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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 FORM 10-Q (Mark One) [X]
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934For the quarterly period ended May 1, 2004,OR[ ]
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934For the transition period from  to .
 Commission file number 33-66342 COLE NATIONAL GROUP, INC.  DELAWARE
(State or other jurisdiction of
incorporation or organization)
    
    34-1744334
(I.R.S. Employer Identification No.)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 X No Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes  No X All of the outstanding capital stock of the registrant is held by Cole
National Corporation. As of May 28, 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 MAY 1, 2004
INDEX Page No.PART I. FINANCIAL INFORMATIONItem 1. Financial Statements (unaudited)Condensed Consolidated Balance Sheets as of May 1, 2004, May 3, 2003 and January 31, 2004
    
    
    1Condensed Consolidated Statements of Operations for the 13 week period ended May 1, 2004 and May 3, 2003
    
    
    2Condensed Consolidated Statements of Cash Flows for the 13 week period ended May 1, 2004 and May 3, 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
    
    
    22Item 4. Controls and Procedures
    
    
    23PART II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    23Item 6. Exhibits and Reports on Form 8-K
    
    
    24Signatures
    
    
    25Exhibit Index
    
    
    26EX-31.1 302 CEO CertificationEX-31.2 302 CFO CertificationEX-32 906 Certifications




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PART I  FINANCIAL INFORMATION 
 ITEM 1. FINANCIAL STATEMENTS 
 COLE NATIONAL GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
(Dollars in thousands) May 1,
    
    May 3,
    
    January 31,2004
    
    2003
    
    2004AssetsCurrent assets:Cash and cash equivalents
    
    $
    65,253
    
    
    $
    29,463
    
    
    $
    59,184Accounts receivable, less allowances of
$3,773, $3,408 and $3,449, respectively
    
    
    55,731
    
    
    
    55,128
    
    
    
    55,238Current portion of notes receivable
    
    
    3,705
    
    
    
    2,219
    
    
    
    2,501Inventories
    
    
    124,186
    
    
    
    134,013
    
    
    
    120,927Prepaid expenses and other
    
    
    24,472
    
    
    
    24,019
    
    
    
    25,610Deferred income taxes
    
    
    31,659
    
    
    
    32,166
    
    
    
    31,612Total current assets
    
    
    305,006
    
    
    
    277,008
    
    
    
    295,072Property and equipment, at cost
    
    
    315,497
    
    
    
    323,214
    
    
    
    311,890Less  accumulated depreciation and amortization
    
    
    (201,419
    )
    
    
    (203,278
    )
    
    
    (194,886
    )Total property and equipment, net
    
    
    114,078
    
    
    
    119,936
    
    
    
    117,004Notes receivable, excluding current portion, less allowances
of $2,224, $3,058 and $2,858, respectively
    
    
    3,607
    
    
    
    4,354
    
    
    
    4,928Deferred income taxes
    
    
    31,146
    
    
    
    28,830
    
    
    
    31,375Other assets
    
    
    33,942
    
    
    
    45,469
    
    
    
    36,959Other intangibles, net
    
    
    49,447
    
    
    
    50,654
    
    
    
    49,773Goodwill, net
    
    
    85,721
    
    
    
    85,708
    
    
    
    85,734Total assets
    
    $
    622,947
    
    
    $
    611,959
    
    
    $
    620,845Liabilities and Stockholders EquityCurrent liabilities:Current portion of long-term debt
    
    $
    613
    
    
    $
    235
    
    
    $
    608Accounts payable
    
    
    73,507
    
    
    
    70,990
    
    
    
    61,180Payable to affiliates, net
    
    
    88,728
    
    
    
    77,606
    
    
    
    97,512Accrued interest
    
    
    8,351
    
    
    
    8,479
    
    
    
    7,715Accrued liabilities
    
    
    90,159
    
    
    
    96,648
    
    
    
    95,041Accrued income taxes
    
    
    2,505
    
    
    
    4,269
    
    
    
    2,789Deferred revenue
    
    
    42,159
    
    
    
    39,239
    
    
    
    41,122Total current liabilities
    
    
    306,022
    
    
    
    297,466
    
    
    
    305,967Long-term debt, net of current portion
    
    
    278,163
    
    
    
    276,781
    
    
    
    279,229Other long-term liabilities
    
    
    34,038
    
    
    
    36,960
    
    
    
    32,726Deferred revenue, long-term
    
    
    12,771
    
    
    
    12,292
    
    
    
    12,129Stockholders equity
    
    
    (8,047
    )
    
    
    (11,540
    )
    
    
    (9,206
    )Total liabilities and stockholders equity
    
    $
    622,947
    
    
    $
    611,959
    
    
    $
    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
(Unaudited)
(In thousands) Thirteen Week Period EndedMay 1,
    
    May 3,2004
    
    2003Net revenues
    
    $
    307,652
    
    
    $
    288,249Costs and expenses:Cost of revenues
    
    
    113,866
    
    
    
    106,592Operating expenses
    
    
    187,379
    
    
    
    183,815Total costs and expenses
    
    
    301,245
    
    
    
    290,407Operating income (loss)
    
    
    6,407
    
    
    
    (2,158
    )Interest and other (income) expense:Interest expense
    
    
    6,206
    
    
    
    6,260Interest and other (income), net
    
    
    (76
    )
    
    
    (183
    )Total interest and other (income) expense, net
    
    
    6,130
    
    
    
    6,077Income (loss) before income taxes
    
    
    277
    
    
    
    (8,235
    )Income tax provision (benefit)
    
    
    130
    
    
    
    (1,647
    )Net income (loss)
    
    $
    147
    
    
    $
    (6,588
    )
 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
(Unaudited)
(Dollars in thousands) Thirteen Week Period EndedMay 1,
    
    May 3,2004
    
    2003(As restated,see Note 10)Cash flows from operating activities:Net income (loss)
    
    $
    147
    
    
    $
    (6,588
    )Adjustments to reconcile net income (loss) to net cash provided by
(used for) operating activities:Depreciation and amortization
    
    
    9,659
    
    
    
    9,275Store closing and impairment losses
    
    
    1,000
    
    
    
    Deferred income tax provision (benefit)
    
    
    116
    
    
    
    (2,800
    )Noncash compensation
    
    
    921
    
    
    
    (93
    )Noncash interest and other, net
    
    
    211
    
    
    
    300Increases (decreases) in cash resulting from changes in operating
assets and liabilities:Accounts and notes receivable, prepaid expenses and other assets
    
    
    636
    
    
    
    (3,713
    )Inventories
    
    
    (3,335
    )
    
    
    (13,103
    )Accounts payable, accrued liabilities and other liabilities
    
    
    (5,745
    )
    
    
    8,498Accrued interest
    
    
    636
    
    
    
    674Accrued and refundable income taxes
    
    
    (289
    )
    
    
    936Net cash provided by (used for) operating activities
    
    
    3,957
    
    
    
    (6,614
    )Cash flows from investing activities:Purchases of property and equipment
    
    
    (5,130
    )
    
    
    (7,467
    )Systems development costs
    
    
    (335
    )
    
    
    (2,170
    )Acquisitions of businesses
    
    
    
    
    
    
    (213
    )Other, net
    
    
    (2
    )
    
    
    Net cash used for investing activities
    
    
    (5,467
    )
    
    
    (9,850
    )Cash flows from financing activities:Repayment of long-term debt
    
    
    (147
    )
    
    
    (57
    )Increase (decrease) in overdraft balances
    
    
    16,321
    
    
    
    2,055Advances from (to) parent, net
    
    
    (8,571
    )
    
    
    1,849Other, net
    
    
    (24
    )
    
    
    79Net cash provided by (used for) financing activities
    
    
    7,579
    
    
    
    3,926Cash and cash equivalents:Net increase (decrease) during the period
    
    
    6,069
    
    
    
    (12,538
    )Balance, beginning of period
    
    
    59,184
    
    
    
    42,001Balance, end of period
    
    $
    65,253
    
    
    $
    29,463
 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
(Unaudited) (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 488 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): Thirteen Week Period Ended
    
    Year EndedMay 1,
    
    May 3,
    
    January 31,2004
    
    2003
    
    2004Deferred revenues:Beginning balance
    
    $
    53,251
    
    
    $
    49,573
    
    
    $
    49,573Warranty contracts sold
    
    
    15,398
    
    
    
    14,782
    
    
    
    56,479Other deferred revenue
    
    
    833
    
    
    
    379
    
    
    
    3,264Amortization of deferred revenue
    
    
    (14,552
    )
    
    
    (13,203
    )
    
    
    (56,065
    )Ending balance
    
    $
    54,930
    
    
    $
    51,531
    
    
    $
    53,251
 Cash Flows Net cash flows from operating activities reflect net cash payments for
income taxes and payments for interest of $0.3 million and $5.3 million,
respectively, for the 13 week period ended May 1, 2004, and $0.2 million and
$5.3 million, respectively, for the 13 week period ended May 3, 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 $34.1
million, $22.4 million and $21.1 million at May 1, 2004, May 3, 2003 and
January 31, 2004, respectively, and to accrued expenses amounted to $7.1
million, $6.9 million and $3.8 million at May 1, 2004, May 3, 2003 and January
31, 2004, respectively. Total Comprehensive Income (Loss) Total comprehensive income (loss) for the 13 week periods ended May 1,
2004 and May 3, 2003 is as follows (dollars in thousands): Thirteen Week Period EndedMay 1,
    
    
    
    May 3,2004
    
    
    
    2003Net income (loss)
    
    $
    147
    
    
    $
    (6,588
    )Translation income (loss)
    
    
    (26
    )
    
    
    489Total comprehensive income (loss)
    
    $
    121
    
    
    $
    (6,099
    )
 Stock- Based Compensation At May 1, 2004, the Company has various stock-based employee compensation
plans which are described more fully in Note 1 of the Notes to Condensed
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 expense of $0.9 million has been recorded for the 13 week period
ended May 1, 2004. No stock-based employee compensation expense for variable
stock options was recorded in the 13 week period ended May 3, 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 EndedMay 1,
    
    May 3,(Dollars in thousands)
    
    2004
    
    2003Net income (loss), as reported
    
    $
    147
    
    
    $
    (6,588
    )Additions for stock-based employee compensation
expense included in reported net income (loss),
net of related taxes
    
    
    604
    
    
    
    Deductions for total stock-based compensation
expense determined under fair value based method
for all awards, net of related taxes
    
    
    (321
    )
    
    
    (446
    )Net income (loss), pro forma
    
    $
    430
    
    
    $
    (7,034
    )
 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 is unable to
conclude 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. Adoption of FSP FAS 106-2 could require the
Company to change previously reported information. (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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May 1,
    
    May 3,
    
    January 31,2004
    
    2003
    
    2004Non-amortizable:Tradename
    
    $
    49,460
    
    
    $
    49,460
    
    
    $
    49,460Amortizable:Noncompete agreements
    
    
    320
    
    
    
    320
    
    
    
    320Contracts
    
    
    8,947
    
    
    
    8,847
    
    
    
    8,947Customer records
    
    
    9
    
    
    
    9
    
    
    
    9Total amortizable
    
    
    9,276
    
    
    
    9,176
    
    
    
    9,276Accumulated amortization
    
    
    (9,289
    )
    
    
    (7,982
    )
    
    
    (8,963
    )Other intangibles, net
    
    $
    49,447
    
    
    $
    50,654
    
    
    $
    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 May 1, 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, Cole National Group 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 (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 May 1, 2004, the floating rate of the swaps was approximately 5.9%
and the fair value of the swap agreements was an unrealized loss of
approximately $0.1 million. There was no impact to earnings in the first three
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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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 May 1, 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 the Company. 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 May 1, 2004, the total availability under the credit facility
totaled $45.9 million after reduction for commitments outstanding of $14.1
million under letters of credit. There were no working capital borrowings under
the credit facility outstanding as of May 1, 2004 and May 3, 2003 and there
were no borrowings during the first quarter 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 May 1, 2004, the
Company had $1.4 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 week period ended May 1, 2004 and
May 3, 2003 is as follows (dollars in thousands): Pension Benefits
    
    Postretirement BenefitsMay 1,
    
    May 3,
    
    May 1,
    
    May 3,2004
    
    2003
    
    2004
    
    2003Service cost  benefits earned during the period
    
    $
    70
    
    
    $
    59
    
    
    $
    
    
    
    $
    Interest cost on the projected benefit obligation
    
    
    686
    
    
    
    652
    
    
    
    40
    
    
    
    30Expected return on plan assets
    
    
    (622
    )
    
    
    (540
    )
    
    
    
    
    
    
    Recognized net actuarial (gain) loss
    
    
    546
    
    
    
    217
    
    
    
    25
    
    
    
    17Amortization of initial asset
    
    
    (40
    )
    
    
    (40
    )
    
    
    
    
    
    
    Amortization of prior service cost
    
    
    
    
    
    
    
    
    
    
    1
    
    
    
    1Net expense (income)
    
    $
    640
    
    
    $
    348
    
    
    $
    66
    
    
    $
    48
 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 May 1, 2004, $1.8 million of contributions have
been made. The Company presently anticipates contributing an additional $4.0
million to fund its pension plan in 2004 for a total of $5.8 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 EndedMay 1,
    
    May 3,2004
    
    2003Net revenues:Cole Vision
    
    $
    249,933
    
    
    $
    233,541Things Remembered
    
    
    57,719
    
    
    
    54,708Total net revenues
    
    $
    307,652
    
    
    $
    288,249Operating income (loss):Cole Vision
    
    $
    12,685
    
    
    $
    9,276Things Remembered
    
    
    (1,065
    )
    
    
    (2,580
    )Total segment operating income
    
    
    11,620
    
    
    
    6,696Unallocated corporate expenses
    
    
    5,213
    
    
    
    8,854Total operating income (loss)
    
    
    6,407
    
    
    
    (2,158
    )Interest and other (income) expense, net
    
    
    6,130
    
    
    
    6,077Income (loss) before income taxes
    
    $
    277
    
    
    $
    (8,235
    )
 (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 $12.8 million, $13.6 million and $13.4 million as of May 1, 2004,
May 3, 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 May 1, 2004. The maximum exposure under the agreement is
$47,000 as of May 1, 2004. (8) Legal Proceedings 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 9




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##### Table of Contents



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 is expected to be appealed, and the infringement
litigation against Cole National Group will remain stayed pending the final
resolution of any such 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) Merger Agreement On January 23, 2004, the Parent and Luxottica Group S.p.A. (Luxottica)
entered into a merger agreement (the Luxottica merger) pursuant to which the
Parent would become a subsidiary of Luxottica. Under the agreement, Luxottica
will acquire all of the outstanding shares of the Parent in a merger for a cash
purchase 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. The Luxottica merger is subject to approval by
the holders of a majority of the outstanding shares of the Parents common
stock and the satisfaction of other 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
(FTC) for additional information and documentary material with respect to the
Luxottica merger. Accordingly, the waiting period under the HSR Act has been
extended until the 30th day after the date of substantial compliance with the
request by both parties, unless earlier terminated by the FTC. The Parent is
working cooperatively with the FTC to provide the additional information
requested. 10




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##### Table of Contents



On April 15, 2004, the Parent

received an unsolicited, non-binding offer
from Moulin International Holdings Limited (Moulin) to

acquire the Parent in
a merger at a price of $25.00 per share in cash. The offer was subject

to,
among other things, the execution of definitive agreements, approval by

the
Parents stockholders, receipt of regulatory approvals and other

customary
conditions. The proposal contemplated that HAL Holdings, N.V.

(HAL), which
owns approximately 19.14% of the Parents outstanding shares,

would provide
substantial financing for the transaction, including by means of a

$33 million
loan and by purchasing the shares of Pearle Europe B.V. and Pearle Inc.

at the
closing of the Moulin merger for aggregate consideration of

$262 million. On May 12, 2004, the Parent

was informed by Moulin that one of Moulins
financing sources was not prepared to provide senior debt financing on

the
terms originally proposed which were contemplated in Moulins

acquisition
proposal. Moulin advised the Parent that HAL and Moulins

mezzanine financing
source were willing to proceed with the transaction on the basis of the

terms
originally proposed and that Moulin was continuing to evaluate

alternatives
which could allow Moulins proposal to proceed. On May 31, 2004,

representatives of Moulin, advised the Parent that the
financing source for the senior debt financing was prepared to

participate in a
restructured financing arrangement for Moulins proposal, although

the terms
and conditions of such financing had not yet been negotiated.

Moulins
representatives also advised that Moulin was in discussions with a

third party
regarding possible additional equity financing for Moulins

proposal, that
Moulin was in discussions with its mezzanine financing source regarding
possible restructuring of the financing as part of a restructured

financing
arrangement and that HAL continued to be willing to proceed with the
transaction on the basis of the terms originally proposed.

Moulins
representatives stated that they did not expect Moulin to be able to

finalize
these financing arrangements for at least another week, but no

assurance was
given as to when and if any revised proposal would be made. There can

be no
assurance as to whether discussions with Moulin will continue, whether

Moulin
will be able to obtain financing for its proposal, whether any

agreement with
the Parent would result from any such discussions, or the terms and

conditions
thereof. On June 1, 2004 the

Parents Board of Directors unanimously approved an
amendment to the Luxottica merger agreement, and set July 20, 2004

as the date
of its annual meeting of stockholders to consider the Luxottica merger
agreement, as amended, and elect the Parentss directors. Under

the amendment
to the Luxottica merger agreement, which was entered into on

June 2, 2004, 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 Luxottica merger, if the Luxottica merger agreement is approved at

the
annual meeting of stockholders on July 20, 2004. No other change

was made to
the Luxottica merger agreement in connection with the
amendment. The Parents Board of Directors has reaffirmed its

recommendation
of the Luxottica merger agreement, as amended. The Luxottica merger

agreement,
as amended, is subject to approval by the Parents stockholders,

receipt of
regulatory approvals and other customary conditions. The Luxottica merger is

expected to
close in the second half of 2004. Stockholders of record of the Parent

as of
May 21, 2004 will be entitled to vote on the matters to be

considered at the
annual meeting of stockholders, including the Luxottica merger. The

Parent
began mailing definitive proxy materials to its stockholders relating

to the
annual meeting on June 7, 2004. Prior to the consummation of the

Luxottica merger, whether before or after
the Parents stockholders approve the Luxottica merger, under the

circumstances
and subject to the conditions set forth in the Luxottica merger

agreement
(including the obligation to provide Luxottica an opportunity to revise

the
terms of its proposed transaction), the Parent has the right to

terminate the
Luxottica merger agreement and enter into an agreement relating to a

superior
proposal. (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 statement 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. In addition, a correction was made to
the previously reported timing of a contingent payment in connection with a
prior acquisition. The payment was previously reported within cash flows from
investing activities in the first quarter
of fiscal 2003, but actually occurred in the second quarter of fiscal
2003. 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 quarter of fiscal 2003 has been restated
from the amounts previously reported to decrease cash flows from operating
activities by $12.3 million, increase cash flows from investing activities by $3.7 million,  and increase cash flows from financing activities by
$8.6 million. In addition, the overdrafts  balances at May 3, 2003 disclosed in
Note 1 have been increased by $4.3 million. 11




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##### Table of Contents



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 quarter 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 reflect 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) pursuant to which the
Parent would become a subsidiary of Luxottica. Under the agreement, Luxottica
will acquire all of the outstanding shares of the Parent in a merger for a cash
purchase 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. The Luxottica merger is subject to approval by
the holders of a majority of the outstanding shares of the Parents common
stock and the satisfaction of other 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
(FTC) for additional information and documentary material with respect to the
Luxottica merger. Accordingly, the waiting period under the HSR Act has been
extended until the 30th day after the date of substantial compliance with the
request by both parties, unless earlier terminated by the FTC. The Parent is
working cooperatively with the FTC to provide the additional information
requested. On April 15, 2004, the Parent received an unsolicited, non-binding offer
from Moulin International Holdings Limited (Moulin) to acquire the Parent in
a merger at a price of $25.00 per share in cash. The offer was subject to,
among other things, the execution of definitive agreements, approval by the
Parents stockholders, receipt of regulatory approvals and other customary
conditions. The proposal contemplated that HAL Holdings, N.V. (HAL), which
owns approximately 19.14% of the Parents outstanding shares, would provide
substantial financing for the transaction, including by means of a $33 million
loan and by purchasing the shares of Pearle Europe B.V. and Pearle Inc. at the
closing of the Moulin merger for aggregate consideration of $262 million. On May 12, 2004, the Parent was informed by Moulin that one of Moulins
financing sources was not prepared to provide senior debt financing on the
terms originally proposed which were contemplated in Moulins acquisition
proposal. Moulin advised the Parent that HAL and Moulins mezzanine financing
source were willing to proceed with the transaction on the basis of the terms
originally proposed and that Moulin was continuing to evaluate alternatives
which could allow Moulins proposal to proceed. On May 31, 2004, representatives of Moulin, advised the Parent that the
financing source for the senior debt financing was prepared to participate in a
restructured financing arrangement for Moulins proposal, although the terms
and conditions of such financing had not yet been negotiated. Moulins
representatives also advised that Moulin was in discussions with a third party
regarding possible additional equity financing for Moulins proposal, that
Moulin was in discussions with its mezzanine financing source regarding
possible restructuring of the financing as part of a restructured financing
arrangement and that HAL continued to be willing to proceed with the
transaction on the basis of the terms originally proposed. Moulins
representatives stated that they did not expect Moulin to be able to finalize
these financing arrangements for at least another week, but no assurance was
given as to when and if any revised proposal would be made. There can be no
assurance as to whether discussions with Moulin will continue, whether Moulin
will be able to obtain financing for its proposal, whether any agreement with
the Parent would result from any such discussions, or the terms and conditions
thereof. On June 1, 2004 the Parents Board of Directors unanimously approved an
amendment to the Luxottica merger agreement, and set July 20, 2004 as the date
of its annual meeting of stockholders to consider the Luxottica merger
agreement, as amended, and elect the Parentss directors. Under the amendment
to the Luxottica merger agreement, which was entered into on June 2, 2004, 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 Luxottica merger, if the Luxottica merger agreement is approved at the
annual meeting of stockholders on July 20, 2004. No other change was made to
the Luxottica merger agreement in connection with the
amendment. The Parents Board of Directors has reaffirmed its recommendation
of the Luxottica merger agreement, as amended. The Luxottica merger agreement,
as amended, is subject to approval by the Parents stockholders, receipt of
regulatory approvals and other customary conditions. The Luxottica merger is expected to
close in the second half of 2004. Stockholders of record of the Parent as of
May 21, 2004 will be entitled to vote on the matters to be considered at the
annual meeting of stockholders, including the Luxottica merger. The Parent
began mailing definitive proxy materials to its stockholders relating to the
annual meeting on June 7, 2004. Prior to the consummation of the Luxottica merger, whether before or after
the Parents stockholders approve the Luxottica merger, under the circumstances
and subject to the conditions set forth in the Luxottica merger agreement
(including the obligation to provide Luxottica an opportunity to revise the
terms of its proposed transaction), the Parent has the right to terminate the
Luxottica merger agreement and enter into an agreement relating to a superior
proposal. 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 488 franchised locations in 50 states,
Canada and the Caribbean. 12




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##### Table of Contents



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. Results of Operations The following schedule sets forth certain operating information for the
first quarters 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. First Quarter
    
    Change2004
    
    2003
    
    Fav/(Unfav)(Dollars in millions)Net revenues:Cole Vision
    
    $
    249.9
    
    
    $
    233.5
    
    
    
    7.0
    %Things Remembered
    
    
    57.7
    
    
    
    54.7
    
    
    
    5.5Total net revenues
    
    $
    307.6
    
    
    $
    288.2
    
    
    
    6.7
    %Gross margin:Cole Vision
    
    $
    151.8
    
    
    $
    142.0
    
    
    
    6.9
    %Things Remembered
    
    
    42.0
    
    
    
    39.7
    
    
    
    6.0Total gross margin
    
    $
    193.8
    
    
    $
    181.7
    
    
    
    6.7
    %Operating expenses:Cole Vision
    
    $
    139.1
    
    
    $
    132.7
    
    
    
    (4.8
    )%Things Remembered
    
    
    43.1
    
    
    
    42.3
    
    
    
    (2.0
    )Unallocated corporate expenses
    
    
    5.2
    
    
    
    8.9
    
    
    
    41.1Total operating expenses
    
    $
    187.4
    
    
    $
    183.8
    
    
    
    (1.9
    )%Operating income (loss):Cole Vision
    
    $
    12.7
    
    
    $
    9.3
    
    
    
    36.8
    %Things Remembered
    
    
    (1.1
    )
    
    
    (2.6
    )
    
    
    58.7Unallocated corporate expenses
    
    
    (5.2
    )
    
    
    (8.9
    )
    
    
    41.1Total operating income (loss)
    
    $
    6.4
    
    
    $
    (2.2
    )
    
    
    396.9
    %Percentage of net revenue:Gross margin
    
    
    63.2
    %
    
    
    66.9
    
    
    
    (1.1
    )Operating expenses
    
    
    63.3
    
    
    
    67.7
    
    
    
    (1.1
    )Operating income (loss)
    
    
    (0.1)
    %
    
    
    (0.7
    )%
    
    
    0.0
 Information on the number of the Companys retail locations by business
open at May 1, 2004 and May 3, 2003 is presented below: 13




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##### Table of Contents



First Quarter2004
    
    2003Number of retail locations at the end of the periodSears Optical
    
    
    938
    
    
    
    945Target Optical
    
    
    241
    
    
    
    249BJs Optical
    
    
    133
    
    
    
    127Total Cole Licensed Brands
    
    
    1,312
    
    
    
    1,321Pearle Company-owned
    
    
    378
    
    
    
    394Pearle franchised
    
    
    488
    
    
    
    465Total Cole Vision
    
    
    2,178
    
    
    
    2,180Things Remembered
    
    
    727
    
    
    
    761Total Cole National
    
    
    2,905
    
    
    
    2,941
 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. First Quarter2004
    
    2003Gross margin:Cole Vision
    
    
    60.7
    %
    
    
    60.8
    %Things Remembered
    
    
    72.8
    %
    
    
    72.5
    %Total gross margin
    
    
    63.0
    %
    
    
    63.0
    %Operating expenses:Cole Vision
    
    
    55.7
    %
    
    
    56.8
    %Things Remembered
    
    
    74.6
    %
    
    
    77.2
    %Unallocated corporate expense
    
    
    1.7
    %
    
    
    3.1
    %Total operating expenses
    
    
    60.9
    %
    
    
    63.8
    %Operating income:Cole Vision
    
    
    5.1
    %
    
    
    4.0
    %Things Remembered
    
    
    (1.8
    )%
    
    
    (4.7
    )%Unallocated corporate expense
    
    
    (1.7
    )%
    
    
    (3.1
    )%Total operating income
    
    
    2.1
    %
    
    
    (0.7
    )%
 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: 14




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##### Table of Contents



2004First QuarterSears Optical (U.S.)
    
    
    5.0
    %Target Optical
    
    
    17.0
    %BJs Optical
    
    
    20.0
    %Cole Licensed Brands (U.S.)
    
    
    7.3
    %Pearle Company-owned (U.S.)
    
    
    1.4
    %Total Cole Vision
    
    
    5.7
    %Things Remembered
    
    
    6.5
    %Total Cole National
    
    
    5.9
    %Pearle franchise stores (U.S.)
    
    
    0.2
    %
 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 $307.6 million in the first quarter of fiscal 2004,
compared with $288.2 million in the same period of fiscal 2003. Total revenues
increased 6.7% in the first quarter of fiscal 2004, primarily attributable to a
5.9% increase in same store sales and increases in revenues from managed vision
care programs. Cole Vision Segment Cole Vision revenues were $249.9 million in the first quarter of fiscal
2004, compared with $233.5 million in the same period of fiscal 2003, an
increase of 7.0%. The revenue increase of 7.0% was primarily due to increased
revenues at 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. 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 at all brands was
primarily due to more aggressive promotional offers. 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. Although revenues decreased at Pearle Vision Company-owned
stores primarily due to fewer stores, same store sales in the first quarter of
fiscal 2004 increased 1.4% due to modest increases in both the average
transaction size and number of transactions and higher exam fees. Improved
merchandise assortment and selling skills designed to address customer needs at
the store level and an increase in sales from the Pearle Preferred Credit Card
are the primary drivers of the increase in average transaction size. Offsetting
the same store sales increases at Pearle Vision were a lower number of
Company-owned stores. Pearle Vision operated 16 fewer Company-owned stores at
the end of the first quarter of fiscal 2004 than it did at the end of the first
quarter of fiscal 2003, due to the net sale of 9 Company stores to franchisees,
the closure of 11 stores and the opening of 4 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. Things Remembered Segment Things Remembered revenues were $57.7 million in the first quarter of
fiscal 2004, compared with $54.7 million the first quarter of fiscal 2003, a
5.5% increase compared to the same period the previous year due to a same store
sales increase of 6.5% and a 57% increase in direct channel revenues. 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. 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 727
Things Remembered store locations operating as of May 1, 2004, compared to 761
at May 3, 2003. The reduction was primarily due to the Companys decision to
allow the leases at under-performing stores to expire. 15




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##### Table of Contents



Gross Margin Consolidated Operations Gross margin was $193.8 million in the first quarter of fiscal 2004,
compared with $181.7 million in the first quarter of fiscal 2003. Compared to
the same period the previous year, gross margin dollars increased 6.7% in the
first quarter of fiscal 2004, attributable to an increase in net revenues. The
gross margin rate was 63.0% in both the first quarter of fiscal 2004 and the
first quarter of fiscal 2003. Cole Vision Segment Gross margin was $151.8 million in the first quarter of fiscal 2004,
compared to $142.0 million in the first quarter of fiscal 2003, an increase of
gross margin dollars of 6.9% compared to the same period the previous year, due
to increased revenues, partially offset by a decrease in the gross margin rate.
Gross margin, as a percent of net revenues, was 60.7% and 60.8% in the first
quarter of fiscal 2004 and fiscal 2003, respectively, a decrease of 0.1
percentage points. Decreases in the gross margin rate at both Cole Licensed
Brands and Pearle Vision U.S. were partially offset by an increase at Cole
Managed Vision. Cole Licensed Brands gross margin rate decreased and was
impacted by higher costs associated with a shift toward lower gross margin rate
premium product, a lower contact lens gross margin rate and an increase in
discounts and other pricing promotions. The decrease in the contact lens gross
margin rate was primarily due to increased selling of annual supplies to
customers, which is a lower gross margin rate transaction and a shift in
product mix to lower gross margin rate premium product. Pearle Vision gross
margin, as a percent of net revenues, decreased slightly due to an increased
mix of sales of products to franchisees compared to revenues from Company-owned
stores, compared to the prior year. 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. Partially offsetting this gross margin
rate decrease at Pearle Vision was lower manufacturing costs compared to the
prior year. Lower manufacturing costs were achieved through in-store lab cost
reductions and reduced costs of insurance and workers compensation. 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. Things Remembered Segment Gross margin was $42.0 million in the first quarter of fiscal 2004,
compared to $39.7 million in the first quarter of fiscal 2003. Compared to the
same period the previous year, the first quarter of fiscal 2004 had an increase
of 6.0% primarily driven by the same store sales performance and changes in the
gross margin rate. Gross margin, as a percent of net revenues, was 72.8% in the
first quarter of fiscal 2004 and 72.5% in the first quarter of fiscal 2003. The
increase was primarily due to higher revenues from gift personalization. Operating Expenses Consolidated Operations Operating expenses were $187.4 million in the first quarter of fiscal
2004, compared with $183.8 million in the first quarter of fiscal 2003. Of the
increase in the first quarter of fiscal 2004, $7.2 million is attributable to
the operating segments. Unallocated corporate expenses decreased $3.7 million
in the first quarter of fiscal 2004, compared to the same period last year. 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 results of the operations, the following table is provided as a
reconciliation of reported operating expense to operating expense excluding
certain unusual items. 16




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##### Table of Contents



(Dollars in millions)
    
    First Quarter2004
    
    2003
    
    Change Fav/(Unfav)Operating expenses, as reported
    
    $
    187.4
    
    
    $
    183.8
    
    
    $
    (3.6
    )Unusual items:Legal & professional fees for
restatement & SEC investigation
    
    
    0.3
    
    
    
    1.7Shareholder litigation settlement
    
    
    
    
    
    
    2.7Audit fees for restatement
    
    
    
    
    
    
    1.7Legal fees for California litigation
    
    
    0.9
    
    
    
    0.8Target Optical store closure costs
    
    
    2.1
    
    
    
    Total unusual items
    
    
    3.3
    
    
    
    6.9Operating expenses, excluding unusual items
    
    $
    184.1
    
    
    $
    177.0
    
    
    $
    (7.1
    )Operating expenses, excluding unusual items,
as a percent of total net revenues
    
    
    59.8
    %
    
    
    61.4
    %Operating expenses, as reported, as a percent
of total net revenues
    
    
    60.9
    %
    
    
    63.8
    %
 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 Group S.p.A. entered into a definitive merger
agreement on January 23, 2004. with the unanimous approval of the Boards of
Directors of both companies. In April, 2004, Moulin International Holdings
Limited submitted an unsolicited non-binding offer to acquire the Company in a
merger. Subsequently, Moulin informed the Company that one of Moulins
financing sources was not prepared to provide senior debt financing on the
terms originally proposed. (See Note 9 of the Notes to 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 are recorded at the Parent. In the first quarter of fiscal 2004, the Company incurred charges of $0.3
million for legal and professional fees related to the SEC investigation
regarding the reaudit and restatement of its financial statements, compared to
$1.7 million of legal and professional fees regarding the reaudit and
restatement of its financial statements for the same period last year.
Settlement costs related to the class action shareholder lawsuit alleging
various violations of federal securities laws related to the Companys publicly
reported revenues and earnings totaled $2.7 million in the first quarter of fiscal 2003.
Audit fees attributable to the restatement and reaudit were $1.7 million in the
first quarter of fiscal 2003. 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 $0.9 million in the first quarter of fiscal 2004 and $0.8 million in
the first quarter of fiscal 2003. As a result of the Companys new agreement with Target Corporation, the
Company closed 25 underperforming Target Optical stores on April 10, 2004.
Costs relating to the closure of these stores were $2.1 million in the first
quarter of fiscal 2004. Unallocated Corporate Expenses Unallocated corporate expenses were $5.2 million in the first quarter of
fiscal 2004, compared to $8.9 million for the first quarter of fiscal 2003.
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 is recorded in the Cole Vision segment. The unusual items
included in unallocated corporate expense totaled $0.3 million and $6.1 million
in the first quarter of fiscal 2004 and fiscal 2003, respectively. Compared to the same period the previous year, unallocated corporate
expenses in the first quarter of fiscal 2004 included incremental compensation
expense of $0.9 million for variable stock options having a feature permitting
the use of vested options in payment of the exercise price. The Company
incurred incremental management bonus expense of $0.5 million and incremental
audit 17




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##### Table of Contents



costs and higher expenses totaling $0.5 million to comply with Section
404 of the Sarbanes-Oxley Act of 2002. Partially offsetting these expense
increases were lower professional costs of $0.5 million. Cole Vision Segment Operating expenses were $139.1 million in the first quarter of fiscal
2004, compared to $132.7 million for the first quarter of fiscal 2003. Compared
to the same period the previous year, operating expenses in the first quarter
of fiscal 2004 increased by 4.8%. However, operating expenses as a percent of
net revenues decreased at Cole Vision by 1.1 percentage points in the first
quarter of fiscal 2004, compared to the prior year. Included in operating
expenses is the unusual item of California litigation charges described above
which totaled $0.9 million and $0.8 million in the first quarter of fiscal 2004
and fiscal 2003, respectively and the $2.1 million charge for the closure of 25
Target Optical locations in the first quarter of fiscal 2004. In the first quarter of fiscal 2004 compared to the same period last year,
store payroll and rent and occupancy costs were $1.9 million and $0.6 million
higher, respectively, to support the increase in net revenues. Store payroll
and rent and occupancy costs, as a percent of net revenues, were lower in the
first quarter of fiscal 2004, compared to the same period last year.
Management bonus expense was $0.7 million higher in the first quarter of fiscal
2004, compared to the same period last year. Claims processing costs were $1.0
million higher in the first 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. Things Remembered Segment Operating expenses were $43.1 million in the first quarter of fiscal 2004,
compared to $42.3 million for the same period last year. Compared to the same
period the previous year, operating expenses in the first quarter of fiscal
2004 increased by 2.0%. However, operating expenses as a percent of net
revenues decreased 2.6 percentage points in the first quarter of fiscal 2004,
compared to the same period last year. Management bonus expense was $0.5 million higher in the first quarter of
fiscal 2004, compared to the same period last year. Store advertising and
expenses to support direct channel were $0.5 million higher than last year in
support of higher net revenues. Nonstore field expenses, including recruiting,
travel and meetings, were $0.2 million higher than the same period last year.
Things Remembered recorded lower store payroll costs in the first quarter of
fiscal 2004, compared to the same period last year due to fewer stores
operating and lower workers compensation costs. Store payroll costs, as a
percent of net revenues, were lower in the first quarter of fiscal 2004,
compared to the same period last year, due to improvements in productivity. Operating Income (Loss) Consolidated Operations Operating income was $6.4 million in the first quarter of fiscal 2004
compared to a $2.2 million loss in the first quarter of fiscal 2003. The
improvement was due to higher operating income at Cole Vision, a lower
operating loss at Things Remembered and lower unallocated corporate expenses,
compared to the same period last year. Cole Vision Segment Operating income at Cole Vision was $12.7 million in the first quarter of
fiscal 2004, compared to $9.3 million in the first quarter of fiscal 2003. The
increase in operating income at Cole Vision in the first quarter of fiscal 2004
compared to the first quarter of fiscal 2003 was due to higher net revenues at
Cole Licensed Brands and revenue increases from managed vision care programs as
well as improvements in operating expenses as a percent of net revenues. These
improvements were partially offset by costs related to store closure at Target
Optical, higher claims processing costs and higher management bonus expenses. Things Remembered Segment Operating loss at Things Remembered was $1.1 million in the first quarter
of fiscal 2004, compared to $2.6 million in the first quarter of fiscal 2003.
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. 18




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##### Table of Contents



Interest and Other (Income) Expense Interest and other (income) expense, net, was $6.1 million in the first
quarter of fiscal 2004, compared to $6.1 million in the first quarter of fiscal
2003. The Company recorded interest expense of $6.2 million and $6.3 million in
the first quarter of fiscal 2004 and fiscal 2003, respectively. Interest and
other (income), net was ($0.1) million and ($0.2) million in the first quarter
of fiscal 2004 and fiscal 2003, respectively. Interest income, primarily from
temporary investments and franchise interest income, totaled $0.3 million in
the first quarter of fiscal 2004 and fiscal 2003. Income Tax Rate The effective income tax rate was 47% in the first quarter of fiscal 2004
compared to 20.0%, in the first quarter of fiscal 2003. The higher effective
tax rate in the first quarter of fiscal 2004, compared to the first quarter of
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: First Quarter2004(Dollars in thousands)Current year same store sales
    
    $
    266,533Prior year same store sales
    
    
    251,695Percent change
    
    
    5.9
    %Current year same store sales
    
    $
    266,533Adjustment for:Sales at new and closed stores
    
    
    2,638Deferred revenue
    
    
    (1,679
    )Order vs. customer receipt
    
    
    (1,788
    )Returns, remakes and refunds
    
    
    (519
    )Other
    
    
    39Store sales
    
    
    265,224Nonstore revenues
    
    
    51,677Intercompany eliminations
    
    
    (9,249
    )GAAP Basis Net revenue
    
    $
    307,652
 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 first quarter of fiscal 2004, the total commitment was $60.0 million and
availability under the credit facility totaled $45.9 million after reduction
for $14.1 million under letters of credit. There were no working capital
borrowings outstanding at any time during the first three months of fiscal 2004
or fiscal 2003. 19




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##### Table of Contents



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. The Company
is currently in compliance with the covenants in the credit agreement. 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 May 1, 2004, the Company has $1.4 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 agreement, 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 $65.3 million at May 1, 2004 compared to
$29.5 million at May 3, 2003. Operations generated net cash of $4.0 million in
the first quarter of fiscal 2004 and used $6.6 million in the first quarter of
fiscal 2003. The Company incurred a net income in the first quarter of fiscal
2004 and a net loss in the fiscal 2003 which is described above in the Results
of Operations section of this report. Depreciation and amortization was $9.7 million and
$9.3 million in the first quarter of fiscal 2004 and fiscal 2003, respectively.
The increase in the first quarter of fiscal 2004, compared to the first quarter
of fiscal 2003, was primarily due to higher systems amortization. Noncash charges related to store closing
and impairment losses were $1.0 million and $0 in the first quarter of fiscal
2004 and 2003, respectively. The increase was related to 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 $0.1
million and ($2.8) million in the first quarter of fiscal 2004 and fiscal 2003,
respectively. The change was primarily due to the tax provision (benefit)
generated from the Companys operating results. Noncash compensation was $0.9
million and ($0.1) million in the first quarter of fiscal 2004 and fiscal 2003,
respectively. The increase was primarily due to compensation expense for
variable stock options. Changes in working capital resulted in a use of funds totaling $8.1
million in the first quarter of fiscal 2004, compared to $6.7 million in
the first quarter of fiscal 2003. Changes in accounts and notes receivable
resulted in a source of funds totaling $0.6 million in the first quarter of
fiscal 2004 and a use of funds totaling $3.7 million in the same period last
year. The change in the first quarter of fiscal 2004 was primarily due to
receipt of insurance reimbursements related to the restatement of the Companys
financial statements offset by revenue increases at Cole Managed Vision and
Cole Licensed Brands .The change in the first quarter of fiscal 2003 was due to
increased revenues at both Cole Licensed Brands and Cole Managed Vision.
Inventories used $3.3 million and $13.1 million in the first quarter of fiscal
2004 and fiscal 2003, respectively. The increase in the first quarter of
fiscal 2004 was primarily due to higher inventory at both Things Remembered and
Cole Licensed Brands due to an increase in premium product. The increase in the
first quarter of fiscal 2003 was due to earlier new product introduction 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 use of funds totaling $5.7 million and a source of funds totaling
$8.5 million in the first quarter of fiscal 2004 and fiscal 2003, respectively.
The change in 2004 was primarily due to the timing of purchases and the change
in 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. 20




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##### Table of Contents



Cash Flows from Investing Activities Net cash from investing activities resulted in a use of funds of $5.5
million in the first quarter of fiscal 2004, compared to $9.8 million in the
first quarter of fiscal 2003. Capital expenditures, which accounted for most of
the cash used for investing activities, were $5.1 million and $7.5 million in the first
quarter 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 $0.3 million and $2.2 million for systems development costs in
the first quarter of fiscal 2004 and fiscal 2003, respectively. Systems
development in the first quarter of fiscal 2003 was primarily for the Companys
Patriot Claims System. Cash Flows from Financing Activities Net cash provided by financing activities totaled $7.6 million in the
first quarter of fiscal 2004 compared to $3.9 million in the first quarter of
fiscal 2003. Changes in overdraft balances provided $16.3 million in the first
quarter of fiscal 2004 compared to $2.1 million in the first quarter 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 May 1, 2004. The maximum exposure under the agreement is
$47,000 as of May 1, 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. 21




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##### Table of Contents



Certain Operating and Expense Trends As discussed in this report, same store sales in the Companys vision
segment experienced increases in the first quarter of 2004 ranging from strong
double-digit increases at Target Optical and BJs Optical to low single digit
increases at Pearle Vision. Same store sales increases were generally stronger
in February and March than in April, when the Companys vision segment
experienced a weakening of same store sales. This trend continued in May, the
first month of the second quarter of 2004, when same store sales in the
Companys vision segment experienced declines in the mid single digits. Things
Remembered experienced same store sales increases in May in the low single
digits. There can be no assurance that these same store sales trends will
continue for the remainder of the second 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 stockholder litigation and
restatement audit fees are not expected to recur. Although there can be no
assurances as to the improvement in same store sales trends, 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, risks that stockholder approval may not be obtained for the
Luxottica merger, legislative or regulatory developments that could have the
effect of delaying or preventing the Luxottica merger, uncertainties as to
whether any transaction will be entered into with Moulin or, if entered into,
will be consummated, 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 first quarter of fiscal 2004, the
market rate for six month LIBOR was 1.38%, which resulted in a rate of 5.9175%
applied from February 15, 2004 through May 1, 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 69 basis points) in the market rates of interest for six month
LIBOR as compared to the 5.9175% rate in effect for the first quarter of fiscal
2004 would increase the Companys annual interest cost by $0.3 million. 22




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The Company does not enter into financial instruments for trading
purposes. 
 Item 4. Controls and Procedures (a) 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 May 1, 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. (b) Based on evaluation, there have not been any changes in the Companys
internal control over financial reporting or in other factors during the
quarter ended May 1, 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. 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. 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. 23




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The Company 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 is expected to be appealed by
the Lemelson Partnership, and the Arizona infringement litigation against the
Company will remain stayed pending the final resolution of any such appeal;
however, this trial court decision favors the Company and its defenses. The
Company believes it has available defenses and does not expect any liability.
However, if the Company 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. 
 Item 6. Exhibits and Reports on Form 8-K (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. (b) Reports on Form 8-K. The Company filed a Form 8-K (Item 5 and 7) on May 13, 2004 announcing
that Moulin International Holdings Limited had informed the Company that
one of its financing sources was not prepared to provide senior debt
financing on the terms originally proposed which were contemplated in
Moulins acquisition proposal. The Company filed a Form 8-K (Item 5 and 7) on April 20, 2004
announcing the Boards decision to authorize discussions with Moulin
International Holdings Limited. The Company filed a Form 8-K (Item 7 and 12) on April 19, 2004
announcing that the Company had received an unsolicited acquisition
proposal and postponing the Special Meeting of Stockholders to consider and
vote on the Luxottica merger. The Company filed a Form 8-K (Item 7 and 12) on April 13, 2004
announcing financial results for the fourth fiscal quarter 2003 and for
fiscal year 2003. The Company filed a report on Form 8-K (Items 5 and 7) on March 30,
2004 announcing that the Federal Trade Commission had requested additional
information related to the Luxottica merger. The Company filed a report on Form 8-K (Items 5 and 7) on March 10,
2004 announcing that it had extended the Target Optical contract. The Company filed a report on Form 8-K (Items 5 and 7) on March 2,
2004 announcing that it had scheduled a Special Meeting of Stockholders to
consider and vote on the Luxottica merger. 24




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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: June 7, 2004 25




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COLE NATIONAL GROUP, INC.
FORM 10-Q
QUARTER ENDED MAY 1, 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.
   
    
    Filed herewith. 26