In accordance with SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS No. 133"), and SFAS No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities," the Company recognizes all derivatives on the balance sheet at fair value. Although the swap essentially provides for matched terms to its underlying obligation, and effectively mitigates its variability, it currently does not qualify for hedge accounting under SFAS No. 133.

The interest rate swap will expire February 2, 2009. The net income or expense from the exchange of interest rate payments is included in interest expense. The estimated fair value of the interest rate swap agreement, based on dealer quotes, at May 5, 2007 was a loss of $15,639 and represents the amount the Company would pay if the

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agreement was terminated as of that date. As of May 5, 2007, the Company reflected a derivative liability in other liabilities for such amount to recognize the fair value of the interest rate swap. Changes in the fair value of derivatives not designated as qualifying cash flow hedges are reported in interest expense. Accordingly, interest expense for the thirteen weeks ended May 5, 2007 includes an unfavorable fair value adjustment of $113,945 related to the interest rate swap.

Options with an exercise price greater than the average market price of the Company's common stock during the period, or outstanding in a period in which the Company reports a net loss, are excluded from the computation of the weighted average number of shares on a diluted basis, as such options are anti-dilutive. Weighted average options outstanding of approximately 1,118,000 and 1,061,000 were excluded from the computation of dilutive shares due to the Company's net loss position in the thirteen weeks ended May 5, 2007 and April 29, 2006, respectively. Had the Company reported profit for these periods, approximately -0- and 317,000 options with exercise prices greater than the average market price of the Company's common stock would have been excluded from the computation of the weighted average number of shares, and the approximate effect of dilutive options would have been 424,000 shares and 360,000 shares for the thirteen weeks ended May 5, 2007 and April 29, 2006, respectively.

On September 19, 2005, the Company became subject to a complaint filed in the Superior Court of California for the County of Santa Cruz alleging violation of California law regarding payment of accrued vacation upon termination of employment. The complaint seeks wage payments for employees who allegedly forfeited accrued vacation, waiting time penalties, interest, injunctive relief and costs. The Company believed settlement of this matter was in its best interests and entered into a memorandum of understanding for class settlement which was approved at a hearing on September 29, 2006. The Company accrued $1.8 million during the fourth quarter of fiscal 2005 for estimated legal fees and settlement costs and an additional $60,000 in the fourth quarter of fiscal 2006. All payments were made in December 2006 and a final accounting for unclaimed payments will take place in the second quarter of fiscal 2007. All expense accounting related to this settlement is reflected in the financial statements as of May 5, 2007. The final expense accounting did not have a material adverse effect on the Company's business, financial condition or results of operations.

The Company is party to other legal proceedings and claims which arise during the ordinary course of business. In the opinion of management, the ultimate outcome of such litigation and claims are not expected to have a material adverse effect on the Company's financial position or results of its operations.

As of May 5, 2007, the Company had issued a total of $1.5 million of standby letters of credit and documentary letters of credit totaling $0.2 million. Management believes that the likelihood of any draws under the standby letters of credit is remote. Documentary letters of credit are issued in the ordinary course of business to facilitate the purchase of merchandise from overseas suppliers. The suppliers draw against the documentary letters of credit upon delivery of the merchandise to the Company's customs broker at a United States port.

The Company closed one underperforming store in the Seattle/Tacoma market during the first quarter of fiscal 2006 This closure is reported as discontinued operations due to the Company's exit from the market area. The loss from operations of discontinued stores includes only revenues generated from, and expenses directly associated with, the operations of such stores and consists of the following:

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The Company recorded a net gain on the sale of the building associated with the store closed during the first quarter of fiscal 2006 of approximately $147,000, which was partially offset by store closure costs of approximately $75,000 related to that store and one store closed at the end of fiscal 2005, primarily consisting of severance and other incremental costs associated with the store closing.

In addition, the Company closed one store in Wasilla, Alaska during the first quarter of fiscal 2007. This closure is not reported as discontinued operations due to the shift of revenues to other stores in the market area.

The Company will close one store in Tacoma, Washington during the third quarter of fiscal 2007. This closure will not be reported as discontinued operations due to the shift of revenues to another store in the market area.

In June 2006, the Financial Accounting Standards Board (FASB) issued Financial Interpretation No. (FIN) 48, "Accounting for Uncertainty in Income Taxes," which clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with FASB Statement No. 109, "Accounting for Income Taxes." The interpretation prescribes a "more likely than not" recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 applies to all tax positions related to income taxes subject to FAS 109 and creates a single model to address accounting for uncertainty in tax positions. FIN 48 requires that tax positions accounted for under FAS 109 be evaluated for recognition based solely on technical merits and the resulting tax benefits be measured using a cumulative probability assessment and the Company's plan for settlement. The Company adopted FIN 48, effective February 4, 2007. The adoption of FIN 48 did not have a material effect on the Company's consolidated financial position or results of operations.

The Company has an unrecognized tax benefit of approximately $2.7 million, reported in the Condensed Balance Sheets in Deferred Income Taxes and Other Liabilities, which did not change significantly during the three months ended May 5, 2007. Of this amount, the amount that would impact the Company's effective tax rate, if recognized, is $0.6 million. The application of FIN 48 would have resulted in an immaterial change in retained earnings, after the application of a valuation allowance. The Company estimates that the unrecognized tax benefit will not change significantly within the next twelve months.

The Company's policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense. Total accrued interest included in the FIN 48 liability was $0.3 million at February 4, 2007 and May 5, 2007. No penalties were accrued at February 4, 2007 or May 5, 2007.

The Company files its tax returns as prescribed by the tax laws of the jurisdiction in which it operates. The Company is no longer subject to U.S. federal tax examinations for years before fiscal 2004 while the fiscal 2004 through fiscal 2006 tax years are still subject to examination. For the various state jurisdictions, tax years from fiscal 2002 through fiscal 2006 remain open to examination as well, although the Company believes any potential assessment would not have a material impact on the Company's financial position or results of operations.

In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements." SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS 157 applies under other accounting pronouncements that require or permit fair value measurement. SFAS 157 does not require any new fair value measurement and the Company is currently evaluating the impact, if any, of SFAS 157 on its financial position, results of operations and cash flows. SFAS 157 requires prospective application for fiscal years beginning after November 15, 2007.

In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities," (SFAS 159). This statement permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to reduce fluctuation in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. Most of the provisions of SFAS 159 apply only to entities that elect the fair value option. However, the amendment to FASB Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities," applies to all entities with available-for-sale and trading

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securities. SFAS 159 is effective for Gottschalks Inc. on February 3, 2008. The Company is currently evaluating the impact, if any, of SFAS 159 on its financial position, results of operations, and cash flows.

The following is management's discussion and analysis of significant factors which have affected the Company's financial position and its results of operations for the periods presented in the accompanying condensed financial statements. The Company's operating results, like those of most retailers, are subject to seasonal influences, with the major portion of sales, gross margin and operating results realized during the fourth quarter of each fiscal year. Accordingly, performance for the thirteen week period ended May 5, 2007 (hereinafter referred to as the "first quarter" of fiscal 2007, respectively), is not necessarily indicative of performance for the remainder of the year.

The Company's financial statements are based on the application of critical accounting policies, many of which require management to make significant estimates and assumptions. Some of these critical accounting policies involve a higher degree of judgment or complexity than its other accounting policies. The Company evaluates its estimates on an ongoing basis, including those related to its revenue recognition policy, the carrying value of its merchandise inventories, and the valuation of its long-lived assets, including goodwill, and its deferred tax assets. The impact and associated risks related to these policies on the Company's business operations are described more fully in the Company's 2006 Annual Report on Form 10-K. The Company does not believe there have been any changes to the critical accounting policies described therein.

The following table sets forth the Company's Statements of Operations as a percent of net sales:

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First Quarter of Fiscal 2007 Compared to First Quarter of Fiscal 2006

Net Sales

The Company operated 59 department stores and 4 specialty stores as of the end of the first quarter of fiscal 2007, as compared to 62 department stores and 6 specialty stores as of the end of the first quarter of fiscal 2006.

Net credit revenues related to the Company's proprietary credit cards increased approximately $0.5 million in the first quarter of fiscal 2007 as compared to the first quarter of fiscal 2006. As a percent of net sales, net credit revenues was 0.8% of net sales in the first quarter of fiscal 2007 and 0.5% in the first quarter of fiscal 2006. This increase is attributable to the new Credit Card Program Agreement with HSBC, which was effective February 4, 2007, which provides for an enhanced percentage of net sales revenue.

Net rental income generated by the Company's various leased departments in the first quarter of fiscal 2007 was $0.1 million lower than the first quarter of fiscal 2006.

Leased department sales are presented net of the related costs for financial reporting purposes. Sales generated in the Company's leased departments in the first quarter of fiscal 2007 consisted primarily of sales in the fine jewelry departments and the beauty salons. These leased department sales were $4.7 million in the first quarter of fiscal 2007 and $5.3 million in the first quarter of fiscal 2006.

Cost of sales from continuing operations, which includes costs associated with the buying, handling and distribution of merchandise, increased by approximately $0.1 million to $95.2 million in the first quarter of fiscal 2007 as compared to $95.1 million in the first quarter of fiscal 2006, an increase of 0.1%. The Company's gross margin percentage was 32.9% in the first quarter of fiscal 2007 and 33.4% in the first quarter of fiscal 2006.

Selling, general and administrative expenses from continuing operations decreased by approximately $0.6 million to $49.3 million in the first quarter of fiscal 2007 as compared to $49.9 million in the first quarter of fiscal 2006, a decrease of 1.1%. The decrease is primarily attributable to decreased payroll fringe benefits, decreased net advertising costs related to changes in advertising media and increased vendor participation; and improvements in rent, taxes, supplies and other accounts due to less stores than last year. The lower costs were partially offset by increased professional fees related to the Company's strategic initiatives. (For further discussion see the Company's 2006 Annual Report on Form 10-K, page 8, "Special Strategic Committee".)

As a percent of net sales, selling, general and administrative expenses from continuing operations decreased in the first quarter of fiscal 2007 by 0.2% to 34.8% as compared to the first quarter of fiscal 2006.

Depreciation and amortization expense, which includes the amortization (accretion) of intangible assets other than goodwill, was $3.9 million in the first quarter of fiscal 2007 as compared to $3.6 million in the first quarter of fiscal

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2006. As a percent of net sales, depreciation and amortization expense increased to 2.8% in the first quarter of fiscal 2007 as compared to 2.5% in the first quarter of fiscal 2006. The dollar increase is the result of 2006 capital additions related to the Company's new store in Eugene, Oregon, major remodel projects at certain existing stores and upgrades to the planning and allocation and point of sale systems.

Interest expense, which includes the amortization of deferred financing costs, increased by approximately $0.4 million to $2.6 million in the first quarter of fiscal 2007 as compared to $2.2 million in the first quarter of fiscal 2006, an increase of 15.7%. As a percent of net sales, interest expense increased to 1.8% in the first quarter of fiscal 2007 as compared to 1.6% in the first quarter of fiscal 2006. These increases are primarily due to continued increases in interest rates charged on the Company's variable rate debt and an unfavorable fair value adjustment of $0.1 million on the Company's $25 million notional amount interest rate swap. The fiscal 2006 interest expense includes a charge of $0.2 million related to the early termination of the Company's 9.39% mortgages. The weighted average interest rate applicable to the revolving credit facility was 7.2% in the first quarter of fiscal 2007 (7.1% at May 5, 2007) as compared to 7.0% in the first quarter of fiscal 2006.

Miscellaneous income, which includes the amortization of deferred income and other non-operating income and expense amounts, was $0.3 million in the first quarter of fiscal 2007 and $0.4 million in the first quarter of fiscal 2006.

The Company's interim effective tax rates from continuing operations of 35.5% in the first quarter of fiscal 2007 and 38.9% in the first quarter of fiscal 2006 relate to the net loss reported in those periods. The decrease in the interim effective tax rate is primarily due to the expiration of certain federal tax credit programs during the first quarter of fiscal 2006, and the subsequent restoration of such programs for calendar years 2006 and 2007.

As a result of the foregoing, the Company reported a loss from continuing operations of $4.7 million, or $0.34 per share (basic and diluted), in the first quarter of fiscal 2007 as compared to a loss from continuing operations of $3.9 million, or $0.29 per share (basic and diluted) in the first quarter of fiscal 2006.

The Company closed one underperforming store in the Seattle/Tacoma market during the first quarter of fiscal 2006 This closure was reported as discontinued operations due to the Company's exit from the market area. The loss from operations of the discontinued store includes only revenues generated from, and expenses directly associated with, the operations of the store and consists of the following:

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The Company recorded a net gain on the sale of the building associated with the store closed during the first quarter of fiscal 2006 of approximately $147,000, which was partially offset by store closure costs of approximately $75,000 related to that store and one store closed at the end of fiscal 2005, primarily consisting of severance and other incremental costs associated with the store closing.

In addition, the Company closed one store in Wasilla, Alaska during the first quarter of fiscal 2007. This closure is not reported as discontinued operations due to the shift of revenues to other stores in the market area.

The Company will close one store in Tacoma, Washington during the third quarter of fiscal 2007. This closure will not be reported as discontinued operations due to the shift of revenues to another store in the market area.

As a result of the foregoing, the Company reported a net loss of approximately $4.7 million in the first quarter of fiscal 2007 as compared to a net loss of $4.0 million in the first quarter of 2006. On a per share basis, the net loss was $0.34 per share (basic and diluted) in the first quarter of 2007 as compared to $0.30 per share (basic and diluted) in the first quarter of 2006.

As described more fully in the Company's 2006 Annual Report on Form 10-K and Note 5 to the accompanying financial statements, the Company's working capital requirements are currently met through a combination of cash provided by operations, borrowings under its senior revolving credit facility, and by short-term trade and factor credit. The Company's liquidity position, like that of most retailers, is affected by seasonal influences, with the greatest portion of cash from operations generated in the fourth quarter of each fiscal year.

The Company's use of cash in operations during the first quarter is primarily the result of the build-up of spring and summer inventory. The decrease in net cash used in operations for the first quarter of fiscal 2007 as compared to the first quarter of fiscal 2006 is primarily due to a slightly higher build-up of inventories accompanied by a significantly larger increase in trade accounts payable.

The increase in net cash used in investing activities are the result of less proceeds related to the sale and closure of one of the Company's stores in the Alaska market this year as compared to the sale and closure of an owned store in the Seattle market area in fiscal 2006. Capital spending during the first quarter of fiscal 2007 primarily relates to renovations of the Clovis, California store and upgrades to the Company's point of sale systems. Capital spending during the first quarter of fiscal 2006 relates to renovations of primarily accessory and shoe areas of certain key stores and to upgrades to the Company's planning and allocations and point of sale systems.

Net cash provided by financing activities during the first quarter primarily relates to increased borrowing on the Company's revolving credit facility to fund the acquisition of inventory and for capital expenditures, partially offset by ongoing payment of principal on long-term obligations. Increases to the Company's revolving line of credit during the first quarter of fiscal 2006 includes the pay-off of the 9.39% mortgages on four of the Company's owned properties of approximately $16.6 million.

The credit facility, as amended, consists of a revolving credit facility of up to $172 million (including a $20 million letter of credit sub- facility) and a fully funded term loan of $9 million. Borrowings under the revolving credit facility, as amended, are limited to the sum of (a) a specified percentage of eligible credit card receivables, (b) the lesser of specified percentages of (i) the cost of eligible inventory and (ii) the net recovery value of the inventory, as determined by periodic valuation performed by an independent appraiser, and (c) the lesser of (i) up to 60% of the fair market value of the designated properties and (ii) $21.6 million. Such borrowings are further limited by a requirement to maintain a minimum of $5 million of excess availability at all times, and other reserves that are in effect. As of May 5, 2007, outstanding borrowings under the credit facility totaled $90.9 million, and excess borrowing availability under the credit facility, after the deduction of the minimum availability requirement and

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other reserves, totaled $56.7 million. Substantially all of the Company's assets, including its merchandise inventories, are pledged under the credit facility. The credit facility expires February 2, 2009, and provides for an optional extension through February 2, 2011.

As of May 5, 2007, interest charged on amounts borrowed under the revolving portion of the credit facility are at the prime rate, or at the Company's option, at the applicable LIBOR rate plus 1.25% per annum, and interest charged on the term loan is a fixed rate of 6.6% per annum. In addition, the Company pays an unused commitment fee equal to 0.375% per annum on the average unused daily balance of the revolving portion of the credit facility. The interest rate applicable to the revolving portion of the credit facility is adjusted upwards or downwards on a quarterly basis based on a pricing matrix which is tied to the Company's daily average excess availability for the preceding fiscal quarter (as defined in the agreement). Under the pricing matrix, the applicable interest rate could range from a rate as low as prime or LIBOR plus 1.25%, to as high as prime plus 0.5%, or LIBOR plus 2.5%.

The credit facility, as amended, contains restrictive financial and operating covenants, including the requirement to maintain a fixed charge coverage ratio of 1:1 (as defined in the agreement) if the Company's excess borrowing availability is below $15 million. As of May 5, 2007, management believes the Company was in compliance with all restrictive financial covenants applicable to the credit facility.

The success of the Company's business is partially dependent upon the adequacy of trade credit offered by key factors and vendors, the vendors' ability and willingness to sell its products at favorable prices and terms, and the willingness of vendors to ship merchandise on a timely basis. The Company has been able to purchase adequate levels of merchandise to support its operations and expects the level of trade credit to be sufficient to support its operations in the foreseeable future. Restrictions to the amount of trade credit granted by key factors and vendors can adversely impact the volume of merchandise the Company is able to purchase. Any significant reduction in the volume of merchandise the Company is able to purchase, or a prolonged disruption in the timing of when merchandise is received, could have a material adverse affect on the Company's business, liquidity position, and results of operations.

The Company may consider various other sources of liquidity in the future, including but not limited to the issuance of additional securities that might have a dilutive effect on existing shareholders, or incurring additional indebtedness which would increase the Company's leverage.

The Company's primary uses of liquidity are for working capital, debt service requirements and capital expenditures. Capital expenditures during the first quarter of fiscal 2007 totaling $2.5 million primarily relate to renovations of the Clovis, California store and upgrades to the Company's point of sale systems.

As of May 5, 2007, the Company had issued a total of $1.5 million of standby letters of credit and documentary letters of credit totaling $0.2 million. The standby letters of credit were issued to provide collateral for workers compensation insurance policies. Management believes that the likelihood of any draws under the standby letters of credit is remote. Documentary letters of credit are issued in the ordinary course of business to facilitate the purchase of merchandise from overseas suppliers. The supplier draws against the documentary letter of credit upon delivery of the merchandise.

Subject to the previously described risks and uncertainties relative to the Company's sources of liquidity, management currently believes that the described sources of liquidity, including cash generated by operations, liquidity provided by the revolving credit facility and other financial resources, will be adequate to meet the Company's planned cash requirements for at least the next 12 months. However, the Company's actual results may differ from the expectations set forth in the preceding sentence. The Company's liquidity and capital resources may be affected by a number of factors and risks (many of which are beyond the control of the Company), including but not limited to the availability of adequate borrowing capacity, adequate cash flows generated by operations and the adequacy of factor and trade credit. If the estimates or assumptions relative to any one of these sources of liquidity

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are not realized, or if these sources of liquidity are significantly reduced or eliminated, the Company's liquidity position, financial condition and results of operations will be materially adversely affected.

Certain statements contained in this Quarterly Report on Form 10-Q are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 and the Company intends that such forward-looking statements be subject to the safe harbors created thereby. These forward-looking statements include the plans and objectives of management for future operations and the future economic performance of the Company that involve risks and uncertainties. In some instances, such statements may be identified by the use of forward-looking terminology such as "may," "will," "expects," "believes," "intends," "projects," "forecasts," "plans," "estimates," "anticipates," "continues," "targets," or similar terms, variations of such terms or the negative of such terms. Such statements are based on management's current expectations and are subject to a number of factors and uncertainties which could cause actual results to differ materially from those described in the forward-looking statements, including, without limitation, the Company's ability to meet debt obligations and adhere to the restrictions and covenants imposed under its various debt agreements; the timely receipt of merchandise and the Company's ability to obtain adequate trade credit from its key factors and vendors; risks arising from general economic and market conditions (including uncertainties arising from future acts of terrorism or war); the ability to modify operations in order to minimize the adverse impact of rising costs, including but not limited to health care, workers' compensation, property and casualty insurance, unemployment insurance, and utilities costs; the effects of seasonality and weather conditions, changing consumer trends and preferences, competition, consumer credit; the Company's dependence on its key personnel; and general labor conditions, all of which are described in more detail under the caption "Risk Factors" in Item 1A. "Business" in the Company's 2006 Annual Report on Form 10-K and other reports filed by the Company with the Securities and Exchange Commission. THE COMPANY DOES NOT PRESENTLY INTEND TO UPDATE THESE STATEMENTS AND UNDERTAKES NO DUTY TO ANY PERSON TO EFFECT ANY SUCH UPDATE UNDER ANY CIRCUMSTANCES.

As described more fully in Part II, Item 7A of the Company's 2006 Annual Report on Form 10-K, the Company is exposed to market risks in the normal course of business due to changes in interest rates on short-term borrowings under its revolving line of credit and on certain of its long- term borrowing arrangements. Based on current market conditions, management does not believe there has been a material change in the Company's exposure to interest rate risks as described in that report.

The Company maintains "disclosure controls and procedures," for purposes of Rules 13a-14 and 15d-14 of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), that are designed to ensure that information required to be disclosed in the Company's reports, pursuant to the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and that such information is accumulated and communicated to the Company's management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding the required disclosures. Management necessarily applied its judgment in assessing the costs and benefits of such controls and procedures, which by their nature can provide only reasonable assurance regarding management's control objectives. The Company has carried out an evaluation, under the supervision and with the participation of the Company's management, including the Company's Chief Executive Officer along with the Company's Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(b). Based upon the foregoing, as of May 5, 2007, the Company's President and Chief Executive Officer along with the Company's Chief Financial Officer, concluded that the Company's disclosure controls and procedures are effective in reaching the level of reasonable assurance regarding management's control objectives.

There has been no change during the Company's fiscal quarter ended May 5, 2007 in the Company's internal control over financial reporting that was identified in connection with the evaluation required by Exchange Act Rule 13a-

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15(d) which has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting.

Multiple risk factors exist which could have a material effect on the Company's operations, results of operations, profitability, financial position, liquidity and capital resources. These risk factors are more fully presented in the Company's 2006 Annual Report on Form 10-K as filed with the SEC.

There have been no material changes with respect to the risk factors disclosed in our 2006 Annual Report on Form 10-K.