SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_________________

FORM 10-K

[X] ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended Commission File Number
January 2, 1999 0-23669

SHOE PAVILION, INC.
(Exact name of registrant as specified in its charter)

Delaware 94-3289691
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification Number)

___________________________

3200-F Regatta Boulevard, Richmond, California 94804
(Address of principal executive offices) (Zip Code)
Telephone Number: (510) 970-9775

SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:

Name of each exchange
Title of each class on which registered
------------------- ---------------------
None None

SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:

Common Stock
------------
(Title of Class)

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K ((S) 229.405 of this chapter) is not contained herein, and
will not be contained, to the best of registrant's knowledge, in definitive
proxy or information statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K. [_]

At March 18, 1999, the aggregate market value of the registrant's Common Stock
held by non affiliates of the registrant was approximately $13,465,500.

At March 18, 1999, the number of shares outstanding of registrant's Common
Stock was 6,800,000.

DOCUMENTS INCORPORATED BY REFERENCE

Definitive Proxy Statement for the Company's 1999 Annual Meeting of
Stockholders - Part III of this Form 10-K.

Shoe Pavilion, Inc.

Index to Annual Report on Form 10-K
For the year ended January 2, 1999

Page
----

PART I

Item 1 Business............................................. 3
Item 2 Properties........................................... 9
Item 3 Legal Proceedings.................................... 9
Item 4 Submission of Matters to a Vote of Security Holders.. 10

PART II

Item 5 Market for the Registrant's Common Equity and
Related Stockholder Matters........................ 10
Item 6 Selected Financial Data.............................. 11
Item 7 Management's Discussion and Analysis of Financial
Condition and Results of Operations................ 12
Item 7A Quantitative and Qualitative Disclosure About
Market Risk........................................ 21
Item 8 Financial Statements and Supplementary Data.......... 22
Item 9 Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure................ 36

PART III

Item 10 Directors and Executive Officers of the Registrant... 36
Item 11 Executive Compensation............................... 36
Item 12 Security Ownership of Certain Beneficial Owners
and Management..................................... 36
Item 13 Certain Relationships and Related Transactions....... 36

PART IV

Item 14 Exhibits, Financial Statement Schedules and
Reports on Form 8-K................................ 36

PART I

Item 1 -- Business

General

Shoe Pavilion, Inc., founded in 1979, is the largest independent off-price
footwear retailer on the West Coast that offers a broad selection of women's and
men's designer label and name brand merchandise. The Company was among the first
footwear retailers on the West Coast to expand the off-price concept into the
designer and name brand footwear market. As of January 2, 1999, the Company
operated 69 retail stores in California, Washington and Oregon under the trade
name Shoe Pavilion.

The Company offers quality designer and name brand footwear such as Amalfi,
Clarks, Dexter, Fila, Florsheim, Naturalizer and Rockport, typically at 30% to
70% below department store regular prices for the same shoes. Such price
discounts appeal to value-oriented consumers seeking quality brand name footwear
not typically found at other off-price retailers or mass merchandisers. The
Company is able to offer lower prices by (i) selectively purchasing large blocks
of production over-runs, over-orders, mid- and late-season deliveries and last
season's stock from manufacturers and other retailers at significant discounts,
(ii) sourcing in-season name brand and branded design merchandise directly from
factories in Italy, Brazil and China and (iii) negotiating favorable prices with
manufacturers by ordering merchandise during off-peak production periods and
taking delivery at one central warehouse.

During 1998, the Company purchased its merchandise from over 100 domestic and
international vendors, independent resellers, manufacturers and other retailers
that have frequent excess inventory for sale. Budgeted production over-runs due
to the long lead-times associated with the design and manufacturing of new
shoes, as well as retail overstock, provide the Company with a wide selection of
branded merchandise. The Company emphasizes brand name merchandise that it
believes has long-term consumer appeal.

The Company's stores utilize a self-service format that allows inventory to be
stored directly under a displayed shoe, thereby eliminating the need for a
stockroom and significantly increasing retail floor space. The functionality and
simplicity of this format enable flexible store layouts that can be easily
reconfigured to accommodate a new mix of merchandise. Moreover, this format
allows customers to locate all available sizes of a particular shoe and to try
them on for comfort and fit without a salesperson's assistance, thereby reducing
in-store staffing needs and allowing customers to make independent, rapid
purchasing decisions.

The Company's stores are strategically located in strip malls, outlet centers
and downtown locations, frequently in close proximity to other off-price apparel
retailers that attract similar customers. Stores generally range in size from
3,000 to 14,000 square feet and offer between 15,000 and 30,000 pairs of shoes.
In early 1997, the Company entered the Los Angeles market by assuming the
leasehold interests of Standard Shoes, a Los Angeles based footwear retailer.
The Company subsequently converted nine Standard Shoes locations to Shoe
Pavilion stores. The Company opened, net of closures, 14 stores in 1998, 14
stores in 1997 and three stores in 1996.

The Company's objective is to be the leading off-price retailer of designer
label and name brand footwear in each of the markets it serves. The Company
intends to create greater name recognition and presence by opening new stores in
existing markets, moving into new markets with multiple store openings and
pursuing opportunities to acquire local and regional footwear retailers. The
Company intends to open 15 to 20 new stores, primarily in its existing markets,
close four to five stores, and relocate two to three stores in 1999.

The Company was incorporated in Delaware in November 1997 and is the successor
to Shoe Pavilion Corporation (formerly Shoe Inn, Inc.), which was incorporated
in Washington in 1983. In connection with the Company's initial public offering,
the previous sole stockholder of Shoe Pavilion Corporation entered into an
agreement providing for a reorganization prior to the offering. Under the terms
of this agreement all of the common stock of Shoe Pavilion Corporation was
exchanged for common stock of the Company and Shoe Pavilion Corporation became a
wholly owned subsidiary. The Company's executive offices are located at 3200-F
Regatta Boulevard, Richmond, California 94804, and its telephone number is
(510) 970-9775.

Recent Developments

In May 1998, the Company launched on-line shopping through its website,
shoepavilion.com, and in December 1998, the Company began offering its shoes on
Yahoo! Shopping. In addition, the Company announced in February 1999 that a
direct link had been established with America Online through it's website,
AOL.com and another direct link with imall.com.

Operating Strategy

The Company's objective is to be the leading off-price retailer of designer
label and name brand footwear in each of the markets it serves. The Company's
operating strategy is designed to allow the Company to offer its customers
quality footwear typically at 30% to 70% below department store prices for the
same shoes. The following summarizes key elements of the Company's operating
strategy:

* Off-Price Concept, Premium Name Brands. The Company differentiates itself
from other off-price retailers and deep discount chains by focusing on
higher price point merchandise, extending the off-price concept into the
designer and name brand footwear market. As such, the Company generally
does not compete with other discount stores in obtaining the majority of
its merchandise. Similarly, while some department store and brand name
retail chains operate discount outlets, such operations generally obtain
merchandise from existing inventory of their retail affiliates rather than
from external sources. The Company's focus on premium brand name footwear
also enables store openings in close proximity to other off-price footwear
retailers. Some of the Company's most successful stores have benefited from
the heightened consumer awareness and preference to shop at discount malls
or outlet centers, both of which typically include other off-price
retailers.

* Broad Selection of Designer Footwear. The Company offers a broad selection
of quality footwear from over 75 name brands such as Amalfi, Clarks,
Dexter, Fila, Florsheim, Naturalizer and Rockport. The availability and
wide variety of premium brand names distinguish Shoe Pavilion and serve to
attract first time buyers and consumers who otherwise might shop at more
expensive department stores. The wide variety of brand names also enables
the Company to tailor its merchandise from store to store to accommodate
consumer preferences that may vary by location.

* Selective Bulk Purchases; Diverse Vendor Network. The Company is able to
offer lower prices by selectively purchasing large blocks of over-runs,
over-orders, mid- and late-season deliveries and last season's stock from
over 100 domestic and international vendors, independent resellers,
manufacturers and other retailers at significant discounts. The diversity
and scope of its vendor network help to provide a constant source of
quality merchandise, and the purchase of name brand, traditional styles
mitigates the likelihood of inventory writedowns. To augment available
merchandise with the latest in-season styles, the Company purchases branded
design footwear directly from factories in Italy, Brazil and China.

* Self-Service Stores. Between late 1993 and 1995, the Company reconfigured
its stores from a traditional retail format to the current self-service
format. The Company believes that the self-service format reinforces its
off-price strategy and appeals to value-oriented consumers. The Company's
format allows inventory to be stored directly under a displayed shoe,
thereby eliminating the need for a stockroom and significantly increasing
retail floor space. The functionality and simplicity of this format enable
flexible store layouts that can be easily rearranged to complement the
current merchandise. Moreover, this format allows customers to locate all
available sizes of a particular shoe and to try them on for comfort and fit
without a salesperson's assistance, thereby reducing in-store staffing
needs and allowing customers to make independent, rapid purchasing
decisions.

* Internet Commerce. The Company sells its products online via its website,
shoepavilion.com. In addition, the Company has formed partnerships with
various internet service providers and multimedia companies to sell its
products on their website or have direct links back to the Company's
website.

Growth Strategy

Since opening its first store in 1979, the Company has grown through internal
expansion and operated 69 stores as of January 2, 1999. The Company intends to
continue to expand by opening new stores, enhancing comparable store sales,
pursuing acquisition opportunities and promoting internet commerce.

* Continue New Store Openings. The Company intends to increase its presence
in its current markets and to enter new markets by selectively opening new
stores, which can be served by the Company's distribution infrastructure.
When entering a new market, the Company prefers to open multiple stores,
thereby creating an immediate market presence and enabling television
advertising costs to be spread economically across a number of stores. The
Company opened 16 stores in 1998, 16 stores in 1997 and nine stores in 1996
and closed two stores in 1998, two stores in 1997 and six stores in 1996.
The Company intends to open 15 to 20 stores, primarily in its existing
markets, in 1999. Management believes that new store openings in the
Company's current markets will further increase name recognition, which, in
turn, will facilitate expansion into new markets.

* Increase Comparable Store Sales. Management intends to continue to seek
additional comparable store growth through a continuing refinement of its
store locations and merchandise selection. However, there can be no
assurance that the Company will experience comparable store growth in the
future.

* Pursue Acquisition Opportunities. The retail footwear industry is highly
fragmented and includes family and specialty shoe stores, which represent
approximately 20% of total retail footwear sales. Accordingly, management
believes that a number of opportunities exist to acquire one or more
regional or local footwear retailers. The Company intends to evaluate
opportunities to acquire existing footwear retailers and convert the
acquired stores to the Company's off-price merchandising concept.

* Promote Internet Commerce. Management intends to continue to expand the
offerings on it's website, shoepavilion.com, and seek alliances with other
electronic retailers that present synergistic opportunities. The Company
believes that internet commerce will enhance revenues and further increase
name recognition.

The Company's ability to execute its operating and growth strategy is subject
to numerous risks and uncertainties. There can be no assurance that the Company
will be successful in implementing its strategy or that its strategy, even if
implemented, will lead to successful achievement of the Company's objectives. If
the Company were unable to implement its strategy effectively, the Company's
business, financial condition and results of operations would be materially
adversely affected.

Merchandising

Unlike deep-discount retailers, Shoe Pavilion offers high quality merchandise
and a consistent selection of name brand dress and casual shoes for men and
women. List prices generally range between $19.99 and $69.99 for women's shoes,
and between $39.99 and $99.99 for men's shoes.

The principal categories of footwear offered by Shoe Pavilion stores, and
selected brands for each, are summarized in the following table:

Women's Men's Athletic
- -------------------- ------------------------ ------------------------
Amalfi Bally Adidas
DKNY Bass Asics
Esprit Bostonian Avia
Easy Spirit Clarks Brooks
Hush Puppies Dexter Fila
Life Stride Florsheim New Balance
Naturalizer Nunn Bush Nike
Nickles Rockport Puma
Rockport Skechers Reebok
Via Spiga Timberland Saucony

The Shoe Pavilion Concept And Store Design

Shoe Pavilion is a standardized concept that offers a bright, clean, low
maintenance and functional shopping environment to customers interested in
purchasing quality men's and women's value priced footwear. The Company's stores
carry between 15,000 and 30,000 pairs of shoes and generally range in size from
3,000 to 16,000 square feet.

Between late 1993 and 1995, the Company reconfigured its stores from a
traditional retail format to the current self-service format. The Company
believes that the self-service format reinforces its off-price strategy and
appeals to value-oriented consumers. The Company's format allows inventory to be
stored directly under a displayed shoe, thereby eliminating the need for a
stockroom and significantly increasing retail floor space. The functionality and
simplicity of this format enable flexible store layouts that can be easily
rearranged to complement the current merchandise. Moreover, this format allows
customers to locate all available sizes of a particular shoe and to try them on
for comfort and fit without the need of a salesperson's assistance, thereby
reducing in-store staffing needs and allowing customers to make independent,
rapid purchasing decisions. The Company believes that these efficiencies and
selling strategies have improved the Company's financial performance while
addressing a shift in consumer buying patterns towards independent, value-
priced shopping. See "Item 7 -- Management's Discussion and Analysis of
Financial Condition and Results of Operations--Factors Affecting Financial
Performance--Inventory Shrinkage."

Site Selection, Opening Costs And Leases

The Company uses an exclusive broker on the West Coast to identify potential
retail sites as well as possible acquisition candidates. Before entering a new
market, management reviews detailed reports on demographics; spending, traffic,
and consumption patterns; and other site and market related data. As of January
2, 1999, 33 of the Company's stores were located in strip malls, 11 were located
in outlet centers, 12 were located in free standing stores and 13 were located
in other types of facilities.

Opening costs for stores are typically minimal, excluding the initial stocking
of inventory. The Company estimates that its total cash requirements to open a
typical new store average $250,000 to $400,000, consisting of approximately
$40,000 to $50,000 for fixtures, equipment and leasehold improvements; $200,000
to $325,000 for inventory; and the balance for working capital needs. Costs vary
from store to store depending on, among other things, the location, size,
property condition, and the tenant improvement package offered by the landlord.
The Company has been able to renegotiate some of its existing leases to be more
heavily revenue-based. The Company does not own any of its real estate.

The Company actively monitors individual store performance and has closed
underperforming stores, including two stores in 1998, two stores in 1997 and six
stores in 1996. The relatively small investment required to open new stores
affords the Company the flexibility to close stores more quickly than other
retailers. The Company intends to

close four to five stores and relocate two to three stores in 1999. If the
Company were to close a number of stores, it could incur significant
termination costs and reductions in net sales. In addition, the Company may
not be able to close certain underperforming stores on a timely basis because
of lease terms. A significant increase in termination costs, or the inability
to close one or more underperforming stores on a timely basis, could have a
material adverse effect on the Company's business, financial condition and
results of operations. See "Item 7 -- Management's Discussion and Analysis of
Financial Condition and Results of Operations--Factors Affecting Financial
Performance--Risks Associated with Expansion."

Sourcing And Purchasing

Vendors. During 1998, the Company purchased its inventory from over 100
domestic and international vendors, independent resellers and other retailers
who have over bought merchandise. Name brands sold include Amalfi, Clarks,
Dexter, Fila, Florsheim, Naturalizer and Rockport, among others. Since the
Company has locations in a number of markets along the West Coast, Shoe Pavilion
can accommodate and distribute a wide variety of merchandise that meets the
needs of customers in different geographic areas. In 1998, the Company's top
ten suppliers accounted for 46.9% of inventory purchases, of which purchases
from Intershoe, Inc. and Global Sports, Inc. accounted for 8.8% and 8.3% of
total inventory purchases, respectively. The Company purchases from its
suppliers on an order-by-order basis and has no long-term purchase contracts or
other contractual assurances of continued supply or pricing. Management believes
that the strength and variety of its supplier network mitigates much of the
Company's exposure to inventory supply risks, attracts first time buyers, and
encourages repeat shopping. See "Item 7 -- Management's Discussion and Analysis
of Financial Condition and Results of Operations--Factors Affecting Financial
Performance--Inventory and Sourcing Risk."

Direct Sourcing. The Company purchases in-season name brand and branded design
merchandise directly from factories in Italy, Brazil and China. These purchases
include both labeled and non-labeled goods and provide a consistent base of in-
season merchandise. Directly sourced goods accounted for approximately 12.9% and
15.7% of the Company's net sales in 1998 and 1997, respectively. The Company
purchases from its manufacturing sources on an order-by-order basis and has no
long-term purchase contracts or other contractual assurances of continued supply
or pricing. See "Item 7 -- Management's Discussion and Analysis of Financial
Condition and Results of Operations--Factors Affecting Financial Performance--
International Purchasing."

Marketing

In 1998 and 1997, the Company spent approximately 5.4% of net sales, or $3.0
million, and 4.5% of net sales, or $2.0 million, respectively, on television
advertising. The Company believes that television advertising benefits all
stores in a common viewing market. The Company believes that advertising costs
for a particular market will be more effectively and economically leveraged as
the number of stores increases in that market. The Company occasionally uses
print advertising, usually upon a new store opening; however, it has found print
advertising to be less effective than television advertising. Shoe Pavilion's
signage is consistent among all of the locations, and highly visible at the
front and, when appropriate, rear of the store.

Merchandise Distribution

In March 1997, the Company relocated from a 20,000 square foot distribution
facility in Bellevue, Washington to a 58,000 square foot and more centrally
located facility in Richmond, California. In September 1998, the Company amended
its lease to add an additional 34,000 square feet effective January 1, 1999.
This expanded distribution facility also houses the Company's executive and
administrative headquarters. Vendors ship all products to this distribution
center where the merchandise is inspected, verified against the original
purchase order, ticketed and repackaged for shipment to stores. The Company
believes that this 92,000 square foot facility can accommodate the Company's
planned growth for the foreseeable future.

Information Systems

The Company's is currently engaged in an enterprise wide project to upgrade
its information systems, including all critical areas of corporate office,
network infrastructure and point of sale (POS) to a fully-integrated and cost

effective means of conducting its business. This upgrade, which is expected to
be completed by the end of the second quarter of 1999, will provide the Company
with a stable platform utilizing an IBM AS 400 that is reliable and scalable
allowing simple upgrades of processing power as the business grows. In addition,
the corporate network infrastructure is being upgraded to a Windows NT
environment with standardized workstations and a common set of desktop
applications being implemented throughout the Company. This upgrade will provide
a more stable networking environment as well as provide a proper foundation for
future growth. The Company currently estimates that the total costs for
implementing the new systems will approximate $2 million of which $1.25 million
has been incurred through January 2, 1999. See "Item 7 -- Management's
Discussion and Analysis of Financial Condition and Results of Operation--Impact
of Year 2000."

Competition

The retail footwear market is highly competitive, and the Company expects the
level of competition to increase. The Company competes with off-price and
discount retailers (e.g., Nordstrom Rack, Payless ShoeSource, Ross Dress for
Less and Famous Footwear), branded retail outlets (e.g., Nine West), national
retail stores (e.g., Nordstrom, Marshalls, Macy's, Sears, J.C. Penney,
Loehmann's, Robinsons-May and Mervyn's), traditional shoe stores and mass
merchants. Many of these competitors have stores in the markets in which the
Company now operates and in which it plans to expand. Many of the Company's
competitors have significantly greater financial, marketing and other resources
than the Company. In addition, there can be no assurance that future
participants will not enter the off-price segment of the footwear market.
Competitive pressures resulting from competitors' pricing policies could
materially adversely affect the Company's gross margins. There can be no
assurance that the Company will not face greater competition from other
national, regional or local retailers or that the Company will be able to
compete successfully with existing and new competitors. The inability of the
Company to respond to such competition could have a material adverse effect on
the Company's business, financial condition and results of operations.

Employees

As of January 2, 1999, the Company had approximately 241 full-time employees
and 235 part-time employees. The number of part-time employees fluctuates
depending upon seasonal needs. The Company's 25 warehouse employees are
represented by Local 315, International Brotherhood of Teamsters. In December
1998, the Company signed a collective bargaining agreement with Local 315 that
terminates on January 31, 2002. The Company generally considers its relationship
with its employees to be good.

Executive Officers

Certain information regarding the executive officers of the Company is set
forth below:

Name Age Position
---- --- --------

Dmitry Beinus.......................... 46 Chairman of the Board, President and Chief Executive Officer
Robert R. Hall......................... 46 Vice President and Chief Operating Officer
Gary A. Schwartz....................... 47 Vice President of Finance, Chief Financial Officer, Secretary and Director
Keith C. Gossett, Jr................... 41 Vice President of Operations
Linda C. Hickey........................ 35 Vice President of Administration

Dmitry Beinus has served as Chairman of the Board, President and Chief
Executive Officer of the Company since founding the Company in 1979. From 1976
to 1978, Mr. Beinus was employed in the shoe department of Nordstrom, Inc. Mr.
Beinus' current responsibilities include overseeing the growth of the Company's
operations, maintaining its competitive position within the marketplace, and
facilitating the acquisition of inventory.

Robert R. Hall has served as Vice President and Chief Operating Officer of the
Company since January 1997. Mr. Hall joined the Company as a Regional Manager in
1990, and has held various positions within the Company including Operations
Manager and Vice President of Merchandising. Mr. Hall's current responsibilities
are to oversee the Regional Managers as well as the Company's centralized
warehouse operations. From 1976 to 1990, Mr. Hall held various positions with
Nordstrom, Inc., most recently as Merchandising Manager for the shoe departments
within the San Francisco Bay Area stores.

Gary A. Schwartz has served as Vice President of Finance and Chief Financial
Officer of the Company since September 1997 and as Secretary and a Director
since November 1997. From January 1997 until April 1997, Mr. Schwartz served as
Vice President, Retail and Licensing of Jessica McClintock, Inc., a women's
apparel and fragrance company. From 1979 to 1996, Mr. Schwartz served as Vice
President and Chief Financial Officer of Byer California, an apparel
manufacturer and commercial real estate company. Mr. Schwartz is a Certified
Public Accountant.

Keith C. Gossett, Jr., has served as Vice President of Operations since April
1997. From 1994 to April 1997, Mr. Gossett was President of Easy Street Shoe
Co., a division of Colby Footwear. From 1990 to 1994, Mr. Gossett served as Vice
President of Sales and Marketing for Mark Lemp Footwear, and from 1986 to 1990,
he was the National Sales Manager for the Women's Division of Florsheim.

Linda C. Hickey has served as Vice President of Administration since January
1997. Ms. Hickey joined the Company in 1984 as a Sales Associate. From 1985 to
1992, Ms. Hickey held various positions that included inventory control,
accounting, payroll, and personnel, and from 1992 to 1996, she served as
Director of Administration. Ms. Hickey's current responsibilities include
overseeing internal administrative functions as well as assisting Mr. Beinus
with lease and vendor negotiations.

The Company's executive offers serve at the discretion of the Board of
Directors. There is no family relationship between any of the Company's
executive officers or between any executive officer and any of the Company's
directors.

Item 2 -- Properties

The Company's corporate offices and distribution facility are located in a
92,000 square foot facility in Richmond, California, which the Company occupies
under a lease expiring in 2002. As of January 2, 1999, the Company's 69 stores
occupied an aggregate of approximately 493,000 square feet of space. The Company
leases all of its stores, with leases expiring between 1999 and 2007. The
Company has options to renew most of its leases.

Store Locations

As of January 2, 1999, the Company operated 69 retail stores in the states of
California, Washington and Oregon. The number of stores in each geographic area
is set forth below:

Stores at Year End
--------------------------------------------------------
Location 1998 1997 1996 1995 1994
- --------- -------- -------- -------- -------- --------

Northern California........................................ 27 24 22 22 22
Southern California........................................ 25 16 4 2 2
Nevada..................................................... 0 1 1 1 1
Oregon..................................................... 4 2 2 0 0
Washington................................................. 13 12 12 13 11
---- ---- ---- ---- ----
Total.................................................... 69 55 41 38 36
==== ==== ==== ==== ====

Item 3 -- Legal Proceedings

The Company is not a party to any material pending legal proceedings.

Item 4 -- Submission of Matters to a Vote of Security Holders

Inapplicable.

PART II

Item 5 -- Market for the Registrant's Common Equity and Related Stockholder
Matters

The Common Stock of the Company has been traded on the Nasdaq National Market
under the symbol SHOE since the Company's initial public offering on February
23, 1998. The following table sets forth, for the periods indicated, the
highest and lowest closing sale prices for the Common Stock, as reported by the
Nasdaq National Market.

High Low
------------- ----------

1998
First Quarter (since February 23, 1998)....................... 11.250 6.625
Second Quarter................................................ 10.625 7.875
Third Quarter................................................. 9.000 5.500
Fourth Quarter................................................ 9.188 3.563

As of January 2, 1999, there were approximately 14 holders of record of the
Company's Common Stock.

From August 1988 through February 1998, the Company made distributions to its
sole stockholder primarily to allow the stockholder to pay taxes on earnings of
the Company included or includable in the taxable income of the stockholder as a
result of the Company's S corporation status. Upon completion of its initial
public offering, the Company made an S corporation distribution in the amount of
$7.8 million to its previous sole stockholder, which approximately equaled the
estimated earned and previously undistributed taxable S corporation income of
the Company through the day preceding the termination date of its S corporation
status. Except as mentioned in the previous sentences, the Company has not paid
any cash dividends in the past. The Company currently intends to retain any
earnings for use in its business and does not anticipate paying any cash
dividends on its Common Stock in the foreseeable future. In addition, the
Company's line of credit restricts the Company's ability to pay dividends. See
Note 4 of Notes to Consolidated Financial Statements.

Item 6 -- Selected Financial Data

The selected consolidated financial and operating data set forth below should
be read in conjunction with "Item 8 -- Financial Statements and Supplemental
Data--Consolidated Financial Statements of the Company and related Notes thereto
and Item 7 -- Management's Discussion and Analysis of Financial Condition and
Results of Operations" included herein.

Year Ended
-------------------------------------------------------
1998(1) 1997 1996 1995 1994
(in thousands, except per share and operating data) ------- ------- ------- ------- -------

Statement of Operations Data:
Net sales.......................................... $55,907 $45,074 $30,315 $25,539 $21,515
Cost of sales and related occupancy expenses....... 35,777 28,922 20,318 17,723 15,007
------- ------- ------- ------- -------
Gross profit....................................... 20,130 16,152 9,997 7,816 6,508
------- ------- ------- ------- -------
Selling expenses................................... 11,472 8,800 5,592 4,835 4,976
General and administrative expenses................ 3,664 3,106 2,630 1,809 1,638
------- ------- ------- ------- -------
Income (loss) from operations...................... 4,993 4,246 1,775 1,172 (106)
Interest and other expense, net.................... (453) (520) (287) (524) (404)
------- ------- ------- ------- -------
Income (loss) before income taxes.................. 4,540 3,726 1,488 648 (510)
Provision for income taxes......................... (1,147) (261) (98) (35) -
------- ------- ------- ------- -------
Net income (loss).................................. $ 3,393 $ 3,465 $ 1,390 $ 613 $ (510)
======= ======= ======= ======= =======
Net income (loss) per share:
Basic............................................ $0.53 $0.77 $0.31 $.09 $(.07)
Diluted.......................................... $0.52 $0.77 $0.31 $.09 $(.07)
Weighted average shares outstanding:
Basic............................................ 6,462 4,500 4,500 4,500 4,500
Diluted.......................................... 6,474 4,500 4,500 4,500 4,500

Pro Forma:
Historical income (loss) before income taxes....... $ 4,540 $ 3,726 $ 1,488 $ 648 $ (510)
Pro forma (provision) benefit for income taxes(2).. (1,748) (1,435) (566) (246) 183
------- ------- ------- ------- -------
Pro forma net income (loss)(2)..................... $ 2,792 $ 2,291 $ 922 $ 402 $ (327)
======= ======= ======= ======= =======
Pro forma net income per share(2).................. $0.42 - - - -
Weighted average shares outstanding(2)............. 6,660 - - - -

Selected Operating Data:
Number of stores:
Opened during period............................. 16 16 9 6 9
Closed during period............................. 2 2 6 4 0
Open at end of period............................ 69 55 41 38 36
Comparable store sales increase (decrease)(1)(3)... 6.1% 4.6% 8.0% (1.0)% (12.4)%

Year Ended
-------------------------------------------------------
1998 1997 1996 1995 1994
------- ------- ------- ------- -------

Balance Sheet Data:
Working capital.................................... $13,739 $ 6,045 $ 3,783 $ 2,876 $ 1,964
Total assets....................................... 33,534 22,646 15,146 9,473 10,079
Total indebtedness (including current portion)..... 8,494 7,658 3,673 3,872 4,912
Shareholders' equity............................... 17,028 7,328 4,567 2,695 2,083

_________________
(1) In 1998, the Company changed its year end to a 52-53 week year ending on the
Saturday nearest to December 31. Due to this change, sales for the fourth
quarter and year ended January 2, 1999 include two additional days; had
these days not been included comparable store sales would have increased
5.3% for the year ended January 2, 1999. All references herein to 1998 refer
to the year ended January 2, 1999.

(continued on following page)

(continued from previous page)

(2) Prior to February 1998, the Company operated as an S corporation and was not
subject to federal and certain state income taxes. Upon the completion of
its initial public offering, the Company became subject to federal and state
income taxes. Pro forma net income (loss) reflects federal and state income
taxes as if the Company had not elected S corporation status for income tax
purposes. Pro forma net income per share is based on the weighted average
number of shares of common stock outstanding during the period plus the
estimated number of shares offered by the Company (1,271,722 shares) which
were necessary to fund the $7.8 million distribution paid to the Company's
stockholder upon termination of the Company's status as an S Corporation.
See Note 3 of Notes to Consolidated Financial Statements.

(3) The Company believes that the decreases in comparable store sales in 1994
and 1995 were due, in part, to temporary store closures and business
disruptions resulting from the reconfiguration of the Company's stores from
a traditional retail format to the current self-service format. The Company
believes that the increase in comparable store sales in 1996 was due, in
part, to the completion of the reconfiguration of the Company's comparable
stores.

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

The statements contained in this Form 10-K which are not historical facts are
forward-looking statements that are subject to risks and uncertainties that
could cause actual results to differ materially from those set forth in or
implied by forward-looking statements. Factors that could cause or contribute
to such differences include those discussed in the Company's filings with the
Securities and Exchange Commission, including, without limitation, the factors
discussed in this Form 10-K under the captions "--Factors Affecting Financial
Performance" and "--Liquidity and Capital Resources," as well as those discussed
elsewhere in this Form 10-K.

Overview

Shoe Pavilion, founded in 1979, is the largest independent off-price footwear
retailer on the West Coast that offers a broad selection of women's and men's
designer label and name brand merchandise. The Company was among the first
footwear retailers on the West Coast to expand the off-price concept into the
designer and name brand footwear market. As of January 2, 1999, the Company
operated 69 retail stores in California, Washington and Oregon under the trade
name Shoe Pavilion.

The Company opened, net of closures, 14 stores in 1998, 14 stores in 1997 and
three stores in 1996. In early 1997, the Company entered the Los Angeles market
by assuming the leasehold interests of Standard Shoes, a Los Angeles based
footwear retailer. In connection therewith, the Company purchased the inventory
of Standard Shoes at 60% of Standard Shoes' cost. The Company subsequently
converted nine Standard Shoes locations to Shoe Pavilion stores. The Company
intends to open approximately 15 to 20 new stores, primarily in its existing
markets, close four to five stores and relocate two to three stores in 1999.

The Company's growth in net sales historically has resulted primarily from
new store openings, and the Company expects that the primary source of future
sales growth, if any, will continue to be new store openings. The Company's
comparable store sales have fluctuated widely, and the Company does not expect
that comparable store sales will contribute significantly, if at all, to future
growth in net sales. The Company defines comparable stores as those stores that
have been open for at least 14 consecutive months. Stores open less than 14
consecutive months are treated as new stores, and stores closed during the
period are excluded from comparable store sales. The Company's comparable store
sales increased 6.1% in 1998, 4.6% in 1997 and 8.0% in 1996 and decreased 1.0%
in 1995 and 12.4% in 1994. In 1998, the Company changed its year end to a 52-53
week year ending on the Saturday nearest to December 31. Due to this change,
sales for the fourth quarter and year ended January 2, 1999 include two
additional days; had these days not been included comparable store sales would
have increased 5.3% for the year ended January 2, 1999. The Company believes
that the decreases in comparable store sales in 1994 and 1995 were due, in part,
to temporary store closures and business disruptions resulting from the
reconfiguration of the Company's stores from a traditional retail format to the
current self-service format. The Company believes that the increase in
comparable store sales in 1996 was due, in part, to the completion of the
reconfiguration of the Company's comparable stores. The Company does not
anticipate realizing similar increases in subsequent periods, and no assurance
can be given as to the Company's ability to maintain recent comparable store
sales growth. See "Item 7 -- Management's Discussion and Analysis of Financial
Condition and Results of Operations--Factors Affecting Financial Performance--
Uncertainty of Future Operating Results; Fluctuations in Comparable Store
Sales."

Between late 1993 and 1995, the Company reconfigured substantially all of its
stores from a traditional retail format to the current self-service format. This
reconfiguration resulted in increased expenses associated with the conversion
and decreased net sales due to the temporary closure of the stores. The majority
of the reconfigurations occurred during 1994 and contributed to a loss before
income taxes of $510,000 in 1994.

The Company acquires merchandise opportunistically to obtain favorable terms
and in quantities large enough to support future growth, which results in
increased inventory levels at various times throughout the year. As a result,
similar to other off-price retailers, the Company's inventory turnover rates are
typically less than full-price retailers. The Company's inventory levels have
increased from $19.8 million at December 31, 1997 to $26.9 million at January 2,
1999. This increase is due in part to the substantial increase in the number of
the Company's stores. To the extent that the Company's current or future
inventory is comprised of older or obsolescent shoes, the Company will be
required to mark-down the sale price of those shoes, which could have a material
adverse effect on operating margins in affected periods. See "--Factors
Affecting Financial Performance--Inventory and Sourcing Risk."

Prior to its initial public offering in February 1998, Shoe Pavilion was
treated as an S corporation for federal and certain state income tax purposes
since August 1988. As a result, the Company's earnings from August 1988 through
February 22, 1998 were taxed, with certain exceptions, directly to the Company's
stockholder rather than to the Company. The Company's S corporation status
terminated on February 22, 1998, and the Company is now subject to state and
federal income taxes as a C corporation. In connection with its conversion to C
corporation status, the Company recorded a nonrecurring tax benefit of $485,000.
The pro forma adjustments reflect federal and state income taxes as if the
Company had not elected S corporation status for income tax purposes. See Note 3
of Notes to Consolidated Financial Statements.

In 1998, the Company changed its year end to a 52-53 week year ending on the
Saturday nearest to December 31. The effect of this change was immaterial. All
references herein to 1998 refer to the year ended January 2, 1999.

Results of Operations

The following table sets forth, for the periods indicated, the relative
percentages that certain income and expense items bear to net sales:

Year Ended
----------------------------------------------------
1998 1997 1996
-------------- -------------- --------------

Net sales............................................. 100.0% 100.0% 100.0%
Gross profit.......................................... 36.0 35.8 33.0
Selling expenses...................................... 20.5 19.5 18.4
General and administrative expenses................... 6.6 6.9 8.7
-------------- -------------- --------------
Income from operations................................ 8.9 9.4 5.9
Interest and other expense, net....................... (0.8) (1.1) (1.0)
-------------- -------------- --------------
Income before income taxes............................ 8.1 8.3 4.9
Pro forma provision for income taxes.................. (3.1) (3.2) (1.9)
-------------- -------------- --------------
Pro forma net income.................................. 5.0% 5.1% 3.0%
============== ============== ==============

1998 Compared with 1997

Net Sales. Net sales increased 24.0% to $55.9 million for 1998 from $45.1
million for 1997. This increase in net sales was primarily attributable to new
store sales, including sales from 16 stores opened during 1998, which
contributed $15.3 million and a 6.1% increase in comparable store sales of $40.6
million.

Gross Profit. Cost of sales includes landed merchandise and occupancy costs.
Gross profit increased 24.6% to $20.1 million for 1998 from $16.2 million for
1997, and increased as a percentage of net sales to 36.0% from 35.8%.

The increase in gross profit percentage was primarily attributable to the
Company's ability to purchase merchandise in larger quantities at a lower cost
per unit in 1998 as well as leverage in occupancy costs.

Selling Expenses. Selling expenses consist of payroll and related costs,
advertising and promotional expenses. Selling expenses increased 30.4% to $11.5
million for 1998 from $8.8 million for 1997, and increased as a percentage of
net sales to 20.5% from 19.5%. The increase in selling expenses was primarily
attributable to increases in payroll and related expenses as a result of new
stores and advertising expenses.

General and Administrative Expenses. General and administrative expenses
consist primarily of corporate and administrative expenses, including payroll,
employee benefits and warehousing costs. General and administrative expenses
increased 18.0% to $3.7 million for 1998 from $3.1 million for 1997, and
decreased slightly as a percentage of net sales to 6.6% from 6.9%, primarily as
a result of improved expense leverage, offset by costs related to being a public
company.

Interest and Other Expense, Net. Interest and other expense, net, decreased
12.8% to $453,000 for 1998 from $520,000 for 1997. The decrease was attributable
to lower average borrowings outstanding on the Company's revolving line of
credit. During the quarter ended March 31, 1998, $6.0 million of the Company's
line of credit was repaid with the proceeds from the Company's initial public
offering.

Pro Forma Taxes. The pro forma taxes on income for 1998 were $1.7 million
compared to $1.4 million for 1997. The pro forma effective tax rate for 1998 and
1997 was 38.5%.

1997 Compared with 1996

Net Sales. Net sales increased 48.7% to $45.1 million for 1997 from $30.3
million for 1996. This increase in net sales was primarily attributable to new
store sales, including sales from 16 stores opened during 1997, which
contributed $15.0 million and a 4.6% increase in comparable store sales of $1.2
million. Stores closed during 1996 and 1997 had contributed an additional $1.4
million to net sales during 1996.

Gross Profit. Gross profit increased 61.6% to $16.2 million for 1997 from
$10.0 million for 1996, and increased as a percentage of net sales to 35.8% from
33.0%. The increase in gross profit was primarily attributable to the Company's
ability to purchase merchandise in larger quantities at a lower cost per unit in
1997 as well as favorable gross profit margins on the inventory purchased from
Standard Shoes. Cost of sales includes landed merchandise costs and occupancy
costs.

Selling Expenses. Selling expenses increased 57.4% to $8.8 million for 1997
from $5.6 million for 1996, and increased as a percentage of net sales to 19.5%
from 18.4%. The increase in selling expenses was primarily attributable to
increases in payroll and related expenses as a result of new stores and, to a
lesser extent, advertising expenses.

General and Administrative Expenses. General and administrative expenses
increased 18.1% to $3.1 million for 1997 from $2.6 million for 1996, and
decreased as a percentage of net sales to 6.9% from 8.7%, primarily as a result
of improved expense leverage.

Interest and Other Expense, Net. Interest and other expense, net, increased
81.0% to $520,000 for 1997 from $287,000 for 1996. The increase was attributable
to higher borrowings outstanding on the Company's revolving line of credit to
support increased inventory levels, including inventory purchased from Standard
Shoes.

Pro Forma Taxes. The pro forma taxes on income for 1997 were $1.4 million
compared to $566,000 for 1996. The pro forma effective tax rate for 1997 was
38.5% compared to 38.0% for 1996.

Inflation

The Company does not believe that inflation has had a material impact on its
results of operations. However, there can be no assurance that inflation will
not have such an effect in future periods.

Liquidity and Capital Resources

The Company had $13.7 million in working capital as of January 2, 1999,
compared to $6.0 million as of December 31, 1997. The Company's capital
requirements relate primarily to merchandise inventory and leasehold
improvements. The Company's working capital needs are typically higher in the
second and third quarters as a result of increased inventory purchases for
spring and fall selling seasons.

Historically, the Company has funded its cash requirements primarily through
cash flow from operations and borrowings under its credit facility, and
beginning in February 1998, proceeds from its initial public offering. Net cash
provided by (used in) operating activities was ($3.0) million, ($1.8) million
and $566,000 for 1998, 1997, and 1996, respectively. Net cash provided by (used
in) operating activities historically has been driven primarily by net income
and fluctuations in inventory and accounts payable. Inventory levels have
increased throughout these periods due to a net increase in the number of
stores. During 1998, the Company experienced delays in the timing of opening
certain new stores. While these delays were largely caused by factors outside
the Company's control, they shifted the timing of the revenue contribution of
certain new stores to a later quarter from the one that was planned. During
1999, the Company anticipates that cash will be used primarily for merchandise
inventory and capital expenditures.

Capital expenditures were $2.6 million, $1.2 million and $569,000 in 1998,
1997 and 1996, respectively. Expenditures for 1998 were primarily for the build-
out of 16 new stores, plus work-in-progress of the Company's new management
information systems. Expenditures for 1997 were primarily for the build-out of
16 new stores and the relocation of the Company's corporate office and
distribution center. The Company estimates that capital expenditures for 1999
will total approximately $2.0 million, primarily for the build-out of
approximately 15 to 20 new stores and costs associated with the Company's
management information systems.

Financing activities provided cash of $7.1 million, $3.2 million and $93,000
in 1998, 1997 and 1996, respectively. The increase in cash provided by financing
activities for 1998, primarily reflects $14.1 million raised in the Company's
initial public offering offset by $7.8 million payment for an S corporation
distribution and a $1.0 million increase on the Company's line of credit. During
1997 and 1996, the Company made distributions to its then sole stockholder of
$704,000 and $300,000, respectively. Upon completion of its initial public
offering, the Company made an S corporation distribution in the amount of $7.8
million to its previous sole stockholder, which approximately equaled the
estimated earned and previously undistributed taxable S corporation income of
the Company through the day preceding the termination date of its S corporation
status. See Note 3 of Notes to Consolidated Financial Statements.

During most of 1998, the Company had a credit facility agreement, which
included a revolving line of credit for $10.0 million along with a $500,000 term
line available for the purchase or lease of equipment. The Company paid interest
on outstanding amounts at a rate of 0.25% over the bank's prime rate or LIBOR
plus 300 basis points, at the Company's option. During the quarter ended March
31, 1998, $6.0 million of this line of credit was repaid with the proceeds from
the initial public offering. The balance of this credit facility was paid off
in December 1998 from borrowings under the Company's new credit facility
described below.

In December 1998, the Company entered into a new a credit facility agreement,
which includes a revolving line of credit for $15.0 million expiring on December
1, 2000. This line of credit is also available for the issuance of commercial
and standby letters of credit up to $4.0 million. The Company pays interest on
outstanding amounts at the bank's prime rate or LIBOR plus 130 basis points, at
the Company's option. Borrowings under the credit facility are secured by the
Company's accounts receivable, general intangibles, inventory and other rights
to payment. The agreement contains restrictive covenants that require, among
other things, that (a) total liabilities may not exceed 1.5 times tangible net
worth, (b) quarterly net income after taxes and pre-tax profit must each not be
less than one dollar, (c) EBITDA must not be less than $3.75 million on a
rolling four-quarter basis and (d) the outstanding balance on the line of credit
may not exceed 0.5 times inventory plus the amount available under outstanding
letters of credit, and prohibits the declaration and payment of cash or stock
dividends. As of January 2, 1999, the Company was in compliance with all
covenants and the unused and available portion of the credit facility was
approximately $6.6 million.

As part of its growth strategy, the Company plans to pursue opportunities to
acquire complementary businesses, although no such transactions are being
considered as of the date of this Form 10-K. To the extent that cash resources
are insufficient to fund the purchase price of future acquisitions, if any, or
the operations of any acquired business, additional external capital may be
required. There can be no assurance that additional financing will be available
on reasonable terms or at all. The Company expects that anticipated cash flow
from operations and available borrowings under the Company's new credit facility
will satisfy its cash requirements for at least the next 12 months. The
Company's capital requirements program may vary significantly from those
anticipated depending upon such factors as operating results, the number and
timing of new store openings, and the number and size of any future
acquisitions.

Impact of Year 2000

The Company is currently in the process of addressing a problem that is facing
all users of automated information systems. The "Year 2000 Issue" is the result
of computer programs being written using two digits rather than four to define
the applicable year. Computer programs that have time-sensitive software may
recognize a date using "00" as the year 1900 rather than the year 2000. This
situation could result in a system failure or miscalculations causing
disruptions to operations, including, among other things, a temporary inability
to process transactions, send payments, or engage in similar normal business
activities.

State of Readiness. Beginning in early 1998, the Company began an overall
assessment of its computer systems, including Year 2000 readiness. The Company
determined that certain of its software was not Year 2000 compliant. In mid-
1998, the Company, with the guidance of outside consultants, implemented a plan
to replace its existing information systems primarily in response to business
demand and growth. The new systems are designed to replace the Company's
information systems for order processing, warehousing, finance and point-of-sale
on a fully integrated enterprise-wide basis. These systems will replace
existing software that is not Year 2000 compliant.

The Company will utilize both internal and external resources to replace and
test its information systems software for Year 2000 compliance. An Executive
Oversight Steering Committee, consisting of internal executive management, the
Company's information systems officer and various outside third parties, has
been formed to supervise the replacement, implementation and testing process.
Installation of the new systems began in June 1998, and Company personnel are
currently being trained on the new systems. The Company estimates that the
installation of the new systems will be completed by the end of the second
quarter of 1999, and testing will be completed thereafter. The Company expects
to fully convert to the new, Year 2000 compliant information systems no later
than September 30, 1999.

The Company has begun communicating with significant suppliers to determine
the extent to which the Company may be vulnerable to a failure by any of these
third parties to remediate their own Year 2000 issues. The Company's exposure to
supplier Year 2000 business disruptions is reduced because it does not currently
communicate electronically with its suppliers. In addition to suppliers, the
Company also relies upon governmental agencies, utility companies,
telecommunication service companies and other service providers outside of the
Company's control. There can be no assurance that the Company's suppliers,
governmental agencies or other third parties will not suffer a Year 2000
business disruption that could have a material adverse effect on the Company's
business, financial condition and operating results. The Company has not been
informed by any supplier of inability to comply with year 2000 issues.

Costs to Address the Year 2000 Issue. The Company has incurred, through
January 2, 1999, approximately $1.25 million relating to the implementation of
the new systems and addressing Year 2000 issues. The Company currently
estimates that the total costs for implementing the new systems will approximate
$2 million. Included in the costs of implementing the new systems is the cost of
equipment which the Company presently plans to lease over 36 to 60 months. The
Company will capitalize and depreciate the new systems technology over its
estimated useful life and to the extent that Year 2000 costs do not qualify as
capital investments, the Company will expense such costs as incurred.

The costs of Year 2000 compliance and the date on which the Company believes
it will complete the project are based on management's best estimates, which
were derived utilizing numerous assumptions of future events, including the
continued availability of certain third party resources and other factors.
However, there can be no

guarantee that these estimates will be achieved and actual results could differ
materially from those anticipated. Specific factors that might cause such
material differences include, but are not limited to, the availability and cost
of personnel trained in this area, supplier compliance and contingency actions,
and similar uncertainties. The Company's total Year 2000 project costs do not
include the estimated costs and time associated with anticipated third party
Year 2000 issues based on presently available information.

Risks Presented by the Year 2000 Issue. The Company presently believes that
with the implementation of new systems and conversion to new software, the Year
2000 Issue will not pose significant operational problems for its computer
systems. However, if such conversions are not made, or are not completed in a
timely manner, the Year 2000 Issue could have a material impact on the
operations of the Company. In addition, if any third parties which provide
goods or services essential to the Company's business activities fail to address
appropriately their Year 2000 issues, such failure could have a material adverse
effect on the Company's business, financial condition and operating results.
For example, a Year 2000 related disruption on the part of the financial
institutions which process the Company's credit card sales would have a material
adverse effect on the Company's business, financial condition and operating
results.

Contingency Plans. The Company's Executive Oversight Steering Committee
intends to develop contingency plans in the event that the Company has not
completed all of its remediation plans in a timely manner or any third parties
who provide goods or services essential to the Company's business fail to
appropriately address their Year 2000 issues. The committee expects to conclude
the development of these contingency plans by the end of the second quarter of
1999.

Weather and Seasonality

The Company has experienced, and expects to continue to experience, seasonal
fluctuations in its net sales and net income. Historically, net sales and net
income have been weakest during the first quarter. Because the Company's
operations are geographically concentrated, it is vulnerable to adverse weather
conditions and natural disasters in the regions in which it operates stores,
including the San Francisco Bay Area, Seattle and Los Angeles. If one of these
regions were to experience prolonged adverse weather conditions or a natural
disaster, the Company's business, financial condition and results of operations
could be materially adversely affected. The Company's quarterly results of
operations may also fluctuate significantly as a result of a variety of factors,
including timing of new store openings, the level of net sales contributed by
new stores, merchandise mix, the timing and level of price markdowns,
availability of inventory, store closures, advertising costs, competitive
pressures and changes in the demand for off-price footwear. Any such
fluctuations could have a material adverse effect on the market price of the
Company's Common Stock.

Factors Affecting Financial Performance

In addition to the other information in this Form 10-K, the following factors
should be considered carefully in evaluating an investment in the shares of
Common Stock of the Company. The statements contained in this Form 10-K which
are not historical facts are forward-looking statements that are subject to
risks and uncertainties that could cause actual results to differ materially
from those set forth in or implied by forward-looking statements. Factors that
could cause or contribute to such differences include those discussed below, as
well as those discussed elsewhere in this Form 10-K.

Risks Associated With Expansion

The Company has experienced rapid and substantial growth in net sales as well
as in its employee base. The Company's continued growth will depend to a
significant degree on its ability to expand its operations through the opening
of new stores, to operate these stores on a profitable basis and to increase
comparable store sales. The success of the Company's planned expansion will be
significantly dependent upon the Company's ability to locate suitable store
sites and negotiate acceptable lease terms. In addition, several other factors
could affect the Company's ability to expand, including the adequacy of the
Company's capital resources, the ability to hire, train and integrate employees
and the ability to adapt the Company's distribution and other operational
systems. There can be no assurance that the Company will achieve its planned
expansion or that any such expansion will be profitable. In addition, there can
be no assurance that the Company's expansion within its existing markets will
not adversely

affect the individual financial performance of the Company's existing stores or
its overall operating results, or that new stores will achieve net sales and
profitability levels consistent with existing stores, or at all. To manage its
planned expansion, the Company regularly evaluates the adequacy of its existing
systems and procedures, including product distribution facilities, store
management, financial controls and management information systems. However,
there can be no assurance that the Company will anticipate all of the changing
demands that expanded operations may impose on such systems. Failure to adapt
its distribution capabilities or other internal systems or procedures as
required could have a material adverse effect on the Company's business,
financial condition and results of operations.

The Company actively monitors individual store performance and has closed
underperforming stores in the past, including two each in 1998 and 1997, six in
1996 and four in 1995. The Company intends to continue to close underperforming
stores in the future, and if it were to close a number of stores, it could incur
significant closure costs and reductions in net sales. In addition, the Company
may be unable to close certain underperforming stores on a timely basis because
of lease terms. A significant increase in closure costs or the inability to
close one or more underperforming stores on a timely basis could have a material
adverse effect on the Company's business, financial condition and results of
operations.

Inventory And Sourcing Risk

The Company's future success will be significantly dependent on its ability to
obtain merchandise that consumers want to buy, particularly name brand
merchandise with long-term retail appeal, and to acquire such merchandise under
favorable terms and conditions. In 1998, the Company's top ten suppliers
accounted for 46.9% of inventory purchases, of which purchases from Intershoe,
Inc. and Global Sports, Inc. accounted for 8.8% and 8.3% of total inventory
purchases, respectively. The deterioration of the Company's relationship with
any key vendor could result in delivery delays, merchandise shortages or less
favorable terms than the Company currently enjoys. The Company deals with its
suppliers on an order-by-order basis and has no long-term purchase contracts or
other contractual assurances of continued supply or pricing. As the Company's
operations expand, its demand for off-price inventory will continue to increase.
The Company's products typically are manufacturing over-runs, over-orders, mid-
or late-season deliveries or last season's stock. The inability of the Company
to obtain a sufficient supply of readily salable, high margin inventory, to
negotiate favorable discount and payment agreements with its suppliers or to
sell large inventory purchases without markdowns could have a material adverse
effect on the Company's business, financial condition and results of operations.
See " Item 1 -- Business--Sourcing and Purchasing."

Reliance On Key Personnel

The Company's future success will be dependent, to a significant extent, on
the efforts and abilities of its executive officers, particularly Dmitry Beinus,
the Company's Chairman of the Board, President and Chief Executive Officer. The
Company has obtained key man life insurance in the amount of $3.0 million on Mr.
Beinus. The loss of the services of any one of the Company's executive officers
could have a material adverse effect on the Company's operating results. In
addition, the Company's continued growth will depend, in part, on its ability to
attract, motivate and retain additional skilled managerial and merchandising
personnel. Competition for such personnel is intense, and there can be no
assurance that the Company will be able to retain its existing personnel or
attract additional qualified personnel in the future.

Uncertainty Of Future Operating Results; Fluctuations In Comparable Store
Sales

Although the Company recently has been profitable, there can be no assurance
that the Company will remain profitable in the future. Future operating results
will depend upon many factors, including general economic conditions, the level
of competition and the ability of the Company to acquire sufficient inventory,
achieve its expansion plans and effectively monitor and control costs. There can
be no assurance that the Company's recent gross margin levels will be
sustainable in the future. Historically, the Company's growth in net sales has
resulted primarily from new store openings, and the Company expects that the
primary source of future sales growth, if any, will continue to be new store
openings.

The Company's comparable store sales have fluctuated widely, and the Company
does not expect that comparable store sales will contribute significantly, if at
all, to future growth in net sales. The Company defines

comparable stores as those stores that have been open for at least 14
consecutive months. Stores open less than 14 consecutive months are treated as
new stores, and stores closed during the period are excluded from comparable
store sales. The Company's comparable store sales increased 6.1% in 1998, 4.6%
in 1997 and 8.0% in 1996 and decreased 1.0% in 1995 and 12.4% in 1994. The
Company believes that the decreases in comparable store sales in 1995 and 1994
were due, in part, to temporary store closures and business disruptions
resulting from the reconfiguration of the Company's stores from a traditional
retail format to the current self-service format. The Company believes that the
increase in comparable store sales in 1996 was due, in part, to the completion
of the reconfiguration of the Company's comparable stores. The Company does not
anticipate realizing similar increases in subsequent periods, and no assurance
can be given as to the Company's ability to maintain recent comparable store
sales growth.

Risks Associated With Possible Acquisitions

The Company may pursue the acquisition of companies and assets that complement
its existing business. Acquisitions involve a number of special risks, including
the diversion of management's attention to the assimilation of the operations
and personnel of the acquired businesses, potential adverse short-term effects
on the Company's operating results and amortization of acquired intangible
assets. The Company has limited experience in identifying, completing and
integrating acquisitions. The Company does not have any current plans to acquire
any other companies, and there can be no assurance that the Company will
identify attractive acquisition candidates, that acquisitions will be
consummated on acceptable terms or that any acquired companies will be
integrated successfully into the Company's operations.

Seasonality And Quarterly Fluctuations

The Company has experienced, and expects to continue to experience, seasonal
fluctuations in its net sales and net income. Historically, net sales and net
income have been weakest during the first quarter. Because the Company's
operations are geographically concentrated, it is vulnerable to adverse weather
conditions and natural disasters in the regions in which it operates stores,
including the San Francisco Bay Area, Seattle and Los Angeles. If one of these
regions were to experience prolonged adverse weather conditions or a natural
disaster, the Company's business, financial condition and results of operations
could be materially adversely affected. The Company's quarterly results of
operations may also fluctuate significantly as a result of a variety of factors,
including timing of new store openings, the level of net sales contributed by
new stores, merchandise mix the timing and level of price markdowns,
availability of inventory, store closures, advertising costs, competitive
pressures and changes in the demand for off- price footwear. Any such
fluctuations could have a material adverse effect on the market price of the
Company's Common Stock.

Dependence On Consumer Spending And Preferences

The success of the Company's operations depends upon a number of factors
relating to consumer spending, including employment levels, business conditions,
interest rates, inflation and taxation. There can be no assurance that consumer
spending will not decline in response to economic conditions, thereby adversely
affecting the Company's operating results.

All of the Company's products are subject to changing consumer preferences.
Consumer preferences could shift to types of footwear other than those that the
Company currently offers. Any such shift could have a material adverse effect on
the Company's operating results. The Company's future success will depend, in
part, on its ability to anticipate and respond to changes in consumer
preferences, and there can be no assurance that the Company will be able to
anticipate effectively or respond to such changes on a timely basis or at all.
Failure to anticipate and respond to changing consumer preferences could lead
to, among other things, lower net sales, excess inventory and lower gross
margins, any of which could have a material adverse effect on the Company's
business, financial condition and results of operations.

International Purchasing

The Company purchases in-season name brand and branded-design merchandise
directly from factories in Italy, Brazil and China. Directly-sourced goods
accounted for approximately 12.9% and 15.7% of net sales in 1998 and 1997,
respectively. The Company has no long-term contracts with direct manufacturing
sources and competes with other companies for production facilities. All of the
manufacturers with which the Company conducts business are located outside of
the United States, and the Company is subject to the risks generally associated
with an import business, including foreign currency fluctuations, unexpected
changes in foreign regulatory requirements, disruptions or delays in shipments
and the risks associated with United States import laws and regulations,
including quotas, duties, taxes, tariffs and other restrictions. There can be no
assurance that the foregoing factors will not disrupt the Company's supply of
directly-sourced goods or otherwise adversely impact the Company's business,
financial condition and results of operations in the future. See "Item 1 --
Business--Sourcing and Purchasing."

Inventory Shrinkage

The retail industry is subject to theft by customers and employees. By
converting to a self-service format, where shoppers have access to both shoes of
a pair, the Company substantially increased the need for store security.
Although the Company has implemented enhanced security procedures, there can be
no assurance that the Company will not suffer from significant inventory
shrinkage in the future, which could have a material adverse effect on the
Company's business, financial condition and results of operations.

Competition

Future Capital Needs

The Company expects that anticipated cash flow from operations and available
borrowings under the Company's credit facility will satisfy its cash
requirements for at least the next 12 months. However, the Company may incur
significant working capital requirements and capital expenditures in connection
with its growth strategy and otherwise. To the extent that the foregoing cash
resources are insufficient to fund the Company's activities, including new store
openings planned for 1999, additional funds will be required. There can be no
assurance that additional financing will be available on reasonable terms or at
all. Failure to obtain such financing could delay or prevent the Company's
planned expansion, which could adversely affect the Company's business,
financial condition and results of operations. In addition, if additional
capital is raised through the sale of additional equity or convertible
securities, dilution to the Company's stockholders could occur.

Substantial Control By Single Stockholder

Dmitry Beinus, the Company's Chairman of the Board, President and Chief
Executive Officer owns approximately 66.2% of the Company's outstanding Common
Stock. As a result, Mr. Beinus is able to decide all matters requiring
stockholder approval, including the election of directors and approval of
significant corporate

transactions. Concentration of stock ownership could also have the effect of
delaying or preventing a change in control of the Company.

Possible Volatility Of Stock Price

The Common Stock is quoted on the NASDAQ National Market, which has
experienced and is likely to experience in the future significant price and
volume fluctuations, either of which could adversely affect the market price of
the Common Stock without regard to the operating performance of the Company. In
addition, the trading price of the Company's Common Stock could be subject to
wide fluctuations in response to quarterly variations in operating results,
fluctuations in the Company's comparable store sales, announcements by other
footwear retailers, the failure of the Company's earnings to meet the
expectations of securities analysts and investors, as well as other events or
factors.

Anti-Takeover Effect Of Certain Charter Provisions

The Board of Directors has the authority to issue up to 1,000,000 shares of
Preferred Stock, and to determine the rights, preferences and restrictions of
such shares, without further stockholder approval. The rights of holders of
Common Stock will be subject to, and may be adversely affected by, the rights of
the holders of any Preferred Stock that may be issued in the future. The
issuance of Preferred Stock may have the effect of delaying or preventing a
change in control of the Company. In addition, certain provisions of the
Company's Certificate of Incorporation and Bylaws and of Delaware law could
discourage potential acquisition proposals and could delay or prevent a change
in control of the Company. Such provisions could diminish the opportunities for
a stockholder to participate in tender offers, including tender offers at a
price above the then-current market value of the Common Stock. Among other
things, these provisions (i) provide that only the Board of Directors or certain
members thereof or officers of the Company may call special meetings of the
stockholders; (ii) eliminate the ability of the stockholders to take action
without a meeting; and (iii) authorize the issuance of "blank check" preferred
stock having such designations, rights and preferences as may be determined from
time to time by the Board of Directors.

Item 7A -- Quantitative and Qualitative Disclosure About Market Risk

The Company is exposed to market risks, which include changes in U.S. interest
rates and foreign exchange rates. The Company does not engage in financial
transactions for trading or speculative purposes.

Interest Rate Risk. The interest payable on the Company's bank line of credit
is based on variable interest rates and therefore affected by changes in market
rates. The Company does not use derivative financial instruments in its
investment portfolio and believes that the market risk is immaterial.

Commodity Prices. The Company is not exposed to fluctuation in market prices
for any commodities.

Foreign Currency Risks. The Company has minimal purchases outside of the
United States that involve foreign currency contracts and, therefore, has only
minimal exposure to foreign currency exchange risks. The Company does not hedge
against foreign currency risks and believes that foreign currency exchange risk
is immaterial.

Item 8 -- Financial Statements and Supplementary Data

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

Shoe Pavilion, Inc.

Independent Auditor's Report............................................................. 23
Consolidated Balance Sheets January 2, 1999 and December 31, 1997........................ 24
Consolidated Statements of Income for Years Ended January 2, 1999,
December 31, 1997 and December 31, 1996............................................... 25
Consolidated Statements of Shareholders' Equity for Years Ended
January 2, 1999, December 31, 1997 and December 31, 1996.............................. 26
Consolidated Statements of Cash Flows for Years Ended January 2, 1999,
December 31, 1997 and December 31, 1996............................................... 27
Notes to Consolidated to Financial Statements for Years Ended January 2, 1999,
December 31, 1997 and December 31, 1996............................................... 28

INDEPENDENT AUDITOR'S REPORT

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

We have audited the accompanying consolidated balance sheets of Shoe Pavilion,
Inc. and subsidiary (the "Company") as of January 2, 1999 and December 31, 1997,
and the related consolidated statements of income, stockholders' equity, and
cash flows for each of the three years in the period ended January 2, 1999.
These financial statements are the responsibility of the Company's management.
Our responsibility is to express an opinion on these financial statements based
on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of the Company as of January 2, 1999
and December 31, 1997, and the results of its operations and its cash flows for
each of the three years in the period ended January 2, 1999 in conformity with
generally accepted accounting principles.

DELOITTE & TOUCHE LLP

San Francisco, California
February 12, 1999

SHOE PAVILION, INC.
CONSOLIDATED BALANCE SHEETS
January 2, December 31,
1999 1997
------------ -------------

ASSETS
CURRENT ASSETS:
Cash ............................................................ $ 1,921,870 $ 394,660
Inventories ..................................................... 26,892,101 19,795,599
Prepaid expenses and other ...................................... 257,378 72,955
------------ ------------
Total current assets ..................................... 29,071,349 20,263,214

FIXED ASSETS:
Store fixtures and equipment .................................... 2,800,448 2,158,704
Leasehold improvements .......................................... 2,144,028 1,499,813
Stores and systems projects in-progress ......................... 1,330,780 99,776
------------ ------------
Total .................................................... 6,275,256 3,758,293
Less accumulated depreciation ................................... 2,440,441 1,683,604
------------ ------------
Net fixed assets ................................................ 3,834,815 2,074,689

DEFERRED INCOME TAXES AND OTHER ...................................... 628,070 307,955
------------ ------------
TOTAL .................................................... $ 33,534,234 $ 22,645,858
============ ============

LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable ................................................ $ 5,967,211 $ 5,920,980
Accrued expenses ................................................ 946,116 842,812
Short-term borrowings ........................................... 8,407,262 7,387,125
Current portion of capitalized lease obligations ................ 11,868 67,542
------------ ------------
Total current liabilities ................................ 15,332,457 14,218,459

DEFERRED RENT ........................................................ 1,098,662 909,226

CAPITALIZED LEASE OBLIGATIONS, less current portion .................. 74,745 190,117

COMMITMENTS AND CONTINGENCIES ........................................ - -

STOCKHOLDERS' EQUITY:
Preferred stock - $.001 par value; 1,000,000 shares authorized;
no shares issued or outstanding ................................ - -
Common stock - $.001 par value: 15,000,000 shares authorized;
issued and outstanding; 6,800,000 and 4,500,000 ................ 6,800 4,500
Additional paid-in capital ...................................... 13,967,258 812,033
Retained earnings ............................................... 3,054,312 6,511,523
------------ ------------
Total stockholders' equity ............................... 17,028,370 7,328,056
------------ ------------
TOTAL .................................................... $ 33,534,234 $ 22,645,858
============ ============

See notes to consolidated financial statements

SHOE PAVILION, INC.
CONSOLIDATED STATEMENTS OF INCOME

December 31,
January 2, ---------------------------
1999 1997 1996
------------- ----------- ------------

NET SALES ................................................ $ 55,907,211 $ 45,074,041 $ 30,315,326
COST OF SALES AND RELATED OCCUPANCY EXPENSES 35,777,493 28,922,392 20,317,844
------------- ----------- ------------
Gross profit .................................... 20,129,718 16,151,649 9,997,482
SELLING EXPENSES ......................................... 11,472,385 8,800,332 5,592,472
GENERAL AND ADMINISTRATIVE EXPENSES 3,663,852 3,105,717 2,630,044
------------- ----------- ------------
Income from operations .......................... 4,993,481 4,245,600 1,774,966
OTHER INCOME (EXPENSE):
Interest ............................................. (430,359) (575,471) (259,281)
Other - net ............................................ (22,716) 55,601 (27,934)
------------- ----------- ------------
Total other expense - net ......................... (453,075) (519,870) (287,215)
------------- ----------- ------------
Income before income taxes .............................. 4,540,406 3,725,730 1,487,751
PROVISION FOR INCOME TAXES ............................... (1,146,954) (260,800) (98,000)
------------- ----------- ------------
NET INCOME ............................................... $ 3,393,452 $ 3,464,930 $ 1,389,751
============= =========== ============

Net income per share:
Basic .................................................... $ 0.53 $ 0.77 $ 0.31
Diluted .................................................. $ 0.52 $ 0.77 $ 0.31

Weighted average shares outstanding:
Basic .................................................... 6,461,580 4,500,000 4,500,000
Diluted .................................................. 6,473,771 4,500,000 4,500,000

PRO FORMA
Historical income before taxes on income ............... $ 4,540,406 $ 3,725,730 $ 1,487,751
Pro forma provision for income taxes ................... (1,748,000) (1,434,406) (565,345)
------------- ----------- ------------
Pro forma net income ................................... $ 2,792,406 $ 2,291,324 $ 922,406
============= =========== ============

Pro forma net income per share:
Basic .................................................... $ 0.42 - -
Diluted .................................................. $ 0.42 - -

Pro forma weighted average shares outstanding:
Basic .................................................... 6,647,871 - -
Diluted .................................................. 6,660,062 - -

See notes to consolidated financial statements

SHOE PAVILION, INC.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY

Common Stock
------------------- Additional
Number Paid-in Retained
of Shares Amount Capital Earnings Total
---------- ------- ------------ ----------- ------------

BALANCE AT JANUARY 1, 1996.................... 4,500,000 $ 4,500 $ 30,500 $ 2,660,385 $ 2,695,385
Net income.................................. 1,389,751 1,389,751
Conversion of note payable to equity........ 781,533 781,533
Distribution to previous sole stockholder... (300,000) (300,000)
--------- ------- ------------ ----------- ------------
BALANCE AT DECEMBER 31, 1996.................. 4,500,000 4,500 812,033 3,750,136 4,566,669
Net income.................................. 3,464,930 3,464,930
Distribution to previous sole stockholder... (703,543) (703,543)
--------- ------- ------------ ----------- ------------
BALANCE AT DECEMBER 31, 1997.................. 4,500,000 4,500 812,033 6,511,523 7,328,056
Issuance of stock through initial
public offering.......................... 2,300,000 2,300 14,104,562 14,106,862
Net income.................................. 3,393,452 3,393,452
Distribution to previous sole stockholder... (949,337) (6,850,663) (7,800,000)
--------- ------- ------------ ----------- ------------
BALANCE AT JANUARY 2, 1999.................... 6,800,000 $ 6,800 $ 13,967,258 $ 3,054,312 $ 17,028,370
========= ======= ============ =========== ============

See notes to consolidated financial statements.

SHOE PAVILION, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS

December 31,
January 2, -----------------------------------
1999 1997 1996
------------ ------------ -----------

OPERATING ACTIVITIES:
Net income ............................................. $ 3,393,452 $ 3,464,930 $ 1,389,751
Adjustments to reconcile net income to net cash
provided (used) by operating activities
Depreciation ......................................... 798,566 617,878 449,864
Other ................................................ 34,965 701 32,134
Deferred income taxes ................................ (485,447) - -
Effect of changes in:
Inventories ....................................... (7,096,502) (6,309,873) (5,303,009)
Prepaid expenses and other ........................ (19,092) (298,844) (2,597)
Accounts payable .................................. 46,231 226,411 3,780,250
Accrued expenses and deferred rent ................ 305,689 527,842 219,501
------------ ------------ ------------
Net cash provided (used) by operating activities (3,022,138) (1,770,955) 565,894
------------ ------------ ------------

INVESTING ACTIVITIES:
Purchase of fixed assets ............................ (2,593,656) (1,210,911) (569,228)
------------ ------------ ------------

FINANCING ACTIVITIES:
Net proceeds from initial public offering ........... 14,106,862 - -
Proceeds from long-term debt ........................ - - 23,129
Short-term borrowings ............................... 1,020,137 3,987,125 459,577
Principal payments on capital leases ................ (183,995) (38,220) (21,067)
Principal payments on long-term debt ................ - (70,633) (68,511)
Distributions paid to previous sole stockholder ..... (7,800,000) (703,543) (300,000)
------------ ------------ ------------
Net cash provided by financing activities ...... 7,143,004 3,174,729 93,128
------------ ------------ ------------
NET INCREASE IN CASH ................................... 1,527,210 192,863 89,794
CASH, BEGINNING OF PERIOD .............................. 394,660 201,797 112,003
------------ ------------ ------------
CASH, END OF PERIOD .................................... $ 1,921,870 $ 394,660 $ 201,797
============ ============ ============

CASH PAID FOR:
INTEREST ............................................... $ 416,072 $ 571,764 $ 259,281
INCOME TAXES ........................................... 1,826,000 332,262 28,031

SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING
AND FINANCING ACTIVITIES:
Note payable to stockholder converted to equity ...... - - $ 781,533
Capital lease obligations for store equipment ........ - $ 105,993 189,918

See notes to consolidated financial statements.

SHOE PAVILION, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION AND OPERATIONS

General--Shoe Pavilion, Inc. (the "Company"), a Delaware corporation, is the
successor to Shoe Pavilion Corporation (formerly Shoe Inn, Inc.), which was
incorporated in the State of Washington in 1983. In connection with the initial
public offering, the previous sole stockholder of Shoe Pavilion Corporation
entered into an agreement providing for a reorganization prior to the offering.
Under the terms of this agreement all of the common stock of Shoe Pavilion
Corporation was exchanged for common stock of the Company and Shoe Pavilion
Corporation became a wholly owned subsidiary. The Company was incorporated in
November 1997 for this purpose. The terms of the reorganization provided for the
issuance of 9,000 shares of the Company's common stock for every one share of
Shoe Pavilion Corporation common stock. The accompanying financial statements
reflect the reorganization as if Shoe Pavilion Corporation had always been a
wholly owned subsidiary of the Company. However, the accompanying financial
statements do not reflect the termination of Shoe Pavilion Corporation's S
corporation status until February 23, 1998. All share and per share information
has been retroactively restated to reflect the reorganization.

Public Offering--On February 27, 1998, the Company sold 2,300,000 shares of
its common stock for net proceeds of $14,107,000. In connection with the
offering, the Company terminated its status as an S corporation and recorded a
deferred income tax benefit of $485,000.

Operations--The Company operates as a single business segment of off-price
shoe stores located in California, Washington and Oregon, under the name Shoe
Pavilion. The Company had 69, 55 and 41 stores open as of January 2, 1999,
December 31, 1997 and 1996, respectively. The Company purchases inventory from
international and domestic vendors. For 1998, the Company's top ten suppliers
accounted for 46.9% of inventory purchases.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Use of Estimates--The preparation of financial statements in conformity with
generally accepted accounting principles 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. Actual results could differ from those estimates.

Consolidation Policy--The consolidated financial statements include the
Company and its wholly owned subsidiary, Shoe Pavilion Corporation. All
significant intercompany balances and transactions have been eliminated.

Change of Year--In December 1998, the Company changed its year end to a 52-53
week year ending on the Saturday nearest to December 31. All references
herein to 1998 refer to the year ending January 2, 1999.

Cash represents cash on hand and cash held in banks.

Inventories are stated at the lower of average cost (determined on a first-
in, first-out basis) or market.

Fixed assets are stated at cost and depreciation and amortization are provided
on the straight-line method over the estimated useful lives of the assets
ranging from three to five years. Leasehold improvements are amortized on the
straight-line method over the shorter of the useful lives of the assets or lease
term, generally five years. At January 2, 1999, the fixed assets include
approximately $1,247,000 in costs related to the implementation of the Company's
new management information systems, which will be completed in 1999.

Other assets at January 2, 1999 primarily represent deferred income taxes and
deposits.

SHOE PAVILION, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Income Taxes--Effective February 23, 1998, the Company is taxed as a C
corporation for federal and state income tax purposes. The income tax provision
as of January 2, 1999 reflects this status. Prior to February 23, 1998, the
Company was taxed as an S corporation for federal income tax reporting
purposes, which provides that taxable income or loss of the Company is generally
passed through to the individual stockholders. Accordingly, no provision for
federal income taxes has been recorded in the accompanying financial statements
prior to February 23, 1998. Upon conversion from an S corporation to a C
corporation, the Company recorded a deferred tax asset of $485,477, which
reduced tax expense. The Company elected to be a C corporation in the state of
California. Accordingly, taxes are provided for income attributable to the
Company's operations in this state.

Deferred Rent--Certain of the Company's store leases provide for free or
reduced rent during an initial portion of the lease term. Deferred rent consists
of the aggregate obligation for lease payments under these leases amortized on a
straight-line basis over the lease term, in excess of amounts paid. In addition,
deferred rent includes construction allowances received from landlords, which
are amortized on a straight-line basis over the initial lease term.

Preopening Costs--Store preopening costs are charged to expense as incurred.

Long-lived Assets--The Company periodically reviews long-lived assets for
impairment to determine whether any events or circumstances indicate that the
carrying amount of the assets may not be recoverable. Such review includes
estimating expected future cash flows. No impairment loss provisions have been
required to date.

Net Income Per Share--Basic income per share is computed as net income divided
by the weighted average number of common shares outstanding during the period.
Diluted income per share reflects the potential dilution that could occur from
the exercise of outstanding stock options and is computed by dividing net income
by the weighted average number of common shares outstanding for the period plus
the dilutive effect of outstanding stock options.

Comprehensive Income equals net income.

New Accounting Pronouncements--In April 1998, the Accounting Standards
Executive Committee issued Statement of Position ("SOP") 98-5, Reporting on the
Costs of Start-Up Activities, which requires costs of start-up activities and
organization costs to be expensed as incurred. The SOP requires entities to
expense as incurred all start-up and preopening costs that are not otherwise
capitalizable as long-lived assets. The SOP will be effective for years
beginning after December 15, 1998. As the Company charges store preopening
costs to expense as incurred, adoption of this statement will not impact the
Company's financial position.

Reclassifications--Certain 1997 amounts have been reclassified to conform with
the 1998 presentation.

3. PRO FORMA INFORMATION

The objective of the pro forma information is to show what the significant
effects on the historical information might have been had the Company not been
treated as an S corporation for tax purposes prior to February 23, 1998, the
effective date of the Company's initial public offering.

Income Taxes--The pro forma information presented in the consolidated
statements of income reflects a provision for income taxes at an effective rate
of 38.5% for the years ended January 2, 1999 and December 31, 1997.

SHOE PAVILION, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

3. PRO FORMA INFORMATION (CONTINUED)

Pro Forma Net Income Per Share--Pro forma basic net income per share is based
on the weighted average number of shares of common stock outstanding during the
period plus the estimated number of shares offered by the Company (1,271,722)
which were necessary to fund the $7,800,000 distribution paid to the Company's
stockholder upon termination of the Company's status as an S corporation. Pro
forma diluted net income per share is calculated using the number of shares used
in the basic calculation plus the dilutive effect of stock options outstanding
during the period.

4. FINANCING AGREEMENTS

In December 1998, the Company entered into a new a credit facility agreement
with a financial institution, which includes a revolving line of credit for
$15.0 million expiring on December 1, 2000. This line of credit is also
available for the issuance of commercial and standby letters of credit up to
$4.0 million. The Company pays interest on outstanding amounts at the bank's
prime rate or LIBOR plus 130 basis points, at the Company's option. The weighted
average interest rate was 6.7% at January 2, 1999. Borrowings under the credit
facility are secured by the Company's accounts receivable, general intangibles,
inventory and other rights to payment. The agreement contains restrictive
covenants that require, among other things, that (a) total liabilities may not
exceed 1.5 times tangible net worth, (b) quarterly net income after taxes and
pre-tax profit must each not be less than one dollar, (c) EBITDA must not be
less than $3.75 million on a rolling four-quarter basis and (d) outstanding
balance on the line of credit may not exceed 0.5 times inventory plus the amount
available under outstanding letters of credit, and prohibits the declaration and
payment of cash or stock dividends . The Company was in compliance with all
covenants for the period ended January 2, 1999. As of January 2, 1999, the
unused and available portion of the credit facility was approximately $6.6
million.

5. COMMITMENTS AND CONTINGENCIES

Leases--The Company is obligated under operating leases for store and
warehouse locations and equipment. While most of the agreements provide for
minimum lease payments and include rent escalation clauses, certain of the store
leases provide for additional rentals contingent upon prescribed sales volumes.
Additionally, the Company is required to pay common area maintenance and other
costs associated with the centers in which the stores operate. Most of the
leases provide for renewal at the option of the Company.

The Company's assets under capital leases as of January 2, 1999 and December
31, 1997 are as follows:

January 2, December 31,
1999 1997
--------- ---------

Total assets under capital leases..................... $ 295,911 $ 295,911
Less accumulated amortization......................... 127,731 74,160
--------- ---------
Total................................................. $ 168,180 $ 221,751
========= =========

SHOE PAVILION, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

5. COMMITMENTS AND CONTINGENCIES (CONTINUED)

Future minimum lease payments required are:

Capital Operating
Leases Leases
--------- ------------

Year ending:
2000............................................... $ 20,832 $ 6,627,506
2001............................................... 20,832 5,666,794
2002............................................... 20,832 5,104,137
2003............................................... 47,614 3,609,458
2004............................................... - 2,374,239
Thereafter...................................... - 4,070,130
-------- ------------
Total minimum lease payments....................... 110,110 $ 27,452,264
============
Less amounts representing interest................. 23,497
--------
Present value of capital lease obligations......... 86,613
Less current portion............................... 11,868
--------
Total long-term portion............................ $ 74,745
========

Rental expense for the years ended January 2, 1999, December 31, 1997 and 1996
was, $5,934,733, $5,438,395 and $3,768,318, respectively, including contingent
rentals of $307,355, $278,740 and $204,587, respectively.

Letters of Credit--The Company has obtained letters of credit in connection
with overseas purchase arrangements. The total amount outstanding was $1,118,114
as of January 2, 1999. The Company also has standby letters of credit relating
to rental agreements of $53,236 as of January 2, 1999.

Contingencies--The Company is party to various legal proceedings arising from
normal business activities. Management believes that the resolution of these
matters will not have an adverse material effect on the Company's financial
position or results of operations.

SHOE PAVILION, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

6. INCOME TAXES

The following table reflects the components of deferred tax assets at January
2, 1999:

Net Deferred
Income Tax
Asset (Liability)
----------------------

Uniform capitalization of inventory costs............................. $182,218
Inventory reserve..................................................... 7,703
Prepaid expenses...................................................... (7,986)
Difference in basis of fixed assets................................... (44,575)
Other................................................................. 2,889
Deferred rent and tenant improvements................................. 345,198
--------
Net Deferred Tax Asset................................................ $485,447
========

The 1998 provision for income taxes consisted of the following:

Current:

Federal............................................................ $1,419,981
State.............................................................. 212,450
----------
Total current...................................................... 1,632,431

Deferred.............................................................. 485,477
----------
Total provision....................................................... $1,146,954
==========

A reconciliation of the statutory federal income tax rate with the Company's
effective income tax rate as of January 2, 1999 is as follows:

Rate Amount
------- -----------

Income before income taxes..................................... $4,540,406

Statutory federal rate......................................... 34.00% 1,543,738
State income taxes, net of federal income tax benefit.......... 3.09 140,217
Other.......................................................... (1.14) (51,554)
Change in tax status........................................... (10.69) (485,447)
------- ----------

Effective tax rate............................................. 25.26% $1,146,954
======= ==========

7. STOCKHOLDERS' EQUITY

Stock Options--In January 1998, the Company adopted the 1998 Equity Incentive
Plan (the "1998 Plan") authorizing the issuance of 1,000,000 shares of Common
Stock to key employees and consultants of the Company. The 1998 Plan provides
for awards of nonqualified stock option grants to purchase Common Stock at
prices equal to fair market value at the date of grant. During 1998, the Company
granted options under this plan for the purchase of 319,000 shares of Common
Stock at exercise prices ranging from $4.75 to $10.25 per share, the fair market
value of the shares at the date of grant. Such options vest at 20% each year,
beginning at the date of grant and expire ten years from that date. At January
2, 1999, 707,000 options were available for grants and no options were
exercisable.

Directors' Stock Options--In January 1998, the Company adopted the Directors'
Stock Option Plan (the "Directors' Plan") authorizing the issuance of 100,000
shares of Common Stock to non-employee directors of the Company. The Directors'
Plan provides for awards of nonqualified stock options to purchase Common Stock
at prices equal to fair market value at the date of grant. During 1998, the
Company granted options under this plan for the purchase of 15,000 shares of
Common Stock at an exercise price of $7.00 per share, the fair market value of
the shares at the date of grant. Such options vest 100% at the expiration of one
year from grant date and expire six years from that date. At January 2, 1999,
85,000 options were available for grant and no options were exercisable.

The following tables summarize information about the stock options under both
plans outstanding at January 2,1999:

Weighted
Number Average
of Shares Exercise Price
--------- --------------

Balance at December 31, 1997 - -
Option granted 334,000 $ 6.96
Options canceled..... (26,000) (7.52)
------- ------
Balance at January 2, 1999. 308,000 $ 6.91
======= ======

Weighted average fair value of
options granted during 1998..... $ 5.06

Weighted Average
Number of Remaining Number
Range of Outstanding at Contractual Life Weighted Average Exercisable at Weighted Average
Exercise Prices January 2, 1999 (in years) Exercise Price January 2, 1999 Exercise Price
- ---------------- --------------- ---------------- ---------------- ------------------- ----------------

$4.75 30,000 9.82 $4.75 0 $0.00
$7.00 264,000 9.15 $7.00 0 $0.00
$9.69-$10.25 14,000 9.39 $9.85 0 $0.00
- ----------------- ------- ------ ----- - -----
$4.75-$10.25 308,000 9.22 $6.91 0 $0.00
================= ======= ====== ===== = =====

The Company accounts for its stock option plans in accordance with Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" and
its related interpretations. Accordingly, no compensation expense has been
recognized in the financial statements for stock option arrangements.

SHOE PAVILION, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

7. STOCKHOLDERS' EQUITY (CONTINUED)

SFAS No. 123, "Accounting for Stock-Based Compensation," requires the
disclosure of pro forma net income and net income per share had the Company
adopted the fair value method as of the beginning of 1995. Under SFAS No. 123,
the fair value of stock-based awards to employees is calculated through the use
of option pricing models, even though such models were developed to estimate the
fair value of freely tradable, fully transferable options without vesting
restrictions, which significantly differ from the Company's stock option awards.
These models also require subjective assumptions, including future stock price
volatility and expected time to exercise, which greatly affect the calculated
values. The Company's calculations were made using the Black-Scholes option
pricing model with the following weighted average assumptions: expected life of
5.7 years following vesting; stock price volatility of 85.17%; risk free
interest rate of 6.0%; and no dividends during the expected term. Forfeitures
are recognized as they occur. If the computed fair values of the 1998 awards had
been amortized to expense over the vesting period of the awards, pro form net
income would have been reduced to the pro form amounts indicated below.

Year Ended
January 2, 1999
-----------------

Net income:
As reported........................................................... $3,393,452
Pro forma for the effect of stock options............................. $2,994,316

Net income per share:
As reported:
Basic................................................................. $ 0.53
Diluted............................................................... $ 0.52
Pro forma for the effect of stock options:
Basic and diluted..................................................... $ 0.46

8. EMPLOYEE BENEFIT PLAN

The Company established a 401(k) Savings Plan (the "Plan") effective January
1, 1998. An employee becomes eligible to participate in the Plan after
completing one year of service and attainment of age 21; however, all employees
hired prior to January 1, 1998, regardless of length of service, were permitted
to enroll in the Plan. Generally, employees may contribute up to 15% of their
compensation or a maximum of $10,000 in accordance with IRC Sections 402(g),
401(k) and 415. For every dollar contributed to the Plan, the Company will match
50 cents, up to a maximum of 3% of the employee's compensation. There were no
Company contributions for the year ending January 2, 1999. The Company's
contributions vest over a five year period.

During 1998, the Plan was not implemented and was subsequently amended to
permit enrollment in the Plan by employees, over the age of 21, hired prior to
January 1, 1999, regardless of length of service. This amendment was a one time
event as the service requirement was later reinstated by an additional
amendment. The Plan was fully implemented and will begin in the year ending
January 1, 2000.

SHOE PAVILION, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

9. QUARTERLY FINANCIAL DATA (UNAUDITED)

(In thousands, Historical Pro Forma (see Note 3)
except per share data) ----------------------------------------- ----------------------------------
Net Income Net Income
Per Share Per Share
Gross Net --------------- Net ---------------
Sales Profit Income Basic Diluted Income Basic Diluted
------- ------ ------ ----- ------- ------ ----- -------

1998 Quarters
4th Quarter ........................ $16,432 $6,145 $ 885 $0.13 $ 0.13 - - -
3rd Quarter ........................ 14,638 5,380 800 0.12 0.12 - - -
2nd Quarter ........................ 13,386 4,795 686 0.10 0.10 - - -
1st Quarter (1) .................... 11,451 3,810 1,022 0.19 0.19 $ 427 $0.07 $ 0.07

1997 Quarters
4th Quarter ........................ $12,889 $4,646 $1,234 $0.27 $ 0.27 $ 797 - -
3rd Quarter ........................ 11,856 4,049 558 0.12 0.12 374 - -
2nd Quarter ........................ 12,174 4,674 1,177 0.26 0.26 788 - -
1st Quarter ........................ 8,155 2,785 496 0.11 0.11 332 - -

(1) In connection with its public offering in February 1998, the Company
terminated its status as an S corporation and recorded a deferred income tax
benefit of $485,000.

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

None.

PART III

Item 10 -- Directors and Executive Officers of the Registrant

The information required by this item is incorporated by reference from the
Company's Definitive Proxy Statement for the Company's 1999 Annual Meeting of
Stockholders under the captions "Election of Directors" and "Section 16(a)
Beneficial Ownership Reporting Compliance." See also Item 1 above.

Item 11 -- Executive Compensation

Item 12 -- Security Ownership of Certain Beneficial Owners and Management

The information required by this item is incorporated by reference from the
Company's Definitive Proxy Statement for the Company's 1999 Annual Meeting of
Stockholders under the caption "Ownership of Management and Principal
Stockholders."

Item 13 -- Certain Relationships and Related Transactions

The information required by this item is incorporated by reference from the
Company's Definitive Proxy Statement for the Company's 1999 Annual Meeting of
Stockholders under the captions "Compensation Committee Interlocks and Insider
Participation" and "Transactions with the Company."

PART IV

Item 14 -- Exhibits, Financial Statement Schedules and Reports on Form 8-K

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

(1) Consolidated Financial Statements of the Company are included in Part
II, Item 8:

Independent Auditors' Report

Consolidated Balance Sheets

Consolidated Statements of Income

Consolidated Statements of Cash Flows

Consolidated Statements of Shareholders' Equity

Notes to Consolidated Financial Statements

(2) Consolidated Supplementary Financial Statement Schedule for the years
ended January 2, 1999 and December 31, 1997:

None.

All other schedules are omitted because of the absence of conditions under
which they are required or because the required information is included in the
consolidated financial statements or notes thereto.

(3) Exhibits:

See attached Exhibit Index.

(b) The Company filed the following reports on Form 8-K during the fourth
quarter of 1998:

(1) A report dated December 29, 1998 disclosing a fiscal year end change.

Signatures

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

Date: March 19, 1999

SHOE PAVILION, INC.

By /s/ Dmitry Beinus
-------------------------------------------
Dmitry Beinus
Chairman of the Board, President
and Chief Executive Officer

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

Signature Capacity Date
--------- -------- ----

/s/ Dmitry Beinus Chairman, President and Chief March 19, 1999
- ------------------------------------ Executive Officer (Principal
Dmitry Beinus Executive Officer)

/s/ Gary A. Schwartz Vice President, Chief Financial March 19, 1999
- ------------------------------------ Officer (Principal Financial Officer
Gary A. Schwartz and Principal Accounting Officer)

/s/ David H. Folkman Director March 19, 1999
- ------------------------------------
David H. Folkman

/s/ Peter G. Hanelt Director March 19, 1999
- ------------------------------------
Peter G. Hanelt

EXHIBIT INDEX

Set forth below is a list of exhibits that are being filed or incorporated by
reference into this Form 10-K:

Exhibit
Number Exhibit
- -------- -------

2.1 Exchange Agreement dated February 23, 1998 by and among Shoe
Pavilion, Inc., Shoe Inn, Inc. and Dmitry Beinus (Incorporated by
reference from Exhibit 2.1 to Registration Statement No. 333-41877).

3.1 Certificate of Incorporation of the Registrant (Incorporated by
reference from Exhibit 3.1 to Registration Statement No. 333-41877).

3.2 Bylaws of the Registrant (Incorporated by reference from Exhibit 3.2
to Registration Statement No. 333-41877).

4.1 Specimen Common Stock Certificate (Incorporated by reference from
Exhibit 4.1 to Registration Statement No. 33-41877).

10.1 Lease Agreement between Lincoln-Whitehall Pacific, LLC and Shoe Inn,
Inc. dated October 28, 1996 (Incorporated by reference from Exhibit
10.1 to Registration Statement No. 333-41877).

10.2 First Amendment to Lease Agreement between Lincoln-Whitehall
Pacific, LLC and Shoe Pavilion Corporation dated September 17, 1998.

10.3 Second Amendment to Lease Agreement between Lincoln-Whitehall
Pacific, LLC and Shoe Pavilion Corporation dated January 11, 1999.

10.4 1998 Equity Incentive Plan with forms of non-qualified and incentive
stock option agreements (Incorporated by reference from Exhibit 10.2
to Registration Statement No. 333-41877).

10.5 Directors' Stock Option Plan with form of stock option agreement
(Incorporated by reference from Exhibit 10.3 to Registration
Statement No. 333-41877).

10.6 Credit Agreement dated December 1, 1998 between Shoe Pavilion
Corporation and Wells Fargo Bank, National Association.

10.7 Revolving Line of Credit Note dated December 1, 1998 between Shoe
Pavilion Corporation and Wells Fargo Bank, National Association.

10.8 Continuing Guaranty dated December 1, 1998 between Shoe Pavilion,
Inc. and Wells Fargo Bank, National Association.

10.9 Tax Allocation Agreement dated February 18, 1998 between Shoe Inn,
Inc. and Dmitry Beinus (Incorporated by reference from Exhibit 10.5
to Registration Statement No. 333-41877).

10.10 Agreement of Purchase and Sale dated as of April 14, 1997 among
Standard Shoe Company and Shoe Inn, Inc. (Incorporated by reference
from Exhibit 10.6 to Registration Statement No. 333-41877).

10.11 Form of Indemnification Agreement between the Registrant and certain
of its officers and directors (Incorporated by reference from
Exhibit 10.7 to Registration Statement No. 333-41877).

21 List of Subsidiaries

23 Independent Auditors' Consent

27 Financial Data Schedule