgrading our ERP system.

Seasonality

Our business is seasonal by nature, with the Christmas season, beginning the week of Thanksgiving and ending the first Saturday after Christmas, and the back-to-school season, beginning the last week of July and ending mid-September, historically accounting for a large percentage of sales volume. For the past three fiscal years, the Christmas and back-to-school seasons together accounted for an average of slightly more than 30% of our annual sales. Our profitability depends, to a significant degree, on the sales generated during these peak periods. Any decrease in sales or margins during these periods, whether as a result of economic conditions, poor weather or other factors, could have a material adverse effect on our company.

Trademarks

Our primary trademarks and service marks are WET SEAL ^® and ARDEN B ^® , which are registered in the U.S. Patent and Trademark Office. We also use and have registered, or have applications pending for, a number of other U.S. trademarks, including, but not limited to, ACCOMPLICE ^® , ARDEN B SPORT ^™ , B. FIRST ^™ ,

B. IN ^™ , B. REWARDED ^® , ENR EVOLUTION NOT REVOLUTION ^® , FIT IN. STAND OUT. ^™ , FORMULA X ^® , GET IT. WEAR IT. FLAUNT IT. ^® , SEAL STASH ^® , STUDIO ARDEN B™, STYLIZER ^® , and TREND SPOT ^™ . In general, the registrations for these trademarks and service marks are renewable indefinitely, as long as we continue to use the marks as required by applicable trademark laws. We are not aware of any adverse claims or infringement actions relating to our trademarks or service marks.

Competition

The women’s retail apparel industry is highly competitive, with fashion, quality, price, location and service being the principal competitive factors. Our Wet Seal and Arden B stores compete with specialty apparel retailers, department stores and certain other apparel retailers, including Aeropostale, Anthropologie, Abercrombie & Fitch, Charlotte Russe, Gap, Banana Republic, H&M, Old Navy, Pacific Sunwear, American Eagle, Target, Urban Outfitters, Forever 21, Express, J.C. Penney, bebe, Zara and BCBG. Many of our competitors are large national chains that have substantially greater financial, marketing and other resources than we do. While we believe we compete effectively for favorable site locations and lease terms, competition for prime locations within malls is intense, and we cannot ensure that we will be able to obtain new locations on terms favorable to us, if at all.

Customers

Our company’s business is not dependent upon a single customer or small group of customers.

Environmental Matters

We are not aware of any federal, state or local environmental laws or regulations that will materially affect our earnings or competitive position, or result in material capital expenditures. However, we cannot predict the effect on our operations of possible future environmental legislation or regulations. During fiscal 2006, there were no material capital expenditures for environmental control facilities and no such material expenditures are anticipated for fiscal 2007.

Government Regulation

Our company is subject to various federal, state and local laws affecting our business. Each of our company’s stores must comply with licensing and regulation by a number of governmental authorities in jurisdictions in which the store is located. To date, our company has not been significantly affected by any difficulty, delay or failure to obtain required licenses or approvals.

Our company is also subject to federal and state laws governing such matters as employment and pay practices, overtime and working conditions. The bulk of our company’s employees are paid on an hourly basis at rates related to the federal and state minimum wages. In the past, we have been assessed penalties or paid settlements to gain dismissal of lawsuits for non-compliance with certain of these laws, and future non-compliance could result in a material adverse effect on our company’s operations.

Our company is also subject to the Fair Credit Reporting Act (the Act) under federal law, as well as to state laws with similar requirements, with respect to the protection our customers’ credit and debit card and other personal data. In January and February 2007, we were served with two class action complaints alleging violations of the Act. The Act provides in part that expiration dates may not be printed together with certain parts of the customer’s account number on credit or debit card receipts given to customers. The Act imposes significant penalties upon violators of these rules and regulations if the lack of compliance is deemed to have been willful. Otherwise, damages are limited to actual losses incurred. Our company does not believe that it has any liability for the violations alleged in the complaints and will vigorously contest these allegations. However, in the event we are found to have liability under the Act for these allegations, significant damages could be assessed against

our company, and this could have a material adverse effect on our results of operations and financial condition. In addition, any future non-compliance with federal or state laws pertaining to the protection of customers’ personal data could result in a material adverse effect on our results of operations.

We continue to monitor our facilities for compliance with the Americans with Disabilities Act, or the ADA, in order to conform to its requirements. Under the ADA, we could be required to expend funds to modify stores to better provide service to, or make reasonable accommodation for the employment of, disabled persons. We believe that expenditures, if required, would not have a material adverse effect on our company’s operations.

Employees

As of February 3, 2007, our operations had 5,678 employees, consisting of 1,930 full-time employees and 3,748 part-time employees. Full-time personnel consisted of 631 salaried employees and 1,299 hourly employees. All part-time personnel are hourly employees. Of all employees, 5,344 were sales personnel and 334 were administrative and distribution center personnel. Personnel at all levels of store operations are provided various opportunities for cash and/or other incentives based upon various individual store sales targets. All of our employees are non-union, and, in management’s opinion, are paid competitively at current industry standards. We believe that our relationship with our employees is good.

Item 1A.

Risk Factors

Risks Related to our Business

Our improvements in comparable store sales and operating results in fiscal 2005 and 2006 may not be indicative of trends in our future performance, and we may not be able to sustain or improve our results and achieve profitability.

During fiscal 2005 and 2006, we experienced seven out of eight consecutive quarters of positive comparable store sales growth, and positive overall cash flow from operations in each of fiscal 2005 and 2006. However, we incurred significant operating losses and negative cash flows during each of fiscal 2003 and 2004 which caused liquidity problems and resulted in very tight vendor payment terms. In fiscal 2005, we raised additional capital that ameliorated our liquidity problems.

Our ability to maintain the success of our Wet Seal and Arden B stores depends in large part on a number of factors, some of which are outside of our control, including accurate forecasting of demand and fashion trends, providing an appropriate mix of appealing merchandise for our targeted customer base, managing inventory effectively, using effective pricing strategies, selecting effective marketing techniques, optimizing store performance, negotiating acceptable renewals of expiring leases and general economic conditions. For example, in the second quarter of fiscal 2006, we experienced an inventory shortage in certain fashion tops and dresses in our Wet Seal division that negatively affected our comparable store sales performance.

We cannot be certain that we will be able to execute our plan to open additional stores or that such store openings will be successful.

Successful implementation of our company’s growth strategy depends on a number of factors including, but not limited to, obtaining desirable store locations, negotiating acceptable leases, completing projects on budget, supplying proper levels of merchandise and the hiring and training of store managers and sales associates. The new stores may place increased demands on our company’s operational, managerial and administrative resources, which could cause our company to operate less effectively. Furthermore, there is a possibility that new stores that are opened in existing markets may have an adverse effect on future sales of previously existing stores in such markets. In addition, our failure to predict accurately the demographic or retail environment at any future store location could have a material adverse effect on our business, financial condition and results of operations.

We have had significant management changes during the past two fiscal years and these changes may impact our ability to execute our business strategy in the near term.

In general, our success depends to a significant extent on the performance of our senior management and on our ability to identify, hire and retain key management personnel.

In December 2004 and January 2005, we appointed a new President and Chief Executive Officer and four members to our Board of Directors. In August 2005, our Executive Vice President and Chief Financial Officer resigned from our company, and was replaced by a new Executive Vice President and Chief Financial Officer in December 2005. On March 6, 2006, two new members joined our Board of Directors. Effective March 1, 2006, the president of our Arden B stores resigned and was replaced by a new president of Arden B Merchandise on March 13, 2006. On May 2, 2006, we hired our Chief Merchandise Officer for our Wet Seal division.

We anticipate that we will continue to experience a transition period as this new management team is fully integrated. Due to the intense competition for qualified personnel in the retail apparel industry, we may not be able to identify, hire or retain key personnel with the merchandising and management skills necessary to consistently offer appealing products to our target market. Moreover, we are also exposed to employment practice litigation due to the large number of employees and high turnover of our sales associates. If we fail to attract, motivate and retain qualified senior management personnel, it could harm our business and limit our ability to implement our growth strategy.

If our President and Chief Executive Officer elects not to extend his employment contract in February 2008, the continued implementation of our growth plan could be adversely impacted.

The term of Mr. Joel N. Waller’s employment contract expires on February 1, 2008. In the event Mr. Waller’s contract is not extended, the retention of a Chief Executive Officer will involve a transition period for our management team and our Board of Directors, which may adversely impact the continued implementation of our growth plan.

The strategy for our Arden B division implemented by our new Arden B management team may not be successful.

Our strategy for our Arden B division may not be successful and we may have to write down the value of our Arden B assets, which could have an adverse effect on our results of operations. The new president of merchandise for our Arden B division, Mr. Gregory Gemette, joined us in March 2006. Although Mr. Gemette has put together a management team of design, operational and merchandising individuals with significant industry experience, the success of Arden B is largely dependent upon its ability to design fashion that satisfies current fashion tastes and to provide merchandise in a timely manner for our customers. To the extent there are design and/or merchandising misjudgments or a lack of customer traffic in Arden B stores, the operating results of Arden B may be adversely and materially impacted.

In addition to our new design and merchandising strategy, we intend to increase the percentage of imported merchandise for our Arden B stores during the next two fiscal years. However, if there are delays in our import chain, cancellations of orders, or quality issues related to imported products, our results of operations could be significantly and adversely impacted due to decreased sales and/or increased markdowns.

If we are unable to anticipate and react to new fashion trends and/or if there is a decrease in the demand for fashionable apparel, our financial condition and results of operations could be adversely affected.

We rely on a limited demographic customer base for a large percentage of our sales. Our brand image is dependent upon our ability to anticipate, identify and provide fresh inventory reflecting current fashion trends. If we fail to anticipate, identify or react appropriately or in a timely manner to these fashion trends, we could experience reduced consumer acceptance of our products, a diminished brand image and higher markdowns.

These factors could result in lower selling prices and sales volumes for our products, which could adversely affect our financial condition and results of operations.

Our sales also depend upon the continued demand by our customers for fashion apparel. Demand for our merchandise could be negatively affected by shifts in consumer discretionary spending to other goods, such as electronic equipment, computers and music. If the demand for apparel and related merchandise declines, our financial condition, cash flow and results of operations would be adversely affected.

Since August 2004, our company has been a defendant in a class action related to our company’s securities.

As previously reported, our company and certain of our former directors and former officers have been named as defendants in several securities class actions filed on behalf of persons who purchased our Class A Common Stock between January 7, 2003 and August 19, 2004. These actions have been consolidated in the United States District Court for the Central District of California.

The consolidated complaint alleged violations of Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder, and Section 20(a) of the Exchange Act by, among other allegations, making false and misleading statements concerning the progress of our company to stem the losses of our Wet Seal stores and return that business to profitability as well as the illegal use of material non-public information by former directors and a company controlled by them. The plaintiffs sought class certification, compensatory damages, interest, costs and attorneys’ fees and expenses.

On September 15, 2005, the consolidated class action was dismissed against all defendants in the lawsuit. However, plaintiffs were granted leave to file an amended complaint, which they filed on November 23, 2005. We filed an additional motion to dismiss the amended complaint. The motion was argued in a court hearing on October 23, 2006, but the court has not yet made a ruling on the motion. In the event plaintiffs achieve a favorable outcome, significant damages could be assessed against our company that exceed available insurance coverage, which would have a material adverse effect on our financial condition, results of operations and cash flows.

Two lawsuits have been filed against us alleging violations of the Fair Credit Reporting Act.

In January and February 2007, we were served with two class action complaints alleging violations of The Fair Credit Reporting Act. The Act provides in part that portions of the credit card number may not be printed together with expiration dates on credit or debit card receipts given to customers. The Act imposes significant penalties upon violators of these rules and regulations where the violation is deemed to have been willful. Otherwise damages are limited to actual losses incurred by the card holder. The Company does not believe that it has any liability for the violations alleged in the complaints and will vigorously contest these allegations. However, in the event we are found to have liability under the Act for these allegations, significant damages could be assessed against our company and could have a material adverse effect on our financial condition and results of operations.

Fluctuations in our results of operations for the third fiscal quarter and the fourth fiscal quarter would have a disproportionate effect on our overall financial condition, results of operations and cash flows.

We experience seasonal fluctuations in revenues and operating income, with a disproportionate amount of our revenues and a majority of our income being generated in the third fiscal quarter “back to school” season, which begins the last week of July and ends during September, and the fourth fiscal quarter “holiday” season. Our revenues and income are generally lower during the first and second fiscal quarters. In addition, any factors that harm our third and fourth fiscal quarter operating results, including adverse weather or unfavorable economic conditions, could have a disproportionate effect on our results of operations for the entire fiscal year.

In order to prepare for our peak shopping season, we must order and keep in stock significantly more merchandise than we would carry at other times of the year. An unanticipated decrease in demand for our

products during our peak shopping season could require us to sell excess inventory at a substantial markdown, which could reduce our net sales and gross profit. Alternatively, an unanticipated increase in demand for certain of our products, as was the case in May and June of fiscal 2006 at our Wet Seal stores, could leave us unable to fulfill customer demand and result in lost sales and customer dissatisfaction.

Our quarterly results of operations may also fluctuate significantly as a result of a variety of other factors, including the timing of new store openings, the revenues contributed by new stores, merchandise mix and the timing and level of inventory markdowns. As a result, historical period-to-period comparisons of our revenues and operating results are not necessarily indicative of future period-to-period results. You should not rely on the results of a single fiscal quarter, particularly the third fiscal quarter “back to school” season or fourth fiscal quarter “holiday” season, as an indication of our annual results or our future performance.

Our failure to effectively compete with other retailers for sales and locations could have a material adverse effect on our financial condition, results of operations and cash flows.

The women’s retail apparel industry is highly competitive, with fashion, quality, price, location and service being the principal competitive factors. Our Wet Seal and Arden B stores compete with specialty apparel retailers, department stores and certain other apparel retailers, including Aeropostale, Anthropologie, Abercrombie & Fitch, Charlotte Russe, Gap, Banana Republic, H&M, Old Navy, Pacific Sunwear, American Eagle, Target, Urban Outfitters, Forever 21, Express, J.C. Penney, bebe, Zara and BCBG. Many of our competitors are large national chains that have substantially greater financial, marketing and other resources than we do. We face a variety of competitive challenges, including:

•

anticipating and quickly responding to changing consumer demands;

•

maintaining favorable brand recognition and effectively marketing our products to consumers in narrowly-defined market segments;

•

developing innovative, high-quality products in sizes, colors and styles that appeal to consumers in our target markets and maintaining a sufficient quantity of these items for which there is the greatest demand;

•

obtaining favorable site locations within malls on reasonable terms;

•

sourcing merchandise efficiently; and

•

pricing our products competitively and achieving customer perception of value.

Our industry has low barriers to entry that allow the introduction of new products or new competitors at a fast pace. Any of these factors could result in reductions in sales or the prices of our products which, in turn, could have a material adverse effect on our financial condition, results of operations and cash flows.

Further, competition for prime locations and lease terms within shopping malls, in particular, is intense, and we may not be able to obtain new locations or maintain our existing locations on terms favorable to us.

The upcoming expiration of leases for approximately 50 of our existing stores could lead to increased costs associated with renegotiating our leases and/or relocating our stores.

We have approximately 50 existing store leases scheduled to expire in fiscal 2007. In connection with the expiration of these leases, we will have to renegotiate new leases which could result in higher rental amounts for each store and landlord requirements to remodel existing locations as a condition for renewal. Although we expect to negotiate new leases with acceptable terms that will allow us to remain in a substantial majority of these locations, we may not be able to obtain new terms that are favorable to us. In addition, as a result of renewal negotiations, we may be required by the landlord to remodel, which could result in significant capital expenditures. In addition, some landlords may refuse to renew our leases due to our lower sales per square foot as

compared with other prospective tenants. If we are unable to agree to new terms with our landlords, we will have to relocate these stores, which could result in a significant expenditure and could lead to an interruption in the operation of our business at the affected stores, and we could be required to relocate to less desirable locations.

Because of the importance of our brand names, we may lose market share to our competitors if we fail to adequately protect our intellectual property rights.

We believe that our trademarks and other proprietary rights are important to our success and our competitive position. We have registered trademarks for Wet Seal and Arden B (which are registered in the retail store services class and pending in others). We take actions to establish and protect our intellectual property. However, others may infringe on our intellectual property rights or seek to block the sale of our products as violative of their intellectual property rights. If we are required to stop using any of our registered or non-registered trademarks, our sales could decline and, consequently, our business and results of operations could be adversely affected.

Our retail store operations are affected by local, regional and national economic conditions.

Our business is sensitive to consumer spending patterns and preferences. Various economic conditions affect the level of spending on the merchandise we offer, including general business conditions, interest rates, taxation, the availability of consumer credit and consumer confidence in future economic conditions. Our growth, sales and profitability may be adversely affected by unfavorable economic conditions on a local, regional or national level.

Further, the majority of our stores are located in shopping malls. We derive sales, in part, from the high volume of traffic in these malls. The inability of mall “anchor” tenants and other area attractions to generate consumer traffic around our stores, or the decline in the popularity of malls as shopping destinations, would reduce our sales volume and, consequently, adversely affect our financial condition, results of operations and cash flows.

Covenants contained in agreements governing our existing indebtedness restrict the manner in which we conduct our business, and our failure to comply with these covenants could result in a default under these agreements, which would have a material adverse effect on our business, financial condition, growth prospects and ability to procure merchandise for our stores.

Our senior credit facility and the indenture, as amended, governing our secured convertible notes contain covenants that restrict the manner in which we conduct our business. Subject to certain exceptions (including an exception to permit limited stock repurchases), these covenants restrict our ability to, among other things:

•

incur or guarantee additional indebtedness or refinance our existing indebtedness;

•

make investments or acquisitions;

•

merge, consolidate, dissolve or liquidate;

•

engage in certain asset sales (including the sale of stock);

•

repurchase stock;

•

grant liens on assets;

•

pay dividends; and

•

close stores.

A breach of any of these covenants could result in a default under the agreements governing our existing indebtedness, acceleration of any amounts then outstanding, the foreclosure upon collateral securing the debt obligations, or the unavailability of the lines of credit.

We depend upon a single center for our corporate offices and distribution activities, and any significant disruption in the operation of this center could harm our business, financial condition, results of operations and cash flows.

Our corporate offices and the distribution functions for all of our stores and Internet business are handled from a single, leased facility in Foothill Ranch, California, and we do not have contracted back-up operating facilities. In general, this area of California is subject to earthquakes. Any significant interruption in the operation of this facility due to a natural disaster, accident, system failure or other unforeseen event could delay or impair our ability to distribute merchandise to our stores and, consequently, lead to a decrease in sales. The financial losses incurred may exceed our insurance for earthquake damages and business interruption costs related to any such disruption. As a result, our business, financial condition, results of operations and cash flows could be adversely affected. Furthermore, we have little experience operating essential functions away from our main corporate offices and are uncertain what effect operating such satellite facilities might have on our business, personnel and results of operations.

We do not authenticate the license rights of our suppliers.

We purchase merchandise from a number of vendors who purport to hold manufacturing and distribution rights under the terms of license agreements or that assert their products are not subject to any restrictions as to distribution. We generally rely upon each vendor’s representation concerning those manufacturing and distribution rights and do not independently verify whether each vendor legally holds adequate rights to the licensed properties they are manufacturing or distributing. If we acquire unlicensed merchandise or merchandise violating a registered trademark, we could be obligated to remove it from our stores, incur costs associated with destruction of the merchandise if the vendor is unwilling or unable to reimburse us and be subject to civil and criminal liability. The occurrence of any of these events could adversely affect our financial condition, results of operations and cash flows.

We are subject to risks associated with our procurement of products from non-U.S. based vendors and U.S. vendors that purchase products internationally, any of which could have a material adverse effect on our business, financial condition, results of operations or cash flows.

A portion of our products is manufactured outside the United States. As a result, we are susceptible to greater losses as a result of a number of risks inherent in doing business in international markets and from a number of factors beyond our control, any of which could have a material adverse effect on our business, financial condition, results of operations or cash flows. These factors include:

•

import or trade restrictions (including increased tariffs, customs duties, taxes or quotas) imposed by the United States government in respect of the foreign countries in which our products are currently manufactured or any of the countries in which our products may be manufactured in the future;

•

political instability or acts of terrorism, significant fluctuations in the value of the U.S. dollar against foreign currencies, restrictions on the transfer of funds between the United States and foreign jurisdictions, and/or potential disruption of imports due to labor disputes at U.S. ports, any of which could adversely affect our merchandise flow and, consequently, cause our sales to decline; and

•

local business practices that do not conform to our legal or ethical guidelines.

Our imports are limited by textile agreements between the United States and a number of foreign jurisdictions, including Hong Kong, China, Taiwan and South Korea. These agreements impose quotas on the amounts and types of merchandise that may be imported into the United States from these countries. These agreements also allow the United States to limit the importation of categories of merchandise that are not now subject to specified limits. The United States and the countries in which our products are produced or sold may also, from time to time, impose new quotas, duties, tariffs or other restrictions, or adversely adjust prevailing quota, duty or tariff levels. In addition, none of our international suppliers or international manufacturers supplies

or manufactures our products exclusively. As a result, we compete with other companies for the production capacity of independent manufacturers and import quota capacity. If we were unable to obtain our raw materials and finished apparel from the countries where we wish to purchase them, either because room under the necessary quotas was unavailable or for any other reason, or if the cost of doing so should increase, it could have a material adverse effect on our business, financial condition, results of operations or cash flows.

Violation of labor laws and practices by our suppliers could harm our business and results of operations.

Our company’s policy is to use only those sourcing agents and independent manufacturers who operate in material compliance with applicable laws and regulations. The violation of laws, particularly labor laws, by an independent manufacturer, or by one of the sourcing agents, or the divergence of an independent manufacturer’s or sourcing agent’s labor practices from those generally accepted as ethical in the United States or in the country in which the manufacturing facility is located, and the public revelation of those illegal or unethical practices, could cause significant damage to our company’s reputation. Although our manufacturer operating guidelines promote ethical business practices, we do not control these manufacturers and cannot guarantee their legal and regulatory compliance.

We are exposed to business risks as a result of our Internet operations.

We operate online stores at www.wetseal.com and www.ardenb.com . Our Internet operations are subject to numerous risks, including:

•

online security breaches and/or credit card fraud;

•

reliance on third-party software providers; and

•

diversion of sales from our retail stores.

In addition, increased Internet sales by our competitors could result in increased price competition and decreased margins. Our inability to effectively address these risks and any other risks that we face in connection with our Internet operations could adversely affect the profitability of our Internet operations.

Risks Related to our Class A Common Stock

Our stockholders may experience additional dilution due to previous private placements of convertible securities as well as the issuance of additional securities in the future.

Since May 2004, we have completed private placements of Class A Common Stock as well as warrants, convertible notes and shares of preferred stock that are convertible into or exercisable for shares of our Class A Common Stock. Through February 3, 2007, we have issued 56,409,734 shares of our Class A Common Stock as a result of these private placements and exercises and conversions of these securities. An additional 19,659,376 shares of Class A Common Stock may be issued under the convertible notes, preferred stock and warrants that remain outstanding, and this number of shares of Class A Common Stock is subject to anti-dilution adjustments based upon the anti-dilution provisions contained in these instruments. The issuance of the additional shares of Class A Common Stock upon conversion and exercise could cause the market price of our Class A Common Stock to decline.

In addition, the issuance of additional equity securities or securities convertible into equity securities would result in dilution of our existing stockholders’ equity interest. The issuance of additional equity securities or securities convertible into equity securities could also trigger an anti-dilution adjustment pursuant to outstanding warrants, convertible notes or preferred stock.

The price of our Class A Common Stock has fluctuated significantly during the past few years and may fluctuate significantly in the future.

Our Class A Common Stock, which is traded on the NASDAQ Global Market, has experienced and may continue to experience significant price and volume fluctuations that could adversely affect the market price of our Class A Common Stock. The market price of our Class A Common Stock is likely to fluctuate, both because of actual and perceived changes in our operating results and prospects and because of general volatility in the stock market. The market price of our Class A Common Stock could continue to fluctuate widely in response to factors such as:

•

actual or anticipated variations in our results of operations;

•

the addition or loss of suppliers, customers and other business relationships;

•

changes in financial estimates of, and recommendations by, securities analysts;

•

conditions or trends in the apparel and consumer products industries;

•

additions or departures of key personnel;

•

sales of our Class A Common Stock;

•

general market and economic conditions; and

•

other events or factors, including the realization of any of the risks described in this risk factors section, many of which are beyond our control.

Fluctuations in the price and trading volume of our Class A Common Stock in response to factors such as those set forth above could be unrelated or disproportionate to our actual operating performance.

We have never paid dividends on our Class A Common Stock and do not plan to do so in the future.

Holders of shares of our Class A Common Stock are entitled to receive any dividends that may be declared by our Board of Directors. However, we have not paid any cash dividends on our Class A Common Stock and we do not expect to for the foreseeable future. Also, our agreements with our senior lenders and the indenture governing our notes restrict the payment of dividends to our stockholders.

Our charter provisions, stockholder rights plan and Delaware law may have anti-takeover effects.

Our certificate of incorporation permits our Board of Directors to designate and issue, without stockholder approval, up to 2,000,000 shares of preferred stock with voting, conversion and other rights and preferences that could differentially and adversely affect the voting power or other rights of the holders of our Class A Common Stock, which could be used to discourage an unsolicited acquisition proposal. In addition, under certain circumstances our Board of Directors may grant rights to our stockholders under our stockholder rights plan. Furthermore, certain provisions of Delaware law applicable to our company could also delay or make more difficult a merger, tender offer or proxy contest involving our company, including Section 203 of the Delaware General Corporation Law, which prohibits a Delaware corporation from engaging in any business combination with any interested stockholder for a period of three years unless certain conditions are met.

The possible issuance of preferred stock, the granting of rights to stockholders under our stockholder rights plan and the application of anti-takeover provisions of Delaware law could each have the effect of delaying, deferring or preventing a change in control of our company, including, without limitation, discouraging a proxy contest, making more difficult the acquisition of a substantial block of Class A Common Stock and limiting the price that investors might in the future be willing to pay for shares of our Class A Common Stock.

Item 1B.

Unresolved Staff Comments

None.

Item 2. Properties

Our principal executive offices are located at 26972 Burbank, Foothill Ranch, California, with 301,408 square feet of leased office and distribution facility space, including 215,192 square feet of merchandise handling and storage space in the distribution facility and 86,216 square feet of office space. On October 28, 2006 we amended the operating lease for our principal executive offices and warehouse facility. This amendment includes a lease extension term through December 4, 2017 with the option for us to terminate on December 4, 2014 upon payment by us of an early termination fee of $0.7 million.

We lease all of our stores. Lease terms for our stores typically are 10 years. The leases generally provide for a fixed minimum rental and additional rental based on a percentage of sales once a minimum sales level has been reached. Certain leases include cash reimbursements received from landlords for leasehold improvements and other cash payments received from landlords as lease incentives. When a lease expires, we generally renew that lease at current market terms. However, each renewal is based upon an analysis of the individual store’s profitability and sales potential. We closed four Wet Seal stores and four Arden B stores during fiscal 2006. At the end of fiscal 2006, we had 1,612,807 square feet of leased space under retail store leases.

The following table sets forth our 430 stores by state or territory as of February 3, 2007:


State	# of Stores	State	# of Stores	State	# of Stores
Alabama	5	Louisiana	5	Oklahoma	3
Alaska	1	Massachusetts	13	Oregon	4
Arizona	6	Maryland	10	Pennsylvania	23
Arkansas	2	Michigan	13	Rhode Island	2
California	54	Minnesota	14	South Carolina	4
Colorado	6	Mississippi	1	Tennessee	9
Connecticut	1	Missouri	8	Texas	26
Delaware	1	Montana	2	Utah	7
Florida	31	Nebraska	3	Virginia	11
Georgia	11	Nevada	5	Washington	8
Hawaii	7	New Hampshire	3	West Virginia	1
Idaho	1	New Jersey	17	Wisconsin	8
Illinois	23	New Mexico	4	Washington D.C.	2
Indiana	10	New York	18	Puerto Rico	2
Iowa	4	North Carolina	9
Kansas	5	North Dakota	3
Kentucky	5	Ohio	19

The following table sets forth information with respect to store openings and closings since fiscal 2002:


	Fiscal Years
	2006	2005	2004	2003	2002
Stores open at beginning of year	400	502	604	606	571
Stores opened during the year	38	11	8	31	69
Stores closed during the year	8	113	110	33	34

Stores open at end of year	430	400	502	604	606

Item 3.

Legal Proceedings

Between August 26, 2004 and October 12, 2004, six securities class action lawsuits were filed in the United States District Court for the Central District of California, or the Court, on behalf of persons who purchased our common stock between January 7, 2003 and August 19, 2004. We and certain of our former directors and executives were named as defendants. The complaints allege violations of Sections 10(b) and 20(a) of the

Exchange Act, and Rule 10b-5 of the Exchange Act, on the grounds that, among other things, we failed to disclose and misrepresented material adverse facts that were known to us or disregarded by us. On November 17, 2004, the Court consolidated the actions and appointed lead plaintiffs and counsel. On January 29, 2005, the lead plaintiffs filed their consolidated class action complaint with the Court, which consolidated all of the previously reported class actions. The consolidated complaint alleges that we violated the federal securities laws by making material misstatements of fact or failing to disclose material facts during the class period, from March 2003 to August 2004, concerning our prospects to stem ongoing losses in our Wet Seal concept and return that business to profitability. The consolidated complaint also alleges that our former directors and La Senza Corporation, a Canadian company controlled by them, unlawfully utilized material non-public information in connection with the sale of our common stock by La Senza. The consolidated complaint seeks class certification, compensatory damages, interest, costs, attorney’s fees and injunctive relief. We filed a motion to dismiss the consolidated complaint in April 2005. On September 15, 2005, the consolidated class action was dismissed against us in the lawsuit. However, plaintiffs were granted leave to file an amended complaint, which they did file on November 23, 2005. We filed a motion to dismiss the amended complaint on January 25, 2006. A court hearing on this motion was held on October 23, 2006, but the Court has not yet made a ruling on the motion. There can be no assurance that this litigation will be resolved in a favorable manner. We are vigorously defending this litigation and are unable to predict the likely outcome in this matter and whether such outcome may have a material adverse effect on our results of operations or financial condition.

On July 19, 2006, a complaint was filed in the Superior Court of the State of California for the County of Los Angeles, or the Superior Court, on behalf of certain of our current and former employees that were employed and paid by us on an hourly basis during the four-year period from July 19, 2002, through July 19, 2006. We were named as defendants. The complaint alleged various violations under the State of California Labor Code, the State of California Business and Professions Code, and orders issued by the Industrial Welfare Commission. On November 30, 2006, we reached agreement to pay approximately $0.3 million to settle this matter, subject to Superior Court approval, which has not yet been received. As of February 3, 2007, we had accrued an amount that approximates this settlement amount within accrued liabilities on our consolidated balance sheet.

In January 2007, a class action complaint was filed against us in the Central District of the United States District Court of California, Southern Division alleging violations of The Fair Credit Reporting Act (or “the Act”), and in February 2007 a class action complaint was filed against us alleging similar violations in United States District Court, Central District of California, Western Division. The Act provides in part that expiration dates may not be printed on credit or debit card receipts given to customers. The Act imposes significant penalties upon violators of these rules and regulations where the violation is deemed to have been willful. Otherwise damages are limited to actual losses incurred by the card holder. The Company does not believe that it has any liability for the violations alleged in the complaints and will vigorously contest these allegations. We are unable to predict the likely outcome in these matters and whether such outcome may have a material adverse effect on our results of operations or financial condition.

From time to time, we are involved in other litigation matters relating to claims arising out of our operations in the normal course of business. We believe that, in the event of a settlement or an adverse judgment on certain of our pending litigation, we are adequately covered by insurance; however, certain other matters may exist or arise for which we do not have insurance coverage. As of February 3, 2007, we were not engaged in any such other legal proceedings that are expected, individually or in the aggregate, to have a material adverse effect on our results of operations or financial condition.

Item 4.

Submission of Matters to a Vote of Security Holders

None.

PART II

Item 5.

Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

We have two classes of common stock: Class A and Class B. Our Class A Common Stock is listed on The NASDAQ Global Stock Market under the symbol “WTSLA.” As of April 16, 2007, there were 452 stockholders of record of our Class A Common Stock. The closing price of our Class A Common Stock on April 16, 2007, was $6.34 per share. As of April 16, 2007, there were no shares of our Class B Common Stock outstanding.

Price Range of Stock

The following table reflects the high and low closing sale prices of our Class A Common Stock as reported by NASDAQ for the last two fiscal years:


Quarter	Fiscal 2006				Fiscal 2005
Quarter	High		Low		High		Low
First Quarter	$	6.77	$	5.02	$	4.29	$	2.22
Second Quarter	$	5.75	$	4.22	$	6.93	$	3.23
Third Quarter	$	6.23	$	4.30	$	6.00	$	3.96
Fourth Quarter	$	7.48	$	5.73	$	5.50	$	4.23

Dividend Policy

We have reinvested earnings in the business and have never paid any cash dividends to holders of our common stock. The declaration and payment of future dividends, which are subject to the terms and covenants contained in the agreements governing our existing indebtedness, are at the sole discretion of the Board of Directors and will depend upon our profitability, financial condition, cash requirements, future prospects and other factors deemed relevant by the Board of Directors. Our senior credit facility and the indenture associated with our notes restrict our ability to declare or pay dividends on any of our shares without consent from the lenders.

Securities Authorized for Issuance Under Equity Compensation Plans

The following table provides information as of February 3, 2007, about our common stock that may be issued upon the exercise of options, warrants and rights granted to employees, consultants or members of our Board of Directors under all of our existing equity compensation plans, including our 1996 Long-Term Incentive Plan, as amended, the 2000 Stock Incentive Plan and the 2005 Stock Incentive Plan, as amended:


Plan category	Equity Compensation Plan Information
Plan category	Number of securities to be issued upon exercise of outstanding options, warrants and rights	Weighted-average exercise price of outstanding options, warrants and rights		Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a))
Equity compensation plans approved by security holders	3,460,020	$	7.03	1,673,600
Equity compensation plans not approved by security holders	—		—	—

Total	3,460,020	$	7.03	1,673,600

Stock Price Performance Graph

The following graph compares the cumulative stockholder return on the Company’s Class A Common Stock with the return on the Total Return Index for the NASDAQ Stock Market (US) and the NASDAQ Retail Trade Stocks. The graph assumes $100 invested on February 2, 2002 in the stock of The Wet Seal, Inc., the NASDAQ Stock Market (US) and the NASDAQ Retail Trade Stocks. It also assumes that all dividends are reinvested.

Performance Graph for the Class A Common Stock of The Wet Seal, Inc.

LOGO


	January 31, 2003*		January 30, 2004*		January 28, 2005*		January 27, 2006*		February 2, 2007*
The Wet Seal, Inc.	$	50	$	49	$	13	$	31	$	37
NASDAQ Stock Market (US)	$	70	$	109	$	107	$	122	$	131
NASDAQ Retail Trade Stocks	$	81	$	119	$	143	$	155	$	168

*	Closest preceding trading date to the beginning of the Company’s fiscal year.

The historical stock performance shown on the graph is not necessarily indicative of future price performance.

Unregistered Sales of Equity Securities

(a) None.

(b) None.

There were 2,918,235 shares of the Company’s Class A Common Stock repurchased by the Company during the fiscal year ended February 3, 2007 (see Note 10 of the Notes to Consolidated Financial Statements included elsewhere in this Annual Report). Following is a summary of repurchases of the Company’s Class A Common Stock made by the Company during the fiscal quarter ended February 3, 2007:


Period	Total Number of Shares Purchased	Average Price Paid per Share		Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs(1)	Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs
October 29, 2006 to November 25, 2006	—		—	—	2,309,865
November 26, 2006 to December 30, 2006	—		—	—	2,309,865
December 31, 2006 to February 3, 2007	400,000	$	6.00	400,000	1,909,865

(1)

In October 2002, the Company’s Board of Directors had authorized the repurchase of up to 5.4 million of the outstanding shares of the Company’s Class A Common Stock. Pursuant to this repurchase plan, during the fiscal year ended February 3, 2007, the Company repurchased 2,418,235 shares of its Class A Common Stock at an average market price of $5.12, for a total cost, including commissions, of approximately $12.4 million, and up to 1,909,865 shares had remained available for repurchase as of February 3, 2007. On March 28, 2006, the Company’s Board of Directors superseded the October 2002 repurchase plan with an authorization to repurchase prospectively 4.0 million of the outstanding shares of the Company’s Class A Common Stock.

Item 6.

Selected Financial Data

The following table sets forth selected consolidated financial and other data as of and for the 2002 through 2006 fiscal years. The following selected financial data has been derived from our consolidated financial statements. The data set forth below should be read in conjunction with the consolidated financial statements and notes thereto, which are included elsewhere in this Annual Report on Form 10-K.

Five-Year Financial Summary

(In thousands, except per share and per square foot amounts, ratios, share data, store data and square footage data)


Fiscal Year	2006			2005			2004			2003			2002
Fiscal Year Ended	February 3, 2007			January 28, 2006			January 29, 2005			January 31, 2004			February 1, 2003
Operating Results
Net sales	$	564,324		$	500,807		$	435,582		$	517,870		$	590,624
Cost of sales	$	370,888		$	339,483		$	377,664		$	420,520		$	414,174
Gross margin	$	193,436		$	161,324		$	57,918		$	97,350		$	176,450
Selling, general and administrative expenses	$	178,703		$	171,988		$	162,047		$	160,224		$	169,218
Operating income (loss)	$	15,038		$	(16,170	)	$	(161,905	)	$	(62,874	)	$	7,232
(Loss) income before provision (benefit) for income taxes	$	(12,530	)	$	(29,032	)	$	(164,080	)	$	(61,287	)	$	10,309
(Loss) income from continuing operations	$	(12,838	)	$	(29,362	)	$	(194,762	)	$	(40,014	)	$	6,642
Loss from discontinued operations, net of income taxes(1)	$	—		$	—		$	(6,967	)	$	(8,300	)	$	(4,161	)
Net (loss) income	$	(12,838	)	$	(29,362	)	$	(201,729	)	$	(48,314	)	$	2,481
Accretion of non-cash dividends on convertible preferred stock	$	—		$	(23,317	)	$	—		$	—		$	—
Net (loss) income attributable to common stockholders	$	(12,838	)	$	(52,679	)	$	(201,729	)	$	(48,314	)	$	2,481
Per Share Data
Net (loss) income attributable to common stockholders, basic	$	(0.18	)	$	(1.19	)	$	(5.99	)	$	(1.62	)	$	0.08
Net (loss) income attributable to common stockholders, diluted	$	(0.18	)	$	(1.19	)	$	(5.99	)	$	(1.62	)	$	0.08
Weighted-average shares outstanding, basic		72,577,398			44,340,894			33,698,912			29,748,888			30,044,673
Weighted-average shares outstanding, diluted		72,577,398			44,340,894			33,698,912			29,748,888			31,078,549
Other Financial Information
Cash, cash equivalents and investments	$	105,254		$	96,806		$	71,702		$	63,457		$	94,845
Working capital(5)	$	89,954		$	65,203		$	26,886		$	38,567		$	64,473
Ratio of current assets to current liabilities(5)		2.5			2.0			1.4			1.8			2.2
Total assets	$	208,167		$	181,055		$	161,492		$	262,452		$	305,680
Long-term debt, including current portion(2)	$	2,739		$	19,824		$	30,388		$	—		$	—
Total stockholders’ equity	$	116,797		$	64,470		$	37,053		$	166,728		$	209,182
Other Operating Information
Number of stores open at year end		430			400			502			604			606
Number of stores opened during the year		38			11			8			31			69
Number of stores closed during the year		8			113			110			33			34
Square footage of leased store space at year end		1,612,807			1,498,638			1,920,460			2,273,349			2,279,517
Average sales per square foot of leased store space(3)	$	348		$	330		$	203		$	228		$	267
Average sales per store(3)	$	1,301		$	1,236		$	768		$	861		$	1,027
Comparable store sales—continuing operations increase (decrease)(1)(4)		6.1	%		44.7	%		(13.0	)%		(16.4	)%		(5.5	)%

(1)	The Zutopia concept was designated as a discontinued operation, which had an insignificant impact on the comparable store sales.

(2)	Long-term debt is presented net of unamortized discount of $6.0 million, $35.6 million and $44.3 million for fiscal 2006, fiscal 2005 and fiscal 2004, respectively.

(3)	Sales during the 53 ^rd week of fiscal 2006 were excluded from “Sales” for purposes of calculating “Average sales per square foot of leased space” and “Average sales per store” in order to make fiscal 2006 comparable to fiscal 2002 through fiscal 2005.

(4)

“Comparable store sales” for fiscal 2006 (a 53-week fiscal year) includes a comparison of the 53 ^rd week of comparable store sales in fiscal 2006 to the 1 ^st week of comparable store sales in fiscal 2006. Stores are deemed comparable stores on the first day of the month following the one-year anniversary of their opening or significant remodel/relocation.

(5)	Working capital and the ratio of current assets to current liabilities for fiscal 2005 reflect a reclassification of $4.0 million of deferred rent to current portion of deferred rent on the consolidated balance sheet, in order to conform to current year presentation.

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with our audited consolidated financial statements and notes thereto included elsewhere in this Form 10-K. The following discussion and analysis contains forward-looking statements which involve risks and uncertainties, and our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth under the heading “Statement Regarding Forward Looking Disclosure and Risk Factors” included elsewhere in this Annual Report on Form 10-K.

Executive Overview

We are a national specialty retailer operating stores selling fashionable and contemporary apparel and accessory items designed for female customers aged 15 to 45. We are a Delaware corporation that operates two nationwide, primarily mall-based, chains of retail stores under the names “Wet Seal” and “Arden B”. At February 3, 2007, we had 430 retail stores in 46 states, Puerto Rico and Washington D.C. Of the 430 stores, there were 338 Wet Seal stores and 92 Arden B stores.

We report our results of operations as one reportable segment representing the aggregation of our two retail brands and our Internet business due to the similarities of the economic and operating characteristics of the operations represented by our two store concepts and Internet business.

Our fiscal year ends on the Saturday closest to the end of January. Fiscal 2006 includes 53 weeks of operations and fiscal 2005 and 2004 each includes 52 weeks of operations.

We consider the following to be key performance indicators in evaluating our performance:

Comparable store sales— Stores are deemed comparable stores on the first day of the month following the one-year anniversary of their opening or significant remodel/relocation, which we define to be a square footage increase or decrease of at least 20%. Stores that are remodeled or relocated with a resulting square footage change of less than 20% are maintained in the comparable store base with no interruption. However, stores that are closed for four or more days in a fiscal month, due to remodel, relocation or other reasons, are removed from the comparable store base that fiscal month as well as for the comparable fiscal month in the following fiscal year. Comparable store sales results are important in achieving operating leverage on certain expenses such as store payroll, occupancy, depreciation and amortization, general and administrative expenses, and other costs that are at least partially fixed. Positive comparable store sales results generate greater operating leverage on expenses while negative comparable store sales results negatively affect operating leverage. Comparable store sales results also have a direct impact on our total net sales, cash, and working capital.

Average transaction counts —We consider the trend in the average number of sales transactions occurring in our stores to be a key performance metric. To the extent we are able to increase transaction counts in our stores

that more than offset any decrease in the average dollar sale per transaction, we will generate increases in our comparable store sales.

Gross margins —We analyze the components of gross margin, specifically initial markups and markdowns, buying costs, distribution costs, shrink and store occupancy costs. Any inability to obtain acceptable levels of initial markups, a significant increase in our use of markdowns or an inability to generate sufficient sales leverage on other components of cost of sales could have an adverse impact on our gross margin results and results of operations.

Operating income (loss) —We view operating income (loss) as a key indicator of our success. The key drivers of operating income (loss) are comparable store sales, gross margins, and our ability to control operating costs.

Cash flow and liquidity (working capital) —We evaluate cash flow from operations, liquidity and working capital to determine our short-term operational financing needs. We expect that our cash on hand and cash flows from operations will be sufficient to finance operations without borrowing under our senior revolving credit facility, or the Facility, for at least the next 12 months.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (GAAP) requires the appropriate application of certain accounting policies, some of which require us to make estimates and assumptions about future events and their impact on amounts reported in our consolidated financial statements. Since future events and their impact cannot be determined with absolute certainty, the actual results will inevitably differ from our estimates.

We believe the application of our accounting policies, and the estimates inherently required therein, are reasonable. Our accounting policies and estimates are reevaluated on an ongoing basis, and adjustments are made when facts and circumstances dictate a change. Our accounting policies are more fully described in Note 1 of Notes to Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K. The policies and estimates discussed below involve the selection or application of alternative accounting policies that are material to our consolidated financial statements. Management has discussed the development and selection of these critical accounting policies and estimates with the Audit Committee of our Board of Directors.

We have certain accounting policies that require more significant management judgment and estimates than others. These include our accounting policies with respect to revenue recognition, merchandise inventories, long-lived assets, impairment of goodwill, stock-based compensation, recovery of deferred income taxes, insurance reserves and derivative financial instruments.

Revenue Recognition

Sales are recognized upon purchase by customers at our retail store locations. Taxes collected from our customers are and have been recorded on a net basis. For online sales, revenue is recognized at the estimated time goods are received by customers. Shipping and handling fees billed to internet customers are classified as revenue. Online customers typically receive goods within five to seven days of shipment. We have recorded accruals to estimate sales returns by customers based on historical sales return results. A customer generally may return merchandise within 30 days of the original purchase date. Actual return rates have historically been within management’s estimates and the accruals established. As the accrual for merchandise returns is based on estimates, the actual returns could differ from the accrual, which could impact sales.

We recognize the sales from gift cards, gift certificates and the issuance of store credits as they are redeemed for merchandise. Prior to redemption, we maintain an unearned revenue liability for gift cards, gift

certificates and store credits until we are released from such liability. We have not recognized breakage on gift cards, gift certificates and store credits in our consolidated financial statements as of February 3, 2007. Our gift cards, gift certificates and store credits do not have expiration dates. We are in the process of analyzing our responsibility to escheat unredeemed gift cards, gift certificates and store credits to various state authorities and historical redemption patterns. We may have changes in the estimate of our liability depending on the results of this analysis.

Through our Wet Seal concept, we have a frequent buyer program that entitles the customer to receive a 10% to 20% discount on all purchases made during the 12-month program period. The annual membership fee of $20 is non-refundable. We recognize membership fee revenue on a straight-line basis over the 12-month membership period due to a lack of sufficient program history to date to determine the spending pattern under the program. Upon gaining sufficient program history to assess spending patterns, we may, in the future, determine that recognition of membership fee revenue on a different basis may be appropriate. Discounts received by customers on purchases using the frequent buyer program are recognized at the time of such purchases.

We maintain a customer loyalty program at Arden B. Under the program, customers accumulate points based on purchase activity. Once a loyalty program member achieves a certain point level, the member earns awards that may be redeemed at any time for merchandise. Estimated merchandise redemptions are accrued as unearned revenue and recorded as a reduction of sales as points are accumulated by the member.

During fiscal 2006, we modified the terms of the Arden B loyalty program with respect to the number of points required to earn an award and the value of awards when earned. At the time of the program change, we also established expiration terms (i) for prospectively earned awards of two months from the date the award is earned and (ii) for pre-existing awards of either two or twelve months from the program change date. This resulted in a reduction to the Company’s estimate of ultimate award redemptions under the program. As a result, we recorded a benefit of $3.7 million, which was recorded as an increase to net sales and a decrease to accrued liabilities.

The unearned revenue for this program is recorded in accrued liabilities on the consolidated balance sheets and was $1.9 million and $6.2 million at February 3, 2007, and January 28, 2006, respectively. If actual redemptions ultimately differ from accrued redemption levels, or if we further modify the terms of the program in a way that affects expected redemption value and levels, we could record further adjustments to the unearned revenue accrual, which would affect net sales.

Merchandise Inventories

Merchandise inventories are stated at the lower of cost or market. Market is determined based on the estimated net realizable value, which generally is the merchandise selling price. Cost is calculated using the retail inventory method. Under the retail inventory method, inventory is stated at its current retail selling value and then is converted to a cost basis by applying a cost-to-retail ratio based on beginning inventory and the fiscal year purchase activity. The retail inventory method inherently requires management judgments and estimates, such as the amount and timing of permanent markdowns to clear unproductive or slow-moving inventory, which may impact the ending inventory valuation as well as gross margins.

Markdowns are recorded when the sales value of the inventory has diminished. Factors considered in the determination of permanent markdowns include current and anticipated demand, customer preferences, age of the merchandise and fashion trends. When a decision is made to permanently mark down merchandise, the resulting gross margin reduction is recognized in the period the markdown is recorded. Total markdowns on a cost basis in fiscal 2006, fiscal 2005 and 2004 were $72.2 million, $60.6 million and $88.6 million, respectively, and represented 12.8%, 12.1%, and 20.3% of net sales, respectively. We accrued on a cost basis for planned but unexecuted markdowns as of February 3, 2007, and January 28, 2006, $4.7 million and $3.2 million, respectively.

To the extent that management’s estimates differ from actual results, additional markdowns may be required that could reduce our gross margin, operating income and the carrying value of inventories. Our success is largely dependent upon our ability to anticipate the changing fashion tastes of our customers and to respond to those changing tastes in a timely manner. If we fail to anticipate, identify or react appropriately to changing styles, trends or brand preferences of our customers, we may experience lower sales, excess inventories and more frequent and extensive markdowns, which would adversely affect our operating results.

Long-Lived Assets

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” we evaluate the carrying value of long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Factors that are considered important that could trigger an impairment review include a current-period operating or cash flow loss combined with a history of operating or cash flow losses and a projection or forecast that demonstrates continuing losses or insufficient income associated with the use of a long-lived asset or asset group. Other factors include a significant change in the manner of the use of the asset or a significant negative industry or economic trend. This evaluation is performed based on undiscounted estimated future cash flows from operating activities compared with the carrying value of the related assets. If the undiscounted estimated future cash flows are less than the carrying value, an impairment loss is recognized, measured by the difference between the carrying value and the estimated fair value of the assets, with such estimated fair values determined using the best information available, generally the discounted estimated future cash flows of the assets using a rate that approximates our weighted-average cost of capital. Quarterly, we assess whether events or changes in circumstances have occurred that potentially indicate the carrying value of long-lived assets may not be recoverable.

During fiscal 2006 and fiscal 2005, we determined such events or changes in circumstances had occurred with respect to certain of our retail stores, and that operating losses or insufficient operating income would likely continue. As such, we recorded non-cash charges of a combined total of $0.4 million and $1.0 million, respectively, in our consolidated statement of operations for fiscal 2006 and fiscal 2005 to write-down the carrying value of these stores’ long-lived assets to their estimated fair value.

During fiscal 2004, we concluded that an indication of impairment existed with respect to a large number of our retail stores. Based on the results of impairment analyses, we wrote down the carrying value of certain impaired long-lived assets during fiscal 2004 by $41.4 million, including impairment of goodwill (see below). The impairment charges were a non-cash charge to our consolidated statements of operations.

The estimation of future cash flows from operating activities requires significant estimates of factors that include future sales growth and gross margin performance. If our sales growth, gross margin performance or other estimated operating results are not achieved at or above our forecasted level, or cost inflation exceeds our forecast and we are unable to recover such costs through price increases, the carrying value of certain of our retail stores may prove to be unrecoverable and we may incur additional impairment charges in the future.

Impairment of Goodwill

In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” we test goodwill for impairment no less frequently than annually, and also may test on an interim basis if an event or circumstance indicates that it is more likely than not impairment may have occurred. The impairment, if any, is measured based on the estimated fair value of a reporting unit. Fair value can be determined based on discounted cash flows, comparable sales or valuations of other retail businesses. Impairment occurs when the carrying amount of the goodwill exceeds its estimated fair value.

The most significant assumptions we use in this analysis are those made in estimating future cash flows. In estimating future cash flows, we use assumptions for items such as comparable store sales, store count growth

rates, the rate of inflation and the discount rate we consider to represent our weighted-average cost of capital and/or the market discount rate for acquisitions of retail businesses.

If our assumptions used in performing the impairment test prove inaccurate, the fair value of our goodwill may ultimately prove to be significantly lower, thereby causing the carrying value to exceed the fair value and indicating impairment has occurred. As of February 3, 2007, goodwill was $3.5 million, of which the entire amount is directly associated with the Arden B division. Based on the February 3, 2007 and January 28, 2006, analyses, we determined that no impairment of the Company’s goodwill had occurred. However, based on the results of the January 29, 2005, analysis, we wrote down the carrying value of goodwill as of January 29, 2005, by $0.3 million, which was recorded within asset impairments in the consolidated statements of operations.

Stock-Based Compensation

Effective January 29, 2006, we adopted the provisions of SFAS No. 123(R), “Shared-Based Payment,” which requires the measurement and recognition of compensation expense for all share-based payment awards to employees and directors based on estimated fair values. SFAS No. 123(R) supersedes our previous accounting methodology using the intrinsic value method under Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees.” Under the intrinsic value method, stock-based compensation associated with stock options and awards was determined as the difference, if any, between the fair market value of the related common stock on the measurement date and the price an employee must pay to exercise the award. Accordingly, stock-based compensation expense had been recognized for restricted stock grants as well as for stock options that were granted at prices that were below the fair market value of the related stock at the measurement date.

We adopted SFAS No. 123(R) using the modified prospective application method. Under this method, compensation expense recognized includes (a) compensation expense for all share-based awards granted prior to, but not yet vested, as of January 28, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” and (b) compensation expense for all share-based awards granted subsequent to January 28, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R). In accordance with the modified prospective application method, our consolidated financial statements for prior periods have not been restated to reflect the impact of SFAS No. 123(R).

On November 10, 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. FAS 123R-3, “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards.” We have elected to adopt the alternative transition method provided in FAS 123R-3 for calculating the tax effects of share-based compensation pursuant to SFAS 123(R). The alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in capital pool (“APIC Pool”) related to the tax effects of employee share-based compensation, and to determine the subsequent impact on the APIC Pool and consolidated statements of cash flows of the tax effects of employee and director share-based awards that are outstanding upon adoption of SFAS No. 123(R).

We also apply the provisions of Emerging Issues Task Force (“EITF”) Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Connection with Selling, Goods and Services,” and EITF Issue No. 00-18, “Accounting Recognition for Certain Transactions Involving Equity Instruments Granted to Other Than Employees” for stock-based compensation to other than employees.

We currently use the Black-Scholes option-pricing model to value stock options granted to employees. We use these values to recognize stock compensation expense for stock options in accordance with SFAS No. 123(R). The Black-Scholes model is complex and requires significant exercise of judgment to estimate future common stock dividend yield, common stock expected volatility, and the expected life of the stock options. These assumptions significantly affect our stock option valuations, and future changes in these

assumptions could significantly change valuations of future stock option grants and, thus, affect future stock compensation expense. In addition, if circumstances were to change such that we determined stock options values were better represented by an alternative valuation method, such change could also significantly affect future stock compensation expense.

We also apply the Black-Scholes and Monte-Carlo simulation models to value performance shares granted to employees and consultants. Use of the Black-Scholes model for this purpose requires the same exercise of judgment noted above. The Monte-Carlo simulation model is also complex and requires significant exercise of judgment to estimate expected returns on our common stock, expected common stock volatility and our maximum expected share value during applicable vesting periods. This valuation approach also requires us to estimate a marketability discount in consideration of trading restrictions on performance share grants.

We currently believe Monte-Carlo simulation provides the most relevant value of performance share grants as the simulation allows for vesting throughout the vesting period and includes an assumption for equity returns over time, while the Black-Scholes method does not. As the Monte-Carlo simulation provides a more precise estimate of fair value, we have used that approach to value our performance shares for accounting purposes.

The assumptions we use to value our performance shares significantly affect the resulting values used for accounting purposes. Accordingly, changes in these assumptions could significantly change valuations and, thus, affect future stock compensation expense. In addition, if circumstances were to change such that we determined performance share values were better represented by the Black-Scholes model or an alternative valuation method, and such changes resulted in a significant change in the value of performance shares, such changes could also significantly affect future stock compensation.

Recovery of Deferred Income Taxes

We account for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes.” SFAS No. 109 requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the net deferred tax asset will not be realized. As a result of disappointing sales results during the 2004 back-to-school season and our historical operating performance, management concluded during fiscal 2004 that it was more likely than not that we would not realize our net deferred tax assets. As a result of this conclusion, we reduced to zero our net deferred tax assets by establishing a tax valuation allowance of $100.4 million in fiscal 2004. In addition, we have discontinued recognizing income tax benefits in the consolidated statements of operations until it is determined that it is more likely than not that we will generate sufficient taxable income to realize our deferred tax assets.

As of February 3, 2007, we had federal net operating loss carryforwards of $161.0 million, which begin to expire in 2023. Section 382 of the Internal Revenue Code, or Section 382, contains provisions that may limit the availability of net operating loss carryforwards to be used to offset taxable income in any given year upon the occurrence of certain events, including significant changes in ownership interests. Under Section 382, an ownership change that triggers potential limitations on net operating loss carryforwards occurs when there has been a greater than 50% change in ownership interest by shareholders owning 5% or more of a company over a period of three years or less. Based on our analysis, we had an ownership change on April 1, 2005, which results in Section 382 limitations applying to federal net operating loss carryforwards generated prior to that date, which were approximately $152.9 million. We estimate we will have approximately $103.5 million of this “pre-ownership change” federal net operating loss carryforward available within five years after the ownership change, at a rate of approximately $20.7 million annually, with the remaining net operating loss carryforward of $49.5 million becoming available prior to expiration between 2023 and 2025. Of the $152.9 million, we used approximately $13.3 million in fiscal 2006, leaving $139.6 million of the “pre-ownership change” federal net operating loss carryforward still available as of February 3, 2007. However, if future taxable income were to exceed the sum of (i) the applicable annual loss limitation, (ii) carryforwards of prior years’ unutilized losses, if any, and (iii) carryforwards of post-ownership change losses, if any, in any given fiscal year, then we would be required to pay federal and state income taxes on the excess amount in such fiscal year.

We estimate we will have approximately $66.7 million of federal net operating loss carryforwards available to offset taxable income in fiscal 2007. However, we may also generate income in fiscal 2007 and/or future periods on a federal alternative minimum tax basis, which would result in alternative minimum taxes payable, of which only 90% may be offset by alternative minimum tax net operating loss carryforwards. In addition, we may determine that varying state laws with respect to net operating loss carryforward utilization may result in lower limits, or an inability to utilize loss carryforwards in some states altogether, which could result in our incurring additional state income taxes.

Insurance Reserves

We are partially self-insured for our worker’s compensation and group health plans. Under the workers’ compensation insurance program, we are liable for a deductible of $0.25 million for each individual claim and an aggregate annual liability of $1.5 million. Under our group health plan, we are liable for a deductible of $0.15 million for each claim and an aggregate monthly liability of $0.5 million. The monthly aggregate liability is subject to adjustment based on the number of participants in the plan each month. For both of the insurance plans, we record a liability for the costs associated with reported claims and a projected estimate for unreported claims considering historical experience and industry standards. We will continue to adjust the estimates as the actual experience dictates. A significant change in the number or dollar amount of claims could cause us to revise our estimate of potential losses and affect our reported results.

Derivative Financial Instruments

We account for derivative financial instruments in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended by SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 133 requires that all derivative financial instruments be recorded on the consolidated balance sheets at fair value.

As of February 3, 2007, our only derivative financial instrument was an embedded derivative associated with our secured convertible notes. The gain or loss as a result of the change in fair value of this embedded derivative is recognized in interest expense in the consolidated statements of operations each period.

We apply the Black-Scholes and Monte-Carlo simulation models to value this embedded derivative. In applying the Black-Scholes and Monte-Carlo simulation models, changes and volatility in our common stock price, and changes in risk-free interest rates, our expected dividend yield and expected returns on our common stock could significantly affect the fair value of this derivative instrument, which could then result in significant charges or credits to interest expense in our consolidated statements of operations.

We have determined that value is best represented by a blend of valuation outcomes under Black-Scholes modeling and Monte-Carlo simulation. In addition to the estimate changes noted above, if circumstances were to change such that we determined that the embedded derivative value was better represented by an alternative valuation method, and such changes resulted in a significant change in the value of the embedded derivative, such changes could also significantly affect future interest expense.

Current Trends and Outlook

In December 2004, we initiated a new strategy for our Wet Seal stores, which, among other things, consisted of closure of approximately 150 under performing Wet Seal stores, lower retail prices, a broader assortment of fashion-right merchandise and more frequent delivery of fresh merchandise. With the introduction of this strategy, we experienced consolidated comparable store sales growth of 44.7% in fiscal 2005. During fiscal 2006, we built upon the turnaround that started in fiscal 2005, with further comparable sales growth of 6.1%. During fiscal 2006, we also increased transaction counts per store and the number of items purchased per customer, which were partially offset by a decrease in average unit retail in comparison to the prior year. During the four weeks ended March 3, 2007, and the five weeks ended April 7, 2007, we continued the positive sales trend with increases of 5.0% and 10.9% in comparable store sales, respectively.

Our long term strategy is to expand our existing retail store base, take advantage of our compelling store economics, continue our trend of positive comparable store sales growth, revive the Arden B business and expand our online business. We are also taking several steps to drive higher sales productivity in our retail stores, including improved store layout and visual displays, and have embarked on several initiatives to improve gross margins, including efforts to increase direct foreign sourcing of merchandise, rationalize our vendor base and improve supply chain efficiency through better synergies among and within our vendor, internal distribution and store operations organizations.

Our current operating performance trend and financing transactions completed in fiscal 2004 and 2005 have resulted in increased liquidity and, in turn, improved our current credit standing with suppliers, which may further improve our liquidity. However, we may experience future declines in comparable store sales or may be unsuccessful in executing some or all of our business strategy. If our comparable store sales drop significantly or we falter in execution of our business strategy, we may not achieve our financial performance goals, which could impact our results of operations and operating cash flow, and we may be forced to seek alternatives to address cash constraints, including seeking additional debt and/or equity financing.

Store Openings and Closures

During fiscal 2006, we opened 34 Wet Seal and four Arden B stores and closed four Wet Seal and four Arden B stores. We believe future closures for at least the next 12 months will primarily result from lease expirations where we decide not to extend, or are unable to extend, a store lease.

We expect to open 58 to 62 new Wet Seal and/or Arden B stores, net of closings, during fiscal 2007.

Credit Extensions

Due to our financial results through fiscal 2004, we experienced a tight credit environment. Credit extended to us by vendors, factors, and others for merchandise and services was extremely limited. This credit tightening required us to issue letters of credit outside of the ordinary course of business, or, in many instances, shorten vendor credit terms. The lack of credit created a considerable need for working capital. Our improving sales trend, the completion of financing transactions in fiscal 2004 and 2005, and our improved operating results in fiscal 2005 and fiscal 2006 have significantly improved our cash position and liquidity profile. As a result, we achieved improvements in credit terms with several vendors in fiscal 2006, and we believe, but cannot provide assurance, that we could now obtain longer credit terms with additional vendors. However, we continue to maintain shorter credit terms in order to take advantage of favorable purchase discounts.

Merchandising Consultant

Beginning in late 2004, a consultant assisted our company with merchandising initiatives for our Wet Seal concept. On July 6, 2005, we entered into a consulting agreement and an associated stock award agreement with the consultant that expired on January 31, 2007.

Under the terms of the consulting agreement, we paid the consultant $2.1 million upon agreement execution and $0.1 million per month from July 2005 through January 2007. We recorded $1.2 million and $2.8 million of consulting expense within selling, general and administrative expenses in our consolidated statements of operations during fiscal 2006 and fiscal 2005, respectively, to recognize this cash compensation. Since the term of the consulting agreement ended in fiscal 2006, we will not incur any further cash compensation expense under this arrangement in future periods.

Under the terms of the stock award agreement, we awarded the consultant 2.0 million shares of non-forfeitable restricted stock, for which we recognized $13.3 million of stock compensation expense during the second quarter of fiscal 2005. We also awarded two tranches of 1.75 million performance shares, under the stock

award agreement, or the Performance Shares. The Performance Shares vest upon our achievement of certain common stock market price levels on or before January 1, 2008, as specified in the stock award agreement. The second tranche of Performance Shares may also vest upon our achievement of certain sales and gross margin levels on or before January 1, 2008, also as specified in the stock award agreement; however, we believe the achievement of vesting through reaching the specified common stock market price levels is significantly more likely than achievement of vesting through achieving the specified sales and gross margin targets. During fiscal 2006, the entire first tranche of the Performance Shares and one of the five 350,000-share sub-tranches of the second tranche of the Performance Shares had vested due to our achievement of the specified common stock market price levels pertaining thereto.

As more fully described in Note 8 of Notes to Consolidated Financial Statements, we recorded a charge of $9.8 million of non-cash consulting expense within selling, general and administrative expenses during fiscal 2006, based on the vesting of a portion of the Performance Shares, the consulting agreement period elapsed and the fair value of the remaining unvested Performance Shares, which included consideration of vesting probability for the second tranche as of the end of fiscal 2006. Given the completion of the consulting agreement term as of the end of fiscal 2006, in fiscal 2007 and beyond we will incur no additional consulting expense or credit with respect to the Performance Shares, regardless of the eventual vesting or non-vesting of the 1.4 million non-vested shares remaining as of February 3, 2007.

Stock-Based Compensation

Effective January 29, 2006, we adopted the provisions of SFAS No. 123(R), which requires the measurement and recognition of compensation expense for all share-based payment awards to employees and directors based on estimated fair values. The adoption of SFAS No. 123(R) resulted in the recognition of incremental compensation expense of $2.3 million related to stock options and $0.6 million related to employee performance shares during fiscal 2006.

The following table summarizes stock-based compensation recorded in the consolidated statements of operations, including the expense for the performance shares granted to the merchandising consultant as discussed above:


(in thousands)	February 3, 2007		January 28, 2006		January 29, 2005
Cost of sales	$	986	$	—	$	—
Selling, general and administrative expenses		14,030		24,601		1,715

Stock-based compensation	$	15,016	$	24,601	$	1,715

Results of Operations

Except as otherwise noted, the following discussion of our financial position and results of operations excludes our discontinued Zutopia concept, which was closed by May 2004.

The following table sets forth selected statements of operations data as a percentage of net sales for the fiscal year indicated. The discussion that follows should be read in conjunction with the table below:


	As a Percentage of Sales
Fiscal Year	2006		2005		2004
Fiscal Year Ended	February 3, 2007		January 28, 2006		January 29, 2005
Net sales	100.0	%	100.0	%	100.0	%
Cost of sales	65.7		67.8		86.7

Gross margin	34.3		32.2		13.3
Selling, general and administrative expenses	31.7		34.3		37.2
Store closure (adjustments) costs	(0.1	)	0.9		3.8
Asset impairment	0.1		0.2		9.5

Operating income (loss)	2.6		(3.2	)	(37.2	)
Interest expense, net	(4.9	)	(2.6	)	(0.5	)

Loss before provision for income taxes	(2.3	)	(5.8	)	(37.7	)
Provision for income taxes	—		0.1		7.0

Loss from continuing operations	(2.3	)	(5.9	)	(44.7	)
Loss from discontinued operations, net of income taxes	—		—		(1.6	)

Net loss	(2.3	)	(5.9	)	(46.3	)
Accretion of non-cash dividends on convertible preferred stock	—		(4.6	)	—

Net loss attributable to common stockholders	(2.3	)%	(10.5	)%	(46.3	)%

Fiscal 2006 compared to Fiscal 2005

Net Sales


	2006		Change From Prior Fiscal Year				2005
	($ in millions)
Net sales	$	564.3	$	63.5	12.7	%	$	500.8
Comparable store sales					6.1	%

Net sales in fiscal 2006 increased as a result of the following:

•

Our comparable store sales increase of 6.1% as a result of a 10.2% increase in transaction counts per store, partially offset by a 4.5% decrease in average dollar sale. The decrease in average dollar sale resulted from a 14.6% decrease in our average unit retail, driven by the continuation of our new merchandising strategy in our Wet Seal stores, partially offset by a 10.5% increase in units per customer;

•

Modification of the terms of our Arden B customer loyalty program to expire unredeemed awards after specified periods of time, which resulted in recognition of sales previously deferred of $3.7 million and which is not a factor in calculating our comparable store sales;

•

An increase of $10.1 million in net sales for our Internet business compared to the prior year, which is also not a factor in calculating our comparable store sales;

•

The inclusion of 53 weeks of operations in fiscal 2006 versus 52 weeks in fiscal 2005, which added $9.4 million in net sales to fiscal 2006; and

•

An increase in the number of stores open, from 400 Wet Seal and Arden B stores as of January 28, 2006, to 430 Wet Seal and Arden B stores as of February 3, 2007.

Cost of Sales


	2006			Change From Prior Fiscal Year				2005
	($ in millions)
Cost of sales	$	370.9		$	31.4	9.3	%	$	339.5
Percent of net sales		65.7	%			(2.1	)%		67.8	%

Cost of sales includes the cost of merchandise, markdowns, inventory shortages, inventory valuation adjustments, inbound freight, payroll expenses associated with design, buying, planning and allocation, processing, receiving and other warehouse costs, and rent and depreciation and amortization expense associated with our stores and distribution center.

Cost of sales increased in dollars primarily due to the 12.7% increase in net sales. Cost of sales decreased as a percent to net sales, due to:

•

Modification of the terms of our Arden B customer loyalty program to expire unredeemed awards after a specified period of time, resulting in recognition of sales previously deferred of $3.7 million with no corresponding charge to cost of sales;

•

Improvement in merchandise margin due to increases in cumulative markup rates and increased amortization of frequent buyer program revenues, partially offset by increased markdowns for discounts associated with the frequent buyer program, increased markdowns in connection with the transition of merchandise leadership within the Arden B concept, and additional markdowns at Wet Seal stores due to relatively weak sales performance in the fourth quarter; and

•

The positive effect of sales leverage on occupancy costs.

However, the decrease was partially offset by the following:

•

An increase in buying, planning and allocation payroll and related costs due to higher staffing levels and $0.9 million in stock compensation expense resulting from our adoption of SFAS 123(R) as of the beginning of fiscal 2006; and

•

An increase in distribution costs associated with transferring security-tagging activity from our stores to our distribution center, an increase in inventory receipts and $0.1 million in stock compensation expense resulting from our adoption of SFAS 123(R) as of the beginning of fiscal 2006.

Selling, General and Administrative Expenses (SG&A)


	2006			Change From Prior Fiscal Year				2005
	($ in millions)
Selling, general and administrative expenses	$	178.7		$	6.7	3.9	%	$	172.0
Percent of net sales		31.7	%			(2.6	)%		34.3	%

Our SG&A expenses are comprised of two components. Selling expenses include store and field support costs including personnel, advertising, and merchandise delivery costs as well as internet/catalog processing costs. General and administrative expenses include the cost of corporate functions such as executives, legal, finance and accounting, information systems, human resources, real estate and construction, loss prevention, and other centralized services.

Selling expenses increased approximately $17.3 million over the prior year. As a percentage of net sales, selling expenses were 23.3% of net sales, or 0.6 points higher as a percentage of net sales, than a year ago. The increase in selling expenses from last year, in dollars, was primarily due to a $9.2 million increase in payroll and

benefits costs as a result of increased sales, labor-intensive store promotion set-ups, heavy inventory receipts and our increase in store count, partially offset by transfer of security-tagging activity from our stores to our distribution center during fiscal 2006; a $2.8 million increase in Internet production and ordering costs due to higher Internet sales compared to the prior year; a $2.2 million increase in spending for advertising associated with visual presentation, in-store signage, promotional contests and publication placements; a $1.0 million increase in store supply costs; a $0.4 million increase in credit card and other banking fees; a $0.5 million increase in security costs due to increased purchases of inventory sensor tags; a $1.0 million increase in store-related travel and field support costs; and a $0.2 million increase in inventory services due to our increased number of stores and higher inventory levels.

General and administrative expenses decreased approximately $10.6 million from the prior year to $47.5 million. As a percentage of net sales, general and administrative expenses were 8.4%, or 3.2 points lower, than a year ago.

The following contributed to the current year decrease in general and administrative expenses:

•

A decrease in charges associated with the July 2005 merchandise consultant agreement of $14.0 million, which resulted from prior year stock and cash compensation charges of $22.2 million and $2.8 million, respectively, versus only $9.8 million and $1.2 million of such charges, respectively, in the current year; and

•

A $2.0 million decrease in legal fees, due primarily to a decrease in the amount of legal charges associated with shareholder class action litigation initiated in mid-fiscal 2004 and an SEC investigation initiated in early fiscal 2005.

However, the decrease in general and administrative expenses was partially offset by the following increases:

•

$1.6 million in non-cash stock compensation expense for employee stock options and performance shares primarily as a result of our adoption of SFAS No. 123(R), as of the beginning of fiscal 2006;

•

A $2.6 million increase in corporate payroll due to increased staff levels in real estate and store construction functions in order to accommodate store growth plans as well as achievement of full staffing in several other corporate support functions;

•

A $1.0 million increase in payroll taxes and benefit costs due to increased corporate payroll and an increase in claims in our group health plan; and

•

A $0.2 million increase in other miscellaneous charges.

Store Closure (Adjustments) Costs


	2006			Change From Prior Fiscal Year					2005
	($ in millions)
Store closure (adjustments) costs	$	(0.7	)	$	(5.2	)	(115.6	)%	$	4.5
Percent of net sales		(0.1	)%				(1.0	)%		0.9	%

As a result of decreases in estimated costs for lease terminations, primarily due to settlement agreements and a decrease in estimated legal and other costs, during fiscal 2006, we recognized a $0.7 million credit to store closure costs.

Fiscal 2005 included store closure costs of $4.5 million primarily related to the estimated lease termination costs for 150 Wet Seal store closures as part of our turnaround strategy.

Asset Impairment


	2006			Change From Prior Fiscal Year					2005
	($ in millions)
Asset impairment	$	0.4		$	(0.6	)	(57.0	)%	$	1.0
Percent of net sales		0.1	%				(0.1	)%		0.2	%

Based on our quarterly assessments of the carrying value of long-lived assets, in fiscal 2006 we identified five stores with carrying values of their assets, including leasehold improvements, furniture, fixtures and equipment, in excess of such stores’ respective forecasted undiscounted cash flows. Accordingly, we reduced their respective carrying values to their estimated fair market values. We incurred non-cash charges of $0.4 million to write down these stores to their respective fair values.

During fiscal 2005, we recorded impairment charges of $1.0 million to write down seven stores’ assets to their respective fair values, as well as to write down the value of certain capital additions made to previously impaired stores.

Interest Expense, Net


	2006			Change From Prior Fiscal Year					2005
	($ in millions)
Interest expense, net	$	(27.6	)	$	(14.7	)	114.3	%	$	(12.9	)
Percent of net sales		(4.9	)%				(2.3	)%		(2.6	)%

We incurred interest expense, net, of $27.6 million in fiscal 2006 comprised of:

•

A net write-off of $29.1 million of unamortized debt discount, deferred financing costs and accrued interest upon investor conversions into Class A Common Stock of $37.5 million of our secured convertible notes;

•

Non-cash interest expense of $2.1 million with respect to our secured convertible notes comprised of annual interest at 3.76% and discount amortization;

•

Amortization of deferred financing costs of $0.5 million associated with our senior credit facility, term loan and secured convertible notes;

•

A non-cash credit of $0.4 million to interest expense to recognize the decrease in market value during the period of a derivative liability resulting from a “change in control” put option held by the investors in our secured convertible notes;

•

Non-cash interest expense of $0.2 million to write-off unamortized deferred financing costs and cash interest expense of $0.1 million for a prepayment penalty upon our repayment of the $8.0 million term loan in March 2006;

•

Interest expense of $0.4 million under our senior credit facility, for an $8.0 million term loan, plus related senior credit facility, appraisal and amendment fees; and

•

Interest income of $4.4 million from investment of cash.

In fiscal 2005, we incurred interest expense, net, of $12.9 million, comprised of $8.8 million of net accelerated interest charges upon investor conversions into Class A Common Stock of $10.4 million of our $56.0 million of secured convertible notes, $1.2 million associated with our senior credit facility and the term loan thereunder, $1.2 million of interest expense on a $10.0 million bridge loan, $3.0 million of interest on our secured convertible notes and discount amortization, and amortization of $1.0 million of deferred financing cost, partially offset by $2.1 million of interest income from investment of cash and a non-cash credit of $0.2 million to recognize the decrease in market value of derivative liabilities.

Provision for Income Taxes


	2006		Change From Prior Fiscal Year					2005
	($ in millions)
Provision for income taxes	$	0.3	$	(0.0	)	(0.0	)%	$	0.3

We ceased recognizing tax benefits related to our net operating losses and other deferred tax assets beginning with our second quarter of fiscal 2004, and we currently recognize the tax benefits associated with our deferred tax assets only when they are realized.

Due primarily to the non-deductibility for tax purposes of the interest expense associated with our secured convertible notes, we generated taxable income in fiscal 2006 despite our loss before provision for income taxes. We had sufficient net operating loss carryforwards available to fully offset our taxable income for fiscal 2006; however, under federal tax law, we are permitted to use net operating loss carryforwards to offset only 90% of our taxable income, as calculated on the alternative minimum tax basis. As such, our remaining 10% of income, as calculated on the alternative minimum tax basis, is subject to federal income taxes payable at a rate of 20%. Our fiscal 2006 provision for income taxes is primarily comprised of this alternative minimum tax.

During fiscal 2005, we incurred a provision for income taxes of $0.3 million to write off certain state tax receivables we no longer believe to be realizable.

Accretion of non-cash dividends on convertible preferred stock

During fiscal 2005, we issued 24,600 shares of our Series C Convertible Preferred Stock, with a stated value of $24.6 million. We initially recorded this preferred stock at a discount of $23.3 million. During fiscal 2005, we immediately accreted this discount in its entirety in the form of a deemed non-cash preferred stock dividend since the preferred stock is immediately convertible and has no stated redemption date.

Fiscal 2005 compared to Fiscal 2004

Net Sales


	2005		Change From Prior Fiscal Year				2004
	($ in millions)
Net sales	$	500.8	$	65.2	15.0	%	$	435.6
Comparable store sales					44.7	%

Net sales in fiscal 2005 increased as a result of significant growth in comparable store sales. Comparable store sales increased 44.7% as a result of an 85.3% increase in transaction count per store, partially offset by a 13.0% decrease in average dollar sale driven substantially all by a decrease in our average unit retail, which resulted from our change in merchandising strategy in our Wet Seal stores.

The net sales growth from increased comparable store sales was partially offset by having a lower average number of stores in operation during fiscal 2005 than in fiscal 2004. This decrease primarily resulted from closing 103 Wet Seal stores during the period from December 2004 through January 2005 and 50 Wet Seal Stores from February 2005 through early March 2005 pursuant to the Wet Seal turn-around strategy. The fewer stores in operation during fiscal 2005 versus fiscal 2004 was also affected by closure of 25 stores primarily from February through September of fiscal 2004 and closure of an additional 14 stores from late March 2005 through the end of fiscal 2005. The lower average number of stores in operation was partially offset by openings of 8 stores during fiscal 2004 followed by openings of 11 stores during fiscal 2005, which included re-openings of 8 previously closed Wet Seal stores.

Cost of Sales


	2005			Change From Prior Fiscal Year					2004
	($ in millions)
Cost of sales	$	339.5		$	(38.2	)	(10.1	)%	$	377.7
Percent of net sales		67.8	%				(18.9	)%		86.7	%

Cost of sales includes the cost of merchandise, markdowns, inventory shortages, inventory valuation adjustments, inbound freight, payroll expenses associated with design, buying, planning and allocation, inspection costs, processing, receiving and other warehouse costs, and rent and depreciation and amortization expense associated with our stores and distribution center.

Cost of sales, in dollars and as a percent to net sales, decreased due to:

•

The positive effect of higher average store sales on design, buying, planning and allocation and occupancy costs;

•

Significantly lower markdown volume due primarily to benefits from the new merchandising approach in our Wet Seal stores; and

•

The volume impact of having a lower average number of stores open in fiscal 2005 versus fiscal 2004 due mainly to the effect of the Wet Seal turn-around strategy that included closing of 153 stores in late 2004 and early 2005.

Selling, General and Administrative Expenses (SG&A)


	2005			Change From Prior Fiscal Year				2004
	($ in millions)
Selling, general and administrative expenses	$	172.0		$	10.0	6.1	%	$	162.0
Percent of net sales		34.3	%			(2.9	)%		37.2	%

Selling expenses decreased $11.3 million to 22.7% of net sales, or 6.0 points as a percentage of net sales, from a year ago. The decrease in store operating expenses from last year, in dollars, was primarily due to having a lower average number of stores open in fiscal 2005 versus fiscal 2004 due mainly to the effect of the Wet Seal turn-around strategy, which resulted in an $11.5 million decrease in store and field operations payroll and benefit costs, and a $4.1 million decrease in spending for advertising, which included the discontinuance of our Wet Seal in-store fashion and entertainment network, partially offset by increases of $1.5 million for merchandise delivery, $1.5 million for bags and boxes and $0.4 million for store supplies as a result of our significant transaction count increase, and an increase of $0.7 million in credit card fees due to our sales growth. The decrease in selling expenses as a percentage of net sales was primarily due to efficiencies resulting from changes in our store staffing model and the leverage benefits on store labor from the comparable store sales increases in ongoing stores, partially offset by the increases in store supplies, bag and box and merchandise delivery costs, which exceeded our net sales growth rate.

General and administrative expenses increased approximately $21.3 million over last year to $58.1 million. General and administrative expenses were 11.6%, or 3.1 points higher, as a percentage of net sales, than a year ago. The following contributed to the current year increase in general and administrative expenses:

•

$2.8 million in cash charges and $22.2 million in non-cash stock compensation charges incurred under the terms of the consulting and stock award agreements we executed with a merchandising consultant in July 2005;

•

An increase in Board of Director fees of $0.5 million, primarily associated with non-cash stock compensation; and

•

An increase of $0.4 million of provisions for estimated costs of state sales and use tax audits.

However, the increase in general and administrative expenses was partially offset by the following decreases:

•

A $1.5 million charge for consulting expenses in the prior year associated with our assessment of strategic alternatives;

•

A $1.0 million decrease in salaries, wages, bonuses and benefits primarily due to lower head count and the incurrence of $1.9 million of employee retention bonuses in the prior year, partially offset by a $2.5 million increase in performance bonuses due to our significantly improved financial performance in the current year;

•

A $0.6 million decrease in computer maintenance costs;

•

A $0.3 million decrease in fees incurred for the audits of our consolidated financial statements and of our internal controls over financial reporting in accordance with the Sarbanes-Oxley Act of 2002; and

•

A $1.6 million decrease in severance charges, due to $2.7 million in severance charges in the prior year related to the resignation of our former CEO and our former Wet Seal division president, which was partially offset by $1.1 million in severance charges in the current year related to the resignation of the company’s former CFO, an Executive Vice President and certain other employees.

Store Closure Costs


	2005			Change From Prior Fiscal Year					2004
	($ in millions)
Store closure costs	$	4.5		$	(11.9	)	(72.5	)%	$	16.4
Percent of net sales		0.9	%				(2.9	)%		3.8	%

In December 2004, we announced that we would close approximately 150 Wet Seal stores as part of our turn-around strategy. We completed our inventory liquidation sales and closing of 153 Wet Seal stores by early March 2005. Subsequently, we closed eight additional Wet Seal stores due to their poor performance. We took charges of $4.5 million related to the estimated lease termination costs for the store closures that occurred through early March 2005 and related liquidation fees and expenses, partially offset by a benefit related to the write-off of deferred rent associated with these stores. We have completed our previously announced store closure effort and related lease terminations.

With respect to fiscal 2004, of the 153 stores that were part of our Wet Seal turn-around strategy, we had ceased use of property at 103 Wet Seal stores on or about January 29, 2005, and took a charge of approximately $13.2 million for the estimated cost of lease buyouts and other related costs. In addition, for all the stores we identified for closure, we took a charge of approximately $4.4 million for the write-down of the carrying value of the store assets (primarily leasehold improvements) to realizable value. In addition, we recognized a benefit of approximately $1.2 million related to the write-off of deferred rent associated with these stores.

Asset Impairment


	2005			Change From Prior Fiscal Year					2004
	($ in millions)
Asset impairment	$	1.0		$	(40.4	)	97.6	%	$	41.4
Percent of net sales		0.2	%				(9.3	)%		9.5	%

Based on our quarterly assessments of the carrying value of long-lived assets, in fiscal 2005, we identified seven stores with carrying values of their assets, including leasehold improvements, furniture, fixtures and equipment, in excess of such stores’ respective forecasted undiscounted cash flows. Accordingly, we reduced

their respective carrying values to their estimated fair market values. We incurred non-cash charges of $1.0 million to write down these stores to their respective fair values, as well as to write-down the value of certain capital additions made to previously impaired stores.

During fiscal 2004, we recorded impairment charges of $41.4 million, including impairment of goodwill, on certain long-lived assets, primarily as a result of disappointing sales results for the “Back-To-School” period, our expectations at that time for operating results for the balance of fiscal 2004 and recent historical results.

Interest Expense, Net


	2005			Change From Prior Fiscal Year					2004
	($ in millions)
Interest expense, net	$	(12.9	)	$	(10.7	)	(491.4	)%	$	(2.2	)
Percent of net sales		(2.6	)%				(2.1	)%		(0.5	)%

We incurred interest expense, net, of $12.9 million in fiscal 2005 comprised of:

•

Interest expense of $1.2 million under our senior credit facility, or the Facility, for our $8.0 million term loan, which bears interest at prime plus 7%, plus our senior credit facility, appraisal and amendment fees. The term loan was repaid in full on March 23, 2006.

•

A net write-off of $8.8 million of unamortized debt discount, deferred financing costs and accrued interest upon investor conversions into Class A Common Stock of $10.4 million of our $56.0 million of secured convertible notes.

•

Interest expense of $1.2 million incurred through the May 2005 repayment date on our $10.0 million bridge loan, which had an annual rate of interest of 25.0%.

•

Non-cash interest expense of $3.0 million with respect to our convertible notes issued in the January 2005 private placement financing, which includes both an annual interest rate of 3.76%, which we have elected to add to principal, and discount amortization.

•

Amortization of deferred financing costs of $1.0 million associated with the placement of our senior credit facility, term loan and our secured convertible notes.

•

Non-cash credits of $0.2 million to interest expense to recognize the decrease in market value during the period of derivative liabilities resulting from a “change in control” put option held by the investors in our secured convertible notes and the registration rights agreement associated with our Series C Convertible Preferred Stock.

•

Interest income of $2.1 million from investment of excess cash.

In fiscal 2004, we incurred net interest expense of $2.1 million, comprised of $0.7 million associated with our senior credit facility and the term loan thereunder, $0.6 million of interest expense on our $10.0 million bridge loan, $0.3 million of interest on our notes issued shortly before that fiscal year-end and $1.0 million of deferred financing cost amortization, partially offset by $0.5 million of interest income on investments.

Provision for Income Taxes


	2005		Change From Prior Fiscal Year					2004
	($ in millions)
Provision for income taxes	$	0.3	$	(30.4	)	(98.9	)%	$	30.7

As discussed further below, we ceased recognizing tax benefits related to our net operating losses and other deferred tax assets beginning with our second quarter of fiscal 2004. We also did not recognize income tax

benefits related to net operating losses generated in fiscal 2005. During fiscal 2005, we incurred a provision for income taxes of $0.3 million primarily to write off certain state tax receivables we no longer believe to be realizable.

In fiscal 2004, we incurred a benefit for current income taxes of $1.9 million and a provision for deferred income taxes of $32.6 million. The provision for deferred income taxes was comprised of the establishment of a tax valuation allowance of $43.5 million against all of our deferred tax assets, partially offset by a benefit to income taxes of $10.9 million recognized prior to our decision in 2004 to cease recognizing such benefits. The tax valuation allowance was deemed necessary in light of disappointing sales results, our expectations at that time for weak future operating results and our historical operating performance. We established this tax valuation allowance in accordance with SFAS No. 109, “Accounting for Income Taxes,” which requires deferred tax assets to be reduced by a valuation allowance if it is more likely than not that some or all of the deferred tax assets will not be realized in the foreseeable future. Also, see Note 3 of Notes to Consolidated Financial Statements included elsewhere in this Annual Report for discussion of limitations on our ability to utilized net operating loss carryforwards.

Accretion of Non-Cash Dividends on Convertible Preferred Stock

As discussed further in Note 7 of Notes to Consolidated Financial Statements contained elsewhere in this Annual Report on Form 10-K, during fiscal year 2005 we issued 24,600 shares of the Preferred Stock, with a stated value of $24.6 million. We initially recorded the Preferred Stock at a discount of $23.3 million. We immediately accreted this discount in its entirety in the form of a non-cash dividend on Preferred Stock since the Preferred Stock is immediately convertible and has no stated redemption date.

Liquidity and Capital Resources

Net cash provided by operating activities was $28.8 million for fiscal 2006, compared to $11.0 million for the same period last year. For fiscal 2006, operating cash flows were directly impacted by net non-cash charges (primarily stock compensation expense, depreciation and amortization, and amortization of debt discount and deferred financing costs) of $59.8 million, partially offset by our net loss of $12.8 million; an increase in merchandise inventories, net of merchandise accounts payable of $11.6 million due to our increased store count, an increase in average inventory per store, and a decrease in merchandise accounts payable versus a year ago due to variances in the timing of inventory receipts near year-end; and a use of cash from changes in other operating assets and liabilities of $6.6 million due primarily to our payment of February 2007 store rents prior to the end of fiscal 2006. For fiscal 2006, net cash used in investing activities of $16.7 million was comprised primarily of capital expenditures. Capital expenditures for the period were primarily for new stores and store relocations and remodeling for our Wet Seal concept and for various information technology projects. Capital expenditures do not include $3.2 million in capital assets purchased on account for which we have not yet made payment, which is $2.9 million higher than the similar balance as of the end of fiscal 2005 due to increase capital expenditure activity in late fiscal 2006. We expect such payments will be made primarily during the first quarter of fiscal 2007.

We estimate that, in fiscal 2007, capital expenditures will be approximately $47.0 million, primarily for the construction of 68 to 72 new stores, remodeling or relocation of existing stores and various other store-related capital projects. We anticipate receiving approximately $10 million in landlord tenant improvement allowances in connection with certain of our new store lease agreements.

For fiscal 2006, net cash used in financing activities was $3.7 million, comprised primarily of the repayment of our $8.0 million term loan and common stock repurchases for a cost of $15.1 million, partially offset by $19.3 million in proceeds from investor exercises of common stock warrants. On March 28, 2006, our Board of Directors authorized the repurchase of up to 4.0 million of the outstanding shares of our Class A Common Stock. Repurchases are at our option and can be discontinued at any time.

Total cash and cash equivalents at February 3, 2007, was $105.3 million, compared to $96.8 million at January 28, 2006. Our working capital at February 3, 2007, increased to $90.0 million from $65.2 million at January 28, 2006, due primarily to our increase in cash, merchandise inventories and prepaid expenses, especially prepaid rents, and our decrease in accounts payable, partially offset by our increase in accrued liabilities during fiscal 2006.

We previously maintained a $50.0 million senior revolving credit facility (the Facility), which was scheduled to mature in May 2007. On August 14, 2006, we replaced the Facility with an Amended and Restated Credit Agreement (the Restated Credit Agreement) to provide for a senior revolving credit facility of $35.0 million, which can be increased up to $50.0 million in the absence of any default and upon the satisfaction of certain conditions precedent specified in the Restated Credit Agreement. In addition to extending the current agreement term from May 2007 to May 2011, the Restated Credit Agreement provides us, subject to the satisfaction of certain conditions precedent, with the ability to make certain levels of investments, acquisitions and common stock repurchases without lender consent, and reduces our letter of credit and other facility fees. Under the Restated Credit Agreement, we are subject to borrowing base limitations on the amount that can be borrowed and certain customary covenants, including covenants limiting our ability to incur additional indebtedness, make investments and acquisitions, grant liens, pay dividends, close stores and dispose of assets, subject to certain exceptions. Our ability to borrow and request the issuance of letters of credit is subject to the requirement that we maintain an excess of the borrowing base over the outstanding credit extensions of not less than $5.0 million. The interest rate on the revolving line of credit under the Restated Credit Agreement is the prime rate or, if we elect, the London Interbank Offered Rate (“LIBOR”) plus a margin ranging from 1.0% to 1.5%. The applicable LIBOR margin is based on the level of average Excess Availability, as defined under the Restated Credit Agreement, at the time of election, as adjusted quarterly. The applicable LIBOR margin was 1.0% as of February 3, 2007. We also incur fees on outstanding letters of credit under the Restated Credit Agreement in effect at a rate equal to the applicable LIBOR margin for standby letters of credit and 33.3% of the applicable LIBOR margin for commercial letters of credit.

The Restated Credit Agreement ranks senior in right of payment to our secured convertible notes. Borrowings under the Restated Credit Agreement are secured by all of our presently owned and hereafter acquired assets. Our obligations thereunder are guaranteed by one of our wholly owned subsidiaries, Wet Seal GC, Inc.

At February 3, 2007, the amount outstanding under the Restated Credit Agreement consisted of $5.3 million in open documentary letters of credit related to merchandise purchases and $1.3 million in standby letters of credit. At February 3, 2007, we had $28.4 million available for cash advances and/or for the issuance of additional letters of credit. At February 3, 2007, we were in compliance with all covenant requirements in the Restated Credit Agreement.

We believe we will have sufficient cash and credit availability to meet our operating and capital requirements for at least the next 12 months. However, we may experience future declines in comparable store sales or experience other events that negatively affect our operating results. Such decline could result in a reduction in our operating cash flows and a decrease in or elimination of excess availability under our Restated Credit Agreement, which could force us to seek alternatives to address our cash constraints, including seeking additional debt and/or equity financing.

Seasonality and Inflation

Our business is seasonal in nature, with the Christmas season, beginning the week of Thanksgiving and ending the first Saturday after Christmas, and the back-to-school season, beginning the last week of July and ending in mid-September, historically accounting for a large percentage of our sales volume. For the past three fiscal years, the Christmas and back-to-school seasons together accounted for an average of slightly more than 30% of our annual sales. We do not believe that inflation has had a material effect on our results of operations during the past three years. However, we cannot be certain that our business will not be affected by inflation in the future.

Commitments and Contingencies

At February 3, 2007, our contractual obligations consist of:


	Payments Due By Period
Contractual Obligations (in thousands)	Total		Less Than 1 Year		1–3 Years		4–5 Years		Over 5 Years
Lease commitments:
Operating leases	$	260,298	$	49,311	$	83,536	$	64,118	$	63,333
Fixed common area maintenance		31,625		4,892		8,918		7,982		9,833
Convertible notes, including accrued interest		8,713		—		—		—		8,713
Supplemental Employee Retirement Plan		2,173		220		440		440		1,073
Projected interest on contractual obligations		1,739		—		—		—		1,739

Total	$	304,548	$	54,423	$	92,894	$	72,540	$	84,691

Lease commitments include operating leases for our retail stores, principal executive offices, warehouse facilities and computers under operating lease agreements expiring at various times through 2017. During fiscal 2006, we amended our principal executive office and warehouse facility operating lease. The addendum includes a lease extension term through December 4, 2017 with the option to terminate on December 4, 2014 upon payment by us of an early termination fee of $0.7 million. Certain leases for our retail stores include fixed common area maintenance obligations.

We have a defined benefit Supplemental Employee Retirement Plan (the “SERP”) for one former director. The SERP provides for retirement death benefits through life insurance. We funded a portion of the SERP obligation in prior years through contributions to a trust arrangement known as a “Rabbi” trust.

The projected interest component on our company’s contractual obligations was estimated based on the prevailing or contractual interest rates for the respective obligations over the period of the agreements (see Note 7 of Notes to Consolidated Financial Statements). This projected interest pertains to the 3.76% interest, compounded annually, on our convertible notes. Upon investor conversions of our convertible notes, we become no longer obligated to pay a ratable portion of such interest.

Our other commercial commitments consist of letters of credit primarily for the procurement of domestic and imported merchandise and to secure obligations to certain insurance providers, and are secured through our Restated Credit Agreement. At February 3, 2007, our contractual commercial commitments under these letter of credit arrangements were as follows:


Other Commercial Commitments (in thousands)	Total Amounts Committed		Amount of Commitment Expiration Per Period
Other Commercial Commitments (in thousands)	Total Amounts Committed		Less Than 1 Year		1-3 Years	4-5 Years	Over 5 Years
Letters of credit	$	6,619	$	6,619	—	—	—

We do not maintain any long-term or exclusive commitments or arrangements to purchase merchandise from any single supplier.

New Accounting Pronouncements

In October 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. 13-1, “Accounting for Rental Costs Incurred During a Construction Period” (“FAS 13-1”), which requires rental costs associated with ground or building operating leases that are incurred during a construction period to

be recognized as rental expense. FAS 13-1 was effective for periods beginning after December 15, 2005. We adopted this pronouncement at the beginning of fiscal 2006. The adoption of FAS 13-1 did not affect our consolidated financial statements.

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 requires that a position taken or expected to be taken in a tax return be recognized in the financial statements when it is more likely than not that the position would be sustained upon examination by tax authorities. A recognized tax position is then measured at the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. Upon adoption, the cumulative effect of applying the recognition and measurement provisions of FIN 48, if any, shall be reflected as an adjustment to the opening balance of our accumulated deficit.

FIN 48 requires that, subsequent to initial adoption, a change in judgment that results in subsequent recognition, derecognition or change in a measurement of a tax position taken in a prior annual period (including any related interest and penalties) be recognized as a discrete item in the period in which the change occurs. FIN 48 also requires expanded disclosures, including identification of tax positions for which it is reasonably possible that total amounts of unrecognized tax benefits will significantly change in the next 12 months, a description of tax years that remain subject to examination by major tax jurisdiction, a tabular reconciliation of the total amount of unrecognized tax benefits at the beginning and end of each annual reporting period, the total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate and the total amounts of interest and penalties recognized in the statements of operations and financial position. FIN 48 is effective for fiscal years beginning after December 15, 2006, for us the fiscal year beginning February 4, 2007. We have not yet determined what impact the adoption of FIN 48 will have on our consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 provides a new single authoritative definition of fair value and provides enhanced guidance for measuring the fair value of assets and liabilities and requires additional disclosures related to the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. We will be required to adopt SFAS No. 157 effective for the fiscal year beginning February 3, 2008. We have not yet determined what impact the adoption of SFAS No. 157 will have on our consolidated financial statements.

In September 2006, the FASB issued SFAS No. 158, “ Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans — an amendment of FASB Statements No. 87, 88, 106 and 132(R) ” , (“SFAS No. 158”). SFAS No. 158 requires recognition of the overfunded or underfunded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in our statement of financial position and recognition of changes in that funded status in the year in which the changes occur through comprehensive income of a business entity. This statement also requires us to measure the funded status of a plan as of the date of our year-end statement of financial position. SFAS No. 158 is effective for fiscal years ending after December 15, 2006, except for the measurement date provisions, which are effective for fiscal years ending after December 15, 2008. Our adoption of SFAS No. 158 resulted in a reduction of $0.6 million in our liability related to our SERP and an increase of $0.6 million in our accumulated other comprehensive income on our consolidated balance sheet as of February 3, 2007.

In September 2006, the Securities and Exchange Commission, or “SEC”, issued Staff Accounting Bulletin 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 provides guidance on the consideration of effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. The SEC staff believes registrants must quantify errors using both a balance sheet and income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 was effective for the first annual period ending after November 15, 2006, with early application encouraged. The adoption of SAB 108 did not have an impact on our consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities. ” SFAS No. 159 provides companies with an option to report many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. The objective of SFAS No. 159 is to reduce both complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently. The FASB believes that SFAS No. 159 helps to mitigate accounting-induced volatility by enabling companies to report related assets and liabilities at fair value, which would likely reduce the need for companies to comply with detailed rules for hedge accounting. SFAS No. 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities, and would require entities to display the fair value of those assets and liabilities for which the company has chosen to use fair value on the face of the balance sheet. The new statement does not eliminate disclosure requirements included in other accounting standards, including requirements for disclosures about fair value measurements included in SFAS No. 157, “Fair Value Measurements.” This statement is effective as of the beginning of an entity’s first fiscal year beginning after November 15, 2007. We are in the process of evaluating the impact, if any, that the adoption of SFAS No. 159 will have on our consolidated financial statements.

In June 2006, the FASB ratified the consensus reached on Emerging Issues Task Force (“EITF”) Issue No. 06-03, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (that is, Gross versus Net Presentation).” The EITF reached a consensus that the presentation of taxes on either a gross or net basis is an accounting policy decision that requires disclosure. EITF Issue No. 06-03 is effective for the first interim or annual reporting period beginning after December 15, 2006. Taxes collected from our customers are and have been recorded on a net basis. We have no intention of modifying this accounting policy. As such, the adoption of EITF Issue No. 06-03 will not have an effect on our consolidated financial position or results of operations.

Additional information regarding new accounting pronouncements is contained in Note 1 of Notes to Consolidated Financial Statements herein.

Item 7A.

Quantitative and Qualitative Disclosures About Market Risk

To the extent that we borrow under our senior credit facility, we are exposed to market risk related to changes in interest rates. At February 3, 2007, no borrowings were outstanding under the Restated Credit Agreement. As of February 3, 2007, we are not a party to any derivative financial instruments, except as discussed in “Market Risk—Change in Value of our Common Stock” immediately below.

We contract for and settle all purchases in US dollars, and in fiscal 2006 we directly imported less than 20% of our merchandise inventories. Thus, we consider the effect of currency rate changes to be indirect and, given the small amount of imported product, we believe the effect of a major shift in currency exchange rates would be insignificant to our results.

Market Risk—Change in Value of our Common Stock

Our secured convertible notes (see Note 7 of the Notes to Consolidated Financial Statements) contain an embedded derivative, which upon the occurrence of a change of control, as defined, allows each note holder the option to require us to redeem all or a portion of the notes at a price equal to the greater of (i) the product of (x) the conversion amount being redeemed and (y) the quotient determined by dividing (A) the closing sale price of our Class A Common Stock on the business day on which the first public announcement of such proposed change of control is made by (B) the conversion price and (ii) 125% of the conversion amount being redeemed. We account for this derivative at fair value on the consolidated balance sheets within other long-term liabilities in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” We determine the fair value of the derivative instrument each period using a combination of the Black-Scholes model and the Monte-Carlo simulation model. Such models are complex and require significant judgments in the estimation of

fair values in the absence of quoted market prices. Changes in the fair market value of the derivative liability are recognized in earnings.

In applying the Black-Scholes and Monte-Carlo simulation models, changes and volatility in our common stock price, and changes in risk-free interest rates, our expected dividend yield and expected returns on our common stock could significantly affect the fair value of this derivative instrument, which could then result in significant charges or credits to interest expense in our consolidated statements of operations. During fiscal 2006, there was a $0.4 million decrease in the fair value of this derivative, which we recognized as a decrease to the carrying value of the derivative liability and a reduction of interest expense in the consolidated statements of operations.

Item 8.

Financial Statements and Supplementary Data

Information with respect to this item is set forth under Item 15.

Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

None.

Item 9A.

Controls and Procedures

Disclosure Controls and Procedures

We conducted an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, our disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by us in the reports that we file or submit under the Exchange Act and are effective in ensuring that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

Changes in Internal Control Over Financial Reporting

During the fiscal quarter ended February 3, 2007, no changes occurred with respect to our internal control over financial reporting that materially affected, or are reasonably likely to materially affect, internal control over financial reporting.

Management’s Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, our management conducted an evaluation of the effectiveness of our internal control over financial reporting as of February 3, 2007, based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our management’s evaluation under the framework in Internal Control—Integrated Framework , our management concluded that our internal control over financial reporting was effective as of February 3, 2007.

Our independent registered public accounting firm has issued an attestation report on management’s assessment of our internal control over financial reporting. This report appears below.

Independent Registered Public Accounting Firm Report on Internal Control Over Financial Reporting

Report of Independent Registered Public Accounting Firm

To the Board of Directors and Shareholders of

The Wet Seal, Inc.

Foothill Ranch, California:

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that The Wet Seal, Inc. (“the Company”) maintained effective internal control over financial reporting as of February 3, 2007, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

We conducted our audit 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 effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and is effected by the company’s Board of Directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes these policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorization of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of the changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of February 3, 2007 is fairly stated, in all material respects, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of February 3, 2007, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended February 3, 2007 of the Company, and our report dated April 17, 2007, expressed an unqualified opinion and included an explanatory paragraph referring to the adoption of Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment,” in 2006.

/s/ DELOITTE & TOUCHE LLP

Costa Mesa, California

April 17, 2007

Item 9B.

Other Information

None.

PART III

Item 10.

Directors and Executive Officers of the Registrant

The following is a list, as of April 17, 2007, of the names and ages of the executive officers of The Wet Seal, Inc.


Name	Officers and Other Positions Held With the Company	Age
Joel N. Waller	Chairman of the Board, President and Chief Executive Officer	67
John J. Luttrell	Executive Vice President, Chief Financial Officer and Corporate Secretary	52
Gary White	Chief Operating Officer	55
Gregory S. Gemette	President, Arden B Merchandise	43
Dyan Jozwick	Chief Merchandise Officer, Wet Seal Division	49

Joel N. Waller. Mr. Joel N. Waller has been a director of the Company since December 30, 2004. Effective February 1, 2005, Mr. Waller was appointed President and Chief Executive Officer of the Company. On June 6, 2006, Mr. Waller was appointed Chairman of the Board of Directors. From 1983 to January 2005, Mr. Waller served as Chief Executive Officer of Wilsons The Leather Experts Inc., a specialty retailer of leather outerwear, accessories and apparel in the United States.

John J. Luttrell. Mr. John J. Luttrell has served as Executive Vice President, Chief Financial Officer and Corporate Secretary of the Company since December 12, 2005. Prior to joining the Company, from August 2001 to December 2005, Mr. Luttrell served as Senior Vice President or Executive Vice President and Chief Financial Officer of Cost Plus, Inc., a specialty retailer of casual home furnishings and entertaining products in the United States. Mr. Luttrell also served as Vice President Controller of Cost Plus, Inc. from May 2000 to August 2001.

Gary White. Mr. Gary White has served as Chief Operating Officer of the Company since April 2, 2006 and as Executive Vice President of the Company since April 2005. From July 2004 to April 2005, Mr. White served as Senior Vice President, Sales and Operations of the Wet Seal division. Prior to joining the Company, from November 2000 to May 2004, Mr. White served as Chief Executive Officer and President of Saver’s Inc., a for profit thrift store chain. Prior to this, Mr. White was the Chief Executive Officer and Vice Chairman of Gymboree Corporation.

Gregory S. Gemette. Mr. Gregory S. Gemette has served as President of Merchandise for Arden B since March 13, 2006. From July 2005 to March 2006, Mr. Gemette served as Senior Vice President, Merchandise and Chief Merchandising Officer of G & G Retail, Inc. From July 2004 to May 2005, Mr. Gemette was Executive Vice President and Chief Merchant for the Home Shopping Network, LLC. From February 2001 to December 2003, Mr. Gemette was Vice President and General Merchandise Manager, Women’s, for American Eagle Outfitters, Inc. He has also previously served as Vice President of Merchandising, Sportswear, for Lane Bryant Stores, formerly a division of the Limited, Inc.

Dyan Jozwick. Ms. Dyan Jozwick has served as Chief Merchandise Officer for the Wet Seal division since May 2, 2006. Prior to joining the Company, from 1975 to 1995 and from July 1998 to April 2006, Ms. Jozwick served in various capacities, most recently as the Retail Senior Vice President and General Merchandise Manager at Robinsons-May Department Stores, a subsidiary of Federated Department Stores. From October 1995 to July 1998, Ms. Jozwick was the Executive Vice President of Sales, Merchandising and Production for Carole Little, Inc.

The remaining information called for by this item and for items 11 through 14 are incorporated by reference to our definitive proxy statement to be filed with the SEC no later than 120 days after the end of the year covered by this Form 10-K or, alternatively, by amendment to this Form 10-K under cover of Form 10-K/A, not later than the end of such 120-day period.

PART IV

Item 15.

Exhibits and Financial Statement Schedules

(a)	The following documents are filed as part of this report:

Financial Statements: The financial statements listed in the “Index to Consolidated Financial Statements and Financial Statement Schedules” at F-1 are filed as part of this report.

Financial Statement Schedules: All schedules are omitted as they are not required, or the required information is shown in the consolidated financial statements or notes thereto.

Exhibits: See “Exhibit Index.”

(b)	See (a) 3 above.

(c)	See (a) 1 and 2 above.

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.


T HE W ET S EAL , I NC . (Registrant)

By:		/s/ J OEL N. W ALLER
		Joel N. Waller
		President and
		Chief Executive Officer

By:		/s/ J OHN J. L UTTRELL
		John J. Luttrell
		Executive Vice President and
		Chief Financial Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated and on the dates indicated.


Signatures	Title	Date Signed

/s/ J OEL N. W ALLER Joel N. Waller	President and Chief Executive Officer (Principal Executive Officer) and Chairman of the Board of Directors	April 17, 2007

/s/ J OHN J. L UTTRELL John J. Luttrell	Executive Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)	April 17, 2007

/s/ J ONATHAN D USKIN Jonathan Duskin	Director	April 17, 2007

/s/ S IDNEY M. H ORN Sidney M. Horn	Director	April 17, 2007

/s/ H AROLD D. K AHN Harold D. Kahn	Director	April 17, 2007

/s/ K ENNETH M. R EISS Kenneth M. Reiss	Director	April 17, 2007

/s/ A LAN S IEGEL Alan Siegel	Director	April 17, 2007

/s/ H ENRY D. W INTERSTERN Henry D. Winterstern	Director	April 17, 2007

/s/ M ICHAEL Z IMMERMAN Michael Zimmerman	Director	April 17, 2007

THE WET SEAL, INC.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

AND FINANCIAL STATEMENT SCHEDULES


		Page

Report of Independent Registered Public Accounting Firm		F-2

FINANCIAL STATEMENTS:
Consolidated balance sheets as of February 3, 2007, and January 28, 2006		F-3
Consolidated statements of operations for the fiscal years ended February 3, 2007, January 28, 2006, and January 29, 2005		F-4
Consolidated statements of stockholders’ equity for the fiscal years ended February 3, 2007, January 28, 2006, and January 29, 2005		F-5
Consolidated statements of cash flows for the fiscal years ended February 3, 2007, January 28, 2006, and January 29, 2005		F-6
Notes to consolidated financial statements		F-8

FINANCIAL STATEMENT SCHEDULES:
All schedules are omitted as they are not required, or the required information is shown in the consolidated financial statements or the notes thereto.

F-1

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders of

The Wet Seal, Inc.

We have audited the accompanying consolidated balance sheets of The Wet Seal, Inc. and subsidiaries (the “Company”) as of February 3, 2007 and January 28, 2006, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended February 3, 2007. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated 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. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes 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 February 3, 2007 and January 28, 2006, and the results of its operations and its cash flows for each of the three years in the period ended February 3, 2007, in conformity with accounting principles generally accepted in the United States of America.

As discussed in Notes 1 and 2 to the consolidated financial statements, the Company changed its method of accounting for share-based compensation upon adoption of Statement of Financial Accounting Standards No. 123(R), “Shared-Based Payment,” in 2006.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of February 3, 2007, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated April 17, 2007, expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

/s/ DELOITTE & TOUCHE LLP

Costa Mesa, California

April 17, 2007

F-2

THE WET SEAL, INC.

CONSOLIDATED BALANCE SHEETS


	February 3, 2007			January 28, 2006
	(In thousands, except share data)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	105,254		$	96,806
Income taxes receivable		56			136
Other receivables		3,604			2,683
Merchandise inventories		34,231			25,475
Prepaid expenses and other current assets		8,795			3,953

Total current assets		151,940			129,053

EQUIPMENT AND LEASEHOLD IMPROVEMENTS:
Leasehold improvements		84,758			74,786
Furniture, fixtures and equipment		55,698			48,734
Leasehold rights		—			5

		140,456			123,525
Less accumulated depreciation and amortization		(89,931	)		(79,888	)

Net equipment and leasehold improvements		50,525			43,637

OTHER ASSETS:
Deferred financing costs, net of accumulated amortization of $5,159 and $2,869, at February 3, 2007, and January 28, 2006 respectively		555			3,236
Other assets		1,651			1,633
Goodwill		3,496			3,496

Total other assets		5,702			8,365

TOTAL ASSETS	$	208,167		$	181,055

LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
Accounts payable—merchandise	$	11,143		$	13,953
Accounts payable—other		10,078			9,883
Income taxes payable		128			—
Accrued liabilities		37,256			36,041
Current portion of deferred rent		3,381			3,973

Total current liabilities		61,986			63,850

LONG-TERM LIABILITIES:
Long-term debt		—			8,000
Secured convertible notes, including accrued interest of $634 and $1,801 at February 3, 2007, and January 28, 2006, respectively, and net of unamortized discount of $5,974 and $35,562, at February 3, 2007, and January 28, 2006, respectively		2,739			11,824
Deferred rent		22,501			20,023
Other long-term liabilities		1,977			3,228

Total long-term liabilities		27,217			43,075

Total liabilities		89,203			106,925

COMMITMENTS AND CONTINGENCIES (Note 9)
CONVERTIBLE PREFERRED STOCK, $0.01 par value, authorized 2,000,000 shares; 2,167 and 9,660 shares issued and outstanding at February 3, 2007, and January 28, 2006, respectively		2,167			9,660

STOCKHOLDERS’ EQUITY:
Common stock, Class A, $0.10 par value, authorized 300,000,000 shares; 96,218,013 shares issued and 95,818,013 shares outstanding at February 3, 2007, and 63,636,643 shares issued and outstanding at January 28, 2006		9,622			6,364
Common stock, Class B convertible, $0.10 par value, authorized 10,000,000 shares; no shares issued and outstanding at February 3, 2007, and January 28, 2006, respectively		—			—
Paid-in capital		280,163			222,000
Deferred stock compensation		—			(5,518	)
Accumulated deficit		(171,214	)		(158,376	)
Treasury stock, 400,000 shares, at cost, at February 3, 2007 (Note 10)		(2,400	)		—
Accumulated other comprehensive income		626			—

Total stockholders’ equity		116,797			64,470

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	208,167		$	181,055

See accompanying notes to consolidated financial statements.

F-3

THE WET SEAL, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS


	Fiscal Years Ended
	February 3, 2007			January 28, 2006			January 29, 2005
	(In thousands, except share data)
Net sales	$	564,324		$	500,807		$	435,582
Cost of sales		370,888			339,483			377,664

Gross margin		193,436			161,324			57,918
Selling, general and administrative expenses		178,703			171,988			162,047
Store closure (adjustments) costs		(730	)		4,517			16,398
Asset impairment		425			989			41,378

Operating income (loss)		15,038			(16,170	)		(161,905	)

Interest income		4,387			2,288			475
Interest expense		(31,955	)		(15,150	)		(2,650	)

Interest expense, net		(27,568	)		(12,862	)		(2,175	)

Loss before provision for income taxes		(12,530	)		(29,032	)		(164,080	)
Provision for income taxes		308			330			30,682

Loss from continuing operations		(12,838	)		(29,362	)		(194,762	)
Loss from discontinued operations, net of income taxes		—			—			(6,967	)

Net loss		(12,838	)		(29,362	)		(201,729	)
Accretion of non-cash dividends on convertible preferred stock		—			(23,317	)		—

Net loss attributable to common stockholders	$	(12,838	)	$	(52,679	)	$	(201,729	)

Net loss attributable to common stockholders per share, basic and diluted:
Continuing operations	$	(0.18	)	$	(1.19	)	$	(5.78	)
Discontinued operations		—			—			(0.21	)

Net loss attributable to common stockholders per share	$	(0.18	)	$	(1.19	)	$	(5.99	)

Weighted-average shares outstanding, basic and diluted		72,577,398			44,340,894			33,698,912

See accompanying notes to consolidated financial statements.

F-4

THE WET SEAL, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY


	Common Stock										Paid-In Capital			Deferred Stock Compensation			(Accumulated Deficit) Retained Earnings			Treasury Stock			Accumulated Other Comprehensive Income		Total Stockholders’ Equity
	Class A					Class B
	Shares		Par Value			Shares		Par Value
	(In thousands, except share data)
Balance at January 31, 2004	25,599,801		$	2,560		4,502,833		$	450		$	69,716		$	(2,030	)	$	96,032		$	—		$	—	$	166,728
Stock issued pursuant to long-term incentive plans	2,451,175			245		—			—			(245	)		—			—			—			—		—
Deferred stock compensation pursuant to long-term incentive plans	—			—		—			—			6,648			(6,648	)		—			—			—		—
Cancellation of deferred stock compensation due to employee terminations	—			—		—			—			(1,709	)		1,709			—			—			—		—
Amortization of deferred stock compensation	—			—		—			—			—			1,627			—			—			—		1,627
Variable stock compensation credit	—			—		—			—			(181	)		—			—			—			—		(181	)
Modification to terms of stock options	—			—		—			—			269			—			—			—			—		269
Exercise of stock options	31,523			3		—			—			186			—			—			—			—		189
Shares converted from Class B to Class A	4,079,234			408		(4,079,234	)		(408	)		—			—			—			—			—		—
Sale of Class A Common Stock	6,026,500			603		—			—			18,542			—			—			—			—		19,145
Beneficial conversion feature of secured convertible notes	—			—		—			—			30,100			—			—			—			—		30,100
Issuance of common stock warrants	—			—		—			—			20,905			—			—			—			—		20,905
Net loss	—			—		—			—			—			—			(201,729	)		—			—		(201,729	)

Balance at January 29, 2005	38,188,233			3,819		423,599			42			144,231			(5,342	)		(105,697	)		—			—		37,053
Stock issued pursuant to long-term incentive plans	8,481,893			848		—			—			(848	)		—			—			—			—		—
Deferred stock compensation—non-employee performance shares	—			—		—			—			550			(550	)		—			—			—		—
Deferred stock compensation pursuant to long-term incentive plans	—			—		—			—			2,079			(2,079	)		—			—			—		—
Cancellation of deferred stock compensation due to employee terminations	—			—		—			—			(595	)		595			—			—			—		—
Amortization of deferred stock compensation	—			—		—			—			—			2,419			—			—			—		2,419
Deferred stock compensation—stock issued in lieu of rent	365,000			37		—			—			1,029			(1,066	)		—			—			—		—
Amortization of deferred stock compensation—stock issued in lieu of rent	—			—		—			—			—			200			—			—			—		200
Exercise of stock options	501,000			50		—			—			881			—			—			—			—		931
Exercise of common stock warrants	3,753,284			376		—			—			7,006			—			—			—			—		7,382
Shares converted from Class B to Class A	423,599			42		(423,599	)		(42	)		—			—			—			—			—		—
Beneficial conversion feature of convertible preferred stock	—			—		—			—			14,692			—			—			—			—		14,692
Issuance of common stock warrants	—			—		—			—			8,509			—			—			—			—		8,509
Conversions of convertible preferred stock into common stock	4,980,000			498		—			—			14,442			—			—			—			—		14,940
Transaction costs for convertible preferred stock and other equity securities	—			—		—			—			(1,574	)		—			—			—			—		(1,574	)
Conversions of convertible notes into common stock	6,943,634			694		—			—			9,721			—			—			—			—		10,415
Stock-based compensation—non-employee performance shares	—			—		—			—			21,877			305			—			—			—		22,182
Net loss	—			—		—			—			—			—			(29,362	)		—			—		(29,362	)
Accretion of non-cash dividends on convertible preferred stock	—			—		—			—			—			—			(23,317	)		—			—		(23,317	)

Balance at January 28, 2006	63,636,643			6,364		—			—			222,000			(5,518	)		(158,376	)		—			—		64,470
Reclassification of deferred stock compensation to paid-in capital upon adoption of Statement of Financial Accounting Standards No. 123(R)	—			—		—			—			(5,518	)		5,518			—			—			—		—
Stock issued pursuant to long-term incentive plans	374,956			37		—			—			(37	)		—			—			—			—		—
Stock-based compensation—directors and employees	—			—		—			—			5,219			—			—			—			—		5,219
Stock-based compensation—non-employee performance shares	—			—		—			—			9,797			—			—			—			—		9,797
Amortization of stock payment in lieu of rent	—			—		—			—			216			—			—			—			—		216
Exercise of stock options	18,333			2		—			—			98			—			—			—			—		100
Exercise of common stock warrants	7,204,866			721		—			—			18,550			—			—			—			—		19,271
Conversions of convertible preferred stock into common stock	2,497,667			250		—			—			7,243			—			—			—			—		7,493
Conversions of secured convertible notes into common stock	25,003,783			2,500		—			—			35,005			—			—			—			—		37,505
Adjustment to initially apply SFAS No. 158, net of tax	—			—		—			—			—			—			—			—			626		626
Repurchase of common stock	—			—		—			—			—			—			—			(15,062	)		—		(15,062	)
Retirement of treasury stock	(2,518,235	)		(252	)	—			—			(12,410	)		—			—			12,662			—		—
Net loss	—			—		—			—			—			—			(12,838	)		—			—		(12,838	)

Balance at February 3, 2007	96,218,013		$	9,622		—		$	—		$	280,163		$	—		$	(171,214	)	$	(2,400	)	$	626	$	116,797

See accompanying notes to consolidated financial statements.

F-5

THE WET SEAL, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS


	Fiscal Years Ended
	February 3, 2007			January 28, 2006			January 29, 2005
	(in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss	$	(12,838	)	$	(29,362	)	$	(201,729	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Net loss from discontinued operations, net of tax		—			—			6,967
Depreciation and amortization		12,388			11,810			22,147
Amortization of discount on secured convertible notes		29,588			9,214			244
Amortization of deferred financing costs		3,505			1,901			968
Amortization of stock payment in lieu of rent		216			200			—
Adjustment of derivatives to fair value		(370	)		(216	)		—
Interest (extinguished from) added to principal of bridge loan payable and secured convertible notes		(1,167	)		2,999			—
Store closure costs		—			262			3,209
Asset impairment		425			989			41,378
Loss on disposal of equipment and leasehold improvements		186			500			976
Deferred income taxes		—			—			32,455
Stock-based compensation		15,016			24,601			1,715
Changes in operating assets and liabilities:
Income taxes receivable		80			411			10,648
Other receivables		(1,223	)		295			(1,614	)
Merchandise inventories		(8,756	)		(7,103	)		10,682
Prepaid expenses and other current assets		(5,635	)		(189	)		448
Other non-current assets		(18	)		(38	)		(387	)
Accounts payable and accrued liabilities		(4,271	)		(615	)		7,695
Income taxes payable		128			—			(1,752	)
Deferred rent		1,835			(4,597	)		(3,772	)
Other long-term liabilities		(255	)		(45	)		267

Net cash provided by (used in) operating activities of continuing operations		28,834			11,017			(69,455	)
Net cash used in operating activities of discontinued operations		—			—			(7,940	)

Net cash provided by (used in) operating activities		28,834			11,017			(77,395	)

CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of equipment and leasehold improvements		(16,965	)		(5,418	)		(7,143	)
Proceeds from sale of marketable securities		—			—			49,482
Proceeds from disposal of equipment and leasehold improvements		302			117			362

Net cash (used in) provided by investing activities of continuing operations		(16,663	)		(5,301	)		42,701
Net cash used in investing activities of discontinued operations		—			—			—

Net cash (used in) provided by investing activities		(16,663	)		(5,301	)		42,701

F-6

THE WET SEAL, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)


	Fiscal Years Ended
	February 3, 2007			January 28, 2006			January 29, 2005
	(in thousands)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of debt		—			—			18,000
Proceeds from issuance of secured convertible notes and common stock warrants		—			—			56,000
Proceeds from issuance of convertible preferred stock and common stock warrants		—			24,600			—
Payment of deferred financing costs		(32	)		(89	)		(6,949	)
Payment of convertible preferred stock and other equity securities transaction costs		—			(1,574	)		—
Repayment of term loan		(8,000	)		—			—
Repayment of bridge loan		—			(11,862	)		—
Repurchase of common stock		(15,062	)		—			—
Proceeds from exercise of stock options		100			931			189
Proceeds from sale of common stock, net		—			—			25,630
Proceeds from exercise of common stock warrants		19,271			7,382			—

Net cash (used in) provided by financing activities		(3,723	)		19,388			92,870

NET INCREASE IN CASH AND CASH EQUIVALENTS		8,448			25,104			58,176
CASH AND CASH EQUIVALENTS, beginning of year		96,806			71,702			13,526

CASH AND CASH EQUIVALENTS, end of year	$	105,254		$	96,806		$	71,702

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the year for:
Interest	$	469		$	3,177		$	1,596
Income taxes	$	180			—		$	234
SUPPLEMENTAL DISCLOSURES OF NON-CASH TRANSACTIONS:
Allocation of a portion of proceeds from issuance of convertible preferred stock to beneficial conversion feature	$	—		$	14,692			—
Allocation of a portion of proceeds from issuance of convertible preferred stock to Registration Rights Agreement	$	—		$	116			—
Conversion of 7,493 and 14,940 shares of convertible preferred stock into 2,497,667 and 4,980,000 shares of Class A Common Stock, respectively	$	7,493		$	14,940			—
Conversion of secured convertible notes into 25,003,783 and 6,943,634 shares of Class A Common Stock, respectively	$	37,506		$	10,415			—
Allocation of a portion of proceeds from issuance of secured convertible notes to beneficial conversion feature	$	—			—		$	30,100
Issuance of common stock warrants	$	—		$	8,509		$	20,905
Conversions of Class B Common Stock to Class A Common Stock	$	—		$	42		$	408
Restricted stock grants pursuant to long-term incentive plans	$	—		$	2,021		$	6,641
Cancellation of restricted stock grants due to employee terminations	$	—		$	557		$	560
Issuance of restricted stock to non-employee	$	—		$	550			—
Common stock issued in lieu of rent	$	—		$	1,066			—
Accretion of non-cash dividends on convertible preferred stock	$	—		$	23,317			—
Reclassification of deferred stock compensation to paid-in capital upon adoption of Statement of Financial Accounting Standards No. 123(R)	$	5,518		$	—			—
Retirement of treasury stock	$	12,662		$	—			—
Purchase of equipment and leasehold improvements on account	$	2,871		$	179			—

See accompanying notes to consolidated financial statements.

F-7

THE WET SEAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

For the fiscal years ended February 3, 2007, January 28, 2006, and January 29, 2005

NOTE 1: Summary of Significant Accounting Policies

Nature of the Business

The Wet Seal, Inc. (the “Company”) is a national specialty retailer of fashionable and contemporary apparel and accessory items designed for female consumers with a young, active lifestyle. The Company operates two primarily mall-based chains of retail stores under the names “Wet Seal” and “Arden B.” The Company’s success is largely dependent upon its ability to gauge the fashion tastes of its customers and to provide merchandise that satisfies customer demand.

The Company’s fiscal year ends on the Saturday closest to the end of January. The reporting periods includes 53 weeks of operations in fiscal 2006 and 52 weeks of operations in fiscal 2005 and fiscal 2004.

Principles of Consolidation

The consolidated financial statements include the accounts of The Wet Seal, Inc. and its subsidiaries, which are all wholly owned subsidiaries. All inter-company balances and transactions have been eliminated in consolidation.

Basis of Presentation

The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP).

Reclassification

The Company has reclassified $4.0 million of deferred rent to current portion of deferred rent on the consolidated balance sheet as of January 28, 2006, in order to conform to current year presentation.

Estimates and Assumptions

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Actual results could differ from those estimates.

The Company’s most significant areas of estimation and assumption are:

•

determination of the appropriate amount and timing of markdowns to clear unproductive or slow-moving inventory;

•

estimation of future cash flows used to assess the recoverability of long-lived assets, including goodwill;

•

estimation of ultimate redemptions of awards under the Company’s Arden B concept customer loyalty program;

•

determination of the revenue recognition pattern for cash received under the Company’s Wet Seal frequent buyer program;

•

estimation of expected customer merchandise returns;

•

determination of the appropriate assumptions to use to estimate the fair value of stock-based compensation for purposes of recording stock-based compensation and disclosing pro forma net loss;

•

estimation of its net deferred income tax asset valuation allowance; and

F-8

THE WET SEAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

For the fiscal years ended February 3, 2007, January 28, 2006, and January 29, 2005

NOTE 1: Summary of Significant Accounting Policies (Continued)

•

estimation, using actuarially determined methods, of its self-insured claim losses under its worker’s compensation plan.

Cash and Cash Equivalents

The Company considers all highly liquid debt instruments purchased with an initial maturity of three months or less to be cash equivalents. Cash equivalents are carried at cost, which approximates their fair market value. As of February 3, 2007 cash equivalents principally consist of money market funds.

Merchandise Inventories

Markdowns are recorded when the sales value of the inventory has diminished. Factors considered in the determination of permanent markdowns include current and anticipated demand, customer preferences, age of the merchandise and fashion trends. When a decision is made to permanently markdown merchandise, the resulting gross margin reduction is recognized in the period the markdown is recorded. Total markdowns on a cost basis in fiscal 2006, 2005 and 2004 were $72.2 million, $60.6 million, and $88.6 million, respectively, and represented 12.8%, 12.1%, and 20.3% of net sales, respectively.

The Company accrued for planned but unexecuted markdowns as of February 3, 2007, and January 28, 2006, of $4.7 million and $3.2 million, respectively. To the extent the Company’s estimates differ from actual results, additional markdowns may be required that could reduce the Company’s gross margin, operating income and the carrying value of inventories.

Equipment and Leasehold Improvements

Equipment and leasehold improvements are stated at cost. Expenditures for betterment or improvement are capitalized, while expenditures for repairs and maintenance that do not significantly increase the life of the asset are expensed as incurred.

Depreciation and amortization is provided using the straight-line method over the estimated useful lives of the assets. Furniture, fixtures and equipment are typically depreciated over three to five years. Leasehold improvements and the cost of acquiring leasehold rights are amortized over the lesser of the term of the lease or 10 years.

Long-Lived Assets

The Company evaluates the carrying value of long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable in accordance with

F-9

THE WET SEAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

For the fiscal years ended February 3, 2007, January 28, 2006, and January 29, 2005

NOTE 1: Summary of Significant Accounting Policies (Continued)

Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment of Long-Lived Assets.” Factors that are considered important that could trigger an impairment review include a current-period operating or cash flow loss combined with a history of operating or cash flow losses and a projection or forecast that demonstrates continuing losses or insufficient income associated with the use of a long-lived asset or asset group. Other factors include a significant change in the manner of the use of the asset or a significant negative industry or economic trend. This evaluation is performed based on estimated undiscounted future cash flows from operating activities compared with the carrying value of the related assets. If the undiscounted future cash flows are less than the carrying value, an impairment loss is recognized, measured by the difference between the carrying value and the estimated fair value of the assets, with such estimated fair values determined using the best information available, generally the discounted future cash flows of the assets using a rate that approximates the Company’s weighted-average cost of capital.

No less frequently than quarterly, the Company assesses whether events or changes in circumstances have occurred that potentially indicate the carrying value of long-lived assets may not be recoverable. The Company’s evaluations during fiscal 2006 and fiscal 2005 indicated that operating losses or insufficient operating income existed at certain retail stores with a projection that the operating losses or insufficient operating income for these locations would continue. As such, the Company recorded non-cash charges of $0.4 million and $1.0 million during fiscal 2006 and fiscal 2005, respectively, within asset impairment in the consolidated statements of operations to write-down the carrying value of these stores’ long-lived assets to their estimated fair values.

During fiscal 2004, the Company concluded that an indication of impairment existed with respect to a large number of the Company’s retail stores. Based on the results of impairment analyses, the Company wrote down the carrying value of certain impaired long-lived assets during fiscal 2004 by $41.4 million, including impairment of goodwill (see below). The impairment charges were a non-cash charge to its consolidated statements of operations.

Goodwill

Goodwill and intangible assets that have indefinite useful lives are tested for impairment no less frequently than annually and are also tested for impairment between annual tests when circumstances or events have occurred that may indicate a potential impairment has occurred. The goodwill test for impairment consists of a two-step process that begins with an estimation of the fair value of the reporting unit. The first step of the test is a screen for potential impairment and the second step measures the amount of impairment, if any. Accordingly, management conducted annual impairment evaluations in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” as of the end of fiscal 2006, 2005 and 2004. Based on its analyses as of the end of fiscal 2006 and 2005, no impairment had occurred as of those dates. Based on the results of the end of fiscal 2004 analysis, the Company wrote down the carrying value of goodwill as of January 29, 2005, by $0.3 million, which was recorded within asset impairment in the consolidated statements of operations.

Deferred Financing Costs

Costs incurred to obtain long-term financing are amortized over the terms of the respective debt agreements using the interest method. In addition, deferred financing costs associated with the Company’s secured convertible notes are expensed immediately, upon the conversion of portions of such notes into Class A Common Stock. Amortization expense included in interest expense and amortization of deferred financing costs was $3.5 million, $1.9 million and $1.0 million in fiscal 2006, 2005 and 2004, respectively.

F-10

THE WET SEAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

For the fiscal years ended February 3, 2007, January 28, 2006, and January 29, 2005

NOTE 1: Summary of Significant Accounting Policies (Continued)

Discount on Secured Convertible Notes

As discussed further in Note 7, upon issuance of its secured convertible notes, the Company recorded such notes net of a discount of $45.0 million. The Company is amortizing this discount over the seven-year term of the secured convertible notes using the interest method. In addition, the unamortized portion of the discount on secured convertible notes is expensed immediately upon conversions of portions of such notes into Class A Common Stock. Amortization of this discount included in interest expense and amortization of discount on secured convertible notes was $29.6 million, $9.2 million and $0.2 million in fiscal 2006, 2005 and 2004, respectively.

Revenue Recognition

Sales are recognized upon purchases by customers at the Company’s retail store locations. Taxes collected from the Company’s customers are and have been recorded on a net basis. For online sales, revenue is recognized at the estimated time goods are received by customers. Shipping and handling fees billed to customers for online sales are included in net sales. Customers typically receive goods within five to seven days of being shipped. The Company has recorded accruals to estimate sales returns by customers based on historical sales return results. A customer generally may return merchandise within 30 days of the original purchase date. Actual return rates have historically been within management’s estimates and the accruals established. As the accrual for merchandise returns is based on estimates, the actual returns could differ from the accrual, which could impact sales. The accrual for merchandise returns is recorded in accrued liabilities on the consolidated balance sheets and was $0.8 million and $0.6 million at February 3, 2007, and January 28, 2006, respectively. For fiscal 2006, 2005 and 2004, shipping and handling fee revenues were $1.5 million, $0.7 million, and $0.3 million, respectively.

The Company recognizes the sales from gift cards, gift certificates and store credits as they are redeemed for merchandise. Prior to redemption, the Company maintains an unearned revenue liability for gift cards, gift certificates and store credits until the Company is released from such liability, which includes consideration of potential obligations arising from state escheatment laws. The Company has not recognized breakage on gift cards, gift certificates and store credits in the consolidated financial statements as of February 3, 2007. The Company’s gift cards, gift certificates and store credits do not have expiration dates. The unearned revenue for gift cards, gift certificates and store credits is recorded in accrued liabilities on the consolidated balance sheets and was $8.9 million and $7.7 million at February 3, 2007, and January 28, 2006, respectively.

The Company, through its Wet Seal concept, has a frequent buyer program that entitles the customer to receive between a 10% and 20% discount on all purchases made during a twelve-month period. The annual membership fee of $20 is non-refundable. The Company recognizes membership fee revenue on a straight-line basis over the twelve-month membership period, due to a lack of sufficient program history to date to determine spending pattern under the program. Discounts received by customers on purchases using the frequent buyer program are recognized at the time of such purchases. The unearned revenue for this program is recorded in accrued liabilities on the consolidated balance sheets and was $10.1 million and $7.0 million at February 3, 2007, and January 28, 2006, respectively.

The Company maintains a customer loyalty program through its Arden B concept. Under the program, customers accumulate points based on purchase activity. Once a loyalty program member achieves a certain point level, the member earns awards that may be redeemed at any time for merchandise. Merchandise redemptions are accrued as unearned revenue and recorded as a reduction of sales as points are accumulated by the member.

F-11

THE WET SEAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

For the fiscal years ended February 3, 2007, January 28, 2006, and January 29, 2005

NOTE 1: Summary of Significant Accounting Policies (Continued)

During fiscal 2006, the Company modified the terms of the Arden B loyalty program with respect to the number of points required to earn an award and the value of awards when earned. At the time of the program change, the Company also established expiration terms (i) for prospectively earned awards of two months from the date the award is earned and (ii) for pre-existing awards of either two or twelve months from the program change date. This resulted in a reduction to the Company’s estimate of ultimate award redemptions under the program. Additionally, during fiscal 2006, the Company further reduced its estimate of ultimate redemptions based upon lower than anticipated redemption levels under the program’s revised terms. As a result, the Company recorded a benefit of $3.7 million, which was recorded as an increase to net sales and a decrease to accrued liabilities.

The unearned revenue for this program is recorded in accrued liabilities on the consolidated balance sheets and was $1.9 million and $6.2 million at February 3, 2007 and January 28, 2006, respectively. If actual redemptions ultimately differ from accrued redemption levels, or if the Company further modifies the terms of the program in a way that affects expected redemption value and levels, the Company could record further adjustments to the unearned revenue accrual, which would affect net sales.

Cost of Sales

Cost of sales includes the cost of merchandise, markdowns, inventory shortages, inbound freight, payroll expenses associated with design, buying, planning and allocation, inspection cost, processing, receiving and other warehouse costs, rent and depreciation and amortization expense associated with the Company’s stores and distribution center.

Leases

The Company recognizes rent expense for operating leases on a straight-line basis (including the effect of reduced or free rent and rent escalations) over the lease term, as defined by SFAS No. 13, “Accounting for Leases,” as amended. The difference between the cash paid to the landlord and the amount recognized as rent expense on a straight-line basis is included in deferred rent on the consolidated balance sheets. Cash reimbursements received from landlords for leasehold improvements and other cash payments received from landlords as lease incentives are also recorded as deferred rent and are amortized using the straight-line method over the lease term as an offset to rent expense.

Store Pre-Opening Costs

Store opening and pre-opening costs are charged to expense as they are incurred.

Advertising Costs

Costs for advertising related to operations, consisting of magazine advertisements, in-store signage and promotions, are expensed as incurred. Total advertising expenses in fiscal 2006, 2005, and 2004 were $6.3 million, $4.1 million, and $8.2 million, respectively.

Vendor Discounts

The Company receives certain discounts from its vendors in accordance with agreed-upon payment terms. These discounts are reflected as a reduction of merchandise inventories in the period they are received and charged to cost of sales when the items are sold.

F-12

THE WET SEAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

For the fiscal years ended February 3, 2007, January 28, 2006, and January 29, 2005

NOTE 1: Summary of Significant Accounting Policies (Continued)

Income Taxes

The Company accounts for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes.” SFAS No. 109 requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the net deferred tax assets will not be realized. As a result of disappointing sales results during fiscal 2004 and the Company’s historical operating performance, the Company concluded during fiscal 2004 that it was more likely than not that the Company would not realize its net deferred tax assets. As a result of this conclusion, the Company reduced its deferred tax assets during fiscal 2004 by establishing a tax valuation allowance for 100% of its net deferred tax assets. In addition, the Company discontinued recording income tax benefits in the consolidated statements of operations at that time. The Company will not record such income tax benefits until it is determined that it is more likely than not that the Company will generate sufficient taxable income to realize the deferred income tax assets.

As discussed further in Note 3, the Company is subject to certain limitations on its ability to utilize its federal and state net operating loss carryforwards.

Net Loss Per Share

In accordance with SFAS No. 128, “Earnings Per Share,” and additional guidance from Emerging Issues Task Force (“EITF”) Issue No. 03-6, “Participating Securities and the Two-Class Method under FASB Statement No. 128,” net loss per share, basic, is computed based on the weighted-average number of common shares outstanding for the period, including the shares issuable upon conversion of the Company’s convertible preferred stock to the extent such inclusion would be dilutive (see Note 16). Net loss per share, diluted, is computed based on the weighted-average number of common and potentially dilutive common equivalent shares outstanding for the period.

Comprehensive Income (Loss)

In accordance with SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans—an amendment of FASB Statements No. 87, 88, 106 and 132(R),” employers are required to recognize the over or under funded status of defined benefit plans of defined benefit plans and other postretirement plans in the statement of financial position and to recognize changes in the funded status in the year in which the changes occur through comprehensive income. The Company was required to adopt the provisions of SFAS No. 158 as of the end of fiscal 2006, resulting in the recognition of other comprehensive income on the consolidated balance sheet for the difference between the previous carrying value of the accrued liability under the Company’s supplement employee retirement plan and the carrying value required per SFAS No. 158 (see Note 14). For fiscal 2006, fiscal 2005 and fiscal 2004, there was no difference between the Company’s net loss and comprehensive loss.

Insurance/Self-Insurance

The Company uses a combination of insurance and self-insurance for its workers’ compensation and employee health care programs. A portion of the employee health care plan is funded by employees. Under the workers’ compensation insurance program, the Company is liable for a deductible of $0.25 million for each individual claim and an aggregate annual liability of $1.5 million. Under the group health plan, the Company is liable for a deductible of $0.15 million for each individual claim and an aggregate monthly liability of $0.5 million. The monthly aggregate liability is subject to adjustment based on the number of participants in the

F-13

THE WET SEAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

For the fiscal years ended February 3, 2007, January 28, 2006, and January 29, 2005

NOTE 1: Summary of Significant Accounting Policies (Continued)

plan each month. For both of the insurance plans, the Company records a liability for the costs associated with reported claims and a projected estimate for unreported claims considering historical experience and industry standards. The Company adjusts these liabilities based on historical claims experience, demographic factors, severity factors and other actuarial assumptions. A significant change in the number or dollar amount of claims could cause the Company to revise its estimates of potential losses, which would affect its reported results. The following summarizes the activity within the Company’s accrued liability for the self-insured portion of unpaid claims and estimated unreported claims:


	February 3, 2007			January 28, 2006			January 29, 2005
	(in thousands)
Balance at beginning of period	$	1,715		$	2,026		$	2,036
Accruals		5,374			3,687			4,858
Payment of claims		(5,408	)		(3,998	)		(4,868	)

Balance at end of period	$	1,681		$	1,715		$	2,026

Stock-Based Compensation

Prior to January 28, 2006, the Company accounted for its share-based compensation under the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), the disclosure-only provisions of SFAS No. 123, Accounting for Stock-Based Compensation related to options issued to employees, and SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure—an amendment of FASB Statement No. 123”. Under APB 25, the Company recognized stock-based compensation associated with stock options and awards under the intrinsic value method, whereby stock-based compensation was determined as the difference, if any, between the current fair value of the related common stock on the measurement date and the price an employee had to pay to exercise the award. Accordingly, stock-based compensation expense had been recognized for restricted stock grants as well as for stock options that were granted at prices that were below the fair market value of the related stock at the measurement date.

Effective January 29, 2006, the Company adopted SFAS No. 123(R), “Share-Based Payment”, in accordance with the modified-prospective-transition method and therefore has not restated prior period results. Under this transition method, the Company began recognizing compensation expense using the fair-value method as determined using SFAS No. 123 for stock options granted during fiscal 2005 or in prior years and that were not yet fully vested as of January 29, 2006 (see Note 2) and the fair-value method, as determined using SFAS No. 123(R ), for stock options granted or modified subsequent to January 29, 2006.

Derivative Financial Instruments

The Company accounts for derivative financial instruments in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended by SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 133 requires that all derivative financial instruments be recorded on the consolidated balance sheets at fair value.

As of February 3, 2007, the Company’s only derivative financial instrument was an embedded derivative associated with the Company’s secured convertible notes (see Note 7). The gain or loss as a result of the change in fair value of the embedded derivative associated with the Company’s secured convertible notes is recognized in interest expense in the consolidated statements of operations each period.

F-14

THE WET SEAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

For the fiscal years ended February 3, 2007, January 28, 2006, and January 29, 2005

NOTE 1: Summary of Significant Accounting Policies (Continued)

The Company applies the Black-Scholes and Monte-Carlo simulation models to value this embedded derivative. In applying the Black-Scholes and Monte-Carlo simulation models, changes and volatility in the Company’s common stock price, and changes in risk-free interest rates, the Company’s expected dividend yield and expected returns on its common stock could significantly affect the fair value of this derivative instrument, which could then result in significant charges or credits to interest expense in the consolidated statements of operations.

The Company has determined that fair value is best represented by a blend of valuation outcomes under Black-Scholes modeling and Monte-Carlo simulation. In addition to the estimate changes noted above, if circumstances were to change such that the Company determined that the embedded derivative value was better represented by an alternative valuation method, and such changes resulted in a significant change in the value of the embedded derivative, such changes could also significantly affect future interest expense.

Segment Information

The Company has one reportable segment representing the aggregation of its two retail brands and its Internet business due to the similarities of the economic and operating characteristics of the operations represented by the Company’s two store concepts and its Internet business.

New Accounting Pronouncements

In July 2006, the Financial Accounting Standards Board (the “FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 requires that a position taken or expected to be taken in a tax return be recognized in the financial statements when it is more likely than not that the position would be sustained upon examination by tax authorities. A recognized tax position is then measured at the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. Upon adoption, the cumulative effect of applying the recognition and measurement provisions of FIN 48, if any, shall be reflected as an adjustment to the opening balance of the Company’s accumulated deficit.

FIN 48 requires that, subsequent to initial adoption, a change in judgment that results in subsequent recognition, derecognition or change in a measurement of a tax position taken in a prior annual period (including any related interest and penalties) be recognized as a discrete item in the period in which the change occurs. FIN 48 also requires expanded disclosures, including identification of tax positions for which it is reasonably possible that total amounts of unrecognized tax benefits will significantly change in the next twelve months, a description of tax years that remain subject to examination by major tax jurisdiction, a tabular reconciliation of the total amount of unrecognized tax benefits at the beginning and end of each annual reporting period, the total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate and the total amounts of interest and penalties recognized in the statements of operations and financial position. FIN 48 is effective for fiscal years beginning after December 15, 2006, which is the year beginning February 4, 2007, for the Company. The Company has not yet determined what impact the adoption of FIN 48 will have on its consolidated financial statements.

In October 2005, the FASB issued FASB Staff Position No. 13-1, “Accounting for Rental Costs Incurred During a Construction Period” (“FAS 13-1”), which requires rental costs associated with ground or building operating leases that are incurred during a construction period to be recognized as rental expense. FAS 13-1 was

F-15

THE WET SEAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

For the fiscal years ended February 3, 2007, January 28, 2006, and January 29, 2005

NOTE 1: Summary of Significant Accounting Policies (Continued)

effective for periods beginning after December 15, 2005. The Company adopted this pronouncement at the beginning of fiscal 2006. The adoption of FAS 13-1 did not affect the Company’s consolidated financial statements.

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3” (“SFAS No. 154”). SFAS No. 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retrospective application as the required method for reporting a change in accounting principle. SFAS No. 154 provides guidance for determining whether retrospective application of a change in accounting principle is impracticable and for reporting a change when retrospective application is impracticable. SFAS No. 154 also addresses the reporting of a correction of an error by restating previously issued financial statements. SFAS No. 154 was effective for accounting changes and error corrections made in fiscal years beginning after December 15, 2005. The Company adopted this pronouncement at the beginning of fiscal 2006. The adoption of SFAS No. 154 did not affect the Company’s consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 provides a new single authoritative definition of fair value and provides enhanced guidance for measuring the fair value of assets and liabilities and requires additional disclosures related to the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. The Company will be required to adopt SFAS No. 157 effective for the fiscal year beginning February 3, 2008. The Company has not yet determined what impact the adoption of SFAS No. 157 will have on its consolidated financial statements.

In September 2006, the FASB issued SFAS No. 158, “ Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans — an amendment of FASB Statements No. 87, 88, 106 and 132(R) ” , (“SFAS No. 158”). SFAS No. 158 requires recognition of the overfunded or underfunded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in the statement of financial position and recognition of changes in that funded status in the year in which the changes occur through comprehensive income of a business entity. This Statement also requires an employer to measure the funded status of a plan as of the date of the Company’s year-end statement of financial position. SFAS No. 158 is effective for fiscal years ending after December 15, 2006, except for the measurement date provisions, which are effective for fiscal years ending after December 15, 2008. The adoption of SFAS No. 158 resulted in a reduction of $0.6 million in the Company’s liability related to its supplemental employee retirement plan and an increase of $0.6 million in accumulated other comprehensive income on its consolidated balance sheet as of February 3, 2007.

In September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 provides guidance on the consideration of effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. The SEC staff believes registrants must quantify errors using both a balance sheet and income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 is effective for the first annual period ending after November 15, 2006, with early application encouraged. The adoption of SAB 108 did not affect the Company’s consolidated financial statements.

F-16

THE WET SEAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

For the fiscal years ended February 3, 2007, January 28, 2006, and January 29, 2005

NOTE 1: Summary of Significant Accounting Policies (Continued)

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115.” SFAS No. 159 provides companies with an option to report many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. The objective of SFAS No. 159 is to reduce both complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently. The FASB believes that SFAS No. 159 helps to mitigate accounting-induced volatility by enabling companies to report related assets and liabilities at fair value, which would likely reduce the need for companies to comply with detailed rules for hedge accounting. SFAS No. 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities, and would require entities to display the fair value of those assets and liabilities for which the company has chosen to use fair value on the face of the balance sheet. The new statement does not eliminate disclosure requirements included in other accounting standards, including requirements for disclosures about fair value measurements included in SFAS No. 157, “Fair Value Measurements.” This statement is effective as of the beginning of an entity’s first fiscal year beginning after November 15, 2007. The Company has not yet determined the impact, if any, that the adoption of SFAS No. 159 will have on its consolidated financial statements.

In June 2006, the FASB ratified the consensus reached on EITF Issue No. 06-03, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (that is, Gross versus Net Presentation).” The EITF reached a consensus that the presentation of taxes on either a gross or net basis is an accounting policy decision that requires disclosure. EITF Issue No. 06-03 is effective for the first interim or annual reporting period beginning after December 15, 2006. Taxes collected from the Company’s customers are and have been recorded on a net basis. The Company has no intention of modifying this accounting policy. As such, the adoption of EITF Issue No. 06-03 will not have an effect on the Company’s consolidated financial position or results of operations.

NOTE 2: Stock-Based Compensation

Effective January 29, 2006, the Company adopted the provisions of SFAS No. 123(R), which requires the measurement and recognition of compensation expense for all share-based payment awards to employees and directors based on estimated fair values. SFAS No. 123(R) supersedes the Company’s previous accounting methodology using the intrinsic value method under APB 25. Under the intrinsic value method, stock-based compensation associated with stock options and awards was determined as the difference, if any, between the fair market value of the related common stock on the measurement date and the price an employee had to pay to exercise the award. Accordingly, stock-based compensation expense has been recognized for restricted stock grants as well as for stock options that were granted at prices that were below the fair market value of the related stock at the measurement date.

The Company adopted SFAS No. 123(R) using the modified prospective application method. Under this method, compensation expense recognized during fiscal 2006, included: (a) compensation expense for all share-based awards granted prior to, but not yet vested as of, January 28, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” and (b) compensation expense for all share-based awards granted subsequent to January 28, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R). In accordance with the modified prospective application method, the Company’s consolidated financial statements for prior periods have not been restated to reflect the impact of SFAS No. 123(R).

F-17

THE WET SEAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

For the fiscal years ended February 3, 2007, January 28, 2006, and January 29, 2005

NOTE 2: Stock-Based Compensation (Continued)

On November 10, 2005, the FASB issued FASB Staff Position No. FAS 123R-3, “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards.” The Company has elected to adopt the alternative transition method provided in FAS 123R-3 for calculating the tax effects of share-based compensation pursuant to SFAS No. 123(R). The alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in capital pool (“APIC Pool”) related to the tax effects of employee share-based compensation, and to determine the subsequent impact on the APIC Pool and consolidated statements of cash flows of the tax effects of employee and director share-based awards that are outstanding upon adoption of SFAS No. 123(R). In addition, in accordance with SFAS No. 123(R), SFAS No. 109 and EITF Topic D-32, “Intraperiod Tax Allocation of the Tax Effect of Pretax Income from Continuing Operations,” the Company has elected to recognize excess income tax benefits from stock option exercises and vesting of restricted stock and performance shares in additional paid-in capital only if an incremental income tax benefit would be realized after considering all other tax attributes presently available to the Company. The Company measures the tax benefit associated with excess tax deductions related to stock-based compensation expense by multiplying the excess tax deductions by the statutory tax rates.

The Company had the following two stock option plans under which shares were available for grant at February 3, 2007: the 2005 Stock Incentive Plan (the “2005 Plan”) and the 2000 Stock Incentive Plan (the “2000 Plan”). The Company also previously granted share awards under its 1996 Long-Term Incentive Plan (the “1996 Plan”) that remain unvested and/or unexercised as of February 3, 2007; however, the 1996 Plan expired during fiscal 2006, and no further share awards may be granted under the 1996 Plan. The 2005 Plan, the 2000 Plan and the 1996 Plan are collectively referred to as the “Plans.”

The 2005 Plan and 2000 Plan permit the granting of options, restricted common stock, performance shares or other equity-based awards to the Company’s employees, officers, directors and consultants. The Company believes the granting of equity-based awards helps to align the interests of its employees, officers, directors and consultants with those of its stockholders. The Company has a practice of issuing new shares to satisfy stock option exercises, as well as for restricted stock and performance share grants. The 2005 Plan was approved by the Company’s shareholders on January 10, 2005, as amended with shareholder approval on July 20, 2005, for the issuance of incentive awards covering 12,500,000 shares of Class A Common Stock. An aggregate of 19,565,551 shares of the Company’s Class A Common Stock have been issued or may be issued pursuant to the Plans. As of February 3, 2007, 1,673,600 shares were available for future grants.

Options

The Plans provide that the per-share exercise price of a stock option may not be less than the fair market value of the Company’s Class A Common Stock on the date the option is granted. However, for accounting purposes, the Company’s previous incorrect measurement date determinations for a portion of its stock option grants resulted in the per-share exercise price of certain stock options being below the per-share Class A Common Stock price on the correct measurement dates. As a result, for periods prior to its adoption of SFAS No. 123(R) in fiscal 2006, the Company recognized stock-based compensation expense based on the intrinsic value of such options on their measurement dates, in accordance with APB 25. Under the Plans, outstanding options generally vest over periods ranging from three to five years from the grant date and generally expire from five to ten years after the grant date. Certain stock option and other equity-based awards provide for accelerated vesting if there is a change in control (as defined in the Plans). The Company records compensation expense for employee stock options based on the estimated fair value of the options on the date of grant using the Black-Scholes option-pricing model. The Company uses historical data, the implied volatility of market-traded options and other factors to estimate the expected price volatility, option lives and forfeiture rates.

F-18

THE WET SEAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

For the fiscal years ended February 3, 2007, January 28, 2006, and January 29, 2005

NOTE 2: Stock-Based Compensation (Continued)

Separate groups of employees that have similar historical exercise behavior are considered separately for valuation purposes. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for the estimated life of the option. The following weighted-average assumptions were used to estimate the fair value of options granted during the periods indicated using the Black-Scholes option-pricing model:


	Fiscal 2006		Fiscal 2005		Fiscal 2004
Dividend Yield	0.00	%	0.00	%	0.00	%
Expected Volatility	63.00	%	81.91	%	82.14	%
Risk-Free Interest Rate	4.82	%	4.09	%	3.69	%
Expected Life of Options (in Years)	3.4		5.0		5.0

The Company recorded $2.3 million of compensation expense, or $0.03 per basic and diluted share, related to stock options outstanding during fiscal 2006. In accordance with the accounting standard previously applied by the Company, $0.3 million and $0.4 million of stock compensation expense was recorded related to employee stock options during fiscal 2005 and fiscal 2004, respectively.

At February 3, 2007, there was $3.4 million of total unrecognized compensation expense related to nonvested stock options under the Company’s share-based payment plans, which will be recognized over the course of the remaining vesting periods of such options through fiscal 2010.

The following table summarizes the Company’s stock option activities with respect to its Plans for fiscal 2006, as follows (aggregate intrinsic value in thousands):


Options	Number of Shares		Weighted- Average Exercise Price Per Share		Weighted- Average Remaining Contractual Life (in years)	Aggregate Intrinsic Value
Outstanding at January 28, 2006	3,670,563		$	7.82
Granted	675,000		$	5.69
Exercised	(18,333	)	$	5.45
Canceled	(867,210	)	$	9.34

Outstanding at February 3, 2007	3,460,020		$	7.03	5.03	$	3,459
Vested and expected to vest in the future at February 3, 2007	3,353,854		$	7.09	5.05	$	3,332
Exercisable at February 3, 2007	1,852,584		$	8.73	4.92	$	1,075

Options vested and expected to vest in the future is comprised of all options outstanding at February 3, 2007, net of estimated forfeitures.

F-19

THE WET SEAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

For the fiscal years ended February 3, 2007, January 28, 2006, and January 29, 2005

NOTE 2: Stock-Based Compensation (Continued)

Additional information regarding stock options outstanding as of February 3, 2007, is as follows:


	Options Outstanding				Options Exercisable
Range of Exercise Prices	Number Outstanding as of February 3, 2007	Weighted- Average Remaining Contractual Life (in years)	Weighted- Average Exercise Price Per Share		Number Exercisable as of February 3, 2007	Weighted- Average Exercise Price Per Share
$ 1.77 -$ 4.35	700,500	7.92	$	3.20	236,267	$	3.21
4.50 - 5.84	1,153,520	3.84		5.57	268,215		5.62
5.88 - 8.00	740,550	4.62