J. Crew Group, Inc. Annual Report 2005

Plain-text annual report

Table of ContentsUNITED STATES SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549Form 10-K(Mark One) xxANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the fiscal year ended January 28, 2006or ¨¨TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 CommissionFile Number Registrant, State of IncorporationAddress and Telephone Number I.R.S. EmployerIdentification No.333-42427 J. CREW GROUP, INC.(Incorporated in Delaware)770 BroadwayNew York, New York 10003Telephone: (212) 209 2500 22-2894486333-42423 J. CREW OPERATING CORP.(Incorporated in Delaware)770 BroadwayNew York, New York 10003Telephone: (212) 209 2500 22-3540930Securities Registered Pursuant to Section 12(b) of the Act: NoneSecurities Registered Pursuant to Section 12(g) of the Act: NoneIndicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.¨ Yes x NoIndicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.¨ Yes x NoIndicate 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 duringthe 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 requirementsfor the past 90 days.x Yes ¨ NoIndicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and willnot be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this form 10-K orany amendment to this Form 10-K. xIndicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer andlarge accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):Large accelerated filer ¨ Accelerated filer ¨ Non-accelerated filer xIndicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).¨ Yes x NoThe common stock of each registrant is not publicly traded. Therefore, the aggregate market value is not readily determinable.The number of shares if the registrants’ common stock outstanding at April 15, 2006 was: J. Crew Group, Inc. 13,264,665 shares of common stock, par value $.01 per shareJ. Crew Operating Corp. 100 shares of common stock, par value $.01 per share(all of which are owned by J.Crew Group, Inc.)This Annual Report on Form 10-K is a combined report being filed by two different registrants: J.Crew Group, Inc. and J.Crew Operating Corp. (awholly owned direct subsidiary of J.Crew Group, Inc.). The information contained herein relating to each individual registrant is filed by such registrant on itsown behalf. No registrant makes any representation as to information relating to any other registrant.Documents incorporated by reference: NoneJ.Crew Operating Corp. meets the conditions set forth in General Instruction (I)(1)(a) and (b) of the Form 10-K and is therefore filing this Form 10-Kwith the reduced disclosure format. Table of ContentsFILING FORMATThis Annual Report on Form 10-K is a combined report being filed by two different registrants: J.Crew Group, Inc. (“Group”) and J.Crew OperatingCorp., a wholly owned direct subsidiary of Group (“Operating”). Except where the content clearly indicates otherwise, any references in this report to the“Company”, “J.Crew” or “Group” include all subsidiaries of Group, including Operating. Operating does not make any representations as to the informationcontained in this report in relation to Group and its subsidiaries other than Operating.References herein to fiscal years are to the fiscal years of Group and Operating, which end on the Saturday closest to January 31 in the followingcalendar year for fiscal years 2001, 2002, 2003, 2004 and 2005. Accordingly, fiscal years 2001, 2002, 2003, 2004 and 2005 ended on February 2,2002, February 1, 2003, January 31, 2004, January 29, 2005 and January 28, 2006. All fiscal years for which financial information is included are 52weeks.DISCLOSURE REGARDING FORWARD LOOKING STATEMENTSThis report contains “forward-looking statements,” which include information concerning our plans, objectives, goals, strategies, future events, futurerevenues or performance, capital expenditures, financing needs and other information that is not historical information. Many of these statements appear, inparticular, under the headings “Business,” “Selected Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results ofOperations.” When used in these reports, the words “estimate,” “expect,” “anticipate,” project,” “plan,” “intend,” “believe” and variations of such words orsimilar expressions are intended to identify forward-looking statements. All forward-looking statements, including, without limitation, our examination ofhistorical operating trends, are based upon our current expectations and various assumptions. We believe there is a reasonable basis for our expectations andbeliefs, but there can be no assurance that we will realize our expectations or that our beliefs will prove correct.There are a number of risks and uncertainties that could cause our actual results to differ materially from the forward-looking statements contained inthis report. Important factors that could cause our actual results to differ materially from those expressed as forward-looking statements are set forth in thisreport, including but not limited to those under the heading “Risk Factors.” There may be other factors of which we are currently unaware or deem immaterialthat may cause our actual results to differ materially from the forward-looking statements.All forward-looking statements attributable to us or persons acting on our behalf apply only as of the date they are made and are expressly qualified intheir entirety by the cautionary statements included in this report. Except as may be required by law, we undertake no obligation to publicly update or reviseany forward-looking statement to reflect events or circumstances occurring after the date they were made or to reflect the occurrence of unanticipated events. 2Table of ContentsPART I ITEM 1.BUSINESS.In this section, “we,” “us” and “our” refer to Group and our wholly owned subsidiaries, including Operating.GeneralJ.Crew is a nationally recognized apparel and accessories brand that we believe embraces a high standard of style, craftsmanship, quality and customerservice while projecting an aspirational American lifestyle. We are a fully integrated multi-channel specialty retailer. We seek to consistently communicate ourvision of J.Crew through every aspect of our business, including through the imagery in our catalogs and on our Internet website and the inviting atmosphereof our stores. In fiscal 2005, our revenues were $953.2 million, which represents an 18.5% increase over fiscal 2004. Growth in our comparable store salesfor this period was 13.4%. Our net income for fiscal 2005 was $3.8 million compared to a loss of $100.3 million in fiscal 2004. The net loss in fiscal 2004included a significant loss on the refinancing of debt in our fourth fiscal quarter, excluding which our net loss would have been $50.5 million in fiscal 2004.We focus on creating product lines featuring the high quality design, fabrics and craftsmanship as well as consistent fits and detailing that ourcustomers expect of J.Crew. We offer complete assortments of women’s and men’s apparel and accessories, including business attire, weekend clothes,swimwear, loungewear, outerwear, wedding and special occasion attire, shoes, bags, belts and jewelry. The J.Crew brand is widely recognized and featureshigh quality designs, fabrics and craftsmanship. We believe that we differentiate ourselves from our competitors in three primary ways: • through our signature product design, which we refer to as “classic with a twist”—meaning our iconic styles refined with differentiating prints,fabrics, colors and high quality craftsmanship, • by using a multi-tiered pricing strategy of offering select designer-quality products at higher price points and more casual items at lower pricepoints, and • by offering our customers “one stop shopping” for their wardrobe needs, including apparel and accessories for weekend, business, wedding andspecial occasions.We seek to project our brand image through consistent creative messages in our catalog and through our Internet website, our store environments and oursuperior customer service. We believe that our brand image, which we describe as an “aspirational lifestyle,” is key to our success.J.Crew products are distributed through our retail and factory stores, our J.Crew catalog and our Internet website located at www.jcrew.com. As ofJanuary 28, 2006, we operated 159 retail stores and 44 factory stores throughout the United States. In fiscal 2005, we distributed 20 catalog editions with acirculation of approximately 55 million copies and our website logged over 64 million visits, representing a 33% increase over fiscal 2004. Our retail stores aredesigned by our in-house design staff and are fixtured to create a distinctive, sophisticated and inviting atmosphere, with clear displays that highlight thequality of our products and their fabrication. Our factory stores are designed with simple, volume-driving visuals to maximize sales of our key items anddrive faster inventory turns. In addition, as of January 28, 2006, J.Crew products were distributed through 43 freestanding, mall and shop-in-shop stores inJapan (of which 36 stores are currently operating) under a licensing agreement with Itochu Corporation.We conduct our business through two primary sales channels: Stores (consisting of our retail and factory outlet stores) and Direct (consisting of ourcatalog and Internet website), each of which operates under the J.Crew 3Table of Contentsbrand name. In fiscal 2005, products sold under the J.Crew brand contributed $924.1 million in revenues, comprised of: • $670.4 million from Stores; and • $253.7 million from Direct.In addition, in fiscal 2005, we generated other revenues of $29.1 million, consisting principally of shipping and handling fees derived from Direct.Group was incorporated in the State of New York in 1988 and reincorporated in the State of Delaware in October 2005. Operating was incorporated inthe State of Delaware in 1997. Group owns 100% of the outstanding shares of Operating. Our principal executive offices are located at 770 Broadway, NewYork, NY 10003, and our telephone number is (212) 209-2500.The Proposed Initial Public Offering and Related TransactionsOn August 17, 2005, Group filed a Registration Statement on Form S-1 with the United States Securities and Exchange Commission (the “SEC”)relating to the proposed initial public offering of its common stock (the “IPO”). The Registration Statement was subsequently amended on September 23,2005, October 11, 2005, October 28, 2005 and December 22, 2005.In connection with the IPO, on August 16, 2005, we entered into a Purchase Agreement (the “TPG Subscription”) with TPG Partners II, L.P. (“PartnersII”), TPG Parallel II L.P. (“Parallel II”) and TPG Investors II L.P. (“Investors II,” and together with Partners II and Parallel II, “the TPG II Funds”), pursuant towhich the TPG II Funds agreed to purchase from us, upon the redemption of all of our outstanding 14 1/2% Cumulative Preferred Stock (the “Series APreferred Stock”) (plus accrued and unpaid dividends) and 14 1/2% Mandatorily Redeemable Cumulative Preferred Stock (the “Series B Preferred Stock”)(plus accrued and unpaid dividends), at the IPO price, shares of common stock with an aggregate purchase price equal to $73.5 million. The TPG II Fundsare affiliates of Texas Pacific Group (“TPG”), a private investment group that through Partners II and certain other of its affiliates is Group’s majorityshareholder.In addition, on August 16, 2005, we entered into a Letter Agreement (the “Letter Agreement”) with TPG-MD Investment, LLC, an entity controlled byTPG and our Chief Executive Officer and Chairman, Millard S. Drexler, pursuant to which TPG-MD Investment, LLC agreed to exchange Operating’s 5.0%Notes Payable due 2008 (the “5.0% Notes Payable”) into shares of Group’s common stock at an exchange price of $6.82 per share (subject to customary anti-dilution adjustments) immediately prior to the consummation of the IPO. The exchange of the 5.0% Notes Payable into shares of Group’s common stock willbe effected pursuant to the Credit Agreement, dated as of February 4, 2003, as amended, by and among TPG-MD Investment, LLC, Group, Operating andcertain subsidiaries of Operating.On October 3, 2005, Operating announced a cash tender offer and consent solicitation in which it offered to purchase all of its outstanding 9 3/4% SeniorSubordinated Notes due 2014 (the “9 3/4% Notes”), and asked the holders of the 9 3/4% Notes to consent to a supplemental indenture dated October 17, 2005,supplementing the Indenture dated as of March 18, 2005 providing for the issuance of the 9 3/4% Notes, as supplemented by the First Supplemental Indenturedescribed below (the “Second Supplemental Indenture”). If it becomes operative, the Second Supplemental Indenture will eliminate or modify all restrictivecovenants and security and collateral provisions in the indenture relating to the 9 3/4% Notes, including the provision obligating Operating to make an offer torepurchase the Notes in the event of a change in control of Operating, and will terminate the security agreement relating to the indenture. The SecondSupplemental Indenture will become effective as of the date Operating accepts for payment the 9 3/4% Notes that have been validly tendered (and not validlywithdrawn) pursuant to the tender offer and consent solicitation. On October 17, 2005, Operating announced that 100% of the outstanding 9 3/4% Notes hadbeen tendered. On November 1, 2005, Operating extended the expiration date of its tender offer and consent solicitation to January 23, 2006. On January 23,2006, Operating further extended the expiration date to March 1, 2006. On March 1, 2006, Operating further extended the expiration date to May 1, 2006. 4Table of ContentsOn April 24, 2006, Operating entered into commitment letters with Goldman Sachs Credit Partners L.P., Bear Stearns Corporate Lending Inc., Bear,Stearns & Co. Inc., and Wachovia Bank, National Association (“Wachovia”) under which those institutions and their affiliates have committed to provide asenior secured term loan (the “New Term Loan”) to Operating with an aggregate principal amount of up to $285.0 million (which commitment letters includean accordion feature by which this principal amount may be increased to up to $385.0 million subject to certain conditions). The closing and funding of theNew Term Loan are conditioned on (a) Operating’s and our other outstanding indebtedness and preferred stock at the time of closing and funding not exceedinga maximum amount, (b) the amendment of our Amended and Restated Loan and Security Agreement (the “Credit Facility”) with Wachovia Capital Markets,LLC, as arranger and bookrunner, Wachovia, as administrative agent, Bank of America N.A., as syndication agent, Congress Financial Corporation, ascollateral agent, and a syndicate of lenders to permit, among other things, the New Term Loan and the security interest in and liens on the collateral securingthe New Term Loan, (c) the release of the security interest in and liens on the collateral securing the 9 3/4% Notes, (d) the amendment of the terms of the 5.0%Notes Payable to subordinate the obligations under the 5.0% Notes Payable to Operating’s and each of the guarantors’ obligations under the New Term Loanand (e) the satisfaction of certain other customary conditions. Borrowings under the New Term Loan will be secured by a perfected first or second prioritysecurity interest in substantially all of our and our subsidiaries’ assets, subject to inter-creditor arrangements to be negotiated between the lenders under theCredit Facility and the lenders under the New Term Loan.Operating intends to use the proceeds of the New Term Loan, along with cash on hand, to repay or redeem the 9 3/4% Notes and to pay premiums, fees,commissions and expenses related to this repayment or redemption. Operating entered into the April 24, 2006 commitment letters to replace the commitmentletter dated October 3, 2005, as amended (the “October 3, 2005 Commitment Letter”), under which the same institutions and their affiliates had committed toprovide a senior secured term loan to Operating. The commitment under the October 3, 2005 Commitment Letter terminated on March 30, 2006 according toits terms.Corporate RestructuringOn October 11, 2005, we reincorporated in Delaware by incorporating J. Crew Group, Inc., a Delaware corporation (for purposes of this section,“Group (DE)”), and entering into a merger agreement whereby J. Crew Group, Inc., a New York corporation (“Group (NY)”) merged with and into Group(DE) with the latter as the surviving corporation. Also on October 11, 2005, we dissolved our former subsidiary, J.Crew Intermediate LLC (“Intermediate”), aDelaware limited liability company by merging Intermediate into Group (DE).In connection with these mergers, on October 10, 2005, Group (NY), Operating and Intermediate and certain of their subsidiaries, Wachovia, asadministrative agent and collateral agent, and certain other lenders under the Credit Facility entered into Amendment No. 1 to the Credit Facility wherebyconsent was granted to the restructuring described above, and on October 12, 2005, Group (DE) entered into a joinder agreement whereby it affirmed andassumed the obligations of a guarantor under the Credit Facility as a result of that restructuring. On October 17, 2005, Group (DE), Operating, certain of theirsubsidiaries and U.S. Bank National Association, as trustee, entered into the First Supplemental Indenture to the 9 3/4% Notes Indenture, under which Group(DE) assumed the obligation of Intermediate as a guarantor under the 9 3/4% Notes Indenture.See “Disclosure Regarding Forward Looking Statements” and “Risk Factors”.ProductsWe offer complete assortments of women’s and men’s apparel and accessories that include business attire, weekend clothes, swimwear, loungewear,outerwear, wedding and special occasion attire, shoes, bags, belts and jewelry. We focus on creating product lines featuring the high quality design, fabricsand craftsmanship as well as consistent fits and detailing that our customers expect of J.Crew, and are designed internally by our design team to embody our“classic with a twist” branding and styling strategies. We use a multi-tiered pricing strategy of offering a product assortment ranging from casual t-shirts andbroken-in chinos at lower price points, to cashmere items and limited edition “collection” items, such as dresses, hand-beaded skirts and double-facedcashmere jackets, at higher price points, which we believe elevates the overall perception of our brand. Our assortments also include styled classics such asour cable knit sweaters and Legacy blazers. We also offer “twists” on our products with items such as our English silk tie belts, which use traditional necktiedesigns for women’s and men’s belts.We have introduced several successful new product lines and product line expansions, including men’s haberdashery, fine Italian cashmere, women’sand men’s suits made in Italy, footwear made in Italy, English leather accessories and J.Crew Wedding. Our J.Crew factory line offers the J.Crew brand withsimilar styles made at lower costs and sold at lower price points. We have launched crewcuts®, an apparel and accessories line for children ages two througheight, as part of our growth strategy. Crewcuts includes a product assortment that reflects the high quality, styled-classic apparel and accessories we offerunder the J.Crew brand, such as argyles, embroidered critters 5Table of Contentsand cable knits for the children’s market. We currently market the crewcuts line through our Direct sales channels and in 10 existing retail stores and in 2006plan to open two separate crewcuts retail stores. In addition, we are developing a supplemental clothing, footwear and accessories line using a trademarklicensed to us by Mr. Drexler and in 2006 plan to open two to three separate stores offering this line. See “Certain Relationships and Related Transactions—License Agreement”.Design and MerchandisingWe believe one of our key strengths is our internal design team, which designs products that reinforce our brand image. Our products are designed toreflect a clean and fashionable aesthetic that incorporates high quality fabrics and construction as well as comfortable, consistent fits and detailing.Our products are developed in four seasonal collections and are subdivided for monthly product introductions in our monthly catalog mailings and inour retail stores. The design process begins with our designers developing seasonal collections eight to twelve months in advance. Our designers regularly traveldomestically and internationally to develop color and design ideas. Once the design team has developed a season’s color palette and design concepts, they ordera sample assortment in order to evaluate the details of the assortment, such as how color takes to a particular fabric.Our design team consists of seasoned, talented designers who have experience in the specialty apparel industry, and we give them a significant amountof creative freedom in the design process. This method, which we refer to as “design-driven retailing,” allows our designers to be driven primarily by theirartistic vision and industry experience, enables them to incorporate high quality fabrics, yarns and prints into their designs, and allows them to collaboratewith our merchandisers rather than being directed by them, all of which we believe leads to high quality products that reinforce the J.Crew brand image.From the sample assortment, our merchandising team selects which items to market in each of our sales channels and edits the assortment as necessaryto increase its commerciality. Our teams communicate regularly and work closely with each other in order to leverage market data, ensure the quality of J.Crewproducts and remain true to a unified brand image. Our technical design teams develop construction and fit specifications for every product, ensuring qualityworkmanship and consistency across product lines. Because our product offerings originate from a single concept assortment, we believe that we are able toefficiently offer an assortment of styles within each season’s line while still maintaining a unified brand image. As a final step that is intended to ensure imageconsistency, our senior management reviews all of our products from all of our sales channels before they are manufactured.We believe we further maintain our brand image by exercising substantial control over the presentation and pricing of our merchandise by selling all ourproducts ourselves in North America.Pricing and Merchandise ManagementWe offer our customers a mix of select designer-quality products at higher price points and more casual items at lower price points, consistent with ourmulti-tiered pricing strategy and our signature styling strategy of pairing luxury items with more casual items. We have introduced limited edition “collection”items, such as hand-beaded skirts, which we believe elevates the overall perception of our brand. We also offer more moderately priced products, such as t-shirts, broken-in chinos and jeans. We believe offering a broad range of price points maintains a more accessible, less intimidating atmosphere.We focus on controlling our inventory in order to maximize full-price sales and increase inventory turns. We control our inventory of certain products sothat demand for our products exceeds their supply, which is intended to encourage customers not to delay purchases, maximize full-price sales and increaseinventory turns. Our merchandise managers are guided by return on investment objectives in determining their inventory purchases. 6Table of ContentsSales ChannelsWe conduct our business through two primary sales channels: Stores, which consists of our retail and factory stores, and Direct, which consists of theJ.Crew catalog and our Internet website. We encourage our customers to make purchases through all of our sales channels—a concept we refer to as “seamlessretailing,” and over 61% of the households in our customer database shop in multiple sales channels. We believe the seamless retailing concept supports ourbrand message while capitalizing on the unique attributes of each channel. Our research has shown that our cross-channel customers purchase on averagetwice as much merchandise, measured in dollars, than our single-channel customers. We foster multi-channel relationships with our customers to build a baseof customers loyal to the J.Crew brand rather than a single sales channel.StoresStores consists of our retail and factory store operations. During fiscal 2005, Stores generated revenues of $670.4 million, representing 70.3% of ourtotal revenues.Retail StoresAs of January 28, 2006, we operated 159 retail stores throughout the United States. Our retail stores are located in upscale regional malls, lifestylecenters, shopping centers and street locations. We believe situating our stores in desirable locations is key to the success of our business, and we determinestore locations based on several factors, including geographic location, demographic information, presence of anchor tenants in mall locations and proximity toother higher-end specialty retail stores. Our retail stores are designed by our in-house design staff and fixtured with the goal of creating a distinctive,sophisticated and inviting atmosphere, with clear displays and information about product quality and fabrication.Each of our retail stores is led by a single store director, and each store has a management team that includes one manager primarily responsible foroverseeing our customers’ shopping experience and another manager primarily responsible for overseeing operations. Our store directors have experience in theretail industry prior to joining our team, or have been promoted from within J.Crew based on performance. Each store director has discretion, within company-wide guidelines, to implement marketing and store presentation strategies that he or she feels are appropriate for the particular local atmosphere. For example,store directors decide whether to organize special marketing events held within their store or at area locations, such as fashion shows where J.Crewmerchandise is shown to an assembled group of invited guests. Store directors decide, within guidelines, which local businesses to partner with for cross-marketing initiatives. To improve our responsiveness to customer feedback, our management holds regular conference calls with store managers in whichcustomer feedback is discussed and appropriate responses are formulated in a timely manner. In addition to their base salary, store directors are eligible toreceive monthly bonuses that are determined against sales and payroll goals.In order to provide our sales associates with incentive to deliver superior customer service and to drive sales, each sales associate’s compensationconsists of a base hourly rate supplemented by eligibility for commissions on sales above a certain dollar amount. In addition, our associates are eligible toearn a bonus based on fiscal year sales thresholds, payable at the end of each month in which the threshold sales goal has been met. We believe our associatehiring policy and compensation structure enables us to maintain high standards of visual presentation and customer service standards in our stores. Our non-sales store employees’ compensation consists of a base hourly rate supplemented by eligibility for a bonus based on store-wide sales goals.Through our “We’ll Find it For You”SM service a customer in one of our retail stores who desires to purchase an item that is out of stock in that store oravailable only through our catalog can be connected via a “redphone” telephone hotline located in the store to our customer service center to obtain the desireditem directly by mail from another retail store or from our distribution center. In addition to our “We’ll Find it For You”SM service, we also make available toour customers “Client Specialists,” who serve as personal shoppers and wardrobe consultants. We have also implemented designated product areas withinstores and also expect to implement specialized accessory “shops” within stores in the near future. 7Table of ContentsOur retail stores averaged $3.5 million sales per store and produced sales per gross square foot of $462 at the end of fiscal 2005. Our retail storesaveraged approximately 7,600 total square feet, but are “sized to the market,” which means that we adjust the size of a particular retail store based on theprojected revenues from that particular store. For example, at the end of fiscal 2005, our largest retail store, located in New York, was approximately 15,000square feet, and our smallest retail store, also located in New York, was approximately 1,200 square feet. The table below highlights certain informationregarding our retail stores open during the five years ended January 28, 2006: Fiscal Year RetailStores OpenAtBeginningof Period RetailStoresOpenedDuringPeriod RetailStoresClosedDuringPeriod RetailStoresOpen atEnd ofPeriod Total GrossSquareFootage (inthousands) AverageGrossSquareFootage PerRetail Store2001 105 34 3 136 1,054 7,7522002 136 16 0 152 1,172 7,7122003 152 4 2 154 1,183 7,6802004 154 5 3 156 1,198 7,6822005 156 5 2 159 1,209 7,604We expanded our retail store base by three stores in fiscal 2005. We plan to further expand our store base by between 10 and 20 retail stores in fiscal2006, in addition to two crewcuts stores and two to three stores offering a supplemental clothing, footwear and accessories line using a trademark licensed tous by Mr. Drexler. See “Certain Relationships and Related Transactions—License Agreement”. Thereafter, in the near term, we plan to expand our retail storebase by between 15 and 25 retail stores annually. In each year, we plan to open and close retail stores in varying numbers. Our new retail store operatingmodel assumes a target store size of 5,500 square feet that achieves sales per square foot of $425 in the first twelve months. We will look to open new storespredominately in affluent markets where we have demonstrated strong Direct sales, and to adhere to our already-successful retail store formats, which webelieve reinforce our brand image and generate strong sales per square foot. Our average net investment to open a retail store is approximately $844,000, whichincludes $660,000 of build-out costs net of landlord contributions, $149,000 of initial inventory net of payables and pre-opening expenses of $35,000. Thisoperating model results in an average pretax cash return on investment of approximately 69%.Factory StoresAs of January 28, 2006, we operated 44 factory stores throughout the United States. Our factory stores are located primarily in large factory-outletmalls. Factory stores are designed with simple, volume-driving visuals to maximize sales of key items and drive faster inventory turns. Our factory stores alsouse strategic and focused short-term promotional offerings designed to achieve higher margins and faster inventory turns. Sales associates in our factory storesadhere to the same customer-service focus as in our retail stores, and are trained to help customers locate styles similar to those they have seen in our retailstores or catalog. Compensation of factory sales associates is based on a similar model as that of our retail sales associates, with differences relating to bonusand commission structure. 8Table of ContentsOur factory stores averaged $2.7 million sales per store and produced sales per gross square foot of $447 at the end of fiscal 2005. Our factory storesaveraged 6,100 total square feet, but are “sized to the market,” which means that we adjust the size of a particular factory store based on the projected revenuesfrom that particular store. For example, at the end of fiscal 2005, our largest factory store, located in New Hampshire, was 10,000 square feet, and oursmallest factory store, also located in New Hampshire, was 3,600 square feet. The table below highlights certain information regarding our factory stores openduring the five years ended January 28, 2006: Fiscal Year FactoryStores OpenAtBeginningof Period FactoryStoresOpenedDuringPeriod FactoryStoresClosedDuringPeriod FactoryStoresOpen atEnd ofPeriod Total GrossSquareFootage (inthousands) AverageGrossSquareFootage PerFactoryStore2001 41 0 0 41 260 6,3442002 41 2 1 42 265 6,3062003 42 0 0 42 265 6,3062004 42 0 1 41 258 6,2962005 41 6 3 44 269 6,120We expanded our factory store base by three stores in fiscal 2005. We plan to further expand our store base by between five and 10 factory stores infiscal 2006. Thereafter, in the near term, we plan to expand our factory store base by between five and 15 factory stores annually. In each year, we plan toopen and close factory stores in varying numbers. Our new factory store operating model assumes a target factory store size of 4,700 square feet that achievessales per square foot of $380 in the first twelve months. Our average net investment to open a factory store is approximately $511,000, which includes$353,000 of build-out costs net of landlord contributions, $133,000 of initial inventory net of payables and pre-opening expenses of $25,000. This operatingmodel results in an average pretax cash return on investment of approximately 87%.Central Real Estate Management for Retail and Factory StoresOur real estate management team focuses on a specific set of guidelines and considerations when selecting locations for retail and factory store openings,relocations, repositionings and closures. We lease all of our stores and generally seek to locate our stores in affluent markets where we previously haveexperienced strong catalog or Internet website sales. We analyze factors such as the demographics of the local markets, the performance of a particularshopping center, the quality and nature of existing shopping center tenants, the quality of the location, the configuration of the space and the lease terms beingoffered to us. We also try to limit our capital investment in new stores by seeking significant construction allowances from landlords, and size our storesbased on the anticipated strength of the market.Our real estate management team consists of real estate, construction, purchasing and lease administration professionals. While we use the services ofoutside architects and contractors in designing and constructing our stores, our in-house design and construction directors supervise and manage the process.Our real estate management team is also assisted by a third party that negotiates leases and lease renewals on our behalf.DirectDirect consists of the J.Crew catalog and our Internet website. During fiscal 2005, Direct generated $253.7 million in revenues, including $93.9 millionfrom our catalog and $159.8 million from our Internet website, representing 26.6% of our total revenues. In addition to driving sales and revenue, we use ourdirect channel to introduce and test new product offerings, to sell specialty product lines such as J.Crew Wedding and to offer extended sizes and colors onvarious products and to expand customer files to drive targeted marketing campaigns by collecting customer data to further segment customer groups.We currently obtain customer information for 100% of our catalog and Internet customers. As of April 2006, our customer database containedapproximately 21 million individual customer names, of which 2.0 million were households that had placed a catalog or Internet order with us or made a storepurchase from us within the previous 12 months, and 2.7 million email addresses that had agreed to receive promotional emails from us. 9Table of ContentsWe maintain a database of “customer files,” which include sales patterns, detailed purchasing information, certain demographic information,geographic locations and email addresses of our customers. This database enables us to see how our customers use our various sales channels to shop andfacilitates targeted marketing strategies. We segment our customer files based on several variables, and we tailor our catalog offerings and email notifications toaddress the different product needs of our customer groups. For example, we currently send targeted emails to such customer groups as purchasers of shoes,petite items and high dollar amount items. We focus on continually improving the segmentation of customer files and the acquisition of additional customernames from several sources, including our retail stores, our Internet website, list rentals and list exchanges with other catalog companies.In fiscal 2005, approximately 60% of Direct revenues were generated by customers who had made a purchase from a J.Crew catalog or on our Internetwebsite in the prior 12 months.CatalogThe J.Crew catalog is the primary branding and advertising vehicle for the J.Crew brand. We believe our catalog reinforces the J.Crew brand image anddrives sales across all of our sales channels. For example, over 30% of our Internet customers reported that they had received a catalog in the mail prior to theirInternet purchase, which we believe shows that our catalog drives sales on our Internet channel. We believe we have distinguished ourselves from other catalogretailers by utilizing high quality photography and paper, and placing our products in settings designed to reflect our brand’s aspirational lifestyle image suchas beach houses in the summer and country cabins in the holiday months. We have furthered this image recently by eliminating clearance catalogs and insteadredirecting primary liquidation activity through our website. In fiscal 2005, we distributed 20 catalog editions with a circulation of approximately 55 millioncopies and approximately 6.1 billion pages circulated.We segment our customer files and tailor our catalog offerings to address the different product needs of our customer groups. To increase catalogproductivity and improve the effectiveness of marginal and prospecting circulation, each customer group is offered a distinct array of catalog editions. Forexample, we continue to circulate a “Women’s Collections” edition to our women’s product customers. In addition, we are exploring a similar strategy for ourmen’s product customers. In both cases, our focus is consistently to deliver the most relevant catalogs possible to identified customer groups.All creative work on the J.Crew catalog is coordinated by our in-house personnel, and we believe this allows us to shape and reinforce our brand image.Photography is executed both on location and in studios, and creative design and copy writing are executed on a desktop publishing system. Digital images aretransmitted directly to outside printers, thereby reducing lead times and improving reproduction quality.While we do not have long-term contracts with our suppliers of paper for our catalog, we believe our long-standing relationships with a number of thelargest coated paper mills in the United States allow us to purchase paper at favorable prices. Projected paper requirements are communicated on an annualbasis to paper mills to ensure the availability of an adequate supply.Internet WebsiteSince 1996, our website located at www.jcrew.com has allowed our customers to purchase our merchandise over the Internet. In fiscal 2005, our websitelogged over 64 million visits, an increase of 33% over our fiscal 2004 visits of 48 million, which represented 63% of the Direct business in fiscal 2005compared to 61% of the Direct business in fiscal 2004. We design and operate our website using an in-house technical staff. Our website emphasizessimplicity and ease of customer use while integrating the J.Crew brand’s aspirational lifestyle imagery used in the catalog. We update our website periodicallythroughout the day to accurately reflect product availability and to determine where on the website a particular product generates the best sales. In addition toselling our regular merchandise on our website, we also use our website as a means to sell marked-down merchandise.We have enhanced our Internet business by adding category-based “shops” to our website, such as J.Crew swimfinder, wedding & party shop anddenim shop. We believe these “shops” will offer our customers a more personalized and interactive shopping experience. 10Table of ContentsMarketing and AdvertisingThe J.Crew catalog is the primary branding and advertising vehicle for the J.Crew brand. We believe our catalog reinforces the J.Crew brand image anddrives sales in all of our sales channels. Our direct sales channels enable us to maintain a database of customer sales patterns and we are thus able to targetsegments of our customer base with specific marketing. Depending on their spending habits, we send certain customers special catalog editions, such asResort Edition. J.Crew Wedding and Women’s Collection, and/or emails. We also collect customer information in our retail stores and send our catalog andtargeted emails highlighting specific product offerings to those retail customers. In addition, our catalogs contain information about a customer’s nearest J.Crewstore in order to encourage the customer to visit that store.Our other marketing approach seeks to attract positive attention to our brand and products in less conventional, but, we believe, highly effectivemanners. We refer to this marketing approach as “advertising without advertising.” For example, during the summer of 2004, we ran a “beach deliveryservice” in which our beach delivery team delivered some of our summer items to the East Hampton area and generated positive press coverage. We have alsorecognized the loyalty of our top customers by sending them “thank you letters” from top executives, some of which include shopping incentives such asdiscount offerings. We also plan to test print advertising in select publications targeting specific markets.We also offer a private-label credit card through an agreement with World Financial Network National Bank (“WFNNB”), under which WFNNB ownsthe credit card accounts and Alliance Data Systems Corporation provides services to our private-label credit card customers. In fiscal 2005, sales on J.Crewcredit cards made up 15% of our total net sales. We believe that our credit card program encourages frequent store and website visits and catalog sales andpromotes multiple-item purchases, thereby cultivating customer loyalty to the J.Crew brand and increasing sales.Sourcing Production and QualityOur Sourcing StrategyWe do not own or operate any manufacturing facilities and instead contract with third-party vendors for production of our merchandise. Our sourcingstrategy emphasizes the quality fabrics and construction that our customers expect of the J.Crew brand. To ensure that our high standards of quality andtimely delivery of merchandise are met, we work with a select group of vendors and factories among which are some of what we believe to be the mostreputable producers currently supplying the designer fashion industry with such products as English silk, Scottish tweed and Italian leather and cashmere.We seek to ensure the quality of our manufacturers’ products by inspecting pre-production samples, making periodic site visits to our vendors’ foreignproduction factories and by selectively inspecting inbound shipments at our distribution center. We also monitor quality by “scoring” each factory at the endof each year on the basis of the number of defective products detected in that factory’s output.We believe our sourcing strategy maximizes our speed to market and allows us to respond quickly to our customers’ preferences. The majority of ourvendors can have merchandise ready to be shipped to us within 45 to 60 days of us placing a refill order with them, enabling quick inventory replenishment.We believe our strong relationships with our vendors have also provided us with the ability to negotiate favorable pricing terms, further improving our overallcost structure.Our Sourcing MethodsWe have no long-term merchandise supply contracts, and we typically transact business on an order-by-order basis. We source our merchandise in twoways: through the use of buying agents, and by purchasing merchandise directly from trading companies and manufacturers. In fiscal 2005, we worked withnine buying agents, who together supported our relationships with vendors of approximately 70% to 75% of our merchandise, with one buying agentsupporting our relationships with vendors that supplied approximately 50% of our merchandise. In exchange for a commission, our buying agents identifysuitable vendors and coordinate our 11Table of Contentspurchasing requirements with the vendors by placing orders for merchandise on our behalf, ensuring the timely delivery of goods to us, obtaining samples ofmerchandise produced in the factories, inspecting finished merchandise and carrying out other administrative communications on our behalf. In fiscal 2005,we worked with three trading companies, purchasing approximately 15% of our merchandise from one trading company. Trading companies control factorieswhich manufacture merchandise and also handle certain other shipping and customs matters related to importing the merchandise into the United States. Wesourced the remainder of our merchandise by dealing directly with manufacturers both within the United States and abroad with the majority of whom wehave long-term, and we believe, stable relationships.Our sourcing base currently consists of approximately 100 vendors who operate 250 factories in approximately 23 countries, with about half of ourmerchandise supplied by our top 10 vendors.Each of our top 10 vendors uses multiple factories to produce its merchandise, which we believe gives us a high degree of flexibility in placingproduction of our merchandise. We believe we have developed strong relationships with our vendors, some of which rely upon us for a significant portion oftheir business.In fiscal 2005, approximately 80% of our merchandise was sourced in Asia (with 55% of our products sourced from China, Hong Kong and Macau),5% was sourced in the United States and 15% was sourced in Europe and other regions. Substantially all of our foreign purchases are negotiated and paid forin U.S. dollars.Vendors located abroad ship our merchandise to us primarily by boat, which in most cases takes approximately 28 to 30 days in transit. The remainderof our merchandise from abroad is shipped to us by plane, which takes an average of approximately seven to 10 days in transit. In the case of merchandisemanufactured abroad, vendors deliver merchandise to one of our overseas consolidators. From there, the merchandise is shipped to one of our two U.S.deconsolidators, one of which is located on the east coast and the other on the west coast. From our U.S. deconsolidators, independent trucking companiestransport our merchandise to one of our distribution centers, which generally takes two to three days of transit time. In the case of merchandise manufacturedin the United States, we contract with an independent trucking company to transport merchandise from its manufacturer to one of our distribution centers,which generally takes a week or less.Regardless of the sourcing method used, each factory, subcontractor, supplier and agent that manufactures our merchandise is required to adhere to ourCode of Vendor Conduct, which is designed to ensure that each of our suppliers’ operations are conducted in a legal, ethical and responsible manner. OurCode of Vendor Conduct requires that each of our suppliers operates in compliance with applicable wage, benefit, working hours and other local laws, andforbids the use of practices such as child labor or forced labor. Our Code of Vendor Conduct is currently administered internally by J.Crew employees,including a dedicated J.Crew employee, and two outside compliance audit firms that we contract with to make periodic visits to the facilities that produce ourgoods to monitor compliance, and includes prequalification of new suppliers and a requirement that each supplier execute an annual compliance certification.Distribution FacilitiesWe operate one customer call center and two distribution facilities. We own a 162,000 square foot facility in Asheville, North Carolina that houses ourdistribution operations for our retail stores. This facility employs approximately 100 full and part-time employees during our non-peak season andapproximately 30 additional employees during our peak season. Merchandise is transported from this distribution center to our retail stores by independenttrucking companies, Federal Express or UPS, with a transit time of approximately two to five days.We also own a 262,000 square foot facility, and lease a 63,700 square foot facility, both located in Lynchburg, Virginia. These facilities contain ourcustomer call center, order fulfillment operations for Direct and distribution operations for our factory stores. These facilities employ approximately 800 fulland part-time employees during our non-peak season and an additional 600 employees during our peak season. Merchandise is transported from thisdistribution center to our factory stores by Federal Express or UPS, with a transit time of approximately two to five days. Merchandise sold via our Directchannels is sent directly to customers from this distribution center via the United States Postal Service, UPS or Federal Express. 12Table of ContentsEach owned facility is equipped with an automated warehouse locator system and inventory bar coding system and our owned facility in Lynchburghas automated packing and shipping sorters. We believe our customer call center, order fulfillment operations and distribution operations are designed tohandle customer orders and distribute merchandise to stores in a customer-friendly, efficient and cost-effective manner. We currently outsource a portion ofcustomer calls to two vendors and plan to use only one of these vendors beginning in the near future.Management Information SystemsOur management information systems are designed to provide, among other things, comprehensive order processing, production, accounting andmanagement information for the marketing, manufacturing, importing and distribution functions of our business. Since February 2001, we have used anSAP Enterprise Resource Planning system along with an IBM mainframe system for our information technology requirements. We have point-of-sale systemsin our retail and factory stores that enable us to track inventory from store receipt to final sale on a real-time basis. We have an agreement with Electronic DataSystems Corporation, a third party, to provide services and administrative support for most of the information systems in our headquarters, stores anddistribution and call center facilities. Our website is hosted by a third party at its data center.We believe our merchandising and financial systems, coupled with our point-of-sale systems and software programs, allow for rapid stockreplenishment, concise merchandise planning and real-time inventory accounting practices. Our telephone and telemarketing systems, warehouse packagesorting systems, automated warehouse locator and inventory bar coding systems use current technology, and are designed with our highest-volume periods,such as the holiday season, in mind, which results in our having substantial flexibility and ample capacity in our lower-volume periods. We periodicallyupdate our ATG website software and our point-of-sale systems, and implemented standard upgrades in 2005 to provide additional functionality to bothinformation systems.We believe our management information systems provide us with a number of benefits, including enhanced customer service, improved operationalefficiency and increased management control and reporting. In addition, our real-time inventory systems provide inventory management on a stock keepingunit basis and allow for an efficient fulfillment process.Employees and Labor RelationsAs of January 28, 2006, we had approximately 6,800 employees (including seasonal employees), of whom approximately 2,500 were full-timeemployees and 4,300 were part-time employees. Approximately 1,000 of these employees are employed in our customer call center and order fulfillmentoperations facility in Lynchburg, Virginia, and approximately 110 of these employees work in our store distribution center in Asheville, North Carolina.Approximately 2,000 employees are hired on a seasonal basis to meet demand during the peak season.None of our employees are represented by a union. We have had no labor-related work stoppages and we believe our relationship with our employees isgood.CompetitionThe specialty retail industry is highly competitive. We compete primarily with specialty retailers, higher-end department stores, catalog retailers andInternet businesses that engage in the retail sale of women’s and men’s apparel, accessories, shoes and similar merchandise. We believe the principal basesupon which we compete are quality, design, customer service and price. We believe that our primary competitive advantages are consumer recognition of theJ.Crew brand name and our presence in many major shopping malls in the United States as well as our multiple sale channels which enable our customers toshop in the setting they prefer. We believe that we also differentiate ourselves from competitors on the basis of our J.Crew signature product design, our abilityto offer both designer-quality products at higher price points and more casual items at lower price points, our focus on the quality of our product offerings andour customer-service oriented culture. We believe our success depends in substantial part on our ability to originate and define product and fashion trends aswell as to timely anticipate, gauge and react to changing consumer demands. Certain of our competitors are larger and have greater financial, marketing and 13Table of Contentsother resources than us. Accordingly, there can be no assurance that we will be able to compete successfully with them in the future.Trademarks and LicensingThe J.Crew trademark and variations thereon such as crewcuts are registered or are subject to pending trademark applications with the United StatesPatent and Trademark Office and with the registries of many foreign countries. We believe our trademarks have significant value and we intend to continue tovigorously protect them against infringement.In addition, we license our J.Crew trademark and know-how to Itochu Corporation in Japan for which we receive royalty fees based on a percentage ofsales. Under the license agreement, which is an exclusive license with regard to Japan, we retain a high degree of control over the manufacture, design,marketing and sale of merchandise by Itochu Corporation under the J.Crew trademark. This agreement is currently scheduled to expire in January 2007. Infiscal 2005, licensing revenues totaled $2.9 million.Government RegulationWe are subject to customs, truth-in-advertising and other laws, including consumer protection regulations and zoning and occupancy ordinances thatregulate retailers and/or govern the promotion and sale of merchandise and the operation of retail stores and warehouse facilities. We monitor changes in theselaws and believe that we are in material compliance with applicable laws.A substantial portion of our products are manufactured outside the United States. These products are imported and are subject to U.S. customs laws,which impose tariffs as well as import quota restrictions for textiles and apparel. Some of our imported products are eligible for duty-advantaged programs.While importation of goods from foreign countries from which we buy our products may be subject to embargo by U.S. Customs authorities if shipmentsexceed quota limits, we closely monitor import quotas and believe we have the sourcing network to efficiently shift production to factories located in countrieswith available quotas. The existence of import quotas has, therefore, not had a material adverse effect on our business.Available InformationWe make available free of charge on our internet website, www.jcrew.com, copies of our annual reports on Form 10-K, quarterly reports on Form 10-Q,current reports on Form 8-K and all amendments to these reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934,as amended (the “Exchange Act”), as soon as reasonably practicable after filing such material electronically with, or otherwise furnishing it to, the SEC. Thereference to our website address does not constitute incorporation by reference of the information contained on the website, and the information contained on thewebsite is not part of this document. 14Table of ContentsITEM 1A.RISK FACTORS.The following risk factors should be carefully considered when evaluating our business and the forward-looking statements in this report. See“Disclosure Regarding Forward Looking Statements”.We operate in the highly competitive specialty retail industry and the size and resources of some of our competitors may allow them to competemore effectively than we can, which could result in loss of our market share.We face intense competition in the specialty retail industry. We compete primarily with specialty retailers, high-end department stores, catalog retailersand Internet businesses that engage in the retail sale of women’s and men’s apparel, accessories, shoes and similar merchandise. We believe that the principalbases upon which we compete are the quality and design of merchandise and the quality of customer service. We also believe that price is an important factorin our customers’ decision-making process. Many of our competitors are, and many of our potential competitors may be, larger and have greater financial,marketing and other resources and therefore may be able to adapt to changes in customer requirements more quickly, devote greater resources to the marketingand sale of their products, generate greater national brand recognition or adopt more aggressive pricing policies than we can. In addition, increased catalogmailings by our competitors may adversely affect response rates to our own catalog mailings. As a result, we may lose market share, which would reduce ourrevenues and gross profit.If we are unable to gauge fashion trends and react to changing consumer preferences in a timely manner, our sales will decrease.We believe our success depends in substantial part on our ability to: • originate and define product and fashion trends, • anticipate, gauge and react to changing consumer demands in a timely manner, and • translate market trends into appropriate, saleable product offerings far in advance of their sale in our stores, our catalog or our Internet website.Because we enter into agreements for the manufacture and purchase of merchandise well in advance of the season in which merchandise will be sold, weare vulnerable to changes in consumer demand, pricing shifts and suboptimal merchandise selection and timing of merchandise purchases. We attempt toreduce the risks of changing fashion trends and product acceptance in part by devoting a portion of our product line to classic styles that are not significantlymodified from year to year. Nevertheless, if we misjudge the market for our products, we may be faced with significant excess inventories for some productsand missed opportunities for others. Our brand image may also suffer if customers believe we are no longer able to offer the latest fashions. The occurrence ofthese events could hurt our financial results by decreasing sales. We may respond by increasing markdowns or initiating marketing promotions to reduceexcess inventory, which would further decrease our gross profits and net income.The specialty retail industry is cyclical, and a decline in consumer spending on apparel and accessories could reduce our sales and slow ourgrowth.The industry in which we operate is cyclical. Purchases of apparel and accessories are sensitive to a number of factors that influence the levels ofconsumer spending, including general economic conditions and the level of disposable consumer income, the availability of consumer credit, interest rates,taxation and consumer confidence in future economic conditions. Because apparel and accessories generally are discretionary purchases, declines in consumerspending patterns may impact us more negatively as a specialty retailer. Therefore, we may not be able to maintain our recent rate of growth in revenues if thereis a decline in consumer spending patterns, and we may decide to slow or alter our growth plans. 15Table of ContentsWe rely on the experience and skills of key personnel, the loss of whom could damage our brand image and our ability to sell our merchandise.We believe we have benefited substantially from the leadership and strategic guidance of, in particular, Mr. Drexler, Jeffrey Pfeifle, our president, andTracy Gardner, our executive vice-president of merchandising, planning and production, who are primarily responsible for repositioning our brand anddeveloping our philosophy. The loss, for any reason, of the services of any of these individuals and any negative market or industry perception arising fromsuch loss could damage our brand image and delay the implementation of our strategy. Our other officers have substantial experience and expertise in thespecialty retail industry and have made significant contributions to our growth and success. The unexpected loss of one or more of these individuals coulddelay the development and introduction of, and harm our ability to sell, our merchandise. In addition, products we develop without the guidance and directionof these key personnel may not receive the same level of acceptance.In addition, our success depends in part on our ability to attract and retain other key personnel. Competition for these personnel is intense, and we maynot be able to attract and retain a sufficient number of qualified personnel in the future.Our plan to expand our store base may not be successful, and implementation of this plan may divert our operational, managerial andadministrative resources, which could impact our competitive position.We expanded our store base by six stores in fiscal 2005. We plan to further expand our store base by between 15 and 30 stores in fiscal 2006.Thereafter, in the near term, we plan to expand our store base by between 25 and 35 stores annually. The success of our business depends, in part, on ourability to open new stores and renew our existing store leases on terms that meet our financial targets. Our ability to open new stores on schedule or at all, torenew existing store leases on favorable terms or to operate them on a profitable basis will depend on various factors, including our ability to: • identify suitable markets for new stores and available store locations, • negotiate acceptable lease terms for new locations or renewal terms for existing locations, • manage and expand our infrastructure to accommodate growth, • hire and train qualified sales associates, • develop new merchandise and manage inventory effectively to meet the needs of new and existing stores on a timely basis, • foster current relationships and develop new relationships with vendors that are capable of supplying a greater volume of merchandise, and • avoid construction delays and cost overruns in connection with the build-out of new stores.Our plans to expand our store base may not be successful and the implementation of these plans may not result in an increase in our revenues eventhough they increase our costs. Currently, our average net investment to open a retail store is approximately $844,000 and our average net investment to open afactory store is approximately $511,000. In addition, we believe the opening of J.Crew stores has diverted some revenues from Direct, and future storeopenings may continue to have this effect. Moreover, implementing our plans to expand our store base will place increased demands on our operational,managerial and administrative resources. The increased demands of operating additional stores could cause us to operate less effectively, which could causethe performance of our existing stores and our Direct operations to suffer materially. As a result, our revenues would decline and our profitability would beadversely affected. 16Table of ContentsOur plans to expand our product offerings and sales channels may not be successful, and implementation of these plans may divert ouroperational, managerial and administrative resources, which could impact our competitive position.In addition to our store base expansion strategy, we plan to grow our business by expanding our product offerings and sales channels, including bymarketing our crewcuts line of children’s apparel and accessories. These plans involve various risks discussed elsewhere in these risk factors, including: • implementation of these plans may be delayed or may not be successful, • if our expanded product offerings and sales channels fail to maintain and enhance our distinctive brand identity, our brand image may bediminished and our sales may decrease, • if we fail to expand our infrastructure, including by securing desirable store locations at reasonable costs and hiring and training qualifiedemployees, we may be unable to manage our expansion successfully, and • implementation of these plans may divert management’s attention from other aspects of our business and place a strain on our management,operational and financial resources, as well as our information systems.In addition, our ability to successfully carry out our plans to expand our product offerings and our sales channels may be affected by, among otherthings, economic and competitive conditions, changes in consumer spending patterns and changes in consumer preferences and style trends. Our expansionplans could be delayed or abandoned, could cost more than anticipated and could divert resources from other areas of our business, any of which couldimpact our competitive position and reduce our revenue and profitability.If we fail to maintain the value of our brand, our sales are likely to decline.Our success depends on the value of the J.Crew brand. The J.Crew name is integral to our business as well as to the implementation of our strategies forexpanding our business. Maintaining, promoting and positioning our brand will depend largely on the success of our marketing and merchandising effortsand our ability to provide a consistent, high quality customer experience. Our brand could be adversely affected if we fail to achieve these objectives or if ourpublic image or reputation were to be tarnished by negative publicity. Any of these events could result in decreases in sales.The capacity of our order fulfillment and distribution facilities may not be adequate to support our growth plans, which could prevent thesuccessful implementation of these plans or cause us to incur costs to expand these facilities.The success of our stores depends on their timely receipt of merchandise, and the success of Direct depends on our ability to fulfill customer orders on atimely basis. The efficient flow of our merchandise requires that we have adequate capacity in our order fulfillment and distribution facilities to support ourcurrent level of operations, and the anticipated increased levels that may follow from our growth plans. We believe our current facilities have the capacity tosupport current operations and the growth we anticipate in our business in the near future. However, we may need to increase the capacity of these facilitiessooner than anticipated to support our growth, and any further expansion may require us to secure favorable real estate for these facilities and may require usto obtain additional financing. Appropriate locations or financing for the purchase or lease of such locations may not be available at all or at reasonable costs.Our failure to secure adequate order fulfillment and distribution facilities when necessary could impede our growth plans, and the expansion of these facilitieswould increase our costs.We may not be able to maintain recent levels of comparable store sales.Our recent comparable store sales have been higher than our historical average, and we may not be able to maintain these levels of comparable store salesin the future. In addition, the results of operations of individual 17Table of ContentsJ.Crew stores have fluctuated in the past and can be expected to continue to fluctuate in the future. For example, over the past twelve fiscal quarters, ourquarterly comparable store sales have ranged from a decrease of 11% in the first quarter of fiscal 2003 to an increase of 37% in the first quarter of fiscal 2005.A variety of factors affect comparable store sales, including fashion trends, competition, current economic conditions, pricing, inflation, the timing of therelease of new merchandise and promotional events, changes in our merchandise mix, the success of marketing programs, timing and level of markdowns andweather conditions. These factors may cause our comparable store sales results to be materially lower than recent periods and our expectations, which couldcause declines in our quarterly earnings.An inability or failure to protect our trademarks could diminish the value of our brand and reduce demand for our merchandise.The J.Crew trademark and variations thereon, such as crewcuts, are valuable assets that are critical to our success. We intend to continue to vigorouslyprotect our trademarks against infringement, but we may not be successful in doing so. The unauthorized reproduction or other misappropriation of ourtrademarks would diminish the value of our brand, which could reduce demand for our products or the prices at which we can sell our products.A reduction in the volume of mall traffic could significantly reduce our sales and leave us with unsold inventory.Most of our stores are located in shopping malls. Sales at these stores are derived, in part, from the volume of traffic in those malls. Our stores benefitfrom the ability of the malls’ “anchor” tenants, generally large department stores, and other area attractions to generate consumer traffic in the vicinity of ourstores and the continuing popularity of the malls as shopping destinations. Sales volume and mall traffic may be adversely affected by regional economicdownturns, the closing of anchor department stores and competition from non-mall retailers and other malls where we do not have stores. Any of these events,or a decline in the desirability of the shopping environment of a particular mall or in the popularity of mall shopping generally among our customers, wouldreduce our sales and leave us with excess inventory. We may respond by increasing markdowns or initiating marketing promotions to reduce excess inventory,which would further decrease our gross profits and net income.Fluctuations in our results of operations for the fourth fiscal quarter would have a disproportionate effect on our overall financial condition andresult of operations.We experience seasonal fluctuations in revenues and operating income, with a disproportionate amount of our revenues and a majority of our incomebeing generated in the fourth fiscal quarter holiday season. Our revenues and income are generally weakest during the first and second fiscal quarters. Inaddition, any factors that harm our fourth fiscal quarter operating results, including adverse weather or unfavorable economic conditions, could have adisproportionate effect on our results of operations for the entire fiscal year.In order to prepare for our peak shopping season, we must order and keep in stock significantly more merchandise than we would carry at other timesof the year. Any unanticipated decrease in demand for our products during our peak shopping season could require us to sell excess inventory at a substantialmarkdown, which could reduce our net sales and gross profit.Our quarterly results of operations may also fluctuate significantly as a result of a variety of other factors, including the timing of new store openingsand of catalog mailings, the revenues contributed by new stores, merchandise mix and the timing and level of inventory markdowns. As a result, historicalperiod-to-period comparisons of our revenues and operating results are not necessarily indicative of future period-to-period results. You should not rely on theresults of a single fiscal quarter, particularly the fourth fiscal quarter holiday season, as an indication of our annual results or our future performance.If our manufacturers are unable to produce our goods on time or to our specifications, we could suffer lost sales.We do not own or operate any manufacturing facilities and therefore depend upon independent third party vendors for the manufacture of all of ourproducts. Our products are manufactured to our specifications primarily by foreign manufacturers. We cannot control all of the various factors, whichinclude inclement weather, natural 18Table of Contentsdisasters and acts of terrorism that might affect a manufacturer’s ability to ship orders of our products in a timely manner or to meet our quality standards.Late delivery of products or delivery of products that do not meet our quality standards could cause us to miss the delivery date requirements of our customersor delay timely delivery of merchandise to our stores for those items. These events could cause us to fail to meet customer expectations, cause our customers tocancel orders or cause us to be unable to deliver merchandise in sufficient quantities or of sufficient quality to our stores, which could result in lost sales.Third party failure to deliver merchandise from our distribution center to our stores and to customers could result in lost sales or reduce demandfor our merchandise.The success of our stores depends on their timely receipt of merchandise from our distribution facility, and the success of Direct depends on the timelydelivery of merchandise to our customers. Independent third party transportation companies deliver our merchandise to our stores and to our customers. Someof these third parties employ personnel represented by a labor union. Disruptions in the delivery of merchandise or work stoppages by employees of these thirdparties could delay the timely receipt of merchandise, which could result in cancelled sales, a loss of loyalty to our brand and excess inventory. Timely receiptof merchandise by our stores and our customers may also be affected by factors such as inclement weather, natural disasters and acts of terrorism. We mayrespond by increasing markdowns or initiating marketing promotions, which would decrease our gross profits and net income.Interruption in our foreign sourcing operations could disrupt production, shipment or receipt of our merchandise, which would result in lostsales and could increase our costs.In fiscal 2005, approximately 95% of our products were sourced from foreign factories. In particular, approximately 55% of our products were sourcedfrom China, Hong Kong and Macau. Any event causing a sudden disruption of manufacturing or imports from Asia or elsewhere, including the imposition ofadditional import restrictions, could materially harm our operations. We have no long-term merchandise supply contracts, and many of our imports aresubject to existing or potential duties, tariffs or quotas that may limit the quantity of certain types of goods that may be imported into the United States fromcountries in Asia or elsewhere. We compete with other companies for production facilities and import quota capacity. Our business is also subject to a varietyof other risks generally associated with doing business abroad, such as political instability, currency and exchange risks, disruption of imports by labordisputes and local business practices.Our sourcing operations may also be hurt by political and financial instability, strikes, health concerns regarding infectious diseases in countries inwhich our merchandise is produced, adverse weather conditions or natural disasters that may occur in Asia or elsewhere or acts of war or terrorism in theUnited States or worldwide, to the extent these acts affect the production, shipment or receipt of merchandise. Our future operations and performance will besubject to these factors, which are beyond our control, and these factors could materially hurt our business, financial condition and results of operations ormay require us to modify our current business practices and incur increased costs.In addition, the raw materials used to manufacture our products are subject to availability constraints and price volatility caused by high demand forfabrics, weather, supply conditions, government regulations, economic climate and other unpredictable factors. Increases in the demand for, or the price of,raw materials could hurt our profitability.Our ability to source our merchandise profitably or at all could be hurt if new trade restrictions are imposed or existing trade restrictions becomemore burdensome.Trade restrictions, including increased tariffs, safeguards or quotas, on apparel and accessories could increase the cost or reduce the supply ofmerchandise available to us. Under the World Trade Organization (“WTO”) Agreement, effective January 1, 2005, the United States and other WTO membercountries removed quotas on goods from WTO members, which in certain instances affords us greater flexibility in importing textile and apparel productsfrom WTO countries from which we source our merchandise. However, as the removal of quotas resulted in an import surge from China, the United States inMay 2005 imposed safeguard quotas on seven categories of goods and apparel imported from China. Effective January 1, 2006, the United States imposedquotas 19Table of Contentson approximately twelve categories of goods and apparel from China, and may impose additional quotas in the future. These and other trade restrictions couldhave a significant impact on our sourcing patterns in the future. The extent of this impact, if any, and the possible effect on our purchasing patterns andcosts, cannot be determined at this time. We cannot predict whether any of the countries in which our merchandise is currently manufactured or may bemanufactured in the future will be subject to additional trade restrictions imposed by the U.S. and foreign governments, nor can we predict the likelihood, typeor effect of any such restrictions. Trade restrictions, including increased tariffs or quotas, embargoes, safeguards and customs restrictions against apparelitems, as well as U.S. or foreign labor strikes, work stoppages or boycotts could increase the cost or reduce the supply of apparel available to us or mayrequire us to modify our current business practices, any of which could hurt our profitability.Increases in costs of mailing, paper and printing will affect the cost of our catalog and promotional mailings, which will reduce our profitability.Postal rate increases and paper and printing costs affect the cost of our catalog and promotional mailings. In fiscal 2005, approximately 13% of ourselling, general and administrative expenses were attributable to such costs. In January 2006, the U.S. Postal Service implemented a postal rate increase of5.5%. We have undertaken certain actions such as reductions in catalog circulation and size of certain catalog editions to mitigate the effect of the increasedcosts of mailing. In addition, we rely on discounts from the basic postal rate structure, such as discounts for bulk mailings and sorting by zip code andcarrier routes. We are not a party to any long-term contracts for the supply of paper. Our cost of paper has fluctuated significantly, and our future paper costsare subject to supply and demand forces that we cannot control. Future additional increases in postal rates or in paper or printing costs would reduce ourprofitability to the extent that we are unable to pass those increases directly to customers or offset those increases by raising selling prices or by implementingmailings that result in increased purchases.If our independent manufacturers and Japan licensing partner do not use ethical business practices or comply with applicable laws andregulations, the J.Crew brand name could be harmed due to negative publicity.While our internal and vendor operating guidelines promote ethical business practices and we, along with third parties that we retain for this purpose,monitor compliance with those guidelines, we do not control our independent manufacturers, our licensing partner or their business practices. Accordingly, wecannot guarantee their compliance with our guidelines.Violation of labor or other laws by our independent manufacturers or our licensing partner, or the divergence of an independent manufacturer’s or ourlicensing partner’s labor practices from those generally accepted as ethical in the United States could diminish the value of the J.Crew brand and reducedemand for our merchandise if, as a result of such violation, we were to attract negative publicity.Any significant interruption in the operations of our customer call, order fulfillment and distribution facilities could disrupt our ability to processcustomer orders and to deliver our merchandise in a timely manner.Our customer call center, Direct’s order fulfillment operations and distribution operations for J.Crew factory stores are housed together in a singlefacility, while distribution operations for J.Crew retail stores are housed in another single facility. Although we maintain back-up systems for these facilities,they may not be able to prevent a significant interruption in the operation of these facilities due to natural disasters, accidents, failures of the inventory locatoror automated packing and shipping systems we use or other events. Any such interruption could reduce our ability to receive and process orders and provideproducts and services to our stores and customers, which could result in lost sales, cancelled sales and a loss of loyalty to our brand.We are subject to customs, advertising, consumer protection, zoning and occupancy and labor and employment laws that could require us tomodify our current business practices and incur increased costs.We are subject to numerous regulations, including customs, truth-in-advertising, consumer protection and zoning and occupancy laws and ordinancesthat regulate retailers generally and/or govern the importation, promotion and sale of merchandise and the operation of retail stores and warehouse facilities. Ifthese regulations were to change or were violated by our management, employees, suppliers, buying agents or trading companies, the 20Table of Contentscosts of certain goods could increase, or we could experience delays in shipments of our goods, be subject to fines or penalties, or suffer reputational harm,which could reduce demand for our merchandise and hurt our business and results of operations. In addition, changes in federal and state minimum wagelaws and other laws relating to employee benefits could cause us to incur additional wage and benefits costs, which could hurt our profitability.Legal requirements are frequently changed and subject to interpretation, and we are unable to predict the ultimate cost of compliance with theserequirements or their effect on our operations. We may be required to make significant expenditures or modify our business practices to comply with existingor future laws and regulations, which may increase our costs and materially limit our ability to operate our business.Any material disruption of our information systems could disrupt our business and reduce our sales.We are increasingly dependent on information systems to operate our website, process transactions, respond to customer inquiries, manage inventory,purchase, sell and ship goods on a timely basis and maintain cost-efficient operations. We may experience operational problems with our information systemsas a result of system failures, viruses, computer “hackers” or other causes. Any material disruption or slowdown of our systems could cause information,including data related to customer orders, to be lost or delayed which could—especially if the disruption or slowdown occurred during the holiday season—result in delays in the delivery of merchandise to our stores and customers, which could reduce demand for our merchandise and cause our sales to decline.Moreover, we may not be successful in developing or acquiring technology that is competitive and responsive to the needs of our customers and might lacksufficient resources to make the necessary investments in technology to compete with our competitors. Accordingly, if changes in technology cause ourinformation systems to become obsolete, or if our information systems are inadequate to handle our growth, we could lose customers.We have taken over certain portions of our information systems needs that were previously outsourced to a third party and plan to make significantupgrades to our information systems and may take over other outsourced portions of our information systems in the near future. If we are unable to managethese aspects of our information systems or the planned upgrades, our receipt and delivery of merchandise could be disrupted, which could result in a declinein our sales.A failure in our Internet operations, which are subject to factors beyond our control, could significantly disrupt our business and lead to reducedsales and reputational damage.Our Internet operations are an increasingly substantial part of our business, representing 63% of the Direct business in fiscal 2005. The success of ourInternet operations depends on certain factors that we cannot control. In addition to changing consumer preferences and buying trends relating to Internet usage,we are vulnerable to certain additional risks and uncertainties associated with the Internet, including changes in required technology interfaces, websitedowntime and other technical failures, security breaches, and consumer privacy concerns. Our failure to successfully respond to these risks and uncertaintiescould reduce Internet sales and damage our brand’s reputation.Our substantial amount of debt may limit the cash flow available for our operations and place us at a competitive disadvantage and may limit ourability to pursue our expansion plans.We have a substantial amount of debt. On January 28, 2006, we had total debt of approximately $724.7 million. Our level of indebtedness hasimportant consequences. For example, our level of indebtedness may: • require us to use a substantial portion of our cash flow from operations to pay interest and principal on our debt, which would reduce the fundsavailable to use for working capital, capital expenditures and other general corporate purposes, • limit our ability to obtain additional financing for working capital, capital expenditures, expansion plans and other investments, which may limitour ability to implement our business strategy, • result in higher interest expense if interest rates increase on our floating rate borrowings, 21Table of Contents • heighten our vulnerability to downturns in our business, the industry or in the general economy and limit our flexibility in planning for or reactingto changes in our business and the retail industry, or • prevent us from taking advantage of business opportunities as they arise or successfully carrying out our plans to expand our store base, productofferings and sales channels.We cannot assure you that our business will generate sufficient cash flow from operations or that future borrowings will be available to us in amountssufficient to enable us to make payments on our indebtedness or to fund our operations.The terms of our indebtedness contain various covenants that may limit our business activities.The terms of our indebtedness contain, and our future indebtedness may contain, various restrictive covenants that limit our management’s discretion inoperating our business. In particular, these agreements are expected to include covenants relating to limitations on: • dividends on, and redemptions and repurchases of, capital stock, • liens and sale-leaseback transactions, • loans and investments, • debt and hedging arrangements, • mergers, acquisitions and asset sales, • transactions with affiliates, and • changes in business activities conducted by us and our subsidiaries.In addition, our indebtedness may require us, under certain circumstances, to maintain certain financial ratios. It also is expected to limit our ability tomake capital expenditures. Compliance with these covenants and these ratios may prevent us from pursuing opportunities that we believe would benefit ourbusiness, including opportunities that we might pursue as part of our plans to expand our store base, our product offerings and sales channels. ITEM 1B.UNRESOLVED STAFF COMMENTS.None. ITEM 2.PROPERTIES.We are headquartered in New York City. Our headquarter offices are leased under a lease agreement expiring in 2012, with an option to renew thereafter.We own two facilities: a 262,000 square foot customer contact call center, order fulfillment and distribution center in Lynchburg, Virginia and a 162,000square foot distribution center in Asheville, North Carolina. We also lease a 63,700 square foot facility in Lynchburg, Virginia under a lease agreementexpiring in April 2008, with an option to renew thereafter.As of January 28, 2006 we operated 159 retail stores and 44 factory stores in 39 states and the District of Columbia. All of the retail and factory storesare leased from third parties and the leases historically have in most cases had terms of 10 to 12 years. A portion of our leases have options to renew forperiods typically ranging from five to ten years. Generally, the leases contain standard provisions concerning the payment of rent, events of default and therights and obligations of each party. Rent due under the leases is generally comprised of annual base rent plus a contingent rent payment based on the store’ssales in excess of a specified threshold. Some of the leases also contain early termination options, which can be exercised by us or the landlord under certainconditions. The leases 22Table of Contentsalso generally require us to pay real estate taxes, insurance and certain common area costs. Excluding our stores and headquarter offices, all of our properties,whether owned or leased, are subject to liens or security interests under our working capital facility.The table below sets forth the number of retail and factory stores operated by us in the United States as of January 28, 2006. Retail Stores Factory Stores Total Number of StoresAlabama 2 1 3Arizona 4 — 4California 20 4 24Colorado 4 2 6Connecticut 6 1 7Delaware — 1 1Florida 4 4 8Georgia 4 2 6Illinois 9 1 10Indiana 1 2 3Iowa 1 — 1Kansas 1 — 1Kentucky 2 — 2Louisiana 1 — 1Maine — 2 2Maryland 3 1 4Massachusetts 6 2 8Michigan 6 1 7Minnesota 4 — 4Missouri 2 — 2Nevada 1 — 1New Hampshire 1 2 3New Jersey 9 1 10New Mexico 1 — 1New York 16 4 20North Carolina 5 — 5Ohio 7 — 7Oklahoma 2 — 2Oregon 3 — 3Pennsylvania 8 3 11Rhode Island 1 — 1South Carolina 2 2 4Tennessee 3 1 4Texas 6 1 7Utah 2 — 2Vermont 1 1 2Virginia 5 2 7Washington 3 2 5Wisconsin 1 1 2District of Columbia 2 — 2Total 159 44 203 23Table of ContentsITEM 3.LEGAL PROCEEDINGS.In June 2005, we settled a suit alleging patent infringement brought against us and seventeen other defendants by Charles E. Hill & Associates, Inc. Theterms of the settlement did not have a material adverse effect on our financial condition or results of operations.We are subject to various legal proceedings and claims that arise in the ordinary course of our business. Although the outcome of these other claimscannot be predicted with certainty, management does not believe that the ultimate resolution of these matters will have a material adverse effect on our financialcondition or results of operations. ITEM 4.SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.No matters were submitted to a vote of security holders during the quarter ended January 28, 2006. 24Table of ContentsPART II ITEM 5.MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.There is no established public trading market for the common stock of Group or Operating. As of April 15, 2006, there were 65 shareholders of recordof Group’s common stock. See “Item 12. Security Ownership of Certain Beneficial Owners and Management” for more information on ownership of Group’scommon stock. Operating is a wholly owned direct subsidiary of Group.Group has not paid cash dividends on its common stock and does not anticipate paying any such dividends in the foreseeable future. Operating mayfrom time to time pay cash dividends on its common stock to permit Group to make required payments relating to Group’s outstanding 13 1/8% SeniorDiscount Debentures due 2008 (the “13 1/8% Debentures”).Our Credit Facility and the Indenture relating to the 13 1/8% Debentures (the “Group Indenture”) prohibit Group from paying dividends on shares ofcommon stock (other than dividends payable solely in shares of Group capital stock). In addition, because Group is a holding company, its ability to paydividends is dependent upon the receipt of dividends from Operating. Each of the Credit Facility, the Group Indenture and the indenture governing the 9 3/4%Notes contain covenants that impose substantial restrictions on Operating’s ability to pay dividends or make distributions to Group.In the fiscal year ended January 28, 2006, we issued unregistered securities in the transactions described below. These securities were offered and soldby us in reliance upon the exemptions provided for in Section 4(2) of the Securities Act of 1933, as amended (the “Securities Act”) relating to sales notinvolving any public offering. The sales were made without the use of an underwriter and the certificates representing the securities sold contain a restrictivelegend that prohibits transfers without registration or an applicable exemption.We issued restricted shares of our common stock to some of our employees, non-employee directors and former executive officers, as further describedbelow: Grant Date Number of Shares ofRestricted Stock Granted5/05/2005 40,0008/08/2005 60,0008/14/2005 35,0009/07/2005 35,000The recipients of these restricted shares of common stock did not pay any consideration for their awards. 25Table of ContentsEquity Compensation Plan InformationThe following table summarizes information about the Amended and Restated J.Crew Group, Inc. 1997 Stock Option Plan (the “1997 Plan”) and theJ.Crew Group, Inc. 2003 Equity Incentive Plan (the “2003 Plan”), as of January 28, 2006. Our shareholders have approved both of these plans. Plan Category (a)Number ofSecurities to beIssued UponExercise ofOutstanding OptionsWarrants andRights (b)Weighted AverageExercise Price ofOutstanding Options,Warrants and Rights (c)Number ofSecuritiesRemaining Availablefor Future IssuanceUnder EquityCompensation Plans(ExcludingSecurities Reflectedin Column(a)Equity Compensation Plans Approved by Shareholders 4,769,349 $14.25 99,413Equity Compensation Plans Not Approved by Shareholders N/A N/A N/ATOTAL 4,769,349 $14.25 99,413In addition to options, the 2003 Plan authorizes the issuance of restricted shares of Group’s common stock. The 2003 Plan contains a sub-limit of1,450,724 shares on the aggregate number of restricted shares that may be issued, of which 1,446,229 shares are outstanding and 4,495 shares are availablefor grant as of January 28, 2006. 26Table of ContentsITEM 6.SELECTED CONSOLIDATED FINANCIAL DATA.The selected historical consolidated financial data for each of the years in the three-year period ended January 28, 2006 and as of January 28, 2006 havebeen derived from our audited consolidated financial statements included elsewhere herein. The selected historical consolidated financial data for each of theyears in the two-year period ended February 1, 2003 have been derived from our audited consolidated financial statements which are not included herein. Theconsolidated financial statements for each of the years in the five-year period ended January 28, 2006 and as of the end of each such year have been audited.The historical results presented below are not necessarily indicative of the results to be expected for any future period. The information should be read inconjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our financial statements and the relatednotes included herein. Year Ended February 2,2002 February 1,2003 January 31,2004 January 29,2005 January 28,2006 (in thousands) Income Statement Data Revenues $777,940 $768,344 $689,965 $804,216 $953,188 Cost of goods sold(1) 454,491 472,262 440,276 478,829 555,192 Gross profit 323,449 296,082 249,689 325,387 397,996 Selling, general and administrative expense 303,448 301,718 280,464 287,745 318,499 Income (loss) from operations 20,001 (5,636) (30,775) 37,642 79,497 Interest expense (net) 36,512 40,954 63,844 87,571 72,903 (Gain) loss on debt refinancing — — (41,085) 49,780 — Insurance proceeds — (1,800) (3,850) — — Provision (benefit) for income taxes (5,500) (4,200) 500 600 2,800 Net income (loss) $(11,011) $(40,590) $(50,184) $(100,309) $3,794 As of February 2,2002 February 1,2003 January 31,2004 January 29,2005 January 28,2006 (in thousands) Balance Sheet Data Cash and cash equivalents $16,201 $18,895 $49,650 $23,647 $61,275 Working capital 39,164 38,015 46,217 12,168 72,657 Total assets 401,320 348,878 297,611 278,194 337,321 Total long-term debt and preferred stock 510,147 556,038 609,440 669,733 724,667 Stockholders’ deficit (319,043) (391,663) (468,066) (581,712) (587,843)(1)Includes buying and occupancy costs. 27Table of Contents Year Ended February 2,2002 February 1,2003 January 31,2004 January 29,2005 January 28,2006 (in thousands except percentages; numbers of stores; catalogs andpages; and per square foot data) Operating Data Revenues Stores $483,083 $484,292 $487,092 $579,793 $670,447 Direct Catalog 135,353 108,531 61,883 76,548 93,870 Internet 122,844 139,456 111,653 121,954 159,812 Other(1) 36,660 36,065 29,337 25,921 29,059 Total revenues $777,940 $768,344 $689,965 $804,216 $953,188 Stores: Sales per gross square foot(2) $412 $349 $338 $400 $459 Number of stores open at end of period 177 194 196 197 203 Comparable stores sales change(3) (14.5)% (11.2)% (2.5)% 16.4% 13.4%Direct: Number of catalogs circulated 71,000 66,000 53,000 50,000 55,000 Number of pages circulated (in millions) 8,300 7,800 5,800 5,400 6,100 Depreciation and amortization $39,963 $43,197 $43,075 $37,061 $33,461 Capital expenditures: New store openings 36,859 17,202 5,663 5,910 8,243 Other(4) 25,003 9,718 4,245 7,521 13,695 Total capital expenditures $61,862 $26,920 $9,908 $13,431 $21,938 (1)Consists primarily of shipping and handling fees and royalties. (2)Includes only stores that have been open for the full period. (3)Comparable store sales includes sales at stores open at least twelve months. (4)Consists primarily of expenditures on store remodels, information technology and warehouse equipment. 28Table of ContentsITEM 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.This discussion summarizes our consolidated operating results, financial condition and liquidity during the three-year period ended January 28, 2006.Our fiscal year ends on the Saturday closest to January 31. The fiscal years 2003, 2004 and 2005 ended on January 31, 2004, January 29, 2005, andJanuary 28, 2006 respectively, and consisted of 52 weeks each. You should read the following discussion and analysis in conjunction with the consolidatedfinancial statements and related notes and other financial information included in this Form 10-K.Management’s discussion and analysis of the results of operations are provided solely with respect to Operating and its subsidiaries since substantiallyall of the Company’s operations are conducted by Operating. However, Group has additional debt securities and preferred stock that are outstanding.Accordingly, information with respect to interest expense of Group is also provided herein. The discussion of liquidity and capital resources pertains to Groupand its consolidated subsidiaries, including Operating.This discussion contains forward-looking statements involving risks, uncertainties and assumptions that could cause our results to differ materiallyfrom expectations. Factors that might cause such differences include those described under “Risk Factors,” “Disclosure Regarding Forward-LookingStatements” and elsewhere in this Form 10-K.OverviewJ.Crew is a nationally recognized apparel and accessories brand that we believe embraces a high standard of style, craftsmanship, quality and customerservice, while projecting an aspirational American lifestyle.On the basis of data collected on our Internet channel customers, we believe our customer base consists primarily of affluent, college-educated andprofessional and fashion-conscious women and men. As of January 28, 2006, we operated 159 retail stores and 44 factory stores throughout the UnitedStates.We conduct our business through two primary sales channels: Stores, which consists of our retail and factory stores, and Direct, which consists of ourcatalog and Internet website at www.jcrew.com, each of which operate under the J.Crew brand name. In fiscal 2005, net sales under the J.Crew brand generated$924.1 million in revenues, comprised of: • $670.4 million from Stores, and • $253.7 million from Direct.How We Assess the Performance of Our BusinessIn assessing the performance of our business, we consider a variety of performance and financial measures. The key measures for determining how ourbusiness is performing are comparable store sales for Stores and net sales for Direct. We also consider gross profit and selling, general and administrativeexpenses in assessing the performance of our business.Net SalesNet sales reflect our revenues from the sale of our merchandise less returns and discounts.We aggregate our merchandise into three sales categories: women’s and men’s apparel, which consist of items of clothing such as shirts, sweaters,pants, dresses, jackets, outerwear and suits, and accessories, which consists of items such as shoes, socks, jewelry, bags and belts. 29Table of ContentsThe approximate percentage of our sales derived from these three categories, based on our internal merchandising systems, is as follows: Year Ended January 31,2004 January 29,2005 January 28,2006 Apparel Women’s 62% 64% 65%Men’s 27% 25% 21%Accessories 11% 11% 14% 100% 100% 100%The increase of accessories as a percentage of sales in fiscal 2005 is due to management’s efforts to expand the number of items in our accessoriescategory.Comparable Store SalesComparable store sales reflects net sales at stores that have been open for at least twelve months. Therefore, a store is included in comparable store saleson the first day it has comparable prior year sales. Non-comparable store sales include sales from new stores that have not been open for twelve months andsales from closed stores and temporary stores.By measuring the change in year-over-year net sales in stores that have been open for twelve months or more, comparable store sales allows us toevaluate how our core store base is performing. Various factors affect comparable store sales, including: • consumer preferences, buying trends and overall economic trends, • our ability to anticipate and respond effectively to fashion trends and customer preferences, • competition, • changes in our merchandise mix, • pricing, • the timing of our releases of new merchandise and promotional events, • the level of customer service that we provide in our stores, • changes in sales mix among sales channels, • our ability to source and distribute products efficiently, and • the number of stores we open, close (including for temporary renovations) and expand in any period.As we continue our store expansion program, we expect that a greater percentage of our revenues will come from non-comparable store sales. 30Table of ContentsThe industry in which we operate is cyclical, and consequently our revenues are affected by general economic conditions. Purchases of apparel andaccessories are sensitive to a number of factors that influence the levels of consumer spending, including economic conditions and the level of disposableconsumer income, consumer debt, interest rates and consumer confidence.Our business is seasonal. As a result, our revenues fluctuate from quarter to quarter. We have four distinct selling seasons that align with our four fiscalquarters. Revenues are usually substantially higher in our fourth fiscal quarter, particularly December, as customers make holiday purchases. For example,in fiscal 2005, we realized approximately 30% of our revenues in the fourth fiscal quarter.Gross ProfitGross profit is equal to our revenues minus our cost of good sold. Cost of goods sold includes the direct cost of purchased merchandise, inboundfreight, design, buying and production costs, occupancy costs related to store operations (such as rent and utilities) and all shipping costs associated with ourDirect business. Our cost of goods sold is substantially higher in the holiday season because cost of goods sold generally increases as revenues increase andcost of goods sold includes the cost of purchasing merchandise that we sell to generate revenues. Cost of goods sold also generally changes as we expand orcontract our store base and incur higher or lower store occupancy and related costs. The primary drivers of the costs of individual goods are the costs of rawmaterials and labor in the countries where we source our merchandise. Gross margin measures gross profit as a percentage of our revenues.Our gross profit may not be comparable to other specialty retailers, as some companies include all of the costs related to their distribution network incost of goods sold while others, like us, exclude all or a portion of them from cost of goods sold and include them in selling, general and administrativeexpenses.Selling, General and Administrative ExpensesSelling, general and administrative expenses include all operating expenses not included in cost of goods sold, primarily catalog production and mailingcosts, certain warehousing expenses, administrative payroll, store expenses other than occupancy costs, depreciation and amortization and credit card fees.These expenses do not necessarily vary proportionally with net sales. As a result, selling, general and administrative expenses as a percentage of net sales areusually higher in the spring season than the fall season.Results of OperationsThe following table presents, for the periods indicated, our operating results as a percentage of revenues as well as selected store data: Fiscal Year Ended January 31,2004 January 29,2005 January 28,2006 Revenues 100.0% 100.0% 100.0%Cost of goods sold, including buying and occupancy costs(1) 63.8 59.5 58.2 Gross profit(1) 36.2 40.5 41.8 Selling, general and administrative expenses(1) 40.7 35.8 33.5 Income (loss) from operations (4.5) 4.7 8.3 Interest expense, net 9.3 10.9 7.6 (Gain) loss on refinancing of debt (6.0) 6.2 — Insurance proceeds (0.6) — — Income (loss) before income taxes (7.2) (12.4) 0.7 Provision for income taxes 0.1 0.1 0.3 Net income (loss) (7.3)% (12.5)% 0.4% 31Table of Contents Fiscal Year Ended January 31,2004 January 29,2005 January 28,2006 Selected store data: Number of stores open at end of period 196 197 203 Sales per gross square foot $338 $400 $459 Comparable store sales change (2.5)% 16.4% 13.4%(1)We exclude a portion of our distribution network costs from the cost of goods sold and include them in selling, general and administrative expenses. Ourgross profit therefore may not be directly comparable to that of some of our competitors.Fiscal 2005 Compared to Fiscal 2004RevenuesRevenues in fiscal 2005 increased by $149.0 million, or 18.5%, to $953.2 million from $804.2 million in fiscal 2004. We believe this increase reflectsthe continuing appeal of our expanded product line in both Stores and Direct and continuing improvements in our customer service. The increase in revenueswas also due to the fact that low inventories in the first quarter of fiscal 2004 caused revenues for fiscal 2004 to be lower than they would otherwise have been.Stores sales increased by $90.7 million, or 15.6%, to $670.4 million in fiscal 2005 from $579.7 million in fiscal 2004. Comparable store salesincreased by 13.4% to $650.5 million in fiscal 2005 from $573.6 million in the prior year. Non-comparable store sales in fiscal 2005 were $19.9 million.Direct sales increased by $55.2 million, or 27.8%, to $253.7 million in fiscal 2005 from $198.5 million in fiscal 2004. In addition to the factors thatdrove overall revenue growth, the Direct sales increase is also attributable to a 13% increase in the number of catalog pages circulated in fiscal 2005.The increase in Stores and Direct sales occurred primarily in women’s apparel, and in accessories. The increase in women’s apparel sales was drivenby sales of jackets, loungewear, dresses and sweaters, while the increase in accessories sales was driven by an emphasis on increasing the assortment ofproducts.Other revenues increased by $3.0 million due primarily to an increase in shipping and handling fees of $4.8 million from $21.6 million in fiscal 2004to $26.4 million in fiscal 2005 as a result of a 19% increase in orders in the Direct business. This increase was partially offset by an adjustment of $1.3million in the first quarter of fiscal 2005 due to the reversal of income recognized on unredeemed gift cards in prior years.Gross ProfitIn fiscal 2005, gross profit increased by $72.6 million, or 22.3%, to $398.0 million from $325.4 million in fiscal 2004. This increase resulted from thefollowing factors: (a) increase in revenues $79.4 (b) increase in gross margin 4.6 (c) increase in buying and occupancy costs (11.4) $72.6 Gross margin increased from 40.5% in fiscal 2004 to 41.8% in fiscal 2005. The increase in gross margin was due primarily to an increase of 50 basispoint in merchandise margins (which is equal to cost of goods sold, excluding buying and occupancy costs, divided by revenues) resulting from a decrease inmarkdowns in the first half of fiscal 2005 and an 80 basis point decrease in buying and occupying costs as a percentage of revenues resulting from the factthat buying and occupancy costs increased at a lower rate than revenues. 32Table of ContentsSelling, General and Administrative ExpensesSelling, general and administrative expenses increased by $30.0 million, or 10.4%, to $317.7 million in fiscal 2005 from $287.7 million in fiscal 2004.The increase resulted primarily from: • an increase in Direct and Stores variable operating expenses of $22.0 million, • an increase in selling expense of $6.0 million, and • the write off in the fourth quarter of 2005 of $2.8 million of expenses related to the postponement of the IPO.These increases were offset by: • a reduction in depreciation expense of $3.6 million related to an increase in fully depreciated assets (primarily computer equipment and software),and • income of $1.1 million related to our estimated share of proceeds from the Visa/MasterCard antitrust litigation settlement.The increase in Direct and Stores variable operating expenses was primarily attributable to payroll related costs related to the increased sales in fiscal2005. The increase in selling expense resulted primarily from an increase in pages circulated to 6.1 billion in fiscal 2005 from 5.4 billion in fiscal 2004. As apercentage of revenues, selling, general and administrative expenses decreased to 33.3% in fiscal 2005 from 35.8% in fiscal 2004, resulting primarily from thefact that these expenses increased at a slower rate than revenues during fiscal 2005.Interest ExpenseGroupOur interest expense decreased by $14.7 million to $72.9 million in fiscal 2005 from $87.6 million in fiscal 2004. This decrease was due primarily todecreases in the rate of interest on our long-term debt and the amount of long-term debt outstanding as a result of the refinancings in the fourth quarter of fiscal2004. In the refinancings, we redeemed in full $150.0 million principal amount of 10 3/8% Senior Subordinated Notes due 2007 (the “10 3/8% Notes”) and$169.0 million principal amount of Intermediate’s 16% Senior Discount Contingent Principal Notes due 2008 (the “16% Notes”), with the proceeds of a new$275.0 million 9 3/4% term loan, which was converted into the 9 3/4% Notes in accordance with the terms of the loan agreement in March 2005, and $44.0million in internally available funds. This decrease was partially offset by an increase of $7.2 million in dividends on the Series A and Series B PreferredStock.OperatingInterest expense increased by $8.1 million to $29.7 million in fiscal 2005 from $21.6 million in fiscal 2004 due to an increase in the amount of long-term debt outstanding at Operating as a result of the refinancings in the fourth quarter of fiscal 2004.Income TaxesThe income tax provisions for fiscal years 2004 and 2005 are $0.6 million and $2.8 million which consist of state and foreign taxes of $0.6 million and$2.3 million, respectively, and federal taxes of $0.5 million in 2005. We incurred significant losses in fiscal years 2003 and 2004 that we are unable to carryback to prior years. The federal tax provision in 2005 differs from statutory rates due to the utilization of these net operating loss carryovers, which foralternative minimum tax purposes are limited to 90% of taxable income in any fiscal year. As of January 28, 2006, we have approximately $83 million in netoperating losses available to offset future federal taxable income. 33Table of ContentsNet deferred tax assets at January 29, 2005 and January 28, 2006 were fully reserved.Fiscal 2004 Compared to Fiscal 2003RevenuesRevenues in fiscal 2004 increased by $114.2 million, or 16.6%, to $804.2 million from $690.0 million in fiscal 2003. We believe this increase reflects apositive customer response to our merchandise assortment and an emphasis on customer service.Stores sales increased by $92.6 million, or 19.0%, to $579.7 million in fiscal 2004 from $487.1 million in fiscal 2003. Comparable store salesincreased by 16.4% to $559.3 million in fiscal 2004 from $480.6 million in the prior year. Non-comparable store sales in fiscal 2004 were $20.4 million.Direct sales increased by $25.0 million, or 14.4%, to $198.5 million in fiscal 2004 from $173.5 million in fiscal 2003. In addition to the factors thatdrove overall revenue growth, the Direct sales increase is also attributable to a 59% increase in the number of styles presented in our catalog and on ourwebsite, as well as the mailing of four new catalog editions, in the second half of fiscal 2004.The increase in Stores and Direct sales occurred primarily in women’s apparel, and was driven by sales of sweaters and jackets.Other revenues decreased by $3.4 million due primarily to a decrease in shipping and handling fees of $3.6 million from $25.2 million in fiscal 2003 to$21.6 million in fiscal 2004 as a result of an 8.0% decline in orders in the Direct business and an increase in retail phone orders, which carry no shipping andhandling fees.Gross ProfitIn fiscal 2004, gross profit increased by $75.7 million, or 30.3%, to $325.4 million from $249.7 million in fiscal 2003. This increase resulted from thefollowing factors: (a) increase in revenues $55.8 (b) increase in gross margin 35.5 (c) increase in buying and occupancy costs (15.6) $75.7 Gross margin increased to 40.5% in fiscal 2004 from 36.2% in fiscal 2003, due primarily to a 440 basis point increase in merchandise margins. Theincrease in merchandise margins resulted from fewer markdowns and improved inventory management in fiscal 2004 when compared to fiscal 2003, duringwhich margins were negatively affected by the liquidation of prior season inventories in the first half of the year. The increase in buying and occupancy costsof 10 basis points as a percentage of revenues resulted primarily from increases in merchandise design expenses. 34Table of ContentsSelling, General and Administrative ExpensesSelling, general and administrative expenses increased by $7.3 million, or 2.6%, to $287.7 million in fiscal 2004 from $280.4 million in fiscal 2003.Variable operating expenses in Direct and Stores increased by $14.9 million to $136.2 million in fiscal 2004 from $121.3 million in fiscal 2003. Theseincreases were primarily attributable to payroll related costs resulting from the significant sales increases in our Direct and Stores operations in fiscal 2004.Furthermore, incentive compensation increased by $6.5 million due to the improvement in our operating results in fiscal 2004 compared to fiscal 2003. Theseincreases were offset in part by a decrease in depreciation and amortization of $6.0 million related to an increase in fully depreciated assets, primarilycomputer equipment, and a decrease in catalog selling costs of $3.7 million due primarily to a reduction in pages circulated from 5.8 billion to 5.4 billion. Asa percentage of revenues, selling, general and administrative expenses decreased to 35.8% in fiscal 2004 from 40.7% in fiscal 2003, resulting primarily fromthe fact that these expenses increased at a slower rate than revenues during fiscal 2004.Interest ExpenseGroupOur interest expense increased by $23.8 million to $87.6 million in fiscal 2004 from $63.8 million in fiscal 2003. This increase consisted of $18.9million in dividends on the Series A Preferred Stock and Series B Preferred Stock that were classified as interest for all of fiscal 2004 but only for the secondhalf of fiscal 2003. We reclassified dividends on the Series A Preferred Stock and Series B Preferred Stock as interest beginning in the third quarter of 2003 inaccordance with our adoption of Statement of Financial Accounting Standards (“SFAS”) No. 150, “Accounting for Certain Financial Instruments withCharacteristics of both Liabilities and Equity.” For more information on our adoption of SFAS No. 150, see Note 7 to our consolidated financial statements.Another significant component of the increase in interest expense was a $4.9 million increase in interest on debt securities attributable primarily to: • an increase of $8.2 million in interest and amortization of debt issuance discount and deferred financing charges on the 16% Notes issued in ourMay 2003 exchange offer, and • $2.7 million of interest accrued on the $275.0 million 9 3/4% term loan we obtained in December 2004.These increases were partially offset by: • a $4.4 million decrease in interest on our 13 1/8% Debentures, approximately 85% of which were exchanged for the 16% Notes in our May 2003exchange offer, and • a $1.5 million decrease in interest on the 10 3/8% Notes that we redeemed in full in December 2004 with a portion of the proceeds of the $275.0million 9 3/4% term loan.OperatingInterest expense for Operating increased by $1.1 million to $21.6 million in fiscal 2004 from $20.5 million in fiscal 2003. The increase was primarilydue to $2.7 million of interest on the 9 3/4% Notes, reduced by $1.6 million of interest on the 10 3/8% Notes that were redeemed in such transaction.Loss on Refinancing of DebtIn fiscal 2004 we had a loss on refinancing of debt of $49.8 million compared to a gain of $41.1 million in fiscal 2003. The fiscal 2004 loss of $49.8million was incurred in connection with our fourth quarter redemption in full of $150.0 million aggregate principal amount of the 10 3/8% Notes and $169.1million of the 16% Notes. 35Table of ContentsAs a result of the refinancing, we: • paid $15.3 million of redemption premiums, • wrote off $3.2 million of deferred financing costs related to the redeemed notes, and • wrote off $31.3 million of unamortized debt issuance costs related to the 16% Notes.The gain of $41.1 million in fiscal 2003 resulted from the issuance of the 16% Notes in May 2003.The loss on refinancing of debt at Operating in fiscal 2004 was $4.0 million, consisting of redemption premiums of $2.6 million and the write-off ofdeferred financing costs of $1.4 million.Insurance ProceedsWe did not receive any insurance proceeds in fiscal 2004. Insurance proceeds of $3.8 million in fiscal 2003 and $1.8 million in fiscal 2002 representrecoveries for claims related to the destruction of our World Trade Center store on September 11, 2001. The insurance proceeds received in fiscal 2003 are thefinal settlement of this claim.Income TaxesWe have incurred significant losses during the last three years and are unable to carry back these losses to prior years. Fiscal 2004 and 2003 includecertain state and foreign tax provisions of $0.6 million and $0.5 million, respectively.For a discussion of our current tax position, see “—Critical Accounting Policies—Income Taxes.”Liquidity and Capital ResourcesOur primary sources of liquidity are cash flows from operations and borrowings under the Credit Facility. Our primary cash needs are capitalexpenditures in connection with opening new stores, making information technology system enhancements, meeting debt service requirements and fundingworking capital requirements. The most significant components of our working capital are cash and cash equivalents, merchandise inventories, accountspayable and other current liabilities. See “—Outlook” below.Operating Activities Year Ended January 31,2004 January 29,2005 January 28,2006 (in millions) Net Income (loss) $(50.2) $(100.3) $3.8 Adjustments to reconcile net loss to net cash provided by operations: Depreciation and amortization 43.1 37.1 33.5 Accreted dividends on redeemable preferred stock 14.2 33.1 40.3 Non-cash interest 28.9 32.8 2.2 (Gain) loss on refinancing of debt (41.1) 49.8 — Other non-cash reconciling items 5.0 0.1 0.8 Changes in inventories 41.3 (22.1) (28.1)Changes in accounts payable and other current liabilities (19.3) 32.6 10.1 Other changes in operating assets and liabilities (3.7) (4.3) (5.8)Net cash provided by operations $18.2 $58.8 $56.8 36Table of ContentsCash provided by operating activities decreased by $2.0 million to $56.8 million in fiscal 2005 compared to $58.8 million in fiscal 2004. Cashprovided by operating activities in fiscal 2005 consisted of net income of $3.8 million and non-cash adjustments of $76.8 million, reduced by an increase inworking capital of $23.8 million. The increase in working capital consisted primarily of an increase in inventories of $28.1 million, offset by an increase inaccounts payable and other current liabilities of $10.1 million. Inventories were higher than prior years due to expected sales increases in Spring 2006, and theearlier receipt of a portion of these inventories. The increase in accounts payable and other current liabilities was primarily due to a $7.3 million increase inaccounts payable which is attributable to the increase in inventories.Cash provided by operating activities in fiscal 2004 was $58.8 million and consisted of a net loss of $100.3 million offset by non-cash adjustments of$152.9 million and a decrease in working capital of $6.2 million. The reduction in working capital was due primarily to a $32.6 million increase inaccounts payable and other current liabilities, offset by an increase in inventories of $22.1 million. The increase in accounts payable and other currentliabilities consisted of an increase of $19.2 million in accounts payable reflecting the increase in inventories and an increase of $13.4 million in other currentliabilities. The increase in other current liabilities consisted primarily of (1) an increase of $5.0 million in customer liabilities from additional gift certificates,(2) an increase in accrued compensation of $5.0 million attributable to an increase in accrued bonuses in fiscal 2004 resulting from the improved operatingperformance, and (3) a $2.0 million increase in sales returns accrual due to increased sales in the fourth quarter of 2004. The increase in inventories reflectedan increase of inventories for Spring 2005.Cash provided by operating activities in fiscal 2003 was $18.2 million and consisted of a net loss of $50.2 million offset by non-cash adjustments of$50.1 million and a reduction in working capital of $18.3 million. The reduction in working capital was due primarily to a $41.3 million decrease inmerchandise inventories, partially offset by a decrease of $19.3 million in accounts payable and other current liabilities. The decrease in merchandiseinventories resulted from the liquidation of prior season inventories primarily in the first half of fiscal year 2003 as a result of a change in inventory strategythat emphasized the liquidation of inventories in the current season. Furthermore, orders placed for spring 2004 merchandise were conservative, reducing theamount of spring 2004 inventories on hand at January 31, 2004 compared to the prior year. The decrease in accounts payable and other current liabilities of$19.3 million consisted of $5.6 million in accounts payable, resulting largely from the decrease in inventories, and $13.7 million in other current liabilities.The decrease in other current liabilities consisted primarily of (1) a $4.3 million decrease in accrued interest as a result of the May 2003 exchange offer, whichconverted cash pay interest to accreted interest that is reflected in long-term debt, (2) a $4.0 million decrease in accrued compensation due to severance and one-time bonus accruals at February 1, 2003, and (3) a $2.3 million decrease in sales returns accrual related to a decrease in sales during the fourth quarter of2003.Investing ActivitiesCapital expenditures were $21.9 million in fiscal 2005, $13.4 million in fiscal 2004 and $9.9 million in fiscal 2003. Capital expenditures for theopening of new stores were $7.9 million in fiscal 2005 (11 stores), $5.9 million in fiscal 2004 (five stores) and $5.7 million in fiscal 2003 (four stores). Theremaining capital expenditures in each period were for store renovation and refurbishment programs, investments in information systems and distributioncenter initiatives. Capital expenditures are planned at $55.0 million for fiscal 2006, including $27.0 million for 29 new store openings, $13.0 million for storerenovation and refurbishment programs and $10 million for information technology enhancements. 37Table of ContentsFinancing Activities Fiscal Year Ended January 31,2004 January 29,2005 January 28,2006 (in millions)Proceeds from issuance of debt, net of costs incurred $23.2 $252.9 $— Repayment of debt (0.8) (324.2) — Exercise of stock options — — 2.7Net cash (used in) provided by financing activities $22.4 $(71.3) $2.7Cash provided by financing activities was $2.7 million in fiscal 2005 resulting from the exercise of stock options, compared to a use of cash of $71.3million for fiscal 2004. The $71.3 million use of cash in fiscal 2004 resulted primarily from the redemption of $150.0 million aggregate principal amount ofthe 10 3/8% Notes and $169.0 million of the 16% Notes, partially offset by the proceeds of a $275.0 million 9 3/4% term loan net of costs of $22.1 millionincurred in connection with the refinancing. Cash provided by financing activities in fiscal 2003 resulted from the issuance of $20.0 million aggregateprincipal amount of 5.0% Notes Payable and a $5.8 million term loan under the Credit Facility partially offset by costs incurred in the May 2003 exchangeoffer.Credit FacilityOn December 23, 2004, we, Operating and certain of its subsidiaries entered into an Amended and Restated Loan and Security Agreement (the “CreditFacility”) with Wachovia Capital Markets, LLC, as arranger and bookrunner, Wachovia Bank, National Association, as administrative agent (“Wachovia”),Bank of America N.A., as syndication agent, Congress Financial Corporation, as collateral agent, and a syndicate of lenders. The Credit Facility provides forrevolving loans and letters of credit of up to $170.0 million (which can be increased to $250.0 million subject to certain conditions) at floating interest ratesbased on Wachovia’s prime rate plus a margin of up to 0.25% or LIBOR plus a margin ranging from 1.25% to 2.00%. The total amount of availability islimited to the sum of: (a) invested cash, (b) 90% of eligible receivables, (c) 95% of the net recovery percentage of inventories (as determined by inventoryappraisal) for the period August 1 through December 15, or 92.5% of the net recovery percentage of inventories for the period December 16 through July 31,and (d) real estate availability of 65% of appraised fair market value. The Credit Facility expires in December 2009. Borrowings under the Credit Facility areguaranteed by us and all of Operating’s domestic direct or indirect subsidiaries and are secured by a perfected first priority security interest in substantially allof our and our subsidiaries’ assets.The Credit Facility includes restrictions on our ability to incur additional indebtedness, pay dividends or make other distributions, make investments,make loans and make capital expenditures. We are required to maintain a fixed interest charge coverage ratio of 1.1x if excess availability is less than $20.0million for any 30 consecutive day period. We have at all times been in compliance with this financial covenant.See “Business — Corporate Restructuring” and “Business — The Proposed Initial Public Offering and Related Transactions” for a discussion of therecent amendments to the Credit Facility in connection with our October 2005 restructuring and the IPO.There was $78.3 million available in short-term borrowings under the Credit Facility at January 28, 2006 based on the factors described above. Therewere no borrowings in fiscal 2005 and fiscal 2004, and average borrowings of $1.0 million in fiscal 2003.Senior Subordinated Term Loan and 9 3/4% NotesOn November 21, 2004, Operating entered into a Senior Subordinated Loan Agreement with entities managed by Black Canyon Capital LLC andCanyon Capital Advisors LLC, which provided for a term loan of $275.0 million. We used the proceeds of the term loan to redeem in full the aggregateprincipal amount of the 10 3/8% Notes ($150.0 million) and in part the 16% Notes ($125.0 million). In January 2005, we redeemed the remaining $44.0million of the 16% Notes using internally available funds. On March 18, 2005, the term loan was converted into equivalent 9 3/4% Notes in accordance withthe terms of the loan agreement. 38Table of ContentsSee “Business — The Proposed Initial Public Offering and Related Transactions” for a discussion of Operating’s cash tender offer and consentsolicitation with respect to the 9 3/4% Notes.The IPO and Related TransactionsSee “Business — The Proposed Initial Public Offering and Related Transaction” for a discussion of the IPO and related transactions.OutlookWe believe our current cash position, cash flow from operations and availability under the Credit Facility will be adequate to finance our working capitalneeds, planned capital expenditures and debt service obligations for the next twelve months.Off Balance Sheet ArrangementsWe enter into documentary letters of credit to facilitate the international purchase of merchandise. We also enter into standby letters of credit to securecertain of our obligations, including insurance programs and duties related to import purchases. As of January 28, 2006, we had the following obligationsunder letters of credit in future periods. Letters of credit Within1 Year 2-3 Years 4-5 Years After5 Years Total (in millions)Standby $— $— $— $6.0 $6.0Documentary 63.9 — — — 63.9Total $63.9 $— $— $6.0 $69.9Contractual ObligationsThe following table summarizes our contractual obligations as of January 28, 2006 and the effect such obligations are expected to have on our liquidityand cash flows in future periods. Payments Due By Period Total Less than1 Year 2-3 Years 4-5 Years After5 Years (in millions)Long-term debt obligations $319.9 $— $44.9 $— $275.0Interest on long-term debt obligations 246.3 29.7 58.5 53.6 104.5Redeemable preferred stock 312.0 — — 312.0 — Operating lease obligations(1) 327.9 55.4 102.4 83.6 86.5Purchase obligations Inventory commitments 224.4 224.4 — — — Other 8.1 4.5 3.6 — — Employment agreements 5.0 1.9 3.1 — — Total Purchase Obligations 237.5 230.8 6.7 — — Total(2) $1,443.6 $315.9 $212.5 $449.2 $466.0(1)Operating lease obligations represent obligations under various long-term operating leases entered in the normal course of business for retail and factorystores, warehouses, office space and equipment requiring minimum annual rentals. Operating lease expense is a significant component of our operatingexpenses. The lease terms range for various periods of time in various rental markets and are entered into at different times, which mitigates exposure tomarket changes that could have a material effect on our results of operations within any given year. Our operating leases do not include common areamaintenance, insurance, taxes and other occupancy costs, which constitute approximately an additional 50% of the minimum lease obligations. (2)These amounts do not include dividends on the Series A Preferred Stock and the Series B Preferred Stock. 39Table of ContentsImpact of InflationOur results of operations and financial condition are presented based on historical cost. While it is difficult to accurately measure the impact of inflationdue to the imprecise nature of the estimates required, we believe the effects of inflation, if any, on our results of operations and financial condition have beenminor.Recent Accounting PronouncementsIn December 2004, the Financial Accounting Standards Board, (FASB) issued SFAS No. 123 (revised 2004), “Share-Based Payment” (SFASNo. 123R), which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS No. 123R supercedes APB Opinion No. 25,“Accounting for Stock Issued to Employees,” and amends SFAS No. 95, “Statement of Cash Flows.” Generally, the approach in SFAS No. 123R issimilar to the approach described in SFAS 123. However, SFAS No. 123R requires all share-based payments to employees, including grants of employeestock options, to be recognized in the income statement based on their fair values. SFAS No. 123R must be adopted no later than the first interim or annualperiod beginning after June 15, 2005.As permitted by SFAS No. 123, we have accounted for share-based payments to employees using APB Opinion No. 25’s intrinsic value method and,as such, generally recognize no compensation cost for employee stock options. We will adopt SFAS No. 123R effective January 29, 2006 using the modifiedprospective application option. As a result, the compensation cost for the portion of awards we granted before January 29, 2006 for which the requisite servicehas not been rendered and that are outstanding as of January 29, 2006 will be recognized as the remaining requisite service is rendered. In addition, theadoption of SFAS No. 123R will require us to change from recognizing the effect of forfeitures as they occur to estimating the number of outstandinginstruments for which the requisite service is not expected to be rendered. Accordingly, the adoption of SFAS No. 123R’s fair value method will have asignificant impact on our results of operations. The impact of the adoption of SFAS No. 123R cannot be determined at this time because it will depend uponlevels of share-based payments granted in the future. However, had we adopted SFAS No. 123R in prior periods, the impact of that standard would haveapproximated the impact as described in the disclosure of pro forma net income pursuant to SFAS No. 123 in Note 1q of Notes to Consolidated FinancialStatements.In May 2005, the FASB issued Statement No. 154, “Accounting Changes and Error Corrections,” a replacement of APB Opinion No. 20, “AccountingChanges” and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements,” effective for fiscal years beginning afterDecember 15, 2005. Statement No. 154 changes the requirements for the accounting for and reporting of a voluntary change in accounting principle as well asthe changes required by an accounting pronouncement that does not include specific transition provisions. The Company does not expect the implementationof Statement No. 154 to have a significant effect on the Company’s consolidated financial position, results of operations or cash flows.In October 2005, the FASB issued FASB Staff Position FAS 13-1, “Accounting for Rental Costs Incurred During a Construction Period.” FAS 13-1concludes that there is no distinction between the right to use a leased asset during and after the construction period; therefore rental costs incurred during theconstruction period should be recognized as rental expense and included in income from continuing operations. FAS 13-1 is effective for the first reportingperiod beginning after December 15, 2005; early adoption is permitted. The Company adopted FAS 13-1 in the fourth quarter of fiscal 2005 and the effectwas not material.Critical Accounting PoliciesManagement’s discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which havebeen prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires estimatesand judgments that affect the reported amounts of our assets, liabilities, revenues and expenses. Management bases estimates on historical experience and otherassumptions it believes to be reasonable under the circumstances and evaluates these 40Table of Contentsestimates on an on-going basis. Actual results may differ from these estimates under different assumptions or conditions.The following critical accounting policies, which we have discussed with our audit committee, reflect the significant estimates and judgments used inthe preparation of our consolidated financial statements. We do not believe that changes in these assumptions and estimates are likely to have a material impacton our consolidated financial statements.Revenue RecognitionWe recognize Store sales at the time of sale, and Direct sales at the time merchandise is shipped to customers. Amounts billed to customers for shippingand handling of catalog and Internet sales are classified as other revenues and recognized at the time of shipment. We must make estimates of future salesreturns related to current period sales. Management analyzes historical returns, current economic trends and changes in customer acceptance of our productswhen evaluating the adequacy of the reserve for sales returns. We license our trademark and know-how to Itochu Corporation in Japan, for which we receivepercentage royalty fees. We defer recognition of advance royalty payments and recognize royalty revenue when sales entitling us to royalty revenue occur.Employee discounts are classified as a reduction of revenue. We account for gift cards by recognizing a liability at the time a gift card is sold, and recognizingrevenue at the time the gift card is redeemed for merchandise. We review our gift card liability on an ongoing basis and recognize our estimate of theunredeemed gift card liability on a ratable basis over the estimated period of redemption.Inventory ValuationMerchandise inventories are carried at the lower of average cost or market value. We capitalize certain design, purchasing and warehousing costs ininventory. We evaluate all of our inventories to determine excess inventories based on estimated future sales. Excess inventories may be disposed of through ourfactory channel, Internet clearance sales and other liquidations. Based on historical results experienced through various methods of disposition, we write downthe carrying value of inventories that are not expected to be sold at or above costs. Additionally, we reduce the cost of inventories based on an estimate of lost orstolen items each period.Deferred Catalog CostsThe costs associated with direct response advertising, which consist primarily of catalog production and mailing costs, are capitalized and amortizedover the expected future revenue stream of the catalog mailings, which we currently estimate to be four months. The expected future revenue stream isdetermined based on historical revenue trends developed over an extended period of time. If the current revenue streams were to diverge from the expected trend,our amortization of deferred catalog costs would be adjusted accordingly.Asset ImpairmentWe are exposed to potential impairment if the book value of our assets exceeds their expected future cash flows. The major components of our long-livedassets are store fixtures, equipment and leasehold improvements. The impairment of unamortized costs is measured at the store level and the unamortized costis reduced to fair value if it is determined that the sum of expected discounted future net cash flows is less than net book value.Income TaxesWe have significant deferred tax assets resulting from net operating loss carryforwards and temporary differences, which will reduce taxable income infuture periods. SFAS No. 109, “Accounting for Income Taxes” states that a valuation allowance is required when it is more likely than not that all or a portionof a deferred tax asset will not be realized. A review of all available positive and negative evidence needs to be considered, including a company’s current andpast performance, projections of future operating results, the market environment in which a company operates, and length of carryback and carryforwardperiods. Forming a conclusion that a valuation allowance is not needed is difficult when there is negative evidence such as cumulative losses in recent years.Cumulative losses weigh heavily in the overall assessment. As a result of our assessments, we established a 41Table of Contentsvaluation allowance to fully reserve our net deferred tax assets at January 29, 2005 and January 28, 2006. Although we realized pre-tax income in fiscal 2005,we do not expect to recognize any net tax benefits in future results of operations until we can demonstrate that an appropriate level of profitability can besustained. ITEM 7A.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.Our principal market risk relates to interest rate sensitivity, which is the risk that future changes in interest rates will reduce our net income or netassets. Our variable rate debt consists of borrowings under the Credit Facility. The interest rates are a function of Wachovia’s prime rate or LIBOR. A onepercentage point increase in the base interest rate would result in a change in income before taxes of approximately $100,000 for each $10.0 million ofborrowings.We have a licensing agreement in Japan that provides for royalty payments in yen based on sales of J.Crew merchandise. We have entered into forwardforeign exchange contracts from time to time in order to minimize this risk. At January 28, 2006, there were no forward foreign exchange contractsoutstanding.We also enter into letters of credit to facilitate the international purchase of merchandise. The letters of credit are primarily denominated in U.S. dollars.Outstanding letters of credit at January 28, 2006 were $69.9 million, including $6.0 million of standby letters of credit. ITEM 8.FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.The following consolidated financial statements of Group and Operating for the fiscal years ended January 31, 2004, January 29, 2005 andJanuary 28, 2006 are included in Item 15 of this report:J. Crew Group, Inc. and subsidiaries:Consolidated Balance Sheets as of January 29, 2005 and January 28, 2006Consolidated Statements of Operations for the fiscal years ended January 31, 2004, January 29, 2005 and January 28, 2006Consolidated Statements of Changes in Stockholders’ Deficit for the fiscal years ended January 31, 2004, January 29, 2005 and January 28, 2006Consolidated Statements of Cash Flows for the fiscal years ended January 31, 2004, January 29, 2005 and January 28, 2006J. Crew Operating Corp. and subsidiaries:Consolidated Balance Sheets as of January 29, 2005 and January 28, 2006Consolidated Statements of Operations for the fiscal years ended January 31, 2004, January 29, 2005 and January 28, 2006Consolidated Statements of Changes in Stockholders’ Deficit for the fiscal years ended January 31, 2004, January 29, 2005 and January 28, 2006Consolidated Statements of Cash Flows for the fiscal years ended January 31, 2004, January 29, 2005 and January 28, 2006 ITEM 9.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.None. 42Table of ContentsITEM 9A.CONTROLS AND PROCEDURES.Our management, with the participation of our Chief Executive Officer and our Executive Vice President and Chief Financial Officer, carried out anevaluation of the effectiveness of the design and operation our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under theExchange Act) as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and our Executive Vice President andChief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report to ensure thatinformation required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported with thetime periods specified in SEC rules and forms.Such officers also confirm that there were no changes in our internal control over financial reporting during the period covered by this report that havematerially affected, or are reasonably likely to materially affect, our internal control over financial reporting. ITEM 9B.OTHER INFORMATION.None. 43Table of ContentsPART IIIInformation required by items 10-14 with respect to Operating has been omitted pursuant to General Instruction I of Form 10-K. Information required byitems 10-14 with respect to Group is described below. ITEM 10.DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.The following table sets forth the name, age and position of individuals who are serving as directors and executive officers of Group as of April 1, 2006. Name Age PositionMillard Drexler 61 Chief Executive Officer and Chairman of the BoardJeffrey Pfeifle 47 PresidentTracy Gardner 42 Executive Vice President, Merchandising, Planning & ProductionJames Scully 41 Executive Vice President, Chief Financial OfficerBridget Ryan Berman 45 DirectorRichard Boyce 51 DirectorJonathan Coslet 41 DirectorJames Coulter 46 DirectorSteven Grand-Jean 63 DirectorEmily Scott 44 DirectorThomas Scott 40 DirectorStuart Sloan 62 DirectorJosh Weston 77 DirectorMillard Drexler. Mr. Drexler has been our Chief Executive Officer since January 2003 and Chairman of the Board of Directors and a director sinceMarch 2003. Before joining J.Crew, Mr. Drexler was Chief Executive Officer of The Gap, Inc. from 1995 until September 2002, and was President of TheGap, Inc. from 1987 to 1995. Mr. Drexler also serves on the Board of Directors of Apple Computer, Inc.Jeffrey Pfeifle. Mr. Pfeifle has been our President since February 2003. Before joining J.Crew, Mr. Pfeifle was Executive Vice President, Product andDesign of the Old Navy division of The Gap, Inc. from 1995 and Vice President of Men’s Product and Design for the Banana Republic division of The Gap,Inc. from 1993. Prior to that, Mr. Pfeifle was Director of Merchandising for Ralph Lauren from 1989.Tracy Gardner. Ms. Gardner has been our Executive Vice President, Merchandising, Planning & Production since March 2004. Prior to joining J.Crew,Ms. Gardner held various positions at The Gap, Inc., including Senior Vice President of Adult Merchandising for the GAP brand from 2002 to March 2004,Vice President of Women’s Merchandising for the Banana Republic division from 2001 to 2002, Vice President of Men’s Merchandising for the BananaRepublic division from 1999 to 2001 and Divisional Merchandising Manager of Men’s Wovens for the Banana Republic division prior to 1999.James Scully. James Scully became our Executive Vice President and Chief Financial Officer on September 7, 2005. Prior to joining us, Mr. Scullyserved as Executive Vice President of Human Resources and Strategic Planning of Saks Incorporated from 2004. Before that Mr. Scully served as SaksIncorporated’s Senior Vice President of Strategic and Financial Planning from 1999 to 2004 and as Senior Vice President, Treasurer from 1997 to 1999.Prior to joining Saks Incorporated, Mr. Scully held the position of Senior Vice President of Corporate Finance at Bank of America (formerly NationsBank)from 1994 to 1997.Bridget Ryan Berman. Ms. Berman has been a director since August 2005. Ms. Berman was appointed as Chief Executive Officer of Giorgio ArmaniCorporation, a U.S. subsidiary of Giorgio Armani S.p.A., effective April 2006. Prior thereto, Ms. Berman was Vice President and Chief Operating Officer ofRetail Stores for Apple Computer, Inc. from April 2004 to August 2005. Prior to joining Apple Computer, Inc., Ms. Berman held various 44Table of Contentspositions at Polo Ralph Lauren Corporation, including Group President of Polo Global Retail from 2003 to 2004, President and Chief Operating Officer of PoloRalph Lauren Retail from 2001 to 2003 and President of Polo Factory Store Concepts from 1998 to 2001.Richard Boyce. Mr. Boyce has been a director since 1997. Mr. Boyce periodically served as our Chief Executive Officer between 1997 and 1999,while also providing operating oversight to the remainder of the Texas Pacific Group portfolio. Mr. Boyce is a Senior Operating Partner of Texas Pacific Group,an affiliate of ours, and joined Texas Pacific Group in 1997. Mr. Boyce is Chairman of the Executive Committee of the Board of Directors of Burger KingCorporation and serves on the Board of Directors of KRATON Polymers, Inc., ON Semiconductor and Spirit Group Holdings Ltd (UK).Jonathan Coslet. Mr. Coslet has been a director since 2003. Mr. Coslet has been a partner of Texas Pacific Group, an affiliate of ours, since 1993 andis currently a senior partner and member of the firm’s Executive, Management and Investment Committees. Prior to joining Texas Pacific Group, Mr. Cosletworked at Donaldson, Lufkin & Jenrette, specializing in leveraged acquisitions and high yield finance from 1991 to 1993. Mr. Coslet also serves on theBoard of Directors of Quintiles Transnational Corp., IASIS Healthcare Corp., Fidelity National Information Services and The Neiman Marcus Group, Inc.James Coulter. Mr. Coulter has been a director since 1997. Mr. Coulter co-founded Texas Pacific Group, an affiliate of ours, in 1993 and has beenManaging General Partner of Texas Pacific Group for more than eight years. From 1986 to 1992, Mr. Coulter was a Vice President of Keystone, Inc. From1986 to 1988, Mr. Coulter was also associated with SPO Partners, an investment firm that focuses on public market and private minority investments.Mr. Coulter also serves on the Board of Directors of Lenovo Group Limited, Seagate Technology, Zhone Technologies, Inc. and The Neiman Marcus Group,Inc.Steven Grand-Jean. Mr. Grand-Jean has been a director since 2003. Mr. Grand-Jean has been President of Grand-Jean Capital Management for morethan five years.Emily Scott. Ms. Scott has been a director since 1992. Ms. Scott served as Chairman of the Board of Directors from 1997 to 2003. Ms. Scott workedat J.Crew from 1983, the year that it was founded, until 2003 and has previously served as our Chief Executive Officer and Vice Chairman. Ms. Scott ismarried to Thomas Scott, a director of J.Crew, and is a founding partner of Plum TV, LLC, a television station network operating in select resort markets.Thomas Scott. Mr. Scott has been a director since 2002. Mr. Scott is a founding partner of Plum TV, LLC, and has served as its Chief ExecutiveOfficer and Executive Co-Chairman since September 2003. He is also a founding partner of Nantucket Allserve Inc., a beverage supplier, and has served asCo-Chairman thereof since 1989 and as Co-Chairman and Co-Chief Executive Officer from 1989 to 2000. Mr. Scott has also served as Co-Chairman ofShelflink, a supply chain software company, since 2000. Mr. Scott is married to Emily Scott, a director of J.Crew.Stuart Sloan. Mr. Sloan has been a director since September 2003. Mr. Sloan is the founder of Sloan Capital Companies, a private investmentcompany, and has been a Principal thereof since 1984. Mr. Sloan also serves on the Board of Directors of Anixter International, Inc. and Rite Aid Corp.Josh Weston. Mr. Weston has been a director since 1998. Mr. Weston also served as Honorary Chairman of the Board of Directors of Automatic DataProcessing, a computing services business, from 1998 to November 2004. Mr. Weston was Chairman of the Board of Directors of Automatic Data Processingfrom 1996 until 1998, and Chairman and Chief Executive Officer for more than five years prior thereto. Mr. Weston also serves on the Board of Directors ofGentiva Health Services, Inc. and Russ Berrie & Company, Inc.All of our directors were nominated pursuant to the terms of stockholders’ agreements. Ms. Scott and Mr. Scott were nominated by Ms. Scott pursuantto a stockholders’ agreement between her and Partners II. Messrs. Boyce, Coslet and Coulter were nominated by Partners II pursuant to this stockholders’agreement. See “Executive Compensation—Shareholders’ Agreements.” 45Table of ContentsMessrs. Drexler, Grand-Jean and Sloan were nominated by Mr. Drexler pursuant to a stockholders’ agreement between him and Partners II. See“Executive Compensation—Shareholders’ Agreements.” Mr. Weston and Ms. Berman were nominated by Mr. Drexler and Partners II pursuant to thisagreement.Our Board of DirectorsBoard Size and Composition. Our board of directors currently has 10 members. Our bylaws provide that our board of directors consists of no lessthan three persons. The exact number of members of our board of directors will be determined from time to time by resolution of a majority of our full board ofdirectors.Committees of the Board. Our standing board committees consist of an audit committee and a compensation committee.Audit Committee. The audit committee currently consists of Messrs. Weston (Chairperson), Boyce and Grand-Jean. The board of directors hasdetermined that Mr. Weston qualifies as an “audit committee financial expert” under SEC rules and regulations.The audit committee assists the board in monitoring the integrity of our financial statements, our independent auditors’ qualifications and independence,the performance of our audit function and independent auditors, and our compliance with legal and regulatory requirements. The audit committee has directresponsibility for the appointment, compensation, retention (including termination) and oversight of our independent auditors, and our independent auditorsreport directly to the audit committee.Compensation Committee. The compensation committee currently consists of Messrs. Coulter (Chairperson) and Sloan and Ms. Scott.The primary duty of the compensation committee is to discharge the responsibilities of the board of directors relating to compensation practices for ourexecutive officers and other key employees, as the committee may determine and to ensure that management’s interests are aligned with the interests of ourequity holders. The compensation committee also reviews and makes recommendations to the board of directors with respect to our employee benefits plans,compensation and equity-based plans and compensation of directors. The compensation committee makes recommendations to the board of directors withrespect to the compensation and benefits of the chief executive officer and approves the compensation and benefits of the other executive officers.Compensation of Directors. Directors who are our employees or representatives of TPG (Messrs. Boyce, Coslet, Coulter and Drexler) do not receiveany compensation for their services. All other Directors (Messrs. Grand-Jean, Scott, Sloan and Weston and Ms. Scott) received the following as compensationin 2005: (1) a cash retainer of $30,000 and (2) a non-qualified stock option to purchase 20,000 shares of Group common stock. The options have an exerciseprice of $12.60 per share, have a term of 10 years and become exercisable and vest in equal installments over a two year period. Ms. Berman became aDirector in August 2005 and therefore received a pro-rated share of the cash retainer and a non-qualified stock option to purchase 20,000 shares of Groupcommon stock. Ms. Berman’s options have an exercise price of $13.40 per share and all other terms are the same. If a Director ceases to serve as a Director forany reason, other than removal for cause, any options vested at the time of termination of his or her services will remain exercisable for 90 days (but no longerthan the 10 year term of the options). In addition, Mr. Weston, the Chairman of the audit committee, received additional cash compensation of $10,000 for hisservices on such committee.Our board of directors has also approved the following to be paid as compensation to all eligible directors for their services in 2006: (1) a cash retainer of$35,000; (2) an additional cash payment of $2,000 for each Board meeting attended in person; and (3) a non-qualified stock option to purchase 7,500 sharesof Group common stock. The options will have an exercise price per share equal to the fair market value at the time of grant, have a term of 10 years and vestin equal installments over a two year period. If a Director ceases to serve as a Director for any reason, other than removal for cause, any options vested at thetime of termination of his or her services will remain exercisable for 90 days (but no longer than the 10 year term of the options). In addition, the Chairman ofthe audit 46Table of Contentscommittee will receive additional cash compensation of $20,000 and the Chairman of the compensation committee will receive additional cash compensation of$10,000 for their respective services on such committees.Code of Ethics and Business PracticesWe have adopted a Code of Ethics and Business Practices that applies to all of our Directors and employees, including to our chief executive officer,chief financial officer, controller and our other senior financial officers. A copy of the Code is filed as an exhibit to this report and is available free of chargeupon written request to the Corporate Secretary, J.Crew Group, Inc., 770 Broadway, New York, NY 10003. ITEM 11.EXECUTIVE COMPENSATION.The following table sets forth compensation paid by Group for fiscal 2005, 2004 and 2003: • to our chief executive officer, • to each of our three other most highly compensated executive officers as of the end of fiscal 2005, and • to an additional executive officer who was not employed as of the end of fiscal 2005.We refer to these individuals as the named executive officers elsewhere in this Form 10-K.Summary Compensation Table Name and Principal Position FiscalYear Annual Compensation Long Term Compensation Other AnnualCompensation($)(1) Awards Payouts All OtherCompensation($)(3) Salary($) Bonus($) RestrictedStockAward(s)($)(2) SecuritiesUnderlyingOptions/SARS(#) LTIPPayouts($) Millard DrexlerChief Executive Officer andChairman 200520042003 200,000200,000200,000 — — — 751,000484,500500,000(4)(4)(4) 804,00055,500598,654(5)(5)(5) 80,0001,698,778— (6) — — — — — — Jeffrey PfeiflePresident 200520042003 781,200760,000760,000 400,000500,0002,400,000 (7) — — — 201,00018,500119,731(8)(8)(8) 50,000223,170— (9) — 800,000400,000 8,4008,900— James ScullyExecutive Vice President and ChiefFinancial Officer 200520042003 188,200— — 250,000— — (10) 230,700— — (11) 469,000— — (12) 130,000— — — — — — — — Tracy GardnerExecutive Vice President,Merchandising, Planning &Production 200520042003 492,300398,100— 350,000450,000— (13) — 95,500— (14) 327,00037,000— (15)(15) 145,00090,000— — — — — — — Roxane Al-Fayez(16)Former Executive Vice President,Catalog & e-Commerce 200520042003 243,300377,900155,400 — 275,000100,000 (17)(17) 55,50083,800— (18)(18) 126,0007,40018,500(19)(19)(19) 45,00010,00035,000 — — — 8,4001,700— (1)We have concluded that the aggregate amount of perquisites and other personal benefits paid to each of the named executive officers, other thanMr. Drexler, for each of fiscal 2005, 2004 and 2003 did not exceed the lesser of 10% of his or her total annual salary and bonus for such year or$50,000; such amounts are not included in the table. (2)Holders of restricted stock have the same right to receive dividends as other holders of Group’s common stock. Group has not paid any cash dividendson its common stock. There is no established public market for shares of our common stock. Based on customary corporate valuation techniques,including an analysis of the discounted value of our potential earnings and cash flow, the valuation of comparable companies and current book valueper share, the value of a share of Group’s common stock was estimated to be $12.60 as of March 31, 2005 and $13.40 as of August 8, 2005. Restrictedstock awards in fiscal 2005 reflect an estimated share value on the respective dates of grant, and awards in 2004 and fiscal 2003 reflect an estimatedshare value of $0.74 on the date of grant. As of April 1, 2006, the named executive officers held the following aggregate number of restricted shares ofour common stock: Mr. Drexler—664,031 vested shares and 335,754 unvested shares; Mr. Pfeifle—121,349 vested shares and 80,449 unvestedshares; Mr. Scully—0 vested shares and 35,000 unvested shares; Ms. Gardner—12,500 vested shares and 62,500 unvested shares; Ms. Al-Fayez—6,250 vested shares and 0 unvested shares. 47Table of Contents(3)For Mr. Pfeifle and Ms. Al-Fayez, all amounts represent contributions made by us on behalf of such named executive officers to our 401(k) plan. (4)Under the terms of his services agreement and amended and restated employment agreement, Mr. Drexler is entitled to the reimbursement of businessexpenses, provided that in each of fiscal 2005, 2004 and 2003, his salary, bonus and reimbursement of business expenses could not exceed $700,000per annum in the aggregate. We have determined that for fiscal year 2005, only business expenses related to aircraft usage (which is described furtherbelow) will count toward the aggregate $700,000 cap. We have also reimbursed Mr. Drexler for other business expenses not subject to the cap that wereincurred in the ordinary course of business and therefore are not reflected in the table above. For Mr. Drexler, the amount listed under “Other AnnualCompensation” for fiscal 2005 also includes: (i) reimbursement for relocation expenses ($201,000) and (ii) the portion of annual salary and benefits fora driver provided by us that is allocable to personal use ($50,000). We have reimbursed a company of which Mr. Drexler is a principal for the use forcorporate business of a private aircraft owned by that company. The total reimbursements for the use of such aircraft in fiscal 2004 and 2005 wereapproximately $255,600 and $636,000 respectively. The amounts applicable to Mr. Drexler’s business use of the aircraft in fiscal 2004 and 2005 were$255,600 and $500,000, respectively, and are included in the total amounts described in this footnote. The remaining $136,000 reimbursed toMr. Drexler’s company was for other employees’ use of the aircraft for business purposes during fiscal year 2005. (5)In August 2005, Mr. Drexler was granted 60,000 shares of our common stock, of which 50% will vest on each of August 8, 2008 and August 8, 2009.In November 2004, Mr. Drexler was granted 75,000 shares of our common stock, of which 50% will vest on each of November 1, 2007 andNovember 1, 2008. In September 2003, Mr. Drexler was granted 83,689 shares of our common stock, of which 5,976 shares vested immediately upongrant, 19,429 shares vested on January 27, 2004, 19,428 shares vested on January 27, 2005 and 19,428 shares vested on January 27, 2006, and theremainder will vest on January 27, 2007. In February 2003, Mr. Drexler was granted 725,303 shares of our common stock, of which 181,326 sharesvested on each of January 27, 2004, January 27, 2005 and January 27, 2006 the remainder of which will vest on January 27, 2007. Mr. Drexler paidus $800,000 for the shares granted to him in February 2003, which was in excess of their fair market value at the time of grant. In addition, in February2003, a corporation of which Mr. Drexler is a principal was also granted 55,793 shares of our common stock, all of which vested immediately upongrant. (6)This amount includes the grant of 1,673,778 replacement stock options to Mr. Drexler in May 2004 following his surrender of the same number ofstock options in September 2003. We refer you to “Employment Agreements and Other Compensation Arrangements—Employment and OtherAgreements” for information on these replacement options. (7)This amount represents one-time bonuses in the total amount of $2,000,000 and a $400,000 guaranteed annual bonus for fiscal 2003. (8)In August 2005, Mr. Pfeifle was granted 15,000 shares of our common stock, of which 100% will vest on August 14, 2009. In November 2004,Mr. Pfeifle was granted 25,000 shares of our common stock, of which 50% will vest on each of November 1, 2007 and November 1, 2008. InSeptember 2003, Mr. Pfeifle was also granted 50,213 shares of our common stock, of which 12,554 shares vested on February 1, 2004, 12,553 sharesvested on February 1, 2005 and 12,553 shares vested on February 1, 2006, and the remainder will vest on February 1, 2007. In addition, in February2003, Mr. Pfeifle was granted 111,585 shares of our common stock, of which 27,897 shares vested on February 1, 2004, 27,896 shares vested onFebruary 1, 2005 and 27,896 shares vested on February 1, 2006, and the remainder will vest on February 1, 2007. (9)This amount includes the grant of 223,170 replacement stock options to Mr. Pfeifle in May 2004 following his surrender of the same number of stockoptions in September 2003. We refer you to “Employment Agreements and Other Compensation Arrangements—Employment and Other Agreements” forinformation on these replacement options. (10)This amount represents a guaranteed annual bonus for fiscal 2005. (11)This amount represents $65,700 in housing allowances and commuting reimbursements, including applicable tax gross-up amounts, and a $165,000transition bonus. (12)In September 2005, Mr. Scully was granted 35,000 shares of our common stock, of which 25% will vest on each of September 7, 2006, 2007, 2008and 2009. (13)This amount represents a $150,000 sign-on bonus and a $300,000 annual bonus for fiscal 2004. (14)This amount represents $95,500 in reimbursement for or payment of relocation expenses and includes applicable tax gross-up amounts. (15)In August 2005, Ms. Gardner was granted 15,000 shares of our common stock, of which 100% will vest on August 14, 2009. In May 2005,Ms. Gardner was granted 10,000 shares of our common stock, of which 50% will vest on each of May 5, 2008 and May 5, 2009. In May 2004,Ms. Gardner was granted 50,000 shares of our common stock, which will vest in equal annual installments on each of April 1 of 2006, 2007, 2008 and2009. (16)Ms. Al-Fayez resigned from her position with us effective as of August 19, 2005. (17)In fiscal 2004, this amount represents a $25,000 one-time bonus paid in October 2004 and a $250,000 annual bonus for fiscal 2004. In fiscal 2003, thisamount represents a $50,000 sign-on bonus and a $50,000 guaranteed annual bonus for fiscal 2003. (18)These amounts represent $83,800 and $55,500 in fiscal 2004 and 2005, respectively, in housing allowances and commuting reimbursements andincludes applicable tax gross-up amounts. (19)In May 2005, Ms. Al-Fayez was granted 10,000 shares of our common stock, of which 50% were scheduled to vest on each of May 5, 2008 andMay 5, 2009. In November 2004, Ms. Al-Fayez was also granted 10,000 shares of our common stock, of which 50% were scheduled to vest on each ofNovember 1, 2007 and November 1, 2008. In October 2003, Ms. Al-Fayez was granted 25,000 shares of our common stock, of which 6,250 sharesvested on October 22, 2004 and the remainder were scheduled to vest in equal annual installments on each of October 22, 2005, 2006 and 2007. All ofthese shares, other than the 6,250 shares that vested on October 22, 2004, were forfeited upon Ms. Al-Fayez’s resignation. 48Table of ContentsThe following table shows information concerning options to purchase shares of Group’s common stock granted to each of the named executive officersduring fiscal 2005.Option Grants in Last Fiscal Year Individual Grants Potential Realizable Value atAssumed Annual Rates ofStock Price Appreciationfor Option Term(a)Name Number ofSecuritiesUnderlyingOptionsGranted Percent ofTotal OptionsGranted toEmployeesIn Fiscal Year ExercisePrice($/Sh) ExpirationDate 5% ($) 10% ($)Millard Drexler 40,00040,000 3.93.9%% 15.0025.00 20152015 273,088— 790,246390,246Jeffrey Pfeifle 25,00025,000 2.52.5%% 12.6013.40 20152015 198,102210,680 502,029533,904James Scully 50,00040,00040,000 4.93.93.9%%% 13.4015.0025.00 201520152015 421,359273,088— 1,067,807790,246390,246Tracy Gardner 20,00020,00050,00010,00010,00035,000 2.02.04.91.01.03.5%%%%%% 15.0025.0012.6015.0025.0013.40 201520152015201520152015 — — 396,20455,241— 294,952 94,249— 1,004,058176,81276,812747,465Roxane Al-Fayez 25,00010,00010,000 2.51.01.0%%% 12.6015.0025.00 200520052005 15,750— — 31,500— — (a)There is no established public market for shares of Group’s common stock. Based on customary corporate valuation techniques, including an analysisof the discounted value of our potential earnings and cash flow, the valuation of comparable companies and current book value per share, the value of ashare of Group’s common stock was estimated to be $12.60 as of March 31, 2005 and $13.40 as of August 8, 2005.The following table shows the number of options to purchase shares of Group’s common stock held by each of the named executive officers at the end offiscal 2005 and the number of shares of common stock acquired by each named executive officer upon the exercise of options in fiscal 2005.Aggregated Option Exercises in Last Fiscal Year and Fiscal Year-End Option Values Name SharesAcquired onExercise(#) ValueRealized($) Number of SecuritiesUnderlying UnexercisedOptions atFiscal Year End Value of UnexercisedIn-the-Money-Options atFiscal Year End($)(a) Exercisable Unexercisable Exercisable UnexercisableMillard Drexler 139,482 806,206 982,662 1,214,600 0/0 0/0Jeffrey Pfeifle 41,845 241,864 55,794 342,909 0/0 0/0James Scully — — — — 0/0 0/0Tracy Gardner — — — — 0/0 0/0Roxane Al-Fayez 11,250 65,025 — — 0/0 0/0(a)There is no established public market for shares of Group’s common stock. Based on customary corporate valuation techniques, including an analysisof the discounted value of our potential earnings and cash flow, the valuation of comparable companies and current book value per share, the value of ashare of Group’s common stock was estimated to be $6.40 as of January 28, 2006. Therefore, since the exercise price of the options exceeds theestimated value of a share of Group’s common stock at January 28, 2006, the value of unexercised in-the-money options is shown as zero. 49Table of ContentsEmployment Agreements and Other Compensation ArrangementsEmployment and Other AgreementsMillard Drexler. On October 20, 2005, we entered into an amended and restated employment agreement with Mr. Drexler, which replaces the servicesagreement that previously governed Mr. Drexler’s employment. Pursuant to this amended and restated agreement, Mr. Drexler will continue to serve as ourChief Executive Officer until August 31, 2008, provided that the amended and restated agreement will automatically extend for successive one-year periodsunless we or Mr. Drexler provide at least 90 days’ written notice prior to the expiration of the then-current term. The amended and restated agreement providesMr. Drexler with a minimum annual base salary of $200,000, an opportunity to earn an annual bonus based on the achievement of earnings objectives to bedetermined each year and the reimbursement of business expenses, provided that his total cash compensation cannot exceed $700,000 per year. We have agreedto reimburse Mr. Drexler $250,000 of moving expenses in connection with his relocation from California to New York, and have reimbursed Mr. Drexler$250,000 pursuant to this provision. The reimbursement of such relocation expenses shall be excluded from the $700,000 cap. Beginning February 1, 2006,Mr. Drexler will be eligible to receive a target bonus of $800,000 (provided that his bonus may be greater or lesser in the compensation committee’s discretion)and his total annual cash compensation will no longer be subject to a cap. Pursuant to the amended and restated agreement, if we terminate Mr. Drexler’semployment without “cause” or he terminates his employment for “good reason” (each as defined in the employment agreement), Mr. Drexler will be entitled toreceive (i) a payment of his annual base salary through the termination date, any accrued vacation pay and any unreimbursed expenses, (ii) a payment equalto his annual base salary and target bonus, one-half of such payment to be paid on the first business day that is six months and one day following thetermination date and the remaining one-half of such payment to be paid in six equal monthly installments commencing on the first business day of the seventhcalendar month following the termination date, (iii) a pro-rated bonus based on (A) the last bonus Mr. Drexler received prior to the termination date and (B) thenumber of days of service completed by Mr. Drexler in the year of termination, such amount to be paid on the first business day that is six months and oneday following the termination date, and (iv) the accelerated vesting of any unvested restricted shares and/or unvested stock options as provided for in anyapplicable grant agreement. In the event that any payment or benefit provided to Mr. Drexler following the IPO becomes subject to the excise taxes imposed bythe “parachute payment” provisions of the Internal Revenue Code, Mr. Drexler will be entitled to receive a “gross-up” payment in connection with any suchexcise taxes. Mr. Drexler remains subject to customary non-solicitation, non-competition and confidentiality covenants.In September 2003, Mr. Drexler surrendered to us all of his “premium options” which were granted to him in accordance with his previous servicesagreement. The premium options consisted of options to purchase 836,889 shares at an exercise price equal to $25.00 per share and 836,889 shares at anexercise price equal to $35.00 per share. In consideration of the surrender, we granted to Mr. Drexler replacement premium options in May 2004 as follows:options to purchase 836,889 shares at an exercise price equal to $15.00 per share and options to purchase an additional 836,889 shares at an exercise priceequal to $25.00 per share. The replacement premium options are subject to the same terms and conditions (other than the expiration date and exercise price),including vesting schedule, as the surrendered premium options. This option repricing was approved by a majority of our board of directors.Mr. Drexler’s previous services agreement provided for the grant of 55,793 restricted shares of our common stock that vested immediately and the grantof 725,303 restricted shares of our common stock that vest in equal annual installments over four years commencing on January 27, 2005 (the secondanniversary of the date his service commenced). We refer to these shares collectively as the “Drexler Restricted Shares.” Mr. Drexler paid us $800,000 for the725,303 share grant of the Drexler Restricted Shares. The Drexler Restricted Shares remain subject to these terms under Mr. Drexler’s amended and restatedemployment agreement.We refer you to footnote (4) to the Summary Compensation Table for information on the Drexler Restricted Shares and vesting of those shares.Mr. Drexler has entered into a stockholders’ agreement with us and Partners II relating to the Drexler Restricted Shares and any other shares of ourcommon stock that he may subsequently acquire. Under the provisions of this stockholders’ agreement: (i)Mr. Drexler is subject to certain restrictions on the transfer of his shares (Drexler Restricted Shares and any other shares he may subsequentlyacquire), and we have rights to purchase Mr. Drexler’s shares in certain circumstances, 50Table of Contents (ii)Mr. Drexler has the right to include the Drexler Restricted Shares in any registered offering of our common stock that includes shares of ourcommon stock held by Partners II (or any of its permitted transferees) and, on the first anniversary of the existence of a public market for ourcommon stock, to require us to register the Drexler Restricted Shares under the Securities Act, (iii)if a third party acquires all or substantially all of our shares and Partners II intends to transfer its shares to such purchaser, Partners II mayrequire Mr. Drexler to transfer the Drexler Restricted Shares as well, (iv)Mr. Drexler has the right to transfer the Drexler Restricted Shares in a transaction described in paragraph (iii), (v)Mr. Drexler has the right to nominate three directors directly and three additional directors by mutual agreement with Partners II, (vi)Mr. Drexler has the right to consent to our operating/capital budgets, and (vii)Mr. Drexler had certain anti-dilution and co-investment rights which expired according to the terms of the agreement on January 31, 2004 andJanuary 31, 2005, respectively.The provisions of Mr. Drexler’s stockholders’ agreement described in paragraphs (v) – (vi) above will terminate upon the existence of a public marketfor our common stock.Jeffrey Pfeifle. Mr. Pfeifle has entered into an employment agreement with us pursuant to which he has agreed to serve as President for five yearsbeginning on February 1, 2003, subject to automatic one-year renewals unless we or Mr. Pfeifle provide at least three months’ written notice prior to theexpiration of the then current term. The agreement provides for an annual base salary of $760,000, (with such amount to be reviewed by the board annually),one-time bonuses in the total amount of $2,000,000 which became payable after his start date, an annual bonus based on the achievement of earningsobjectives to be determined each year provided that the minimum bonus payable for fiscal 2003 would be $400,000, a long-term cash incentive paymentbetween $800,000 and $1,200,000 based on the achievement of performance objectives to be determined each year payable in installments at the end of fiscalyears 2003 and 2004, and reimbursement of business expenses. The annual bonus shall be a percentage of the base salary, with the target bonus ranging from25% to a maximum of 100% of base salary. The agreement also provides for (i) the grant of options to purchase 167,378 shares of our common stock at anexercise price equal to $6.82 per share, which we refer to as “initial options,” and (ii) the grant of premium options to purchase an additional 111,585 sharesat an exercise price equal to $25.00 per share and 111,585 shares at an exercise price equal to $35.00 per share, which we refer to as “premium options.” Theinitial options and the premium options vest in equal annual installments over four years commencing on the second anniversary of the date Mr. Pfeiflecommenced his employment with us. The agreement also provides for the grant of 111,585 shares of our common stock, which we refer to as the “PfeifleRestricted Shares.” Under the agreement, Mr. Pfeifle is subject to customary non-solicitation, non-competition and confidentiality covenants.Under Mr. Pfeifle’s employment agreement, if Mr. Pfeifle’s employment is terminated by us without “cause” or by him for “good reason” (each asdefined in the employment agreement), or as a result of the provision of notice of our intent not to renew his employment period, Mr. Pfeifle will be entitled toreceive his base salary for two years, a pro-rated amount of any bonus that he would have otherwise received for the fiscal year ending before the terminationdate, and the immediate vesting of that portion of the initial options, premium options and Pfeifle Restricted Shares that would have become vested on the nextscheduled vesting date following the termination date. If termination occurs within the two year period following a “change in control” (as defined in theemployment agreement) or within six months before a “change in control,” all of the unvested initial options, premium options and Pfeifle Restricted Shareswill immediately vest and become exercisable. 51Table of ContentsIn September 2003, Mr. Pfeifle surrendered all of his premium options to us. In consideration of the surrender, we granted Mr. Pfeifle replacementpremium options in May 2004 as follows: options to purchase 111,585 shares at an exercise price equal to $15.00 per share and options to purchase anadditional 111,585 shares at an exercise price equal to $25.00 per share. The replacement premium options are subject to the same terms and conditions (otherthan expiration date), including vesting schedule, as the surrendered premium options. This option repricing was approved by a majority of our board ofdirectors.We refer you to footnote (6) to the Summary Compensation Table for information on the Pfeifle Restricted Shares and the vesting of those shares.Mr. Pfeifle has entered into a stockholders’ agreement with us and Partners II. This stockholders’ agreement: (i)imposes certain restrictions on the transfer of Mr. Pfeifle’s shares (Pfeifle Restricted Shares and any other shares he may subsequently acquire)and give us rights to purchase Mr. Pfeifle’s shares in certain circumstances, and (ii)provides for certain transfer restrictions and customary tag-along and drag-along rights.The provisions of Mr. Pfeifle’s stockholders’ agreement described in paragraph (ii) above will terminate upon the existence of a public market for our commonstock.James Scully. We have entered into an employment agreement dated August 16, 2005, with James Scully, pursuant to which he has agreed to serve asour Executive Vice President and Chief Financial Officer, effective September 7, 2005, for a three year period, subject to automatic one-year renewals unlesswe or Mr. Scully provide four month’s written notice prior to the expiration of the then current term. The agreement provides for a base salary of $475,000,which will be reviewed annually by us. He is eligible to receive an annual bonus with a target bonus of 50% of base salary and a maximum of 100% of basesalary, based upon the achievement of certain company and individual performance objectives, provided that for fiscal 2005, Mr. Scully received a guaranteedbonus of $250,000. Mr. Scully also received a $165,000 transition support payment, provided that in the event he voluntarily terminates his employmentwithout “good reason” or we terminate his employment for “cause” (each as defined in the agreement) within the first year of employment, Mr. Scully will berequired to immediately pay us back a pro-rata portion of the transition support payment. The agreement also provides Mr. Scully with relocation assistance inconnection with his relocation to New York in accordance with our executive homeowner relocation policy, provided that in the event that he voluntarilyterminates his employment without good reason prior to the first anniversary of his employment, he will be required to immediately pay back a pro-rataportion of all relocation assistance payments that he received. In addition we have granted to Mr. Scully the following equity awards: (i) options to purchase50,000 shares of our common stock at an exercise price per share equal to $13.40 on the date of grant, which we refer to as “initial options,” (ii) premiumoptions to purchase an additional 40,000 shares at an exercise price equal to $15.00 per share and 40,000 shares at an exercise price equal to $25.00 per share,which we refer to as “premium options,” and (iii) 35,000 restricted shares, all of which will vest in equal annual installments beginning on the firstanniversary of the grant date. We refer to these restricted shares as the “Scully Restricted Shares.” Under the agreement, Mr. Scully is subject to customarynon-solicitation, non-competition and confidentiality covenants.Under Mr. Scully’s agreement, if we terminate his employment without “cause” or he terminates his employment for “good reason”, he will be entitled toreceive his base salary for one year, continuation of medical benefits for one year, which may be provided by us reimbursing payment of COBRA premiums,and a pro-rated amount of any bonus that he would have otherwise received for the fiscal year that includes the termination date. However, Mr. Scully’s rightto the continuation of his base salary and medical coverage for the one-year period following termination of employment will cease, respectively, upon the datethat he becomes employed by a new employer or otherwise begins providing services for another entity and the date he becomes eligible for coverage underanother group health plan, provided that if the cash compensation he receives from his new employer or otherwise is less than his base salary in effectimmediately prior to his termination date, he will be entitled to receive the difference between his base salary and his new amount of cash compensation duringthe remainder of the severance period. 52Table of ContentsWe refer you to footnote (11) to the Summary Compensation Table for information on the Scully Restricted Shares and vesting of those shares.Mr. Scully has entered into a stockholders’ agreement with us and Partners II. This stockholders’ agreement: (i)imposes certain restrictions on the transfer of Mr. Scully’s shares (Scully Restricted Shares and any other shares he may subsequently acquire)and give us rights to purchase Mr. Scully’s shares in certain circumstances, and (ii)provides for certain transfer restrictions and customary tag-along and drag-along rights.The provisions of Mr. Scully’s stockholders’ agreement described in paragraph (ii) above will terminate upon the existence of a public market for our commonstock.Tracy Gardner. Ms. Gardner has entered into an employment agreement with us pursuant to which she has agreed to serve as Executive Vice President,Merchandising, Planning and Production for four years beginning in March 2004, subject to renewal upon mutual agreement. The agreement provides for aminimum annual base salary of $450,000, a one-time sign-on bonus of $150,000, and an annual bonus with a target of 50% of base salary and a maximumof 100% of base salary, based on the achievement of earnings objectives and individual performance goals to be determined each year, provided that theminimum bonus payable with respect to fiscal 2004 was $112,500. The agreement also provides for (i) the grant of options to purchase 50,000 shares of ourcommon stock at an exercise price equal to $6.82 per share, which we refer to as “initial options,” and (ii) the grant of premium options to purchase anadditional 20,000 shares of our common stock at an exercise price equal to $15.00 per share and 20,000 shares of our common stock at an exercise price equalto $25.00 per share, which we refer to as “premium options.” The agreement also provides for the grant in March 2005 of (x) an additional option to purchase20,000 shares of our common stock at an exercise price equal to $15.00 per share and (y) an additional option to purchase 20,000 shares of our common stockat an exercise price equal to $25.00 per share, which we refer to as the “additional premium options.” The initial options vest in equal annual installments overfour years commencing on the first anniversary of the grant date. The premium options and the additional premium options vest in equal installments overfour years commencing on the second anniversary of their respective grant dates. The agreement also provides for the grant of 50,000 shares of our commonstock, which we refer to as the “Gardner Restricted Shares.” Ms. Gardner also received relocation benefits in connection with her relocation to the New YorkCity area. Under the agreement, Ms. Gardner is subject to customary non-solicitation, non-competition and confidentiality covenants.We refer you to footnote (14) to the Summary Compensation Table for information on the Gardner Restricted Shares and vesting of those shares.Ms. Gardner has entered into a stockholders’ agreement with us and Partners II. This stockholders’ agreement: (i)imposes certain restrictions on the transfer of Ms. Gardner’s shares (Gardner Restricted Shares and any other shares she may subsequentlyacquire) and give us rights to purchase Mr. Gardner’s shares in certain circumstances, and (ii)provides for certain transfer restrictions and customary tag-along and drag-along rights.The provisions of Ms. Gardner’s stockholders’ agreement described in paragraph (ii) above will terminate upon the existence of a public market for ourcommon stock.Under Ms. Gardner’s employment agreement, if we terminate her employment without “cause” or she terminates her employment for “good reason” (eachas defined in the employment agreement), Ms. Gardner will be entitled to receive her base salary for one year and a pro-rated amount of any bonus that shewould have otherwise received for the fiscal year ending before the termination date. However, Ms. Gardner’s right to the continuation of her base salary for oneyear following the termination of her employment will cease upon the date that she becomes 53Table of Contentsemployed by a new employer or otherwise begins providing services for another entity, provided that if the cash compensation she receives from her newemployer or otherwise is less than her base salary in effect immediately prior to her termination date, she will be entitled to receive the difference between herbase salary and her new amount of cash compensation during the remainder of the severance period.Group’s Amended and Restated 1997 Stock Option PlanGroup’s board of directors adopted the 1997 Stock Option Plan (“1997 Plan”) on October 17, 1997, and Group’s stockholders approved the 1997Plan on December 29, 1997.Share Reserve. We have authorized 1,910,000 shares of our common stock for issuance under the 1997 Plan. The aggregate number of sharesavailable for issuance under the 1997 Plan may be adjusted in the case of a stock dividend, recapitalization, stock split, reverse stock split, merger, or othersimilar corporate transaction or event, in order to prevent dilution or enlargement of the benefits or potential benefits intended to be provided under the 1997Plan. In addition, shares subject to stock awards that have expired, been forfeited or otherwise terminated without having been exercised may be subject to newawards under the 1997 Plan. As of January 28, 2006, options to purchase 1,682,448 shares of our common stock at a weighted average exercise price of$9.40 per share were outstanding under the 1997 Plan.Eligibility. Key employees, officers, and consultants of our company or our subsidiaries are eligible to participate in the 1997 Plan.Administration. The 1997 Plan is currently administered by our compensation committee. Our compensation committee determines, among otherthings, which eligible persons are to receive awards, the number of shares of our common stock subject to each award, the exercise price per share underlyingeach option, the vesting schedule for each stock option, and the other terms and conditions of each award, consistent with the provisions of the 1997 Plan.The terms and conditions of each award shall be set forth in a written award agreement with the recipient. Our compensation committee has authority tointerpret and administer the 1997 Plan and any award agreement and to establish rules and regulations for the administration of the 1997 Plan.Options. Options granted under the 1997 Plan will be nonqualified stock options. The holder of an option granted under the 1997 Plan will be entitledto purchase a number of shares of our common stock at a specified exercise price during a specified time period, as determined by our compensationcommittee. Options granted under the 1997 Plan may become exercisable based on the optionee’s continued employment and, prior to a public offering of ourcommon stock, may be exercised only if the optionee agrees to be bound by a stockholders’ agreement. The exercise price for an option may be paid in cash, inshares of our common stock valued at fair market value on the exercise date, or by such other method as the compensation committee may approve. Optionsgranted under the 1997 Plan generally may be transferred with or without written consent only by will or by the laws of descent and distribution.Certain Corporate Transactions; Change in Control. In the event of certain corporate transactions, such as a merger or consolidation in which we arenot the surviving entity or a sale of all or substantially all of the assets of our company, the 1997 Plan provides that the compensation committee has thepower to provide for the exchange of each outstanding option for a comparable option or stock appreciation right issued by our successor company or itsparent and make an equitable adjustment to the exercise price and number of shares or, if appropriate, provide for a cash payment to the optionee in partialconsideration for the option exchange. No award agreement entered into pursuant to the 1997 Plan provides for the acceleration of any exercise schedule orvesting schedule with respect to an award solely because of a “change in control” of our company. However, awards may provide for the acceleration of theexercise schedule or vesting schedule in the event of the termination of the recipient’s employment with us by us without cause or by the recipient for goodreason within a specified period of time following a change in control.Amendment and Termination. The compensation committee may amend or modify the 1997 Plan or the terms of any option at any time, subject to anyrequired approval of our stockholders or the recipients of outstanding awards. The compensation committee may, at any time, terminate any outstandingoption for consideration equal to the fair market value per share less the exercise price. 54Table of ContentsFederal Income Tax Consequences. The following is a summary of the general federal income tax consequences to our company and to U.S. taxpayersof awards granted under the 1997 Plan. Tax consequences for any particular individual or under state or non-U.S. tax laws may be different.Non-Qualified Stock Option (each, an “NSO”). No taxable income is reportable when an NSO is granted. Upon exercise, generally, the recipient willhave ordinary income equal to the fair market value of the underlying shares of stock on the exercise date minus the exercise price. Any gain or loss upon thedisposition of the stock received upon exercise will be capital gain or loss to the recipient.Tax Effect for Our Company. We generally will receive a tax deduction for any ordinary income recognized by a participant in respect of an awardunder the 1997 Plan (for example, upon the exercise of a NSO). Special rules limit the deductibility of compensation paid to our CEO and to each of our fourmost highly compensated executive officers. Under Section 162(m), the annual compensation paid to each of these executives may not be deductible to theextent that it exceeds $1 million. However, we intend to rely on Treas. Reg. Section 1.162-27(f) which provides that the deduction limit of Section 162(m) doesnot apply to any remuneration paid pursuant to a compensation plan or agreement that existed during the period in which the company was not publicly held.We may rely on this grandfather provision for up to three years after we become publicly held. Additionally, after the expiration of the grandfather, we canpreserve the deductibility of compensation over $1 million if certain conditions of Section 162(m) are met, including obtaining shareholder approval of the1997 Plan and setting limits on the number of awards that any individual may receive. Our deduction may also be limited by Section 280G of the Code.Group’s 2003 Equity Incentive PlanGroup’s board of directors adopted the 2003 Equity Incentive Plan (“2003 Plan”) on January 25, 2003, and Group’s stockholders approved the 2003Plan on February 10, 2003.Share Reserve. We have authorized 4,798,160 shares of our common stock for issuance under the 2003 Plan. Unless our compensation committeedetermines otherwise, of the maximum number of shares reserved for issuance: (a) 1,115,812 shares are reserved for the issuance of stock options with anexercise price of $6.82 per share, provided that if the fair market value of a share of our common stock is greater than $6.82, such exercise price may begreater than $6.82 per share; (b) 1,115,812 shares are reserved for the issuance of stock options with an exercise price of $25.00 per share, provided that ifthe fair market value of a share of our common stock is greater than $25.00, such exercise price may be greater than $25.00 per share; (c) 1,115,812 sharesare reserved for the issuance of stock options with an exercise price of $35.00 per share, provided that if the fair market value of a share of our common stockis greater than $35.00, such exercise price may be greater than $35.00 per share; and (d) 1,450,724 shares are reserved for the issuance of restricted shares.The aggregate number of shares available for issuance under the 2003 Plan may be adjusted in the case of a stock dividend, recapitalization, stock split,reverse stock split, merger, or other similar corporate transaction or event, in order to prevent dilution or enlargement of the benefits or potential benefitsintended to be provided under the 2003 Plan. As of January 28, 2006, options to purchase 3,086,901 shares of our common stock at a weighted averageexercise price of $16.90 per share were outstanding under the 2003 Plan.Eligibility. Key employees, officers, directors and consultants of our company or our subsidiaries are eligible to participate in the 2003 Plan.Types of Awards. The 2003 Plan permits the granting of nonqualified stock options and shares of restricted stock.Administration. The 2003 Plan is currently administered by our compensation committee. Our compensation committee determines, among other things,which eligible persons are to receive awards, the number of shares of our common stock subject to each award, the exercise price of shares underlying thestock options, the vesting schedule for each stock option and restricted stock award, and the other terms and conditions of each award, consistent with theprovisions of the 2003 Plan. The terms and conditions of each award shall be set forth in a written award agreement with the recipient. Our compensationcommittee has authority to interpret and administer 55Table of Contentsthe 2003 Plan and any award agreement and to establish rules and regulations for the administration of the 2003 Plan.Options. Options granted under the 2003 Plan will be nonqualified stock options. The holder of an option granted under the 2003 Plan will be entitled topurchase a number of shares of our common stock at a specified exercise price during a specified time period, as determined by our compensation committee.Options granted under the 2003 Plan may become exercisable based on the recipient’s continued employment and, prior to an initial public offering of ourcommon stock, may be exercised only if the optionee agrees to be bound by a stockholders’ agreement. To the extent that any option or restricted stock grantedunder the 2003 Plan is forfeited, terminates, expires or is canceled without having been exercised, the shares of common Stock covered by such option orrestricted stock shall again be available for grant under the 2003 Plan. The exercise price for an option may be paid in cash, in shares of our common stockvalued at fair market value on the exercise date, or by such other method as the compensation committee may approve. Options granted under the 2003 Plangenerally may be transferred without our prior written consent only by will or by the laws of descent and distribution.Shares of Restricted Stock. A participant who is issued shares of restricted stock pursuant to the 2003 Plan will own shares of our common stocksubject to such restrictions as determined by our compensation committee. Shares of restricted stock and restricted stock units granted under the 2003 Planwill vest at such times or upon the occurrence of such events as determined by our compensation committee. Shares of restricted stock that have not vestedgenerally will be subject to forfeiture by the participant, without payment of any consideration by our company, if the participant’s employment or serviceterminates. Unless otherwise permitted by our compensation committee, shares of restricted stock granted under the 2003 Plan may not be transferred by theparticipant prior to vesting.Certain Corporate Transactions; Change in Control. In the event of certain corporate transactions, such as a merger or consolidation in which we arenot the surviving entity or a sale of all or substantially all of the assets of our company, the 2003 Plan provides that (a) each outstanding option or restrictedstock award may be assumed or substituted with a comparable option or restricted stock award by our successor company or its parent, (b) each outstandingoption or restricted stock award may be cancelled and the recipient will receive a cash payment equal to, with respect to a stock option, the excess of the valueof securities and property (including cash) received by the holders of shares of our common stock as a result of such event over the exercise price of suchoption, and with respect to restricted stock, the value of securities and property (including cash) received by the holders of the shares of our common stock asa result of such event; or (c) any combination of (a) or (b). No award agreement entered into pursuant to the 2003 Plan provides for the acceleration of anyexercise schedule or vesting schedule with respect to an award solely because of a “change in control” of our company. However, awards may provide for theacceleration of the exercise schedule or vesting schedule in the event of the termination of the recipient’s employment with us by us without cause or by therecipient for good reason within a specified period of time following a change in control.Amendment and Termination. Group’s board of directors may amend or modify the 2003 Plan at any time, subject to any required approval of ourstockholders or the recipients of outstanding awards. The compensation committee may, at any time, terminate any outstanding option for consideration equalto the fair market value per share less the exercise price.Federal Income Tax Consequences. The following is a summary of the general federal income tax consequences to our company and to U.S. taxpayersof awards granted under the 2003 Plan. Tax consequences for any particular individual or under state or non-U.S. tax laws may be different.Non-Qualified Stock Options (each, an “NSO”). No taxable income is reportable when an NSO is granted. Upon exercise, generally, the recipient willhave ordinary income equal to the fair market value of the underlying shares of stock on the exercise date minus the exercise price. Any gain or loss upon thedisposition of the stock received upon exercise will be capital gain or loss to the recipient.Restricted Stock. A recipient of restricted stock will not have taxable income upon the grant unless he or she elects to be taxed at that time. Instead, he orshe will have ordinary income at the time of vesting equal to the fair market value on the vesting date of the shares (or cash) received minus any amount paidfor the shares. 56Table of ContentsTax Effect for Our Company. We generally will receive a tax deduction for any ordinary income recognized by a participant in respect of an awardunder the 2003 Plan (for example, upon the exercise of a NSO). Special rules limit the deductibility of compensation paid to our CEO and to each of our fourmost highly compensated executive officers. Under Section 162(m), the annual compensation paid to each of these executives may not be deductible to theextent that it exceeds $1 million. However, we intend to rely on Treas. Reg. Section 1.162-27(f) which provides that the deduction limit of Section 162(m) doesnot apply to any remuneration paid pursuant to a compensation plan or agreement that existed during the period in which the company was not publicly held.We may rely on this grandfather provision for up to three years after we become publicly held. Additionally, after the expiration of the grandfather, we canpreserve the deductibility of compensation over $1 million if certain conditions of Section 162(m) are met, including obtaining shareholder approval of the2003 Plan and setting limits on the number of awards that any individual may receive. Our deduction may also be limited by Section 280G of the Code.Company Bonus PlanOn April 10, 2006, our compensation committee approved the financial goals under our bonus plan for fiscal 2006, which we refer to as the “2006Plan,” for the annual cash bonus awards payable to eligible employees participating in the 2006 Plan, including Messrs. Pfeifle and Scully and Ms. Gardner.The bonuses payable under the 2006 Plan will be based on the extent to which we meet or exceed specific financial goals established by the compensationcommittee and individual performance assessments as determined in the discretion of our management. For Messrs. Drexler, Pfeifle and Scully andMs. Gardner, the amount of the actual bonus award could range from zero to 100% of annual base salary, with a target of 50% of his or her annual basesalary. Mr. Drexler is eligible to receive a target bonus of $800,000.Shareholders Agreements’Under a stockholders’ agreement, as amended by a letter agreement, among us, Ms. Scott and Partners II, Ms. Scott has a right to include her shares ina registered offering that includes shares of common stock held by Partners II or its affiliates. Under the terms of this agreement, we are required to obtainMs. Scott’s consent before engaging in a transaction with any affiliate of Partners II, provided that her consent may not be unreasonably withheld. Thisstockholders’ agreement also imposes certain restrictions on the transfer of shares of our common stock held by Ms. Scott and Partners II, and containscustomary tag-along and drag-along rights. Under this agreement, Partners II has agreed to vote for Ms. Scott and a nominee chosen by her as members of theboard of directors and Ms. Scott has agreed to vote for three director nominees chosen by Partners II. This agreement will terminate following the existence of apublic market for our common stock, including the drag-along rights. However, the transfer restrictions, tag-along rights, right to include shares in a registeredoffering and rights in connection with the election of directors will survive the termination of the agreement.Under a stockholders’ agreement between Partners II and Mr. Drexler, Mr. Drexler has registration rights with respect to shares of our common stockowned by him or acquired pursuant to the exercise of options. Mr. Drexler’s stockholders’ agreement also imposes certain restrictions on the transfer of thecommon shares held by Mr. Drexler and Partners II, and contains customary tag-along and drag-along rights. In addition, Mr. Drexler’s shareholders’agreement provides him with the right to nominate three directors directly and three additional directors by mutual agreement with Partners II. Mr. Drexler alsohas the right to consent to our operating/capital budgets. Mr. Drexler’s right to nominate directors directly and by mutual agreement with TPG will terminatefollowing the existence of a public market for our common stock. Mr. Drexler’s shareholders’ agreement also provided him with certain anti-dilution and co-investment rights which expired according to the terms of the agreement on January 31, 2004 and January 31, 2005, respectively.The Pfeifle Restricted Shares, the Scully Restricted Shares, the Gardner Restricted Shares and the Al-Fayez Restricted Shares, and any shares of ourcommon stock acquired by Messrs. Pfeifle or Scully or Mss. Al-Fayez or Gardner pursuant to the exercise of options are subject to shareholders’ agreementsproviding for certain transfer restrictions and customary tag-along and drag-along rights. These agreements will terminate following the completion of an initialpublic offering of our common stock, including the tag-along and drag-along rights. The transfer restrictions, however, will survive the termination of theagreement. Similar agreements with former 57Table of Contentsemployees will also terminate on the same terms in connection with an initial public offering of our common stock. We refer you to “Executive Compensation—Employment Agreements and other Agreements” for more information.Compensation Committee Interlocks and Insider ParticipationIn fiscal 2005, the members of our compensation committee were Messrs. Coulter (Chairman) and Sloan and Ms. Scott. Ms. Scott is a formerChairman, former Chief Executive Officer and former Vice-Chairman of J.Crew. Mr. Sloan is the President of UV, Inc., which is the general partner ofUniversity Village Limited Partnership, the owner and operator of University Village Shopping Center in Seattle, Washington. J.Crew has entered into a 10-year lease agreement with University Village Limited Partnership with respect to the lease of 7,400 square feet at the University Village Shopping Center for theoperation of one of our retail stores. See “Certain Relationships and Related Transactions—University Village Lease.” 58Table of ContentsITEM 12.SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS.Beneficial ownership of shares is determined under the rules of the SEC and generally includes any shares over which a person exercises sole or sharedvoting or investment power. Except as indicated by footnote, and subject to applicable community property laws, we believe that each person identified in thetable possesses sole voting and investment power with respect to all shares of common stock held by that person. Shares of common stock subject to optionscurrently exercisable or exercisable within 60 days of April 15, 2006 are deemed outstanding for calculating the percentage of outstanding shares of the personholding these options, but are not deemed outstanding for calculating the percentage of any other person.The following table sets forth information regarding the beneficial ownership of the shares of Group’s common stock as of April 15, 2006 bystockholders known by us to beneficially own more than five percent of Group’s outstanding common stock. Title of Class Name and Address ofBeneficial Owner Amount and Nature ofBeneficial Ownership Percent of Class Common stock TPG Advisors II, L.P. 301 Commerce Street,Suite 3300 Fort Worth, TX 76102 9,014,298 shares(a)(b) 56%Common stock Millard S. Drexler J. Crew Group, Inc. 770Broadway New York, NY 10003 3,486,636 shares(c) 22%Common stock Emily Scott J. Crew Group, Inc. 770Broadway New York, NY 10003 2,782,377 shares(d) 17%(a)TPG Advisors II, Inc. is the general partner of TPG Gen Par II, L.P. (“GenPar II”), which is the general partner of each of the TPG II Funds and TPG1999 Equity II, L.P. (“Equity II”). The TPG II Funds and Equity II beneficially own 9,014,298 shares of our common stock directly. TPG AdvisorsII, Inc. may be deemed to be the beneficial owner of shares beneficially owned by the TPG II Funds and Equity II but disclaims such beneficialownership pursuant to rules promulgated under the Exchange Act. David Bonderman, James G. Coulter and William S. Price, III (the “Shareholders”)are directors, officers and shareholders of TPG Advisors II, Inc. and may be deemed to be the beneficial owners of shares owned by the TPG II Fundsand Equity II. Each Shareholder disclaims beneficial ownership of any securities beneficially owned by the TPG II Funds and Equity II. (b)Includes 1,700,500 shares not currently owned but issuable to the TPG II Funds and Equity II upon conversion of the 5.0% Notes Payable. The TPG IIFunds and Equity II together hold a 50% membership interest in TPG-MD Investment, LLC, which beneficially owns the 5.0% Notes Payable directly.We refer you to “Certain Relationships and Related Transactions—TPG-MD Investment Notes Payable” for more information. (c)Includes (i) 686,722 shares owned by Mr. Drexler, (ii) 262,524 shares beneficially owned by a family trust for which Mr. Drexler is a trustee,(iii) 836,890 shares not currently owned but issuable upon the exercise of stock options awarded under our stock option plans that are currentlyexercisable, and (iv) 1,700,500 shares not currently owned but issuable to TPG-MD Investment, LLC upon conversion of the 5.0% Notes Payable. Werefer you to “Certain Relationships and Related Transactions—TPG-MD Investment Notes Payable” for more information. An entity controlled byMr. Drexler, MDJC LLC, holds a 50% membership interest in TPG-MD Investment LLC, which beneficially owns the 5.0% Notes Payable directly. (d)Includes 512,200 shares not currently owned but issuable upon the exercise of stock options awarded under our stock option plans that are currentlyexercisable. 59Table of ContentsThe following table sets forth information regarding the beneficial ownership of each class of Group’s equity securities of as of April 15, 2006 by(i) each of Group’s directors, (ii) each of Group’s named executive officers listed in the “Summary Compensation Table” and (iii) all of Group’s directors andexecutive officers as a group. The holders listed have sole voting power and investment power over the shares held by them, except as indicated by the notesfollowing the table. Title of Class Name of Beneficial Owner Amount and Nature ofBeneficial Ownership Percent of Class Common stock Bridget Ryan Berman 10,000 * Common stock Richard Boyce 55,200 * Common stock James Coulter 9,014,298(a) 56%Common stock Steven Grand-Jean 28,750(b) * Common stock Emily Scott 2,782,377(c) 17%Common stock Thomas Scott 28,750(b) * Common stock Stuart Sloan 28,750(b) * Common stock Josh Weston 44,228(d) * Common stock Millard Drexler 3,486,636(e) 22%Common stock Roxane Al-Fayez 17,500 * Common stock Tracy Gardner 47,500(f) * Common stock Jeffrey Pfeifle 276,176(g) 2%Common stock All directors and executive officers as a group 15,820,165 98%Series A preferred stock James Coulter 73,475(h) 79%Series A preferred stock Emily Scott 2,979 3%Series A preferred stock Josh Weston 60 * Series A preferred stock All directors and executive officers as a group 76,514 83%(*)Represents less than 1% of the class. (a)As a Shareholder, Mr. Coulter may be deemed to be the beneficial owner of shares owned by the TPG II Funds and Equity II. Includes 1,700,500 sharesnot currently owned but issuable to the TPG II Funds and Equity II upon conversion of the 5.0% Notes Payable. We refer you to “Certain Relationshipsand Related Transactions—TPG-MD Investment Notes Payable” for more information. Mr. Coulter disclaims beneficial ownership of the shares ownedby the TPG II Funds and Equity II. (b)Includes 23,750 shares for Messrs. Scott and Sloan and 16,250 shares for Mr. Grand-Jean not currently owned but issuable upon the exercise of stockoptions awarded under our stock option plans that are currently exercisable or become exercisable within 60 days. (c)Includes 512,200 shares not currently owned but issuable upon the exercise of stock options awarded under our stock option plans that are currentlyexercisable or become exercisable within 60 days. (d)Includes 13,750 shares not currently owned but issuable upon the exercise of stock options awarded under our stock option plans that are currentlyexercisable or become exercisable within 60 days. (e)Includes (i) 686,722 shares owned by Mr. Drexler, (ii) 262,524 shares beneficially owned by a family trust of which Mr. Drexler is a trustee,(iii) 836,890 shares not currently owned but issuable upon the exercise of stock options awarded under our stock option plans that are currentlyexercisable or become exercisable within 60 days, and (iv) 1,700,500 shares not currently owned but issuable to TPG-MD Investment, LLC uponconversion of the 5.0% Notes Payable. An entity controlled by Mr. Drexler, MDJC LLC, holds a 50% membership interest in TPG-MD InvestmentLLC, which beneficially owns the 5.0% Notes Payable directly. We refer you to “Certain Relationships and Related Transactions—TPG-MD InvestmentNotes Payable” for more information. (f)Includes 35,500 shares not currently owned but issuable upon the exercise of stock options awarded under our stock option plans that are currentlyexercisable or become exercisable within 60 days. (g)Includes 153,431 shares not currently owned but issuable upon the exercise of stock options awarded under our stock option plans that are currentlyexercisable or become exercisable within 60 days. (h)Mr. Coulter, together with Messrs. Bonderman and Price, are directors, officers and shareholders of TPG Advisors II, Inc., which is the general partnerof GenPar II, which in turn is the general partner of each of the TPG II Funds. Mr. Coulter may be deemed to be the beneficial owner of 73,475 shares ofour Series A Preferred Stock held directly by TPG II Funds. Mr. Coulter disclaims beneficial ownership of any securities beneficially owned by suchfunds.We know of no arrangements, including any pledge by any person of our securities, the operation of which may at a subsequent date result in a changein control of us. 60Table of ContentsITEM 13.CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.Tax Sharing ArrangementWe and our subsidiaries entered into a tax sharing agreement which generally provides (among other things) that our consolidated tax liability will beallocated among us and our subsidiaries in proportion to separate taxable incomes.TPG-MD Investment Notes PayableOn February 4, 2003, Operating entered into a credit agreement with TPG-MD Investment, LLC, an entity controlled by TPG and Mr. Drexler. Under theterms of the credit agreement, Operating issued to TPG-MD Investment, LLC $20.0 million principal amount of the 5.0% Notes Payable, which consist of: • a Tranche A loan in an aggregate principal amount of $10.0 million, and • a Tranche B loan in an aggregate principal amount of $10.0 million.The 5.0% Notes Payable are due in February 2008 and bear interest at 5.0% per annum payable semi-annually in arrears on January 31 and July 31,commencing on July 31, 2003. Interest is compounded and capitalized and added to the principal amount on each interest payment date. The 5.0% NotesPayable are guaranteed by certain subsidiaries of Operating.In November 2004, the credit agreement with TPG-MD Investment, LLC was amended to subordinate the Tranche A loan in right of payment to the9 3/4% Notes while the Tranche B loan is equal in right of payment with the 9 3/4% Notes.TPG-MD Investment, LLC has the right, exercisable at any time prior to the maturity date of the 5.0% Notes Payable, to exchange the principal amountof and accrued and unpaid interest on the 5.0% Notes Payable into shares of our common stock at an exchange price of $6.82 per share. TPG-MDInvestment, LLC has agreed to exercise this conversion right immediately prior to the consummation of the IPO. TPG-MD Investment, LLC also has the rightto require Operating to prepay the Tranche B loan without premium or penalty under certain circumstances.Under the terms of TPG-MD Investment, LLC’s operating agreement, the distributions payable to Mr. Drexler under this credit agreement go directly toMDJC LLC, an entity whose sole members are Mr. Drexler, a trust for which Mr. Drexler and his wife are trustees, and Grand-Jean Capital Management,which is owned by Steven Grand-Jean, a director of J.Crew. As payment for certain financial advisory services that Mr. Grand-Jean rendered to Mr. Drexlerand pursuant to MDJC LLC’s operating agreement, Mr. Grand-Jean is entitled to distributions under certain circumstances from his equity interest in MDJCLLC. As a result of this arrangement, Mr. Grand-Jean will receive shares that MDJC LLC acquires from TPG-MD Investment, LLC, which TPG-MDInvestment, LLC, in turn, acquires pursuant to its agreed-upon conversion in connection with the IPO.License AgreementOn October 20, 2005, we entered into a trademark license agreement with Mr. Drexler, our Chairman and Chief Executive Officer, and Millard S.Drexler, Inc., a corporation of which Mr. Drexler is a principal, whereby Mr. Drexler granted us a thirty-year exclusive, worldwide license to use a trademarkand associated intellectual property rights owned by him to develop a supplemental clothing, footwear and accessories line. In consideration for the license, wewill reimburse Mr. Drexler’s actual costs expended in acquiring and developing this mark (not to exceed $300,000 in total), pay royalties of $1 per year duringthe term of the license, and recognize Mr. Drexler as “founder” and “creator” of any business developed in connection with this mark. We also agreed that,during Mr. Drexler’s employment, we will not assign or spin off ownership of the mark without his consent other than as part of 61Table of Contentsa sale of the entire company (except that we may pledge or hypothecate our interest in the mark as part of bank or other financings).Mr. Drexler has further agreed to assign to us all of his residual rights in this mark and all associated intellectual property for no additionalconsideration if we (a) establish an operating business unit using this mark and (b) invest at least $7.5 million in developing this mark; provided, however,that Mr. Drexler will have no obligation to assign such rights if we terminate his employment without cause or he resigns with good reason before we meetconditions (a) and (b) above.In addition, if one of the following events occurs prior to his assignment of his residual rights, Mr. Drexler will have the right to terminate the licensewithin the first ninety days of the occurrence of such event: (a) we have not made the $7.5 million capital commitment prior to Mr. Drexler’s terminationwithout cause or resignation with good reason, (b) we decide, before making the $7.5 million commitment, to discontinue our plans to use this mark and wehave no bona fide intention to resume such use, or (c) we determine, during Mr. Drexler’s employment and without his consent, to pursue a supplementalproduct line under any mark other than the licensed trademark or J. Crew. If Mr. Drexler terminates the license, he must repay all consideration we paid himon execution of the license.University Village LeaseStuart Sloan, a director, is the President of UV, Inc., which is the general partner of University Village Limited Partnership, the owner and operator ofUniversity Village Shopping Center in Seattle, Washington. Mr. Sloan’s sons are the beneficiaries of trusts that are limited partners of University VillageLimited Partnership. On October 14, 2003, we entered into a lease agreement with University Village Limited Partnership for a 7,400 square foot space at theUniversity Village Shopping Center for the operation of one of our retail stores. The term of the lease is 10 years. We received an allowance for tenant’simprovements in the amount of $450,000 from University Village Limited Partnership. Annual rent due under the lease is comprised of (i) base rent paymentof $296,000 for years one through five and $326,000 for years six through 10 and (ii) contingent rent payment based on the store’s sales in excess of aspecified threshold. The lease also requires us to pay real estate taxes, insurance and certain common-area costs. We believe the terms of the lease are consistentwith arms-length negotiations.Plum TV Sponsorship AgreementEmily Scott and Thomas Scott, both directors, are founding partners of Plum TV, LLC, a television station network operating in select resort markets.Mr. Scott is also the Chief Executive Officer and Executive Co-Chairman of Plum TV, LLC. In May 2004, we entered into a sponsorship agreement with PlumTV under which Plum TV provided us with airtime on its network to televise commercials and related services. We entered into a new agreement for a four-month period upon the old agreement’s expiration in May 2005. We did not renew the agreement past September 15, 2005. In fiscal 2004, we paid Plum TV,LLC a total amount of $250,000. Under the renewed sponsorship agreement, we paid Plum TV, LLC a total amount of $375,000 in 2005, which we believe isthe fair market value of the services provided. Mr. and Ms. Scott are married. ITEM 14.PRINCIPAL ACCOUNTING FEES AND SERVICES.Independent Auditor Fees and ServicesThe following presents fees billed for professional services rendered by KPMG for fiscal years 2005 and 2004.Audit Fees. The aggregate fees billed to us by KPMG for professional services rendered in connection with the audit of our financial statementsincluded in this report, and for review of our statements included in our Quarterly Reports on Form 10-Q during fiscal 2005, totaled approximately$705,000. The aggregate fees billed to us by KPMG for professional services rendered in connection with the audit of our financial statements includedin our Annual Report on Form 10-K for fiscal 2004, and for the review of our financial statements included in our Quarterly Reports on Form 10-Qduring fiscal 2004, totaled approximately $740,000. 62Table of ContentsAudit-Related Fees. The aggregate fees billed to us by KPMG for assurance and related services that are reasonably related to the performance ofthe audit and review of our financial statements that are not already reported in the paragraph immediately above totaled approximately $495,000 forfiscal 2005 related to services provided in connection with the IPO. There were no audit-related fees in fiscal 2004.Tax Fees. The aggregate fees billed to us by KPMG for tax related services totaled approximately $25,000 for fiscal 2005. There were no taxrelated fees in fiscal 2004.Auditor IndependenceThe audit committee has considered whether the provision of the above-noted services is compatible with maintaining the auditor’s independence and hasdetermined that the provision of such services has not adversely affected the auditor’s independence.Policy on Audit Committee Pre-Approval of Audit and Permitted Non-Audit ServicesThe audit committee has established policies and procedures regarding the pre-approval of audit and other services that our independent auditor mayperform for us. Under the policy, the audit committee must pre-approve the annual audit fees payable to our independent auditor on an annual basis. The auditcommittee must also approve on a case-by-case basis the engagement of our independent auditor to be performed any other work for us that is not an integralcomponent of the audit services as well as the compensation payable to the independent auditor therefore. Approval can be made by one or more members of theaudit committee as designated by the audit committee and/or the chairman of the committee. 63Table of ContentsPART IV ITEM 15.EXHIBITS, FINANCIAL STATEMENT SCHEDULES. (a)The following are filed as part of this annual report: 1.Financial Statements(i) Report of KPMG LLP, Independent Registered Public Accounting Firm(ii) Financial StatementsJ. Crew Group, Inc. and subsidiaries: Consolidated Balance Sheets as of January 29, 2005 and January 28, 2006; Consolidated Statementsof Operations for the fiscal years ended January 31, 2004, January 29, 2005 and January 28, 2006; Consolidated Statements of Changes inStockholders’ Deficit for the fiscal years ended January 31, 2004, January 29, 2005 and January 28, 2006; Consolidated Statements of CashFlows for the fiscal years ended January 31, 2004, January 29, 2005 and January 28, 2006.J. Crew Operating Corp. and subsidiaries: Consolidated Balance Sheets as of January 29, 2005 and January 28, 2006; ConsolidatedStatements of Operations for the fiscal years ended January 31, 2004, January 29, 2005 and January 28, 2006; Consolidated Statements ofChanges in Stockholders’ Deficit for the fiscal years ended January 31, 2004, January 29, 2005 and January 28, 2006; Consolidated Statementsof Cash Flows for the fiscal years ended January 31, 2004, January 29, 2005 and January 28, 2006.(iii) Notes to consolidated financial statements 2.Financial Statement Schedules. Schedule II Valuation and Qualifying Accounts. 3.The exhibits listed on the accompanying Exhibit Index are incorporated by reference herein and filed as part of this report. (b)The exhibits listed on the accompanying Exhibit Index are incorporated by reference herein and filed as part of this report. (c)Schedule II Valuation and Qualifying Accounts. 64Table of ContentsSIGNATURESPursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, each registrant has duly caused this report to be signed onits behalf by the undersigned, thereunto duly authorized. Date: April 24, 2006 J. CREW GROUP, INC.J. CREW OPERATING CORP. By: /s/ Millard S. Drexler Millard S. Drexler Chief Executive Officer 65Table of ContentsPursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of eachregistrant and in the capacities indicated, on April 24, 2006. Signature Title/s/ Millard DrexlerMillard Drexler Chairman of the Board, Chief Executive Officer and a Director(Principal Executive Officer)/s/ James ScullyJames Scully Executive Vice President and Chief Financial Officer (PrincipalFinancial and Accounting Officer)/s/ Bridget Ryan BermanBridget Ryan Berman Director/s/ Richard BoyceRichard Boyce Director/s/ Jonathan CosletJonathan Coslet Director/s/ James CoulterJames Coulter Director/s/ Steven Grand-JeanSteven Grand-Jean Director/s/ Emily ScottEmily Scott Director/s/ Thomas ScottThomas Scott Director/s/ Stuart SloanStuart Sloan Director/s/ Josh WestonJosh Weston Director 66Table of ContentsINDEX TO FINANCIAL STATEMENTS Report of KPMG LLP, Independent Registered Public Accounting Firm F-2J. Crew Group, Inc. and subsidiaries: Consolidated Balance Sheets as of January 29, 2005 and January 28, 2006 F-3Consolidated Statements of Operations for the fiscal years ended January 31, 2004, January 29, 2005 and January 28, 2006 F-4Consolidated Statements of Changes in Stockholders’ Deficit for the fiscal years ended January 31, 2004, January 29, 2005 and January 28, 2006 F-5Consolidated Statements of Cash Flows for the fiscal years ended January 31, 2004, January 29, 2005 and January 28, 2006 F-6J. Crew Operating Corp. and subsidiaries: Consolidated Balance Sheets as of January 29, 2005 and January 28, 2006 F-7Consolidated Statements of Operations for the fiscal years ended January 31, 2004, January 29, 2005 and January 28, 2006 F-8Consolidated Statements of Changes in Stockholders’ Equity (Deficit) for the fiscal years ended January 31, 2004, January 29, 2005 and January 28,2006 F-9Consolidated Statements of Cash Flow for the fiscal years ended January 31, 2004, January 29, 2005 and January 28, 2006 F-10Notes to Consolidated Financial Statements F-11Financial Statement Schedules: Schedule II—Valuation and Qualifying Accounts for the fiscal years ended January 31, 2004, January 29, 2005 and January 28, 2006 F-30 F-1Table of ContentsREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMThe Board of Directors and StockholdersJ. Crew Group, Inc. and J. Crew Operating Corp.We have audited the consolidated financial statements of J. Crew Group, Inc. (“Group”) and J. Crew Operating Corp., a wholly owned subsidiary ofGroup (“Operating”) (together referred to as the “Companies”) as listed in the accompanying index. In connection with our audits of the consolidated financialstatements, we also have audited the financial statement schedule listed in the accompanying index. These consolidated financial statements and financialstatement schedule are the responsibility of the Companies management. Our responsibility is to express an opinion on these consolidated financial statementsand financial statement schedule based on our audits.We conducted our audits in accordance with auditing standards of the Public Company Accounting Oversight Board (United States). Those standardsrequire that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. TheCompanies are not required to have, nor were we engaged to perform, an audit of their internal controls over financial reporting. An audit includes examining,on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles usedand significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide areasonable basis for our opinion.In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Group andOperating as of January 29, 2005 and January 28, 2006 and the results of their operations and their cash flows for each of the years in the three-year periodended January 28, 2006, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the relatedfinancial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all materialrespects, the information set forth therein.As discussed in Note 7 to the consolidated financial statements, in the third quarter of fiscal 2003, Group adopted Statement of Financial AccountingStandard No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.”KPMG LLPNew York, New YorkApril 24, 2006 F-2Table of ContentsJ.CREW GROUP, INC. AND SUBSIDIARIESConsolidated Balance Sheets January 29,2005 January 28,2006 (in thousands, except forshares) Assets Current assets: Cash and cash equivalents $23,647 $61,275 Merchandise inventories 88,093 116,191 Prepaid expenses and other current assets 22,217 29,132 Refundable income taxes 9,320 8,600 Total current assets 143,277 215,198 Property and equipment—at cost 259,098 252,328 Less accumulated depreciation and amortization (138,285) (142,920) 120,813 109,408 Other assets 14,104 12,715 Total assets $278,194 $337,321 Liabilities and Stockholders’ Deficit Current liabilities: Accounts payable $68,569 $75,833 Other current liabilities 61,148 64,031 Federal and state income taxes 1,392 2,677 Total current liabilities 131,109 142,541 Deferred credits 59,064 57,956 Long-term debt 576,933 631,867 Preferred stock 92,800 92,800 Stockholders’ deficit Common stock $.01 par value; authorized 100,000,000 shares; issued 13,780,175 and 14,338,939 shares; outstanding13,207,086 and 13,701,100 shares 137 143 Accumulated deficit (579,183) (582,645)Deferred compensation (253) (2,655)Treasury stock, at cost (573,089 and 637,839 shares) (2,413) (2,686)Total stockholders’ deficit $(581,712) $(587,843)Total liabilities and stockholders’ deficit $278,194 $337,321 See notes to consolidated financial statements. F-3Table of ContentsJ.CREW GROUP, INC. AND SUBSIDIARIESConsolidated Statements of Operations Years Ended January 31,2004 January 29,2005 January 28,2006 (in thousands)Revenues: Net sales $660,628 $778,165 $924,129Other 29,337 26,051 29,059 689,965 804,216 953,188Cost of goods sold, including buying and occupancy costs 440,276 478,829 555,192Gross profit 249,689 325,387 397,996Selling, general and administrative expenses 280,464 287,745 318,499Income (loss) from operations (30,775) 37,642 79,497Interest expense-net of interest income of $(162)in 2003, $(256) in 2004 and $(584) in 2005 63,844 87,571 72,903Insurance proceeds (3,850) — — (Gain) loss on refinancing of debt (net of expenses of $2,922 in 2003) (41,085) 49,780 — Income (loss) before income taxes (49,684) (99,709) 6,594Provision for income taxes 500 600 2,800Net income (loss) $(50,184) $(100,309) $3,794See notes to consolidated financial statements. F-4Table of ContentsJ.CREW GROUP, INC. AND SUBSIDIARIESConsolidated Statements of Changes in Stockholders’ Deficit(in thousands, except shares) Common Stock Additionalpaid-incapital Accumulateddeficit Treasurystock Deferredcompensation Stockholders’deficit Shares Amount Balance at February 1, 2003 13,359,773 $134 $— $(389,281) $(2,351) $(165) $(391,663)Net loss — — — (50,184) — — (50,184)Issuance of restricted stock 224,402 2 163 — — (165) — Restricted stock expense — — — — — 41 41 Forfeiture of restricted stock — — — — (62) 62 — Preferred stock dividends — — (163) (26,097) — — (26,260)Balance at January 31, 2004 13,584,175 136 — (465,562) (2,413) (227) (468,066)Net loss — — — (100,309) — — (100,309)Issuance of restricted stock 196,000 1 144 — — (145) — Restricted stock expense — — — — — 119 119 Preferred stock dividends — — (144) (13,312) — — (13,456)Balance at January 29, 2005 13,780,175 $137 — (579,183) (2,413) (253) (581,712)Net income — — — 3,794 — — 3,794 Issuance of restricted stock 170,000 2 2,825 — — (2,827) — Restricted stock expense — — — — — 556 556 Forfeiture of restricted stock — — — — (273) 273 — Preferred stock dividends — — (6,200) (7,256) — — (13,456)Exercise of stock options 388,764 4 2,727 — — — 2,731 Issuance of stock options — — 525 — — (525) — Stock option expense — — — — — 121 121 Non-employee stock option expense — — 83 — — — 83 Tax effect from exercise of stock options — — 40 — — — 40 Balance at January 28, 2006 14,338,939 $143 — $(582,645) $(2,686) $(2,655) $(587,843)See notes to consolidated financial statements. F-5Table of ContentsJ.CREW GROUP, INC. AND SUBSIDIARIESConsolidated Statements of Cash Flows Years Ended January 31,2004 January 29,2005 January 28,2006 (in thousands) Cash flows from operating activities: Net income (loss) $(50,184) $(100,309) $3,794 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation and amortization of property and equipment 43,075 37,061 33,461 Amortization of deferred financing costs 2,179 2,425 1,063 Non-cash interest expense (including redeemable preferred stock dividends of $14,206 in 2003, $33,106in 2004 and $40,284 in 2005) 40,991 63,536 41,478 Deferred income taxes 5,000 — — Non-cash compensation expense 41 119 760 (Gain) loss on refinancing of debt (41,085) 49,780 — Changes in operating assets and liabilities: Merchandise inventories 41,290 (22,065) (28,098)Prepaid expenses and other current assets 4,153 (1,484) (6,915)Other assets 832 664 326 Accounts payable and other liabilities (23,211) 28,819 8,921 Federal and state income taxes (4,845) 217 2,045 Net cash provided by operating activities 18,236 58,763 56,835 Cash flow from investing activities: Capital expenditures (9,908) (13,431) (21,938)Cash flow from financing activities: Proceeds from long-term debt 25,820 275,000 — Costs incurred in refinancing debt (2,617) (22,137) — Repayment of long-term debt (776) (324,198) — Proceeds from the exercise of stock options — — 2,731 Net cash provided by (used in) financing activities 22,427 (71,335) 2,731 Increase (decrease) in cash and cash equivalents 30,755 (26,003) 37,628 Cash and cash equivalents at beginning of year 18,895 49,650 23,647 Cash and cash equivalents at end of year $49,650 $23,647 $61,275 Supplemental cash flow information: Income taxes paid $345 $411 $366 Interest paid $20,400 $23,270 $30,362 Non-cash financing activities: Dividends on preferred stock (charged directly to stockholder’s deficit) $26,260 $13,456 $13,456 Interest payable on 13 1/8% Senior Discount Debentures at February 1, 2003 capitalized and added to theprincipal amount of the debt $4,416 Exchange of 16% Senior Discount Contingent Principal Notes of J.Crew Intermediate LLC with a fairvalue of $87,006 for $131,083 carrying value of 13 1/8% Debentures of J.Crew Group, Inc. $— See notes to consolidated financial statements. F-6Table of ContentsJ.CREW OPERATING CORP. AND SUBSIDIARIESConsolidated Balance Sheets January 29,2005 January 28,2006 (in thousands) Assets Current assets: Cash and cash equivalents $23,647 $61,275 Merchandise inventories 88,093 116,191 Prepaid expenses and other current assets 22,217 29,132 Refundable income taxes 9,320 8,600 Total current assets 143,277 215,198 Property and equipment—at cost 259,098 252,328 Less accumulated depreciation and amortization (138,285) (142,920) 120,813 109,408 Due from J.Crew Group, Inc. 178,757 178,830 Other assets 13,971 12,619 Total assets $456,818 $516,055 Liabilities and Stockholder’s (Deficit) Equity Current liabilities: Accounts payable $68,569 $75,833 Other current liabilities 60,314 63,197 Federal and state income taxes 1,392 2,677 Total current liabilities 130,275 141,707 Deferred credits 59,064 57,956 Long-term debt 297,000 298,195 Stockholder’s (deficit) equity (29,521) 18,197 Total liabilities and stockholder’s (deficit) equity $456,818 $516,055 See notes to consolidated financial statements. F-7Table of ContentsJ.CREW OPERATING CORP. AND SUBSIDIARIESConsolidated Statements of Operations Years Ended January 31,2004 January 29,2005 January 28,2006 (in thousands)Revenues: Net sales $660,628 $778,165 $924,129Other 29,337 26,051 29,059 689,965 804,216 953,188Costs of goods sold, including buying and occupancy costs 440,276 478,829 555,192Gross profit 249,689 325,387 397,996Selling, general and administrative expenses 280,423 287,704 317,739Income (loss) from operations (30,734) 37,683 80,257Interest expense—net of interest income of $(162) in 2003, $(256) in 2004 and $(584) in 2005 20,496 21,615 29,739Insurance proceeds (3,850) — — Loss on refinancing of debt — 4,024 — Income (loss) before income taxes (47,380) 12,044 50,518Income tax provision (benefit) (5,410) 600 2,800Net income (loss) $(41,970) $11,444 $47,718See notes to consolidated financial statements. F-8Table of ContentsJ.CREW OPERATING CORP. AND SUBSIDIARIESConsolidated Statements of Changes in Stockholders (Deficit) / Equity (in thousands) Balance at February 1, 2003 $10,325 Net loss (41,970)Dividends to affiliates (9,320)Balance at January 31, 2004 (40,965)Net income 11,444 Balance at January 29, 2005 (29,521)Net income 47,718 Balance at January 28, 2006 $18,197 Note: Operating Corp. has authorized 100 shares of common stock, par value $.01 per share, all of which were issued and outstanding during the three yearperiod ended January 28, 2006.See notes to consolidated financial statements. F-9Table of ContentsJ.CREW OPERATING CORP. AND SUBSIDIARIESConsolidated Statements of Cash Flows Years Ended January 31,2004 January 29,2005 January 28,2006 (in thousands) Cash flows from operating activities: Net income (loss) $(41,970) $11,444 $47,718 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation and amortization 43,075 37,061 33,461 Amortization of deferred financing costs 1,724 1,855 1,027 Deferred income taxes (910) — — Non-cash interest expense 1,000 1,000 1,194 Loss on refinancing of debt — 4,024 — Changes in operating assets and liabilities: Merchandise inventories 41,290 (22,065) (28,098)Prepaid expenses and other current assets 4,153 (1,484) (6,915)Other assets 832 664 326 Accounts payable and other liabilities (23,267) 28,860 8,921 Federal and state income taxes (4,845) 217 2,005 Net cash provided by operating activities 21,082 61,576 59,639 Cash flow from investing activities: Capital expenditures (9,908) (13,431) (21,938)Cash flow from financing activities: Proceeds from long-term debt 25,820 275,000 — Transfers to affiliates (5,463) (184,654) (73)Costs incurred in refinancing debt — (9,450) — Repayment of long-term debt (776) (155,044) — Net cash provided by (used in) financing activities 19,581 (74,148) (73)Increase (decrease) in cash and cash equivalents 30,755 (26,003) 37,628 Cash and cash equivalents at beginning of year 18,895 49,650 23,647 Cash and cash equivalents at end of year $49,650 $23,647 $61,275 Supplemental cash flow information: Income taxes paid $345 $411 $366 Interest paid $15,502 $18,502 $26,813 See notes to consolidated financial statements F-10Table of ContentsJ.CREW GROUP, INC. AND SUBSIDIARIESJ.CREW OPERATING CORP. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSFiscal Years Ended January 31, 2004, January 29, 2005 and January 28, 2006Dollars in thousands, unless otherwise indicated1. Nature Of Business And Summary Of Significant Accounting Policies(a) Basis of PresentationThe consolidated financial statements presented herein are:(1) J. Crew Operating Corp. and subsidiaries (Operating), which consist of the accounts of J. Crew Operating Corp. and its wholly owned subsidiaries.(2) J.Crew Group, Inc. and its wholly-owned subsidiaries (collectively, the Company or Group), which consist of the accounts of J.Crew Group, Inc.and its wholly-owned subsidiaries, including J.Crew Intermediate LLC (Intermediate) and J.Crew Operating Corp. (Operating). Intermediate was formed inMarch 2003 as a limited liability company. Effective May 2003, Group transferred its investment in Operating to Intermediate. On October 11, 2005,Intermediate was merged into J.Crew Group, Inc., and J. Crew Group Inc. became the direct parent of Operating.All significant intercompany balances and transactions are eliminated in consolidation.Except where otherwise specified all notes to the consolidated financial statements apply to both Operating and Group.(b) BusinessThe Company designs, contracts for the manufacture of, markets and distributes women’s and men’s apparel, shoes and accessories under the J.Crewbrand name. The Company’s products are marketed, primarily in the United States, through various channels of distribution, including retail and factorystores, catalogs, and the Internet. The Company is also party to a licensing agreement which grants the licensee exclusive rights to use the Company’strademarks in connection with the manufacture and sale of products in Japan. The license agreement provides for payments based on a specified percentage ofnet sales.The Company is subject to seasonal fluctuations in its merchandise sales and results of operations. The Company expects its sales and operating resultsgenerally to be lower in the first and second quarters than in the third and fourth quarters (which include the back-to-school and holiday seasons) of eachfiscal year.A significant amount of the Company’s products are produced in Asia through arrangements with independent contractors. As a result, the Company’soperations could be adversely affected by political instability resulting in the disruption of trade from the countries in which these contractors are located or bythe imposition of additional duties or regulations relating to imports or by the contractor’s inability to meet the Company’s production requirements.(c) Segment InformationThe Company operates in one reportable business segment. All of the Company’s identifiable assets are located in the United States. Export sales are notsignificant.(d) Fiscal YearThe Company’s fiscal year ends on the Saturday closest to January 31. The fiscal years 2003, 2004 and 2005 ended on January 31, 2004, January 29,2005 and January 28, 2006 and each fiscal year consisted of 52 weeks. F-11Table of ContentsJ.CREW GROUP, INC. AND SUBSIDIARIESJ.CREW OPERATING CORP. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSFiscal Years Ended January 31, 2004, January 29, 2005 and January 28, 2006Dollars in thousands, unless otherwise indicated (e) Cash EquivalentsFor purposes of the consolidated statements of cash flows, the Company considers all highly liquid debt instruments, with maturities of 90 days or lesswhen purchased, to be cash equivalents. Cash equivalents, which were $14,192 and $47,853 at January 29, 2005 and January 28, 2006, respectively, arestated at cost, which approximates market value.(f) Merchandise InventoriesMerchandise inventories are stated at the lower of average cost or market. The Company capitalizes certain design, purchasing and warehousing costs ininventory and these costs are included in cost of goods sold as the inventories are sold.(g) Advertising and Catalog CostsDirect response advertising, which consists primarily of catalog production and mailing costs, are capitalized and amortized over the expected futurerevenue stream. The Company accounts for catalog costs in accordance with the AICPA Statement of Position (“SOP”) 93-7, “Reporting on AdvertisingCosts.” SOP 93-7 requires that the amortization of capitalized advertising costs be the amount computed using the ratio that current period revenues for thecatalog cost pool bear to the total of current and estimated future period revenues for that catalog cost pool. The capitalized costs of direct response advertisingare amortized, commencing with the date catalogs are mailed, over the duration of the expected revenue stream, which was four months for the fiscal years2003, 2004 and 2005. Deferred catalog costs, included in prepaid expenses and other current assets, as of January 29, 2005 and January 28, 2006 were$6,478 and $7,497, respectively. Catalog costs, which are reflected in selling, general and administrative expenses, for the fiscal years 2003, 2004 and 2005were $43,978, $41,258 and $44,286, respectively.All other advertising costs, which are not significant, are expensed as incurred.(h) Property and EquipmentProperty and equipment are stated at cost and are depreciated over the estimated useful lives by the straight-line method. Buildings and improvements aredepreciated over estimated useful lives of twenty years. Furniture, fixtures and equipment are depreciated over estimated useful lives, ranging from three to tenyears. Leasehold improvements (including rent capitalized during the construction period) are amortized over the shorter of their useful lives or related leaseterms (without consideration of optional renewal periods).Systems development costs are capitalized and amortized on a straight-line basis over periods ranging from three to five years. F-12Table of ContentsJ.CREW GROUP, INC. AND SUBSIDIARIESJ.CREW OPERATING CORP. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSFiscal Years Ended January 31, 2004, January 29, 2005 and January 28, 2006Dollars in thousands, unless otherwise indicated (i) Debt Issuance CostsDebt issuance costs (included in other assets) are amortized over the term of the related debt agreements. Unamortized debt issuance costs are as follows: January 29,2005 January 28,2006Group $132 $96Operating 7,897 6,979Total $8,029 $7,075(j) Income TaxesThe Company accounts for income taxes in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for IncomeTaxes”. This statement requires the use of the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred taxesare determined based on the difference between the financial reporting and tax bases of assets and liabilities using enacted tax rates in effect in the years inwhich the differences are expected to reverse. The provision for income taxes includes taxes currently payable and deferred taxes resulting from the tax effectsof temporary differences between the financial statement and tax bases of assets and liabilities.(k) Revenue RecognitionRevenue is recognized for catalog and Internet sales when merchandise is shipped to customers and at the time of sale for retail sales. Shipping terms forcatalog and Internet sales are FOB shipping point, and title passes to the customer at the time and place of shipment. Prices for all merchandise are listed in theCompany’s catalogs and website and are confirmed with the customer upon order. The customer has no cancellation privileges other than customary rights ofreturn that are accounted for in accordance with SFAS No. 48, “Revenue Recognition When Right of Return Exists.” The Company accrues a sales returnallowance for estimated returns of merchandise subsequent to the balance sheet date that relate to sales prior to the balance sheet date. Amounts billed tocustomers for shipping and handling fees related to catalog and Internet sales are included in other revenues at the time of shipment. Royalty revenue isrecognized as it is earned based on contractually specified percentages applied to reported sales. Advance royalty payments are deferred and recorded asrevenue when the related sales occur. Other revenues include the estimated amount of unredeemed gift card liability based on Company specific historicaltrends, which amounted to $1,676, $1,410 and $806 in fiscal years 2003, 2004 and 2005, respectively. Furthermore, the Company recorded an adjustmentin fiscal 2005 to reverse income of $1,254 recognized on unredeemed gift cards in prior years. In the fourth quarter of fiscal 2005, the Company changed itspolicy to recognize unredeemed gift cards on a ratable basis over the redemption period, rather than at time of issuance. This change in policy did not have amaterial impact on the Company’s financial position or statements of operations for the periods presented.(l) Operating ExpensesCost of goods sold (including buying and occupancy costs) includes the direct cost of purchased merchandise, inbound freight, design, buying andproduction costs, occupancy costs related to store operations and all shipping and handling and delivery costs associated with our Direct business.Selling, general and administrative expenses include all operating expenses not included in cost of goods sold, primarily catalog production and mailingcosts, certain warehousing expenses, which aggregated $9,860, $10,816 and $14,042 for fiscal years 2003, 2004, and 2005, respectively, administrativepayroll, store expenses other than occupancy costs, depreciation and amortization and credit card fees. F-13Table of ContentsJ.CREW GROUP, INC. AND SUBSIDIARIESJ.CREW OPERATING CORP. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSFiscal Years Ended January 31, 2004, January 29, 2005 and January 28, 2006Dollars in thousands, unless otherwise indicated (m) Store Pre-opening CostsCosts associated with the opening of new retail and factory stores are expensed as incurred.(n) Derivative Financial InstrumentsDerivative financial instruments have been used by the Company from time to time to manage its interest rate and foreign currency exposures. TheCompany does not enter into derivative financial instruments for speculative purposes. For interest rate swap agreements, the net interest paid is recorded asinterest expense on a current basis. Gains or losses resulting from market fluctuations are not recognized. The Company from time to time enters into forwardforeign exchange contracts as hedges relating to identifiable currency positions to reduce the risk from exchange rate fluctuations. The Company used noderivative financial instruments in fiscal years 2003, 2004 and 2005.(o) Use of Estimates in the Preparation of Financial StatementsThe preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statementsand the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.(p) Impairment of Long-Lived AssetsThe Company reviews long-lived assets and certain identifiable intangibles for impairment whenever events or changes in circumstances indicate thatthe carrying amount of an asset may not be recoverable. The Company assesses the recoverability of such assets based upon estimated cash flow forecasts.Charges of $675, $146 and $747 were incurred in fiscal 2003, 2004 and 2005 to write-down the carrying value of certain long-lived assets.(q) Stock Based CompensationThe Company accounts for stock-based compensation using the intrinsic value method of accounting for employee stock options as permitted by SFASNo. 123, “Accounting for Stock-Based Compensation”. Accordingly, compensation expense is not recorded for options granted to employees if the optionprice is equal to or in excess of the fair market price at the date of grant. In fiscal 2005, the Company recorded compensation expense of $121 with respect toemployee stock options using the intrinsic value method, and $83 with respect to stock options granted to non-employees. F-14Table of ContentsJ.CREW GROUP, INC. AND SUBSIDIARIESJ.CREW OPERATING CORP. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSFiscal Years Ended January 31, 2004, January 29, 2005 and January 28, 2006Dollars in thousands, unless otherwise indicated The following table illustrates the effect on net income if the Company had applied the fair value recognition provisions of SFAS No. 123 to measurestock-based compensation expense in fiscal 2005: (in thousands) Net income as reported $3,794 Compensation expense included in reported net income, net of income tax benefit 720 Compensation expense under fair value method, net of income tax benefit (1,540)Pro forma net income $2,974 The fair value of each option grant in fiscal 2005 was estimated at the grant date using a Black-Scholes option-pricing model. The weighted-average fairvalue of options granted in fiscal 2005 was $5.35 and the following assumptions were used: Weighted-average risk free rate of interest 4.06%Expected volatility 40%Weighted-average expected award life 6.25 years Dividend yield 0%The Black-Scholes option valuation model was developed for estimating the fair value of traded options that have no vesting restrictions and are fullytransferable. Because option valuation models require the use of subjective assumptions, changes in these assumptions can materially affect the fair value ofthe options, and because the Company’s options do not have the characteristics of traded options, the option valuation models do not necessarily provide areliable measure of the fair value of its options.If the Company had adopted the fair value recognition provisions of SFAS No. 123 for fiscal 2003 or 2004 the effect on net income would not bematerial.Restricted stock awards result in the recognition of deferred compensation, which is charged to expense over the vesting period of the awards. Deferredcompensation is presented as a reduction of stockholders’ equity. Compensation expense recorded with respect to stock-based compensation, related torestricted stock awards, amounted to $41, $119 and $556 in 2003, 2004 and 2005, respectively.(r) Deferred Rent and Lease IncentivesRental payments under operating leases are charged to expense on a straight-line basis after consideration of rent holidays, step rent provisions andescalation clauses. Differences between rental F-15Table of ContentsJ.CREW GROUP, INC. AND SUBSIDIARIESJ.CREW OPERATING CORP. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSFiscal Years Ended January 31, 2004, January 29, 2005 and January 28, 2006Dollars in thousands, unless otherwise indicated expense and actual rental payments are recorded as deferred rent and included in deferred credits. Rent is expensed from the date of possession. The Companyadopted FAS 13-1, “Accounting for Rental Costs Incurred During a Construction Period,” in the fourth quarter of fiscal 2005. Accordingly, rental costsincurred during the construction period will be recognized as rental expense and no longer capitalized. The unamortized balance of rent capitalized in priorperiods will be amortized over the remaining lease terms (without consideration of option renewal periods).The Company receives construction allowances upon entering into certain store leases. These construction allowances are recorded as deferred creditsand are amortized as a reduction of rent expense over the term of the related lease. Deferred construction allowances were $39,250 and $37,498 at January 29,2005 and January 28, 2006, respectively.(s) ReclassificationCertain prior year amounts have been reclassified to conform with current year’s presentation.2. Related Party TransactionOn October 20, 2005, the Company, Millard Drexler, Chairman of the Board and Chief Executive Officer and Millard S. Drexler, Inc. entered into aTrademark License Agreement whereby Mr. Drexler granted the Company a thirty-year exclusive, worldwide license to use a trademark and associatedintellectual property rights owned by him (the “Properties”). In consideration for the license, the Company will reimburse Mr. Drexler’s actual costs expendedin acquiring and developing the Properties (not to exceed $300,000 in total) (the “Up-Front Fee”) and pay royalties of $1 per year during the term of the license.The Company also agreed that it will not assign or spin off ownership of the Properties during the term of Mr. Drexler’s employment without his consent otherthan as part of a sale of the entire company (except that the Company may pledge or hypothecate its interest in the Properties as part of a bank or otherfinancings). Mr. Drexler has further agreed to assign to the Company all of his residual rights in the Properties for no additional consideration if the Company(a) establishes an operating business unit using the Properties and (b) invests at least $7.5 million in developing the Properties; provided, however, thatMr. Drexler will have no obligation to assign such rights if the Company terminates his employment without cause or he resigns with good reason before theCompany meets conditions (a) and (b) above. In addition, if one of the following events occurs prior to his assignment of his residual rights, Mr. Drexler willhave the right to terminate the license within the first ninety days of the occurrence of such event: (a) the Company has not made the $7.5 million capitalcommitment prior to Mr. Drexler’s termination without cause or resignation with good reason, (b) the Company decides to discontinue its plans to use thelicensed trademark and the Company has no bona fide intention to resume such use, or (c) the Company determines, during Mr. Drexler’s employment andwithout his consent, to pursue a supplemental product line under any mark other than the licensed trademark of J. Crew. If Mr. Drexler terminates the licensehe must repay the Up-Front Fee.3. Insurance ProceedsThe terrorist events of September 11, 2001 resulted in the destruction of the Company’s retail store located at the World Trade Center in New York City,resulting in the loss of inventories and store fixtures, equipment and leasehold improvements. These losses and the resulting business interruption werecovered by insurance policies maintained by the Company.The statement of operations for the year ended January 31, 2004 includes a gain of $3,850 from insurance recoveries. No additional insurance recoveriesare payable to the Company relating to this loss. F-16Table of ContentsJ.CREW GROUP, INC. AND SUBSIDIARIESJ.CREW OPERATING CORP. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSFiscal Years Ended January 31, 2004, January 29, 2005 and January 28, 2006Dollars in thousands, unless otherwise indicated 4. Property and EquipmentProperty and equipment, net consists of: January 29,2005 January 28,2006Land $1,710 $1,710Buildings and improvements 11,712 11,691Fixtures and equipment 68,811 71,014Leasehold improvements 173,725 163,184Construction in progress 3,140 4,729 259,098 252,328Less accumulated depreciation and amortization 138,285 142,920 $120,813 $109,4085. Other Current LiabilitiesOther current liabilities consist of: January 29,2005 January 28,2006Customer liabilities $14,095 $17,611Taxes, other than income taxes 3,115 2,433Accrued interest(a) 3,664 3,664Accrued occupancy 1,141 1,842Reserve for sales returns 4,831 6,216Accrued compensation 8,465 8,493Other 25,837 23,772 $61,148 $64,031 (a)includes Group accrued interest of $835 as of January 29, 2005 and January 28, 20066. Lines of CreditOn December 23, 2004, Operating entered into an Amended and Restated Loan and Security Agreement with Wachovia Capital Markets, LLC, asarranger, Wachovia Bank, National Association, as administrative agent, Bank of America N.A., as syndication agent, and Congress Financial Corporation,as collateral agent, and a syndicate of lenders (the “Amended Wachovia Credit Facility”) which provides for a maximum credit availability of up to $170.0million (which may be increased to $250.0 million subject to certain conditions).The Amended Wachovia Credit Facility provides for revolving loans and letter of credit accommodations. The Amended Wachovia Credit Facilityexpires in December 2009. The total amount of availability is subject to limitations based on specified percentages of eligible receivables, inventories and realproperty. As of January 28, 2006, excess availability under the Amended Wachovia Credit Facility was $78.3 million.Borrowings are secured by a perfected first priority security interest in all the assets of Operating and its subsidiaries and bear interest, at theCompany’s option, at the prime rate plus a margin of up to 0.25% or the Eurodollar rate plus a margin ranging from 1.25% to 2.00%. The Company isrequired to pay a monthly F-17Table of ContentsJ.CREW GROUP, INC. AND SUBSIDIARIESJ.CREW OPERATING CORP. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSFiscal Years Ended January 31, 2004, January 29, 2005 and January 28, 2006Dollars in thousands, unless otherwise indicated unused line fee ranging from .25% to .375%. Fees for outstanding commercial letters of credit range from .625% to 1.0% and fees for outstanding standbyletters of credit are 1.25%.The Amended Wachovia Credit Facility includes restrictions, including the incurrence of additional indebtedness, the payment of dividends and otherdistributions, the making of investments, the granting of loans and the making of capital expenditures. The Amended Wachovia Credit Facility permitsrestricted payments (by way of dividends or other distributions) with respect to, among other things, the Company’s capital stock payable solely in additionalshares of its capital stock, the Company’s tax sharing agreement, the Series A Preferred Stock of Group, the Series B Preferred Stock of Group and the13 1/8% Senior Discount Debentures due 2008 of Group. The ability of Operating to declare dividends on its capital stock is also limited by Delaware law,which permits a company to pay dividends on its capital stock only out of its surplus or, in the event that it has no surplus, out of its net profits for the yearin which a dividend is declared or for the immediately preceding fiscal year. Under the Amended Wachovia Credit Facility, Operating is required to maintain afixed interest charge coverage ratio of 1.1 if excess availability is less than $20.0 million for any 30 consecutive day period. Operating has at all times been incompliance with all financial covenants.Maximum borrowings under our working capital credit agreements during fiscal 2003 were $10,000 and average borrowings were $1,020. There were noborrowings during fiscal years 2004 and 2005 and there were no borrowings outstanding at January 29, 2005 and January 28, 2006.Outstanding letters of credit established primarily to facilitate international merchandise purchases at January 29, 2005 and January 28, 2006amounted to $58,700 and $69,900, respectively.7. Long-Term Debt and Preferred Stock January 29,2005 January 28,2006Operating: 9 3/4% senior subordinated notes(a) $275,000 $275,0005.0% notes payable(b) 22,000 23,195Total Operating long-term debt 297,000 298,195Group: 13 1/8% Debentures(c) 21,667 21,667Mandatorily redeemable preferred stock(d) 258,266 312,005Total Group long-term debt 576,933 631,867Group preferred stock(d) 92,800 92,800Total Group long-term debt and preferred stock $669,733 $724,667The scheduled payments of long-term debt are $44.9 million in 2008, $312.0 million in 2009 and $275.0 million in 2014.(a) On November 21, 2004, Operating entered into a Senior Subordinated Loan Agreement with entities managed by Black Canyon Capital LLC andCanyon Capital Advisors LLC, which provided for a term loan of $275 million. The proceeds of the term loan were used to redeem in full Operating’soutstanding 10 3/8% senior subordinated notes due 2007 ($150 million) and to redeem in part Intermediate’s 16% senior discount contingent principal notesdue 2008 ($125 million). On March 18, 2005, the term loan was converted into equivalent new 9 3/4% senior subordinated notes of Operating due 2014(9 3/4% senior subordinated notes) in accordance with the terms of the loan agreement. F-18Table of ContentsJ.CREW GROUP, INC. AND SUBSIDIARIESJ.CREW OPERATING CORP. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSFiscal Years Ended January 31, 2004, January 29, 2005 and January 28, 2006Dollars in thousands, unless otherwise indicated The 9 3/4% senior subordinated notes are general senior subordinated obligations of Operating and certain subsidiaries of Operating, are subordinated inright of payment to their existing and future senior debt, are pari passu in right of payment with any of their future senior subordinated debt and are senior inright of payment to any of their future subordinated debt. Operating’s existing domestic subsidiaries, other than non-guarantor subsidiaries, are guarantors ofthe 9 3/4% senior subordinated notes. The 9 3/4% senior subordinated notes are secured by the assets of Operating and certain subsidiaries of Operating and byOperating’s common stock owned by Group and such security interest is junior in priority to that securing first-lien obligations, including those under theAmended Wachovia Credit Facility.Interest on the notes accrues at the rate of 9 3/4% per annum and is payable semi-annually in arrears on each June 23 and December 23. The notes matureon December 23, 2014. The notes may be redeemed at the option of the issuer, in whole or in part, at 101% of the principal amount at any time until June 23,2006 and thereafter, at any time on or after December 23, 2009 at prices ranging from 104.875% to 100% of the principal amount, in each case, plus accruedand unpaid interest on the notes.The indenture governing the 9 3/4% senior subordinated notes contains covenants that, among other things, limit the ability of Operating and certainsubsidiaries of Operating to incur additional indebtedness or issue disqualified stock or preferred stock, pay dividends or make other distributions on, redeemor repurchase the capital stock of Operating, make certain investments, create certain liens, guarantee indebtedness, engage in transactions with affiliates andconsolidate, merge or transfer all or substantially all of the assets of Operating and certain subsidiaries of Operating.Under the indenture governing the 9 3/4% senior subordinated notes, Operating may declare cash dividends payable to Group in an amount sufficient toenable Group to make the regularly scheduled payment of interest in respect of the senior discount debentures of Group so long as no default or event of defaulthas occurred and is continuing under the indenture. The ability of Operating to declare dividends on its capital stock is also limited by Delaware law, whichpermits a company to pay dividends on its capital stock only out of its surplus or, in the event that it has no surplus, out of its net profits for the year inwhich a dividend is declared or for the immediately preceding fiscal year. In order to pay dividends in cash, Operating must have surplus or net profits equalto the full amount of the cash dividend at the time such dividend is declared. In determining Operating’s ability to pay dividends, Delaware law permits theboard of directors of Operating to revalue its assets and liabilities from time to time to their fair market value in order to create a surplus.On October 3, 2005, Operating announced a cash tender offer and consent solicitation for all its outstanding 9 3/4% senior subordinated notes. OnOctober 17, 2005, Operating announced that 100% of the outstanding 9 3/4% senior subordinated notes had been tendered. Holders of the 9 3/4% seniorsubordinated notes will receive total consideration equal to $1,015.07 per $1,000 principal amount, or 101.507% of their par value, comprising tenderconsideration of 1.1% and a consent payment of $5.07. On November 1, 2005, Operating extended the expiration date of its tender offer, and further extendedit on January 23, 2006 and March 1, 2006. The offer will now expire on May 1, 2006 unless further extended.On April 24, 2006, Operating entered into commitment letters with Goldman Sachs Credit Partners L.P., Bear, Stearns & Co. Inc., Bear StearnsCorporate Lending Inc., and Wachovia Bank, National Association under which such institutions and their affiliates have committed to provide a seniorsecured term loan (the “Term Loan”) to Operating with a principal amount of up to $285 million, subject to Operating’s ability to increase the principalamount in the form of an additional tranche of up to $100 million under certain terms and conditions. Operating intends to use the proceeds of the Term Loanto repay or redeem certain outstanding indebtedness of Operating and to pay fees and expenses related to such transactions. The closing and funding of theTerm Loan are conditioned on (i) the satisfaction of certain customary conditions and (ii) the amendment of the existing revolving credit agreement of Operatingand certain of its subsidiaries with Wachovia Bank, National Association and certain other lenders (the “Revolving Credit Facility”) to permit thecontemplated Term Loan. The Term Loan will be secured by security F-19Table of ContentsJ.CREW GROUP, INC. AND SUBSIDIARIESJ.CREW OPERATING CORP. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSFiscal Years Ended January 31, 2004, January 29, 2005 and January 28, 2006Dollars in thousands, unless otherwise indicated interests in substantially all of our assets, subject to inter-creditor arrangements to be negotiated with the lenders under the Revolving Credit Facility.(b) On February 4, 2003, Group and Operating entered into a credit agreement with TPG-MD Investment, LLC, a related party, which provides for aTranche A loan to Operating in an aggregate principal amount of $10.0 million and a Tranche B loan to Operating in an aggregate principal amount of $10.0million. The loans are due in February 2008 and bear interest at 5.0% per annum payable semi-annually in arrears on January 31 and July 31, commencingon July 31, 2003. Interest will compound and be capitalized and added to the principal amount on each interest payment date, resulting in an effective interestrate of 5.6%. The outstanding amount of these loans is convertible into shares of common stock of Group at $6.82 per share. These loans are subordinated inright of payment to the prior payment of all senior debt. On November 21, 2004, this credit agreement was amended to subordinate the Tranche A loan in rightof payment to Operating’s 9 3/4% senior subordinated notes while the Tranche B loan is pari passu in right of payment with such notes.(c) The 13 1/8% senior discount debentures are senior unsecured obligations of Group and mature on October 15, 2008. Interest is payable in arrears onApril 15 and October 15 of each year subsequent to October 15, 2002. The 13 1/8% senior discount debentures may be redeemed at the option of Group at100%.(d) The restated certificate of incorporation of our predecessor, a New York corporation, authorized issuance of up to:(1) 1,000,000 shares of Series A cumulative preferred stock, par value $.01 per share, and(2) 1,000,000 shares of Series B cumulative preferred stock, par value $.01 per share.At January 29, 2005 and January 28, 2006, 92,800 shares of Series A preferred stock and 32,500 shares of Series B preferred stock were issued andoutstanding.Each series of the preferred stock accumulates dividends at the rate of 14.5% per annum (payable quarterly) for periods ending on or prior toOctober 17, 2009. Dividends compound to the extent not paid in cash. A default in the payment of the Series A preferred stock redemption price will triggerdividends accruing and compounding quarterly at a rate of (i) 16.50% per annum with respect to periods ending on or before October 17, 2009, and(ii) 18.50% with respect to periods starting after October 17, 2009. A default in the payment of the Series B preferred stock redemption price will triggerdividends accruing and compounding quarterly at a rate of 16.50% per annum.On October 17, 2009, Group is required to redeem the Series B preferred stock and to pay all accumulated but unpaid dividends on the Series Apreferred stock. Thereafter, the Series A preferred stock will accumulate dividends at the rate of 16.5% per annum. Subject to restrictions imposed by certainindebtedness of the Company, Group may redeem shares of the preferred stock at a redemption price equal to 100% of liquidation value plus accumulated andunpaid dividends. F-20Table of ContentsJ.CREW GROUP, INC. AND SUBSIDIARIESJ.CREW OPERATING CORP. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSFiscal Years Ended January 31, 2004, January 29, 2005 and January 28, 2006Dollars in thousands, unless otherwise indicated In certain circumstances (including a change of control of Group), subject to restrictions imposed by certain indebtedness of the Company, Group maybe required to repurchase shares of the preferred stock at liquidation value plus accumulated and unpaid dividends. If Group liquidates, dissolves or windsup, whether voluntary or involuntary, no distribution shall be made either (i) to those holders of stock ranking junior to the preferred stock, unless priorthereto the holders of the preferred stock receive the total value for each share of preferred stock plus an amount equal to all accrued dividends thereon as of thedate of such payment or (ii) to the holders of stock ranking pari passu with the preferred stock (which we refer to as the “parity stock”), except distributionsmade ratably on the preferred stock and all such parity stock in proportion to the total amounts to which the holders of all such shares are entitled uponliquidation, dissolution or winding up of Group.Effective at the beginning of the third quarter of 2003, the Company adopted SFAS No. 150 “Accounting for Certain Financial Instruments withCharacteristics of both Liabilities and Equity”. This pronouncement required the reclassification to long-term debt of the liquidation value of Group Series Bpreferred stock and the related accumulated and unpaid dividends and the accumulated and unpaid dividends related to the Series A preferred stock sincethese amounts are required to be redeemed in October 2009. The preferred dividends related to the liquidation value of the Series B preferred stock and to theaccumulated and unpaid dividends of the Series A and Series B preferred stock for the third and fourth quarters of 2003 and fiscal 2004 and 2005 areincluded in interest expense. The Series A preferred stock is only redeemable in certain circumstances (including a change of control at Group) and does notqualify for reclassification under SFAS No. 150. Accordingly, the dividends related to the Series A preferred stock are deducted from stockholders’ deficit.Accumulated but unpaid dividends amounted to $279,506 at January 28, 2006. F-21Table of ContentsJ.CREW GROUP, INC. AND SUBSIDIARIESJ.CREW OPERATING CORP. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSFiscal Years Ended January 31, 2004, January 29, 2005 and January 28, 2006Dollars in thousands, unless otherwise indicated 8. Gain (loss) on Refinancing of DebtDuring the fourth quarter of 2004, the Company redeemed in full the outstanding 10 3/8% senior subordinated notes due 2007 ($150.0 million) andredeemed the outstanding 16% senior discount contingent principal notes due 2008 ($169.1 million). Funds used for the redemption were generated from theproceeds of a $275 million term loan and internally available funds. This refinancing resulted in a loss of $49.8 million for Group in fiscal 2004, whichconsisted of: (a) redemption premiums of $15.3 million, (b) the write-off of deferred financing costs of $3.2 million and (c) the write-off of deferred debtissuance costs of $31.3 million related to the 16% senior discount contingent principal notes issued in May 2003.On May 6, 2003, Group completed an offer to exchange 16% senior discount contingent principal notes due 2008 of Intermediate (new notes) for itsoutstanding 13 1/8% senior discount debentures due 2008 (existing debentures). Approximately 85% of the outstanding debentures were tendered for exchange.Group exchanged $87,006 fair value of new notes for $131,083 face amount (including accrued interest of $10,750) of existing debentures. Thedifference between the fair value of the new notes and the carrying value of the existing debentures of $44,077 was included as a gain in the statement ofoperations in fiscal year 2003.9. Commitments and Contingencies(a) Operating LeasesAs of January 28, 2006, Operating was obligated under various long-term operating leases for retail and factory outlet stores, warehouses, office spaceand equipment requiring minimum annual rentals.These operating leases expire on varying dates through 2019. At January 28, 2006 aggregate minimum rentals are, as follows: Fiscal year Amount2006 $55,4322007 54,5222008 47,8602009 44,2232010 39,365Thereafter 86,537Certain of these leases include renewal options and escalation clauses and provide for contingent rentals based upon sales and require the lessee to paytaxes, insurance and other occupancy costs.Rent expense for fiscal 2003, 2004 and 2005 was $42,997, $46,583 and $49,144, respectively, including contingent rent, based on store sales, of$814, $1,700 and $2,768.(b) Employment AgreementsThe Company is party to employment agreements with certain executives, which provide for compensation and certain other benefits. The agreementsalso provide for severance payments under certain circumstances. F-22Table of ContentsJ.CREW GROUP, INC. AND SUBSIDIARIESJ.CREW OPERATING CORP. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSFiscal Years Ended January 31, 2004, January 29, 2005 and January 28, 2006Dollars in thousands, unless otherwise indicated (c) LitigationThe Company is subject to various legal proceedings and claims that arise in the ordinary conduct of its business. Although the outcome of these claimscannot be predicted with certainty, management does not believe that it is reasonably possible that resolution of these legal proceedings will result in unaccruedlosses that would be material.10. Employee Benefit PlanThe Company has a 401(K) Savings Plan pursuant to Section 401 of the Internal Revenue Code whereby all eligible employees may contribute up to15% of their annual base salaries subject to certain limitations. The Company’s contribution is based on a percentage formula set forth in the plan agreement.Company contributions to the 401(K) Savings Plan were $1,288, $1,306 and $1,428 for fiscal 2003, 2004 and 2005, respectively.11. License AgreementOperating has a licensing agreement through January 2007 with Itochu Corporation, a Japanese trading company. The agreement permits Itochu todistribute J.Crew merchandise in Japan.Operating earns royalty payments under the agreement based on the sales of its merchandise. Royalty income, which is included in other revenues, forfiscal 2003, 2004 and 2005 was $2,456, $2,757 and $2,864, respectively.12. Other RevenuesOther revenues consist of the following: 2003 2004 2005 Shipping and handling fees $25,205 $21,624 $26,430 Royalties 2,456 2,757 2,864 Other 1,676 1,670 (235) $29,337 $26,051 $29,059 13. Financial InstrumentsThe fair value of the Company’s long-term debt (including redeemable preferred stock) is estimated to be approximately $596,400 and $595,100 atJanuary 29, 2005 and January 28, 2006, respectively, and is based on current rates offered to the Company for debt of similar maturities or quoted marketprices of the same or similar instruments. The carrying amounts of long-term debt were $576,933 and $631,867 at January 29, 2005 and January 28,2006, respectively. The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents, accounts payable and other currentliabilities approximate fair value because of the short-term maturity of those financial instruments. The estimates presented herein are not necessarily indicativeof amounts the Company could realize in a current market exchange.14. Income TaxesGroup files a consolidated federal tax return, which includes all its wholly owned subsidiaries. Each subsidiary files separate state tax returns in therequired jurisdictions. Group and its subsidiaries have entered into a tax sharing agreement providing (among other things) that each of the subsidiaries will F-23Table of ContentsJ.CREW GROUP, INC. AND SUBSIDIARIESJ.CREW OPERATING CORP. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSFiscal Years Ended January 31, 2004, January 29, 2005 and January 28, 2006Dollars in thousands, unless otherwise indicated reimburse Group for its share of income taxes based on the proportion of such subsidiaries’ tax liability on a separate return basis to the total tax liability ofGroup.The income tax provision (benefit) consists of: 2003 2003 2004 2005 Group Operating Group andOperating Group andOperatingCurrent: Foreign $250 $250 $300 $290Federal (3,744) (3,744) — 580State and local (1,006) (1,006) 300 1,930 (4,500) (4,500) 600 2,800Deferred 5,000 (910) — — Total $500 $(5,410) $600 $2,800A reconciliation between the provision (benefit) for income taxes based on the U.S. Federal statutory rate and the effective rate, is as follows: 2003 2004 2005 Group Operating Group Operating Group Operating Federal income tax rate (35.0)% (35.0)% (35.0)% 35.0% 35.0% 35.0%State and local income taxes, net of federal benefit 0.8 0.8 0.4 3.4 19.0 2.5 Foreign income tax — — — — 4.4 0.6 Valuation allowance 64.0 36.9 5.6 (32.3) (245.8) (34.7)Additional NOL carryback (7.4) (7.8) — — — — Adjustment of prior tax accruals (2.6) (2.7) — — (8.1) (1.1)Non-deductible expenses (primarily Group preferred dividends) 8.4 — 18.6 — 242.6 3.8 Non-recognized gain (loss) on exchange of debt (27.2) — 11.0 — — — Other — (3.6) — (.9) (4.7) (0.6)Effective tax rate 1.0% (11.4)% 0.6% 5.2% 42.4% 5.5% F-24Table of ContentsJ.CREW GROUP, INC. AND SUBSIDIARIESJ.CREW OPERATING CORP. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSFiscal Years Ended January 31, 2004, January 29, 2005 and January 28, 2006Dollars in thousands, unless otherwise indicated The tax effect of temporary differences which give rise to deferred tax assets and liabilities are: January 29,2005 January 29,2005 January 28,2006 January 28,2006 Group Operating Group Operating Deferred tax assets: Original issue discount $3,900 $— $3,900 $— Rent 17,800 17,800 17,000 17,000 Federal NOL carryforwards 47,200 6,200 29,800 — State and local NOL carryforwards 4,500 4,500 3,200 3,200 Reserve for sales returns 1,900 1,900 2,500 2,500 Other 4,400 4,400 3,700 3,700 79,700 34,800 60,100 26,400 Valuation allowance (63,400) (18,500) (46,500) (12,800) 16,300 16,300 13,600 13,600 Deferred tax liabilities: Prepaid catalog and other prepaid expenses (6,600) (6,600) (7,600) (7,600)Difference in book and tax basis for property and equipment (9,700) (9,700) (6,000) (6,000) (16,300) (16,300) (13,600) (13,600)Net deferred income tax assets $— $— $— $— F-25Table of ContentsJ.CREW GROUP, INC. AND SUBSIDIARIESJ.CREW OPERATING CORP. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSFiscal Years Ended January 31, 2004, January 29, 2005 and January 28, 2006Dollars in thousands, unless otherwise indicated The Company has significant deferred tax assets resulting from net operating loss carryforwards and deductible temporary differences, which willreduce taxable income in future periods. SFAS No. 109 “Accounting for Income Taxes” states that a valuation allowance is required when it is more likelythan not that all or a portion of a deferred tax asset will not be realized. A review of all available positive and negative evidence needs to be considered,including a company’s current and past performance, the market environment in which a company operates, length of carryback and carryforward periods,existing contracts or sales backlog that will result in future profits, etc. Forming a conclusion that a valuation allowance is not needed is difficult when there isnegative evidence such as cumulative losses in recent years. Cumulative losses weigh heavily in the overall assessment. As a result of our assessment, weestablished a valuation allowance for the net deferred tax assets at February 1, 2003. The valuation allowance was adjusted at January 29, 2005 andJanuary 28, 2006 to fully reserve net deferred tax assets at such dates. The Company did not recognize any net tax benefits in fiscal 2005 and does not expectto recognize any net tax benefits in future results of operations until an appropriate level of profitability is sustained.The Company has net operating loss carryforwards, which expire in 2025, of approximately $83 million to offset future taxable income for federalincome tax purposes. The amount and expiration date of net operating loss carryforwards for state and local income tax purposes vary by tax jurisdiction.15. Stock Compensation PlansAmended and Restated 1997 Stock Option PlanUnder the terms of the Amended and Restated 1997 Stock Option Plan (1997 Plan), an aggregate of 1,910,000 shares of Group common stock areavailable for grant to key employees and consultants in the form of non-qualified stock options. The options have terms of seven to ten years and becomeexercisable over a period of four to five years. Options granted under the 1997 Plan are subject to various conditions, including under some circumstances,the achievement of certain performance objectives.2003 Equity Incentive PlanIn January 2003, the Board of Directors of Group approved the adoption of the 2003 Equity Incentive Plan (2003 Plan). Under the terms of the 2003Plan, an aggregate of 4,798,160 shares of Group common stock are available for award to key employees and consultants in the form of non-qualified stockoptions and restricted shares, as follows: • 1,115,812 shares are reserved for the issuance of stock options at an exercise price of $6.82 or fair market value, whichever is greater, • 1,115,812 shares are reserved for the issuance of stock options at an exercise price of $25.00 or fair market value, whichever is greater, • 1,115,812 shares are reserved for the issuance of stock options at an exercise price of $35.00 or fair market value, whichever is greater, and • 1,450,724 shares are reserved for the issuance of restricted shares.The options have terms of ten years and become exercisable over the period provided in each grant agreement. Under the Plan, the CompensationCommittee of the Board of Directors of Group has the discretion to modify the exercise price and the number of shares reserved for the issuance of stockoptions and restricted shares. F-26Table of ContentsJ.CREW GROUP, INC. AND SUBSIDIARIESJ.CREW OPERATING CORP. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSFiscal Years Ended January 31, 2004, January 29, 2005 and January 28, 2006Dollars in thousands, unless otherwise indicated A summary of stock option activity for the three years ended January 28, 2006, is as follows: 2003 2004 2005 Shares Weightedaverageexercise price Shares Weightedaverageexercise price Shares Weightedaverageexercise priceOutstanding, beginning of year 4,474,469 $18.22 2,410,606 $8.37 4,582,265 $13.15Granted 377,750 6.85 2,515,848 17.07 1,014,914 14.66Exercised — — — — (388,674) 7.03Cancelled (2,441,613) 26.19 (344,189) 8.33 (439,156) 10.05Outstanding, end of year 2,410,606 $8.37 4,582,265 $13.15 4,769,349 $14.25Options exercisable at end of year 849,302 $10.59 1,706,775 $11.81 2,011,665 $14.03The following table summarizes information about stock options outstanding as of January 28, 2006: Outstanding Weightedaverageremainingcontractual life(in months) ExercisableRange Number ofoptions Weightedaverage optionprice Number ofoptions Weightedaverage optionprice$6.82-$8.53 1,642,463 $6.87 74 798,237 $6.89$10.00-$20.81 1,994,936 $14.14 97 733,652 $14.38$25.00-$35.00 1,131,950 $25.15 99 479,776 $25.35$6.82-$35.00 4,769,349 $14.25 89 2,011,665 $14.03Under the 2003 Plan, 224,402, 196,000 and 170,000 restricted shares were issued in fiscal 2003, 2004 and 2005, respectively, of which 83,689 and64,750 shares were forfeited in fiscal 2003 and 2005, respectively. On January 28, 2006, there were 1,446,229 restricted shares outstanding, of which809,951 shares were vested. F-27Table of ContentsJ.CREW GROUP, INC. AND SUBSIDIARIESJ.CREW OPERATING CORP. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSFiscal Years Ended January 31, 2004, January 29, 2005 and January 28, 2006Dollars in thousands, unless otherwise indicated The weighted-average grant-date fair value per share of restricted stock issued in fiscal years 2003, 2004 and 2005 was $0.74, $1.12 and $12.76,respectively.16. Recent Accounting PronouncementsIn December 2004, the Financial Accounting Standards Board, (FASB) issued SFAS No. 123 (revised 2004), “Share-Based Payment” (SFASNo. 123R), which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS No. 123R supercedes APB Opinion No. 25,“Accounting for Stock Issued to Employees,” and amends SFAS No. 95, “Statement of Cash Flows.” Generally, the approach in SFAS No. 123R issimilar to the approach described in SFAS 123. However, SFAS No. 123R requires all share-based payments to employees, including grants of employeestock options, to be recognized in the income statement based on their fair values. SFAS No. 123R must be adopted no later than the first interim or annualperiod beginning after June 15, 2005.As permitted by SFAS No. 123, we have accounted for share-based payments to employees using APB Opinion No. 25’s intrinsic value method and,as such, generally recognize no compensation cost for employee stock options. We will adopt SFAS No. 123R effective January 29, 2006 using the modifiedprospective application option. As a result, the compensation cost for the portion of awards we granted before January 29, 2006 for which the requisite servicehas not been rendered and that are outstanding as of January 29, 2006 will be recognized as the remaining requisite service is rendered. In addition, theadoption of SFAS No. 123R will require us to change from recognizing the effect of forfeitures as they occur to estimating the number of outstandinginstruments for which the requisite service is not expected to be rendered. Accordingly, the adoption of SFAS No. 123R’s fair value method will have asignificant impact on our results of operations. The impact of the adoption of SFAS No. 123R cannot be determined at this time because it will depend uponlevels of share-based payments granted in the future. However, had we adopted SFAS No. 123R in prior periods, the impact of that standard would haveapproximated the impact as described in the disclosure of pro forma net income pursuant to SFAS No. 123 in Note 1q of Notes to Consolidated FinancialStatements.In May 2005, the FASB issued Statement No. 154, Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20, AccountingChanges and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements, effective for fiscal years beginning afterDecember 15, 2005. Statement No. 154 changes the requirements for the accounting for and reporting of a voluntary change in accounting principles as wellas the changes required by an accounting pronouncement that does not include specific transition provisions. The Company does not expect theimplementation of Statement No. 154 to have a significant effect on the Company’s consolidated financial position, results of operations or cash flows.In October 2005, the FASB issued Staff Position FAS 13-1, Accounting For Rental Costs Incurred During A Construction Period. FAS 13-1provides that there is no distinction between the right to use a leased asset during and after the construction period; therefore rental costs incurred during theconstruction period should be recognized as rental expense and included in income from continuing operations. FAS 13-1 is effective for the first reportingperiod beginning after December 15, 2005; early adoption is permitted. The Company adopted FAS 13-1 in the fourth quarter of fiscal 2005 and the effectwas not material. F-28Table of ContentsJ.CREW GROUP, INC. AND SUBSIDIARIESJ.CREW OPERATING CORP. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSFiscal Years Ended January 31, 2004, January 29, 2005 and January 28, 2006Dollars in thousands, unless otherwise indicated 17. Quarterly Financial Information (Unaudited) (in millions) Thirteen WeeksEndedMay 1, 2004 Thirteen WeeksEndedJuly 31, 2004 Thirteen WeeksEndedOctober 30, 2004 Thirteen WeeksEndedJanuary 29, 2005(a) Fifty-two WeeksEndedJanuary 29, 2005 Net sales $140.6 $182.1 $200.9 $254.7 $778.3 Gross profit 60.7 74.2 89.0 101.5 325.4 Net loss-Group (23.7) (13.8) (9.9) (52.9) (100.3)Net income / (loss)-Operating (7.7) 3.2 7.5 8.4 11.4 Thirteen WeeksEndedApril 30, 2005 Thirteen WeeksEndedJuly 30, 2005 Thirteen WeeksEndedOctober 29, 2005 Thirteen WeeksEndedJanuary 28, 2006 Fifty-two WeeksEndedJanuary 28, 2006 Net sales $204.6 $221.3 $217.2 $281.2 $924.3 Gross profit 96.5 97.0 97.8 106.7 398.0 Net income (loss) – Group 4.9 1.7 3.0 (5.8) 3.8 Net income-Operating 15.1 12.4 14.3 5.9 47.7 (a)Net loss of Group includes a pre-tax loss on the refinancing of debt of $49.8 million and net income of Operating includes a pre-tax loss of $4.0 millionrelated to the refinancing of debt. F-29Table of ContentsJ.CREW GROUP, INC. AND SUBSIDIARIESJ.CREW OPERATING CORP. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSFiscal Years Ended January 31, 2004, January 29, 2005 and January 28, 2006Dollars in thousands, unless otherwise indicated SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS BeginningBalance Charged toCost andExpenses(a) Charged tootherAccounts Deductions(a) EndingBalance (in thousands)Inventory reserve(deducted from inventories) Fiscal year ended: January 31, 2004 $12,420 $— $— $7,380 $5,040January 29, 2005 5,040 — — 557 4,483January 28, 2006 4,483 3,537 — — 8,020Allowance for sales returns(included in other current liabilities) Fiscal year ended: January 31, 2004 $5,313 $— $— $2,309 $3,004January 29, 2005 3,004 1,827 — — 4,831January 28, 2006 4,831 1,385 — — 6,216(a)The inventory reserve and allowance for sales returns are evaluated at the end of each fiscal quarter and adjusted (plus or minus) based on the quarterlyevaluation. During each period inventory write-downs and sales returns are charged to the statement of operations as incurred. F-30Table of ContentsEXHIBIT INDEX Exhibit No. Document 2.1 Agreement and Plan of Merger between J.Crew Group, Inc. (a New York corporation) and J.Crew Group, Inc. (a Delaware corporation), datedas of October 11, 2005. Incorporated by reference to Exhibit 10.1 to the Form 8-K/A filed on October 17, 2005. 2.2 Agreement of Merger between Group and Intermediate, dated as of October 11, 2005. Incorporated by reference to Exhibit 10.2 to the Form 8-K/A filed on October 17, 2005. 3.1 Certificate of Incorporation of J.Crew Group, Inc. Incorporated by reference to Exhibit 3.1 to the Registration Statement of J.Crew Group, Inc.on Form S-1/A filed on October 11, 2005 (File No. 333-127628) (the “October 11, 2005 S-1/A”). 3.2 By-laws of J.Crew Group, Inc. Incorporated by reference to Exhibit 3.2 to the Form 8-K/A filed on October 17, 2005. 3.3 Certificate of Incorporation of J.Crew Operating Corp., as amended. Incorporated by reference to Exhibits 3.1 and 3.2 to the RegistrationStatement of J.Crew Operating Corp. on Form S-4 filed on December 16, 1997 (File No. 333-42423) (the “Operating S-4”). 3.4 By-laws of J.Crew Operating Corp., as amended. Incorporated by reference to Exhibit 3 to the Form 10-Q for the period ended October 31,1998 and Exhibit 3.14 to the Operating S-4. Instruments Defining the Rights of Security Holders, Including Indentures 4.1 Indenture, dated as of October 17, 1997, between J.Crew Group, Inc. as Issuer and State Street Bank and Trust Company as Trustee (the“Group Indenture”). Incorporated by reference to Exhibit 4.3 to the Registration Statement of J.Crew Group, Inc. on Form S-4 filed onDecember 16, 1997 (File No. 333-42427) (the “S-4 Registration Statement”). 4.2 Amendment No. 1, dated as of May 6, 2003, of the Group Indenture. Incorporated by reference to Exhibit 4.3 to the Form 8-K filed on May8, 2003. 4.3 Stockholders’ Agreement, dated as of October 17, 1997, between J.Crew Group, Inc. and the Stockholder signatories thereto. Incorporatedby reference to Exhibit 4.1 to the S-4 Registration Statement (File No. 333-42427). 4.4 Employment Agreement, dated as of October 17, 1997, among J.Crew Group, Inc., J.Crew Operating Corp. and TPG Partners II, L.P. andEmily Woods. Incorporated by reference to Exhibit 10.1 to the S-4 Registration Statement (File No. 333-42427). 4.5 Stockholders’ Agreement, dated as of October 17, 1997, among J.Crew Group, Inc., TPG Partners II, L.P. and Emily Woods. Incorporatedby reference to Exhibit 4.4(b) to the S-1 Registration Statement filed on August 17, 2005 (File No. 333-127628) (the “S-1 RegistrationStatement”). 4.6 Amendment to Stockholders’ Agreement, dated as of June 11, 1998, between TPG Partners II, L.P. and Emily Woods. Incorporated byreference to Exhibit 4.4(c) to the S-1 Registration Statement. 4.7 Amendment to Stockholders’ Agreement, dated as of February 3, 2003, among J.Crew Group, Inc., TPG Partners II, L.P. and Emily Woods.Incorporated by reference to Exhibit 4.1 to the Form 8-K filed on February 7, 2003.Table of ContentsExhibit No. Document 4.8 Stockholders’ Agreement, dated as of January 24, 2003, among J.Crew, TPG Partners II, L.P. and Millard Drexler. Incorporated by referenceto Exhibit 4.1 to the Form 8-K filed on February 3, 2003. 4.9 Stockholders’ Agreement, dated as of February 20, 2003, among J.Crew Group, Inc., TPG Partners II, L.P. and Jeffrey Pfeifle. Incorporatedby reference to Exhibit 4.1 to the Form 8-K filed on February 26, 2003. 4.10 Indenture, dated as of March 18, 2005, among J.Crew Operating Corp. as Issuer, J.Crew Intermediate LLC, Grace Holmes, Inc., H.F.D. No.55, Inc., J.Crew, Inc. and J.Crew International, Inc. as Guarantors, and U.S. Bank National Association as Trustee (the “9 3/4% NotesIndenture”). Incorporated by reference to Exhibit 4.1 to the Form 8-K filed on March 23, 2005. 4.11 First Supplemental Indenture, dated as of October 17, 2005, supplementing the 9 3/4% Notes Indenture. Incorporated by reference to Exhibit4.2 to the Form 8-K filed on October 18, 2005. 4.12 Second Supplemental Indenture, dated as of October 17, 2005, supplementing the 9 3/4% Notes Indenture. Incorporated by reference toExhibit 10.2 to the Form 8-K filed on October 18, 2005. 4.13 Security Agreement, dated as of November 21, 2004, by and among J.Crew Operating Group, J.Crew Inc., Grace Holmes, Inc., H.F.D. No.55, Inc., J.Crew International, Inc. and J.Crew Intermediate LLC as Grantors, and U.S. Bank National Association as Collateral Agent.Incorporated by reference to Exhibit 4.2 to the Form 8-K filed on December 28, 2004. 4.14 Intercreditor Agreement, dated as of November 21, 2004, among Congress Financial Corporation as Senior Credit Agent, U.S. BankNational Association as Collateral Agent, J.Crew Operating Corp., J.Crew, Inc., Grace Holmes, Inc., H.F.D. No. 55, Inc., J.CrewInternational, Inc. and J.Crew Intermediate LLC. Incorporated by reference to Exhibit 4.3 to the Form 8-K filed on December 28, 2004. Material Contracts10.1 Amended and Restated Loan and Security Agreement, dated as of December 23, 2004, by and among J.Crew Operating Corp., J.Crew Inc.,Grace Holmes, Inc. d/b/a J.Crew Retail, H.F.D. No. 55, Inc. d/b/a J.Crew Factory as Borrowers, J.Crew Group, Inc., J.Crew International,Inc., J.Crew Intermediate LLC as Guarantors, Wachovia Capital Markets, LLC as Arranger and Bookrunner, Wachovia Bank, NationalAssociation as Administrative Agent, Bank of America, N.A. as Syndication Agent, Congress Financial Corporation as Collateral Agent,and the Lenders (the “Credit Facility”). Incorporated by reference to Exhibit 4.6 to the Form 8-K filed on December 28, 2004.10.2 Amendment No. 1, dated as of October 10, 2005, to the Credit Facility. Incorporated by reference to Exhibit 4.1 to the Form 8-K/A filed onOctober 17, 2005.10.3 Joinder Agreement between the Company and Wachovia Bank, National Association, as Agent under the Credit Facility, dated October 12,2005. Incorporated by reference to Exhibit 4.1 to the Form 8-K filed on October 18, 2005.10.4 Credit Agreement, dated as of February 4, 2003, by and between J.Crew Group, Inc., J.Crew Operating Corp., and certain subsidiariesthereof, and TPG-MD Investment, LLC (the “TPG-MD Credit Agreement”). Incorporated by reference to Exhibit 10.1 to the Form 8-K filedon February 7, 2003.10.5 Amendment No. 1, dated as of November 21, 2004, to the TPG-MD Credit Agreement. Incorporated by reference to Exhibit 4.4 to the Form 8-K filed on December 28, 2004.10.6 Purchase Agreement, dated as of August 16, 2005, between the Company and TPG Partners II L.P., TPG Parallel II L.P. and TPG InvestorsII L.P. Incorporated by reference to Exhibit 10.3 to the S-1 Registration Statement.Table of ContentsExhibit No. Document10.7 Letter Agreement, dated as of August 16, 2005, between the Company and TPG-MD Investment, LLC. Incorporated by reference to Exhibit10.4 to the S-1 Registration Statement. Management Contracts and Compensatory Plans and Arrangements10.8 Amended and Restated J.Crew Group, Inc. 1997 Stock Option Plan. Incorporated by reference to Exhibit 10.1 to the Form 10-Q for theperiod ended August 3, 2002.10.9 J.Crew Group, Inc. 2003 Equity Incentive Plan (the “2003 Plan”). Incorporated by reference to Exhibit 10.4 to the Form 10-K for the fiscalyear ended February 1, 2003.10.10 Amendment No. 1 to the 2003 Plan. Incorporated by reference to Exhibit 10.4(b) to the Form 10-K for the fiscal year ended January 31, 2004.10.11 Services Agreement, dated January 24, 2003, between the Company, Millard S. Drexler, Inc. and Millard S. Drexler. Incorporated byreference to Exhibit 10.9 to the Form 10-K for the fiscal year ended February 1, 2003.10.12 Option Surrender Agreement, dated September 25, 2003, between the Company and Millard S. Drexler. Incorporated by reference to Exhibit10.9(b) to the Form 10-K for the fiscal year ended January 31, 2004.10.13 Employment Agreement, dated January 24, 2003, between the Company and Jeffrey Pfeifle. Incorporated by reference to Exhibit 10.10 to theForm 10-K for the fiscal year ended February 1, 2003.10.14 Option Surrender Agreement, dated September 25, 2003, between the Company and Jeffrey Pfeifle. Incorporated by reference to Exhibit10.10(b) to the Form 10-K for the fiscal year ended January 31, 2004.10.15 Offer letter, dated September 15, 2003, from the Company to Roxane Al-Fayez. Incorporated by reference to Exhibit 10.16 to the Form 10-Kfor the fiscal year ended January 29, 2005.10.16 Employment Agreement, dated January 23, 2004, between the Company and Tracy Gardner. Incorporated by reference to Exhibit 10.14 to theForm 10-K for the fiscal year ended January 31, 2004.10.17 Employment Agreement, dated August 16, 2005, between the Company and James Scully. Incorporated by reference to Exhibit 10.13 to theS-1 Registration Statement.10.18 Amended and Restated Employment Agreement by and among the Company, Operating and Millard S. Drexler dated as of October 20, 2005.Incorporated by reference to Exhibit 10.1 to the Form 8-K filed on October 21, 2005.10.19 Trademark License Agreement by and among the Company, Millard S. Drexler and Millard S. Drexler, Inc. dated as of October 20, 2005.Incorporated by reference to Exhibit 10.2 to the Form 8-K filed on October 21, 2005.Table of ContentsExhibit No. Document Other Exhibits14 Code of Ethics and Business Practices of the Company. Incorporated by reference to Exhibit 14 to Form 10-K for the fiscal year endedJanuary 31, 2004.21.1 Subsidiaries of J.Crew Group, Inc. Incorporated by reference to Exhibit 21.1 to the October 11, 2005 S-1/A.23.1† Consent of KPMG LLP, Independent Auditors.31.1† Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2† Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1† Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.†Filed herewith.Exhibit 23.1The Board of DirectorsJ. Crew Group, Inc.:We consent to the incorporation by reference in this registration statement on Form S-8 for the J. Crew Group, Inc. 2003 Equity Incentive Plan of our reportdated April 24, 2006, with respect to the consolidated balance sheets of J. Crew Group, Inc. and subsidiaries as of January 28, 2006 and January 29, 2005,and the related consolidated statements of operations, cash flows, and changes in stockholders’ deficit for each of the years in the three-year period endedJanuary 28, 2006, and the related financial statement schedule, which report appears in the January 28, 2006 annual report on Form 10-K of J. Crew Group,Inc.Our report refers to the adoption of Statement of Financial Accounting Standard No. 150, “Accounting for Certain Financial Instruments with Characteristicsof both Liabilities and Equity” in the third quarter of fiscal 2003.New York, New YorkApril 24, 2006EXHIBIT 31.1CERTIFICATION PURSUANT TO SECTION 302OF THE SARBANES-OXLEY ACT OF 2002I, Millard S. Drexler, certify that: 1.I have reviewed this Annual Report on Form 10-K of J. Crew Group, Inc. and J. Crew Operating Corp.; 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 thestatements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by thisreport; 3.Based on my knowledge, the financial statements and other financial information included in this report fairly present in all material respects thefinancial condition, results of operations and cash flows of each registrant as of, and for, the periods presented in this report; 4.Each registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined inExchange Act Rules 13a-15(e) and 15d-15(e)) for such registrant and have: a)Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under oursupervision, to ensure that material information relating to such registrant, including its consolidated subsidiaries, is made known to usby others within those entities, particularly during the period in which this report is being prepared; b)Evaluated the effectiveness of such registrant’s disclosure controls and procedures and presented in this report our conclusions about theeffectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c)Disclosed in this report any change in such registrant’s internal control over financial reporting that occurred during the registrant’s mostrecent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonablylikely to materially affect, such registrant’s internal control over financial reporting; and 5.Each registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, tosuch registrant’s auditors and the audit committee of such 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 arereasonably likely to adversely affect such 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 such registrant’s internalcontrol over financial reporting. Date: April 24, 2006/s/ MILLARD S. DREXLERMillard S. DrexlerChief Executive OfficerEXHIBIT 31.2CERTIFICATION PURSUANT TO SECTION 302OF THE SARBANES-OXLEY ACT OF 2002I, James S. Scully, certify that: 1.I have reviewed this Annual Report on Form 10-K of J. Crew Group, Inc. and J. Crew Operating Corp.; 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 thestatements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by thisreport; 3.Based on my knowledge, the financial statements and other financial information included in this report fairly present in all material respects thefinancial condition, results of operations and cash flows of each registrant as of, and for, the periods presented in this report; 4.Each registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined inExchange Act Rules 13a-15(e) and 15d-15(e)) for such registrant and have: a)Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under oursupervision, to ensure that material information relating to such registrant, including its consolidated subsidiaries, is made known to usby others within those entities, particularly during the period in which this report is being prepared; b)Evaluated the effectiveness of such registrant’s disclosure controls and procedures and presented in this report our conclusions about theeffectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c)Disclosed in this report any change in such registrant’s internal control over financial reporting that occurred during the registrant’s mostrecent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonablylikely to materially affect, such registrant’s internal control over financial reporting; and 5.Each registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, tosuch registrant’s auditors and the audit committee of such 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 arereasonably likely to adversely affect such 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 such registrant’s internalcontrol over financial reporting. Date: April 24, 2006/s/ JAMES S. SCULLYJames S. ScullyExecutive Vice-President and Chief Financial OfficerEXHIBIT 32.1CERTIFICATION PURSUANT TO SECTION 906OF THE SARBANES-OXLEY ACT OF 2002In connection with the Annual Report of J.Crew Group, Inc. and J.Crew Operating Corp. (collectively, the “Company”) on Form 10-K for the period endedJanuary 28, 2006 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), we, Millard S. Drexler, Chief Executive Officer ofthe Company, and James S. Scully, Executive Vice-President and Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, asadopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to the best of each of our knowledge: 1.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. Date: April 24, 2006/s/ MILLARD S. DREXLERMillard S. DrexlerChief Executive Officer /s/ JAMES S. SCULLYJames S. ScullyExecutive Vice-President and Chief Financial OfficerThe foregoing certification is being furnished solely pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350) and is not beingfiled as part of the Report or as a separate disclosure document.A signed original of this written statement required by Section 906 has been provided to the Company and will be retained by the Company andfurnished to the Securities and Exchange Commission or its staff upon request.

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