Celebrate Express, Inc. - Quarterly Report (10-Q)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)


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

		For the quarterly period ended February 29, 2008


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

		For the transition period from to

Commission file number 000-50973

CELEBRATE EXPRESS, INC.

(Exact name of registrant as specified in its charter)


Washington		91-1644428
(State or other jurisdiction of		(I.R.S. Employer Identification No.)
incorporation or organization)

11232 — 120 ^th Avenue NE
Kirkland, Washington		98033
(Address of principal executive offices)		(Zip Code)

(425) 250-1061
(Registrant’s telephone number, including area code)

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 than 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 o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):


Large accelerated filer o		Accelerated filer o		Non-accelerated filer þ (Do not check if a smaller reporting company)		Smaller Reporting Company o

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

As of March 31, 2008, there were 7,981,584 shares of the registrant’s common stock outstanding.

CELEBRATE EXPRESS, INC.

INDEX


	Page
PART I. FINANCIAL INFORMATION		1
Item 1. Financial Statements (unaudited)		1
Balance Sheets at February 29, 2008 and May 31, 2007		2
Statements of Operations for the Three and Nine Months Ended February 29, 2008 and February 28, 2007		3
Statement of Shareholders’ Equity for the Nine Months Ended February 29, 2008		4
Statements of Cash Flows for the Nine Months Ended February 29, 2008 and February 28, 2007		5
Notes to Financial Statements		6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		11
Item 3. Quantitative and Qualitative Disclosures About Market Risk		18
Item 4. Controls and Procedures		18
PART II. OTHER INFORMATION		18
Item 1. Legal Proceedings		18
Item 1A. Risk Factors		18
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		29
Item 6. Exhibits		30
SIGNATURES		31
EXHIBIT 3.6
EXHIBIT 10.2
EXHIBIT 10.3
EXHIBIT 10.4
EXHIBIT 10.5
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

****

We end our fiscal year on May 31. In this report, we refer to our fiscal periods as follows:


Reference in this report

		Fiscal years ending

Fiscal 2009		May 31, 2009

Fiscal 2008		May 31, 2008

Fiscal 2007		May 31, 2007

Fiscal 2006		May 31, 2006

		Interim fiscal period

Third quarter fiscal 2008		Three month period ended February 29, 2008

Third quarter fiscal 2007		Three month period ended February 28, 2007

Nine months fiscal 2008		Nine month period ended February 29, 2008

Nine months fiscal 2007		Nine month period ended February 28, 2007

Cautionary Note Regarding Forward-Looking Statements

This quarterly report on Form 10-Q contains forward-looking statements that involve many risks and uncertainties. These statements relate to future events and our future performance that are based on current expectations, estimates, forecasts and projections about the industries in which we operate and the beliefs and assumptions of our management. In some cases, you can identify forward-looking statements by terms such as “would,” “could,” “may,” “will,” “should,” “expect,” “intend,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “seek,” or “continue,” the negative of these terms or other variations of such terms. In addition, any statements that refer to projections of our future financial performance, our anticipated growth and trends in our business and other characterizations of future events or circumstances, are forward-looking statements. These statements are only predictions based upon assumptions made that are believed to be reasonable at the time and are subject to risk and uncertainties. Therefore, actual events or results may differ materially and adversely from those expressed in any forward-looking statement. In evaluating these statements, you should specifically consider the risks described under Part II—Item 1A “Risk Factors” and elsewhere in this quarterly report on Form 10-Q. These factors may cause our actual results to differ materially from any forward-looking statements. If one or more of the factors affecting our forward-looking statements proves incorrect, then our actual results, performance or achievements could differ materially from those expressed in, or implied by, forward-looking statements contained in this report. Consequently, you should not place undue reliance on our forward-looking information and statements. Except as required by law, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

CELEBRATE EXPRESS, INC.

BALANCE SHEETS


	February 29, 2008			May 31, 2007
	(unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	14,815,992		$	21,224,178
Accounts receivable, net		1,031,364			1,490,383
Inventories		10,139,849			9,039,029
Prepaid expenses		3,104,442			3,692,573
Deferred income taxes		—			347,019

Total current assets		29,091,647			35,793,182

Fixed assets, net		5,685,545			4,453,476
Deferred income taxes		—			7,771,657
Other assets, net		100,656			101,186

Total assets	$	34,877,848		$	48,119,501


LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	2,026,023		$	2,751,155
Accrued liabilities		3,069,501			3,648,457
Current portion of capital leases		21,837			—

Total current liabilities		5,117,361			6,399,612

Long-term captial lease obligations		37,312			—
Commitments and contingencies		—			—

Shareholders’ equity:
Common stock, $0.001 par value and additional paid-in capital — authorized, 10,000,000 shares; issued and outstanding, 7,981,584 shares at February 29, 2008; 7,953,724 shares at May 31, 2007		68,246,136			67,122,392
Accumulated deficit		(38,522,961	)		(25,402,503	)

Total shareholders’ equity		29,723,175			41,719,889

Total liabilities and shareholders’ equity	$	34,877,848		$	48,119,501

See notes to financial statements.

CELEBRATE EXPRESS, INC.

STATEMENTS OF OPERATIONS
(unaudited)


	Three months ended						Nine months ended
	February 29, 2008			February 28, 2007			February 29, 2008			February 28, 2007
Net sales	$	13,289,434		$	16,680,660		$	62,174,598		$	65,133,891
Cost of sales (1)		7,262,218			7,582,273			29,914,033			31,719,268

Gross profit		6,027,216			9,098,387			32,260,565			33,414,623


Operating expenses:
Fulfillment (1)		2,567,617			2,495,112			8,195,132			8,906,764
Selling and marketing (1)		5,296,776			4,714,073			20,501,478			17,783,541
General and administrative (1)		3,072,914			2,490,987			9,181,245			7,733,552

Total operating expenses		10,937,307			9,700,172			37,877,855			34,423,857

Loss from operations		(4,910,091	)		(601,785	)		(5,617,290	)		(1,009,234	)

Other income, net:
Interest income, net		158,663			400,004			640,962			1,209,638


Net income (loss) before income taxes		(4,751,428	)		(201,781	)		(4,976,328	)		200,404

Income tax benefit (expense)		(8,222,171	)		64,403			(8,144,130	)		(95,747	)


Net income (loss)		(12,973,599	)		(137,378	)		(13,120,458	)		104,657

Net income (loss) per share:
Basic	$	(1.63	)	$	(0.02	)	$	(1.65	)	$	0.01

Diluted	$	(1.63	)	$	(0.02	)	$	(1.65	)	$	0.01


Weighted average shares outstanding:
Basic		7,979,199			7,858,484			7,970,749			7,821,698
Diluted		7,979,199			7,858,484			7,970,749			7,950,782


(1) Stock-based compensation is included in the expense line items above in the following amounts:

Cost of Sales	$	2,221	$	8,569	$	5,907	$	26,726
Fulfillment		11,730		15,740		38,979		46,943
Selling and marketing		25,835		43,349		117,848		148,133
General and administrative		240,594		284,218		812,312		741,667

	$	280,380	$	351,876	$	975,046	$	963,469

See notes to financial statements.

CELEBRATE EXPRESS, INC.

STATEMENT OF SHAREHOLDERS’ EQUITY
(unaudited)


	Common stock and additional							Total
	paid-in-capital				Accumulated			shareholders’
	Shares		Amount		deficit			equity
BALANCE—May 31, 2007		7,953,724	$	67,122,392		($25,402,503	)	$	41,719,889

Exercise of common stock options and issuance of restricted stock		23,345		95,505					95,505
Issuance of common stock in connection with employee stock purchase plan		4,515		35,939					35,939
Tax effect of stock option exercises				17,254					17,254
Stock-based compensation				975,046					975,046
Net loss						(13,120,458	)		(13,120,458	)


BALANCE—February 29, 2008		7,981,584	$	68,246,136		($38,522,961	)	$	29,723,175

See notes to financial statements.

CELEBRATE EXPRESS, INC.

STATEMENTS OF CASH FLOWS
(unaudited)


	Nine months ended
	February 29, 2008			February 28, 2007
Cash flows from operating activities:
Net income (loss)	$	(13,120,458	)	$	104,657
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Deferred income taxes		8,135,930			75,942
Depreciation and amortization		1,609,851			1,182,184
Stock-based compensation		975,046			963,469
Excess tax benefit from exercise of stock options		—			(205,283	)
Loss on disposal of fixed assets		12,187			—
Changes in operating assets and liabilities:
Accounts receivable		459,019			(946,331	)
Inventories		(1,100,820	)		148,322
Prepaid expenses and other assets		588,132			(38,811	)
Accounts payable		(725,132	)		(724,773	)
Accrued liabilities		(578,956	)		444,085


Net cash provided by (used in) operating activities		(3,745,201	)		1,003,461


Cash flows from investing activities:
Payments for purchases of fixed assets		(2,781,411	)		(675,964	)

Net cash used in investing activities		(2,781,411	)		(675,964	)

Cash flows from financing activities:
Principal payments on capital lease obligation		(13,018	)		—
Proceeds from shares issued under the employee stock purchase plan		35,939			24,524
Proceeds from exercise of stock options		95,505			196,404
Excess tax benefit from exercise of stock options		—			205,283


Net cash provided by financing activities		118,426			426,211


Net increase (decrease) in cash and cash equivalents		(6,408,186	)		753,708

Cash and cash equivalents:
Beginning of period		21,224,178			31,326,804

End of period	$	14,815,992		$	32,080,512

Supplemental disclosures of cash flow information:
Cash paid for interest	$	3,929		$	—

Supplemental disclosures of noncash financing and investing activities:
Purchase of fixed assets under capital leases	$	72,167		$	—

See notes to financial statements.

Notes to Financial Statements

1. Organization of Business and Summary of Significant Accounting Policies

Description of Business — Celebrate Express, Inc. (the “Company”), a Washington corporation, is a provider of celebration products for families with children, via the Internet and catalogs. The Company’s primary brands are Birthday Express, which offers children’s party products, and Costume Express, which features children’s and family costumes and accessories. Another brand, Storybook Heirlooms, was phased out during fiscal 2007. The Company also sells everyday party supplies and seasonal party goods. The Company sells both products it produces and products that it purchases for resale.

Basis of Presentation — Management has prepared the accompanying financial statements in accordance with the accounting principles generally accepted in the United States of America for interim financial information and pursuant to the rules and regulations of the Securities Exchange Commission (the “SEC”). The financial information as of February 29, 2008 and for the fiscal quarters and nine month periods ended February 29, 2008 and February 28, 2007 is unaudited. In the opinion of management, such information contains all adjustments, consisting of normal, recurring accruals, necessary for a fair presentation of the results for such periods. The results of operations for such interim periods are not necessarily indicative of the expected results of operations for the full fiscal year. These financial statements and related notes should be read in connection with the Company’s Notes to Financial Statements contained in the Company’s Annual Report on Form 10-K filed for the year ended May 31, 2007. Certain information and note disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to the rules and regulations of the SEC.

New Accounting Pronouncements — In July 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109 (“FIN 48”). This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FAS No. 109, Accounting for Income Taxes . This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. We adopted the provisions of FIN 48 on June 1, 2007. The adoption of this statement did not have an impact on our results of operations or financial condition.

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“FAS 157”). FAS 157 establishes a common definition for fair value, establishes a framework for measuring fair value, and expands disclosure about such fair value measurements. FAS 157 is effective for fiscal years beginning after November 15, 2008. We will apply this guidance beginning June 1, 2009. We do not expect that the adoption of this statement will have a material impact on our results of operations or financial condition.

In February 2007, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities , (“FAS 159”). FAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. FAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. FAS 159 is effective for fiscal years beginning after November 15, 2007. We will apply this guidance beginning June 1, 2008. We do not expect that the adoption of this statement will have a material impact on our results of operations or financial condition.

In December 2007, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 160, Noncontrolling Interests in Consolidated Financial Statements , (“FAS 160”). FAS 160 addresses the accounting and financial reporting for minority interests in consolidated subsidiaries. FAS 160 is effective for fiscal years beginning on or after December 15, 2008, with earlier adoption prohibited. We will apply this guidance beginning June 1, 2009. We do not expect that the adoption of this statement will have a material impact on our results of operations or financial condition.

Use of Estimates — The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the

reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Some of the more significant estimates include allowance for sales returns, lower of cost or market adjustments to inventory and deferred income taxes. Actual results could differ from those estimates.

Summary of significant accounting policies — The significant accounting policies used in the preparation of our financial statements are disclosed in our Annual Report on Form 10-K for the year ended May 31, 2007.

2. Inventories

Inventories are stated at the lower of market or weighted-average cost on a first-in first-out basis. The Company writes down inventory for estimated obsolescence or damage for the excess cost of the inventory over estimated market value based upon assumptions about future demand and market conditions.

The components of inventories were as follows:


	February 29, 2008		May 31, 2007
Finished goods	$	9,925,687	$	8,706,354
Raw materials		214,162		332,675

	$	10,139,849	$	9,039,029

3. Income Per Share

Basic net income (loss) per share is based on the weighted-average number of common shares outstanding. Diluted net income (loss) per share is based on the weighted number of common shares and common share equivalents outstanding. Common shares and common share equivalents included in the computation represent shares issuable upon assumed exercise of outstanding stock options, except when the effect of their inclusion would be antidilutive.

The following table sets forth the computation of basic and diluted net income (loss) per share:


	Three Months Ended						Nine Months Ended
	February 29, 2008			February 28, 2007			February 29, 2008			February 28, 2007
Net income (loss)	$	(12,973,599	)	$	(137,378	)	$	(13,120,458	)	$	104,657

Weighted average common shares outstanding		7,979,199			7,858,484			7,970,749			7,821,698
Basic net income (loss) per share	$	(1.63	)	$	(0.02	)	$	(1.65	)	$	0.01

Common share equivalents:
Dilutive effect of common stock options		—			—			—			129,084

Weighted average common shares and common share equivalents		7,979,199			7,858,484			7,970,749			7,950,782
Diluted net income (loss) per share	$	(1.63	)	$	(0.02	)	$	(1.65	)	$	0.01

The following is a summary of the weighted average securities during the respective periods that have been excluded from the calculation because the effect on net income (loss) per share would be antidilutive:


	Three Months Ended				Nine Months Ended
	February 29, 2008		February 28, 2007		February 29, 2008		February 28, 2007
Unvested restricted stock		3,794		5,886		2,868		1,003
Common stock options		712,629		601,961		671,404		602,783

4. Brand Revenues

The following table provides detail of our revenues by brand:


	Three Months Ended				Nine Months Ended
	February 29, 2008		February 28, 2007		February 29, 2008		February 28, 2007
Birthday Express	$	12,362,009	$	15,694,759	$	42,323,477	$	49,528,409
Costume Express		407,806		338,945		18,596,248		13,066,015
Holiday		331,571		—		577,782		—
Storybook Heirlooms		—		467,048		—		2,150,655

Total Brand Revenue	$	13,101,386	$	16,500,752	$	61,497,507	$	64,745,079

In the fiscal quarter and nine month period ended February 29, 2008, the Company also had approximately $188,000 and $677,000 in other revenue, respectively. In the fiscal quarter and nine month period ended February 28, 2007, the Company had approximately $180,000 and $389,000 in other revenue, respectively.

5. Stock Based Compensation

Equity Incentive Plan — Our 2004 Amended and Restated Equity Incentive Plan (the “2004 Plan”) permits the grant of options to directors, officers, employees, consultants, and advisors. Options may be either incentive stock options or nonqualified stock options. The 2004 Plan also permits the grant of stock bonuses and rights to purchase restricted stock. There were 434,339 shares remaining for future grant under the 2004 Plan as of February 29, 2008. Generally, options vest at the rate of 25% on the first anniversary of the grant and 25% each successive year until fully vested. Options granted under the 2004 Plan are exercisable over a period of time, generally either 7 or 10 years, designated by the Company’s Board of Directors and are subject to other terms and conditions as determined by the Board. When a stock award expires or is terminated before it is exercised, the shares become available for issuance under the 2004 Plan.

Employee Stock Purchase Plan — Effective in October 2004, the Company adopted an Employee Stock Purchase Plan (the “ESPP”). Eligible employees may purchase common stock for a purchase price per share that is equal to 85% of the fair market value of a share on the offering date for the applicable offering period, or if lower, the fair market value of a share on the applicable purchase date in such a period. During the nine month period ended February 29, 2008, employees purchased 4,515 shares of our common stock under the ESPP in exchange for approximately $36,000.

Stock Compensation Expense

We account for the 2004 Plan and the ESPP under the recognition and measurement principles of FASB Statement No. 123 (revised 2004), Share-Based Payment (“FAS 123R”), which requires measurement of compensation cost for all stock-based awards at fair value on the date of grant and recognition of compensation over the service period for awards expected to vest. The fair value of stock-based awards is determined using the Black-Scholes option pricing model using the single option award approach. This fair value is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period. As required by FAS 123R, management makes an estimate of expected forfeitures, and we are recognizing compensation costs only for those equity awards expected to vest. The estimation of stock awards that will ultimately vest requires judgment, and to the extent actual results or updated estimates differ from our current estimates, we will record such amounts retrospectively as an increase or decrease in stock-based compensation in the period we revise the estimates. We consider many factors when estimating expected forfeitures, including historical voluntary termination behavior and actual option forfeitures. Actual results, and future changes in estimates, may differ substantially from our current estimates.

As of February 29, 2008, the total compensation cost related to unvested options and restricted stock units granted to employees totaled $2.4 million, inclusive of estimated forfeitures. This cost will be amortized on a straight-line basis over a weighted-average period of 1.4 years and will be adjusted for estimated forfeitures.

Determining Fair Value

We calculate the fair value of our stock options granted to employees using the Black-Scholes option pricing model using the single option award approach. This fair value is then amortized on a straight-line basis over the requisite

service periods of the awards, which is generally the vesting period. The following weighted-average assumptions were used to compute fair value of the stock options granted for the three- and nine month periods ended February 29, 2008 and February 28, 2007:


	Three months ended						Nine months ended
	February 29, 2008			February 28, 2007			February 29, 2008			February 28, 2007
Expected volatility		47.4	%		47.2	%		47.2	%		58.9	%
Expected term (in years)		4.6			4.6			4.6			5.7
Risk-free interest rate		2.5	%		4.8	%		3.3	%		5.1	%
Expected dividend		0	%		0	%		0	%		0	%
Weighted-average fair value	$	2.88		$	5.34		$	3.69		$	7.08

Stock Option Activity

Additional information regarding stock option activity for the nine-month period ended February 29, 2008 is as follows:


						Weighted-
				Weighted-		average
				average		remaining
				exercise		contractual		Aggregate
	Shares			price		term		Intrinsic Value
Outstanding at June 1, 2007		717,746		$	12.07
Granted		216,872			8.25
Exercised		(22,308	)		4.28
Cancelled or expired		(109,359	)		11.92

Outstanding at February 29, 2008		802,951		$	11.26		8.41	$	36,705

Exercisable at February 29, 2008		306,676		$	12.43		7.64	$	36,849

The aggregate intrinsic value is calculated as the difference between the exercise price of the underlying awards and the market price of our common stock for the shares subject to options that were in-the-money at February 29, 2008.

Certain employees are granted restricted stock unit awards pursuant to the 2004 Plan. As of May 31, 2007 there were 2,800 shares outstanding and unvested. In fiscal 2008, an additional 3,000 shares were granted and were valued at the closing stock price of $9.07 on the date of grant. During the nine months fiscal 2008, 1,250 shares vested and 1,175 shares were forfeited. As of February 29, 2008 there were 3,375 unvested shares outstanding.

6. Income Taxes

We record income taxes using the asset and liability method in accordance with SFAS No. 109, Accounting for Income Taxes . Deferred income taxes are recognized for temporary differences — the differences between the GAAP financial statement carrying amounts of assets and liabilities and those required for use in the tax return. The tax effect of these temporary differences are reported as deferred income tax assets and liabilities on the balance sheet, measured using enacted laws and income tax rates that are currently in effect.

In accordance with the Financial Accounting Standards Board’s Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes , the Company has evaluated its deferred tax assets quarterly to determine if valuation allowances were required, and determined in prior periods during fiscal 2007 and fiscal 2008 that a valuation allowance was not necessary for its deferred tax assets. SFAS No. 109 requires that companies assess whether valuation allowances should be established against their deferred tax assets based on the consideration of all available evidence using a “more likely than not” standard. In making such judgments, significant weight is given to evidence that can be objectively verified. A company’s current or previous losses are given more weight than its future outlook, and a recent three-year historical cumulative loss is considered a significant factor that is difficult to overcome for purposes of this analysis.

Based upon these SFAS No. 109 guidelines, we determined that a valuation allowance should now be established due to more recent events and developments during the third quarter fiscal 2008. While we believe that our long-term financial outlook remains positive, we concluded that our ability to rely on our long-term outlook as to future taxable income was limited due to uncertainty created by the weight of the negative evidence, particularly the Company’s three-year historical cumulative loss in the third quarter fiscal 2008, the recent and anticipated near term effects associated with the efforts to improve Company systems and staffing and the more challenging near-term economic conditions. Accordingly, based on our current circumstances and uncertainty regarding our future taxable income, we have recorded a full valuation allowance against these deferred tax assets during the third quarter fiscal 2008. If and when our operating performance improves on a sustained basis, our conclusion regarding the need for a full valuation allowance could change, resulting in the reversal of some or all of the valuation allowance in the future. This non-cash charge of approximately $8.2 million is reported as income tax expense for the third quarter fiscal 2008.

As of February 29, 2008, the Company had approximately $24.1 million in operating loss carryforwards for federal income tax purposes, which expire in varying amounts between 2020 and 2026, if unused. In addition, the Company has approximately $2.5 million of operating loss carryforwards for state income tax purposes, which are scheduled to expire in varying amounts between 2016 and 2021, if unused. Under the Internal Revenue Code, the amounts of and benefits from net operating loss and tax credit carryforwards may be impaired or limited in certain circumstances. Events which could cause limitations in the amount of net operating losses that the Company may utilize in any one year, include, but are not limited to, a cumulative ownership change of more than 50%, as defined, over a three year period. The Company evaluates whether changes in its stock ownership have resulted in annual limitations to the utilization of our deferred tax assets. In addition, realization is dependent on generating sufficient taxable income prior to the expiration of the loss carryforwards.

In June 2006, the FASB issued FASB Interpretation No. 48 Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109 (“FIN 48”) to create a single model to address accounting for uncertainty in tax positions. FIN 48 clarifies income tax accounting by prescribing a minimum recognition threshold that a tax position is required to meet before being recognized in financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting for interim periods, disclosure and transition, and clearly excludes uncertainty in income taxes from guidance prescribed by FASB No. 5, Accounting for Contingencies . We adopted the provisions of FIN 48, on June 1, 2007. The adoption had no impact on our financial condition or results of operations. There were no unrecognized tax benefits under FIN 48 as of June 1, 2007 or February 29, 2008.

The Company has adopted a policy whereby penalties incurred in connection with tax matters will be classified as general and administrative expenses, and interest assessments incurred in connection with tax matters will be classified as interest expense. No tax-related interest or penalties were recognized during the nine months February 29, 2008.

Tax years that remain open for examination by federal and state taxing authorities include fiscal 2004 through fiscal 2008. In addition, previous tax years may be subject to examination to the extent that the Company utilizes the NOLs from those years in its current year or future years’ tax returns.

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

The following discussion should be read in conjunction with our financial statements and the related notes contained elsewhere in this quarterly report on Form 10-Q as well as the audited financial statements and the notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” included in our annual report on Form 10-K for the fiscal year ended May 31, 2007 filed with the SEC on August 17, 2007. This discussion and analysis contains “forward-looking statements” that involve risk, uncertainties, and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including, but not limited to, general economic factors, successful execution of our business plans, the impact of competition, the effect of regulation and legal proceedings, and others described in the “Risk Factors” section of our fiscal 2007 Form 10K and elsewhere in this report. Readers are urged to carefully review and consider the various disclosures made by us which attempt to advise interested parties of the factors which affect our business, including without limitation the financial statements and the related notes contained elsewhere in this quarterly report, “Risk Factors” set forth in Part II—Item 1A of this quarterly report and disclosures included in our annual report on Form 10-K for the fiscal year ended May 31, 2007, including the audited financial statements and the notes thereto, “Risk Factors,” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Business developments

During fiscal 2007, the Company engaged in an eight month process, concluded in May 2007, to review strategic alternatives, including the possible sale of the Company. The conclusion of the strategic review permitted the Company to return its focus to business improvements.

Company management has determined that certain improvements to the Company’s systems and processes are essential to the business. We have pursued these improvements on an accelerated schedule in fiscal 2008. During the first three quarters of fiscal 2008, these business improvement efforts have resulted in increased costs and some short-term adverse effects on customers. Additionally, focusing on these important initiatives has led to distractions from other matters and to some execution issues. While pressuring short-term results, this important work is expected to produce future benefits through increased sales and cost efficiencies commencing in fiscal 2009.

The Company has achieved significant progress on a number of these initiatives during fiscal 2008:

	•		A new warehouse management system was implemented during the third quarter fiscal 2008, to better manage and track our distribution center operations and inventory,

	•		A new off-site data center was established with upgraded hardware and software during the third quarter fiscal 2008, to provide a more reliable and scalable operating and development environment, and we commenced the migration of applications to this data center,

	•		A data warehouse was established on new hardware and software,

	•		Our customer database was moved to the new data warehouse, and

	•		We recruited personnel to fill key positions, including our chief financial officer (January 2008) and our vice president, marketing (completed March 2008).

We also have sought to leverage our customer database, marketing and operating resources to increase sales outside of our core Birthday Express brand:

	•		We increased our marketing expenditures and merchandise purchases for the Costume Express brand, particularly for the 2007 Halloween season, to support increased sales and the addition of new customers, and

	•		A limited Holiday marketing test was conducted for Christmas and other seasonal merchandise during the second and third quarters of fiscal 2008.

Other initiatives are in earlier stages of assessment or implementation and are priorities for our fourth quarter and for fiscal 2009:

	•		Further integration of our new warehouse management system with our shipping manifest and enterprise systems,

	•		Selection and implementation of analytical tools to use with the new data warehouse,

	•		Installation and implementation of the new telephone system for our call center and general corporate operations,

	•		Migration of remaining legacy operations to the new data center,

	•		Design, development and implementation of a next generation website, and

	•		Recruitment of currently open key positions, including our vice president, merchandising.

The implementation of the new warehouse management system was a huge effort that we sought to complete in a relatively short time. During this implementation effort, we incurred extra fulfillment labor costs and extra shipping costs in order to minimize delivery delays and other adverse effects on customers. The implementation of our new data center and data warehouse also were significant initiatives that we sought to do rapidly in order to increase the reliability and stability of these resources. These efforts have resulted in additional costs for consultants, labor and depreciation. Management believes these necessary business improvement efforts sometimes had a short-term adverse effect on our customer service, and therefore in our third quarter, we introduced our new “Customer First!” initiative to reemphasize our focus on the customer in our day to day operations and our process improvements.

On April 9, 2008, the Company disclosed that it has been approached by third parties regarding a possible merger or acquisition involving the Company and that the Company has engaged a financial advisor in connection with these discussions. It is our objective, where possible, to complete this effort on an expeditious basis in order to minimize the potential distraction and disruption to our ongoing business and to our business improvement efforts.

Overview

Celebrate Express is a leading provider of celebration products serving families with young children via the Internet and catalogs. We offer a broad assortment of proprietary and third party children’s party products and children’s and family costumes, complemented by a wide variety of accessories. Our centralized inventory management maximizes product availability and allows us to customize our product assortment to meet specific customer needs. We have designed our business infrastructure to share distribution, customer support, marketing, and technology resources across our brands. Our goal is to help busy families celebrate the special moments in their lives.

We review our operations based on our financial results and various non-financial measures. We focus on several financial factors including net sales per order, gross margin, growth in net sales and the percentage of our sales generated by repeat customers. Among the key non-financial measures upon which we focus in reviewing performance are the frequency of purchase by our customers and the number of new customers added to our database.

To date, we have derived our revenue primarily from the sale of party related products and costumes from our website and catalogs. For the third quarter fiscal 2008, we generated $13.3 million in net sales, a decrease of 20.3% from $16.7 million in the same period last year. Our gross margin (our gross profit as a percentage of net sales) decreased to 45.4% in the third quarter fiscal 2008 from 54.5% in the same period last year. For the third quarter fiscal 2008, our net loss before taxes was $4.8 million, compared with a net loss before income taxes of $202,000 in the same period last year. For the nine months fiscal 2008, we generated $62.2 million in net sales, a decrease of approximately 4.5% from $65.1 million in the same period last year. Our gross margin increased to 51.9% in the nine months fiscal 2008 from 51.3% in the same period last year. For the nine months fiscal 2008, we had a net loss before income taxes of $5.0 million, compared with net income before income taxes of $200,000 in the same period last year.

We believe that the decline in revenue in the third quarter fiscal 2008 resulted primarily from a combination of (1) intentional reductions in the number of catalogs circulated, to eliminate less productive mailings in response to the increased costs for postage, printing and paper, (2) sub-optimal catalog circulation selection and mailing, (3) customer service issues, and (4) the general weakness in consumer spending during the past few months. The Company continues to focus on reducing unprofitable mailings and reevaluating circulation quantities in light of catalog postage, paper and print costs. In third quarter fiscal 2008, certain circulation decisions and execution problems resulted in catalog mailings to a mix of customers and prospective customers which we believe was less productive. Further, we believe that the implementation of our new warehouse management system caused various temporary problems that impacted customer service and resulted in lower sales and lower gross margins in the third quarter fiscal 2008. Although we expect that certain of these factors will affect our results to some extent in the remainder of fiscal 2008 and future periods, we seek to improve our sales and improve our operating efficiencies through a number of ongoing initiatives including:

	•		Improved analysis of our catalog circulation and online marketing efforts, facilitated by our new data warehouse and the addition of new management and staff in our marketing team,

	•		Improved customer service in our distribution and consumer call center, through the completion of our warehouse management system implementation and the expected implementation of our new phone system,

	•		Introducing new products and improving catalog and online merchandising strategies,

	•		Recent and anticipated future hiring of key management and staff,

	•		Implementing selective price changes,

	•		Utilization of the information within our growing customer database to better reach and serve our customers, and

	•		Improvements in our catalog and online marketing messaging.

Our business is somewhat seasonal, with the second quarter typically having a greater percentage of our sales and gross profits as a result of our Halloween costume business, and the third quarter typically having the lowest sales and gross profits as consumers have typically focused more on the holiday season rather than birthday celebrations during November and December.

Primarily as a result of these factors, we had a net loss before income taxes of $4,751,428 in the third quarter fiscal 2008 as compared to a net loss before income taxes of $201,781 in the same period last year. Additionally, in the third quarter fiscal 2008, the Company reevaluated its deferred tax assets and recorded a non-cash charge of approximately $8.2 million for the establishment of a valuation allowance against the deferred tax assets, as described below.

Comparison of the Fiscal Quarters Ended February 29, 2008 and February 28, 2007

Net Sales

Our net sales are comprised of product sales and shipping revenue. Net sales decreased 20.3% to $13.3 million in the third quarter fiscal 2008 from $16.7 million in the same period last year mainly due to the factors described above. Total advertising spending for both online and offline direct marketing efforts such as catalog mailings, paid search and affiliate spending was $4.2 million during the third quarter fiscal 2008, up 9.2% from the same period last year, which totaled $3.9 million. The decrease in net sales in the third quarter fiscal 2008 over the same period in fiscal 2007 reflects a decrease of approximately 13% in the number of orders shipped, which decreased to approximately 178,000 orders in the third quarter fiscal 2008 from approximately 206,000 orders in the same period in the prior year. Net sales per order for the third quarter fiscal 2008 was $73.50, compared with net sales per order of $80.15 for the same period last year. Our Birthday Express brand had net sales per order of $74.02 in the third quarter of fiscal 2008, down 8.1% from $80.57 in the same period of fiscal 2007. Our Costume Express brand had net sales per order of $65.56 in the third quarter of fiscal 2008, down 6.6% from $70.23 in the same period of fiscal 2007. We added approximately 99,000 new customers to our database during the third quarter, compared with 118,000 new customers added in the same quarter last year, a decrease of 16%. This brought our total customer database to approximately 3.9 million customers at February 29, 2008. Revenue from our repeat customers represented approximately 44% of revenue during the third quarter fiscal 2008, which is consistent with 44% in the same period as the prior year. Birthday Express net sales decreased to $12.4 million in the third quarter of fiscal 2008 from $15.7 million in the third quarter of fiscal 2007, a decrease of $3.3 million, or approximately 21%. This decrease reflected a reduction in Birthday Express catalog circulation of approximately 17% from the same quarter in the prior year and the factors described above. Costume Express net sales increased to $408,000 in the third quarter of fiscal 2008 from $339,000 in the third quarter of fiscal 2007, an increase of $69,000 or approximately 20%. The Company also generated approximately $332,000 in Holiday revenue related to a test offering of Christmas season products in the third quarter fiscal 2008 as compared to none last year, while the third quarter of fiscal 2007 included approximately $467,000 in Storybook Heirlooms revenue with no comparable revenue in the current year.

Gross Profit and Gross Margin

Our gross profit consists of net sales less cost of sales. Our cost of sales consists primarily of product costs, costs associated with our in-house production facility, including wages and depreciation, inbound and outbound shipping costs, and packaging materials for outbound shipments. Gross profit decreased 33.8% to $6.0 million in the third quarter fiscal 2008 from $9.1 million in the same period last year, reflecting the 20.3% reduction in net sales and a 4.2% decrease in cost of goods sold. Gross margin was 45.4% in the third quarter fiscal 2008, compared with 54.5% in the same period last year. The year over year decline in gross margin for the quarter just ended was driven primarily by increased shipping expense related to generally higher shipping rates and additional expedited shipping cost incurred by the Company to meet customer expectations and party dates. Approximately 65% of this decline in gross margin is attributed to this change in shipping expense. The implementation of our new warehouse management system was the principal factor in causing these excess expedited shipping costs, which we believe will improve in future months as the new warehouse management system moves from the implementation stage and provides the intended efficiencies. Our gross margin may fluctuate from quarter to quarter due to the mix of products sold, as well as the potential introduction of new brands. In the third quarter fiscal 2008, our margin was adversely affected by a lower margin associated with the Holiday

product test and benefited compared to last year’s third quarter when we were liquidating our Storybook Heirlooms brand.

Fulfillment

Our fulfillment expenses consist primarily of labor and other operating costs associated with our customer support center and distribution center in Greensboro, North Carolina. Despite the lower orders and sales in the quarter as compared to last year, our fulfillment expenses increased 2.9% to $2.6 million in the third quarter fiscal 2008 from $2.5 million in the same period last year. As a percentage of net sales, these expenses increased to 19.3% in the third quarter fiscal 2008 from 15.0% in the same period last year. This quarter-over-quarter increase was due primarily to additional labor required in connection with the implementation of our new warehouse management system, as discussed above, which resulted in increased labor hours both in the warehouse and in our customer service call center in order to meet customer service requirements, as well as other related costs. We believe these costs as a percentage of sales will improve in future months as the new warehouse management system moves from the implementation stage and provides the intended efficiencies. We expect further improvements as our customers continue to shift to the more efficient web ordering method, which represented 86% of total orders in the third quarter of fiscal 2008 as compared with 80% of total orders in the third quarter of fiscal 2007.

Selling and Marketing

Our selling and marketing expenses consist primarily of advertising costs, wages and related payroll benefits for our internal marketing and merchandising staff. Advertising costs include online marketing efforts, print advertising and other direct marketing strategies. Online advertising costs are generally expensed as incurred. Prepaid direct marketing expenses consist of third-party costs including paper, printing and mailing costs and are capitalized and amortized over their expected period of future benefit, which is generally from 90 to 120 days. Selling and marketing costs increased 12.4% to $5.3 million in the third quarter fiscal 2008 from $4.7 million in the same period last year. As a percentage of net sales, selling and marketing expenses increased to 39.9% in the third quarter fiscal 2008 from 28.3% in the same period last year. The change as a percentage of net sales is mainly due to higher online advertising, including paid search and significantly higher catalog postage costs as compared to the same period in the prior year, in addition to the lower sales as described above. We have experienced increases, and are potentially subject to further increases, in our online paid search costs, paper prices and postage rates. We expect that marketing will continue to be a major expense line item as we seek to expand sales and prospecting to new customers.

General and Administrative

Our general and administrative expenses consist primarily of wages and related payroll benefits for our administrative and technology employees. These expenses also include credit card fees, legal and accounting professional fees, insurance, network fees, depreciation, bad debt expense, and other general corporate expenses. General and administrative expenses increased 23.4% to $3.1 million in the third quarter fiscal 2008 from $2.5 million in the same period last year. As a percentage of net sales, our general and administrative expenses increased to 23.1% in the third quarter fiscal 2008 from 14.9% in the same period last year. The increase in general and administrative expenses year over year was driven primarily by an increase in depreciation associated with new systems and systems-related consulting fees of $299,000 and $314,000 respectively in the third quarter fiscal 2008, compared with the same period last year.

Other Income, Net

Interest income declined to $159,000 in the third quarter fiscal 2008, from $400,000 in the same period last year. This change is due primarily to the lower average cash balance invested in the period in addition to a decrease in interest rates. The reduction in invested cash is largely due to the approximately $9.9 million dividend paid in April 2007 and other uses of cash in the nine months fiscal 2008 as described below.

Income Taxes

such judgments, significant weight is given to evidence that can be objectively verified. A company’s current or previous losses are given more weight than its future outlook, and a recent three-year historical cumulative loss is considered a significant factor that is difficult to overcome.

Based upon these SFAS No. 109 guidelines, we determined that a valuation allowance should now be established due to more recent events and developments during the third quarter fiscal 2008. While we believe that our long-term financial outlook remains positive, we concluded that our ability to rely on our long-term outlook as to future taxable income was limited due to uncertainty created by the weight of the negative evidence, particularly the Company’s three-year historical cumulative loss in the third quarter fiscal 2008, the recent and anticipated near term effects associated with the efforts to improve Company systems and staffing and the more challenging near-term economic conditions. Accordingly, based on our current circumstances and uncertainty regarding our future taxable income, we recorded a full valuation allowance against these net deferred tax assets during the third quarter fiscal 2008. If and when our operating performance improves on a sustained basis, our conclusion regarding the need for a full valuation allowance could change, resulting in the reversal of some or all of the valuation allowance in the future. This non-cash charge of approximately $8.2 million is reported as income tax expense for the third quarter fiscal 2008.

In the same period last year, we recognized an income tax benefit of $64,000 based on a net loss before taxes of $202,000.

Comparison of Nine Months Ended February 29, 2008 and February 28, 2007

Net Sales

Net sales decreased approximately 4.5% to $62.2 million in the nine months fiscal 2008 from $65.1 million in the same period last year. The decrease in net sales is driven primarily by (1) reduction in Birthday catalog circulation in response to increased costs for postage, paper and printing and (2) the third quarter fiscal 2008 factors described above, partially offset by increased Costume Express net sales as described below. In addition, there was a $2.1 million decrease in revenue from our Storybook brand, whose wind-down was completed in the fourth quarter of fiscal 2007. Net sales decreased despite an increase of approximately 1.3% in the number of orders shipped, which grew to approximately 853,000 orders in the nine months fiscal 2008 from approximately 842,000 orders in the same period last year due to a reduction in the net sales per order. Net sales per order decreased to $72.07 in the nine months fiscal 2008 from $76.87 in the same period last year. Birthday Express net sales decreased to $42.3 million in the nine months fiscal 2008 from $49.5 million in the same period last year, a decrease of 14.5%. Costume Express net sales increased to $18.6 million in the nine months fiscal 2008 from $13.1 million in the same period last year, an increase of 42.3%, primarily as the result of our strong Halloween season growth this year. Storybook Heirlooms net sales were $2.1 million in the same period last year with no corresponding revenue in the current fiscal year due to the wind-down of this brand. The nine months fiscal 2008 also included $578,000 in revenue related to Holiday marketing test in the third quarter fiscal 2008.

Gross Profit and Gross Margin

Gross profit decreased 3.5% to $32.3 million in the nine months fiscal 2008 from $33.4 million in the same period last year, reflecting the 4.5% reduction in net sales and a 5.7% decrease in cost of goods sold. Our gross margin increased to 51.9% in the nine months fiscal 2008 from 51.3% in the same period last year. The improvement in gross margin is due to increases in the merchandise margin due to improved product sourcing, particularly in the Costume Express brand, which was somewhat offset by decreases in our shipping margin and by the third quarter fiscal 2008 factors described above. We had approximately $677,000 in advertising revenue during the nine months fiscal 2008 generated from web advertising sources, which have no corresponding cost of goods sold, as compared with $389,000 of advertising revenue during the same period in fiscal 2007.

Fulfillment

Our fulfillment expenses decreased 8.0% to $8.2 million in the nine months fiscal 2008 from $8.9 million in the same period last year. As a percentage of net sales, these expenses decreased to 13.2% in the nine months fiscal 2008 from 13.7% in the same period last year. This decrease is due primarily to operational efficiencies in customer service center during the first six months of fiscal 2008, partially offset by the third quarter fiscal 2008 factors described above. In the nine months fiscal 2008, the amount of our revenue coming from web orders (which are more efficient than telephone orders), as a percentage of total revenue, increased to approximately 82% as compared to approximately 75% in the same period last year.

Selling and Marketing

Selling and marketing costs increased 15.3% to $20.5 million in the nine months fiscal 2008 from $17.8 million in the same period last year. The increase in selling and marketing expenses was due primarily to an increase in catalog costs and online advertising expenditures totaling approximately $2.0 million. In addition, professional services, wages and related payroll benefits for our internal marketing and merchandising staff increased over the prior year. As a percentage of net sales, selling and marketing expenses increased to 33.0% in the nine months fiscal 2008 from 27.3% in the same period last year. This was driven by multiple factors: increased online search fees due to higher website traffic, the increase in catalog postage rates and generally lower than anticipated response rates, particularly related to the third quarter fiscal 2008 factors described above.

General and Administrative

General and administrative expenses increased 18.7% to $9.2 million in the nine months fiscal 2008 from $7.7 million in the same period last year. The increase in general and administrative expenses is due primarily to higher levels of depreciation and systems related consulting fees related to the Company’s recent investments in capital projects. As a percentage of net sales, our general and administrative expenses increased to 14.8% in the nine months fiscal 2008 from 11.9% in the same period last year.

Other Income (Expense), Net

Interest income declined to $641,000 in the nine months fiscal 2008, compared with $1.2 million in the same period last year. This change is due primarily to the lower average cash balance invested in the period in addition to a decrease in interest rates. The reduction in invested cash is largely due to the approximately $9.9 million dividend paid in April 2007 and other uses of cash in the nine months fiscal 2008 as described below.

Income Taxes

Primarily as a result of the recognition of the non-cash charge for the establishment of a valuation reserve for deferred tax assets as described above, in the nine months of fiscal 2008, we recognized income tax expense of $8,144,000. In the same period last year, we recognized income tax expense of $96,000 on income before taxes of $200,000 for the same period based upon an effective tax rate of 47.8%.

Liquidity and Capital Resources

As of February 29, 2008 we had working capital of $24 million, including cash and cash equivalents of $14.8 million. We believe that our current cash and cash equivalents, as well as cash flows from operations, will be sufficient to continue our operations and meet our capital needs for the foreseeable future.

Net cash used in operating activities was $3.8 million for the nine months fiscal 2008 and cash provided by operating activities was $1.0 million for the same period last year. Net cash used in operating activities in the nine months fiscal 2008 reflects approximately $3 million from the nine month operating loss exclusive of non-cash costs of depreciation, amortization and stock compensation, and a $1.1 million increase in inventories. Additionally, cash was used for decreased accounts payable and accrued liabilities totaling $1.3 million. Cash was provided as prepaid expenses decreased $588,000 and accounts receivable decreased $459,000 during the nine months fiscal 2008. The $1.0 million of cash provided by operating activities in the nine months fiscal 2007 was attributed primarily to approximately $1.1 million from the nine month operating loss exclusive of non-cash costs of depreciation, amortization and stock compensation, and an increase in accrued liabilities. These increases were partially offset by an increase in accounts receivable and a decrease in accounts payable in the same period last year.

Net cash used in investing activities was $2.8 million and $676,000 for the nine months fiscal 2008 and 2007, respectively, representing cash used for capital expenditures. The increased level of capital expenditures in the nine months of fiscal 2008 reflects the resumed focus on business improvements after we completed the strategic review, as described above. Approximately $250,000 of the capital expenditures during the nine months fiscal 2008 represents costs related to in-process software development projects capitalized under Statement of Position (SOP) 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use and the associated hardware purchases. We anticipate that our capital expenditures for the full fiscal year ending May 31, 2008 will range from $3.5 million to $4.5 million.

These anticipated fiscal 2008 expenditures include our new warehouse management system, phone system, data center and other projects.

Net cash provided by financing activities was $118,000 and $426,000 for the nine months fiscal 2008 and 2007, respectively. Cash provided by financing activities was due primarily to proceeds from the exercise of stock options and proceeds from shares issued under the Celebrate Express employee stock purchase plan.

The following table summarizes our contractual obligations as of February 29, 2008 and the effect these obligations are expected to have on our liquidity and cash flows in future periods.


	Payments Due by Period
	Total		Less than 1 year		1-3 years		3-5 years
	(in thousands)
Description of Contractual Obligations:
Capital lease obligations	$	59	$	22	$	37	$	—
Operating lease obligations	$	972	$	604	$	368	$	—

Total	$	1,031	$	626	$	405	$	—

Critical Accounting Policies

Certain of our accounting policies require the application of management judgment in making estimates and assumptions that affect the amounts reported in the financial statements and disclosures made in the accompanying notes. Those estimates and assumptions are based on historical experience and various other factors deemed to be applicable and reasonable under the circumstances. The use of judgment in determining such estimates and assumptions is, by nature, subject to a degree of uncertainty. Accordingly, actual results could differ from the estimates made. The critical accounting policies used in the preparation of our financial statements are reported in the Management’s Discussion and Analysis section of our Annual Report on Form 10-K for the year ended May 31, 2007.

New accounting pronouncements - In July 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109 (“FIN 48”). This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FAS No. 109, Accounting for Income Taxes . This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. We adopted the provisions of FIN 48 on June 1, 2007. The adoption of this statement did not have an impact on our results of operations or financial condition.

June 1, 2009. We do not expect that the adoption of this statement will have a material impact on our results of operations or financial condition.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

Interest Rate Risk

The primary objective of our investment activities is to preserve principal while at the same time maximizing yields without significantly increasing risk. To achieve this objective, we invest in highly rated securities. As of February 29, 2008, we held short-term investments that have a maturity date of three months or less at the time of purchase, and consisted primarily of money market accounts. Because of the short-term nature of our investments, we believe that our exposure to market rate fluctuations on those investments is minimal. On February 29, 2008, we had no long-term or short-term bank debt outstanding.

Foreign Currency Risk

Our revenue, expense and capital expenditures are transacted in U.S. dollars. We do source a portion of our product inventories from foreign vendors, primarily manufacturers in China. If the value of the U.S. dollar declines relative to the Chinese yuan, these foreign currency fluctuations could result in an increase in the cost of merchandise sourced from China through price increases. As a result of such fluctuations, we may experience fluctuations in our operating results on an annual or quarterly basis.

Item 4. Controls and Procedures.

As of the end of the period covered by this report, an evaluation was performed under the supervision and with the participation of our management, including our chief executive officer and chief financial officer (collectively, our “certifying officers”), of the effectiveness of the design and operation of our disclosure controls and procedures. Based on their evaluation, our certifying officers concluded that these disclosure controls and procedures are effective in providing reasonable assurance that the information required to be disclosed by us in our periodic reports filed with the Securities and Exchange Commission (“SEC”) is recorded, processed, summarized, and reported within the time periods specified by the SEC’s rules and SEC reports.

We believe that a system of internal controls, no matter how well designed and operated, is based in part upon certain assumptions about the likelihood of future events, and therefore can only provide reasonable, not absolute, assurance that the objectives of the controls system are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.

We have reviewed our internal controls over financial reporting and have made no changes during the quarter ended February 29, 2008 that our certifying officers concluded materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

We are not aware of any pending legal proceedings (other than routine litigation that is incidental to the business).

Item 1A. Risk Factors.

Factors That May Affect Future Operating Results

You should carefully consider the risks described below together with all of the other information included in this report. If any of the following risks actually occurs, our business, financial condition or results of operations could suffer. In that case, the trading price of our common stock could decline and you may lose all or part of your investment.

We have incurred net losses in recent quarters and may not be able to return to or sustain profitability in the future.

In 7 of our 8 most recent fiscal quarters we reported net losses and we expect to report a net loss in the fourth quarter of fiscal 2008 and for fiscal 2008 as a whole. Though we were profitable in fiscal 2005 through fiscal 2007, we

have had a history of losses. We may incur losses again in future fiscal years, especially if we introduce new brands or products, make investments in our systems or infrastructure, or continue to have difficulties in our distribution center. We expect our operating expenses to increase in the future, as we, among other things:

	•		expand into new product categories;

	•		continue with our marketing efforts to build our brand names;

	•		expand our customer base;

	•		upgrade our operational and financial systems, procedures and controls;

	•		invest in and upgrade our distribution center; and

	•		retain existing personnel and hire additional personnel, including senior management.

We may not be able to generate the required sales from our current or new product categories or reduce fulfillment and other operating expenses sufficiently to sustain or increase profitability. If we have a shortfall in sales without a corresponding reduction to our expenses, our operating results will suffer. It is possible that results of operations may be below the expectations of public market analysts and investors, which could cause the trading price of our common stock to fall.

If we do not successfully expand sales into other product categories beyond party goods, we may not be able to achieve our desired revenue growth.

We were incorporated and began selling party products through our direct marketing catalog in June 1994 and on our www.BirthdayExpress.com website in April 1996. In September 2003, we launched our Costume Express brand and became a provider of children’s and family costumes. We have historically derived more than 75% of our annual revenues from the sale of party products and accessories to families with young children under our Birthday Express brand. We conducted a small scale test of Holiday products in third quarter fiscal 2008, which resulted in an operating loss for the test. In order to achieve the desired growth in our sales and business, we may need to expand into new product categories. Challenges that may affect our ability to expand into new product categories include our ability to:

	•		improve the efficiency of our distribution center;

	•		successfully design, produce and market new products;

	•		identify and introduce new product categories;

	•		maintain our gross margins with respect to new product categories;

	•		provide a satisfactory mix of merchandise that is responsive to the needs of our customers;

	•		broaden consumer awareness of our existing and future brands;

	•		manage our selling, marketing and fulfillment costs; and

	•		manage our dual-channel direct marketing model.

Furthermore, we have not demonstrated the ability to expand into other product categories through acquisitions. In April 2001, we acquired certain assets of Storybook Inc., a direct marketer of girls’ specialty and special occasion apparel. Revenue growth from the Storybook Heirlooms brand, however, did not meet management expectations, which was a significant factor leading to our wind-down of the Storybook Heirlooms brand during fiscal 2007.

In addition, we may experience a higher degree of seasonality in our business as we expand our brands or expand into new brands or product categories that have seasonal significance. If we are unsuccessful in addressing these risks and uncertainties, our business, financial condition and results of operations may be harmed.

The loss of our senior management or other key personnel could harm our current and future operations and prospect, and newly hired personnel may not successfully integrate with the Company.

Our performance is substantially dependent on the services of our senior management and other key personnel, particularly, Kevin Green, our president and chief executive officer. Our senior management team is comprised of several individuals, and we have had many of these positions open at some time during the past several quarters. The loss of key personnel has had, and may continue to have, an adverse impact on our operations and financial results. We have hired several members of our senior management team in fiscal 2007 and 2008, including most recently our chief financial officer and vice president of marketing. We are also currently engaged in a search for a

vice president of merchandising. We cannot assure you that we will find a qualified candidate in a timely manner, or that these new senior executives will successfully integrate with the Company.

Our performance also depends on our ability to retain and motivate our officers and key employees. We do not have employment agreements with our senior executives or other key personnel except Kevin Green. In March 2008 we entered into agreements with our senior executives (other than Mr. Green),which provide for severance payments under certain circumstances in connection with a change in control of the Company, but we cannot assure you that these agreements will prevent the loss of any of these executives. The loss of the services of Mr. Green or any of our other senior executives or key employees for any reason could harm our business, financial condition and operating results. Our future success also depends on our ability to identify, attract, hire, train, retain, and motivate senior management and other technical, managerial, editorial, merchandising, marketing, and customer support personnel. Competition for such personnel is intense and we cannot assure you that we will be able to successfully attract, assimilate or retain sufficiently qualified personnel.

We must compete with other party goods and costume retailers and mass merchandisers on the selection, quality and price of our products, and failure to do so successfully could negatively affect our stock price.

In order to meet our strategic goals, we must successfully offer, on a continuous basis, a broad selection of appealing products to families with young children. To successfully compete against other party goods retailers, costume retailers and mass merchandisers, our product offerings must be affordable, high-quality, innovative and attractive to a wide range of consumers whose preferences may change from time to time. We cannot predict with certainty that we will be successful in offering products that meet these requirements. If consumers do not find our products attractive or our products otherwise become less popular with consumers, we may see increased merchandise returns, inventory write-downs and increased costs. Any shortcomings in our merchandise strategy could adversely affect our operating results and cash flows.

Children’s tastes change and are often difficult to predict, and any failure by us to correctly identify and react appropriately to these changing preferences could hurt our sales and gross margins and render a portion of our inventory obsolete.

Our failure to anticipate, identify or react appropriately to changes in consumer demand could lead to excess inventories and significant markdowns or a shortage of products and lost sales. Our strategy, relations with our customers and margins are dependent, in part, on our identification and regular introduction of new designs that are appealing to our customers, especially children. We cannot assure you that we will be able to identify, obtain or license popular third-party designs or that our design personnel will be able to timely identify and introduce appealing designs in sufficient volume to support our strategy and operations.

We must also anticipate changes in the tastes and preferences of consumers in order to compete for their business successfully. In particular, our ability to anticipate changes in the tastes and preferences of children, which change often and quickly, is crucial to our success, and we could misinterpret or fail to identify trends on a timely basis. Further, product orders must be placed with suppliers before we receive orders from our customers, and the demand for specific products can change between the time the products are ordered by us and the date we receive them. If we underestimate consumer demand, we may disappoint customers and lose potential sales to our competitors. If we overestimate consumer acceptance of our products, we may be required to take significant inventory markdowns or sell our products at discounted prices, which could reduce our sales and gross margins.

If we fail to promote and maintain our brands effectively, we may not be able to compete successfully with better-known competitors.

Building and maintaining recognition of our brands by families with young children is critical to expanding our customer base and competing successfully against other party goods retailers and mass merchandisers with greater brand recognition. In order to continue building consumer recognition of our brands, we will need to increase our financial commitment to creating and maintaining brand awareness in a manner targeted at families with young children. We cannot be certain that our marketing efforts will attract new customers, enable us to retain existing customers, or encourage repeat purchases. If these efforts are not successful, our sales may not grow to desired levels, or could even decline.

If we do not successfully maintain and expand our customer and prospect databases our sales volume could suffer and our marketing costs could increase.

We depend on our proprietary customer and prospect databases to facilitate repeat sales and attract new customers. If we fail to keep these databases current, or if the information in these databases is damaged or destroyed, our sales could stagnate or even decline. If we do not expand our databases of customers and prospects, or if we fail to enhance and refine our techniques for segmenting this information to maximize its usefulness, our sales volume could suffer and our marketing costs could increase. In addition, if federal or state governments enact privacy legislation resulting in the increased regulation of mailing lists, we could experience increased costs in complying with new regulations concerning the solicitation of consents or be unable to achieve the desired database and sales volume growth.

Our operating results could suffer if we are unable to successfully manage the costs of our catalog and email marketing efforts or if our catalogs and emails fail to produce sales at satisfactory levels.

Our catalogs and emails have been an important tool for the acquisition and retention of customers. We believe that the success of our catalogs and emails as a cost-effective marketing tool depends on the following factors:

	•		effective management of costs associated with the production and distribution of our catalogs;

	•		achievement of adequate response rates to our emails and catalog mailings;

	•		displaying a mix of merchandise in our catalogs and emails that is attractive to our customers;

	•		timely delivery of catalog mailings to our customers;

	•		maintaining adequate delivery rates of emails to our customers’ inboxes;

	•		managing our email campaigns to avoid classification as SPAM by significant email service providers.

Catalog production and mailings entail substantial paper, printing, postage and labor costs. Increases in the costs of producing and distributing our catalogs, including increases in postage rates, or paper, photography or printing costs, may reduce the margin on sales derived from our catalogs. As we incur nearly all of the costs associated with our catalogs prior to mailing, we are unable to adjust the costs incurred in connection with a particular mailing to reflect the actual performance of the catalog. Further, in the third quarter the Company experienced issues in catalog circulation, which adversely affected catalog response rates. In addition, response rates to our mailings and, as a result, sales generated by each mailing are affected by factors such as consumer preferences, economic conditions, the timing and mix of our catalog mailings, the timely delivery of these mailings by the postal system, and changes in our merchandise assortment, some of which are outside of our control. A significant increase in the costs associated with producing or distributing our catalogs, a recurrence of the errors in catalog circulation tactics, or other failure of our catalogs to produce sales at satisfactory levels, could have a negative effect on our operating results.

Capacity constraints, systems failures or security breaches could prevent access to our website, which could lower our sales and harm our reputation.

Our service goals of performance, reliability and availability require that we have adequate capacity in our computer systems to cope with the volume of customers on our website. As our operations grow in size and scope, we will need to improve and upgrade our systems and infrastructure to maintain or improve the efficiency of our operations as well as to offer customers enhanced services, capacity, features and functionality. The expansion and/or upgrade of our systems and infrastructure will require us to commit substantial financial, operational and technical resources before the volume of our business increases and with no assurance of a corresponding increase in sales. If we cannot expand and/or upgrade our systems in a timely or efficient manner, we could experience increased costs, disruptions in service, slower response times, lower customer satisfaction and delays in the introduction of new products and services. Any of these problems could impair our reputation, damage our brands and cause our sales to decline.

Our ability to provide high-quality service depends on the efficient and uninterrupted operation of our computer and communications systems. Our systems and operations are vulnerable to damage or interruption from human error, natural disasters, power loss, telecommunication failures, break-ins, sabotage, computer viruses, design defects, vandalism, denial-of-service attacks and similar events. Our website has experienced system interruptions from time to

time and could experience periodic system interruptions in the future. We do not have a formal disaster recovery plan or alternate providers of web hosting services, and a natural disaster or other disruption at our data center could mean the temporary loss of the use of our website. Our business interruption insurance may not adequately compensate us for the associated losses. Any system failure or security breach that causes an interruption in service or decreases the responsiveness of our customer support center or website could impair our reputation, damage our brands and cause a decrease in sales.

If we are unable to provide satisfactory telephone-based customer support, we could lose customers.

Our ability to provide satisfactory levels of customer support also depends, to a large degree, on the efficient and uninterrupted operation of our customer support centers. Any material disruption or slowdown in our telephone order processing systems resulting from capacity constraints, labor disputes, telephone or Internet failures, power or service outages, natural disasters or other events could make it difficult or impossible to provide adequate telephone-based customer support. Further, we may be unable to attract and retain an adequate number of competent customer support representatives, which is essential in creating a favorable customer experience. If we are unable to continually provide adequate staffing for our customer support operations, our reputation could be seriously harmed. In addition, we cannot assure you that call volumes will not exceed our present system capacities. If this occurs, we could experience delays in accepting orders, responding to customer inquiries and addressing customer concerns. Also, we may be required to expand our customer support center in the near future. We cannot assure you that we will be able to find additional suitable facilities on acceptable terms or at all, which could seriously hinder our ability to provide satisfactory levels of customer support. Because our success depends in large part on keeping our customers satisfied, any failure to provide satisfactory levels of customer support would likely impair our reputation and we could lose customers.

Failure to successfully manage our fulfillment and distribution operations could cause us to incur increased costs or lose customers.

Our fulfillment and distribution operations are located in Greensboro, North Carolina. These operations are critical to the cost-effective and efficient fulfillment and shipment of customer orders. We are making modifications to our distribution center to accommodate more streamlined distribution procedures. We have incurred higher than anticipated costs in implementing these procedures, as well as higher fulfillment costs related to our transition to a more automated order picking process. We have also observed some erosion in the repeat buying rates of our customers, which we attribute partially to the distribution center problems we have experienced over the past year. If we are unable to successfully manage our fulfillment operations, including further process improvements planned for the future, we may experience higher than anticipated costs, hurt our reputation and discourage repeat sales.

Increased product returns, or a failure by us to accurately predict the level of product returns, could harm our business.

As part of our customer support commitment, we maintain a product return policy that allows recipients to return most items received from us with which they are dissatisfied. We make allowances for product returns in our financial statements based on historical return rates. We cannot assure you that actual product returns will not significantly exceed our allowances for returns. In addition, because our allowances are based on historical return rates, we cannot assure you that the introduction of new merchandise within existing or new product categories, increased sales over the Internet, changes in the habits of our customers or other factors will not cause actual returns to exceed return allowances, perhaps significantly. Any increase in product returns above our allowances could have a negative impact on our financial results and may, in turn, cause our stock price to decline.

We may not be able to compete successfully against current and future competitors.

We operate in several competitive markets including party goods and children’s and family costumes. Our primary competition comes from traditional retailers that offer a variety of products in the party goods and children’s and family costume markets. We believe our primary competition in party goods and costumes is from mass merchandisers such as Target and Wal-Mart, party goods superstores such as Party City and Party America, and online retailers such as Oriental Trading and Buy Costumes. We also compete in these markets with a variety of other companies including: traditional card and gift specialty retailers; supermarkets and drugstores; and catalog retailers of novelty items.

Competitors can enter our market with little difficulty and can launch new websites or catalogs at a relatively low cost. Many of these current and potential competitors may have the ability to devote substantially more resources to marketing, customer support, product development and order fulfillment operations than we can. Some of our suppliers also may choose to compete with us directly and may in the future choose not to supply products to us. In addition,

larger or more well-financed entities have acquired and may in the future acquire, invest in or form joint ventures with our competitors. Some of our competitors may be able to secure products from suppliers on more favorable terms, fulfill orders more efficiently or adopt more aggressive pricing than we can. If we are unable to compete effectively in our markets, our business, financial condition and operating results may suffer.

We depend on search engines to attract customers to our website, and losing these customers would adversely affect our revenues and financial results.

Many consumers access our website by clicking through search results displayed by Internet search engines. Internet search engines typically provide two types of search results, algorithmic listings and purchased listings. Algorithmic listings cannot be purchased, and instead are determined and displayed solely by a set of formulas utilized by the search engine. Purchased listings can be bought by advertisers in order to attract users to their websites. We rely on both algorithmic and purchased listings to attract and direct consumers to our website. Search engines revise their algorithms from time to time in an attempt to optimize their search results. If one or more of the search engines on which we rely for algorithmic listings were to modify its algorithms, resulting in fewer consumers clicking through to our website, we would need to increase our marketing expenditures, which would adversely affect our financial results. In addition, the rates for purchased listings have significantly increased. If one or more of the search engines on which we rely for purchased listings modifies or terminates its relationship with us or if the rates for purchased listings continues to rise, our online marketing expenses as a percentage of revenue could rise, we could lose customers, we could be forced to look for other advertising avenues and traffic to our website could decrease.

Because we do not have long-term contracts for third-party products, we may not have continued access to popular products.

Our business depends significantly on the use of third-party proprietary products and our future success is contingent upon the continued availability of these products. We do not have long-term arrangements with any vendor or distributor that would guarantee the availability of third-party proprietary products and, as a result, we do not have a predictable or guaranteed supply of these products. We cannot assure you we will have access to any third-party products in sufficient quantities. If we are unable to provide our customers with continued access to popular or exclusive third-party products, our sales could decline.

If we are unable to maintain or acquire licenses to intellectual property, we may have fewer proprietary products and our sales may decline.

Many of our proprietary products are based on or incorporate intellectual property and other character or story rights licensed from third parties. These license agreements are limited in scope, typically have a two- or three-year term and lack renewal rights. We may not be able to renew key licenses when they expire or include new products in existing licenses. Moreover, most of these licenses may be terminated immediately if we breach their terms. If we are unable to maintain these licenses and obtain additional licenses with significant commercial value, or maintain them at reasonable costs, we will be unable to increase our revenue in the future unless we offset the loss of the products that depend on these licenses with an increase in sales of our independently created proprietary products.

Because we do not have long-term contracts with our suppliers, we may not have continued access to necessary materials and our sales may suffer.

Our financial performance depends on our ability to purchase our products in sufficient quantities at competitive prices. We purchase our products from over 250 foreign and domestic manufacturers and distributors. We have no long-term purchase contracts with any of these suppliers, and therefore, have no contractual assurances of continued supply, access to products or favorable pricing. Any vendor could increase prices or discontinue selling to us at any time. The lack of long-term contracts also exposes us to increased risks associated with changes in local economic conditions, trade issues and foreign currency fluctuations. In the third quarter of fiscal 2008 ended February 29, 2008, products supplied by our ten largest suppliers represented approximately 48.3% of inventory purchases, with our largest supplier representing 19.8%. If we are unable to maintain these supplier relationships, our ability to offer high-quality, favorably-priced products to our customers may be impaired, and our sales and gross margins could decline.

Our reliance on smaller or independent vendors and suppliers and manufacturers located abroad exposes us to various risks including disruption in product supply.

Some of our smaller vendors have limited resources, production capacities and operating histories, which means that they may not be able to timely produce sufficient quantities of certain products demanded by our customers. In addition, our relationships with independent foreign suppliers and manufacturers are also subject to a number of risks, including:

	•		work stoppages;

	•		transportation delays and interruptions;

	•		political instability;

	•		foreign currency fluctuations;

	•		changing economic conditions;

	•		an increased likelihood of counterfeit, knock-off or gray market goods;

	•		product liability claims;

	•		expropriation, nationalization, imposition of tariffs, import and export controls and other non-tariff barriers, including quotas and restrictions on the transfer of funds;

	•		environmental regulation; and

	•		other changes in governmental policies.

Because of these factors, we may be subject to liability claims or may not be able to acquire desired products in sufficient quantities on terms acceptable to us. Any inability to acquire suitable products, the loss of one or more key vendors, or the settlement or outcome of a product liability suit could have a negative effect on our sales and operating results. We may not be able to develop relationships with new vendors, and products from alternative sources, if any, may be of lesser quality or more expensive than those we currently purchase. We cannot be certain that such factors will not prevent us from procuring manufactured products in a cost-effective or timely manner.

We may face product liability claims that are costly and create adverse publicity.

If any of the products that we sell causes harm or damages to any of our customers or other individuals, we could be vulnerable to product liability claims. We have in the past recalled, and may in the future recall, products that we sold. Although we maintain insurance against product liability claims, our coverage may be inadequate to cover any liabilities we may incur. We work with experts to test some of our products for safety compliance, but our tests may not identify all potential product defects before products are sold. Even if we successfully defend ourselves against product liability claims, we could be forced to spend a substantial amount of money in litigation expenses, our management could be required to spend valuable time in the defense against these claims, we could be required to remove products from inventory, and we could suffer adverse publicity about the safety and fitness of our products, any of which could harm our business.

Product safety regulations may restrict availability of products and reduce our sales or increase our costs.

Certain products that we sell are subject to government regulations related to product safety, and other products may become subject to such regulations in the future. During 2007, a number of consumer product companies had product issues, including product recalls which were widely reported. As a result, state and federal legislative bodies and regulatory agencies are considering modification of current laws and regulations or the adoption of further laws and regulations related to toys and other consumer products. The standards which may be adopted are not predictable and they may vary between jurisdictions. If such regulations are adopted, we may determine that certain products may not be in compliance with the new standards and it may become necessary to replace, modify or discontinue the products. Such regulations may restrict our ability to sell certain products within one or more localities or may result in higher costs for the products and for the administrative costs associated with compliance with the new laws and regulations, in amounts which cannot be predicted.

Failure of third parties to deliver our products efficiently and in a timely manner could cause us to lose customers.

We rely upon other parties for product shipments to and from our Greensboro, North Carolina fulfillment and distribution center. It is possible that events beyond our control, such as strikes, trucking shortages, the imposition of tariffs, rail disruption, or other disruption, could affect the ability of these parties to deliver inventory items to our facilities or merchandise to our customers. The failure of these parties to deliver goods to or from our facilities could result in delays in fulfillment of customer orders. Because our customer orders are often time-sensitive, delays by our third-party shipment providers could hurt our reputation and our ability to obtain repeat orders.

Fluctuations in commodity prices may increase our operating costs and make our expenses difficult to predict.

We are vulnerable to fluctuations in commodity prices, particularly the price of paper stock. Paper goods comprise a significant portion of our total inventory. In addition, a portion of our marketing expenditures are related to our direct marketing efforts which include our paper catalogs. If the price of paper increases significantly, we may be unable to pass the additional costs on to our customers, which could hurt our profitability. In addition, fluctuations in commodity prices could make it difficult for us to accurately forecast our expenses.

We may consider acquisitions as part of our growth strategy, and failure to adequately evaluate or integrate any acquisitions could harm our business.

We have limited experience in acquiring other businesses. In April 2001, we acquired the assets of Storybook Inc. Integration expenses were higher than anticipated and despite considerable effort and time spent, revenue growth from the Storybook brand did not meet management expectations. In June of 2006, we announced the wind-down of the Storybook brand which was completed in the fourth quarter of fiscal 2007. We may consider opportunities to acquire other products and businesses that could enhance or complement our current products and services or expand the breadth of our product categories or customer base. Potential and completed acquisitions involve numerous risks, including unanticipated costs associated with the acquisition and risks associated with entering product categories in which we have no or limited prior experience. If we fail to properly evaluate and execute future acquisitions, our management team may be distracted from our day-to-day operations, our business may be disrupted, and our operating results may suffer.

Our business involves the extensive use of intellectual property, and related claims against us could be costly or force us to abandon popular products.

Third parties have asserted, and may in the future assert, that our business or the products we make or use infringe upon their rights. We cannot predict whether third parties will assert claims of infringement against us, or whether any past or future assertions or prosecutions of infringement will harm our business. If we are forced to defend against any such claims, whether they are with or without merit and even if they are determined in our favor, we may face costly litigation, diversion of the attention of our technical and management personnel and product shipment delays. As a result of any infringement dispute, we may have to develop non-infringing products or enter into royalty or licensing agreements, which may be on unfavorable terms. If there is a successful claim of infringement against us, and we are unable to develop non-infringing products or license the infringed or similar product on a timely basis or at all, we will need to drop the infringed product from our offerings and our sales could suffer.

If the protection of our trademarks and proprietary rights is inadequate, our brands and reputation could be impaired and we could lose customers.

The steps we take to protect our proprietary rights may be inadequate. We regard our copyrights, service marks, trademarks, trade dress, trade secrets and similar intellectual property as critical to our success. We rely on trademark and copyright law, trade secret protection and confidentiality or license agreements with our employees, customers, partners and others to protect our proprietary rights. Birthday Express and BirthdayExpress.com are registered with the United States Patent and Trademark office, and we have filed federal trademark applications for Costume Express and Celebrate Express. We cannot be certain we will be able to obtain registration for our filed trademarks or for trademarks we submit applications for in the future. Effective trademark, service mark, copyright and trade secret protection may not be available in every country in which we will sell our products and services. Furthermore, the relationship between

regulations governing domain names and laws protecting trademarks and similar proprietary rights is unclear. Therefore, we may be unable to prevent third parties from acquiring domain names that are similar to, infringe upon or otherwise decrease the value of our trademarks and other proprietary rights and our brands and reputation could be impaired and we could lose customers.

If we cannot maintain and protect our existing domain names or acquire suitable new domain names as needed, we may not be able to successfully build our brands.

We may be unable to acquire or maintain Internet domain names relating to our brands in the United States and other countries in which we may conduct business. As a result, we may be unable to prevent third parties from acquiring and using domain names relating to our brands. Such use could damage our brands and reputation and divert customers away from our website. We currently hold various relevant domain names, including www.CelebrateExpress.com, www.BirthdayExpress.com, and www.CostumeExpress.com. The acquisition and maintenance of domain names generally is regulated by governmental agencies. Governing bodies may establish additional top-level domains, appoint additional domain name registrars or modify the requirements for holding domain names, any of which may affect our ability to maintain the domain names we need for our business. If we cannot prevent others from using similar domain names we may be unable to successfully build our brands.

Temporary or permanent disruption at our fulfillment facility could prevent timely shipment of customer orders and hurt our sales.

We assemble, package, and ship our orders, and process all product returns, at our Greensboro, North Carolina fulfillment and distribution facility. In the future, we may be unable to fulfill our customers’ orders at this facility in a timely manner, or at all, due to a number of factors, including:

	•		a failure to maintain or renew our existing lease agreement;

	•		a power, telecommunications or other systems failure;

	•		an employee strike or other labor stoppage;

	•		terrorist attacks, acts of war or break-ins;

	•		a disruption in the transportation infrastructure including air traffic and roads; or

	•		fire, flood, hurricane or other disaster.

In the event that we are temporarily unable to timely fulfill our customers’ orders through our Greensboro facility, we will either upgrade the shipping or attempt to re-ship the orders from another source. However, we cannot guarantee that we will be able to fulfill all orders or that we will be able to deliver the affected orders in a timely manner. This could result in increased fulfillment costs or a decrease in sales, as well as the potential loss of repeat orders from affected customers. In addition, if operations at our Greensboro facility become permanently disrupted due to any of the above or other factors, we may not be able to secure a replacement fulfillment and distribution facility on terms acceptable to us or at all. We do not currently maintain back-up power systems at our Greensboro facility, nor do we have a formal disaster recovery plan and our business interruption insurance may be insufficient to compensate us for losses that occur in the event operations at our fulfillment and distribution center are interrupted.

We may incur significant costs or experience product availability delays in complying with regulations applicable to the sale of our manufactured products.

We use a variety of water-based inks, paper and coatings in the manufacture of our paper party products. We are required to maintain our manufacturing operations in compliance with United States federal, state and local laws and regulations, including but not limited to rules and regulations associated with consumer protection and safety, the Comprehensive Environmental Response, Compensation, and Liability Act, or CERCLA, the Food and Drug Administration and the Occupational Safety and Health Administration, or OSHA. Changes in laws and regulations applicable to our business could significantly increase our costs of goods sold and we may not be able to pass these increases on to our customers. If we fail to comply with current laws and regulations applicable to our business, or to pass annual inspections of our facilities by regulatory bodies, we could be subject to fines and penalties or even

interruptions of our operations. In addition, failure to comply with applicable laws and regulations could subject us to the risk of private lawsuits and damages.

If use of the Internet, particularly with respect to online commerce, does not continue to increase as rapidly as we anticipate, our sales may not grow to desired levels.

For the quarter ended February 29, 2008, our online sales represented approximately 86% of our total sales. Our future sales and profits are substantially dependent upon the continued use of the Internet as an effective medium of business and communication by our customers. Internet use may not continue to develop at historical rates and consumers may not continue to use the Internet and other online services as a medium for commerce. Highly-publicized failures of some online retailers in meeting consumer demands could result in consumer reluctance to adopt the Internet as a means for commerce, and thereby damage our reputation and brands and reduce our revenues and results of operations.

In addition, the Internet may not be accepted as a viable long-term commercial marketplace for a number of reasons, including:

	•		actual or perceived lack of security of information or privacy protection;

	•		possible disruptions, computer viruses or other damage to the Internet servers or to users’ computers; and

	•		excessive governmental regulation.

If the Internet fails to continue growing as a commercial marketplace, our sales may not increase as much as desired by our shareholders, or at all.

Risks related to the Internet, including security and reliability issues, are largely outside our control and may hurt our reputation or sales.

Our online business is subject to numerous risks, many of which are outside our control. In addition to changing consumer preferences and buying trends relating to Internet usage, we are vulnerable to additional risks and uncertainties associated with the Internet. These risks include changes in required technology interfaces, website downtime or slowdowns and other technical failures or human errors, changes in applicable federal and state regulation, security breaches, and consumer privacy concerns. Our failure to respond successfully to these risks and uncertainties might adversely affect the sales through our online business, as well as damage our reputation and increase our selling and marketing and general and administrative expenses. In addition, our success will depend, in large part, upon third parties maintaining the Internet infrastructure to provide a reliable network backbone with the speed, data capacity, security and hardware necessary for reliable Internet access and services. Our business, which relies on a graphically-rich website that requires the transmission of substantial data, is also significantly dependent upon the availability and adoption of broadband Internet access and other high-speed Internet connectivity technologies. Any significant reliability, data capacity or connectivity problems experienced by the Internet or its users could harm our sales and profitability.

Government regulation of database use in direct marketing and Internet and online commerce is evolving. Unfavorable changes in these regulations could substantially harm our business and results of operations.

We are subject to general business regulations and laws, as well as regulations and laws that specifically govern database use in direct marketing and Internet and online commerce. Existing and future regulations and laws may impede the growth of database direct marketing, Internet or other online services. These regulations and laws may cover taxation, restrictions on imports and exports, customs, tariffs, user privacy, data protection, pricing, content, copyrights, distribution, electronic contracts and other communications, consumer protection, email restrictions, the provision of online payment services, broadband residential Internet access and the characteristics and quality of products and services. It is not clear how existing laws and regulations governing issues such as property ownership, sales and other taxes, libel and personal privacy apply to database direct marketing, the Internet and online commerce. Unfavorable resolution of these issues may slow the growth of database direct marketing, online commerce and, in turn, our business.

Our failure to protect confidential information of our customers and our network against security breaches could damage our reputation and brands and subject us to legal liability.

A significant barrier to online commerce and communications is the secure transmission of confidential information over public networks. Currently, a majority of our sales are billed to our customers’ credit card accounts directly. We

rely on encryption and authentication technology licensed from third parties to effect secure transmission of confidential information, including credit card numbers. Advances in computer capabilities, new discoveries in the field of cryptography or other developments may result in a compromise or breach of the technology we use to protect customer transaction data. Any compromise of our security could damage our reputation and brands and expose us to a risk of lost sales, or litigation and possible legal liability. In addition, anyone who is able to circumvent our security measures could misappropriate proprietary information or cause interruptions in our operations. We may need to expend significant resources to protect against security breaches or to address problems caused by breaches.

Our failure to address risks associated with credit card fraud and bad debt could damage our reputation, brands and results of operations.

Under current credit card practices, we are liable for fraudulent credit card transactions because we do not obtain a cardholder’s signature. We do not currently carry insurance against this risk. To date, we have experienced minimal losses from credit card fraud, but we face the risk of significant losses from this type of fraud as our net sales increase. Losses incurred from fraudulent transactions or bad debt associated with the extension of credit to our customers could impair our results of operations. In addition, any failure to adequately control fraudulent credit card transactions could damage our reputation and brands, and reduce our sales.

Our sales may decrease if we are required to collect taxes on purchases.

We do not collect or have imposed upon us sales, use or other taxes related to the products we sell, except for certain corporate-level taxes and sales taxes with respect to purchases by customers located in the states of North Carolina and Washington. However, one or more states may seek to impose sales, use or other tax collection obligations on us in the future. A successful assertion by one or more states that we should be collecting sales, use or other taxes on the sale of our products could result in substantial tax liabilities and penalties in connection with past sales. In addition, if we are required to collect these taxes we will lose one of our current cost advantages, which may decrease our ability to compete with traditional retailers and substantially harm our sales.

We have based our policies for sales and use tax collection on our interpretation of certain decisions of the U.S. Supreme Court that restrict the imposition of obligations to collect state and local sales and use taxes with respect to sales made through catalogs or over the Internet. However, implementation of the restrictions imposed by these Supreme Court decisions is subject to interpretation by state and local taxing authorities. While we believe that these Supreme Court decisions currently restrict state and local taxing authorities outside the states of North Carolina and Washington from requiring us to collect sales and use taxes from purchasers located within their jurisdictions, taxing authorities outside of North Carolina and Washington could disagree with our interpretation of these decisions. Moreover, a number of states, as well as the U.S. Congress, have been considering various initiatives that could limit or supersede the Supreme Court’s position regarding sales and use taxes on Internet sales. If any state or local taxing jurisdiction were to disagree with our interpretation of the Supreme Court’s current position regarding state and local taxation of Internet sales, or if any of these initiatives were to address the Supreme Court’s constitutional concerns and result in a reversal of its current position, we could be required to collect sales and use taxes from purchasers located in states other than North Carolina and Washington. The imposition of additional tax obligations on our business by state and local governments could create significant administration burdens for us, decrease our future sales and harm our cash flow and operating results.

Failure to rapidly respond to technological change could result in our services or systems becoming obsolete.

As the Internet and online commerce industries evolve, we may be required to license emerging technologies useful to our business, enhance our existing services, develop new services and technologies that address the increasingly sophisticated and varied needs of our prospective customers and respond to technological advances and emerging industry standards and practices on a cost-effective and timely basis. We may not be able to successfully implement these new services and technologies or adapt our website, telephone and transaction-processing systems to customer requirements or emerging industry standards. Some of our computer systems use antiquated software that is no longer supported by the vendor. If we were to encounter problems with these systems it could be costly and time consuming to correct, and may disrupt operations. If we fail to respond to these issues in a timely manner, we may lose existing customers and be unable to attract sufficient numbers of new customers.

Future sales of our common stock may depress our stock price.

If our shareholders sell substantial amounts of common stock in the public market, or if the market perceives that these sales may occur, the market price of our common stock may decline. We have registered all shares of common stock that we may issue under our employee benefits plans. As a result, these shares can be freely sold in the public market upon issuance, subject to restrictions under the securities laws. The holders of a significant portion of our common stock have rights, subject to some conditions, to require us to file registration statements covering the resale of their shares or to include their shares in registration statements that we may file for ourselves or other shareholders. These registration rights of our shareholders could impair our ability to raise capital by depressing the price at which we could sell our common stock.

Our directors, executive officers and significant shareholders hold a substantial portion of our stock, which may lead to conflicts with other shareholders over corporate transactions and other corporate matters.

Our directors and current beneficial holders of 5% or more of our outstanding common stock own a significant portion of our stock. These individuals, acting together, are able to control or influence significantly all matters requiring shareholder approval, including the election of directors and significant corporate transactions such as mergers or other business combinations. This control may delay, deter or prevent a third-party from acquiring or merging with us and limit the ability of smaller shareholders to influence corporate matters.

We will need to implement additional finance and accounting systems, procedures and controls as we grow our business and organization and to satisfy new reporting requirements.

As a public reporting company, we are required to comply with the Sarbanes-Oxley Act of 2002 and the related rules and regulations of the SEC, including expanded disclosures and accelerated reporting requirements and more complex accounting rules. Compliance with Section 404 of the Sarbanes-Oxley Act of 2002 and other requirements will increase our costs and require additional management time and resources. We may need to continue to implement additional finance and accounting systems, procedures and controls to satisfy new reporting requirements. If our internal controls over financial reporting are determined to be ineffective, investors could lose confidence in the reliability of our internal controls over financial reporting, which could adversely affect our stock price.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

On October 19, 2004 (the “registration effective date”), the Company’s registration statement on Form S-1 (Registration No. 333-117459) was declared effective for the Company’s initial public offering. Net proceeds to the Company after all expenses were approximately $34 million. From the registration effective date through February 29, 2008, the Company has used the net proceeds from the offering for repayment of the Company’s $5.0 million term loan. Through February 29, 2008, we estimate that approximately $9.6 million of the proceeds have been used to purchase fixed assets and approximately $5.0 million of proceeds have been used for working capital purposes. On April 26, 2007, approximately $9.9 million was paid to shareholders in the form of a one time special dividend. The remaining proceeds from the offering are invested in money market securities.

Item 6. Exhibits.


Exhibit No.		Description
3.1(1)		Amended and Restated Articles of Incorporation of Celebrate Express, Inc.

3.2(2)		Articles of Amendment of the Amended and Restated Articles of Incorporation of Celebrate Express, Inc. (Series A Participating Preferred Stock).

3.3(1)		Amended and Restated Bylaws of the Celebrate Express, Inc.

3.4(3)		Amendments to Sections 2.1, 2,2 and 3.3 of the Amended and Restated Bylaws of Celebrate Express, Inc.

3.5(4)		Amendments to Sections 3.9 and 11.1 of the Amended and Restated Bylaws of Celebrate Express, Inc.

3.6		Articles of Amendment of the Amended and Restated Articles of Incorporation of Celebrate Express, Inc.

4.1(1)		Specimen Common Stock Certificate.

4.2(1)		Amended and Restated Investor’s Rights Agreement dated November 15, 2001, by and among Celebrate Express, Inc. and the investors named therein.

4.3(2)		Preferred Shares Rights Agreement, dated July 25, 2005.

4.4(2)		Form of Preferred Shares Rights Certificate.

10.1(5)		Lease Amendment No. 7 between Registrant and Queen Investment Company LLC dated October 4, 2007.

10.2		Employment offer letter with Mr. Harold Egler, dated March 7, 2008.

10.3		Employment offer letter with Mr. Kristopher Galvin, dated January 10, 2008.

10.4		Severance and Change in Control Agreement with Mr. Harold Egler, dated March 13, 2008.

10.5		Form of Severance and Change in Control Agreement with Mr. Kristopher Galvin, Ms. Lisa Tuttle, and Mr. Dennis Everhart, dated March 13, 2008

31.1		Certification of Chief Executive Officer Required Under Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended.

31.2		Certification of Chief Financial Officer Required Under Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended.

32.1		Certification of Chief Executive Officer Required Under Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934, as amended, and 18 U.S.C. Section 1350.

32.2		Certification of Chief Financial Officer Required Under Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934, as amended, and 18 U.S.C. Section 1350.


(1)		Incorporated by reference to Registrant’s Registration Statement on Form S-1 (File No. 333-117459), as amended, initially filed with the Securities and Exchange Commission on July 16, 2004.

(2)		Incorporated by reference to Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on July 25, 2006.

(3)		Incorporated by reference to Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on July 11, 2006.

(4)		Incorporated by reference to Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on July 20, 2006.

(5)		Incorporated by reference to Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on October 10, 2007.

SIGNATURES

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


	CELEBRATE EXPRESS, INC.
Date: April 11, 2008	By:	/s/ Kevin A. Green
		Kevin A. Green
		Chief Executive Officer and President (Principal Executive Officer)


Date: April 11, 2008	By:	/s/ Kristopher S. Galvin
		Kristopher S. Galvin
		Chief Financial Officer (Principal Financial and Accounting Officer)

EXHIBIT INDEX


Exhibit No.		Description
3.1(1)		Amended and Restated Articles of Incorporation of Celebrate Express, Inc.

3.2(2)		Articles of Amendment of the Amended and Restated Articles of Incorporation of Celebrate Express, Inc. (Series A Participating Preferred Stock).

3.3(1)		Amended and Restated Bylaws of the Celebrate Express, Inc.

3.4(3)		Amendments to Sections 2.1, 2,2 and 3.3 of the Amended and Restated Bylaws of Celebrate Express, Inc.

3.5(4)		Amendments to Sections 3.9 and 11.1 of the Amended and Restated Bylaws of Celebrate Express, Inc.

3.6		Articles of Amendment of the Amended and Restated Articles of Incorporation of Celebrate Express, Inc.

4.1(1)		Specimen Common Stock Certificate.

4.2(1)		Amended and Restated Investor’s Rights Agreement dated November 15, 2001, by and among Celebrate Express, Inc. and the investors named therein.

4.3(2)		Preferred Shares Rights Agreement, dated July 25, 2005.

4.4(2)		Form of Preferred Shares Rights Certificate.

10.1(5)		Lease Amendment No. 7 between Registrant and Queen Investment Company LLC dated October 4, 2007.

10.2		Employment offer letter with Mr. Harold Egler, dated March 7, 2008.

10.3		Employment offer letter with Mr. Kristopher Galvin, dated January 10, 2008.

10.4		Severance and Change in Control Agreement with Mr. Harold Egler, dated March 13, 2008.

10.5		Form of Severance and Change in Control Agreement with Mr. Kristopher Galvin, Ms. Lisa Tuttle, and Mr. Dennis Everhart, dated March 13, 2008

31.1		Certification of Chief Executive Officer Required Under Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended.

31.2		Certification of Chief Financial Officer Required Under Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended.

32.1		Certification of Chief Executive Officer Required Under Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934, as amended, and 18 U.S.C. Section 1350.

32.2		Certification of Chief Financial Officer Required Under Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934, as amended, and 18 U.S.C. Section 1350.


(1)		Incorporated by reference to Registrant’s Registration Statement on Form S-1 (File No. 333-117459), as amended, initially filed with the Securities and Exchange Commission on July 16, 2004.

(2)		Incorporated by reference to Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on July 25, 2006.

(3)		Incorporated by reference to Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on July 11, 2006.

(4)		Incorporated by reference to Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on July 20, 2006.

(5)		Incorporated by reference to Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on October 10, 2007.

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