2006 Annual Report The Cato Corporation is a leading specialty retailer of value-priced women’s fashion apparel operating two divisions, “Cato” and “It’s Fashion!”. The Company currently operates over 1,275 apparel specialty stores principally in the southeastern United States. Cato offers exclusive merchandise with updated fashion and quality comparable to mall specialty stores at low prices, every day. Most Cato stores range from 3,500 to 6,000 square feet and are located primarily in strip shopping centers anchored by national discounters or market dominant grocery stores. It’s Fashion! provides junior-inspired fashion apparel and accessories with stores ranging from 3,000 to 4,000 square feet. The Company is headquartered in Charlotte, North Carolina. FINANCIAL HIGHLIGHTS FISCAL YEAR (Dollars in thousands, except per share data) FOR THE YEAR ENDED Retail sales Total revenues Comparable store sales increase (decrease) Income before income taxes Net income Net income as a percent of retail sales Cash dividends paid per share Basic earnings per share Diluted earnings per share Number of stores Number of stores opened Number of stores closed Net increase in number of stores AT YEAR END Cash, cash equivalents and investments Working capital Current ratio Total assets Stockholders’ equity 2006 2005 2004 2003 2002 $ 862,813 875,885 $ 821,639 836,381 $ 773,809 789,604 $ 731,770 747,267 $ 732,742 748,331 (2)% 1% 0% (7)% 0% 79,631 51,450 70,375 44,829 54,695 34,841 6.0% .58 1.64 1.62 1,276 58 26 32 5.5% 4.5% .507 1.44 1.41 1,244 82 15 67 .457 1.13 1.11 1,177 80 5 75 48,687 31,014 4.2% .42 .89 .88 1,102 87 7 80 71,230 45,445 6.2% .39 1.19 1.17 1,022 90 5 85 $ 123,542 176,464 2.4 432,322 276,793 $ 107,819 139,114 2.0 406,636 239,948 $ 107,228 136,980 2.0 397,323 211,175 $ 71,402 117,403 2.0 356,284 186,075 $ 106,936 166,264 2.7 387,272 262,505 The fiscal year ended February 3, 2007 contained 53 weeks versus 52 weeks in the prior fiscal years 2005 – 2002. A MESSAGE TO OUR SHAREHOLDERS John P. D. Cato Over the last several years, my annual message to shareholders has focused on the many changes we have made to improve our operations and merchandise offering. We have transformed our merchandising strategy from one that was highly promotional with primarily a domestic importer vendor base to one that offers low prices every day on exclusive merchandise that is largely sourced overseas. Our store count has grown from approximately 700 stores to more than 1,200. But regardless of any operational or merchandising changes, our focus will not change: Cato will continue to offer great fashion, great quality and great value to our customers, and we will continue to work to deliver profitable growth to shareholders. Cato met shareholders’ expectations in 2006 by delivering record net income, offering customers more exclusive fashions than ever before and continuing to improve operations. Net sales for the year increased to $863 million, up 5% over 2005. Merchandise gross margin increased to 33.6% of sales. Net income was a record $51.5 million and earnings per share were $1.62, both a 15% increase over last year. Net income was a record on a comparative 52 and a 53-week basis. Cato returned $18.2 million in dividends to its share- holders in 2006, which reflects a 15% increase in the annualized dividend after an 11% increase in 2005. In 2006, the second year of our Cato private label, we continued to develop the Cato brand by focusing on exclusive fashions and further expanding our direct sourcing of more fashionable and proprietary merchandise. This strategy resulted in improved gross margins as well as better quality and value for our customer. Also, we developed the foundation for an enhanced quality assurance process to ensure our customer is increasingly satisfied with the quality of our merchandising offering. We improved operations by investing more than $27 million in the growth of our business. We opened 58 new stores and developed a new store prototype to provide a more pleasant shopping experience with upgraded finishes that create a more upscale feel. We have continued to invest in technology to refine merchandise planning and assortment systems, improve and shorten the product development process, reduce transactional costs and reduce customer checkout times. Finally, we continued to reduce distribution costs by increasing product flow through our distribution center and developing more efficient store delivery methods. As we look to 2007, we expect a more challenging year because of the additional week in the retail calendar for 2006 and a number of non-operational items that positively impacted our earnings for the year. We will meet this challenge by continuing to review our business with a rigorous analysis focused on improving all areas of the Company. Additionally, we will continue and expand recent successful initiatives. For example, we will continue to improve the training program for our field organization, which has been a great success to date, and we will implement a more formal training and development program for our corporate office management and staff. We also will continue to cultivate the talent within our Company as demonstrated by several executive level promotions in 2006. As for technology and business processes, we will continue to invest in and implement new technology and develop processes to improve efficiency and lower costs. For example, we are installing a new loss prevention system to better control inventory, lower shrinkage costs and provide greater cash accountability in our stores. To improve and refine our new store development process as we continue to expand beyond our core geography, we are developing a new site selection and evaluation process to better define opportunities in new markets. More than 10,000 Cato associates come to work every day to satisfy the expectations of our customers and shareholders. Their efforts delivered a record performance in 2006 and I appreciate all they do. As managers, we expect to see our people grow. As shareholders, we expect to see profits grow. Both are happening at Cato. John P. D. Cato Chairman, President and Chief Executive Officer 1,276 1,244 1,177 1,102 1,022 937 859 809 1 10 5 1 4 10 39 148 1 12 25 56 70 11 18 27 35 48 75 81 115 76 4 15 71 142 90 1 5 7 73 99 00 01 02 03 04 05 06 TOTAL NUMBER OF STORES (at year end) TOTAL NUMBER OF STORES PER STATE (at year end) The Cato Brand… Designed with Fashion and Quality New styles and unique fashions. That’s the promise of the Cato brand. Our customers know that to find on-trend fashion, high quality, exclusive styling and exceptional value, all they need to do is look for the Cato label. We are committed to building the Cato brand by ensuring that it reflects the on-trend fashion that customers want, the quality and fit they deserve and the value that is so essential today. This commitment will allow us to continue to meet our customers’ fashion needs even as fashions change. Great Fashion. Great Quality. Great Value. One great place to shop. Cato. MANAGEMENT EXECUTIVE GROUP John P. D. Cato Chairman, President and Chief Executive Officer Michael T. Greer Executive Vice President, Director of Stores Howard A. Severson Executive Vice President, Chief Real Estate and Store Development Officer Thomas W. Stoltz Executive Vice President, Chief Financial Officer Stuart L. Uselton Executive Vice President, Chief Administrative Officer B. Allen Weinstein Executive Vice President, Chief Merchandising Officer BOARD OF DIRECTORS John P. D. Cato Chairman, President and Chief Executive Officer Robert W. Bradshaw, Jr. 1,3 Of Counsel – Robinson, Bradshaw & Hinson, P.A. George S. Currin 1,2 Chairman and Managing Director of The Fourth Stockton Company LLC and Chairman Currin-Patterson Properties LLC William H. Grigg 1,3 Chairman Emeritus (Retired) Duke Energy Corporation Grant L. Hamrick 3 Retired Senior Vice President, Chief Financial Officer American City Business Journals James H. Shaw 1,2 Retired Chairman and Chief Executive Officer Ivey’s Department Stores A. F. (Pete) Sloan 2,3 Retired Chairman and Chief Executive Officer Lance, Inc. D. Harding Stowe 1,2 President and Chief Executive Officer R. L. Stowe Mills, Inc. 1 Member of the Corporate Governance and Nominating Committee 2 Member of the Compensation Committee 3 Member of the Audit Committee UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-K ¥ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended February 3, 2007 or n TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number 1-31340 The Cato Corporation Registrant Delaware State of Incorporation 8100 Denmark Road Charlotte, North Carolina 28273-5975 Address of Principal Executive Offices 56-0484485 I.R.S. Employer Identification Number 704/554-8510 Registrant’s Telephone Number Securities registered pursuant to Section 12(b) of the Act: Class A Common Stock New York Stock Exchange Preferred Share Purchase Rights New York Stock Exchange Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¥ No n Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes n No ¥ 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 ¥ No n Indicate by check mark, if disclosure of delinquent filers pursuant to Item 405 of the Regulation S-K is not contained herein, and will not be contained, to the best of the 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. n Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non- accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. Accelerated filer n Large accelerated filer ¥ Non-accelerated filer n is a shell company (as defined in Exchange Act Indicate by check mark whether the registrant No ¥ Rule 12b-2). Yes n The aggregate market value of the Registrant’s Class A Common Stock held by non-affiliates of the Registrant as of July 28, 2006, the last business day of the Company’s most recent second quarter, was $732,631,650 based on the last reported sale price per share on the New York Stock Exchange on that date. As of March 27, 2007, there were 30,875,865 shares of Class A Common Stock and 690,525 shares of Convertible Class B Common Stock outstanding. DOCUMENTS INCORPORATED BY REFERENCE Portions of the proxy statement relating to the 2007 annual meeting of shareholders are incorporated by reference into the following part of this annual report: Part III — Items 10, 11, 12, 13 and 14 THE CATO CORPORATION FORM 10-K TABLE OF CONTENTS PART I Item 1. Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 1A. Risk Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 1B. Unresolved Staff Comments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Properties. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 2. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 3. Submission of Matters to a Vote of Security Holders . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 4. Item 4A. Executive Officers of the Registrant . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 3 – 7 7 – 9 9 9 9 9 10 Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 – 12 13 Selected Financial Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 6. Item 7. Management’s Discussion and Analysis of Financial Condition and Results of PART II Item 7A. Quantitative and Qualitative Disclosures about Market Risk . . . . . . . . . . . . . . . . . . . . . . . Item 8. Item 9. Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 – 20 20 Financial Statements and Supplementary Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 – 44 Changes in and Disagreements with Independent Registered Public Accounting Firm on Accounting and Consolidated Financial Disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 9A. Controls and Procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 9B. Other Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 45 45 PART III Item 10. Directors, Executive Officers and Corporate Governance . . . . . . . . . . . . . . . . . . . . . . . . . Item 11. Executive Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Security Ownership of Certain Beneficial Owners and Management and Related Item 12. Stockholder Matters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 13. Certain Relationships and Related Transactions and Director Independence . . . . . . . . . . . Principal Accountant Fees and Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 14. 45 45 46 46 46 PART IV Item 15. Exhibits and Financial Statement Schedule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47 – 56 1 Forward-looking Information The following information should be read along with the Consolidated Financial Statements, including the accompanying Notes appearing later in this report. Any of the following are “forward-looking” statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended: (1) statements in this Annual Report on Form 10-K that reflect projections or expectations of our future financial or economic performance; (2) statements that are not historical information; (3) statements of our beliefs, intentions, plans and objectives for future operations, including those contained in “Business,” “Properties,” “Legal Proceedings,” “Controls and Procedures” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations”; (4) statements relating to our operations or activities for fiscal 2007 and beyond, including, but not limited to, statements regarding expected amounts of capital expenditures and store openings, relocations, remodelings and closures; and (5) statements relating to our future contingencies. When possible, we have attempted to identify forward-looking statements by using words such as “expects,” “anticipates,” “approximates,” “believes,” “estimates,” “hopes,” “intends,” “may,” “plans,” “should” and variations of such words and similar expressions. We can give no assurance that actual results or events will not differ materially from those expressed or implied in any such forward-looking statements. Forward-looking statements included in this report are based on information available to us as of the filing date of this report, but subject to known and unknown risks, uncertainties and other factors that could cause actual results to differ materially from those contemplated by the forward-looking statements. Such factors include, but are not limited to, the following: general economic conditions; competitive factors and pricing pressures; our ability to predict fashion trends; consumer apparel buying patterns; adverse weather conditions; inventory risks due to shifts in market demand; and other factors discussed under “Risk Factors” in Part I, Item 1A of this annual report on Form 10-K for the fiscal year ended February 3, 2007 (fiscal 2006), as amended or supplemented, and in other reports we file with or furnish to the SEC from time to time. We do not undertake, and expressly decline, any obligation to update any such forward-looking information contained in this report, whether as a result of new information, future events, or otherwise. As used herein, the terms “we,” “our,” “us” (or similar terms), the “Company” or “Cato” include The Cato Corporation and its subsidiaries, except that when used with reference to common stock or other securities described herein and in describing the positions held by management of the Company, such terms include only The Cato Corporation. Our website is located at www.catocorp.com. We make available free of charge, through our website, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements and other reports (including amendments to these reports) filed or furnished pursuant to Section 13(a) or 15(d) under the Securities Exchange Act of 1934. These reports are available as soon as reasonably practicable after we electronically file those materials with the SEC. We also post on our website the charters of our Audit, Compensation and Corporate Governance and Nominating Committees; our Corporate Governance Guidelines, Code of Business Conduct and Ethics; and any amendments or waivers thereto; and any other corporate governance materials contemplated by SEC or New York Stock Exchange regulations. The documents are also available in print to any shareholder who requests by contacting our corporate secretary at our Company offices at 8100 Denmark Road, Charlotte, North Carolina 28273-5975. 2 PART I Item 1. Business: General The Company, founded in 1946, operated 1,276 women’s fashion specialty stores at February 3, 2007, in 31 states, principally in the southeastern United States, under the names “Cato,” “Cato Fashions”, “Cato Plus” and “It’s Fashion!”. The Company seeks to offer quality fashion apparel and accessories at low prices, every day in junior/missy, plus sizes and girls sizes 7 to 16. The Company’s stores feature a broad assortment of apparel and accessories, including dressy, career, and casual sportswear, dresses, coats, shoes, lingerie, costume jewelry and handbags. A major portion of the Company’s merchandise is sold under its private label and is produced by various vendors in accordance with the Company’s specifications. Most stores range in size from 3,500 to 6,000 square feet and are located primarily in strip shopping centers anchored by national discounters or market-dominant grocery stores. The Company emphasizes friendly customer service and coordinated merchandise presentations in an appealing store environment. The Company offers its own credit card and layaway plan. Credit and layaway sales represented 12% of retail sales in fiscal 2006. See Note 14 to the Consolidated Financial Statements, “Reportable Segment Information” for a discussion of information regarding the Company’s two reportable segments: retail and credit. Business The Company’s primary objective is to be the leading fashion specialty retailer for fashion and value conscious females in its markets. Management believes the Company’s success is dependent upon its ability to differentiate its stores from department stores, mass merchandise discount stores and competing women’s specialty stores. The key elements of the Company’s business strategy are: Merchandise Assortment. The Company’s stores offer a wide assortment of on-trend apparel and accessory items in junior/missy, plus sizes and girls sizes 7 to 16 and emphasize color, product coordination and selection. Colors and styles are coordinated and presented so that outfit selection is easily made. Value Pricing. The Company offers quality merchandise that is generally priced below comparable mer- chandise offered by department stores and mall specialty apparel chains, but is generally more fashionable than merchandise offered by discount stores. Management believes that the Company has positioned itself as the everyday low price leader in its market segment. Strip Shopping Center Locations. The Company locates its stores principally in convenient strip centers anchored by national discounters or market-dominant grocery stores that attract large numbers of potential customers. Customer Service. Store managers and sales associates are trained to provide prompt and courteous service and to assist customers in merchandise selection and wardrobe coordination. Credit and Layaway Programs. The Company offers its own credit card and a layaway plan to make the purchase of its merchandise more convenient for its customers. Expansion. The Company plans to continue to expand into northern, midwestern and western adjacent states, as well as to fill-in its existing southeastern core geography. Merchandising Merchandising The Company seeks to offer a broad selection of high quality and exceptional value apparel and accessories to suit the various lifestyles of fashion and value conscious females. In addition, the Company strives to offer on-trend fashion in exciting colors with consistent fit and quality. 3 The Company’s merchandise lines include dressy, career, and casual sportswear, dresses, coats, shoes, lingerie, costume jewelry and handbags. The Company primarily offers exclusive merchandise with fashion and quality comparable to mall specialty stores at low prices, every day. The collaboration of the merchandising team with an expanded in-house product development and direct sourcing function has enhanced merchandise offerings delivering quality exclusive on-trend styles at lower costs. The product development and direct sourcing operations provide research on emerging fashion and color trends, technical services and direct sourcing options. As a part of its merchandising strategy, members of the Company’s merchandising staff frequently visit selected stores, monitor the merchandise offerings of other retailers, regularly communicate with store operations associates and frequently confer with key vendors. The Company also takes aggressive markdowns on slow-selling merchandise and does not carry over merchandise to the next season. Purchasing, Allocation and Distribution Although the Company purchases merchandise from approximately 1,500 suppliers, most of its merchandise is purchased from approximately 100 primary vendors. In fiscal 2006, purchases from the Company’s largest vendor accounted for approximately 4% of the Company’s total purchases. No other vendor accounted for more than 3% of total purchases. The Company is not dependent on its largest vendor or any other vendor for merchandise purchases, and the loss of any single vendor or group of vendors would not have a material adverse effect on the Company’s operating results or financial condition. A substantial portion of the Company’s merchandise is sold under its private labels and is produced by various vendors in accordance with the Company’s strict specifications. The Company purchases most of its merchandise from domestic importers and vendors, which typically minimizes the time necessary to purchase and obtain shipments in order to enable the Company to react to merchandise trends in a more timely fashion. Although a significant portion of the Company’s merchandise is manufactured overseas, principally in the Far East, the Company does not expect that any economic, political or social unrest in any one geographic region would have a material adverse effect on the Company’s ability to obtain adequate supplies of merchandise. However, the Company can give no assurance that any changes or disruptions in its merchandise supply chain would not materially and adversely affect the Company. See “Risk Factors — Risks Relating To Our Business — Changes or other disruptions in the Company’s merchandise supply chain including those affecting the importation of goods from the foreign markets that supply a significant amount of the Company’s merchandise, could materially and adversely affect the Company’s costs and results of operations.” An important component of the Company’s strategy is the allocation of merchandise to individual stores based on an analysis of sales trends by merchandise category, customer profiles and climatic conditions. A merchandise control system provides current information on the sales activity of each merchandise style in each of the Company’s stores. Point-of-sale terminals in the stores collect and transmit sales and inventory information to the Company’s central database, permitting timely response to sales trends on a store-by-store basis. All merchandise is shipped directly to the Company’s distribution center in Charlotte, North Carolina, where it is inspected and then allocated by the merchandise distribution staff for shipment to individual stores. The flow of merchandise from receipt at the distribution center to shipment to stores is controlled by an on-line system. Shipments are made by common carrier, and each store receives at least one shipment per week. The centralization of the Company’s distribution process also subjects it to risks in the event of damage to or destruction of its distribution facility or other disruptions affecting the distribution center or the flow of goods into or out of Charlotte, North Carolina generally. See “Risk Factors — Risks Relating To Our Business — A disruption or shutdown of our centralized distribution center could materially and adversely affect our business and results of operations.” Advertising The Company uses radio, television, in store signage, graphics and a Company website as its primary advertising media. The Company’s total advertising expenditures were approximately .8% of retail sales in fiscal 2006. 4 Store Operations The Company’s store operations management team consists of 1 director of stores, 4 territorial managers, 16 regional managers and 141 district managers. Regional managers receive a salary plus a bonus based on achieving targeted goals for sales, payroll, shrinkage control and store profitability. District managers receive a salary plus a bonus based on achieving targeted objectives for district sales increases and shrinkage control. Stores are staffed with a manager, two assistant managers and additional part-time sales associates depending on the size of the store and seasonal personnel needs. Store managers receive a salary and all other store personnel are paid on an hourly basis. Store managers, assistant managers and sales associates are eligible for monthly and semi-annual bonuses based on achieving targeted goals for their store’s sales increases and shrinkage control. The Company constantly strives to improve its training programs to develop associates. Over 80% of store and field management are promoted from within, allowing the Company to internally staff an expanding store base. The Company has training programs at each level of store operations. New store managers are trained in training stores managed by experienced associates who have achieved superior results in meeting the Company’s goals for store sales, payroll expense and shrinkage control. The type and extent of district manager training varies depending on whether the district manager is promoted from within or recruited from outside the Company. All district managers receive at a minimum a one-week orientation program at the Company’s corporate office. Store Locations Most of the Company’s stores are located in the southeastern United States in a variety of markets ranging from small towns to large metropolitan areas with trade area populations of 20,000 or more. Stores range in size from 3,500 to 6,000 square feet and average approximately 3,900 square feet. All of the Company’s stores are leased. Approximately 95% are located in strip shopping centers and 5% in enclosed shopping malls. The Company locates stores in strip shopping centers anchored by a national discounter, primarily Wal-Mart Supercenters, or market-dominant grocery stores. The Company’s strip center locations provide ample parking and shopping convenience for its customers. The Company’s store development activities consist of opening new stores in new and existing markets, and relocating selected existing stores to more desirable locations in the same market area. The following table sets forth information with respect to the Company’s development activities since fiscal 2002. Fiscal Year Store Development Number of Stores Beginning of Year Number Opened Number Closed Number of Stores End of Year 2002 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2006 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 937 1,022 1,102 1,177 1,244 90 87 80 82 58 5 7 5 15 26 1,022 1,102 1,177 1,244 1,276 In Fiscal 2006 the Company relocated 20 stores and remodeled 8 stores. In Fiscal 2007 the Company plans to open approximately 90 new stores, relocate 25 stores, close up to 15 stores, and remodel 15 stores. The Company periodically reviews its store base to determine whether any particular store should be closed based on its sales trends and profitability. The Company intends to continue this review process to close underperforming stores. The 26 stores closed in 2006 were not material to the Company’s results of operations. 5 Credit and Layaway Credit Card Program The Company offers its own credit card, which accounted for 7.9%, 8.4% and 9.3% of retail sales in fiscal 2006, 2005 and 2004, respectively. The Company’s net bad debt expense was 4.1%, 7.2% and 7.3% of credit sales in fiscal 2006, 2005 and 2004, respectively. Customers applying for the Company’s credit card are approved for credit if they have a satisfactory credit record. Customers are required to make minimum monthly payments based on their account balances. If the balance is not paid in full each month, the Company assesses the customer a finance charge. If payments are not received on time, the customer is assessed a late fee. Layaway Plan Under the Company’s layaway plan, merchandise is set aside for customers who agree to make periodic payments. The Company adds a nonrefundable administrative fee to each layaway sale. If no payment is made for four weeks, the customer is considered to have defaulted, and the merchandise is returned to the selling floor and again offered for sale, often at a reduced price. All payments made by customers who subsequently default on their layaway purchase are returned to the customer upon request, less the administrative fee and a restocking fee. The Company defers recognition of layaway sales and its related fees to the accounting period when the customer picks up layaway merchandise. Layaway sales represented approximately 4% of retail sales in fiscal 2006, 2005 and 2004. Management Information Systems The Company’s systems provide daily financial and merchandising information that is used by management to enhance the timeliness and effectiveness of purchasing and pricing decisions. Management uses a daily report comparing actual sales with planned sales and a weekly ranking report to monitor and control purchasing decisions. Weekly reports are also produced which reflect sales, weeks of supply of inventory and other critical data by product categories, by store and by various levels of responsibility reporting. Purchases are made based on projected sales but can be somewhat modified to accommodate unexpected increases or decreases in demand for a particular item. Sales information is projected by merchandise category and, in some cases, is further projected and actual performance measured by stock keeping unit (SKU). Merchandise allocation models are used to distribute merchandise to individual stores based upon historical sales trends, climatic differences, customer demographic differences and targeted inventory turnover rates. Competition The women’s retail apparel industry is highly competitive. The Company believes that the principal com- petitive factors in its industry include merchandise assortment and presentation, fashion, price, store location and customer service. The Company competes with retail chains that operate similar women’s apparel specialty stores. In addition, the Company competes with mass merchandise chains, discount store chains and major department stores. The Company expects its stores in larger cities and metropolitan areas to face more intense competition. Seasonality Due to the seasonal nature of the retail business, the Company has historically experienced and expects to continue to experience seasonal fluctuations in its revenues, operating income and net income. A disproportionate amount of the Company’s revenues and a substantial amount of the Company’s operating and net income are realized during the first and fourth quarters. Results of a period shorter than a full year may not be indicative of results expected for the entire year. Furthermore, the seasonal nature of our business may affect comparisons between periods. 6 Regulation A variety of laws affect the revolving credit program offered by the Company. The Federal Consumer Credit Protection Act (Truth-in Lending) and Regulation Z promulgated thereunder require written disclosure of information relating to such financing, including the amount of the annual percentage rate and the finance charge. The Federal Fair Credit Reporting Act also requires certain disclosures to potential customers concerning credit information used as a basis to deny credit. The Federal Equal Credit Opportunity Act and Regulation B promulgated thereunder prohibit discrimination against any credit applicant based on certain specified grounds. The Federal Trade Commission has adopted or proposed various trade regulation rules dealing with unfair credit and collection practices and the preservation of consumers’ claims and defenses. The Company is also subject to the U.S. Patriot Act and the Bank Secrecy Act, which require the Company to monitor account holders and account transactions, respectively. Additionally, the Gramm-Leach-Bliley Act requires the Company to disclose, initially and annually, to its customers, the Company’s privacy policy as it relates to a customer’s non-public personal information. Associates As of February 3, 2007, the Company employed approximately 10,400 full-time and part-time associates. The Company also employs additional part-time associates during the peak retailing seasons. The Company is not a party to any collective bargaining agreements and considers its associate relations to be good. Item 1A. Risk Factors: An investment in our common stock involves numerous types of risks. You should carefully consider the following risk factors, in addition to the other information contained in this report, including the disclosures under “Forward Looking Information” above in evaluating our Company and any potential investment in our common stock. If any of the following risks or uncertainties occurs, our business, financial condition and operating results could be materially and adversely affected, the trading price of our common stock could decline and you could lose all or a part of your investment in our common stock. The risks and uncertainties described in this section are not the only ones facing us. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also materially and adversely affect our business operating results and financial condition. Risks Relating To Our Business: If we are unable to anticipate, identify and respond to rapidly changing fashion trends and customer demands in a timely manner, our business and results of operations could materially suffer. Customer tastes and fashion trends, particularly for women’s apparel, are volatile and tend to change rapidly. Our success depends in part upon our ability to anticipate and respond to changing merchandise trends and consumer preferences in a timely manner. Accordingly, any failure by us to anticipate, identify and respond to changing fashion trends could adversely affect consumer acceptance of our merchandise, which in turn could adversely affect our business and our image with our customers. If we miscalculate either the market for our merchandise or our customers’ tastes or purchasing habits, we may be required to sell a significant amount of unsold inventory at below average markups over cost, or below cost, which would adversely affect our margins and results of operations. Unusual weather, natural disasters or similar events may adversely affect our sales or operations. Extreme changes in weather patterns or natural disasters can influence customer trends and shopping habits. For example, heavy rainfall or other extreme weather conditions over a prolonged period might make it difficult for our customers to travel to our stores and thereby reduce our sales and profitability. Our business is also susceptible to unseasonable weather conditions. For example, extended periods of unseasonably warm temperatures during the winter season or cool weather during the summer season could render a portion of our inventory incompatible with those unseasonable conditions. Reduced sales from extreme or prolonged unseasonable weather conditions would adversely affect our business. Extreme weather patterns, natural disasters, power outages, terrorist acts or other catastrophic events could reduce customer traffic in our stores and likewise disrupt our ability to conduct operations, which could materially and adversely affect us. 7 Changes or other disruptions in the Company’s merchandise supply chain, including those affecting the pricing or importation of goods from the foreign markets that supply a significant amount of the Company’s merchandise, could materially and adversely affect the Company’s costs and results of operations. A significant amount of our merchandise is manufactured overseas, principally in the Far East. As a result, political instability or other events resulting in the disruption of trade from other countries or the imposition of additional regulations relating to or duties on imports could cause significant delays or interruptions in the supply of our merchandise or increase our costs, either of which could have a material adverse effect on our business. If we are forced to source merchandise from other countries, those goods may be more expensive or of a different or inferior quality from the ones we now sell. If we were not able to timely or adequately replace the merchandise we currently source with merchandise produced elsewhere, our business could be adversely affected. Our costs are affected by foreign currency fluctuations. Because we purchase a significant portion of our inventory from foreign suppliers, our cost of these goods is affected by the fluctuation of the local currencies where these goods are produced against the dollar. Accordingly, changes in the value of the dollar relative to foreign currencies may increase our cost of goods sold and, if we are unable to pass such cost increases on to our customers, decrease our gross margins and ultimately our earnings. Accordingly, foreign currency fluctuations may have a material adverse effect on our business, financial condition and results of operations. An actual or perceived decline in general economic conditions or outlook may reduce consumer demand for our apparel and accessories. Consumer spending habits, including spending for our apparel and accessories, are affected by, among other things, prevailing economic conditions, levels of employment, fuel and energy costs, salaries and wage rates, tax rates, the availability of consumer credit, consumer confidence generally or consumer perceptions of economic conditions or trends. A general slowdown in the United States economy or a negative or uncertain economic outlook may adversely affect consumer spending habits, which may result in lower net sales. Numerous events, whether or not related to actual economic conditions, such as downturns in the stock markets, acts of war or terrorism, political unrest or natural disasters, or similar events, may dampen consumer confidence, and accordingly lead to reduced consumer spending. A prolonged economic downturn or loss of consumer confidence could have a material adverse effect on our business, results of operations and financial condition. A disruption or shutdown of our centralized distribution center could materially and adversely affect our business and results of operations. The distribution of our products is centralized in one distribution center in Charlotte, North Carolina. The merchandise we purchase is shipped directly to our distribution center where it is prepared for shipment to the appropriate stores. If the distribution center were to be shut down or lose significant capacity for any reason, our operations would likely be seriously disrupted. Such problems could occur as the result of any loss, destruction or impairment of our ability to use our distribution center, as well as any broader problem generally affecting the ability to ship goods into or out of the Charlotte metropolitan area. As a result, we could incur significantly higher costs and longer lead times associated with distributing our products to our stores during the time it takes for us to reopen or replace the distribution center. A delay in the successful opening of the number of new stores we have planned could adversely affect our business and results of operations. Our ability to open and operate new stores depends on many factors including our ability to identify suitable store locations, negotiate acceptable lease terms, and hire and train appropriate store personnel. In addition, we continue to expand our operations to new regions of the country where we have not done business before. This expansion may present new challenges in competition, distribution and merchandising as we enter these new markets. 8 Risks Relating To Our Common Stock: Our operating results are subject to seasonal and quarterly fluctuations, which could adversely affect the market price of our common stock. Our business varies with general seasonal trends that are characteristic of the retail apparel industry. As a result, our stores typically generate a higher percentage of our annual net sales and profitability in the first quarter of our fiscal year compared to other quarters. Such seasonal and quarterly fluctuations could adversely affect the market price of our common stock. The interests of a principal shareholder may limit the ability of other shareholders to influence the direction of the Company. As of March 27, 2007, John P. D. Cato, Chairman, President and Chief Executive Officer, beneficially controlled approximately 37% of the voting power of our common stock. As a result, Mr. Cato may be able to control or significantly influence substantially all matters requiring approval by the shareholders including the election of directors and the approval of mergers and other business combinations. Mr. Cato may have interests that differ from those of other shareholders, and may vote in a way with which other shareholders disagree or perceive as adverse to their interests. In addition, the concentration of voting power held by Mr. Cato could have the effect of preventing, discouraging or deferring a change in control of the Company, which could depress the market price of our common stock. Item 1B. Unresolved Staff Comments: None Item 2. Properties: The Company’s distribution center and general offices are located in a Company-owned building of approximately 492,000 square feet located on a 15-acre tract in Charlotte, North Carolina. The Company’s automated merchandise handling and distribution activities occupy approximately 418,000 square feet of this building and its general offices and corporate training center are located in the remaining 74,000 square feet. A building of approximately 24,000 square feet located on a 2-acre tract adjacent to the Company’s existing location is used for receiving and staging shipments prior to processing. Substantially all of the Company’s retail stores are leased from unaffiliated parties. Most of the leases have an initial term of five years, with two to three five-year renewal options. Many of the leases provide for fixed rentals plus a percentage of sales in excess of a specified volume. Item 3. Legal Proceedings: From time to time, claims are asserted against the Company arising out of operations in the ordinary course of business. The Company currently is not a party to any pending litigation that it believes is likely to have a material adverse effect on the Company’s financial position or results of operations. Item 4. Submission of Matters to a Vote of Security Holders: None. 9 Item 4A. Executive Officers of the Registrant: The executive officers of the Company and their ages as of March 31, 2007 are as follows: Name Age Position John P. D. Cato . . . . . . . . . . . . . . . . . . . Michael T. Greer . . . . . . . . . . . . . . . . . . 56 Chairman, President and Chief Executive Officer 44 Executive Vice President, Director of Stores Howard A. Severson . . . . . . . . . . . . . . . 59 Executive Vice President, Chief Real Estate and Store Development Officer Thomas W. Stoltz . . . . . . . . . . . . . . . . . 46 Executive Vice President, Chief Financial Officer Stuart L. Uselton . . . . . . . . . . . . . . . . . . 46 Executive Vice President, Chief Administrative Officer B. Allen Weinstein . . . . . . . . . . . . . . . . 60 Executive Vice President, Chief Merchandising Officer John P. D. Cato has been employed as an officer of the Company since 1981 and has been a director of the Company since 1986. Since January 2004, he has served as Chairman, President and Chief Executive Officer. From May 1999 to January 2004, he served as President, Vice Chairman of the Board and Chief Executive Officer. From June 1997 to May 1999, he served as President, Vice Chairman of the Board and Chief Operating Officer. From August 1996 to June 1997, he served as Vice Chairman of the Board and Chief Operating Officer. From 1989 to 1996, he managed the Company’s off-price division, serving as Executive Vice President and as President and General Manager of the It’s Fashion! Division from 1993 to August 1996. Mr. John Cato is currently a director of Ruddick Corporation. Michael T. Greer has been employed by the Company since 1985. Since May 2006, he has served as Executive Vice President, Director of Stores of the Company. From November 2004, until May 2006, he served as Senior Vice President, Director of Stores of the Company. From February 2004 until November 2004, he served as Senior Vice President, Director of Stores of the Cato Division. From 2002 to 2003 Mr. Greer served as Vice President, Director of Stores of the It’s Fashion! Division. From 1999 to 2001 he served as Territorial Vice President of Stores of the Cato Division and from 1996 to 1999 he served as Regional Vice President of Stores of the Cato Division. From 1985 to 1995, Mr. Greer held various store operational positions in the Cato Division. Howard A. Severson has been employed by the Company since 1985. Since January 1993, he has served as Executive Vice President, Chief Real Estate and Store Development Officer and Assistant Secretary. From 1993 to 2001 Mr. Severson also served as a director. From August 1989 through January 1993, Mr. Severson served as Senior Vice President — Chief Real Estate Officer. Thomas W. Stoltz joined the Company as Executive Vice President, Chief Financial Officer in December 2006. From 2000 through 2006, he was employed by Citi Trends, Inc., a specialty retailer, as Chief Financial Officer. From 1999 to 2000, he was employed by Sharon Luggage and Gifts, a luggage and gift retailer, as Chief Financial Officer. From 1996 through 1998, he was employed by Factory Card Outlet Corp, a card specialty retailer, as Chief Financial Officer. From 1994 to 1996, he was employed by Dollar General Corp, a discount retailer, as Interim Chief Financial Officer and Corporate Controller. Stuart L. Uselton joined the Company as Vice President, Tax and Treasury in July 2000. Since November 2006, he has served as Executive Vice President, Chief Administrative Officer. From 1991 to 2000, he was employed by Tractor Supply Company, a supply specialty retailer, as Director of Tax and Assistant Treasurer. From 1984 to 1991, he was employed by Deloitte & Touche LLP, as a Tax Manager. B. Allen Weinstein joined the Company as Executive Vice President, Chief Merchandising Officer of the Cato Division in August 1997. Since November 2004, he has served as Executive Vice President, Chief Merchandising Officer of the Company. From 1995 to 1997, he was Senior Vice President — Merchandising of Catherines Stores Corporation. From 1981 to 1995, he served as Senior Vice President of Merchandising for Beall’s, Inc. 10 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities: Market & Dividend Information The Company’s Class A Common Stock trades on the New York Stock Exchange (“NYSE”) under the symbol CTR. As required by Section 3.03A.12(a) of the NYSE listing standards, The Cato Corporation filed with the NYSE the annual certification of its Chief Executive Officer that he is not aware of any violation by the Company of NYSE corporate governance listing standards. Below is the market range and dividend information for the four quarters of fiscal 2006 and 2005 which have been adjusted for a three-for-two stock split in the form of a stock dividend of the Company’s Class A and Class B Common Stock effected June 27, 2005. 2006 Price High Low Dividend First quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $23.86 26.25 Second quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25.52 Third quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24.94 Fourth quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $19.80 21.86 21.91 21.70 $.13 .15 .15 .15 2005 Price High Low Dividend First quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $22.17 21.80 Second quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21.45 Third quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23.35 Fourth quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $17.09 17.07 18.51 19.52 $.117 .13 .13 .13 As of March 27, 2007 the approximate number of record holders of the Company’s Class A Common Stock was 1,430 and there was 1 record holder of the Company’s Class B Common Stock. The Board of Directors had authorized the repurchase of 7,581,025 shares from time to time when, in the opinion of management, market conditions warrant. No shares were repurchased in the fiscal year ended February 3, 2007, while 1,556,775 shares remain open to purchase pursuant to this authorization. 11 Stock Performance Graph The following graph compares the yearly change in the Company’s cumulative total shareholder return on the Company’s Common Stock (which includes Class A Stock and Class B Stock) for each of the Company’s last five fiscal years with (i), the Dow Jones U.S. Retailers Apparel Index and (ii) the Russell 2000 Index. The Cato Corporation Stock Performance Graph 250 200 150 100 50 2/1/2002 1/31/2003 1/30/2004 1/28/2005 1/27/2006 2/2/2007 The Cato Corporation Dow Jones U.S. Retailers, Apparel Index Russell 2000 Index THE CATO CORPORATION STOCK PERFORMANCE TABLE (BASE 100 — IN DOLLARS) LAST TRADING DAY OF THE FISCAL YEAR THE CATO CORPORATION DOW JONES U.S. RETAILERS APPL INDEX RUSSELL 2000 INDEX 2/01/02 1/31/03 1/30/04 1/28/05 1/27/06 2/02/07 100 88 103 148 160 169 100 87 116 140 160 193 100 79 124 133 160 179 The graph assumes an initial investment of $100 on February 1, 2002, the last trading day prior to the commencement of the Company’s 2002 fiscal year, and that all dividends were reinvested. 12 Item 6. Selected Financial Data: Certain selected financial data for the five fiscal years ended February 3, 2007 have been derived from the Company’s audited financial statements. The financial statements and Independent Registered Public Accounting Firm’s reports for the three most recent fiscal years are contained elsewhere in this report. All data set forth below are qualified by reference to, and should be read in conjunction with, the Company’s Consolidated Financial Statements (including the Notes thereto) and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere in this annual report. The five-year selected consolidated financial data presented in this Item 6 has been adjusted to reflect a three-for-two stock split in the form of a stock dividend of the Company’s Class A and Class B Common Stock effected June 27, 2005. Fiscal Year STATEMENT OF OPERATIONS DATA: Retail sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . Other income . . . . . . . . . . . . . . . . . . . . . . . . . . Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . Cost of goods sold (exclusive of depreciation shown below) . . . . . . . . . . . . . . . . . . . . . . . . Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . Gross margin percent . . . . . . . . . . . . . . . . . . . . Selling, general and administrative . . . . . . . . . . Selling, general and administrative percent of retail sales . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . Interest and other income . . . . . . . . . . . . . . . . . Income before income taxes . . . . . . . . . . . . . . . Income tax expense . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . Basic earnings per share . . . . . . . . . . . . . . . . . . Diluted earnings per share . . . . . . . . . . . . . . . . Cash dividends paid per share . . . . . . . . . . . . . . SELECTED OPERATING DATA: Stores open at end of year. . . . . . . . . . . . . . . . . Average sales per store(1) . . . . . . . . . . . . . . . . . Average sales per square foot of selling space . . Comparable store sales increase (decrease) . . . . BALANCE SHEET DATA (at period end): Cash, cash equivalents and short-term investments. . . . . . . . . . . . . . . . . . . . . . . . . . Working capital . . . . . . . . . . . . . . . . . . . . . . . . Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . Total stockholders’ equity . . . . . . . . . . . . . . . . . 2006 2004 (Dollars in thousands, except per share data and selected operating data) 2002 2005 2003 $862,813 13,072 875,885 $821,639 14,742 836,381 $773,809 15,795 789,604 $731,770 15,497 747,267 $732,742 15,589 748,331 572,712 290,101 546,955 274,684 528,916 244,893 508,991 222,779 496,954 235,788 33.6% 33.4% 31.6% 30.4% 32.2% 212,157 203,156 187,618 174,202 168,914 24.6% 24.7% 24.2% 23.8% 23.1% 20,941 41 (9,597) 79,631 28,181 $ 51,450 1.64 $ 1.62 $ .58 $ 20,275 183 (4,563) 70,375 25,546 $ 44,829 1.44 $ 1.41 $ .507 $ 20,397 717 (2,739) 54,695 19,854 $ 34,841 1.13 $ 1.11 $ .457 $ 18,695 306 (3,614) 48,687 17,673 $ 31,014 .89 $ .88 $ .42 $ 14,913 21 (3,701) 71,230 25,785 $ 45,445 1.19 $ 1.17 $ .39 $ 1,276 $685,000 175 $ 1,244 $684,000 173 $ 1,177 $682,000 170 $ 1,102 $692,000 171 $ 1,022 $753,000 184 $ (2)% 1% 0% (7)% 0% $123,542 176,464 432,322 276,793 $107,819 139,114 406,636 239,948 $107,228 136,980 397,323 211,175 $ 71,402 117,403 356,284 186,075 $106,936 166,264 387,272 262,505 (1) Calculated using actual sales volume for stores open for the full year and an estimated annual sales volume for new stores opened during the year. (2) The fiscal year ended February 3, 2007 contained 53 weeks versus 52 weeks in the prior fiscal years 2005-2002. 13 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations: Results of Operations The table below sets forth certain financial data of the Company expressed as a percentage of retail sales for the years indicated: Fiscal Year Ended February 3, 2007 January 28, 2006 January 29, 2005 Retail sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Selling, general and administrative . . . . . . . . . . . . . . . . . . . . Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest and other income . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100.0% 1.5 101.5 66.4 24.6 2.4 0.0 (1.1) 9.2 6.0% 100.0% 1.8 101.8 66.6 24.7 2.5 0.0 (0.6) 8.6 5.5% 100.0% 2.0 102.0 68.4 24.2 2.6 0.1 (0.4) 7.1 4.5% Fiscal 2006 Compared to Fiscal 2005 Retail sales increased by 5% to $862.8 million in fiscal 2006 compared to $821.6 million in fiscal 2005. The fiscal year ended February 3, 2007 contained 53 weeks versus 52 weeks in fiscal year ended January 28, 2006. The increase in retail sales in fiscal 2006 was attributable to sales from new stores and the additional week. The additional week in fiscal 2006 increased total sales by $17.2 million for the year. On an equivalent 53 week basis, comparable stores decreased 2% from the prior year. Total revenues, comprised of retail sales and other income (principally finance charges and late fees on customer accounts receivable and layaway fees), increased by 5% to $875.9 million in fiscal 2006 compared to $836.4 million in fiscal 2005. The Company operated 1,276 stores at February 3, 2007 compared to 1,244 stores operated at January 28, 2006. In fiscal 2006, the Company opened 58 new stores, relocated 20 stores, remodeled 8 stores and closed 26 stores. Credit revenue of $10.9 million represented 1.2% of total revenue in fiscal 2006. This is comparable to 2005 credit revenue of $12.7 million or 1.5% of total revenue. The decrease in credit revenue was primarily due to reductions in finance charge income and late fee income as a result of lower accounts receivable balances and a higher percentage of accounts current. Credit revenue is comprised of interest earned on the Company’s private label credit card portfolio and related fee income. Related expenses include principally bad debt expense, payroll, postage and other administrative expenses and totaled $5.9 million in fiscal 2006 compared to $7.9 million in fiscal 2005. The decrease in these expenses was principally due to lower bad debt expense in fiscal 2006. See Note 14 of the Consolidated Financial Statements for a schedule of credit related expenses. Total credit income before taxes increased $0.2 million from $4.7 million in 2005 to $4.9 million in 2006 due to decreased bad debt expense. Total credit income of $4.9 million in 2006 represented 6.1% of total income before taxes of $79.6 million. Other income in total, as included in total revenues in fiscal 2006, decreased slightly to $13.1 million from $14.7 million in fiscal 2005. The decrease resulted primarily from a decrease in finance and late charges. Cost of goods sold was $572.7 million, or 66.4% of retail sales, in fiscal 2006 compared to $547.0 million, or 66.6% of retail sales, in fiscal 2005. The decrease in cost of goods sold as a percent of retail sales resulted primarily from lower procurement costs and reduced markdowns. The reduction in procurement costs is primarily the result of increased direct sourcing and the reduction in markdowns is primarily due to improved inventory control and increased sales of regular priced merchandise. Cost of goods sold includes merchandise costs, net of discounts and allowances, buying costs, distribution costs, occupancy costs, freight and inventory shrinkage. Net merchandise costs and in-bound freight are capitalized as inventory costs. Buying and distribution costs include payroll, payroll- related costs and operating expenses for the buying departments and distribution center. Occupancy expenses 14 include rent, real estate taxes, insurance, common area maintenance, utilities and maintenance for stores and distribution facilities. Total gross margin dollars (retail sales less cost of goods sold) increased by 6% to $290.1 million in fiscal 2006 from $274.7 million in fiscal 2005. Gross margin as presented may not be comparable to those of other companies. Selling, general and administrative expenses (SG&A), which primarily include corporate and store payroll, related payroll taxes and benefits, insurance, supplies, advertising, bank and credit card processing fees and bad debts were $212.2 million in fiscal 2006 compared to $203.2 million in fiscal 2005, an increase of 4%. As a percent of retail sales, SG&A was 24.6% compared to 24.7% in the prior year. The overall dollar increase in SG&A resulted primarily from increased salary expense driven by store development, offset by a decrease in incentive based compensation expenses. Depreciation expense was $20.9 million in fiscal 2006 compared to $20.3 million in fiscal 2005. The depreciation expense in fiscal 2006 and 2005 resulted primarily from the Company’s store development activity and investment in technology. Interest expense was $0.0 million in fiscal 2006 compared to $0.2 million in fiscal 2005. The decline was attributable to the early retirement of the remaining balance of $20.5 million on the Company’s unsecured loan facility, paid on April 5, 2005. Interest and other income was $9.6 million in fiscal 2006 compared to $4.6 million in fiscal 2005. The increase in fiscal 2006 resulted primarily from higher interest rates, settlement of insurance claims for losses attributable to hurricanes during the third quarter of fiscal 2005 of $2.4 million received in the fourth quarter of fiscal 2006, and a refund settlement on third-party credit card fees of $0.5 million received in the second quarter of fiscal 2006. Income tax expense was $28.2 million, or 3.2% of retail sales in fiscal 2006 compared to $25.5, or 3.1% of retail sales in fiscal 2005. The increase resulted from higher pre-tax income, partially offset by a reduction in the effective tax rate. The effective tax rate was 35.4% in fiscal 2006 and 36.3% in fiscal 2005. The Company expects the effective rate in 2007 to be approximately 35.7%. Fiscal 2005 Compared to Fiscal 2004 Retail sales increased by 6% to $821.6 million in fiscal 2005 compared to $773.8 million in fiscal 2004. Total revenues increased by 6% to $836.4 million in fiscal 2005 compared to $789.6 million in fiscal 2004. The Company operated 1,244 stores at January 28, 2006 compared to 1,177 stores operated at January 29, 2005. The increase in retail sales in fiscal 2005 was attributable to sales from new stores and increased sales in comparable stores (open more than 15 months) of 1%. In fiscal 2005, the Company increased its number of stores 6% by opening 82 new stores, relocating 16 stores, remodeling 9 stores and closing 15 stores. Credit revenues decreased $1.5 million from $14.2 million in 2004 to $12.7 million in 2005 mainly due to decreased finance charges and late fees. Credit revenues represented 1.5% of total revenues in 2005 and 1.8% in 2004. Related expenses totaled $7.9 million in 2005 compared to $8.7 million in 2004 principally due to lower bad debt expenses in 2005. Total credit income before taxes decreased $0.7 million from $5.4 million in 2004 to $4.7 million in 2005 as a result of the decreased revenues, partially offset by decreased bad debt expense. Total credit income of $4.7 million in 2005 represented 6.7% of total income before taxes of $70.4 million. Other income in total, as included in total revenues in fiscal 2005, decreased slightly to $14.7 million from $15.8 million in fiscal 2004. The decrease resulted primarily from a decrease in finance and late charges. Cost of goods sold was $547.0 million, or 66.6% of retail sales, in fiscal 2005 compared to $528.9 million, or 68.4% of retail sales, in fiscal 2004. The decrease in cost of goods sold as a percent of retail sales resulted primarily from lower procurement costs and reduced markdowns. SG&A expenses were $203.2 million in fiscal 2005 compared to $187.6 million in fiscal 2004, an increase of 8%. As a percent of retail sales, SG&A was 24.7% compared to 24.2% in the prior year. The overall increase in SG&A resulted primarily from increased incentive and discretionary bonuses and increased infrastructure expenses attributable to the Company’s store development activities. 15 Depreciation expense was $20.3 million in fiscal 2005 compared to $20.4 million in fiscal 2004. The depreciation expense in fiscal 2005 and 2004 resulted primarily from the Company’s store development activity. Interest and other income was $4.6 million in fiscal 2005 compared to $2.7 million in fiscal 2004. The increase in fiscal 2005 resulted primarily from higher interest rates earned on short-term investments. Income tax expense was $25.5 million, or 3.1% of retail sales in fiscal 2005 compared to $19.9 million, or 2.6% of retail sales in fiscal 2004. The increase resulted from higher pre-tax income. During the third quarter of fiscal 2005, the Company revised its process for determining the amount of accounts receivable that should be written off each period. This change in process was consistent with industry and regulatory guidelines and resulted in an acceleration of accounts receivable write-off of approximately $1,700,000. This write-off reduced the gross Accounts Receivable balance and the Allowance for Doubtful Accounts in the third quarter of 2005. Accordingly, this change in process had no effect on the prior period’s earnings or the current year and management does not expect that the change will have a material effect on the Company’s future earnings or financial position. Off Balance Sheet Arrangements Other than operating leases in the ordinary course of business, the Company is not a party to any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on the Company’s financial condition, revenues, expenses, results of operations, liquidity, capital expenditures or capital resources. Critical Accounting Policies The Company’s accounting policies are more fully described in Note 1 to the Consolidated Financial Statements. As disclosed in Note 1 of Notes to Consolidated Financial Statements, the preparation of the Company’s financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results inevitably will differ from those estimates, and such differences may be material to the financial statements. The most significant accounting estimates inherent in the preparation of the Company’s financial statements include the allowance for doubtful accounts receivable, reserves relating to workers’ compensation, general and auto insurance liabilities, reserves for inventory markdowns, calculation of asset impairment, shrinkage accrual and reserves for uncertain tax positions. The Company’s critical accounting policies and estimates are discussed with the Audit Committee. Allowance for Doubtful Accounts The Company evaluates the collectibility of accounts receivable and records an allowance for doubtful accounts based on estimates of actual write-offs and the accounts receivable aging roll rates over a period of up to 12 months. The allowance is reviewed for adequacy and adjusted, as necessary, on a monthly basis. The Company also provides for estimated uncollectible late fees charged based on historical write-offs. The Company’s financial results can be significantly impacted by changes in bad debt write-off experience and the aging of the accounts receivable portfolio. During the third quarter of fiscal 2005, the Company revised its process for determining the amount of accounts receivable that should be written off each period. This change in process was consistent with industry and regulatory guidelines and resulted in an acceleration of accounts receivable write-off of approximately $1,700,000. This write-off reduced the gross accounts receivable balance and the Allowance for Doubtful Accounts in the third quarter of 2005. Accordingly, this change in process had no effect on the period’s earnings and management does not expect that the change will have a material effect on the Company’s future earnings or financial position. Merchandise Inventories The Company’s inventory is valued using the retail method of accounting and is stated at the lower of cost (first-in, first-out method) or market. Under the retail inventory method, the valuation of inventory at cost and 16 resulting gross margin are calculated by applying an average cost to retail ratio to the retail value of inventory. The retail inventory method is an averaging method that has been widely used in the retail industry. Inherent in the retail method are certain significant estimates, including initial merchandise markup, markdowns and shrinkage, which significantly impact the ending inventory valuation at cost and the resulting gross margins. Physical inventories are conducted throughout the year to calculate actual shrinkage and inventory on hand. Estimates based on actual shrinkage results are used to estimate inventory shrinkage, which is accrued for the period between the last inventory and the financial reporting date. The Company continuously reviews its inventory levels to identify slow moving merchandise and uses markdowns to clear slow moving inventory. The general economic environment for retail apparel sales could result in an increase in the level of markdowns, which would result in lower inventory values and increases to cost of goods sold as a percentage of net sales in future periods. Management makes estimates regarding markdowns based on inventory levels on hand and customer demand, which may impact inventory valuations. Markdown exposure with respect to inventories on hand is limited due to the fact that seasonal merchandise is not carried forward. Historically, actual results have not significantly deviated from those determined using the estimates described above. Lease Accounting The Company recognizes rent expense on a straight-line basis over the lease term as defined in SFAS No. 13, “Accounting for Leases”. Our lease agreements generally provide for scheduled rent increases during the lease term or rent holidays, including rental payments commencing at a date other than the date of initial occupancy. We include any rent escalation and rent holidays in our straight-line rent expense. In addition, we record landlord allowances for normal tenant improvements as deferred rent, which is included in other noncurrent liabilities in the consolidated balance sheets. This deferred rent is amortized over the lease term as a reduction of rent expense. Also, leasehold improvements are amortized using the straight-line method over the shorter of their estimated useful lives or the related lease term. See Note 1 to the Consolidated Financial Statements for further information on the Company’s accounting for its leases. Impairment of Long-Lived Assets The Company primarily invests in property and equipment in connection with the opening and remodeling of stores and in computer software and hardware. The Company periodically reviews its store locations and estimates the recoverability of its assets, recording an impairment charge, if necessary, when the Company decides to close the store or otherwise determines that future undiscounted cash flows associated with those assets will not be sufficient to recover the carrying value. This determination is based on a number of factors, including the store’s historical operating results and cash flows, estimated future sales growth, real estate development in the area and perceived local market conditions that can be difficult to predict and may be subject to change. In addition, the Company regularly evaluates its computer-related and other long-lived assets and may accelerate depreciation over the revised useful life if the asset is expected to be replaced or has limited future value. When assets are retired or otherwise disposed of, the cost and related accumulated depreciation or amortization are removed from the accounts, and any resulting gain or loss is reflected in income for that period. Insurance Liabilities The Company is primarily self-insured for health care, workers’ compensation and general liability costs. These costs are significant primarily due to the large number of the Company’s retail locations and employees. The Company’s self-insurance liabilities are based on the total estimated costs of claims filed and estimates of claims incurred but not reported, less amounts paid against such claims, and are not discounted. Management reviews current and historical claims data in developing its estimates. The Company also uses information provided by outside actuaries with respect to workers’ compensation and general liability claims. If the underlying facts and circumstances of the claims change or the historical experience upon which insurance provisions are recorded is not indicative of future trends, then the Company may be required to make adjustments to the provision for insurance costs that could be material to the Company’s reported financial condition and results of operations. Historically, actual results have not significantly deviated from estimates. 17 Tax Reserves The Company records liabilities for uncertain tax positions principally related to state income taxes. These liabilities reflect the Company’s best estimate of its ultimate income tax liability based on the tax code, regulations, and pronouncements of the jurisdictions in which we do business. Estimating our ultimate tax liability involves significant judgments regarding the application of complex tax regulations across many jurisdictions. Despite our belief that our estimates and judgments are reasonable, differences between our estimated and actual tax liabilities could exist. These differences may arise from settlements of tax audits, expiration of the statute of limitations, or the evolution and application of the various jurisdictional tax codes and regulations. Any differences will be recorded in the period in which they become known and could have a material effect on the results of operations in the period the adjustment is recorded. Revenue Recognition While the Company’s recognition of revenue is predominantly derived from routine retail transactions and does not involve significant judgement, revenue recognition represents an important accounting policy of the Company. As discussed in Note 1 to the Consolidated Financial Statements, the Company recognizes sales at the point of purchase when the customer takes possession of the merchandise and pays for the purchase, generally with cash or credit. Sales from purchases made with Cato credit, gift cards and layaway sales are also recorded when the customer takes possession of the merchandise. Gift cards, layaway deposits and merchandise credits granted to customers are recorded as deferred revenue until they are redeemed or forfeited. A provision is made for estimated product returns based on sales volumes and the Company’s experience; actual returns have not varied materially from amounts provided historically. Credit revenue on the Company’s private label credit card portfolio is recognized as earned under the interest method. Late fees are recognized as earned, less provisions for estimated uncollectible fees. Liquidity, Capital Resources and Market Risk The Company has consistently maintained a strong liquidity position. Cash provided by operating activities during fiscal 2006 was $58.7 million as compared to $70.9 million in fiscal 2005. These amounts have enabled the Company to fund its regular operating needs, capital expenditure program, cash dividend payments and any repurchase of the Company’s common stock. In addition, the Company maintains $35 million of unsecured revolving credit facilities for short-term financing of seasonal cash needs, none of which was outstanding at February 3, 2007. Cash provided by operating activities for these periods was primarily generated by earnings adjusted for depreciation, deferred taxes, and changes in working capital. The decrease of $12.2 million for fiscal 2006 over fiscal 2005 is primarily due to a higher payables reduction offset by a decrease in prepaid expenses, other assets and the increase in net earnings of $6.6 million. The Company believes that its cash, cash equivalents and short-term investments, together with cash flows from operations and borrowings available under its revolving credit agreement, will be adequate to fund the Company’s proposed capital expenditures, dividends, purchase of treasury stock and other operating requirements for fiscal 2007 and for the foreseeable future. At February 3, 2007, the Company had working capital of $176.5 million compared to $139.1 million at January 28, 2006. Additionally, the Company had $1.9 million invested in privately managed investment funds at February 3, 2007, which are reported under other noncurrent assets of the consolidated balance sheets. At February 3, 2007, the Company had an unsecured revolving credit agreement, which provided for borrowings of up to $35 million. The revolving credit agreement is committed until August 2008. The credit agreement contains various financial covenants and limitations, including the maintenance of specific financial ratios with which the Company was in compliance as of February 3, 2007. There were no borrowings outstanding under these credit facilities during the fiscal year ended February 3, 2007 or the fiscal year ended January 28, 2006. 18 On August 22, 2003, the Company entered into a new unsecured $30 million five-year term loan facility, the proceeds of which were used to purchase Class B Common Stock from the Company’s founders. Payments were due in monthly installments of $500,000 plus accrued interest based on LIBOR. On April 5, 2005, the Company repaid the remaining balance of $20.5 million on this loan facility with no early prepayment penalty. With the early retirement of this loan, the Company had no outstanding debt as of February 3, 2007 or January 28, 2006. The Company had approximately $4.5 million and $2.8 million at February 3, 2007 and January 28, 2006, respectively, of outstanding irrevocable letters of credit relating to purchase commitments. Expenditures for property and equipment totaled $27.5 million, $28.5 million and $25.3 million in fiscal 2006, 2005 and 2004, respectively. The expenditures for fiscal 2006 were primarily for store development, store remodels and investments in new technology. In fiscal 2007, the Company is planning to invest approximately $30 million in capital expenditures. This includes expenditures to open 90 new stores, relocate 20 stores and close up to 15 stores. In addition, the Company plans to remodel 15 stores and has planned for additional investments in technology scheduled to be implemented over the next 12 months. Net cash used in investing activities totaled $40.0 million for fiscal 2006 compared to $26.0 million used for the comparable period of 2005. The increase was due primarily to an increase in purchases of short-term investments, offset by an increase of sales of short-term investments. On May 25, 2006, the Board of Directors increased the quarterly dividend by 15% from $.13 per share to $.15 per share, or an annualized rate of $.60 per share. The Company does not use derivative financial instruments. At February 3, 2007, the Company’s investment portfolio was primarily invested in governmental and other debt securities with maturities less than 36 months. These securities are classified as available-for-sale and are recorded on the balance sheet at fair value, with unrealized gains and temporary losses reported net of taxes as accumulated other comprehensive income. Other than temporary declines in fair value of investments are recorded as a reduction in the cost of investments in the accompanying Consolidated Balance Sheets. The following table shows the Company’s obligations and commitments as of February 3, 2007, to make future payments under noncancellable contractual obligations (in thousands): Contractual Obligations Total Payments Due During One Year Fiscal Period Ending 2007 2011 2009 2010 2008 Thereafter Merchandise letters of credit . . . . . . . $ Operating leases . . . . . . . . . . . . . . . . 4,533 $ 4,533 $ — $ — $ — $ — $ — 29 26,462 16,904 39,103 51,001 8,235 141,734 Total Contractual Obligations . . . . . . $146,267 $55,534 $39,103 $26,462 $16,904 $8,235 $ 29 Recent Accounting Pronouncements Effective January 29, 2006, the Company began recording compensation expense associated with stock options and other forms of equity compensation in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123R, Share-Based Payment, as interpreted by SEC Staff Accounting Bulletin No. 107. Prior to January 29, 2006, the Company had accounted for stock options according to the provisions of Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations, and therefore no related compensation expense was recorded for awards granted with no intrinsic value at the date of the grant. The Company adopted the modified prospective transition method provided under SFAS No. 123R, and, consequently, has not adjusted results from prior periods to retroactively reflect compensation expense. Under this transition method, compensation cost associated with stock options recognized in fiscal 2006 included: 1) quarterly amortization related to the remaining unvested portion of all stock option awards granted prior to January 29, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123; and 2) quarterly amortization related to all stock option awards granted subsequent to January 29, 2006, based on the 19 grant date fair value estimated in accordance with the provisions of SFAS No. 123R. The impact on the Company’s consolidated financial statements for fiscal 2006 was an additional compensation expense of $235,000. In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109.” This Interpretation prescribes the recognition threshold a tax position is required to meet before being recognized in the financial statements. The Interpretation also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods and disclosure of uncertain tax positions. The Interpretation is effective for fiscal years beginning after December 15, 2006. The Company is in the process of evaluating the impact of the adoption of this Interpretation on the Company’s consolidated financial statements. In September 2006, the SEC issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in the Current Year Financial Statements” (SAB 108). SAB 108 addresses how the effects of prior-year uncorrected misstatements should be considered when quantifying misstatements in current-year financial statements. SAB 108 requires an entity to quantify misstatements using a balance sheet and income-statement approach and to evaluate whether either approach results in quantifying an error that is material in light of relevant quantitative and qualitative factors. The adoption of SAB 108 is effective for fiscal years ending on or after November 15, 2006. The adoption of SAB 108 did not have a material impact on the Company’s financial statements. In September 2006, FASB issued SFAS 157, “Fair Value Measurements.” SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosure of fair value measurements. SFAS 157 applies under other accounting pronouncements that require or permit fair value measurements and, accordingly does not require any new fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. The Company is in the process of evaluating the impact that the adoption of SFAS 157 will have on its financial statements. Item 7A. Quantitative and Qualitative Disclosures About Market Risk: The Company is subject to market rate risk from exposure to changes in interest rates based on its financing, investing and cash management. 20 Item 8. Financial Statements and Supplementary Data: INDEX TO FINANCIAL STATEMENTS AND SCHEDULE Report of Independent Registered Public Accounting Firm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consolidated Statements of Income and Comprehensive Income for the fiscal years ended February 3, 2007, January 28, 2006 and January 29, 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consolidated Balance Sheets at February 3, 2007 and January 28, 2006 . . . . . . . . . . . . . . . . . . . . . . Consolidated Statements of Cash Flows for the fiscal years ended February 3, 2007, January 28, 2006 and January 29, 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consolidated Statements of Stockholders’ Equity for the fiscal years ended February 3, 2007, January 28, 2006 and January 29, 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Notes to Consolidated Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Schedule II — Valuation and Qualifying Accounts for the fiscal years ended Page 22 – 23 24 25 26 27 28 February 3, 2007, January 28, 2006 and January 29, 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . S-2 21 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of The Cato Corporation: We have completed integrated audits of The Cato Corporation’s consolidated financial statements and of its internal control over financial reporting as of February 3, 2007, in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below. Consolidated financial statements and financial statement schedule In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of The Cato Corporation and its subsidiaries at February 3, 2007 and January 28, 2006, and the results of their operations and their cash flows for each of the three years in the period ended February 3, 2007 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under item 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and supplemental schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. Internal control over financial reporting Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of February 3, 2007 based on those criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of February 3, 2007 based on those criteria established in Internal Control — Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effec- tiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions. 22 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM — (Continued) A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ PricewaterhouseCoopers LLP Charlotte, North Carolina April 3, 2007 23 THE CATO CORPORATION CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME February 3, 2007 Fiscal Year Ended January 28, 2006 (Dollars in thousands, except per share data) January 29, 2005 $ 862,813 $ 821,639 $ 773,809 REVENUES Retail sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other income (principally finance charges, late fees and layaway charges) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total revenues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . COSTS AND EXPENSES, NET Cost of goods sold (exclusive of depreciation shown below) . . . . Selling, general and administrative. . . . . . . . . . . . . . . . . . . . . . . Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest and other income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Basic earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,072 875,885 572,712 212,157 20,941 41 (9,597) 796,254 79,631 28,181 51,450 1.64 $ $ Basic weighted average shares . . . . . . . . . . . . . . . . . . . . . . . . . . 31,281,163 Diluted earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1.62 Diluted weighted average shares . . . . . . . . . . . . . . . . . . . . . . . . 31,815,332 Dividends per share. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ .580 14,742 836,381 546,955 203,156 20,275 183 (4,563) 766,006 70,375 25,546 44,829 1.44 $ $ 15,795 789,604 528,916 187,618 20,397 717 (2,739) 734,909 54,695 19,854 34,841 1.13 31,117,214 30,876,393 1.41 $ 1.11 31,789,887 31,478,061 .507 $ .457 $ $ $ $ Comprehensive income: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrealized gains on available-for-sale securities, net of deferred income tax liability or benefit . . . . . . . . . . . . . . . . . . $ 51,450 $ 44,829 $ 34,841 147 7 13 Net comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 51,597 $ 44,836 $ 34,854 See notes to consolidated financial statements. 24 THE CATO CORPORATION CONSOLIDATED BALANCE SHEETS January 28, February 3, 2007 2006 (Dollars in thousands) Current Assets: ASSETS Cash and cash equivalents. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts receivable, net of allowance for doubtful accounts of $3,554 at February 3, 2007 and $3,694 at January 28, 2006 . . . . . . . . . . . . . . . . . . . . . . Merchandise inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total Current Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Property and equipment — net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 24,833 98,709 $ 21,734 86,085 45,958 115,918 7,508 6,587 299,513 128,461 4,348 49,644 103,370 8,526 2,318 271,677 124,104 10,855 Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 432,322 $ 406,636 Current Liabilities: LIABILITIES AND STOCKHOLDERS’ EQUITY Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued bonus and benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued income taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Total Current Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other noncurrent liabilities (primarily deferred rent) . . . . . . . . . . . . . . . . . . . . . . . . 77,046 29,526 10,756 5,721 123,049 8,817 23,663 $ 78,036 31,967 17,570 4,990 132,563 9,261 24,864 Commitments and contingencies Stockholders’ Equity: Preferred stock, $100 par value per share, 100,000 shares authorized, none issued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Class A common stock, $.033 par value per share, 50,000,000 shares authorized; 35,955,815 and 35,622,516 shares issued at February 3, 2007 and January 28, 2006, respectively . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Convertible Class B common stock, $.033 par value per share, 15,000,000 shares authorized; issued 690,525 shares at February 3, 2007 and January 28, 2006, respectively. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated other comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unearned compensation — restricted stock awards. . . . . . . . . . . . . . . . . . . . . . . . — — 1,199 1,188 23 42,475 327,684 225 — 371,606 23 39,244 294,462 78 (229) 334,766 Less Class A common stock in treasury, at cost (5,093,609 shares at February 3, 2007 and 5,093,840 shares at January 28, 2006, respectively) . . . . . . (94,813) (94,818) Total Stockholders’ Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276,793 239,948 Total Liabilities and Stockholders’ Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 432,322 $ 406,636 See notes to consolidated financial statements. 25 THE CATO CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS OPERATING ACTIVITIES Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to reconcile net income to net cash provided by operating activities: Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for doubtful accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . Share — based compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Excess tax benefits from share-based compensation . . . . . . . . . . . . . Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loss on disposal of property and equipment . . . . . . . . . . . . . . . . . . . Changes in operating assets and liabilities which provided (used) cash: Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Merchandise inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Prepaid and other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts payable, accrued expenses and other liabilities . . . . . . . . February 3, 2007 Fiscal Year Ended January 28, 2006 (Dollars in thousands) January 29, 2005 $ 51,450 $ 44,829 $ 34,841 20,941 2,633 1,326 (768) 574 2,079 1,053 (12,548) 2,238 1,499 (11,776) 20,275 4,650 682 — (3,656) 1,757 (3,405) (2,832) (1,065) 525 9,183 20,397 5,096 682 — (817) 1,554 (3,271) (3,246) 3,406 (41) 21,250 79,851 Net cash provided by operating activities . . . . . . . . . . . . . . . . . . . . . . . 58,701 70,943 INVESTING ACTIVITIES Expenditures for property and equipment . . . . . . . . . . . . . . . . . . . . . . . Purchases of short-term investments. . . . . . . . . . . . . . . . . . . . . . . . . . . Sales of short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (27,547) (180,463) 167,985 (28,512) (94,845) 97,355 (25,301) (122,380) 81,350 Net cash used in investing activities. . . . . . . . . . . . . . . . . . . . . . . . . . . (40,025) (26,002) (66,331) FINANCING ACTIVITIES Change in cash overdrafts included in accounts payable . . . . . . . . . . . . Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchases of treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Payments to settle long term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from employee stock purchase plan . . . . . . . . . . . . . . . . . . . . Excess tax benefits from share-based compensation . . . . . . . . . . . . . . . Proceeds from stock options exercised . . . . . . . . . . . . . . . . . . . . . . . . . 500 (18,228) — — 413 768 970 (3,100) (15,867) (3,536) (22,000) 430 — 2,226 (2,800) (14,134) — (5,500) 478 — 3,219 Net cash used in financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . (15,577) (41,847) (18,737) Net increase (decrease) in cash and cash equivalents . . . . . . . . . . . . . . Cash and cash equivalents at beginning of year . . . . . . . . . . . . . . . . . . 3,099 21,734 3,094 18,640 (5,217) 23,857 Cash and cash equivalents at end of year . . . . . . . . . . . . . . . . . . . . . . . $ 24,833 $ 21,734 $ 18,640 See notes to consolidated financial statements. 26 THE CATO CORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY Balance — January 31, 2004 . . . . . . . . . . . . . . . . . . *Comprehensive income: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrealized gains on available-for-sale securities, net of deferred income tax liability of $7 . . . . . . . . . . . . Dividends paid ($.457 per share) . . . . . . . . . . . . . . . . . Class A common stock sold through employee stock purchase plan — 40,965 shares . . . . . . . . . . . . . . . . Class A common stock sold through stock option plans — 294,000 shares . . . . . . . . . . . . . . . . . . . . . Income tax benefit from stock options exercised . . . . . . . Unearned compensation — restricted stock awards . . . . . Balance — January 29, 2005 . . . . . . . . . . . . . . . . . . *Comprehensive income: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrealized gains on available-for-sale securities, net of deferred income tax liability of $3 . . . . . . . . . . . . Dividends paid ($.507 per share) . . . . . . . . . . . . . . . . . Class A common stock sold through employee stock purchase plan — 28,684 shares . . . . . . . . . . . . . . . . Class A common stock sold through stock option plans — 172,025 shares . . . . . . . . . . . . . . . . . . . . . Income tax benefit from stock options exercised . . . . . . . Purchase of treasury shares — 186,531 . . . . . . . . . . . . . Cancellation of treasury shares — 6,136,354 . . . . . . . . . Shares reclassified from Class B to Class A — 4,907,309 shares (see Note 8) . . . . . . . . . . . . . . . . . Unearned compensation — restricted stock awards . . . . . Balance — January 28, 2006 . . . . . . . . . . . . . . . . . . *Comprehensive income: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrealized gains on available-for-sale securities, net of deferred income tax liability of $78 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends paid ($.58 per share) Class A common stock sold through employee stock purchase plan — 22,873 shares . . . . . . . . . . . . . . . . Class A common stock sold through stock option plans — 95,775 shares . . . . . . . . . . . . . . . . . . . . . . Class A common stock issued through restricted stock grant plans 214,882 shares . . . . . . . . . . . . . . . . . . . Income tax benefit from stock options exercised . . . . . . . Cancellation of treasury shares — 231 shares . . . . . . . . . Unearned compensation — restricted stock awards . . . . . Class A Common Stock Convertible Class B Common Stock Additional Paid-in Capital Retained Earnings Accumulated Other Comprehensive Income Unearned Compensation Restricted Stock Awards Treasury Stock Total Stockholders’ Equity (Dollars in thousands) 867 187 99,676 244,792 58 (1,593) (157,912) 186,075 34,841 (14,134) 13 34,841 13 (14,134) 478 2,361 859 682 682 1 7 477 2,354 859 875 187 103,366 265,499 71 (911) (157,912) 211,175 44,829 (15,866) 7 1 5 143 164 (164) 429 1,310 912 (66,773) 44,829 7 (15,866) 430 1,315 912 (3,536) — — 682 (3,536) 66,630 682 1,188 23 39,244 294,462 78 (229) (94,818) 239,948 51,450 (18,228) 147 1 3 7 484 1,127 857 768 (5) 51,450 147 (18,228) 485 1,130 864 768 — 229 5 (94,813) 276,793 229 — Balance — February 3, 2007 . . . . . . . . . . . . . . . . . . 1,199 23 42,475 327,684 225 * Total comprehensive income for the years ended February 3, 2007, January 28, 2006 and January 29, 2005 was $51,597, $44,836 and $34,854, respectively. See notes to consolidated financial statements. 27 THE CATO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Summary of Significant Accounting Policies: Principles of Consolidation: The consolidated financial statements include the accounts of The Cato Corporation and its wholly-owned subsidiaries (“the Company”). All significant intercompany accounts and transactions have been eliminated. Description of Business and Fiscal Year: The Company has two business segments — the operation of women’s fashion specialty stores and a credit card division. The apparel specialty stores operate under the names “Cato,” “Cato Fashions,” “Cato Plus” and “It’s Fashion!” and are located primarily in strip shopping centers principally in the southeastern United States. The Company’s fiscal year ends on the Saturday nearest January 31. Fiscal 2006 had 53 weeks while fiscal 2005 and fiscal 2004 had 52 weeks. Use of Estimates: The preparation of the Company’s financial statements in conformity with accounting principles generally accepted in the United States 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. Significant accounting estimates reflected in the Company’s financial statements include the allowance for doubtful accounts receivable, reserves relating to self insured health insurance, workers’ compensation liabilities, general and auto insurance liabilities, reserves for inventory markdowns, calculation of asset impairment, inventory shrinkage accrual and tax contingency reserves. Cash and Cash Equivalents and Short-Term Investments: Cash equivalents consist of highly liquid investments with original maturities of three months or less. Investments with original maturities beyond three months are classified as short-term investments. The fair values of short-term investments are based on quoted market prices. The Company’s short-term investments are all classified as available-for-sale. As they are available for current operations, they are classified in Consolidated Balance Sheets as current assets. Available-for-sale securities are carried at fair value, with unrealized gains and temporary losses, net of income taxes, reported as a component of accumulated other comprehensive income. Other than temporary declines in fair value of investments are recorded as a reduction in the cost of the investments in the accompanying Consolidated Balance Sheets and a reduction of interest and other income in the accompanying Statements of Consolidated Income. The cost of debt securities is adjusted for amortization of premiums and accretion of discounts to maturity. The amortization of premiums, accretion of discounts and realized gains and losses are included in Interest and other income. Concentration of Credit Risk: Financial instruments that potentially subject the Company to a concen- tration of credit risk principally consist of cash equivalents and accounts receivable. The Company places its cash equivalents with high credit qualified institutions and, by practice, limits the amount of credit exposure to any one institution. Concentrations of credit risks with respect to accounts receivable are limited due to the dispersion across different geographies of the Company’s customer base. Supplemental Cash Flow Information: Income tax payments, net of refunds received, for the fiscal years ended February 3, 2007, January 28, 2006 and January 29, 2005 were $26,651,000, $28,415,000 and $18,454,000, respectively. Cash paid for interest for the fiscal years ended February 3, 2007, January 28, 2006 and January 29, 2005 were $-0- $143,000 and $610,000, respectively. Inventories: Merchandise inventories are stated at the lower of cost (first-in, first-out method) or market as determined by the retail method. 28 THE CATO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) Property and Equipment: Property and equipment are recorded at cost. Maintenance and repairs are charged to operations as incurred; renewals and betterments are capitalized. The Company accounts for its software development costs in accordance with the American Institute of Certified Public Accountants Statement of Position (“SOP”) 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.” Depreciation is provided on the straight-line method over the estimated useful lives of the related assets excluding leasehold improvements. Leasehold improvements are amortized over the shorter of the estimated useful life or lease term. For leases with renewal periods at the Company’s option, the Company generally uses the original lease term plus reasonably assured renewal option periods (generally one five year option period) to determine estimated useful lives. Typical estimated useful lives are as follows: Classification Estimated Useful Lives Land improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 years Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30-40 years 5-10 years Leasehold improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-10 years Fixtures and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-10 years Information Technology equipment and software . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Impairment of Long-Lived Assets The Company primarily invests in property and equipment in connection with the opening and remodeling of stores and in computer software and hardware. The Company periodically reviews its store locations and estimates the recoverability of its assets, recording an impairment charge, if necessary, when the Company decides to close the store or otherwise determines that future undiscounted cash flows associated with those assets will not be sufficient to recover the carrying value. This determination is based on a number of factors, including the store’s historical operating results and cash flows, estimated future sales growth, real estate development in the area and perceived local market conditions that can be difficult to predict and may be subject to change. Store asset impairment charges incurred in fiscal 2006, 2005 and 2004 were $479,178, $387,139 and $306,983, respectively. In addition, the Company regularly evaluates its computer-related and other long-lived assets and may accelerate depreciation over the revised useful life if the asset is expected to be replaced or has limited future value. When assets are retired or otherwise disposed of, the cost and related accumulated depreciation or amortization are removed from the accounts, and any resulting gain or loss is reflected in income for that period. Leases The Company determines the classification of leases consistent with FASB issued Statement No. 13 (“SFAS 13”), “Accounting for Leases”. The Company leases all of its retail stores. Most lease agreements contain construction allowances and rent escalations. For purposes of recognizing incentives and minimum rental expenses on a straight-line basis over the terms of the leases including renewal periods considered reasonably assured, the Company uses the date of initial possession to begin amortization which is when the Company enters the space and begins to make improvements in preparation for intended use. For construction allowances, the Company records a deferred rent liability in “Other noncurrent liabilities” on the consolidated balance sheets and amortizes the deferred rent over the term of the respective lease as reduction to “Cost of goods sold” on the consolidated statements of income. For scheduled rent escalation clauses during the lease terms or for rental payments commencing at a date other than the date of initial occupancy, the Company records minimum rental expenses on a straight-line basis over the terms of the leases as defined by SFAS 13. 29 THE CATO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) Revenue Recognition The Company recognizes sales at the point of purchase when the customer takes possession of the merchandise and pays for the purchase, generally with cash or credit. Sales from purchases made with Cato credit, gift cards and layaway sales are also recorded when the customer takes possession of the merchandise. Gift cards, layaway deposits and merchandise credits granted to customers are recorded as deferred revenue until they are redeemed or forfeited. A provision is made for estimated product returns based on sales volumes and the Company’s experience; actual returns have not varied materially from amounts provided historically. Credit revenue on the Company’s private label credit card portfolio is recognized as earned under the interest method. Late fees are recognized as earned, less provisions for estimated uncollectible fees. Cost of Goods Sold: Cost of goods sold includes merchandise costs, net of discounts and allowances, buying costs, distribution costs, occupancy costs, freight, and inventory shrinkage. Net merchandise costs and in-bound freight are capitalized as inventory costs. Buying and distribution costs include payroll, payroll- related costs and operating expenses for our buying departments and distribution center. Occupancy expenses include rent, real estate taxes, insurance, common area maintenance, utilities and maintenance for stores and distribution facilities. Buying, distri- bution, occupancy and internal transfer costs are treated as period costs and are not capitalized as part of inventory. Credit Sales: The Company offers its own credit card to customers. All credit activity is performed by the Company’s wholly-owned subsidiaries. None of the credit card receivables are secured. Finance income is recognized as earned under the interest method and late charges are recognized in the month in which they are assessed, net of provisions for estimated uncollectible amounts. The Company evaluates the collectibility of accounts receivable and records an allowance for doubtful accounts based on the aging of accounts and estimates of actual write-offs. Advertising: Advertising costs are expensed in the period in which they are incurred. Advertising expense was $6,546,000, $6,103,000 and $5,504,000 for the fiscal years ended February 3, 2007, January 28, 2006 and January 29, 2005, respectively. Earnings Per Share: FASB No. 128 requires dual presentation of basic EPS and diluted EPS on the face of all income statements for all entities with complex capital structures. The Company has presented one basic EPS and one diluted EPS amount for all common shares in the accompanying consolidated statement of income. While the Company’s articles of incorporation provide the right for the Board of Directors to declare dividends on Class A shares without declaration of commensurate dividends on Class B shares, the Company has historically paid the same dividends to both Class A and Class B shareholders and the Board of Directors has resolved to continue this practice. Accordingly, the Company’s allocation of income for purposes of EPS computation is the same for Class A and Class B shares and the EPS amounts reported herein are applicable to both Class A and Class B shares. Basic EPS is computed as net income divided by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur from common shares issuable through stock options, warrants and other convertible securities. Unvested restricted stock is included in the computation of diluted EPS using the treasury stock method. Three Months Ended Twelve Months Ended February 3, 2007 January 28, 2006 February 3, 2007 January 28, 2006 Weighted-average shares outstanding . . . . . 31,326,640 31,049,631 31,281,163 31,117,214 Dilutive effect of: Stock options . . . . . . . . . . . . . . . . . . . Restricted stock . . . . . . . . . . . . . . . . . Employee stock purchase plan . . . . . . . 545,350 37,464 — 542,423 138,163 — 512,814 21,355 — 547,891 124,782 — Weighted-average shares and common stock equivalents outstanding . . . . . . . . . 31,909,454 31,730,217 31,815,332 31,789,887 30 THE CATO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) Vendor Allowances: The Company receives certain allowances from vendors primarily related to purchase discounts and markdown and damage allowances. All allowances are reflected in cost of goods sold as earned, generally as the related products are sold in accordance with EITF 02-16, “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor.” Under this EITF, cash consideration received from a vendor is presumed to be a reduction of the purchase cost of merchandise and should be reflected as a reduction of cost of sales. The Company does not receive cooperative advertising allowances. Income Taxes: The Company files a consolidated federal income tax return. Income taxes are provided based on the asset and liability method of accounting, whereby deferred income taxes are provided for temporary differences between the financial reporting basis and the tax basis of the Company’s assets and liabilities. Store Opening and Closing Costs: Costs relating to the opening of new stores or the relocating or expanding of existing stores are expensed as incurred. A portion of construction, design, and site selection costs are capitalized to new, relocated and remodeled stores. Closed Store Lease Obligations: At the time stores are closed, provisions are made for the rentals required to be paid over the remaining lease terms, reduced by expected sublease rentals. Insurance: The Company is self-insured with respect to employee healthcare, workers’ compensation and general liability. The Company’s self-insurance liabilities are based on the total estimated cost of claims filed and estimates of claims incurred but not reported, less amounts paid against such claims, and are not discounted. Management reviews current and historical claims data in developing its estimates. The Company has stop-loss insurance coverage for individual claims in excess of $250,000 for employee healthcare, $350,000 for worker’s compensation and $200,000 for general liability. Employee health claims are funded through a VEBA trust to which the Company makes periodic contributions. Contributions to the VEBA trust were $10,430,000 $12,110,000 and $11,205,000 in fiscal 2006, 2005 and 2004, respectively. Accrued healthcare was $814,000 and $1,503,000 and assets held in VEBA trust were $791,000 and $573,000 at February 3, 2007 and January 28, 2006, respectively. The Company paid worker’s compensation and general liability claims of $3,329,000, $2,977,000 and $3,227,000 in fiscal years 2006, 2005 and 2004, respectively. Including claims incurred, but not yet paid, the Company recognized an expense of $3,971,000, $3,518,000 and $3,513,000 in fiscal 2006, 2005 and 2004, respectively. Accrued workers’ compensation and general liabilities were $4,602,000 and $4,650,000 at February 3, 2007 and January 28, 2006, respectively. The Company had no outstanding letters of credit relating to such claims at February 3, 2007 or at January 28, 2006. Fair Value of Financial Instruments: The Company’s carrying values of financial instruments, such as cash and cash equivalents, approximate their fair values due to their short terms to maturity and/or their variable interest rates. Recent Accounting Pronouncements Effective January 29, 2006, the Company began recording compensation expense associated with stock options and other forms of equity compensation in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123R, Share-Based Payment, as interpreted by SEC Staff Accounting Bulletin No. 107. Prior to January 29, 2006, the Company had accounted for stock options according to the provisions of Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations, and therefore no related compensation expense was recorded for awards granted with no intrinsic value at the date of the grant. The Company adopted the modified prospective transition method provided under SFAS No. 123R, and, consequently, has not adjusted results from prior periods to retroactively reflect compensation expense. Under this transition method, compensation cost associated with stock options recognized in fiscal 2006 included: 1) quarterly amortization related to the remaining unvested portion of all stock option awards granted prior to January 29, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123; and 2) quarterly amortization related to all stock option awards granted subsequent to January 29, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123R. The impact on the Company’s consolidated financial statements for fiscal 2006 was an additional compensation expense of $235,000. 31 THE CATO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109.” This Interpretation prescribes the recognition threshold a tax position is required to meet before being recognized in the financial statements. The Interpretation also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods and disclosure of uncertain tax positions. The Interpretation is effective for fiscal years beginning after December 15, 2006. The Company is in the process of evaluating the impact of the adoption of this Interpretation on the Company’s consolidated financial statements. In September 2006, the SEC issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in the Current Year Financial Statements” (SAB 108). SAB 108 addresses how the effects of prior-year uncorrected misstatements should be considered when quantifying misstatements in current-year financial statements. SAB 108 requires an entity to quantify misstatements using a balance sheet and income-statement approach and to evaluate whether either approach results in quantifying an error that is material in light of relevant quantitative and qualitative factors. The adoption of SAB 108 is effective for fiscal years ending on or after November 15, 2006. The adoption of SAB 108 did not have a material impact on the Company’s financial statements. In September 2006, FASB issued SFAS 157, “Fair Value Measurements.” SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosure of fair value measurements. SFAS 157 applies under other accounting pronouncements that require or permit fair value measurements and, accordingly does not require any new fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. The Company is in the process of evaluating the impact that the adoption of SFAS 157 will have on its financial statements. 2. Interest and Other Income: The components of Interest and other income are shown below in gross amounts (in thousands): February 3, 2007 January 28, 2006 January 29, 2005 Dividend income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Hurricane claims settlement . . . . . . . . . . . . . . . . . . . . . . . . . Visa/Mastercard claims settlement . . . . . . . . . . . . . . . . . . . . . Miscellaneous income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (Gain)/loss investment sales . . . . . . . . . . . . . . . . . . . . . . . . . $ (23) (4,221) (2,384) (470) (2,100) (399) $ (17) (2,593) — — (1,836) (117) $ (20) (1,499) — — (1,473) 253 Interest and other income . . . . . . . . . . . . . . . . . . . . . . . . . . . $(9,597) $(4,563) $(2,739) 3. Short-Term Investments: Short-Term investments at February 3, 2007 and January 28, 2006 include the following (in thousands): Security Type: Debt Securities issued by February 3, 2007 January 28, 2006 Cost Unrealized Gain/(Loss) Estimated Fair Value Cost Unrealized Gain/(Loss) Estimated Fair Value states of the United States and political subdivisions of the states: With unrealized (loss). . . . . . $98,761 Total . . . . . . . . . . . . . . . . . . . . $98,761 $98,709 $86,207 $(122) $86,085 $98,709 $86,207 $(122) $86,085 $(52) $(52) 32 THE CATO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) The table above reflects accumulated unrealized losses in short-term investments at February 3, 2007 of $34,000, net of a deferred income tax benefit of $18,000 and accumulated unrealized losses in short-term investments at January 28, 2006 of $78,000, net of a deferred income tax benefit of $44,000. Additionally, the Company had $1.9 million invested in privately managed investment funds at February 3, 2007 and $1.9 million at January 28, 2006, which are reported within other noncurrent assets in the Consolidated Balance Sheets. Accumulated other comprehensive income in the Consolidated Balance Sheets reflects the accumulated unrealized losses in short-term investments shown above, which at February 3, 2007 was offset by unrealized gains in equity investments of $259,000, net of a deferred income tax liability of $141,000 and at January 28, 2006 was offset by the accumulated unrealized gains in equity investments of $156,000, net of a deferred income tax liability of $88,000. All investments with unrealized losses disclosed were in a loss position for less than 12 months. As disclosed in Note 2, the Company had realized gains of $399,000 in fiscal 2006, realized gains of $117,000 in fiscal 2005 and realized losses of $253,000 in fiscal 2004. The amortized cost and estimated fair value of debt securities at February 3, 2007, by contractual maturity, are shown below (in thousands): Security Type Cost Estimated Fair Value Due in one year or less . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $98,761 $98,709 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $98,761 $98,709 4. Accounts Receivable: Accounts receivable consist of the following (in thousands): Customer accounts — principally deferred payment accounts . . . . . . . . . . . Miscellaneous trade receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less allowance for doubtful accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . February 3, 2007 January 28, 2006 $43,939 5,573 49,512 3,554 $47,581 5,757 53,338 3,694 Accounts receivable — net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $45,958 $49,644 During the third quarter of fiscal 2005, the Company revised its process for determining the amount of accounts receivable that should be written off each period. This change in process was consistent with industry and regulatory guidelines and resulted in an acceleration of accounts receivable write-off of approximately $1,700,000. This write-off reduced the gross Accounts Receivable balance and the Allowance for Doubtful Accounts in the third quarter of 2005. Accordingly, this change in process had no effect on the period’s earnings and management does not expect that the change will have a material effect on the Company’s future earnings or financial position. Finance charge and late charge revenue on customer deferred payment accounts totaled $10,866,000, $12,507,000 and $13,918,000 for the fiscal years ended February 3, 2007, January 28, 2006 and January 29, 2005, respectively, and charges against the allowance for doubtful accounts were $2,633,000, $4,650,000 and $5,096,000 for the fiscal years ended February 3, 2007, January 28, 2006 and January 29, 2005, respectively. Expenses charged relating to the allowance for doubtful accounts are classified as a component of selling, general and administrative expenses in the accompanying Consolidated Statements of Income. 33 THE CATO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) 5. Property and Equipment: Property and equipment consist of the following (in thousands): Land and improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leasehold improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fixtures and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Information Technology equipment and software . . . . . . . . . . . . . . . . . . . . Construction in progress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . February 3, 2007 January 28, 2006 $ 3,266 17,990 51,308 158,614 45,594 2,833 279,605 151,144 $ 3,266 17,758 48,084 145,965 43,276 2,186 260,535 136,431 Property and equipment — net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $128,461 $124,104 Construction in progress primarily represents costs related to a new point-of-sale system, the implementation of which is expected to be completed in 2007. 6. Accrued Expenses: Accrued expenses consist of the following (in thousands): February 3, 2007 January 28, 2006 Accrued payroll and related items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Property and other taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,524 504 11,446 5,227 6,825 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $29,526 $ 7,728 1,013 10,825 6,059 6,342 $31,967 7. Financing Arrangements: At February 3, 2007, the Company had an unsecured revolving credit agreement which provided for borrowings of up to $35 million. This revolving credit agreement was entered into on August 22, 2003 and is committed until August 2008. The credit agreement contains various financial covenants and limitations, including the maintenance of specific financial ratios with which the Company was in compliance as of February 3, 2007. There were no borrowings outstanding under this facility during the fiscal year ended February 3, 2007 or January 28, 2006. Interest is based on LIBOR, which was 5.32% on February 3, 2007. On August 22, 2003, the Company entered into an unsecured $30 million five-year term loan facility, the proceeds of which were used to purchase Class B Common Stock from the Company’s founders. Payments were due in monthly installments of $500,000 plus accrued interest. Interest was based on LIBOR. On April 5, 2005, the Company repaid the remaining balance of $20.5 million on this loan facility. With the early retirement of this loan, the Company had no outstanding debt as of February 3, 2007 or January 28, 2006. The Company had approximately $4,533,000 and $2,790,000 at February 3, 2007 and January 28, 2006, respectively, of outstanding irrevocable letters of credit relating to purchase commitments. 34 THE CATO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) 8. Stockholders’ Equity: The holders of Class A Common Stock are entitled to one vote per share, whereas the holders of Class B Common Stock are entitled to ten votes per share. Each share of Class B Common Stock may be converted at any time into one share of Class A Common Stock. Subject to the rights of the holders of any shares of Preferred Stock that may be outstanding at the time, in the event of liquidation, dissolution or winding up of the Company, holders of Class A Common Stock are entitled to receive a preferential distribution of $1.00 per share of the net assets of the Company. Cash dividends on the Class B Common Stock cannot be paid unless cash dividends of at least an equal amount are paid on the Class A Common Stock. The Company’s certificate of incorporation provides that shares of Class B Common Stock may be transferred only to certain “Permitted Transferees” consisting generally of the lineal descendants of holders of Class B Stock, trusts for their benefit, corporations and partnerships controlled by them and the Company’s employee benefit plans. Any transfer of Class B Common Stock in violation of these restrictions, including a transfer to the Company, results in the automatic conversion of the transferred shares of Class B Common Stock held by the transferee into an equal number of shares of Class A Common Stock. In April 2004, the Board of Directors adopted the 2004 Incentive Compensation Plan, of which 1,350,000 shares are issuable. As of February 3, 2007, 258,382 shares had been granted from this Plan. In May 2003, the shareholders approved a new 2003 Employee Stock Purchase Plan with 250,000 Class A shares of Common Stock authorized. Under the terms of the Plan, substantially all employees may purchase Class A Common Stock through payroll deductions of up to 10% of their salary, up to a maximum market value of $25,000 per year. The Class A Common Stock is purchased at the lower of 85% of market value on the first or last business day of a six-month payment period. Additionally, each April 15, employees are given the opportunity to make a lump sum purchase of up to $10,000 of Class A Common Stock at 85% of market value. The number of shares purchased by participants through the plan were 22,873 shares, 28,684 shares and 40,965 shares for the years ended February 3, 2007, January 28, 2006 and January 29, 2005, respectively. In December 2003, the Board of Directors authorized a dividend of one preferred share purchase right (a “Right”) for each share of Class A Common Stock and Class B Common Stock, each par value $.033 per share of the Company outstanding at the close of business on January 7, 2004. In connection with the authorization of the Rights, the Company entered into a Rights Agreement, dated as of December 18, 2003 (the “Rights Agreement”), with American Stock Transfer & Trust Company, as Rights Agent (the “Rights Agent”). The Company adopted in 1987 an Incentive Compensation Plan and a Non-Qualified Stock Option Plan for key employees of the Company. Total shares issuable under the plans are 5,850,000, of which 1,237,500 shares were issuable under the Incentive Compensation Plan and 4,612,500 shares are issuable under the Non-Qualified Stock Option Plan. The purchase price of the shares under an option must be at least 100 percent of the fair market value of Class A Common Stock at the date of the grant. Options granted under these plans vest over a 5-year period and expire 10 years after the date of the grant unless otherwise expressly authorized by the Board of Directors. As of February 3, 2007, 5,840,723 shares had been granted under the plans. In August 1999, the Board of Directors adopted the 1999 Incentive Compensation Plan, of which 1,000,000 shares are issuable. The ability to grant awards under the 1999 Plan expired on July 31, 2004. In May 2002, the Board of Directors approved and granted to a key executive under the 1999 Incentive Compensation Plan restricted stock awards of 150,000 shares of Class B Common Stock, with a per share fair value of $18.21. These stock awards cliff vested after four years and the unvested portion is included in stockholders’ equity as unearned compensation in the accompanying financial statements. The charge to compensation expense for these stock awards was $229,000, $682,000 and $682,000 in fiscal 2006, 2005 and 2004, respectively. As of February 3, 2007, all such shares were fully vested. 35 THE CATO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) Option plan activity for the three fiscal years ended February 3, 2007 is set forth below: Options Range of Option Prices Weighted Average Price Outstanding options, January 31, 2004 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cancelled . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,731,600 113,625 (294,000) (45,900) $ 3.42 – $17.84 13.09 – 15.42 3.42 – 14.01 6.39 – 14.60 $ 7.69 14.37 7.98 11.51 Outstanding options, January 29, 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cancelled . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,505,325 22,250 (172,025) (12,150) 5.13 – 17.84 18.96 – 21.75 5.13 – 17.84 11.50 – 20.50 Outstanding options, January 28, 2006 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cancelled . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,343,400 — (95,775) (10,950) 5.50 – 21.75 — 5.50 – 21.37 13.47 – 21.37 8.05 20.05 7.63 14.62 8.23 — 10.12 17.24 Outstanding options, February 3, 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,236,675 $ 5.50 – $21.75 $ 8.01 The following tables summarize stock option information at February 3, 2007: Range of Exercise Prices Options $ 5.50 – $ 9.42 1,119,850 87,000 11.10 – 14.79 28,325 15.08 – 19.99 1,500 21.75 – 21.75 Options Outstanding Weighted Average Remaining Contractual Life Weighted Average Exercise Price 1.32 years 6.58 years 7.77 years 8.88 years $ 7.35 13.28 17.19 21.75 Options Exercisable Options 1,119,850 36,000 9,550 300 Weighted Average Exercise Price $ 7.35 12.83 17.01 21.75 $ 5.50 – $21.75 1,236,675 1.84 years $ 8.01 1,165,700 $ 7.61 Outstanding options at February 3, 2007 covered 1,053,000 shares of Class B Common Stock and 183,675 shares of Class A Common Stock. Outstanding options at January 28, 2006 covered 1,053,000 shares of Class B Common Stock and 290,400 shares of Class A Common Stock. See Note 15 to the Consolidated Financial Statements for further information on the Company’s Stock Based Compensation. On May 25, 2006 the Board of Directors increased the quarterly dividend by 15% from $.13 per share to $.15 per share, or an annualized rate of $.60 per share. 9. Employee Benefit Plans: The Company has a defined contribution retirement savings plan (“401(k)”) which covers all employees who meet minimum age and service requirements. The 401(k) plan allows participants to contribute up to 60% of their annual compensation up to the maximum elective deferral, designated by the IRS. The Company is obligated to 36 THE CATO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) make a minimum contribution to cover plan administrative expenses. Further Company contributions are at the discretion of the Board of Directors. The Company’s contributions for the years ended February 3, 2007, January 28, 2006 and January 29, 2005 were approximately $1,455,000, $1,589,000 and $1,663,000, respectively. The Company has an Employee Stock Ownership Plan (“ESOP”), which covers substantially all employees who meet minimum age and service requirements. The Board of Directors determines contributions to the ESOP. The Company’s contributions for the years ended February 3, 2007, January 28, 2006 and January 29, 2005 were approximately $1,789,000, $5,637,000 and $0, respectively. The Company is primarily self-insured for healthcare, workers’ compensation and general liability costs. These costs are significant primarily due to the large number of the Company’s retail locations and employees. The Company’s self-insurance liabilities are based on the total estimated costs of claims filed and estimates of claims incurred but not reported, less amounts paid against such claims, and are not discounted. Management reviews current and historical claims data in developing its estimates. If the underlying facts and circumstances of the claims change or the historical trend is not indicative of future trends, then the Company may be required to record additional expense or a reduction to expense which could be material to the Company’s reported financial condition and results of operations. The Company has stop-loss insurance coverage for individual claims in excess of $250,000. Employee health claims are funded through a VEBA trust to which the Company makes periodic contributions. 10. Leases: The Company has operating lease arrangements for store facilities and equipment. Facility leases generally are fixed rate for periods of five years with renewal options and most provide for additional contingent rentals based on a percentage of store sales in excess of stipulated amounts. For leases with landlord capital improvement funding, the funded amount is recorded as a deferred liability and amortized over the term of the lease as a reduction to rent expense on the Consolidated Statements of Income. Equipment leases are generally for one to three year periods. The minimum rental commitments under non-cancelable operating leases are (in thousands): Fiscal Year 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2008 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Thereafter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 51,001 39,103 26,462 16,904 8,235 29 Total minimum lease payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $141,734 The following schedule shows the composition of total rental expense for all leases (in thousands): Fiscal Year Ended February 3, 2007 January 28, 2006 January 29, 2005 Minimum rentals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Contingent rent $49,169 106 Total rental expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $49,275 $47,278 74 $47,352 $44,493 85 $44,578 11. Related Party Transactions: The Company leases certain stores from entities in which Mr. George S. Currin, a director of the Company has a controlling or non-controlling ownership interest. Rent expense and related charges totaling $371,716, $303,612 and $286,860 were paid to entities controlled by Mr. Currin or his family in fiscal 2006, 2005, and 2004, 37 THE CATO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) respectively, under these leases. Rent expense and related charges totaling $939,443, $770,563 and $800,929 were paid to entities in which Mr. Currin or his family had a non-controlling ownership interest in fiscal 2006, 2005, and 2004, respectively, under these leases. In November 2006, the Company received $6,996,021 as payment for the purchase of a split-dollar life insurance policy by The Wayland H. Cato, Jr. Irrevocable Trust, the grantor of which is Wayland H. Cato, Jr., a Company founder and Chairman Emeritus. Mr. Cato was the insured and owned 50% of the death benefit, while the Company owned the policy and any cash value associated with it and 50% of the death benefit. The purchase was made under an agreement between the Company and the trust that allowed the trust to purchase the policy within three years of the date of Mr. Cato’s termination of employment for an amount equal to the policy’s cash value as of the date of transfer to the trust. Mr. Cato’s employment with the Company terminated January 31, 2004. 12. Income Taxes: The provision for income taxes consists of the following (in thousands): Fiscal Year Ended Current income taxes: February 3, 2007 January 28, 2006 January 29, 2005 Federal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . State. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $26,480 1,205 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,685 $27,895 1,311 29,206 $20,142 535 20,677 Deferred income taxes: Federal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . State. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 443 53 496 (3,271) (389) (3,660) (735) (88) (823) Total income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . $28,181 $25,546 $19,854 Significant components of the Company’s deferred tax assets and liabilities as of February 3, 2007 and January 28, 2006 are as follows (in thousands): February 3, 2007 January 28, 2006 Deferred tax assets: Bad debt reserve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Inventory valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Restricted stock options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred lease liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Capital loss carryover . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,364 1,830 184 5,277 393 4,828 Total deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,876 Deferred tax liabilities: Fixed assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrealized gains on short-term investments . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total deferred tax liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,489 123 1,573 15,185 $ 1,417 1,870 941 5,325 393 4,815 14,761 14,048 44 1,404 15,496 Net deferred tax liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,309 $ 735 38 THE CATO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) Capital loss carryovers included in the Company’s deferred tax assets have a limited life and will expire in 2009 if not utilized. The Company believes realization is more likely than not. The reconciliation of the Company’s effective income tax rate with the statutory rate is as follows: Fiscal Year Ended February 3, 2007 January 28, 2006 January 29, 2005 Federal income tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . State income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Effective income tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . 35.0% 2.4 (2.0) 35.4% 35.0% 3.2 (1.9) 36.3% 35.0% 2.1 (0.8) 36.3% The Company records liabilities for uncertain tax positions principally related to state income taxes as of the balance sheet date. These liabilities reflect the Company’s best estimate of the ultimate income tax liabilities based on facts and circumstances. Changes in facts and/or settlements with individual states related to previously filed tax returns could result in material adjustment to the estimated liabilities recorded as of the balance sheet date. 13. Quarterly Financial Data (Unaudited): Summarized quarterly financial results are as follows (in thousands, except per share data): Fiscal 2006 First Second Third Fourth Retail sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $229,741 233,060 Total revenues. . . . . . . . . . . . . . . . . . . . . . . . . . . . 142,113 Cost of goods sold (exclusive of depreciation) . . . . 32,754 Income before income taxes . . . . . . . . . . . . . . . . . 20,799 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.67 Basic earnings per share . . . . . . . . . . . . . . . . . . . . $ 0.65 Diluted earnings per share . . . . . . . . . . . . . . . . . . . $ $214,633 217,845 143,746 19,044 12,093 0.39 0.38 $ $ $187,727 190,882 127,229 9,133 5,861 0.19 0.18 $ $ $230,712 234,097 159,625 18,698 12,696 0.41 0.40 $ $ Fiscal 2005 First Second Third Fourth Retail sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $215,064 218,927 Total revenues. . . . . . . . . . . . . . . . . . . . . . . . . . . . 136,434 Cost of goods sold (exclusive of depreciation) . . . . 28,911 Income before income taxes . . . . . . . . . . . . . . . . . 18,416 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.59 Basic earnings per share . . . . . . . . . . . . . . . . . . . . $ 0.58 Diluted earnings per share . . . . . . . . . . . . . . . . . . . $ $208,316 211,964 140,426 16,809 10,707 0.34 0.34 $ $ $177,762 181,354 119,869 6,385 4,067 0.13 0.13 $ $ $220,497 224,136 150,226 18,270 11,638 0.37 0.37 $ $ 39 THE CATO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) 14. Reportable Segment Information: The Company has two reportable segments: retail and credit. The Company operates its women’s fashion specialty retail stores in 31 states, principally in southeastern United States. The Company offers its own credit card to its customers and all credit authorizations, payment processing, and collection efforts are performed by a separate subsidiary of the Company. The following schedule summarizes certain segment information (in thousands): Fiscal 2006 Retail Credit Total Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest and other income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Capital expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $864,987 20,849 (9,597) 74,772 368,786 27,483 $10,898 92 0 4,859 63,536 64 $875,885 20,941 (9,597) 79,631 432,322 27,547 Fiscal 2005 Retail Credit Total Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest and other income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Capital expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $823,685 20,173 (4,563) 65,682 339,788 28,477 $12,696 102 0 4,693 66,848 35 $836,381 20,275 (4,563) 70,375 406,636 28,512 Fiscal 2004 Retail Credit Total Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest and other income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Capital expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $775,421 20,320 (2,739) 49,268 332,199 25,102 $14,183 77 0 5,427 65,124 199 $789,604 20,397 (2,739) 54,695 397,323 25,301 The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance based on profit or loss from operations before income taxes. The Company does not allocate certain corporate expenses to the credit segment. The following schedule summarizes the credit segment and related direct expenses which are reflected in selling, general and administrative expenses (in thousands): February 3, 2007 January 28, 2006 January 29, 2005 Bad debt expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Payroll . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Postage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,633 1,008 1,034 1,272 $5,947 $4,650 1,043 1,061 1,147 $7,901 $5,096 1,142 1,075 1,366 $8,679 40 THE CATO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) 15. Stock Based Compensation: Effective January 29, 2006, the Company began recording compensation expense associated with stock options and other forms of equity compensation in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123R, Share-Based Payment, as interpreted by SEC Staff Accounting Bulletin No. 107. Prior to January 29, 2006, the Company had accounted for stock options according to the provisions of Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations, and therefore no related compensation expense was recorded for awards granted with no intrinsic value at the date of the grant. The Company adopted the modified prospective transition method provided under SFAS No. 123R, and, consequently, has not adjusted results from prior periods to retroactively reflect compensation expense. Under this transition method, compensation cost associated with stock options recognized in fiscal 2006 includes: 1) quarterly amortization related to the remaining unvested portion of all stock option awards granted prior to January 29, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123; and 2) quarterly amortization related to all stock option awards granted subsequent to January 29, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123R. As of February 3, 2007, the Company had three long-term compensation plans pursuant to which stock-based compensation was outstanding or could be granted. The Company’s 1987 Non-Qualified Stock Option Plan authorized 5,850,000 shares for the granting of options to officers and key employees. The 1999 Incentive Compensation Plan and 2004 Incentive Compensation Plan authorized 1,000,000 and 1,350,000 shares, respec- tively, for the granting of various forms of equity-based awards, including restricted stock and stock options to officers and key employees. The 1999 Plan has expired as to the ability to grant new awards. The following table presents the number of options and shares of restricted stock initially authorized and available to grant under each of the plans as of February 3, 2007: Options and/or restricted stock initially authorized . . . . . . Options and/or restricted stock available for grant: 1987 Plan 1999 Plan 2004 Plan Total 5,850,000 1,000,000 1,350,000 8,200,000 January 28, 2006 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . February 3, 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,227 9,277 — 1,300,500 — 1,091,618 1,305,727 1,100,895 Stock option awards outstanding under the Company’s current plans were granted at exercise prices which were equal to the market value of the Company’s stock on the date of grant, vest over five years and expire no later than ten years after the grant date. The following is a summary of the changes in stock options outstanding during the twelve months ended February 3, 2007: Shares Weighted Average Exercise Price Weighted Average Remaining Contractual Term Aggregate Intrinsic Value(a) Options outstanding at January 28, 2006 . . . . . 1,343,400 — Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Forfeited or expired . . . . . . . . . . . . . . . . . . . . (10,950) (95,775) Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . Outstanding at February 3, 2007 . . . . . . . . . . . 1,236,675 Vested and exercisable at February 3, 2007 . . . 1,165,700 $8.23 — $8.01 $7.61 3.05 years — 1.86 years 1.52 years $18,363,084 $17,784,759 (a) The intrinsic value of a stock option is the amount by which the market value of the underlying stock exceeds the exercise price of the option. 41 THE CATO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) No options were granted in fiscal 2006 and there were 22,250 options granted in fiscal 2005. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions. Twelve Months Ended January 28, 2006 Risk free interest rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expected life . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expected volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expected dividend yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Weighted-average grant date fair value per share. . . . . . . . . . . . . . . . . . . . . . . . 4.27% 5.0 years 37.04% 2.49% $6.20 As of February 3, 2007, there was approximately $297,000 of total unrecognized compensation cost related to nonvested options, which is expected to be recognized over a remaining weighted-average vesting period of 2.33 years. The total intrinsic value of options exercised during the fourth quarter and twelve months ended February 3, 2007 was approximately $436,000 and $1,289,000, respectively. Effective January 29, 2006, the Company began recognizing share-based compensation expense ratably over the vesting period, net of estimated forfeitures. The Company recognized share-based compensation expense of $355,000 and $1,338,000 for the fourth quarter and twelve month period ended February 3, 2007, respectively, which was classified as a component of selling, general and administrative expenses. No share-based compensation expense was recognized prior to January 29, 2006 except for the amortization of restricted stock grants. Had stock-based compensation costs been determined based on the fair value at the grant dates, consistent with SFAS No. 123R prior to January 29, 2006, the Company’s net income and earnings per share would have been adjusted to the pro forma amounts indicated below: Net Income as Reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Add: Stock-based employee compensation expense included in reported Fiscal Year Ended January 28, 2006 January 29, 2005 $44,829 $34,841 net income, net of related tax effects . . . . . . . . . . . . . . . . . . . . . . . . . . . 435 435 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects . . (513) (499) Pro forma Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings per share: Basic — as reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Basic — pro forma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted — as reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted — pro forma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $44,751 $34,777 $ 1.44 $ 1.44 $ 1.41 $ 1.41 $ 1.13 $ 1.13 $ 1.11 $ 1.11 Prior to the adoption of SFAS No. 123R, the Company presented all benefits of tax deductions resulting from the exercise of share-based compensation as operating cash flows in the Statements of Cash Flows. SFAS No. 123R requires the benefits of tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as financing cash flows. For the twelve months ended February 3, 2007, the Company reported $768,000 of excess tax benefits as a financing cash inflow in addition to $1,383,000 in cash proceeds received from the exercise of stock options and Employee Stock Purchase Plan purchases. 42 THE CATO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) The Company’s Employee Stock Purchase Plan allows eligible full-time employees to purchase a limited number of shares of the Company’s Class A Common Stock during each semi-annual offering period at a 15% discount through payroll deductions. During the twelve months ended February 3, 2007, the Company sold 22,873 shares to employees at an average discount of $3.19 per share under the Employee Stock Purchase Plan. The compensation expense recognized for the 15% discount given under the Employee Stock Purchase Plan was approximately $73,000 for the twelve months ended February 3, 2007. Prior to the adoption of SFAS 123R, the discount was not required to be charged to expense. In accordance with SFAS No. 123R, the fair value of current restricted stock awards is estimated on the date of grant based on the market price of the Company’s stock and is amortized to compensation expense on a straight-line basis over the related vesting periods. As of February 3, 2007, there was $4,396,000 of total unrecognized compensation cost related to nonvested restricted stock awards, which is expected to be recognized over a remaining weighted-average vesting period of 4.25 years. The total fair value of the shares recognized as compensation expense during the fourth quarter and twelve months ended February 3, 2007 was $298,000 and $1,093,000, respectively. The following summary shows the changes in the shares of restricted stock outstanding during the twelve months ended February 3, 2007: Number of Shares Weighted Average Grant Date Fair Value Per Share Restricted stock awards at January 28, 2006 . . . . . . . . . . . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Vested . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Forfeited . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 235,754 (150,000) (20,872) Restricted stock awards at February 3, 2007 . . . . . . . . . . . . . . . 214,882 $18.21 22.88 18.21 22.43 $22.92 16. Commitments and Contingencies: Workers compensation and general liability claims are settled through a claims administrator and are limited by stop-loss insurance coverage for individual claims in excess of $350,000 and $200,000, respectively. The Company paid claims of $3,329,000, $2,977,000 and $3,227,000 in fiscal 2006, 2005 and 2004, respectively. Including claims incurred, but not yet paid, the Company recognized an expense of $3,971,000, $3,518,000 and $3,513,000 in fiscal 2006, 2005 and 2004, respectively. Accrued workers’ compensation and general liabilities was $4,602,000 and $4,650,000 at February 3, 2007 and January 28, 2006, respectively. The Company had no outstanding letters of credit relating to such claims at February 3, 2007 or at January 28, 2006. See Note 7 for letters of credit related to purchase commitments, Note 9 for 401(k) plan contribution obligations and Note 10 for lease commitments. 43 THE CATO CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) The Company does not have any guarantees with third parties. The Company has placed a $2 million deposit with Cedar Hill National Bank (“Cedar Hill”), a wholly owned subsidiary, as security and collateral for the payment of amounts due from CatoWest LLC, a wholly owned subsidiary, to Cedar Hill. The deposit has no set term. The deposit was made at the request of the Office of the Comptroller of the Currency because the receivable is not settled immediately and Cedar Hill has a risk of loss until payment is made. CatoWest LLC purchases receivables from Cedar Hill on a daily basis (generally one day in arrears). In the event CatoWest LLC fails to transfer to Cedar Hill the purchase price for any receivable within two business days, Cedar Hill has the right to withdraw any amount necessary from the account established by the Company to satisfy the amount due Cedar Hill from CatoWest LLC. Although the amount of potential future payments is limited to the amount of the deposit, Cedar Hill may require, at its discretion, the Company to increase the amount of the deposit with no limit on the increase. The deposit is based upon the amount of payments that would be due from CatoWest LLC to Cedar Hill for the highest credit card sales weekends of the year that would remain unpaid until the following business day. The Company has no obligations related to the deposit at year-end. No recourse provisions exist nor are any assets held as collateral that would reimburse the Company if Cedar Hill withdraws a portion of the deposit. In addition, the Company has $4.7 million in escrow with Branch Banking & Trust Co. on behalf of Zurich American Insurance Company as security and collateral for administration of the Company’s self-insured workers compensation and general liability coverage. The Company is a defendant in legal proceedings considered to be in the normal course of business and none of which, singularly or collectively, are expected to have a material effect on the Company’s results of operations, cash flows and financial position. 44 Item 9. Changes in and Disagreements with Independent Registered Public Accounting Firm on Accounting and Consolidated Financial Disclosure: None. Item 9A. Controls and Procedures: Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures We carried out an evaluation, with the participation of our principal executive officer and principal financial officer, of the effectiveness of our disclosure controls and procedures as of February 3, 2007. Based on this evaluation, our principal executive officer and principal financial officer concluded that, as of February 3, 2007, our disclosure controls and procedures, as defined in Rule 13a-15(e), under the Securities Exchange Act of 1934 (the “Exchange Act”), were effective to ensure that information we are required to disclose in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. Management’s Report on Internal Control Over Financial Reporting Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Exchange Act Rule 13a-15(f). Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we carried out an evaluation of the effectiveness of our internal control over financial reporting as of February 3, 2007 based on the Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Com- mission (“COSO”). Based on this evaluation, our management concluded that our internal control over financial reporting was effective as of February 3, 2007. PricewaterhouseCoopers LLP, our independent registered public accounting firm, has audited our manage- ment’s assessment of the effectiveness of our internal control over financial reporting as of February 3, 2007, as stated in their report which is included herein. Changes in Internal Control Over Financial Reporting No change in the Company’s internal control over financial reporting (as defined in Exchange Act Rule 13a-15(f)) has occurred during the Company’s fiscal quarter ended February 3, 2007 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. Item 9B. Other Information: None. PART III Item 10. Directors, Executive Officers and Corporate Governance: Information contained under the captions “Election of Directors,” “Meetings and Committees,” “Corporate Governance Matters” and “Section 16(a) Beneficial Ownership Reporting and Compliance” in the Registrant’s Proxy Statement for its 2007 annual stockholders’ meeting (the “2007 Proxy Statement”) is incorporated by reference in response to this Item 10. The information in response to this Item 10 regarding executive officers of the Company is contained in Item 4A, Part I hereof under the caption “Executive Officers of the Registrant.” Item 11. Executive Compensation: Information contained under the captions “Executive Compensation” in the Company’s 2007 Proxy Statement is incorporated by reference in response to this Item. 45 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters: Equity Compensation Plan Information. The following table provides information about stock options outstanding and shares available for future awards under all of Cato’s equity compensation plans. The information is as of February 3, 2007. Plan Category Equity compensation plans approved by security holder . . . . . . . . . . . . . . . . . Equity compensation plans not approved by security holders . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . (a) (b) Number of securities to be issued upon exercise of outstanding options, warrants and rights(1) Weighted-average exercise price of outstanding options, warrants and rights(1) (c) Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a) (2) 1,236,675 — 1,236,675 $8.01 1,381,969 $8.01 1,381,969 (1) This column contains information regarding employee stock options only; there are no outstanding warrants or stock appreciation rights. (2) Includes the following: 1,091,618 shares available for grant under the Company’s stock incentive plan, referred to as the 2004 Incentive Compensation Plan. Under this plan, non-qualified stock options may be granted to key employees. Additionally, 9,227 shares available for grant under the Company’s stock incentive plan, referred to as the “1987 Non-qualified Stock Option Plan.” Stock options have terms of 10 years, vest evenly over 5 years, and are assigned an exercise price of not less than the fair market value of the Company’s stock on the date of grant; and 281,074 shares available under the 2003 Employee Stock Purchase Plan. Eligible employees may participate in the purchase of designated shares of the Company’s common stock. The purchase price of this stock is equal to 85% of the lower of the closing price at the beginning or the end of each semi-annual stock purchase period. Information contained under “Security Ownership of Certain Beneficial Owners and Management in the 2007 Proxy Statement is incorporated by reference in response to this Item. Item 13. Certain Relationships and Related Transactions and Director Independence: Information contained under the caption “Certain Transactions” and “Director Independence” in the 2007 Proxy Statement is incorporated by reference in response to this Item. Item 14. Principal Accountant Fees and Services: The information required by this Item is incorporated herein by reference to the section entitled “Audit Fees” and “Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Service by the Independent Auditor” in the 2007 Proxy Statement. 46 PART IV Item 15. Exhibits and Financial Statement Schedules: (a) The following documents are filed as part of this report: (1) Financial Statements: Report of Independent Registered Public Accounting Firm . . . . . . . . . . . . . . . . . . . . . . . . . Consolidated Statements of Income and Comprehensive Income for the fiscal years ended February 3, 2007, January 28, 2006 and January 29, 2005 . . . . . . . . . . . . . . . . . . . . . . . Consolidated Balance Sheets at February 3, 2007 and January 28, 2006 . . . . . . . . . . . . . . . Consolidated Statements of Cash Flows for the fiscal years ended February 3, 2007, January 28, 2006 and January 29, 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consolidated Statements of Stockholders’ Equity for the fiscal years ended February 3, 2007, January 28, 2006 and January 29, 2005. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Notes to Consolidated Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 22 – 23 24 25 26 27 28 (2) Financial Statement Schedule: The following report and financial statement schedule is filed herewith: Schedule II — Valuation and Qualifying Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . S-2 All other schedules are omitted as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes thereto. (3) Index to Exhibits: The following exhibits are filed with this report or, as noted, incorporated by reference herein. The Company will supply copies of the following exhibits to any shareholder upon receipt of a written request addressed to the Corporate Secretary, The Cato Corporation, 8100 Denmark Road, Charlotte, NC 28273 and the payment of $.50 per page to help defray the costs of handling, copying and postage. In most cases, documents incorporated by reference to exhibits to our registration statements, reports or proxy statements filed by the Company with the Securities and Exchange Commission are available to the public over the Internet from the SEC’s web site at http://www.sec.gov. You may also read and copy any such document at the SEC’s public reference room located at Room 1580, 100 F. Street, N.E., Washington, D.C. 20549 under the Company’s SEC file number (1 — 31340). Exhibit Number Description of Exhibit 3.1 3.2 4.1 10.2* 10.3* 10.4* 10.5* 10.6* Registrant’s Restated Certificate of Incorporation of the Registrant dated March 6, 1987, incorporated by reference to Exhibit 4.1 to Form S-8 of the Registrant filed February 7, 2000 (SEC File No. 333 — 96283). Registrant’s By Laws incorporated by reference to Exhibit 4.2 to Form S-8 of the Registrant filed February 7, 2000 (SEC File No. 333 — 96283). Rights Agreement dated December 18, 2003, incorporated by reference to Exhibit 4.1 to Form 8-A12G of the Registrant filed December 22, 2003 and as amended in Form 8-A12B/A filed on January 6, 2004. 1999 Incentive Compensation Plan dated August 26, 1999, incorporated by reference to Exhibit 4.3 to Form S-8 of the Registrant filed February 7, 2000 (SEC File No. 333 — 96283). Form of Agreement, dated as of August 29, 2003, between the Registrant and Wayland H. Cato, Jr., incorporated by reference to Exhibit 99(c) to Form 8-K of the Registrant filed on July 22, 2003. Form of Agreement, dated as of August 29, 2003, between the Registrant and Edgar T. Cato, incorporated by reference to Exhibit 99(d) to Form 8-K of the Registrant filed on July 22, 2003. Retirement Agreement between Registrant and Wayland H. Cato, Jr. dated August 29, 2003 incorporated by reference to Exhibit 10.1 to Form 10-Q of the Registrant for quarter ended August 2, 2003. Retirement Agreement between Registrant and Edgar T. Cato dated August 29, 2003, incorporated by reference to Exhibit 10.2 to Form 10-Q of the Registrant for the quarter ended August 2, 2003. 47 Exhibit Number Description of Exhibit 10.7* 10.8* 10.9* Letter Agreement between Registrant and Reynolds C. Faulkner dated as of March 21, 2006, incorporated by reference to Exhibit 99.1 to Form 8-K of the Registrant filed March 22, 2006. Resignation Agreement between Registrant and Reynolds C. Faulkner dated as of October 30, 2006, incorporated by reference to Exhibit 99.1 to Form 8-K of the Registrant filed November 1, 2006. Letter Agreement between Registrant and Thomas W. Stoltz dated as of December 4, 2006, incorporated by reference to Exhibit 99.1 to Form 8-K of the Registrant filed December 5, 2006. 10.10* Summary of Named Executive Officer Compensation Determinations incorporated by reference to Exhibit 99.1 to Form 8-K filed April 12, 2006. Summary of Named Executive Officer Restricted Stock Grants, incorporated by reference to Exhibit 99.1 to Form 8-K filed May 2, 2006. Subsidiaries of Registrant. Consent of Independent Registered Public Accounting Firm. Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer. Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer. Section 1350 Certification of Chief Executive Officer. Section 1350 Certification of Chief Financial Officer. 10.11 21 23.1 31.1 31.2 32.1 32.2 * Management contract or compensatory plan required to be filed under Item 15 of this report and Item 601 of Regulation S-K. 48 Designation of Exhibit EXHIBIT INDEX 21 23.1 31.1 31.2 32.1 32.2 Subsidiaries of the Registrant . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consent of Independent Registered Public Accounting Firm . . . . . . . . . . . . . . . . . . . . . . . Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer . . . . . . . . . . . . . . . . . . . Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer. . . . . . . . . . . . . . . . . . . . Section 1350 Certification of Chief Executive Officer . . . . . . . . . . . . . . . . . . . . . . . . . . . . Section 1350 Certification of Chief Financial Officer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 50 51 53 54 55 56 49 EXHIBIT 21 Name of Subsidiary State of Incorporation/Organization Name under which Subsidiary does Business SUBSIDIARIES OF THE REGISTRANT CHW LLC Providence Insurance Company, Delaware A Bermudian Company Limited CatoSouth LLC Cato of Texas L.P. Cato Southwest, Inc. CaDel LLC CatoWest LLC Cedar Hill National Bank catocorp.com, LLC North Carolina Texas Delaware Delaware Nevada A Nationally Chartered Bank Delaware CHW LLC Providence Insurance Company, Limited CatoSouth LLC Cato of Texas L.P. Cato Southwest, Inc. CaDel LLC CatoWest LLC Cedar Hill National Bank catocorp.com, LLC 50 EXHIBIT 23.1 CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM We hereby consent to the incorporation by reference in the Registration Statement No. 333-119300 on Form S-8 pertaining to The Cato Corporation 2004 Incentive Compensation Plan, in Registration Statement No. 333-119299 pertaining to The Cato Corporation 2003 Employee Stock Purchase Plan in Registration Statement No. 333-96283 on Form S-8 pertaining to The Cato Corporation 1999 Incentive Compensation Plan, in Registration Statement No. 33-41314 on Form S-8 pertaining to The Cato Corporation 1987 Incentive Stock Option Plan, in Registration Statement No. 33-41315 on Form S-8 pertaining to The Cato Corporation 1987 Nonqualified Stock Option Plan, and in Registration Statements Nos. 33-69844 and 333-96285 on Forms S-8 pertaining to The Cato Corporation 1993 Employee Stock Purchase Plan, of our report dated April 3, 2007 relating to the financial statements, financial statement schedule, management’s assessment of the effectiveness of internal control over financial reporting and the effectiveness of internal control over financial reporting, which appears in this Form 10-K. /s/ PRICEWATERHOUSECOOPERS LLP Charlotte, North Carolina April 3, 2007 51 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Cato has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SIGNATURES The Cato Corporation By /s/ THOMAS W. STOLTZ Thomas W. Stoltz Executive Vice President Chief Financial Officer By /s/ JOHN P. D. CATO John P. D. Cato Chairman, President and Chief Executive Officer By /s/ ROBERT M. SANDLER Robert M. Sandler Senior Vice President Controller Date: April 3, 2007 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 and on the date indicated: /s/ JOHN P. D. CATO /s/ GRANT L. HAMRICK John P. D. Cato (President and Chief Executive Officer (Principal Executive Officer) and Director) Grant L. Hamrick (Director) /s/ THOMAS W. STOLTZ /s/ JAMES H. SHAW Thomas W. Stoltz (Executive Vice President (Chief Financial Officer)) James H. Shaw (Director) /s/ ROBERT W. BRADSHAW, JR. /s/ A.F. (PETE) SLOAN Robert W. Bradshaw, Jr. (Director) A.F. (Pete) Sloan (Director) /s/ GEORGE S. CURRIN /s/ D. HARDING STOWE George S. Currin (Director) D. Harding Stowe (Director) /s/ WILLIAM H. GRIGG William H. Grigg (Director) 52 EXHIBIT 31.1 CHIEF EXECUTIVE OFFICER CERTIFICATION PURSUANT TO SECURITIES EXCHANGE ACT OF 1934 RULE 13a-14a/15d-14(a), AS ADOPTED PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, John P. D. Cato, certify that: 1. I have reviewed this Annual Report on Form 10-K of The Cato Corporation (the “registrant”); 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and 5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting. Date: April 3, 2007 /s/ John P. D. Cato John P. D. Cato Chairman, President and Chief Executive Officer 53 EXHIBIT 31.2 CHIEF FINANCIAL OFFICER CERTIFICATION PURSUANT TO SECURITIES EXCHANGE ACT OF 1934 RULE 13a-14a/15d-14(a), AS ADOPTED PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, Thomas W. Stoltz, certify that: 1. I have reviewed this Annual Report on Form 10-K of The Cato Corporation (the “registrant”); 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and 5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting. Date: April 3, 2007 /s/ Thomas W. Stoltz Thomas W. Stoltz Executive Vice President Chief Financial Officer 54 EXHIBIT 32.1 CERTIFICATION OF PERIODIC REPORT I, John P. D. Cato, Chairman, President and Chief Executive Officer of The Cato Corporation, certify, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350, that on the date of this Certification: 1. the Annual Report on Form 10-K of the Company for the annual period ended February 3, 2007 (the “Report”) fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and 2. the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. Dated: April 3, 2007 /s/ John P. D. Cato John P. D. Cato Chairman, President and Chief Executive Officer 55 EXHIBIT 32.2 CERTIFICATION OF PERIODIC REPORT I, Thomas W. Stoltz, Executive Vice President, Chief Financial Officer of The Cato Corporation, certify, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350, that on the date of this Certification: 1. the Annual Report on Form 10-K of the Company for the annual period ended February 3, 2007 (the “Report”) fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and 2. the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. Dated: April 3, 2007 /s/ Thomas W. Stoltz Thomas W. Stoltz Executive Vice President Chief Financial Officer 56 CORPORATE INFORMATION A copy of the Company’s Annual Report to the Securities and Exchange Commission (Form 10-K) for the fiscal year ended February 3, 2007 is available to shareholders without charge upon written request to: Mr. Thomas W. Stoltz Executive Vice President, Chief Financial Officer The Cato Corporation P.O. Box 34216 Charlotte, North Carolina 28234 CORPORATE HEADQUARTERS The Cato Corporation 8100 Denmark Road Charlotte, North Carolina 28273-5975 Telephone: (704) 554-8510 MAILING ADDRESS P.O. Box 34216 Charlotte, North Carolina 28234 INDEPENDENT AUDITOR PricewaterhouseCoopers LLP Charlotte, North Carolina 28202 CORPORATE COUNSEL Robinson, Bradshaw & Hinson, P.A. Charlotte, North Carolina 28246 TRANSFER AGENT AND REGISTRAR American Stock Transfer Securities Transfer Department, CMG-5 Charlotte, North Carolina 28288 ANNUAL MEETING NOTICE The Annual Meeting of Shareholders 11:00 a.m., Thursday, May 24, 2007 Corporate Office, 8100 Denmark Road, Charlotte, NC 28273-5975 MARKET & DIVIDEND INFORMATION The Company’s Class A Common Stock trades on the New York Stock Exchange (NYSE) under the symbol CTR. Below is the market range and dividend information for the four quarters of 2006 and 2005. 2006 First quarter Second quarter Third quarter Fourth quarter 2005 First quarter Second quarter Third quarter Fourth quarter PRICE HIGH $ 23.86 26.25 25.52 24.94 LOW $ 19.80 21.86 21.91 21.70 PRICE HIGH $ 22.17 21.80 21.45 23.35 LOW $ 17.09 17.07 18.51 19.52 DIVIDEND $ .13 .15 .15 .15 DIVIDEND $ .117 .13 .13 .13 As of March 27, 2007 the approximate number of record holders of the Company’s Class A Common Stock was 3,549 and there was 1 record holder of the Company’s Class B Common Stock. 8100 Denmark Road Charlotte, NC 28273-5975 www.catocorp.com