The accompanying unaudited condensed consolidated financial statements have been prepared from the records of Shoe Pavilion, Inc. and subsidiary (the "Company"or "Shoe Pavilion, Inc.") in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q. Accordingly, they do not include all information and footnotes in conformity with accounting principles generally accepted in the United States of America for complete financial statements and should be read in conjunction with the audited consolidated financial statements and related notes contained in the Company's Annual Report on Form 10-K for the year ended December 31, 2005 (the "2005 Annual Report") as filed with the Securities and Exchange Commission ("SEC"). In the opinion of management, all adjustments (consisting of normal recurring adjustments and accruals) considered necessary for a fair presentation of the results of operations for the periods presented have been included in the interim report. Interim results are not necessarily indicative of results for the full year. The financial data at December 31, 2005 presented herein is derived from the 2005 Annual Report.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

The Financial Accounting Standards Board ("FASB") periodically issues Statements of Financial Accounting Standards ("SFAS"), some of which require implementation by a date falling within or after the close of the fiscal year.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. This statement clarifies the definition of fair value, establishes a framework for measuring fair value, and expands the disclosures on fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. The Company has not determined the effect, if any, the adoption of this statement will have on its results of operations or financial position.

In October 2005, the FASB issued FASB Staff Position No. 13-1, "Accounting for Rental Costs Incurred During a Construction Period" ("FSP No. 13-1"), which requires rental costs associated with ground or building operating leases that are incurred during a construction period to be recognized as rental expense. FSP No. 13-1 is effective for periods beginning after December 15, 2005. The adoption of this pronouncement in the first quarter of 2006 did not have a material impact on the Company.

In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error Corrections - A Replacement of APB Opinion No. 20 and FASB Statement No. 3" ("SFAS No. 154"). SFAS No. 154 changes the requirements for the accounting for and reporting of accounting changes and error corrections. SFAS No. 154 establishes retrospective application as the required method for reporting a change in accounting principle and provides guidance for determining whether retrospective application of a change in accounting principle is impracticable and for reporting a change when retrospective application is impracticable. SFAS No. 154 also addresses the reporting of a correction of an error by restating previously issued financial statements. SFAS No. 154 is effective for accounting changes and corrections of an error made in fiscal years beginning after December 15, 2005. The adoption of this pronouncement in the first quarter of 2006 did not have a material impact on the Company.

In December 2004, the FASB issued SFAS No. 123 (Revised 2004), "Share-Based Payment" ("SFAS No. 123R"), which replaced SFAS No. 123, "Accounting for Stock-Based Compensation," and supersedes Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS No. 123R requires a fair value measurement of all share-based payments to employees, including grants of employee stock options, and recognition of those compensation expenses in the financial statements. SFAS No. 123R establishes standards for the accounting for transactions in which an entity exchanges its equity or liability instruments for goods and services

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and focuses on accounting for transactions in which an entity obtains employee services in share-based payment transactions. The share-based compensation expense is required to be measured based on the fair value of the equity or liability instruments issued. In addition, SFAS No. 123R requires the recognition of compensation expense over the period during which an employee is required to provide service in exchange for an award. Effective the first quarter of 2006, the Company adopted SFAS 123R and recognized compensation expense related to share-based payment transactions using the modified prospective method. (See Note 4).

In March 2005, the SEC issued Staff Accounting Bulletin No. 107 ("SAB No. 107"), which provides guidance on the implementation of SFAS No. 123R. In particular, SAB No. 107 provides key guidance related to valuation methods (including assumptions such as expected volatility and expected term), the accounting for income tax effects of share-based payment arrangements upon adoption of SFAS 123R, the modification of employee share options prior to the adoption of SFAS 123R, the classification of compensation expense, capitalization of compensation costs related to share-based payment arrangements, first-time adoption of SFAS 123R in an interim period and disclosures in Management's Discussion and Analysis subsequent to the adoption of SFAS 123R. SAB No. 107 became effective on March 29, 2005. The Company has adopted SFAS 123R and it now applies the principles of SAB No. 107.

In July 2006, the FASB issued FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109" ("FIN 48"). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in a company's financial statements in accordance with SFAS 109, "Accounting for Income Taxes". FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective as of January 1, 2007. The Company is currently evaluating the impact of FIN 48 on its consolidated financial statements.

Basic earnings per share is computed as net income divided by the weighted average number of common shares outstanding for the period. Diluted earnings per share is computed as net income divided by the weighted average number of common shares outstanding and potentially dilutive common equivalent shares outstanding for the period. The following table summarizes the incremental shares from these potentially dilutive securities, calculated using the treasury stock method.

An aggregate of 887,783 and 292,857 options and warrants for the thirteen and thirty-nine weeks ended September 30, 2006, respectively, were excluded from the computation of diluted earnings per share because their effect would have been anti-dilutive.

The Company has two share-based compensation plans: the Amended and Restated 1998 Equity Incentive Plan and the Amended and Restated Non-Employee Director Stock Option Plan.

Prior to the January 1, 2006 adoption of SFAS 123R, the Company accounted for stock-based compensation using the intrinsic value method prescribed in APB Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. Because the stock option grant price equaled the market price on the date of grant, no compensation expense was recognized by the Company for stock-based compensation. As permitted by SFAS No. 123, stock-based compensation was included as a pro forma disclosure in the notes to the consolidated financial statements.

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Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS 123R, using the modified prospective transition method. Under this transition method, stock-based compensation expense is recognized in the consolidated financial statements for granted, modified or settled stock options. Results for prior periods have not been restated, as provided for under the modified prospective method.

Prior to the adoption of SFAS 123R, the Company presented all tax benefits resulting from the exercise of stock options as operating cash inflows in the consolidated statements of cash flows, in accordance with the provisions of the Emerging Issues Task Force ("EITF") Issue No. 00-15, "Classification in the Statement of Cash Flows of the Income Tax Benefit Received by a Company upon Exercise of a Nonqualified Employee Stock Option." SFAS 123R requires the benefits of tax deductions in excess of the compensation cost recognized for those options to be classified as financing cash inflows rather than operating cash inflows, on a prospective basis. The impact of this change was not material to the Company.

The following table shows the effect on net income and earnings per share for the periods ended October 1, 2005, had compensation cost been recognized based upon the estimated fair value on the grant date of stock options in accordance with SFAS 123, as amended by SFAS No. 148 "Accounting for Stock-Based Compensation - Transition and Disclosure":

Disclosures for the periods ended September 30, 2006 are not presented because the amounts are recognized in the consolidated financial statements.

The fair value of stock options granted subsequent to the adoption of SFAS 123R (January 1, 2006) is estimated using the binomial lattice method of option valuation. Assumptions relative to volatility, anticipated forfeitures and exercises are determined at the time of grant and reflected in the lattice-based valuation. Prior to the adoption of SFAS 123R, the fair value for stock awards was estimated at the date of grant using the Black-Scholes-Merton ("BSM") option valuation model with the following weighted average assumptions:

Assumptions relative to the binomial lattice method of option valuation include the expectation that non-executive grantees will exercise all vested stock options once the market price exceeds 200% of the option's exercise price. For executive grantees, it is assumed that they will not exercise their options based on market price per share, but rather will hold the options until one year after they are fully vested. The Company has also assumed

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a forfeiture rate of 10% for non-executives and 0% for executives. The assumed volatility for valuing the options was 55%. The following table shows the assumptions used:

The expected term of the options represents the estimated period of time until exercise and is based on historical experience of similar awards, giving consideration to the contractual terms, vesting schedules and expectations of future employee behavior. The expected stock price volatility is based on historical volatility of the Company's stock for the related vesting periods. The risk-free interest rate is based on the implied yield available on U.S. Treasury zero-coupon issues with an equivalent remaining term. The Company has not paid dividends in the past and does not plan to pay any dividends in the near future.

Stock options to purchase the Company's common stock are typically granted at prices equal to the fair market value on the date of grant. Employee stock options generally become exercisable in four equal installments beginning a year from the date of grant and generally expire 10 years from the date of grant. Options granted to non-employee directors generally vest over a one year period. Outstanding stock options are a combination of incentive stock options and non-qualified stock options.

The fair value of each stock option granted prior to adoption of SFAS 123R was estimated on the date of grant using the BSM option valuation model. Subsequent to the adoption of SFAS 123R, the Company has used the binomial lattice method of estimating the fair value of stock options. The assumptions used to calculate the fair value of options granted are evaluated and revised, as necessary, to reflect market conditions and the Company's experience. Once the fair value of the options is calculated, the resulting expense is recognized using the graded, or accelerated attribution method consistent with the multiple option valuation approach. Compensation expense is recognized only for those options expected to vest, with forfeitures estimated at the date of grant based on the Company's historical experience and future expectations. Prior to the adoption of SFAS 123R, the effect of forfeitures on the pro forma expense amounts was recognized as the forfeitures occurred.

A summary of the Company's stock option activity during the thirty-nine weeks ended September 30, 2006 is presented in the following table:

The aggregate intrinsic value in the table above is before applicable income taxes and is based on the Company's closing stock price of $7.30 as of the last trading day of the period ended September 30, 2006, which

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would have been received by the optionees had all options been exercised on that date. As of September 30, 2006, total unrecognized stock-based compensation expense related to nonvested stock options was approximately $997,000, which is expected to be recognized over a weighted average period of approximately 2.4 years. During the thirteen weeks ended September 30, 2006, the total intrinsic value of stock options exercised was $89,725. During the thirty-nine weeks ended September 30, 2006, the total intrinsic value of stock options exercised was $152,920.

A summary of the status of the Company's nonvested options as of January 1, 2006, and changes during the thirty-nine weeks ended September 30, 2006, is presented below:

During the thirteen and thirty-nine weeks ended September 30, 2006, the total fair value of options vested was $60,933 and $193,370, respectively.

The Company issues new shares of common stock upon the exercise of stock options.

As of September 30, 2006, there were 360,635 shares of common stock available for issuance pursuant to future stock option grants.

Additional information regarding options outstanding as of September 30, 2006, is as follows:

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The Company is involved in various routine legal proceedings incidental to the conduct of its normal business activities. Management does not believe that any of these legal proceedings will have a material adverse impact on the business, financial condition or results of operations, either due to the nature of the claims, or because management believes that such claims would not exceed the limits of the Company's insurance coverage.

The Company has obtained documentary and standby letters of credit from Wells Fargo Retail. These letters of credit are used to guarantee payments to various third parties. The total of these letters of credit was $1,089,115 at September 30, 2006. When the Company receives the related goods or services, the Company records the liability. When the liability is paid, the related letters of credit are cancelled.

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

The following should be read in conjunction with the Company's financial statements and related notes thereto provided under "Item 1-Financial Statements" above.

Shoe Pavilion, Inc., a Delaware corporation, is an independent off-price branded footwear retailer in the Western and Southwestern United States. As of September 30, 2006, the Company operated 100 stores located throughout California, Washington, Oregon, Arizona, Nevada, Texas and New Mexico. The Company was among the first footwear retailers on the West Coast to expand the off-price concept into the branded footwear market. The Company offers a broad selection of quality designer label and branded footwear, typically at 20% to 60% below regular department store prices for the same shoes, in a convenient self-service format.

The Company is positioned in the market between discount stores and department stores. Unlike discount stores, it offers designer label and branded footwear that, in its opinion, has long-term customer appeal. As a result, the Company appeals to quality, style and designer label-oriented customers with relatively higher spending power. Unlike department stores, the Company's prices are designed to appeal to value-oriented consumers seeking quality branded footwear typically found at department stores or branded retail outlets at higher everyday prices.

The Company's stores are strategically located in strip malls, outlet centers, large format retail centers and downtown locations, frequently in close proximity to other off-price apparel retailers that attract similar customers. On average, over 20,000 pairs of shoes representing over 100 brands are displayed on the selling floor of most of its stores, compared to a significantly smaller product offering at typical department stores. Mature stores are evaluated for remodeling based on each store's age and competitive situation, as well as how much the landlord will contribute toward the required improvements. Future store remodeling plans will depend upon several factors, including, but not limited to, general economic conditions, competition trends and the availability of adequate capital.

The Company's growth strategy had historically focused on the Western United States, but now includes opening new stores throughout the Southwestern United States as suitable locations are found. For fiscal 2006, the Company expects to open twenty-four new stores, by adding stores in existing markets, expanding into new Texas markets and going into New Mexico for the first time. Future store openings are subject to availability of satisfactory store locations based on local competitive conditions, site availability and cost and quality brand merchandising at competitive prices. Over the last several years, the Company has focused on closing its smaller stores and replacing them with larger stores in more attractive locations. The average square footage of these new

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stores has been and is expected to continue to be approximately 18,000 to 20,000 square feet. As a result, the Company expects the average size of its stores to increase for the foreseeable future.

The Company plans to continue to strengthen its position as an independent off-price branded footwear retailer by pursuing the following three primary strategies for growth in sales and profitability - continue to expand and improve its store base, leverage its operating model and enhance merchandising.

The following tables set forth statements of income data and relative percentages of net sales for the thirteen weeks ended September 30, 2006 and thirteen weeks ended October 1, 2005 (dollar amounts in thousands).

Net Sales. Net sales for the thirteen week period ended September 30, 2006 increased by 28.0%, or $7.0 million, to $31.8 million from $24.8 million in the thirteen week period ended October 1, 2005. The sales increase was due to the addition of seven new stores and a comparable store sales increase of 3.7%. Comparable store sales are based upon stores open at least 13 consecutive months.

Gross Profit. Cost of sales includes landed merchandise and occupancy expenses. Gross profit for the thirteen week period ended September 30, 2006 increased by 19.6%, or $1.6 million, to $10.0 million from $8.4 million in the thirteen week period ended October 1, 2005, primarily as a result of increased sales. As a percent of sales, gross profit decreased to 31.6% for the thirteen week period ended September 30, 2006 from 33.8% in the thirteen week period ended October 1, 2005, due to higher occupancy expenses of 2.1%, primarily related to new stores.

Selling, General and Administrative Expenses. Selling, general and administrative expenses for the thirteen week period ended September 30, 2006 increased by 33.7%, or $2.6 million, to $10.4 million from $7.8 million in the thirteen week period ended October 1, 2005. The increase is primarily from expenses related to additional stores, which resulted in approximately $850,000 in store salaries, $490,000 in advertising, $250,000 in utilities and $150,000 in freight expenses. As a percent of sales, SG&A expenses increased to 32.7% for the thirteen week period ended September 30, 2006 from 31.3% in the thirteen week period ended October 1, 2005. The increase as a percent of sales is primarily due to increases of 0.6% in advertising, 0.4% in utilities and 0.4% in warehouse fees, partially offset by savings of 0.3% in corporate salaries.

Interest Expense. Interest expense for the thirteen week period ended September 30, 2006 increased by 29.0%, or $42,000, to $187,000 from $145,000 in the thirteen week period ended October 1, 2005, due to a higher average interest rate and increased borrowings under the Company's Revolving Credit Facility during the thirteen week period ended September 30, 2006 compared to the thirteen week period ended October 1, 2005.

Income Tax Benefit. The Company's effective income tax rate increased to 40.4% from 39.2%, due primarily to the effect of incentive stock options that were issued in prior years. Because the Company adopted SFAS 123R effective January 1, 2006, it began recognizing compensation expense that corresponds to the vesting of stock options. Most of the options that are now vesting are incentive stock options. The compensation expense recorded

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for the vesting of this type of option is not deductible for income tax purposes. As a result, income tax as a percentage of taxable income increased.

The following tables set forth statements of income data and relative percentages of net sales for the thirty-nine weeks ended September 30, 2006 and thirty-nine weeks ended October 1, 2005 (dollar amounts in thousands).