BDAY Celebrate Express (MM)

 

 

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 November 30, 2007

OR

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

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 or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. Check one:

                    Large accelerated filer  o                     Accelerated filer  o                     Non-accelerated filer  þ

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 December 31, 2007, there were 7,978,559 shares of the registrant’s common stock outstanding.

 

 

CELEBRATE EXPRESS, INC.

INDEX

PART I. FINANCIAL INFORMATION			1
Item 1. Financial Statements (unaudited)			1
Balance Sheets at November 30, 2007 and May 31, 2007			2
Statements of Operations For the Three and Six Months Ended November 30, 2007 and November 30, 2006			3
Statement of Shareholders’ Equity For the Six Months Ended November 30, 2007			4
Statements of Cash Flows For the Six Months Ended November 30, 2007 and November 30, 2006			5
Notes to Financial Statements			6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			10
Item 3. Quantitative and Qualitative Disclosures About Market Risk			15
Item 4. Controls and Procedures			16
PART II. OTHER INFORMATION			16
Item 1. Legal Proceedings			16
Item 1A. Risk Factors			16
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			26
Item 4. Submission of Matter to a Vote of Securityholders			26
Item 6. Exhibits			28
SIGNATURES			29
EXHIBIT 31.1
EXHIBIT 32.1

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 Form 10-Q. These factors may cause our actual results to differ materially from any forward-looking 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.

See notes to financial statements.

See notes to financial statements.

See 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 young children, via the Internet and catalogs. The Company operates two brands, Birthday Express and Costume Express, which respectively offer children’s party products, and children’s and family costumes and accessories. The Company began winding down the operations of its Storybook Heirlooms brand in the first quarter of fiscal 2007 and completed the wind-down in the fourth quarter of fiscal 2007.

      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 financial information as of November 30, 2007 and for the three- and six- month periods ended November 30, 2007 and November 30, 2006 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. The balance sheet at May 31, 2007 has been derived from the audited financial statements at that date, but does not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.

      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, 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 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.

      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:

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:

     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:

4. Brand Revenues

     The following table provides detail of our revenues by brand:

In the three- and six- month periods ended November 30, 2007, the Company also had approximately $337,000 and $490,000 in other revenue, respectively. In the three- and six- month periods ended November 30, 2006, the Company had approximately $209,000 in other revenue.

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 458,917 shares remaining for future grant under the Plan as of November 30, 2007. 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 Board 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 six-month period ended November 30, 2007, 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 November 30, 2007, the total compensation cost related to unvested options and restricted stock units granted to employees totaled $2.7 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 six- month periods ended November 30, 2007 and November 30, 2006:

     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 November 30, 2007.

     During fiscal 2007, certain employees were granted restricted stock unit awards pursuant to the Company’s 2004 Amended and Restated Equity Incentive Plan. In fiscal 2007, a total of 2,000 shares were granted and were valued at the closing stock price of $13.07 on the date of grant. During the six months ended November 30, 2007, 625 shares vested and 1,175 shares were forfeited. 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. As of November 30, 2007 there were 4,250 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. A valuation allowance is recorded to reduce deferred tax assets when realization of the tax benefit is unlikely.

     As of November 30, 2007, the Company had recorded deferred tax assets of $8.2 million, of which $6.9 million reflects the benefit of $20.4 million in operating loss carryforwards for federal income tax purposes, which expire in varying amounts between 2020 and 2026, if unused. In addition, $1.3 million represents net 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 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. Although realization is not assured, management believes it is more likely than not that all of the deferred tax asset will be realized. The amount of the deferred tax asset considered realizable, however, could be reduced in the near term if estimates of future taxable income during the carryforward period are reduced.

     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 November 30, 2007.

     No interest or penalties were recognized during the six months ended November 30, 2007. 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.

     Tax years that remain open for examination by federal and state taxing authorities include the years ending May 31, 2004, 2005, 2006, and 2007. In addition, tax years from May 31, 1998 through May 31, 2003 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 and our annual report of Form 10-K filed for our fiscal year ended May 31, 2007. All statements in the following discussion that are not reports of historical information or descriptions of current accounting policy are forward-looking statements. 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 “Risk Factors” set forth in Part II—Item 1A of this Form 10-Q and the audited financial statements and the notes thereto and disclosures made under the captions “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Financial Statements,” and “Notes to Financial Statements,” included in annual report of Form 10-K filed for our fiscal year ended May 31, 2007.

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 from our Celebrate Express website and catalogs. For the three months ended November 30, 2007, we generated $31.3 million in net sales, an increase of 9.9% from $28.5 million in the three months ended November 30, 2006. Our gross margin as a percentage of sales increased to 53.1% in the three months ended November 30, 2007 from 50.2% in the three months ended November 30, 2006. For the three months ended November 30, 2007, our net income before taxes was $648,000,

compared with a net income before income taxes of $760,000 in the three months ended November 30, 2006. For the six months ended November 30, 2007, we generated $48.9 million in net sales, an increase of approximately 1.0% from $48.5 million in the six months ended November 30, 2006. Our gross margin as a percentage of sales increased to 53.7% in the six months ended November 30, 2007 from 50.2% in the six months ended November 30, 2006. For the six months ended November 30, 2007, we had a net loss before income taxes of $225,000, compared with a net income before income taxes of $402,000 in the six months ended November 30, 2006.

Comparison of Three Months Ended November 30, 2007 and November 30, 2006

Net Sales

Our net sales are comprised of product sales and shipping revenue. Net sales increased 9.9% to $31.3 million in the three months ended November 30, 2007 from $28.5 million in the three months ended November 30, 2006 mainly due to increased catalog circulation and online marketing spending. Total advertising spending for both online and offline direct marketing efforts such as catalog mailings, paid search and affiliate spending was $8.6 million during the second quarter of fiscal 2008, up 24% from the second quarter of fiscal 2007, which totaled $6.9 million. The increase in net sales in the three months ended November 30, 2007 over the same period in fiscal 2007 reflects an increase of approximately 16% in the number of orders shipped, which increased to approximately 453,000 orders in the three months ended November 30, 2007 from approximately 390,000 orders in the three months ended November 30, 2006. Net sales per order for the three months ended November 30, 2007 was $68.41, compared with net sales per order of $72.65 for the three months ended November 30, 2006. We added approximately 229,000 new customers to our database during the second quarter, compared with 194,000 new customers added in the same quarter last year, an increase of 18%. Revenue from our repeat customers represented approximately 46% of revenue during the three months ended November 30, 2007, which was the same as the prior year. Birthday Express net sales decreased to $13.7 million in the second quarter of fiscal 2008 from $15.9 million in the second quarter of fiscal 2007, a decrease of $2.2 million, or approximately 14%. This decrease was primarily due to a reduction in Birthday Express catalog circulation of roughly 21% from the prior year. The Company continues to focus on reducing unprofitable mailings and reevaluating breakeven points in light of catalog postage cost increases. Costume Express net sales increased to $17.1 million in the second quarter of fiscal 2008 from $11.8 million in the second quarter of fiscal 2007, an increase of $5.3 million or approximately 45%. The increase in Costume Express revenue is due primarily to increased direct marketing efforts in the second quarter of fiscal 2008. Storybook Heirlooms net sales were $0.6 million in the three months ended November 30, 2006 with no corresponding revenue in the current fiscal quarter due to the wind-down of this brand.

Gross Margin

Our gross margin 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 margin increased 16.2% to $16.6 million in the three months ended November 30, 2007 from $14.3 million in the three months ended November 30, 2006. Our gross margin as a percentage of net sales was 53.1% in the three months ended November 30, 2007, compared with 50.2% in the three months ended November 30, 2006. Year-over-year improvements in gross margin as a percentage of net sales for the quarter just ended were driven by an increase in merchandise margins in both the Birthday Express and Costume Express brands due to improved sourcing opportunities, including volume discounts. In addition, there was a slight increase in our shipping margin. We also recorded approximately $337,000 in advertising revenue during the second quarter of fiscal 2008 generated from web advertising sources with no corresponding cost of goods sold. Advertising revenue recorded in the second quarter of fiscal 2007 was $209,000. Our gross margin includes the cost of shipping packages to our customers. We have been subject to increases in these outbound shipping costs as a result of increases in fuel surcharges and rates charged by our third party carriers. Further increases in these costs will have an impact on our gross margin. 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.

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. Our fulfillment expenses decreased 5.1% to $3.3 million in the three months ended November 30, 2007 from $3.4 million in the three months ended November 30, 2006. As a percentage of net sales, these expenses decreased to 10.4% in the three months ended November 30, 2007 from 12.0% in the three months ended November 30, 2006. This quarter-over-quarter decrease was due to a continued reduction in distribution center and customer service labor costs as a percentage of revenue, which was driven by continued

operational process improvements as well as the increase in web orders as a percentage of total revenue. We reduced fulfillment labor and related costs by 5% in the second quarter from the same period in the prior year, while we shipped 16% more orders over the same timeframe.

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 25.2% to $9.7 million in the three months ended November 30, 2007 from $7.8 million in the three months ended November 30, 2006. As a percentage of net sales, selling and marketing expenses increased to 31.0% in the three months ended November 30, 2007 from 27.2% in the three months ended November 30, 2006. The change as a percentage of net sales is mainly due to higher online advertising, including paid search and banner ad costs. Advertising costs as a percentage of revenue also increased due to significantly higher catalog postage costs as well as lower response rates as compared to the same period in the prior year, which was partially related to an increase in prospecting circulation. 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 our largest operating expense line item and will increase in absolute dollars 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 16.5% to $3.3 million in the three months ended November 30, 2007 from $2.8 million in the three months ended November 30, 2006. As a percentage of net sales, our general and administrative expenses increased to 10.4% in the three months ended November 30, 2007 from 9.8% in the three months ended November 30, 2006. Bad debt, merchant fees, and systems related consulting fees increased $437,000 in the three months ended November 30, 2007, compared with the three months ended November 30, 2006.

Other Income, Net

Other income declined to $241,000 in the three months ended November 30, 2007, from $427,000 in the three months ended November 30, 2006. This change is due to a reduction in interest income resulting from a decrease in the cash balance as well as a decrease in interest rates. The reduction in cash is largely due to the approximately $9.9 million dividend paid in April 2007.

Income Taxes

In the three months ended November 30, 2007, we recognized an income tax expense of $219,000 on net income before taxes of $648,000, an effective tax rate of 33.7%. In the three months ended November 30, 2006, we recognized an income tax expense of $192,000 based on a net income before taxes of $760,000, an effective tax rate of 25.2%. Our effective tax rate for the six-month period ending November 30, 2007 is 34.7%, which represents our current expectation of the effective tax rate for the full fiscal year ending May 31, 2008. In arriving at the current 34.7% effective tax rate, we considered a variety of factors, including estimated annual pre-tax results, the U.S. federal rate of 35%, estimated annual nondeductible expenses and estimated state income taxes. We evaluate our tax rate each quarter and make adjustments when necessary. Our final effective tax rate for the full year may be materially different than our current estimate and is highly dependent upon the level of pre-tax income or loss, the magnitude of any nondeductible expenses in relation to that pre-tax amount and various other factors.

Comparison of Six Months Ended November 30, 2007 and November 30, 2006

Net Sales

Net sales increased approximately 1.0% to $48.9 million in the six months ended November 30, 2007 from $48.5 million in the six months ended November 30, 2006. The increase in net sales is driven primarily by our expanded direct marketing efforts. These efforts included paid search, email marketing and other online marketing programs, as well as catalog circulation. These increases were partially offset by a $1.7 million decrease in revenue from our Storybook brand, whose wind-down was completed in the fourth quarter of fiscal 2007. The increase in net sales reflects an increase of approximately 6% in the number of orders shipped, which grew to approximately 675,000 orders in the six months ended November 30, 2007 from approximately 636,000 orders in the six months ended November 30, 2006. However, net sales was also impacted by a decrease in net sales per order to $71.70 in the six months ended November 30, 2007 from $75.81 in the six months ended November 30, 2006. Birthday Express net sales decreased to $30.0 million in the six months ended November 30, 2007 from $33.8 million in the six months ended November 30, 2006, a decrease of 11.4%. Costume Express net sales increased to $18.2 million in the six months ended November 30, 2007 from $12.7 million in the six months ended November 30, 2006, an increase of 42.9%. Storybook Heirlooms net sales were $1.7 million in the six months ended November 30, 2006 with no corresponding revenue in the current fiscal year due to the wind-down of this brand.

Gross Margin

Gross margin increased 7.9% to $26.2 million in the six months ended November 30, 2007 from $24.3 million in the six months ended November 30, 2006 due primarily to the increased gross margin rate. Our gross margin as a percentage of net sales increased to 53.7% of net sales in the six months ended November 30, 2007 from 50.2% in the six months ended November 30, 2006. The improvement in gross margin as a percentage of net sales is due to increases in the merchandise margin due to improved product sourcing as well as an increase in our shipping margin. We also recorded approximately $490,000 in advertising revenue during the second quarter of fiscal 2008 generated from web advertising sources with no corresponding cost of goods sold. Advertising revenue recorded in the second quarter of fiscal 2007 was $209,000.

Fulfillment

Our fulfillment expenses decreased 12.2% to $5.6 million in the six months ended November 30, 2007 from $6.4 million in the six months ended November 30, 2006. As a percentage of net sales, these expenses decreased to 11.5% in the six months ended November 30, 2007 from 13.2% in the six months ended November 30, 2006. This decrease is due primarily to operational inefficiencies in our warehouse and customer service center in the six months ended November 30, 2006 that led to higher labor, overtime and temporary labor costs incurred to take and ship customer orders. In addition, the percentage of web orders as a percentage of total revenue increased over the prior year.

Selling and Marketing

Selling and marketing costs increased 16.3% to $15.2 million in the six months ended November 30, 2007 from $13.1 million in the six months ended November 30, 2006. The increase in selling and marketing expenses was due primarily to catalog circulation increases, additional catalog postage, and online advertising expenditures totaling $1.5 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 31.1% in the six months ended November 30, 2007 from 27.0% in the six months ended November 30, 2006. 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, partially related to an increase in prospecting circulation.

General and Administrative

General and administrative expenses increased 16.5% to $6.1 million in the six months ended November 30, 2007 from $5.2 million in the six months ended November 30, 2006. The increase in general and administrative expenses is due primarily to depreciation, bad debt, legal and professional fees, and wages and related costs for our administrative and technology personnel. As a percentage of net sales, our general and administrative expenses increased to 12.5% in the six months ended November 30, 2007 from 10.8% in the six months ended November 30, 2006.

Other Income (Expense), Net

Other income declined to $482,000 in the six months ended November 30, 2007, compared with other income of $810,000 in the six months ended November 30, 2006. This change is due to a reduction in interest income resulting from a decrease in the cash balance as well as a decrease in interest rates. The reduction in cash is largely due to the approximately $9.9 million dividend paid in April 2007.

Income Taxes

In the six months ended November 30, 2007, we recognized an income tax benefit of $78,000 on a loss before taxes of $225,000 for the same period based upon an effective tax rate of 34.7%. In the six months ended November 30, 2006, we recognized income tax expense of $160,000 on income before taxes of $402,000 for the same period based upon an effective tax rate of 39.8%. In arriving at the current 34.7% effective tax rate, we considered a variety of factors, including estimated annual pre-tax results, the U.S. federal rate of 35%, estimated annual nondeductible expenses and estimated state income taxes. We evaluate our tax rate each quarter and make adjustments when necessary. Our final effective tax rate for the full year may be materially different than our current estimate and is highly dependent upon the level of pre-tax income or loss, the magnitude of any nondeductible expenses in relation to that pre-tax amount and various other factors.

Liquidity and Capital Resources

As of November 30, 2007 we had working capital of $28.7 million, including cash and cash equivalents of $18.7 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 ($432,000) for the six months ended November 30, 2007 and cash provided by operating activities was $2.5 million for the six months ended November 30, 2006. Net cash used in operating activities in the first half of fiscal 2008 can be attributed to an increase in inventory of $1.2 million. Additionally, accounts payable and accrued liabilities together decreased approximately $1.5 million. Prepaid expenses decreased $1.3 million during the six months ended November 30, 2007 due primarily to a decrease in prepaid inventory and prepaid catalog and related costs. Net cash provided by operating activities in the six months ended November 30, 2006 was attributed primarily to a decrease in inventory and prepaid expenses.

Net cash used in investing activities was ($2.2 million) and ($500,000) for the six months ended November 30, 2007 and 2006, respectively. Cash used in investing activities in the first half of fiscal 2008 and 2007 was used for capital expenditures. Approximately $1.3 million of this activity in the current quarter is due to 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 $4.0 million to $5.5 million. These expenditures will include, but not be limited to, our warehouse management system, investments to upgrade our phone system, data center and website.

Net cash provided by financing activities was $137,000 and $199,000 for the six months ended November 30, 2007 and 2006, respectively. Cash provided by financing activities in the first half of fiscal 2008 and fiscal 2007 was due to proceeds from the exercise of stock options, proceeds from shares issued under the Celebrate Express employee stock purchase plan, and the tax benefit associated with option exercises.

The following table summarizes our contractual obligations as of November 30, 2007 and the effect these obligations are expected to have on our liquidity and cash flows in future periods.

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.

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, 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 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.

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 November 30, 2007, 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 November 30, 2007, 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 November 30, 2007 that our certifying officers concluded materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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 www.CostumeExpress.com website and catalog for Costume Express, 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. In order to achieve the desired growth in our sales and business, we will 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. In February 2002, we re-launched the Storybook Heirlooms brand and the website www.Storybook.com. Revenue growth from the Storybook Heirlooms brand, however, did not meet management expectations, which was a significant factor in our decision in June 2006 to wind-down the brand.

     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 prospects.

     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. Several of our former officers terminated their employment with Celebrate Express in the recent past, including the departure of our vice president of finance and secretary effective October 12, 2007 and our vice president of merchandising effective December 11, 2007. These departures have had, and may continue to have, an adverse impact on our operations and financial results. In fiscal 2007 we hired several members of our senior management team. We are also currently engaged in a search for replacements for our vice president of finance and our vice president of merchandising. We cannot assure you that we will find qualified candidates 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. 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. 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, or 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 power outage 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 in fiscal 2008, 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 second quarter of fiscal 2008 ended November 30, 2007, products supplied by our ten largest suppliers represented approximately 62.0% of inventory purchases, with our largest supplier representing 18.8%. 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.

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 November 30, 2007, our online sales represented approximately 81% 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. We have also instituted a promotional offer which allows customers to purchase products from us with the associated billing to their credit card occurring on a predetermined date in the future, generally within 90 days of the purchase date. We are currently assuming the credit risk associated with the delayed collection of funds for this customer offer. 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 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 was approximately $34 million. From the effective date of the registration statement through November 30, 2007, the Company has used the net proceeds from the offering for repayment of the Company’s $5.0 million term loan. 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 4. Submission of Matter to a Vote of Securityholders.

The following is a description of matters submitted to a vote of our shareholders at an annual meeting of shareholders held on October 18, 2007:

A. Donald R. Hughes and Jean Reynolds were elected as directors to hold office until the annual meeting in the expiration year detailed below and until their successors are elected and qualified. Votes cast for and votes withheld with respect to each nominee were as follows:

B. A brief description of the other matters presented by the board of directors to be voted upon at the annual meeting and the votes cast for, votes cast against, abstentions and broker non-votes as to such matters follows:

Item 6. Exhibits.

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.

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