** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D. C. 20549**

** **

**FORM 10-Q**

** **

**(Mark One)**

 

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

 

**FOR THE QUARTERLY PERIODENDEDJune 30, 2006**

** **

**OR**

** **

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

 

**FOR THE TRANSITION PERIODFROM           TO           **

** **

**Commission file number0-19658**

** **

**TUESDAY MORNING 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 LBJ FreewayDallas, Texas 75240**

(Address,including zip code, of principal executive offices)

**(972) 387-3562**

(Registrant’s telephone number, including area code)

** **

**Not applicable**

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

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes  x  No  o

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

| Large accelerated  filer x |   | Accelerated  filer o |   | Non-accelerated  filer o |
|---------------------------------|--------|---------------------------|--------|-------------------------------|

 

Indicateby check mark whether the registrant is a shell company (as defined inRule 12b-2 of the Exchange Act). Yes o No x

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

 

|                                         | **Class** | ** ** | ** ** | ** ** | **Outstanding at July 28, 2006** | ** ** |
|-----------------------------------------|-----------|------------|------------|------------|----------------------------------|------------|
| Common Stock, par value $0.01 per share |      | 41,386,816 |

 

 

 

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**Forward-Looking Statements**

*This Quarterly Report on Form 10-Q contains forward-lookingstatements within the meaning of the federal securities laws and the PrivateSecurities Litigation Reform Act of 1995. These statements may be found throughout this Form 10-Q particularlyunder the heading “Management’s Discussion and Analysis of Financial Conditionand Results of Operations,” among others. Forward-looking statements typically are identified by the use of termssuch as “may,” “will,” “should,” “expect,” “anticipate,” “believe,” “estimate,”“intend” and similar words, although some forward-looking statements areexpressed differently.  You shouldconsider statements that contain these words carefully because they describeour expectations, plans, strategies and goals and our beliefs concerning futurebusiness conditions, our future results of operations, our future financialposition, and our business outlook or state other “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 thisQuarterly Report on Form 10Q  for**examples of risks, uncertainties and events that could cause ouractual results to differ materially from the expectations expressed in ourforward-looking statements.  These risks,uncertainties and events also include, but are not limited to, the following:*

·                  *uncertainties regarding our ability to open stores in new and existingmarkets and operate these stores on a profitable basis;*

·                  *conditions affecting consumer spending, such as high gasoline prices;*

·                  *general regional and national economic conditions;*

·                  *inclement weather, such as the pattern of hurricanes that affected theSoutheast U.S. in August and September 2004 and again in September 2005;*

·                  *changes in our merchandise mix;*

·                  *timing and type of sales events, promotional activities and otheradvertising;*

·                  *uncertainties arising out of world events;*

·                  *increased or new competition;*

·                  *our ability to continuously attract buying opportunities for closeoutmerchandise and anticipate consumer demand as closeout merchandise becomesavailable;*

·                  *loss of, or disruption in, our centralized distribution center;*

·                  *loss or departure of one or more members of our senior management;*

·                  *our dependence on external funding sources;*

·                  *an increase in the cost or a disruption in the flow of 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 to update our forward-looking statements toreflect events and circumstances after the date on which the statements weremade or to reflect the occurrence of unanticipated 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

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| **PART I - FINANCIAL  INFORMATION**                                                                       |       |
|-----------------------------------------------------------------------------------------------------------|------------|
|                                                                                                      |       |
| Item 1 — Financial  Statements                                                                       |       |
|                                                                                                      |       |
| Consolidated Balance Sheets as of  June 30, 2006 and December 31, 2005                          |       |
|                                                                                                      |       |
| Consolidated Statements of  Income for the Three Months and Six Months Ended June 30, 2006 and 2005  |       |
|                                                                                                      |       |
| Consolidated Statements of  Cash Flows for the Six Months Ended June 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 4 —  Submission of Matters to a Vote of Security Holders                                        |       |
|                                                                                                      |       |
| Item 5 — Other  Information                                                                          |       |
|                                                                                                      |       |
| Item 6 — Exhibits                                                                                    |       |

 

3

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## **PART I —FINANCIAL INFORMATION**

**Item 1.Financial Statements**

**Tuesday Morning CorporationConsolidated Balance Sheets(In thousands, except for share data)**
| ** **                                                                                                                                                                               | ** ** | **June 30,  2006** | ** ** | **Dec. 31,  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                                                                                                                                                               | ** ** | ** **              | ** ** | ** **              | ** ** |
| **ASSETS**                                                                                                                                                                               |       |                    |       |                    |       |
| Current assets:                                                                                                                                                                          |       |                    |       |                    |       |
| Cash and cash  equivalents                                                                                                                                                               |       | $                       | 5,766      |                    | $          | 43,547 |   |
| Inventories                                                                                                                                                                              |       | 241,660                 |       | 230,639                 |       |
| Prepaid expenses  and other current assets                                                                                                                                               |       | 7,413                   |       | 7,258                   |       |
| Deferred income  taxes                                                                                                                                                                   |       | 5,071                   |       | 5,071                   |       |
| Total current  assets                                                                                                                                                                    |       | 259,910                 |       | 286,515                 |       |
|                                                                                                                                                                                     |       |                    |       |                    |       |
| Property and equipment,  net                                                                                                                                                             |       | 86,868                  |       | 87,786                  |       |
| Deferred financing  costs                                                                                                                                                                |       | 599                     |       | 685                     |       |
| Other assets                                                                                                                                                                             |       | 4,930                   |       | 4,941                   |       |
|                                                                                                                                                                                     |       |                    |       |                    |       |
| Total Assets                                                                                                                                                                             |       | $                       | 352,307    |                    | $          | 379,927 |   |
|                                                                                                                                                                                     |       |                    |       |                    |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                           |       |                    |       |                    |       |
| Current liabilities:                                                                                                                                                                     |       |                    |       |                    |       |
| Accounts payable                                                                                                                                                                         |       | $                       | 72,302     |                    | $          | 74,975 |   |
| Accrued  liabilities                                                                                                                                                                     |       | 29,444                  |       | 42,372                  |       |
| Income taxes  payable                                                                                                                                                                    |       | 4,736                   |       | 16,520                  |       |
| Total current  liabilities                                                                                                                                                               |       | 106,482                 |       | 133,867                 |       |
|                                                                                                                                                                                     |       |                    |       |                    |       |
| Revolving credit  facility                                                                                                                                                               |       | 21,000                  |       | —                  |       |
| Deferred rent                                                                                                                                                                            |       | 4,553                   |       | 4,431                   |       |
| Deferred income taxes                                                                                                                                                                    |       | 6,267                   |       | 6,267                   |       |
|                                                                                                                                                                                     |       |                    |       |                    |       |
| Total  Liabilities                                                                                                                                                                       |       | 138,302                 |       | 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; 41,386,816 shares  issued and outstanding at June 30, 2006 and 41,369,922 shares at  December 31, 2005 |       | 414                     |       | 414                     |       |
| Additional  paid-in capital                                                                                                                                                              |       | 193,482                 |       | 191,229                 |       |
| Retained  earnings                                                                                                                                                                       |       | 20,100                  |       | 43,763                  |       |
| Accumulated  other comprehensive income (loss)                                                                                                                                           |       | 9                       |       | (44                     | )          |
|                                                                                                                                                                                     |       |                    |       |                    |       |
| Total  Stockholders’ Equity                                                                                                                                                         |       | 214,005                 |       | 235,362                 |       |
|                                                                                                                                                                                     |       |                    |       |                    |       |
| Total Liabilities and Stockholders’ Equity                                                                                                                                          |       | $                       | 352,307    |                    | $          | 379,927 |   |

 

The accompanying notes are an integral part of theseconsolidated financial statements.

4

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**Tuesday Morning CorporationConsolidated Statements of Income(In thousands, except per share data)**
| ** **                                    | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                    | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                          |       |                                                |       |                                              |       |   |   |   |   |
| Net sales                                     |       | $                                                   | 207,669    |                                              | $          | 218,756 |   | $ | 395,428 |   | $ | 404,350 |   |
| Cost of sales                                 |       | 133,396                                             |       | 137,338                                           |       | 247,564 |   | 250,374 |   |
| Gross profit                                  |       | 74,273                                              |       | 81,418                                            |       | 147,864 |   | 153,976 |   |
| Selling, general  and administrative expenses |       | 69,227                                              |       | 64,672                                            |       | 132,390 |   | 126,794 |   |
| Operating income                              |       | 5,046                                               |       | 16,746                                            |       | 15,474 |   | 27,182 |   |
| Other income  (expense):                      |       |                                                |       |                                              |       |   |   |   |   |
| Interest income                               |       | 2                                                   |       | 64                                                |       | 101 |   | 98 |   |
| Interest expense                              |       | (567                                                | )          | (164                                              | )          | (753 | ) | (370 | ) |
| Other income, net                             |       | 253                                                 |       | 239                                               |       | 386 |   | 432 |   |
|                                          |       | (312                                                | )          | 139                                               |       | (266 | ) | 160 |   |
| Income before income taxes                    |       | 4,734                                               |       | 16,885                                            |       | 15,208 |   | 27,342 |   |
| Income tax  expense                           |       | 1,835                                               |       | 6,355                                             |       | 5,769 |   | 10,146 |   |
|                                          |       |                                                |       |                                              |       |   |   |   |   |
| Net income                                    |       | $                                                   | 2,899      |                                              | $          | 10,530 |   | $ | 9,439 |   | $ | 17,196 |   |
|                                          |       |                                                |       |                                              |       |   |   |   |   |
| **Earnings  Per Share**                       |       |                                                |       |                                              |       |   |   |   |   |
| Net income per  common share:                 |       |                                                |       |                                              |       |   |   |   |   |
| Basic                                         |       | $                                                   | 0.07       |                                              | $          | 0.26 |   | $ | 0.23 |   | $ | 0.42 |   |
| Diluted                                       |       | $                                                   | 0.07       |                                              | $          | 0.25 |   | $ | 0.23 |   | $ | 0.41 |   |
| Weighted average  number of common shares:    |       |                                                |       |                                              |       |   |   |   |   |
| Basic                                         |       | 41,384                                              |       | 41,204                                            |       | 41,380 |   | 41,167 |   |
| Diluted                                       |       | 41,626                                              |       | 41,743                                            |       | 41,647 |   | 41,714 |   |
|                                          |       |                                                |       |                                              |       |   |   |   |   |
| Dividends per common  share                   |       | $                                                   | —     |                                              | 0.65       |   | $ | 0.80 |   | 0.65 |   |

 

The accompanying notes are an integral part of theseconsolidated financial statements.

5

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**Tuesday Morning CorporationConsolidated Statements of Cash Flows(In thousands)**
| ** **                                                                        | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                        | ** ** | **2006**                                      | ** ** | **2005** | ** ** |
|                                                                              |       |                                          |       |   |   |
| **Net  cash flows from operating activities:**                                    |       |                                          |       |   |   |
| Net income                                                                        |       | $                                             | 9,439      |   | $ | 17,196 |   |
| Adjustments to  reconcile net income to net cash used in operating activities:    |       |                                          |       |   |   |
| Depreciation and amortization                                                     |       | 8,102                                         |       | 6,978 |   |
| Amortization of financing fees                                                    |       | 86                                            |       | 86 |   |
| Stock-based compensation                                                          |       | 1,601                                         |       | — |   |
| Other non-cash items                                                              |       | 70                                            |       | (62 | ) |
| Change in operating assets and liabilities:                                       |       |                                          |       |   |   |
| Inventories                                                                       |       | (10,371                                       | )          | (18,610 | ) |
| Prepaid and other assets                                                          |       | (144                                          | )          | (1,138 | ) |
| Accounts payable                                                                  |       | (2,673                                        | )          | (3,303 | ) |
| Accrued liabilities                                                               |       | (12,928                                       | )          | (6,188 | ) |
| Deferred rent                                                                     |       | 122                                           |       | 4,139 |   |
| Income taxes payable                                                              |       | (11,784                                       | )          | (8,900 | ) |
| Net cash used in operating activities                                             |       | (18,480                                       | )          | (9,802 | ) |
|                                                                              |       |                                          |       |   |   |
| **Net  cash flows from investing activities:**                                    |       |                                          |       |   |   |
| Capital expenditures                                                              |       | (7,184                                        | )          | (8,586 | ) |
| Net cash used in investing activities                                             |       | (7,184                                        | )          | (8,586 | ) |
|                                                                              |       |                                          |       |   |   |
| **Net  cash flows from financing activities:**                                    |       |                                          |       |   |   |
| Payment of dividends to common stockholders                                       |       | (33,102                                       | )          | (26,854 | ) |
| Proceeds from revolving credit facility, net                                      |       | 21,000                                        |       | 3,500 |   |
| Proceeds from exercise of common stock options and  stock purchase plan purchases |       | (15                                           | )          | 2,161 |   |
| Net cash used in financing activities                                             |       | (12,117                                       | )          | (21,193 | ) |
| Net decrease in  cash and cash equivalents                                        |       | (37,781                                       | )          | (39,581 | ) |
| Cash and cash  equivalents, beginning of period                                   |       | 43,547                                        |       | 45,067 |   |
| Cash and cash  equivalents, end of period                                         |       | $                                             | 5,766      |   | $ | 5,486 |   |

 

The accompanying notes are an integral part of theseconsolidated financial statements.

 

 

6

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**Tuesday MorningCorporationNotes to Consolidated Financial Statements**

1.               Basis of presentation — The consolidatedinterim financial statements included herein have been prepared by us pursuantto the rules and regulations of the Securities and Exchange Commission.  Certain information and footnote disclosuresnormally included in financial statements prepared in accordance withaccounting principles generally accepted in the United States have beencondensed or omitted pursuant to such rules and regulations.  These financial statements include alladjustments, consisting only of those of a normal recurring nature, which, inthe opinion of management, are necessary to present fairly the results of theinterim periods presented and should be read in conjunction with theconsolidated financial statements and notes thereto in our Form 10-K filing forthe year ended December 31, 2005. Because of the seasonal nature of our business, the results ofoperations for the quarter are not indicative of the results to be expected forthe entire year.

2.                 Stock-based compensation — OnDecember 16, 2004, the Financial Accounting Standards Board (“FASB”)issued FASB Statement No. 123 (revised 2004), *Share-BasedPayment*(Statement 123(R)), which is a revision of FASB StatementNo. 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 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 toadopt its requirements using one of two methods: (1) a “modifiedprospective” method in which compensation cost is recognized beginning with theeffective date (a) based on the requirements of Statement 123(R) forall share-based payments granted after the effective date and (b) based onthe requirements of Statement 123 for all awards granted to employees prior tothe effective date of Statement 123(R) that remain unvested on theeffective date; (2) a “modified retrospective” method which includes therequirements of the modified prospective method described above, but alsopermits entities to restate based on the amounts previously recognized underStatement 123 for purposes of pro forma disclosures either (a) all priorperiods presented or (b) prior interim periods of the year ofadoption.  We have adopted Statement123(R) based on the modified prospective method effective January 1, 2006.

Stock-based compensation amounts recognized in thethree months and six months ended June 30, 2006 upon the adoption of Statement123(R) is as follows (in thousands):
|                                                            | ** ** | **Three Months Ended  June 30, 2006** | ** ** | **Six Months Ended  June 30, 2006** | ** ** |
|------------------------------------------------------------|------------|-----------------------------------------------------------|------------|---------------------------------------------------------|------------|
|                                                       |       |                                                      |       |                                                    |       |
| Total cost of stock-based  compensation during the period  |       | $                                                         | 1,101      |                                                    | $          | 2,251 |   |
| Amounts  capitalized in ending inventory                   |       | (309                                                      | )          | (650                                                    | )          |
|                                                       |       |                                                      |       |                                                    |       |
| Amounts charged  against income for the period before tax  |       | $                                                         | 792        |                                                    | $          | 1,601 |   |
|                                                       |       |                                                      |       |                                                    |       |
| Amount of  related income tax benefit recognized in income |       | $                                                         | (233       | )                                                       | $          | (463 | ) |
|                                                       |       |                                                      |       |                                                    |       |

 

Consistent with our inventory accounting policies, thepayroll costs of buying, distribution and certain other general andadministrative expenses, and with the adoption of Statement 123(R), the relatedstock-based compensation of these functions, are capitalized as a part ofinventory and expensed as cost of sales when the related inventory issold.  The adoption of Statement 123(R)also caused a $0.01 and $0.02 decrease in basic and diluted earnings per sharefor the three and six months ended June 30, 2006, respectively.  Based on non-vested stock options outstanding at June 30, 2006, weexpect to incur approximately $2.9 million, net of tax, in stock-basedcompensation for the year ended December 31, 2006.

Statement 123(R) includes several modificationsto the way that incomes taxes are provided for in the financial statements. Theexpense for stock option grants is only deductible for tax purposes at the timethe taxable event takes place, which will cause variability in our effectivetax rates recorded throughout each year. The expected variability in oureffective tax rate is caused by Statement 123(R)’s forbiddance of companiesfrom predicting when these taxable events will take place. Statement123(R) also requires the benefits of tax deductions in excess ofrecognized compensation cost to be reported as a financing cash flow, ratherthan as an operating cash flow as required under current literature. Thisrequirement will reduce net operating cash flows and increase net financingcash flows in annual periods after adoption.

7

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In the prior year, weaccounted for our stock-based compensation plans utilizing the intrinsic valuemethod in accordance with the provisions of Accounting Principles Board OpinionNo. 25 (APB 25).   Generally, nocompensation expense was recognized for fixed stock option plans because theexercise prices of employee stock options equaled or exceeded the market pricesof the underlying stock on the dates of grant. Had we applied the fair value based method and recognition provisions ofStatement of Financial Accounting Standards (SFAS) No. 123, “*Accounting for Stock-Based Compensation*,” (as amended byStatement of Financial Accounting Standards No. 148, “*Accountingfor Stock-Based Compensation Transition and Disclosure*”) the proforma effects of stock-based compensation on net income and net income percommon share for the three and six months ended June 30, 2005 were as follows(in thousands except per share amounts):
|                                                                                                                      | ** ** | **Three Months  Ended  June 30, 2005** | ** ** | **Six Months  Ended  June 30, 2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| Net income as  reported                                                                                              |       | $                                                     | 10,530     |                                                | $          | 17,196 |   |
| Less:  Stock-based employee compensation expense determined under the fair value  method, net of related tax effects |       | 956                                                   |       | 1,956                                               |       |
| Pro forma net  income                                                                                                |       | $                                                     | 9,574      |                                                | $          | 15,240 |   |
|                                                                                                                 |       |                                                  |       |                                                |       |
| Net income per  common share:                                                                                        |       |                                                  |       |                                                |       |
| Basic as  reported                                                                                                   |       | $                                                     | 0.26       |                                                | $          | 0.42 |   |
| Basic pro forma                                                                                                      |       | $                                                     | 0.23       |                                                | $          | 0.37 |   |
| Diluted as  reported                                                                                                 |       | $                                                     | 0.25       |                                                | $          | 0.41 |   |
| Diluted pro forma                                                                                                    |       | $                                                     | 0.23       |                                                | $          | 0.37 |   |

 

We have established the Tuesday Morning Corporation1997 Long-Term Equity Incentive Plan, as amended (the “1997 Plan”), and theTuesday Morning Corporation 2004 Long-Term Equity Incentive Plan, as amended(the “2004 Plan”), which allow our Board of Directors to grant stock options todirectors, officers and key employees of, and certain other key individuals whoperform services for us and our subsidiaries. The 1997 Plan and the 2004 Planauthorizes grants of options to purchase up to 4,800,000 and 2,000,000 shares,respectively, of authorized, but unissued common stock. Stock options aregranted with an exercise price, terms and vesting determined by theCompensation Committee of the Board of Directors, with certain limitations.

Options granted under the 1997 Plan and the 2004 Planvest daily over periods of four to five years and expire in ten years. Theexercise prices of the options range between $0.20 and $35.23, which representsfair value on the grant date of the shares of common stock into which suchoptions are exercisable. At June 30, 2006, there were 87,705 and 1,781,000shares available for grant under the 1997 Plan and the 2004 Plan, respectively.

Consistent with prior years, the fair value of eachstock option granted during the six months ended June 30, 2006 was estimated atthe date 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%.  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 optionis based on our historical review of employee exercise behavior based on theemployee class (executive or non-executive) and based on our consideration ofthe remaining contractual term, if limited exercise activity existed for acertain employee class.  The risk-freeinterest rate is the constant maturity interest rate for U.S. Treasuryinstruments with terms consistent with the expected lives of the awards.

A summary of stock option activity as of June 30, 2006and changes during the six months ended June 30, 2006 is presented below (inthousands 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                                 |       | 174,000                    |       | 19.25                                             |       | —                                                            |       | —                              |       |
| Exercised                               |       | (16,894                    | )          | 2.07                                              |       | —                                                            |       | —                              |       |
| Cancelled                               |       | (132,707                   | )          | 29.31                                             |       | —                                                            |       | —                              |       |
| Options  Outstanding at June 30, 2006   |       | 2,040,692                  |       | $                                                 | 19.55      |                                                              | 6.6        |                                | (13,064    | ) |
| Exercisable at June 30,  2006           |       | 1,375,322                  |       | $                                                 | 17.24      |                                                              | 5.7        |                                | (5,618     | ) |

 

The weighted average grant-date fair value of shareoptions granted during the six months ended June 30, 2006 was $5.68.  The total intrinsic value of share optionsexercised during the six months ended June 30, 2006 was $308 thousand.

As of June 30, 2006, wehad $9.0 million of total unrecognized stock-based compensation expense relatedto stock options that is expected to be recognized over a weighted averageperiod of 4.21 years.

3*.**              *Lease accounting adjustment - Based oncertain views expressed in a letter of February 7, 2005 from the Office ofthe Chief Accountant of the Securities and Exchange Commission to the AmericanInstitute of Certified Public Accountants, we reviewed our accounting policiesand practices associated with operating leases. Consistent with industrypractices, we historically reported straight-line rental expense beginning onthe lease commencement date. This had the effect of excluding the rent holidayassociated with the pre-opening or build-out period of our stores from thecalculation of the period over which we expensed rent. Following our review, wemodified our accounting policies such that we begin recording rent expense onthe date we take 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 fiscal2005. The adjustment did not impact historical or future net cash flows nor thetiming of the payments under related leases. Prior years’ financial statements were not restated as the impact ofthis issue was immaterial to previously reported results for any individualprevious period.

8

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4.               Comprehensiveincome - Comprehensive income isdefined as net income plus the change in equity during a period from transactionsand other events, excluding those resulting from investments by anddistributions to stockholders. Total comprehensive income for the three monthperiod ended June 30, 2006 and 2005 was $2.9 million and $10.5 million,respectively and for the six month period ended June 30, 2006 and 2005 was$9.5 million and $17.1 million, respectively.

5.               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 January 2007.  We have a similarlawsuit filed in Orange, County California in 2004 that we have filed a motionto disqualify the class representative. The motion was heard by the court in July 2006 with the outcome expectedto be communicated in August 2006.  Thecase is still in discovery. We do not expect either of these complaints to havea material impact to our financial statements.

InJune 2004, we were named as a defendant in a complaint filed in the U.S.District Court, Central District of California. The plaintiff, Thomas KinkadeCompany (f/k/a/ Media Arts Group Inc.), alleged copyright infringement andfalse advertisements on merchandise we sold in the second quarter of 2004.  The case went to trial in March 2006.  The jury found in favor of us on thetrademark infringement claim.  The jurywas unable to reach a verdict on the remaining claims.  The parties have agreed to mediate with thepresiding judge regarding the remaining claims. A mediation date has been set for August 2006.

Weintend to vigorously defend all pending actions. We do not believe these or anyother legal proceedings pending or threatened against us would have a materialadverse effect on our financial condition or results of operations.

6.               Earningsper common share
|                                                                                                     | ** ** | **Three Months Ended  June 30** | ** ** | **Six Months Ended  June 30** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|----------------------------------------------|------------|
| **(in thousands, except per share data)**                                  | ** ** | **2006**                                       | ** ** | **2005**                                     | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                                                |       |                                           |       |                                         |       |   |   |   |   |
| **Basic  earnings per share:**                                                                      |       |                                           |       |                                         |       |   |   |   |   |
| Net income                                                                                          |       | $                                              | 2,899      |                                         | $          | 10,530 |   | $ | 9,439 |   | $ | 17,196 |   |
| Weighted average  number of common shares outstanding                                               |       | 41,384                                         |       | 41,204                                       |       | 41,380 |   | 41,167 |   |
| Net income per  common share                                                                        |       | $                                              | 0.07       |                                         | $          | 0.26 |   | $ | 0.23 |   | $ | 0.42 |   |
|                                                                                                |       |                                           |       |                                         |       |   |   |   |   |
| **Diluted  earnings per share:**                                                                    |       |                                           |       |                                         |       |   |   |   |   |
| Net income                                                                                          |       | $                                              | 2,899      |                                         | $          | 10,530 |   | $ | 9,439 |   | $ | 17,196 |   |
|                                                                                                |       |                                           |       |                                         |       |   |   |   |   |
| Dilutive effect  of employee stock options                                                          |       | 242                                            |       | 539                                          |       | 267 |   | 547 |   |
| Weighted average  number of common shares outstanding                                               |       | 41,384                                         |       | 41,204                                       |       | 41,380 |   | 41,167 |   |
| Weighted average  number of common shares and diluted effect of outstanding employee stock  options |       | 41,626                                         |       | 41,743                                       |       | 41,647 |   | 41,714 |   |
|                                                                                                |       |                                           |       |                                         |       |   |   |   |   |
| Net income per common  share                                                                        |       | $                                              | 0.07       |                                         | $          | 0.25 |   | $ | 0.23 |   | $ | 0.41 |   |

7.               Revolving credit facility — Our $210 millionrevolving credit facility expires in December 2009.  We incur commitment fees of up to 0.25% onthe unused portion of the revolving credit facility. Any borrowings under therevolving credit facility incur interest at LIBOR or the prime rate, depending onthe type of borrowing, plus an applicable margin. These rates are increased orreduced as our average total leverage ratio changes.

At June 30, 2006, we had$21.0 million outstanding under the revolving credit facility and hadavailability of $180.9 million.

8.               In July 2006, the Financial Accounting Standards Board (“FASB”)issued Interpretation 48 (“FIN 48”), *Accounting for Uncertaintyin Income*Taxes, aninterpretation of FASB Statement No. 109, *Accounting for IncomeTaxes*.  FIN 48 clarifies theaccounting for uncertainty in income taxes recognized in an enterprise’sfinancial statements in accordance with FASB Statement No. 109.  This interpretation clarifies the applicationof Statement 109 by defining a criterion that an individual tax position mustmeet for any part of the benefit of that position to be recognized in anenterprise’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 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 onmanagement’s best judgment given the facts, circumstances and informationavailable 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 of this statement to have a materialeffect on our financial position or results of operation.

9

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**Item 2. Management’s Discussion and Analysis of FinancialCondition and Results of Operations**

**Introduction**

We sell upscale, name brand home furnishings, gift andrelated items significantly below retail prices charged by department andspecialty stores.  We have a uniqueevent-based selling strategy that creates a sense of urgency and excitement forour customer base.  These events are heldten times a year.  Each event featuresmerchandise selections of well-known and nationally advertised manufacturersand name brands from both domestic and European closeouts that are priced 50%to 80% off regular retail prices.

We have continued to grow our store base byapproximately 10% per year for the last five years.  During the first six months of 2006, weexpanded our store base by a net of 30 stores consisting of 35 new storeopenings and 5 store closures.  As ofJune 30, 2006, we operated 762 stores in 47 states.

**Business Overview**

Net sales for the second quarter of 2006 were $207.7million, a decrease of 5.1% compared to the same period last year and acomparable store sales decrease of 10.8%. Net income for the quarter was $2.9 million and diluted earnings pershare were $0.07.

For the six months ended June 30, 2006, net sales were$395.4 million for a decrease of 2.2% versus the prior year and a comp storedecrease of 7.9%.  Net income for theyear-to-date period was $9.4 million and diluted earnings per share were $0.23.

The second quarter of 2006 was a challenging quarterfor the company due primarily to macroeconomic pressures on consumers, anoverall increase in supply of home décor merchandise and a competitivepromotional environment in the home furnishings sector.  We have plans in place that respond to thecurrent environment.  We are adjustingthe product mix in our stores by shifting product assortments to meet ourcustomer’s changing priorities.  Inaddition, we expect to drive traffic through a reassertion of our advertisingand marketing efforts.  It is too earlyto determine the success of our plans and the impact on comparable store sales,but we will continue to closely monitor our position.

**Recent Accounting 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, *Accountingfor Income Taxes*.  FIN 48clarifies the accounting for uncertainty in income taxes recognized in anenterprise’s financial statements in accordance with FASB Statement No.109.  This interpretation clarifies theapplication of Statement 109 by defining a criterion that an individual taxposition must meet for any part of the benefit of that position to berecognized in an enterprise’s financial statements.  The interpretation would require us to reviewall tax positions accounted for in accordance with Statement 109 and apply amore-likely-than-not recognition threshold. A tax position that meets the more-likely-than-not recognition thresholdis initially and subsequently measured as the largest amount of tax benefitthat 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 is based on management’s best judgment given thefacts, circumstances and information available at the reporting date.  The guidance is effective for fiscal yearsbeginning after December 15, 2006, which we 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.

**Stock-based Compensation**

On December 16, 2004,the Financial Accounting Standards Board (“FASB”) issued FASB StatementNo. 123 (revised 2004), *Share-Based Payment*(Statement123(R)), which is a revision of FASB Statement No. 123, *Accounting for Stock-Based Compensation*. Statement123(R) supersedes APB Opinion No. 25, *Accountingfor Stock Issued to Employees*, and amends FASB StatementNo. 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 toadopt its requirements using one of two methods: (1) a “modifiedprospective” method in which compensation cost is recognized beginning with theeffective date (a) based on the requirements of Statement 123(R) forall share-based payments granted after the effective date and (b) based onthe requirements of Statement 123 for all awards granted to employees prior tothe effective date of Statement 123(R) that remain unvested on theeffective date; (2) a “modified retrospective” method which includes therequirements of the modified prospective method described above, but alsopermits entities to restate based on the amounts previously recognized under Statement123 for purposes of pro forma disclosures either (a) all prior periodspresented or (b) prior interim periods of the year of adoption.  We have adopted Statement 123(R) based on themodified prospective method effective January 1, 2006.

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Stock-based compensation amounts recognized in thethree months and six months ended June 30, 2006 upon the adoption of Statement123(R) is as follows (in thousands):
|                                                            | ** ** | **Three Months Ended  June 30, 2006** | ** ** | **Six Months Ended  June 30, 2006** | ** ** |
|------------------------------------------------------------|------------|-----------------------------------------------------------|------------|---------------------------------------------------------|------------|
|                                                       |       |                                                      |       |                                                    |       |
| Total cost of  stock-based compensation during the period  |       | $                                                         | 1,101      |                                                    | $          | 2,251 |   |
| Amounts  capitalized in ending inventory                   |       | (309                                                      | )          | (650                                                    | )          |
| Amounts charged  against income for the period before tax  |       | $                                                         | 792        |                                                    | $          | 1,601 |   |
| Amount of  related income tax benefit recognized in income |       | $                                                         | (233       | )                                                       | $          | (463 | ) |
|                                                       |       |                                                      |       |                                                    |       |

 

Consistent with our inventory accounting policies, thepayroll costs of buying, distribution and certain other general andadministrative expenses, and with the adoption of Statement 123(R), the relatedstock-based compensation of these functions, are capitalized as a part ofinventory and expensed as cost of sales when the related inventory issold.  The adoption of Statement 123(R)also caused a $0.01 and $0.02 decrease in basic and diluted earnings per sharefor the three and six months ended June 30, 2006, respectively.  Based on non-vested stock options outstanding at June 30, 2006, weexpect to incur approximately $2.9 million, net of tax, in stock-basedcompensation for the year ended December 31, 2006.

Statement 123(R) includes several modificationsto the way that incomes taxes are provided for in the financial statements. Theexpense for stock option grants is only deductible for tax purposes at the timethe taxable event takes place, which will cause variability in our effectivetax rates recorded throughout each year. The expected variability in oureffective tax rate is caused by Statement 123(R)’s forbiddance of companiesfrom predicting when these taxable events will take place. Statement123(R) also requires the benefits of tax deductions in excess ofrecognized compensation cost to be reported as a financing cash flow, ratherthan as an operating cash flow as required under current literature. Thisrequirement will reduce net operating cash flows and increase net financingcash flows in annual periods after adoption.

In the prior year, weaccounted for our stock-based compensation plans utilizing the intrinsic valuemethod in accordance with the provisions of Accounting Principles Board OpinionNo. 25 (APB 25).   Generally, nocompensation expense was recognized for fixed stock option plans because theexercise prices of employee stock options equaled or exceeded the market pricesof the underlying stock on the dates of grant. Had we applied the fair value based method and recognition provisions ofStatement of Financial Accounting Standards (SFAS) No. 123, “*Accounting for Stock-Based Compensation*,” (as amended byStatement of

 

 

11

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Financial Accounting Standards No. 148, “*Accountingfor Stock-Based Compensation Transition and Disclosure*”) the proforma effects of stock-based compensation on net income and net income percommon share for the three and six months ended June 30, 2005 were as follows(in thousands except per share amounts):
|                                                                                                                      | ** ** | **Three Months   Ended  June 30, 2005** | ** ** | **Six Months   Ended  June 30, 2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| Net income as reported                                                                                               |       | $                                                           | 10,530     |                                                      | $          | 17,196 |   |
| Less: Stock-based  employee compensation expense determined under the fair value method, net of  related tax effects |       | 956                                                         |       | 1,956                                                     |       |
| Pro forma net income                                                                                                 |       | $                                                           | 9,574      |                                                      | $          | 15,240 |   |
|                                                                                                                 |       |                                                        |       |                                                      |       |
| Net income per common  share:                                                                                        |       |                                                        |       |                                                      |       |
| Basic as reported                                                                                                    |       | $                                                           | 0.26       |                                                      | $          | 0.42 |   |
| Basic pro forma                                                                                                      |       | $                                                           | 0.23       |                                                      | $          | 0.37 |   |
| Diluted as reported                                                                                                  |       | $                                                           | 0.25       |                                                      | $          | 0.41 |   |
| Diluted pro forma                                                                                                    |       | $                                                           | 0.23       |                                                      | $          | 0.37 |   |

 

Consistent withprior years, the fair value of each stock option granted during the six monthsended June 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 4.2 years and a risk-freeinterest rate of 4.2%.  The expectedvolatility is based on our consideration of the implied volatility of ourminimally traded options on our shares and the historical volatility of ourstock based on our historical stock prices. The expected term of an option is based on our historical review ofemployee 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.  The risk-free interest rate is the constantmaturity interest rate for U.S. Treasury instruments with terms consistent withthe expected lives of the awards.

As ofJune 30, 2006, we had $9.0 million of total unrecognized stock-basedcompensation expense related to stock options that is expected to be recognizedover a weighted average period of 4.21 years.

**Lease Accounting Adjustment**

Based on certain views expressed in a letter ofFebruary 7, 2005 from the Office of the Chief Accountant of the Securitiesand Exchange Commission to the American Institute of Certified PublicAccountants, we reviewed 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 2005. The adjustment did not impacthistorical or future net cash flows nor the timing of the payments underrelated leases. We believe that the new lease accounting policies will not havea material effect on future diluted earnings per share. Prior years’ financialstatements were not restated as the impact of this issue was immaterial topreviously reported results for any individual previous periods.

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** **

**Results of Operations**

The following table sets forth certain financial information from ourconsolidated statements of income expressed as a percentage of net sales.  Our business is highly seasonal, with asignificant portion of our net sales and most of our operating income generatedin the fourth quarter, which includes the holiday season. There can be noassurance that the trends in sales growth or operating results will continue inthe future.

 
|                                                  | ** ** | **Three Months Ended  June 30** | ** ** | **Six Months Ended   June 30** | ** ** |
|--------------------------------------------------|------------|------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                       | ** ** | **2005**                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net sales                                        |       | 100.0                                          | %          | 100.0                                              | %          | 100.0 | % | 100.0 | % |
| Cost of sales                                    |       | 64.2                                           |       | 62.8                                               |       | 62.6 |   | 61.9 |   |
| Gross profit                                     |       | 35.8                                           |       | 37.2                                               |       | 37.4 |   | 38.1 |   |
| Selling, general  and administrative expense     |       | 33.3                                           |       | 29.6                                               |       | 33.5 |   | 31.4 |   |
| Operating income                                 |       | 2.5                                            |       | 7.6                                                |       | 3.9 |   | 6.7 |   |
| Net interest  expense and other income (expense) |       | (0.2                                           | )          | 0.1                                                |       | (0.1 | ) | 0.1 |   |
| Income before  income taxes                      |       | 2.3                                            |       | 7.7                                                |       | 3.8 |   | 6.8 |   |
| Income tax  expense                              |       | 0.9                                            |       | 2.9                                                |       | 1.4 |   | 2.5 |   |
|                                             |       |                                           |       |                                               |       |   |   |   |   |
| Net income                                       |       | 1.4                                            | %          | 4.8                                                | %          | 2.4 | % | 4.3 | % |

** **

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** **

**ThreeMonths Ended June 30, 2006****Comparedto the Three Months Ended June 30, 2005**

During the second quarter of 2006, net sales decreased to $207.7million from $218.8 million, a decrease of $11.1 million or 5.1% compared tothe same quarter of 2005. The decrease in second quarter sales is primarily dueto the decrease in comparable store sales partially offset by the $18.7 millionincrease in sales from non-comparable new stores.  The decrease in comparable sales for thesecond quarter of 2006 was comprised of a 13.8% decrease in the number oftransactions offset by a 3.0% increase in the average transaction amount.  Total average store sales for the secondquarter of 2006 decreased 13.2% when compared to the same prior yearquarter.  Comparable store sales andsales per store decreased primarily due to lower traffic levels thananticipated.  Management believes trafficlevels are lower due to a number of factors, including a deceleration in thesales trends of home-related merchandise due to a slowdown in the housingmarket and reduced disposable income of our consumers given the pressure ofrising gasoline and energy costs and higher interest rates on their householdbudget, as well as an increased supply of home décor merchandise andcompetitive promotional environment.

Gross profit decreased $7.1 million, or 8.8%, to $74.3 million for thethree months ended June 30, 2006 as compared to last year’s second quarter of$81.4 million, primarily as a result of our decreased net sales.  Our gross profit percentage decreased to35.8% from 37.2% in the prior year’s second quarter.  This 1.4% decrease in gross profit percentageis comprised of a 0.9% decrease due to merchandise mix and markdowns and a 0.5%decrease due to an increase in damaged merchandise and freight costs.

Selling, general and administrative expenses are comprised of storelabor, store occupancy costs, advertising, miscellaneous store operatingexpenses and corporate office costs. Increases in dollar amounts of theseexpenses are attributable to increases in the number of stores and changes invariable expenses.  Variable expensesinclude payroll and related benefits, advertising expense and other expensessuch as credit card fees.

Selling, general and administrative expenses increased $4.6 million, or7.0%, to $69.2 million from $64.7 million in the second quarter of 2005.  The increase was attributable to a $3.8million increase in store occupancy costs, store personnel costs and storedepreciation expense primarily due to the expansion in our store base, anincrease of $600 thousand of store maintenance and other store expenses, the$800 thousand stock-based compensation recorded upon the adoption of Statement123(R) and $500 thousand of other corporate expenses.  These were somewhat offset by the $1.1million decrease in advertising expense. As a percentage of net sales, these expenses increased 3.7% to 33.3% inthe second quarter of 2006 from 29.6% in the second quarter of 2005.  The increased percentage is primarily due tothe reduced expense leveraging given our negative comparable store sales forthe second quarter of 2006 and includes a 2.9% increase related to storeoccupancy costs, store personnel costs and store depreciation expense, a 0.3%increase in store maintenance and other store expenses, a 0.4% increase due tothe recording of stock-based compensation upon the adoption of Statement 123(R)and a 0.4% increase in other corporate expenses but were somewhat offset by the0.3% decrease in advertising expense.

The income tax provision for the three month periods ended June 30,2006 and 2005 was $1.8 million and $6.4 million, respectively, reflecting aneffective tax rate of 38.8% and 37.6%, respectively.  The effective tax rate is higher in the secondquarter of 2006 as compared to the second 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 timing difference associatedwith non-deductible stock compensation expense for incentive stock optionsgranted to employees prior to January 2006.

**SixMonths Ended June 30, 2006****Compared to the Six Months Ended June 30, 2005**

During the first six months of 2006, net sales decreased to $395.4million from $404.4 million, a decrease of $8.9 million or 2.2% compared to thesame period of 2005. The decrease in sales for the first six months isprimarily due to the 7.9% decrease in comparable store sales, offset bythe  $35.1 million increase in sales fromnon-comparable new stores. The decrease in comparable sales for the first sixmonths of 2006 was comprised of a 9.8% decrease in the number of transactionsoffset by a 1.9% increase in the average transaction amount.  Total average store sales for the first sixmonths of 2006 decreased 10.6% when compared to the same prior yearperiod.  Comparable store sales and salesper store decreased primarily due to lower traffic levels than anticipated.  Management believes traffic levels are lowerdue to a number of factors, including a deceleration in the sales trends ofhome-related merchandise due to a slowdown in the housing market and reduceddisposable income of our consumers given the pressure of rising gasoline andenergy costs and higher interest rates on their household budget, as well as anincreased supply of home décor merchandise and competitive promotionalenvironment.

Gross profit decreased $6.1 million, or 4.0%, to $147.9 million for thesix months ended June 30, 2006 as compared to the six month period last year of$154.0 million, primarily as a result of our decreased net sales.  Our gross profit percentage decreased to37.4% from 38.1% in the prior year’s six month period.  This 0.7% decrease in the gross profitpercentage is comprised of a 0.3% decrease due to merchandise mix and markdownsand a 0.4% decrease due to damaged merchandise and  freight costs.

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Selling, general and administrative expenses increased $5.6 million, or4.4%, to $132.4 million from $126.8 million in the first six months of 2005.  The increase was attributable to a $7.5million increase in store occupancy costs, store personnel costs and store  depreciation expense primarily due to theexpansion in our store base, $1.6 million stock-based compensation recordedupon the adoption of Statement 123(R), and $1.0 million other corporate expenses, offset by the $3.9 millionnon-cash lease accounting adjustment in the same prior year period and the $800thousand decrease in advertising expense. As a percentage of net sales, these expenses increased 2.1% to 33.5% inthe first six months of 2006 from 31.4% in the first six months of 2005.  The increased percentage is primarily due tothe reduced expense leveraging given our negative comparable store sales andincludes a 2.4% increase related to store occupancy costs, store personnelcosts and store depreciation expense, a 0.4% increase due to the recording ofstock-based compensation upon the adoption of Statement 123(R) and a 0.4%increase of other corporate expenses, offset  primarily by the 1.0%decrease related to the lease accounting adjustment recorded in the prior yearand by the 0.1% decrease in advertising expense.

The income tax provision for the six month periods ended June 30, 2006and 2005 was $5.8 million and $10.1 million, respectively, reflecting aneffective tax rate of 37.9% and 37.1%, respectively.  The effective tax rate is higher in the sixmonths ended June 30, 2006 as compared to the six months ended 2005 adjustmentin the effective tax rate to reflect projected lower pretax income for thefull-year 2006 which is impacted by the permanent timing difference associatedwith non-deductible stock compensation expense for incentive stock optionsgranted to employees prior to January 2006 somewhat offset by a favorable settlementof certain tax issues in the prior year period.

**Liquidityand Capital Resources**

We have financed our operations with funds generated from operatingactivities and borrowings under our revolving credit facility. Our cash flowswill continue to be utilized for the expansion of our business and future cashdividends to our stockholders. We have no off-balance sheet arrangements ortransactions with unconsolidated, limited purpose or variable interestentities, nor do we have material transactions or commitments involving relatedpersons or entities.

Net cash used in operating activities for thesix months ended June 30, 2006 and 2005 was $18.5 million and $9.8million, respectively, representing a $8.7 million increase. This increase isprimarily due to the decrease in sales and related operating income.

Capital expenditures principally associated with new stores opening andwarehouse equipment were $7.2 million and $8.6 million for the six months endedJune 30, 2006 and 2005, respectively. We expect to spend approximately $11 million for additional capitalexpenditures for the remainder of 2006, which will include the opening of newstores, enhancements of selected stores, and purchases of equipment for ourdistribution center.

We have a $210 million revolving credit facility that expires inDecember 2009.  Any borrowingunder the revolving credit facility will incur interest at LIBOR or the primerate, depending on the type of borrowing, plus an applicable margin. We incurcommitment fees of up to 0.25% on the unused portion of the revolving creditfacility. This rate is reduced or increased as our average total leverage ratiochanges. Our indebtedness under the credit facility is secured by a lien on ourinventory and cash accounts, as well as a pledge of our ownership interests inall of our subsidiaries.

At June 30, 2006, we had $21 million in debt outstanding under therevolving credit facility and had availability of $180.9 million.  As of June 30, 2006, we had outstandingletters of credit of $8.1 million, primarily for self-insurance.

The revolving credit facility contains certain restrictive covenants,which among other things, require us to comply with certain financial ratioscovering maximum leverage, minimum fixed charge coverage and minimum interestcoverage. Other restrictions affect our ability to incur liens or make certainother restricted payments, sell assets or merge or consolidate with any otherperson. As of June 30, 2006, we were in compliance with all covenants.

We anticipate that our future net cash flowsfrom operations and unused borrowings under our revolving credit facility willbe sufficient to fund our working capital needs, an annual dividend and plannedcapital expenditures for the next 12 months.

**StoreOpenings/Closings**
|                                     | ** ** | **Six Months  Ended  June 30,  2006** | ** ** | **Six Months  Ended  June 30,  2005** | ** ** | **Twelve Months  Ended  December 31,  2005** | ** ** |
|-------------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|--------------------------------------------------------|------------|
|                                |       |                                            |       |                                            |       |                                                   |       |
| Stores open at  beginning of period |       | 732                                             |       | 662                                             |       | 662                                                    |       |
| Stores opened  during the period    |       | 35                                              |       | 38                                              |       | 81                                                     |       |
| Stores closed  during the period    |       | (5                                              | )          | (8                                              | )          | (11                                                    | )          |
| Stores open at end of  period       |       | 762                                             |       | 692                                             |       | 732                                                    |       |

 

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**Item 3.Quantitative and Qualitative Disclosures About Market Risk**

We are exposed to various market risks, including changes in foreigncurrency exchange rates and interest rates. Market risk is the potential loss arising from adverse changes in marketprices and rates, such as foreign currency exchange and interest rates.  Based on our market risk sensitiveinstruments outstanding as of June 30, 2006, we have determined that therewas no material market risk exposure to our consolidated financial position,results of operations or cash 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 derivativesor other financial instruments for trading or speculative purposes.  There have been no significant changes in theforeign currency exchange rate or interest rate market risks since December 31,2005.

**Item 4. Controls and Procedures**

**Disclosure Controls and Procedures**

Based on ourmanagement’s evaluation (with participation of our principal executive officerand our principal financial officer), our principal executive officer and ourprincipal financial officer have concluded that our disclosure controls andprocedures (as defined in Rule 13a-15(e) or Rule 15d-15(e) underthe Securities Exchange Act of 1934, as amended (the “Exchange Act”)) wereeffective as of June 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 our principalexecutive and principal financial officers, to allow timely decisions regardingrequired disclosure.

A control system,no matter 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 are designedto provide reasonable, not absolute, assurance that the objectives of ourdisclosure 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 inInternal Control Over Financial Reporting**

There were no changes in our internal control over financial reportingthat occurred during the quarter ended June 30, 2006 that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

**PART II — OTHERINFORMATION**

**Item 1. Legal Proceedings**

During 2001 and 2002, we were named as a defendant in three complaintsfiled in the Superior Court of California in and for the County of Los Angeles.The plaintiffs are seeking to certify a statewide class made up of some of ourcurrent and former employees, which they claim are owed compensation forovertime wages, penalties and interest. The plaintiffs are also seekingattorney’s fees and costs. In October 2003, we entered into a settlementagreement 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 January 2007.  Wehave a similar lawsuit in Orange County, California in 2004 that we have fileda motion to disqualify the class representative.  The motion was heard by the court in July2006 with the outcome expected to be communicated in August 2006.  The case is still in discovery.  We do not expect either of these complaintsto have a material impact to our financial statements.

In June 2004, we were named as a defendant in acomplaint filed in the U.S. District Court, Central District of California. Theplaintiff, Thomas Kinkade Company (f/k/a/ Media Arts Group Inc.), allegedcopyright infringement and false advertisements on merchandise we sold in thesecond quarter of 2004.  The case went totrial in March 2006.  The jury found infavor of us on the trademark infringement claim.  The jury was unable to reach a verdict on theremaining claims.  The parties haveagreed to mediate with the presiding judge regarding the remaining claims.  Amediation date has been set for August 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.

**Item 1A. Risk Factors**

There have been no material changes from our risk factors previouslydisclosed in “Item 1A. Risk Factors” of our Form 10K for the year endedDecember 31, 2005.

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** **

**Item 4. Submission ofMatters to a Vote of Security Holders**

At the AnnualMeeting of Stockholders held on May 16, 2006, the following proposals weresubmitted to stockholders with the following results:

1.                              Electionof six directors to serve until their terms expire at the annual meeting ofstockholders to be held in 2007, or the earlier of retirement, resignation orremoval
|                           | ** ** | **Number of Shares** | ** ** |
|---------------------------|------------|--------------------------------|------------|
| ** **                | ** ** | **For**                        | ** ** | **Withheld** | ** ** | **Broker Non-Votes** | ** ** |
|                      |       |                           |       |   |   |   |   |
| Benjamin D.  Chereskin    |       | 38,161,753                     |       | 1,075,850 |   | — |   |
| Kathleen Mason            |       | 31,294,072                     |       | 7,943,531 |   | — |   |
| William J.  Hunckler, III |       | 36,533,297                     |       | 2,704,306 |   | — |   |
| Robin P. Selati           |       | 38,800,403                     |       | 437,200 |   | — |   |
| Henry F. Frigon           |       | 36,359,027                     |       | 2,878,576 |   | — |   |
| Giles H. Bateman          |       | 38,934,953                     |       | 302,650 |   | — |   |

 

2.                              Ratification of theselection of Ernst & Young as our independent registered public accountingfirm for the year ending December 31, 2006

 
|         | ** ** | **Number of Shares** | ** ** |
|---------|------------|--------------------------------|------------|
|    |       |                           |       |
| For     |       | 39,161,748                     |       |
|    |       |                           |       |
| Against |       | 58,812                         |       |
|    |       |                           |       |
| Abstain |       | 17,043                         |       |

 

No other matterswere voted upon at the meeting.

**Item 5. Other Information**

There have been no material changes to the procedures by which securityholders may recommend nominees to our Board of Directors since April 21,2003.

 

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** **

**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 *                                                                                                                                                        |

 

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W                  Managementagreement or compensatory plan or arrangement

*                    The certifications attached heretoas Exhibit 32.1 and Exhibit 32.2 are furnished with this Quarterly Reporton Form 10-Q and shall not be deemed “filed” by the Company forpurposes of Section 18 of the Securities Exchange Act of 1934, as amended.

 

 

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SIGNATURE

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
|            | ** ** | ** **     |       | **TUESDAY MORNING CORPORATION** |
|------------|------------|----------------|------------|---------------------------------|
| ** ** |       |           | ** ** | ** **                      | (Registrant) | ** ** |
|       |       |           |       |                            |   |   |
|       |       |           |       |                            |   |   |
| DATE:      |       | August 3, 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) |
|            |            |                |            |                                 |  |  |  |

 

 

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**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*                                                                                                                                                       |

 

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W                  Managementagreement or compensatory plan or arrangement

*                    The certifications attached heretoas Exhibit 32.1 and Exhibit 32.2 are furnished with this Quarterly Reporton Form 10-Q and shall not be deemed “filed” by the Company forpurposes of Section 18 of the Securities Exchange Act of 1934, as amended.

 

 

 

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