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  **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****Forthe quarterly period ended March 31, 2006****OR**   o **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934****For the transition period from                      to                    ****CommissionFile 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’sTelephone 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 NoOnMay 5, 2006, 52,157,108 shares of the registrant’s Class A Common Stock wereoutstanding and 11,743,660 shares of the registrant’s Class B Common Stock were outstanding.  
 

 
**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 -March 31, 2006, April 1, 2005 and December 31, 2005  3      Unaudited Condensed Consolidated Statements of Income -For the Three Months Ended March 31, 2006 and April 1, 2005  4      Unaudited Condensed Consolidated Statements of Cash Flows -For the Three Months Ended March 31, 2006 and April 1, 2005  5      Notes to Unaudited Condensed Consolidated Financial Statements  6-14      **Item 2. Management’s Discussion and Analysis of FinancialCondition and Results of Operations**  15-23      **Item 3. Quantitative and Qualitative Disclosures About Market Risk**  24      **Item 4. Controls and Procedures**  24      **Part II Other Information**         **Item 1A. Risk Factors**  25      **Item 2. Unregistered Sales of Equity Securities and Use of Proceeds**  26      **Item 6. Exhibits**  27      Signatures  28      Exhibit Index  29      Exhibits     Ex-31.1 Section 302 Certification of CEO Ex-31.2 Section 302 Certification of CFO Ex-32.1 Section 906 Certification of CEO Ex-32.2 Section 906 Certification of CFO
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**PART I FINANCIAL INFORMATION****Item 1. FINANCIAL STATEMENTS****THE TIMBERLAND COMPANY****UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS**(Dollars in Thousands)               **March 31,**  **April 1,**  **December 31,**   **2006**  **2005**  **2005** **Assets**            Current assets            Cash and equivalents $125,284  $203,715  $213,163 Accounts receivable, net of allowance for doubtful accounts of $8,009 atMarch 31, 2006, $8,888 at April 1, 2005 and $8,755 at December 31, 2005  192,087   187,523   168,831 Inventory  174,945   161,027   167,132 Prepaid expense  37,424   28,410   33,502 Deferred income taxes  19,813   15,990   26,934 Derivative assets  2,099   —   6,044           Total current assets  551,652   596,665   615,606           Property, plant and equipment, net  81,998   78,232   82,372 Deferred income taxes  541   —   — Goodwill  39,533   14,163   39,503 Intangible assets, net  40,216   5,095   40,909 Other assets, net  10,579   10,493   10,264           Total assets $724,519  $704,648  $788,654                        **Liabilities and Stockholders’ Equity**            Current liabilities            Accounts payable $70,025  $53,009  $97,294 Accrued expense            Payroll and related  25,512   26,831   48,721 Other  54,477   61,764   53,121 Income taxes payable  18,228   14,359   44,210 Derivative liabilities  —   4,380   —           Total current liabilities  168,242   160,343   243,346           Deferred compensation and other long-term liabilities  15,633   13,935   16,046 Deferred income taxes  —   6,537   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; 72,381,887 shares issued at March 31, 2006,71,156,442 shares issued at April 1, 2005 and 71,804,959 shares issuedat December 31, 2005  724   712   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 March 31, 2006,April 1, 2005 and December 31, 2005  117   117   117 Additional paid-in capital  206,771   208,242   214,483 Deferred compensation  —   (34,107)  (27,166)Retained earnings  768,191   616,623   739,004 Accumulated other comprehensive income  6,992   10,722   8,696 Treasury Stock at cost; 19,924,851 Class A shares at March 31, 2006,15,336,086 Class A shares at April 1, 2005 and 18,921,290 Class A sharesat December 31, 2005  (442,151)  (278,476)  (407,665)          Total stockholders’ equity  540,644   523,833   528,187           Total liabilities and stockholders’ equity $724,519  $704,648  $788,654           *The accompanying notes are an integral part of these unaudited condensed consolidated financialstatements.*
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**THE TIMBERLAND COMPANY****UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF INCOME**(Amounts in Thousands, Except Per Share Data)           **For the Three Months Ended**   **March 31,**  **April 1,**   **2006**  **2005** Revenue $349,811  $354,211 Cost of goods sold  173,708   167,050        Gross profit  176,103   187,161                 Operating expense        Selling  104,740   100,739 General and administrative  28,629   24,502 Restructuring costs  481   —        Total operating expense  133,850   125,241                 Operating income  42,253   61,920                 Other income        Interest income, net  1,105   1,101 Other, net  1,202   990        Total other income  2,307   2,091                 Income before provision for income taxes  44,560   64,011          Provision for income taxes  15,373   21,764                 Net income $29,187  $42,247                 Earnings per share        Basic $.46  $.63 Diluted $.45  $.61 Weighted-average shares outstanding        Basic  63,583   67,587 Diluted  64,996   69,026 *The accompanying notes are an integral part of these unaudited condensed consolidated financialstatements.*
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**THE TIMBERLAND COMPANY****UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**(Dollars in Thousands)           **For the Three Months Ended**   **March 31,**  **April 1,**   **2006**  **2005** Cash flows from operating activities:        Net income $29,187  $42,247 Adjustments to reconcile net income to net cash used by operating activities:        Deferred income taxes  4,215   6,567 Share-based compensation  5,255   662 Depreciation and other amortization  6,500   5,962 Tax benefitfrom share-based compensation, net ofexcess benefit  1,405   2,845 Changes in other long-term assets and liabilities  (275)  64 Increase/(decrease) in cash from changes in working capital:        Accounts receivable  (21,676)  (36,116)Inventory  (7,521)  (33,474)Prepaid expense  (3,670)  (1,333)Accounts payable  (28,079)  3,462 Accrued expense  (20,530)  (35,400)Income taxes payable  (24,549)  (20,309)       Net cash used by operating activities  (59,738)  (64,823)                Cash flows from investing activities:        Additions to property, plant and equipment  (5,528)  (4,334)Other  (238)  (102)       Net cash used by investing activities  (5,766)  (4,436)                Cash flows from financing activities:        Common stock repurchases  (35,902)  (41,868)Issuance of common stock  10,454   7,947 Excess taxbenefit from share-based compensation  2,270   —        Net cash used by financing activities  (23,178)  (33,921)        Effect of exchange rate changes on cash and equivalents  803   (2,221)                Net decrease in cash and equivalents  (87,879)  (105,401)Cash and equivalents at beginning of period  213,163   309,116        Cash and equivalents at end of period $125,284  $203,715                 Supplemental disclosures of cash flow information:        Interest paid $90  $164 Income taxes paid $31,979  $32,730 *The accompanying notes are an integral part of these unaudited condensed consolidated financialstatements.*
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**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 the first quarters of 2006 and 2005, we recorded $1,025 and $1,195 of reimbursed shippingexpenses within revenues and the related shipping costs within selling expense, respectively.Shipping costs are included in selling expense and were $4,623 and $4,482 for the first quarters of2006 and 2005, respectively.We maintain allowances for doubtful accounts for estimated losses resulting from the potentialinability of our customers to make required payments. We estimate potential losses primarily basedon our historical rate of credit losses and our knowledge of the financial condition of ourcustomers. We also make other estimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses as described in the “Critical Accounting Policies” discussion inPart I Item 2 of this report.**Note 2. Historical Financial Results**The results of operations for the three months ended March 31, 2006 are not necessarily indicativeof the results to be expected for the full year. Historically, our revenue has been more heavilyweighted 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 transition method, compensation expense is recognized on all share-based awards granted priorto, but not yet vested as of adoption based on the grant date fair value estimated in accordancewith the original provisions of SFAS 123. The Company recognizes thecost of share-based awardson a straight-line basis over the award’s requisite service period (generally the vesting periodof the award), with the exception of certain stock options for officers, directors and keyemployees granted prior to, but not yet vested as of adoption, for which expense continues to berecognized on a graded schedule over the vesting period of the award. Share-based compensation costs,which are recorded in cost of goods sold and selling and general and administrative expenses,totaled $5,255 ($3,442 net of taxes) for the three months ended March 31, 2006.As a result of adopting SFAS 123(R), the Company’s income before provision for income taxes and netincome for the three months ended March 31, 2006, are $2,915 and $1,909 lower, respectively, thanif we had continued to account for share-based compensation under APB Opinion 25. Basic anddiluted earnings per share for the three months ended March 31, 2006 would have been $.49 and $.48,respectively, if the Company had not adopted SFAS 123(R), compared to reported basic and dilutedearnings per share of $.46 and $.45, respectively.
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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 income for the threemonths ended April 1, 2005, no compensation expense was recognized for stock option grants; however, the Company recognized compensation expense fornonvested share awards of $662 ($437 net of taxes). The following table illustrates the effects onnet income and earnings per share had compensation expense for stock option grants issued beendetermined under the fair value method of SFAS 123 for the three months ended April 1, 2005:       **For the Three**   **Months Ended**   **April 1, 2005** Net income, as reported $42,247 Add: Share-based employee compensation expense included inreported net income, net of related tax effect  437 Deduct: Total share-based employee compensation expensedetermined under fair value based method for all awards, netof related tax effect  2,447     Pro forma net income $40,237     Basic earnings per share, as reported $.63 Pro forma basic earnings per share $.60 Diluted earnings per share, as reported $.61 Pro forma diluted earnings per share $.58 Financial statement amounts for the three months ended April 1, 2005 have not been restated toreflect 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 forshare-based awards (excess tax benefits)are now classified as financing cash flows. In the unaudited condensed consolidated statement ofcash flows for the three months ended March 31, 2006, the total excess tax benefit of $2,270related to share-based compensation included in cash flows from financing activities would havebeen included in cash flows from operating activities if the Company had not adopted SFAS 123(R).
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The Company received $10,454 in proceeds on the exercise of stock options under the Company’s stockoption and employee stock purchase plans and recorded a tax benefitof $3,645 related to thesestock option exercises during the three months ended March 31, 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.Sharesissued upon the exercise of stock options under the Company’sstock option and employee stockpurchase plans are normally from authorized but unissued shares of the Company’s Class A CommonStock. However, to the extent that the Company has treasury shares outstanding, such shares may bereissued upon the exercise of stock options.*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.The option price per share and vesting periods of stock options are determined by the ManagementDevelopment and Compensation Committee of the Board of Directors. Outstanding stock optionsgranted under the 1997 Plan are granted at market value atdate of grant and become exercisable either in equal installments over three years, beginning oneyear after the grant date, or become exercisable two years after grant date. Prior to 2006, moststock options granted under the 1997 Plan were exercisable in equal installments over four years.All options expire ten years after 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 fair marketvalue of the stock on the date of the grant. Initial awards of stock options granted under the2001 Plan to new directors become exercisable in equal installments over three years and annualawards of options granted under the 2001 Plan become fully exercisable one year from the date ofgrant and, in each case, expire ten years after grant date. Stock options granted under the 2001Plan prior to December 31, 2004 become exercisable in equal installments over four years, beginningone year 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 granted under the 1997 Plan is estimated using the historical exercise behavior ofemployees. The expected term of options granted under the 2001 Plan is calculated using thesimplified method as prescribed by the Securities and Exchange Commission’s Staff AccountingBulletin No. 107. Prior to adoption of SFAS 123(R), the expected term of options granted under the2001 Plan was estimated using the historical exercise behavior of 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**  **March 31, 2006** **April 1, 2005**Expected volatility  30.1%  29.7%Risk-free interest rate  4.6%  3.5%Expected life (in years)  4.0   4.6 Expected dividends  —   — The following summarizes transactions under all stock option arrangements for the three monthsended March 31, 2006:
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                           **Weighted-**          **Weighted-**  **Average**          **Average**  **Remaining**  **Aggregate**       **Exercise**  **Contractual**  **Intrinsic**   **Shares**  **Price**  **Term (Years)**  **Value** Outstanding at January 1,2006  5,708,184  $25.15         Granted  525,000   34.98         Exercised  (576,928)  18.26         Expired or forfeited  (148,164)  26.98                      Outstanding at March 31, 2006  5,508,092  $26.76   7.23  $42,801               Exercisable at March 31, 2006  2,958,749  $23.07   6.13  $33,252              The weighted-average grant date fair values per share of stock options granted, for which exerciseprice equals market value at the date of grant, were $10.78 and $10.82 for the three months endedMarch 31, 2006 and April 1, 2005, respectively. The total intrinsic values of stock optionsexercised during the three months ended March 31, 2006 and April 1, 2005 were $9,625 and $7,639,respectively.
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Information on stock options outstanding and exercisable as of March 31, 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** $  2.17  —  17.74    891,954   4.56  $14.07   884,029  $14.05 17.81  —  19.10  130,179   6.08   18.21   75,354   18.22 19.12  —  19.49  726,569   6.91   19.47   450,639   19.48 19.50  —  26.86  490,456   7.13   24.33   275,231   24.11 27.22  —  28.50  558,580   4.96   28.44   552,205   28.45 28.63  —  31.19  137,550   8.41   29.52   20,175   30.01 31.29  —  31.29  935,107   7.92   31.29   464,735   31.29 31.32  —  35.01  787,100   9.55   34.07   51,050   31.81 35.02  —  35.27  5,250   9.09   35.22   1,050   35.23 35.42  —  39.70  845,347   8.96   35.69   184,281   35.45                 $  2.17—  39.70    5,508,092   7.23  $26.76   2,958,749  $23.07                 Total unrecognized share-based compensation expense related to nonvested stock options was $13,988as of March 31, 2006. The cost is expected to be recognized over the weighted-average period of1.5 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. 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 grant.Changes in the Company’s nonvested shares for the three months ended March 31, 2006 are as follows:               **Weighted-**       **Average**       **Grant Date**   **Shares**  **Fair Value** Unvested at January 1, 2006  698,061  $36.27 Vested  (59,142)  27.10        Unvested at March 31, 2006  638,919  $37.12        Unrecognized compensation expense related to nonvested share grants was $14,839 as of March 31,2006. The expense is expected to be recognized over a weighted-average period of 1.3 years.Under the provisions of SFAS 123(R), we are no longer required to record deferred compensation forthe unvested portion of nonvested share grants. Accordingly, upon adoption of SFAS 123(R), thebalance of deferred compensation was reversed to zero, resulting in an offsetting reduction toadditional paid-in capital in the unaudited condensed consolidated balance sheet.*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.
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           **For the Three Months Ended**  **March 31, 2006** **April 1, 2005**Expected volatility  32.8%  25.9%Risk-free interest rate  4.4%  2.5%Expected life (in months)  6   6 Expected dividends  —   — The weighted-average fair values of the Company’s ESP Plan purchase rights were approximately $8.31and $6.50 for the three months ended March 31, 2006 and April 1, 2005, respectively.Total unrecognized compensation expense related to the unvested portion of the Company’s ESP awardswas $144 as of March 31, 2006. The expense is expected to be recognized in the second quarter of2006.**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 months ended March 31, 2006 and April 1, 2005:                           **March 31, 2006** **April 1, 2005**      **Weighted -** **Per-**     **Weighted-** **Per-**  **Net** **Average** **Share** **Net** **Average** **Share**  **Income** **Shares** **Amount** **Income** **Shares** **Amount**     Basic EPS $29,187   63,583  $.46  $42,247   67,587  $.63 Effect of dilutivesecurities  —   1,413   (.01)  —   1,439   (.02)     Diluted EPS $29,187   64,996  $.45  $42,247   69,026  $.61      The following options (in thousands) were outstanding as of March 31, 2006 and April 1, 2005, butwere not included in the computation of diluted EPS because the options’ exercise price was greaterthan the average market price of the common shares:           **March 31, 2006**  **April 1, 2005** Options to purchase shares of common stock  1,177   256 **Note 5. Comprehensive Income**Comprehensive income for the three months ended March 31, 2006 and April 1, 2005 is as follows:           **For the Three Months Ended**   **March 31, 2006**  **April 1, 2005** Net income $29,187  $42,247 Change in cumulative translation adjustment  2,044   (4,523)Change in fair value of derivative financial instruments, net of taxes  (3,748)  5,018        Comprehensive income $27,483  $42,742        For the three months ended March 31, 2006 and April 1, 2005, the after tax hedging gains/(losses)reclassified to earnings were $2,226 and ($1,427), 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
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licensed products sold in the UnitedStates, the management costs and expenses associated with our worldwide licensingefforts and certain marketing expenses and value added services. The U.S. Consumer Direct segmentincludes the Company-operated specialty and factory outlet stores in the United States and oure-commerce business. The International segment consists of the marketing, selling and distributionof footwear, apparel and accessories and licensed products outside of the United States. Productsare sold outside of the United States through our subsidiaries (which use wholesale and retailchannels to sell footwear, 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, amajority of United States marketing expenses, worldwide product development and other costsincurred in support of Company-wide activities. It also includes allcosts related to share-basedcompensation. Additionally, Unallocated Corporate includes total other income, which is primarily interestincome, net, and other miscellaneous income, net. Such income is not allocated among the reportedbusiness 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 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,and United States transportation and distribution equipment.**For the Three Months Ended March 31, 2006 and April 1, 2005**                           **U.S.**          **U.S.** **Consumer**     **Unallocated**    **Wholesale** **Direct** **International** **Corporate** **Consolidated****2006**                    Revenue $124,704  $33,060  $192,047  $—  $349,811 Operating income/(loss)  33,303   183   51,516   (42,749)  42,253 Income/(loss) before income taxes  33,303   183   51,516   (40,442)  44,560 Total assets  219,223   30,821   344,400   130,075   724,519 Goodwill  31,745   794   6,994   —   39,533                      **2005**                    Revenue $116,818  $38,319  $199,074  $—  $354,211 Operating income/(loss)  36,151   4,466   55,039   (33,736)  61,920 Income/(loss) before income taxes  36,151   4,466   55,039   (31,645)  64,011 Total assets  151,581   27,854   306,273   218,940   704,648 Goodwill  6,804   794   6,565   —   14,163 **Note 7. Inventory**Inventory consists of the following:               **March 31, 2006**  **April 1, 2005**  **December 31, 2005** Materials $2,880  $3,144  $3,483 Work-in-process  677   1,411   762 Finished goods  171,388   156,472   162,887           Total $174,945  $161,027  $167,132           
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**Note 8. Nonvested Share Awards and Other**In 2004, our Board of Directors approved future awards 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 is 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, $10,000 of nonvested shares will be awardedon July 5, 2006. The number of shares to be awarded will be determined by the share price at thatdate. These shares will fully vest three years from the award date. Based on the achievement of2004 performance targets, 275,117 of nonvested shares with a value of $10,873 were awarded on July5, 2005 and will vest equally over three years from the award date. An additional grant, based onthe achievement of a separate performance target, of 200,000 nonvested shares with a value of$7,904 was also awarded on July 5, 2005 and will vest two years after the award date. All of theseshares are subject to restrictions on sale and transferability, a risk of forfeiture and certainother terms and conditions. Through December 31, 2005, we recorded deferred compensation on ourbalance sheet to reflect these future awards. Under the provisions of SFAS 123(R), we are nolonger required to record deferred compensation for these future awards. For the measurementperiod from January 1, 2006 through December 31, 2006, a grant of $8,732 may be made in 2007 ifcertain targeted performance goals are achieved. The award amount will vary based upon the degreeto which these performance goals are attained. The number of shares to be awarded will bedetermined by the share price on the award date. Additionally, a cash incentive award of up to$3,000 may be awarded in 2007 based on the achievement of a performance target over a three yearmeasurement period from January 1, 2004 through December 31, 2006.In March 2005, our Board of Directors approved an additional cash incentive award of up to $1,250,which will be awarded in 2007 and was based on the achievement of a performance target over a oneyear measurement period from January 1, 2005 through December 31, 2005.**Note9. Restructuring Costs**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.During the first quarter of 2006, we commenced 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, which are currently performed by our locallybased finance organizations.The following table sets forth our restructuring activity for the three months ended March 31,2006:                   **Restructuring**          **Restructuring**   **Liabilities at**      **Cash**  **Liabilities at**   **December31, 2005**  **Charges**  **Payments**  **March31, 2006** Severance and employment relatedcharges $3,784  $237  $3,063  $958 Other charges  179   244   232   191              Total $3,963  $481  $3,295  $1,149              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.Of the total restructuring charges of $481 for the three month period ended March 31, 2006, $324 isdue to the closing of our manufacturing facility in Puerto Rico and $157 is attributable tothe elimination of positions in our locally based financeorganizations in Europe. We expect to complete the Puerto Ricoclosure in the second quarter of 2006, but will continue to make cash payments for severancebenefits through the second quarter of 2007. European finance shared service center restructuringactivity will also continue through the second quarter of 2007.Totaladditional charges of approximately $649 million will be incurred over the balance of 2006and $100 million in 2007, which are expected to cover the remaining severance and employmentrelated charges, largely for the European finance shared servicecenter restructuring activity.
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**Note 10. Income Taxes**The effective tax rate for the three months ended March 31, 2006 and April 1, 2005 was 34.5% and34.0%, respectively.**Note 11. Share Repurchase**On September 23, 2003, our Board of Directors approved an additional repurchase of 4,000,000 sharesof our Class A Common Stock. On March 3, 2005, our Board of Directors approved a 100% increase inshares remaining under its previously announced October 2003 repurchase program as of April 14,2005, the record date of the 2-for-1 stock split. The increase was effective immediately after theMay 2, 2005 distribution date. The repurchase of shares under these authorizations was completedon December 1, 2005.On August 12, 2005 and February 7, 2006, our Board of Directors approved additional repurchases of2,000,000 and 6,000,0000 shares, respectively, of our Class A Common Stock. As of March 31, 2006,6,472,019 shares remained under these authorizations. Shares repurchased totaled 1,003,561 duringthe quarter ended March 31, 2006.We may use repurchased shares to offset future issuances under the Company’s stock-based employeeincentive plans or for other purposes. From time to time, we use Rule 10b5-1 plans to facilitateshare repurchases.**Note 12. 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.
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**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 total Company and International revenue changes to constant dollar revenuegrowth, diluted earnings per share (“EPS”) to diluted EPS excluding restructuringand related costs, diluted EPS to diluted EPS excluding restructuring and related costs and including share-basedemployee compensation costs related to stock option and employeestock purchase plans for 2005 and operating income includingshare-based employee compensation costs related to stock option andemployee stock purchase plans for the first quarter of 2005. Constant dollar revenue growth, which excludes the impact ofchanges in foreign exchange rates, diluted EPS excludingrestructuring and related costs, diluted EPS excluding restructuring and related costs and including share-based employeecompensation costs related to stock option and employee stockpurchase plans and operating income including share-based employeecompensation costs related to stock option and employee stockpurchase plans are not Generally Accepted Accounting Principle (“GAAP”) performance measures.We provide constant dollar revenue growth for total Company and International results because weuse the measure to understand revenue changes excluding any impact from foreign exchange ratechanges. Management provides diluted EPS excluding restructuring and related costs because we usethe measure to understand earnings excluding these identifiable expenses. Management providesdiluted EPS excluding restructuring and related costs and including share-based employeecompensation costs related to stock option and employee stockpurchase plans for 2005 and operating income including share-basedemployee compensation costs related to stock option and employeestock purchase plans for the first quarter of 2005 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 SFAS123(R) which is noted below. Our estimates,assumptions and judgments involved in applying the critical accounting policies are described inthe Management’s Discussion and Analysis of Financial Condition and Results of Operations sectionof 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 materiallyimpacted in future periods. See Note 3 for additional information regarding the Company’s adoption of SFAS 123(R).**Recent Developments**EuropeanUnion (EU) DutiesOn 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, are expected to be effective for a six-month period and willbe phased in over a period of five months, beginning at a rate of about 4% and ending at a 19.4%rate for China sourced footwear and at a 16.8% rate for Vietnam sourced footwear. These duties may
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become definitive on or before October 7, 2006. The Company is advancing strategies in response tothis action, including potential price increases on footwear products sold in Europe. Our estimateis that the implementation of such duties will likely reduce our 2006 operating profits in therange of $10 million. The implementation of these duties, whichresults in additional expenses in lower tax rate jurisdictions, has also had a negative impact on theCompany’s effective tax rate, which is now estimated at 34.5% for 2006.SmartWoolOn December 20, 2005, the Company acquired SmartWool Corporation (“SmartWool”). The first quarter2006 results include the results of SmartWool.Adoption of SFAS 123(R)Effective January 1, 2006, the Company adopted SFAS 123(R), which requires a company to measure thegrant date fair value of equity awards given to employees in exchange for services and recognizethat cost over the period that such services are performed. ThisStandard is a revision of SFAS123, “Accounting for Stock-Based Compensation,” and supersedes Accounting Principles Board (“APB”)Opinion 25, “Accounting for Stock Issued to Employees,” and its related implementation guidance.The Company adopted the provisions of SFAS 123(R) using the modified prospective applicationmethod. Under this transition method, compensation expense is recognized on all share-based awardsgranted prior to, but not yet vested as of adoption based on the grant date fair value estimated inaccordance with the original provisions of SFAS 123. The Companyrecognizes the cost of allshare-based awards on a straight-line basis over the award’s requisite service period (generallythe vesting period of the award), with the exception of certain stockoptions for officers, directors and key employees granted prior to,but not yet vested as of adoption, for which expense continues to berecognized on a graded schedule over the vesting period of the award. Share-based compensation costs, which are recorded in cost ofgoods sold and selling and general and administrative expenses,totaled $5.3 million ($3.4 million net oftaxes) for the three months ended March 31, 2006.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 income for the threemonths ended April 1, 2005, no compensation expense was recognized for stock option grants; however, the Company recognized compensation expense fornonvested share awards of $0.7 million ($0.4 million net oftaxes).Management provides information on diluted EPS including impacts from share-basedcompensation for 2005 to assist in comparability to 2006 reported results that include share-based employeecompensation costs as prescribed by SFAS 123(R). The following table illustrates the effects on netincome and earnings per share had compensation expense for stock option grants issued beendetermined under the fair value method of SFAS 123 for the three months ended April 1, 2005:       **For the Three**   **Months Ended** **Amounts in Thousands Except Per ShareData** **April 1, 2005**  Net income, as reported $42,247 Add: Share-based employee compensation expense included inreported net income, net of related tax effect  437 Deduct: Total share-based employee compensation expensedetermined under fair value based method for all awards, netof related tax effect  2,447     Pro forma net income $40,237     Basic earnings per share, as reported $.63 Pro forma basic earnings per share $.60 Diluted earnings per share, as reported $.61 Pro forma diluted earnings per share $.58 Financial statement amounts for the three months ended April 1, 2005 have not been restated toreflect the fair value method of expensing share-based compensation.See Note 3 for additional information regarding the adoption of SFAS 123(R).
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]**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 first quarter of 2006 financial performance, compared to the first quarter of2005, include the following: **•** First quarter revenue decreased 1.2% from strong prior year results to $349.8 million asconstant dollar gains in international markets and growth in our U.S. casual, outdoorperformance and industrial categories were offset by U.S. boot declines and negativeforeign exchange impacts. On a constant dollar basis, first quarter revenue expanded 2.4%.  **•** Operating profit for the quarter was $42.3 million including impacts of a restructuringcharge of $0.5 million related to the closure of our Puerto Rico manufacturing operationsand our establishment of a European finance shared service center.  **•** Gross margin declined 250 basis points driven by product mix impacts reflecting lowerboot sales, higher product costs and relatively higher levels of sales discounts andallowances.  **•** Operating expenses increased 6.9% to $133.9 million, or 6.5% excluding restructuringcosts. Growth reflects increased costs associated with business portfolio development,investments in international expansion and higher costs associated with share-based paymentcompensation reflecting new accounting requirements.  **•** Net income decreased 30.9% from record prior year results to $29.2 million.  **•** Diluted EPS decreased 26.2% from $.61 to $.45.  **•** Cash at the end of the quarter was $125.3 million with no debt outstanding.While our first quarter results were largely in line with our expectations, we are modifying our2006 financial outlook to incorporate the impact of provisionalanti-dumping duties on EU footwear sourced in China and Vietnam, proactive steps that we are taking to ensurebalanced inventory positions for our retail partners in the U.S. boot business and impacts fromcontinued soft trends in U.S. boots. For 2006, we are now targeting flat to modest revenue growthand declines in comparable EPS in the 20%-25% range. Included in this outlook is an increase in ouroverall effective tax rate to 34.5% due to the imposition of provisional EU duties. For thepurpose of comparison, we estimate that our 2005 EPS would have been approximately $2.35 afterexcluding restructuring and related costs and including costs related to stock options and our employee stockpurchase plan.Impacts from these factors are expected to be greatest in the second quarter of 2006. Weanticipate second quarter sales declines in the mid single-digit range and a likely operating lossin the $20-$25 million range. For the second half we expect lower comparable earnings, impacted byanticipated pressure on third quarter results. In the third quarter we expect low single-digitrevenue growth overall and gross margin declines in the 300-400 basis point range, includingimpacts from EU duties in the $5-$6 million range. For thefourth quarter of 2006 we are targeting improved performance with midsingle-digit revenue growth and more moderate gross margin pressures.
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**Results of Operations for the Three Months Ended March 31, 2006 and April 1, 2005**RevenueConsolidated revenue was down 1.2% in comparison to the first quarter of 2005, as modest constantdollar gains in international markets and growth in our U.S. business, supported by our acquisitionof SmartWool, were offset by foreign exchange impacts. Changes in foreign exchange rates reducedfirst quarter consolidated revenues by $12.9 million or 3.6%. On a constant dollar basis, revenuegrew 2.4% over the prior year. U.S. business revenue totaled $157.8 million in the first quarterof 2006, up 1.7% from the prior year, benefiting from gains in targeted expansion categories suchas casual, outdoor and professional offset by declines in our U.S. boot business. Internationalrevenues were $192.0 million, down 3.5% from the first quarter of 2005, reflecting unfavorablechanges in foreign exchange rates over the past year. On a constant dollar basis, Internationalrevenues grew 3.0%, supported by gains in Asia and Canada.Segments Review We have three reportable business segments (see Note 6): U.S. Wholesale, U.S. Consumer Direct andInternational.U.S. Wholesale revenues increased 6.8% to $124.7 million, benefiting from Timberland’s recentacquisition of SmartWool and growth in key footwear categories such as Timberland PRO®,men’s casual and outdoor performance and apparel. Timberland’s acquisition of SmartWool added $7.8million to first quarter 2006 U.S. Wholesale revenues. These gains were offset by declines inboots, kids and women’s casual footwear.Timberland’s U.S. Consumer Direct business recorded revenues of $33.1 million, down $5.3 million or13.7% compared with the first quarter of 2005, impacted by a narrower assortment of excess productavailability in outlet stores and unseasonably warm weather conditions which hurt sales of winterproducts. The sales decrease was driven by declines in boots, men’s casual and kids footwear andapparel and accessories. A decline in comparable specialty and factory outlet store sales of 12.8%was partially offset by a 25.3% increase in our e-commerce business, including the addition ofSmartWool’s e-commerce business. During the first quarter of 2006, we closed three U.S. stores.We intend to offset these closures with openings over the balance of the year and are targetingfive net store additions in the U.S. this year.International revenues for the first quarter of 2006 were $192.0 million, down 3.5% from the prioryear, reflecting unfavorable foreign exchange rate changes of $12.9 million. On a constant dollarbasis, International revenues grew 3.0%, driven by solid gains in Asia and the continued growth ofour Canadian subsidiary. Overall, International revenues decreased to 54.9% of total consolidatedrevenues for the quarter. European revenues were $152.5 million, down 6.1% compared to very strongprior year sell-in results. On a constant dollar basis, European revenues were up 1.0% with gainsin our European distributor business, the U.K. and Spain offset by declines in France andpan-European accounts. European footwear posted strong gains in men’s and women’s casual, kids andTimberland PRO® series products, offset by declines in outdoor performance footwear andboots. Apparel sales declined modestly impacted by lower levels of clearance sales in outletstores. In Asia, first quarter 2006 revenues of $31.6 million were flat with the prior yearperiod. On a constant dollar basis, Asian revenues increased 5.4%, driven by gains in our Asiandistributor business, Taiwan, Malaysia and Hong Kong. Asia’s growth reflected gains in outdoorperformance footwear, men’s and women’s casual footwear and apparel.ProductsWorldwide footwear revenue was $253.9 million in the first quarter of 2006, down $12.1 million or4.5% from the prior year period. On a constant dollar basis, footwear revenues were down 0.7%,reflecting gains in men’s casual and Timberland PRO® series footwear offset by declinesin boots, outdoor performance footwear and kids footwear. Overall, worldwide footwear unit salesdecreased 3.0%, while the average selling price was down 1.6% in comparison to the prior year.Worldwide apparel and accessories revenue expanded 8.0%, or 13.4% in constant dollars, to $91.4million for the first quarter of 2006, benefiting from Timberland’s recent acquisition ofSmartWool. SmartWool added $9.5 million to global apparel and accessory revenues. Apparel andaccessories unit sales increased 34.2%, while the average selling price decreased by 19.5%,reflecting the impacts of the addition of SmartWool’s products, which have lower average sellingprices.
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Channels Revenue growth in the first quarter of 2006 was driven by growth in wholesale revenues, whichincreased 1.4% to $279.6 million. Retail revenues declined 10.6% to $70.2 million, impacted bysoft U.S. sales reflecting unseasonably warm weather conditions, lower excess product globally inour outlet stores and pressure on specialty store results due to the later timing of Easter thisyear. Global comparable store sales declined 10.8% from the prior year period impacted by softU.S. performance and lower excess product sales globally in Timberland outlet stores. We closedseven stores, shops and outlets worldwide and opened five in the first quarter of 2006.Gross ProfitGross profit as a percentage of sales, or gross margin, was 50.3% for the first quarter of 2006,250 basis points lower than in the first quarter of 2005. Gross margins were pressured by productmix related to lower boot sales, higher comparable costs reflecting macro factors such as increasedoil related commodity costs and higher levels of markdowns and allowances. In the second quarterof 2006, we anticipate pressure on gross margins in the range of400-500 basis points reflectingbusiness mix impacts, effects from the initiation of provisionalduties on EUfootwear sourced in China and Vietnam and expected higher levels of markdowns and allowances.We include the costs of procuring inventory (inbound freight and duty, overhead and other similarcosts) in cost of goods sold. These costs amounted to $20.2 million and $21.5 million for the firstquarters of 2006 and 2005, respectively.Operating ExpenseOperating expense for the first quarter of 2006 was $133.9 million, $8.6 million or 6.9% higherthan the $125.2 million reported in the first quarter of 2005. The operating expense increase wasdriven by a $4.0 million increase in selling expense, a $4.1 million increase in general andadministrative expense and restructuring costs of $0.5 million related to theconsolidation of our Caribbean manufacturing facilities and the establishment of a Europeanfinance shared service center. Foreign exchange rate changes offset total operating expensegrowth by $4.3 million or 3.4%. As a percentage of revenue, operating expense increased 290basis points to 38.3% compared to 35.4% in the prior year period. Excluding SmartWool’s $4.0million in operating expenses, $3.9 million in additional share-based employee compensation costsand $0.5 million in restructuring costs, operating expense growth was controlled to relativelythe same level as the prior year, with spending impacted in part by a re-phasing of marketingsupport costs towards the Spring season.Selling expense for the first quarter of 2006 was $104.7 million, up $4.0 million or 4.0%compared to the prior year period. The increase was driven by $2.5 million in share-basedemployee compensation costs, $2.0 million in distribution costs, $1.6 million related toInternational retail expansion, $1.1 million due to the SmartWool acquisition and $0.7 million oforganizational investments to establish an outdoor performance dedicated sales team. Foreignexchange rate changes offset selling expense growth by $3.9 million or 3.9%.We include the costs of physically managing inventory (warehousing and handling costs) in sellingexpense. These costs totaled $9.4 million and $9.0 million in the first quarters of 2006 and 2005,respectively.Advertising expense, which is also included in selling expense, was $5.8 million and $7.3 millionin the first 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. The decrease inadvertising expense reflects lower levels in co-op spending and later timing of plannedexpenditures in 2006.Prepaid advertising recorded on our unaudited condensed consolidated balance sheets as of March 31,2006 and April 1, 2005 was $1.9 million and $0.4 million, respectively.General and administrative expense for the first quarter of 2006 was $28.6 million, $4.1 millionor 16.8% higher than the prior year period. As a percentage of revenue, general andadministrative expense increased 130 basis points over the first quarter of 2005. The increase wasdriven by $1.4 million of share-based employee compensationcosts, a $1.4 million increase in costsrelated to our global support services, $1.1 million in costs associated with new businessinitiatives and $0.9 million of legal and compliance costs offset by a $0.4 million foreignexchange rate benefit.
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Operating IncomeOperating income for the first quarter of 2006 was $42.3 million, $19.7 million or 31.8% lowerthan first quarter of 2005. Operating income as a percentage of revenue decreased 540 basis pointsto 12.1%, impacted by declines in U.S. footwear sales and negative foreign exchange rate changes.Excluding restructuring costs, operating income for the first quarter of 2006 was $42.7million. For purposes of comparison, operating income for the first quarter of 2005 would havebeen $58.9 million had we expensed share-based employee compensation costs related to our stockoption and employee stock purchase plans.Operatingincome for our U.S. Wholesale segment was $33.3 million,$2.8 million or 7.9% lower thanthe prior year. The revenue increase of 6.8% includes $7.8 million of sales from SmartWool, abusiness that was acquired during the fourth quarter of 2005. Gross margins declined 120 basispoints primarily due to change in product mix impacted by lower boot sales. Operating expense as apercentage of sales increased by 300 basis points, reflecting moderate cost growth over a lowerrevenue base including a 180 basis point impact from the addition of SmartWool.U.S. Consumer Direct segment operating income for the first quarter was $0.2 million, down $4.3million from last year’s strong first quarter results. Sales declined by 13.7% while gross margindeclined by 370 basis points reflecting negative product mix impacts and relatively higher levelsof promotional activity. Operating expense increased by 2.8% compared to the prior year’s firstquarter, driven by two additional stores operated this year.Operating income for our International business declined 6.4% to $51.5 million for the quarter. Arevenue decline of 3.5% and gross margin decline of 90 basis points drove the decrease.Unfavorable foreign exchange rates drove revenue down by $12.9 million. On a constant dollarbasis, International revenues grew by 3.0%. The gross margin decline was driven by increasedproduct costs and increased markdowns and allowances. Operating expense rates for ourInternational business were flat.Our Unallocated Corporate expenses, which include central support and administrative costs, notallocated to our business segments, increased 26.7% to $42.7 million. Unallocated Corporateexpenses as a percentage of total revenue increased 270 basis points to 12.2% of total revenue.Excluding share-based employee compensation costs of $3.9 million and restructuringcosts of $0.5 million resulting from the consolidation of our Caribbean manufacturing operationsand our establishment of a European finance shared service center, Unallocated Corporate expensesincreased 13.6% or $4.6 million from the prior year and represent 10.9% of total revenue. Thisincrease was driven by unfavorable product cost variances of $3.0 million and legal and compliancecosts of $0.9 million.Other Income and TaxesInterest income, net, which is comprised of interest income offset by fees related to theestablishment and maintenance of our revolving credit facility and interest paid on short-termborrowings, was $1.1 million for each of the first quarters of 2006 and 2005. Interest income, netwas unchanged as higher interest rates were offset by lower cash balances resulting from theacquisition of SmartWool.Other, net, included $1.3 million and $1.0 million of foreign exchange gains for the first quartersof 2006 and 2005, respectively, resulting from the timing of settlement of local currencydenominated receivables and payables. These gains were driven by the volatility of exchange rateswithin the first quarters of 2006 and 2005 and should not be considered indicative of expectedfuture results.The effective income tax rate for the first quarter of 2006 was 34.5%, reflecting full yearestimates incorporating projected impacts from anti-dumping duties on EU footwear. The effectiveincome tax rate for the first quarter of 2005 was 34.0%.
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Reconciliation of Total Company and International Revenue Decreases To Constant Dollar RevenueIncreasesTotal Company Revenue Reconciliation:           **For the Three Months**  **Ended March 31, 2006**  **$ Millions**    **Change** **% Change**   Revenue decrease (GAAP) $(4.4)  (1.2%)Decrease due to foreign exchange rate changes  (12.9)  (3.6%)   Revenue increase in constant dollars $8.5   2.4%International Revenue Reconciliation:           **For the Three Months**  **Ended March 31, 2006**  **$ Millions**    **Change** **% Change**   Revenue decrease (GAAP) $(7.0)  (3.5%)Decrease due to foreign exchange rate changes  (12.9)  (6.5%)   Revenue increase in constant dollars $5.9   3.0%Management provides constant dollar revenue growth for total Company and International resultsbecause we use the measure to understand revenue changes excluding any impact from foreignexchange rate changes.Reconciliation of Diluted EPS to Diluted EPS ExcludingRestructuring and Related Costs andIncluding Share-Based Employee Compensation Costs Related to Stock Option and Employee StockPurchase Plans           **For the Three Months**  **For the Twelve Months**   **Ended April 1, 2005**  **Ended December 31, 2005** Diluted EPS (GAAP) $.61  $2.43 Per shareimpact of restructuring and related costs  —   .04        Diluted EPS excluding restructuring and related costs  .61   2.47 Per share impact of share-based employeecompensation costs related to stock option andemployee stock purchase plans  (.03)  (.12)       Diluted EPS excludingrestructuring and related costs and including share-based employeecompensation costs related to stock option andemployee stock purchase plans $.58  $2.35        Management provides diluted EPS excluding restructuring and related costs because we use themeasure to understand earnings excluding these identifiable expenses. Management provides dilutedEPS excluding restructuring and related costs and including share-based employee compensationcosts to provide comparability to reported results that include share-based employee compensationcosts as prescribed by SFAS 123(R).Reconciliation ofOperating Income to Operating Income Including Share-Based Employee Compensation Costs Related toStock Option and Employee Stock Purchase Plans       **For the Three Months** Amounts in Millions **Ended April 1, 2005**  Operating income, as reported $61.9 Add:Share-based employee compensation expense included in reported operatingincome  0.7 Deduct: Total share-based employee compensation expense determined underfair value based method for all awards  3.7     Pro forma operating income $58.9     Management providesoperating income including share-based employee compensationcosts related to stock option and employee stock purchase plans toprovide comparability to reported results that include share-based employee compensationcosts as prescribed by SFAS 123(R).
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Accounts Receivable and InventoryAccounts receivable was $192.1 million as of March 31, 2006. Excluding SmartWool’s $7.5 million,accounts receivable decreased 1.5% to $184.6 million as of March 31, 2006, compared with $187.5million as of April 1, 2005. The reduction in comparable receivables in the first quarter of 2006reflected solid collection efforts offset by the timing of shipments. Days sales outstanding were49 days as of March 31, 2006, compared with 48 days as of April 1, 2005. Wholesale days salesoutstanding were 52 days and 54 days for the first quarters ended 2006 and 2005, respectively.Inventory was $174.9 million as of March 31, 2006. Excluding SmartWool’s $9.0 million, inventoryincreased 3.0% to $165.9 million as of March 31, 2006, compared with $161.0 million as of April 1,2005. This growth is related to timing of inventory receipts and support for launch of newbusinesses such asMiōn.**Liquidity and Capital Resources**Net cash used by operations for the first three months of 2006 was $59.7 million, compared with$64.8 million for the first three months of 2005. The decrease in the use of cash in the firstthree months of 2006 compared with 2005 was primarily due to the reduced use of cash from accrualsresulting from lower payroll related accruals at March 31, 2006, compared with December 31, 2005,than in the comparable period for the prior year. In addition, Timberland’s use of cash foroperating working capital declined to $57.3 million for the quarter as compared to $66.1 million in2005. These benefits were offset by reduced net income and the timing of tax payments.Net cashused for investing activities amounted to $5.8 million in the first three months of 2006,compared with $4.4 million in the first three months of 2005. Capital expenditures accounted for$1.2 million of this increase with growth primarily driven by investments in manufacturingequipment and IT infrastructure.Net cash used for financing activities was $23.2 million in the first three months of 2006,compared with $33.9 million in the first three months of 2005. Cash flows from financingactivities reflected share repurchases of $34.5 million in the first three months of 2006, comparedwith $41.9 million in the first three months of 2005. We received cash inflows of $10.5 million inthe first three months of 2006 from the issuance of common stock related to the exercise ofemployee stock options, compared with $7.9 million in the first three months of 2005.We have an unsecured committed revolving credit agreement with a group of banks, which matures onApril 30, 2007 (“Agreement”), unless prior to April 30, 2006, we elect to extend the final maturitydate to April 30, 2008. On April 13, 2006, we signed a commitment letter to amend and extend thiscredit facility which we expect to complete in the second quarter of 2006. The current Agreementprovides for $200 million of committed borrowings, of which up to $125 million may be used forletters of credit. Under certain circumstances, we may increase the committed borrowing limit by$50 million for a total commitment of $250 million. Under the terms of the Agreement, we mayborrow at interest rates based on eurodollar rates (approximately 4.8% at March 31, 2006), plus anapplicable margin based on a fixed-charge coverage grid of between 50 and 100 basis points that isadjusted quarterly. At March 31, 2006, the applicable margin under the facility was 60 basispoints. We will pay a commitment fee of 12.5 to 25 basis points per annum on the total commitment,based on a fixed-charge coverage grid that is adjusted quarterly. At March 31, 2006, thecommitment fee was 15 basis points. The Agreement places certain limitations on additional debt,stock repurchases, 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, a leverage ratio of 1.5:1 and under certain conditions, a minimum level ofearnings before income tax, depreciation and amortization. We measure compliance with thefinancial and non-financial covenants and ratios as required by the terms of the Agreement on afiscal quarter basis.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 at March 31,2006. Any borrowings under these lines would be at prevailing money market rates (approximately5.3% at March 31, 2006). Further, we had an uncommitted letter of credit facility of $80 millionto support inventory purchases. These arrangements may be terminated at any time at the option ofthe banks or the Company.As of March 31, 2006 and April 1, 2005, we had no borrowings outstanding under any of our creditfacilities.
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Management believes that our capital needs and our share repurchase program for the balance of2006 will be funded through our current cash balances, our existing and planned new creditfacilities and cash from operations, 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 endedDecember 31, 2005 and in Part II, Item 1A, Risk Factors, of this report, several risks anduncertainties could cause the Company to need to raise additional capital through equity and/ordebt financing. From time to time the Company considers acquisition opportunities which, ifpursued, could also result in the need for additional financing. The availability and terms of anysuch financing would be subject to prevailing market conditions and other factors at that time.Off Balance Sheet ArrangementsAs of March 31, 2006 and April 1, 2005, we had letters of credit outstanding of $21.7 million and$16.7 million, respectively. These letters of credit were issued predominantly for the purchase ofinventory. The increase in letters of credit outstanding was driven by the timing of inventorypurchases. As of March 31, 2006, the Company had $177.7 million in foreign currency contractsoutstanding, all of which are due to settle within the next 10 months.We have the following off balance sheet arrangements: