**UNITEDSTATES SECURITIES AND EXCHANGE COMMISSION**

**Washington,D. C. 20549**

**FORM10-Q**

**(MarkOne)**

**x****                                  ****QUARTERLY REPORTPURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

**FORTHE QUARTERLY PERIOD ENDEDSeptember 30, 2006**

**OR**

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

**FORTHE TRANSITION PERIODFROM           TO           **

**Commissionfile number 0-19658**

**TUESDAYMORNING CORPORATION**

(Exact Name of Registrant as Specified in its Charter)

| **Delaware**                     |   | **75-2398532**          |
|----------------------------------|--------|-------------------------|
| (State or Other  Jurisdiction of |   | (I.R.S. Employer        |
| Incorporation or  Organization)  |   | Identification  Number) |

 

**6250 LBJFreewayDallas, Texas 75240**

(Address, including zipcode, of principal executive offices)

 

**(972)387-3562**

(Registrant’stelephone number, including area code)

**Notapplicable**

(Former name,former address and former fiscal year, if changed since last report)

Indicate by checkmark 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 preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.  Yes  x  No  o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act.(Check one):
| Large accelerated  filer x | Accelerated  filer o | Non-accelerated  filer o |
|---------------------------------|---------------------------|-------------------------------|

 

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes oNo x

Indicate thenumber of shares outstanding of each of the issuer’s classes of common stock,as of the latest practicable date.
| Class                                    | ** ** | **Outstanding at November 1, 2006** |
|------------------------------------------|------------|---------------------------------------------------------|
| Common Stock,  par value $0.01 per share |       | 41,402,026                                              |

 

 

----

**Forward-LookingStatements**

*ThisQuarterly Report on Form 10-Q contains forward-looking statements within themeaning of the federal securities laws and the Private Securities LitigationReform Act of 1995.  These statements may be found throughout this Form10-Q particularly under the heading “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations,” among others. Forward-looking statements typically are identified by the use of terms such as“may,” “will,” “should,” “expect,” “anticipate,” “believe,” “estimate,” “intend”and similar words, although some forward-looking statements are expresseddifferently.  You should consider statements that contain these wordscarefully because they describe our expectations, plans, strategies and goalsand our beliefs concerning future business conditions, our future results ofoperations, our future financial position, and our business outlook or stateother “forward-looking” information.*

*Readersare referred to “Item 1A. Risk Factors” in our Annual Report on Form 10-K forthe year ended December 31, 2005 and “Item 1A. Risk Factors” of thisQuarterlyReport on Form 10-Q for examples of risks, uncertainties and eventsthat could cause our actual results to differ materially from the expectationsexpressed in our forward-looking statements.  These risks, uncertaintiesand events also include, but are not limited to, the following:*

·                     *uncertainties regarding our ability to open stores innew and existing markets and operate these stores on a profitable basis;*

·                     *conditions affecting consumer spending, such as highgasoline prices and higher interest rates;*

·                     *general regional and national economic conditions;*

·                     *inclement weather, such as the pattern of hurricanesthat affected the Southeast U.S. in August and September 2004 and again inSeptember 2005;*

·                     *changes in our merchandise mix;*

·                     *timing and type of sales events, promotionalactivities and other advertising;*

·                     *uncertainties arising out of world events;*

·                     *increased or new competition;*

·                     *our ability to continuously attract buyingopportunities for closeout merchandise and anticipate consumer demand ascloseout merchandise becomes available;*

·                     *loss of, or disruption in, our centralizeddistribution center;*

·                     *loss or departure of one or more members of oursenior management;*

·                     *our dependence on external funding sources;*

·                     *an increase in the cost or a disruption in the flowof our products;*

·                     *environmental regulations;*

·                     *seasonal and quarterly fluctuations; and*

·                     *fluctuations in our comparable store results.*

*Theforward-looking statements made in this Form 10-Q relate only to events as ofthe date on which the statements were made.  We undertake no obligation toupdate our forward-looking statements to reflect events and circumstances afterthe date on which the statements were made or to reflect the occurrence ofunanticipated events.*

*Theterms “Tuesday Morning,” “we,” “us” and “our” as used in this Quarterly Reporton Form 10-Q refer to Tuesday Morning Corporation and its subsidiaries.*

2

----

 
| **PART I - FINANCIAL  INFORMATION**                                                                            |
|----------------------------------------------------------------------------------------------------------------|
|                                                                                                           |
| Item 1 — Financial  Statements                                                                            |
|                                                                                                           |
| Consolidated Balance Sheets as of September 30,  2006 and December 31, 2005                          |
|                                                                                                           |
| Consolidated Statements of Income for the Three Months  and Nine Months Ended September 30, 2006 and 2005 |
|                                                                                                           |
| Consolidated Statements of Cash Flows for the Nine  Months Ended September 30, 2006 and 2005              |
|                                                                                                           |
| Notes to Consolidated Financial Statements                                                                     |
|                                                                                                           |
| Item  2 — Management’s Discussion and Analysis of Financial Condition and Results  of Operations     |
|                                                                                                           |
| Item 3 — Quantitative and Qualitative Disclosures  About Market Risk                                      |
|                                                                                                           |
| Item 4 — Controls and Procedures                                                                          |
| ** **                                                                                                     |
| **PART  II — OTHER INFORMATION**                                                                          |
| ** **                                                                                                     |
| Item  1 — Legal Proceedings                                                                               |
|                                                                                                           |
| Item  1A — Risk Factors                                                                                   |
|                                                                                                           |
| Item  5 — Other Information                                                                               |
|                                                                                                           |
| Item 6  — Exhibits                                                                                        |

 

3

----

 

**PART I — FINANCIAL INFORMATION**

**Item1. Financial Statements**

**Tuesday Morning CorporationConsolidated Balance Sheets(In thousands, except for share data)**
| ** **                                                                                                                                                                                   | ** ** | **Sept 30,  2006** | ** ** | **Dec 31,  2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                   | ** ** | ** **              | ** ** | ** **             | ** ** |
| **ASSETS**                                                                                                                                                                                   | ** ** | ** **              | ** ** | ** **             | ** ** |
| Current assets:                                                                                                                                                                              |       |                    |       |                   |       |
| Cash and cash equivalents                                                                                                                                                                    |       | $                       | 8,906      |                   | $          | 43,547 |   |
| Inventories                                                                                                                                                                                  |       | 302,533                 |       | 230,639                |       |
| Prepaid expenses and other current assets                                                                                                                                                    |       | 8,887                   |       | 7,258                  |       |
| Deferred income taxes                                                                                                                                                                        |       | 5,071                   |       | 5,071                  |       |
| Total current assets                                                                                                                                                                         |       | 325,397                 |       | 286,515                |       |
|                                                                                                                                                                                         |       |                    |       |                   |       |
| Property and  equipment, net                                                                                                                                                                 |       | 86,888                  |       | 87,786                 |       |
| Deferred  financing costs                                                                                                                                                                    |       | 556                     |       | 685                    |       |
| Other assets                                                                                                                                                                                 |       | 4,781                   |       | 4,941                  |       |
|                                                                                                                                                                                         |       |                    |       |                   |       |
| Total Assets                                                                                                                                                                                 |       | $                       | 417,622    |                   | $          | 379,927 |   |
|                                                                                                                                                                                         |       |                    |       |                   |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                | ** ** | ** **              | ** ** | ** **             | ** ** |
| Current  liabilities:                                                                                                                                                                        |       |                    |       |                   |       |
| Accounts payable                                                                                                                                                                             |       | $                       | 103,778    |                   | $          | 74,975 |   |
| Accrued liabilities                                                                                                                                                                          |       | 31,119                  |       | 42,372                 |       |
| Income taxes payable                                                                                                                                                                         |       | 6,199                   |       | 16,520                 |       |
| Total current liabilities                                                                                                                                                                    |       | 141,096                 |       | 133,867                |       |
|                                                                                                                                                                                         |       |                    |       |                   |       |
| Revolving credit  facility                                                                                                                                                                   |       | 47,000                  |       | —                 |       |
| Deferred rent                                                                                                                                                                                |       | 4,571                   |       | 4,431                  |       |
| Deferred income  taxes                                                                                                                                                                       |       | 6,267                   |       | 6,267                  |       |
|                                                                                                                                                                                         |       |                    |       |                   |       |
| Total Liabilities                                                                                                                                                                            |       | 198,934                 |       | 144,565                |       |
|                                                                                                                                                                                         |       |                    |       |                   |       |
| Commitments and  contingencies                                                                                                                                                               |       |                    |       |                   |       |
| Stockholders’  equity:                                                                                                                                                                  |       |                    |       |                   |       |
| Preferred stock, par value $.01 per share,  authorized 10,000,000 shares, none issued or outstanding                                                                                         |       | —                  |       | —                 |       |
| Common stock, par value $.01 per share, authorized  100,000,000 shares; 41,402,026 shares issued and outstanding at  September 30, 2006 and 41,369,922 shares at December 31, 2005 |       | 414                     |       | 414                    |       |
| Additional paid-in capital                                                                                                                                                                   |       | 195,006                 |       | 191,229                |       |
| Retained earnings                                                                                                                                                                            |       | 23,263                  |       | 43,763                 |       |
| Accumulated other comprehensive income (loss)                                                                                                                                                |       | 5                       |       | (44                    | )          |
|                                                                                                                                                                                         |       |                    |       |                   |       |
| Total Stockholders’ Equity                                                                                                                                                              |       | 218,688                 |       | 235,362                |       |
|                                                                                                                                                                                         |       |                    |       |                   |       |
| Total Liabilities and  Stockholders’ Equity                                                                                                                                             |       | $                       | 417,622    |                   | $          | 379,927 |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

4

----

 

**TuesdayMorning CorporationConsolidated Statements of Income(In thousands, except per share data)**
| ** **                                    | ** ** | **Three Months Ended Sept 30,** | ** ** | **Nine Months Ended Sept 30,** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                    | ** ** | **2006**                                            | ** ** | **2005**                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                          |       |                                                |       |                                               |       |   |   |   |   |
| Net sales                                     |       | $                                                   | 194,412    |                                               | $          | 192,276 |   | $ | 589,841 |   | $ | 596,626 |   |
| Cost of sales                                 |       | 121,348                                             |       | 117,577                                            |       | 368,912 |   | 367,951 |   |
| Gross profit                                  |       | 73,064                                              |       | 74,699                                             |       | 220,929 |   | 228,675 |   |
| Selling, general  and administrative expenses |       | 67,341                                              |       | 61,387                                             |       | 199,732 |   | 188,181 |   |
| Operating income                              |       | 5,723                                               |       | 13,312                                             |       | 21,197 |   | 40,494 |   |
| Other income  (expense):                      |       |                                                |       |                                               |       |   |   |   |   |
| Interest income                               |       | 5                                                   |       | 0                                                  |       | 106 |   | 98 |   |
| Interest expense                              |       | (792                                                | )          | (552                                               | )          | (1,545 | ) | (922 | ) |
| Other income, net                             |       | 174                                                 |       | 201                                                |       | 560 |   | 633 |   |
|                                          |       | (613                                                | )          | (351                                               | )          | (879 | ) | (191 | ) |
| Income before income taxes                    |       | 5,110                                               |       | 12,961                                             |       | 20,318 |   | 40,303 |   |
| Income tax  expense                           |       | 1,947                                               |       | 4,748                                              |       | 7,716 |   | 14,894 |   |
|                                          |       |                                                |       |                                               |       |   |   |   |   |
| Net income                                    |       | $                                                   | 3,163      |                                               | $          | 8,213 |   | $ | 12,602 |   | $ | 25,409 |   |
|                                          |       |                                                |       |                                               |       |   |   |   |   |
| **Earnings  Per Share**                       | ** ** | ** **                                          | ** ** | ** **                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income per  common share:                 |       |                                                |       |                                               |       |   |   |   |   |
| Basic                                         |       | $                                                   | 0.08       |                                               | $          | 0.20 |   | $ | 0.30 |   | $ | 0.62 |   |
| Diluted                                       |       | $                                                   | 0.08       |                                               | $          | 0.20 |   | $ | 0.30 |   | $ | 0.61 |   |
| Weighted average  number of common shares:    |       |                                                |       |                                               |       |   |   |   |   |
| Basic                                         |       | 41,392                                              |       | 41,352                                             |       | 41,384 |   | 41,229 |   |
| Diluted                                       |       | 41,584                                              |       | 41,872                                             |       | 41,642 |   | 41,768 |   |
|                                          |       |                                                |       |                                               |       |   |   |   |   |
| Dividends per common  share                   |       | $                                                   | —     |                                               | $          | — |   | $ | 0.80 |   | $ | 0.65 |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

5

----

 

**TuesdayMorning CorporationConsolidated Statements of Cash Flows(In thousands)**
| ** **                                                                        | ** ** | **Nine Months Ended  Sept 30,** | ** ** |
|-----------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                                        | ** ** | **2006**                                       | ** ** | **2005** | ** ** |
|                                                                              |       |                                           |       |   |   |
| **Net  cash flows from operating activities:**                                    | ** ** | ** **                                     | ** ** | ** ** | ** ** |
| Net income                                                                        |       | $                                              | 12,602     |   | $ | 25,409 |   |
| Adjustments to  reconcile net income to net cash used in operating activities:    |       |                                           |       |   |   |
| Depreciation and amortization                                                     |       | 12,255                                         |       | 10,713 |   |
| Amortization of financing fees                                                    |       | 129                                            |       | 128 |   |
| Stock-based compensation                                                          |       | 2,445                                          |       | — |   |
| Other non-cash items                                                              |       | 49                                             |       | (4 | ) |
| Change in operating assets and liabilities:                                       |       |                                           |       |   |   |
| Inventories                                                                       |       | (70,753                                        | )          | (104,226 | ) |
| Prepaid and other assets                                                          |       | (1,469                                         | )          | (4,178 | ) |
| Accounts payable                                                                  |       | 28,803                                         |       | 30,217 |   |
| Accrued liabilities                                                               |       | (11,253                                        | )          | (4,513 | ) |
| Deferred rent                                                                     |       | 140                                            |       | 4,316 |   |
| Income taxes payable                                                              |       | (10,321                                        | )          | (9,197 | ) |
| Net cash used in operating activities                                             |       | (37,373                                        | )          | (51,335 | ) |
|                                                                              |       |                                           |       |   |   |
| **Net  cash flows from investing activities:**                                    | ** ** | ** **                                     | ** ** | ** ** | ** ** |
| Capital expenditures                                                              |       | (11,357                                        | )          | (12,991 | ) |
| Net cash used in investing activities                                             |       | (11,357                                        | )          | (12,991 | ) |
|                                                                              |       |                                           |       |   |   |
| **Net  cash flows from financing activities:**                                    | ** ** | ** **                                     | ** ** | ** ** | ** ** |
| Payment of dividends to common stockholders                                       |       | (33,102                                        | )          | (26,854 | ) |
| Proceeds from revolving credit facility, net                                      |       | 47,000                                         |       | 49,500 |   |
| Proceeds from exercise of common stock options and  stock purchase plan purchases |       | 191                                            |       | 2,759 |   |
| Net cash provided by financing activities                                         |       | 14,089                                         |       | 25,405 |   |
| Net decrease in  cash and cash equivalents                                        |       | (34,641                                        | )          | (38,921 | ) |
| Cash and cash  equivalents, beginning of period                                   |       | 43,547                                         |       | 45,067 |   |
| Cash and cash  equivalents, end of period                                         |       | $                                              | 8,906      |   | $ | 6,146 |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

6

----

 

**TuesdayMorning CorporationNotes to Consolidated Financial Statements**

1.                 Basisof presentation — The consolidated interim financial statements included hereinhave been prepared by us pursuant to the rules and regulations of theSecurities and Exchange Commission.  Certain information and footnotedisclosures normally included in financial statements prepared in accordancewith accounting principles generally accepted in the United States have beencondensed or omitted pursuant to such rules and regulations.  Thesefinancial statements include all adjustments, consisting only of those of anormal recurring nature, which, in the opinion of management, are necessary topresent fairly the results of the interim periods presented and should be readin conjunction with the consolidated financial statements and notes thereto inour Form 10-K filing for the year ended December 31, 2005.  Becauseof the seasonal nature of our business, the results of operations for thequarter are not indicative of the results to be expected for the entire year.

2.                   Stock-basedcompensation — On December 16, 2004, the Financial Accounting StandardsBoard (“FASB”) issued FASB Statement No. 123 (revised 2004),*  Share-BasedPayment*  (Statement 123(R)),which is a revision of FASB Statement No. 123,*  Accounting for Stock-BasedCompensation* . Statement 123(R) supersedes APB OpinionNo. 25,* Accounting for Stock Issued to Employees* , and amends FASBStatement No. 95,*  Statement of Cash Flows* .Generally, the approach in Statement 123(R) is similar to the approachdescribed in Statement 123. However, Statement 123(R) requires all share-basedpayments to employees, including grants of employee stock options, to berecognized in the income statement based on their fair values at the time ofgrant. Pro forma disclosure is no longer an alternative.

Statement 123(R) permits public companies to adopt itsrequirements using one of two methods: (1) a “modified prospective” methodin which compensation cost is recognized beginning with the effective date(a) based on the requirements of Statement 123(R) for all share-basedpayments granted after the effective date and (b) based on therequirements of Statement 123 for all awards granted to employees prior to theeffective date of Statement 123(R) that remain unvested on the effectivedate; (2) a “modified retrospective” method which includes the requirementsof the modified prospective method described above, but also permits entitiesto restate based on the amounts previously recognized under Statement 123 forpurposes of pro forma disclosures either (a) all prior periods presentedor (b) prior interim periods of the year of adoption.  We haveadopted Statement 123(R) based on the modified prospective method effectiveJanuary 1, 2006.

Stock-based compensation amounts recognized in thethree months and nine months ended September 30, 2006 upon the adoption ofStatement 123(R) is as follows (in thousands):
| ** **                                                 | ** ** | **Three Months Ended   Sept 30, 2006** | ** ** | **Nine Months Ended   Sept 30, 2006** | ** ** |
|------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
|                                                       |       |                                                            |       |                                                           |       |
| Total cost of  stock-based compensation during the period  |       | $                                                               | 1,335      |                                                           | $          | 3,586 |   |
| Amounts  capitalized in ending inventory                   |       | (491                                                            | )          | (1,141                                                         | )          |
| Amounts  recognized in expense previously capitalized      |       | 384                                                             |       | 384                                                            |       |
| Amounts charged  against income for the period before tax  |       | $                                                               | 1,228      |                                                           | $          | 2,829 |   |
|                                                       |       |                                                            |       |                                                           |       |
| Amount of  related income tax benefit recognized in income |       | $                                                               | (255       | )                                                              | $          | (718 | ) |

 

Consistent with our inventory accounting policies, the payroll costs ofbuying, distribution and certain other general and administrative expenses, andwith the adoption of Statement 123(R), the related stock-based compensation ofthese functions, are capitalized as a part of inventory and expensed as cost ofsales when the related inventory is sold.  The adoption of Statement123(R) also caused a $0.02 and $0.05 decrease in basic and diluted earnings pershare for the three and nine months ended September 30, 2006, respectively. Based on non-vested stock options outstanding at September 30, 2006, we expectto incur approximately $2.9 million, net of tax, in stock-based compensationfor the year ended December 31, 2006.

Statement 123(R) includes several modifications to the way thatincomes taxes are provided for in the financial statements. The expense forstock option grants is only deductible for tax purposes at the time the taxableevent takes place, which causes variability in our effective tax rates recordedthroughout each year. The expected variability in our effective tax rate iscaused by Statement 123(R)’s forbiddance of companies from predicting whenthese taxable events will take place. Statement 123(R) also requires thebenefits of tax deductions in excess of recognized compensation cost to bereported as a financing cash flow, rather than as an operating cash flow. Thisrequirement reduces net operating cash flows and increase net financing cashflows in annual periods after adoption.

In the prior year, we accounted for our stock-basedcompensation plans utilizing the intrinsic value method in accordance with theprovisions of Accounting Principles Board Opinion No. 25 (APB 25).  Generally, no compensation expense was recognized for fixed stock option plansbecause the exercise prices of employee stock options equaled or exceeded themarket prices of the underlying stock on the dates of grant.  Had weapplied the fair value based method and recognition provisions of Statement of 

7

----

Financial Accounting Standards (SFAS) No. 123, “*Accounting for Stock-Based Compensation* ,”(as amended by Statement of Financial Accounting Standards No. 148, “*Accounting for Stock-Based Compensation Transitionand Disclosure* “) the pro forma effects of stock-based compensationon net income and net income per common share for the three and nine monthsended September 30, 2005 were as follows (in thousands except per shareamounts):
| ** **                                                                                                           | ** ** | **Three Months  Ended  Sept 30, 2005** | ** ** | **Nine Months  Ended  Sept 30, 2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|------------------------------------------------------|------------|
| Net income as  reported                                                                                              |       | $                                                     | 8,213      |                                                 | $          | 25,409 |   |
| Less:  Stock-based employee compensation expense determined under the fair value  method, net of related tax effects |       | 959                                                   |       | 2,915                                                |       |
| Pro forma net  income                                                                                                |       | $                                                     | 7,254      |                                                 | $          | 22,494 |   |
|                                                                                                                 |       |                                                  |       |                                                 |       |
| Net income per  common share:                                                                                        |       |                                                  |       |                                                 |       |
| Basic as  reported                                                                                                   |       | $                                                     | 0.20       |                                                 | $          | 0.62 |   |
| Basic pro forma                                                                                                      |       | $                                                     | 0.18       |                                                 | $          | 0.55 |   |
| Diluted as  reported                                                                                                 |       | $                                                     | 0.20       |                                                 | $          | 0.61 |   |
| Diluted pro forma                                                                                                    |       | $                                                     | 0.17       |                                                 | $          | 0.54 |   |

 

We have established the Tuesday Morning Corporation 1997 Long-TermEquity Incentive Plan, as amended (the “1997 Plan”), and the Tuesday Morning Corporation2004 Long-Term Equity Incentive Plan, as amended (the “2004 Plan”), which allowour Board of Directors to grant stock options to directors, officers and keyemployees of, and certain other key individuals who perform services for us andour subsidiaries. The 1997 Plan and the 2004 Plan authorizes grants of optionsto purchase up to 4,800,000 and 2,000,000 shares, respectively, of authorized,but unissued common stock. Stock options are granted with an exercise price,terms and vesting determined by the Compensation Committee of the Board ofDirectors, with certain limitations.

Options granted under the 1997 Plan and the 2004 Plan vest daily overperiods of four to five years and expire in ten years. The exercise prices ofthe options range between $0.20 and $35.23, which represents fair value on thegrant date of the shares of common stock into which such options areexercisable. At September 30, 2006, there were 143,694 and 1,638,355 sharesavailable for grant under the 1997 Plan and the 2004 Plan, respectively.

Consistent with prior years, the fair value of each stock optiongranted during the nine months ended September 30, 2006 was estimated at thedate of grant using a Black-Scholes option pricing model based on theassumptions of expected volatility of 35%, expected dividend yield of 2.5%,expected term of 4.5 years and a risk-free interest rate of 4.2%.  Theexpected volatility is based on our consideration of the implied volatility ofour minimally traded options on our shares and the historical volatility of ourstock based on our historical stock prices.  The expected term of anoption is based on our historical review of employee exercise behavior based onthe employee class (executive or non-executive) and based on our considerationof the remaining contractual term, if limited exercise activity existed for acertain employee class.  The risk-free interest rate is the constantmaturity interest rate for U.S. Treasury instruments with terms consistent withthe expected lives of the awards.

A summary of stock option activity as of September 30,2006 and changes during the nine months ended September 30, 2006 is presentedbelow (in thousands except share and per share amounts):
| ** **                                 | ** ** | **Number of  Shares** | ** ** | **Weighted-  Average  Exercise Price** | ** ** | **Weighted-  Average  Remaining  Contractual  Term (Years)** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|--------------------------------------------|------------|----------------------------|------------|---------------------------------------------|------------|-------------------------------------------------------------------|------------|-------------------------------------|------------|
| Options  Outstanding at January 1, 2006    |       | 2,016,293                  |       | $                                           | 20.07      |                                                              | —     |                                | —     |   |
| Granted                                    |       | 364,000                    |       | 15.76                                       |       | —                                                            |       | —                              |       |
| Exercised                                  |       | (32,104                    | )          | 7.70                                        |       | —                                                            |       | —                              |       |
| Cancelled                                  |       | (236,051                   | )          | 26.74                                       |       | —                                                            |       | —                              |       |
| Options  Outstanding at September 30, 2006 |       | 2,112,138                  |       | $                                           | 18.77      |                                                              | 6.6        |                                | $          | 2,601 |   |
| Exercisable at  September 30, 2006         |       | 1,350,438                  |       | $                                           | 17.23      |                                                              | 5.6        |                                | $          | 2,350 |   |

 

The weighted average grant-date fair value of share options grantedduring the nine months ended September 30, 2006 was $4.80.  The totalintrinsic value of share options exercised during the nine months endedSeptember 30, 2006 was $312 thousand. As of September 30, 2006, we had $10.2million of total unrecognized stock-based compensation expense related to stockoptions that is expected to be recognized over a weighted average period of3.48 years.

3*.**                 *Lease accounting adjustment -Based on certain views expressed in a letter of February 7, 2005 from theOffice of the Chief Accountant of the Securities and Exchange Commission to theAmerican Institute of Certified Public Accountants, we reviewed 

8

----

 

our accounting policies and practices associated withoperating leases. Consistent with industry practices, we historically reportedstraight-line rental expense beginning on the lease commencement date. This hadthe effect of excluding the rent holiday associated with the pre-opening orbuild-out period of our stores from the calculation of the period over which weexpensed rent. Following our review, we modified our accounting policies suchthat we begin recording rent expense on the date we take possession of or havethe right to use the premises.

As a result of this adjustment, we recorded a non-cash,$3.9 million ($2.4 million, net of income tax) cumulative charge toearnings during the first quarter of fiscal 2005. The adjustment did not impacthistorical or future net cash flows nor the timing of the payments underrelated leases.  Prior years’ financial statements were not restated asthe impact of this issue was immaterial to previously reported results for anyindividual previous period.

4.                 Comprehensiveincome - Comprehensive income is defined as net income plus the change inequity during a period from transactions and other events, excluding thoseresulting from investments by and distributions to stockholders. Totalcomprehensive income for the three month period ended September 30, 2006and 2005 was $3.2 million and $8.3 million, respectively and for the nine monthperiod ended September 30, 2006 and 2005 was $12.7 million and $25.4million, respectively.

5.                 Legalproceedings — During 2001 and 2002, we were named as a defendant in threecomplaints filed in the Superior Court of California in and for the County ofLos Angeles. The plaintiffs are seeking to certify a statewide class made up ofsome of our current and former employees, which they claim are owedcompensation for overtime wages, penalties and interest. The plaintiffs arealso seeking attorney’s fees and costs. In October 2003, we entered into asettlement agreement with a sub-class of these plaintiffs consisting ofmanager-in-training and management trainees which was paid inNovember 2005 with no material impact to our financial statements. Theremaining complaint relating to our salaried managers is still open with ascheduled trial date of July 2007.  We have a similar lawsuit filedin Orange, County California in 2004 where our motion to disqualify the namedplaintiff as a class representative has been accepted.  The case is stillin discovery. We do not expect either of these complaints to have a materialimpact on our financial statements.

In June 2004, we were named as a defendant in a complaint filed inthe U.S. District Court, Central District of California. The plaintiff, ThomasKinkade Company (f/k/a/ Media Arts Group Inc.), alleged copyright infringementand false advertisements on merchandise we sold in the second quarter of2004.  The case went to trial in March 2006.  The jury found in favorof us on the trademark infringement claim.  The jury was unable to reach averdict on the remaining claims.  The parties have agreed to mediate withthe presiding judge regarding the remaining claims.  A mediation date hasbeen set for November 2006.

We intend to vigorously defend all pending actions. We do not believethese or any other legal proceedings pending or threatened against us wouldhave a material adverse effect on our financial condition or results ofoperations.

9

----

 

6.                 Earningsper common share
| ** **                                                                                          | ** ** | **Three Months Ended  Sept 30** | ** ** | **Nine Months Ended  Sept 30** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|
| **(in thousands, except per share data)**                                  | ** ** | **2006**                                       | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                                                |       |                                           |       |                                          |       |   |   |   |   |
| **Basic  earnings per share:**                                                                      | ** ** | ** **                                     | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                                          |       | $                                              | 3,163      |                                          | $          | 8,213 |   | $ | 12,602 |   | $ | 25,409 |   |
| Weighted average  number of common shares outstanding                                               |       | 41,392                                         |       | 41,352                                        |       | 41,384 |   | 41,229 |   |
| Net income per  common share                                                                        |       | $                                              | 0.08       |                                          | $          | 0.20 |   | $ | 0.30 |   | $ | 0.62 |   |
|                                                                                                |       |                                           |       |                                          |       |   |   |   |   |
| **Diluted  earnings per share:**                                                                    | ** ** | ** **                                     | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                                          |       | $                                              | 3,163      |                                          | $          | 8,213 |   | $ | 12,602 |   | $ | 25,409 |   |
|                                                                                                |       |                                           |       |                                          |       |   |   |   |   |
| Dilutive effect  of employee stock options                                                          |       | 192                                            |       | 520                                           |       | 258 |   | 539 |   |
| Weighted average  number of common shares outstanding                                               |       | 41,392                                         |       | 41,352                                        |       | 41,384 |   | 41,229 |   |
| Weighted average  number of common shares and diluted effect of outstanding employee stock  options |       | 41,584                                         |       | 41,872                                        |       | 41,642 |   | 41,768 |   |
|                                                                                                |       |                                           |       |                                          |       |   |   |   |   |
| Net income per common  share                                                                        |       | $                                              | 0.08       |                                          | $          | 0.20 |   | $ | 0.30 |   | $ | 0.61 |   |

 

7.                 Revolvingcredit facility — Our $210 million revolving credit facility expires inDecember 2009.  We incur commitment fees of up to 0.25% on the unusedportion of the revolving credit facility. Any borrowings under the revolvingcredit facility incur interest at LIBOR or the prime rate, depending on thetype of borrowing, plus an applicable margin. These rates are increased orreduced as our average total leverage ratio changes.  At September 30, 2006, we had $47 millionoutstanding under the revolving credit facility and had availability of $154.9million.

8.                 InJuly 2006, the Financial Accounting Standards Board (“FASB”) issuedInterpretation 48 (“FIN 48”),*Accounting forUncertainty in Income*  Taxes,an interpretation of FASB Statement No. 109,*  Accounting for Income Taxes*..  FIN 48 clarifies the accounting for uncertainty in income taxesrecognized in an enterprise’s financial statements in accordance with FASBStatement No. 109.  This interpretation clarifies the application ofStatement 109 by defining a criterion that an individual tax position must meetfor any part of the benefit of that position to be recognized in an enterprise’sfinancial statements.  The interpretation would require us to review alltax positions accounted for in accordance with Statement 109 and apply amore-likely-than-not recognition threshold.  A tax position that meets themore-likely-than-not recognition threshold is initially and subsequentlymeasured as the largest amount of tax benefit that is greater than 50 percentlikely of being realized upon ultimate settlement with a taxing authority thathas full knowledge of all relevant information.  Subsequent recognition,derecognition, and measurement is based on management’s best judgment given thefacts, circumstances and information available at the reporting date.  Theguidance is effective for fiscal years beginning after December 15, 2006, whichwe intend to adopt on January 1, 2007.  We do not expect the adoption ofthis statement to have a material effect on our financial position or resultsof operation.

**Item 2.Management’s Discussion and Analysis of Financial Condition and Results ofOperations**

**Introduction**

We sell upscale, namebrand home furnishings, gift and related items significantly below retailprices charged by department and specialty stores.  We have a uniqueevent-based selling strategy that creates a sense of urgency and excitement forour customer base.  These events are held ten times a year.  Eachevent features merchandise selections of well-known and nationally advertisedmanufacturers and name brands from both domestic and European closeouts thatare priced 50% to 80% off regular retail prices.

We have historicallygrown our store base by approximately 10% per year for the last fiveyears.  During the first nine months of 2006, we expanded our store baseby a net of 40 stores consisting of 47 new store openings and 7 storeclosures.  As of September 30, 2006, we operated 772 stores in 47 states.

**BusinessOverview**

Net sales for the thirdquarter of 2006 were $194.4 million, an increase of 1.1% compared to the sameperiod last year and a comparable store sales decrease of 4.6%.  Netincome for the quarter was $3.2 million and diluted earnings per share were$0.08.

For the nine months endedSeptember 30, 2006, net sales were $589.8 million for a decrease of 1.1% versusthe prior year and a comparable store decrease of 6.9%.  Net income forthe year-to-date period was $12.6 million and diluted earnings per share were$0.30.  The home furnishings sectorcontinues to be challenging due to an overall increase in supply of home décormerchandise and a

10

----

 

highly competitivepromotional environment.  During thethird quarter of 2006, we improved the age, content and level of ourinventory.  On a per store basis,inventory decreased 4.8% from the same quarter last year representing the firstquarter since June 30, 2005 that our per store inventory levels have decreasedyear over year.  High end decorative homemerchandise continues to be challenging. We have not committed as much inventory dollars to the seasonal categoryas we have in the past in an effort to be more selective with ourassortment.  Customer traffic stabilizedduring the quarter contributing to the improvement in comparable storeperformance versus prior quarters.  It istoo early to determine if our planned actions will continue to improvecomparable store sales and overall traffic trends.

**RecentAccounting Pronouncements**

In July 2006, theFinancial Accounting Standards Board (“FASB”) issued Interpretation 48 (“FIN 48”),*Accounting for Uncertainty in Income Taxes*,an interpretation of FASB Statement No. 109,*Accounting for Income Taxes*.  FIN 48 clarifies the accountingfor uncertainty in income taxes recognized in an enterprise’s financialstatements in accordance with FASB Statement No. 109.  This interpretationclarifies the application of Statement 109 by defining a criterion that anindividual tax position must meet for any part of the benefit of that positionto be recognized in an enterprise’s financial statements.  Theinterpretation would require us to review all tax positions accounted for inaccordance with Statement 109 and apply a more-likely-than-not recognitionthreshold.  A tax position that meets the more-likely-than-not recognitionthreshold is initially and subsequently measured as the largest amount of taxbenefit that is greater than 50 percent likely of being realized upon ultimatesettlement with a taxing authority that has full knowledge of all relevantinformation.  Subsequent recognition, derecognition, and measurement isbased on management’s best judgment given the facts, circumstances andinformation available at the reporting date.  The guidance is effectivefor fiscal years beginning after December 15, 2006, which we intend to adopt onJanuary 1, 2007.  We are assessing the potential impact that the adoptionof FIN 48 will have on our financial statements.

**Stock-basedCompensation**

On December 16,2004, the Financial Accounting Standards Board (“FASB”) issued FASB StatementNo. 123 (revised 2004),*Share-BasedPayment*  (Statement 123(R)), whichis a revision of FASB Statement No. 123,*  Accounting for Stock-Based Compensation*.. Statement 123(R) supersedes APB Opinion No. 25,*  Accountingfor Stock Issued to Employees* , and amends FASB StatementNo. 95,* Statement of Cash Flows* . Generally, the approach inStatement 123(R) is similar to the approach described in Statement 123.However, Statement 123(R) requires all share-based payments to employees,including grants of employee stock options, to be recognized in the incomestatement based on their fair values at the time of grant. Pro forma disclosureis no longer an alternative.

Statement123(R) permits public companies to adopt its requirements using one of twomethods: (1) a “modified prospective” method in which compensation cost isrecognized beginning with the effective date (a) based on the requirementsof Statement 123(R) for all share-based payments granted after theeffective date and (b) based on the requirements of Statement 123 for allawards granted to employees prior to the effective date of Statement123(R) that remain unvested on the effective date; (2) a “modifiedretrospective” method which includes the requirements of the modifiedprospective method described above, but also permits entities to restate basedon the amounts previously recognized under Statement 123 for purposes of proforma disclosures either (a) all prior periods presented or (b) priorinterim periods of the year of adoption.  We have adopted Statement 123(R)based on the modified prospective method effective January 1, 2006.

Stock-basedcompensation amounts recognized in the three months and nine months endedSeptember 30, 2006 upon the adoption of Statement 123(R) is as follows (inthousands):
| ** **                                                 | ** ** | **Three Months Ended   Sept 30, 2006** | ** ** | **Nine Months Ended   Sept 30, 2006** | ** ** |
|------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| Total cost of  stock-based compensation during the period  |       | $                                                               | 1,335      |                                                           | $          | 3,586 |   |
| Amounts  capitalized in ending inventory                   |       | (491                                                            | )          | (1,141                                                         | )          |
| Amount  recognized in expense previously capitalized       |       | 384                                                             |       | 384                                                            |       |
| Amounts charged  against income for the period before tax  |       | $                                                               | 1,228      |                                                           | $          | 2,829 |   |
| Amount of related  income tax benefit recognized in income |       | $                                                               | (255       | )                                                              | $          | (718 | ) |

 

Consistent with ourinventory accounting policies, the payroll costs of buying, distribution andcertain other general and administrative expenses, and with the adoption ofStatement 123(R), the related stock-based compensation of these functions, arecapitalized as a part of inventory and expensed as cost of sales when therelated inventory is sold.  The adoption of Statement 123(R) also caused a$0.02 and $0.05 decrease in basic and diluted earnings per share for the threeand nine months ended September 30, 2006, respectively.  Based onnon-vested stock options outstanding at September 30, 2006, we expect to incurapproximately $2.9 million, net of tax, in stock-based compensation for theyear ended December 31, 2006.

Statement123(R) includes several modifications to the way that incomes taxes areprovided for in the financial statements. The expense for stock option grantsis only deductible for tax purposes at the time the taxable event takes place,which will cause variability in our effective tax rates recorded throughouteach year. The expected variability in our effective tax rate is caused by 

11

----

 

Statement 123(R)’sforbiddance of companies from predicting when these taxable events will takeplace. Statement 123(R) also requires the benefits of tax deductions inexcess of recognized compensation cost to be reported as a financing cash flow,rather than as an operating cash flow. This requirement will reduce netoperating cash flows and increase net financing cash flows in annual periodsafter adoption.

In the prior year,we accounted for our stock-based compensation plans utilizing the intrinsicvalue method in accordance with the provisions of Accounting Principles BoardOpinion No. 25 (APB 25).   Generally, no compensation expense wasrecognized for fixed stock option plans because the exercise prices of employeestock options equaled or exceeded the market prices of the underlying stock onthe dates of grant.  Had we applied the fair value based method andrecognition provisions of Statement of Financial Accounting Standards (SFAS)No. 123, “*Accounting for Stock-BasedCompensation* ,” (as amended by Statement of Financial AccountingStandards No. 148, “*Accounting forStock-Based Compensation Transition and Disclosure*”) the pro formaeffects of stock-based compensation on net income and net income per commonshare for the three and nine months ended September 30, 2005 were as follows(in thousands except per share amounts):
| ** **                                                                                                           | ** ** | **Three Months   Ended   Sept 30, 2005** | ** ** | **Nine Months   Ended   Sept 30, 2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|------------------------------------------------------------------|------------|
| Net income as  reported                                                                                              |       | $                                                                 | 8,213      |                                                             | $          | 25,409 |   |
| Less:  Stock-based employee compensation expense determined under the fair value  method, net of related tax effects |       | 959                                                               |       | 2,915                                                            |       |
| Pro forma net  income                                                                                                |       | $                                                                 | 7,254      |                                                             | $          | 22,494 |   |
|                                                                                                                 |       |                                                              |       |                                                             |       |
| Net income per  common share:                                                                                        |       |                                                              |       |                                                             |       |
| Basic as  reported                                                                                                   |       | $                                                                 | 0.20       |                                                             | $          | 0.62 |   |
| Basic pro forma                                                                                                      |       | $                                                                 | 0.18       |                                                             | $          | 0.55 |   |
| Diluted as  reported                                                                                                 |       | $                                                                 | 0.20       |                                                             | $          | 0.61 |   |
| Diluted pro forma                                                                                                    |       | $                                                                 | 0.17       |                                                             | $          | 0.54 |   |

 

Consistent with prioryears, the fair value of each stock option granted during the nine months endedSeptember 30, 2006 was estimated at the date of grant using a Black-Scholesoption pricing model based on the assumptions of expected volatility of 35%,expected dividend yield of 2.5%, expected term of 4.5 years and a risk-freeinterest rate of 4.2%.  The expected volatility is based on ourconsideration of the implied volatility of our minimally traded options on ourshares and the historical volatility of our stock based on our historical stockprices.  The expected term of an option is based on our historical reviewof employee exercise behavior based on the employee class (executive ornon-executive) and based on our consideration of the remaining contractual termif limited exercise activity existed for a certain employee class.  Therisk-free interest rate is the constant maturity interest rate for U.S.Treasury instruments with terms consistent with the expected lives of the awards.

As of September 30, 2006,we had $10.2 million of total unrecognized stock-based compensation expenserelated to stock options that is expected to be recognized over a weightedaverage period of 3.48 years.

**LeaseAccounting Adjustment**

Based on certain viewsexpressed in a letter of February 7, 2005 from the Office of the ChiefAccountant of the Securities and Exchange Commission to the American Instituteof Certified Public Accountants, we reviewed our accounting policies andpractices associated with operating leases. Consistent with industry practices,we historically reported straight-line rental expense beginning on the leasecommencement date. This had the effect of excluding the rent holiday associatedwith the pre-opening or build-out period of our stores from the calculation ofthe period over which we expensed rent. Following our review, we modified ouraccounting policies such that we begin recording rent expense on the date wetake possession of or have the right to use the premises.

As a result of thisadjustment, we recorded a non-cash, $3.9 million ($2.4 million, netof income tax) cumulative charge to earnings during the first quarter of 2005.The adjustment did not impact historical or future net cash flows nor thetiming of the payments under related leases. We believe that the new leaseaccounting policies will not have a material effect on future diluted earningsper share. Prior years’ financial statements were not restated as the impact ofthis issue was immaterial to previously reported results for any individualprevious periods.

**Resultsof Operations**

Our business is highlyseasonal, with a significant portion of our net sales and most of our operatingincome generated in the fourth quarter, which includes the holiday season.There can be no assurance that current trends in sales and operating resultswill improve in the future.  Thefollowing table sets forth certain financial information from our consolidatedstatements of income expressed as a 

12

----

 

percentage of netsales:
| ** **                                       | ** ** | **Three Months Ended  Sept 30** | ** ** | **Nine Months Ended  Sept 30** | ** ** |
|--------------------------------------------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                       | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net sales                                        |       | 100.0                                          | %          | 100.0                                         | %          | 100.0 | % | 100.0 | % |
| Cost of sales                                    |       | 62.4                                           |       | 61.2                                          |       | 62.5 |   | 61.7 |   |
| Gross profit                                     |       | 37.6                                           |       | 38.8                                          |       | 37.5 |   | 38.3 |   |
| Selling, general  and administrative expense     |       | 34.7                                           |       | 31.9                                          |       | 33.9 |   | 31.5 |   |
| Operating income                                 |       | 2.9                                            |       | 6.9                                           |       | 3.6 |   | 6.8 |   |
| Net interest  expense and other income (expense) |       | (0.3                                           | )          | (0.2                                          | )          | (0.2 | ) | 0.0 |   |
| Income before  income taxes                      |       | 2.6                                            |       | 6.7                                           |       | 3.4 |   | 6.8 |   |
| Income tax  expense                              |       | 1.0                                            |       | 2.4                                           |       | 1.3 |   | 2.5 |   |
|                                             |       |                                           |       |                                          |       |   |   |   |   |
| Net income                                       |       | 1.6                                            | %          | 4.3                                           | %          | 2.1 | % | 4.3 | % |

 

**Three Months Ended September 30,2006**

**Comparedto the Three Months Ended September 30, 2005**

During the third quarterof 2006, net sales increased to $194.4 million from $192.3 million in the thirdquarter of 2005, an increase of $2.1 million or 1.1%.  The increase in third quarter sales isprimarily due to the $16.5 million increase in sales from non-comparable newstores and an increase in customer traffic of 6.2% partially offset by thedecrease in sales at comparable stores and a decrease in average ticket of4.8%.  The decrease in comparable sales for the third quarter of 2006resulted primarily from a 4.3% decline in the average transaction and a 0.4%decline in customer traffic.  Total average store sales for the thirdquarter of 2006 decreased 6.7% when compared to the same prior yearquarter.  Comparable store sales andsales per store decreased primarily due to a lower average ticket whilecustomer traffic stabilized.  Comparablestore sales and sales per store, though remaining negative, posted sequentiallybetter results than those achieved during the second quarter of this year.  Customer traffic stabilized during thequarter, contributing to the improvement in comparable performance versus priorquarter trends.  The home furnishingsretail sector remains very challenging due to an increase in supply of homedécor merchandise and a highly competitive promotional environment.

Gross profit decreased$1.6 million, or 2.2%, to $73.1 million for the three months ended September30, 2006 as compared to last year’s third quarter of $74.7 million, due to thereduction in inventory levels and associated costs as a result of promotionalevents structured to stimulate sales and drive traffic.  Our gross profit percentage decreased to37.6% from 38.9% in the prior year’s third quarter.  This decrease of 1.3% in gross profitpercentage is comprised of a 1.1% change in costs associated with the buyingand distribution of inventory and a  0.2%decrease due to freight costs .

Selling, general andadministrative expenses are comprised of store labor, store occupancy costs,advertising, miscellaneous store operating expenses and corporate office costs.Increases in dollar amounts of these expenses are attributable to increases inthe number of stores and changes in variable expenses.  Variable expensesinclude payroll and related benefits, advertising expense and other expensessuch as credit card fees.

Selling, general andadministrative expenses increased $6.0 million, or 9.7%, to $67.3 million from$61.4 million in the third quarter of 2005.  The increase was attributableto a $4.0 million increase in store occupancy costs, store personnel costs andstore depreciation expense primarily due to the expansion in our store base, anincrease of $900 thousand of store maintenance and other store expenses, the$1.2 million stock-based compensation as a result of the adoption of Statement123(R) and $900 thousand of other corporate expenses.  These were somewhatoffset by the $800 thousand decrease in advertising expense.  As apercentage of net sales, these expenses increased 2.7% to 34.6% in the thirdquarter of 2006 from 31.9% in the third quarter of 2005.  The increasedpercentage is primarily due to the reduced expense leveraging given ournegative comparable store sales for the third quarter of 2006 and includes a1.8% increase related to store occupancy costs, store personnel costs and storedepreciation expense, a 0.4% increase in store maintenance and other storeexpenses, a 0.6% increase due to the recording of stock-based compensation as aresult of the adoption of Statement 123(R) and a 0.4% increase in othercorporate expenses but were somewhat offset by the 0.5% decrease in advertisingexpense.

The income tax provisionfor the three month periods ended September 30, 2006 and 2005 was $1.9 millionand $4.7 million, respectively, reflecting an effective tax rate of 38.1% and36.6%, respectively.  The effective tax rate is higher in the thirdquarter of 2006 as compared to the third quarter of 2005 due to an adjustmentto the effective tax rate to reflect projected lower pretax income for thefull-year 2006 which is impacted by the permanent difference associated withnon-deductible stock compensation expense for incentive stock options grantedto employees prior to January  2006 and a favorable settlement of certaintax issues in the prior year period.

13

----

 

**Nine Months Ended September 30,2006**

**Comparedto the Nine Months Ended September 30, 2005**

During the first nine monthsof 2006, net sales decreased to $589.8 million from $596.6 million, a decreaseof $6.8 million or 1.1% compared to the same period of 2005. The decrease insales for the first nine months is primarily due to the 6.9% decrease incomparable store sales, offset by a $51.6 million increase in sales fromnon-comparable new stores.  The decrease in comparable store sales for thefirst nine months of 2006 was primarily the result of a 6.8% decline incustomer traffic.  Total average storesales for the first nine months of 2006 decreased 9.4% when compared to thesame prior year period.   Comparablestore sales and average sales per store for the year-to-date period continue tobe impacted by lower than anticipated store traffic coupled with a slightdecrease in average ticket.  This is aresult of the challenging retail environment and weakened discretionaryspending by consumers.  Customer trafficstabilized during the third quarter, contributing to a sequential improvementin both comparable store sales and average sales per store versus theyear-to-date period ended June 30, 2006.

Gross profit decreased$7.7 million, or 3.4%, to $220.9 million for the nine months ended September30, 2006 as compared to the nine month period last year of $228.7 million, primarilyas a result of our decreased net sales.  Our gross profit percentagedecreased to 37.5% from 38.3% in the prior year’s nine month period.  This0.8% decrease in the gross profit percentage is comprised of a 0.4% decreasedue to merchandise mix and markdowns and a 0.4% decrease due to damagedmerchandise and freight costs.

Selling, general andadministrative expenses increased $11.6 million, or 6.1%, to $199.7 millionfrom $188.2 million in the same period last year.  The increase wasattributable to a $11.6 million increase in store occupancy costs, storepersonnel costs and store depreciation expense primarily due to theexpansion in our store base, $2.8 million stock-based compensation recorded asa result of the adoption of Statement 123(R), and $1.9 million othercorporate expenses, offset by the $3.9 million non-cash lease accountingadjustment in the same prior year period and the $1.6 million decrease inadvertising expense.  As a percentage of net sales, these expensesincreased 2.4% to 33.9% in the first nine months of 2006 from 31.5% in thefirst nine months of 2005.  The increased percentage is primarily due tothe reduced expense leveraging given our negative comparable store sales andincludes a 2.2% increase related to store occupancy costs, store personnelcosts and store depreciation expense, a 0.5% increase due to the recording ofstock-based compensation as a result of the adoption of Statement 123(R) and a0.4% increase of other corporate expenses,  offset  primarily by the0.7% decrease related to the lease accounting adjustment recorded in the prioryear and by the 0.2% decrease in advertising expense.

The income tax provisionfor the nine month periods ended September 30, 2006 and 2005 was $7.7 millionand $14.9 million, respectively, reflecting an effective tax rate of 38.0% and37.0%, respectively.  The effective tax rate is higher in the nine monthsended September 30, 2006 as compared to the nine months ended 2005 due to anadjustment in the effective tax rate to reflect projected lower pretax incomefor the full-year 2006 which is impacted by the permanent difference associatedwith non-deductible stock compensation expense for incentive stock optionsgranted to employees prior to January 2006 and a favorable settlement ofcertain tax issues in the prior year period.

**Liquidityand Capital Resources**

We have financed ouroperations with funds generated from operating activities and borrowings underour revolving credit facility. Our cash flows will continue to be utilized forthe expansion of our business and future cash dividends to our stockholders. Wehave no off-balance sheet arrangements or transactions with unconsolidated,limited purpose or variable interest entities, nor do we have materialtransactions or commitments involving related persons or entities.

Net cash used inoperating activities for the nine months ended September 30, 2006 and 2005was $37.4 million and $51.3 million, respectively, representing a $13.9 milliondecrease. This decrease in cash used is primarily due to the decrease inmerchandise purchases and related vendor payables as we improve the age,content and level of our inventory. Capital expenditures principally associated with new stores opening andwarehouse equipment was $11.4 million and $13.0 million for the nine monthsended September 30, 2006 and 2005, respectively.  We expect to spendapproximately $6.8 million for additional capital expenditures for theremainder of 2006, which will include the opening of new stores, enhancementsof selected stores, and purchases of equipment for our distribution center.

We have a $210 millionrevolving credit facility that expires in December 2009.  Any borrowing under the revolvingcredit facility will incur interest at LIBOR or the prime rate, depending onthe type of borrowing, plus an applicable margin. We incur commitment fees ofup to 0.25% on the unused portion of the revolving credit facility. This rateis reduced or increased as our average total leverage ratio changes. Ourindebtedness under the credit facility is secured by a lien on our inventoryand cash accounts, as well as a pledge of our ownership interests in all of oursubsidiaries.

14

----

 

At September 30, 2006, wehad $47 million in debt outstanding under the revolving credit facility and hadavailability of $154.9 million.  As of September 30, 2006, we hadoutstanding letters of credit of $8.1 million, primarily for self-insurance.

The revolving creditfacility contains certain restrictive covenants, which among other things,require us to comply with certain financial ratios covering maximum leverage,minimum fixed charge coverage and minimum interest coverage. Other restrictionsaffect our ability to incur liens or make certain other restricted payments,sell assets or merge or consolidate with any other person. As of September 30,2006, we were in compliance with all covenants.

We anticipate that ourfuture net cash flows from operations and unused borrowings under our revolvingcredit facility will be sufficient to fund our working capital needs, an annualdividend and planned capital expenditures for the next 12 months.

**StoreOpenings/Closings**
| ** **                          | ** ** | **Nine Months  Ended  Sept 30,  2006** | ** ** | **Twelve Months  Ended  Dec 31,  2005** | ** ** | **Nine Months  Ended  Sept 30,  2005** | ** ** |
|-------------------------------------|------------|--------------------------------------------------|------------|---------------------------------------------------|------------|--------------------------------------------------|------------|
|                                |       |                                             |       |                                              |       |                                             |       |
| Stores open at  beginning of period |       | 732                                              |       | 662                                               |       | 662                                              |       |
| Stores opened  during the period    |       | 47                                               |       | 81                                                |       | 62                                               |       |
| Stores closed  during the period    |       | (7                                               | )          | (11                                               | )          | (11                                              | )          |
| Stores open at end of  period       |       | 772                                              |       | 732                                               |       | 713                                              |       |

 

**Item3. Quantitative and Qualitative Disclosures About Market Risk**

We are exposed to variousmarket risks, including changes in foreign currency exchange rates and interestrates.  Market risk is the potential loss arising from adverse changes inmarket prices and rates, such as foreign currency exchange and interestrates.  Based on our market risk sensitive instruments outstanding as ofSeptember 30, 2006, we have determined that there was no material marketrisk exposure to our consolidated financial position, results of operations orcash flows as of such date.  Our market risk is discussed in more detailin our Annual Report on Form 10-K for the year ended December 31,2005.  We do not enter into derivatives or other financial instruments fortrading or speculative purposes.  There have been no significant changesin the foreign currency exchange rate or interest rate market risks sinceDecember 31, 2005.

**Item4. Controls and Procedures**

**DisclosureControls and Procedures**

Based on our management’sevaluation (with participation of our principal executive officer and ourprincipal financial officer), our principal executive officer and our principalfinancial officer have concluded that our disclosure controls and procedures(as defined in Rule 13a-15(e) or Rule 15d-15(e) under theSecurities Exchange Act of 1934, as amended (the “Exchange Act”)) wereeffective as of September 30, 2006 to ensure that information required to bedisclosed by us in this Quarterly Report on Form 10-Q was(1) recorded, processed, summarized and reported within the time periodsspecified in the Securities and Exchange Commission’s rules and forms and(2) accumulated and communicated to our management, including ourprincipal executive and principal financial officers, to allow timely decisionsregarding required disclosure.

A control system, nomatter how well conceived and operated, can provide only reasonable, notabsolute, assurance that the objectives of the control system are met. Becauseof inherent limitations in all control systems, no evaluation of controls canprovide absolute assurance that all control issues, if any, within a companyhave been detected. Accordingly, our disclosure controls and procedures aredesigned to provide reasonable, not absolute, assurance that the objectives ofour disclosure control system are met and, as set forth above, our chief executiveofficer and chief financial officer have concluded, based on their evaluationas of the end of the period covered by this report, that our disclosurecontrols and procedures were effective to provide reasonable assurance that theobjectives of our disclosure control system were met.

**Changes in Internal Control OverFinancial Reporting**

There were no changes inour internal control over financial reporting that occurred during the quarterended September 30, 2006 that have materially affected, or are reasonablylikely to materially affect, our internal control over financial reporting.

15

----

 

**PART II — OTHER INFORMATION**

**Item1. Legal Proceedings**

During 2001 and 2002, wewere named as a defendant in three complaints filed in the Superior Court ofCalifornia in and for the County of Los Angeles. The plaintiffs are seeking tocertify a statewide class made up of some of our current and former employees,which they claim are owed compensation for overtime wages, penalties andinterest. The plaintiffs are also seeking attorney’s fees and costs. InOctober 2003, we entered into a settlement agreement with a sub-class ofthese plaintiffs consisting of manager-in-training and management traineeswhich was paid in November 2005 with no material impact to our financialstatements. The remaining complaint relating to our salaried managers is stillopen with a scheduled trial date of July 2007.  We have a similar lawsuitfiled in Orange, County California in 2004 where our motion to disqualify thenamed plaintiff as a class representative has been accepted. The case is stillin discovery.  We do not expect either of these complaints to have amaterial impact to our financial statements.

In June 2004, wewere named as a defendant in a complaint filed in the U.S. District Court,Central District of California. The plaintiff, Thomas Kinkade Company (f/k/a/Media Arts Group Inc.), alleged copyright infringement and false advertisementson merchandise we sold in the second quarter of 2004.  The case went totrial in March 2006.  The jury found in favor of us on the trademarkinfringement claim.  The jury was unable to reach a verdict on theremaining claims.  The parties have agreed to mediate with the presidingjudge regarding the remaining claims.  A mediation date has been set forNovember 2006.

We intend to vigorouslydefend all pending actions. We do not believe these or any other legalproceedings pending or threatened against us would have a material adverseeffect on our financial condition or results of operations.

**Item 1A.Risk Factors**

There have been nomaterial changes from our risk factors previously disclosed in “Item 1A. RiskFactors” of our Form 10K for the year ended December 31, 2005.

**Item5. Other Information**

There have been nomaterial changes to the procedures by which security holders may recommendnominees to our Board of Directors since April 21, 2003.

16

----

 

**Item 6. Exhibits**
| Exhibit  Number | ** ** | **Title of Exhibit**                                                                                                                                                                                                                                                                                                     |
|-----------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1             |       | Certificate of Incorporation of Tuesday Morning Corporation  (the “Company”) (incorporated by reference to Exhibit 3.1 to the Company’s  Registration Statement on Form S-4 (File No. 333-46017) as filed with the  Securities and Exchange Commission (the “Commission”) on February 10, 1998) |
| 3.1.2           |       | Certificate of Amendment to the Certificate of  Incorporation of the Company dated March 25, 1999 (incorporated by reference  to Exhibit 3.3 to the Company’s Registration Statement on Form S-1/A (File  No. 333-74365) as filed with the Commission on March 29, 1999)                                       |
| 3.1.3           |       | Certificate of Amendment to the Certificate of  Incorporation of the Company dated May 7, 1999 (incorporated by reference to  Exhibit 3.1.3 to the Company’s Form 10-Q (File No. 000-19658) as filed with  the Commission on May 2, 2005)                                                                           |
| 3.2             |       | Amended and Restated By-laws of the Company  (incorporated by reference to Exhibit 3.7 to the Company’s Registration  Statement on Form S-4 (File No. 333-46017) as filed with the Commission on  February 10, 1998)                                                                                                |
| 3.2.1           |       | First Amendment to the Amended and Restated By-laws  of the Company (incorporated by reference to Exhibit 3.1 to the  Company’s Form 8-K (File No. 000-19658) as filed with the Commission on May  18, 2006)                                                                                                   |
| 10.1            |       | Letter Agreement dated July 18, 2006 from Kathleen  Mason, on behalf of the Company, to Elizabeth Schroeder (incorporated by  reference to Exhibit 10.1 to the Company’s Form 8-K (File No. 000-19658) as  filed with the Commission on July 18, 2006) W                                                            |
| 31.1            |       | Certification by the Chief Executive Officer of the  Company pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                                   |
| 31.2            |       | Certification by the Chief Financial Officer of the  Company pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                                   |
| 32.1            |       | Certification of the Chief Executive Officer of the  Company pursuant to 18 U.S.C §1350, adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 *                                                                                                                                                       |
| 32.2            |       | Certification of the Chief Financial Officer of the  Company pursuant to 18 U.S.C §1350, adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 *                                                                                                                                                       |

----

W                  Managementagreement or compensatory plan or arrangement

*                    Thecertifications attached hereto as Exhibit 32.1 and Exhibit 32.2 arefurnished with this Quarterly Report on Form 10-Q and shall notbe deemed “filed” by the Company for purposes of Section 18 of theSecurities Exchange Act of 1934, as amended.

17

----

 

SIGNATURE

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.
|                                                      | **TUESDAY MORNING CORPORATION**                                                                  |
|------------------------------------------------------|--------------------------------------------------------------------------------------------------|
| ** **                                           | (Registrant)                                                                                     |
|                                                 |                                                                                             |
|                                                 |                                                                                             |
|                                                 |                                                                                             |
| DATE:     November  2, 2006 | By:                                                                                              | /s/ Elizabeth Schroeder |
|                                                 | Elizabeth Schroeder, Executive Vice President, Chief  Financial Officer, Treasurer and Secretary |
|                                                 | (Principal Financial Officer and duly                                                            |
|                                                 | authorized to sign this report on behalf of the  registrant)                                     |

 

18

----

 

**EXHIBIT INDEX**
| Exhibit No. | ** ** | **Description**                                                                                                                                                                                                                                                                                                           |
|-------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1         |       | Certificate of Incorporation of Tuesday Morning  Corporation (the “Company”) (incorporated by reference to Exhibit 3.1 to the  Company’s Registration Statement on Form S-4 (File No. 333-46017) as filed  with the Securities and Exchange Commission (the “Commission”) on February  10, 1998) |
| 3.1.2       |       | Certificate of Amendment to the Certificate of  Incorporation of the Company dated March 25, 1999 (incorporated by reference  to Exhibit 3.3 to the Company’s Registration Statement on Form S-1/A (File  No. 333-74365) as filed with the Commission on March 29, 1999)                                        |
| 3.1.3       |       | Certificate of Amendment to the Certificate of  Incorporation of the Company dated May 7, 1999 (incorporated by reference to  Exhibit 3.1.3 to the Company’s Form 10-Q (File No. 000-19658) as filed with  the Commission on May 2, 2005)                                                                            |
| 3.2         |       | Amended and Restated By-laws of the Company  (incorporated by reference to Exhibit 3.7 to the Company’s Registration  Statement on Form S-4 (File No. 333-46017) as filed with the Commission on  February 10, 1998)                                                                                                 |
| 3.2.1       |       | First Amendment to the Amended and Restated By-laws  of the Company (incorporated by reference to Exhibit 3.1 to the  Company’s Form 8-K (File No. 000-19658) as filed with the Commission on May  18, 2006)                                                                                                    |
| 10.1        |       | Letter Agreement dated July 18, 2006 from Kathleen  Mason, on behalf of the Company, to Elizabeth Schroeder (incorporated by  reference to Exhibit 10.1 to the Company’s Form 8-K (File No. 000-19658) as  filed with the Commission on July 18, 2006) W                                                             |
| 31.1        |       | Certification by the Chief Executive Officer of the  Company pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                                    |
| 31.2        |       | Certification by the Chief Financial Officer of the  Company pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                                    |
| 32.1        |       | Certification of the Chief Executive Officer of the  Company pursuant to 18 U.S.C. § 1350, adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002*                                                                                                                                                       |
| 32.2        |       | Certification of the Chief Financial Officer of the  Company pursuant to 18 U.S.C. § 1350, adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002*                                                                                                                                                       |

 

----

W                  Managementagreement or compensatory plan or arrangement

*                    Thecertifications attached hereto as Exhibit 32.1 and Exhibit 32.2 arefurnished with this Quarterly Report on Form 10-Q and shall notbe deemed “filed” by the Company for purposes of Section 18 of theSecurities Exchange Act of 1934, as amended.

19

----