10-Q

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended May 5, 2007

or

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

Commission File Number: 1-14770

PAYLESS SHOESOURCE, INC.

(Exact name of registrant as specified in its charter)

Delaware	43-1813160
State or other jurisdiction of	(I.R.S. Employer
incorporation or organization	Identification No.)
3231 Southeast Sixth Avenue, Topeka, Kansas	66607-2207
(Address of principal executive offices)	(Zip Code)

Registrant’s telephone number, including area code (785) 233-5171

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES þ NO o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer þ      Accelerated filer o       Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act ). YES o NO þ

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Common Stock, $.01 par value
64,995,945 shares as of June 7, 2007

PAYLESS SHOESOURCE, INC.
FORM 10-Q
FOR THE FISCAL QUARTER ENDED MAY 5, 2007
INDEX

	Page
PART I — FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Statements of Earnings for the 13 Weeks Ended May 5, 2007 and April 29, 2006		3
Condensed Consolidated Balance Sheets as of May 5, 2007, April 29, 2006 and February 3, 2007		4
Condensed Consolidated Statements of Cash Flows for the 13 Weeks Ended May 5, 2007 and April 29, 2006		5
Notes to Condensed Consolidated Financial Statements		6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		23
Item 3. Quantitative and Qualitative Disclosures About Market Risk		31
Item 4. Controls and Procedures		31
PART II — OTHER INFORMATION
Item 1. Legal Proceedings		32
Item 1A. Risk Factors		33
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		34
Item 4. Submission of Matters to a Vote of Security Holders		34
Item 6. Exhibits		35
Signatures		36
Employment Agreement with William E. May
302 Certification of Chief Executive Officer
302 Certification of Sr. VP, CFO and Treasurer
906 Certification of Chief Executive Officer
906 Certification of Sr. VP, CFO and Treasurer

2

PART I — FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

PAYLESS SHOESOURCE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS

(UNAUDITED)

(dollars and shares in millions, except per share)

	13 Weeks Ended
	May 5,			April 29,
	2007			2006
Net sales	$	728.6		$	694.5
Cost of sales		459.7			438.7
Gross margin		268.9			255.8
Selling, general and administrative expenses		209.9			199.1
Restructuring charges		0.2			—
Operating profit from continuing operations		58.8			56.7
Interest expense		4.8			4.9
Interest income		(4.7	)		(4.8	)
Earnings from continuing operations before income taxes and minority interest		58.7			56.6
Provision for income taxes		18.8			19.5
Earnings from continuing operations before minority interest		39.9			37.1
Minority interest, net of income taxes		(0.9	)		(0.3	)
Net earnings from continuing operations		39.0			36.8
Loss from discontinued operations, net of income taxes and minority interest		(0.1	)		(0.8	)
Net earnings	$	38.9		$	36.0
Basic earnings per share:
Earnings from continuing operations	$	0.60		$	0.55
Loss from discontinued operations		—			(0.01	)
Basic earnings per share	$	0.60		$	0.54
Diluted earnings per share:
Earnings from continuing operations	$	0.59		$	0.54
Loss from discontinued operations		—			(0.01	)
Diluted earnings per share	$	0.59		$	0.53
Basic Weighted Average Shares Outstanding		64.7			66.6
Diluted Weighted Average Shares Outstanding		66.0			67.6

See Notes to Condensed Consolidated Financial Statements.

3

PAYLESS SHOESOURCE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(UNAUDITED)

(dollars in millions)

	May 5,			April 29,			February 3,
	2007			2006			2007
ASSETS
Current Assets:
Cash and cash equivalents	$	321.4		$	333.0		$	371.4
Short-term investments		6.1			75.1			90.0
Restricted cash		2.0			2.0			2.0
Inventories		381.7			377.7			361.9
Current deferred income taxes		16.2			19.3			15.6
Prepaid expenses		44.2			41.1			46.5
Other current assets		19.2			18.1			18.1
Current assets of discontinued operations		1.1			4.9			1.1
Total current assets		791.9			871.2			906.6
Property and Equipment:
Land		6.5			7.7			6.6
Property, buildings and equipment		1,284.8			1,201.8			1,245.1
Accumulated depreciation and amortization		(848.6	)		(821.9	)		(830.5	)
Property and equipment, net		442.7			387.6			421.2
Intangible assets, net		95.9			18.2			39.6
Deferred income taxes		43.9			28.9			37.7
Goodwill		40.1			5.9			5.9
Other assets		18.2			21.3			16.4
Noncurrent assets of discontinued operations		—			1.3			—
Total Assets	$	1,432.7		$	1,334.4		$	1,427.4
LIABILITIES AND SHAREOWNERS’ EQUITY
Current Liabilities:
Current maturities of long-term debt	$	0.3		$	0.4		$	0.4
Notes payable		2.0			2.0			2.0
Accounts payable		157.5			175.2			185.6
Accrued expenses		156.0			160.4			190.2
Current liabilities of discontinued operations		2.1			3.4			2.1
Total current liabilities		317.9			341.4			380.3
Long-term debt		201.7			202.9			201.7
Other liabilities		175.3			111.0			132.6
Minority interest		12.6			11.0			12.7
Commitments and contingencies (Note 15)
Total shareowners’ equity		725.2			668.1			700.1
Total Liabilities and Shareowners’ Equity	$	1,432.7		$	1,334.4		$	1,427.4

See Notes to Condensed Consolidated Financial Statements.

4

PAYLESS SHOESOURCE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

(dollars in millions)

	13 Weeks Ended
	May 5,			April 29,
	2007			2006
Operating Activities:
Net earnings	$	38.9		$	36.0
Loss from discontinued operations, net of income taxes and minority interest		0.1			0.8
Adjustments for non-cash items included in net earnings:
Loss on impairment of and disposal of assets		2.6			1.7
Depreciation and amortization		24.3			22.6
Amortization of deferred financing costs		0.2			0.3
Share-based compensation expense		3.1			2.8
Deferred income taxes		(1.3	)		0.4
Minority interest, net of income taxes		0.9			0.3
Income tax benefit from share-based compensation		—			0.4
Accretion of investments		(0.5	)		(0.7	)
Changes in working capital:
Inventories		(18.6	)		(44.6	)
Prepaid expenses and other current assets		7.4			(0.6	)
Accounts payable		(27.4	)		6.7
Accrued expenses		(14.2	)		(5.6	)
Other assets and liabilities, net		5.9			(0.2	)
Net cash used in discontinued operations		(0.1	)		(3.6	)
Cash flow provided by operating activities		21.3			16.7
Investing Activities:
Capital expenditures		(55.7	)		(23.0	)
Proceeds from sale of property and equipment		0.1			1.0
Purchases of investments		(6.1	)		(74.8	)
Sales and maturities of investments		90.5			59.4
Acquisition of business, net of cash acquired		(91.5	)		—
Cash flow used in investing activities		(62.7	)		(37.4	)
Financing Activities:
Repayment of debt		(0.1	)		(1.4	)
Payment of deferred financing costs		—			0.2
Issuances of common stock		3.2			2.4
Purchases of common stock		(15.3	)		(26.6	)
Excess tax benefits from share-based compensation		1.2			—
Distributions to minority owners		—			(0.6	)
Net cash provided by discontinued operations		—			1.0
Cash flow used in financing activities		(11.0	)		(25.0	)
Effect of exchange rate changes on cash		2.4			0.5
Decrease in cash and cash equivalents		(50.0	)		(45.2	)
Cash and cash equivalents, beginning of year		371.4			378.2
Cash and cash equivalents, end of quarter	$	321.4		$	333.0
Supplemental cash flow information:
Interest paid	$	0.8		$	9.3
Income taxes paid	$	1.7		$	6.3
Non-cash investing and operating activities:
Accrued capital additions	$	13.1		$	11.3

See Notes to Condensed Consolidated Financial Statements.

5

PAYLESS SHOESOURCE, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Note 1 – Interim Results.

These unaudited Condensed Consolidated Financial Statements of Payless ShoeSource, Inc., a Delaware corporation, and subsidiaries (the “Company”) have been prepared in accordance with the instructions to Form 10-Q of the United States Securities and Exchange Commission and should be read in conjunction with the Notes to the Consolidated Financial Statements (pages 45-82) in the Company’s 2006 Annual Report on Form 10-K. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, the unaudited Condensed Consolidated Financial Statements are fairly presented and all adjustments (consisting only of normal recurring adjustments) necessary for a fair statement of the results for the interim periods have been included; however, certain items are included in these statements based upon estimates for the entire year. The Company’s operations in the Central and South American Region are operated as joint ventures in which the Company maintains a 60% ownership interest. The reporting period for operations in the Central and South American Regions is a December 31 year-end. The Central American Region is composed of operations in Costa Rica, the Dominican Republic, El Salvador, Guatemala, Honduras, Nicaragua, Panama and Trinidad & Tobago. The South American Region is composed of operations in Ecuador. The effects of the one-month lag for the operations in the Central and South American Regions are not significant to the Company’s financial position and results of operations. During the third quarter of 2006, the Company exited retail operations in Japan, closing its one store location. As discussed in Note 5 below, the financial information for Japan retail operations has been classified as discontinued operations for all periods presented. The results for the thirteen week period ended May 5, 2007, are not necessarily indicative of the results that may be expected for the entire fifty-two week fiscal year ending February 2, 2008.

Note 2 – Acquisition.

Effective March 30, 2007, the Company acquired 100% of the partnership interest of Collective International, LP (“Collective”) for $91.5 million, net of cash acquired of $1.1 million, including transaction costs and subject to a customary purchase price adjustment. The Company acquired Collective to further develop its “house of brands” strategy. Collective is a brand development, management and licensing company that had previously licensed the Airwalk brand to the Company. The acquisition was accounted for using the purchase method in accordance with Statement of Financial Accounting Standards (SFAS) No. 141, “Business Combinations.” Accordingly, net assets were recorded at their estimated fair values, and operating results are included in the Payless Domestic segment from the date of acquisition. The purchase price was allocated on a preliminary basis using information currently available. The allocation of the purchase price to the assets and liabilities acquired will be finalized as more information is obtained regarding asset valuations, liabilities assumed and revisions of preliminary estimates of fair values made at the date of purchase. All goodwill is included in the Payless Domestic segment and is deductible for tax purposes. Supplemental pro forma financial information has not been included due to immateriality.

The preliminary purchase price allocation, net of cash acquired, was as follows:

(dollars in millions)
Current assets	$	5.0
Goodwill		34.2
Trademarks(1)		47.7
Customer relationships(2)		9.2
Other assets(3)		0.2
Current liabilities		(4.8	)
Total	$	91.5

(1)	Comprised of $40.6 million with indefinite lives and $7.1 million with finite lives amortized over a weighted-average period of ten years.
(2)	Amortized over a weighted-average period of seven years.
(3)	Comprised of non-compete contracts, amortized over a weighted-average period of three years.

6

Identification and allocation of value assigned to the identified intangible assets is based on the provisions of SFAS No. 141. The Company utilized a valuation specialist to assist management in its determination of the fair value of identified intangible assets. The fair value was estimated by performing a discounted cash flow analysis using the “income” approach. This method includes a forecast of direct revenues and costs associated with the respective intangible assets and charges for economic returns on tangible and intangible assets utilized in cash flow generation. Net cash flows attributable to the identified intangible assets are discounted to their present value using a rate that is commensurate with the perceived risk. The projected cash flow assumptions included considerations for contractual relationships, customer attrition, and market competition.

The preliminary purchase price and its preliminary allocation could materially change as the result of changes in the estimates and assumptions used in determining certain acquisition related accruals and in the determinations of the fair value of acquired assets.

Note 3 – Exit Costs.

During the first quarter of 2007, the Company’s Board of Directors approved a plan to shift to a dual-distribution center model. As part of the plan, the Company intends to open a new distribution center in Brookville, Ohio which will begin operation in the summer of 2008. This distribution center will be in addition to the Company’s Redlands, California distribution center that will commence operations in the summer of 2007. Once both new distribution centers are operating satisfactorily, the Company plans to close its current distribution center in Topeka, Kansas. Total exit costs related to the closing of the Topeka distribution center are currently estimated to be approximately $14 million, consisting of approximately $4 million of non-cash accelerated depreciation expenses, approximately $8 million for employee severance expenses, and approximately $2 million related to other exit costs. The exit costs will be recorded as costs of sales in the condensed consolidated statement of earnings. Actual results could vary from these estimates.

The significant components of the exit costs incurred as of May 5, 2007, are summarized as follows:

						Accrual Balance
	Total Charges		Cash			as of
(dollars in millions)	to Date		Payments			May 5, 2007
Employee severance costs	$	4.2	$	(0.2	)	$	4.0
Accelerated depreciation		0.6
Total charges	$	4.8

The majority of the remaining exit costs will be recognized over the period until the Topeka distribution center is closed which is estimated to be in fiscal 2008.

Note 4 – Short-Term Investments.

As of May 5, 2007, April 29, 2006, and February 3, 2007, short-term investments consisted of the following:

	May 5,		April 29,		February 3,
(dollars in millions)	2007		2006		2007
Held-to-maturity securities:
Commercial paper	$	6.1	$	74.4	$	90.0
Certificates of deposit		—		0.7		—
Total held-to-maturity securities	$	6.1	$	75.1	$	90.0

Held-to-maturity securities are carried at amortized cost. As of May 5, 2007, the maturities for all held-to-maturity securities were less than one year. As of May 5, 2007, April 29, 2006, and February 3, 2007, the estimated fair value of each investment approximated its amortized cost and, therefore, there were no significant unrecognized holding gains or losses.

7

Note 5 – Discontinued Operations.

Payless Domestic

As part of its restructuring efforts in 2004, the Company closed all of its Parade stores and certain underperforming Payless stores. In accordance SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”), the results of operations for the thirteen weeks ended May 5, 2007, and April 29, 2006, for Parade and 26 closed Payless stores are classified as discontinued operations within the Payless Domestic segment. The following is a summary of these results:

	13 Weeks Ended
(dollars in millions)	May 5, 2007			April 29, 2006
Net sales	$	—		$	—
Loss from discontinued operations before income taxes		(0.2	)		(0.6	)
Benefit for income taxes		(0.1	)		(0.2	)
Loss from discontinued operations, net of income taxes	$	(0.1	)	$	(0.4	)

Additionally, the condensed consolidated balance sheets include the assets of Parade and the 26 Payless closed stores presented as discontinued operations. As of May 5, 2007, April 29, 2006, and February 3, 2007 the current and non-current assets and liabilities of discontinued operations within the Payless Domestic segment were as follows:

	May 5,		April 29,		February 3,
(dollars in millions)	2007		2006		2007
Assets
Current assets:
Current deferred income taxes	$	0.8	$	1.1	$	0.8
Other current assets		0.2		0.2		0.2
Total current assets of discontinued operations	$	1.0	$	1.3	$	1.0
Liabilities
Current liabilities:
Accrued expenses	$	2.1	$	2.8	$	2.1
Total current liabilities of discontinued operations	$	2.1	$	2.8	$	2.1

Payless International

During 2006, the Company exited its retail operations in Japan, and closed its one store location. In accordance with SFAS 144, the results of operations and the balance sheet information for the retail operations in Japan are classified as discontinued operations. As of May 5, 2007, the Company is substantially complete with the exit process. The following is a summary of Japan results and balance sheets of which all activity and balances are components of the Payless International segment:

	13 Weeks Ended
(dollars in millions)	May 5, 2007		April 29, 2006
Net sales	$	—	$	0.3
Loss from discontinued operations before income taxes and minority interest		—		(0.7	)
Minority interest		—		0.3
Loss from discontinued operations, net of income taxes and minority interest	$	—	$	(0.4	)

8

	May 5,		April 29,		February 3,
(dollars in millions)	2007		2006		2007
Assets
Current assets:
Cash and cash equivalents	$	0.1	$	2.9	$	0.1
Inventories		—		0.3		—
Other current assets		—		0.4		—
Total current assets of discontinued operations	$	0.1	$	3.6	$	0.1
Noncurrent assets:
Property and equipment, net		—		0.9		—
Other assets		—		0.4		—
Total noncurrent assets of discontinued operations		—		1.3		—
Total assets of discontinued operations	$	0.1	$	4.9	$	0.1
Liabilities
Current liabilities:
Accounts payable	$	—	$	0.2	$	—
Accrued expenses		—		0.4		—
Total current liabilities of discontinued operations	$	—	$	0.6	$	—

Note 6 – Inventories.

Merchandise inventories in the Company’s stores are valued by the retail method and are stated at the lower of cost, determined using the first-in, first-out (“FIFO”) basis, or market. Prior to shipment to a specific store, inventories are valued at the lower of cost using the FIFO basis, or market. Raw materials of $24.8 million, $24.3 million and $29.5 million are included in inventories in the condensed consolidated balance sheets at May 5, 2007, April 29, 2006, and February 3, 2007, respectively.

Note 7 – Intangible Assets.

The following is a summary of the Company’s intangible assets:

	May 5,			April 29,			February 3,
(dollars in millions)	2007			2006			2007
Intangible assets subject to amortization:
Favorable lease rights:
Gross carrying amount	$	66.1		$	74.5		$	67.2
Less: accumulated amortization		(54.1	)		(57.5	)		(54.4	)
Carrying amount, end of period		12.0			17.0			12.8
Trademarks:
Gross carrying amount		7.1			—			—
Less: accumulated amortization		(0.1	)		—			—
Carrying amount, end of period		7.0			—			—
Other Intangible Assets:
Gross carrying amount		9.5			—			0.1
Less: accumulated amortization		(0.1	)		—			—
Carrying amount, end of period		9.4			—			0.1
Total carrying amount of intangible assets subject to amortization		28.4			17.0			12.9
Indefinite-lived trademarks		67.5			1.2			26.7
Total intangible assets	$	95.9		$	18.2		$	39.6

9

The estimated useful life for each class of intangible assets is as follows:

Favorable lease rights	A weighted-average period of 14 years. Favorable lease rights are amortized over the term of the underlying lease, including renewal options in instances where failure to exercise renewals would result in an economic penalty.
Trademarks	5 to 10 years
Other intangible assets	2 to 8 years

Intangible assets subject to amortization are amortized using the straight-line method. Amortization expense on intangible assets was $0.9 million and $0.8 million for the thirteen weeks ended May 5, 2007 and April 29, 2006, respectively.

The Company expects amortization expense for the next five years to be as follows (in millions):

Year	Amount
Remainder of 2007	$	4.4
2008		4.6
2009		4.2
2010		3.3
2011		3.0

Note 8 – Long-Term Debt.

The Company maintains a $200 million senior secured revolving credit facility (the “Facility”). Funds borrowed under the Facility are secured by domestic merchandise inventory and receivables. In April 2006, the Company entered into its First Amendment to the Facility. Among other things, the amendment extends the term of the Facility until January 15, 2011, allows the Company to increase the maximum borrowing amount up to $250 million from $200 million prior to expiration of the Facility, and decreases the quarterly commitment fee payable on the unborrowed balance from 0.30% to 0.25%. The Facility bears interest at the London Inter-bank Offered Rate (“LIBOR”), plus a variable margin of 1.0% to 1.5%, or the base rate as defined in the agreement governing the Facility, based upon certain borrowing levels. The variable interest rate including the applicable variable margin at May 5, 2007, was 6.36%. No amounts were drawn on the Facility as of May 5, 2007. Based on the Company’s current borrowing base, the Company may borrow up to $156.8 million under its Facility, less $25.8 million in outstanding letters of credit as of May 5, 2007.

In July 2003, the Company sold $200.0 million of 8.25% Senior Subordinated Notes (the “Notes”) for $196.7 million, due 2013. The discount of $3.3 million is being amortized to interest expense over the life of the Notes. The Notes are guaranteed by all of the Company’s domestic subsidiaries. Interest on the Notes is payable semi-annually. The Notes contain various covenants including those that may limit the Company’s ability to pay dividends, repurchase stock, accelerate the retirement of other subordinated debt or make certain investments. As of May 5, 2007, the Company was in compliance with all covenants. As of May 5, 2007, the fair value of the Notes was $210.0 million based on recent trading activity of the Notes. On or after August 1, 2008, the Company may, on any one or more occasions, redeem all or a part of the Notes at the redemption prices set forth below, plus accrued and unpaid interest, if any, on the Notes redeemed, to the applicable redemption date:

Year	Percentage
2008		104.125	%
2009		102.750	%
2010		101.375	%
2011 and thereafter		100.000	%

10

Note 9 – Pension Plan.

The Company has a nonqualified, supplementary defined benefit plan for a select group of management employees. The plan is an unfunded, noncontributory plan and provides for benefits based upon years of service and cash compensation during employment.

Pension expense is based on information provided to an outside actuarial firm that uses assumptions to estimate the total benefits ultimately payable to each management employee and allocates this cost to service periods. The actuarial assumptions used to calculate pension expense are reviewed annually for reasonableness. The components of net periodic benefit costs for the plan were:

	13 Weeks Ended
	May 5,		April 29,
(dollars in millions)	2007		2006
Components of pension expense:
Service cost	$	0.2	$	0.2
Interest cost		0.5		0.4
Amortization of prior service cost		0.1		0.1
Amortization of actuarial loss		0.1		—
Total	$	0.9	$	0.7

Note 10 – Share-Based Compensation.

Under its equity incentive plans, the Company currently grants share appreciation vehicles consisting of stock options, stock-settled stock appreciation rights (“stock-settled SAR’s”) and cash-settled stock appreciation rights (“cash-settled SAR’s”), as well as full value vehicles consisting of nonvested shares and phantom stock units.

Stock-settled SAR’s

During the first quarter of 2007, the Company granted 677,794 stock-settled SAR’s under the 2006 Stock Incentive Plan, of which 458,069 will vest in installments over three years and 219,725 will cliff vest after three years. These grants are not subject to any performance vesting conditions.

Upon exercise of a stock-settled SAR, employees will receive a number of shares of common stock with a value equal to the appreciation in the fair market value of the underlying common stock from the grant date to the exercise date of the SAR. All of the stock-settled SAR’s issued by the Company to-date contain an appreciation cap, which limits the appreciation for which shares of common stock will be granted to 200% of the fair market value of the underlying common stock on the grant date of the SAR. As a result of the appreciation cap, a maximum of 2/3 of a share of common stock may be issued for each stock-settled SAR granted.

Nonvested Shares

During the first quarter of 2007, the Company granted 120,730 nonvested shares to certain associates under the 2006 Stock Incentive Plan. In addition to a service condition, the nonvested shares are subject to a performance condition for vesting purposes (the “performance grant”). The performance grant vests only if the performance condition is met. If the condition is satisfied, the performance grant will vest in thirds on May 31, 2008, 2009 and 2010, respectively. As of May 5, 2007, the Company has assessed the likelihood that the performance conditions will be met and has recorded the related expense based on the estimated outcome.

Cash-settled SAR’s

During the first quarter of 2007, the Company issued 36,525 cash-settled SAR’s under the Stock Appreciation and Phantom Stock Unit Plan of Payless ShoeSource, Inc. and its Subsidiaries for International Employees, of which 22,525 will vest in installments over three years and 14,000 will cliff vest after three years. These grants are not subject to any performance vesting conditions.

Fair Value

Compensation expense for appreciation vehicles is based on the fair market value as of the grant date. For nonvested share grants, compensation expense is based upon the grant date fair value (i.e. – the average of the high and low trading prices of the Company’s stock on the grant date.) The company used a binomial model to determine the fair value of share-based awards.

11

The fair value of stock-settled SAR’s granted were calculated using the following assumptions:

	13 Weeks Ended
	May 5, 2007
Risk-free interest rate		4.5	%
Expected dividend yield		—	%
Expected appreciation vehicle life (in years)		6
Weighted-average expected volatility		38	%

Risk-free interest rate – The rate is based on zero-coupon U.S. Treasury yields in effect at the date of grant, utilizing separate rates for each whole year up to the contractual term of the appreciation vehicle and interpolating for time periods between those not listed.

Expected dividend yield – the Company has not historically paid dividends and has no immediate plans to do so; as a result, the dividend yield is assumed to be zero.

Expected appreciation vehicle life – The expected life is derived from the output of the binomial lattice model and represents the period of time that the appreciation vehicles are expected to be outstanding. This model incorporates time-based early exercise assumptions based on an analysis of historical exercise patterns.

Expected Volatility –The rate used in the binomial model is based on an analysis of historical prices of the Company’s stock. The Company currently believes that historical volatility is a good indicator of future volatility.

Compensation Expense

Total share-based compensation expense of $3.1 million before tax has been included in the Company’s Condensed Consolidated Statement of Earnings for the thirteen weeks ended May 5, 2007. Included in this amount is $0.4 million of expense that was recognized as a result of the grants made in the first quarter of 2007. No amount of share-based compensation was capitalized. Total share-based compensation expense is summarized as follows:

	13 Weeks Ended
(dollars in millions, except per share amounts)	May 5, 2007			April 29, 2006
Cost of sales	$	0.9		$	0.7
Selling, general and administrative expenses		2.2			2.1
Share-based compensation expense before income taxes		3.1			2.8
Tax benefit		(1.2	)		(1.0	)
Share-based compensation expense after income taxes	$	1.9		$	1.8
Effect on:
Basic earnings per share	$	0.03		$	0.03
Diluted earnings per share	$	0.03		$	0.03

As of May 5, 2007, the Company had unrecognized compensation expense related to nonvested awards of approximately $25.7 million, which is expected to be recognized over a weighted average period of 1.8 years.

Note 11 – Income Taxes.

The Company’s effective income tax rate on continuing operations was 32.0% during the thirteen-weeks ended May 5, 2007, compared to 34.5% during the thirteen weeks ended April 29, 2006. The favorable difference in the overall effective tax rate for 2007 compared to 2006 is due to the reinstatement of certain federal employment credits during the fourth quarter of 2006, which were not in effect during the first quarter of 2006, as well as marginal benefit in the foreign tax rate differential for 2007 relative to 2006. In total for fiscal 2007, the effective income tax rate is expected to be approximately 33%, exclusive of any discrete events.

The Company adopted the provisions of FASB interpretation No 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (“FIN 48”), on February 4, 2007. In accordance with the recognition standards established by FIN 48, the Company performed a comprehensive review of potential uncertain tax positions in each jurisdiction in which the Company operates. As a result of the Company’s review, the Company adjusted the carrying amount of the liability for unrecognized tax benefits resulting in a reduction to retained earnings of $11.1 million. Upon adoption, the Company also recorded an increase to deferred tax assets of $4.2 million, an increase to other liabilities of $34.2 million, a reduction to accrued expenses of $18.0 million, and a reduction to minority interest of $0.9 million.

The Company’s liability for unrecognized tax benefits, including interest and penalties, is $34.8 million and $39.6 million as of February 4, 2007 and May 5, 2007, respectively. The portions of these balances which will favorably impact the effective tax rate if recognized is $30.6 million and $34.8 million, respectively.

12

Interest and penalties related to unrecognized tax benefits are included in income tax expense in the condensed consolidated statement of earnings. The amount of accrued interest and penalties is $5.1 million and $5.4 million as of February 4, 2007 and May 5, 2007, respectively.

Liabilities for unrecognized tax benefits are included in other liabilities, except for $0.6 million and $0.3 million, which are included in accrued expenses as of February 4, 2007 and May 5, 2007, respectively.

The Company’s U.S. federal income tax returns have been examined by the Internal Revenue Service through 2004. With limited exception, the Company is no longer subject to audits of our state and foreign income tax returns for years prior to 2001.

The Company has various state and foreign income tax returns in the process of examination or administrative appeal. To the extent that these matters conclude, it is reasonably possible that the amount of our unrecognized tax benefits will increase or decrease. However, the Company does not currently expect resolution of these matters to result in significant changes during the next twelve months.

Note 12 – Comprehensive Income.

The following table shows the computation of comprehensive income:

	13 Weeks Ended
(dollars in millions)	May 5, 2007		April 29, 2006
Net earnings	$	38.9	$	36.0
Foreign currency translation adjustments		5.2		1.5
Total comprehensive income	$	44.1	$	37.5

The changes in the Company’s cumulative foreign currency translation adjustment were not adjusted for income taxes, as they relate to specific indefinite investments in foreign subsidiaries.

Note 13 – Earnings Per Share.

Basic earnings per share are computed by dividing net earnings by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share include the effect of conversions of stock options, stock-settled SAR’s and nonvested shares. Diluted earnings per share has been computed as follows:

	13 Weeks Ended
(dollars in millions, except per share amounts; shares in thousands)	May 5, 2007		April 29, 2006
Net earnings from continuing operations	$	39.0	$	36.8
Weighted average shares outstanding — basic		64,724		66,594
Net effect of dilutive stock options		999		890
Net effect of dilutive SAR’s		110		—
Dilutive shares due to nonvested shares		168		97
Weighted average shares outstanding — diluted		66,001		67,581
Diluted earnings per share from continuing operations	$	0.59	$	0.54

The Company uses the treasury stock method for calculating the dilutive effect of employee stock options, stock-settled SAR’s and nonvested shares. These instruments will have a dilutive effect under the treasury stock method only when the respective period’s average market value of the underlying Company common stock exceeds the actual proceeds. In applying the treasury stock method, assumed proceeds include the amount, if any, the employee must pay upon exercise, the amount of compensation cost for future services that the Company has not yet recognized, and the amount of tax benefits, if any, that would be credited to additional paid-in capital assuming exercise of the options and stock-settled SAR’s and the vesting of nonvested shares. The Company excluded approximately 5,000 stock-settled SAR’s from the calculation of diluted earnings per share for the thirteen weeks ended May 5, 2007, and approximately 1.0 million stock options and stock-settled SAR’s from the calculation of diluted earnings per share for the thirteen weeks ended April 29, 2006, respectively, because to include them would be antidilutive.

13

Note 14 – Segment Reporting.

The Company and its subsidiaries are principally engaged in the operation of retail locations offering family footwear and accessories. The Company operates its business in two reportable business segments: Payless Domestic and Payless International. These segments have been determined based on internal management reporting and management responsibilities. The Payless Domestic segment includes retail operations in the United States, Guam and Saipan, sourcing operations and brand licensing and development operations. The Payless International segment includes retail operations in Canada, the South American Region, the Central American Region, Puerto Rico, and the U.S. Virgin Islands. The Company’s operations in the Central American and South American Regions are operated as joint ventures in which the Company maintains a 60% ownership interest. Minority interest represents the Company’s joint venture partners’ share of net earnings or losses on applicable international operations. Certain management costs for services performed by Payless Domestic and certain royalty fees and sourcing fees charged by Payless Domestic are allocated to the Payless International segment. These total costs and fees amounted to $6.6 million and $6.1 million during the first quarters of 2007 and 2006, respectively. The reporting period for operations in the Central and South American Regions use a December 31 year-end. The effect of this one-month lag on the Company’s financial position and results of operations is not significant. Information on the segments is as follows:

	Payless		Payless		Payless
(dollars in millions)	Domestic		International		Consolidated
13 weeks ended May 5, 2007
Revenues from external customers	$	637.3	$	91.3	$	728.6
Operating profit from continuing operations		53.1		5.7		58.8
Total assets		1,219.5		213.2		1,432.7
13 weeks ended April 29, 2006
Revenues from external customers	$	613.1	$	81.4	$	694.5
Operating profit from continuing operations		52.1		4.6		56.7
Total assets		1,169.9		164.5		1,334.4

As of February 3, 2007, total assets in the Payless Domestic and Payless International segments were $1,232.4 million and $195.0 million, respectively. Total assets for the Payless Domestic segment include $40.1 million in goodwill as of May 5, 2007 and $5.9 million in goodwill as of April 29, 2006, and February 3, 2007, respectively.

Note 15 – Commitments and Contingencies.

On or about February 5, 2004, a complaint was filed against the Company in the U.S. District Court for the Central District of California, captioned K-Swiss, Inc. v. Payless ShoeSource, Inc. The Complaint seeks injunctive relief and unspecified monetary damages for trademark and trade dress infringement, trademark dilution and unfair competition. On May 14, 2005, a First Amended Complaint was filed, to include a breach of contract claim. The Company believes it has meritorious defenses to the claims asserted in the lawsuit and has filed an answer. A pre-trial conference was held on November 13, 2006, during which the trial judge indicated that he was transferring the case to a new judge for all further proceedings. The new judge has yet to assign a new pretrial conference date or trial setting. On October 12, 2006, the Company filed a suit against St. Paul Fire and Marine Insurance Company (“St. Paul”), in Kansas state court seeking damages and a declaratory judgment that St. Paul is obligated to provide coverage in connection with the underlying lawsuit brought by K-Swiss. On October 18, 2006, St. Paul filed a separate declaratory judgment action in the U.S. District Court for the Central District of California seeking a declaration that there is no coverage for the underlying lawsuit. On November 2, 2006, St. Paul filed a Notice of Removal to remove the action from state court to the U.S. District Court for the District of Kansas and has moved to transfer the Kansas action to the U.S. District Court for the Central District of California. The Company has moved to dismiss or stay the California action filed by St. Paul, and are opposing St. Paul’s motion to transfer the Kansas action. Both motions remain pending. An estimate of the possible loss, if any, or the range of the loss cannot be made. However, the ultimate resolution of this matter could have a material adverse effect on the Company’s financial position and results of operations.

On or about December 20, 2001, a First Amended Complaint was filed against the Company in the U.S. District Court for the District of Oregon, captioned adidas America, Inc. and adidas-Salomon AG v. Payless ShoeSource, Inc. The First Amended Complaint seeks injunctive relief and unspecified monetary damages for trademark and trade dress infringement, unfair competition, deceptive trade practices and breach of contract. The Company believes it has meritorious defenses to claims asserted in the lawsuit and has filed an answer and a motion for summary judgment which the court granted in part. On June 18, 2004, the plaintiff appealed the District Court’s ruling on the motion for summary judgment. On January 5, 2006, the 9^th Circuit Court of Appeals entered an order reversing the District Court’s partial summary judgment order. The Company requested a rehearing en banc, which was denied by the 9^th Circuit Court of Appeals. On June 29, 2006, the Company filed a petition for writ of certiorari to the United States Supreme Court, which was denied on October 2, 2006. On May 9, 2007, the District Court vacated the previously scheduled trial date and established a briefing schedule for deposition motions with oral arguments to be held on August 14, 2007. No definitive trial date has been set.

14

An estimate of the possible loss, if any, or the range of loss cannot be made. However, the ultimate resolution of this matter could have a material adverse effect on The Company’s financial position and results of operations.

On or about April 3, 2006, Crocs Inc. filed two companion actions against several manufacturers of foam clog footwear asserting claims for patent infringement, trade dress infringement, and unfair competition. One complaint was filed before the United States International Trade Commission (“ITC”) in Washington D.C. The other complaint was filed in federal district court in Colorado. The Company’s wholly-owned subsidiary, Collective Licensing International LLC (“Collective”), was named as a Respondent in the ITC Investigation, and as a Defendant in the Colorado federal court action. The ITC published notice in the Federal Register on May 8, 2006, announcing that it is commencing an investigation into the allegations contained in Crocs’ complaint. In accordance with federal law, the Colorado federal court action will be stayed pending the outcome of the ITC investigation. A motion to stay the Colorado federal court action was filed on May 12, 2006. Before the ITC, Crocs seeks an order and injunction prohibiting any of the respondents from importing or selling any imported shoes that infringe on Crocs’ patent and trade dress rights. In the federal court action, which, as noted above, will be stayed, Crocs seeks damages and injunctive relief prohibiting the defendants from infringing on Crocs’ intellectual property rights. On November 7, 2006, the Administrative Law Judge entered an order granting summary judgment of non-infringement of one design patent in favor of Collective and the other remaining respondents. Further, because Crocs’ expert and fact witnesses admitted that the recent versions of the shoes of all respondents did not infringe on a separate utility patent, Crocs proposed that the trial, which was to commence on November 13, 2006, be continued pending review. All respondents agreed not to oppose Crocs’ request to continue the trial and on November 8, 2006, the Administrative Law Judge entered an order on Crocs’ motion postponing the trial indefinitely pending review of the summary judgment motion by the commission. The Company believes it has meritorious defenses to the claims asserted in the lawsuits and has filed an answer. An estimate of the possible loss, if any, or the range of loss cannot be made. However, the ultimate resolution of this matter could have a material adverse effect on the Company’s financial position and results of operations.

Note 16 – Impact of Recently Issued Accounting Standards.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” This statement defines fair value, establishes a framework for using fair value to measure assets and liabilities, and expands disclosures about fair value measurements. The statement applies whenever other standards require or permit assets or liabilities to be measured at fair value. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. The Company is evaluating the impact the adoption of SFAS No. 157 will have on the Company’s consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Liabilities.” This statement permits entities to choose to measure many financial instruments and certain other items at fair value. If the fair value option is elected, unrealized gains and losses will be recognized in earnings at each subsequent reporting date. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. The Company is evaluating the impact the adoption of SFAS No. 159 will have on the Company’s consolidated financial statements.

Note 17 – Related Party Transactions.

The Company maintains banking relationships with certain financial institutions that are affiliated with some of the Company’s Latin America joint venture partners.

Total deposits and borrowings in these financial institutions were as follows:

	May 5,		April 29,		February 3,
(dollars in millions)	2007		2006		2007
Deposits	$	3.7	$	6.8	$	7.9
Borrowings		4.0		5.1		4.0

Total interest expense was as follows:

	13 Weeks Ended
	May 5,		April 29,
(dollars in millions)	2007		2006
Interest expense	$	0.1	$	0.1

15

Note 18 – Subsequent Events.

On May 22, 2007, the Company announced that it had entered into an agreement and plan of merger (the “Merger Agreement”) with The Stride Rite Corporation (“Stride Rite”). Under the terms of the Merger Agreement, upon closing, each outstanding share of common stock, par value $0.25 per share, of Stride Rite, will be cancelled and converted into the right to receive $20.50 in cash, representing an aggregate consideration of approximately $800 million. According to its Annual Report on Form 10-K for the fiscal year ended December 1, 2006 filed with the SEC on February 13, 2007, Stride Rite had revenues of approximately $700 million for the year ended December 1, 2006. The Stride Rite acquisition is expected to close during the Company’s third fiscal quarter of 2007. The consummation of the merger is subject to customary closing conditions and regulatory approvals, including, but not limited to: (i) approval by the shareholders of Stride Rite, (ii) expiration or early termination of the waiting period applicable to the consummation of the merger under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, (iii) that no court order or other legal restraint shall be in effect which restrains or enjoins the consummation of the merger and (iv) that, subject to certain exceptions, there has been no change, event or effect that has a material adverse effect on the business, operations, assets, liabilities, properties, results of operations, or financial condition of Stride Rite and its subsidiaries, taken as a whole, since the execution of the Merger Agreement.

Concurrent with the closing of the transaction and subject to stockholder approval, the Company intends to rename itself Collective Brands, Inc.

The Company has obtained commitments for (a) the funding of up to $750 million in term loan debt to partially finance the cash merger consideration for the Stride Rite acquisition, and (b) an increase to $350 million in the size of the Company’s existing undrawn $200 million revolving credit facility. In addition to the term loan proceeds, the Company intends to utilize a portion of its existing cash and cash equivalents to fund the remaining portion of the cash merger consideration. Both the term loan and the revolving credit facility will be guaranteed by all of the direct and indirect wholly owned domestic subsidiaries of the Company (including Stride Rite and its domestic wholly owned subsidiaries) and secured by substantially all assets of the Company and the guarantors. The Company anticipates that the revolving credit facility will be undrawn as of the closing of the acquisition and thereafter will be available as needed for general corporate purposes.

Note 19 – Subsidiary Guarantors of Senior Notes – Condensed Consolidating Financial Information.

The Company has issued Notes guaranteed by all of its domestic subsidiaries (the “Guarantor Subsidiaries”). The Guarantor Subsidiaries are direct or indirect wholly owned domestic subsidiaries of the Company. The guarantees are full and unconditional, to the extent allowed by law, and joint and several.

The following supplemental financial information sets forth, on a consolidating basis, the condensed statements of earnings for the Company (the “Parent Company”), for the Guarantor Subsidiaries and for the Company’s non-guarantor subsidiaries (the “Non-guarantor Subsidiaries”) and total consolidated Payless ShoeSource, Inc. and subsidiaries for the thirteen week period ended May 5, 2007, and April 29, 2006, condensed balanced sheets as of May 5, 2007, April 29, 2006, and February 3, 2007, and the condensed statements of cash flows for the thirteen week period ended May 5, 2007, and April 29, 2006. With the exception of operations in the Central and South American Regions in which the Company has a 60% ownership interest, the Non-guarantor Subsidiaries are direct or indirect wholly-owned subsidiaries of the Guarantor Subsidiaries. The intercompany investment for each subsidiary is recorded by its parent in Other Assets.

The Non-guarantor Subsidiaries are made up of the Company’s operations in the Central and South American Regions, Canada, Saipan and Puerto Rico and the Company’s sourcing organization in Hong Kong, Taiwan, China, Indonesia and Brazil. The operations in the Central and South American Regions use a December 31 year-end. Operations in the Central and South American Regions are included in the Company’s results on a one-month lag relative to results from other regions. The effect of this one-month lag on the Company’s financial position and results of operations is not significant.

Under the indenture governing the Notes, the Company’s subsidiaries in Singapore and Japan are designated as unrestricted subsidiaries. The effect of these subsidiaries on the Company’s financial position and results of operations and cash flows is not significant.

16

CONDENSED CONSOLIDATING STATEMENTS OF EARNINGS
(UNAUDITED)
(dollars in millions)

	13 Weeks Ended May 5, 2007
	Parent			Guarantor			Non-guarantor
	Company			Subsidiaries			Subsidiaries			Eliminations			Consolidated
Net sales	$	—		$	667.2		$	233.6		$	(172.2	)	$	728.6
Cost of sales		—			438.9			190.2			(169.4	)		459.7
Gross margin		—			228.3			43.4			(2.8	)		268.9
Selling, general and administrative expenses		1.1			182.1			29.5			(2.8	)		209.9
Restructuring charges		—			0.2			—			—			0.2
Operating (loss) profit from continuing operations		(1.1	)		46.0			13.9			—			58.8
Interest expense		9.5			0.2			0.3			(5.2	)		4.8
Interest income		—			(8.8	)		(1.1	)		5.2			(4.7	)
Equity in earnings of subsidiaries		(45.7	)		(11.8	)		—			57.5			—
Earnings from continuing operations before income taxes and minority interest		35.1			66.4			14.7			(57.5	)		58.7
(Benefit) provision for income taxes		(3.8	)		20.6			2.0			—			18.8
Earnings from continuing operations before minority interest		38.9			45.8			12.7			(57.5	)		39.9
Minority interest, net of income taxes		—			—			(0.9	)		—			(0.9	)
Net earnings from continuing operations		38.9			45.8			11.8			(57.5	)		39.0
Loss from discontinued operations, net of income taxes and minority interest		—			(0.1	)		—			—			(0.1	)
Net earnings	$	38.9		$	45.7		$	11.8		$	(57.5	)	$	38.9

	13 Weeks Ended April 29, 2006
	Parent			Guarantor			Non-guarantor
	Company			Subsidiaries			Subsidiaries			Eliminations			Consolidated
Net sales	$	—		$	642.3		$	203.2		$	(151.0	)	$	694.5
Cost of sales		—			418.0			168.2			(147.5	)		438.7
Gross margin		—			224.3			35.0			(3.5	)		255.8
Selling, general and administrative expenses		1.1			176.8			24.7			(3.5	)		199.1
Operating (loss) profit from continuing operations		(1.1	)		47.5			10.3			—			56.7
Interest expense		8.9			0.6			—			(4.6	)		4.9
Interest income		—			(8.9	)		(0.5	)		4.6			(4.8	)
Equity in earnings of subsidiaries		(42.4	)		(7.1	)		—			49.5			—
Earnings from continuing operations before income taxes and minority interest		32.4			62.9			10.8			(49.5	)		56.6
(Benefit) provision for income taxes		(3.6	)		20.1			3.0			—			19.5
Earnings from continuing operations before minority interest		36.0			42.8			7.8			(49.5	)		37.1
Minority interest, net of income taxes		—			—			(0.3	)		—			(0.3	)
Net earnings from continuing operations		36.0			42.8			7.5			(49.5	)		36.8
Loss from discontinued operations, net of income taxes and minority interest		—			(0.4	)		(0.4	)		—			(0.8	)
Net earnings	$	36.0		$	42.4		$	7.1		$	(49.5	)	$	36.0

17

CONDENSED CONSOLIDATING BALANCE SHEET
(UNAUDITED)
As of May 5, 2007
(dollars in millions)

	Parent		Guarantor			Non-guarantor
	Company		Subsidiaries			Subsidiaries			Eliminations			Consolidated
ASSETS
Current Assets:
Cash and cash equivalents	$	—	$	180.6		$	140.8		$	—		$	321.4
Short-term investments		—		6.1			—			—			6.1
Restricted cash		—		—			2.0			—			2.0
Inventories		—		311.0			77.9			(7.2	)		381.7
Current deferred income taxes		—		13.8			2.4			—			16.2
Prepaid expenses		0.6		37.1			6.5			—			44.2
Other current assets		46.1		250.1			66.9			(343.9	)		19.2
Current assets of discontinued operations		—		1.0			0.1			—			1.1
Total current assets		46.7		799.7			296.6			(351.1	)		791.9
Property and Equipment:
Land		—		6.5			—			—			6.5
Property, buildings and equipment		—		1,129.5			155.3			—			1,284.8
Accumulated depreciation and amortization		—		(753.2	)		(95.4	)		—			(848.6	)
Property and equipment, net		—		382.8			59.9			—			442.7
Intangible assets, net		—		86.9			9.0			—			95.9
Deferred income taxes		—		37.6			6.3			—			43.9
Goodwill		—		34.7			5.4			—			40.1
Other assets		1,355.3		500.1			1.4			(1,838.6	)		18.2
Total Assets	$	1,402.0	$	1,841.8		$	378.6		$	(2,189.7	)	$	1,432.7
LIABILITIES AND SHAREOWNERS’ EQUITY
Current Liabilities:
Current maturities of long-term debt	$	—	$	0.3		$	—		$	—		$	0.3
Notes payable		—		—			2.0			—			2.0
Accounts payable		—		116.3			66.7			(25.5	)		157.5
Accrued expenses		193.8		224.1			63.7			(325.6	)		156.0
Current liabilities of discontinued operations		—		2.1			—			—			2.1
Total current liabilities		193.8		342.8			132.4			(351.1	)		317.9
Long-term debt		480.7		—			14.1			(293.1	)		201.7
Other liabilities		2.3		153.4			19.6			—			175.3
Minority interest		—		—			12.6			—			12.6
Commitments and contingencies
Total shareowners’ equity		725.2		1,345.6			199.9			(1,545.5	)		725.2
Total Liabilities and Shareowners’ Equity	$	1,402.0	$	1,841.8		$	378.6		$	(2,189.7	)	$	1,432.7

18

CONDENSED CONSOLIDATING BALANCE SHEET
(UNAUDITED)
As of April 29, 2006
(dollars in millions)

	Parent		Guarantor			Non-guarantor
	Company		Subsidiaries			Subsidiaries			Eliminations			Consolidated
ASSETS
Current Assets:
Cash and cash equivalents	$	—	$	264.2		$	68.8		$	—		$	333.0
Short-term investments		—		74.4			0.7			—			75.1
Restricted cash		—		—			2.0			—			2.0
Inventories		—		314.4			70.9			(7.6	)		377.7
Current deferred income taxes		—		19.1			0.2			—			19.3
Prepaid expenses		0.6		35.2			5.3			—			41.1
Other current assets		31.7		47.3			41.2			(102.1	)		18.1
Current assets of discontinued operations		—		1.3			3.6			—			4.9
Total current assets		32.3		755.9			192.7			(109.7	)		871.2
Property and Equipment:
Land		—		7.7			—			—			7.7
Property, buildings and equipment		—		1,057.1			144.7			—			1,201.8
Accumulated depreciation and amortization		—		(738.7	)		(83.2	)		—			(821.9	)
Property and equipment, net		—		326.1			61.5			—			387.6
Intangible assets, net		—		18.2			—			—			18.2
Deferred income taxes		—		19.8			9.1			—			28.9
Goodwill		—		5.9			—			—			5.9
Other assets		1,202.4		410.8			1.3			(1,593.2	)		21.3
Noncurrent assets of discontinued operations		—		—			1.3			—			1.3
Total Assets	$	1,234.7	$	1,536.7		$	265.9		$	(1,702.9	)	$	1,334.4
LIABILITIES AND SHAREOWNERS’ EQUITY
Current Liabilities:
Current maturities of long-term debt	$	—	$	0.4		$	—		$	—		$	0.4
Notes payable		—		—			2.0			—			2.0
Accounts payable		—		161.1			78.6			(64.5	)		175.2
Accrued expenses		84.2		106.0			15.4			(45.2	)		160.4
Current liabilities of discontinued operations		—		2.8			0.6			—			3.4
Total current liabilities		84.2		270.3			96.6			(109.7	)		341.4
Long-term debt		480.5		0.5			5.1			(283.2	)		202.9
Other liabilities		1.9		95.7			13.4			—			111.0
Minority interest		—		—			11.0			—			11.0
Commitments and contingencies
Total shareowners’ equity		668.1		1,170.2			139.8			(1,310.0	)		668.1
Total Liabilities and Shareowners’ Equity	$	1,234.7	$	1,536.7		$	265.9		$	(1,702.9	)	$	1,334.4

19

CONDENSED CONSOLIDATING BALANCE SHEET
(UNAUDITED)
As of February 3, 2007
(dollars in millions)

	Parent		Guarantor			Non-guarantor
	Company		Subsidiaries			Subsidiaries			Eliminations			Consolidated
ASSETS
Current Assets:
Cash and cash equivalents	$	—	$	239.4		$	132.0		$	—		$	371.4
Short-term investments		—		90.0			—			—			90.0
Restricted cash		—		—			2.0			—			2.0
Inventories		—		282.8			83.5			(4.4	)		361.9
Current deferred income taxes		—		13.2			2.4			—			15.6
Prepaid expenses		0.6		40.2			5.7			—			46.5
Other current assets		42.3		15.3			57.9			(97.4	)		18.1
Current assets of discontinued operations		—		1.0			0.1			—			1.1
Total current assets		42.9		681.9			283.6			(101.8	)		906.6
Property and Equipment:
Land		—		6.6			—			—			6.6
Property, buildings and equipment		—		1,096.7			148.4			—			1,245.1
Accumulated depreciation and amortization		—		(741.4	)		(89.1	)		—			(830.5	)
Property and equipment, net		—		361.9			59.3			—			421.2
Intangible assets, net		—		39.6			—			—			39.6
Deferred income taxes		—		31.3			6.4			—			37.7
Goodwill		—		5.9			—			—			5.9
Other assets		1,315.4		460.2			1.3			(1,760.5	)		16.4
Total Assets	$	1,358.3	$	1,580.8		$	350.6		$	(1,862.3	)	$	1,427.4
LIABILITIES AND SHAREOWNERS’ EQUITY
Current Liabilities:
Current maturities of long-term debt	$	—	$	0.4		$	—		$	—		$	0.4
Notes payable		—		—			2.0			—			2.0
Accounts payable		—		146.6			59.5			(20.5	)		185.6
Accrued expenses		175.4		32.3			63.8			(81.3	)		190.2
Current liabilities of discontinued operations		—		2.1			—			—			2.1
Total current liabilities		175.4		181.4			125.3			(101.8	)		380.3
Long-term debt		480.7		0.1			4.0			(283.1	)		201.7
Other liabilities		2.1		115.2			15.3			—			132.6
Minority interest		—		—			12.7			—			12.7
Commitments and contingencies
Total shareowners’ equity		700.1		1,284.1			193.3			(1,477.4	)		700.1
Total Liabilities and Shareowners’ Equity	$	1,358.3	$	1,580.8		$	350.6		$	(1,862.3	)	$	1,427.4

20

CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
(UNAUDITED)
(dollars in millions)

	13 Weeks Ended May 5, 2007
	Parent			Guarantor			Non-guarantor
	Company			Subsidiaries			Subsidiaries			Eliminations			Consolidated
Operating Activities:
Net earnings	$	38.9		$	45.7		$	11.8		$	(57.5	)	$	38.9
Loss from discontinued operations, net of income taxes and minority interest		—			0.1			—			—			0.1
Adjustments for non-cash items included in net earnings:
Loss on impairment of and disposal of assets		—			2.5			0.1			—			2.6
Depreciation and amortization		—			20.7			3.6			—			24.3
Amortization of deferred financing costs		0.2			—			—			—			0.2
Share-based compensation expense		—			3.0			0.1			—			3.1
Deferred income taxes		—			(2.7	)		1.4			—			(1.3	)
Minority interest, net of income taxes		—			—			0.9			—			0.9
Accretion of investments		—			(0.5	)		—			—			(0.5	)
Changes in working capital:
Inventories		—			(28.2	)		6.8			2.8			(18.6	)
Prepaid expenses and other current assets		(3.8	)		(17.8	)		(8.6	)		37.6			7.4
Accounts payable		—			(29.4	)		7.0			(5.0	)		(27.4	)
Accrued expenses		18.4			2.6			0.2			(35.4	)		(14.2	)
Other assets and liabilities, net		(41.6	)		4.0			(14.0	)		57.5			5.9
Net cash used in discontinued operations		—			(0.1	)		—			—			(0.1	)
Cash flow provided by (used in) operating activities		12.1			(0.1	)		9.3			—			21.3
Investing Activities:
Capital expenditures		—			(52.8	)		(2.9	)		—			(55.7	)
Proceeds from sale of property and equipment		—			0.1			—			—			0.1
Acquisition of business, net of cash acquired		—			(91.5	)		—			—			(91.5	)
Purchases of investments		—			(6.1	)		—			—			(6.1	)
Sales and maturities of investments		—			90.5			—			—			90.5
Cash flow used in investing activities		—			(59.8	)		(2.9	)		—			(62.7	)
Financing Activities:
Issuance of debt		—			—			—			—			—
Repayment of debt		—			(0.1	)		—			—			(0.1	)
Issuances of common stock		3.2			—			—			—			3.2
Purchases of common stock		(15.3	)		—			—			—			(15.3	)
Excess tax benefits from share-based compensation		—			1.2			—			—			1.2
Cash flow (used in) provided by financing activities		(12.1	)		1.1			—			—			(11.0	)
Effect of exchange rate changes on cash		—			—			2.4			—			2.4
(Decrease)/increase in cash and cash equivalents		—			(58.8	)		8.8			—			(50.0	)
Cash and cash equivalents, beginning of year		—			239.4			132.0			—			371.4
Cash and cash equivalents, end of quarter	$	—		$	180.6		$	140.8		$	—		$	321.4

21

CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
(UNAUDITED)
(dollars in millions)

	13 Weeks Ended April 29, 2006
	Parent			Guarantor			Non-guarantor
	Company			Subsidiaries			Subsidiaries			Eliminations			Consolidated
Operating Activities:
Net earnings	$	36.0		$	42.4		$	7.1		$	(49.5	)	$	36.0
Loss from discontinued operations, net of income taxes and minority interest		—			0.4			0.4			—			0.8
Adjustments for non-cash items included in net earnings:
Loss on impairment of and disposal of assets		—			1.6			0.1			—			1.7
Depreciation and amortization		—			19.6			3.0			—			22.6
Amortization of deferred financing costs		0.3			—			—			—			0.3
Share-based compensation expense		0.5			2.0			0.3			—			2.8
Deferred income taxes		—			(1.1	)		1.5			—			0.4
Minority interest, net of income taxes		—			—			0.3			—			0.3
Income tax benefit from share-based compensation		0.4			—			—			—			0.4
Accretion of investments		—			(0.7	)		—			—			(0.7	)
Changes in working capital:
Inventories		—			(43.1	)		(6.5	)		5.0			(44.6	)
Prepaid expenses and other current assets		(3.6	)		(0.8	)		(15.0	)		18.8			(0.6	)
Accounts payable		—			1.9			12.5			(7.7	)		6.7
Accrued expenses		32.7			(23.4	)		1.2			(16.1	)		(5.6	)
Other assets and liabilities, net		(42.1	)		(7.9	)		0.3			49.5			(0.2	)
Net cash used in discontinued operations		—			(0.7	)		(2.9	)		—			(3.6	)
Cash flow provided by (used in) operating activities		24.2			(9.8	)		2.3			—			16.7
Investing Activities:
Capital expenditures		—			(20.9	)		(2.1	)		—			(23.0	)
Proceeds from sale of property and equipment		—			1.0			—			—			1.0
Purchases of investments		—			(74.1	)		(0.7	)		—			(74.8	)
Sales and maturities of investments		—			58.9			0.5			—			59.4
Investment in subsidiaries		—			(1.5	)		—			1.5			—
Cash flow used in investing activities		—			(36.6	)		(2.3	)		1.5			(37.4	)
Financing Activities:
Repayment of debt		—			(0.1	)		(1.3	)		—			(1.4	)
Payment of deferred financing costs		—			0.2			—			—			0.2
Issuances of common stock		2.4			—			—			—			2.4
Purchases of common stock		(26.6	)		—			—			—			(26.6	)
Distributions to minority owners		—			—			(0.6	)		—			(0.6	)
Contributions by minority owners		—			—			1.0			—			1.0
Contributions by / distributions to parent		—			—			1.5			(1.5	)		—
Cash flow (used in) provided by financing activities		(24.2	)		0.1			0.6			(1.5	)		(25.0	)
Effect of exchange rate changes on cash		—			—			0.5			—			0.5
(Decrease)/increase in cash and cash equivalents		—			(46.3	)		1.1			—			(45.2	)
Cash and cash equivalents, beginning of year		—			310.5			67.7			—			378.2
Cash and cash equivalents, end of quarter	$	—		$	264.2		$	68.8		$	—		$	333.0

22

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This discussion and analysis should be read in conjunction with the Condensed Consolidated Financial Statements and Notes to the Condensed Consolidated Financial Statements included in this Form 10-Q.

Forward Looking Statements

This report contains forward-looking statements relating to such matters as anticipated financial performance, business prospects, technological developments, products, future store openings and closings, international expansion opportunities, possible strategic initiatives, new business concepts, capital expenditure plans, fashion trends, consumer spending patterns and similar matters. Statements including the words “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” or variations of such words and similar expressions are forward-looking statements. We note that a variety of factors could cause actual results and experience to differ materially from the anticipated results or expectations expressed in our forward-looking statements. The risks and uncertainties that may affect the operations, performance development and results of our business include, but are not limited to, the following: changes in consumer spending patterns; changes in consumer preferences and overall economic conditions; the impact of competition and pricing; changes in weather patterns; the financial condition of the suppliers and manufacturers; changes in existing or potential duties, tariffs or quotas and the application thereof; changes in relationships between the United States and foreign countries, changes in relationships between Canada and foreign countries; economic and political instability in foreign countries, or restrictive actions by the governments of foreign countries in which suppliers and manufacturers from whom we source are located or in which we operate stores or otherwise do business; changes in trade, intellectual property, customs and/or tax laws; fluctuations in currency exchange rates; litigation including intellectual property and employment litigation; availability of suitable store locations on acceptable terms; the ability to terminate leases on acceptable terms; the ability to hire and retain associates; performance of other parties in strategic alliances; general economic, business and social conditions in the countries from which we source products, supplies or have or intend to open stores; performance of partners in joint ventures; the ability to comply with local laws in foreign countries; threats or acts of terrorism or war; strikes, work stoppages and/or slowdowns by unions that play a significant role in the manufacture, distribution or sale of product; congestion at major ocean ports; changes in commodity prices such as oil; and changes in the value of the dollar relative to the Chinese Yuan and other currencies. For more complete discussion of these and other risks that could impact our forward-looking statements, please refer to our 2006 Annual Report on Form 10-K for the fiscal year ended February 3, 2007, including the discussion contained under “Risk Factors.” We do not undertake any obligation to release publicly any revisions to such forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

Overview

We are the largest footwear specialty retailer based upon number of locations in the western hemisphere, with 4,564 retail stores in 15 countries and territories as of the thirteen weeks ended May 5, 2007 (“first quarter”). Our Payless ShoeSource retail stores in the United States, Canada, the Caribbean, Central America, and South America sell a broad assortment of quality footwear, including athletic, casual and dress shoes, sandals, work and fashion boots, slippers, and accessories such as handbags and hosiery. Payless stores offer fashionable, quality, private and branded label footwear and accessories for women, men and children at affordable prices in a self-selection shopping format. Our stores feature several designer and mainstream footwear brands including Abaete for Payless, Airwalk^®, American Eagle™, Champion^® and Spalding^®. We seek to compete effectively by getting to market with differentiated, trend-right merchandise before mass-market discounters and at the same time as department and specialty retailers but at a more compelling value.

Our strategy focuses on four key elements: on-trend, targeted product; effective brand marketing; a great shopping experience; and efficient operations.

By offering on-trend targeted product, we successfully build a connection with our customers. We interpret fashion trends timely and translate this into on-trend product in our stores through an extensive due diligence process. Beginning about a year in advance, we review key fashion markets in Europe and the United States. We employ trend services and examine the industry’s ready-to-wear forecasts; then, we test product. By doing so, we gain valuable intelligence well in advance of the seasons’ arrival. We refine our ideas, commit to a product assortment, and display that assortment in our stores at about the same time as other fashion-conscious higher-priced competitors. Customers demand on-trend products, but have different definitions of what that means. So we inspire possibilities for the classic woman, the fashion woman, for juniors, and for children. Importantly, we believe customers can be on-trend at a great value. Customers will always find segmented pricing at Payless with good-better-best price points. Through elements of promotion and pricing tiers, we plan to maintain market share with budget-oriented shoppers while driving the opportunity to increase market share with expressive customers.

The next component of our strategy is brand marketing effectiveness, and the development of a “House of Brands” architecture in our overall Payless brand positioning. We are building, licensing and buying appropriate aspirational brands to cover our major customer segments. As we continue to increase the proportion of branded footwear in our assortment, we will have more pricing flexibility to

23

increase the average selling price per unit. In the first quarter, in collaboration with Exeter Brands Group LLC, a wholly-owned subsidiary of Nike, Inc., we launched a new brand of performance athletic shoes called Tailwind^®. This is an example of the “House of Brands” strategy that will continue to be implemented over a period of years.

Last year, we introduced two new store designs to improve our ability to showcase our merchandise, improve the in-store experience for our customers, and further support the Payless brand identity. The first design, known as “hot zone,” was the design for virtually all of our 2006 store openings. As of the end of the first quarter of 2007, we had 292 stores in this format. We anticipate about another 130 hot zones by year-end 2007. Fiscal 2006 also marked the launch of the new Payless Fashion Lab^TM concept. This store format allows customers to shop by style first rather than size. It also incorporates several improvements to the store environment such as lighting, gondolas and sight lines. As of the end of the first quarter of 2007, we had 13 fashion lab stores. We expect to open at least 10 more this year. Overall, we intend to remodel approximately 575 stores to some degree in 2007. This is a key part of our strategy, but we plan to approach investing in new store formats thoughtfully, before committing meaningful capital resources. We are also creating a great shopping experience through improved store operations execution. Our passionate and skilled store teams offer friendly helpful service. In the first quarter, we improved our conversion rate and average number of units per transaction versus the prior year period.

The last major component of our strategy is improving the efficiency of our operations. We are reviewing all of the significant operational elements of our business model; whether that entails achieving more cost effective sourcing, improving the efficiency of our supply chain and physical distribution network, or identifying productivity improvements within the four walls of our stores. Where we can realize appropriate returns on capital, we will move quickly but prudently to enhance our overall return on invested capital. An example of this strategy is our recently announced plan to shift to a dual-distribution center model. The new model will allow us to deliver more quickly on-trend, targeted product to our stores and customers. We plan to open our West Coast distribution center in California in the summer of 2007, as well as another distribution center in Ohio in the summer of 2008. Once both new distribution centers are operating satisfactorily, we plan to close our current distribution center in Topeka, Kansas.

Investing in our business will remain a top priority. These investments will take place on a variety of levels. We are increasing the total amount of capital investments driven mostly by supply chain. We will continue to invest in all elements of our business that impact the customer experience, while ensuring that an efficient supporting infrastructure is in place.

First Quarter Results

For the first quarter of 2007, total sales increased 4.9%, or $34.1 million, to $728.6 million as compared to the first quarter of the prior year. Same-store sales, one of the key indicators we consider as a measure of performance, increased 5.0% in the first quarter of 2007. Gross margin was 36.9% of sales in the first quarter of 2007, versus 36.8% in the first quarter of 2006. The improvement in gross margin resulted primarily from higher initial mark-on relative to last year.

Our cash and cash equivalents balance at the end of the 2007 first quarter was $321.4 million, a decrease of $50.0 million from the end of 2006 and a decrease of $11.6 million from the 2006 first quarter. Our short-term investments balance at the end of the 2007 first quarter was $6.1 million, a decrease of $83.9 million from the end of 2006 and a decrease of $69.0 million from the 2006 first quarter. Total inventories at the end of the 2007 first quarter were $381.7 million, an increase of $4.0 million from the 2006 first quarter. Total inventory at cost per store increased by 1.8% compared to the same period last year. We believe that our inventory is well positioned, with a low level of aged merchandise.

Acquisitions

On March 30, 2007, we acquired 100% of the partnership interest of Collective International, LP (“Collective”) for $91.5 million, net of cash acquired of $1.1 million, including transaction costs and subject to a customary purchase price adjustment. We acquired Collective, a brand development and licensing company, to further develop our “House of Brands” strategy. Collective is expected to be neutral to net earnings for fiscal 2007.

For the preliminary purchase price allocation, see Note 2, Acquisition, of the Notes to Condensed Consolidated Financial Statements, in this Quarterly Report on Form 10-Q.

On May 22, 2007, we entered into an agreement and plan of merger (“Merger Agreement”) to acquire The Stride Rite Corporation (“Stride Rite”). Under the terms of the agreement, upon closing, each outstanding share of common stock, par value $0.25 per share, of Stride Rite, will be cancelled and converted into the right to receive $20.50 in cash, representing an aggregate consideration of approximately $800 million. The consummation of the merger is subject to customary closing conditions and regulatory approvals, including, but not limited to: (i) approval by the shareholders of Stride Rite, (ii) expiration or early termination of the waiting period applicable to the consummation of the merger under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, (iii) that no court order or other legal restraint shall be in effect which restrains or enjoins the consummation of the merger and (iv) that, subject to certain exceptions, there has been no change, event or effect that has a material adverse effect on the business, operations, assets,

24

liabilities, properties, results of operations, or financial condition of Stride Rite and its subsidiaries, taken as a whole, since the execution of the Merger Agreement. For additional information on the acquisition of Stride Rite, see Note 18, Subsequent Events, of the Notes to Condensed Consolidated Financial Statements, in this Quarterly Report on Form 10-Q.

Concurrent with the closing of this transaction and subject to stockholder approval, Payless ShoeSource intends to rename itself Collective Brands, Inc. and, as a holding company, will operate three standalone business units – Payless ShoeSource, Stride Rite, and Collective Licensing.

These three standalone business units will have distinct missions in terms of their product offering, distribution channels, and target customer base:

• Payless ShoeSource — focusing on democratizing fashion and design in footwear and accessories through the Payless retail store chain;

• Stride Rite — centering on lifestyle-branded footwear and high quality children’s footwear sold primarily through wholesaling arrangements and more than 300 Stride Rite store locations; and,

• Collective Licensing International — specializing in brand management and global licensing of its expanding portfolio of youth lifestyle and high quality fashion athletic brands.

New Accounting Standards

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” This statement defines fair value, establishes a framework for using fair value to measure assets and liabilities, and expands disclosures about fair value measurements. The statement applies whenever other standards require or permit assets or liabilities to be measured at fair value. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. We are evaluating the impact the adoption of SFAS No. 157 will have on our consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Liabilities.” This statement permits entities to choose to measure many financial instruments and certain other items at fair value. If the fair value option is elected, unrealized gains and losses will be recognized in earnings at each subsequent reporting date. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. We are evaluating the impact the adoption of SFAS No. 159 will have on our consolidated financial statements.

Review Of Operations

The following discussion summarizes the significant factors affecting operating results for the first quarter ended May 5, 2007 (“2007”) compared to April 29, 2006 (“2006”).

Net Earnings

We recorded net earnings of $38.9 million in the first quarter of 2007 compared with net earnings of $36.0 million in the first quarter of 2006.

25

The following table presents the components of costs and expenses, as a percent of net sales, for the first quarter of 2007 and 2006.

	First Quarter
	2007			2006
Net sales		100.0	%		100.0	%
Cost of sales		63.1			63.2
Gross margin		36.9			36.8
Selling, general and administrative expense		28.8			28.7
Operating profit from continuing operations		8.1			8.1
Interest (income) expense, net		0.1			—
Earnings from continuing operations before income taxes and minority interest		8.0			8.1
Effective income tax rate*		32.0			34.5
Earnings from continuing operations before minority interest		5.5			5.3
Minority interest		(0.1	)		—
Earnings from continuing operations		5.4			5.3
Loss from discontinued operations, net of income taxes and minority interest		(0.1	)		(0.1	)
Net earnings		5.3	%		5.2	%

* Percent of pre-tax earnings

Net Sales

Net sales, recognized at the time the sale is made to the customer, are net of estimated returns and current promotional discounts and exclude sales tax. Same-store sales are calculated on a weekly basis. If a store is open the entire week in each of the two years being compared, its sales are included in the same-store sales calculation for that week. Relocated and remodeled stores are also included in the same-store sales calculation if they were open during the entire week in each of the two years being compared. Same-store sales for the first quarter of 2007 and 2006 exclude all stores in Japan and the South American and Central American Regions.

Sales percent increases (decreases) are as follows:

	First Quarter
	2007			2006
Net sales		4.9	%		(0.1	)%
Same-store sales		5.0			0.4
Average selling price per unit		2.1			13.2
Unit volume		3.0			(11.8	)
Footwear average selling price per unit		2.2			11.2
Footwear unit volume		3.3			(8.6	)
Non-footwear average selling price per unit		(0.2	)		7.0
Non-footwear unit volume		2.2			(23.0	)

Net sales for the 2007 first quarter totaled $728.6 million compared with $694.5 million in the 2006 first quarter. Same-store sales increased in the first quarter of 2007 from 2006, primarily due to positive performance in women’s casual and athletics, partially offset by underperformance in sandals.

Cost of Sales

Cost of sales includes cost of merchandise sold and our buying, occupancy, warehousing and product movement costs. Cost of sales was $459.7 million in the 2007 first quarter, up 4.8% from $438.7 million in the 2006 first quarter.

As a percentage of net sales, cost of sales was 63.1% in the first quarter of 2007, compared with 63.2% in the first quarter of 2006. The decrease in cost of sales as a percentage of net sales was due primarily to higher initial mark-on relative to last year, partially offset by $6.1 million (pre-tax) of costs related to our distribution center initiative. Of the $6.1 million pre-tax costs, $4.8 million represents exit costs associated with the closing of the Topeka distribution center and $1.3 million relates to start-up expenses associated with our Redlands, California distribution center.

Total exit costs related to the closing of the Topeka distribution center are currently estimated to be approximately $14 million ($4.8 million of which has been incurred in the first quarter of 2007), consisting of approximately $4 million of non-cash accelerated depreciation expenses, approximately $8 million for employee severance expenses, and approximately $2 million related to other exit

26

costs. The majority of the remaining exit costs will be recognized over the period until the Topeka distribution center is closed. Actual results could vary from these estimates.

Selling, General and Administrative Expenses

Selling, general and administrative expenses were $209.9 million in the first quarter of 2007, an increase of 5.4% from $199.1 million in the first quarter of 2006.

As a percentage of net sales, selling, general and administrative expenses were 28.8% during the first quarter of 2007 compared with 28.7% in the first quarter of 2006. The increase, as a percentage of net sales, primarily reflects the result of 0.4 percentage points of additional costs for advertising and a 0.1 percentage point increase in credit card fees, partially offset by a 0.5 percentage point reduction in payroll and related costs.

Interest (Income) Expense

Interest income and expense components were:

	First Quarter
(dollars in millions)	2007			2006
Interest expense	$	4.8		$	4.9
Interest income		(4.7	)		(4.8	)
Interest expense, net	$	0.1		$	0.1

Interest expense in the first quarter of 2007 decreased due primarily to a reduction in debt. Interest income in the first quarter of 2007 decreased due primarily to a decrease in average cash and cash equivalents and short-term investments balances. The net change in interest (income) expense was flat in the first quarter of 2007 compared with the first quarter of 2006.

Income Taxes

Our effective income tax rate on continuing operations was 32.0% during the first quarter of 2007 compared to 34.5% in the first quarter of 2006. The difference in the overall effective tax rate for 2007 compared to 2006 relates primarily to the reinstatement of certain federal employment credits during the fourth quarter of 2006, which were not in effect during the first quarter of 2006, as well as marginal benefit in the foreign tax rate differential for 2007 relative to 2006. In total for fiscal 2007, the effective income tax rate is expected to be approximately 33%, exclusive of any discreet events. For additional information regarding our income taxes, please see Note 11, Income Taxes, of the Notes to Condensed Consolidated Financial Statements in this Quarterly Report on Form 10-Q.

Minority Interest, Net of Income Taxes

Minority interest represents our joint venture partners’ share of net earnings or losses on applicable international operations.

Discontinued Operations

Discontinued operations include Parade and Japan retail operations. The loss from discontinued operations of $0.1 million, net of income taxes, during the first quarter of 2007 relates to lease termination costs associated with the exit from Parade. The loss from discontinued operations of $0.8 million, net of income taxes and minority interest, during the first quarter of 2006 relates to lease termination costs associated with the exit from Parade as well as Japan operating losses.

International Segment Operating Results

Our international segment includes retail operations in Canada, the Central and South American Regions, Puerto Rico and the U.S. Virgin Islands. The following table summarizes the operating results of the international segment:

	First Quarter
	2007		2006
Revenues from external customers	$	91.3	$	81.4
Operating profit from continuing operations		5.7		4.6

In general, gross margin percentages in our international segment exceed those in the domestic segment. Also, as a percent of revenue, our selling, general and administrative expenses in the international segment are lower than in the domestic segment

27

primarily due to lower payroll-related expenses. Therefore, as a percentage of revenue, operating profits in our international segment exceed those in our domestic segment.

The increase in operating profit from continuing operations from the first quarter of 2006 to the first quarter of 2007 is primarily due to increased sales and improved gross margin percentages in Latin America.

Store Activity

As of May 5, 2007, we operated 4,564 retail shoe stores offering quality footwear and accessories in all 50 of the United States, the District of Columbia, Puerto Rico, Guam, Saipan, the U.S. Virgin Islands, Canada, and the Central and South American Regions. The following table presents the change in store count for the entire company for the first quarter 2007 and 2006. We consider a store relocation to be both a store opening and a store closing.

	First Quarter
	2007			2006
Beginning of period		4,572			4,605
Stores opened		15			52
Stores closed		(23	)		(55	)
Ending store count		4,564			4,602

As of May 5, 2007, we operated 154 stores in the Central America Region, 31 stores in the South America Region and 316 stores in Canada.

Liquidity and Capital Resources

We ended the first quarter of 2007 with a cash and cash equivalents balance of $321.4 million, a decrease of $11.6 million over the 2006 first quarter, and short-term investments of $6.1 million, a decrease of $69.0 million over the 2006 first quarter due to the acquisition of Collective. Internally generated cash flow from operations is expected to continue to be the most important component of our capital resources.

As of May 5, 2007, our foreign subsidiaries and joint ventures had $136.9 million in cash located in financial institutions outside of the United States. A portion of this cash represents undistributed earnings of our foreign subsidiaries, which are indefinitely reinvested. In the event of a distribution to the U.S., those earnings would be subject to U.S. federal and state income taxes, net of foreign tax credits.

We have received a joint commitment letter from two lenders to provide a senior secured term loan to fund up to $750 million for the Stride Rite acquisition. The term loan will bear interest based on the London Inter-bank Offered Rate (“LIBOR’) of one, two, three or six months, plus an applicable margin or the base rate as defined in the commitment letter. All of our direct and indirect wholly owned domestic subsidiaries will guarantee the term loan. We expect our leverage ratio to return to pre-acquisition levels within two to three years of the acquisition’s consummation.

Cash Flow Provided by Operating Activities

Cash flow provided by operations was $21.3 million in the first quarter of 2007, compared with $16.7 million for the same period in 2006. As a percentage of net sales, cash flow from operations was 2.9% in the first quarter of 2007, compared with 2.4% in the same period in 2006. The significant changes in cash flow during the 2007 first quarter as compared with the 2006 period relate to higher net earnings and net positive cash flow from working capital changes including inventories, prepaid expenses and other current assets.

Cash Flow Used in Investing Activities

In the 2007 first quarter, we acquired 100% of the partnership interest of Collective International, LP for $91.5 million, net of cash acquired, including transaction costs. Our capital expenditures totaled $55.7 million during the first quarter of 2007, compared with $23.0 million for the same period in 2006. Total capital expenditures for 2007 are expected to be approximately $160 million. We intend to use internal cash flow and available financing from our $200 million revolving credit agreement to finance all of these expenditures.

28

Cash Flow Used in Financing Activities

The Company has made the following common stock repurchases:

	First Quarter
	2007				2006
(dollars in millions, shares in thousands)	Dollars		Shares		Dollars		Shares
Stock repurchase program	$	15.2		454	$	26.4		1,193
Employee stock purchase, deferred compensation and stock incentive plans		0.1		4		0.2		7
	$	15.3		458	$	26.6		1,200

Under the indenture governing our 8.25% Senior Subordinated Notes, we may repurchase approximately an additional $19.5 million of common stock. This limit may increase or decrease on a quarterly basis based upon our net earnings. As of May 5, 2007, we had approximately $274.1 million of remaining common stock repurchase authorization from our Board of Directors.

We maintain a $200 million senior secured revolving credit facility (the “Facility”). Funds borrowed under the Facility are secured by domestic merchandise inventory and receivables. In April 2006, we entered into our First Amendment to the Facility. Among other things, the amendment extends the term of the Facility until January 15, 2011, allows us to increase the maximum borrowing amount up to $250 million from $200 million prior to expiration of the Facility, and decreases the quarterly commitment fee payable on the unborrowed balance from 0.30% to 0.25%. The Facility bears interest at the London Inter-bank Offered Rate (“LIBOR”), plus a variable margin of 1.0% to 1.5%, or the base rate as defined in the agreement governing the Facility, based upon certain borrowing levels. The variable interest rate including the applicable variable margin at May 5, 2007, was 6.36%. No amounts were drawn on the Facility as of May 5, 2007. Based on our current borrowing base, we may borrow up to $156.8 million under our Facility, less $25.8 million in outstanding letters of credit as of May 5, 2007.

In connection with the Stride Rite acquisition, we have received a joint commitment letter from two lenders to increase the size of our Facility to $350 million. This $350 million dollar Facility will bear interest based on the LIBOR floating rate plus a variable margin of 0.875% to 1.50% or the base rate as defined in the commitment letter.

In July 2003, we sold $200.0 million of 8.25% Senior Subordinated Notes (the “Notes”) for $196.7 million, due 2013. The discount of $3.3 million is being amortized to interest expense over the life of the Notes. The Notes are guaranteed by all of our domestic subsidiaries. Interest on the Notes is payable semi-annually. The Notes contain various covenants including those that may limit our ability to pay dividends, repurchase stock, accelerate the retirement of other subordinated debt or make certain investments. As of May 5, 2007, we were in compliance with all covenants. As of May 5, 2007, the fair value of the Notes was $210.0 million based on recent trading activity of the Notes. On or after August 1, 2008, we may, on any one or more occasions, redeem all or a part of the Notes at the redemption prices set forth below, plus accrued and unpaid interest, if any, on the Notes redeemed, to the applicable redemption date:

Year	Percentage
2008		104.125	%
2009		102.750	%
2010		101.375	%
2011 and thereafter		100.000	%

We have entered into $2.0 million of demand notes payable to efficiently finance our subsidiaries in the Central American Region. We maintain cash balances of $2.0 million in a certificate of deposit as a compensating balance to collateralize the notes payable. The notes payable accrue interest at a rate of 6.75%. The certificate of deposit earns interest at a rate of 6.00% and is reflected as restricted cash in the accompanying condensed consolidated balance sheet.

We believe that our liquid assets, cash generated from operations and the Facility will provide us with sufficient funds for capital expenditures, repurchases of our common stock and other operating activities for the next twelve months and thereafter for the foreseeable future.

29

Financial Commitments

During the first quarter of 2007, we entered into a lease agreement related to our new Ohio distribution center. The lease, which is expected to commence in early 2008, has a base term of fifteen years. The following summarizes annual rent expense per year under the lease:

(dollars in millions)
Years 1-5	$	2.5
Years 6-10		2.8
Years 11-15		3.0

On May 22, 2007, we entered into the “Merger Agreement” with Stride Rite. Under the terms of the Merger Agreement, upon closing, each outstanding share of common stock, par value $0.25 per share, of Stride Rite, will be cancelled and converted into the right to receive $20.50 in cash, representing an aggregate consideration of approximately $800 million. The Stride Rite acquisition, which is subject to customary closing conditions and regulatory approvals, as well as approval by the shareholders of Stride Rite, is expected to close during the third fiscal quarter of 2007. For additional information on the acquisition, see the discussion under this Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and Note 18, Subsequent Events, of the Notes to Condensed Consolidated Financial Statements, in this Quarterly Report on Form 10-Q.

In conjunction with the adoption of FIN 48, our liability for unrecognized tax benefits, including interest and penalties, is $39.6 million as of May 5, 2007. Of this amount, we estimate that $0.3 million will be paid in less than one year. We are unable to make a reasonably reliable estimate of the amount and period of related future payments on the remaining balance.

For a discussion of our other contractual obligations, see a discussion of future commitments under Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” in our Form 10-K for the fiscal year ended February 3, 2007. With the exception of the new distribution center lease, the Stride Rite acquisition and the liability for unrecognized tax benefits, there have been no significant developments with respect to our contractual obligations since February 3, 2007.

Financial Condition Ratios

A summary of key financial information for the periods indicated is as follows:

	May 5,			April 29,			February 3,
	2007			2006			2007
Current Ratio		2.5			2.6			2.4
Debt-capitalization Ratio*		22.0	%		23.6	%		22.6	%

* Debt-to-capitalization has been computed by dividing total debt by capitalization. Total debt is defined as long-term debt including current maturities, notes payable and borrowings under the revolving line of credit. Capitalization is defined as total debt and shareowners’ equity. The debt-to-capitalization ratio, including the present value of future minimum rental payments under operating leases as debt and as capitalization, was 62.7%, 64.2% and 63.5% respectively, for the periods referred to above.

Critical Accounting Policies

In accordance with accounting for business combinations under SFAS No. 141 “Business Combinations,” we allocate the purchase price of an acquired business to its identifiable assets and liabilities based on estimated fair values. The excess of the purchase price over the amount allocated to the assets and liabilities, if any, is recorded as goodwill.

We use all available information to estimate fair values. We typically engage outside appraisal firms to assist management in the fair value determination of identifiable intangible assets such as tradenames, and any other significant assets or liabilities. We adjust the preliminary purchase price allocation, as necessary, up to one year after the acquisition closing date as we obtain more information regarding asset valuations and liabilities assumed.

Our purchase price allocation methodology contains uncertainties because it requires management to make assumptions and to apply judgment to estimate the fair value of acquired assets and liabilities. Management estimates the fair value of assets and liabilities based upon quoted market prices, the carrying value of the acquired assets and widely accepted valuation techniques, including discounted cash flows. Unanticipated events or circumstances may occur which could affect the accuracy of our fair value estimates, including assumptions regarding industry economic factors and business strategies.

30

In July 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FAS 109, Accounting for Income Taxes” (“FIN 48”), which became effective for us beginning in 2007. FIN 48 addresses the determination of how tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements. Under FIN 48, we must recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. Our estimates of the tax benefit from uncertain tax positions may change in the future due to new developments in each matter.

For more information regarding our critical accounting policies, estimates and judgments, see the discussion under Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Form 10-K for the year ended February 3, 2007.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Risk

Interest on our senior secured revolving credit facility, which is entirely comprised of a revolving line of credit, is based on the London Inter-Bank Offered Rate (“LIBOR”) plus a variable margin of 1.0% to 1.5%, or the base rate, as defined in the credit agreement. There are no outstanding borrowings on the revolving line of credit at May 5, 2007; however, if we were to borrow against our revolving line of credit, borrowing costs may fluctuate depending upon the volatility of LIBOR.

Foreign Currency Risk

We have retail operations in foreign countries; therefore, our cash flows in U.S. dollars are impacted by fluctuations in foreign currency exchange rates. We adjust our retail prices, when possible, to reflect changes in exchange rates to mitigate this risk. To further mitigate this risk, we may, from time to time, enter into forward contracts to purchase or sell foreign currencies. For the three months ended May 5, 2007, and April 29, 2006, fluctuations in foreign currency exchange rates did not have a material impact on our operations or cash flows and we did not enter into any forward contracts to purchase or sell foreign currencies.

In the first quarter of 2007, approximately 94% of our footwear, based on cost, was sourced from the People’s Republic of China (the “PRC”). The national currency of the PRC, the Yuan, is currently not a freely convertible currency. The value of the Yuan depends to a large extent on the PRC government’s policies and upon the PRC’s domestic and international economic and political developments. Since 1994, the official exchange rate for the conversion of the PRC’s currency was pegged to the U.S. dollar at a virtually fixed rate of approximately 8.28 Yuan per U.S. dollar. However, during 2005, the PRC’s government revalued the Yuan and adopted a more flexible system based on a trade-weighted basket of foreign currencies of the PRC’s main trading partners. Under the new “managed float” policy, the exchange rate of the Yuan may shift each day up to 0.5% in either direction from the previous day’s close, and as a result, the valuation of the Yuan may increase incrementally over time should the PRC central bank allow it to do so, which could significantly increase the cost of the products we source from the PRC. As of May 4, 2007, the last day of trading in our quarter, the exchange rate was 7.72 Yuan per U.S. dollar. The U.S. dollar continues to weaken and as of June 1, 2007, the exchange rate was 7.66 Yuan per U.S. dollar.

ITEM 4. CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

Our management is responsible for establishing disclosure controls and procedures that are designed to ensure that information required to be disclosed in our periodic Securities Exchange Act of 1934 reports is recorded, processed, summarized and reported within the time periods specified in the Securities Exchange Commission’s (“SEC”) rules and forms and that such information is accumulated and communicated to our management, including the Chief Executive Officer and the Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures.

As of the end of the period covered by this Form 10-Q, we carried out an evaluation, under the supervision and with the participation of our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) are effective and designed to ensure that information required to be disclosed in periodic reports filed with the SEC is recorded, processed, summarized and reported within the time period specified. Our principal executive officer and principal financial officer also concluded that our controls and procedures were effective in ensuring that information required to be disclosed by us in the reports that we file or submit under the Act is accumulated and communicated to management including our principal executive officer and principal financial officer, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

31

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting during the first quarter of fiscal year 2007 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II – OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

Other than as described below, there are no material pending legal proceedings other than ordinary, routine litigation incidental to the business to which we are a party or of which any of our property is subject.

On or about February 5, 2004, a complaint was filed against us in the U.S. District Court for the Central District of California, captioned K-Swiss, Inc. v. Payless ShoeSource, Inc. The Complaint seeks injunctive relief and unspecified monetary damages for trademark and trade dress infringement, trademark dilution and unfair competition. On May 14, 2005, a First Amended Complaint was filed, to include a breach of contract claim. We believe we have meritorious defenses to the claims asserted in the lawsuit and have filed an answer. A pre-trial conference was held on November 13, 2006, during which the trial judge indicated that he was transferring the case to a new judge for all further proceedings. The new judge has yet to assign a new pretrial conference date or trial setting. On October 12, 2006, we filed a suit against St. Paul Fire and Marine Insurance Company (“St. Paul”), in Kansas state court seeking damages and a declaratory judgment that St. Paul is obligated to provide coverage in connection with the underlying lawsuit brought by K-Swiss. On October 18, 2006, St. Paul filed a separate declaratory judgment action in the U.S. District Court for the Central District of California seeking a declaration that there is no coverage for the underlying lawsuit. On November 2, 2006, St. Paul filed a Notice of Removal to remove the action from state court to the U.S. District Court for the District of Kansas and has moved to transfer the Kansas action to the U.S. District Court for the Central District of California. We have moved to dismiss or stay the California action filed by St. Paul, and are opposing St. Paul’s motion to transfer the Kansas action. Both motions remain pending. An estimate of the possible loss, if any, or the range of the loss cannot be made. However, the ultimate resolution of this matter could have a material adverse effect on our financial position and results of operations.

On or about December 20, 2001, a First Amended Complaint was filed against us in the U.S. District Court for the District of Oregon, captioned adidas America, Inc. and adidas-Salomon AG v. Payless ShoeSource, Inc. The First Amended Complaint seeks injunctive relief and unspecified monetary damages for trademark and trade dress infringement, unfair competition, deceptive trade practices and breach of contract. We believe we have meritorious defenses to claims asserted in the lawsuit and have filed an answer and a motion for summary judgment which the court granted in part. On June 18, 2004, the plaintiff appealed the District Court’s ruling on the motion for summary judgment. On January 5, 2006, the 9^th Circuit Court of Appeals entered an order reversing the District Court’s partial summary judgment order. We requested a rehearing en banc, which was denied by the 9^th Circuit Court of Appeals. On June 29, 2006, we filed a petition for writ of certiorari to the United States Supreme Court, which was denied on October 2, 2006. On May 9, 2007, the District Court vacated the previously scheduled trial date and established a briefing schedule for deposition motions with oral arguments to be held on August 14, 2007. No definitive trial date has been set. An estimate of the possible loss, if any, or the range of loss cannot be made. However, the ultimate resolution of this matter could have a material adverse effect on our financial position and results of operations.

On or about April 3, 2006, Crocs Inc. filed two companion actions against several manufacturers of foam clog footwear asserting claims for patent infringement, trade dress infringement, and unfair competition. One complaint was filed before the United States International Trade Commission (“ITC”) in Washington D.C. The other complaint was filed in federal district court in Colorado. Our wholly-owned subsidiary, Collective Licensing International LLC (“Collective”), was named as a Respondent in the ITC Investigation, and as a Defendant in the Colorado federal court action. The ITC published notice in the Federal Register on May 8, 2006, announcing that it is commencing an investigation into the allegations contained in Crocs’ complaint. In accordance with federal law, the Colorado federal court action will be stayed pending the outcome of the ITC investigation. A motion to stay the Colorado federal court action was filed on May 12, 2006. Before the ITC, Crocs seeks an order and injunction prohibiting any of the respondents from importing or selling any imported shoes that infringe on Crocs’ patent and trade dress rights. In the federal court action, which, as noted above, will be stayed, Crocs seeks damages and injunctive relief prohibiting the defendants from infringing on Crocs’ intellectual property rights. On November 7, 2006, the Administrative Law Judge entered an order granting summary judgment of non-infringement of one design patent in favor of Collective and the other remaining respondents. Further, because Crocs’ expert and fact witnesses admitted that the recent versions of the shoes of all respondents did not infringe a separate utility patent, Crocs proposed that the trial, which was to commence on November 13, 2006, be continued pending review. All respondents agreed not to oppose Crocs’ request to continue the trial and on November 8, 2006, the Administrative Law Judge entered an order on Crocs’ motion postponing the trial indefinitely pending review of the summary judgment motion by the commission. We believe we have meritorious defenses to the claims asserted in the lawsuits and have filed an answer. An estimate of the possible loss, if any, or the range of loss cannot be made. However, the ultimate resolution of this matter could have a material adverse effect on our financial position and results of operations.

32

ITEM 1A. RISK FACTORS

There are risks associated with our acquisitions.

Any acquisitions or mergers by us will be accompanied by the risks commonly encountered in acquisitions of companies. These risks include, among other things, higher than anticipated acquisition costs and expenses, the difficulty and expense of integrating the operations and personnel of the companies and the loss of key employees and customers as a result of changes in management.

In addition, geographic distances may make integration of acquired businesses more difficult. We may not be successful in overcoming these risks or any other problems encountered in connection with any acquisitions.

Our acquisitions may cause large one-time expenses or create goodwill or other intangible assets that could result in significant asset impairment charges in the future. We also make certain estimates and assumptions in order to determine purchase price allocation and estimate the fair value of acquired assets and liabilities. If our estimates or assumptions used to value acquired assets and liabilities are not accurate, we may be exposed to gains or losses that may be material.

There is no assurance that the acquisition of Stride Rite will be completed.

On May 22, 2007, we entered into the Merger Agreement. There is no assurance that the Merger Agreement and the merger will be approved by the shareholders of Stride Rite, and there is no assurance that the other conditions to the completion of the merger will be satisfied. While we expect to complete the acquisition during our third quarter of 2007, its consummation is subject to a number of conditions which must either be satisfied or, in certain cases, waived, including, but not limited to:

• the merger must be approved by the shareholders of Stride Rite;

• the waiting period applicable to the consummation of the merger under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 shall have been expired or earlier terminated;

• no court order or other legal restraint shall be in effect which restrains or enjoins the consummation of the merger; and

• subject to certain exceptions, no change, event or effect that has a material adverse effect on the business, operations, assets, liabilities, properties, results of operations, or financial condition of Stride Rite and its subsidiaries, taken as a whole, shall have occurred since the execution of the Merger Agreement.

We cannot assure you that all such conditions will be satisfied or waived on a timely basis or that, accordingly, the merger will be completed.

In addition, we or Stride Rite may terminate the Merger Agreement in certain circumstances related to the receipt of a takeover proposal from a third party. Under certain circumstances, Stride Rite may be required to pay us a termination fee of $23 million.

There are additional risks associated with the pending acquisition of Stride Rite.

In connection with the merger, we will be subject to several risks, including the following:

• the current market price of our common stock may reflect a market assumption that the merger will occur, and failure to complete the merger could result in a decline in the market price of our common stock;

• certain costs relating to the merger, such as legal, accounting and financial advisory fees, are payable by us whether or not the merger is completed; and

• there may be substantial disruption to our business and distraction of our management and employees from day-to-day operations, because matters relating to the merger may require substantial commitments of their time and resources.

Other than the above, there have been no material changes in our risk factors from those disclosed in our 2006 Annual Report on Form 10-K.

33

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

On May 4, 2007, 7,360 shares were credited to Director’s accounts under the Company’s Restricted Stock Plan for Non-Management Directors as the annual restricted stock grant portion of their director’s fees. Each director is permitted to defer receipt of a portion of their compensation including their annual restricted stock grant pursuant to the Company’s Deferred Compensation Plan for Non-Management Directors. Non-Management Directors also deferred an aggregate of 8,832 shares under the Deferred Compensation Plan for Non-Management Directors, which they would have otherwise been entitled to receive as part of their director fee. These grants were made as partial compensation for the recipients’ services as directors. The offer and issuance of these securities are exempt from registration under Section 4(2) of the Securities Act of 1933 and the rules and regulations promulgated thereunder, as transaction by an issuer not involving any public offering or alternatively, registration of such shares was not required because their issuance did not involve a “sale” under Section 2(3) of the Securities Act of 1933.

Issuer Purchases of Equity Securities

The following table provides information about purchases by us (and our affiliated purchasers) during the quarter ended May 5, 2007, of equity securities that are registered by us pursuant to Section 12 of the Exchange Act:

							Approximate
							Dollar Value
					Total Number of		of Shares that
					Shares Purchased		May Yet Be
	Total Number		Average		as Part of Publicly		Purchased Under
	of Shares		Price		Announced Plans		the Plans or
	Purchased(1)		Paid per		or Programs		Programs
Period	(in thousands)		Share		(in thousands)		(in millions)
02/04/07 — 03/03/07		1	$	35.05		—	$	289.3
03/04/07 — 04/07/07		57		32.49		56		287.5
04/08/07 — 05/05/07		400		33.55		398		274.1
Total		458	$	34.42		454	$	274.1	(2)

(1)

Includes an aggregate of approximately four thousand shares of our common stock that was repurchased in connection with our employee stock purchase and stock incentive plans.

(2)

In 2001, our Board of Directors approved the repurchase of our common stock having a value of up to $250 million in the aggregate pursuant to the Program. On March 6, 2007, we announced that on March 2, 2007, our Board of Directors authorized an aggregate of $250 million of share repurchases. The timing and amount of share repurchases, if any, are limited by the terms of our Credit Agreement and Senior Subordinated Notes.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

(a)	The Annual Meeting of Stockholders of the Registrant was held on May 24, 2007.
(b)	At the Annual Meeting of Stockholders of the Registrant held on May 24, 2007, action was taken with respect to the election of three directors of the Registrant: 59,986,621 shares were voted for Daniel Boggan Jr. while authority was withheld with respect to 494,927 shares, 59,865,644 shares were voted for Michael A. Weiss while authority was withheld with respect to 615,904 shares, and 59,856,216 shares were voted for Robert C. Wheeler while authority was withheld with respect to 625,332 shares. Other directors whose term of office continued after the meeting include Howard Fricke, Matthew E. Rubel, Judith K. Hofer, Mylle B. Mangum, John F. McGovern, Robert F. Moran, and D. Scott Olivet. Mr. Michael E. Murphy retired at the end of his current term, which expired at the May 24, 2007 Annual Meeting of Stockholders.
(c)	Stockholders ratified the appointment of Deloitte & Touche LLP as the Company’s independent registered public accounting firm: 60,098,950 votes in favor, 329,868 votes against and 52,730 votes abstaining; approved the amendments to and restatement of the 2006 Payless ShoeSource, Inc. Stock Incentive Plan with 44,864,856 votes in favor, 7,620,373 votes against and 119,091 votes abstaining, and approved the amendment to and restatement of the Payless ShoeSource, Inc. Incentive Compensation Plan with 58,835,228 votes in favor, 1,429,844 votes against and 132,421 votes abstaining.

34

ITEM 6. EXHIBITS

(a) Exhibits:

Number	Description
10.1	Employment Agreement with William E. May entered into as of April 23, 2007.
31.1	Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of the Chief Executive Officer and President*
31.2	Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of the Senior Vice President, Chief Financial Officer and Treasurer*
32.1	Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 of the Chief Executive Officer and President*
32.2	Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 of the Senior Vice President, Chief Financial Officer and Treasurer*

* Filed herewith

35

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

PAYLESS SHOESOURCE, INC.

Date: June 13, 2007	By:	/s/ Matthew E. Rubel
	Matthew E. Rubel Chief Executive Officer and President (Principal Executive Officer)
Date: June 13, 2007	By:	/s/ Ullrich E. Porzig
	Ullrich E. Porzig Senior Vice President — Chief Financial Officer and Treasurer (Principal Financial and Accounting Officer)

36

EX-10.1

EXHIBIT 10.1

EMPLOYMENT AGREEMENT

     THIS AGREEMENT (the “Agreement”) is made and entered into as of the 23rd of April, 2007, by and between PAYLESS SHOESOURCE, INC., a Delaware corporation, (“Payless”) and William E. May (“Executive”). The renewal date of this Agreement is May 31, 2009, for the first Renewal Date and May 31 of each calendar year thereafter (the “Renewal Date”).

     In consideration of mutual promises and agreements set forth in this Agreement, Payless and Executive agree as follows:

1. (a) Payless and/or its subsidiaries and affiliates agree to employ Executive, and Executive agrees to render personal services to Payless, for the period commencing on the date of this Agreement through May 31, 2009, (the “Contract Term”) as Executive Vice President-Chief Operating Officer of Payless and/or to perform such other executive duties as may from time to time be required of Executive by Payless. Upon the Renewal Date of this Agreement, the Contract Term shall automatically be extended by one (1) year unless, within 30 days of the Renewal Date, Payless shall deliver to Executive, or Executive shall deliver to Payless, written notice that the Contract Term shall not be extended.

     (b) Payless agrees to pay Executive basic compensation for such services during the Contract Term at the annual rate of $600,000, payable in equal bi-weekly installments, and in accordance with Paragraph 5, which annual rate will be subject to an annual review during Payless’ regularly scheduled review time.

     (c) Executive shall be eligible to participate in such annual and long-term cash incentive bonus programs and arrangements established from time to time for executives of Payless (the “Incentive Plans”), in accordance with and subject to all of the terms and provisions of such Incentive Plans.

     (d) Payless shall reimburse Executive for all items of normal expense incurred by Executive as an employee of Payless in accordance with Payless’ reimbursement policies in effect from time to time.

     (e) Payless has adopted certain employee benefit plans and has established certain arrangements concerning executive perquisites which may, from time to time, confer rights and benefits on Executive in accordance with their terms, and Payless may, in the future, adopt additional employee benefit plans and establish additional arrangements concerning executive perquisites, and may in the future amend, modify or terminate any of the aforesaid employee benefit plans and arrangements, all in accordance with their terms and in accordance with applicable law. Executive shall be entitled to whatever rights and benefits may be conferred on Executive, from time to time in accordance with the terms of such plans and arrangements, as they may be amended from time to time, independent of this Agreement.

     (f) Executive will be eligible for future grants of restricted stock, stock-settled appreciation rights, and stock options, if any, as may be made under the terms of the Payless ShoeSource, Inc. Stock Incentive Plan, in accordance with the criteria established from time to time by the Compensation Committee of Payless ShoeSource, Inc. Board of Directors.

     (g) All references to payment dates or vesting dates in this Paragraph 1 or in such plans and arrangements, shall require that Executive be employed by Payless on such date to receive such payment or be vested in such benefit.

2. (a) At all times during the Contract Term, Executive will:

     (i) faithfully and diligently perform Executive’s duties in conformity with the directions of Payless and serve Payless to the best of Executive’s ability;

     (ii) devote Executive’s undivided time and attention to the business of Payless, subject to reasonable vacations in accordance with Payless’ vacation policy as it applies from time to time, to such extent as may be reasonably necessary for the proper performance of the personal services to be rendered by Executive under this Agreement;

     (iii) maintain Executive’s residence within reasonable access to the Corporate Headquarters of Payless for the Contract Term.

(b) At all times during the Contract Term, Executive will not:

     (i) engage in any activity which conflicts or interferes with or adversely affects Executive’s performance of Executive’s duties hereunder, or

     (ii) accept any other employment, whether as an Executive or as a consultant or in any other capacity, and whether or not compensated therefor, or

     (iii) violate the terms of any of the policies described in Payless’ Policy of Business Conduct distributed from time to time to Executive.

3. (a) At all times during the Contract Term and for a period of one (1) year immediately following Executive’s last day of employment with Payless or, if there is more than one (1) year remaining in the Contract Term at the time of termination of employment, for the remainder of the Contract Term, Executive will not directly or indirectly:

     (i) own, manage, operate, finance, join, control, or participate in the ownership, management, operation, financing or control of, or be employed by any Competing Business(as defined below), or

     (ii) solicit for employment, hire or offer employment to, or disclose information to or otherwise aid or assist any person or entity other than Payless or any subsidiary of Payless in

2

soliciting for employment, hiring or offering employment to, any employee of Payless or any subsidiary of Payless, or

     (iii) take any action which is intended to harm Payless or its reputation, which Payless reasonably concludes could harm Payless or its reputation or which Payless reasonably concludes could lead to unwanted or unfavorable publicity to Payless.

     Nothing in this Pargaraph 3(a) shall prevent Executive, however, from performing Executive’s duties and responsibilities for Payless. In addition, ownership of an investment of less than the greater of $25,000 or 1% of any class of equity or debt security of a Competing Business shall not constitute ownership or participation in ownership in violation of Paragraph 3(a)(i).

(b) The term “Competing Business” shall include, but not be limited to,

     (i) any retail business with gross sales or revenue in the prior fiscal year of more than $25 million (or which is a subsidiary, affiliate or joint venture partner of a business with gross sales or revenue in the prior fiscal year of more than $25 million) which sells footwear at retail to consumers at price points competitive, or likely to be competitive, with Payless (e.g., including, without limitation, Wal-Mart Stores, Inc., K-Mart Corporation, Target Corporation., Aldo Group, Genesco Inc., Foot Locker, Inc., Brown Shoe Company, Inc., Shoe Carnival, Inc., Jones Apparel Group, Inc., DSW, Inc., Kohl’s Corporation, Liz Claiborne Inc., Big Five Sporting Goods Corporation, Shoe Zone, Bata, J.C. Penney Company, Inc. and Sears, Roebuck and Co.) within 20 miles of any Payless store or the store of any wholesale customer of Payless in the United States, or anywhere in any foreign country in which Payless has retail stores, franchisees or wholesale customers;

     (ii) any franchising or wholesaling business with gross sales or revenue in the prior fiscal year of more than $25 million (or which is a subsidiary, affiliate or joint venture partner of a business with gross sales or revenue in the prior fiscal year of more than $25 million) which sells footwear at wholesale to franchisees, retailers or other footwear distributors located within 20 miles of any Payless store or the store of any wholesale customer of Payless in the United States, or anywhere in any foreign country in which Payless has retail stores, franchisees or wholesale customers:

     (iii) any footwear manufacturing business with gross sales or revenue in the prior fiscal year of more than $25 million (or which is a subsidiary, affiliate or joint venture partner of a business with gross sales or revenue in the prior fiscal year of more than $25 million) which sells footwear to retailers or other footwear distributors located within 20 miles of any Payless store or the store of any wholesale customer of Payless in the United States, or anywhere in any foreign country in which Payless has retail stores, franchisees, or wholesale customers with such footwear manufacturing businesses (including, without limitation, Jones Apparel Group, Inc., Dexter, Stride Rite Corporation, Wolverine Worldwide, Inc., The Timberland Company, Nike Inc., Reebok International Ltd., K-Swiss, Keds and Adidas-Salomon); or

3

     (iv) any business which provides buying office services to any store or group of stores or businesses referred to in Paragraph 3.(b) (i), 3. (b) (ii) or 3. (b) (iii).

(c) Background of non-compete restrictions:

     (i) Payless is one of the leading retail companies in North America, with self-service shoe stores throughout the United States and its territories, Canada and Central America;

     (ii) In connection with its business, Payless has expended a great deal of time, money and effort to develop and maintain its confidential, proprietary and trade secret information; this information, if misused or disclosed, could be very harmful to Payless’ business and its competitive position in the marketplace;

     (iii) Executive desires to be employed by Payless, to be eligible for opportunities for advancement within Payless, to be eligible for potential compensation increases and to be given access to confidential and proprietary information of Payless necessary for Executive to perform Executive’s job, but which Payless would not make available to Executive but for Executive’s signing and agreeing to abide by the terms of this Agreement as a condition of Executive’s employment by Payless;

     (iv) Executive recognizes and acknowledges that Executive’s position with Payless provides Executive with access to Payless’ confidential and proprietary trade secret information and other confidential business information; and

     (v) Payless compensates its associates to, among other things, develop and preserve goodwill and relationships on Payless’ behalf and to develop and preserve business information for Payless’ exclusive ownership and use;

     (vi) long-term customer and supplier relationships often can be difficult to develop and require a significant investment of time, effort and expense;

     (vii) Executive recognizes and acknowledges that if Executive’s employment with Payless were to cease, Payless would need certain protections in order to ensure that Executive does not appropriate or use any confidential information entrusted to Executive during the course of Executive’s employment by Payless or take any other action which could result in a loss of Payless’ goodwill that was generated on Payless’ behalf and at its expense, and, more generally, to prevent Executive from having an unfair competitive advantage over Payless.

     (d) Reasonableness of non-compete restrictions. Executive acknowledges and agrees that the restrictions in Paragraph 3 are reasonable and enforceable in view of the background for the non-compete restrictions set forth in Paragraph 3(c) and in view of, among other things, the following:

     (i) the markets in which Payless and its subsidiaries operate their business;

     (ii) the confidential information to which Executive has or will have access;

4

     (iii) Executive’s training and background, which are such that neither Payless nor Executive believes that the restraint will pose an undue hardship on Executive;

     (iv) a Competing Business could benefit greatly if it were to obtain Payless’ confidential information;

     (v) Payless would not have adequate protection if Executive were permitted to work for any Competing Business since Payless would be unable to verify whether its confidential information was being disclosed or misused;

     (vi) the limited duration and limited scope of, and the limited activities prohibited by, the restrictions in Paragraph 3;

     (vii) Payless’ legitimate interests in protecting its confidential information, goodwill and relationships.

     (e) If Executive violates Executive’s obligations under Paragraph 3, then Payless shall be entitled to all legal and equitable rights and remedies under this Agreement, including all of its rights and remedies referred to in Paragraph 8 of this Agreement. Further, any time in which Executive is in violation of Executive’s obligations shall not count toward satisfying the time during which any injunctive restriction shall apply. For example, if Executive were to join a competitor at the end of the Contract Term in violation of the restrictions in Paragraph 3(a) and work for such competitor for one month before a court enjoined such violation, then the one year time period of the restriction would begin when such injunction were issued; the one month in which Executive violated the restriction would not count toward the time that the restriction applies.

4. If Executive becomes Disabled and remains continuously so Disabled for a period of 180 days, then Payless’ obligations under this Employment Agreement, at Payless’ option, may be terminated by notice in writing to that effect given during the continuance of such Disability, such termination to take effect the later of (a) the last day of the month during which such notice is given or (b) the last day of such 180 day period. If Executive has made a previous election to participate in the Payless ShoeSource, Inc. Long-Term Disability Plan (subject to the terms and provisions of that plan), then the terms of that plan shall apply. “Disability” or “Disabled” shall mean the inability of Executive to perform the essential duties of Executive’s job under this Agreement.

5. (a) If Executive’s employment terminates during the Contract Term by reason of Executive’s death or Disability, by Executive’s voluntary termination of employment or by Payless for Cause,

     (i) Executive’s basic compensation and employee benefits shall cease on the date of such termination, except as otherwise provided herein or in any applicable employee benefit plan or program; and

     (ii) Executive (or Executive’s legal representative(s)) shall be entitled to such portion of any incentive compensation as shall be payable under the terms of the Incentive Plan;

5

     (iii) Executive will have the opportunity to continue coverage in Payless’ medical, dental, and vision plans in which Executive is participating on the date or termination or resignation, through COBRA.

     (b) In addition, if Executive’s employment is terminated by reason of death, then Executive’s obligations under Paragraphs 1 and 2 shall cease on the effective date of such termination.

     (c) In addition, if Executive’s employment is terminated by reason of Disability, by Executive voluntarily or by Payless for Cause, then Executive’s obligations under Paragraphs 1 and 2 shall cease on the effective date of such termination and Executive’s obligations under Paragraphs 3 and 6 remain in full force and effect, and Payless shall be entitled to all legal and equitable rights and remedies under this Agreement, including all of its rights and remedies referred to in Paragraph 8 of this Agreement.

     (d) If Executive’s employment is terminated by Payless without Cause, then

     (i) Executive’s employment (and status as an employee) shall cease immediately;

     (ii) Provided that Executive is not in violation of Paragraphs 3, 6, or 9 of this Agreement, Executive shall be entitled to a severance payment in an amount equal to two (2) times Executive’s then current-base salary at the time of termination of employment, payable in a lump sum, less applicable withholdings and deductions, on the next regular pay period following termination of employment;

     (iii) Executive shall be entitled to the amount of any Annual Award payable to Executive under the Payless ShoeSource, Inc. Incentive Compensation Plan (“ICP”) for the fiscal year in which Executive’s employment is terminated, prorated by the number of days Executive is actively employed in that fiscal year divided by 365, and payable at the time and pursuant to the terms of the ICP, less applicable withholdings and deductions; provided, however, such Annual Award must be paid no later than the time period established under IRC Section 409A and the regulations thereunder to be exempt from IRC Section 409A under the “short-term deferral” exception;

     (iv) Executive shall be entitled to the long-term portion of Executive’s cash incentive bonus, if any, that would be payable under the ICP for the 2005-07, 2006-08, and 2007-09 performance periods, prorated based on the number of months actively employed during each respective performance period, and payable no later than the time period established under IRC Section 409A and the regulations thereunder to be exempt from IRC Section 409A under the “short-term deferral” exception, less applicable taxes and withholding;

     (v) Executive will receive a special payment which is the equivalent, before taxes, to the portion paid by Payless towards 24 months of COBRA coverage under Payless’ medical, dental, and vision plans, provided Executive is participating in such plan(s) on the date or termination;

6

     (vi) Except as expressly provided in this Paragraph 5(d), Executive’s post-termination obligations under this Agreement, including, without limitation, the provisions of Paragraphs 3 and 6, shall continue to apply following such termination.

(e) “Cause” means

     (i) an intentional act of fraud, embezzlement, theft or any other material violation of law in connection with Executive’s duties or in the course of Executive’s employment with Payless; or

     (ii) intentional damage to assets of Payless;

     (iii) intentional disclosure of confidential information of Payless contrary to the policy of Payless;

     (iv) breach of Executive’s obligations under this Agreement;

     (v) intentional engagement in any competitive activity which would constitute a breach of Executive’s duty of loyalty or of Executive’s obligations under this Agreement;

     (vi) intentional breach of any policy of Payless;

     (vii) the willful and continued failure by Executive to substantially perform Executive’s duties with Payless (other than any such failure resulting from Executive’s incapacity due to physical or mental illness); and/or

     (viii) the willful engaging by Executive in conduct which is demonstrably and materially injurious to Payless, monetarily or otherwise.

     For purposes of Paragraph 5(e)(ii),(iii),(iv), an act, or a failure to act, shall not be deemed “willful” or “intentional” unless it is done, or omitted to be done, by Executive in bad faith or without reasonable belief that Executive’s action or omission was in the best interest of Payless. Failure to meet performance standards or objectives, by itself, will not constitute “Cause”.

     (f) Executive agrees that, in addition to any other remedies, Payless shall be permitted, as part of the computation of any final amount or amounts due to Executive as wages, compensation, bonus, deferred compensation or otherwise, and before any such amount shall be due and owing, to reduce any amount which Payless may otherwise owe to Executive by any unpaid amount which Executive owes to Payless.

6. (a) Executive will not, at any time, directly or indirectly, use or disclose any of Payless’ Confidential Information except as authorized and within the scope of Executive’s employment with Payless.

     (b) At Payless’ request and/or termination of Executive’s employment with Payless, Executive will return to Payless all documents, records, notebooks, computer diskettes and tapes and anything

7

else containing Payless’ Confidential Information, including all copies thereof, as well as any other Payless property, in Executive’s possession, custody or control. Executive will also delete from Executive’s own computer or other electronic storage medium any of Payless’ proprietary or Confidential Information. Not later than 20 days after Executive’s employment is terminated, Executive will certify in writing to Payless that Executive has complied with these obligations.

     (c) During Executive’s employment with Payless and thereafter, Executive will

     (i) notify and provide Payless immediately with the details of any unauthorized possession, use or knowledge of any of Payless’ Confidential Information,

     (ii) assist in preventing any reoccurrence of this possession, use or knowledge, and

     (iii) cooperate with Payless in any litigation or other action to protect or retrieve Payless’ Confidential information.

     (d) “Confidential Information” means any non-public information pertaining to Payless’ business. Confidential Information includes information disclosed by Payless to Executive, and information developed or learned by Executive during the course of or as a result of Executive’s employment with Payless, which Executive also agrees is Payless’ property. Executive further agrees that any item of intellectual or artistic property generated or prepared by Executive, for Executive or with others, in connection with Executive’s employment by Payless is Payless’ sole property and shall remain so unless Payless otherwise specifically agrees in writing. Confidential Information includes, without limitation, information and documents concerning Payless’ processes; suppliers (including Payless’ terms, conditions and other business arrangements with suppliers); supplier and customer lists; advertising, marketing plans and strategies; profit margins; seasonal plans, goals, objectives and projections, compilations, analyses and projections regarding Payless’ divisions, businesses, product segments, product lines, suppliers, sales and expenses; files; trade secrets and patent applications (prior to their being public); salary, staffing and employment information (including information about performance of other executives); and “know-how,” techniques or any technical information not of a published nature relating, for example, to how Payless conducts its business.

     (e) Executive agrees that Executive will not disclose to Payless or use, or induce Payless to use, any proprietary information, trade secret or confidential business information of any other person or entity, including any previous employer of Executive. Executive also represents that Executive does not have any property or any confidential, proprietary or trade secret information belonging to any prior employer.

7. (a) If any court of competent jurisdiction determines that, but for the provisions of this Paragraph 7, any provision of this Agreement is illegal, void as against public policy or otherwise unenforceable because it is deemed to be overbroad or unreasonable, then such provision shall automatically be amended to the extent (but only to the extent) necessary to make it sufficiently narrow in scope, time and geographic area so that it is enforceable, not illegal, void as against

8

public policy or unreasonable. All other remaining terms and provisions shall remain in full force and effect.

     (b) If Executive raises any question regarding the enforceability of any aspect of this Agreement, including, without limitation, Paragraphs 3 or 6, Executive specifically agrees that Executive will abide fully by such provisions unless and until a court of competent jurisdiction has rendered a final judgment that such provisions are not fully enforceable.

8. (a) Payless and Executive shall each be entitled to pursue all legal and equitable rights and remedies to secure performance of the obligations and duties of the other under this Agreement, and enforcement of one or more of such rights and remedies shall in no way preclude Payless or Executive from pursuing any and all other rights and remedies available to each of them.

     (b) Executive acknowledges and agrees that the individualized services and capabilities that Executive will render and provide to Payless during the Contract Term are of a personal, special, unique, unusual, extraordinary and intellectual character.

     (c) Executive acknowledges and agrees that the restrictions in this Agreement on Executive are reasonable in order to protect Payless’ expectations and rights under this Agreement and to provide Payless with the protections that Payless needs to, among other things, safeguard its Confidential Information. Executive agrees that any breach of this Agreement by Executive will cause immediate irreparable injury to Payless, for which an award of damages alone may be inadequate. Therefore, Payless shall be entitled, in addition to any other right or remedy it may have, to an injunction without the posting of any bond or other security, enjoining or restraining Executive from any violation or threatened violation of this Agreement. In the event that Payless is successful in any suit or proceeding relating to the enforcement of this Agreement, Executive agrees to pay Payless’ reasonable attorneys’ fees and costs.

9. The Executive agrees to disclose fully to Payless, and hereby assigns and transfers to Payless, and agrees to execute any additional documentation Payless may reasonably request to evidence the assignment and transfer, immediately upon the conception, development, making or acquisition thereof, the right, title, and interest in and to any and all inventions, discoveries, improvements, innovations, and/or designs (the “Work Product”) conceived, discovered, developed, acquired or secured by Executive, solely or jointly with others or otherwise, together with all associated U.S. and foreign intellectual property rights (i.e., patents, copyrights, trademarks or trade secrets) either:

     (a) during the period of Executive’s employment, if such Work Product is related directly or indirectly, to the business of, or to the research or development work of Payless;

     (b) with the use of the time, materials, or facilities of Payless; or

     (c) within one (1) year after termination of such employment if conceived, discovered, developed, acquired or secured as a result of and is attributable to work done during such employment and relates to Work Product within the scope of the business of Payless, together with rights to all intellectual property rights which may be granted thereon.

9

     Upon discovery, development, making, or acquisition of any such Work Product, Executive shall notify Payless and shall execute and deliver to Payless, without further compensation, such documents prepared by Payless as may be reasonable or necessary to prepare or prosecute applications for such Work Product and to assign and transfer to Payless Executive’s right, title and interest in and to such Work Product and intellectual property rights thereof. Executive acknowledges that Executive has carefully read and considered the provisions of this paragraph and, having done so, agrees that the restrictions set forth herein are fair and reasonable and are reasonably required for the protection of the interests of Payless, its officers, directors, and other executives.

10. With the sole exception of the Change of Control Agreement dated April 23, 2007 and the Indemnification Agreement dated April 23, 2007, each between Payless and the Executive, and each amended from time to time (collectively, the “Related Agreements”), the entire understanding and agreement between the parties has been incorporated into this Agreement, and this Agreement supersedes all other agreements (except the Related Agreements) and understandings between the Executive and Payless, with respect to the employment of Executive by Payless and its parents and subsidiaries. This Agreement shall inure to the benefit of, and shall be binding upon, Payless, its successors and assigns and upon Executive and Executive’s heirs, successors and assigns; provided, however, that, since this is an agreement for the rendering of personal services, Executive cannot assign any of Executive’s obligations under this Agreement to anyone else. This Agreement may be executed in counterparts, in which case each of the two (2) counterparts shall be deemed to be an original and the final counterpart shall be deemed to have been executed in Topeka, Kansas.

11. Executive hereby represents and warrants that he is not a party to any instrument, agreement, document, arrangement restricting him from being employed by Payless, or preventing him from entering into this Agreement.

12. This Agreement has been executed by Payless at Payless’ corporate headquarters and principal executive offices in Topeka, Kansas. Any questions or other matter arising under or relating directly or indirectly to this Agreement, including but not limited to any questions concerning the validity, interpretation, or performance of the Agreement, shall be governed by and construed in accordance with the laws of the State of Kansas applicable to agreements made and to be performed in such state without regard to such state’s conflicts of law provision. All actions and proceedings arising out of or relating directly or indirectly to this Agreement shall be filed and litigated exclusively in any state court or federal court located in the City of Topeka, Kansas or in Shawnee County, Kansas. The parties hereto expressly consent to the jurisdiction of any such court and to venue therein and consent to service of process if made upon Payless’ registered agent or if made at Executive’s last known address on the records of Payless.

BY SIGNING THIS AGREEMENT, EXECUTIVE HEREBY CERTIFIES THAT EXECUTIVE (A) HAS RECEIVED A COPY OF THIS AGREEMENT FOR REVIEW AND STUDY BEFORE SIGNING IT; (B) HAS READ THIS AGREEMENT CAREFULLY BEFORE SIGNING IT; (C) HAS HAD SUFFICIENT OPPORTUNITY TO REVIEW THE AGREEMENT WITH ANY ADVISOR WHICH EXECUTIVE MAY DESIRE TO

10

CONSULT, INCLUDING LEGAL COUNSEL; (D) HAS HAD SUFFICIENT OPPORTUNITY BEFORE SIGNING IT TO ASK ANY QUESTIONS EXECUTIVE HAS ABOUT THIS AGREEMENT AND HAS RECEIVED SATISFACTORY ANSWERS TO ALL SUCH QUESTIONS; AND (E) UNDERSTANDS EXECUTIVE’S RIGHTS AND OBLIGATIONS UNDER THIS AGREEMENT.

IN WITNESS WHEREOF, this Agreement has been executed by Executive, and then by Payless in Topeka, Kansas, effective as of the date first above written.

/s/ William E. May
William E. May
Date:	April 11, 2007
Payless ShoeSource, Inc.
By: Name:	/s/ Jay A. Lentz Jay A. Lentz
Title:	Senior Vice President- Human Resources

11

EX-31.1

Exhibit 31.1

CERTIFICATION

I, Matthew E. Rubel, certify that:

1.	I have reviewed this Form 10-Q of Payless ShoeSource, Inc., a Delaware corporation;
2.	Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3.	Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4.	The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

(a)	Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
(b)	Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
(c)	Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
(d)	Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

(a)	All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
(b)	Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: June 13, 2007

/s/ Matthew E. Rubel  

Matthew E. Rubel 

Chief Executive Officer and President
(Principal Executive Officer) 

EX-31.2

Exhibit 31.2

CERTIFICATION

I, Ullrich E. Porzig, certify that:

1.	I have reviewed this Form 10-Q of Payless ShoeSource, Inc., a Delaware corporation;
2.	Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3.	Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4.	The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

(a)	Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
(b)	Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
(c)	Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
(d)	Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

(a)	All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
(b)	Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: June 13, 2007

/s/ Ullrich E. Porzig  

Ullrich E. Porzig 

Senior Vice President,
Chief Financial Officer and Treasurer
(Principal Financial and Accounting Officer) 

EX-32.1

Exhibit 32.1

CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350

In connection with the Quarterly Report of Payless ShoeSource, Inc. (the “Company”) on Form 10-Q for the period ending May 5, 2007, as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Matthew E. Rubel, Chief Executive Officer and President, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

(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: June 13, 2007

/s/ Matthew E. Rubel  

Matthew E. Rubel 

Chief Executive Officer and President
(Principal Executive Officer) 

EX-32.2

Exhibit 32.2

CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350

In connection with the Quarterly Report of Payless ShoeSource, Inc. (the “Company”) on Form 10-Q for the period ending May 5, 2007, as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Ullrich E. Porzig, Senior Vice President — Chief Financial Officer and Treasurer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

(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: June 13, 2007

/s/ Ullrich E. Porzig  

Ullrich E. Porzig 

Senior Vice President,
Chief Financial Officer and Treasurer
(Principal Financial and Accounting Officer)