**UNITED STATES SECURITIES AND EXCHANGE COMMISSION****WASHINGTON, D.C. 20549****FORM 10-Q**   þ **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934******For the quarterly period ended****September 29, 2006******OR**   o **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934******For the transition period from**                                        **to**                                        ****Commission File Number****1-9548****The Timberland Company**(Exact Name of Registrant as Specified in Its Charter)   Delaware 02-0312554 (State or Other Jurisdiction of (I.R.S. Employer Identification No.)Incorporation or Organization)     200 Domain Drive, Stratham, New Hampshire 03885 (Address of Principal Executive Offices) (Zip Code)Registrant’s Telephone Number, Including Area Code: (603) 772-9500Indicate by check mark whether the registrant: (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.þ Yes       o NoIndicate 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” inRule 12b-2 of the Exchange Act. (Check one):Large Accelerated Filer þ       Accelerated Filer o       Non-Accelerated Filer oIndicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).o Yes       þ NoOnOctober 27, 2006, 50,676,027 shares of the registrant’s Class A Common Stock were outstandingand 11,743,660 shares of the registrant’s Class B Common Stock were outstanding.  

 

Page 2**THE TIMBERLAND COMPANY****FORM 10-Q****TABLE OF CONTENTS**           Page(s)**Part I Financial Information (unaudited)**           **Item 1.** **Financial Statements**             Unaudited Condensed Consolidated Balance Sheets -September 29, 2006, September 30, 2005 and December 31, 2005  3          Unaudited Condensed Consolidated Statements of Income -For the Three and Nine Months Ended September 29, 2006 andSeptember 30, 2005  4          Unaudited Condensed Consolidated Statements of Cash Flows -For the Nine Months Ended September 29, 2006 and September 30, 2005  5          Notes to Unaudited Condensed Consolidated Financial Statements  6-16        **Item 2.** **Management’s Discussion and Analysis of FinancialCondition and Results of Operations**  17-28        **Item 3.** **Quantitative and Qualitative Disclosures About Market Risk**  29        **Item 4.** **Controls and Procedures**  29        **Part II Other Information**           **Item 1A.** **Risk Factors**  30        **Item 2.** **Unregistered Sales of Equity Securities and Use of Proceeds**  31        **Item 6.** **Exhibits**  32        Signatures    33        Exhibit Index  34 

 

Page 3     **PART I FINANCIAL INFORMATION**     **Item 1. FINANCIAL STATEMENTS****THE TIMBERLAND COMPANY****UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS**(Dollars in Thousands)               **September 29,**  **September 30,**      **2006**  **2005**  **December 31, 2005** **Assets**            Current assets            Cash and equivalents $61,850  $117,634  $213,163 Accounts receivable, net of allowance for doubtful accounts of $13,002at September 29, 2006, $10,243 at September 30, 2005 and $8,755 atDecember 31, 2005  330,384   298,172   168,831 Inventory, net  250,522   242,622   167,132 Prepaid expense  41,059   31,994   33,502 Deferred income taxes  18,416   23,524   26,934 Derivative assets  1,388   5,122   6,044           Total current assets  703,619   719,068   615,606           Property, plant and equipment, net  86,201   77,373   82,372 Deferred income taxes  8,261   —   — Goodwill  39,533   14,163   39,503 Intangible assets, net  42,597   4,579   40,909 Other assets, net  10,467   10,007   10,264           Total assets $890,678  $825,190  $788,654                        **Liabilities and Stockholders’ Equity**            Current liabilities            Notes payable $54,200  $—  $— Accounts payable  127,440   125,670   97,294 Accrued expense            Payroll and related  34,275   39,520   48,721 Other  88,374   64,173   53,121 Income taxes payable  34,087   47,844   44,210 Derivative liabilities  1,455   —   —           Total current liabilities  339,831   277,207   243,346           Deferred compensation and other long-term liabilities  13,486   15,274   16,046 Deferred income taxes  —   5,051   1,075 Stockholders’ equity            Preferred Stock, $.01 par value; 2,000,000 shares authorized; none issued  —   —   — Class A Common Stock, $.01 par value (1 vote per share); 120,000,000shares authorized; 72,512,804 shares issued at September 29, 2006,71,688,107 shares issued at September 30, 2005 and 71,804,959 sharesissued at December 31, 2005  725   717   718 Class B Common Stock, $.01 par value (10 votes per share); convertibleinto Class A shares on a one-for-one basis; 20,000,000 sharesauthorized; 11,743,660 shares issued and outstanding at September 29,2006, September 30, 2005 and December 31, 2005  117   117   117 Additional paid-in capital  211,370   211,603   214,483 Deferred compensation  —   (30,498)  (27,166)Retained earnings  807,093   692,124   739,004 Accumulated other comprehensive income  10,443   10,203   8,696 Treasury Stock at cost; 21,603,950 Class A shares at September 29, 2006,17,330,185 Class A shares at September 30, 2005 and 18,921,290 Class Ashares at December 31, 2005  (492,387)  (356,608)  (407,665)          Total stockholders’ equity  537,361   527,658   528,187           Total liabilities and stockholders’ equity $890,678  $825,190  $788,654           *The accompanying notes are an integral part of these unaudited condensed consolidated financialstatements.*

 

Page 4**THE TIMBERLAND COMPANY****UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF INCOME**(Amounts in Thousands, Except Per Share Data)                   **For the Three Months Ended**  **For the Nine Months Ended**   **September 29,**  **September 30,**  **September 29,**  **September 30,**   **2006**  **2005**  **2006**  **2005** Revenue $502,980  $505,913  $1,079,396  $1,100,393 Cost of goods sold  266,324   258,555   563,816   547,894              Gross profit  236,656   247,358   515,580   552,499                               Operating expense                Selling  123,660   111,259   324,014   297,236 General and administrative  32,300   28,462   88,568   77,304 Restructuring and related costs  (92)  2,531   820   2,531              Total operating expense  155,868   142,252   413,402   377,071                               Operating income  80,788   105,106   102,178   175,428                               Other income/(expense)                Interest income/(expense), net  (308)  570   1,463   2,734 Other, net  494   (900)  2,087   238              Total other income/(expense)  186   (330)  3,550   2,972                               Income before provision for income taxes  80,974   104,776   105,728   178,400                  Provision for income taxes  29,099   35,624   37,639   60,656                               Net income $51,875  $69,152  $68,089  $117,744                               Earnings per share                Basic $.84  $1.04  $1.08  $1.76 Diluted $.82  $1.02  $1.06  $1.72 Weighted-average shares outstanding                Basic  62,120   66,175   62,910   66,892 Diluted  63,062   67,697   64,069   68,359 *The accompanying notes are an integral part of these unaudited condensed consolidated financialstatements.*

 

Page 5**THE TIMBERLAND COMPANY****UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**(Dollars in Thousands)           **For the Nine Months Ended**   **September 29,**  **September 30,**   **2006**  **2005** Cash flows from operating activities:        Net income $68,089  $117,744 Adjustments to reconcile net income to net cash used by operating activities:        Deferred income taxes  (495)  (3,488)Share-based compensation  16,417   3,791 Depreciation and other amortization  20,413   18,190 Tax benefit from share-based compensation, net of excess benefit  1,284   6,490 Other non-cash charges/(credits), net  (1,969)  1,966 Increase/(decrease) in cash from changes in working capital:        Accounts receivable  (155,614)  (154,003)Inventory  (79,369)  (116,360)Prepaid expense  (6,302)  (5,881)Accounts payable  27,204   79,693 Accrued expense  19,365   (18,837)Income taxes payable  (10,204)  13,157         Net cash used by operating activities  (101,181)  (57,538)                Cash flows from investing activities:        Additions to property, plant and equipment  (21,878)  (15,704)Other  (4,241)  147         Net cash used by investing activities  (26,119)  (15,557)                Cash flows from financing activities:        Common stock repurchases  (95,543)  (128,906)Issuance of common stock  13,478   17,668 Net borrowing under short-term credit facilities  54,200   — Excess tax benefit from share-based compensation  2,605   —        Net cash used by financing activities  (25,260)  (111,238)                Effect of exchange rate changes on cash and equivalents  1,247   (7,149)                Net decrease in cash and equivalents  (151,313)  (191,482)Cash and equivalents at beginning of period  213,163   309,116        Cash and equivalents at end of period $61,850  $117,634                 Supplemental disclosures of cash flow information:        Interest paid $693  $290 Income taxes paid $44,416  $43,987 *The accompanying notes are an integral part of these unaudited condensed consolidated financialstatements.*

 

Page 6**THE TIMBERLAND COMPANY****NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**(Amounts in Thousands, Except Share and Per Share Data)**Note 1. Summary of Significant Accounting Policies**In the opinion of management, the accompanying unaudited condensed consolidated financialstatements contain the adjustments necessary to present fairly The Timberland Company’s (“we”,“our”, “us”, “Timberland” or the “Company”) financial position, results of operations and changesin cash flows for the interim periods presented. Such adjustments consist of normal recurringitems. The unaudited condensed consolidated financial statements should be read in conjunctionwith our consolidated financial statements and notes thereto included in our Annual Report on Form10-K for the year ended December 31, 2005.Our revenue consists of sales to wholesale customers, retail store revenues, license fees androyalties. We record wholesale revenues when title passes and the risks and rewards of ownershiphave passed to the customer, based on the terms of sale. Title passes generally upon shipment orupon receipt by the customer, depending on the country of sale and the agreement with the customer.Retail store revenues are recorded at the time of the sale. License fees and royalties arerecognized as earned per the terms of our licensing agreements.In thethird quarter and the first nine months of 2006, we recorded $1,107and $2,774 of reimbursedshipping expenses within revenues and the related shipping costs within selling expense,respectively. In the third quarter and the first nine months of 2005, we recorded $1,295 and$3,223 of reimbursed shipping expenses within revenues and the related shipping costs withinselling expense, respectively. Shipping costs are included in sellingexpense and were $3,846 and$5,733 for the third quarters of 2006 and 2005, and $11,910 and $14,744 for the first nine months of2006 and 2005, respectively.**Note 2. Historical Financial Results**The results of operations for the three and nine months ended September 29, 2006 are notnecessarily indicative of the results to be expected for the full year. Historically, our revenuehas been more heavily weighted to the second half of the year.**Note 3. Share-Based Compensation**Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”)123(R), “Share-Based Payment,” which requires a company to measure the grant date fair value ofequity awards given to employees in exchange for services and recognize that cost over the periodthat such services are performed. This Standard is a revision of SFAS 123, “Accounting forStock-Based Compensation,” and supersedes Accounting Principles Board (“APB”) Opinion 25,“Accounting for Stock Issued to Employees,” and its related implementation guidance. The Companyadopted the provisions of SFAS 123(R) using the modified prospective application method. Underthis method, compensation expense is recognized on all share-based awards granted prior to, but notyet vested as of adoption based on the grant date fair value estimated in accordance with theoriginal provisions of SFAS 123. The Company recognizes the cost of share-based awards on astraight-line basis over the award’s requisite service period, with the exception of certain stock options for officers, directors and key employeesgranted prior to, but not yet vested as of adoption, for which expense continues to be recognizedon a graded schedule over the vesting period of the award. Share-based compensation costs, whichare recorded in cost of goods sold and selling and general and administrative expenses, totaled$5,450 ($3,493 net of taxes) and $16,417 ($10,573 net of taxes) for the three and nine months endedSeptember 29, 2006, respectively.As a result of adopting SFAS 123(R), the Company’s income before provision for income taxes for thethree and nine months ended September 29, 2006 are $2,375 and $7,906 lower, respectively, and theCompany’s net income for the three and nine months ended September 29, 2006 are $1,521 and $5,091lower, respectively, than if we had continued to account for share-based compensation under APBOpinion 25. Had the Company not adopted SFAS 123(R), basic and diluted earnings per share for thethree and nine months ended September 29, 2006 would have been:

 

Page 7           **For the Three** **For the Nine**  **Months Ended** **Months Ended**  **September 29, 2006** **September 29, 2006**Basic earnings per share, as reported $.84  $1.08 Pro forma basic earnings per share  .86   1.16 Diluted earnings per share, as reported  .82   1.06 Pro forma diluted earnings per share  .85   1.14 Prior to January 1, 2006, the Company applied the intrinsic value method in APB Opinion 25 andrelated interpretations in accounting for our stock plans, SFAS 123, and SFAS 148, “Accounting forStock-Based Compensation-Transitional and Disclosure-An Amendment of FASB Statement No. 123,” fordisclosure purposes. In our unaudited condensed consolidated statements of operations for thethree and nine months ended September 30, 2005, no compensation expense was recognized for stockoption grants. However, the Company recognized compensation expense for nonvested share awards of$2,467 ($1,629 net of taxes) and $3,791 ($2,502 net of taxes), respectively. The following tableillustrates the effects on net income and earnings per share had compensation expense for stockoption grants issued been determined under the fair value method of SFAS 123 for the three and ninemonths ended September 30, 2005:           **For the Three** **For the Nine**  **Months Ended** **Months Ended**  **September 30, 2005** **September 30, 2005**Net income as reported $69,152  $117,744 Add: Share-based employee compensationexpense included in reported netincome, net of related tax effect  1,629   2,502 Deduct: Total share-based employeecompensation expense determined underfair value based method for allawards, net of related tax effect  3,822   8,585    Pro forma net income $66,959  $111,661    Basic earnings per share, as reported $1.04  $1.76 Pro forma basic earnings per share $1.01  $1.67 Diluted earnings per share, as reported $1.02  $1.72 Pro forma diluted earnings per share $.99  $1.63 Financial statement amounts for the three and nine months ended September 30, 2005 have not beenrestated to reflect the fair value method of expensing share-based compensation.Prior to the adoption of SFAS 123(R), the Company presented all tax benefits of deductionsresulting from the exercise of stock options as operating cash flows in the statement of cashflows. Effective January 1, 2006 and in accordance with SFAS 123(R), the Company changed its cashflow presentation whereby the cash flows resulting from the tax benefits arising from taxdeductions in excess of the compensation expense recognized for share-based awards (“excess taxbenefits”) are now classified as financing cash flows. In the unaudited condensed consolidatedstatement of cash flows for the nine months ended September 29, 2006, the total excess tax benefitof $2,605 related to share-based compensation included in cash flows from financing activitieswould have been included in cash flows from operating activities if the Company had not adoptedSFAS 123(R).The Company received $13,478 in proceeds on the exercise of stock options under the Company’s stockoption and employee stock purchase plans and recorded a tax benefit of $4,288 related to thesestock option exercises during the nine months ended September 29, 2006.Under the provisions of SFAS 123(R), the Company is required to estimate the number of allshare-based awards that will be forfeited. Effective January 1, 2006, the Company uses historicaldata to estimate forfeitures. Prior to the adoption of SFAS 123(R), the Company recognized theimpact of forfeitures as they occurred.Shares issued upon the exercise of stock options under the Company’s stock option and employeestock purchase plans are normally from authorized but unissued shares of the Company’s Class ACommon Stock. However, to the extent that the Company has treasury shares issued, such shares maybe reissued upon the exercise of stock options.

 

Page 8*Stock Options*Under the Company’s 1997 Incentive Plan, as amended (the “1997 Plan”), 16,000,000 shares of Class ACommon Stock have been reserved for issuance to officers, directors and key employees. In additionto stock options, any of the following incentives may be awarded to participants under the 1997Plan: stock appreciation rights (“SARs”), nonvested shares, unrestricted stock, awards entitlingthe recipient to delivery in the future of Class A Common Stock or other securities, securitiesthat are convertible into, or exchangeable for, shares of Class A Common Stock and cash bonuses.Option grants and vesting periods are determined by the Management Development and CompensationCommittee of the Board of Directors. Outstanding stock options granted under the 1997 Plan aregranted with an exercise price equal to market value at date of grant and become exercisable eitherin equal installments over three years, beginning one year after the grant date, or becomeexercisable two years after the grant date. Prior to 2006, most stock options granted under the1997 Plan were exercisable in equal installments over four years. All options expire ten yearsafter the grant date.Under our 2001 Non-Employee Directors Stock Plan, as amended (the “2001 Plan”), we have reserved400,000 shares of Class A Common Stock for the granting of stock options to eligible non-employeedirectors of the Company. Under the terms of the 2001 Plan, stock option grants are awarded on apredetermined formula basis. Unless terminated by our Board of Directors, the 2001 Plan will be ineffect until all shares available for issuance have been issued, pursuant to the exercise of alloptions granted. The exercise price of options granted under the 2001 Plan is the market value ofthe stock on the date of the grant. Initial awards of stock options granted under the 2001 Plan tonew directors become exercisable in equal installments over three years and annual awards ofoptions granted under the 2001 Plan become fully exercisable one year from the date of grant and,in each case, expire ten years after the grant date. Stock options granted under the 2001 Planprior to December 31, 2004 become exercisable in equal installments over four years, beginning oneyear after the grant date, and expire ten years after the grant date.The Company estimates the fair value of its stock option awards on the date of grant using theBlack-Scholes option valuation model that uses the assumptions noted in the following table.Expected volatility is based on historical volatility of the Company’s stock. The expected term ofoptions is estimated using the historical exercise behavior ofemployees and directors. The risk-freeinterest rate for periods within the contractual life of the option is based on the U.S. Treasuryyield curve corresponding to the stock option’s average life.                   **For the Three Months Ended** **For the Nine Months Ended**  **September 29, 2006** **September 30, 2005** **September 29, 2006** **September 30, 2005**Expected volatility  29.9%  28.3%  30.2%  29.6%Risk-free interest rate  4.9%  4.0%  4.7%  3.6%Expected life (in years)  4.0   4.1   4.2   5.1 Expected dividends  —   —   —   — The following summarizes transactions under all stock option arrangements for the nine monthsended September 29, 2006:                           **Weighted-Average**          **Weighted-**  **Remaining**  **Aggregate**       **Average**  **Contractual Term**  **Intrinsic**   **Shares**  **Exercise Price**  **(Years)**  **Value** Outstanding at January 1, 2006  5,708,184  $25.15         Granted  784,231   33.06         Exercised  (707,845)  17.63         Expired or forfeited  (285,954)  29.35                      Outstanding at September 29, 2006  5,498,616  $27.02   6.9  $21,874                                            Exercisable at September 29, 2006  3,034,174  $23.67   5.7  $18,630              

 

Page 9The weighted-average grant date fair values per share of stock options granted, for whichexercise price equals market value at the date of grant, were $8.55 and $9.94 for the threemonths ended September 29, 2006 and September 30, 2005, respectively, and $10.46 and $11.57 forthe nine months ended September 29, 2006 and September 30, 2005, respectively. The totalintrinsic values of stock options exercised during the three months ended September 29, 2006 andSeptember 30, 2005 were $1,354 and $4,252, respectively, and $11,307 and $17,631 for the ninemonths ended September 29, 2006 and September 30, 2005, respectively.Information on stock options outstanding and exercisable as of September 29, 2006 is as follows:                                       **Options Outstanding**  **Options Exercisable**               **Weighted-**                         **Average**  **Weighted-**      **Weighted-**               **Remaining**  **Average**      **Average** **Range of**  **Number**  **Contractual**  **Exercise**  **Number**  **Exercise** **Exercise Prices**  **Outstanding**  **Term (Years)**  **Price**  **Exercisable**  **Price** $5.27  —  17.74   804,539   4.05  $14.28   802,414  $14.28  17.81  —  19.10   125,129   5.56   18.20   112,254   18.20  19.12  —  19.49   683,890   6.42   19.48   431,784   19.47  19.50  —  27.22   561,207   6.89   24.67   363,706   24.21  27.53  —  28.50   654,326   5.51   28.40   520,180   28.50  28.63  —  30.82   119,384   8.10   29.28   24,100   29.50  30.88  —  31.29   928,902   7.36   31.29   465,848   31.29  31.32  —  35.01   822,050   9.03   34.06   63,311   32.12  35.02  —  35.27   3,950   8.99   35.14   486   35.23  35.42  —  39.70   795,239   8.36   35.69   250,091   35.78                         $5.27  —  39.70   5,498,616   6.86  $27.02   3,034,174  $23.67                         Total unrecognized share-based compensation expense related to nonvested stock options was $11,585as of September 29, 2006. The cost is expected to be recognized over the weighted-average period of1.1 years.*Nonvested Shares*As noted above, the Company’s 1997 Plan provides for grants of nonvested shares. The Companygenerally grants nonvested shares with a three year vesting period, which is the same as thecontractual term. Expense is recognized over the award’srequisite service period, which begins on the first day of themeasurement period and ends on the last day of the vesting period. The Company has assumed no forfeitures with respect to nonvested shares. Thefair value of nonvested share grants is determined by the market value at the date of the grant.Changes in the Company’s nonvested shares for the nine months ended September 29, 2006 are asfollows:               **Weighted-**       **Average**       **Grant Date**   **Shares**  **Fair Value** Unvested at January 1, 2006  698,061  $36.27 Awarded  377,770   26.47 Vested  (143,355)  34.40        Unvested at September 29, 2006  932,476  $32.59        The total fair value of shares vested during the nine months endedSeptember 29, 2006 was $4,250.Unrecognized compensation expense related to nonvested share grants was $20,546 as of September 29,2006. The expense is expected to be recognized over a weighted-average period of 1.7 years.Under the provisions of SFAS 123(R), we are no longer permitted to record deferred compensation forthe unvested portion of nonvested share grants. Accordingly, upon adoption of SFAS 123(R), thebalance of deferred compensation was reduced to zero, resulting in an offsetting reduction toadditional paid-in capital in the unaudited condensed consolidated balance sheet.
 

 

Page 10*Employee Stock Purchase Plan*Pursuant to the terms of our 1991 Employee Stock Purchase Plan, as amended (the “ESP Plan”), we areauthorized to issue up to an aggregate of 2,400,000 shares of our Class A Common Stock to eligibleemployees electing to participate in the ESP Plan. Eligible employees may contribute, throughpayroll withholdings, from 2% to 10% of their regular base compensation during six-monthparticipation periods beginning January 1 and July 1 of each year. At the end of eachparticipation period, the accumulated deductions are applied toward the purchase of Class A CommonStock at a price equal to 85% of the market price at the beginning or end of the participationperiod, whichever is lower.The fair value of the Company’s ESP Plan was estimated on the date of grant using the Black-Scholesoption valuation model that uses the assumptions in the following table. Expected volatility isbased on the six-month participation period (the stock option’s contractual and expected lives).The risk-free interest rate is based on the six-month U.S. Treasury rate.                            **For the Three Months Ended** **For the Nine Months Ended**  **September 29, 2006** **September 30, 2005** **September 29, 2006** **September 30, 2005**Expected volatility  28.7%  25.9%  28.7%  25.9%Risk-free interest rate  5.3%  3.2%  4.7%  2.8%Expected life (inmonths)  6   6   6   6 Expected dividends  —   —   —   — The weighted-average fair values of the Company’s ESP Plan purchase rights wereapproximately $6.27 and $7.99 forthe three months ended September 29, 2006 and September 30, 2005, respectively. Theweighted-average fair values of the Company’s ESP Plan purchaserights were approximately $6.64 and $6.91 for thenine months ended September 29, 2006 and September 30, 2005, respectively.Total unrecognized compensation expense related to the unvested portion of the Company’s ESP awardswas $119 as of September 29, 2006. The expense is expected to be recognized in the fourthquarter of 2006.**Note 4. Earnings Per Share**Basic earnings per share excludes common stock equivalents and is computed by dividing net incomeby the weighted-average number of common shares outstanding for the periods presented. Dilutedearnings per share (“EPS”) reflects the potential dilution that would occur if potentially dilutivesecurities such as stock options were exercised and nonvested shares vested. The following is areconciliation of the number of shares (in thousands) for the basic and diluted EPS computationsfor the three and nine months ended September 29, 2006 and September 30, 2005:                           **For the Three Months Ended**  **September 29, 2006** **September 30, 2005**      **Weighted** **Per-**     **Weighted** **Per-**  **Net** **-Average** **Share** **Net** **-Average** **Share**  **Income** **Shares** **Amount** **Income** **Shares** **Amount**     Basic EPS $51,875   62,120  $.84  $69,152   66,175  $1.04 Effect of dilutivesecurities  —   942   (.02)  —   1,522   (.02)     Diluted EPS $51,875   63,062  $.82  $69,152   67,697  $1.02                                 **For the Nine Months Ended**  **September 29, 2006** **September 30, 2005**      **Weighted** **Per-**     **Weighted** **Per-**  **Net** **-Average** **Share** **Net** **-Average** **Share**  **Income** **Shares** **Amount** **Income** **Shares** **Amount**     Basic EPS $68,089   62,910  $1.08  $117,744   66,892  $1.76 Effect of dilutivesecurities  —   1,159   (.02)  —   1,467   (.04)     Diluted EPS $68,089   64,069  $1.06  $117,744   68,359  $1.72      

 

Page 11The following securities (in thousands) were outstanding as of September 29, 2006 and September 30,2005, but were not included in the computation of diluted EPS because the options’ exercise pricewas greater than the average market price of the common shares:                            **For the Three Months Ended** **For the Nine Months Ended**  **September 29, 2006** **September 30, 2005** **September 29, 2006** **September 30, 2005**Options to purchaseshares of commonstock  3,392   903   2,573   659 **Note 5. Comprehensive Income**     Comprehensive income for the three and nine months ended September 29, 2006 and September 30, 2005is as follows:                            **For the Three Months Ended**  **For the Nine Months Ended**       **September 30,**         **September 29, 2006**  **2005**  **September 29, 2006**  **September 30, 2005** Net income $51,875  $69,152  $68,089  $117,744 Change incumulativetranslationadjustment  (769)  (699)  7,584   (14,068)Change in fairvalue of derivativefinancialinstruments, net oftaxes  4,468   (1,176)  (5,837)  14,045              Comprehensive income $55,574  $67,277  $69,836  $117,721              For the three months ended September 29, 2006 and September 30, 2005, the after tax hedginggains/(losses) reclassified to earnings were $(2,165) and $2,444, respectively. For the ninemonths ended September 29, 2006 and September 30, 2005, the after tax hedging gains/(losses)reclassified to earnings were $(259) and $1,384, respectively.**Note 6. Business Segments and Geographic Information**We manage our business in three reportable segments, each sharing similar product, distribution andmarketing. The reportable segments are U.S. Wholesale, U.S. Consumer Direct and International.The U.S. Wholesale segment is comprised of the sale of products to wholesale customers in theUnited States. This segment also includes royalties from licensed products sold in the UnitedStates, the management costs and expenses associated with our worldwide licensing efforts andcertain marketing expenses and value added services. For the three and nine months ended September30, 2005, marketing expenses of $3,121 and $4,132, respectively, were reclassified from ourunallocated corporate segment to U.S. Wholesale as the expenses were deemed to be primarily relatedto our U.S. Wholesale business.The U.S. Consumer Direct segment includes the Company-operated specialty and factory outlet storesin the United States and our e-commerce business.The International segment consists of the marketing, selling and distribution of footwear, appareland accessories and licensed products outside of the United States. Products are sold outside ofthe United States through our subsidiaries (which use wholesale and retail channels to sellfootwear, apparel and accessories), independent distributors and licensees.The Unallocated Corporate component of segment reporting consists primarily of corporate finance,information services, legal and administrative expenses, United States distribution expenses,global marketing support expenses, worldwide product development and other costs incurred insupport of Company-wide activities. It also includes the costs related to share-basedcompensation. Additionally, Unallocated Corporate includes total other income, which is primarilyinterest income, net, and other miscellaneous income, net. Such income is not allocated among thereported business segments.The accounting policies of the segments are the same as those described in the summary ofsignificant accounting policies. We evaluate segment performance based on operating contribution,which represents pre-tax income before unallocated corporate expenses, interest and otherincome/(expense), net, and operating cash flow measurements. Total assets are

 

Page 12 disaggregated to theextent that assets apply specifically to a single segment. Unallocated Corporate assets primarilyconsist of cash and equivalents, manufacturing/sourcing assets, computers and related equipment andUnited States transportation and distribution equipment.**For the Three Months Ended September 29, 2006 and September 30, 2005**                           **U.S.**          **U.S.** **Consumer**     **Unallocated**    **Wholesale** **Direct** **International** **Corporate** **Consolidated****2006**                                         Revenue $202,110  $45,858  $255,012  $—  $502,980 Operating income/(loss)  61,814   2,867   71,290   (55,183)  80,788 Income/(loss) before income taxes  61,814   2,867   71,290   (54,997)  80,974 Total assets  347,505   36,772   418,182   88,219   890,678 Goodwill  31,745   794   6,994   —   39,533                      **2005**                                         Revenue $220,694  $46,595  $238,624  $—  $505,913 Operating income/(loss)  75,243   5,512   76,498   (52,147)  105,106 Income/(loss) before income taxes  75,243   5,512   76,498   (52,477)  104,776 Total assets  291,324   34,424   369,029   130,413   825,190 Goodwill  6,804   794   6,565   —   14,163 **For the Nine Months Ended September 29, 2006 and September 30, 2005**                           **U.S.**              **Consumer**     **Unallocated**    **U.S. Wholesale** **Direct** **International** **Corporate** **Consolidated****2006**                                         Revenue $414,263  $112,157  $552,976  $—  $1,079,396 Operating income/(loss)  108,904   2,944   124,753   (134,423)  102,178 Income/(loss) before income taxes  108,904   2,944   124,753   (130,873)  105,728                      **2005**                                         Revenue $438,036  $119,899  $542,458  $—  $1,100,393 Operating income/(loss)  139,616   12,746   140,588   (117,522)  175,428 Income/(loss) before income taxes  139,616   12,746   140,588   (114,550)  178,400 

 

Page 13**Note 7. Inventory**Inventory, net of reserves, consists of the following:               **September 29, 2006**  **September 30, 2005**  **December 31, 2005** Materials $4,469  $3,792  $3,483 Work-in-process  998   2,068   762 Finished goods  245,055   236,762   162,887           Total $250,522  $242,622  $167,132           **Note 8. Notes Payable**We have an unsecured committed revolving credit agreement with a group of banks which matures onJune 2, 2011 (“Agreement”). The Agreement provides for $200,000 of committed borrowings, of whichup to $125,000 may be used for letters of credit. Upon approval of the bank group, we may increasethe committed borrowing limit by $100,000 for a total commitment of $300,000. Under the terms ofthe Agreement, we may borrow at interest rates based on Eurodollar rates (5.3% as of September 29,2006), plus an applicable margin of between 13.5 and 47.5 basis points based on a fixed chargecoverage grid that is adjusted quarterly. As of September 29, 2006, the applicable margin underthe facility was 27 basis points. We will pay a utilization fee of an additional 5 basis points ifour outstanding borrowings under the facility exceed $100,000. We will also pay a commitment feeof 6.5 to 15 basis points per annum on the total commitment, based on a fixed-charge coverage gridthat is adjusted quarterly. As of September 29, 2006, the commitment fee was 8 basis points. TheAgreement places certain limitations on additional debt, stock repurchases, acquisitions, amount ofdividends we may pay and certain other financial and non-financial covenants. The primaryfinancial covenants relate to maintaining a minimum fixed charge coverage of 3:1 and a leverageratio of 2:1. We measure compliance with the financial and non-financial covenants and ratios asrequired by the terms of the Agreement on a fiscal quarter basis.We had uncommitted lines of credit available from certain banks totaling $50,000 as of September29, 2006. Borrowings under these lines are at prevailing money market rates (5.8% as of September29, 2006). Further, we had an uncommitted letter of credit facility of $80,000 to supportinventory purchases. These arrangements may be terminated at any time at the option of the banksor the Company.As of September 29, 2006, we had short-term borrowings outstanding of $54,200, comprised of $45,000from our revolving credit agreement and $9,200 from our uncommitted lines of credit. As ofSeptember 29, 2006, the weighted-average interest rate on these borrowings was 5.6%. As ofSeptember 30, 2005, we had no short-term borrowings outstanding under any of our credit facilities.**Note 9. Nonvested Share Awards and Other**In 2004, our Board of Directors approvedawards of nonvested share grants of Class A CommonStock under the Company’s 1997 Incentive Plan, as amended, and a cash incentive award. The awardof these nonvested share grants and the cash incentive award are based on achieving certainperformance targets for the periods occurring between January 1, 2004 through December 31, 2006.Based on the achievement of 2005 performance targets, 377,770 of nonvested shares with a value of$10,000 were issued on July 5, 2006 and will fully vest threeyears from that date. Based onthe achievement of 2004 performance targets, 275,117 of nonvested shares with a value of $10,873were issued on July 5, 2005 and will vest equally over threeyears from that date. Anadditional award, based on the achievement of a separate performance target, of 200,000 nonvestedshares with a value of $7,904 was also issued on July 5, 2005and will vest two years after that date. All of these shares are subject to restrictions on sale and transferability, a risk offorfeiture and certain other terms and conditions. Through December 31, 2005, we recorded deferredcompensation in stockholders’ equity on our unaudited condensed consolidated balance sheet toreflect these awards. Under the provisions of SFAS 123(R), we are no longer permitted to recorddeferred compensation in stockholders’ equity for unvested awards. For the measurement period fromJanuary 1, 2006 through December 31, 2006, an award of $8,732 may be made in 2007 if certaintargeted performance goals are achieved. The award amount will vary based upon the degree to whichthese performance goals are attained. As of September 29, 2006, we estimate the award amount willbe approximately $1,424.

 

Page 14The number of shares to be awarded will be determined by the share priceon the issuance date. Additionally, a cash incentive award of up to $3,000 may be awarded in 2007based on the achievement of a performance target over a three year measurement period from January1, 2004 through December 31, 2006. As of September 29, 2006, we estimate the performance targetfor the cash incentive award will not be achieved.In March 2005, our Board of Directors approved an additional cash incentiveaward of $1,250, whichwill be paid in 2007 and was based on the achievement of a performance target over a one yearmeasurement period from January 1, 2005through December 31, 2005. This award is recorded in other long-term liabilities on the unauditedcondensed consolidated balance sheet as of September 29, 2006.In September 2006, our Board of Directors approved an additional future award of $1,000 ofnonvested share grants of Class A Common Stock under the Company’s 1997 Incentive Plan, as amended,and a $2,000 cash incentive award. These awards may be issued in 2007 based on the achievementof a revenue target over a twelve month measurement period from September 30, 2006 throughSeptember 28, 2007.**Note 10. Restructuring Costs**During the first quarter of 2006, we initiated a plan to create a European finance shared servicecenter in Schaffhausen, Switzerland. This shared service center will be responsible for alltransactional and statutory financial activities for which certain activities are currentlyperformed by our locally based finance organizations.On July 6, 2005, the Company announced plans to consolidate our Caribbean manufacturing operations.We ceased operations in our Puerto Rico manufacturing facility at the end of 2005 and areexpanding our manufacturing volume in the Dominican Republic.The following table sets forth our restructuring activity for the nine months ended September 29,2006:                                **Restructuring**          **Restructuring**   **Liabilities as of**      **Cash**  **Liabilities as of**   **December 31, 2005**  **Charges**  **Payments**  **September 29, 2006** Severance and employment relatedcharges $3,784  $612  $(3,562) $834 Other charges  179   208   (373)  14              Total $3,963  $820  $(3,935) $848              Severance and employment related charges consist primarily of severance, health benefits and otheremployee related costs incurred due to these two restructuring plans. Other charges consist offees related to the closing of our manufacturing facility in Puerto Rico only. Credits recordedfor the three months ended September 29, 2006 reflect adjustments to our estimated restructuringliabilities related to the closing of the Puerto Rico manufacturing facility. The following tablesdetail the charges and payments by location:           **For the Three**  **For the Nine**   **Months Ended**  **Months Ended**   **September 29, 2006**  **September 29, 2006** Severance and employment related charges:        European shared service center $91  $596 Puerto Rico manufacturing facility  (153)  16        Total severance and employment related charges  (62)  612 Other charges  (30)  208        Total $(92) $820                   **For the Three**  **For the Nine**   **Months Ended**  **Months Ended**   **September 29, 2006**  **September 29, 2006** Severance and employment related cash payments:        European shared service center $270  $270 Puerto Rico manufacturing facility  42   3,292        Total severance and employment related cash payments  312   3,562 Other cash payments  90   373        Total $402  $3,935        

 

Page 15European finance shared service center restructuring activity will continue through the secondquarter of 2007. The Puerto Rico closure was completed in the second quarter of 2006, but we willcontinue to make cash payments for severance benefits through the second quarter of 2007.Total additional charges of approximately $200 are expected to be incurred in the fourth quarter of2006 and $100 in 2007, which are expected to cover the remaining severance and employment relatedcharges for the European finance shared service center restructuring activity.**Note 11. Income Taxes**The effective tax rate for the three and nine months ended September 29, 2006 was 35.9% and 35.6%,respectively. The effective tax rate was adjusted in the third quarter of 2006 to increase ourfull year 2006 tax rate estimate from 34.5% to 35.6%. This increase reflects updated estimates ofthe geographic mix of our profits and provisions for specific taxreserves. The effective tax rate for the three and nine months ended September 30, 2005 was 34.0%.**Note 12. Share Repurchase**On February 7, 2006, our Board of Directors approved an additional repurchase of 6,000,000 sharesof our Class A Common Stock. As of September 29, 2006, 4,370,203 shares remained under thisauthorization. Shares repurchased totaled 928,735 during the quarter ended September 29, 2006.We may use repurchased shares to offset future issuances under the Company’s stock-based employeeincentive plans. From time to time, we use Rule 10b5-1 plans to facilitate share repurchases.**Note 13. Litigation**We are involved in various litigation and legal matters that have arisen in the ordinary course ofbusiness. Management believes that the ultimate resolution of any existing matter will not have amaterial adverse effect on our consolidated financial statements.**Note 14. New Accounting Pronouncements**In June 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48(“FIN 48”), “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No.109”, which clarifies the accounting for uncertainty in income tax positions. FIN 48 requires acompany to recognize in its financial statements the impact of a tax position, if that position ismore likely than not of being sustained upon examination by the appropriate taxing authority, basedon the technical merits of the position. FIN 48 also provides guidance on derecognition,classification, interest and penalties, accounting in interim periods, disclosure and transition.FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is currentlyevaluating the impact FIN 48 will have on our consolidated financial position and results ofoperations.In September 2006, the FASB issued Statement of Financial Accounting Standards (“SFAS”) 157, “FairValue Measurements”. SFAS 157 defines fair value, establishes a framework for measuring fair valuein generally accepted accounting principles (GAAP) and expands disclosures about fair valuemeasurements. SFAS is effective for fiscal years beginning after November 15, 2007 and interimperiods within those fiscal years. The Company is currently evaluating the effect SFAS 157 willhave on our consolidated financial position and results of operations.In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin (“SAB”)108 which provides interpretations regarding the process of quantifying prior year financialstatement misstatements for the purposes of a materiality assessment. SAB 108 provides guidancethat the following two methodologies should be used to quantify prior year income statementmisstatements: i) the error is quantified as the amount by which the current period incomestatement is misstated and ii) the error is quantified as the cumulative amount by which thecurrent year balance sheet is misstated.

 

Page 16 SAB 108 concludes that a Company should evaluate whethera misstatement is material using both of these methodologies. The interpretation is effective forevaluations made on or after November 15, 2006. The adoption of SAB 108 is not expected to have amaterial effect on the Company’s consolidated financial position or results of operations.

 

Page 17**Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**The following discusses The Timberland Company’s (“we”, “our”, “us”, “Timberland” or the “Company”)results of operations and liquidity and capital resources. The discussion, including known trendsand uncertainties identified by management, should be read in conjunction with the unauditedcondensed consolidated financial statements and related notes. Included herein are discussions andreconciliations of (i) total Company and International revenue changes to constant dollar revenuechanges and (ii) diluted EPS to diluted EPS excluding restructuring and related costs and includingshare-based employee compensation costs related to stock option and employee stock purchase plansfor 2005. Constant dollar revenue changes, which exclude the impact of changes in foreign exchangerates, and diluted EPS to diluted EPS excluding restructuring and related costs and includingshare-based employee compensation costs related to stock option and employee stock purchase plansare not Generally Accepted Accounting Principle (“GAAP”) performance measures. We provide constantdollar revenue changes for total Company and International results because we use the measure tounderstand revenue changes excluding any impact from foreign exchange rate changes. Managementprovides diluted EPS excluding restructuring and related costs and including share-based employeecompensation costs related to stock option and employee stockpurchase plans for 2005 to understand earnings excludingrestructuring and related costs and to providecomparability to reported results that include share-based employee compensation costs asprescribed by Statement of Financial Accounting Standards (“SFAS”) 123(R), “Share-Based Payment.”**Critical Accounting Policies**Our discussion and analysis of our financial condition and results of operations are based upon ourunaudited condensed consolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States of America. The preparation of thesefinancial statements requires us to make estimates and judgments that affect the reported amountsof assets, liabilities, revenues, expenses and related disclosure of contingent assets andliabilities. On an on-going basis, we evaluate our estimates, including those related to salesreturns and allowances, realization of outstanding accounts receivable, the carrying value ofinventories, derivatives, other contingencies, impairment of assets, incentive compensationaccruals, share-based compensation and the provision for income taxes. We base our estimates onhistorical experience and on various other assumptions that are believed to be reasonable under thecircumstances, the results of which form the basis for making judgments about the carrying valuesof assets and liabilities that are not readily apparent from other sources. Historically, actualresults have not been materially different from our estimates. Because of the uncertainty inherentin these matters, actual results could differ from the estimates used in applying our criticalaccounting policies. The Company is not aware of any reasonably likely events or circumstancesthat would result in materially different amounts being reported. Our significant accountingpolicies are described in Note 1 to the Company’s consolidated financial statements of our AnnualReport on Form 10-K for the year ended December 31, 2005, except for the Company’s accounting forshare-based compensation in connection with the adoption of SFAS 123(R) which is noted below. Ourestimates, assumptions and judgments involved in applying the critical accounting policies aredescribed in the Management’s Discussion and Analysis of Financial Condition and Results ofOperations section of our Annual Report on Form 10-K for the year ended December 31, 2005.Under SFAS 123(R), the Company estimates the fair value of its stock option awards and employeestock purchase plan (the “ESP Plan”) rights on the date of grant using the Black-Scholes optionvaluation model. The Black-Scholes model includes various assumptions, including the expectedvolatility for stock options and ESP Plan rights and the expected term of stock options. Theseassumptions reflect the Company’s best estimates, but they involve inherent uncertainties based onmarket conditions generally outside of the Company’s control. As a result, if other assumptionshad been used, share-based compensation expense, as calculated and recorded under SFAS 123(R) couldhave been materially impacted. Furthermore, if the Company uses different assumptions in futureperiods, share-based compensation expense could be materially impacted in future periods. See Note3 for additional information regarding the Company’s adoption of SFAS 123(R).**Recent Developments**European Union (EU) Duties On March 22, 2006, the European Commission imposed provisional duties on leather upper footwearoriginating from China and Vietnam and imported into European Member States. These provisionalduties, which began on April 7, 2006, were effective for a six month period and were phased in overa period of five months, beginning at a rate of about 4% and ending at a 19.4% rate for Chinasourced footwear and at a 16.8% rate for Vietnam sourced footwear. These duties became definitiveon October 7, 2006, for a period of two years, with a final 16.5% rate for China sourced footwearand a 10% rate for

 

Page 18Vietnam sourced footwear. Pursuant to EU regulations, only provisional dutieswhich do not exceed the definitive duty rates will be collected. Children’s footwear with leatheruppers was excluded from the provisional duties, but is subject to definitive duties. Our estimateis that the implementation of these duties will likely reduce our 2006 operating profits in therange of $6-$7 million and our 2007 operating profits in the range of $9-$10 million. Theimplementation of these duties, which results in additional expenses in lower tax ratejurisdictions, has also had a negative impact on the Company’seffective tax rate, which is estimated at 35.6% for 2006.**Overview**Our principal strategic goal is to become the authentic outdoor brand of choice globally. Wecontinue to develop a diverse portfolio of footwear, apparel and accessories that reinforces thefunctional performance, benefits and classic styling that consumers have come to expect from ourbrand. We sell our products to consumers who embrace an outdoor-inspired lifestyle throughhigh-quality distribution channels, including our own retail stores, which reinforce the premiumpositioning of the Timberlandâ brand.To deliver against our long-term goals, we are focused on driving progress on key strategic fronts.These include enhancing our leadership position in our core footwear business, capturing theopportunity that we see for outdoor-inspired apparel, extending enterprise reach throughdevelopment of new brand platforms and brand building licensing arrangements, expandinggeographically and driving operational and financial excellence while setting the standard forcommitment to the community and striving to be a global employer of choice.Highlights of our third quarter 2006 financial performance, compared to the third quarter of2005, include the following: **•** Third quarter revenue of $503.0 million was down slightly versus the prior year periodas gains in new brands (including SmartWool®), Timberland® apparel,casual footwear and Timberland PRO® footwear were offset by anticipated declinesin boots and kids’ sales.  **•** Operating profit for the quarter was $80.8 million compared to $105.1 million in thethird quarter of 2005. Profit declines reflected gross margin pressures from business miximpacts and higher comparable product costs, as well as increased operating expensesassociated with new businesses, global business expansion and growth category development.  **•** Gross margin decreased from 48.9% to 47.1%, reflecting higher comparable product costs,including effects from anti-dumping duties on footwear imported into the European Union,unfavorable foreign exchange hedge rate changes and lower U.S. outlet store margins.  **•** Operating expenses increased 9.6% to $155.9 million with growth primarily attributed toinvestments in new businesses and global category development, International businessexpansion and higher share-based compensation costs, reflecting new accountingrequirements. Excluding restructuring, operating expenses increased 11.6%.  **•** Diluted EPS decreased from $1.02 to $.82.  **•** Cash at the end of the quarter was $61.9 million.  **•** Short-term debt outstanding at the end of the quarter was $54.2 million.  **•** We continue to maintain our focus on serving as a reference for socially responsiblecompanies through our commitment to community. In September, we hosted our ninth annualServa-a-palooza, mobilizing over 6,300 employees, consumers and community partners inprojects that impacted 150 communities in 32 countries. In addition, six employees spentthree weeks conducting environmental research in the Rift Valley of Kenya in conjunctionwith Earthwatch Institute. We are also pleased to report that for the third consecutiveyear, we have been recognized by *Working Mother*as one of the top companies to work for inthe U.S.Based on current trends, we are modifying our outlook for full year 2006 financial results,reflecting expectations for more moderate growth in the fourth quarter. We are now targetingfourth quarter revenue growth in the mid-single digit range, reflecting goals for relatively flatU.S. growth which will offset targeted double digit gains in our International business. We alsoexpect continued pressure on operating margins. We expect that gross margin will be approximately200 basis points

 

Page 19below prior year levels, reflecting anticipated business mix impacts and effectsfrom the implementation of anti-dumping duties on EU footwear sourced in China and Vietnam whichwill lower gross profit by approximately $3 million in the fourth quarter of 2006. We plan tocontinue to support investment against our growth strategies, including continued global expansionand development of Timberland’s business portfolio, which will drive fourth quarter operatingexpense growth in the 10% range. These factors contribute to our updated outlook for a decline incomparable EPS performance this year in the 30% range. For the purpose of comparison, we estimatethat our 2005 EPS would have been approximately $2.35 after excluding restructuring and relatedcosts and including costs related to stock options and our employee stock purchase plan.As we look ahead to 2007, we anticipate continued pressure on operating profits in the first halfof next year. We expectthat soft sell-through rates in boots and kids’ products in the first half of 2006 will contributeto lower overall U.S. Wholesale sales in the first half of 2007 and will continue to constrainEuropean growth results during this period. These factors will likely constrain first half revenuegrowth to the low single digit range. We also expect continued pressure on gross margins next yearrelated to higher comparable product costs, reflecting rising material costs and wage costpressures in Asia in 2007. We also expect gross margin pressures related to the implementation ofanti-dumping duties on EU sourced footwear from China and Vietnam. The implementation of theseduties will add an estimated $9-$10 million to product costs next year, with a likely $5 millionimpact in the first half of 2007. While we are targeting positive earnings gains in the secondhalf of 2007, first half pressures will likely limit full year 2007 earnings per share to prioryear levels.**Results of Operations for the Three Months Ended September 29, 2006 and September 30, 2005**RevenueConsolidated revenue was $503.0 million in the third quarter of 2006, down 0.6% from the prior yearperiod. Revenue results reflected gains in new brands, including the addition of SmartWool whichadded $15.3 million to third quarter revenues. Revenue results also reflected progress indeveloping key growth categories for Timberland includingTimberland®apparel and women’sand men’s casual and Timberland PRO® footwear. These gains were offset by declinesin boots and kids’ sales, primarily driven by lower sales in the U.S. and northern Europeanmarkets.Segments Review We have three reportable business segments (see Note 6): U.S. Wholesale, U.S. Consumer Direct andInternational.U.S. Wholesale revenues for the third quarter of 2006 were $202.1 million, down 8.4% in comparisonto the prior year period, driven primarily by declines in kids’ footwear and boots. U.S. Wholesalerevenues benefited from the addition of SmartWool, which added $12.0 million to third quarter 2006revenues, and strong growth in Timberland PRO® footwear and Timberland® brandapparel sales.U.S. Consumer Direct posted revenues of $45.9 million, down 1.6% from the prior year period. Salesresults were driven primarily by lower comparable store sales at outlet stores, which were impactedby our decision to remove classic boot product from these stores as part of our strategy tostrengthen overall pricing for these products in the U.S. market. U.S. specialty stores recordedsolid comparable store gains in the third quarter of 2006. Our e-commerce business also postedstrong gains over the prior year period. During the third quarter of 2006, we opened two newoutlet stores in the U.S.International revenues grew 6.9% to $255.0 million in the third quarter of 2006, reflecting 3.6%constant dollar growth, supported by gains across Asia, Canada and Europe. Overall, Internationalrevenues increased to 50.7% of total consolidated revenues for the quarter. European revenuesincreased 4.4%, or 0.4% on a constant dollar basis to $205.3 million. European sales resultsreflected strong gains in sales of casual footwear and apparel which were offset by lower sales ofboots and kids’ footwear product, particularly in northern Europe, reflecting comparisons to verystrong prior year sell-in levels for these categories. We continued to expand our retail presencein Europe with the third quarter 2006 addition of our new flagship store on Regent Street inLondon, which focuses on our new store format targeted at the casual “engager” consumer. For thefourth quarter of 2006, we are targeting solid revenue gains in Europe. This outlook reflectsexpectations for more favorable sell-in comparisons, as the prior year second half sell-in wasweighted more heavily towards the third quarter.In Asia, revenues grew 12.9%, or 14.9% in constant dollars, to $36.7 million, driven by stronggains in Japan and our Asian distributor business, which benefited from our continued expansion inChina. Asia’s growth reflected gains in apparel and accessories,boots and casual footwear,supported by continued expansion of our integrated brand presence
 

 

Page 20across the region. Our Asian retail business continued to expand in the third quarter of 2006with the addition of six new stores and shops.ProductsWorldwidefootwear revenue was $368.0 million in the third quarter of 2006, down 7.8% from the prioryear period. Footwear results were driven primarily by declines in boots and kids’ footwear saleswhich offset gains in Timberland PRO® and women’s and men’s casual footwear. Footwearunit sales declined 15.1% primarily reflecting lower sales of kids’ footwear. The average sellingprice increased 8.6%, driven primarily by business mix impacts including lower kids’ sales, highersales in international markets and benefits from favorable foreign exchange rate changes.Worldwide apparel and accessories revenue expanded 27.5% to $129.4 million. This increase wassupported by the addition of SmartWool, which added $15.3 million to global apparel and accessoriesrevenue, and strong gains in Timberland® brand apparel sales globally. Apparel andaccessories unit sales increased 48.4%, while the average selling price decreased by 14.1%,reflecting impacts from the addition of SmartWool’s products, which have lower average sellingprices.Channels Worldwidewholesale revenues decreased 1.0% to $416.2 million as declines in sales of boots and kids’footwear offset increases in apparel and accessories, TimberlandPRO®footwear and women’s andmen’s casual footwear. Global consumer direct revenues increased 1.3% over the prior year periodto $86.8 million. Benefits from global door expansion and growth in our e-commerce business offseta 4.1% decline in global comparable store sales, which was driven primarily by a decline incomparable outlet store performance. During the quarter, we opened nine stores, shops and outletsand closed three worldwide.Gross ProfitGross profit as a percentage of sales, or gross margin, was 47.1% for the third quarter of 2006,down 180 basis points from the prior year period. This decrease reflects higher product costs,including effects from anti-dumping duties on EU footwear, unfavorable foreign exchange hedge ratechanges and lower U.S. outlet store margins.We include the costs of procuring inventory (inbound freight and duty, overhead and other similarcosts) in cost of goods sold. These costs amounted to $29.9 million and $32.7 million for the thirdquarters of 2006 and 2005, respectively.Operating ExpenseOperating expense for the third quarter of 2006 was $155.9 million, up $13.6 million or 9.6% fromthe $142.3 million reported in the third quarter of 2005. As a percentage of revenue, operatingexpense increased 290 basis points to 31.0% compared to 28.1% in the prior year period. Operatingexpense growth was driven by $7.0 million of incremental costs associated with new businesses andcategory development, including the addition of SmartWool, $4.6 million of constant dollar costgrowth related to International expansion and $2.5 million of incremental costs associated withshare-based compensation, reflecting new accounting requirements. We anticipate fourth quarteroperating expense growth in the range of 10% as we continue to support our investment in globalexpansion and develop Timberland’s business portfolio.Third quarter 2006 selling expense was $123.7 million, an increase of $12.4 million or 11.1%compared to the prior year period. The increase was driven by $5.6 million in costs related tonew businesses and category development, $4.6 million in International business expansion, $1.6million in share-based employee compensation costs and $1.3 million in distribution costs,partially offset by a reduction in marketing expenses of $2.6 million. Foreign exchange ratechanges added $1.7 million, or 1.5%, to overall selling expense growth.We include the costs of physically managing inventory (warehousing and handling costs) in sellingexpense. These costs totaled$10.7 million and $9.9 million in the third quarters of 2006 and2005, respectively.Advertising expense, which is also included in selling expense, was $6.5 million and $8.5 millionin the third quarters of 2006 and 2005, respectively. Advertising costs are expensed at the timethe advertising is used, predominantly in the season that the advertising costs are incurred. Thedecrease in advertising expense reflects shifts in spending towards other brand

 

Page 21building activities. Prepaid advertising recorded on our unaudited condensed consolidated balancesheets was $3.7 million as of both September 29, 2006 and September 30, 2005.General and administrative expense for the third quarter of 2006 was $32.3 million, $3.8 million or13.5% higher than the prior year period. The increase was driven by $1.4 million related to newbusiness initiatives, $1.3 million in costsassociated with operating the new European finance shared service center and $0.9 million inshare-based employee compensation costs. Foreign exchange rate changes contributed to overallgeneral and administrative expense growth by $0.3 million or 1.0%.Operating IncomeThird quarter 2006 operating income was $80.8 million, down 23.1% in comparison to the $105.1million recorded in the prior year period. Operating income as a percentage of revenue decreasedfrom 20.8% to 16.1% reflecting gross margin pressures and increased expenses associated withinvestments against new businesses and growth category development,International expansion and effects from the implementation of new accountingrequirements related to share-basedcompensation.Operating income for our U.S. Wholesale segment was $61.8 million, down 17.8% from the thirdquarter of 2005. Revenue decreased 8.4%, driven by lower sales of kids’ footwear and boots.Operating profit margins were pressured by negative product mix impacts and moderate cost growthover a smaller revenue base.Third quarter operating income for our U.S. Consumer Direct segment declined $2.6 million to $2.9million. Revenue decreased 1.6%, impacted by a comparable store sales decline of 4.5%, partiallyoffset by 30.0% growth in our e-commerce business. Operating profits were impacted by a 310 basispoint decrease in gross margin resulting from negative mix impacts and increased promotions inoutlet stores.International operating income was $71.3 million, down 6.8% from the prior year period.International profit margins were pressured by a decline in gross margins impacted by negativeproduct mix impacts from lower boot sales and higher comparable product costs, including effectsfrom EU anti-dumping duties.Our Unallocated Corporate expenses, which include central support and administrative costs, notallocated to our business segments, increased 5.8% to $55.2 million. Unallocated Corporateexpenses as a percentage of total revenue increased 70 basis points to 11.0% of total revenue.Excluding restructuring costs in both the third quarters of 2006 and 2005 and increased share-basedemployee compensation costs of $2.9 million, Unallocated Corporate expenses increased $2.7 millionor 5.5% from the prior year and represent 10.4% of total revenue. This increase was driven by $1.5million in unfavorable product cost variances and $0.9 million in costs associated with operatingthe new European finance shared service center.Other Income and TaxesInterest income/(expense), net is comprised of interest income offset by fees related to theestablishment and maintenance of our revolving credit facility and interest paid on short-termborrowings. For the third quarter of 2006, we incurred $0.3 million of interest expense related toour short-term borrowings used for our seasonal working capital needs. For the third quarter of2005, we had net interest income of $0.6 million resulting from higher cash balances prior to ouracquisition of SmartWool.Other, net, included $0.1 million and $(0.9) million of foreign exchange gains/(losses) for thethird quarters of 2006 and 2005, respectively, resulting from the timing of settlement of localcurrency denominated receivables and payables. These gains/(losses) were driven by the volatilityof exchange rates within the third quarters of 2006 and 2005 and should not be consideredindicative of expected future results.The effective income tax rate for the third quarter of 2006 was 35.9% compared to 34.0% for theprior year period. The effective tax rate was adjusted in the third quarter of 2006 to increaseour full year 2006 tax rate estimate from 34.5% to 35.6%. This increase reflects updated estimatesof the geographic mix of our profits and provisions for specific tax reserves.**Results of Operations for the Nine Months Ended September 29, 2006 and September 30, 2005**

 

Page 22RevenueConsolidated revenues of $1,079.4 million declined 1.9%, or 1.3% on a constant dollar basis, whencompared to the first nine months of 2005. These results reflect declines in boots and kids’sales, primarily in the U.S. and northern Europe, which offset progress in expanding key growthcategories including men’s and women’s casual footwear,TimberlandPRO® footwear andTimberland® brand apparel. Results also include benefits from new brands, includingSmartWool which added $31.7 million to year-to-date sales.Segments Review Timberland’s U.S. Wholesale revenues for the first nine months of 2006 were $414.3 million, down5.4% from the prior year period, driven primarily by declines in boots and kids’ footwear sales.These decreases were partially offset by the addition of SmartWool, which added $25.3 million toU.S. Wholesale revenues, and double-digit growth in Timberland PRO® footwear andTimberland® brand apparel.U.S. Consumer Direct revenues were $112.2 million, down 6.5% from the prior year. The decrease wasdriven by a 7.7% decline in comparable store sales, reflecting soft first half results and comparable store sales declines at outlet stores, which were impacted by our decision to removeclassic boot product from these stores as part of our strategy to strengthen overall pricing forthese products in the market place.International revenues for the first nine months of 2006 increased 1.9% to $553.0 million, despiteunfavorable foreign exchange rate changes of $6.3 million. On a constant dollar basis,International revenues grew 3.1%, reflecting continued growth in Asia, Canada and Europe. Overall,International revenues increased to 51.2% of total consolidated revenues for the first nine monthsof 2006.European revenues decreased 0.3% to $430.8 million, impacted by unfavorable foreign exchange ratechanges. On a constant dollar basis, European revenues increased 0.7%, driven by strong growth inthe key southern European markets of Italy and Spain and gains in our European distributorbusiness, which offset soft sales results in France, Benelux and the U.K. Double digit growth inmen’s and women’s casual footwear and solid gains in apparel and accessories were partially offsetby declines in boots and outdoor performance and kids’ footwear, particularly in northern Europeanmarkets.Asia posted revenues of $96.2 million, up 4.8%, or 8.2% in constant dollars, in comparison to theprior year period. Gains in Japan, our Asian distributor business, reflecting our expansion inChina, and Taiwan were responsible for most of the constant dollar increase. Asia’s growth issupported by sales gains in apparel and accessories, boots, men’s and women’s casual footwear andkids’ footwear.Canada contributed significant growth to our International business with year-to-date revenues of$19.3 million, representing a 49.1% increase over 2005. Sales results reflect increased footwearrevenues and benefits from the re-acquisition of distribution rights for apparel in Canada in 2006.ProductsWorldwide footwear revenue was $772.7 million in the first nine months of 2006, down 8.3% from theprior year period. Footwear results reflected declines in boots and kids’ footwear sales whichwere partially offset by gains in men’s and women’s casualfootwear and TimberlandPRO®footwear.Footwear unit sales decreased 10.8% primarily reflecting lower sales of boots and kids’ footwear.Average selling price increased 2.9% largely due to business mix impacts, including lower kids’sales and higher sales in international markets.Worldwide apparel and accessories revenue expanded 19.0% to $292.4 million. This increase wassupported by the addition of SmartWool, which added $31.7 million to global apparel and accessoriesrevenue, and strong gains in Timberland® brand apparel sales. Apparel and accessoriesunit sales increased 42.7%, while the average selling price decreased by 16.6%, reflecting impactsfrom of the addition of SmartWool’s products, which have lower average selling prices.Channels Worldwide wholesale revenues decreased 1.5% to $851.8 million as declines in sales of boots andkids’ footwear offset

 

Page 23increasesin apparel and accessories, TimberlandPRO®footwear and men’s casual footwear. Global consumer direct revenues decreased 3.5% to $227.6 million. Benefits fromglobal door expansion and growth in our e-commerce business were more than offset by a 6.7% declinein worldwide comparable store sales, impacted by soft U.S. results and declines in outlet storesales globally. During the first nine months of 2006, we opened twenty-two stores, shops andoutlets and closed ten worldwide.

 

Page 24Gross ProfitGross profit as a percentage of sales, or gross margin, was 47.8% for the first nine months of2006, down 240 basis points from the prior year period. The decrease was primarily driven byproduct mix impacts, including lower sales of boots and kids’footwear; higher product costs,including effects from anti-dumping duties on EU footwear; and impacts from higher levels ofoff-price and discounted sales.We include the costs of procuring inventory (inbound freight and duty, overhead and other similarcosts) in cost of goods sold. These costs amounted to $70.5 million and $75.9 million in the firstnine months of 2006 and 2005, respectively.Operating ExpenseOperating expense for the first nine months of 2006 was $413.4 million, $36.3 million or 9.6%higher than the $377.1 million reported in the prior year period. As a percentage of revenue,operating expense was 38.3%, up 400 basis points from the 34.3% reported in the first nine monthsof 2005. Operating expense growth was driven by $18.5 million of incremental costs associated withnew businesses and category development, including the addition of SmartWool, $11.7 million of costgrowth related to International expansion and $10.6 million of incremental costs associated withshare-based compensation, reflecting new accounting requirements.Selling expense for the first nine months of 2006 was $324.0 million, up $26.8 million or 9.0%compared to the prior year period. The increase was driven by $14.8 million in costs related tonew businesses and category development, $11.7 million in International business expansion, $6.8million in share-based employee compensation costs and $3.1 million in distribution expenses.These increases were partially offset by decreases of $6.1 million in marketing costs and $1.3million in product development expenses. Foreign exchange rate changes further reduced sellingexpense growth by $2.6 million or 0.9%.We include the costs of physically managing inventory (warehousing and handling costs) in sellingexpense. These costs totaled $28.3 million and $27.5 million in the first nine months of 2006 and2005, respectively.Advertising expense, which is also included in selling expense, was $14.9 million and $19.8 millionin the first nine months of 2006 and 2005, respectively. The decrease reflects shifts in spendingtowards other brand building activities.General and administrative expense was $88.6 million, an increase of $11.3 million or 14.6% higherthan the prior year period. The increase was driven by $3.9 million of share-based employeecompensation costs, $3.7 million related to new business initiatives, $3.0 million in globalsupport services and $2.4 million in costs associated with operating the new European financeshared service center. These increases were offset by a $4.0 million decline in worldwideincentive compensation costs. Foreign exchange rate changes had little impact on general andadministrative expense.Operating IncomeOperating income for the first nine months of 2006 was $102.2 million compared to $175.4 million inthe prior year period. Operating income as a percentage of revenue decreased from 15.9% to 9.5%reflecting gross margin pressures and increased expenses associated with investments against newbusinesses and growth category development, International expansionand effects from theimplementation of new accounting requirements related to share-based employee compensation costs.The U.S. Wholesale segment’s operating income decreased 22.0% to $108.9 million in the first ninemonths of 2006, driven by declines in both revenue and gross margin and increased operatingexpense. Revenue was down 5.4%, driven by decreases in boots and kids’ footwear sales. Grossmargin fell 160 basis points impacted by negative mix effects from decreased sales of boots andkids’ footwear, higher product costs and increased off-price sales. Operating expense increased26.2%, primarily due to the impact of SmartWool and moderate cost growth over a lower revenuebase.Operating income for our U.S. Consumer Direct segment was $2.9 million for the first nine months of2006 compared to$12.7 million in the prior year period. Revenue decreased 6.5%, reflecting a 7.7%decline in comparable store sales. Gross margin was down 350 basis points primarily due tonegative product mix impacts. During the first nine months of 2006, U.S. Consumer Direct operatedfive additional stores contributing to a 4.9% increase in operating expense.

 

Page 25International operating income was $124.8 million, down 11.3% from the prior year period.International profit margins were pressured by a decline in gross margins impacted by negativeproduct mix impacts from lower boot sales and higher comparable product costs, including effectsfrom EU anti-dumping duties.Our Unallocated Corporate expenses increased 14.4% to $134.4 million. Unallocated Corporateexpenses as a percentage of total revenue increased 180 basis points to 12.5% of total revenue.Excluding restructuring costs in the first nine months of 2006 and 2005 and increased share-basedemployee compensation costs of $12.5 million, Unallocated Corporate expenses increased $6.1 millionor 5.3% from the prior year and represent 11.2% of total revenue. This increase was driven by $4.5million in unfavorable product cost variances, $2.1 million in costs related to operating the newEuropean finance shared service center, $1.6 million of expenses associated with strategicinitiatives, $1.5 million of legal and compliance costs and $1.4 million in product management expenses,offset by a $6.0 million reduction in worldwide incentive compensation costs.Other Income and TaxesInterest income, net is comprised of interest income offset by fees related to the establishmentand maintenance of our revolving credit facility and interest paid on short-term borrowings. Forthe first nine months of 2006, interest income, net was $1.5 million compared to $2.7 million forthe prior year period. The decrease is primarily due to higher levels of short-term borrowings tomeet our seasonal working capital needs and lower cash balances, largely attributable to ourSmartWool acquisition.Other, net included $0.8 million and $(0.6) million of foreign exchange gains/(losses) for thefirst nine months of 2006 and 2005, respectively, resulting from the timing of settlement of localcurrency denominated receivables and payables. These gains/(losses) were driven by the volatilityof exchange rates within the first nine months of 2006 and 2005 and should not be considered indicativeof expected future results.The effective income tax rate for the first nine months of 2006 was 35.6% compared to 34.0% for theprior year period. The effective tax rate was adjusted in the third quarter of 2006 to increaseour full year 2006 tax rate estimate from 34.5% to 35.6%. This increase reflects updated estimatesof the geographic mix of our profits and provisions for specific tax reserves.Reconciliation of Total Company and International Revenue Changes to Constant Dollar RevenueChangesTotal Company Revenue Reconciliation:                   **For the Three Months** **For the Nine Months Ended**  **Ended September 29, 2006** **September 29, 2006**  **$ Change**     **$ Change**    **(in Millions)** **% Change** **(in Millions)** **% Change**     Revenue (decrease) $(2.9)  -0.6% $(21.0)  -1.9%Increase/(decrease) due to foreignexchange rate changes  7.9   1.5%  (6.3)  -0.6%     Revenue (decrease) in constant dollars $(10.8)  -2.1% $(14.7)  -1.3%International Revenue Reconciliation:                   **For the Three Months** **For the Nine Months Ended**  **Ended September 29, 2006** **September 29, 2006**  **$ Change**     **$ Change**    **(in Millions)** **% Change** **(in Millions)** **% Change**     Revenue increase $16.4   6.9% $10.5   1.9%Increase/(decrease) due to foreignexchange rate changes  7.9   3.3%  (6.3)  -1.2%     Revenue increase in constant dollars $8.5   3.6% $16.8   3.1%Management provides constant dollar revenue changes for total Company and International resultsbecause we use the measure to understand revenue changes excluding any impact from foreignexchange rate changes.

 

Page 26Reconciliation of Diluted EPS to Diluted EPS Excluding Restructuring and Related Costs andIncluding Share-Based Employee Compensation Costs Related to Stock Option and Employee StockPurchase Plans       **For the Twelve Months**   **Ended December 31, 2005** Diluted EPS,as reported $2.43 Per share impact of restructuring and related costs  .04     Diluted EPS excluding restructuring and related costs  2.47 Per share impact of share-based employeecompensation costs related to stock option andemployee stock purchase plans  (.12)    Diluted EPS excluding restructuring and relatedcosts and including share-based employeecompensation costs related to stock option andemployee stock purchase plans $2.35     Management provides dilutedEPS excluding restructuring and related costs and including share-based employee compensationcosts to understand earnings excluding restructuring and related costsand to provide comparability to reported results that include share-based employee compensationcosts as prescribed by SFAS 123(R).Accounts Receivable and InventoryAccounts receivable was $330.4 million as of September 29, 2006. Excluding SmartWool’s $12.9million, accounts receivable increased 6.5% to $317.5 million as of September 29, 2006, comparedwith $298.2 million as of September 30, 2005. The increase in comparable receivables in the thirdquarter of 2006 reflected the timing of sales in the quarter compared to the prior year and theimpacts of foreign exchange. Days sales outstanding were 59 days as of September 29, 2006,compared with 53 days as of September 30, 2005. Wholesale days sales outstanding were 63 days and56 days for the third quarters ended 2006 and 2005, respectively.Inventory was $250.5 million as of September 29, 2006. Excluding SmartWool’s $13.1 million,inventory decreased 2.1% to $237.4 million as of September 29, 2006, compared with $242.6 millionas of September 30, 2005. The reduction in comparable inventories in the third quarter of 2006reflected continued efforts to reduce excess inventory as a percentage of overall mix.**Liquidity and Capital Resources**Net cash used by operations for the first nine months of 2006 was $101.2 million, compared with$57.5 million for the first nine months of 2005. The increase in the use of cash in the first ninemonths of 2006 compared with 2005 was primarily due to reduced net income and an increase in ourinvestment in working capital. In the first nine months of 2006, our net investment in workingcapital was $204.9 million, compared to $202.2 million in 2005. Working capital increases primarilyreflect higher quarter-end receivables balances, impacted by sales timing, and higher inventorylevels related to the addition of new businesses, including SmartWool. The increase in accruedexpenses is primarily related to increased accruals for freight and duty and the timing of valueadded tax (“VAT”) payments, offset by lower payroll related accruals as of September 29, 2006,compared with December 31, 2005, than in the comparable period for the prior year. The increase inprepaids was driven by the timing of VAT payments and increased investment in concept shopfixturing and samples. The reduction in income taxes payable is due to reduced net income.Net cash used for investing activities amounted to $26.1 million in the first nine months of 2006,compared with $15.6 million in the first nine months of 2005. Capital expenditures accounted for$21.9 million of this increase with growth primarily driven by investments in information systems,manufacturing equipment and retail stores. The increase in other investing activities primarilyrelates to our acquisition of certain assets of GoLite LLC, including trademarks.Net cash used for financing activities was $25.3 million in the first nine months of 2006, comparedwith $111.2 million in the first nine months of 2005. Cash flows from financing activitiesreflected share repurchases of $95.5 million in the first nine months of 2006, compared with $128.9million in the first nine months of 2005. As of September 29, 2006, we had outstanding balancesunder our short-term credit facilities of $54.2 million, compared with no borrowings as ofSeptember 30, 2005. We received cash inflows of $13.5 million in the first nine months of 2006from the issuance of common stock related

 
Page 27to the exercise of employee stock options and employee stock purchases, compared with $17.7million in the first nine months of 2005.We have an unsecured committed revolving credit agreement with a group of banks which matures onJune 2, 2011 (“Agreement”). The Agreement provides for $200 million of committed borrowings, ofwhich up to $125 million may be used for letters of credit. Upon approval of the bank group, wemay increase the committed borrowing limit by $100 million for a total commitment of $300 million.Under the terms of the Agreement, we may borrow at interest rates based on Eurodollar rates (5.3%as of September 29, 2006), plus an applicable margin of between 13.5 and 47.5 basis points based ona fixed charge coverage grid that is adjusted quarterly. As of September 29, 2006, the applicablemargin under the facility was 27 basis points. We will pay a utilization fee of an additional 5basis points if our outstanding borrowings under the facility exceed $100 million. We will alsopay a commitment fee of 6.5 to 15 basis points per annum on the total commitment, based on afixed-charge coverage grid that is adjusted quarterly. As of September 29, 2006, the commitmentfee was 8 basis points. The Agreement places certain limitations on additional debt, stockrepurchases, acquisitions, amount of dividends we may pay and certain other financial andnon-financial covenants. The primary financial covenants relate to maintaining a minimum fixedcharge coverage of 3:1 and a leverage ratio of 2:1. We measure compliance with the financial andnon-financial covenants and ratios as required by the terms of the Agreement on a fiscal quarterbasis.On December 20, 2005, we entered into a $4.5 million committed revolving credit agreement thatmatures on December 19, 2006 to provide for SmartWool’s working capital requirements. Up to $3million of the facility may be used for letters of credit.We had uncommitted lines of credit available from certain banks totaling $50 million as ofSeptember 29, 2006. Borrowings under these lines are at prevailing money market rates (5.8% as ofSeptember 29, 2006). Further, we had an uncommitted letter of credit facility of $80 million tosupport inventory purchases. These arrangements may be terminated at any time at the option of thebanks or the Company.As of September 29, 2006, we had short-term debt outstanding of $54.2 million and no long-term debtoutstanding under our credit facilities. As of September 30, 2005, we had no short-term orlong-term debt outstanding under any of our credit facilities.Management believes that our capital needs and our share repurchase program for the balance of 2006will be funded through our current cash balances, our existing credit facilities and cash fromoperations, without the need for additional permanent financing. However, as discussed in Item 1A,Risk Factors, of our Annual Report on Form 10-K for the year ended December 31, 2005 and in PartII, Item 1A, Risk Factors, of this report, several risks and uncertainties could cause the Companyto need to raise additional capital through equity and/or debt financing. From time to time theCompany considers acquisition opportunities which, if pursued, could also result in the need foradditional financing. The availability and terms of any such financing would be subject toprevailing market conditions and other factors at that time.Off Balance Sheet ArrangementsAs of September 29, 2006 and September 30, 2005, we had letters of credit outstanding of $25.4million and $14.0 million, respectively. These letters of credit were issued predominantly for thepurchase of inventory. The increase in letters of credit outstanding was driven by higher apparelpurchases and obligations associated with provisional anti-dumping duties on European Unionfootwear sourced in China and Vietnam. As of September 29, 2006, the Company had $224.4 million inforeign currency contracts outstanding, all of which are due to settle within the next 16 months.We have the following off balance sheet arrangements: