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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION  FORM 10-Q (Mark One) þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the quarterly period ended July 31, 2004,
 OR o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the transition period from
________ to ________.
 Commission file number 33-66342 COLE NATIONAL GROUP, INC.  DELAWARE
    
    34-1744334(State or other jurisdiction of
    
    (I.R.S. Employer Identification No.)incorporation or organization)1925 ENTERPRISE PARKWAY
TWINSBURG, OHIO
(Address of principal executive offices)
    
    44087
(Zip Code)
 (330) 486-3100
(Registrants telephone number, including area code) The Registrant meets the conditions set forth in General Instruction
H(1)(a) and (b) of Form 10-Q and is therefore filing this form in the reduced
disclosure format. Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes
þ            No
o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yeso            No
þ All of the outstanding capital stock of the registrant is held by Cole
National Corporation. As of August 27, 2004, 1,100 shares of the registrants common stock, $.01
par value were outstanding.




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COLE NATIONAL GROUP, INC. AND SUBSIDIARIES
FORM 10-Q
QUARTER ENDED JULY 31, 2004
INDEX Page No.PART I. FINANCIAL INFORMATIONItem 1. Financial Statements (unaudited)Condensed Consolidated Balance Sheets as of July 31, 2004, August 2, 2003
and January 31, 2004
    
    
    1Condensed Consolidated Statements of Operations for the 13 and 26 week periods
ended July 31, 2004 and August 2, 2003
    
    
    2Condensed Consolidated Statements of Cash Flows for the 26 week period
ended July 31, 2004 and August 2, 2003
    
    
    3Notes to Condensed Consolidated Financial Statements
    
    
    4Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    12Item 3. Quantitative and Qualitative Disclosures about Market Risk
    
    
    23Item 4. Controls and Procedures
    
    
    24PART II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    24Item 6. Exhibits
    
    
    25Signatures
    
    
    26Exhibit Index
    
    
    27EX-31.1EX-31.2EX-32




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PART I  FINANCIAL INFORMATION 
 ITEM 1. FINANCIAL STATEMENTS COLE NATIONAL GROUP, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 July 31,
    
    August 2,
    
    January 31,2004
    
    2003
    
    2004AssetsCurrent assets:Cash and cash equivalents
    
    $
    63,975
    
    
    $
    17,074
    
    
    $
    59,184Accounts receivable, less allowances of
$4,239, $3,455 and $3,449, respectively
    
    
    62,007
    
    
    
    57,254
    
    
    
    55,238Current portion of notes receivable, less allowances
of $852, $427 and $571, respectively
    
    
    2,905
    
    
    
    2,137
    
    
    
    1,930Inventories
    
    
    119,932
    
    
    
    130,727
    
    
    
    120,927Prepaid expenses and other
    
    
    23,663
    
    
    
    23,291
    
    
    
    25,610Deferred income taxes
    
    
    31,713
    
    
    
    32,196
    
    
    
    31,612Total current assets
    
    
    304,195
    
    
    
    262,679
    
    
    
    294,501Property and equipment, at cost
    
    
    323,610
    
    
    
    324,415
    
    
    
    311,890Less  accumulated depreciation and amortization
    
    
    (207,555
    )
    
    
    (203,931
    )
    
    
    (194,886
    )Total property and equipment, net
    
    
    116,055
    
    
    
    120,484
    
    
    
    117,004Notes receivable, excluding current portion, less allowances
of $829, $2,384 and $2,287, respectively
    
    
    4,707
    
    
    
    6,025
    
    
    
    5,499Deferred income taxes
    
    
    27,007
    
    
    
    30,836
    
    
    
    31,375Other assets
    
    
    32,547
    
    
    
    45,190
    
    
    
    36,959Other intangibles, net
    
    
    49,121
    
    
    
    50,425
    
    
    
    49,773Goodwill, net
    
    
    85,734
    
    
    
    85,713
    
    
    
    85,734Total assets
    
    $
    619,366
    
    
    $
    601,352
    
    
    $
    620,845Liabilities and Stockholders EquityCurrent liabilities:Current portion of long-term debt
    
    $
    614
    
    
    $
    250
    
    
    $
    608Accounts payable
    
    
    65,351
    
    
    
    68,687
    
    
    
    61,180Payable to affiliates, net
    
    
    81,369
    
    
    
    79,415
    
    
    
    97,512Accrued interest
    
    
    7,679
    
    
    
    7,847
    
    
    
    7,715Accrued liabilities
    
    
    95,182
    
    
    
    93,450
    
    
    
    95,041Accrued income taxes
    
    
    3,165
    
    
    
    4,099
    
    
    
    2,789Deferred revenue
    
    
    42,161
    
    
    
    39,855
    
    
    
    41,122Total current liabilities
    
    
    295,521
    
    
    
    293,603
    
    
    
    305,967Long-term debt, net of current portion
    
    
    278,214
    
    
    
    275,992
    
    
    
    279,229Other long-term liabilities
    
    
    34,376
    
    
    
    35,525
    
    
    
    32,726Deferred revenue, long-term
    
    
    12,558
    
    
    
    12,567
    
    
    
    12,129Stockholders equity (deficit)
    
    
    (1,303
    )
    
    
    (16,335
    )
    
    
    (9,206
    )Total liabilities and stockholders equity
    
    $
    619,366
    
    
    $
    601,352
    
    
    $
    620,845
 The accompanying notes to condensed consolidated financial statements are an
integral part of these condensed consolidated financial statements. 1




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COLE NATIONAL GROUP, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 Thirteen Week Period Ended
    
    Twenty-Six Week Period EndedJuly 31,
    
    August 2,
    
    July 31,
    
    August 2,2004
    
    2003
    
    2004
    
    2003Net revenues
    
    $
    312,767
    
    
    $
    307,659
    
    
    $
    620,419
    
    
    $
    595,908Costs and expenses:Cost of revenues
    
    
    115,930
    
    
    
    115,515
    
    
    
    229,796
    
    
    
    222,107Operating expenses
    
    
    178,694
    
    
    
    192,750
    
    
    
    366,073
    
    
    
    376,565Total costs and expenses
    
    
    294,624
    
    
    
    308,265
    
    
    
    595,869
    
    
    
    598,672Operating income (loss)
    
    
    18,143
    
    
    
    (606
    )
    
    
    24,550
    
    
    
    (2,764
    )Interest and other (income) expense:Interest expense
    
    
    6,318
    
    
    
    6,201
    
    
    
    12,524
    
    
    
    12,461Interest and other (income), expense net
    
    
    (448
    )
    
    
    (506
    )
    
    
    (524
    )
    
    
    (689
    )Total interest and other (income) expense, net
    
    
    5,870
    
    
    
    5,695
    
    
    
    12,000
    
    
    
    11,772Income (loss) before income taxes
    
    
    12,273
    
    
    
    (6,301
    )
    
    
    12,550
    
    
    
    (14,536
    )Income tax provision (benefit)
    
    
    5,267
    
    
    
    (1,551
    )
    
    
    5,397
    
    
    
    (3,198
    )Net income (loss)
    
    $
    7,006
    
    
    $
    (4,750
    )
    
    $
    7,153
    
    
    $
    (11,338
    )
 The accompanying notes to condensed consolidated financial statements are an
integral part of these condensed consolidated financial statements. 2




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COLE NATIONAL GROUP, INC. AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 Twenty-Six Week Period EndedJuly 31,
    
    August 2,2004
    
    2003(As restated,See Note 10)Cash flows from operating activities:Net income (loss)
    
    $
    7,153
    
    
    $
    (11,338
    )Adjustments to reconcile net income (loss) to net cash provided by
(used for) operating activities:Depreciation and amortization
    
    
    19,094
    
    
    
    19,617Store closing and impairment losses
    
    
    1,000
    
    
    
    Deferred income tax provision (benefit)
    
    
    4,267
    
    
    
    (4,797
    )Noncash compensation
    
    
    500
    
    
    
    232Noncash interest and other, net
    
    
    497
    
    
    
    (559
    )Increases (decreases) in cash resulting from changes in operating
assets and liabilities:Accounts and notes receivable, prepaid expenses and other assets
    
    
    (5,331
    )
    
    
    (6,004
    )Inventories
    
    
    997
    
    
    
    (9,892
    )Accounts payable, accrued liabilities and other liabilities
    
    
    1,111
    
    
    
    6,544Accrued interest
    
    
    (36
    )
    
    
    42Accrued and refundable income taxes
    
    
    377
    
    
    
    777Net cash provided by (used for) operating activities
    
    
    29,629
    
    
    
    (5,378
    )Cash flows from investing activities:Purchases of property and equipment
    
    
    (11,024
    )
    
    
    (15,424
    )Systems development costs
    
    
    (1,198
    )
    
    
    (4,308
    )Acquisitions of businesses
    
    
    
    
    
    
    (4,056
    )Net cash used for investing activities
    
    
    (12,222
    )
    
    
    (23,788
    )Cash flows from financing activities:Repayment of long-term debt
    
    
    (295
    )
    
    
    (119
    )Increase in overdraft balances
    
    
    3,605
    
    
    
    824Advances from (to) parent, net
    
    
    (16,134
    )
    
    
    3,625Payment of deferred financing fees
    
    
    
    
    
    
    (238
    )Other, net
    
    
    208
    
    
    
    147Net cash provided by (used for) financing activities
    
    
    (12,616
    )
    
    
    4,239Cash and cash equivalents:Net increase (decrease) during the period
    
    
    4,791
    
    
    
    (24,927
    )Balance, beginning of period
    
    
    59,184
    
    
    
    42,001Balance, end of period
    
    $
    63,975
    
    
    $
    17,074
 The accompanying notes to condensed consolidated financial statements are an
integral part of these condensed consolidated financial statements. 3




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COLE NATIONAL GROUP, INC. AND SUBSIDIARIES 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 (1) Summary of Significant Accounting Policies Basis of Presentation Cole National Group, Inc. is a wholly owned subsidiary of Cole National
Corporation (the Parent). The condensed consolidated financial statements
include the accounts of Cole National Group and its wholly owned subsidiaries
(collectively, the Company). All significant intercompany transactions have
been eliminated in consolidation. Fiscal years end on the Saturday closest to January 31 and are identified
according to the calendar year in which they begin. For example, the fiscal
year ended January 31, 2004 is referred to as fiscal 2003. The current fiscal
year, which ends January 29, 2005, is referred to as fiscal 2004. Fiscal 2004
and fiscal 2003 each consists of 52 weeks. The accompanying condensed consolidated financial statements have been
prepared without audit and certain information and footnote disclosures
normally included in financial statements prepared in accordance with
accounting principles generally accepted in the United States have been
condensed or omitted, although management believes that the disclosures herein
are adequate to make the information not misleading. The condensed consolidated
financial statements should be read in conjunction with the consolidated
financial statements and notes thereto included in the Companys 2003 Annual
Report on Form 10-K/A. Results for interim periods are not necessarily
indicative of the results to be expected for the full year. Nature of Operations The Company is a specialty service retailer operating in both host and
nonhost environments, whose primary lines of business are optical products and
services and personalized gifts. The Company sells its products through 2,417
company-owned retail locations and 484 franchised locations in 50 states,
Canada, and the Caribbean. In connection with its optical business, the Company
is a managed vision care benefits provider and claims payment administrator
whose programs provide comprehensive eyecare benefits primarily marketed
directly to large employers, health maintenance organizations (HMO) and other
organizations. The Company has two reportable segments: Cole Vision and Things
Remembered (see Note 6). Use of Estimates The preparation of financial statements, in conformity with accounting
principles generally accepted in the United States, requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements, and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates. Significant estimates are required in determining the allowance for
uncollectible accounts, inventory reserves, depreciation, amortization and
recoverability of long-lived assets, deferred income taxes, remakes and returns
allowances, managed vision underwriting results, self-insurance reserves and
retirement and post-employment benefits. Reclassifications Certain reclassifications have been made to prior year financial
statements and the notes to conform to the current year presentation. Deferred Revenue The Company sells separately priced extended warranty contracts with terms
of coverage of 12 and 24 months. Revenues from the sale of these contracts are
deferred and amortized over the lives of the contracts, while the costs to
service the warranty claims are expensed as incurred. Incremental costs
directly related to the sale of such contracts, such as sales commissions and
percentage rent, are deferred in prepaid expenses and charged to expense in
proportion to the revenue recognized. 4




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A reconciliation of the changes in deferred revenue from the sale of
warranty contracts and other deferred items follows (dollars in thousands): Twenty-Six Week Period Ended
    
    Year EndedJuly 31,
    
    August 2,
    
    January 31,2004
    
    2003
    
    2004Deferred revenues:Beginning balance
    
    $
    53,251
    
    
    $
    49,573
    
    
    $
    49,573Warranty contracts sold
    
    
    28,993
    
    
    
    28,412
    
    
    
    56,479Other deferred revenue
    
    
    1,585
    
    
    
    1,304
    
    
    
    3,264Amortization of deferred revenue
    
    
    (29,110
    )
    
    
    (26,867
    )
    
    
    (56,065
    )Ending balance
    
    $
    54,719
    
    
    $
    52,422
    
    
    $
    53,251
 Cash Flows Net cash flows from operating activities reflect cash payments for income
taxes and interest of $0.8 million and $12.0 million, respectively, for the 26
week period ended July 31, 2004 and $0.9 million and $11.8 million,
respectively, for the 26 week period ending August 2, 2003. Overdrafts resulting from outstanding checks at the end of each reporting
period are reclassified as current liabilities in either accounts payable or
accrued expenses. This reclassification to accounts payable amounted to $24.9
million, $24.7 million and $21.1 million at July 31, 2004, August 2, 2003 and
January 31, 2004, respectively, and to accrued expenses amounted to $3.6
million, $3.3 million and $3.8 million at July 31, 2004, August 2, 2003 and
January 31, 2004, respectively. Total Comprehensive Income (Loss) Total comprehensive income (loss) for the 13 and 26 week periods ended
July 31, 2004 and August 2, 2003 is as follows (dollars in thousands): Thirteen Week Period Ended
    
    Twenty-Six Week Period EndedJuly 31,
    
    August 2,
    
    July 31,
    
    August 2,2004
    
    2003
    
    2004
    
    2003Net income (loss)
    
    $
    7,006
    
    
    $
    (4,750
    )
    
    $
    7,153
    
    
    $
    (11,338
    )Translation income (loss)
    
    
    40
    
    
    
    (26
    )
    
    
    14
    
    
    
    444Total comprehensive income (loss)
    
    $
    7,046
    
    
    $
    (4,776
    )
    
    $
    7,167
    
    
    $
    (10,894
    )
 Stock-Based Compensation At July 31, 2004, the Company has various stock-based employee
compensation plans which are described more fully in Note 1 of the Notes to
Consolidated Financial Statements in the Companys 2003 Annual Report on Form
10-K/A. The Company accounts for those plans in accordance with Accounting
Principles Board Opinion No. 25, Accounting For Stock Issued to Employees,
and related Interpretations. In connection with the variable stock options,
compensation (income) expense of ($0.4) million and $0.5 million has been
recorded for the 13 and 26 week periods ended July 31, 2004, respectively, due
to the exercise of variable stock options at a price lower than the amount
recorded in the first quarter of fiscal 2004. No stock-based employee
compensation expense for variable stock options was recorded in the 13 and 26
week periods ended August 2, 2003. The following table illustrates the pro forma effect on net income of the
Company had the Company applied the fair value recognition provisions of
Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for
Stock-Based Compensation. 5




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Thirteen Week Period Ended
    
    Twenty-Six Week Period EndedJuly 31,
    
    August 2,
    
    July 31,
    
    August 2,(In thousands)
    
    2004
    
    2003
    
    2004
    
    2003Net income (loss), as reported
    
    $
    7,006
    
    
    $
    (4,750
    )
    
    $
    7,153
    
    
    $
    (11,338
    )Additions for stock-based employee compensation
expense included in reported net income (loss), net of related taxes
    
    
    (259
    )
    
    
    
    
    
    
    345
    
    
    
    Deductions for total stock-based employee compensation
expense determined under fair value based method for all
awards, net of related taxes
    
    
    (379
    )
    
    
    (236
    )
    
    
    (700
    )
    
    
    (682
    )Net income (loss), pro forma
    
    $
    6,368
    
    
    $
    (4,986
    )
    
    $
    6,798
    
    
    $
    (12,020
    )
 Recently Issued Accounting Standards The Financial Accounting Standards Board (FASB) issued FASB Interpretation
No. 46, Consolidation of Variable Interest Entities (FIN 46) in January 2003
and revised FIN 46 (FIN 46R) in December 2003. The Interpretations require
certain variable interest entities (VIE), including certain special purpose
entities, to be consolidated by the primary beneficiary if the equity investors
in the entity do not have all the essential characteristics of a controlling
financial interest or do not have sufficient equity at risk. The
Interpretations immediately applied to entities created after January 31, 2003,
was effective at the end of the fourth quarter of fiscal 2003 for certain
special purpose entities and was effective for the first quarter of fiscal 2004
for other existing VIE. The synthetic operating lease for the Highland Heights,
Ohio facility required consolidation under this Interpretation. The
consolidation resulted in an additional $2.2 million in assets and liabilities
on the consolidated balance sheet as of January 31, 2004 and the consolidation
of operating results into the financial statements of the Company beginning
February 1, 2004. The remaining portion of FIN 46R was adopted in the first quarter of
fiscal 2004. In adopting FIN 46R, the Company considered its financial
relationships with Pearle Vision franchisees, and concluded that it is not
required to consolidate any franchise entities. The Company has no equity
interest in any of its franchisees, has no off-balance sheet exposure
relative to any of its franchisees except for certain lease and other
guarantees, and generally does not provide financial support to franchise
entities in a typical franchise relationship. Creditors of the franchise
entities have no recourse to the Company. There are certain franchise entities
for which the Company has provided financial support and are considered to be
VIE. However, the Company is not the primary beneficiary, as it is not the
entity that is expected to absorb a majority of the risk of loss for the VIEs
activities, nor is it entitled to receive a majority of the VIEs residual
returns. The Company did not consolidate any franchise entities and the
adoption of the remaining portion of FIN 46R had no effect on the Companys
financial position or results of operations. In December 2003, the FASB issued SFAS No. 132 (Revised 2003), Employers
Disclosures about Pensions and Other Postretirement Benefits (SFAS 132). This
statement revises employers disclosures about pension plans and other
postretirement benefit plans to require more information about the economic
resources and obligations of such plans. Certain disclosure provisions were
effective for fiscal 2003 and were adopted. The remaining disclosure
provisions of SFAS 132 have been adopted in fiscal 2004. On December 8, 2003, the Medicare Prescription Drug, Improvement and
Modernization Act of 2003 (the Act) was signed into law. In accordance with
FASB Staff Position 106-1 (FSP FAS 106-1), the Companys measurement of the
accumulated postretirement benefit obligation and net periodic benefit cost in
the consolidated financial statements do not reflect the effects of the Act on
the Companys postretirement benefit plan because the Company has not concluded whether the benefits provided by the plan are actuarially equivalent
to Medicare Part D under the act. The FASB has since issued FSP FAS 106-2,
which supersedes FSP FAS 106-1, and is effective for the Companys third
quarter beginning August 1, 2004. The Company has not yet determined whether it will be using retroactive or prospective adoption. (2) Goodwill and Other Intangible Assets Goodwill and tradenames are tested at least annually for impairment and
are not amortized. All other intangible assets with finite lives are amortized
over their estimated useful economic lives based on managements estimates of
the period that the assets will generate revenue. Other intangible assets
consist of (dollars in thousands): 6




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July 31,
    
    August 2,
    
    January 31,2004
    
    2003
    
    2004Non-amortizable:Tradename
    
    $
    49,460
    
    
    $
    49,460
    
    
    $
    49,460Amortizable:Noncompete agreements
    
    
    320
    
    
    
    320
    
    
    
    320Contracts
    
    
    8,947
    
    
    
    8,947
    
    
    
    8,947Customer records
    
    
    9
    
    
    
    9
    
    
    
    9Total amortizable
    
    
    9,276
    
    
    
    9,276
    
    
    
    9,276Accumulated amortization
    
    
    (9,615
    )
    
    
    (8,311
    )
    
    
    (8,963
    )Other intangibles, net
    
    $
    49,121
    
    
    $
    50,425
    
    
    $
    49,773
 During the first quarter of fiscal 2003, the Company purchased the
operations of three Sears Optical departments in California for a total
purchase price of $242,500. The amount allocated to the tangible fixed assets
acquired including exam equipment and inventory was $29,500. The remainder of
the purchase price was allocated to intangible assets under the provisions of
Statement of Financial Accounting Standards No. 141, Business Combinations.
Goodwill related to this transaction was $124,000 and noncompete agreements and
customer records totaled $89,000. The additional changes in the carrying amount
of goodwill were due to foreign currency translation at Cole Vision. The net
carrying amount of goodwill at July 31, 2004, by business segment was $64.3
million at Cole Vision and $21.4 million at Things Remembered. (3) Long-Term Debt On August 15, 2003, the Company retired $385,000 of 8-5/8% Senior
Subordinated Notes due December 31, 2006. The notes were contributed to the
Company by its parent, Cole National Corporation, after receiving them as part
of the full payment for a note receivable from the Companys former Chairman. A
$15,400 gain on early extinguishment of debt and $15,400 of compensation
expense were recorded in connection with the transaction. On May 22, 2002, the Company issued $150.0 million of 8-7/8% Senior
Subordinated Notes that mature in 2012. Interest on the notes is payable
semi-annually on each May 15 and November 15. On August 22, 1997, the Company issued $125.0 million of 8-5/8% Senior
Subordinated Notes that mature in 2007 with no earlier scheduled redemption or
sinking fund payments. Interest on the 8-5/8% notes is payable semi-annually on
February 15 and August 15. The 8-5/8% notes and the 8-7/8% notes are general unsecured obligations of
the Company, subordinated in right of payment to senior indebtedness of the
Company and senior in right of payment to any current or future subordinated
indebtedness of the Company. The indentures pursuant to which the 8-5/8% notes
and the 8-7/8% notes were issued restrict dividend payments to the Companys
parent, Cole National Corporation. The indentures also contain certain optional
and mandatory redemption features and other financial covenants. The Company has no significant principal payment obligations under its
outstanding indebtedness until 2007, when the $125.0 million of 8-5/8% Senior
Subordinated Notes become due. Following the consummation of the merger of the
Parent and Luxottica Group S.p.A. (see Note 9 of the Notes to Condensed
Consolidated Financial Statements), the holders of the 8-5/8% notes and the
8-7/8% notes will have the right to put the notes to the Company at a price of
101% plus accrued interest. During the third quarter of fiscal 2002, the Company entered into interest
rate swap agreements to take advantage of favorable market interest rates.
These agreements require the Company to pay an average floating interest rate
based on six-month LIBOR plus 4.5375% to a counter party while receiving a
fixed interest rate on a portion of the Companys $125.0 million of 8-5/8%
Senior
Subordinated Notes due 2007. The counter party is a major commercial bank.
The agreements mature August 15, 2007 and qualify as fair value hedges. The
aggregate notional amount of the interest rate swap agreements is $50.0
million. At July 31, 2004, the floating rate of the swaps was approximately
6.5% and the fair value of the swap agreements was an unrealized gain of
approximately $0.1 million. There was no impact to earnings in the first six
months of fiscal 2004 due to hedge ineffectiveness. The Company leases an office and general operating facility in Highland
Heights, Ohio from a special purpose entity (the Trust), which was created in
1997 specifically for the purpose of structuring a four-year operating lease
with annual renewal options 7




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##### Table of Contents



up to six years. The lease provides for regular
payments based on LIBOR plus 1.50%. In accordance with this agreement, the
Company must maintain compliance with a minimum net worth covenant. At the end
of this lease in 2007, the Company has the option to purchase the property or
arrange for the sale of the property. If the Company does not exercise its
purchase option at the end of the lease, it is contingently liable to the Trust
for up to $1.7 million. The Company does not believe it will have any payment
obligation at the end of the lease because either the Company will exercise the
purchase option, or the net proceeds from the sale of the property will exceed
the amount payable to the Trust. The Trust assets and liabilities have been
consolidated into the financial statements of the Company as of January 31,
2004 and operating results beginning February 1, 2004. (4) Credit Facility The operating subsidiaries of the Company have a working capital credit
facility of $60.0 million with their bank lenders that extends to February 1,
2007. Borrowings under the credit facility presently bear interest based on
leverage ratios of the Company at a rate equal to either (a) the Eurodollar
Rate plus 2.50% or (b) 1.50% plus the highest of (i) the CIBC prime rate, (ii)
the three-week moving average of the secondary market rates for three-month
certificates of deposit plus 1.0% or (iii) the federal funds rate plus 0.5%.
The Company pays a commitment fee of 0.75% per annum on the total unused
portion of the facility based on the percentage of revolving credit commitments
used. Cole National Corporation and the Company guarantee this credit facility.
The credit facility is secured by the assets of the operating subsidiaries of
the Company. The credit facility permits indebtedness of up to $10.0 million of
documentary letters of credit from sources other than the lenders and liens on
inventory pursuant to documentary letters of credit issued under such
financing. The credit facility requires the principal operating subsidiaries of the
Company to comply with various operating covenants that restrict corporate
activities, including covenants restricting the ability of the subsidiaries to
incur additional indebtedness, pay dividends, prepay subordinated indebtedness,
dispose of certain investments or make acquisitions. The credit facility also
requires the Company to comply with certain financial covenants, including
covenants regarding interest coverage and maximum leverage. The Company is in
compliance with the covenants in the credit agreement as of July 31, 2004. The credit facility restricts dividend payments to the Company from its
subsidiaries to amounts needed to pay interest on the 8-7/8% notes and the
8-5/8% notes, certain amounts related to taxes and $7.5 million for direct
expenses of the Company, along with up to 0.25% of the Companys consolidated
net revenue annually for other direct expenses of Cole National Corporation. If
certain maximum leverage targets are met, the credit facility restricts
dividend payments to the Company in an aggregate amount not to exceed $25.0
million to allow for the repurchase of Senior Subordinated Notes. As of July 31, 2004, the total availability under the credit facility
totaled $43.7 million after reduction for commitments outstanding of $16.3
million under letters of credit. There were no working capital borrowings under
the credit facility outstanding as of July 31, 2004 and August 2, 2003 and
there were no borrowings during the first six months of fiscal 2004 and fiscal
2003. The Company has an agreement with a bank to provide documentary letters of
credit for import inventory purchases not to exceed $7.0 million. The letters
of credit are secured by the inventory purchased. As of July 31, 2004, the
Company had $3.8 million outstanding under this facility. (5) Retirement Plans The Company uses a December 31 measurement date for its plans. Net pension
expense and postretirement expense for the 13 and 26 week periods ended July
31, 2004 and August 2, 2003 are as follows (dollars in thousands): Pension Benefits
    
    Postretirement BenefitsJuly 31,
    
    August 2,
    
    July 31,
    
    August 2,2004
    
    2003
    
    2004
    
    2003Service cost  benefits earned during the period
    
    $
    140
    
    
    $
    119
    
    
    $
    
    
    
    $
    Interest cost on the projected benefit obligation
    
    
    1,373
    
    
    
    1,303
    
    
    
    80
    
    
    
    60Expected return on plan assets
    
    
    (1,244
    )
    
    
    (1,080
    )
    
    
    
    
    
    
    Recognized net actuarial (gain) loss
    
    
    1,092
    
    
    
    434
    
    
    
    49
    
    
    
    34Amortization of initial asset
    
    
    (80
    )
    
    
    (80
    )
    
    
    
    
    
    
    Amortization of prior service cost
    
    
    
    
    
    
    
    
    
    
    3
    
    
    
    2Net expense (income)
    
    $
    1,281
    
    
    $
    696
    
    
    $
    132
    
    
    $
    96
 8




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##### Table of Contents



The Company previously disclosed in its financial statements for the year
ended January 31, 2004, that it expected to contribute $7.5 million to its
pension plan in 2004. As of July 31, 2004, $1.8 million of contributions have
been made. The Company presently anticipates contributing an additional $3.7
million to fund its pension plan in 2004 for a total of $5.5 million. The
decrease in expected funding for fiscal 2004 is due to passage of further
pension relief by Congress. (6) Segment Information Information on the Companys reportable segments is as follows (dollars in
thousands): Thirteen Week Period Ended
    
    Twenty-Six Week Period EndedJuly 31,
    
    August 2,
    
    July 31,
    
    August 2,2004
    
    2003
    
    2004
    
    2003Net revenues:Cole Vision
    
    $
    232,854
    
    
    $
    228,832
    
    
    $
    482,787
    
    
    $
    462,373Things Remembered
    
    
    79,913
    
    
    
    78,827
    
    
    
    137,632
    
    
    
    133,535Total net revenues
    
    $
    312,767
    
    
    $
    307,659
    
    
    $
    620,419
    
    
    $
    595,908Operating income (loss):Cole Vision
    
    $
    9,630
    
    
    $
    3,186
    
    
    $
    22,315
    
    
    $
    12,462Things Remembered
    
    
    11,790
    
    
    
    9,940
    
    
    
    10,725
    
    
    
    7,360Total segment operating income
    
    
    21,420
    
    
    
    13,126
    
    
    
    33,040
    
    
    
    19,822Unallocated corporate expenses
    
    
    3,277
    
    
    
    13,732
    
    
    
    8,490
    
    
    
    22,586Total operating income (loss)
    
    
    18,143
    
    
    
    (606
    )
    
    
    24,550
    
    
    
    (2,764
    )Interest and other (income) expense, net
    
    
    5,870
    
    
    
    5,695
    
    
    
    12,000
    
    
    
    11,772Income (loss) before income taxes
    
    $
    12,273
    
    
    $
    (6,301
    )
    
    $
    12,550
    
    
    $
    (14,536
    )
 (7) Commitments and Contingencies The Company leases a substantial portion of its computers, equipment and
facilities including laboratories, office and warehouse space, and retail store
locations. These leases generally have initial terms of up to 10 years and
often contain renewal or purchase options. Operating and capital lease
obligations are based upon contractual minimum rates and, in most leases
covering retail store locations, additional rents are payable based on store
sales. In addition, Cole Vision operates departments in various host stores
paying occupancy costs solely as a percentage of sales. The Sears agreement
contains a short-term cancellation clause. Generally, the Company is required
to pay taxes and normal expenses of operating the premises for laboratory,
office, warehouse and retail store leases; the host stores pay these expenses
for departments operated on a percentage-of-sales basis. The Company guarantees future minimum lease payments for certain store
locations leased directly by franchisees. These guarantees totaled
approximately $12.2 million, $13.3 million and $13.4 million as of July 31,
2004, August 2, 2003 and January 31, 2004, respectively. Performance under a
guarantee by the Company is triggered by default of a franchisee in their lease
commitment. Generally, these guarantees also extend to payments of taxes and
other normal expenses payable under these leases, the amounts of which are not
readily quantifiable. In fiscal 2003, the Company entered into an agreement to guarantee a
portion of the amount owed to a bank by a franchisee as a result of a loan
granted in connection with the purchase of five stores. The guaranteed amount
equals the cumulative value of the store assets. The Company is released from
its obligation once the landlords of the store locations execute subordination
agreements or the bank is granted access to the store assets in the event of
the default by the franchisee. The Company received four executed subordination
agreements as of July 31, 2004. The maximum exposure under the agreement is
$47,000. (8) Legal Proceedings On July 14, 2004, a Cole National Corporation shareholder filed a
shareholders class action complaint against the Parent, its directors, and
Luxottica Group S.p.A. (Luxottica). The complaint alleges, among other
things, that the individual defendants breached their fiduciary duties as
directors and/or officers to the Parent by causing the Parent to enter into an
agreement to be acquired by Luxottica for $22.50 per share without having
exposed the Parent to the marketplace through fair and open negotiations with
all potential bidders and/or an active market check or open auction for sale of
the company. The complaint seeks preliminary and 9




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permanent injunctive relief
against the merger, rescission of the merger if it is consummated, and/or
damages and other associated relief. The Parent believes that the action is
without merit. The Company and its optical subsidiaries have been sued by the State of
California, which alleges claims for various statutory violations related to
the operation of 23 Pearle Vision Centers in California. The claims include
untrue or misleading advertising, illegal dilation fees, unlawful advertising
of eye exams, maintaining an optometrist on or near the premises of a
registered dispensing optician, unlawful advertising of an optometrist,
unlicensed practice of optometry, and illegal relationships between dispensing
opticians, optical retailers and optometrists. The action seeks unspecified
damages, restitution and injunctive relief. In July 2002, the State of
California obtained a preliminary injunction to enjoin certain advertising
practices and from charging dilation fees. The trial courts decision was
appealed by both the Company and the State. On November 26, 2003, the appellate
court ruled on the appeal in a manner adverse to the Company with respect to
continued advertising in California by Pearle Vision that expressly or
implicitly advertises the furnishing of optometric services, disallowing
continued advertising of the availability of optometric services with a
disclaimer that had been previously approved by the trial court. The appellate
court ruled in the Companys favor with respect to charging dilation fees. On
March 3, 2004, the California Supreme Court granted the Companys petition for
review of the Appellate Courts decision. Although the Company believes that
its advertising and operational practices in California complied with
California law, the appellate ruling may, if unmodified by the Supreme Court,
compel the Company to modify or close its activities in California. Further,
the Company might be required to pay damages and or restitution in a currently
undeterminable amount, the cost of which might have a material adverse effect
on the Companys operating results and cash flow in one or more periods. Cole National Corporation settled a class action lawsuit alleging claims
for various violations of federal securities laws related to the Companys
publicly reported revenues and earnings. The action, which pleaded claims under
Section 10(b) and 20(a) of the Securities Exchange Act of 1934, and named the
Company and certain present and former officers and directors as defendants,
sought unspecified compensatory damages, punitive damages where appropriate,
costs, expenses and attorneys fees. On May 30, 2003, the Company and the
plaintiffs reached an agreement to resolve the lawsuit. On September 29, 2003,
the Court approved final settlement of the lawsuit. A charge of $2,687,500 was
recorded in the first quarter of fiscal 2003 with respect to the Companys
portion of the settlement. Following the Companys announcement in November 2002 of the restatement
of the Companys financial statements, the Securities and Exchange Commission
began an investigation into the Companys previous accounting. The course of
this investigation or other litigation or investigations arising out of the
restatement of the Companys financial statements cannot be predicted. In
addition, under certain circumstances the Company would be obliged to
indemnify the individual current and former directors and officers who are
named as defendants in litigation or who are or become involved in an
investigation. The Company believes it has insurance that should be available
with respect to a portion of its indemnification obligations. If the Company is
unsuccessful in defending against the current investigation or any litigation,
there may be a material adverse effect on the Companys financial condition,
cash flow and results of operations. Cole National Group, Inc. has been named as a defendant along with
numerous other retailers, in patent infringement litigation challenging the
defendants use of bar code technology. A stay of the proceeding has been
sought and was granted, in deference to prior pending declaratory judgment
suits brought by the manufacturers and suppliers of the implicated technology
seeking to declare the patents in suit invalid, unenforceable and not
infringed. On January 23, 2004, a court in Nevada entered a memorandum of
decision in favor of the manufacturers declaring the patents unenforceable and
not infringed. This judgment has been appealed, and the infringement litigation
against Cole National Group will remain stayed pending the final resolution of
the appeal. Cole National Group, Inc. believes it has available defenses and
does not expect any liability. However, if Cole National Group, Inc. were to be
found liable for an infringement, it might have a material adverse effect on
its operating results and cash flow in the period incurred. In the ordinary course of business, the Company is involved in various
other legal proceedings. The Company is of the opinion that the ultimate
resolution of these matters will not have a material adverse effect on the
results of operations, liquidity or financial position of the Company. (9) Luxottica Merger Agreement On January 23, 2004, the Parent and Luxottica Group S.p.A. (Luxottica)
entered into a merger agreement (the Luxottica merger agreement) pursuant to
which a subsidiary of Luxottica would be merged with and into the Parent and
the Parent would thereafter become a subsidiary of Luxottica. Under the
Luxottica merger agreement, Luxottica would acquire all of the outstanding
shares of the Parent in a merger for a cash price of $22.50 per share,
together with the purchase of all outstanding options and similar equity rights
at the same price per share, less their respective exercise price. On June 2,
2004, the Parent and Luxottica entered into the first of two amendments to the
Luxottica merger agreement. Under the first amendment to the Luxottica merger
agreement, the original $22.50 per share cash merger consideration would be
increased by an amount equal to 4% per annum from the date on which the
Parents stockholders approve the Luxottica merger agreement, as amended,
through the closing date of the merger, subject to 10




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certain conditions. On July
14, 2004, the Parent amended its merger agreement with Luxottica once again.
Under the Luxottica merger agreement, as amended, the original $22.50 per share
cash merger consideration to be paid by Luxottica was increased to $27.50 per
share in cash, plus an additional amount equal to 4% per annum from the date of
stockholder approval through the closing date of the merger. On July 22, 2004,
at the 2004 annual meeting of the Parents stockholders which was held on July
20, 2004 and subsequently adjourned to July 22, 2004, the Parent received votes
from a majority of the outstanding shares to approve the Luxottica merger
agreement, as amended. Based upon the $27.50 price, the total purchase price of
the Parents outstanding shares and related equity rights is approximately $495
million, plus an amount equal to 4% per annum from July 22, 2004 through the
date of closing. The Luxottica merger is subject to the satisfaction of customary
conditions, including compliance with applicable antitrust clearance
requirements. On February 27, 2004, the Parent and Luxottica filed pre-merger
notifications with the U.S. antitrust authorities pursuant to the
Hart-Scott-Rodino Antitrust Improvements Act of 1976 (the HSR Act). On March
30, 2004, the Parent and Luxottica jointly announced that they had received a
request from the Federal Trade Commission (the FTC) for additional
information and documentary material with respect to the Luxottica merger.
Luxottica and the Parent completed their required information submissions and
related certifications to the FTC in connection with its antitrust review on
July 19, 2004 and have committed to the FTC not to close the transaction before
September 30, 2004, without its consent. The Luxottica merger is expected to
close in the second half of 2004. (10) Restatement of Cash Flows Subsequent to the issuance of the fiscal 2003 condensed consolidated
financial statements, the Company determined that certain components in its
condensed consolidated statements of cash flows for fiscal 2003 were
incorrectly classified. Mistakes were discovered in the calculation of the
fiscal 2002 overdraft balance resulting in misstatements of changes in accounts
payable, accrued liabilities and other liabilities within cash flows from
operating activities with corresponding misstatements of changes in overdraft
balances within cash flows from financing activities. Certain other
individually insignificant items for fiscal 2003 were also incorrectly
classified. As a result, the accompanying condensed consolidated statement of
cash flows for the first half of fiscal 2003 has been restated from the amounts
previously reported to decrease cash flows from operating activities by $3.7
million, increase cash flows from investing activities by $0.1 million and
increase cash flows from financing activities by $3.6 million. 11




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Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations Subsequent to the issuance of the Companys condensed consolidated
financial statements for fiscal 2003, the Company determined that certain
components in its condensed consolidated statement of cash flows for fiscal
2003 were incorrectly classified. As a result, the accompanying condensed
consolidated statement of cash flows for the first six months of fiscal year
2003 has been restated from the amounts previously reported. See Note 10 of the
Notes to the Condensed Consolidated Financial Statements for a summary of the
significant effects of the restatement. This managements discussion and
analysis of financial condition and results of operations reflects the effect
of the restatement. On January 23, 2004, the Parent and Luxottica Group S.p.A. (Luxottica)
entered into a merger agreement (the Luxottica merger agreement) pursuant to
which a subsidiary of Luxottica would be merged with and into the Parent and
the Parent would thereafter become a subsidiary of Luxottica. Under the
Luxottica merger agreement, Luxottica would acquire all of the outstanding
shares of the Parent in a merger for a cash price of $22.50 per share, together
with the purchase of all outstanding options and similar equity rights at the
same price per share, less their respective exercise price. On June 2, 2004,
the Parent and Luxottica entered into the first of two amendments to the
Luxottica merger agreement. Under the first amendment to the Luxottica merger
agreement, the original $22.50 per share cash merger consideration would be
increased by an amount equal to 4% per annum from the date on which the
Parents stockholders approve the Luxottica merger agreement, as amended,
through the closing date of the merger, subject to certain conditions. On July
14, 2004, the Parent amended its merger agreement with Luxottica once again.
Under the Luxottica merger agreement, as amended, the original $22.50 per share
cash merger consideration to be paid by Luxottica was increased to $27.50 per
share in cash, plus an additional amount equal to 4% per annum from the date of
stockholder approval through the closing date of the merger. On July 22, 2004,
at the 2004 annual meeting of the Parents stockholders which was held on July
20, 2004 and subsequently adjourned to July 22, 2004, the Parent received votes
from a majority of the outstanding shares to approve the Luxottica merger
agreement, as amended. Based upon the $27.50 price, the total purchase price of
the Parents outstanding shares and related equity rights is approximately $495
million, plus an amount equal to 4% per annum from July 22, 2004 through the
date of closing. The Luxottica merger is subject to the satisfaction of customary
conditions, including compliance with applicable antitrust clearance
requirements. On February 27, 2004, the Parent and Luxottica filed pre-merger
notifications with the U.S. antitrust authorities pursuant to the
Hart-Scott-Rodino Antitrust Improvements Act of 1976 (the HSR Act). On March
30, 2004, the Parent and Luxottica jointly announced that they had received a
request from the Federal Trade Commission (the FTC) for additional
information and documentary material with respect to the Luxottica merger.
Luxottica and the Parent completed their required information submissions and
related certifications to the FTC in connection with its antitrust review on
July 19, 2004 and have committed to the FTC not to close the transaction before
September 30, 2004, without its consent. The Luxottica merger is expected to
close in the second half of 2004. Overview Cole National Group, Inc., a wholly owned subsidiary of Cole National
Corporation is a leading provider of optical products and services and
personalized gifts. The Company sells its products and services through 2,417
Company-owned retail locations and 484 franchised locations in 50 states,
Canada and the Caribbean. Fiscal years end on the Saturday closest to January 31 and are identified
according to the calendar year in which they begin. For example, the fiscal
year ended January 29, 2005 is referred to as fiscal 2004. Fiscal 2004 and
fiscal 2003 each consisted of a 52-week period. The Company has two reportable segments, Cole Vision and Things
Remembered. Most of Cole Visions revenue represents sales of prescription
eyewear, accessories and services through its Cole Licensed Brands and Pearle
Vision retail locations. Cole Vision revenue also includes sales of merchandise
to franchisees, royalties based on franchise sales and initial franchise fees
for Pearle Vision and capitation revenue, administrative service fee revenue
and discount program service fees from its Cole Managed Vision business. Things Remembereds revenue represents sales of engraveable gift
merchandise, personalization and other services primarily through retail
in-line stores and kiosks. Things Remembered revenue also includes direct sales
through its e-commerce site, http://www.ThingsRemembered.com, sales through
Things Remembered catalogs and through third party partner programs. 12




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##### Table of Contents



Results of Operations The following schedule sets forth certain operating information for the
second quarters and the first six months of fiscal 2004 and fiscal 2003. This
schedule and subsequent discussions should be read in conjunction with the
condensed consolidated financial statements included in this Form 10-Q. Second Quarter
    
    
    
    
    
    First Six MonthsChange
    
    
    
    
    
    
    
    
    
    Change2004
    
    2003
    
    Fav/(Unfav)
    
    2004
    
    2003
    
    Fav/(Unfav)(Dollars in millions)
    
    
    
    
    
    (Dollars in millions)Net revenues:Cole Vision
    
    $
    232.9
    
    
    $
    228.9
    
    
    
    1.8
    %
    
    $
    482.8
    
    
    $
    462.4
    
    
    
    4.4
    %Things Remembered
    
    
    79.9
    
    
    
    78.8
    
    
    
    1.4
    
    
    
    137.6
    
    
    
    133.5
    
    
    
    3.1Total net revenues
    
    $
    312.8
    
    
    $
    307.7
    
    
    
    1.7
    %
    
    $
    620.4
    
    
    $
    595.9
    
    
    
    4.1
    %Gross margin:Cole Vision
    
    $
    139.7
    
    
    $
    136.0
    
    
    
    2.8
    %
    
    $
    291.5
    
    
    $
    278.0
    
    
    
    4.9
    %Things Remembered
    
    
    57.1
    
    
    
    56.1
    
    
    
    1.6
    
    
    
    99.1
    
    
    
    95.8
    
    
    
    3.4Total gross margin
    
    $
    196.8
    
    
    $
    192.1
    
    
    
    2.4
    %
    
    $
    390.6
    
    
    $
    373.8
    
    
    
    4.5
    %Operating expenses:Cole Vision
    
    $
    130.1
    
    
    $
    132.8
    
    
    
    2.0
    %
    
    $
    269.2
    
    
    $
    265.5
    
    
    
    (1.4
    )%Things Remembered
    
    
    45.3
    
    
    
    46.2
    
    
    
    2.0
    
    
    
    88.4
    
    
    
    88.5
    
    
    
    0.1Unallocated corporate expenses
    
    
    3.3
    
    
    
    13.7
    
    
    
    76.1
    
    
    
    8.5
    
    
    
    22.6
    
    
    
    62.4Total operating expenses
    
    $
    178.7
    
    
    $
    192.7
    
    
    
    7.3
    %
    
    $
    366.1
    
    
    $
    376.6
    
    
    
    2.8
    %Operating income (loss):Cole Vision
    
    $
    9.6
    
    
    $
    3.2
    
    
    
    202.2
    %
    
    $
    22.3
    
    
    $
    12.5
    
    
    
    79.1
    %Things Remembered
    
    
    11.8
    
    
    
    9.9
    
    
    
    18.6
    
    
    
    10.7
    
    
    
    7.3
    
    
    
    45.7Unallocated corporate expenses
    
    
    (3.3
    )
    
    
    (13.7
    )
    
    
    76.1
    
    
    
    (8.5
    )
    
    
    (22.6
    )
    
    
    62.4Total operating income (loss)
    
    $
    18.1
    
    
    $
    (0.6
    )
    
    
    N/A
    
    
    $
    24.5
    
    
    $
    (2.8
    )
    
    
    N/A
 Information on the number of the Companys retail locations by business
open at July 31, 2004 and August 2, 2003 is presented below: Second Quarter2004
    
    2003Number of retail locations at the end of the periodSears Optical
    
    
    938
    
    
    
    943Target Optical
    
    
    248
    
    
    
    253BJs Optical
    
    
    134
    
    
    
    128Total Cole Licensed Brands
    
    
    1,320
    
    
    
    1,324Pearle Company-owned
    
    
    375
    
    
    
    394Pearle franchised
    
    
    484
    
    
    
    463Total Cole Vision
    
    
    2,179
    
    
    
    2,181Things Remembered
    
    
    722
    
    
    
    754Total Cole National
    
    
    2,901
    
    
    
    2,935
 Results of operations below are reflected as a percentage of net revenues.
Data for the Cole Vision and Things Remembered segments are shown as a
percentage of their respective net revenues. Unallocated corporate expenses and
classification totals are shown as a percentage of total net revenues. 13




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##### Table of Contents



Second Quarter
    
    First Six Months2004
    
    2003
    
    2004
    
    2003Gross margin:Cole Vision
    
    
    60.0
    %
    
    
    59.4
    %
    
    
    60.4
    %
    
    
    60.1
    %Things Remembered
    
    
    71.5
    %
    
    
    71.3
    %
    
    
    72.0
    %
    
    
    71.8
    %Total gross margin
    
    
    62.9
    %
    
    
    62.5
    %
    
    
    63.0
    %
    
    
    62.7
    %Operating expenses:Cole Vision
    
    
    55.9
    %
    
    
    58.0
    %
    
    
    55.8
    %
    
    
    57.4
    %Things Remembered
    
    
    56.7
    %
    
    
    58.7
    %
    
    
    64.2
    %
    
    
    66.2
    %Unallocated corporate expense
    
    
    1.0
    %
    
    
    4.5
    %
    
    
    1.4
    %
    
    
    3.8
    %Total operating expenses
    
    
    57.1
    %
    
    
    62.7
    %
    
    
    59.0
    %
    
    
    63.2
    %Operating income:Cole Vision
    
    
    4.1
    %
    
    
    1.4
    %
    
    
    4.6
    %
    
    
    2.7
    %Things Remembered
    
    
    14.8
    %
    
    
    12.6
    %
    
    
    7.8
    %
    
    
    5.5
    %Unallocated corporate expense
    
    
    (1.0
    )%
    
    
    (4.5
    )%
    
    
    (1.4
    )%
    
    
    (3.8
    )%Total operating income
    
    
    5.8
    %
    
    
    (0.2
    )%
    
    
    4.0
    %
    
    
    (0.5
    )%
 As used in Item 2 of this Form 10-Q, same store sales growth is a non-GAAP
financial measure, which includes deferred warranty sales on a cash basis and
undelivered customer orders, and does not reflect provisions for returns,
remakes and certain other items. The Companys current systems do not gather
data on these items on an individual store basis. Adjustments to the cash basis
sales information accumulated at the store level are made for these items on an
aggregate basis. As a retailer, the Company believes that a measure of same
store sales performance is important for understanding its operations. The
Company calculates same store sales for stores opened for at least twelve
months. A reconciliation of same store sales to revenue is presented in the
section Reconciliation of Same Store Sales Growth. Same store sales growth
follows: Second Quarter
    
    First Six MonthsSears Optical (U.S.)
    
    
    (4.0
    )%
    
    
    0.5
    %Target Optical
    
    
    4.7
    %
    
    
    10.9
    %BJs Optical
    
    
    11.0
    %
    
    
    15.2
    %Cole Licensed Brands (U.S.)
    
    
    (2.0
    )%
    
    
    2.6
    %Pearle Company-owned (U.S.)
    
    
    (2.0
    )%
    
    
    (0.3
    )%Total Cole Vision
    
    
    (1.3
    )%
    
    
    2.2
    %Things Remembered
    
    
    1.9
    %
    
    
    3.8
    %Total Cole National
    
    
    (0.5
    )%
    
    
    2.6
    %Pearle franchise stores (U.S.)
    
    
    (1.4
    )%
    
    
    (0.5
    )%
 Same store sales for Pearle U.S. franchise stores is a non-GAAP financial
measure that is provided for comparative purposes only. The Company believes
that its franchisees method of reporting sales is consistent on a year-to-year
basis. Net Revenues Consolidated Operations Total revenues were $312.8 million in the second quarter of fiscal 2004,
compared with $307.7 million in the same period of fiscal 2003, an increase of
1.7%, primarily attributable to increases in revenues from managed vision care
programs, partially offset by a 0.5% decrease in same store sales. Total
revenues were $620.4 million in the first six months of fiscal 2004, compared
with $595.9 million in the same period of fiscal 2003, an increase of 4.1%,
primarily attributable to a 2.6% increase in same store sales and increases in
revenues from managed vision care programs. 14




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##### Table of Contents



Cole Vision Segment For the second quarter of fiscal 2004, Cole Vision revenues were $232.9
million, compared with $228.9 million in the same period of fiscal 2003, an
increase of 1.8%. The revenue increase was primarily due to increased revenues
from managed vision care programs, increases at the Companys Canadian
operations and at Cole Licensed Brands, partially offset by revenue decreases
at Pearle Vision U.S. Revenues from managed vision care programs were higher
than last year primarily due to an increase in the number of capitated plans
and increases in revenues from existing plans sold to employers, health plans
and associations, increases in administrative revenues from capitated and fee
for service programs and increased laser procedure volume. The increase at the
Companys Canadian operation was due to improved merchandise assortment
compared to last year and to the impact in 2003 of SARS to the Canadian
economy. The increase in Cole Licensed Brands revenues was attributable to
store sales increases at Target Optical and BJs Optical, partially offset by a
same store sales decrease at Sears Optical. Same store sales increases at both
Target Optical and BJs Optical were driven by increases in the average
transaction size and in the number of transactions. A continuing focus on
selling premium products and additional features were the key factors in the
average transaction size increase. The increase in the number of transactions
was primarily due to more aggressive promotional offers. Same store sales
decreased 4.0% at Sears Optical due to decreases in the average transaction
size and in the number of transactions. Aggressive promotions which focus less
on premium products and additional features resulted in a lower average
transaction. Revenues decreased at Pearle Vision Company-owned stores primarily
due to fewer stores and a 2.0% decrease in same store sales in the second
quarter of fiscal 2004 due to a decrease in the number of transactions. The
Company believes that the decrease in the number of transactions in Pearle
Vision and Sears Optical during the quarter is due primarily to the increasingly competitive
promotional nature of the optical retail industry. Pearle Vision operated 19
fewer Company-owned stores at the end of the second quarter of fiscal 2004 than
it did at the end of the second quarter of fiscal 2003, due to the net sale of
10 Company stores to franchisees, the closure of 12 stores and the opening of 3
new stores. The Company is continuing to divest Company-owned stores in markets
that are predominantly franchised in order to lower its store supervision
costs, and provide growth opportunities for franchisees already operating in
those markets. For the first six months of fiscal 2004, Cole Vision revenues were $482.8
million, compared with $462.4 million in the same period of fiscal 2003, an
increase of 4.4%. The revenue increase was primarily due to increased revenues
from Cole Licensed Brands and from managed vision care programs, partially
offset by revenue decreases at Pearle Vision U.S. The increase in Cole Licensed
Brands revenues was attributable to same store sales increases at all brands
driven by increases in the average transaction size and an increase in the
number of transactions. Revenues from managed vision care programs were higher
than last year due to the reasons discussed above. Revenues decreased at Pearle
Vision Company-owned stores primarily due to fewer stores and a 0.3% decrease
in same store sales in the first six months of fiscal 2004. Same store sales
decreased in the first six months of fiscal 2004 due to a decrease in the
number of transactions. Things Remembered Segment For the second quarter of fiscal 2004, Things Remembered revenues were
$79.9 million compared with $78.8 million in the same period of fiscal 2003, a
1.4% increase, due to a same store sales increase of 1.9% and a 43% increase in
direct channel revenues,
partially offset by a lower number of stores operating than last year. For
the first six months of fiscal 2004, Things Remembered revenues were $137.6
million compared with $133.5 million in the same period last year, a 3.1%
increase, due to a same store sales increase of 3.8% and a 49% increase in
direct channel revenues, partially offset by a lower number of stores
operating. Direct channel revenues include revenues from its e-commerce site,
www.ThingsRemembered.com, revenues from Things Remembered catalogs, and
revenues generated through third party partner programs. For the second quarter
and first six months of fiscal 2004, improvements in the average transaction
size were partially offset by a lower number of transactions and a reduction in
the number of stores operating. There were 722 Things Remembered store
locations operating as of July 31, 2004, compared to 754 at August 2, 2003.
The reduction was primarily due to the Companys decision to allow the leases
at under-performing stores to expire. Gross Margin Consolidated Operations Gross margin was $196.8 million in the second quarter of fiscal 2004, compared
with $192.1 million in the second quarter of fiscal 2003, an increase of 2.4%.
Gross margin was $390.6 million in the first six months of fiscal 2004,
compared with $373.8 million in the same period last year, an increase of 4.5%.
Both periods increases are attributable to an increase in net revenues and an
increase in the gross margin rate. The gross margin rate was 62.9% in the
second quarter of fiscal 2004 compared to 62.5% in the second quarter of fiscal
2003 and the gross margin rate was 63.0% in the first six months of fiscal
2004, compared to 62.7% for the same period last year. 15




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##### Table of Contents



Cole Vision Segment For the second quarter of fiscal 2004, gross margin was $139.7 million
compared to $136.0 million in the second quarter of fiscal 2003, an increase of
gross margin dollars of 2.8% compared to the previous year, due to increased
revenues and an increase in the gross margin rate. Gross margin, as a percent
of net revenues, was 60.0% and 59.4% in the second quarter of fiscal 2004 and
fiscal 2003, respectively. Increases in the gross margin rate occurred at Cole
Licensed Brands, in Canada and at Cole Managed Vision, partially offset by a
lower gross margin rate at Pearle Vision U.S. Cole Licensed Brands gross margin
rate increased and was impacted by a higher contact lens gross margin rate and
improved inventory shrink and obsolescence results. The increase in contact
lens gross margin rate was due primarily to an increase in the average
transaction size. The increase in the gross margin rate in Canada was due
primarily to costs incurred in the second quarter of fiscal 2003 resulting from
the Companys decision to close its manufacturing and distribution facility in
Toronto, Canada and a change in the Canadian product assortment. As a result of
this decision, the Company recorded a $0.3 million charge to gross margin for
obsolescence in the second quarter of fiscal 2003. The gross margin rate at
Cole Managed Vision increased primarily due to a projected lower benefit
utilization by plan members within funded programs, a reduction in the
estimated reserve for underwriting gains and from increases in administrative
revenues from capitated and fee-for-service programs. The underwriting gain
reserve percentage was reduced based on historical experience. The Pearle
Vision gross margin rate decreased slightly compared to the same period last
year, due to an increased mix of sales of products to franchisees compared to
revenues from Company-owned stores. Sales to franchisees carry a lower gross
margin rate than revenues from Company-owned stores, but offer benefits to the
Company, including producing a more uniform merchandise assortment and a
consistent brand look across all stores. The gross margin rate was also lower
due to increased promotional activity in the second quarter of fiscal 2004.
Partially offsetting the gross margin rate decline was lower manufacturing
costs compared to the prior year. Lower manufacturing costs were achieved
primarily through in-store lab cost reductions and central lab efficiencies. For the first six months of fiscal 2004, gross margin was $291.5 million
compared to $278.0 million in the first six months of fiscal 2003, an increase
of gross margin dollars of 4.9% compared to the same period the previous year,
due to increased revenues and an increase in the gross margin rate. Gross
margin, as a percent of net revenues, was 60.4% and 60.1% in the first six
months of fiscal 2004 and fiscal 2003, respectively. The Company recorded
increases in the gross margin rate at both Cole Managed Vision and from its
Canadian operations due to the reasons discussed above. The gross margin rate
for Cole Licensed Brands was the same as last year for the first six months.
The Pearle Vision gross margin rate was slightly lower than last year due to
promotional activity. Things Remembered Segment For the second quarter of fiscal 2004, gross margin was $57.1 million
compared to $56.1 million in the second quarter of fiscal 2003, an increase of
1.6%. For the first six months of fiscal 2004, gross margin was $99.1 million
compared to $95.8 million in the first six months of fiscal 2003, an increase
of 3.4%. The increase in the second quarter and the first six months was
primarily driven by the same store sales performance and an increase in the
gross margin rate. Gross margin, as a percent of net revenues, was 71.5% in the
second quarter of fiscal 2004 compared to 71.3% in the second quarter of fiscal
2003 and gross margin rate was 72.0% in the first
six months of fiscal 2004 compared to 71.8% in the first six months of
fiscal 2003. The increase was primarily due to higher revenues from gift
personalization. Operating Expenses Consolidated Operations For the second quarter of fiscal 2004, operating expenses were $178.7
million compared to $192.7 million in the second quarter of fiscal 2003. Of the
decrease in the second quarter of fiscal 2004 compared to the same period last
year, $3.6 million is attributable to the operating segments and $10.4 million
to unallocated corporate expenses. For the first six months of fiscal 2004,
operating expenses were $366.1 million compared with $376.6 million in the
first six months of fiscal 2003. Of the decrease in the first six months of
fiscal 2004 compared to the same period last year, $14.1 million is
attributable to unallocated corporate expenses partially offset by an increase
in operating expenses at the operating segments of $3.6 million. As discussed in detail below, certain unusual items affected the Companys
operating expenses during these periods. The Company defines unusual items as
transactions that are non-comparable or infrequent in nature, including
significant one time transactions unrelated to core operations and special
charges and impairments. Management believes that operating expenses excluding
unusual items is a useful measure for understanding trends in core operations
and excludes some of these items in the management bonus plans. Operating
expenses excluding unusual items is a non-GAAP financial measure and should not
be used as a substitute for the directly comparable GAAP financial measure. In
order to facilitate an understanding of such unusual items and their effect on
the 16




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##### Table of Contents



results of the operations, the following table is provided as a
reconciliation of reported operating expense to operating expense excluding
certain unusual items. Second Quarter
    
    First Six Months(Dollars in millions)
    
    2004
    
    2003
    
    ChangeFav/(Unfav)
    
    2004
    
    2003
    
    ChangeFav/(Unfav)Operating expenses, as reported
    
    $
    178.7
    
    
    $
    192.7
    
    
    $
    14.0
    
    
    $
    366.1
    
    
    $
    376.6
    
    
    $
    10.5Unusual items:Legal & professional fees for
restatement & SEC investigation
    
    
    0.8
    
    
    
    0.9
    
    
    
    
    
    
    
    1.1
    
    
    
    2.6Legal fees for California litigation
    
    
    0.4
    
    
    
    1.1
    
    
    
    
    
    
    
    1.3
    
    
    
    1.9Target Optical store closure costs
    
    
    (0.6
    )
    
    
    
    
    
    
    
    
    
    
    1.5
    
    
    
    CEO Retirement
    
    
    
    
    
    
    9.2
    
    
    
    
    
    
    
    
    
    
    
    9.2Shareholder settlement
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2.7Audit fees for restatement
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1.7Total unusual items
    
    
    0.6
    
    
    
    11.2
    
    
    
    
    
    
    
    3.9
    
    
    
    18.1Operating expenses, excluding unusual items
    
    $
    178.1
    
    
    $
    181.5
    
    
    $
    3.4
    
    
    $
    362.2
    
    
    $
    358.5
    
    
    $
    (3.7
    )Operating expenses, excluding unusual items,
as a percent of total net revenues
    
    
    56.9
    %
    
    
    59.0
    %
    
    
    
    
    
    
    58.4
    %
    
    
    60.1
    %Operating expenses, as reported, as a percent
of total net revenues
    
    
    57.1
    %
    
    
    62.7
    %
    
    
    
    
    
    
    59.0
    %
    
    
    63.2
    %
 Unusual Items Cole National Corporation announced on October 8, 2003 that its Board of
Directors had formed a Special Committee of independent directors on July 28,
2003 to evaluate the Companys strategic alternatives, including a possible
merger or sale of the Company, a corporate restructuring or other alternatives.
The Parent and Luxottica entered into a definitive merger agreement on January
23, 2004 with the unanimous approval of the Boards of Directors of both
companies, which was subsequently amended on June 2, 2004 and
July 14, 2004. On
July 22, 2004, the Parent received votes from a majority of the outstanding
shares to approve the merger agreement with Luxottica. (See Note 9 of the Notes
to Condensed Consolidated Financial Statements). Costs related to legal
advisory and other professional expenses related to the evaluation of
strategic alternatives and the negotiation of the definitive merger agreement
and its amendments are recorded at the Parent. The Company incurred charges of $0.8 million and $1.1 million in the
second quarter and first six months of fiscal 2004, respectively, for legal and
professional fees related to the SEC investigation regarding the reaudit and
restatement of its financial statements, compared to $0.9 million and $2.6
million for the second quarter and first six months of fiscal 2003,
respectively. The Company and certain of its optical subsidiaries have been sued by the
State of California. (See Note 8 of the Notes to Condensed Consolidated
Financial Statements). Legal costs associated with the defense of this matter
totaled $0.4 million and $1.3 million in the second quarter and first six
months of fiscal 2004, respectively, and $1.1 million and $1.9 million in the
second quarter and first six months of fiscal 2003, respectively. As a result of the Companys modified agreement with Target Corporation,
the Company closed 25 underperforming Target Optical stores on April 10, 2004.
Under the terms of the modified agreement, the Company was required to pay
Target Corporation a fee of up to $30,000 for each closed store. During the
second quarter of fiscal 2004, Target Corporation informed the Company that the
actual fee would be significantly lower. As a result, in the second quarter of
fiscal 2004, the Company reversed $0.6 million of charges, which had been
accrued in the first quarter of fiscal 2004. Costs relating to the closure of
these stores were $1.5 million in the first six months of fiscal 2004. In the second quarter of fiscal 2003, the Companys former Chairman and
Chief Executive Officer retired and the Company fulfilled its obligations,
including certain contingent obligations, under his employment agreement and
for retirement and life insurance benefits. These obligations required a
one-time cash payment of $11.9 million with a charge to operating expense in
the second quarter of fiscal 2003 of $9.2 million. 17




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##### Table of Contents



Settlement costs related to a class action shareholder lawsuit, that
alleged claims of various violations of federal securities laws related to the
Companys reported revenues and earnings totaled $2.7 million in the first six
months of fiscal 2003. Audit fees attributable to the restatement and reaudit
of the Companys financial statements were $1.7 million in the first six months
of fiscal 2003. Unallocated Corporate Expenses Unallocated corporate expenses were $3.3 million and $8.5 million in the
second quarter and first six months of fiscal 2004, respectively, compared to
$13.7 million and $22.6 million for the second quarter and first six months of
fiscal 2003, respectively. Included in unallocated corporate expense are all
of the unusual items listed above except for the California litigation charges
and the Target Optical store closure costs, which are recorded in the Cole
Vision segment. The unusual items included in unallocated corporate expense
totaled $0.8 million and $10.1 million in the second quarter of fiscal 2004 and
fiscal 2003, respectively and $1.1 million and $16.2 million in the first six
months of fiscal 2004 and fiscal 2003, respectively. For the second quarter of fiscal 2004, excluding the unusual items above,
unallocated corporate expenses were $2.5 million compared to $3.6 million for
the same period last year. The Companys legal expenses were $0.7 million
lower and professional costs were $0.6 million lower in the second quarter of
fiscal 2004, due primarily to costs incurred in the second quarter of fiscal
2003 for management changes and other management initiatives, which were not
repeated in the second quarter of fiscal 2004. The Company recorded $0.4
million lower compensation expense for variable stock options having a feature
permitting the use of vested options in payment of the exercise price. The
lower amount relates to the exercise of variable stock options at a price lower
than the amount recorded in the first quarter of fiscal 2004. Partially
offsetting these expense reductions were incremental bonus costs of $0.5
million and higher audit costs of $0.3 million in the second quarter of fiscal
2004 compared to the same period last year. For the first six months of fiscal 2004, excluding the unusual items
above, unallocated corporate expenses were $7.4 million compared to $6.4
million for the same period last year. The Company incurred incremental
management bonus expense of $1.0 million for the first six months of fiscal
2004, compared to the same period last year. The Company incurred incremental
audit and professional fees of $0.7 million compared to the same period last
year due to higher audit costs and higher expenses incurred to comply with
Section 404 of the Sarbanes-Oxley Act of 2002. Unallocated corporate expenses
included compensation expense of $0.5 million for variable stock options in the
first six months of fiscal 2004 as discussed above. Partially offsetting these
expense increases were lower professional fees of $1.1 million associated with
management changes and management initiatives taken in the first six months of
fiscal 2003. Cole Vision Segment Operating expenses were $130.1 million and $269.2 million in the second
quarter and first six months of fiscal 2004, respectively, compared to $132.8
million and $265.5 million for the second quarter and first six months of
fiscal 2003, respectively. Operating expense decreased by 2.0% and totaled
55.9% of net revenues in the second quarter of fiscal 2004, compared to 58.0%
in the same period last year. Operating expenses in the first six months of
fiscal 2004 increased by 1.4% and totaled 55.8% of net revenues, compared with
57.4% for the same period last year. Included in operating expenses are the
unusual items of California litigation charges described above which totaled
$0.4 million and $1.3 million in the second quarter and first six months of
fiscal 2004, respectively, and $1.1 million and $1.9 million in the second
quarter and first six months of fiscal 2003, respectively, and the $0.6 million
reversal of charges in the second quarter and $1.5 million charge for the first
six months of fiscal 2004 for the closure of 25 Target Optical locations. For the second quarter of fiscal 2004 compared to the same period last
year, store advertising and store payroll costs were $1.7 million and $0.9
million lower in the second quarter of fiscal 2004, compared to the same period
last year. Management bonus expense was $1.2 million higher in the second
quarter of fiscal 2004, compared to the same period last year. Claims
processing costs were $0.3 million higher in the second quarter of fiscal 2004,
compared to the same period last year, primarily due to increased production
and distribution expense for explanation of benefit statements, system support
costs and systems amortization. For the first six months of fiscal 2004, management bonus expense was $1.9
million higher compared to the same period last year. Claims processing costs
were $1.2 million higher in the first six months of fiscal 2004, compared to
the same period last year, primarily due to the reasons discussed above. In the
first six months of fiscal 2004 compared to the same period last year, store
payroll was $1.2 million higher to support the increase in net revenues. The
first six months of fiscal 2003 included a $1.0 gain on the sale of five
Company-owned Pearle Vision stores to a franchisee. There were no gains
recorded in the first six months of fiscal 2004. 18




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##### Table of Contents



Partially offsetting expense
increases were lower store advertising costs. The Company recorded $2.3 million
lower advertising costs in the first six months of fiscal 2004, compared to the
same period last year primarily due to the timing of advertising spending. Things Remembered Segment Operating expenses were $45.3 million and $88.4 million in the second
quarter and first six months of fiscal 2004, respectively, compared to $46.2
million and $88.5 million for the second quarter and first six months of fiscal
2003, respectively. Compared to the same period the previous year, operating
expenses in the second quarter of fiscal 2004 decreased by 2.0% and totaled
56.7% of net revenues, compared to 58.7% in the same period last year. Compared
to the same period the previous year, operating expenses in the first six
months of fiscal 2004 decreased by 0.1% and totaled 64.2% of net revenues. For the second quarter of fiscal 2004, management bonus expense was $0.7
million lower compared to the same period last year. Store payroll was $0.6
million lower in the second quarter of fiscal 2004, compared to the same period
last year, due to fewer stores operating and lower workers compensation costs.
Field management wages and bonuses were $0.4 million lower in the second
quarter than the same period last year due to open staff positions in the
second quarter of fiscal 2004. Partially offsetting expense reductions were
$0.5 million increased costs of advertising and $0.3 million direct channel
expenses in support of higher net revenues. For the first six months of fiscal 2004, Things Remembered recorded lower
store payroll costs compared to the same period last year due to fewer stores
operating and lower workers compensation and fringe benefits costs. Store
payroll costs, as a percent of net revenues, were lower in the first six months
of fiscal 2004, compared to the same period last year, due to improvements in
productivity. Home office expenses, including recruiting, bonus and legal fees,
were $0.4 million lower than the same period last year. Partially offsetting
these lower expenses were increased costs of store advertising and direct
channel, which were $1.2 million higher than last year in support of higher net
revenues. Operating Income (Loss) Consolidated Operations Operating income was $18.1 million and $24.5 million in the second quarter
and first six months of fiscal 2004, respectively, compared to operating losses
of $0.6 million and $2.8 million in the second quarter and first six months of
fiscal 2003, respectively. The improvement was due to lower unallocated
corporate expenses and higher operating income at Cole Vision and Things
Remembered, compared to the same period last year. Cole Vision Segment Operating income at Cole Vision was $9.6 million and $22.3 million in the
second quarter and first six months of fiscal 2004, respectively, compared to
$3.2 million and $12.5 million in the second quarter and first six months of
fiscal 2003, respectively. The increase in operating income at Cole Vision
compared to the same period last year was due to higher net revenues at Cole
Licensed Brands and revenue increases from managed vision care programs as well
as improvements in the gross margin rate and lower operating expenses as a
percent of net revenues. These improvements were partially offset by higher
management bonus, costs related to store closure at Target Optical, and higher
claims processing costs. Things Remembered Segment Operating income at Things Remembered was $11.8 million and $10.7 million
in the second quarter and first six months of fiscal 2004, respectively,
compared to $9.9 million and $7.3 million in the second quarter and first six
months of fiscal 2003, respectively. The improvement in operating results at
Things Remembered was due to higher net revenues, improvements in the gross
margin rate and lower operating costs as a percent of net revenues. Interest and Other (Income) Expense Interest and other (income) expense, net, was $5.9 million and $12.0
million in the second quarter and first six months of fiscal 2004,
respectively, compared to $5.7 million and $11.8 million in the second quarter
and first six months of fiscal 2003, respectively. The Company recorded
interest expense of $6.3 million and $6.2 million in the second quarter of
fiscal 2004 and fiscal 2003, respectively and $12.5 million in the first six
months of fiscal 2004 and fiscal 2003. Interest income, primarily from
temporary 19




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investments and franchise interest income, totaled $0.3 million and
$0.6 million in the second quarter and first six months of fiscal 2004,
respectively, and $0.5 million and $0.7 million in the second quarter and first
six months if fiscal 2003, respectively. Income Tax Rate The effective income tax rate was 43% for the first six months of fiscal
2004 compared to 22% for the first six months of fiscal 2003. The higher
effective tax rate in fiscal 2004, compared to fiscal 2003 was primarily due to
the expected full year results and the non-deductibility of certain expenses. Reconciliation of Same Store Sales Growth Same store sales growth is a non-GAAP financial measure, which includes
deferred warranty sales on a cash basis and undelivered customer orders, and
does not reflect provisions for returns, remakes and certain other items. The
Companys current systems do not gather data on these items on an individual
store basis. Adjustments to the cash basis sales information accumulated at the
store level are made for these items on an aggregate basis. As a retailer, the
Company believes that a measure of same store performance is important to
investors and management for understanding its operations. The Company
calculates same store sales for stores opened for at least twelve months. A
reconciliation of same store sales to revenue reported on a GAAP basis follows: 2004Second Quarter
    
    First Six Months(Dollars in thousands)Current year same store sales
    
    $
    267,917
    
    
    $
    534,450Prior year same store sales
    
    
    269,137
    
    
    
    520,832Percent change
    
    
    (0.5
    )%
    
    
    2.6
    %Current year same store sales
    
    $
    267,917
    
    
    $
    534,450Adjustment for:Sales at new and closed stores
    
    
    2,184
    
    
    
    4,822Deferred revenue
    
    
    211
    
    
    
    (1,468
    )Order vs. customer receipt
    
    
    (1,098
    )
    
    
    (2,886
    )Returns, remakes and refunds
    
    
    268
    
    
    
    13Other
    
    
    285
    
    
    
    60Store sales
    
    
    269,767
    
    
    
    534,991Nonstore revenues
    
    
    50,602
    
    
    
    102,279Intercompany eliminations
    
    
    (7,602
    )
    
    
    (16,851
    )GAAP Basis Net revenue
    
    $
    312,767
    
    
    $
    620,419
 Liquidity and Capital Resources The Companys primary source of liquidity is funds provided from
operations of its operating subsidiaries. In addition, the Company and its
operating subsidiaries have a working capital line of credit. As of the end of
the second quarter of fiscal 2004, the total commitment was $60.0 million and
availability under the credit facility totaled $43.7 million after reduction
for $16.3 million under letters of credit. There were no working capital
borrowings outstanding at any time during the first six months of fiscal 2004
or fiscal 2003. The credit facility, which is guaranteed by the Company and Cole National
Corporation, requires the Company and its principal operating subsidiaries to
comply with various operating covenants that restrict corporate activities,
including covenants restricting the ability of the subsidiaries to incur
additional indebtedness, pay dividends, prepay subordinated indebtedness,
dispose of certain investments or make acquisitions. The credit facility also
requires the Company to comply with certain financial covenants, including
covenants regarding minimum interest coverage and maximum leverage. As of July
31, 2004, the Company was in compliance with the covenants in the credit
agreement. 20




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On November 3, 2003, the Company entered into an agreement with a bank to
provide documentary letters of credit for import inventory purchases not to
exceed $7.0 million. The letters of credit are secured by the inventory
purchased. As of July 31, 2004, the Company has $3.8 million outstanding under
this facility. The indentures pursuant to which the 8-5/8% notes and the 8-7/8% notes
were issued contain certain optional and mandatory redemption features and
other financial covenants, including restrictions on the ability of the Company
to incur additional indebtedness, pay dividends or make other restricted
payments to Cole National Corporation. The indentures also permit payments to
Cole National Corporation for certain tax obligations and for administrative
expenses not to exceed 0.25% of net sales. See Note 3 of the Notes to Condensed
Consolidated Financial Statements. Following the consummation of the Luxottica
merger, the holders of the 8-5/8% notes and the 8-7/8% notes will have the
right to put the notes to the Company at a price of 101% of par plus accrued
interest. If the holders exercise such right, the Company may be required to
obtain financing from its parent or a third party to satisfy such obligation. No significant principal payment obligations are due under the Companys
outstanding indebtedness until 2007, when the 8-5/8% senior subordinated note of
$125.0 million is due. The ability of the Company and its subsidiaries to
satisfy their obligations will be primarily dependent upon the future financial
and operating performance of the subsidiaries and upon the Companys ability to
renew or refinance borrowings or raise additional capital through equity
financing or sales of assets. Cash Flows from Operating Activities Cash and cash equivalents were $64.0 million at July 31, 2004 compared to
$17.1 million at August 2, 2003. Operations generated net cash of $29.6 million
in the first six months of fiscal 2004 and used $5.4 million in the first six
months of fiscal 2003. The Company realized net income in the first six months
of fiscal 2004 and incurred a net loss in the first six months of fiscal 2003,
which is described above in the Results of Operations section of this report.
Depreciation and amortization was $19.1 million and $19.6 million in the first
six months of fiscal 2004 and fiscal 2003, respectively. The decrease in the
first six months of fiscal 2004,
compared to the first six months of fiscal 2003, was primarily due to
lower fixed asset depreciation attributable to lower capital spending. Non-cash
charges related to store closing and impairment losses were $1.0 million in the
first six months of fiscal 2004 for the write-off of assets and fixtures for
the Target Optical stores closed in the first quarter of fiscal 2004. Changes
in deferred income tax provision (benefit) were $4.3 million and ($4.8) million
in the first six months of fiscal 2004 and fiscal 2003, respectively. The
change was primarily due to the tax provision generated from the Companys
operating results. Non-cash interest and other expense (income) was $0.5
million in the first six months of fiscal 2004, compared to ($0.6) million in
the same period last year. The change was primarily due to a $1.0 million gain
on the sale of five Company-owned stores to a Pearle franchisee recorded in the
first six months of fiscal 2003. Changes in working capital resulted in a use of funds totaling $2.9
million in the first six months of fiscal 2004, compared to $8.5 million in the
first six months of fiscal 2003. Changes in accounts and notes receivable
resulted in a use of funds totaling $5.3 million in the first six months of
fiscal 2004 compared to $6.0 million in the same period last year. The change
in the first six months of fiscal 2004 was primarily due to increases in
revenues at Cole Licensed Brands, partially offset by receipt of insurance
reimbursements related to the restatement of the Companys financial
statements. The change in the first six months of fiscal 2003 was due to
increased revenues at both Cole Licensed Brands and Cole Managed Vision.
Inventories provided $1.0 million and used $9.9 million in the first six months
of fiscal 2004 and fiscal 2003, respectively. The inventory decrease in the
first six months of fiscal 2004 was primarily due to lower inventory at both
Pearle Vision and Things Remembered due to a lower number of stores open,
partially offset by an inventory increase at Cole Licensed Brands. The increase
in the first six months of fiscal 2003 was due to earlier new product
introductions at Cole Licensed Brands and Things Remembered, an increased mix
of premium products and additional inventory needed to support the increase in
store count at Cole Licensed Brands. Changes in accounts payable and other
liabilities resulted in a source of funds totaling $1.1 million and a source of
funds totaling $6.5 million in the first six months of fiscal 2004 and fiscal
2003, respectively. The change in fiscal 2004 was primarily due to the timing
of purchases and the change in fiscal 2003 was due to the timing of purchases
and payments, increases in liabilities for legal and audit costs related to the
restatement of the Companys financial statements, increases in liabilities for
the settlement of the class action lawsuit, increases in advertising, fringe
benefits, workers compensation and deferred revenues. 21




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Cash Flows from Investing Activities Net cash from investing activities resulted in a use of funds of $12.2
million in the first six months of fiscal 2004, compared to $23.8 million in
the first six months of fiscal 2003. Capital expenditures, which accounted for
most of the cash used for investing activities, were $11.0 million and $15.4
million in the first six months of fiscal 2004 and fiscal 2003, respectively.
The majority of capital expenditures were for remodeling of existing stores and
store fixtures, equipment and leasehold improvements for new stores in both
years. The reduction in capital expenditures was primarily due to lower capital
spending for remodeling at Things Remembered and lower spending at Cole
Licensed Brands. The Company paid $1.2 million and $4.3 million for systems
development costs in the first six months of fiscal 2004 and fiscal 2003,
respectively. Systems development in the first six months of fiscal 2003 was
primarily for the Companys Patriot Claims System. The Company used $3.7
million in the first six months of fiscal 2003 for a contingent payment in
connection with the prior acquisition of MetLifes managed vision business. Cash Flows from Financing Activities Net cash used for financing activities totaled $12.6 million in the first
six months of fiscal 2004 compared to cash provided from financing totaling
$4.2 million in the first six months of fiscal 2003. Advances from (to) the
Parent used ($16.1) million and provided $3.6 million for the first six months
of fiscal 2004 and fiscal 2003 respectively. Changes in overdraft balances
provided $3.6 million in the first six months of fiscal 2004 compared to $0.8
million in the first six months of fiscal 2003. The change in overdraft
balances was due to the timing of payments. The Company believes that funds provided from operations, including cash
on hand, along with funds available under the credit facility will provide
adequate sources of liquidity to allow its operating subsidiaries to continue
to expand the number of stores and to fund capital expenditures and systems
development costs. Off-Balance Sheet Arrangements and Contractual Obligations The Company leases a substantial portion of its equipment and facilities
including laboratories, office and warehouse space, and retail locations. In
addition, Cole Vision operates departments in various host stores and pays
occupancy costs solely as a percentage of revenues. A more complete discussion
of the Companys lease and license commitments is included in Note 7 of the
Notes to Condensed Consolidated Financial Statements. The Company guarantees future minimum lease payments for certain store
locations leased directly by Pearle franchisees. The term of these guarantees
range from one to ten years and many are limited to periods that are less than
the full term of the leases involved. A more complete discussion of the
Companys guarantees is included in Note 7 of the Notes to Condensed
Consolidated Financial Statements. In fiscal 2003, the Company entered into an agreement to guarantee a
portion of the amount owed to a bank by a franchisee as a result of a loan
granted in connection with the purchase of five stores. The guaranteed amount
equals the cumulative value of the store assets. The Company is released from
its obligation once the landlords of the store locations execute subordination
agreements or the bank is granted access to the store assets in the event of
the default by the franchisee. The Company received four executed subordination
agreements as of July 31, 2004. The maximum exposure under the agreement is
$47,000 as of July 31, 2004. Significant Accounting Policies The Companys significant accounting policies are discussed in the Notes
to the Consolidated Financial Statements that are included in the Companys
2003 Annual Report on Form 10-K/A that is filed with the Securities and
Exchange Commission. In most cases, the accounting policies utilized by the
Company are the only ones permissible under U.S. Generally Accepted Accounting
Principles for businesses in our industry. However, the application of certain
of these policies requires significant judgments or a complex estimation
process that can affect the results of operations and financial position of the
Company, as well as the related footnote disclosures. The Company bases its
estimates on historical experience and other assumptions that it believes are
reasonable. If actual amounts are ultimately different from previous estimates,
the revisions are included in the Companys results of operations for the
period in which the actual amounts become known. The accounting policies and
estimates that can have a significant impact on the operating results,
financial position and footnote disclosures of the Company are described in the
Management Discussion and Analysis in the Companys 2003 Annual Report on Form
10-K/A. 22




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Certain Operating and Expense Trends As
discussed in this report, consolidated same store sales in the Companys vision
segment declined in the second quarter of 2004, although there was
variability within the Companys brand, ranging from
single-digit increases at Target Optical and low double-digit
increases at BJs Optical to low single digit
decreases at Sears Optical and Pearle Vision. During August, the first month of
the third quarter of fiscal 2004, consolidated same store sales in the
Companys vision segment increased in the low double-digits.
While there was growth in all brands, sales performance in August was driven
primarily by a successful promotion at Sears Optical. Things
Remembered experienced a same store sales decline in August of less
than one percent. There can be no assurance that these same store sales trends will
continue for the remainder of the third quarter of 2004, or for the remainder
of the fiscal year. Costs associated with the California litigation and the SEC investigation
are expected to continue in fiscal 2004. However, many of the unusual expenses,
such as the costs related to the settlement of the stockholder litigation and audit
fees related to the restatement are not expected to recur. Although there can
be no assurances regarding the level of same store sales, the Company
believes its profit performance will improve in fiscal 2004 as a result of
revenue growth, expense controls and the non-recurrence of the aforementioned
unusual expenses. Forward Looking Statements The Companys expectations and beliefs concerning the future contained in
this document are forward looking statements within the meaning of the Private
Securities Litigation Reform Act of 1995. Such statements involve risks,
uncertainties and other factors that could cause actual results to differ
materially from those which are anticipated. Such risks and uncertainties
include, but are not limited to, risks that the Luxottica merger will not be
completed, legislative or regulatory developments that could have the effect of
delaying or preventing the Luxottica merger, fluctuations in exchange rates,
liquidity and financial condition such as risks associated with potential
adverse consequences of the restatement of the Companys financial statements,
including those resulting from litigation or government investigations,
restrictions or curtailment of the Companys credit facility and other credit
situations, costs and other effects associated with the California litigation,
the timing and achievement of improvements in the operations of the optical
business, the results of Things Remembered, which is highly dependent on the
fourth quarter holiday season, the nature and extent of
disruptions of the economy from terrorist activities or major health
concerns and from governmental and consumer responses to such situations, the
actual utilization of Cole Managed Vision funded eyewear programs, the success
of new store openings and the rate at which new stores achieve profitability,
the Companys ability to select, stock and price merchandise attractive to
customers, success of systems development and integration, costs and other
effects associated with litigation, competition in the optical industry,
integration of acquired businesses, economic and weather factors affecting
consumer spending, operating factors affecting customer satisfaction, including
manufacturing quality of optical and engraved goods, the Companys
relationships with host stores, franchisees, and managed care clients, the mix
of goods and services sold, pricing and other competitive factors, and the
seasonality of the Companys business. 
 Item 3. Quantitative and Qualitative Disclosures About Market Risk The Companys major market risk exposure is to changes in foreign currency
exchange rates in Canada, which could impact its results of operations and
financial condition. Foreign exchange risk arises from the Companys exposure
to fluctuations in foreign currency exchange rates because the Companys
reporting currency is the United States dollar. Management seeks to minimize
the exposure to foreign currency fluctuations through natural internal offsets
to the fullest extent possible. In addition, the Company is exposed to changes in the fair value of its
debt portfolio, primarily resulting from the effects of changes in interest
rates. The Company utilizes interest rate swaps to manage its exposure.
Management believes that its use of these financial instruments is in the
Companys best interest. These agreements require the Company to pay an average
floating interest rate based on six month LIBOR plus 4.5375% to a counter party
while receiving a fixed rate on $50.0 million of the Companys $125.0 million
8-5/8% Senior Subordinated Notes due 2007. The agreements mature August 15,
2007 and qualify as fair value hedges. The LIBOR rate is reset in arrears in
February and August of each year. For the second quarter of fiscal 2004, the
market rate for six month LIBOR was 1.98%, which resulted in a rate of 6.5175%
applied from February 17, 2004 through July 31, 2004. A change in six-month LIBOR would affect the interest cost associated with
the $50.0 million notional value of the swap agreements. A 50% change
(approximately 99 basis points) in the market rates of interest for six month
LIBOR as compared to the 6.5175% rate in effect for the second quarter of
fiscal 2004 would increase the Companys annual interest cost by $0.5 million. The Company does not enter into financial instruments for trading
purposes. 23




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Item 4. Controls and Procedures Attached as Exhibits 31.1 and 31.2 to this Quarterly Report are
certifications of the Companys Chief Executive Officer and Chief Financial
Officer required in accordance with Section 302 of the Sarbanes-Oxley Act of
2002 (the Section 302 Certifications). This portion of the Companys
Quarterly Report on Form 10-Q is the disclosure of the results of the control
evaluation referred to in paragraphs (4) and (5) of the Section 302
Certifications and should be read in conjunction with the Section 302
Certifications for a more complete understanding of the topics presented. The Company carried out an evaluation, under the supervision and with the
participation of its Chief Executive Officer and Chief Financial Officer,
pursuant to Rule 13a-15 promulgated under the Securities Exchange Act of 1934
(the Exchange Act), as amended, of the design, operation and effectiveness of
the Companys disclosure controls and procedures. The Companys Chief Executive
Officer and Chief Financial Officer concluded that based on such evaluation, as
of July 31, 2004, the Companys disclosure controls and procedures were
effective and reasonably designed to ensure that information required to be
disclosed by the Company in the reports it files or submits under the Exchange
Act is recorded, processed, summarized and reported within the time periods
specified in the rules and forms of the Securities and Exchange Commission. There have not been any changes in the Companys internal control over
financial reporting or in other factors during the quarter ended July 31, 2004
that have materially affected, or are reasonably likely to materially affect,
the Companys internal controls over financial reporting. 
 PART II  OTHER INFORMATION 
 Item 1. Legal Proceedings From time to time during the ordinary course of business, the Company may
be threatened with, or may become a party to, a variety of legal actions and
other proceedings incidental to its business. On July 14, 2004, a Cole National Corporation shareholder filed a
shareholders class action complaint against the Parent, its directors, and
Luxottica in the Delaware Chancery Court, known as Pfeiffer v. Cole National
Corp., et al., Civil Action No. 569-N. The complaint alleges, among other
things, that the individual defendants breached their fiduciary duties as
directors and/or officers to the Parent by causing the Parent to enter into an
agreement to be acquired by Luxottica for $22.50 per share without having
exposed the Parent to the marketplace through fair and open negotiations with
all potential bidders and/or an active market check or open auction for sale of
the company. The complaint seeks preliminary and permanent injunctive relief
against the merger, rescission of the merger if it is consummated, and/or
damages and other associated relief. The Parent believes that the action is
without merit. Cole National Group has been named as a defendant along with numerous
other retailers, in patent infringement litigation challenging the defendants
use of bar code technology in the United States District Court of Arizona,
known as Lemelson Medical, Education & Research Foundation, Limited
Partnerships v. CompUSA, Inc. et. al., No. Civ. 00-0663. A stay of the
proceeding has been sought and was granted, in deference to prior pending
declaratory judgment suits brought by the manufacturers and suppliers of the
implicated technology seeking to declare the patents in suit invalid,
unenforceable and not infringed. On January 23, 2004, a court in Nevada entered
a memorandum of decision in favor of the manufacturers declaring the Lemelson
patents unenforceable and not infringed. This judgment has been appealed by the
Lemelson Partnership, and the Arizona infringement litigation against Cole
National Group will remain stayed pending the final resolution of the appeal;
however, this trial court decision favors the Company and its defenses. Cole
National Group believes it has available defenses and does not expect any
liability. However, if Cole National Group were to be found liable for an
infringement, it might have a material adverse effect on the Companys
operating results and cash flow in the period incurred. See Note 8 of Notes to Consolidated Financial Statements for further
discussion of these legal proceedings. 24




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##### Table of Contents



Item 6. Exhibits (a) Exhibits. The following Exhibits are filed herewith and made a part
hereof: 31.1
    
    Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a) of the Exchange Act.31.2
    
    Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a) of the Exchange Act.32
    
    Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 25




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##### Table of Contents



SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this Report to be signed on its behalf by the
undersigned thereunto duly authorized. COLE NATIONAL GROUP, INC.By:
    
    /s/ Lawrence E. HyattLawrence E. HyattExecutive Vice President and Chief Financial Officer(Duly Authorized Officer)By:
    
    /s/ Ann M. HoltAnn M. HoltSenior Vice President and Corporate Controller(Principal Accounting Officer)
 Date: September 7, 2004 26




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##### Table of Contents



COLE NATIONAL GROUP, INC.
FORM 10-Q
QUARTER ENDED JULY 31, 2004 
 EXHIBIT INDEX ExhibitNumber
    
    Description31.1
    
    Certification of Chief Executive Officer Pursuant to Rule
13a-14(a)/15d-14(a) of the Exchange Act.31.2
    
    Certification of Chief Financial Officer Pursuant to Rule
13a-14(a)/15d-14(a) of the Exchange Act.32
    
    Certification of Chief Executive Officer and Chief Financial
Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
 27