The following discussion of our financial condition and results of operations should be read together with our consolidated financial statements and notes to those statements included in PART II, ITEM 8 of this report.

Overview of Our Business

Shoe Carnival, Inc. is one of the nation's largest family footwear retailers. As of January 31, 2009, we operated 304 stores in 29 states primarily in the Midwest, South and Southeast regions of the United States. We offer a distinctive shopping experience, a broad merchandise assortment and value to our customers while maintaining an efficient store level cost structure.

Our stores combine competitive pricing with a highly promotional, in-store marketing effort that encourages customer participation and creates a fun and exciting shopping experience. We believe this highly promotional atmosphere results in various competitive advantages, including increased multiple unit sales; the building of a loyal, repeat customer base; the creation of word-of-mouth advertising; and enhanced sell through of in-season goods. Our objective is to be the destination store-of-choice for a wide range of consumers seeking moderately priced, current season name brand and private label footwear. Our product assortment includes dress and casual shoes, sandals, boots and a wide assortment of athletic shoes for the entire family. We believe that by offering a wide selection of both athletic and non-athletic footwear, we are able to reduce our exposure to shifts in fashion preferences between those categories.

Our marketing effort targets moderate income, value-conscious consumers seeking name brand footwear for all age groups. We believe that by offering a wide selection of popular styles of name brand merchandise at competitive prices, we generate broad customer appeal. Our cost-efficient store operations and real estate strategy enable us to price products competitively. Low labor costs are achieved by housing merchandise directly on the selling floor in an open-stock format, enabling customers to serve themselves, if they choose. This reduces the staffing required to assist customers and reduces store level labor costs as a percentage of sales. We locate stores predominantly in strip shopping centers in order to take advantage of lower occupancy costs and maximize our exposure to value-oriented shoppers.

In fiscal 2006, our Board of Directors authorized a $50.0 million share repurchase program, which was to terminate upon the earlier of the repurchase of the maximum amount or December 31, 2008. On October 8, 2008, the Board of Directors extended the date of termination one year to December 31, 2009. Share repurchases under this authorization may be made in the open market or in privately negotiated transactions. The timing and actual number of shares repurchased will depend on a variety of factors including price, corporate and regulatory requirements and other market conditions. As of January 31, 2009, approximately 1.2 million shares had been repurchased at an aggregate cost of $28.1 million. The amount that remained available under the existing repurchase authorization at January 31, 2009 was $21.9 million.

Our fiscal year is a 52/53 week year ending on the Saturday closest to January
31. Unless otherwise stated, references to years 2008, 2007, 2006, 2005, and 2004, relate respectively to the fiscal years ended January 31, 2009, February 2, 2008, February 3, 2007, January 28, 2006, and January 29, 2005. Fiscal year 2006 consisted of 53 weeks and the other fiscal years consisted of 52 weeks.

Executive Summary

Fiscal 2008, and especially the second half of the year, proved to be a difficult economic environment during which our targeted moderate income consumer further reduced their discretionary spending. Consequently, like many retailers in the United States, we experienced a continuing decline in customer traffic which negatively impacted our business. This resulted in a comparable store sales decrease of 4.6% for the year.

Sales results by product category were uneven during the fiscal year. Weakness throughout the year in our non-athletic product categories, particularly women's non-athletic, accounted for approximately 70% of the comparable store sales decline for the year. Athletic sales saw benefit from the economic stimulus checks in the second quarter along with the need presented by the back-to-school period, resulting in a comparable store sales increase through August. However, as the economic climate worsened in the second half of the fiscal year, and particularly in the fourth quarter, we saw our athletic category accelerate in comparable store sales declines to also end the year negative. Total comparable store sales reached their lowest levels during the fourth quarter, as general economic conditions worsened and consumer confidence continued to deteriorate.

During fiscal 2008, selling, general and administrative expenses were reduced $764,000 from the prior year. Reductions in advertising and employee incentive and benefit costs were able to more than offset the cost of operating an average of 17 more stores and incurring an additional $1.4 million in store closing costs.

We opened 24 new stores during fiscal 2008, and consistent with our real estate strategy, these stores were located in large and small markets in both new and existing geographic areas. We continued to fill in under-penetrated markets with additional stores and enter smaller one or two store markets. We closed 11 under-performing stores and identified an additional 13 under-performing stores for closure in future periods.

During fiscal 2008, we were able to generate free cash flow of $13.9 million and end the year with $24.8 million in cash and cash equivalents and no interest bearing debt. We realize the current level of economic uncertainty and rising unemployment within the U.S. marketplace has altered the spending habits of most consumers and we believe the economy will continue to have a negative impact on customer traffic during fiscal 2009. Therefore, we intend to scale back plans to open new stores, significantly reduce capital expenditures, slightly lower per-store inventories from fiscal 2008 levels and maintain tight control over expense. We believe these are tremendously important strategies during what we expect to be a volatile year in retail. Through proper execution, we expect to continue to generate free cash flow and maintain a debt free balance sheet.

Critical Accounting Policies

It is necessary for us to include certain judgments in our reported financial results. These judgments involve estimates that are inherently uncertain and actual results could differ materially from these estimates. The accounting policies that require the more significant judgments are:

Merchandise Inventories - Merchandise inventories are stated at the lower of cost or market using the first-in, first-out (FIFO) method. In determining market value, we estimate the future sales price of items of merchandise contained in the inventory as of the balance sheet date. Factors considered in this determination include, among others, current and recently recorded sales prices, the length of time product has been held in inventory and quantities of various product styles contained in inventory. The ultimate amount realized from the sale of certain product could differ materially from our estimates. We also estimate a shrinkage reserve for the period between the last physical count and the balance sheet date. The estimate for the shrinkage reserve can be affected by changes in merchandise mix and changes in actual shrinkage trends.

Valuation of Long-Lived Assets - We review long-lived assets whenever events or circumstances indicate the carrying value of an asset may not be recoverable and annually when no such event has occurred. We evaluate the ongoing value of assets associated with retail stores that have been open longer than one year. When events such as these occur, the assets subject to impairment are adjusted to estimated fair value and, if applicable, an impairment loss is recorded in selling, general and administrative expenses. Our assumptions and estimates used in the evaluation of impairment, including current and future economic trends for stores, are subject to a high degree of judgment and if actual results or market conditions differ from those anticipated, additional losses may be recorded.

Income Taxes - We calculate income taxes in accordance with Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes" ("SFAS No. 109") and account for uncertain tax positions in accordance with Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - an interpretation of Financial Accounting Standards Board ("FASB") Statement No. 109" ("FIN 48"). Under SFAS No. 109, deferred tax assets and liabilities are recognized based on the difference between the consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using the estimated tax rates in effect in the years when those temporary differences are expected to reverse. Under FIN 48, we are required to make many subjective assumptions and judgments regarding our income tax exposures. Interpretations of and guidance surrounding income tax laws and regulations are often complex, ambiguous and change over time. As such, changes in our subjective assumptions and judgments can materially affect amounts recognized in the consolidated financial statements.

Results of Operations

The following table sets forth our results of operations expressed as a percentage of net sales for the following fiscal years:

Fiscal years                                        2008        2007        2006
Net Sales                                          100.0 %     100.0 %     100.0 %
Cost of sales (including buying, distribution, and
    occupancy costs)                                73.1        71.8        70.8
Gross profit                                        26.9        28.2        29.2
Selling, general and
    administrative expenses                         25.6        25.3        23.7
Operating income                                     1.3         2.9         5.5
Interest income                                     (0.0 )      (0.1 )      (0.2 )
Interest expense                                     0.0         0.1         0.0
Income before income taxes                           1.3         2.9         5.7
Income tax expense                                   0.5         1.0         2.2
Net income                                           0.8 %       1.9 %       3.5 %

In the regular course of business, we offer our customers sales incentives including coupons, discounts, and free merchandise. Sales are recorded net of such incentives and returns and allowances. If an incentive involves free merchandise, that merchandise is recorded as a zero sale and the cost is included in cost of sales. Comparable store sales for the periods indicated below include stores that have been open for 13 full months prior to the beginning of the period, including those stores that have been relocated or remodeled. Therefore, stores opened or closed during the periods indicated are not included in comparable store sales.

2008 Compared to 2007

Net Sales

Net sales decreased $11.1 million to $647.6 million in fiscal 2008, a 1.7% decrease from net sales of $658.7 million in fiscal 2007. Comparable store sales decreased 4.6%, or approximately $28.4 million, compared to the prior fiscal year. This decrease in net sales was partially offset by a $17.3 million increase in sales generated by the 24 stores opened in fiscal 2008 and the effect of a full year's worth of sales for the 25 stores opened in fiscal 2007, net of the sales loss from the 16 stores which were closed during the last two years.

Gross profit decreased $11.5 million to $174.3 million in fiscal 2008, a 6.2% decrease from gross profit of $185.8 million in fiscal 2007. The gross profit margin for fiscal 2008 decreased to 26.9% from 28.2% in fiscal 2007. As a percentage of sales, the merchandise margin decreased 0.8% compared to the prior year, while buying, distribution and occupancy costs increased 0.5%. As was seen across the retail sector, heavy promotions throughout the year were necessary to keep inventory turning at an acceptable level and consequently negatively impacted margins. We experienced a 0.6% increase in occupancy costs, as a percentage of sales, primarily as a result of the lower comparable store sales, an increase in costs due to the additional stores we operated throughout the year and additional store closing costs. This increase, as a percentage of sales, was partially offset by a 0.2% decline in distribution costs. Our distribution costs, both as a percentage of sales and in dollars, declined as a result of the increased costs associated with the conversion to our new distribution center during the first quarter of the prior year, a reduction in volume for fiscal 2008 and increased efficiencies.

Selling, General and Administrative Expenses

Selling, general and administrative expenses decreased $764,000 to $166.0 million in fiscal 2008 from $166.7 million in fiscal 2007. As a percentage of sales, selling, general and administrative expenses increased to 25.6% during fiscal 2008 from 25.3% in fiscal 2007. The savings in dollars was primarily the result of a $6.2 million reduction in advertising costs from our decision to decrease advertising during non-peak periods along with a $1.2 million decrease in the expense for employee incentives and benefits. These decreases were partially offset by $6.0 million of additional costs incurred from the operation and support of the net new stores opened since the beginning of fiscal 2007.

Pre-opening costs included in selling, general and administrative expenses were $1.0 million, or 0.2% of sales, in both fiscal 2008 and in fiscal 2007. We opened 24 stores in fiscal 2008 as compared to 25 stores in fiscal 2007. Pre-opening costs, such as advertising, payroll and supplies, incurred prior to the opening of a new store are charged to expense in the period they are incurred. The total amount of pre-opening expense incurred will vary by store depending on the specific market and the promotional activities involved. Our average pre-opening costs per store were $41,000 in fiscal 2008 as compared to $40,000 in fiscal 2007.

The portion of store closing costs included in selling, general and administrative expenses for fiscal 2008 was $3.3 million, or 0.5% as a percentage of sales. These costs related to the closing of 11 stores in fiscal 2008 and the impairment and acceleration of expenses associated with management's determination to close certain underperforming stores at future dates. In fiscal 2007, we incurred $1.9 million, or 0.3% as a percentage of sales, in costs related to the closing of five stores in fiscal 2007 and the impairment and acceleration of expenses associated with management's determination to close certain underperforming stores at future dates. Currently, we have identified 10 stores to close in fiscal 2009, eight in fiscal 2010, four in fiscal 2011, and one in fiscal 2012. We are currently accelerating applicable expenses on all of these stores. We will continue to evaluate underperforming stores for possible closing on a routine basis, which may result in the identification of additional store closings for the current or future fiscal years. The timing and actual amount of expense recorded in closing a store can vary significantly depending, in part, on the period in which management commits to a closing plan, the remaining basis in the fixed assets to be disposed of at closing and the amount of any lease buyout.

Interest Income and Expense

Interest income decreased to $148,000 in fiscal 2008 from $690,000 in fiscal 2007. The decrease was primarily attributable to a decrease in the rate available on investments. Interest expense decreased to $153,000 in fiscal 2008 from $264,000 in fiscal 2007.

Income Taxes

The effective income tax rate was 36.5% for fiscal 2008 and 34.5% in fiscal 2007. The effective income tax rate for both years differed from the statutory rate due primarily to state and local income taxes, net of the federal tax benefit and tax credits. In the first quarter of fiscal 2007, we recorded $980,000 of state tax credits related to the investment in our new distribution center, which was the primary factor in reducing our effective tax rate in fiscal 2007.

Net Sales

Net sales decreased $23.0 million to $658.7 million in fiscal 2007, a 3.4% decrease from net sales of $681.7 million in fiscal 2006. Comparable store sales for the 52-week period ended February 2, 2008 decreased 5.2%, or approximately $34.5 million, compared to the 52-week period ended February 3, 2007. This decrease in net sales was partially offset by a $23.3 million increase in sales generated by the 25 stores opened in fiscal 2007 and the effect of a full year's worth of sales for the 14 stores opened in fiscal 2006, net of the sales loss from the 11 stores which were closed during the same periods. Additional sales of approximately $11.5 million were recorded in the 53rd week of fiscal 2006.

We believe the constriction of the general economy during fiscal 2007 directly affected our target customer through higher gasoline prices, escalating food costs, housing and mortgage issues and increased consumer debt loads. These conditions had a direct negative impact on traffic in our stores, and consequently, resulted in lower sales for fiscal 2007. The 5.2% decline in comparable store sales was broad-based, with all product categories experiencing a decline.

Gross Profit

Gross profit decreased $13.0 million to $185.8 million in fiscal 2007, a 6.5% decrease from gross profit of $198.8 million in fiscal 2006. The gross profit margin for fiscal 2007 decreased to 28.2% from 29.2% in fiscal 2006. As a percentage of sales, the merchandise margin remained unchanged compared to the prior year, while buying, distribution and occupancy costs increased 1.0%. An increase in occupancy costs related primarily to the operation of 28 net new stores coupled with declining sales accounted for 0.6% of the 1.0% increase. The remaining 0.4% was primarily related to increases in fixed distribution costs.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased $5.6 million to $166.7 million in fiscal 2007 from $161.1 million in fiscal 2006. As a percentage of sales, selling, general and administrative expenses increased to 25.3% during fiscal 2007 from 23.7% in fiscal 2006.

Pre-opening costs were $1.0 million, or 0.2% of sales, in fiscal 2007 as compared to $494,000, or 0.1% of sales in fiscal 2006. We opened 25 stores in fiscal 2007 as compared to 14 stores in fiscal 2006. Pre-opening costs, such as advertising, payroll and supplies, incurred prior to the opening of a new store are charged to expense in the period they are incurred. Our average pre-opening costs per store were $40,000 in fiscal 2007 as compared to $35,000 in fiscal 2006. This increase was primarily due to an increase in advertising expenditures.

The portion of store closing costs included in selling, general and administrative expenses for fiscal 2007 was $1.9 million, or 0.3% as a percentage of sales. These costs related to five fiscal 2007 store closings and the impairment and acceleration of expenses associated with management's determination to close 10 stores in fiscal 2008, four in fiscal 2009 and one each in fiscal 2010 and 2011. In fiscal 2006, we incurred $621,000, or 0.1% as a percentage of sales, in store closing costs related to six fiscal 2006 store closings and an impairment charge for one store. The timing and actual amount of expense recorded in closing a store can vary significantly on a store-by-store basis depending, in part, on the period in which management commits to a closing plan, the remaining basis in the fixed assets at the store and any amounts required to be paid as part of the lease termination.

Additional significant items associated with this net increase in selling, general and administrative expenses included $7.2 million of additional expense to operate and support the 28 net new stores (stores opened since the beginning of fiscal 2006, net of store closings), which was partially offset by $3.6 million in comparable store expense savings primarily attributable to variable expense controls along with a $2.0 million decrease in performance based incentive compensation expense. The increase in costs associated with providing general and administrative services to the corporation account for the balance of the increase in selling, general and administrative expenses and are not materially significant as individual items.

Interest income decreased to $690,000 in fiscal 2007 from $1.2 million in fiscal 2006. The decrease was primarily attributable to lower average cash and cash equivalents balances available for investment purposes throughout fiscal 2007. Interest expense increased to $264,000 in fiscal 2007 from $152,000 in fiscal 2006.

Income Taxes

The effective income tax rate was 34.5% for fiscal 2007 and 38.6% in fiscal 2006. The effective income tax rate for both years differed from the statutory rate due primarily to state and local income taxes, net of the federal tax benefit and tax credits. In the first quarter of fiscal 2007, we recorded $980,000 of state tax credits related to the investment in our new distribution center, which was the primary factor in reducing the company's effective tax rate in fiscal 2007 as compared to fiscal 2006.

Discontinued Operations

We evaluate our store closings for discontinued operations classification utilizing the guidance within FASB Statement No. 144 ("SFAS No. 144"), "Accounting for the Impairment or Disposal of Long-Lived Assets." Based on this evaluation, we have determined that each of our stores is the lowest level at which the operations and cash flows can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the company. Although each of our stores, on its own, is a component of the company, there may be cases in which we expect significant sales from store closures to transfer to our other existing stores that we continue to operate. In these cases, we believe the operations and cash flows from the store closures will not be eliminated from the ongoing operations of the company, and should not be classified as discontinued operations in accordance with the provisions of SFAS No. 144.

The following table summarizes our discontinued operations for the years ended January 31, 2009, February 2, 2008 and February 3, 2007:

(in thousands, except per store data)
Fiscal years                                                               2008         2007         2006
Total stores closed during year                                               11            5            6
Stores closed in which sales transferred to existing store locations           4            2            0
Discontinued operations stores (1)                                             7            3            6

Net sales for discontinued operations stores (1)                        $  6,800      $ 3,900      $ 5,500
Net loss for discontinued operations stores, net of tax (1)             $ (1,500 )    $  (475 )    $  (639 )

(1) These stores are not located near other existing stores to facilitate transference of sales nor do we have significant continuing involvement in their operations after closing. We have not segregated the results of operations for these stores in our consolidated financial statements as the amounts are deemed immaterial.

Our sources and uses of cash are summarized as follows:

(000's)
Fiscal years                                                            2008           2007           2006
Net income plus depreciation and amortization                        $  22,164      $  28,613      $  38,232
Deferred income taxes                                                      780           (387 )       (2,383 )
Lease incentives                                                         2,038            663            953
Changes in operating assets and liabilities                              6,480        (11,378 )       (8,676 )
Other operating activities                                                 616          2,368          1,141
Net cash provided by operating activities                               32,078         19,879         29,267
Net cash used in investing activities                                  (18,201 )      (18,041 )      (17,748 )
Net cash provided by (used in) financing activities                      1,763        (27,500 )        3,016
Net increase (decrease) in cash and cash equivalents                 $  15,640      $ (25,662 )    $  14,535

Our primary sources of funds are cash flows from operations and borrowings under our revolving credit facility. For fiscal 2008, net cash provided by operating activities was $32.1 million compared to net cash provided by operating activities of $19.9 million for fiscal 2007. These amounts reflect the income from operations adjusted for non-cash items and working capital changes. This $12.2 increase in cash provided by operations, when comparing the two periods of each year, was primarily due to a reduction in inventory on a per store basis and the timing of payments for accounts payable and accrued liabilities partially offset by a decrease in net income.

Working capital increased to $150.9 million at January 31, 2009 from $141.5 million at February 2, 2008. This was primarily attributable to a $15.6 million increase in cash and cash equivalents and a $7.5 million decrease in accounts . . .