TABLE OF CONTENTS

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549





FORM 10-Q



x
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR
    SECTION 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JULY
    1, 2006.ORo
    TRANSITION REPORT PURSUANT TO SECTION 13 OR
    SECTION 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM
    __________ TO __________.








Commission file number 0-21577





WILD OATS MARKETS, INC.

(Exact name of registrant as specified in its charter)



Delaware
    84-1100630(State or other
    jurisdiction of
    (I.R.S. Employer
    Identification Number)Incorporation or
    organization)












3375 Mitchell Lane

Boulder, Colorado 80301

(Address of principal executive offices, including zip code)







(303) 440-5220

(Registrants telephone number, including area code)







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 a large accelerated
filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the
Exchange Act).

Large Accelerated Filer( )         Accelerated
Filer( X )Non-Accelerated Filer( )

Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12-b of the Exchange Act).

Yes( )No( X )



As of July 28, 2006, there were 29,462,616 shares outstanding of the registrant's
common stock (par value $0.001 per share).





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> TABLE OF CONTENTS

|PART I.                |  | FINANCIAL
    INFORMATION                                                                                                                    | Page
|---------------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------- | ----
|                       |  |                                                                                                                                              |     
|Item 1.                |  | Financial Statements:                                                                                                                        |     
|                       |  |                                                                                                                                              |     
|                       |  | Consolidated Balance Sheets, July
        1, 2006 (unaudited) and December 31, 2005                                                          | 3   
|                       |  |                                                                                                                                              |     
|                       |  | Consolidated Statements
        of Operations (unaudited), Three and Six Months Ended July 1, 2006 and July 2, 2005                          | 4   
|                       |  |                                                                                                                                              |     
|                       |  | Consolidated
        Statements of Comprehensive Income (Loss) (unaudited), Three and Six Months Ended July 1,
        2006 and July 2, 2005 | 5   
|                       |  |                                                                                                                                              |     
|                       |  | Consolidated Statements
        of Cash Flows (unaudited), Six Months Ended July 1, 2006 and July 2, 2005                                    | 6   
|                       |  |                                                                                                                                              |     
|                       |  | Notes to
        Consolidated Financial Statements (unaudited)                                                                               | 7   
|                       |  |                                                                                                                                              |     
|Item 2.                |  | Managements Discussion and Analysis of Financial Condition and Results of
      Operations                                                  | 19  
|                       |  |                                                                                                                                              |     
|Item 3.                |  | Quantitative
      and Qualitative Disclosures About Market Risk                                                                             | 31  
|                       |  |                                                                                                                                              |     
|Item 4.                |  | Controls and Procedures                                                                                                                      | 31  
|                       |  |                                                                                                                                              |     
|PART II.               |  | OTHER INFORMATION                                                                                                                            |     
|                       |  |                                                                                                                                              |     
|Item 1.                |  | Legal Proceedings                                                                                                                            | 32  
|                       |  |                                                                                                                                              |     
|Item 1A.               |  | Risk Factors                                                                                                                                 | 32  
|                       |  |                                                                                                                                              |     
|Item 2.                |  | Unregistered
      Sales of Equity Securities and Use of Proceeds                                                                            | 32  
|                       |  |                                                                                                                                              |     
|Item 3.                |  | Defaults
      Upon Senior Securities                                                                                                        | 32  
|                       |  |                                                                                                                                              |     
|Item 4.                |  | Submission
      of Matters to a Vote of Security Holders                                                                                    | 33  
|                       |  |                                                                                                                                              |     
|Item 5.                |  | Other Information                                                                                                                            | 33  
|                       |  |                                                                                                                                              |     
|Item 6.                |  | Exhibits                                                                                                                                     | 33  
|                       |  |                                                                                                                                              |     
|SIGNATURE AND EXHIBITS | 
|                       |  |                                                                                                                                              |     
|                       |  | Signatures                                                                                                                                   | 34  
|                       |  |                                                                                                                                              |     



---

PART I.  FINANCIAL INFORMATION





Item 1.  Financial Statements



WILD OATS MARKETS, INC.

Consolidated Balance Sheets

(in thousands, except share data)

|                                         |                                                              |                                                                                                                                                                               |                            |          | July 1, 2006 |          | December 31, 2005
|---------------------------------------- | ------------------------------------------------------------ | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------- | -------- | ------------ | -------- | -----------------
|                                         |                                                              |                                                                                                                                                                               |                            |          |              |          |                  
|                                         |                                                              |                                                                                                                                                                               |                            |          | (unaudited)  |          |                  
|ASSETS                                   |                                                              |                                                                                                                                                                               |                            |         
|                                         |                                                              |                                                                                                                                                                               |                            |         
|                                         | Current assets:                                              |                                                                                                                                                                               |                            |          |             
|                                         |                                                              | Cash and cash equivalents                                                                                                                                                     |                            | $ 39,620 |              | $ 35,250
|                                         |                                                              | Short-term investments                                                                                                                                                        |                            | 27,100   |              | 14,522  
|                                         |                                                              | Inventories (net of reserves of
    $1,050 and $960, respectively)                                                                                                            |                            | 69,111   |              | 63,056  
|                                         |                                                              | Accounts receivable (net of
    allowance for doubtful accounts of $145 and $190, respectively)                                                                               |                            | 5,028    |              | 4,006   
|                                         |                                                              | Prepaid expenses and other current
    assets                                                                                                                                 |                            | 6,425    |              | 5,962   
|                                         |                                                              |                                                                                                                                                                               |                            |          |              |          |                  
|                                         |                                                              |                                                                                                                                                                               | Total current assets       |          | 147,284      |          | 122,796          
|                                         |                                                              |                                                                                                                                                                               |                            |          |              |          |                  
|                                         | Property and equipment, net                                  |                                                                                                                                                                               | 180,958                    |          | 178,867     
|                                         | Goodwill, net                                                |                                                                                                                                                                               | 105,124                    |          | 105,124     
|                                         | Other intangible assets, net                                 |                                                                                                                                                                               | 5,925                      |          | 6,122       
|                                         | Deposits and other assets                                    |                                                                                                                                                                               | 5,621                      |          | 5,897       
|                                         | Deferred tax asset, net                                      |                                                                                                                                                                               | 67                         |          | 64          
|                                         |                                                              |                                                                                                                                                                               |                            |          |              |          |                  
|                                         |                                                              |                                                                                                                                                                               |                            |          | $ 444,979    |          | $ 418,870        
|                                         |                                                              |                                                                                                                                                                               |                            |          |              |          |                  
|LIABILITIES AND
    STOCKHOLDERS EQUITY |                                                              |                                                                                                                                                                               |                            |         
|                                         |                                                              |                                                                                                                                                                               |                            |         
|                                         | Current liabilities:                                         |                                                                                                                                                                               |                            |          |             
|                                         |                                                              | Accounts payable                                                                                                                                                              |                            | $ 59,693 |              | $ 56,078
|                                         |                                                              | Book overdraft                                                                                                                                                                |                            | 25,208   |              | 23,351  
|                                         |                                                              | Accrued liabilities                                                                                                                                                           |                            | 53,697   |              | 53,354  
|                                         |                                                              | Current portion of debt, capital
    leases and financing obligations                                                                                                         |                            | 599      |              | 614     
|                                         |                                                              |                                                                                                                                                                               |                            |          |              |          |                  
|                                         |                                                              |                                                                                                                                                                               | Total current liabilities  |          | 139,197      |          | 133,397          
|                                         |                                                              |                                                                                                                                                                               |                            |          |              |          |                  
|                                         | Long-term debt, capital leases and
    financing obligations |                                                                                                                                                                               | 147,935                    |          | 148,181     
|                                         | Other long-term obligations                                  |                                                                                                                                                                               | 29,835                     |          | 27,750      
|                                         |                                                              |                                                                                                                                                                               |                            |          |              |          |                  
|                                         |                                                              |                                                                                                                                                                               | 316,967                    |          | 309,328     
|                                         |                                                              |                                                                                                                                                                               |                            |          |              |          |                  
|                                         | Commitments and contingencies                                |                                                                                                                                                                               |                            |          |             
|                                         |                                                              |                                                                                                                                                                               |                            |          |              |          |                  
|                                         | Stockholders equity:                                        |                                                                                                                                                                               |                            |          |             
|                                         |                                                              | Preferred stock, $0.001 par value;
    5,000,000 shares authorized, no shares issued and outstanding                                                                          |                            | -        |              | -       
|                                         |                                                              | Common stock, $0.001 par value;
    60,000,000 shares authorized, 32,098,165 and 31,036,834 shares issued; and 29,443,918 and
    29,059,034 shares outstanding, respectively |                            | 32       |              | 31      
|                                         |                                                              | Treasury stock, at cost: 2,659,263
    and 1,977,800 shares as of July 1, 2006 and December 31, 2005                                                                          |                            | (37,181) |              | (24,999)
|                                         |                                                              | Additional paid-in capital                                                                                                                                                    |                            | 237,012  |              | 226,645 
|                                         |                                                              | Note receivable, related party                                                                                                                                                |                            | -        |              | (12,051)
|                                         |                                                              | Accumulated deficit                                                                                                                                                           |                            | (73,569) |              | (81,324)
|                                         |                                                              | Accumulated other comprehensive
    income                                                                                                                                    |                            | 1,718    |              | 1,240   
|                                         |                                                              |                                                                                                                                                                               |                            |          |              |          |                  
|                                         |                                                              |                                                                                                                                                                               | Total stockholders equity |          | 128,012      |          | 109,542          
|                                         |                                                              |                                                                                                                                                                               |                            |          |              |          |                  
|                                         |                                                              |                                                                                                                                                                               |                            |          | $ 444,979    |          | $ 418,870        
|                                         |                                                              |                                                                                                                                                                               |                            |          |              |          |                  
|                                         |                                                              |                                                                                                                                                                               |                            |          |              |          |                  





The accompanying notes are an integral part of these consolidated financial statements.





---

WILD OATS MARKETS, INC.

Consolidated Statements
of Operations

(in thousands, except per share amounts) (unaudited)

|                                                                     |                                                        | THREE MONTHS 
    ENDED    |         | SIX MONTHS
    
    ENDED
|-------------------------------------------------------------------- | ------------------------------------------------------ | -------------------------- | ------- | -------------------------
|                                                                     |                                                        |                            |         |                          
|                                                                     |                                                        | July 1,                    |         | July 2,                  
|                                                                     |                                                        | 2006                       |         | 2005                     
|                                                                     |                                                        |                            |         |                          
|                                                                     |                                                        |                            |         |                          
|Sales                                                                |                                                        | $ 296,561                  |         | $ 284,608                
|Cost of goods sold and occupancy
    costs                           |                                                        | 206,876                    |         | 202,049                  
|                                                                     |                                                        |                            |         |                          
|Gross profit                                                         |                                                        | 89,685                     |         | 82,559                   
|Operating expenses:                                                  |                                                        |                            |         |                          
|                                                                     | Direct store expenses                                  |                            | 69,939  |                          
|                                                                     | Selling, general and
    administrative    expenses    |                            | 12,328  |                          
|                                                                     | Loss on disposal of assets                             |                            | 77      |                          
|                                                                     | Pre-opening expenses                                   |                            | 792     |                          
|                                                                     | Restructuring and asset impairment
       charges, net |                            | 295     |                          
|                                                                     |                                                        |                            |         |                          
|                                                                     |                                                        | Income from operations     |         | 6,254                    
|                                                                     |                                                        |                            |         |                          
|                                                                     | Loss on early extinguishment of
    debt               |                            | -       |                          
|                                                                     | Interest income                                        |                            | 699     |                          
|                                                                     | Interest expense                                       |                            | (1,836) |                          
|                                                                     |                                                        |                            |         |                          
|                                                                     |                                                        | Income before income taxes |         | 5,117                    
|                                                                     | Income tax expense                                     |                            | 247     |                          
|                                                                     |                                                        |                            |         |                          
|Net income (loss)                                                    |                                                        | $ 4,870                    |         | $ 922                    
|                                                                     |                                                        |                            |         |                          
|                                                                     |                                                        |                            |         |                          
|Net earnings (loss) per common
    share:                            |                                                        |                            |         |                          
|                                                                     | Basic                                                  |                            | $0.17   |                          
|                                                                     | Diluted                                                |                            | $0.16   |                          
|                                                                     |                                                        |                            |         |                          
|Weighted-average common shares
       outstanding, basic             |                                                        | 29,236                     |         | 28,667                   
|Dilutive effect of stock options
    and    restricted stock units   |                                                        | 730                        |         | 518                      
|                                                                     |                                                        |                            |         |                          
|                                                                     |                                                        |                            |         |                          
|Weighted-average common shares
       outstanding, assuming dilution |                                                        | 29,966                     |         | 29,185                   
|                                                                     |                                                        |                            |         |                          
|                                                                     |                                                        |                            |         |                          



The accompanying notes are an integral part of these consolidated financial statements.



---









WILD OATS MARKETS, INC.

Consolidated
Statements of Comprehensive Income (Loss)

(in thousands) (unaudited)



|                                   |                                                                |         |     |       | THREE MONTHS
    ENDED |         | SIX MONTHS
    ENDED
|---------------------------------- | -------------------------------------------------------------- | ------- | --- | ----- | ---------------------- | ------- | --------------------
|                                   |                                                                |         |     |       |                        |         |                     
|                                   |                                                                |         |     |       | July 1,                |         | July 2,             
|                                   |                                                                |         |     |       | 2006                   |         | 2005                
|                                   |                                                                |         |     |       |                        |         |                     
|                                   |                                                                |         |     |       |                        |         |                     
|Net income (loss)                  |                                                                | $ 4,870 |     | $ 922 |                        | $ 7,755 |                     
|Other comprehensive income (loss): |                                                                |         |     |       |                        |         |                     
|                                   | Foreign currency translation
    adjustments                   |         | 526 |       | (198)                  |         | 481                 
|                                   | Unrealized gain (loss) on
    available-for-sale    securities |         | -   |       | 2                      |         | (3)                 
|                                   |                                                                |         |     |       |                        |         |                     
|Other comprehensive income (loss)  |                                                                | 526     |     | (196) |                        | 478     |                     
|                                   |                                                                |         |     |       |                        |         |                     
|                                   |                                                                |         |     |       |                        |         |                     
|Comprehensive income (loss)        |                                                                | $ 5,396 |     | $ 726 |                        | $ 8,233 |                     
|                                   |                                                                |         |     |       |                        |         |                     
|                                   |                                                                |         |     |       |                        |         |                     



The accompanying notes are an integral part of these consolidated financial statements.



---

WILD OATS MARKETS, INC.

Consolidated Statements
of Cash Flows

(in thousands) (unaudited)

|                                                                           |                                                                                              |                                                     |                                                         |          | SIX MONTHS
    ENDED
|-------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------- | --------------------------------------------------- | ------------------------------------------------------- | -------- | --------------------
|                                                                           |                                                                                              |                                                     |                                                         |          |                     
|                                                                           |                                                                                              |                                                     |                                                         |          | July 1, 2006        
|                                                                           |                                                                                              |                                                     |                                                         |          |                     
|CASH FLOWS FROM OPERATING
    ACTIVITIES:                                  |                                                                                              |                                                     |                                                         |         
|                                                                           | Net income (loss)                                                                            |                                                     | $ 7,755                                                 |          | $ (229)             
|                                                                           | Adjustments to reconcile net
    income (loss) to net cash provided by operating activities: |                                                     |                                                         |          |                     
|                                                                           |                                                                                              | Depreciation and amortization                       |                                                         | 13,057   |                     
|                                                                           |                                                                                              | Loss on disposal of property and
    equipment      |                                                         | 187      |                     
|                                                                           |                                                                                              | Deferred tax expense                                |                                                         | -        |                     
|                                                                           |                                                                                              | Restructuring and asset impairment
    expense, net |                                                         | 1,965    |                     
|                                                                           |                                                                                              | Interest on related party
    receivable            |                                                         | (88)     |                     
|                                                                           |                                                                                              | Stock-based compensation                            |                                                         | 1,289    |                     
|                                                                           |                                                                                              | Accretion of debt issuance costs                    |                                                         | 312      |                     
|                                                                           |                                                                                              | Loss on early extinguishment of
    debt            |                                                         | -        |                     
|                                                                           | Change in assets and liabilities:                                                            |                                                     |                                                         |          |                     
|                                                                           |                                                                                              | Inventories, net                                    |                                                         | (5,992)  |                     
|                                                                           |                                                                                              | Receivables, net, and other assets                  |                                                         | (1,513)  |                     
|                                                                           |                                                                                              | Accounts payable                                    |                                                         | 3,562    |                     
|                                                                           |                                                                                              | Accrued liabilities and other
    liabilities       |                                                         | 496      |                     
|                                                                           |                                                                                              |                                                     |                                                         |          |                     
|                                                                           |                                                                                              |                                                     | Net cash provided by operating
    activities           |          | 21,030              
|                                                                           |                                                                                              |                                                     |                                                         |          |                     
|                                                                           |                                                                                              |                                                     |                                                         |          |                     
|CASH FLOWS FROM INVESTING
    ACTIVITIES:                                  |                                                                                              |                                                     |                                                         |         
|                                                                           | Capital expenditures                                                                         |                                                     | (15,059)                                                |          | (11,978)            
|                                                                           | Purchase of short-term investments                                                           |                                                     | (71,830)                                                |          | -                   
|                                                                           | Proceeds from sale of short-term
    investments                                             |                                                     | 59,249                                                  |          | 11,116              
|                                                                           | Proceeds from sale of property and
    equipment                                             |                                                     | 16                                                      |          | 26                  
|                                                                           |                                                                                              |                                                     | Net cash used in investing
    activities               |          | (27,624)            
|                                                                           |                                                                                              |                                                     |                                                         |          |                     
|CASH FLOWS FROM FINANCING
    ACTIVITIES:                                  |                                                                                              |                                                     |                                                         |         
|                                                                           | Net increase (decrease) in book
    overdraft                                                |                                                     | 1,857                                                   |          | (2,351)             
|                                                                           | Repayments on notes payable,
    long-term debt and capital leases                           |                                                     | (261)                                                   |          | (183)               
|                                                                           | Proceeds from issuance of common
    stock, net                                              |                                                     | 9,079                                                   |          | 1,548               
|                                                                           | Purchase of treasury stock                                                                   |                                                     | (43)                                                    |          | -                   
|                                                                           |                                                                                              |                                                     |                                                         |          |                     
|                                                                           |                                                                                              |                                                     | Net cash provided by (used in)
    financing activities |          | 10,632              
|                                                                           |                                                                                              |                                                     |                                                         |          |                     
|                                                                           |                                                                                              |                                                     |                                                         |          |                     
|Effect of exchange rate changes
    on cash                                |                                                                                              | 332                                                 |                                                         | (168)   
|                                                                           |                                                                                              |                                                     |                                                         |          |                     
|Net increase in cash and cash
    equivalents                              |                                                                                              | 4,370                                               |                                                         | 12,747  
|Cash and cash equivalents at
    beginning of period                       |                                                                                              | 35,250                                              |                                                         | 30,671  
|                                                                           |                                                                                              |                                                     |                                                         |          |                     
|Cash and cash equivalents at
    end of period                             |                                                                                              | $ 39,620                                            |                                                         | $ 43,418
|                                                                           |                                                                                              |                                                     |                                                         |          |                     
|                                                                           |                                                                                              |                                                     |                                                         |          |                     
|SUPPLEMENTAL DISCLOSURE OF NONCASH
    INVESTING AND FINANCING ACTIVITIES:
|                                                                           | Equipment acquired through capital
    lease                                                 |                                                     | $
             -                                        |          | $
          262     
|                                                                           |                                                                                              |                                                     |                                                         |          |                     
|                                                                           |                                                                                              |                                                     |                                                         |          |                     





The accompanying notes are an integral part of these consolidated
financial statements.



---

WILD OATS MARKETS, INC.

Notes to
Consolidated Financial Statements

(unaudited)



|1. | Basis of Presentation
    and Summary of Significant Accounting Policies
|-- | ------------------------------------------------------------------------



The accompanying unaudited consolidated financial statements have been
prepared by the Company in accordance with United States generally accepted accounting
principles for interim financial information and pursuant to instructions to Form 10-Q and
Article 10 of Regulation S-X. Certain information and footnote disclosures normally
included in consolidated financial statements prepared in accordance with United States
generally accepted accounting principles have been condensed or omitted pursuant to
Securities and Exchange Commissions ("SEC") rules and regulations. In the
opinion of the Company, all adjustments necessary to present fairly the financial position
at July 1, 2006 and results of operations and cash flows for all periods presented have
been made. The consolidated balance sheet at December 31, 2005 has been derived from the
audited financial statements at that date.



These consolidated financial statements should be read in conjunction
with the Companys audited financial statements and notes thereto included in the
Company's 2005 Annual Report on Form 10-K as filed with the SEC. The preparation of
financial statements requires management to make estimates and assumptions that affect the
reported amounts of assets, liabilities, revenue, expenses and related disclosures of
contingent assets and liabilities. Examples include accounting for self-insurance
reserves, stock-based compensation, restructuring charges and store closing costs, asset
impairment charges, goodwill, inventory valuation, and contingencies. Actual results may
differ from these estimates. The results of operations for the three and six months ended
July 1, 2006 are not necessarily indicative of the operating results to be expected for
any subsequent quarter or for the entire fiscal year ending December 30, 2006.



The unaudited information included in the consolidated financial
statements for the three and six months ended July 1, 2006 and July 2, 2005 includes the
results of operations of the Company for the 13 and 26 weeks then ended.



Principles of consolidation. The Companys consolidated
financial statements include the amounts of the Company and its wholly-owned subsidiaries.
All significant intercompany accounts and transactions have been eliminated.



Inventories. Store inventories are valued principally at the lower
of cost or market, with cost primarily determined under the retail method on a first in
first out ("FIFO") basis. FIFO cost is determined using the retail inventory
method for approximately 80% of inventories and using the item cost method for highly
perishable products representing approximately 20% of inventories. Under the retail
inventory method, the valuation of inventories at cost and the resulting gross margins are
determined by applying a cost-to-retail ratio for various categories of similar items to
the retail value of inventories. Inherent in the retail inventory method calculations are
certain management judgments and estimates, including shrinkage, which could impact the
ending inventory valuation at cost as well as the resulting gross margins. Certain other
highly perishable inventories are valued primarily at the lower of cost or market on a
specific item basis, with cost determined on a FIFO basis.



Reclassifications. Certain prior period information has been
reclassified to conform to the current year presentation. This includes a reclassification
of the Companys 2005 results of operations to more accurately reflect Selling,
General and Administrative expenses and Direct Store expenses. For the three and six
months ended July 2, 2005, approximately $5.8 million and $10.8 million, respectively, was
reclassified from Selling, General and Administrative expenses to Direct Store expenses in
order to reflect regional store support services more appropriately.





|2. | Short-Term Investments
|-- | ----------------------



The amortized cost of debt securities in this category is adjusted for
amortization of premiums and accretion of discounts to maturity computed under the
effective interest method. Such amortization and accretion is included in interest income.
Realized gains and losses and declines in value judged to be other than temporary on
available-for-sale securities are included in interest income. The cost of securities sold
is based on the specific identification method. Realized income and dividends on
securities classified as available-for-sale are included in interest income. Investments
classified as available-for-sale are marked to market each reporting period with the
unrealized gain or loss reflected as a component of other comprehensive income (loss).





|3. | Stock-Based Compensation
|-- | ------------------------



Effective January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards
("SFAS") No. 123 (revised 2004), Share-Based Payment ("SFAS No.
123R") and related interpretations, using the Black-Scholes valuation model and
the modified prospective application. Accordingly, the financial statements for periods
prior to January 1, 2006, will not include compensation cost calculated under the fair
value method of SFAS No. 123R. SFAS No. 123R requires companies to recognize the cost of
employee services received in exchange for awards of equity instruments based upon the
grant-date fair value of those awards.



Stock-based compensation expense recognized under SFAS No. 123R in the
Consolidated Statement of Operations for the three and six months ended July 1, 2006 was
$511,000 and $1.3 million, respectively. The stock-based compensation expense for the
three and six months ended July 1, 2006 included $97,000 and $200,000, respectively,
related to restricted stock units ("RSUs") that were issued as Board of
Directors compensation that would have been included in the Companys
Consolidated Statements of Operations under the provisions of Accounting Principles Board
Opinion No. 25, Accounting for Stock Issued to Employees("APB No. 25"),and related interpretations. For the three and six month periods ended July 1, 2006,
there were no income tax benefits recognized in the Consolidated Statement of Operations
for stock-based compensation arrangements. Basic and diluted earnings per share for the
three and six month periods ended July 1, 2006 are $0.01 and $0.02, and $0.03 and $0.04
lower, respectively, than if the Company had continued to account for stock-based
compensation under APB No. 25. The estimated fair value of the Companys stock-based
awards, less estimated forfeitures, is amortized over the awards expected life on a
straight-line basis.



The Employee Stock Purchase Plan ("ESPP") was modified in
response to the adoption of SFAS No. 123R. Beginning in the first quarter of 2006, the
discount on the price of the shares was reduced to 5% and will be applied to the price of
shares on the date in which the buy period closes each quarter.



The following table illustrates the effect on net income and earnings
per share as if the Company had applied the fair value recognition provisions of SFAS No.
123R to its stock option plans for the three and six months ended July 2, 2005:



|                                                |                                                                                                                                    | THREE MONTHS ENDED |        | SIX MONTHS ENDED
|----------------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------- | ------------------ | ------ | ----------------
|                                                |                                                                                                                                    |                    |        |                 
|                                                |                                                                                                                                    | July 2, 2005       |        | July 2, 2005    
|                                                |                                                                                                                                    |                    |        |                 
|                                                |                                                                                                                                    |                    |        |                 
|Net income (loss), as reported                  |                                                                                                                                    | $ 922              |        | $ (229)         
|                                                | Add: Stock-based employee compensation expense included in reported net
      income (loss), net of tax*                           |                    | 70     |                 
|                                                | Deduct: Total stock-based employee compensation expense determined under
      fair value based method for all awards, net of tax* |                    | (145)  |                 
|                                                |                                                                                                                                    |                    |        |                 
|Pro forma net income (loss):                    |                                                                                                                                    | $ 847              |        | $ (1,193)       
|                                                |                                                                                                                                    |                    |        |                 
|Basic earnings (loss) per share:                |                                                                                                                                    |                    |        |                 
|                                                | As reported                                                                                                                        |                    | $ 0.03 |                 
|                                                | Pro forma fair value expense, net of income taxes                                                                                  |                    | $ 0.00 |                 
|                                                |                                                                                                                                    |                    |        |                 
|Pro forma basic earnings (loss)
    per share   |                                                                                                                                    | $ 0.03             |        | $ (0.04)        
|                                                |                                                                                                                                    |                    |        |                 
|Diluted earnings (loss) per share:              |                                                                                                                                    |                    |        |                 
|                                                | As reported                                                                                                                        |                    | $ 0.03 |                 
|                                                | Pro forma fair value expense, net of income taxes                                                                                  |                    | $ 0.00 |                 
|                                                |                                                                                                                                    |                    |        |                 
|Pro forma diluted earnings (loss)
    per share |                                                                                                                                    | $ 0.03             |        | $ (0.04)        
|                                                |                                                                                                                                    |                    |        |                 
|                                                |                                                                                                                                    |                    |        |                 

* Amounts are net of a pro-forma tax rate which is not necessarily
indicative of our effective tax rate for the respective periods.



At July 1, 2006, the Company had six stock-based compensation plans:
the 1996 Equity Incentive Plan ("1996 Plan"), the 2001 Non-Officer/Non-Director
Equity Incentive Plan ("2001 Plan"), the 2006 Equity Incentive Plan ("2006
Plan"), and three individual nonqualified stock option plans. The 1996 Plan provides
for grant of incentive stock options to employees (including officers and
employee-directors) and nonqualified stock options, restricted stock and restricted stock
units ("RSUs") and stock bonuses to employees, directors and consultants. The
1996 Plan expired in May of 2006, however, there are still outstanding nonvested options
that will continue to affect the Companys stock-based compensation expense. The 2001
Plan provides for the grant of nonqualified stock options to employees of the Company who
are not officers or directors. The 2006 Plan provides for the grant of stock options,
restricted stock, RSUs, stock appreciation rights ("SARs"), stock-based and
cash-based performance awards and stock bonuses to employees, directors and consultants.
The individual stock option plans were created during 2001, 2005 and 2006 as inducements
to certain executives to accept offers of employment with the Company. For all six
stock-based compensation plans, the exercise price of the options is determined by the
Board of Directors, provided that the exercise price for an incentive stock option cannot
be less than 100% of the fair market value of the common stock on the grant date and the
exercise price for a nonqualified stock option cannot be less than 85% of the fair market
value of the common stock on the grant date. The outstanding options for all six plans
generally vest over a period of four years and generally expire 10 years from the grant
date.



For all of the Companys stock-based compensation plans, the fair
value of each grant was estimated at the date of grant using the Black-Scholes option
pricing model. Black-Scholes utilizes assumptions related to volatility, the risk-free
interest rate, the dividend yield and expected life. Expected volatilities utilized in the
model are based on the historical volatility of the Companys stock price. The
risk-free interest rate is derived from the U.S. Treasury yield curve in effect at the
time of grant. The model incorporates exercise and post-vesting forfeiture assumptions
based on an analysis of historical data. The expected life of the fiscal 2006 grants is
derived from historical information and other factors. The following summary presents the
weighted-average assumptions used for grants issued in fiscal 2006 and fiscal 2005:





|                                          |  | SIX MONTHS
    ENDED
|----------------------------------------- |  | --------------------
|                                          |  |                     
|                                          |  | July 1, 2006        
|                                          |  |                     
|                                          |  |                     
|Estimated dividends                       |  | None                
|Expected volatility                       |  | 55% - 56%           
|Risk-free interest rate                   |  | 4.34% - 4.98%       
|Expected life (years)                     |  | 4.0                 
|Weighted-average fair value
    per share |  | $6.27               





The following summary presents information regarding outstanding stock
options as of July 1, 2006 and changes during the six months then ended with regard to
options under the Plans:



|                                        |  | Number of Options |  | Weighted-Average
    Exercise Price |  | Weighted- Average
    Remaining Contractual Life |  | Aggregate Intrinsic
    Value
|--------------------------------------- |  | ----------------- |  | ----------------------------------- |  | ------------------------------------------------ |  | -----------------------------
|                                        |  |                   |  |                                     |  |                                                  |  |                              
|                                        |  |                   |  |                                     |  | (in years)                                       |  | (in thousands)               
|Outstanding as of
    December 31, 2005 |  | 2,570,199         |  | $ 10.19                             |  |                                                  |  |                              
|Granted                                 |  | 120,500           |  | $ 13.29                             |  |                                                  |  |                              
|Cancellations and
    expirations       |  | (67,133)          |  | $ 10.00                             |  |                                                  |  |                              
|Exercised                               |  | (947,972)         |  | $ 9.00                              |  |                                                  |  |                              
|                                        |  |                   |  |                                     |  |                                                  |  |                              
|Outstanding as of July
    1, 2006      |  | 1,675,594         |  | $ 11.10                             |  | 6.22                                             |  | $ 18,593                     
|                                        |  |                   |  |                                     |  |                                                  |  |                              
|Exercisable as of July 1, 2006          |  | 1,280,893         |  | $ 11.34                             |  | 5.49                                             |  | $ 14,523                     
|                                        |  |                   |  |                                     |  |                                                  |  |                              
|                                        |  |                   |  |                                     |  |                                                  |  |                              



The aggregate instrinsic value in the table above represents the total
pretax intrinsic value, based on the Companys closing stock price of $19.60 at June
30, 2006, which would have been received by award holders had all award holders exercised
their options that were in-the-money as of that date. The total number of in-the-money
options exercisable as of June 30, 2006 was approximately 1.2 million. The aggregate
intrinsic value of awards exercised during the six months ended July 1, 2006 was $8.1
million.



In February 2006, the Compensation Committee and the Board of Directors
approved a grant of restricted stock awards under the 1996 Plan. The Company recorded
compensation expense related to these restricted stock awards totaling $545,000 during the
first quarter, 2006. A portion of the restricted stock awards granted under the 1996 Plan
vested on the date of grant and the remainder vest on the passage of time. The Company
records compensation expense ratably over the vesting period equal to the number of shares
multiplied by the closing price of the Companys common stock on the date of grant
less an estimated forfeiture rate. During the second quarter, 2006, the Company incurred
$93,000 related to the ratable expensing of the first quarter grant of restricted stock.



During the three months ended July 1, 2006, the Board of Directors
approved a 2007 grant of performance based stock and option awards under the 2006 Plan.
The Company recorded compensation expense based on the portion of future restricted stock
that is estimated to be vested immediately on the 2007 grant date since the Company
believes that the achievement of the performance targets stipulated in these option awards
is probable. The total expense recorded during the second quarter ended July 1, 2006 was
$184,000.



A summary of the status of the Companys nonvested options to buy
shares as of July 1, 2006, and changes during the six months then ended is presented
below:



|                               |  |          |  |        | Number of shares |  | Weighted-Average
    Grant-Date Fair Value | 
|------------------------------ |  | -------- |  | ------ | ---------------- |  | ------------------------------------------ | 
|                               |  |          |  |        |                  |  |                                            | 
|                               |  |          |  |        |                  |  |                                            | 
|Nonvested at December 31, 2006 |  | 406,086  |  | $ 4.30 |                 
|Granted                        |  | 120,500  |  | $ 6.28 |                 
|Vested                         |  | (86,104) |  | $ 4.20 |                 
|Forfeited                      |  | (45,781) |  | $ 2.85 |                 
|                               |  |          |  |        |                  |  |                                            | 
|Nonvested at July 1, 2006      |  | 394,701  |  | $ 5.09 |                 
|                               |  |          |  |        |                  |  |                                            | 
|                               |  |          |  |        |                 



As of July 1, 2006, the total unrecorded deferred stock-based
compensation balance for nonvested shares, net of expected forfeitures, was $1.5 million
which is expected to be amortized over a weighted-average period of 1.3 years.



Cash received from option
exercises was $4.7 million and $8.6 million for the three and six months ended July 1,
2006, respectively, and $914,000 and $1.1 million for the three and six months ended July
2, 2005.For periods subsequent to the adoption of SFAS No. 123R, the Company presents
excess tax benefits from the exercise of stock options, if any, in the Consolidated
Statement of Cash Flows as a financing cash inflow and as a corresponding reduction in
operating cash flow.





|4. | Property and Equipment
|-- | ----------------------



Property, plant and equipment are recorded at cost and consist of the
following (in thousands):



|                                         |  |           |  |           | July 1, 2006 |  | December 31, 2005 | 
|---------------------------------------- |  | --------- |  | --------- | ------------ |  | ----------------- | 
|                                         |  |           |  |           |              |  |                   | 
|                                         |  |           |  |           |              |  |                   | 
|Machinery and equipment                  |  | $ 146,132 |  | $ 140,171 |             
|Buildings and leasehold
    improvements |  | 170,916   |  | 167,265   |             
|Construction in progress                 |  | 15,782    |  | 10,784    |             
|                                         |  |           |  |           |              |  |                   | 
|                                         |  | 332,830   |  | 318,220   |             
|Less: accumulated depreciation           |  | (151,872) |  | (139,353) |             
|                                         |  |           |  |           |              |  |                   | 
|Property and equipment, net              |  | $ 180,958 |  | $ 178,867 |             
|                                         |  |           |  |           |              |  |                   | 
|                                         |  |           |  |           |             



Depreciation expense was $6.3 million for the three months ended July 1, 2006 and July
2, 2005, and $12.9 million for the three and six months ended July 1, 2006 and July 2,
2005, respectively.



|5. | Debt
|-- | ----



Contingent convertible senior debentures. In June 2004, the Company
issued $115.0 million aggregate principal amount of its 3.25% Convertible Senior
Debentures due May 15, 2034 in a private placement. The debentures bear regular interest
at the annual rate of 3.25%, payable semiannually on May 15 and November 15 of each year
until May 15, 2011, after which date, no regular interest will be due. Commencing May 20,
2011 and ending November 14, 2011, and for any six-month period thereafter, contingent
interest will be due and payable in the amount of 0.25% of the average trading price of
the debentures during a specified period, if the average trading price of the debentures
equals or exceeds 125% of the principal amount of the debentures. Refer to Note 7
 Earnings per Sharefor the potentially dilutive impact of the convertible
debentures on future periods.



During the second quarter of 2005, the Company made an irrevocable
election to pay the principal amount of debentures in cash upon conversion, however, the
Company retains the ability to satisfy the remainder of any conversion payment, exceeding
the debenture defined principal, in cash or any combination of cash and common stock.
According to their terms, the debentures are callable and convertible into the Company's
common stock prior to maturity at the option of the holders under the following
circumstances: (1) during any calendar quarter commencing after June 30, 2004 and before
March 31, 2029, if the last reported sale price of the Companys common stock is
greater than or equal to 130% of the conversion price of $17.70 per share for at least 20
trading days in the period of 30 consecutive trading days ending on the last trading day
of the proceeding calendar quarter; (2) at any time on or after April 1, 2029 if the last
reported sale price of the Companys common stock on any date on or after March 31,
2029 is greater than or equal to 130% of the conversion price; (3) subject to certain
limitations, during the five business-day period after any five consecutive trading-day
period in which the trading price per debenture for each day of that period was less than
98% of the product of the conversion rate and the last reported sale price of the
Company's common stock; (4) if the Company calls the debentures for redemption; (5) upon
the occurrence of certain corporate transactions; or (6) if the Company requests a credit
rating for the debentures, at any time when the credit ratings assigned to the debentures
are below specified levels. While a credit rating has been issued for the debentures, the
rating was not requested by the Company, but initiated by the rating agency. Therefore, a
change in the current rating will not trigger a call provision. The debentures are
initially convertible into 56.5099 shares of the Company's common stock per $1,000
principal amount, which is equivalent to approximately $17.70 per share, for total initial
underlying shares of 6,498,639. The conversion rate will be subject to adjustment upon the
occurrence of specified events. Pursuant to the underwriting agreement and within 90 days
of issuance, the Company filed a shelf registration statement covering resales of the
debentures and the common stock issuable upon conversion thereof. The registration
statement was declared effective August 26, 2005.



On or after May 20, 2011, the Company may redeem for cash some or all
of the debentures at any time and from time to time, for a price equal to 100% of the
principal amount of the debentures plus accrued and unpaid contingent interest, if any.
Holders have the right to require the Company to repurchase any or all debentures for
cash, at a repurchase price equal to 100% of the principal amount of the debentures, plus
accrued and unpaid interest on: (1) May 15, 2011, May 15, 2014, and May 15, 2024; and (2)
upon the occurrence of a fundamental change (as defined in the debenture indenture). In
the case of a fundamental change in which all of the consideration for the common stock in
the transaction or transactions constituting the fundamental change consists of cash, the
Company also will pay to the holders a make-whole premium (as defined in the debenture
indenture), the amount of which could be significant but would not be determinable unless
and until there were to be a public announcement of such a fundamental change. Any
make-whole premium would be payable to all holders regardless of whether the holder elects
to require the Company to repurchase the debentures or elects to surrender the debentures
for conversion.



The debentures are unsecured and unsubordinated obligations, and rank
equal in priority with all of the Company's existing and future unsecured and
unsubordinated indebtedness and senior in right of payment to all of its subordinated
indebtedness. The debentures will effectively rank junior to any of the Company's secured
indebtedness and any of its indebtedness that is guaranteed by its subsidiaries. Payment
of principal and interest on the debentures will be structurally subordinated to the
liabilities of the Company's subsidiaries.



There are no financial covenants within the debenture indenture,
however, the Company paid penalty interest of 0.25% for the first 90 days of 2005 and paid
0.50% thereafter until the debentures were publicly registered on August 26, 2005. In
2005, the Company paid $305,102 in additional interest to debenture holders due to not
having an effective registration statement within the specified timeframe.



In 2004, total proceeds from the issuance of the debentures were $115.2
million. The Company used $25.0 million of the net proceeds to repurchase 1,977,800
outstanding shares of its common stock, $31.2 million to pay the outstanding balance on
its credit facility, and approximately $3.7 million to pay related debt issuance costs.



Credit facility. On March 31, 2005, the Company entered into a
five-year revolving secured credit facility with Bank of America, N.A. (the "B of A
Facility"). Concurrent with the execution of the B of A Facility, the Company
terminated its existing $95.0 million credit facility (the "Wells Facility")
with Wells Fargo Bank N.A. as administrative agent. The B of A Facility allows borrowings
and letters of credit up to a maximum of $40.0 million, with an option to increase
borrowings up to $100.0 million, subject to a borrowing base determined by the value of
certain inventory, credit card receivables, invested cash and, at the Companys
discretion, mortgaged leaseholds. The B of A Facility is secured by certain assets
including, but not limited to, cash, inventory and fixed assets. Borrowings under the B of
A Facility bear interest, at the Companys election, at the prime rate or at London
Interbank Offering Rate ("LIBOR") plus a margin ranging from 1.00% to 1.50%,
depending on the excess borrowing availability over amounts borrowed. Interest rates are
determined quarterly. The Company is charged a commitment fee on the unused portion of the
B of A Facility. There are no financial covenants, other than the obligation to maintain a
certain percentage of minimum excess availability (as defined in the agreement) at all
times. The B of A Facility requires compliance on a monthly basis with certain
non-financial covenants, including limitations on incurring additional indebtedness and
making investments, the use and disposition of collateral, changes of control, as well as
cash management provisions. In conjunction with the debt refinancing, the Company wrote
off approximately $559,000 related to the remaining unamortized debt issuance cost from
the Wells Facility and capitalized debt issuance costs of approximately $331,000 through
December 31, 2005 to be amortized over the life of the agreement using the effective
interest method. As of July 1, 2006, the Company had letters of credit outstanding
totaling $14.5 million which reduce our availability to approximately $25.5 million.





|6. | Derivatives and Hedging
    Activities
|-- | --------------------------------------



The Company does not have any derivative financial instruments as of
July 1, 2006 that meet the criteria of SFAS No. 133,Accounting for Derivative
Instruments and Hedging Activities.





|7. | Earnings Per Share
|-- | ------------------



Earnings per share are calculated in accordance with the provisions of
SFAS No. 128, Earnings Per Share("SFAS No. 128"). SFAS No. 128 requires
the Company to report both basic earnings per share, which is based on the
weighted-average number of common shares outstanding, and diluted earnings per share,
which is based on the weighted-average number of common shares outstanding and all
dilutive potential common shares outstanding, except where the effect of their inclusion
would be anti-dilutive. Anti-dilutive stock options of 154,479 and 994,948 for the three
months ended July 1, 2006 and July 2, 2005, respectively, and 202,406 and 1,728,802 for
the six months ended July 1, 2006 and July 2, 2005, respectively, were not included in the
diluted earnings per share calculations.



The Emerging Issues Task Force ("the Task Force") of the
Financial Accounting Standards Board ("FASB") concluded in Issue No. 04-8, The
Effect of Contingently Convertible Debt on Diluted Earnings per Share that
contingently convertible debt should be included in diluted earnings per share
computations using the if-converted method regardless of whether any of the conversion
contingencies have been met. During the second quarter of 2005, the Company irrevocably
elected to satisfy 100% of the principal amount of the debentures in cash to be converted
on or after July 1, 2005. The Company maintains the right to satisfy the remainder of the
conversion obligation to the extent it exceeds the principal amount in cash or common
stock or any combination of cash and common stock. In calculating diluted earnings per
share for the six months ending July 1, 2006, no shares related to the debentures
conversion have been included as the effect would have been anti-dilutive.





|8. | Goodwill and Intangible
    Assets
|-- | ----------------------------------



During the first and second quarters of fiscal 2006, no goodwill was
recorded as a result of acquisitions, the Company concluded goodwill was not impaired and
no other changes in the carrying amount of goodwill occurred. During the first quarter of
fiscal 2005, the Company closed its remaining store in Eugene, Oregon and exited the
market area. Associated goodwill of $960,000, net of accumulated amortization recorded
prior to the adoption of FASB No. 142, Goodwill and Other Intangible Assets, was
written off resulting in an ending net balance of $105.1 million.



Other intangible assets consist of the following (in thousands):



| |  |                                        |  |         | July 1, 
    2006 |         | December 31, 2005
| |  | -------------------------------------- |  | ------- | ----------------- | ------- | -----------------
| |  |                                        |  |        
| |  |                                        |  |        
| |  | Leasehold interests                    |  | $ 8,374 |                   | $ 8,374
| |  | Less accumulated amortization          |  | (2,755) |                   | (2,576)
| |  |                                        |  |        
| |  | Leasehold interests, net               |  | 5,619   |                   | 5,798  
| |  | Liquor licenses (indefinite
    lived) |  | 306     |                   | 324    
| |  |                                        |  |        
| |  |                                        |  | $ 5,925 |                   | $ 6,122
| |  |                                        |  |        
| |  |                                        |  |         |                   |        



Amortization expense related to finite lived intangible assets was
$89,000 and $93,000 for the three months ended July 1, 2006 and July 2, 2005,
respectively, and $179,000 and $196,000 for the six months ended July 1, 2006 and July 2,
2005, respectively. The estimated amortization of finite lived intangible assets for the
remainder of 2006 and each of the fiscal years through 2011 is as follows (in thousands):



| | FISCAL 
    YEAR  |  | AMORTIZATION EXPENSE | 
| | ----------------- |  | -------------------- | 
| |                   |  |                      | 
| |                   |  |                      | 
| | Remainder of 2006 |  | $ 179                | 
| | 2007              |  | 358                  | 
| | 2008              |  | 358                  | 
| | 2009              |  | 358                  | 
| | 2010              |  | 358                  | 
| | 2011              |  | 352                  | 





|9. | Restructuring and Asset
    Impairment Charges
|-- | ----------------------------------------------



During the second quarter of fiscal 2006, the Company recorded
restructuring and asset impairment charges of $295,000 consisting of the following
components (in thousands):



| | Change in estimate related to
    lease-related liabilities for sites previously identified for closure |                                                      | $ 70 |      
| | ------------------------------------------------------------------------------------------------------- | ---------------------------------------------------- | ---- | -----
| | Severance for employees
    terminated during the second quarter of fiscal 2006                         |                                                      | 5    |      
| | Accretion expense on
    lease-related liabilities                                                      |                                                      | 184  |      
| | Asset impairment charges                                                                                |                                                      | 36   |      
| |                                                                                                         |                                                      |      |      
| |                                                                                                         | Total restructuring and asset impairment
    expense |      | $ 295
| |                                                                                                         |                                                      |      |      



Details of the significant components are as follows:



- Changes in estimate related to lease-related liabilities for sites previously identified
    for closure ($70,000 of restructuring expense)



- Severance for employees notified of termination in the second quarter of fiscal 2006
    ($5,000 of restructuring expense)



- Accretion expense on lease-related liabilties ($184,000 of restructuring expense)



- Asset impairment charges ($36,000 of restructuring expense)



During the second quarter of 2006, there were no asset impairment
charges in accordance with the provisions of SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. In determining whether an impairment
exists, the Company estimates the stores future cash flows on an undiscounted basis,
and if the cash flows are not sufficient to recover the carrying value, then the Company
uses a discounted cash flow based on a risk-adjusted discount rate, to adjust its carrying
value of the assets, and records a provision for impairment as appropriate. The Company
continually re-evaluates its stores performance to monitor the carrying value of its
long-lived assets in comparison to projected cash flows.



For the six months ended July 1, 2006, the Company recorded net
restructuring and asset impairment charges of $2.0 million consisting of the following
components (in thousands):



| | Change in estimate related to
    lease-related liabilities for sites previously identified for closure |                                                      | $ 136 |        
| | ------------------------------------------------------------------------------------------------------- | ---------------------------------------------------- | ----- | -------
| | Lease-related liability for
    sites closed during the year                                            |                                                      | 1,362 |        
| | Severance for employees
    terminated during the six months ended 2006                                 |                                                      | 119   |        
| | Accretion expense on
    lease-related liabilities                                                      |                                                      | 312   |        
| | Asset impairment charges                                                                                |                                                      | 36    |        
| |                                                                                                         |                                                      |       |        
| |                                                                                                         | Total restructuring and asset impairment
    expense |       | $ 1,965
| |                                                                                                         |                                                      |       |        



Details of the significant components are as follows:



- Changes in estimate related to lease-related liabilities for sites previously identified
    for closure ($136,000 of restructuring expense)



- Lease-related liability for sites closed year to date through July 1, 2006 ($1.4 million
    of restructuring expense)



- Severance for employees notified of termination ($119,000 of restructuring expense)



- Accretion expense on lease-related liabilties



- Asset impairment charges ($36,000 of restructuring expense)



The Company incurred charges for accelerated depreciation related to
planned store closures of $34,000 and $55,000 for the three months ended July 1, 2006 and
July 2, 2005, respectively, and $86,000 and $448,000 for the six months ended July 1, 2006
and July 2, 2005, respectively. These costs are included in the "Cost of goods sold
and occupancy costs" line of the Consolidated Statements of Operations.



The following table summarizes accruals related to the Companys
restructuring charges (in thousands):



|                          | 2002 and   |          |          |          | 1st Qtr    | 2nd Qtr |        
|------------------------- | ---------- | -------- | -------- | -------- | ---------- | ------- | -------
|EXIT PLANS                | Prior      | 2003     | 2004     | 2005     | 2006       | 2006    | Total  
|                         
|                          |            |          |          |          |            |         |        
|Balance at                |            |          |          |          |            |         |        
|January 1, 2005:          | $ 6,665    | $ -      | $ 762    | $ -      | $ -        | $ -     | $ 7,427
|                          |            |          |          |          |            |         |        
|Severance expense         | -          | -        | -        | 134      | -          | -       | 134    
|Lease-related expense     | (315)      | 539      | (76)     | 1,355    | -          | -       | 1,503  
|                          |            |          |          |          |            |         |        
|Cash paid:                |            |          |          |          |            |         |        
|Severance                 | -          | -        | (167)    | (159)    | -          | -       | (326)  
|Lease-related liabilities | (1,539)    | (132)    | (324)    | (720)    | -          | -       | (2,715)
|                          |            |          |          |          |            |         |        
|Provision adjustments     | 731        | -        | 92       | 573      | -          | -       | 1,396  
|                          |            |          |          |          |            |         |        
|Balance at                |            |          |          |          |            |         |        
|December 31, 2005:        | $ 5,542    | $ 407    | $ 287    | $ 1,183  | $ -        | $ -     | $ 7,419
|                          |            |          |          |          |            |         |        
|Severance expense         | -          | -        | -        | -        | 114        | -       | 114    
|Lease-related expense     | 164        | 21       | -        | 9        | 1,362      | -       | 1,556  
|                          |            |          |          |          |            |         |        
|Cash paid:                |            |          |          |          |            |         |        
|Severance                 | -          | -        | -        | -        | (105)      | -       | (105)  
|Lease-related liabilities | (347)      | (31)     | -        | (177)    | (47)       | -       | (602)  
|                          |            |          |          |          |            |         |        
|Provision adjustments     | 20         | -        | -        | -        | 8          | -       | 28     
|                          |            |          |          |          |            |         |        
|Balance at                |            |          |          |          |            |         |        
|April 1, 2006:            | $ 5,379    | $ 397    | $ 287    | $ 1,015  | $ 1,332    | $ -     | $ 8,410
|                          |            |          |          |          |            |         |        
|Severance expense         | -          | -        | -        | -        | -          | 5       |        
|Lease-related expense     | 176        | 10       | -        | 21       | 47         | -       | 254    
|                          |            |          |          |          |            |         |        
|Cash paid:                |            |          |          |          |            |         |        
|Severance                 | -          | -        | -        | -        | -          | -       | -      
|Lease-related liabilities | (318)      | (20)     | -        | (197)    | (81)       | -       | (616)  
|                          |            |          |          |          |            |         |        
|Provision adjustments     | -          | -        | (7)      | -        | (8)        | -       | (15)   
|                          |            |          |          |          |            |         |        
|Balance at                |            |          |          |          |            |         |        
|July 1, 2006:             | $ 5,237(1) | $ 387(1) | $ 280(1) | $ 839(1) | $ 1,290(2) | $ 5(3)  | $ 8,038
|                          |            |          |          |          |            |         |        
|                          |            |          |          |          |            |         |        





























































|Note: | 1. The restructuring accrual balance
    consists of lease-related liabilities.                                 
|----- | ----------------------------------------------------------------------------------------------------------------
|      | 2. The restructuring accrual balance
    consists of lease-related liabilities and $12 for employee termination.
|      | 3. The restructuring accrual balance
    consists of lease-related liabilities and $5 for employee termination. 



As of July 1, 2006, the Companys restructuring balances consist of $2.5 million
in accrued liabilities and other long-term obligations of $5.5 million.





|10. | Income Taxes
|--- | ------------



For the six months ended July 1, 2006, the Company recorded $452,000 of
income tax expense, as a result of income before income taxes of $8.2 million during the
period. The tax expense relates to income generated by the Companys Canadian
operations. The Company has a $67,000 net deferred tax asset, which was generated
primarily as a result of temporary differences related to its Canadian operations. The
Company performs assessments of the realization of its net deferred tax assets according
to SFAS No. 109 ("SFAS No. 109"), Accounting for Income Taxes. As a
result of these assessments, the Company concluded at January 1, 2005, that it should
place a full valuation allowance against its US net deferred tax asset. The Company has
assessed its valuation allowance during the current quarter and continues to record a full
valuation allowance against its US net deferred tax asset.



In July 2006, the FASB issued Interpretation No. 48, Accounting for
Uncertainty in Income Taxes  An Interpretation of FASB Statement No. 109("FIN
No. 48"). FIN No. 48 clarifies the accounting for uncertainty in income taxes
recognized in an enterprises financial statements in accordance with SFAS No. 109.
FIN No. 48 also prescribes a recognition threshold and measurement attribute for the
financial statement recognition and measurement of a tax position taken or expected to be
taken in a tax return. FIN No. 48 also provides guidance on derecognition, classification,
interest and penalties, accounting in interim periods, disclosure, and transition. The
provisions of FIN No. 48 are effective for fiscal years beginning after December 15, 2006.
The Company is currently assessing the possible impact implementing FIN No. 48 may have on
its financial position and results of operations.





|11. | Related Party
    Transactions
|--- | ------------------------------



Perry D. Odak. In May 2002, the Companys Board of Directors
amended the employment agreement of Perry D. Odak, the Companys CEO and President.
The amendment extended through December 2002, the period during which the issuance by the
Company of additional securities as part of an equity financing would entitle Mr. Odak to
receive up to 300,000 stock options exercisable for the Companys common stock. In
March 2002, Mr. Odak was issued options to purchase 5,856 shares of common stock under a
provision of his employment agreement that provided for the maintenance of his 5% equity
position in the event of a capital-raising transaction, based upon the issuance of 111,269
shares of common stock, the resale of which was registered on Form S-3, filed in April
2002. In August 2002, the Companys Board of Directors approved a third amendment to
Mr. Odaks employment agreement, pursuant to which up to 70,000 of the stock options
to which Mr. Odak would be entitled under his employment agreement as a result of the
closing of a capital-raising transaction could be granted to other employees of the
Company designated by Mr. Odak. The options would only be granted upon the closing of the
capital-raising transaction, have a 10-year term, vest over four years and have an
exercise price equal to the closing price of the Companys stock on the date the
capital-raising transaction was concluded. An equal number of options would be granted
simultaneously to Mr. Odak, provided that the options granted to Mr. Odak would only be
exercisable as the options granted to other employees terminated (as opposed to expired)
without exercise.



As a result of the completion of an equity offering of 4.45 million
shares of the Companys common stock in September 2002, the Company issued options
exercisable for 164,211 shares of the Companys stock to Mr. Odak pursuant to the
terms of his employment agreement. An additional 70,000 options, to which Mr. Odak would
have been entitled under his employment agreement, were issued to executives of the
Company designated by Mr. Odak. The Company also issued an additional 70,000 options to
Mr. Odak, provided that the options granted to Mr. Odak are only exercisable as the
options granted to the designated executives under the third amendment to Mr. Odaks
employment agreement terminate (as opposed to expire) without exercise. The Company also
made a matching grant of 70,000 additional options from the Companys 1996 Equity
Incentive Plan to the same executives. The Company may incur quarterly compensation
expense, based on any increase in the then-current stock price over the exercise price, as
a result of the issuance of the initial 70,000 options (as opposed to the Companys
matching grant of 70,000 additional options) to the designated executives and Mr. Odak.



The Odak Employment Agreement, as amended, provides for the payment of
the existing $9.2 million supplemental bonus in the event of Mr. Odak's death or
disability, as defined in the Odak Employment Agreement, while employed by the Company,
and for payment of a bonus of approximately $1.6 million: (i) in the event Mr. Odak
terminates his employment for "good reason", as defined in the Odak Employment
Agreement, or (ii) in the event Mr. Odak is terminated without "Cause", as
defined in the Odak Employment Agreement. The Company has acquired an insurance policy for
the benefit of the Company to cover Mr. Odak's death or disability in the approximate
amount of the supplemental bonus.



In March 2001, Mr. Odak purchased 1,332,649 shares of Common Stock for
$6.969 per share for an aggregate purchase price of $9.3 million. Mr. Odak paid $13,326 in
cash and executed a full recourse, five-year promissory note for the balance of $9,273,905
to the Company, with interest accruing at 5.5% per annum, compounding semiannually. On
February 19, 2006, pursuant to the termination of the five-year promissory note, Mr. Odak
sold 678,530 shares of Common Stock for $17.89 per share to the Company. The Company
repurchased the shares for $12,138,902, effectively relieving all debt owed by Mr. Odak
and reducing the number of shares outstanding by 678,530. The repurchased shares are
reflected as treasury shares in the Companys consolidated balance sheet.



On June 16, 2006, the Company and Mr. Odak entered into the Fifth
Amendment to the Employment Agreement to extend the period during which a notice of
non-renewal could be given under the Odak Employment Agreement, which continued on a
year-to-year basis after expiration of the initial five year term in March 2006. With
respect to the existing one-year term, the Company must provide to Mr. Odak notice of
non-renewal of the Employment Agreement not later than August 15, 2006 (the period between
June 19, 2006 and August 15, 2006 being referred to as the "Extended Notice
Period"). The deadline for notice of non-renewal of the Employment Agreement for all
years after March 19, 2007 remains unchanged. The Fifth Amendment also provides that Mr.
Odak may terminate his employment with the Company for Good Reason (as defined in the
Employment Agreement) if (a) the Company, in bad faith, fails to engage in negotiations
regarding a new employment agreement or modifications to the Employment Agreement during
the Extended Notice Period or (b) during the Extended Notice Period, the Company provides
Mr. Odak with a notice of non-renewal of the Employment Agreement prior to August 14,
2006.



Other. Mark A. Retzloff was a member of the Companys Board of
Directors and sat on its Real Estate Committee until the expiration of his term as
director at the Companys Annual Meeting of Shareholders on May 3, 2006. As a result
of Mr. Retzloffs position as Chief Organic Officer of Aurora Organic Dairy, a vendor
that derives 6% of its total revenues from sales of organic milk to the Company under the
Companys private label brand, the Company considered the organic milk transactions
to include a related party relationship until Mr. Retzloffs term as a director
expired on May 3, 2006. Stacey J. Bell, a current member of the Companys Board of
Directors, is an indirect employee of Ideasphere, Inc., which sells vitamins and
supplements to the Company. Total purchases from these vendors for the three and six
months ended July 1, 2006 were $1.1 million and $2.1 million, and $1.2 million and $2.2
million for the same periods in 2005. A majority of these purchases are made primarily
through the Companys primary distributor, UNFI and are therefore indirect in nature.
These costs are all for inventory and the related cost of goods sold. As of July 1, 2006
and July 2, 2005, amounts owed to these vendors were $175,000 and $70,000, respectively.





|12. | Contingencies
|--- | -------------



Tim Auchterlonie, individually and on behalf of all others similarly
situated and the general public, and Roes 1 to 1000 vs. Wild Oats Markets, Inc. and Does 1
through 100, is a suit brought in August 2004 in the Superior Court, County of Los
Angeles, for payment of overtime and damages relating to alleged violations of the
California Business and Professions Code by a former store director claiming that he
should have been classified as an employee paid on an hourly basis, together with other
related claims. In mid-2005, five additional named plaintiffs were added to the suit, and
the trials of the original plaintiff and the new plaintiffs were bifurcated. The Company
believes that all of the named plaintiffs were correctly classified as exempt employees
based upon their job duties. The Company has settled with the original plaintiff, and the
trial date has been vacated. A trial for the remaining plaintiffs has been set for third
quarter 2006.



Ana Marie Hoeppner et al. v. Wild Oats Markets, Inc., Superior
Court, County of Los Angeles, is a case filed by seven California plaintiffs involving
parties and claims found in the Auchterlonie lawsuit disclosed above. The Company
believes that it will prevail on the issue of improper classification as managerial
employees. The lawsuit is in the initial discovery phase.



In June 2002 an administrative law judge ("ALJ") found
against the Company in Wild Oats Markets, Inc. and Local 371, United Food &
Commercial Workers, in certain unfair labor practice charges brought in connection
with the opening of the Companys store in Westport, Connecticut. In May 2005, the
NLRB issued a Decision and Order, setting forth certain equitable, injunctive and monetary
remedies to be undertaken by the Company, including payment of backpay less interim
earnings, and offers of employment to certain former employees of a store that the Company
sold in 2000 (the "Sold Store"). The Company agreed to reinstate one former
employee and paid an immaterial amount to settle all claims related to the Sold Store.



The Company also is named as defendant in various actions and
proceedings arising in the normal course of business. In all of these cases, the Company
is denying the allegations and is vigorously defending against them and, in some cases,
has filed counterclaims. Although the eventual outcome of the various lawsuits cannot be
predicted, it is managements opinion that these lawsuits will not result in
liabilities that would materially affect the Companys consolidated results of
operations, financial position, or cash flows.





Item
2.  Management's Discussion and Analysis of Financial Condition and Results of
Operations

This report on Form 10-Q contains certain forward-looking statements
regarding our future results of operations and performance. Important factors that could
cause differences in results of operations include, but are not limited to, the timing,
execution and performance of new store openings, relocations and remodels; the timing and
liability resulting from store closures; the amount of time before new stores become
profitable; the timing and impact of merchandising programs and promotional and
advertising campaigns; the impact of competition; changes in merchandising strategies,
product supply or suppliers; changes in management information needs; changes in customer
needs and expectations; governmental and regulatory actions; general industry or business
trends or events; changes in economic or business conditions in general or affecting the
natural foods industry in particular; and competition for and the availability of sites
for new stores and potential acquisition candidates. See Management's Discussion and
Analysis of Financial Condition and Results of Operations - Cautionary Statement Regarding
Forward-Looking Statements.



Executive Summary



This Executive Summary section of Managements Discussion and
Analysis of Financial Condition and Results of Operationsprovides a broad summary of
the more specific and detailed information disclosed in other sections of this report. The
context that it provides should be viewed as a supplement to, and read in conjunction
with, the details contained elsewhere in this report.



Wild Oats Markets, Inc. is one of the largest natural foods supermarket
chains in North America. As of the date of this report, we operated 113 natural foods
stores in 24 states and British Columbia, Canada. We operate in the retail grocery
industry with two store formats: the natural foods supermarket format, under the Wild Oats
Natural Marketplace(R)name
nationwide and the Capers Community Market(R)name in Canada; and the farmers market format, under the Henrys Farmers
Market(R)name in southern
California and Phoenix, Arizona, and the Sun Harvest name in Texas. Both formats
emphasize natural and organic products with a wide selection of products in a full-service
environment. The formats share a core demographic customer profile. We manage support
services provided to the stores centrally from our Boulder, Colorado headquarters. All of
our stores in the United States, regardless of format, purchase from the same primary
distributor based on centralized negotiations, merchandising and marketing strategies. Our
Riverside, California distribution center ("DC") supplies produce, private label
groceries, and selected other items for the majority of our stores west of the Mississippi
River. We continue to identify additional procurement opportunities to maximize
efficiencies of the DC.



In 2006, we continued to improve our gross margins over last year,
which is the result of strengthening of our marketing and merchandising initiatives and
improvements in supply chain efficiencies. Through the date of this report in 2006, all
three of our new store openings this year set records for the highest grand opening sales
in the Companys history by their respective format. To date, we have also closed
three smaller, older, under-performing stores.



As of the end of the second quarter of fiscal 2006, we had 113 stores
located in 24 states and Canada, as compared to 111 stores located in 24 states and Canada
at the end of the second quarter of fiscal 2005.





Results of Operations



Our net income for the three and six months ended July 1, 2006 was $4.9
million or $0.16 per diluted share and $7.8 million or $0.26 per diluted share,
respectively, compared with net income of $922,000 or $0.03 per diluted

share and a net loss of $229,000 or $0.01 per diluted share, in the
same periods in fiscal 2005. The following tables set forth, for the periods indicated,
certain selected income statement data expressed as a percentage of sales and in dollars (in
thousands  percentages may not add due to rounding):



| |                                                     |  | THREE MONTHS
    ENDED
| | --------------------------------------------------- |  | ----------------------
| |                                                     |  |                       
| |                                                     |  | July 1,
    2006      
| |                                                     |  |                       
| | Sales                                               |  | $ 296,561             
| | Cost of goods sold and occupancy costs              |  | 206,876               
| |                                                     |  |                       
| | Gross profit                                        |  | 89,685                
| | Direct store expenses                               |  | 69,939                
| | Selling, general and administrative expenses        |  | 12,328                
| | Loss on disposal of assets                          |  | 77                    
| | Pre-opening expenses                                |  | 792                   
| | Restructuring and asset impairment charges,
    net |  | 295                   
| |                                                     |  |                       
| | Income from operations                              |  | 6,254                 
| |                                                     |  |                       
| | Interest income                                     |  | 699                   
| | Interest expense                                    |  | (1,836)               
| |                                                     |  |                       
| | Income before income taxes                          |  | 5,117                 
| | Income tax expense                                  |  | 247                   
| |                                                     |  |                       
| | Net income                                          |  | $ 4,870               
| |                                                     |  |                       
| |                                                     |  |                       







| |                                                     |  | SIX MONTHS
    ENDED
| | --------------------------------------------------- |  | --------------------
| |                                                     |  |                     
| |                                                     |  | July 1,
    2006    
| |                                                     |  |                     
| | Sales                                               |  | $ 594,918           
| | Cost of goods sold and occupancy costs              |  | 413,861             
| | Gross profit                                        |  | 181,057             
| | Direct store expenses                               |  | 139,772             
| | Selling, general and administrative expenses        |  | 26,293              
| | Loss on disposal of assets                          |  | 167                 
| | Pre-opening expenses                                |  | 2,251               
| | Restructuring and asset impairment charges,
    net |  | 1,965               
| |                                                     |  |                     
| | Income from operations                              |  | 10,609              
| |                                                     |  |                     
| | Loss on early extinguishment of debt                |  | -                   
| | Interest income                                     |  | 1,288               
| | Interest expense                                    |  | (3,690)             
| |                                                     |  |                     
| | Income before income taxes                          |  | 8,207               
| | Income tax expense                                  |  | 452                 
| |                                                     |  |                     
| | Net income (loss)                                   |  | $ 7,755             
| |                                                     |  |                     
| |                                                     |  |                     





Income Statement Analysis



Sales

|                                               |  | July 1, 2006 |  | July 2, 2005 |  | % Change 2005 to 2006 | 
|---------------------------------------------- |  | ------------ |  | ------------ |  | --------------------- | 
|                                               |  |              |  |              |  |                       | 
|For the three months ended
    (in thousands): |  | $296,561     |  | $284,608     |  | 4.2%                  | 
|For the six months ended (in
    thousands):   |  | $594,918     |  | $562,687     |  | 5.7%                  | 



Sales for the three and six months ended July 1, 2006 increased 4.2%
and 5.7%, respectively, as compared to the same periods in fiscal 2005. These increases
were primarily driven by positive comparable sales and a greater number of stores in our
store base compared to 2005. Total square feet of open stores increased 2.8% over the
second quarter of 2005, as the second fiscal quarter 2006 ended with 2.60 million total
square feet as compared to 2.53 million total square feet in the second fiscal quarter of
2005. Comparable store sales increased 1.3% for the second quarter of 2006 and 2.7% for
the year to date period ended July 1, 2006 as compared to an increase of 5.4% and 2.5% in
the same periods last year. Reduced comparable store sales in the second quarter of 2006
relative to last year is attributed to the short-term impact of new competition and a
shift in timing for major promotional activity.



Gross profit

|                                                      |  | July 1, 2006 |  | July 2, 2005 |  | % Change 2005 to 2006 | 
|----------------------------------------------------- |  | ------------ |  | ------------ |  | --------------------- | 
|                                                      |  |              |  |              |  |                       | 
|For the three months ended
    (in thousands):        |  | $89,685      |  | $82,559      |  | 8.6%                  | 
|As a percent of sales for
    the three months ended: |  | 30.2%        |  | 29.0%        |  | 1.2%                  | 
|For the six months ended (in
    thousands):          |  | $181,057     |  | $162,815     |  | 11.2%                 | 
|As a percent of sales for
    the six months ended:   |  | 30.4%        |  | 28.9%        |  | 1.5%                  | 



Gross profit consists of sales less cost of goods sold and store
occupancy costs. Occupancy costs include store related depreciation, rent and utilities.
As a percentage of sales, gross profit increased to 30.2% in the second quarter of fiscal
2006 and 30.4% for the year to date period ended July 1, 2006 from 29.0% and 28.9% for the
same periods in fiscal 2005, respectively. The improvement in gross margin relative to
last year can be attributed to continued strength in higher margin product categories,
improvements in supply chain efficiencies, as well as having fewer new stores open in this
years second quarter relative to 2005. Traditionally, the gross margins of new
stores are lower due to higher shrink and heavy promotional activity.



Direct store expenses

|                                                      |  | July 1, 2006 |  | July 2, 2005 |  | % Change 2005 to 2006 | 
|----------------------------------------------------- |  | ------------ |  | ------------ |  | --------------------- | 
|                                                      |  |              |  |              |  |                       | 
|For the three months ended
    (in thousands):        |  | $69,939      |  | $66,512      |  | 5.2 %                 | 
|As a percent of sales for
    the three months ended: |  | 23.6%        |  | 23.4%        |  | 0.2 %                 | 
|For the six months ended (in
    thousands):          |  | $139,772     |  | $131,880     |  | 6.0 %                 | 
|As a percent of sales for
    the six months ended:   |  | 23.5%        |  | 23.4%        |  | 0.1 %                 | 





Direct store expenses include payroll, payroll taxes and benefits,
marketing and advertising, regional store support services, store supplies and
maintenance, and other store-specific costs. As a percentage of sales, direct store
expenses remained relatively constant in the three and six months ended July 1, 2006, from
the same periods last year.







Selling, general and administrative expenses

|                                                      |  | July 1, 2006 |  | July 2, 2005 |  | % Change 2005 to 2006 | 
|----------------------------------------------------- |  | ------------ |  | ------------ |  | --------------------- | 
|                                                      |  |              |  |              |  |                       | 
|For the three months ended
    (in thousands):        |  | $12,328      |  | $11,413      |  | 8.0%                  | 
|As a percent of sales for
    the three months ended: |  | 4.2%         |  | 4.0%         |  | 0.2%                  | 
|For the six months ended (in
    thousands):          |  | $26,293      |  | $21,456      |  | 22.5%                 | 
|As a percent of sales for
    the six months ended:   |  | 4.4%         |  | 3.8%         |  | 0.6%                  | 



Selling, general and administrative ("SG&A") expenses
include corporate administrative support services and purchasing. SG&A expenses for
the quarter ended July 1, 2006 increased 0.2% as a percentage of sales compared to the
same period in fiscal 2005. For the six months ended July 1, 2006, SG&A expenses
increased 0.6% as a percentage of sales as compared to the same period in fiscal 2005.
SG&A expenses in the second quarter and year to date period ended July 1, 2006 were
higher as a percentage of sales compared to the same periods in 2005 primarily due to an
increase in accrued bonuses, professional fees, and the impact of expensing stock
compensation resulting from the implementation of Statement of Financial Accounting
Standards ("SFAS") No. 123 (revised 2004), Share-Based Payment
("SFAS No. 123R").



Pre-opening expenses



|                                                      |  | July 1, 2006 |  | July 2, 2005 |  | % Change 2005 to 2006 | 
|----------------------------------------------------- |  | ------------ |  | ------------ |  | --------------------- | 
|                                                      |  |              |  |              |  |                       | 
|For the three months ended
    (in thousands):        |  | $792         |  | $780         |  | 0.2 %                 | 
|As a percent of sales for
    the three months ended: |  | 0.3%         |  | 0.3%         |  | 0.0 %                 | 
|For the six months ended (in
    thousands):          |  | $2,251       |  | $2,697       |  | (16.5)%               | 
|As a percent of sales for
    the six months ended:   |  | 0.4%         |  | 0.5%         |  | (0.1)%                | 



Pre-opening expenses include labor, rent, advertising, utilities,
training, supplies and certain other costs incurred prior to a stores opening.
Pre-opening expenses for the second quarter of fiscal 2006 increased to $792,000 compared
to $780,000 during the same period in fiscal 2005, due to the timing of the opening of new
stores, in addition to the costs related to future planned store openings. Furthermore, as
we move into denser market areas causing the number of our non-turnkey leases to increase,
we are experiencing additional rent expense earlier in the opening process due to longer
construction periods.



The number of stores opened is as follows:



|           |  | THREE MONTHS
    ENDED |  | SIX MONTHS
    ENDED | 
|---------- |  | ---------------------- |  | -------------------- | 
|           |  |                        |  |                      | 
|           |  | July 1, 2006           |  | July 2, 2005         | 
|           |  |                        |  |                      | 
|New stores |  | 1                      |  | 2                    | 



In the second quarter of fiscal 2006, we opened one new Wild Oats
Natural Marketplace store in Tampa, Florida. As of the date of this report, we have also
opened a new Capers Community Market in Vancouver, British Columbia.



Restructuring and asset impairment charges, net



Restructuring and asset impairment charges consist of the following
components (in thousands):



|                                                                                                          |  | THREE MONTHS
    ENDED |  | SIX MONTHS 
    ENDED | 
|--------------------------------------------------------------------------------------------------------- |  | ---------------------- |  | --------------------- | 
|                                                                                                          |  |                        |  |                       | 
|                                                                                                          |  | July 1, 2006           |  | July 2, 2005          | 
|                                                                                                          |  |                        |  |                       | 
|Change in estimate related to lease related liabilities
      for sites previously identified for closure |  | $ 70                   |  | $(287)                | 
|Lease-related liability for sites closed during the
      current period                                  |  | -                      |  | 304                   | 
|Severance for employees terminated during the period                                                      |  | 5                      |  | (104)                 | 
|Accretion expense on lease-related liabilities                                                            |  | 184                    |  | 112                   | 
|Write off of goodwill                                                                                     |  | -                      |  | -                     | 
|Asset impairment charges                                                                                  |  | 36                     |  | 884                   | 
|                                                                                                          |  |                        |  |                       | 
|Total restructuring and asset impairment expense                                                          |  | $295                   |  | $909                  | 



Restructuring and asset impairment charges include lease termination
costs, severance for employees notified of termination, accretion expense on reserves for
lease-related liabilities that were calculated using the net present value of minimum
lease payments (net of sublease income), and non-cash charges for asset impairments and
write off of goodwill. Restructuring and asset impairment charges of $295,000 for the
second quarter of 2006 decreased from $909,000 in the same period ended July 2, 2005 due
mainly to a decrease in asset impairment charges in 2006 compared to charges incurred in
2005 for two stores held for use. During the six month period ended July 1, 2006,
restructuring and asset impairment charges decreased from $2.5 million for the six months
ended July 2, 2005 to $2.0 million for the six months ended July 1, 2006. This is due to a
decrease in asset impairment charges, and no goodwill written off during 2006, offset by
an increase of $1.3 million of lease-related liabilities due to the recording of charges
for two closed stores in 2006 compared to one closed store in 2005. Refer to Note 9
 Restructuring and Asset Impairment Chargesfor more details.



Interest income

|                                                      |  | July 1, 2006 |  | July 2, 2005 |  | % Change 2005 to 2006 | 
|----------------------------------------------------- |  | ------------ |  | ------------ |  | --------------------- | 
|                                                      |  |              |  |              |  |                       | 
|For the three months ended
    (in thousands):        |  | $699         |  | $361         |  | 93.6%                 | 
|As a percent of sales for
    the three months ended: |  | 0.2%         |  | 0.1%         |  | 0.1%                  | 
|For the six months ended (in
    thousands):          |  | $1,288       |  | $685         |  | 88.0%                 | 
|As a percent of sales for
    the six months ended:   |  | 0.2%         |  | 0.1%         |  | 0.1%                  | 



Interest income was $699,000 and $1.3 million for the three and six
months ended July 1, 2006, respectively, compared to $361,000 and $685,000 for the same
periods in fiscal 2005. This is due to a combination of an increase in the average balance
of cash invested and the increase in our rate of return on our invested cash.



Interest expense



|                                                      |  | July 1, 2006 |  | July 2, 2005 |  | % Change 2005 to 2006 | 
|----------------------------------------------------- |  | ------------ |  | ------------ |  | --------------------- | 
|                                                      |  |              |  |              |  |                       | 
|For the three months ended
    (in thousands):        |  | $1,836       |  | $2,144       |  | (14.4)%               | 
|As a percent of sales for
    the three months ended: |  | 0.6%         |  | 0.8%         |  | (0.2)%                | 
|For the six months ended (in
    thousands):          |  | $3,690       |  | $4,311       |  | (14.4)%               | 
|As a percent of sales for
    the six months ended:   |  | 0.6%         |  | 0.8%         |  | (0.2)%                | 



Interest expense for the fiscal quarter ended July 1, 2006 decreased to
$1.8 million from $2.1 million in the same period in fiscal 2005. Interest expense for the
six months ended July 1, 2006 was $3.7 million compared to $4.3 million for the same
period ended July 2, 2005. The decline in interest expense is attributable to elimination
of penalty interest on our debentures in 2006 as compared to 2005 due to the effective
filing of our registration statement in August 2005. In addition, we have lower fees and
interest rates as a result of a change in our bank credit facility.



Income tax expense



|                                                      |  | July 1, 2006 |  | July 2, 2005 |  | % Change 2005 to 2006 | 
|----------------------------------------------------- |  | ------------ |  | ------------ |  | --------------------- | 
|                                                      |  |              |  |              |  |                       | 
|For the three months ended
    (in thousands):        |  | $247         |  | $187         |  | 32.1%                 | 
|As a percent of sales for
    the three months ended: |  | 0.1%         |  | 0.1%         |  | 0.0%                  | 
|Effective tax rate for the
    three months ended:    |  | 4.8%         |  | 16.9%        |  | (12.1%)               | 
|For the six months ended (in
    thousands):          |  | $452         |  | $322         |  | 40.4%                 | 
|As a percent of sales for
    the six months ended:   |  | 0.1%         |  | 0.1%         |  | 0.0%                  | 
|Effective tax rate for the
    six months ended:      |  | 5.5%         |  | 346.2%       |  | (340.7%)              | 



For the quarter and year to date period ended July 1, 2006, we recorded
$247,000 and $452,000, respectively, of income tax expense, as a result of taxable foreign
income during the period. The tax benefit resulting from the loss in previous years on
domestic operations has been fully offset by the tax valuation allowance that was
established at fiscal 2004 year end. The Company has determined that any expected federal
or state income tax expense for the current quarter and fiscal year, except as described
above, will be expected to be fully offset by deferred tax assets that are currently
subject to a 100% valuation allowance.



Earnings before interest, taxes, depreciation and amortization, loss on
early extinguishment of debt, loss (gain) on asset disposals, net, restructuring and asset
impairment charges (income), net, and stock-based compensation expense, as adjusted
("EBITDA, as adjusted")



|                                                      |  | July 1, 2006 |  | July 2, 2005 |  | % Change 2005 to 2006 | 
|----------------------------------------------------- |  | ------------ |  | ------------ |  | --------------------- | 
|                                                      |  |              |  |              |  |                       | 
|For the three months ended
    (in thousands):        |  | $13,507      |  | $10,376      |  | 30.2%                 | 
|As a percent of sales for
    the three months ended: |  | 4.6%         |  | 3.6%         |  | 1.0%                  | 
|For the six months ended (in
    thousands):          |  | $27,087      |  | $20,143      |  | 34.5%                 | 
|As a percent of sales for
    the six months ended:   |  | 4.6%         |  | 3.6%         |  | 1.0%                  | 



We believe that the reconciliation of earnings before interest, taxes,
depreciation and amortization ("EBITDA") and EBITDA, as adjusted, provides
meaningful non GAAP financial measures to help management and investors understand and
compare business trends among different reporting periods on a consistent basis,
independently of regularly reported non-cash charges and infrequent or unusual events as
determined by management. Readers are cautioned not to view EBITDA or EBITDA, as adjusted,
as an alternative to GAAP results or as being comparable to results reported or forecasted
by other companies, and should refer to the reconciliation of GAAP net income (loss)
results to EBITDA and EBITDA, as adjusted, for the three and six month periods ending July
1, 2006 and July 2, respectively. For an explanation and reconciliation of EBITDA, and
EBITDA, as adjusted, see Non GAAP Financial Information.





Liquidity and Capital Resources

Our primary sources of capital have been cash flow from operations
(which includes trade payables), bank indebtedness, sale of equity securities, and the
issuance of contingent convertible senior debentures in a private placement in June 2004,
as discussed below. Primary uses of cash have been the financing of new store development,
new store openings, relocations, remodels and acquisitions, repurchase of common stock and
repayment of debt.



Net cash generated by operating activities increased by $6.3 million to
$21.0 million during the first six months of fiscal 2006, as compared to $14.7 million
during the same period in fiscal 2005. This increase is due primarily to an increase in
net income of $8.0 million and a non-cash increase in stock-based compensation expense of
$1.0 million due to the implementation of SFAS No. 123R.



Net cash used in investing activities was $27.6 million during the
first six months of fiscal 2006 as compared to $836,000 of cash used in investing
activities during the same period in fiscal 2005. The $26.8 million increase in cash
utilized is due to a $3.1 million increase in capital expenditures and an increase of
$23.7 million in the net purchase of short-term investments during the first six months of
2006 compared to the same period in 2005.



Net cash provided by financing activities of $10.6 million during the
first six months of 2006 was $11.6 million more than the $1.0 million of cash used in
financing activities during the same period in fiscal 2005. The change in cash flows from
financing activities is the result of an increase of $7.5 million in proceeds from the
issuances of common stock due primarily to option exercises and a $4.2 million increase in
book overdraft.



EBITDA. EBITDA was $23.7 million for the six month period ended
July 1, 2006, as compared to $16.8 million for the six months ended July 2, 2005. The increase in EBITDA is primarily
attributable to the increase in gross margin as well as the Companys ability to
leverage higher sales against expenses. For an explanation and reconciliation of EBITDA,
see Non GAAP Financial Information.



Contingent convertible senior debentures. In June 2004, we issued
$115.0 million aggregate principal amount of our 3.25% Convertible Senior Debentures due
May 15, 2034 in a private placement. The debentures bear regular interest at the annual
rate of 3.25%, payable semiannually on May 15 and November 15 of each year until May 15,
2011, after which date, no regular interest will be due. Commencing May 20, 2011 and
ending November 14, 2011, and for any six-month period thereafter, contingent interest
will be due and payable in the amount of 0.25% of the average trading price of the
debentures during a specified period, if the average trading price of the debentures
equals or exceeds 125% of the principal amount of the debentures.



During the second quarter of 2005, we made an irrevocable election to
pay the principal amount of debentures in cash upon conversion; however, we retain the
ability to satisfy the remainder of any conversion payment, exceeding the debenture
defined principal, in cash or any combination of cash and common stock. According to their
terms, the debentures are callable and convertible into our common stock prior to maturity
at the option of the holders under the following circumstances: (1) during any calendar
quarter commencing after June 30, 2004 and before March 31, 2029, if the last reported
sale price of our common stock is greater than or equal to 130% of the conversion price of
$17.70 per share for at least 20 trading days in the period of 30 consecutive trading days
ending on the last trading day of the proceeding calendar quarter; (2) at any time on or
after April 1, 2029 if the last reported sale price of our common stock on any date on or
after March 31, 2029 is greater than or equal to 130% of the conversion price; (3) subject
to certain limitations, during the five business-day period after any five consecutive
trading-day period in which the trading price per debenture for each day of that period
was less than 98% of the product of the conversion rate and the last reported sale price
of our common stock; (4) if we call the debentures for redemption; (5) upon the occurrence
of certain corporate transactions; or (6) if we request a credit rating for the
debentures, at any time when the credit ratings assigned to the debentures are below
specified levels. While a credit rating has been issued for the debentures, the rating was
not requested by us, but initiated by the ratings agency. Therefore, a change in the
current rating will not trigger a call provision. The debentures are initially convertible
into 56.5099 shares of our common stock per $1,000 principal amount, which is equivalent
to approximately $17.70 per share, for total initial underlying shares of 6,498,639. The
conversion rate will be subject to adjustment upon the occurrence of specified events.
Pursuant to the underwriting agreement and within 90 days of issuance, we filed a shelf
registration statement covering resales of the debentures and the common stock issuable
upon conversion thereof. The registration statement was declared effective August 26,
2005.



On or after May 20, 2011, we may redeem for cash some or all of the
debentures at any time and from time to time, for a price equal to 100% of the principal
amount of the debentures plus accrued and unpaid contingent interest, if any. Holders have
the right to require us to repurchase any or all debentures for cash, at a repurchase
price equal to 100% of the principal amount of the debentures, plus accrued and unpaid
interest on: (1) May 15, 2011, May 15, 2014, and May 15, 2024; and (2) upon the occurrence
of a fundamental change (as defined in the debenture indenture). In the case of a
fundamental change in which all of the consideration for the common stock in the
transaction or transactions constituting the fundamental change consists of cash, we also
will pay to the holders a make-whole premium (as defined in the debenture indenture), the
amount of which could be significant but would not be determinable unless and until there
were to be a public announcement of such a fundamental change. Any make-whole premium
would be payable to all holders regardless of whether the holder elects to require us to
repurchase the debentures or elects to surrender the debentures for conversion.



The debentures are unsecured and unsubordinated obligations, and rank
equal in priority with all of our existing and future unsecured and unsubordinated
indebtedness and senior in right of payment to all of our subordinated indebtedness. The
debentures will effectively rank junior to any of our secured indebtedness and any of its
indebtedness that is guaranteed by our subsidiaries. Payment of principal and interest on
the debentures will be structurally subordinated to the liabilities of our subsidiaries.



There are no financial covenants within the debenture indenture,
however, we paid penalty interest of 0.25% for the first 90 days of 2005 and paid 0.50%
thereafter until the debentures were publicly registered on August 26, 2005. During 2005,
the Company paid $305,102 in additional interest to debenture holders due to not having an
effective registration statement within the specified timeframe.



In 2004, total proceeds from the issuance of the debentures were $115.2
million. We used $25.0 million of the net proceeds to repurchase 1,977,800 outstanding
shares of its common stock, $31.2 million to pay the outstanding balance on its credit
facility, and approximately $3.7 million to pay related debt issuance costs.



Credit facility. On March 31, 2005, we entered into a five-year
revolving secured credit facility with Bank of America, N.A. ("B of A
Facility"). Concurrent with the execution of the B of A Facility, we terminated our
existing $95 million credit facility with Wells Fargo Bank N.A. as administrative agent.
The B of A Facility allows borrowings and letters of credit up to a maximum of $40.0
million, with an option to increase borrowings up to $100.0 million, subject to a
borrowing base determined by the value of certain inventory, credit card receivables,
invested cash and, at our discretion, mortgaged leaseholds. The B of A Facility is secured
by certain of our assets including, but not limited to, cash, inventory and fixed assets.
Borrowings under the B of A Facility bear interest, at our election, at the prime rate or
at London Interbank Offering Rate ("LIBOR") plus a margin ranging from 1.00% to
1.50%, depending on the excess borrowing availability over amounts borrowed. Interest
rates are determined quarterly. We are charged a commitment fee on the unused portion of
the B of A Facility. There are no financial covenants, other than the obligation to
maintain a certain percentage of minimum excess availability (as defined in the agreement)
at all times. The B of A Facility requires compliance on a monthly basis with certain
non-financial covenants, including limitations on incurring additional indebtedness and
making investments, the use and disposition of collateral, changes of control, as well as
cash management provisions. We expect that we will be in compliance with all covenants. We
further expect that our cash requirements will be generated from operations and borrowings
under the new credit facility. As of July 1, 2006, the Company had letters of credit
outstanding totaling $14.5 million, which reduces are availability to approximately $25.5
million.



As of July 1, 2006, we had no off-balance sheet arrangements,
unconsolidated subsidiaries, commitments or guarantees, except as disclosed in the notes
to the consolidated financial statements. As of July 1, 2006, we have working capital of
$8.1 million, an increase of $29.5 million over the six months ended July 2, 2005.



Capital expenditures. We spent approximately $15.1 million during
the six months ended July 1, 2006 for new store construction, remodels and other capital
expenditures. Our average capital expenditures to open a leased store, including leasehold
improvements, equipment and fixtures, has ranged from approximately $2.0 million to $5.0
million historically, excluding inventory costs and initial operating losses. We
anticipate that the average capital expenditures to open a natural foods supermarket
format store will be $2.5 million to $3.5 million in the future, on a turnkey lease basis.
Under turnkey leases, the landlord constructs the building to our specifications, up to a
cost cap per foot, and installs equipment we purchase. Average capital expenditures for
non turnkey leases are expected to be between $5.0 million and $6.5 million. Our average
capital expenditures to open a farmers market format store are estimated at $2.0
million to $2.5 million in the future. Delays in opening new stores may result in
increased capital expenditures and increased pre-opening costs for the site, as well as
lower than planned sales for the Company.



Based upon the current level of operations, we believe that cash flows
from operations and other sources available such as cash from our debentures and available
line of credit will be adequate to meet anticipated requirements for working capital,
capital expenditures, interest payments and future debenture payments in the foreseeable
future. However, there can be no assurance that the business will continue to generate
cash flows from operations at current levels or that we will be able to maintain our
ability to borrow under the line of credit.





New Accounting Pronouncements



In July 2006, the FASB issued Interpretation No. 48, Accounting for
Uncertainty in Income Taxes  An Interpretation of FASB Statement No. 109("FIN
No. 48"). FIN No. 48 clarifies the accounting for uncertainty in income taxes
recognized in an enterprises financial statements in accordance with SFAS No. 109.
FIN No. 48 also prescribes a recognition threshold and measurement attribute for the
financial statement recognition and measurement of a tax position taken or expected to be
taken in a tax return. FIN No. 48 also provides guidance on derecognition, classification,
interest and penalties, accounting in interim periods, disclosure, and transition. The
provisions of FIN No. 48 are effective for fiscal years beginning after December 15, 2006.
We are currently assessing the possible impact implementing FIN No. 48 may have on its
financial position and results of operations.





Critical Accounting Policies and Estimates



Our discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have been prepared
in accordance with accounting principles generally accepted in the United States of
America. The preparation of these financial statements requires us to make estimates and
judgments that affect the reported amounts of assets, liabilities, revenues and expenses,
and related disclosures of contingent assets and liabilities. We base our estimates on
historical experience and on various other assumptions that are believed to be reasonable
under the circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from other
sources. Actual results may differ from these estimates.



On an ongoing basis, we evaluate the continued appropriateness of our
accounting policies and resulting estimates, including those related to:



- Goodwill valuation,
- Asset impairment charges,
- Restructuring charges and store closing costs,
- Inventory valuation and reserves,
- Self-insurance reserves, and
- Tax valuation allowances
- Stock-based compensation expense



We believe the following critical accounting policies affect our most
significant judgments and estimates used in the preparation of our consolidated financial
statements. Due to the implementation of SFAS 123R, we identified a new critical
accounting policy related to stock-based compensation, which is listed below. There have
been no changes in the application of the Companys other critical accounting
policies and estimates in 2006:



Goodwill. Goodwill consists of the excess cost of acquired
companies over the sum of the fair market value of their underlying assets acquired and
liabilities assumed. In accordance with SFAS No. 142, "Goodwill and Other Intangible
Assets", goodwill is reviewed for impairment annually at the end of the second
quarter at a reporting unit level, or more frequently, if certain indicators of impairment
exist. We have one reporting unit at the enterprise level to which goodwill is allocated.
We estimate fair value utilizing a combination of three different methods, consisting of
market capitalization, discounted future cash flows, and earnings before interest, taxes,
depreciation, amortization ("EBITDA") multiples, and compare it to the carrying
value of the enterprise for purposes of identifying potential impairment.



The annual review for impairment relies heavily on our ability to
accurately project future cash flows, which in itself, requires the extensive use of
accounting judgment and financial assumptions and estimates. These projections can be
affected by many items that are interdependent on one another and are outside of our
control and ability to predict except at the time of evaluation, such as changes in the
economy, trends affecting the natural and organic food industry, and changing competitive
pressures.



Two of the most significant assumptions underlying the determination of
the fair value of goodwill and other intangible assets are the EBITDA multiples and the
growth rate on our free cash flow projections. In connection with our annual goodwill
impairment measurement which was completed during the second quarter, we determined that a
33.0% reduction in our estimated EBITDA multiple would have decreased the valuation by
$104.0 million. A reduction of 2.0% in our estimated free cash flow projection percentage
would have resulted in a decrease of $147.4 million. Despite these calculated decreases,
our lowest valuation still exceeds book value, and therefore, no impairment would be
recognized.



Impairment of long-lived assets. We monitor the carrying value of
our long-lived assets, including finite-lived intangible assets, for potential impairment
whenever changes in circumstance indicate a potential for impairment may exist. The
triggering events for evaluations of finite lived intangible assets include a significant
decrease in the market value of an asset, acquisition and construction costs in excess of
budget, new stores that do not achieve expected results, or current store operating losses
combined with a history of losses or a projection of continuing losses. If impairment is
identified, based on undiscounted future cash flows, management compares the assets
future cash flows, discounted to present value using a risk-adjusted discount rate, to its
current carrying value and records a provision for impairment as appropriate. With respect
to equipment and leasehold improvements associated with closed stores, the value of these
assets is adjusted to reflect recoverable values estimated based on our previous efforts
to dispose of similar assets, with consideration for current economic conditions.



Our review for impairment relies heavily on our ability to accurately
project future cash flows related to our stores and support facilities. Our cash flow
projections look several years into the future and include assumptions about sales growth
and cost trends that could be significantly impacted by changes in the local and national
economy, trends in the natural and organic food industry, local competitive pressures, as
well as the effectiveness of various operational initiatives underway in our stores.



A 2.0% increase in our sales growth percentage assumption utilized in
the cash flow projection would have resulted in no stores identified for impairment and no
related asset impairment charges. A 2.0% decrease in our sales growth percentage
assumption would have resulted in the impairment of three stores held for use and
approximately $5.6 million of additional asset impairment charges.



Restructuring and store closure costs. We reserve for the present
value of lease related costs associated with store and support facility closures,
relocations, and sales when the store or facility is closed. The calculation of the lease
related liabilities involves applying a discount rate to the estimation of our remaining
lease obligations, taxes and common area maintenance, net of future estimated subtenant
income. The lease liabilities usually are paid over the lease terms associated with the
closed stores, which have had remaining terms ranging from one month to 25 years. Store
closing liabilities are reviewed each reporting period to ensure that the amounts recorded
reasonably reflect our future obligations associated with closed stores and facilities
based on the most current information available. Adjustments to existing lease related
liabilities are primarily a result of changes in the expected timing or amount of
subtenant income, and are made in the period in which the change in facts and
circumstances, as well as their related impacts, become known and estimable. Lease related
closure costs and associated severance costs are made in accordance with SFAS No. 146
"Accounting for Costs Associated with Exit of Disposal Activities." Severance
costs incurred in connection with store closings are recorded when the employees have been
identified and notified of the termination benefits to be made to the employees.



In evaluating the reserves for lease related liabilities, management
considers a number of variables that would affect the marketability of the space such as
recent demand for similar space in the market area, the number of potential subtenants
expressing interest, specific characteristics of the property, any limitations in the use
of the space imposed by the landlord, as well as the creditworthiness of actual
subtenants. The above factors are continuously reevaluated and have a significant impact
on managements assumptions used in estimating the timing and amount of any subtenant
income, and thus the amount of required reserves.



In calculating the lease related liabilities, we apply a discount rate
to our estimated remaining lease obligations. For stores closed in the second quarter,
2006, we did not apply a discount rate to our estimated remaining lease obligations
because our lease expired shortly after we closed the store. Therefore, in the second
quarter, we would have no changes to restructuring expense if we calculated our obligation
using a different discount rate.



Inventory. Our inventory is stated at the lower of cost or market
on a first-in, first-out basis using the retail method of accounting to determine cost of
sales and inventory for approximately 80% of inventories and using the item cost method
for highly perishable products representing approximately 20% of inventories in our
stores. Under the retail inventory method, the valuation of inventories at cost and the
resulting gross margins are determined by applying a cost-to-retail ratio for various
categories of similar items to the retail value of inventories. Inherent in the retail
inventory method calculations are certain management judgments and estimates, including
shrinkage, which could significantly impact the ending inventory valuation at cost as well
as the resulting gross margins. Physical inventory counts are taken at each location to
ensure that the amounts reflected in the consolidated financial statements are properly
stated as of the end of each reporting period.



We maintain allowances for excess or unsaleable inventory as a
percentage of its gross inventory balance based on historical experience and assumptions
about market conditions. If actual market conditions are less favorable than those
projected by management, or if we expand our forward buying of inventory, which will
increase our inventory levels, then additional inventory write-downs may be required.



Relative to the above, a hypothetical increase of 1.0% to our
cost-to-retail ratio would result in an increase of approximately $879,000 to our
inventory valuation. Conversely, a hypothetical decrease of 1.0% would result in a
decrease of approximately $879,000 to our inventory balance as of the end of second
quarter, 2006. With regards to our allowance for inventory, an increase or decrease of
1.0% would cause our allowance to fluctuate by about $702,000.



Self-insurance. We use a combination of stop-loss insurance and are
self-insured for losses relating to workers compensation claims, general liability
and employee medical and dental benefits. We have purchased stop-loss coverage in order to
limit exposure to any significant claim or levels of claims that would be catastrophic to
our Company. Self-insured losses are accrued based upon estimates of the aggregate
uninsured claims incurred using certain actuarial assumptions followed in the insurance
industry which are based on our industrys experience as well as our historical
claims experience. While we believe that the assumptions and methodology used are
appropriate, the estimated accruals for these liabilities could be significantly affected
if actual loss development and payment patterns vary significantly from the assumptions
and historical trends utilized.



Tax valuation allowances. We utilize the concepts and guidance of
SFAS No. 109, "Accounting for Income Taxes" in assessing the ability to realize
our deferred tax assets. The Company establishes valuation allowances based on historical
taxable income, projected future income, the expected timing of the reversals of existing
temporary differences and the implementation of tax planning strategies. Based on our
analysis in 2004, we established a full valuation allowance against our net deferred tax
assets as it was not more likely than not that the assets would be realized under SFAS No.
109 Accounting for Income Taxes.

When we are able to show a profitable trend and have generated cumulative income for a
reasonable period, we will re-evaluate the need for a valuation allowance using all
factors available to us at that time.



Stock-based compensation expense. Effective January 1, 2006, we
adopted the provisions of SFAS No. 123R and related interpretations, using the
Black-Scholes valuation model and the modified prospective application. Under the fair
value recognition provisions of this statement, stock-based compensation cost is measured
at the grant date based on the value of the award and is recognized as expense on a
straight-line basis over the awards vesting period. Determining the fair value of
stock-based awards at grant date requires judgment, including estimating the amount of
stock-based awards expected to be forfeited. If actual results differ significantly from
these estimates, our results of operations could be materially impacted. These estimates
are outlined in Note 3  Stock-Based Compensation.





Cautionary Statement Regarding Forward-Looking Statements



This Report on Form 10-K contains "forward-looking
statements," within the meaning of the Private Securities Litigation Reform Act of
1995, which involve known and unknown risks. Such forward-looking statements include
statements as to the number of stores we plan to open or relocate in future periods and
the anticipated performance of such stores; the impact of competition; the sufficiency of
funds to satisfy our cash requirements through the remainder of fiscal 2006; the impact of
changes resulting from our merchandising and marketing programs; our ability to benefit
from past supply chain modifications; expected pre-opening expenses and capital
expenditures; and other statements containing words such as "believes,"
"anticipates," "estimates," "expects," "may,"
"intends" and words of similar import or statements of management's opinion.
These forward-looking statements and assumptions involve known and unknown risks,
uncertainties and other factors that may cause our actual results, market performance or
achievements to differ materially from any future results, performance or achievements
expressed or implied by such forward-looking statements. Important factors that could
cause differences in results of operations include, but are not limited to, the timing and
execution of new store openings, relocations, remodels and closures; new competitive
impacts; changes in product supply or suppliers and supplier performance levels; changes
in management information needs; changes in customer needs and expectations; changes in
government regulations applicable to our business; changes in economic or business
conditions in general or affecting the natural foods industry in particular; cost and
stability of fuel and power sources; and competition for and the availability of sites for
new stores. We undertake no obligation to update any forward-looking statements in order
to reflect events or circumstances that may arise after the date of this Report.





Non GAAP Financial Information



The following is a reconciliation of EBITDA and EBITDA, as adjusted, to
net income (in thousands):



| |                                                     |  | THREE MONTHS
    ENDED
| | --------------------------------------------------- |  | ----------------------
| |                                                     |  |                       
| |                                                     |  | July 1, 2006          
| |                                                     |  |                       
| |                                                     |  |                       
| | Net income                                          |  | $ 4,870               
| | Interest expense, net of
    interest income        |  | 1,137                 
| | Income tax expense                                  |  | 247                   
| | Depreciation and
    amortization                   |  | 6,370                 
| |                                                     |  |                       
| | EBITDA                                              |  | 12,624                
| | Loss on asset disposals,
    net                    |  | 77                    
| | Stock-based compensation
    expense                |  | 511                   
| | Restructuring and asset
    impairment charges, net |  | 295                   
| |                                                     |  |                       
| | EBITDA, as adjusted                                 |  | $ 13,507              
| |                                                     |  |                       
| |                                                     |  |                       
| | EBITDA, as a percentage of
    sales                |  | 4.3%                  
| | EBITDA, as adjusted, as a
    percentage of sales   |  | 4.6%                  



|                                                    |  | SIX MONTHS
    ENDED
|--------------------------------------------------- |  | --------------------
|                                                    |  |                     
|                                                    |  | July 1, 2006        
|                                                    |  |                     
|Net income (loss)                                   |  | $ 7,755             
|Interest expense, net of
    interest income        |  | 2,402               
|Income tax expense                                  |  | 452                 
|Depreciation and
    amortization                   |  | 13,057              
|                                                    |  |                     
|EBITDA                                              |  | 23,666              
|Loss on early
    extinguishment of debt            |  | -                   
|Loss on asset disposals,
    net                    |  | 167                 
|Stock-based compensation
    expense                |  | 1,289               
|Restructuring and asset
    impairment charges, net |  | 1,965               
|                                                    |  |                     
|EBITDA, as adjusted                                 |  | $ 27,087            
|                                                    |  |                     
|                                                    |  |                     
|EBITDA, as a percentage of
    sales                |  | 4.0%                
|EBITDA, as adjusted, as a
    percentage of sales   |  | 4.6%                



EBITDA and EBITDA, as adjusted, are measures used by management to
measure operating performance.  EBITDA is defined as net income plus interest, taxes,
depreciation, and amortization.  EBITDA, as adjusted, excludes certain non-cash
charges and other items that management does not utilize in assessing operating
performance or for purposes of corporate and regional level bonuses.  The items
included in the reconciliation from EBITDA to EBITDA, as adjusted, are either (a) non-cash
items (e.g. asset impairments and stock-based compensation expense) or (b) items that
management does not consider to be relevant to assessing operating performance (e.g.
restructuring, gain/loss on sale of assets, net).  Due to the implementation of SFAS
123R during the first quarter of 2006 using the modified prospective application, the
financial statements for periods prior to January 1, 2006, will not include compensation
cost calculated under the fair value method. Regarding the non-cash items, management
believes that investors can better assess operating performance if the measures are
presented without such items.  In the case of the items that management does not
consider relevant to assessing operating performance, management believes that investors
can better assess ongoing operating performance if the measures are presented without
these items because their financial impact has no continuing relevance to our ongoing
business.  The above table reconciles net income to EBITDA and EBITDA, as adjusted.
   Management believes that EBITDA and EBITDA, as adjusted, are useful to
investors because securities analysts, lenders and other interested parties frequently
utilize them to evaluate our peer companies and us. Neither EBITDA nor EBITDA, as
adjusted, are recognized terms under GAAP and do not purport to be an alternative to net
income as an indicator of operating performance or any other GAAP measure.  Not all
companies utilize identical calculations, therefore, the presentation of EBITDA and
EBITDA, as adjusted, may not be comparable to other identically titled measures of other
companies.  In addition, EBITDA and EBITDA, as adjusted, are not intended to be
measures of free cash flow for managements discretionary use since they do not
consider certain cash requirements, such as interest payments, tax payments and capital
expenditures.



Comparable stores sales. We deem sales of a new or acquired stores
comparable commencing in the thirteenth full month of operations.





Item
3.  Quantitative and Qualitative Disclosures about Market Risk

In the normal course of business, the Company is exposed to
fluctuations in fossil fuel commodity prices, interest rates and the value of foreign
currency. Fossil fuels commodity prices directly impact the costs the Company pays for
utilities and distribution, and are subject to fluctuation due to availability and other
natural causes. The Company attempts to balance retail price increases against lost
profits without losing customer loyalty. The Company will employ various financial
instruments to manage certain exposures to foreign currency and interest rate risk when
considered practical.



The Company is exposed to foreign currency exchange risk. As of the
date of this report, the Company owns and operates four natural foods supermarkets and a
commissary kitchen in British Columbia, Canada. The commissary supports the four Canadian
stores and does not independently generate sales revenue. Sales made from the Canadian
stores are made in exchange for Canadian dollars. To the extent that those revenues are
repatriated to the United States, the amounts repatriated are subject to the exchange rate
fluctuations between the two currencies. The Company does not hedge against this risk
because of the small amounts of funds at risk.



Should we begin drawing on the B of A Facility for additional capital,
our exposure to interest rate changes would be primarily related to our variable rate debt
issued under the B of A Facility. The total commitment available is $40.0 million under a
revolving line of credit, with a five-year term expiring March 31, 2010. The interest rate
on the credit facility is prime or LIBOR plus 1.25%, at our election, and the rates modify
depending on the excess borrowings availability over amounts borrowed. Because the
interest rate on the facility is variable, based upon the prime rate or LIBOR, the
Company's interest expense and net income would be affected by interest rate fluctuations.



> 

Item 4. Controls and
Procedures



Disclosure Controls and Procedures. The Company's management, with
the participation of the Company's Chief Executive Officer and Chief Financial Officer,
has evaluated the effectiveness of the Company's disclosure controls and procedures (as
such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of
1934, as amended (the "Exchange Act")) as of July 1, 2006. Based on such
evaluation, the Company's Chief Executive Officer and Chief Financial Officer have
concluded that, as of July 1, 2006, the Company's disclosure controls and procedures are
effective in recording, processing, summarizing and reporting, on a timely basis,
information required to be disclosed by the Company in the reports that it files or
submits under the Exchange Act and are effective in ensuring that information required to
be disclosed by the Company in the reports that it files or submits under the Exchange Act
is accumulated and communicated to the Company's management, including the Company's Chief
Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions
regarding required disclosure.



Internal Control Over Financial Reporting. There have not been any
changes in the Company's internal control over financial reporting (as such term is
defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter
ended July 1, 2006 that have materially affected, or are reasonably likely to materially
affect, the Companys internal control over financial reporting.





Part II.  OTHER INFORMATION



Item 1.  Legal Proceedings



Tim Auchterlonie, individually and on behalf of all others similarly
situated and the general public, and Roes 1 to 1000 vs. Wild Oats Markets, Inc. and Does 1
through 100, is a suit brought in August 2004 in the Superior Court, County of Los
Angeles, for payment of overtime and damages relating to alleged violations of the
California Business and Professions Code by a former store director claiming that he
should have been classified as an employee paid on an hourly basis, together with other
related claims. In mid-2005, five additional named plaintiffs were added to the suit, and
the trials of the original plaintiff and the new plaintiffs were bifurcated. We believe
that all of the named plaintiffs were correctly classified as exempt employees based upon
their job duties. We have settled with the original plaintiff, and the trial date has been
vacated. A trial for the remaining plaintiffs has been set for third quarter 2006.



Ana Marie Hoeppner et al. v. Wild Oats Markets, Inc., Superior
Court, County of Los Angeles, is a case filed by seven California plaintiffs involving
parties and claims found in the Auchterlonie lawsuit disclosed above. We believe
that we will prevail on the issue of improper classification as managerial employees. The
lawsuit is in the initial discovery phase.



In June 2002 an administrative law judge ("ALJ") found
against us in Wild Oats Markets, Inc. and Local 371, United Food & Commercial
Workers, in certain unfair labor practice charges brought in connection with the
opening of our store in Westport, Connecticut. In May 2005, the NLRB issued a Decision and
Order, setting forth certain equitable, injunctive and monetary remedies to be undertaken
by us, including payment of backpay less interim earnings, and offers of employment to
certain former employees of a store that we sold in 2000 (the "Sold Store"). We
agreed to reinstate one former employee and paid an immaterial amount to settle all claims
related to the Sold Store.



We also are named as defendant in various actions and proceedings
arising in the normal course of business. In all of these cases, we are denying the
allegations and are vigorously defending against them and, in some cases, have filed
counterclaims. Although the eventual outcome of the various lawsuits cannot be predicted,
it is managements opinion that these lawsuits will not result in liabilities that
would materially affect our consolidated results of operations, financial position, or
cash flows.





Item 1A.  Risk Factors



There have not been any material changes from the risk factors previously disclosed in
our Form 10-K for the fiscal year ended December 31, 2005.





Item
2.  Unregistered Sales of Equity Securities and Use of Proceeds



None.





Item
3.  Defaults Upon Senior Securities



None.



Item
4.  Submission of Matters to a Vote of Security Holders



At the Companys Annual Meeting of Stockholders held on May 2,
2006, the Companys stockholders elected Perry D. Odak to the Companys Board of
Directors for a three-year term. The results of the election of director appear below:



Director
    For
    WithheldPerry D. Odak
    26,804,034
    221,753




The Companys stockholders ratified the selection of Ernst &
Young, LLP as independent auditors for the Company for its fiscal year ending December 30,
2006. The shareholders voted for the ratification by the following number of votes:



For
    Against
    Abstain
    Broker Non-Votes26,964,970
    28,742
    32,075
    0




The Companys stockholders voted to approve the Companys
2006 Equity Incentive Plan. The following reflects the votes cast on the proposal:



For
    Against
    Abstain
    Broker Non-Votes9,952,705
    1,756,726
    1,187,442
    14,128,914






Item 5.  Other Information



None.





Item 6.  Exhibits

|                            | Exhibit Number | Description                                                          
|--------------------------- | -------------- | ---------------------------------------------------------------------
|                            |                |                                                                      
|                            | 31.1+          | CEO
    Certification under Section 302 of Sarbanes-Oxley Act of 2002
|                            | 31.2+          | CFO
    Certification under Section 302 of Sarbanes-Oxley Act of 2002
|                            | 32.1+          | CEO
    Certification under Section 906 of Sarbanes-Oxley Act of 2002
|                            | 32.2+          | CFO
    Certification under Section 906 of Sarbanes-Oxley Act of 2002
|                            |                |                                                                      
|+    Included
    herewith.



---

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, in the City of Boulder, County of Boulder, State of Colorado,
on the 10th day of August 2006.



| | Wild Oats Markets, Inc.                      
| | ---------------------------------------------
| | (Registrant)                                 
| |                                              
| |                                              
| | By: /s/ Robert B. Dimond                     
| |                                              
| | Robert B. Dimond                             
| | Executive Officer and Chief Financial Officer
| | (Principal Financial and Accounting Officer) 
| |